Peru - Public expenditure review

Report No. 13190-PE Peru Public Expenditure Review October 31, 1994 Country Department III Country Operations Division I Latin America and the Caribbean Region Document of the World Bank   Peru: Public Expenditure Review Table of Contents Executive Summary and Recommendations ............................ i CHAPTER I: THE CHANGING ROLE OF THE PERUVIAN STATE .... ..... 1 A. The State in the New Constitution ........................... 1 B. The Privatization Plan ................................... 4 C. Rationalization of Public Administration ....................... 4 The Retrenchment Program ............................. 4 The Need to Build an Efficient Civil Service ................... 5 CHAPTER II: AN OVERVIEW OF PUBLIC EXPENDITURES .... ......... 8 A. Introduction ......................................... 8 B. Current Expenditures ................................... 8 Wages and Salaries .................................. 9 The Civil Servant Pension ("Cedula Viva") .................... 11 Current Transfers (pensions excluded) ....................... 12 C. Debt Service Issues: Unfunded and Unserviced Liabilities ............. 12 Fiscal Implications of a Brady-Deal ........................ 12 Fiscal Implications of the Pension Reform .................... 13 Combined Public Sector Liabilities ......................... 13 D. Capital Expenditures ................................... 15 Infrastructure ...................................... 15 Large Hydroelectric Projects ............................ 20 CHAPTER III: BUDGETING AND EARMARKING .................... 23 A. Earmarking and Extrabudgetary Funds ........................ 23 Description ....................................... 23 FONAVI ......................................... 24 B. Public Investment Planning ............................... 26 Introduction . ....................................... 26 Rationalizing the Investment Decision Process .................. 27 C. Budgeting Process and Control ............................. 28 Background on the Budget Process ......................... 28 Preparation and Control of the Budget ....................... 29 Agenda for Reform .................................. 31  CHAPTER IV.: CENTRAL-LOCAL GOVERNMENT RELATIONSHIP: THE CASE FOR DECENTRALIZATION ................ 32 A. Introduction ............................................ 32 B. Central-Local Fiscal and Political Relationship in Peru ................. 32 Historical Background ................................ 32 The Political Structure Resulting from the 1993 Constitution ... ...... 33 Distribution of Functions across levels of Govemment .... ......... 37 Sector-Specific Issues in Decentralization ..................... 37 C. Concluding Remarks: a Decentralization Strategy for Peru .42 Bibliography .105 Appendices Appendix 1.1: An Assessment of the Retrenchment Program .45 Appendix 2.1: Public Sector Salary Structure and Level .................... 52 Appendix 2.2: An Analysis of the Civil Servant Pension System .60 Appendix 2.3: The Fiscal Cost of Social Security Reform in Peru .64 Appendix 2.4: Analysis of the Road Investment Program .77 Appendix 2.5: Review of the Electric Train .90 Appendix 3.1: Proyecto de Ley. Creaci6n del Sistema Privado de Ahorro y Prestamo para Vivienda .99 Boxes Box 1: The Changing Role of the Peruvian State in Education. 3 Box 2: The Successful Reorganization of Sunat. 7 Tables Table 1.1: The Changing Role of the State in the Constitution. 2 Table 2.1: A Cross-Country Comparison of Per-Capita Expenditures ............ 9 Table 2.2: Realized and Budgeted Public Sector Expenditures in Peru .. ... 10 Table 2.3: Present Value of Government Liabilities towards Pensioners and Private Banks ..... 14 Table 2.4: Composition of Capital Expenditures ..... 15 Table 2.5: Description and Recommendations on Large Hydroelectric Projects ......... 22 Table 3.1: Earmarked Funds and Central Government Revenues. . .... 25 Table 3.2: A National Public Investment System for Peru ..... 30 Table 4.1: Levels of Government, Authorities, and Sources of Revenue Established by the 1993 Constitution ..... 33 Table 4.2: Probable Distribution of Functions Among the four Levels of Government . 38 Table 4.3: Total Government Spending by Sectors for 1993. . .... 39 Table 4.4: Spending on Schooling in Peru Under a Voucher Scenario.. .... 41  The findings of this report are based on two missions that visited Peru in November 15-24, 1993 and February 1-11, 1994. The identification mission was comprised of Cheikh Kane (LAlCO), Roland Dacosta (LAlCO), Luiz Ramirez (LA3C1), Patrick Saint-Pol Maydien (1DB), and Rafael de la Cruz (Consultant). The second and main mission was comprised of Cheikh Kane (LAlCO), Gary Reid (LATPS), Francesca Ardito (LAlCO), Rafael Rofman (consultant). This report was written by Cheikh Kane (Task Manager) and received additional contributions from non-mission members. Carlos Elias and Maria Georgalos (LAlCO) contributed to the analysis on decentralization and public investment issues, respectively. The analysis of infrastructure investment is based on a background paper prepared by Frannie Humplick, Bill Dillinger, Gerhard Menckhoff, Gerard Liautaud, Thomas Olivier Nasser, Abel Mejia, Yoko Katakura, Surhid Gautam, and Eid Nouhra (LAlIN). An input on privatization and regulatory reforms was provided by Tercan Baysan (LAIEI). Jamil Salmi, Ernesto Cuadra, and Polly Jones, and Juliana Weissman (LAlHR) contributed to the review on social sectors. Editorial support was provided by Angelica Silvero (LAlCO). The following participants to various review meetings provided useful suggestions: Rainer Steckhan, Homi Kharas, Orville Grimes (LA1DR), Paul Meo, Edgardo Favaro (LAlCO), Larry Simpson (LAlEA), Demetris Papageorgiou, Valeriano Garcia, Norman Hicks (LACCE), and Luis Duran-Downing (IMF). The Green Cover report was discussed with the Peruvian Government on August 9, 1994.  I  CURRENCY EQUIVALENTS (as of October 31, 1994) Currency Unit - Nuevo Sol (S.) US$1.00 - S/.2.24 S/. 1.00 - US$0.45 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS AND ACRONYMS AEROPERU Peruvian Airlines (Aerolineas del Peru) AFP Retirement Fund Administration (Administraci6n de Fondos de Pensiones) BCR Central Reserve Bank (Banco Central de Reservas) CENTROMIN Central Peru Mining Company (Empresa Minera del Centro del Peru) COFIDE Financial Development Corporation (Corporaci6n Financiera de Desarrollo) COPRI Privatization Commission (Comisi6n de Privatizaci6n) COPRIN Public Investment Project Commission (Comisi6n de Proyectos de Inversi6n iliblica) CONADE National Development Corporation (Corporaci6n Nacional de Desarrollo) COOPPOP Coopertive Action Program (Cooperaci6n Popular) CORDE Regional Development Corporation (Corporaci6n Regional de Desarrollo) CORPAC Airport Authority (Corporaci6n Nacional de Aeropuertos y Aviaci6n) DGPP Office of the Budget (Direcci6n General del Presupuesto Publico) DGTA Air Transport General Directorate (Direcci6n General de Transporte Aereo) ELECTROLIMA Lima Electricity Company (Empresa de Electricidad de Lima) ELECTROPERU Peru Electricity Company (Empresa de Electricidad del Perl) ENDEPALMA Palm Oil Company (Empresa para Desarrollo y Explotaci6n) ESAP Institute of Public Administration (Escuela Superior de Administraci6n Publica) FONAVI National Housing Fund (Fondo Nacional de Vivienda) FONCODES National Compensation and Development Fund (Fondo Nacional de Compensaci6n y Desarrollo) FOPRIVI Private Housing Fund (Fondo Privado de Vivienda) FRASA Fund for Agricultural Reactivation and Food Security (Fondo de Reactivaci6n Agropecuaria y de Seguridad Alimentaria)  GDP Gross Domestic Product (Producto Intemo Bruto) HIERROPERU