Colombia - Programmatic Fiscal and Institutional Structural Adjustment Loan Project

Document of The World Bank Report No: 25476 CO PROGRAM DOCUMENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAMMATIC FISCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN IN THE AMOUNT OF US$300 MILLION FOR THE REPUBLIC OF COLOMBIA February 20, 2003 Colombia-Mexico Country Management Unit Latin America and the Caribbean Region  REPUBLIC OF COLOMBIA-FISCAL YEAR January I-December 31 CURRENCY EQUIVALENTS (as of 20 February 2003) Currency Unit Peso 2,903.00 Pesos US$1 0.92 Euros US$1 WEIGHTS AND MEASURES Metric System SELECTED ABBREVIATIONS AND ACRONYMS ATPA Andean Trade Preference Act IDF Institutional Development Facility CAS Country Assistance Strategy IMF International Monetary Fund CIT Corporate Income Tax ISA International Standards on Auditing CONFIS Consejo Superior de Polftica Fiscal: IVA Impuesto al Valor Agregado (Value Added Tax) Superior Council for Fiscal Policy LDP Letter of Development Policy CONPES National Commission for Economic LIL Learning And Innovation Loan and Social Policy MAPF Proyecto Modernizaci6n De La Administracion CPAR Country Procuremnent Assessment Piblica Financiera (Public Financial Report Management Project) DIAN Directorate of National Taxes and MHCP Ministerio de Hacienda y Credito Publico Customs MTEF Medium Term Expenditure Framework DNP National Planning Office PBG Policy Based Guarantee EUR Euro Currency PFMP Public Financial Management Project FIAL Programmatic Fiscal and Institutional PSAL Programmatic Structural Adjustment Loan Adjustment Loan RAS Social Support Network FOREC Fondo para la Reconstrucci6n y el SAL Structural Adjustment Loan Desarrollo Social del Eje Cafetero: SFAL Structural Fiscal Adjustment Loan Fund for the Reconstruction of the SINERGIA Evaluation System for Public Management Coffee Region SNGS Subnational Governments FRL Fiscal Reformn Law SSAL Social Sector Adjustment Loan FSL Fixed Spread Loan TAL Technical Assistance Loan GDP Gross domestic product VAT Value added tax IDB Inter-American Development Bank WBG World Bank Group IBRD Vice President David de Ferranti Chief Economist: Guillermo Perry Director, LCSPR Ernesto May Sector Manager, LCSPS Ronald Myers Country Director: Isabel Guerrero Acting Sector Lead Economist: Steven B. Webb Task Manager Fernando Rojas Team Production Support: Patricia Mendez This operation was prepared by a World Bank team composed of Messrs/Mmes. Rojas, Sangines, Leyton, Frank, del Villar (LCSPS). The team was led by Messrs. Rojas (LCSPS), and Steven Webb (LCC1C) and worked under the general guidance of Mr. Ronald Myers (Sector Manager, LCSPS), Mr. Ernesto May (Director, LCSPR) and Isabel Guerrero (Director, LCC1C).  REPUBLIC OF COLOMBIA PROGRAMMATIC FISCAL AND INSTITUTIONAL S;TRUCTURAL ADJUSTMENT LOAN (FIAL) Program Document Table of Contents I. Context of the Operation ........................................................... 2 A. Relevant Socio-economic Background ............................................................2 B. Fiscal Rigidities: The Key Constraint to Effective Public Policy ............... .................. 5 C. Past Government Actions ............................................................7 D. The Challenges Ahead ........................................................... 11 II. The Fiscal and Institutional Reform Program ...................................................... 13 A. Revenue Rigidities and Tax Reform ........................................................... 15 - Fiscal Revenue B. Fiscal Responsibility ........................................................... 19 C. Expenditure Rigidities and Institutional Reform ............................................................ 20 - Horizontal Reforms - Vertical Reforms III. The Proposed Programmatic Operation and Loan . ............................................. 32 A. The Bank's Assistance Strategy ........................................................... 32 B. Objectives and Description of the Program ...... ...................................................... 34 C. The Proposed Loan ........................................................... 35 D. Subsequent Loans ........................................................... 37 E. Fiduciary Policies ............................................................ 38 F. Benefits ............................................................ 39 G. Risks ........................................................... 44 Annex I. Letter of Development Policy ........................................................... 46 Annex II International Monetary Fund Relations Note ........................................................... 64 Annex m. Policy Matrix ........................................................... 67 Annex IV. Colombia at a Glance ........................................................... 79 APPENDIX I: Institutions for Fiscal Responsibility ........................................................... 82 APPENDIX IIX : Tax Policy Reform in Colombia: Challenges and Achievements .................... 85 Figures Figure 1. Fiscal Deficit 1994-2001 ....................................................... 4 Figure 2. NFPS Primary Balance, Real GDP Growth, and Poverty Rates (1990-2001) ..14 Figure 3. Timeline of Changes in Tax Policy ....................................................... 16 Figure 4. Accumulated Fiscal Cost of Contingent Liabilities Against the State ............... 26 Figure 5 & 6. NFPS Expenditure and Revenues Excluding Interest Payments. Alternative Reform Scenarios (2000-2006) ...................................................... 40 Figure 7. NFPS Primary Balance: Alternative Reform Scenarios. 2000-2006 .40 Figure 8. Net Public Debt. Alternative Reform Scenarios. 2000-2006 ............................. 41  Tables Table 1. Colombia - National Taxes and Payroll Contributions .......................................... 17 Table 2. Key Measures of the 2002 Tax Reform (Law 788) ................................................. 17 Table 3. Renovation of Public Administration: Selected Vertical and Horizontal Dimensions ................................................................................................................................. 20 Table 4. Contingent Liabilities -Off Balance Sheet Items ..................................................... 27 Table 5. Reforms Supported by the FIAL First Loan (US$300 million) ................. .............. 36 Table 6. Public Sector Fiscal Balances. Scenario with Reforms 2001-2006 ........................ 42 Box Box 1. SFAL Contribution to Fiscal Stabilization and Expenditure Flexibility .................. 10 PROGRAM DOCUMENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAMMATIC FiSCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF COLOMBIA 1. This program document proposes the first of four loans using a Programmatic Structural Adjustment Loan (PSAL) instrument, and will support short- and medium- term reforms with twofold objectives: First, to help attain the substantial fiscal adjustment required to ensure macroeconomic stability and ease the significant fiscal rigidities that make the implementation of public policy extremely difficult; and Second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The program would consist of four single-tranche loans, adding to a notional amount of US$900 million in total. Decisions about whether and when the subsequent loans would go forward will depend on the progress of the reform program. 2. This document attempts to highlight the situation in which the recently elected Government of Colombia finds itself and the issues that this program seeks to address. The incoming administration is faced by mounting social demands to provide essential services - among them, and most importantly, security and peace. It is also faced by a persistent form of budgetary constraint that prevents it from having adequate resources to address these demands: structural rigidities in the tax and public expenditure systems, which make it extremely difficult to allocate scarce resources in an efficient and effective way. The proposed program will support the reforms necessary to attain fiscal adjustment and will constitute an important first step towards liberating Colombian public finance from structural rigidities. The proposed program will also support and help address important issues of administrative efficiency and public sector modernization, which will continue in the subsequent loans of the program. 3. This program supports the policy agenda that the administration of President Uribe has undertaken to resolve Colombia's long and costly internal conflict while at the same time reversing fiscal deterioration so as to safeguard macroeconomic stability. President Uribe, who was elected with a strong mandate in the first ballot, has been gaining even greater internal support through promoting reforms as well as fighting courageously against terrorism. These reforms include the approval of a strong tax iii  Annex 1: Letter of Development Policy package, congressional approval of a referendum, important pension reform legislation, labor market reform, and measures to strengthen the financial sector, and new powers granted to the President to streamline public administration. I. CONTEXT OF THE OPERATION A. RELEVANT SOCIOECONoMIc BACKGROUND 4. Macroeconomic Performance. Despite its long tradition of very prudent and successful macroeconomic management, including good debt management, Colombia's economic performance began to deteriorate in the early 1990's and has continued to stagnate, growing by only 1.4 percent in 2001 and about 1.6 percent in 2002. Major domestic obstacles to a more robust recovery include weak domestic demand associated with high unemployment, currently at almost 15 percent in urban areas, and historically low private investment levels. Moreover, exports, which had led the recovery in 2000, have languished over the past year due to a combination of domestic and international factors. This has in turn affected the performance of manufacturing, much of the production of which is directed toward exports as a result of weak demand at home. Sluggish domestic demand and worsening internal security conditions are reflected in the continued weakness of private investment. 5. Private GDP has grown little since the mid-1990s, and private investment has deteriorated from its peak of nearly 12 percent of GDP in 1994 to under 6 percent today. Total investment now stands at about 14 percent of GDP, incompatible with what the resumption of significant growth would require. While government consumption grew by two thirds between 1994 and 2002, household consumption remained basically unchanged. 6. Colombia's traditional exports fell by over one-fourth in 2001 and 2002, because of declining petroleum production (despite the recent rise of world oil prices), historically low international coffee prices, difficulties in the important Venezuelan market, and the real appreciation of the peso in 2001 and early 2002. While the country's non-traditional exports, mainly manufactured goods and cut flowers, performed well in recent years and now amount to over half of total merchandise exports, the appreciation of the peso in early 2002 and the economic slowdown in the United States, Venezuela, and other Andean countries affected them negatively in 2002. Declining imports have, however, maintained a surplus in the trade balance. The total external current account had a deficit of about 1.7 percent of GDP in 2002. 7. Inflation declined in 2002, assisted by sluggish demand, and was about 7 percent over the last 12 months. This allowed the Central Bank to reduce interest rates, which, along with enhanced prudential regulation, helped the financial sector rebound from the significant crisis of 1998-1999. 8. Fiscal Performance. Over the past half-decade, new realities have emerged in Colombia's fiscal domain, including significant deficits and large future fiscal liabilities. The rapid expansion of the public sector over the previous decade, from spending one fourth of GDP in 1990 to over one third of GDP today, combined with growing 4  Annex I: Letter of Development Policy Figure 1: Fiscal Deficit 1994-2001 Source: Departamento Nacional de Planeaci6n 2.0 - as 0- a 2.1-<17_1 00 -03 0 __ ^4 8 -3.0 -- IL.-4.0- 1 -5.0 -6.0 - -7.0 1994 1995 1996 1997 1998 1999 2000 2001 - eNatlonal Government Deficit -U- Decentralized Sector Deficit - Total Deficit NFPS liabilities, particularly on the pensions front, have led to significant and persistent deficits of a structural nature. As public spending rapidly outstripped the sector's revenue- generating capacity, much of the fiscal deficit was financed with debt, both domestic and external. Today, total public sector debt in Colombia stands at about 56 percent of GDP. The estimated deficit of the combined public sector for 2002 is 4 percent of GDP, largely due to election year spending, higher military outlays, and a weakening of the social security institutions. On security spending alone, the administration estimates that it will need an additional 1 percent of GDP per year. 9. Nevertheless, the Uribe Administration has stressed its commitment to continue the fiscal adjustment efforts of the previous administration. On December 20, 2002, Congress approved a strong tax package estimated to yield an increase of tax collections of about 1 percent of GDP in 2003, 1.2 percent in 2004, and 1.7 percent of GDP by 2005. In addition, Congress recently passed two key structural reforms: a pension reform to address the looming deficits of the social security sector, Colombia's largest future fiscal liability; and a labor reform to increase flexibility in Colombia's rigid labor market. 10. The fiscal deficit for the Non-Financial Public Sector is expected to come down to 2.5 percent of GDP in 2003 and 2.1 percent in 2004. Financing has been planned so that the total public debt will start being reduced in 2004. As a precaution, the Government requested a Stand-By agreement from the IMF, which was recently approved by the IMF Board. 11. The External Environment. Colombia's vulnerability to external shocks has risen in the past year as a result of several factors: increased violence domestically and uncertainty about the future path of the internal conflict; the deterioration in sovereign debt spreads (though some recovery has been seen in recent months); the worsening of market sentiment toward Latin America; problems in Venezuela, the largest market for Colombia's nontraditional exports; and an uncertain outlook for the U.S. economy, Colombia's main trading partner. However, given its floating exchange rate, falling 5  Annex I: Letter of Development Policy inflation and adequate international reserve levels, Colombia should be well equipped to deal with moderate external shocks if it undertakes the necessary fiscal adljustment. 12. Poverty. In Colombia, there has been a close positive correlation between fiscal balance, growth and poverty reduction (see Figure 2). During periods of positive growth (and fiscal balance), Colombia enjoyed substantial declines in poverty (even though inequality increased). Specifically, from 1988 to 1995, as GDP grew on average at about 4.2 percent per year, poverty rates declined from about 65 to 60 percent of the population. This reduction, and the government's efforts that helped achieved it, were completely wiped out by the 1998-99 recession. Poverty levels today are not substantially different from what they were in the late 1980s. More immediately, unemployment climbed to, and has since remained at, almost 15.7 percent of the labor force at the national level. Put differently, the evidence suggests that sustainable growth and fiscal balance has been Colombia's best social safety net. A fiscal balance program that increases revenue and makes expenditure more efficient, as well as within prudent limits, is a sine qua non for Colombia's attaining the human development Millennium Development Goals (MDGs). 13. Insecurity and Violence. Colombia has captured headlines around the world for its alarming indices of violence. Since the 1980's, the multidimensional problem of violence has become more widespread and is exacting an increasing economic and social toll. Recently, trends in violence have worsened and are now among the highest in the world. Figure 2. NFPS Primary Balance, Real GDP Growth, and Poverty Rates (1990-2001) _jt- _ -4 Poverty Rate3 65 55O - C 1991-1996 1997-2001 50 I I I I -1 1990 1995 2000 _ Average Real GDP Growth Rate - Average NFPS Primry Balance (Percentage of GDP) Poverty Rate 14. From 1999 onwards, the number of attacks on petroleum infrastructure increased by 160 percent, on electric infrastructure by 680 percent, and kidnappings by 126 percent over the average of the previous 13 years. It is estimated that the conflict reduces the annual economic growth rate by at least 2 percent. There is consensus around the 6  Annex I: Leuer of Development Policy unacceptability of the current levels of violence, which translated into an overwhelming electoral mandate for the Uribe administration and its determined stance to restore security. The current conflicts places the country in a particularly vulnerable and difficult position. The repercussions of the armed conflict on the economy and the overwhelming social demand for its settlement make peace the paramount priority of the government's public policy agenda'. As crucial complements to the direct counter-insurgency measures, the government recognizes the need to sustain fiscal balances and improve the quality and efficiency of public service. B. FISCAL RIGIDITIES: TIE KEY CONSTRAINT TO EFFECTIVE PUBLIC POLICY 15. The fundamental issue that constrains the effective implementation of public policy in Colombia is the inability of the Government to access the necessary budgetary resources to attend policy priorities. Regardless of the political commitment to promote peace and development, there is little that can be done without resources. Budgetary shortfalls are clearly not uncommon; fiscal adjustment is a worldwide reality. However, the nature of the Colombian fiscal imbalance is particularly difficult to unravel, and fiscal rigidities play a critical part in the picture. 16. Fiscal rigidities, in the broad sense, incorporate a number of concepts that cover areas such as tax policy and administration, budget management, civil service, judicial decisions, and administrative processes such as public procurement and contracting and asset management. The common thread that connects these diverse areas is that they all generate an entrenched expenditure that is difficult to reduce, produce excessive costs derived from fundamental inefficiencies, and/or prevent a revenue source from reaching its full potential. 17. Some of the most important types of fiscal rigidities that have hampered the implementation of public policy in Colombia are: * Legal and judicial expenditure entitlements and revenue earmarks that create permanent rigidities in public spending; * Generous tax expenditures-in the form of exemptions, tax credits or zero tax rates- which weaken revenue elasticity, reduce the tax base and damage tax neutrality and tax efficiency; and * Opportunities for the capture of portions of public spending due to administrative weaknesses of the public sector, such as the complex and fragmented budgetary process, deficient asset management and legal protection of State interests, inadequate public procurement rules and institutions, and profuse entitlement- based spending that is not adequately monitored and evaluated. '. It has been estimated, for instance, that war-related additional public expenditures will reach 1.5 percent of GDP by 2006. 7  Annex I: Letter of Development Policy 18. Taken together with the economic contraction and the instability generated by the armed conflict, these factors explain why Colombia has had such difficulty in making the necessary fiscal adjustment and mobilizing resources adequately for the implementation of public policy. It'is clear that an effort to increase revenues is not sufficient; reducing expenditure layouts and strengthening the capacity of the Government to manage the budget according to priorities is a necessary condition. Furthermore, areas where efficiency gains can be achieved or under-utilized assets more wisely used, must be explored and exploited. 19. During the previous decade the country tried to introduce expenditure flexibility and enhance efficiency via state decentralization, incipient evaluation measures or privatization and contracting out with the plivate sector. Those efforts have not fully reached their objectives, due to: i) resistance from powerful nation-wide trade unions to the transfer of personnel to subnational governments, ii) constitutional or legal budget entitlements defended by rent seekers, iii) growing court and arbitration decisions that condemn the. state to make payments beyond present budget capacity; iv) fragmented procurement arrangements that allow for sector capture of state contracts, and/or v) weak government capacity for contracting, execution, evaluation, monitoring or otherwise delivering efficient services and protecting state interests. 20. Pre-committed expenditures (wages and salaries, inter-government transfers, social security transfers, interest, budget carryover of the central administration and in the unpaid bills of selected non-financial public enterprises) amountedl to a substantial portion of Central Government Primary Spending in 2002. Such a restricted fiscal position made Colombia particularly vulnerable and ill-prepared to respond to the economic recession that has unfolded since 1998. Moreover, it has left scarce budgetary room to respond to new government priorities regarding security, rural development and social expenditures. 21. Governance consequences of fiscal imd administrative rigidities. Revenue and expenditure rigidities that cause inefficiency in allocation and production of public services also weaken governance and impose a heavy toll on the state's capacity to reach conflict-ridden areas. 22. This means that the technical design for policy implementation needs to take into account the capacity of corporatist interests to undermine reform. In addition, other forces lie outside the formal political system and often attempt to influence policy through non-transparent ways. Given this broader political environment, the Colombian public administration has faced difficulties in passing or implementing economic and political policy reforms critical for longer term sustainability of the country. The lack of such reforms threatens to seriously disrupt social services and safety nets and exacerbate the undesirable social consequences of the internal conflict, economic recession, and the slow growth of the last few years. 23. The current government recognized the importance of, and obtained a new political mandate for taking decisive policy measures to add flexibility to fiscal management, not only to make the response to social demands possible but also to enable 8  Annex 1: Letter of Development Policy the country to weather future external shocks more resiliently. As discussed later in this report, the key political and governance requirements are in place for a substantial overhaul of the legacy of years of misguided corporatist public policy. C. PAST GOVERNMENT ACTIONS 24. Past government responses. All recent governments have attempted to reverse these negative trends. However, the responses primarily addressed revenue and were partially ineffective with respect to the expenditure side, that is, reform of the public sector. In order to deal with the immediate effects of the recession, the then-incoming Pastrana Administration formulated a three-year stabilization program for the period 1999 through 2002 based on increased exchange rate flexibility, fiscal stabilization, and the implementation of structural reforms, including financial sector restructuring, tax reform and privatization. 25. The international financial community mobilized to support that program, and in December 1999 the IMF Board of Directors approved a three-year, SDRI.96 billion Extended Arrangement Facility-the first of its kind for Colombia. This arrangement was entered into with a clear understanding on the part of the Colombian authorities that: (a) it was precautionary in nature, (b) it was meant to send a confidence-building signal to international markets, and (c) it would not be drawn upon unless there was a pressing balance-of-payments need. The authorities proceeded along the precautionary path by not drawing upon the arrangement -despite the deteriorating external environment-with a view to avoiding possible wrong signals to the markets. 26. To deal with excessive spending, previous administrations had launched several public sector reform programs. Yet these initiatives-during 1992 and 1994; during 1998 and 1999; and in 2000-did not fully reach their desired outcomes. The limited success of these past reforms was primarily due to: (a) some reforms, especially those between 1998 and 1999 -though explicitly focused on expenditure reduction-- faced legal or political obstacles; and (b) other reforms were not primarily targeted to expenditure reduction or to effectively tackle the inner roots of rigid growth in fiscal transfers or legal claims against the state. After these attempts at reform, the Colombian public sector still requires a significant effort to reduce inefficiencies, align responsibilities, foster transparency and improve management and accountability. 27. From the point of view of reform management, the limited success of administrative reform efforts in Colombia can be largely explained by the lack of consensus, limited involvement of-leading to lack of ownership by-potential beneficiaries, inadequate monitoring or evaluation disclosure, and policy discontinuity between one government and the next. Successful public sector reforms calls for a realistic strategy for implementation and sustainability-an approach that is built on stable political consensus, ownership at various levels of the administration, and the mobilization of civil society in support of the reforms. 9  Annex 1 Letter of Development Policy 28. World Bank support. The World Bank has joined the stabilization efforts and the country's quest for minimizing tax expenditure and public spending rigidities. Beginning in 1999, four Bank projects have sought to tackle the structural factors that are at the bottom of Colombia's weakening fiscal balances and limited efficiency in allocation and service delivery: Financial Sector Adjustment Loan, MAFP II, SFAL and SECAL I. 29. In November 1999, the Bank Board approved an EUR482 million Financial Sector Adjustment Loan, the second tranche of which was converted, in February 2001, to a Policy Based Guarantee (PBG) operation of about EUR238 million, further reinforcing credibility in international markets. 30. In 2001, the Bank approved MAFP II, a Technical Assistance Project for modernization of revenue and financial administration and public sector evaluation.2 MAFP II set ambitious goals in Colombia's road map toward overall public sector modernization. The core of this project is the establishment of a framework for improved public expenditure management and increased transparency and accountability for outcomes, as well as substantial modernization of the tax and customs administrations. 31. One of its elements, intended to integrate financial management (Sistema Integrado de Informacion Financiera, SUF), is still being implemented. The results to date, indicate that it will contribute to enforcing hard budget constraints, upgrading budget and treasury planning, producing reliable accounting data in real time, and ultimately enhancing Government resource allocation. A second element-the evaluation component (Sistema Nacional de Evaluaci6n de Resultados, SINERGIA)- should deliver state-of-the art, objective performance and result assessments when it is fully developed. It is also expected to provide the inputs needed for transforming planning, budgeting and public administration generally into greater result-oriented, performance-based operations. SINERGIA could ultimately bring Colombia to the level of Chile and Brazil-the two most advanced Latin American countries in public sector evaluation. 32. Both SIIF and SINERGIA have faced circumstances which have slowed down their implementation. As far as SINERGIA is concerned, despite its conceptual and technical advances, structural features of the Colombian budget have become significant obstacles for its complete implementation. The incentive framework around public sector policymaking is not conducive to the efficient and effective use of resources. Public sector managers do not have the flexibility in the allocation of resources to implement 2 Public Financial Management Project H (2001) is a follow-up to the Bank-financed MAFP I, and has two components. First, it proposes to strengthen Colombian revenue administration to foster voluntary compliance and revenue collection and combat tax evasion and smuggling. It will do this through organizational, managerial, and procedural changes and improving the policy and the legal framework for revenue administration. Second, it aims to strengthen public expenditure management at the central government level, to facilitate achievement of fiscal and national development objectives, improve cost effectiveness of public services, and increase transparency and accountability. It will do this through improving macro-programming and formulation and monitoring of the budget; strengthening budget execution, treasury, and public credit and accounting; improving the evaluation of results of public expenditure; and strengthening public procurement and contracting. 10  Annex 1: Letter of Development Policy public policy and therefore the integrated financial information or evaluation assessments are not yet feeding a results oriented framework 33. Furthermore, the budgetary rigidities discussed earlier impose a severe limitation on the capacity of these instruments to develop fully and have a real impact on the quantity and quality of public expenditure and on fiscal stabilization efforts in general. The present institutional framework also calls for separate preparation and execution of the current and investment columns of the expenditure budget. Therefore, as elaborated below, coordinating these two key part of the budget process will be essential to implement sector or service efficiency measures-or to adequately introduce result- driven budgets and adequate evaluation. 34. The Structural Fiscal Adjustment Loan (SFAL) of 2001-02 further contributed to the country's stabilization efforts through the measures described in Box 1. It supported the Government's program for reaching an inflection point in the path of fiscal accounts-an essential first step toward achieving full fiscal sustainability, economic growth, and poverty reduction. It strengthened fiscal accounts by: (a) rationalizing the system of transfers to sub-national governments (especially education-related transfers) and imposing more market-driven and binding budget constraints on their finances; (b) establishing mechanisms to arrest the exploding cost and inefficiency of public health services (particularly the cost of public hospitals and the health arm of the Social Security Institute); (c) advancing the reorganization of public agencies and their current expenditures; (d) halting the accumulation of pension-related contingent liabilities; and (e) setting up a better system for managing public debt. The combination of measures to improve intergovernmental fiscal relations, rationalize and reallocate public sector expenditures, and improve financial management of assets and liabilities of the public sector helped to bring about both a more sustainable fiscal path in the long run-a necessary condition for sustaining economic growth and poverty reduction-and greater efficiency in allocation of public resources in the social sectors-a necessary condition for improving the provision of key public services, particularly education, health and pensions. 35. SFAL supported ceilings on transfers to subnational governments that were aimed at restraining growth in spending and reducing the moral hazard from the deficits of subnational governments and decentralized social security institutions. By so doing, SFAL supported the first step towards reducing expenditure rigidities. Supplementary measures are still needed to reduce budget entitlements promptly and effectively.3 The next step is to reduce and eliminate powerful rent-seekers' influence in the actual allocation of expenditures and tax exemptions. Since most budget rigidities are enshrined in the Constitution or in the laws, that next step requires legal or constitutional measures that can only be enacted when governments are backed by multi-party coalitions and country-wide political support -such as the support expressed in the elections and 3. Some of the reforms-although urgently needed-can only be expected to produce fiscal relief in the medium or long term. This is the case of the pension reform, just approved by Congress, whose positive impact on the fiscal accounts will only be felt 5 or 6 years from now. Transformation of the current pay-as-you-go system in a provision-based system usually creates additional fiscal demands in the early years of the reform while fiscal benefits come later-in the form of saving the country from the potentially devastating effect of a pension crisis or government bail out of the pension system.  