Peruvian Iron Mining Company (Empresa Minera del Hierro del Peru) IDB Interamerican Development Bank (Banco Interamericano de Desarrollo) INADE National Development Institute (Instituto Nacional de Desarrollo) INDECOPI National Institute for the Defense of Competition and the Protection of Intellectual Property (Instituto Nacional de Defensa de la Competencia y de la Protecci6n de la Propiedad Intelectual) INP National Planning Institute (Instituto Nacional de Planificaci6n) IPSS Peruvian Social Security Institute (Instituto Peruano de Seguridad Social) MEF Ministry of Economy and Finance (Ministerio de Economfa y Finanzas) MINEROPERU Peru Mining Company (Empresa Minera del Peru) MORAVECO State Consumer Durables Company MTC Ministry of Transport and Communications (Ministerio de Transporte y Comunicaciones) PETROMAR State Petroleum Company (Petr6leos del Mar) PETROPERU State Petroleum Company (Petr6leos del Peru) PESCAPERU State Fishmeal Company (Empresa Nacional Pesquera del Peru) SAFP Superintendent of Retirement Fund and Administration (Superintendencia de Administradoras Privadas de Fondos y Pensiones) SECI International Technical Executive Secretariat (Secretarfa Ejecutiva de Direcci6n Tecnica Intemacional) SEDAPAL Lima Water and Sewage Company (Servicio de Agua Potable y Alcantarillado de Lima) SENAPA National Water and Sewage Company (Servicio Nacional de Agua Potable y Alcantarillado) SIDERPERU State Steel Company (Empresa Siderurgica del Peru)  Executive Summary and Recommendations 1. The new Peruvian administration that took office in 1990 inherited an economy suffering from hyperinflation and managed to improve macroeconomic stability while undertaking broad structural reforms. This administration has also redefined the role of the state, including the adoption of a divestiture plan that is intended to shift the ownership of all state-owned enterprises to the private sector by mid-1995. This change has been codified in the new Constitution adopted in 1993, which narrows the state's mandate away from productive activities and establishes that spending priorities must be reflected in a national budget that includes regional govemments as well as decentralized institutions. 2. The challenge for Peru to deliver public services is enormous. Achieving fiscal adjustment in a context of low tax collection has entailed reducing public spending. Central govemment spending, relative to GDP, fell by about 10 percentage points between 1983 and 1993. Today, in both health and education Peru has far lower per-capita expenditures than the region's averages while its social indicators are also poorer. Infrastructure is also in decay; road rehabilitation and secondary and feeder road maintenance, airports, and water and sanitation deserve special attention. Increasing public expenditures, however, is constrained by Peru's resource mobilization capacity. Peru has a tax collection of 10-12 percent of GDP, which is 5-7 percentage points lower than that of countries at similar stages of development. But increasing expenditures would not alone guarantee a better provision of public services. For Peru, at least four other factors are critical: (i) improving the efficiency of expenditure allocation; (ii) establishing a well defined central-local fiscal relationship; (iii) improving human resource management in the public sector; (iv) strengthening public sector financial management processes. This report focuses on these four themes and complements the 1993 World Bank Country Economic Memorandum on Peru that examined, inter- alia, ways to improve resource mobilization in Peru. I. Expenditure Allocation 3. This report highlights two areas where a reassessment of expenditures is urgently required: priorities for capital expenditures and associated maintenance needs; and provisioning for public debt and pension liabilities. 4. Capital Expenditure: With respect to public investment, there is scope for reducing expenditures devoted to large hydroelectric projects (accounting for 22 percent of total capital expenditures in the 1994 budget), particularly for projects that are still at a very early stage with high incremental costs compared to expected benefits (e.g., Olmos). A joint World Bank-IDB mission agreed on an action plan which emphasizes cost recovery, delineation of water rights, private operation of water schemes, and privatization of certain irrigation and water rights. Contrary to this plan, however, the Government has budgeted for 1994 important outlays (US$307 million) that exceed the recommended ceiling (US$200 million). Probably more worrying is the fact that Peru has wasted considerable resources to these large hydroelectric projects over the last two decades, despite periodic reviews questioning their economic justification. The notorious project of Majes, for which cancellation was recommended a decade ago (see World Bank 1985) has absorbed over US$1.5 billion (at 1992 prices) between 1974 and 1992.  ii 5. Capital expenditures in water and sanitation should be reoriented to emphasize rehabilitation and maintenance as opposed to new construction. The severity of maintenance neglect in the last decade has led to serious water losses due to leakage and is largely responsible for the cholera epidemic through the infiltration of contaminants into a deteriorated piped system. Reduction of water losses, which are estimated at 50 percent for the Lima water company (SEDAPAL), can eliminate substantially the water shortage at the national level. This report, therefore, recommends that about 40 percent of the public investment in water and sanitation be devoted to rehabilitation. 6. In roads the Government is planning to allocate about 70 percent of expenditures to rehabilitation. Although the emphasis on rehabilitation is warranted, the Government should also consider rescheduling major investments on roads subject to very low traffic volume, and concentrating on minimum repairs and rehabilitation for these roads. This report recommends changes along these lines that could lead to a 16 percent reduction in the road budget. The Government's commitment to maintenance is also a matter of concern. The 1994 budget allocation for maintenance (US$20 million) is far below what the Bank recommends for the maintenance of the national highway network alone (US$50 million). Another critical issue is related to the maintenance of secondary and feeder roads, which account for 78 percent of the road network. This maintenance falls under the responsibility of subnational governments who lack the needed resources for this task. This must be resolved to avoid the cycle of investment-deterioration-and-rehabilitation that has been typical of the road sector in Peru. The lack of timely and adequate funding for maintenance has been a recurrent theme of all reviews of the Peruvian road sector (see World Bank 1990). In short, the importance of road rehabilitation should not hide the fact that it must be done in a selective and efficient way, and under-funding for maintenance as was done in the past two decades should be corrected at last. 7. The current administration inherited an electric train project that was initiated in 1986. The Government has decided to finish the first section of the project and set-up a combined train bus operation through a franchise agreement with the private sector. However, the passenger-flow forecasts are unreasonably optimistic, and recurrent subsidies of roughly US$10 million a year might be required to operate passenger services. It should be noted that a 1990 World Bank report had already suggested that the Government refrains from any further investment in this project. Unfortunately, further resources were devoted to this project, which up to now has absorbed US$229 million. It is recommended that no further funds be committed to the system, but instead that a study be undertaken to examine the passenger demand and finances for the proposed train-bus operation, and the broader issues of public transport in southern Lima. 8. Unfunded and Unserviced Liabilities: Another issue that deserves immediate attention is that of government's liabilities towards commercial banks. Peru has resumed its debt service payments to international institutions and Paris-club bilaterals, but has made no payments to commercial banks since 1984. It is important for Peru to enter an agreement with commercial banks as early as possible and stop accumulating arrears, which have typically proven to be an expensive source of finance. Along with external debt, the Government has also significant unfunded long-term liabilities towards Peruvian pensioners. The Government is committed to issuing "recognition bonds" to pensioners moving to a private pension fund for their past contributions into the public social insurance system. Although a large number of workers have  iii already joined the private pension system, the Government has neither issued these bonds nor designed a financing plan for them. In addition to these recognition bonds, the Government should also take into account its commitments towards civil servant pensioners that are financed out of general revenues. The present value of "recognition bonds' and civil servant pension liabilities combined are estimated at US$2.5-4.7 billion, while the face value of commercial bank debt is over US$7 billion. The importance of quantifying these liabilities lies in the fact that they affect the medium-term fiscal accounts and the sustainability of other planned investments. For this reason, the Government should design a financing plan for these liabilities by taking into account all resources available, including the proceeds from privatization. Indeed, sound fiscal management dictates that proceeds of privatization should be used to reduce Government liabilities rather than finance recurrent expenditures. II. Central-Local Fiscal Relationship 9. Despite many decentralization attempts in the past 20 years, Peru remains very centralized compared to countries such as Chile, and Colombia. As an integral part of the broad structural reforms implemented, Peru is considering decentralization as a way of improving the efficiency of public services. In fact, in the case of water services, decentralization is already effective, as municipalities are managing local water companies. This report argues that a prerequisite for decentralization in Peru is moving away from the current duplication of responsibilities between line ministries and the Ministry of Presidency. The broad sectoral mandate of the Ministry of Presidency, which absorbs one-fifth of tax revenues, in the long run undermines both line ministries and sub-national governments. 10. The new Constitution, by calling regional presidents to be elected, rather than appointed by the President as before, gives considerable autonomy to regions. In sharp contrast to this political autonomy, regions entirely depend on central government transfers for their resources. In principle, Peru has the option of matching the existing political autonomy by granting fiscal autonomy or instead counterbalancing this political autonomy by maintaining the current fiscal dependence. There are indicaticns that Congress favors the counterbalancing strategy. Under this structure the Government should ensure that transfers provide an incentive for sound fiscal management by regions. Today, regions may overestimate their employment needs, hence increase transfers received from central government. This helps explain the fact that today regions account for as much as 44 percent of public workers. Solving this problem requires identifying and cancelling all "ghost" public workers in regions and evaluating true public employment needs in regions. The reviewing of regional employment could well be undertaken by the Controller General, which has recently opened regional offices. 11. Unlike regions, municipalities have their own tax instruments (e.g., the property tax) and also receive a fixed proportion of the value added tax receipts. It is recommended to truly grant taxing authority to municipalities by allowing them to determine the assessed value and tax rate for the property tax. The Constitution sets a two-tier municipality system, which gives little room for change. The Govemment should, however, ensure that the relationship between these two entities is not conducive to fiscal and political instability. This probably entails limiting the ability of provincial municipalities to create the so called municipalidades delegadas, hence avoiding building  iv a political hierarchy among municipalities. In principle, the municipal compensation fund serves an equalization objective. As such, the distribution of mechanism should depend on fiscal capacity. The actual distribution mechanism, however, leaves open the possibility for political considerations to prevail over compensation objectives. 12. According to the original decrees, primary and secondary education were to be transferred to newly created commissions (COMUNEDs) at the provincial municipality level. The Government has decided now to bypass municipalities and delegate the administration of selected schools to their principals. It is generally believed that the newly adopted scheme would be less effective than the original one, as it entails monitoring a very large number of schools as opposed to dealing with a few municipalities. m. Human Resource Management in the Public Sector 13. Public sector reform and implementation effectiveness are key ingredients in making macroeconomic stability result in sustainable growth. In this regard, this report emphasizes the need for Peru to create an efficient civil service. Past macroeconomic mismanagement and the 28 percent real reduction in public salaries (1989-93) have adversely affected Peru's ability to retain and attract qualified public workers. Retrenchment programs have not brought the financial savings that would facilitate a civil service reform because the substantial reduction in central government employment was offset by an increase in the number of pensioners and of regional public employees. The Government, though, has managed to improve or maintain the quality of a few agencies, such as the Central Bank, the tax collection agency (SUNAT), and the Controller General's Office, by allowing these agencies to operate under private sector laws and exercise considerable autonomy in hiring and salary decisions. Outside these few agencies, weak administrative capacity prevails and is hindering the efficiency of policy formulation and execution in many areas such as the ambitious decentralization plan; the privatization of education; project execution capacity; and unification of public investment decision making, which today remains very atomized. 