Annex I: Letter of.Development Policy maintained since for President Uribe. Besides, the reformns themselves can only be sustained if stakeholders (other than traditional rent-seekers) and civil society at large are involved in the public sector reforrn agenda through disclosure, greater evidence of protection of state interests and tangible improvements in the day-to-day priority concerns of the population. Box 1. SFAL Contribution to Fiscal Stabilization and Expenditure Flexibility Supported the constitutional amendment of 2001 which simplified the system of inter-government fiscal transfers into one single Sistema General de Participaciones and limited the rate of growth of: (a) total transfers to subnational governments to last year's inflation plus 2 percentage points; and (b) the central admninistration's operational expenditures to last year's inflation plus 1.5 (percentage points). * Supported the new regime for debt and boirrowing by government agencies (Decree 2540 of 2001), which requires credit ratings by authorized institutions and includes provisions for capital-risk weighting. In addition, SFAL supported application of Law 617 that requires that no territorial entities receive further bailouts or guarantees of their debt after July 1, 2002. * Supported acceleration of transfer of education responsibilities and resources to municipalities. Law 715 of 2001 that amended Law 60 of 1993 introduced capitation formulas for education transfers and automatically certified large municipalities, which are now recipients of education transfers and are held accountable for education results. Similarly, SFAL supported design of performance matrices for each certified rnunicipality that signed an inter-government performance agreement with the National Goverrnent for enhancing quality and coverage of education. 36. In the case of transfers to the education sector, for instance, SFAL supported the issuance of a new law that changes the calculation of the transfer from the current payroll (supply)-base to a per-student (demand) base. SFAL also advanced the preparation of inter-government result agreements that would make municipal authorities fully accountable for increasing coverage and enhancing efficiency in education. But the initial implementation, expansion and further institutionalization of the proposed result- based inter-government agreements will take several more years to bear much fruit. Likewise, it is still premature to evaluate the impact of the new performance management contract between the Instituto de los Seguros Sociales and the Ministiy of Finance that was also supported by SFAL. Moreover, SFAL's ultimate fiscal benefits are apt to be offset by the unexpected surge of fiscal requirements to pay for legal decisions against the state. 37. The social sector adjustment loan (SECAL) approved in 2002 has successfully introduced greater flexibility in health and education expenditures. It sought to enhance the efficiency of inter-government transfers for education by changing their governing criteria from supply-side bases to demand-driven allocations. SECAL also has aimed at overcoming legal and constitutional rigidities by effectively transferring human and financial resource management to the local level. These are steps in the right direction since monitoring and evaluation of as well as incentives for teachers need to be managed at that level. For now, the central government is being equipped to monitor results municipality by municipality while local governments evaluate school by school. 38. The expected SECAL II, in addition to other elements of the Government's reform program, will face the subsequent challenges in the path towards raising efficiency and accountability for the country's substantial transfer for education. 12  Annex 1: Letter of Development Policy Subsequent challenges are threefold: i) to ensure effective implementation of Law 715 that transforms fiscal transfer from a supply-side basis to a demand-based transfer; ii) to enhance accountability of subnational governments through better defining education responsibilities of each layer of government, and iii) to apply result-based incentives and monitoring to ensure higher efficiency of current fiscal transfers in terms of coverage and quality. 39. Four main lessons come from recent Bank operations that have supported the country's quest for raising the efficiency of public expenditures, moving towards result- oriented budget and minimizing tax expenditure and public spending rigidities: i) reducing budget entitlements is a pre-requisite for higher flexibility in expenditure allocation and service production functions; ii) further involvement of civil society at large is needed to increase political support for reforms that impinge on interests that have been long entrenched in the country's budget; iii) simpler, targeted and specialized budget reporting is needed to involve congress, political parties and communities in the discussion and approval of a more flexible budget; iv) social efficiency gains from the decentralization of health and education can only be achieved when subnational governments are empowered to manage productions and are fully accountable for service delivery; and when central government fiscal transfers come with clear conditions and incentives for achieving results. D. THE CHALLENGES AHEAD 40. Results of the economic reform program and remaining challenges. The implementation of the stabilization program in the last few years has produced some positive results-key indicators such as growth and inflation have improved; the extemal position and financial system have been strengthened; key legal and constitutional reforms geared to reducing the inflexible growth of inter-govemment and social security transfers have been passed by Congress, and compliance under the past IMF and World Bank operations has been satisfactory. Yet, a number of unresolved issues and challenges remain and require attention, especially regarding the fiscal situation and the working of the public sector. 41. Fiscal reform challenges. The immediate objective for the government of Colombia is to strengthen the fiscal accounts. This will contribute to: i) promoting a more positive atmosphere for new investment and consolidating of the observed, albeit timid, recovery of growth, ii) creating enough fiscal room for financing this government's top priorities in a fiscally responsible way; and iii) reducing the crowding out effect of government over-borrowing in domestic markets. This will also have a positive impact on poverty reduction, since, as mentioned previously, the link between growth and poverty in effect dictates Colombia's economic policy agenda over the next few years. 42. In spite of important progress, the initial round of stabilization-related reforms did not attend to some important structural, sector-specific imbalances continue to weaken, the country's fiscal position. If not properly addressed, these weaknesses will further push down economic growth; indeed, growth has recovered more slowly and tax revenues have therefore not met expectations. Failure to restore peace and the rule of law 13  Annex !: Letter of Development Policy could further undermine investor confidence in Colombia; and external shocks could restrict Colombia's access to international capital markets even more. The financing scenarios for 2003 call for significant foreign funding, of which an important proportion will be lending by multilateral institutions. In brief, in the absence of further structural fiscal strengthening, macroeconomic vulnerability will remain and external or domestic shocks could easily lead to a sharp rise in poverty. 43. Public sector and institutional reform challenges. The institutional factors that underlie today's fiscal problems are not new in Colombia. Enhancing efficiency and accountability of public administration appears to be difficult when public resources are pre-committed to specific interest groups, without regarding the country's changing priorities or fiscal situation. 44. Fiscal problems that long plagued the country have intensified and become more apparent since the end of the Frente Nacional (National Front) in 1974. The National Front (1958-1974), a bi-partisan concert of the two major political parties primarily geared to suppress inter-party fighting and rural violence, expanded the size of government and created a number of expenditure rigidities that were later confirmed or increased by the Constitution of .1991. Although the Front ensured some policy cohesiveness and party and fiscal discipline, this success, has long been dissipated. Fragmented political factions have multiplied special interest pressures on limited budgets. Trade unions and other political clienteles gained independent leverage which they abused for their parochial "captive sectors." Weak national administrations and populist courts gave in too readily to demands on budgets, contracts and fiscal transfers. 45. State capture has remained-and has often been exacerbated by-the introduction of contemporary tools of state modernization. Prominently, the extensive movement towards decentralization has not fully achieved its intent to improve public service delivery. At the same time, inter-government fiscal transfers have become politically difficult to reverse. The intermediate level of government-which receives a substantial part of the. total public budget-is still largely not accountable, neither to the central government nor to the local citizens. As a result of these and other forces, including the country's internal war and drug-trafficking, the weakening of Colombia's governance became perhaps the single most important cause of the country's fiscal and administrative deterioration. 46. Facing this situation, the relatively independent Mr. Alvaro Uribe received a clear mandate, with multi-party votes from the electorate. It is to re-establish security, eradicate political corruption, improve public services, bolster fiscal discipline and bring the internal conflict to an end. Significantly, in December 2002, the government was still as strong in the polls as when it was elected in May 2002. The congressional sessions that ended in December 2002-and ensured the passage of an unprecedented number of legal reforms (including tax, labor and pension reforms) and advancement of constitutional reforms (both via popular referendum and via ordinary Congress approval)-did not appear to diminish people's high regard for the President. On the contrary, those sessions further demonstrated the capacity of Mr. Uribe's government to enact and implement reforms and meet people's high expectations for this government. For the first time in many years, a significant window of opportunity has opened to implement bold reforms that has led significant sectors of the country and the 14  Annex I: Letter of Development Policy international community to be increasingly optimistic about the reversal of years of corporatist public policy. 47. Today, the challenge consists of making sure that the public sector operates under two principles while delivering more and better quality public services: (a) a budget constraint principle, and (b) an efficiency principle. The budget constraint calls for the elimination of rigidities and entitlements that impede flexible fiscal policies; this also creates the need to enhance the transparency and to commit agencies to deliver specified results that can be evaluated. The efficiency principle requires that the government introduce performance and result indicators for agency evaluation and management of human resources, strengthen and modernize external audits, improve asset management, pursue effective procurement, protect the state from spurious legal claims, and introduce electronic government tools for promptly disclosing public information and reducing transaction costs.4 II. THE FISCAL AND INSTITUTIONAL REFORM PROGRAM 48. General Framework: The Estado Comunitario and the Future of the Colombian Public Sector. The idea of "Estado Comunitario" lies at the heart of this government's public sector reform program. The "Estado Comunitario" is a set of basic reform guidelines put together and demonstrated in practice by President Uribe at the time he was governor of the department of Antioquia, perhaps the most developed intermediate level administration in Colombia. Already elaborated and announced during President Uribe's campaign, the concept of Estado Comunitario should inspire criteria for selection of entry points and impact evaluation of public sector reform under the present administration. Although still evolving as a guiding concept of public sector reform, the Estado Comunitario incorporates and adapts to Colombia a number of widely accepted, contemporary principles of public sector reform that will guide the renovation of the Colombian public sector under the current administration. 49. The concept of the Estado Comunitario is the foundation of the National Development Plan 2002-2006. The fundamental principle underlying the concept is that the State should exist for the service of its citizens and not for the benefit of special interests. The Estado Comunitario involves civil society in the attainment of social objectives; it is a modern State where scarce resources are invested wisely and efficiently; and it is a decentralized State that stands for regional autonomy with transparency, political responsibility and community participation. 50. The National Development P!an proposes the development of the Estado Comunitario through four basic pillars: 4. Additional focus on corruption, crime and violence will be supported by a judicial reform project and an anti-corruption project that are anticipated as parallel operations. 15  Annex I: Letter of Development Policy * Democratic Security. The State must provide security and protection to all Colombians, without political, ideological, religious or socio-econoniic distinctions. * Sustainable Development and Employment. Economic growth stagnated during the last few years and unemployment has grown by around 10 percent since 1999. The State must provide the conditions to recover the path to econornic growth. * Social Equity. The State must ensure that the fruits of economic growth are enjoyed by all Colombians. * Renovation of the State. The State must modernize its administration and reform intergovernmental relations. The ultimate goal is to build a managerial, participatory and decentralized public sector. 51. The Estado Comunitario and the Fiscal and Institutional Reform Program The fundamental purpose of the Fiscal and Institutional Reform Program is to liberate resources for the effective implementation of public policy and to generate efficiency and transparency gains that will contribute to fiscal sustainability and the improvement of service delivery. In this sense, the Program is a necessary condition for the attainment of the goals of the National Development Plan as described above. Democratic Security hinges upon the availability of untied fiscal resources, within a framework of macroeconomic stability, to invest in restoring peace to the country; Sustainable Development requires a sound macroeconomic framework and effective fiscal policy; Social Equity requires ability to deliver improved services to the poor and increase their ability to benefit from economic growth; and the Renovation of the State clearly entails efficiency and transparency gains as well as the necessary institutional strengthening actions to deliver more and better public services in a fiscally sustainable way. 52. The new government and the private sector are frank and open to acknowledge the long-entrenched state capture and the gradual deterioration of investment climate. Since the presidential campaign, the government has announced and put together an ambitious yet realistic program for fiscal and institutional reform that covers both the revenue and expenditure sides of the fiscal accounts. This reform program involves a wide array of constitutional, legal and administrative measures that, together, represent the most significant reform effort since the Constitution of 19915. 53. New legal and constitutional framework. Upon taking office, the government launched an array of legislative proposals and actions. Indeed, the unusual number of substantial constitutional and legislative proposals congested the legislature to the point that only selected priority issues were approved in the session that ended in mid- December 2002. Other important proposals, such as the Fiscal Responsibility Law, received only initial consideration and must wait for the next ordinary Congress session that will start in March and end in June 2003. 54. The administration is using a three pronged approach to strengthen its governance and fiscal discipline. First, it targeted two constitutional reform iniliatives, one via 5 World Bank projects are supporting these reform efforts; through a combined package of structural reform projects that include overall rationalization of public expenditures (including pension and social security expenditures), labor reform, tax reform and tax administration, financial reform, and improvement of health, education and family services. 16  Annex !: Letter of Development Policy pending referendum and the other via Congress, to strengthen its capabilities at all levels. One provision of these measures would eliminate the Congress' power to allocate portions of oil and mining royalties. If approved, these funds would become available for use as incentives for improving education performance. Second, several legislative initiatives should remedy a variety of structural impediments contributing to budget expenditure rigidity and the fiscal deficit. These call for merging some ministries and advancing ongoing pension and labor reforms. Third, there are reform proposals for a number of executive branch actions aimed at mitigating important causes of expenditure rigidity. They are directed at improving the management of state assets, installing inter- government incentives for higher efficiency and flexibility in education spending, bolstering the state's protection against excessive-and often unjustified-legal claims, tightening government procurement, advancing the performance and results-based management agreement with and monitoring of the Instituto de Seguros Sociales, and establishing the bases for overall budget reform. 55. The government is already planning substitute measures in case the Referendum is not approved by the voters. Those alternative measures would include: i) gradual elimination of some special pension regimes through legal reform and collective bargaining; ii) legal reform proposals and administrative measures to ensure expenditure cuts and additional tax revenues with a fiscal effect at least equivalent to the expected impact of the current expenditure freeze, and iii) reforms to encourage subnational governments that currently receive royalty transfers to concentrate their project proposals in the education sector. 56. Concept and Structure of the Public Sector Reform Program. The core of the reforms is contained in two reform packages known as the Tax Reforn and the Renovation of Public Administration. These two packages are framed within and supplemented by other government reforms in such a way that the magnitude and expected impact of the former cannot be adequately grasped without reference to the latter. The program is both coherent with and strengthened by the constitutional and legal reforms courageously undertaken by the present administration, involving a popular referendum scheduled for early 2003, a constitutional reform that has completed one of two rounds of congressional review, a pensions reform, and the reform of the central government structure. All these reforms have significant fiscal implications and should establish the necessary basis for the proposed Fiscal Responsibility Law and for Colombia's political reconstruction and economic recovery. A. REVENUE RIGIDITIES AND TAx REFORM Fiscal Revenue 57. Given the pressure to spend for both domestic security and social programs, and the tight borrowing constraints, the government knows that it has to raise more revenue. The additional tax revenue will come from important measures, some already taken and some still pending, along two main fronts: Tax Policy and Tax Administration. 17  Annex 1: Letter of Development Policy 58. Tax Policy. Colombia gets its fiscal revenue from three main sources-oil royalties, customs duties, and domestic taxes. The value of oil revenues depends largely on world market factors beyond the govermnent's control, although there is scope for reform of how these revenues are allocated and shared between different levels of government.6 Customs revenues have generally declined over recent years, with trade liberalization, and should continue this trend for the sake of economic development. The main opportunity for increasing revenues comes from domestic taxation, which is also an important area for reducing economic distortions and administrative complexities. Figure 3: Timeline of Changes in Tax Policy Total Income 1990-2002 (% GDP) 1t8- FL.-2---991Lw383df1997 14.9 Law223of 1993 VA ZI Conb evaon 14 - lTdbutary staNde l _ 14~~~~~~~~~~~~~~~~~~~~~~~~1. 12- < -;~~~~~~~~I 12.-77- 13.37 12 - eX 10 < 0.78 1128 11A 633ctI 1oovA11.%7 1 10a41 ] 8.53 mvret LawBOf 1992 Law488o11998 L; 49 o 19921 VAT14% E02% Fianailmovenents| VAT 12% tnponnt 37.5% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year 59. Previous rounds of tax reform, particularly in 1974 and 1986, left the country with a fundamentally sound array of taxes at the national level-on value added, corporate, and personal income. The two aspects of the income tax are largely integrated by exempting dividends from taxation as personal income and giving all corporate forms equal tax treatment. Prior to 2003 capital gains were not taxed at the individual level, which had the advantage of avoiding double taxation of retained earnings (matching the non-taxation of distributed earnings and further integrating the business and individual tax systems) but had the disadvantage of reducing revenue and offering opportunities for tax avoidance through schemes to convert current income into capital gains. 60. Aside from the major reforms, however, the tax laws have suffered frequent changes that reduced revenue collection and introduced distortions by granting preferential treatment to special interests or, alternatively, increased revenue and intensified distortions by raising the rates on activities already being taxed. Figure 4 6For the last 15 years the value of oil revenues has also suffered from guerrilla attacks on the pipelines. 18  Annex 1: Letter of Development Policy shows the recent time line of changes in tax policy and revenue. Now, the new government of Colombia has an electoral mandate to raise more tax revenue, and the challenge is to do so in a way that reduces privileges and distortions. 61. Key Policy Actions. The enactment of Tax Reform Law 788 in December 2002 brought together some of the key policy actions geared to the modernization of Colombian tax policy. This law: (i) eliminates exemptions and expands the tax base for the Value Added Tax; (ii) establishes a new ceiling on the wage exemption for the personal income tax, and reduces incentives for non-taxed compensation to employees; and (iii) phases out the corporate income tax exemption for capital gains from sales of stock, mutual funds and real estate and for profits from previously privileged corporate forms, contracts, funds or bonds. On a tax-by-tax basis, the 2002 tax reform included the measures shown in Table 2 (a diagnosis of the previous structure and a description of the latest reforms and the remaining agenda is presented in Appendix 1[). TABLE 1. NATIONAL TAXES AND PAYROLL CONTRIBUTIONS 1995 1996 1997 1998 1999 2000 2001 Percent of GDP Income Taxes 4.0 3.8 4.4 4.3 4.2 4.3 5.2 olw Corporate 2.2 2.2 2.7 2.5 2.4 2.5 3.0 Personal 1.8 1.6 1.7 1.9 1.8 1.8 2.2 Tax on Banking 0.6 0.7 Transactions Value Added Tax 4.1 4.7 4.8 4.6 4.4 4.9 5.2 Excise Taxes 0.6 0.7 0.6 0.5 0.5 0.5 0.6 Taxes on 1.0 0.9 1.0 1.2 0.9 1.0 1.1 International Trade Other 0.6 0.7 0.7 0.7 0.7 0.7 0.7 Social Security 3.5 3.5 3.3 3.5 3.3 2.7 2.6 Contributions a Total 13.8 14.3 13.1 14.8 14.0 15.3 16.1 a. Social security contributions and other payroll contributions are collected by institutions outside the national central government. They include pension contributions and health insurance. Sources: Estimates based on data provided by CONFIS, IMF, and High Commission on Taxes. TABLE 2. KEY MEASURES OF THE 2002 TAX REFORM (LAW 788) Tax Key Effects Value-Added * A large number of previously exempted or excluded goods and services will be Tax subject to the VAT at 7 percent from 2003, rising to 10 percent in 2005 * Nearly all other exempted and excluded goods and services will be taxed at 2 percent from 2005 onwards * Mobile phone rate established at 20 percent * Rate on automobile sales will be unified at 25 percent from the current range of 20 percent to 35 percent a Collection of VAT on all capital goods with a 3-year rebate or credit for registered firms making further sales Personal * Reduction of the wage tax exemption from 30% to 25% with a ceiling in the Income Tax amount of Col$16 million in monthly wages and reduction of tax exemptions, tax credit and non-taxed income for the personal income tax 19  Annex I. Letter of Development Policy TABLE 2. KEY MEASURES OIP TH 2002 TAx REFORM (LAW 788) Corporate * Phase-out of exemptions for capital gains from sales of stock, mutual funds and real Income Tax estate and for profiis from a variety of previously privileged corporate forms that often served as tax shelters * Reduced access to the special tax regime (20 percent rather than the standard 35 percent) * 10 percent special surcharge for 2003, to be lowered to 5 percent in 2004 Other National * Does not eliminate the distortionary financial transactions tax implemented in Taxes and 1999; however, it closes some loopholes for transactions in the real economy and Contributions allows exemptions for some inter-bank transactions not meant to be taxed Sub-National * Rationalizes departmental and clistrict taxes on alcoholic drinks Taxes * Increases the gasoline tax surcharge transferred to subnational governments by 5 percent 62. Prior to the Congressional approval of Law 788, the Government established a special, one-time net wealth tax of 1.2 percent (Decree 1838, August 11, 2002) to finance the restoration of public order. The Government has estimated that the total revenue from this one-time tax will be in excess of 1 percent of GDP7. 63. Expected outcomes. These measures will expand the VAT tax base from about 41 percent of consumption in 2002 to about 59 percent by 2005, a major achievement. Regarding the corporate income tax, the phase out of exemptions will reduce them from 70 percent of potential revenue in 2003, to 50 percent in 2004, to 20 percent in 2005, and to 0 percent in 2006. An increase in subnational revenues by one-fifth is expected. Preliminary estimates by the authorities indicate that tax collections would increase by about I percent of GDP in 2003 as a result of the tax package, rising to 1.2 percent of GDP in 2004 and to 1.7 percent of GDP in 2005. These expected outcomes are additional to the one-time wealth tax described in the previous paragraph, which is not a permanent tax policy measure. 64. Tax Administration. Even the best policy reforms would realize their goals of greater revenue yields with fewer distortions only if there are improvements in tax administration. This remains a major weakness in Colombia, where tax revenues are substantially below what the rates and the tax base would normally suggest. 65. The VAT and income taxes each collect only a little over 5 percent of GDP. The Direcci6n de Impuestos y Aduanas Nacionales (DIAN) is the entity responsible for tax and customs administration. Some of the most important areas where the tax administration needs improvement are: * Revision of the relationship with the banking system in order to standardize information flows and reduce-the period during which funds are held by banks (now 14 days); * Improved coverage of withholdings of interest income on individuals, now only at 7 percent and from large accounts only; * Increased integration between the areas of internal revenue and customs, especially in processes such as auditing and information management; * Reduced costs of enforcing compliance. 7 The collection of this tax is done in four installments. The first two installments have yielded approximately US$500 million, close to 0.6 percent of GDP. 20  Annex I: Letter of Development Policy 66. Key Policy Actions. The reform of tax administration will include a number of measures aimed at the aforementioned problems8. In order to improve collection of taxes on interest paid to individuals, DIAN will require all entities (banks, governments, etc.) paying interest to expand their reporting on the recipients. 67. In addition, DIAN will establish unified accounts between customs and domestic taxes, starting with all large taxpayers in 2003. It will clean up data so that it is in standard formats and becomes part of centrally managed taxpayer databases, to which all IASD units contribute and that they can access. To improve enforcement, DLAN will issue a plan for coordinating audits and sharing information across its departments. It will establish a list of collectable tax debts and publish a plan and timetable for their collection, starting with the largest. 68. To improve the system from the point of view of the taxpayer, DLAN will establish indicators and will publish data on the cost and time required for compliance. A series of actions are needed to complement these measures. These should include the improvement of opportunities for electronic filing (especially for large taxpayers); and steps to enhance user friendliness and motivate taxpayers to declare and pay electronically. In addition, DIAN will establish indicators of customs clearance time, and design procedures permitting expedited shipment inspections based on risk-management techniques. B. FISCAL RESPONSIBILITY 69. The fiscal situation in Colombia reflects the extent of excess demand on the State, its inability to meet those demands, and the urgency of achieving sustainable balances. A sound fiscal framework is essential for the national security effort, for the social programs that sustain the State's legitimacy, and for the protection of common citizens against the ravages of inflation. Achieving that will require, among other things, institutional reform of the formulation of macroeconomic policy, and close monitoring and control to meet short- and long-term fiscal targets. 70. Behind the unavoidable fiscal arithmetic by which spending in excess of revenue has led to deficits and the accumulation of debt in Colombia, there lie budgeting and fiscal management procedures that gave rise to the unsustainable fiscal tendencies. Colombia has given increasing attention, therefore, to changing its rules of the game for fiscal policy at all levels of government. Until recently, the Constitution and legal rules for budgeting and treasury have done little to restrain central government deficits and debt, and in some ways they encouraged them. For example, vigencias futuras make commitment for future expenditure and the allowance for arrears based on ad hoc promises for future payment of present expenditures. 71. In the 1990s, the new Constitution broadened political participation, increased spending impulses, and weakened the tax base of the national government (automatically sharing it with subnational governments), all of which compromised overall fiscal prudence. The Acto Legislativo (constitutional amendment) of 2001 sought to put ex ante 8The MAFPII project, mentioned in the introductory section, has tax administration modernization as one of its key objectives and will contribute to the implementation of the key policy actions for DIAN. 21  Annex I: Letter of Development Policy limits on some of the spending impulse coming from transfers to subnational governments. 72. Despite these reforns, the national government believes that at all levels of government there remains too much discretion affecting fiscal deficits and not enough assurance of fiscal sustainability. Evidence to this effect is the fact that Central Government expenditures have increased steadily from 9.4 percent of GDP in 1990 to 20.8 percent of GDP in 20029. 