14. The Civil Servant Pension System: There are a number of issues that must be addressed in the context of a civil service reform. One such issue is related to the civil service pension system. In this area, the Govemment's strategy should be guided by the following three objectives: (i) avoid extending the coverage; (ii) remove the link between pensions and wages arising from the indexing mechanism; (iii) move to a fully-funded system. In the past, the coverage of the civil servant pension system was broadened by extending the closing date for eligibility--which is based on year of entrance to the public sector--from 1962 to 1980. There are also indications that many pensioners are illegally receiving benefits. As a result, the Government faces a civil servant pension bill of US$362 million (1993), which is financed mostly out of general revenues. As a first step, the Government should undertake a comprehensive review of the pension beneficiaries, as was done for Petroperu. Equally, important is to remove the indexing of pensions to wages, which causes any extra US$1 spent on wages to translate into a 30 cents increase in pension payments. Failing to address this issue would compromise the needed reform in the public sector salary structure. Solving the structural problem of the civil servant pension system, however, requires shifting to a defined-contribution system, which is consistent with the privatization of the social insurance system. The Government should consider evaluating, first, the financial implications of such , ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - -----  V reform, and start implementation as soon as public employees that are affiliated with the national insurance system--as opposed to the civil servant pension system--are shifted to private pension funds. 15. Salaries: Another issue that is at the heart of public sector reform in Peru is the conjunction of low salaries and their lack of transparency. One of the reasons why the salary structure is so complex in Peru is the proliferation of salary supplements as a way of increasing earnings without increasing pension payments. But because some sectors and professions are excluded from the most lucrative salary supplements (e.g., cafae), many anomalies arise, such as a messenger earning more than a doctor. In addition to salary supplements, hidden salary payments are made under the heading "current transfers" in order to circumvent salary caps imposed by fiscal austerity measures. Of course, neither the magnitude nor the actual beneficiaries of these transfers is known. Despite these hidden payments, public salaries remain very low. For instance, a professional moving from the private to the public sector would take a pay cut of 50-80 percent. Financial considerations aside, public salaries should not be improved while ignoring the previously discussed issue of central-local fiscal relationship. In particular, regional employment needs to be reviewed and the incentive structure should be modified to make regional governments more accountable. It should be noted that the new Constitution has eliminated the unified system of salaries (i.e., homologado), hence paving the way for reforming the public salary structure. 16. Training and Performance evaluation: Although higher salaries may attract qualified civil servants, it must be accompanied with an emphasis on training. This was recognized by the original public sector labor law (enacted in 1950), which stipulated that it is the state's duty to train its workers on a weekly basis. In practice, training programs and associated budgetary allocations are virtually non existent. A notable exception is the Ministry of External Affairs, which carries a well- defined training program that is mandatory (e.g., cursos de perfeccionamiento). Furthermore, the national school of public administration (ESAP), which by law is responsible for ensuring adequate training of civil servants, does not play its role due to lack of funding, outdated courses, and failure to incorporate ongoing regulatory and legal reforms. This helps explain why so many public employees do not seem to be aware of the changes in procedures and regulatory framework undertaken by the new administration. Since 1992, the Government has introduced a bi-yearly performance evaluation system. This system, however, was designed mainly for downsizing purposes by circumventing the lack of flexibility of public sector law. To sum up, the Government needs to make training an integral component of human resource management policy by ensuring that training is not limited to a few agencies, modernizing its public administration school, adopting a more flexible labor law for the public sector, and setting-up a transparent performance evaluation system based on well defined indicators. IV. FSnancial Management Processes 17. Part of the institutional problem is the proliferation of agencies with overlapping responsibilities and independent financial management processes. To ensure that public spending reflects policy priorities, Peru should adopt a budget based on programs with limits on the scope of extrabudgetary and earmarked funds. The most important earmarked fund that escapes budgetary control is FONAVI, which is based on a payroll tax and generates about US$345 million (1993). It  vi is recommended that FONAVI be integrated into the budget, hence expanding the concept of caja iinica. There is also room for improving the budgetary process itself. Today, resources are allocated based on the previous year's allocation, without any performance indicator and with limited controls. Although the present system maintains overall fiscal discipline by tight cash controls, it does not permit any comprehensive assessment of sectoral and regional expenditures so neither efficiency nor equity can be measured. This contributes to a broad lack of confidence in the effectiveness of public spending programs. For these reasons, improved public financial management and accountability processes are a high priority. To this end, the Ley Marco, governing the current budget process should be modified, in particular the rules related to budget programming and the delineations of functions and responsibilities. These responsibilities should not be confined to the Budget Office but extended to all agencies involved in the budget process. The Controller General should also extend its activities to managerial control as mandated by the law. Today, these activities are limited to strict legal control. Improved financial management also entails rationalizing the public investment decision process. Currently, there are about three different units of decision, with little coordination among them. Short of setting-up a National Public Investment System, for which a draft law already exists, a technical unit coordinating all investment decisions should be set-up in the Ministry of Finance. Ultimately, Peru needs to implement a integrated financial management system, which goes beyond budgeting and control to include accounting, cash management, and debt management. A draft organic law for such system was designed in 1992, but has not been implemented.  CHAPTER I. THE CHANGING ROLE OF THE PERUVIAN STATE 1. Any review of public sector expenditures must be preceded by a critical examination of the state's role. Indeed, the best answer to improving the provision of services need not be found in an analysis of public spending levels and allocations. In many instances, re-engineering institutions that deliver these services, and setting the framework that allow for partial or total substitution of the state by the private sector or local communities provide better answers. In the case of Peru, the fundamental changes in the role of the state that are taking place since 1990 in and of themselves merit attention. These changes culminated with the adoption of a new Constitution in 1993. A. The State in the New Constitution 2. An indication of the new direction taken by Peru regarding the role of the state can be obtained by comparing the 1979 and 1993 Constitutions (see Table 1.1). Certain functions are attributed to the state under both Constitutions (e.g., education, health, security, infrastructure). On the other hand, some functions listed in the 1979 Constitution are excluded from the new Constitution (e.g., promotion of mining and cooperatives, housing). In general, the new Constitution limits the role of the state in productive activities1' while bringing under the state umbrella new functions and modes of operation; for instance, by allowing subsidies to private education and recognizing the need for consumer protection. In accordance with these new principles, the Government of Peru is contemplating a comprehensive reform of the education system (see Box 1). It is also important to note that the new Constitution sets a framework for improving public expenditure management by calling for a more comprehensive budget that consolidates both central and decentralized public sector entities. 