73. Key Policy Actions. The key policy action in relation to fiscal responsibility is the final enactment of the Fiscal Responsibility Law (FRL) and its full application by year 2004. The bill had been prepared and submitted to congress by the previous Pastrana administration. It has already gone through two approvals in Congress and is expected to become law in the forthcoming legislative sessions of March-June 2003. The current draft of the FRL contains rules for fiscal stability, transparency and macroeconomic consistency, fiscal discipline, and sub-national debt limits. The Law to be enacted is expected to contain, at a minimum, rules for: a) setting fiscal targets linked to debt sustainability and primary balance for the NIPS; b) annual reports of fiscal results to Congress, including floating debt; c) publication of the financial plan that will include, among others, information on floating and contingency debt; and d) the obligation to include the fiscal impact and source of financing within any law that creates new tax expenditures. 74. The design of the Colombian FRL has benefited from the regional experience of several countries that have implemented similar fiscal rules, either through fiscal responsibility laws of their own or through other mechanisms that fall short of an integrated FRL. Appendix II offers a more detailed analysis. C. EXPENDITURE RIGIDITIES AND INSTITUTIONAL REFORM 75. The Renovation of Public Administration. The structural rigidities that prevent public expenditure from being flexible enough to address public policy demands constitute a common thread among the areas contained in the public administration reform program. The government has identified the need for shorter- and longer-term actions in a number of horizontal (i.e. systemic, cross-agency) areas and vertical areas (i.e. agency-by-agency reforms to redefine mission, increase efficiency, and improve coordination) of public administration. 76. The initial momentum to this process was Presidential Directive number 10 (August 20, 2002), which establishes the guiding principles for the renovation of the public administration. Based upon this document, the government started a process of consultation with international financing organizations to receive financial and technical support for its implementation. The IBRD focused primarily on the horizontal aspects of the reform process, as well as some vertical elements that can lead to enhanced service delivery by the education sector or government agencies. The Inter-American 9 Source: Departamnento Nacional de Planeaci6n 22  Annex I: Letter of Development Policy Development Bank focused primarily on the vertical reforms and some cross-cutting issues such as information management, e-govemment and civil service reform. TABLE 3. RENOVATION OF PUBLIC ADMINISTRATION: SELECTED VERTICAL AND HORIZONTAL DIMENSIONS Vertical Horizontal Simplification and Rationalization of the Higher efficiency in largely captured sectors and Government's Structure agencies and initial steps towards results-oriented management Agency-by-agency selective retrenchment Budget reform, including regulatory adjustments similar to a Medium-Term Expenditure Framework (MTEF) Agency-by-agency procedural and organizational Administrative reform: Asset management, public simplification and enhanced service delivery procurement, legal protection of the State 77. The timing of reform differs for vertical and horizontal reforms. Some of the vertical reforms can be quickly introduced. Therefore, as soon as the government took office it issued regulations and instructions for implementation of reform in the vertical areas and subrnitted a bill requesting congressional authority to reform the structure of the administration. That bill was recently approved by Congress and was enacted as Law 790 of December 27, 2002. Reform of horizontal areas will take anywhere from a few months to the entire four years of the Uribe administration. Horizontal Reforms 78. Budget Management Colombia's planning and budgetary process is a complex interplay of various entities operating under diverse rules and procedures. It produces the National Development Plan, the Financial Plan, the National Investment Plan, the Annual Investment Operative Plan, and the Budget. Theoretically, they are fully consistent with one another, but in practice they differ among themselves. Budget law figures are actual appropriations instead of expenditure caps which consequently limit the scope for expenditure control during the budget year. Furthermore, the budget process does not produce reliable revenue estimates. 79. Over the years, many Colombian interests have successfully won permanent budget entitlements or revenue earmarks . This has served to circumvent resource constraints and to reduce the scope for government decision-making and good fiscal policy. It has also crimped the mobilization of funds for new prograrns. This problem has been recognized and acknowledged by the Colombian authorities since it was first pointed out by the 1980-81 Presidential Commission for Inter-Government Fiscal Relations. However measures to attenuate it have been too weak or short lived.10 80. Other deficiencies in the system include the absence of suitable controls over budget outcomes. Instead of having effective "checks," Colombian budgeting is too process-oriented. This has hampered the tracking of such important elements as stability, 0. Cf. Bird, R. M. (1981) Colombia. Inter-government Fiscal Relations. Harvard University, International Tax Program. The Presidential Comision de Gasto Publico of the early nineties produced a report of similar category. 23  Annex 1: Letter of D,evelopment Policy effectiveness, and efficiency. In addition, Congress lacks the capacity to properly analyze budget information. 81. Thus, the challenge is to initiate a transformation of the budget system in order to be more policy focused and accountable for results. This will not be an easy task. Besides the inertial tendencies to maintain existing practices, the vested interests who have gained power on budget decisions will resist giving it up. Refoim will require sustained changes in rules and procedures to make budget decisions according to policy priorities (allocative efficiency), performance and results (productive efficiency), and available resources. This would affect how central government and sectoral authorities decide on what should be done, how it is going to be achieved, and who is responsible for it. It would also affect subnational governments to the extent that national rules and practices are also applicable to regional and local governments. The new rules also call for mechanisms to hold policy makers and managers accountable for planned outputs and outcomes to be delivered in a timely fashion. 82. Key Policy Actions. The government has determined that substantial reforms in the budgetary process are essential to restore its capacity to implement fiscal policy within a framework of macroeconomic stability. A number of key policy actions have been identified that when taken together, constitute an important package of reforms that will restore flexibility to budgetary managernent and strengthen the policymaking capacity of the Executive Branch. 83. The key initial steps to be taken by the present government include: Pursuing a Medium-Termn Expenditure. Framework (MTEF) adjusted to the Colombian legal and political constraints. This document must propose aggregate fiscal targets for a multi-annual period (in conjunction with the FRL), identify key strategic and policy issues and propose sectoral allocations. Once these sectoral priorities and 'activities are identified by line-ministries and decentralized agencies, it would be possible to carry out a cost assessment of total requirements within each sector. This medium term perspective would also serve other purposes: provide reliable figures to evaluate possibilities of budget cuts from the standpoint of output impact rather than the more traditional input perspective, and clarify the need to evaluate legal entitlements in the light of sectoral objectives and priorities, and how to shift resources when priorities change. * Restore Budget Powers to the Ministry of Finance. The yearly budget law, once approved by Congress, creates mandatory entitlements for the- public sector institutions that the Executive Branch must honor, regardless of their consistency with fiscal or macroeconomic developments during the fiscal year. To introduce a greater degree of oversight by the Executive Branch during budget implementation, the Government is seeking a Constitutional amendment that would introduce "filters" between budget approval and implementation to ensure overall fiscal coherence. * In addition to the Constitutional amendment, important changes in.the Organic Budaet Law (LOP) are needed. Once the Constitutional amendment is passed, the LOP must be modified to regulate the operation of the "filters" that would be 24  Annex 1: Letter of Development Policy enshrined in the Constitution. Even if the amendment is not passed, a reform to the LOP will still be necessary to enhance the Executive Branch's capacity for budget management within the existing Constitutional constraints. To support this process, a high-level Special Commission comprising s.veral stakeholders will comprehensively review, entitlements and revenue earmarking to identify and recommend necessary reforms and help build broad support for them. * Ensuring Consistency between Current and Capital Expenditures. Over decades, the processes of assigning current and capital experditures by the MOF and by the DNP respectively have resulted in two almost autonomous budgets. This resulted, among other things, in an inability to effectively analyze the current expenditure consequences of public investment. The authorities will act to ensure coherence between current and capital spending. o Greater Transparency and Accountability for Outcomes. This element of the strategy calls for simplifying budgetary information in order to make it easier to understand and available for public use. This proposal goes hand in hand with the government's initiatives to launch a website with comprehensive fiscal information based on SIIF outcomes, and will require the immediate implementation of a Communication Program to convey to the public the present budget figures. * Review of Entitlements and Earmarked Revenues. To promote flexibility in public expenditure, the GOC will establish a high level Special Commission to undertake a process of review of expenditure entitlements and earmarked revenues, and recommend the necessary legal and administrative measures to introduce greater flexibility in budget management. o Budgeting and Accounting Classifications using International Standards. Different government levels have been reluctant to unify accounting and budgeting classifications, instead using non-standard accounting practices. The strategy aims at unifying budgeting and accounting bookkeeping according to international standards in time for the FY2006 budget. * Budget Control. The weakness of political, technical, tiscal, and social controls of budget outcomes has left the budget system without effective "checks." In Colombia, the fundamental problem with control is that it is process oriented, making it virtually impossible to keep track of fiscal outcomes (stability, effectiveness, and efficiency). The Government will implement a performance management exercise that will promote a different approach to analyzing budgetary outcomes. 84. Asset Management. By "asset management" we refer to the rules, regulations, systems and practices with which the Government manages its existing assets, both fixed assets of high value (especially real estate) as well as other lesser assets that are part of the public sector's capital stock. Improper asset management can impose significant rigidities and inefficiencies in public financial management. From the expenditure side, 25  Annex!1: Letter of Development Policy the public sector often needs to makce additional investments because of the inability to use its existing assets due to improper titling, incomplete inventory, or other reasons. From the revenue side, unproductive or unnecessary public sector assets constitute a potential source of capital income should they be sold. 85. The Planning Department (DNP) is taking the leadership to develop a strategic vision on how to approach the subject of asset management. There is no complete information on the total of assets owned, their current value, and their legal status. Although the Contaduria General de la Naci6n has started a sort of inventory process, the public accounts give a partial and out of date view of the real situation. 86. Some agencies have accumulated a varied array of properties and other assets, which with unclear legal status and economic value, incomplete registration, and irregular control, constitute no solid basis to begin applying professional management criteria. The complex legal framework is an additional burden as it doe.s not recognize market principles, nor does it provide adequately for discretionary managerial actions. As a result of all these factors, there is a substantial accumulation of idle assets. 87. Since almost everything is to be done, challenges for asset management are numerous. Nevertheless, there are three major challenges that can be addressed during the life of this program. First, to know precisely what is owned, its value, legal title and effective possession; second, to effectively execute new policies based on criteria encouraging the keeping of useful and productive assets and mandating the release from state ownership of unproductive assets which have no direct connection with governments' mission; and third, to manage all state owned assets within strict parameters of efficiency and transparency. 88. Key Policy Actions. The key policy actions for asset management are divided into the short- and medium-term: * Short-term policy actions. DNP wili, as an initial step, develop a framework for asset management which defines the scope of government action and policy. This is crucial since at present no entity in the central government is in charge of asset management, and strategy, policies, and procedures, have to be develop from scratch. The scope of this initial work also includes the operational planning for the elaboration of consolidated inventories (with verification of title, possession, value and accounting registration), as well as the implementation of a Pilot Program conducive to quick results with positive fiscal impact. A small Committee is being formed with representatives from key agencies and the technical assistance of a limited group of external consultants, for the dual purpose of executing certain actions of this first stage, and coordinating the execution of other actions by government agencies. * The government intends to put in place a quick-action pilot plan, basically an assets sale and optimization program for 2003 and 2004 under the current regulatory framework. Although the government will not have yet developed an adequate asset management capacity, it is important to rapidly produce some needed income in order to send a definite signal of the new public asset policy and reach the more profitable later stages with continuing public support. This 26  Annex I: Lener of Development Policy program will yield by 2005 at least $175,000 million (Colombian pesos of 2002), equivalent to roughly US$60 million. * Medium-term policy actions. Subsequent actions include: (i) the formation of a centralized unit charged with the coordination of the more substantial reforms, develop Manuals of Policies and Procedures, provide technical assistance and overall guidance to other participating agencies, and be responsible for the centralized management of a Data Base system; and (ii) develop a more flexible and open-minded approach to concessions, leasing, privatization, outsourcing, etc., and the publication of the inventory of assets owned by each agency, increasing transparency and accountability. Through these reforms it is expected that assets worth approximately US$1 billion can be registered and prevented from further deterioration, which highlights the considerable fiscal impact of this reform. 89. Development of Incentives for Efficiency Gains. Service delivery in Colombia, as in many other countries, has long emphasized inputs over outcomes. The traditionally centralized public sector management tended to distance public managers even further from the outcomes achieved by the interventions of their programs, yielding mediocre public services at unreasonably high costs. It was hoped that decentralization would be a strategy to reverse this tendency, and since the mid-1980s a shift of resources and decision making authority to local government has occurred. But decentralization has not fully reached its objectives, and its level of implementation varies among the regions. The transfer of powers has resulted in blurred responsibilities in a number of sectors, which further undermines accountability. 