3. In another important departure from the past, the new Constitution explicitly mentions decentalization as a permanent process to achieve economic development and allows regions to be freely created by referendum. It also introduces more political autonomy to municipalities. In general, the new Constitution raises expectations by promising considerably more political autonomy to regions. Finding a central-local fiscal relationship that is consistent with these expectations is a difficult task that lies ahead; today regions, depend on central government transfers for virtually all their resources. The broader issues of decentralization are discussed in Chapter IV. 1/ Article 113 of the 1979 Constitution stipulated that the state exercises productive activities to promote economic development. By contrast the now Constitution in its article 60 stipulates that the state would be involved in productive activities only by special law and in cases of high public interest.  - 2 - TabILU The Changing Role of the State in the Constitution Constitution of 1979 Constitution of 1993 I. FUNDAMENTAL RIGHTS l Art. 10: Each family has a right to a decent housing. No equivalent exists. Constitutional right to housing eUiminated Art. 18: Gives preferential treatment to health, housing, No equivalent exists. Eliminates special treatment for and recreation needs, and regulates the utilization of health, housing, and urban lands urban lands. Art. 25: Pimary education is obligatory and is freely Art. 17: Initial, primary and secondary education are provided by the state along with the contribution of free in state schools. To guarantee equal education nutrition to poorer schools, opportunity the Government will subsidize private education. Art. 40: Scientifi and technological research are No equivalent exists. Elminates special support to supported by the state. rseah II. ECONOMIC REGIME Art.ll1: The state formulates the economic policies and No equivalent exists. Eliminates the concept of central social development plans that regulate the activities of the planning. public sector. Art.112: Thestateguaranteeseconomiicpluralism. Art. 60: The staterecognize economicpluralism. Only when authorized by a specific law, and in case of high public interest can the state realize subsidiary busines. activity. Art. 116: The state promotes and protects the free No equivalent exists. Elminates the promotion of development and autonomy of business and cooperatives. cooperatives. No equivalent exists. Art. 65: The state defends the interest of consumers and guarantees the right to information on goods and ervices provided by the market; in particular for the health and security of the population. Art. 122: The state stimulates mining activity. No equivalent exists. Mining is no longer subject to special treatment. Art 138: Economic and financial administation of the Art 77: The Budget guides the activity of the state. Its Central Government is guided by the annual budget programming and execution respond to criteria of approved by Congres. Local and regional Governments efficiency, basic social needs, and decentralization. have their own budgets Consolidates the budget. 111. STATE STRUCTURE Art. 164: Congress is composed of two Chamber. Art. 90: Introduces a unicameral Congress with five- The Senate and the Chamber of Deputies. year terms. No equivalent exists Art. 188: Decentralization is a permanent process aimed at the integral development of the country. Art. 259: Regionrs are constituted based on size, Art. 190: Regions constitute one or more departments. integrated history, economy, administration, and culture. Provinces and the districts can merge and change. Regions are created by the President. Regions ar created by referendum.  -3- Box 1: The Changing Role of the Peruvian State in Education The new Constitution maintains that the state is responsible for ensuring that primary education be mandatory. Going beyond the 1979 Constitution, however, the new Constitution extends the guarantee of compulsory enrollment to secondary school and allows for subsidies to private schools. Up to now, the Peruvian education system has been predominantly centrally- managed and public. Enrollments in private schools represent only 12 and 16 percent of total enrollments at the primary and secondary levels, respectively. In accordance with the constitutional changes, the Government is currently considering an ambitious educational decentralization and privatization reform, modeled in part after Chile's educational voucher program. This reform is a response to a deteriorating educational system with major regional disparities. -The New Rhm.: Me key features of the reform under consideration are to: (i) grant decentralized schools substantial management autonomy in determining resource allocation and teacher employment and remuneration; (ii) link school budgets to average school attendance; (iii) increase central government spending per pupil by 25 percent in the decentralized schools; and (Wv) allow schools to charge tuition but levy at the same time a tax on tuition revenues in excess of 40 percent of the student capitation grant. The complexity of the task and the need to muster political support for it have prompted the Government to start implementing pilot programs, mainly in the form of management contracts with private organizations, including religious associations with confirmed experience in the education sector. Institutional Constraints The financial and administrative implications of the reforms initiated in 1994 and to be expanded in 1995 require that the Ministry of Education develop the capacity to carry out new regulatory and administrative functions. These functions have been weakened by the 1990 administrative deconcentration measures. Uncoordinated deconcentration combined with the departure'of many professionals have negatively affected the Ministry's ability to perform its planning, monitoring and evaluation functions. At the present time, the Ministry of Education in Lima has totally lost control over the collection and production of all statistics regarding educational expenditures and costs in the provinces outside Lima-Callao. One set of functions- which must be developed quickly is the implementation of the process- by which schools are transferred to private managers (e.g., model contracts between the Ministry' and private managers). -While the transfer of management responsibilities occurs only once, there are some admuinstrative functions which need to be carried out on a continuing basis. These include supervision to ensure that (i) private managers meet minimum national standards of curriculum content; (ii) teachers meet the required qualifications; (iii) physical facilities are appropriate; (iv) schools report accurately daily school attendance. Standards and regulations, as well as means of their supervision and enforcement, need to be specified during 1994 and prior to a larger implementation of school transfers in 1995.  -4- B. The Privatization Plan 4. During the 1980s, the Government of Peru increased its presence in productive activities, mainly through nationalization. As a result, the number of state-owned enterprises increased from 29 in 1968 to 177 in 1990. It is estimated that about sixty-six firms were acquired through nationalization during the 1980s. The bad performance of these state firms contributed to the worsening of fiscal accounts in the 1980s. Most public enterprises were operating at a loss in 1989, when aggregate net losses reached US$531 million. Starting in 1990, the Government adopted a comprehensive structural reform program, including a privatization plan, as one of the principal vehicles for radically reducing the role of the public sector in production activities and for promoting private investment and efficiency. The Government's objective is to privatize all state-owned enterprises by mid-1995, when its term expires. In terms of its scope and speed, this is a major undertaking, particularly given that the Government owns shares in 226 enterprises, which are dominant in most of the key sectors, including oil/gas, electricity, telecommunications, and in two export sectors-mining and fisheries. 5. The program, though launched in September 1991, began in earnest in mid-1992 and was accompanied by regulatory reform. This privatization program is supervised by an inter-ministerial commission (COPRI), established under a privatization law enacted in September 1991. By end-1993, the Government had privatized 19 companies/units for US$522 million (which includes US$200 million lease payment over 20 years for PETROMAR), plus US$650 million in investment commitments. In March 1994, Peru's state owned telephone company was sold to a Spanish company (Telef6nica) for US$2 billion. As expected, the value of sales by state owned enterprises has already fallen from 26.5 percent of GDP in 1975 to 10 percent in 1992. 6. The privatization of the Peruvian telephone company has brought to light the importance of properly using privatization proceeds. Under an agreement with the IMF, the Government will deposit privatization revenues in a separate account of the Treasury at the Central Reserve Bank of Peru. In principle, the first US$250 million will be used for the financing of the cost of structural reforms and social outlays. One fourth of the cash revenue from privatization in excess of the first US$250 million will be used to finance projects, which are believed to carry high social returns. Privatization funds devoted to these projects, however, are subject to a ceiling of US$200 million, which can be raised to US$626 million to finance the external component of these projects. In the context of the above mentioned agreement, the measures designed to improve the efficiency of government expenditures discussed in the next Chapter carry an extra importance. C. Rationalization of Public Administration The Retrenchment Program 7. In 1991, the Government of Peru initiated a retrenchment program based on voluntary retirement and pension enhancement incentives (see Appendix 1.1 for a detailed  - 5 - analysis of the retrenchment program). In the context of this reform, a bi-yearly performance evaluation system was introduced to be used for downsizing purposes while circumventing the rigidity of the public sector labor law. The retrenchment program has been costly and yet brought a rather modest decline in total public employment. We estimate the total cost of the program at US$517 million of which US$112 million is attributed to cash settlements and the rest to enhanced pension liabilities. Although this program resulted in a significant downsizing of central government between 1990 and 1993 (69 percent), this was partly offset by a transfer of employees to regional governments, leading to a significant increase in their employment levels (142 percent). As a result, the number of active workers in the public sector was reduced by only 14 percent. Virtually all ministries within the central government underwent a significant reduction in employment between 1990 and 1993. The biggest decline took place in areas in which the state is clearly reducing its presence: Industry (73 percent), Energy and Mines (78 percent), Transport (82 percent), F.sheries (87 percent). By contrast, employment in the security related ministries went up during the same period: by 8 and 0.8 percent for the ministries of Interior and Defense respectively. 8. Today, there are over 629,216 workers in the public sector, of which 44 percent are in regional governmentsY There are at least three issues that remain to be addressed. First, there is a need to identify and cancel all "ghost" public employees in the regions. This process could very well be undertaken by the Controller General, which has doubled its budget in 1994 and is decentralizing its operations. Second, an assessment of public employment needs in regions is overdue. Such assessment, however, must be preceded by a more clearly defined delineation of responsibilities and financial resources between regions and the center. Third, the Government needs to ensure that the provision forbidding voluntary retirees from joining the public sector in the next 10 years is enforced. Today, such enforcement cannot be guaranteed as the data base of the agency that monitored the retrenchment program (INAP) is not linked to the payroll data base, which leaves the revolving door wide open. The Need to Build an Efficient Civil Service 9. The past macroeconomic mismanagement and its associated decline in public salaries have adversely affected Peru's ability to attract and retain qualified civil servants. The average public salary in real terms fell by 28 percent between 1989 and 1993. This was exacerbated by the practical difficulties in properly targeting the retrenchment program. Many ministries, such as infrastructure and education, lost their most qualified staffs through the voluntary retirement program. This is hardly surprising considering that the average monthly salary of professionals in the public sector, including all salary supplements, is US$316-US$325 while the corresponding average salary in the private sector is US$700-US$1900. Public salaries are even lower in health and education due to their exclusion from certain salary supplements. The Govemment has managed to improve or 2/ Public employees account for 8 percent of the total labor force and 19 percent of the formal labor force.  -6 - maintain the quality of the workforce of a few agencies by allowing them to operate under private sector labor laws, hence granting them considerable autonomy for salary and hiring decisions. This is the case for the Central Bank, the tax collecting agency (SUNAT), and the Controller General's Office."' The successful reorganization of SUNAT gives a good indication of what is called for in the rest of the public sector and the political and financial commitments such bold reforms require: only 39 percent of the staff previously affiliated with the organization were retained and the average salary was increased twenty-fold (see Box 2). Creating enclaves such as SUNAT is certainly a good first step in the sequencing of reforms but should not conceal the need to build an overall efficient civil service. Today, weak administrative capacity is hindering the efficiency of policy formulation and execution in many areas such as the ambitious education reform program; project execution capacity; and budget preparation. 