90. This calls for a reform in which agencies commit themselves to managing for results. International experience suggests that results-based management has the potential to redirect efforts of public servants toward the user by a focus on costs, quality, and outcomes; however, the necessary conditions for results-based management include true managerial discretion for public sector managers to accompany accountability for results, as well as deep reforms in the budgetary process. Although Colombia is not in a position, at this time, to undertake the challenge of implementing results-based management, important steps forward can be taken towards this long-term objective. 91. The present challenge for Colombia lies in the ability to use results-based management to improve the efficiency and effectiveness of fiscal transfers. In the case of mandatory transfers, the government must adopt a role of tutelage: first, technical assistance can improve management in local governments and thereby match their existing autonomy with tools to manage; second, the government can encourage municipalities' voluntary application of the new instruments through non-binding results agreements that enshrine these objectives. The government has the opportunity to turn non-mandatory transfers (particularly royalty transfers or transfers from oil and mining revenues) into incentives to apply the new instruments and to require co-funding from local governments. 92. Key Policy Actions. The government is committed to raising the efficiency of education transfers as a first step towards freeing resources for new sector or inter-sector priorities. 27  Annex I: Letter of Development Policy 93. The government policy for enhancing efficiency in education consists of defining capacity standards for subnational governments to manage the new transfer based on calculations of resources per capita, then providing incentives to those municipalities or departments that meet government standards. The new financial incentive will be drawn from the reallocation of the Royalty Fund. Reallocation of the royalty transfers already has been initiated in the budget for 2003 and will be expanded and consolidated by the national referendum approved by congress and up for popular vote in 2003. 94. Protecting the State against the Extraordinary Growth of Legal Claims. Litigation against the state has a substantial fiscal impact in Colombia, much above known impacts for other countries. Typically, lawsuits against the state arise from poorly drafted contracts, which leave space for litigation regarding the interpretation of rights and obligations. Since 1994, the number of cases filed has increased enormously, and their outcome has contributed negatively to the current fiscal crisis. In 2001, legal liabilities due to formal first instance judicial or arbitration decisions against the state amounted approximately US$500 million"1. This amount alone is cause for serious concern. But the growing trend being shown by statistical data is alarmning. If trends continues, it is estimated that by the year 2006, judgments against the State will represent approximately 2 percent of GDP. Figure 4. Accumulated Fiscal Cost of Contingent Liabilities Against the State 7,000 00 V 7,000 O4M 6,000 T , --000 ' 4,000 300 21000 Li 1995 1996 1997 1998 1999 2000 Sep-01 2002* Sources: Contralorfa General de la Republica, Contadurfa General de la Nacion and The World Bank 95. This scenario is aggravated by the fact that the state cannot afford to honor on time all compensatory payments. An extremely high rate of Penalty Interest (up to 30 percent p.a.) is applied, creating a "snowball effect" in the State's liabililies. This allows ample margin for unethical practices, as creditors "prefer" to be paid late and benefit from a very attractive return on their accounts receivable. iWorld Bank estimates based on data from the Contralorfa General de la Republica and the Contadurfa General de la Naci6n. Before the decision of the appeal level. Note that a single case still pending decision, Telecom, could generate compensation payments of up to US$282 million, adding great fiscal pressure that is not sustainable in the short term. 28  Annex 1: Letter of Development Policy TABLE 4. CONTINGENT LIABILrrIES-O0F BALANCE SHEET ITEMS (IN THOUSANDS OF MILLIONS OF COLOMBL4N PESOS) Dec Dec Var Dec Var Dec Var June Concept 1998 1999 Percent 2000 Percent 2001 Percent 2002 Litigation & claims filed 7.582,1 9.292,2 22,6% 11.892,2 28,0% 17.727,8 49,1% 20.213,7 Civil claims 997,7 1.712,4 71,6% 2.173,0 26,9% 6.512,0 199,7% 6.441,0 Labor claims 91,9 316,6 224,5% 508,9 60,7% 561,5 10,3% 605,0 Crimninal claims 2,3 76,0 ... 69,2 -8,9% 89,7 29,6% 88,5 Administrative 834,8 2.447,7 193,2% 8.227,8 238,2% 9.555,7 15,4% 11.818,3 Fiscal obligations 34,6 46,8 35,2% 43,4 -7,4% 35,2 -18,8% 34,5 Other obligations 5.620,8 4.692,7 -16,5% 819,9 -82,5% 973,7 18,8% 1.226,4 96. Regardless of the complexity of the situation, three distinctive elements can be identified as the main reasons for this problem. Firstly, there seems to be a web of civil servants, contractors, judges, attorneys, etc. engaged in coordinated corruptive practices that materialize in reciprocal favors of poorly drafted contractual agreements, fake accusations and claims, high compensation payments, intentional "erroneous" decisions, etc. 12 Secondly, the Colombian state has a weak capacity to defend itself in Court. The private sector is better equipped to retain expert legal advice and therefore their claims are exerted with much more rigor. Thirdly, the legal framework encourages the State to take the backseat in demands and claims from individuals. In labor and contracting legal issues, the State recognizes certain rights to counterparts, but in doing so, compromises its own position. 97. The Ministry of Finance, the Planning Department and the Ministry of Justice are especially concerned with the fiscal threat that originates from a weak legal and judicial performance of the State. These government units, with the support of sector ministries, the Procuraduria, the Contraloria and the Consejo de Estado, are committed to elevating the institutional capacity of the state to protect itself from legal claims as a precondition for an effective reform. 98. Key Policy Actions. The major challenge for the Colombian government is to introduce enforceable legal provisions that: a) minimize, if not eliminate, errors and/or weaknesses in the execution of government decisions and government contracts; and b) facilitate the strengthening of the government capacity to defend itself mandating a proactive approach in protecting State interests. 99. The key actions in this area seek to ensure effective budget compensation whenever the state is held responsible for contractual or extra-contractual damage, according to Colombian laws and international conventions --including those of the Inter- American Legal System-- signed by the country. The objectives of strengthening legal protection of the state are: i) to reduce negligence and corruption in the management of 12 This appears to have happened, for example, in the recent decisions against the state for the cases of Foncolpuertos and Tennorrio. 29  Annex I: Letter of Development Policy state affairs, including labor and commercial contracts; ii) to reduce fiscal impact of judicial and arbitration decisions against the state by seeking compensation from responsible officers or third parties; iii) to strengthen the state capacity to prepare, monitor and control large investment contracts and labor relations with a view to prevent contractual disputes; iv) to anticipate and prevent state responsibility for infringement of basic rights; and v) to foster a better investment climate through enhancement of transparency, predictability and responsibility in the state contractual and extra- contractual relations. 100. To achieve these goals a comprehensive policy will have to be designed from scratch. A task force of lawyers and procurement specialists will be charged with identifying and directly handling all judicial issues-or issues subject to alternative means of dispute resolution-that could have the most negative fiscal impact. A new binding rule will make it mandatory that sensitive sectors, particularly those representing high value transactions-such as telecommunications, electricity, and road concessions- require technical assistance from specialized professionals. This institutional strengthening program will also include generating information that is currently missing-such as better analytical data, specialized know-how of certain situations, and techniques for developing preventive and/or curative strategies. Together, the above measures should enable the government to systematically prevent and correct ongoing abusive legal claims against the State. 101. Strengthening Public Sector Procurement. Contracting and procurement with clear and transparent rules are critical for making efficient choices in buying goods and services, and averting corruption in the process. In Colombia, inefficiencies in public contracts are due to a large extent to the legacy of traditional patronage systems in the state and the lack of a clear division between the private and public sectors. A dispersed and highly diversified legal framework also contributes to procurement problems. 102. Presently some 80 laws regulate government purchases, with frequent overlaps and omissions. This debilitates monitoring and protects both buyers and vendors of services from being accountable to each other, providing much opportunity for corruption. Moreover, no central agency is in charge of promoting reform and determining rules that could introduce more transparency. Overly complex procedures thus still prevail, partly because the use of modem information technology is relatively weak. Finally, civil society does not yet play a significant supervisory role, which further undermines accountability and transparency. 103. Key Actions. The government has already taken a significant step towards enhanced transparency in procurement contracts. Decree 2170 of 2002, which regulates Law 80, adopted some Bank recommendations and international best practice to this effect. In addition, Congress is considering a draft law which seeks to reform Law 80 in a substantial manner, including simplifying the numerous special procurement regimes, among other measures. In addition, the government will: a) develop a concept for monitoring and evaluating government purchases since strong follow-up and control are critical to holding contractors accountable for results; and b) make extensive use of modern technology towards e-procurement for purposes of transparency and efficiency as well as for helping to lower compliance costs for the user. 30  Annex I: Letter of Development Policy 104. Furthermore, the government will implement a framework to facilitate public access to information on contracts. It intends to create a single data bank for all government purchases showing which contracts are being administered at any particular time. Moreover, civil society will be enabled to take a more prominent role in reviewing in decision-making processes by assuming a supervisory role in the selection process, while the State ensures that decisions are made more publicly. Finally, the central government will try to extend this reform program to municipalities and provide them with incentives for adopting in similar practices. Vertical Reforms 105. The process of public sector modernization emphasizes the need to rethink the role of the State; more systematically determining what activities should be conducted by government. This exercise has produced a "vertical reform" program whose objectives are to: (i) redefine the role of the State in each sector; (ii) design the organizational structure of each sector-leading entity; (iii) establish sensible structures of subsidiary entities; and (iv) rationalize personnel, reduce current expenditures and otherwise liberate public resources that can be reallocated to improvements in the provision of goods and services. 13 106. Cost containment . A large share of the above measures aim at the overall containment of costs, and many actions have already been taken. A decree has been issued for the rationalization of central government current expenditures, notably personnel expenses. There has been a reduction in the National Government's organizational structure. While many of these measures are not expected to produce substantial savings, they will send clear signals to bureaucrats and the public at large that this government is committed to keep public expenditures within available resources- even at the cost of some downsizing or political favoritism. 107. Some of the key downsizing measures include the elimination of three ministries by mergers with other ministries: Health with Labor; Interior with Justice, Development with Foreign Trade or Environment, and a selective retrenchment and training for staff made redundant (an instruction has been issued requesting downsizing of the central 14 administration through an indicative 20 percent cut in personnel) 108. The cost-containment effect of these reforms is supplemented by a number of important policy reforms that are expected to have a significant impact on public expenditures. First, the budget approved for 2003 includes significant reductions in real terms of public expenditures other than debt service. Second, the reform of the constitution via popular referendum includes provisions for freezing current expenditures15 for years 2003 and 2004 to their level (in current terms) in 2002. This initiative should produce savings of 0.7 of GDP in 2003 and 0.5 of GDP in 2004. Third, the government is committed to not-filling and eliminating 30,000 job posts presently empty or occupied by employees that will retire during the current administration. 13 The IDB is also providing technical and financial support to this component of the reform program. 14 If completely implemented, this measure, together with freezing and elimination of vacancy posts, should reduce the number of public employees by 40,000 -or a savings of 0.6 percent of GDP by 2006. '5 With the exception of lowest wages and pensions and military expenditures. 31  Annex 1: Letter of Development Policy 109. Key Policy Actions. Most of the vertical measures aimed towards an immediate reduction in public expenditure have already been taken. The key upcoming policy actions must therefore be geared toward achieving long-term, sustainable gains in efficiency and quality in the delivery of services by key public sector entities. This process of business process reengineering and institutional strengthening will take time and will require close supervision, input from clients, and other elements to guide the reforms in the medium term. 110. Management Contracts for Government Agencies. Colombia has good reasons to be disappointed with the so-called functional decentralization. Promoted by the administrative reform of 1968-70, functional decentralization was expected to create a number of specialized, technically managed, government agencies. With the passage of time,, more than one hundred government agencies were created -often with the expectation of becoming self-financing entities. 111. With only a few exceptions (most notably some local public utility companies such as Empresas Publicas de Medellin), these agencies were either captured by trade unions and other closed circles of stakeholders or have extended their life long beyond their initial raison d'etre. Many agencies create additional fiscal pressure for transfers from the central government or otherwise maintain a confusing system of back and forth transfers and credits with the central government. 112. Key Policy Actions. The government is pursuing some restructuring of at least 30 government agencies during the four years of the Uribe administration. Re-engineering should provide the basis for adjusting and self-financing. A complementary step will be the design and implementation of management contracts with specific revenue and balance targets for two pilot agencies selected among the largest government agencies.'6 If successfully applied, those pilots should lead to further extension of management contracts under subsequent administrations. Manauement of the Public Sector Reform Process 113. Reforming the State is a complex undertaking that challenges any government's capability. This is also true for Colombia as it prepares for its ambitious reform program. For this to be successful it must be able to respond to two fundamental questions: 114. Will the process have enough stakeholder involvement? As the reform process unfolds-but especially in the short run- resistance by political and social groups often tends to increase rather than decrease. Policymakers cannot take for granted that all stakeholders participate in and approve of the changes. Maneuvering through these obstacles requires careful choices and smart communication strategies. This is especially true for Colombia since, during the initial phase of reform design, the public sector reform program very much followed a top-down approach with little room for consultation. and open, participatory politics. To be sure, the DNP enjoys much respect within the government and has the backing of the highest political leadership in the 16The country has already experimented with and drawn lessons from the SFAL-supported management contract for the Social Security Institute, ISS 32  Annex I: Letter of Development Policy country. Moreover, this government was elected by an overwhelming majority that has been fully supportive of the president's reform program -and his government's exceptional capacity to pass and implement long-expected reforms-- since the days of the Presidential campaign. What is needed now -and the government is aware of it-is to instill understanding ownership of the proposed reforms within the legislature, the private sector, academia, think-tanks, NGOs and civil society at large. Management of the reform process has to be primarily geared to extending ownership of the reform beyond the small circle of technocrats that put together the technical details of the reform program. In addition, managing a growing number of participating agencies requires oversight and knowing precisely who is responsible for what at each stage of the process, while simultaneously adjusting to changing circumstances and opportunities. 115. Can the impact of the reform be properly evaluated so that politicians can be held accountable? Contracting for results is not only a modern management tool for service delivery; its principles also apply for reform processes of governments. In an ideal setting, politicians would set clear goals and commit themselves to reach certain results and targets; progress-and more important -outcomes and impact of the reform-would be evaluated and politicians would be held accountable for their actions. Each of these tasks poses a considerable challenge to the government which must respond by creating a conducive institutional framework for reaching the envisaged goals. This is particularly challenging since the reform is already well under way and moving with quickening pace. At the same time, there is a growing demand for results from civil servants, the media and the electorate. 116. Key Policy Actions. To meet the above challenges, common to any administrative reform process, the government has chosen to establish a systematic management of the reform process, consisting of four components: political coordination, technical coordination, communication and public marketing, and monitoring and evaluation. 117. Political coordination. Gaining the acceptance of political actors is key for successful reform. Initially, this role will be played by the National Commission for Economic and Social Policy (CONPES) as the principle planning commission. Over the course of the reform, however, there will be the need to guide the process on a more continuous basis to avoid the danger of loss of political momentum. Not all participating ministries are equally affected or interested in the State reform process, so much specificity will be gained from working only with the most relevant onesby creating a specialized commission in addition to CONPES. This core Commission for State Reform (CSR) has already been established, composed of the Ministry of Finance, the Planning Department and the Departamento Administrativo de la Funcio'n Piiblica. 118. Technical coordination. Transforming political priorities and goals into effective application is the challenge that underlies technical coordination of the process. The DNP will tackle this by regularly incorporating into its work the advice of top experts in State reform, initially for the crafting of general government policy. In the medium term, this should be complemented by a group of seasoned experts to consult independently. Equally important is the establishment or continuing support of technical task teams in both DNP and each of the ministries and agencies subject to reform. The entire process will be supported by CSR. 33  Annex I: Letter of Development Policy 119. Communication and public marketing. The benefits and costs of reform will not be equally distributed and some citizens will not be directly or immediately affected by certain actions. Therefore, an effective public marketing strategy is needed to reaching out to involve and obtain the support of a wide array of Colombians for the requisite institutional changes. This must be tailored to different audiences and their particular information needs. 120. Monitoring and evaluation. Conducting systematic monitoring can critically contribute to informed decision-making at the political and technical level. As a first step, the tasks include development of a baseline and the establishment of indicators. When done properly, monitoring and evaluation add much to the quality and sustainability of reform, providing the necessary information to generate needed public support. In. THE PROPOSED PROGRAM AND OPERATIONS A. LINKS WITH THE BANK'S ASSISTANCE STRATEGY 121. As described in the 2003 CAS discussed at the Board on January 19, the WBG's strategy will seek to support Colombia's quest for peace in three essential areas: a) achieving fast and sustainable growth; b) sharing the fruits of growth; and c) building a government of quality. To support this strategy, the Bank lending program envisioned in the CAS focuses on operations that would: a) have the most tangible impact on poverty alleviation; b) achieve fast and sustainable growth while protecting the poor; c) incorporate the lessons learned from Bank's operations, particularly from on-going Learning and Innovative Loans; and d) pilot innovative interventions with important demonstration effects. 122. The FIAL will directly contribute to achieving the Country Assistance Strategy (CAS) objectives from a variety of perspectives: * CAS Goal "Achieving Fast and Sustainable Growth": The fiscal consolidation supported by the proposed loan would protect the country's rnacroeconomic framework by reducing the likelihood of fiscal crises and inflation that would most impact the poor. Fiscal stabilization will promote a better investment climate and facilitate access to markets in better terms. * CAS Goal "Sharing Growth with all Colombians": While this programn will not directly address inequality, the public sector reform component contributes to better and more uniform spending for all groups of society. More importantly, by broadening tax bases and improving tax administration, the costs of revenue raising will be shared more equally across citizens. By preventing major fiscal crises and focusing on quality and quantity of public service delivery, the FHAL-supported program also ensures that essential public services would continue to be available to those who could not otherwise procure them-namely, the poor and most vulnerable. 34  Annex I: Letter of Development Policy CAS Goal "Building a Government of Quality": Creating a more efficient and more transparent government lies at the core of the institutional reform program. Reforming budgetary institutions, introducing results-oriented management-both intra-government and among levels of government-streamlining the operation of ministries and agencies, making a more transparent procurement system, and evaluating the results of government services would contribute to the achievement of this goal. 123. Linkage between the Programmatic Fiscal and Institutional Adjustment Program and other Bank operations. The proposed Programmatic series of Fiscal and Institutional Adjustment Loans to support public sector reform and fiscal adjustment is the core of the Bank's support to the reform efforts of the government and it will provide the basis upon which complementary policy-based operations will be developed. These include support to the financial sector in the form of Programmatic Financial Sector Adjustment Loan (FY03 and FY04) that aims to promote the development of a well- functioning financial system that can provide adequate services to all segments of the productive sector and the population at large. In addition, building on the achievements of the Financial Sector Adjustment Loan (FY00), it will address the remaining agenda to ensure the health and financial sustainability of the banking system and to foster capital markets development. 124. The anticipated Sustainable Development Sector Adjustment Loan (FY05) will support the mainstreaming of environment in practically all infrastructure sectors, including water and sanitation, energy, transport and disaster management. The tools for mainstreaming environment include: policy setting, strategic environmental assessments, land use planning (planes de ordenamiento territorial), permits and licensing, environmental regulation, economic and fiscal instruments, social impact analysis and valuation, assessment and linkage with global environmental goals, participation and conflict resolution mechanisms, and development of sector-environment indicators linked to health impacts. These tools are currently being used in most sectors, however this operation aims to enhance effectiveness and impact by providing a more rational application based on priority-setting and institutional analysis (how the environmental management institutions set priorities, receive budgets, and function). 125. The anticipated program of Labor and Social Sector Adjustment Loans (FY04 and FY05) will support the policy and institutional framework to enhance decentralization in education. In addition, it will support reforms in the health sector to create a financially sustainable system that provides incentives for greater efficiency and that will deepen the reform initiatives of the early 1990s to improve coverage, access, quality and equity. It will also implement reforms in the treatment of labor, such as improving the efficiency of the training system now in place by means of redefining the role of SENA. Two important issues related to Colombian labor markets are: (i) payroll taxes; and (ii) wage inflexibility. Studies will be carried out to shed light on initial steps that might be taken to tackle these issues. These steps may include the explicit regulation of apprentice contracts (that permit firms to hire apprentices without paying some taxes and at lower wages) and the introduction of portability for many social security benefits financed by means of payroll taxes. 35  Annex 1: Letter of Development Policy 126. In addition, the FIAL program is highly interrelated with the current MAFPII Project, aimed at strengthening budgeting, tax administration, public investment management, procurement, and results management, and will provide significant inputs and support for the proposed FIAL. 127. Complementarities with Other Institutions' Operations. The IMF has signed a stand-by agreement with the Colombian government in January 2003. The IDB is considering to provide support to the government of Colombia in some of the reforms classified as "vertical," that is, sector reforms such as downsizing (including personnel cuts) and adjustments of the government structure. The IDB is also considering to support the expansion of e-government in Colombia. B. OBJECTIVES AND DESCRPTiON OF THE PROGRAM 128. Overall Objective. The objective of the program is twofold: first, to promote reforms addressing fiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The emphasis of the reform programt will gradually shift, from tax andfiscal responsibility at the beginning, to expenditure and public sector reform towards the second and third years of the program. 129. These objectives are the backbone of the government's broad program of reforms, which includes significant policy actions to increase the mobilization of resources to the public sector, improve critical public administration processes, and enhance the efficiency and effectiveness of key government institutions. The Bank's support for this ambitious program is well complemented by the efforts of other development partners and will be structured under a proposed Programmatic Fiscal and Institutional Adjustment Loan (FLAL). The Bank has received a Letter of Development Policy that outlines the Government's vision (Annex 1) and requests the Bank's financial support. 130. Specific Objectives. This program supports the following key elements of the Government's reform program over the next four years17: * Increase tax revenue and reduce distortions in the tax system; * Modernize tax administration; * Improve budget management with modern tools and legal reformns; * Develop incentives for efficiency gains in subnational entities; * Prevent massive losses to the State from judicial claims; * Strengthen the public sector procurement system; * Reduce losses and generate revenues through improved asset management; * Improve performance through management contracts for government agencies; * Promote the development of a sound fiscal responsibility legal framework; and * Support a coherent and comprehensive reform implementation process. 17 The detailed set of benchmarks for the first loan and an indicative detailed list of benchmarks for the second and third loans are specified in the policy matrix in Annex III. 36  Annex I: Letter of Development Policy 131. This program is being supported by a series of up to four loans, with a notional envelope of up to US$900 million in total. Depending on successful implementation of the program, the proposed first loan in the amount of US$300 million would be followed by subsequent loans with the notional amounts of up to US$150 million; US$150 million; and US$300 million. These envisaged loans are fully consistent with the Country Assistance Strategy (CAS) of 2003. 132. The current loan capitalizes on lessons learned by: i) supporting government commitment to undertake constitutional, legal and administrative measures to reduce budget entitlements and enhance expenditure flexibility; ii) enhancing transparency, dissemination and reporting standards that call for participation of civil society in monitoring budget allocations and expenditure efficiency; iii) strengthening subnational capacity to effectively manage social services; and iv) introducing and/or ensuring application of efficiency signaling and conditioning in fiscal transfers for social sectors. 133. Technical Assistance. Many of the technical assistance requirements of several key components - particularly tax administration, budgeting and procurement- as well as the financial management or evaluation features of other components, will be partially or fully provided by the MAFPII project, currently in execution. In addition, the Government and the IDB are considering to include technical assistance support for other FIAL components -particularly asset management and legal protection of the state-- under an IDB-TAL project currently under preparation. Moreover, the GOC and the Bank have initially agreed that, should it become necessary, a technical assistance loan (TAL) can be prepared to support the implementation of other areas of the FIAL reforms, particularly management contracts for government agencies. 134. Fiscal Commitments. Within its macroeconomic framework, the government signed a new Stand-By loan with the IMF in the amount of SDRI.5 billion for the next two years (See Annex if). Achieving the structural benchmarks of the agreement will constitute an overarching policy condition for the FIAL. Some of the targets of the IMF- backed program for 2003 are a consolidated non-financial public sector deficit of 2.5 percent of GDP, a current account deficit of 0.8 percent of GDP and an inflation rate between 5 and 6 percent. 