10. Although higher salaries may attract qualified civil servants, the sustainability of civil service reform hinges on its ability to emphasize training. This was recognized by the original public sector labor law (enacted in 1950), which stipulated that it is the state's duty to train its workers on a weekly basis. Today, training and its associated budgetary allocations are virtually non existent. A few public sector entities have occasional computer training sessions, but nothing specifically related to their own field. The Ministry of Health is a case in hand. A notable exception is the Ministry of External Affairs, which undertakes a mandatory training program (e.g., cursos de perfeccionamiento). In December 1993, the Ministry of Education also launched an ambitious training program for teachers. The effectiveness of this program could very well be compromised by the fact that it is voluntary and does not affect performance evaluations or salaries. 11. In 1968, the Government created a school of public administration (ESAP), which by law is supposed to lead the overall training program in the public sector and enforce the mandatory training of civil servants. Enrollment in this school is voluntary, and in 1993 it attracted only 1260 trainees (or 0.2 percent of total public sector employees). In general, the school suffers from outdated courses, lack of funding, and failure to incorporate ongoing regulatory and legal reforms. This helps explain why so many civil servants do not seem to be aware of the modifications of their functions resulting from the reforms implemented by the new administration. 3/ Other agencies that operate under private sector labor law include: Superintendencia de Banca y Seguros, Conasev, Superintendencia de AFP, Indecopi, Oficina de Normalizacion Provisional, Conafran, and state-owned enterprises, and the Central Bank. In general, agencies that operate under private sector labor laws have to be financially autonomous.  -7- Box 2: The Successful Reorganization of Sunat Despite enjoying administrative and financial autonomy since 1988, the Peruvian tax collec6tng agency (Sunat) was confronted with the following main prohlems prior to its reorganization: (i) inad,.u-:. functional structure characterized by excessive centralization; (ii) overstaffing with low skill workers;. (i.:'i. low salaries; (iv) absence of training and accountability. By the end of 1990 Sunat had about 3025:: employees about, 65 percent of them in Lima and only 8 percent dedicated to tasks directly related tota - collection and enforcement. The average salary was extremely low, about US$50. Sunat was already receiving 2 percent of collected revenues but could not use these resources to improve salaries, since its salary structure was tied to the rest of the public sector. The New Legal Framework: In March 1991, the Government initiated a comprehensive reform of Sunat. A very competent and coherent team was formed, including staff of the Central Bank:, to oversee the reform. With the assistance of international organizations (IMF, IDB) a diagnosis was....... established with a 3 year action plan. The first step, of modifying the legal framework, was facilitat 'by. the fact that law 25289 granted legislative powers to the executive branch. In addition, two laws were-. passed authorizing a performance evaluation and retrenchment program and making Sunat suabject tot ei private sector labor law. A key feature of the reform has been the strong Government support at the highest level combined with technical assistance by international institutions. The Rationalization Program The first step was to identify the organization's needs by adopting a 'Cuadro Analftico de Personal", which defined staff profiles needed in each office. This table.. was distributed to all staff members who were given 10 days to apply for the new positions identified therein. Applications were subject to a test. Workers who failed to apply to any of the new positions were eligible for voluntary retirement and forbidden from joining any public sector entity in the nexto 1 years. Workers that did not apply for the test or voluntary retirement program were cut back immediately with a pension as the only benefit. Workers who failed the test were transferred to a national institute. These workers could not reenter Sunat under any formn of contract. As a result of the retrenchment ... . . program the total number of employees was reduced from 3025 in December 1990 to 991 a year latr- -a: 65 percent reduction. The total cost of the program for the voluntary retirement program was aboqt US$1.4 million. In addition, pensions payments were rmade for US$ 857,000. Only 10 percent of workers opted to remain under the public sector law in order to get a civil servant pension. These pensions will be paid directly by the Ministry of Finance, hence Sunat does not incur any pension liability. During the second stage Sunat increased its labor force from 991 at the end of the retrenchment program to 2300 workers today. Workers that were affiliated with Sunat prior to its: reorganization account for only 40 percent of the total. Entrance to Sunat is now subject to a very competitive exam, as the 2.7 percent admission rate testifies. Workers are subject to a performanco evaluation every six months. Promotions are strictly based on merit. The staff composition has also changed drastically: between December 1989 and July 1992, the proportion of professionals has increa-e ' from 23 to 48 percent. Sunat has autonomy in designing its salary structure which must be approved bY3. Conafi and the Ministry of Finance. The average monthly salary of a professional in the Sunat inced from US$50 before the reorganization to US$1000. The salary structure is very similar to that of a.... private company. While the changes implemented in Sunat are impressive and its image has greatly improved in the eyes of the public, the ultimate challenge for Sunat, however, remains improving tax collection. This now stands at 10-12 percent of GDP compared with 17 percent for countries at a similai stage of development.  CHAPTER II: AN OVERVIEW OF PUBLIC EXPENDITURES A. Introduction 12. The fiscal adjustment implemented by the Peruvian administration that took office in 1990 was a key component in restoring macroeconomic stability. The combined public sector deficit was reduced from 6.8 percent of GDP in 1990, to 2.5 percent in 1993. Improving fiscal accounts in a context of low tax collection has entailed a significant cut in government expenditures. Central government expenditures fell from 24.6 percent of GDP in 1983, to 18.1 percent in 1990, and 13.9 percent in 1992. On average, current expenditures in real terms fell by 11 percent each year in 1983-92, while real capital expenditures fell somewhat less (4.5 percent). 13. A cross-country comparison of per-capita expenditures by function is shown in Table 2.1. For both health and education, Peru has lower per-capita expenditures than the group average while its social indicators are also poorer.4' For instance, while Peru spends about US$5 per-person on health, the remaining 8 Latin American countries in the sample spend an average of US$46. This significant gap takes place while Peruvian infant and mortality rates are among the highest in Latin America. Clearly in this resource-constrained context, allocating expenditures efficiently takes an extra importance. This is the topic of this Chapter, which provides a selected overview of public expenditure issues, focusing on current expenditures, unfunded and unserviced Government's liabilities, and capital expenditures. B. Current Expenditures# 14. Under the budget executed in 1993, current expenditures in the public sector reached US$3.5 billion, or 73 percent of total expenditures and 7 percent of GDP (see Table 2.2)Y The 1994 budget contemplates an increase in current expenditures to US$4.4 billion or 63 percent of total expenditures. Rather than discussing all items included in current expenditures, this Section will focus on three main components: wages and salaries, pensions, and non-pension transfers. In the case of education, for instance, the first two components alone account for 98 percent of total expenditures. 4/ Social indicators in Peru are analyzed in a separate World Bank document titled"Peru: Poverty Assessment and Social Policies and Programs for the Poor' (1993). {E/ Although interest payments are normally classified as current expenditures, they are examined separately in Section C. 6/ Following the budget classification, the public sector here includes central Government regional Governments, decentralized and autonomous organizations (e.g., universities), and public institutions.  - 9 - Table 2.1: A Cross-Country Comparison of Per Capita Expenditures (1991) (US$t1991) Country(GNP/ Head) Defense Education Health Housing Economic Social Services Security Peru (US$1070) 14 18 5 0.5 14 Bolivia (US$650) 16 23 4 23 21 Paraguay (U$1270) 16 15 5 18 15 Ecuador (US$1000) 21 29 18 4 19 Chile (US$2160)1 53 64 38 215 56 El Salvador(US$1080) 23 16 9 2 21 Panama (US$2130) 34 110 132 154 39 Costa Rica (US$1840) 0 91 152 63 41 Guatemala (US$930) 15 22 11 9 24 Average 25 46 46 61 30 l/ Figures are for 1990 Source: World Development Report 1993. Wages and Salaries 15. According to the 1993 budget, the wage bill in Peru is about US$566 million, of which 59 percent is attributed to central government, 32 percent to regional governments, and the rest to autonomous and decentralized institutes. A detail analysis of public salary structure is provided in Appendix 2.1. Today, public sector wages and salaries are very low. Excluding managerial positions (i.e., directors and above), the average monthly salary in the public sector varies between US$192 and US$325. Professionals, for instance, have an average salary of US$315-US$325. Wages are even lower in the health and education sectors due to the exclusion of certain salary supplements such as the "Cafae" fund.2' In the health sector, monthly earnings vary between US$122 and US$136. This is to say that a surgeon dentist, who is not eligible for a cafae supplement, earns less than a messenger in the public sector who can receive such a supplement. The highest paid professional teacher in the public sector earns US$293 a month. The gap between public and private salaries, which was insignificant during the early 1980s, has widened. Today, a professional worker moving from the private to the public sector would take a pay cut of 50-83 percent. 7/ The Cafae fund is managed by Treasury and is designed to complement the very low basic salary of selected public employees. This mechanism circumvents the multiplying effect that an increase in basic salary would have on pensions.  - 10 - Table 2.2: Realized and Budgeted Public Sector Expenditures in Peru Real Growth Expenditures (1983-92) (US$ million) 1993 1994 Budget I Current -10.3 3,503.9 4,438.1 -wages and salaries - 9.7 566.3 413.1 -Pensions +1.6 362.4 217.8 -Goods and services - 4.7 645.5 640.5 -Transfers - 1.7 1,769.6 2,365.5 -Interest -10.8 219.5 809.2 II Capital - 4.5 1,292.8 1,384.1 m Amortization -13.7 216.7 589.3 TOTAL -11.2 5,013.4 6,411.5 NOTE: The exchange rates used are 1.81 for 1993 and 2.52 for 1994. The Average real growth per-year applies to Central Government only. Source: Ministry of Finance 16. The need to increase salaries in the public sector runs into a number of difficulties. First, the budget constraint does not permit any significant and permanent increase in salaries, in particular in sectors with large employment shares (education and health). For instance, extending the salary supplement from the so called Cafae fund to health and education workers would increase the wage bill by more than 22 percent. The second difficulty lies in the fact that any wage increase (as opposed to discretionary salary supplements) in the public sector has a multiplier effect on pensions paid directly by Treasury to retired civil servants. This is because, by law, pension adjustments are tied to wage adjustments. Given the relative number of pensioners, for every extra US$1 spent on wages, over 30 cents extra will have to be disbursed for pensions. The third hurdle is that, as shown by SUNAT's reorganization, competitive public salaries should be implemented in a context of a satisfactory level and composition of public employment. This is particularly relevant for regional governments, which increased their employment by 142 percent between 1990 and 1993. Currently, there is no incentive for regions to reduce employment given that 94 percent of their resources come from the central government. If anything, the incentive would be to overestimate employment in order to receive bigger transfers. This raises the broader issue of implementing a well designed central-local fiscal relationship (see Chapter IV).  - 11 - The Civil Servant Pension System (Cedula Viva) 17. Under the 1993 budget, about US$362 million were spent on the payment of pensions, of which 70 percent are attributed to central government, 26 percent to regions, and the rest to autonomous and decentralized institutes. The pension bill is equal to 64 percent of the wage bill. Although the average pension is very low--about US$71 a month-- the financing of these pensions is becoming an increasing burden for the Government. This is principally due to the design of the civil servant pension system and the effects of the retirement incentives granted. A detailed analysis of the functioning and financial viability of the civil servant pension system is provided in Appendix 2.2. Active workers contribute 8- 15 percent of their pensionable salary and at retirement are entitled, in most cases, to a pension equal to the highest earned pensionable salary. These contributions, however, do not cover more than 5 percent of pension payments; these pensions fall almost entirely on general revenues. The gap that needs to be filled by general revenues is estimated at $347 million a year (1993). Such financing is necessary to satisfy the very high implicit returns promised by the pension system, varying between 8 and 17 percent. 18. It should be noted that fraud and the design of the retrenchment program have both contributed to increasing the pension system's burden. Indeed, many pensioners have entered the system illegally by taking advantage of the disorder that prevailed during the last years of the previous administration. Many cases of fraud have been detected by agencies that undertook a review of pensioner eligibility. The majority of the public sector, however, has yet to undertake such review. The retrenchment program has also made the pension system more costly by offering enhanced pensions incentives in 1991. The present value of these enhanced pension liabilities is estimated at US$400 million.Y' 19. There are a number of short and medium term issues that must be addressed. In the short term, increasing the legal coverage of the civil servant pension system as was done in the past must be avoided."' Detecting pensions fraudulently extracted, as was done for PETROPERU, could also be done in a more comprehensive way. Solving the structural issue, however, requires fully funding the civil servant pension system, as is being done with the national social insurance system. This has far reaching financial implications that need to be studied. The present value of civil servant pension liabilities is estimated at US$1.9 billion, of which one-third is attributed to active workers and two-third to pensioners.L