135. By the end of the program, it is expected that the Colombian Government will be able to address social demands and implement its program under a framework of increased fiscal flexibility, while maintaining macroeconomic stability. C. THE PROPOSED OPERATION 136. The first operation of the program is primarily designed to support the first phase (Congressional approval) of the constitutional referendum, the tax reform, and the initial measures that comprise the building blocks for other/subsequent public sector reform initiatives supported by the overall program. It is proposed as a single tranche loan to be fully disbursed in March 2003. The timing of the first loan is calibrated to support the government in its efforts to deliver an immediate confidence-building signal to the markets through major reforms that have recently been approved or are being implemented in the first weeks of 2003. 37  Annex I: Letter of Development Policy 137. The first loan is linked to, inter alia, the tax reform law, the law that grants special authority to the government to adopt administrative reform measures, and the law that authorizes the constitutional referendum. It also supports government initiatives and preliminary congressional approval for the constitutional reform that gives power to the borrower's Executive Branch to control and manage the budget within fiscal targets and the fiscal responsibility law. Triggers for second loan include, among others, the final approval of the fiscal responsibility law. The second, third and fourth loans, all envisioned as single tranche operations, will be addressed primarily to institutional reforms and improvements in tax administration. The detailed legal and regulatory reforms required as riart of the first loan are shown in the following table: TABLE5: REFORMS SUPPORTED BY THE FIAL FIRST LOAN (US$300 MILLION) I . The Borrower has attained, for the period covered by any three (3) continuous months among the twelve (12) months preceding withdrawals from the Loan Account, an overall deficit of the Combined Public Sector of no more than US$1,352,000,000 equivalent to P$3,874,000,000,000. 2. Borrower has enacted tax reform law (Law 788 of 2002), including: a) reduction of exemptions and expansion of the tax base for the VAT b) reduction of the wage tax exemption from 309% to 25% with a ceiling in the amount of Col$16 million in monthly wages (rentas laborales) and reduction of tax exemptions, tax credit and non-taxed income for the personal income tax, and c) the phasing out of the corporate income tax exemption for capital gains from sales of stock, mutual funds and real estate, and as well as for profits from corporations previously exempted. 3. The Ministry of Fmance, through DIAN, has enacted new rules for tax administration including: a) daily interest payments higher than Col$900 are subject to withholding at the source; b) obligation of financial institutions to report information on taxpayers' accounts that are credited with annual interest of at least Col$5 million'8, and/or have total annual deposits equal or higher than Col$50 million; c) establish a list of collectable tax debts on December 31 of 2002 and elaborate a plan and set up a schedule to collect at least 20 percent of these collectable debts; and d) establish indicators of customs clearance time and procedures to select shipments for inspection based on a risk-management system for the customs offices of BogotA and Medellfn. 4. Borrower has submitted to congress and congress has approved, in first round, constitutional reform that gives power to the borrower's Executive Branch to control and manage the budget within fiscal targets. 5. Royalty transfer: borrower has enacted law to enable constitutional referendum for transfer of royalties for educational services. 6. Borrower has promulgated Law 790 of 2002, that grants authority to central govemment for strengthening the Direcci6n de Defensa Judicial del Ministerio del Interior y de Justicia with the purposes of: a) policy formulation and coordination for the limiting the state's civil liability; b) to demand indemnization by borrower's civil servants who acted with gross negligence and bad faith; and professionalization of judicial defense of the state. 7. Government has issued Decree 2170 dated September 30, 2002 that strengthens transparency and objectivity in public sector procurement. 8. Bill of Law 018/2002 modifying current public sector procurement legal framework in consideration by borrower's Congress. 9. Government has created a Commission for Asset Management charged with preparation of draft government policy, define the scope of work and an operational plan to define accounting systems and inventories in public agencies. 10. Government has selected at least two government agencies, agency intervened 6y central government for pilot management contracts 2003-2006. 11. Borrower has: a) published its strategy of state reform; b) established a high level commission for state reform and a task team for technical coordination; c) formed task teams in each participating agency with coordination mechanism with DNP; and d) developed a concept for public marketing of public sector reform. The borrower has submitted to Congress the proposal for a bill of law for fiscal responsibility. 18DLAN Resolucion 10537, October 29, 2002 38  Annex I: Letter of Development Policy 138. Loan Amount. The proposed (US$300 million) loan in the form of a fixed spread, U.S.-dollar-denominated loan would be made to the Republic of Colombia. Disbursements under the proposed program would be made to an account (Deposit Account) of the Republic of Colombia, established at the Banco de la Republica for this purpose. The first loan would have one tranche of US$300 million - expected to be disbursed in March 2003. D. SUBSEQUENT OPERATIONS 139. The second, third and fourth loans are expected to primarily support the implementation of the institutional reform process, whose basic foundations will have been developed with support of the first loan. 140. Annex m lists the triggers for these future operations. Those triggers will serve as guideposts to signal progress of decisions/actions towards achieving the objectives of the reform program. Triggers were chosen on the basis of their importance in the government's fiscal strengthening program and their contribution to implementation of subsequent reforms. 141. The nine key policy measures that make up the individual triggers for the second loan are listed below. These triggers are critical for the success of the program and their implementation will form the basis for the preparation and presentation of second loan. The triggers for the third and fourth operations will be drawn from the government's program (see Section II of this report) and, in particular, the set of expected key reform measures set out in the Policy Matrix in Annex m. Revenue Rigidities and Tax Reform (1) Government has issued the necessary legislation to regulate the application of Law 788 of 2002 (2) DIAN has: a) developed and implemented software to cross reference information with financial institutions to ensure that interest reported by them match interest reported by taxpayers; b) audited at least 50% of large taxpayers affected by the new taxes; c)established and published indicators of the cost and time required for compliance by the taxpayer, and d) established unified accounts between customs and domestic taxes for large taxpayers beginning in 2003. Expenditure Rigidities and Institutional Reform (3) Borrower has approved a Constitutional reform that restores budget powers to the Borrower's Executive Branch, or Government has submitted to Congress amendments to the organic budget law permitting greater flexibility in annual spending within present constitutional framework. (4) Borrower has submitted to popular vote the provision of the Referendum that reallocates royalty transfers for educational services. 39  Annex 1: Letter oJ Development Policy (5) Borrower has issued a CONPES docurnent establishing the new policy for legal defense of the state, including legal reform if necessary. (6) Borrower has proposed to Congress the. modifications to the legal bill amending Law 80 that incorporate the recommendations of CONPES, emphasizing: a) Common principles for public sector procurement; b) introduction of economic considerations into the procurement process; and c) institutional framework for public sector procurement. (7) Central government has signed management pilot contracts with at least two government agencies. (8) Short terrn Asset Management program has produced revenues or savings equivalent to at least 27,000 million Colombian pesos of 2002. Fiscal Responsibility (9) Borrower has approved a Fiscal Responsibility Law acceptable to the Bank, that contains, at a minimum, rules for: a) setting fiscal targets linked to debt sustainability and primary balance for the NFPS; b) annual reports of fiscal results to Congress, including floating debt; c) publication of the financial plan that will include, among others, information on floating and contingency debt; and d) the obligation to include the fiscal impact and source of financing within any law that creates new tax expenditures. E. FIDUCIARY POLICIES 142. Environmental Aspects. Being a structural adjustment program, the proposed operation does not trigger OP 4.01, and, as a consequence, does not require an environmental rating. The Quality Assurance Team (QAT) has reviewed the Program Document for the project and determined that it has no direct effect on safeguard issues. 143. Procurement and Financial Administration. The Bank plans to advance work in two distinct stages. First, a short financial management risk assessment (FMRA) should be ready by the end of March 2003, then a CFAA should be completed in about eight months. This new CFAA will raise the questions of: a) how does the current state of public financial management in Colombia affect the country's efforts to stimulate economic growth, and b) what remedial measures should be taken to improve the current state of financial management in the country. Both assessments will contribute to the design of subsequent loans of the FIAL. In particular, the CFAA team will be able to contribute relevant Policy- actions which could be embedded in the policy matrix for upcoming FIALs. Moreover, the FMRA team will advise with regard to audit of the depository account at the Central Bank. In addition, a Country Procurement Assessment Report (CPAR) was prepared in March 2001. 144. The program currently takes into consideration the recommendations of the CPAR and the basic guidance of the previous Country Financial Management Assessment (CFMA), dated September 2001. As the new CFAA becomes available, the subsequent loans of the program will incorporate the additional insight into all relevant areas of the operation, in particular the budgetary reform process. 40  Annex I: Letter of Development Policy 145. As mentioned earlier in this document, the Bank is currently financing the implementation of the MAFPII project, which is a joint effort of MHCP, DNP, and DIAN. Among its key objectives are the modernization of the public procurement process (including legal reform), review and reform of the budget process, implementation of financial management information systems, and support to government accounting. All of these efforts are compatible with the FLAL and are the primary source of technical assistance requirements for the implementation of the budget and procurement related components of the program. F. BENEFITS 146. Fiscal Adjustment The reform program supported by the FIAL would put the NFPS accounts on a more sustainable path. Each of its proposed measures carries fiscal implications, which are singled out in the projections, through 2006, shown in the following charts and figures. As shown in Table 6, the reforms are projected to improve the overall balance of the non-financial public sector by 0.8 percent of GDP in 2003, relative to the alternative without reforms. Continued pursuit of the reforms, which the proposed programmatic program will support, is projected to have a fiscal benefit of over two percent of GDP by 2006. Clearly this will contribute to meeting the CAS high-case criteria of making the public sector debt sustainable. As reflected in Table 6, reform of tax policy and tax administration make the largest projected contribution, with the legal defense of the state and public asset management (horizontal reforms) contributing most of the rest of the savings. When combined with the constitutional referendum, the vertical reforms, and the pension and labor reforms just approved by congress, the impact of the whole reform package is projected to reach 4 percent of GDP primary surplus -as envisioned in the CAS. 41  Annex I: Letter of Development Policy Figure 5 and 6. NFPS Expenditure and Revenues Excluding Interest Payments. Alternative Reform Scenarios (2000-2006) Expenditure Revenue 31 ~30 ~29 j2.7 1 _ _ _ _ _ _ _ _ _ _ ___ __ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 27 26 28 .................fi i 27 25 - W*h Refimns ....... Wm Ref Wh Rd*m= -.... -..-- Wkibut Refm 147. The measures supported by the FAL would prevent-and reverse-an otherwise unsustainable debt and debt-service accumulation, while also protecting social sector expenditures and vulnerable groups. To achieve these targets, the combination of policies will enhance revenues and rationalize spending. Those policies include, among others, budget reforms that will produce efficiency gains that will allow the government to finance additional programs and reduce the fiscal pressure. The non-financial public sector deficit of 4 percent of GDP would be virtually eliminated by the year 2006. Figure 7: NFPS Primaiy Balance Alternative Reforms Scenarios (2000-2006) 4.5 4.0 - ..3.5- 3.0- CD 2.5- .. 1.0 0.5 0.0 II No Reformis U With Reforms 42  Annex I. Letter of Development Policy [Figure 8 Net Public Debt. Alternative Reform Scenarios 2000-2006 65L 60 55 50 45 40 200 200 200 200 200 200 200 35 - I 2 , , I , I 6 - No Rdbn -nWith Refonns 148. If no reforms were implemented or if these reforms were delayed, the NFPS would remain on an unsustainable path, and probably spiral into protracted-increasing deficits. Instead, as a result of the reform package, the public sector's debt path will change significantly. Colombia's ratio of net public sector debt to GDP would remain on a more manageable path and stabilize at levels slightly above 50 percent of GDP by 2006 (Figure 8). 43  Annex I. Letter of Development Policy TABLE 6. PUBLIC SEcTOR EISCAL BALANCES, SCENARIO WIrH REFORMS (2001-2006) Percent of GDP' 2001 2002p 2003p 2004p 2005p 206p Total Revenues 29.3 29.5 29.9 29.6 29.6 29.5 Current Revenues 29.3 29.5 29.9 29.6 29.6 29.4 Tax Revenues 19.1 19.3 20.1 2.0.4 20.6 20.7 of which: Tax Administration 0.1 0.2 0.5 0.5 of which: Tax Policy 2 0.6 0.9 1.0 1.1 Non-Tax Revenues 10.2 10.2 9.8 9.2 8.9 8.8 Property Income 1.3 0.9 0.9 0.8 0.8 0.7 Operational Surplus of Public Enterprises 4.2 4.6 4.4 3.9 3.7 3.6 Other 4.7 4.7 4.5 4.4 4.4 4.4 of which: Public Asset Management 0.0 0.1 0.1 0.1 Total Expenditure and Net Lending 33.0 33.9 32.5 31.1 30.7 29.9 Current Expenditures 24.7 25.6 25.3 24.6 23.4 22.3 Wages and Salaries 7.4 7.6 7.2 6.5 6.4 6.3 of which: Effect of Acto Legislativo4 -0.2 -0.3 -0.4 -0.5 Goods and Services andOther 3.5 3.7 3.2 3.1 3.0 2.9 Interest 5.0 4.6 5.1 5.1 4.7 4.4 External 2.2 2.2 2.4 2.4 2.3 2.2 Internad 2.7 2.4 2.6 2.7 2.5 2.3 Transfers to Private Sector 9.7 9.9 10.0 10.0 9.4 8.8 of which: Savings Due to Legal Defense of the State 5 -0.3 -0.3 -0.6 -0.7 Other -0.9 0.0 -0.1 -0.1 0.0 0.0 Capital Expenditure 8.2 8.2 7.1 7.1 7.4 7.6 Fixed Capital Formation, cash basis 8.1 8.1 7.1 7.1 7.3 7.5 Transfers 0.1 0.1 0.1 0.1 0.1 0.1 Net Lending 0.1 0.1 0.0 0.1 0.0 0.0 Statistical Discrepancy 0.3 0.0 0.0 0.0 0.0 0.0 No financial public sector balance -3.4 -4A -2.5 -2.5 -1.1 -Q4 Quasi-fiscal balance 0.7 0.6 0.4 0.4 0.5 0.5 FOGAFIN balance 0.2 0.2 0.1 0.1 0.1 0.1 Net cost of financial restnicturing -0.7 -0.5 -0.5 -0.5 -0.2 -0.2 Overall balance -3.1 -4.0 -2.5 -2.1 .0.7 0.0 Overall Financing 3.1 4.0 2.5 2.1 0.7 0.0 Memorandum itern NFPS Primary Balance, with reforms 1.6 0.2 2.6 2.9 3.6 4.0 NFPS Priniar Balance, no reforms 1.6 0.2 1.2 1.2 1.2 1.2 Source: Ministry of Ftnance, IMF and World Bank Esimates 1. Annual tax collection increases, on average, by about US$250 million in the 2003-2006 period as a result of increased tax compliance and enforcement. Tbese are conservative estimates relative to the government's projections. 2. Annual tax collection increases, on average, by about US$700 million in the 2003-2006 period as a result of changes in income tax, VAT and territorial taxes. These are conservative estimates relative to the government's projections. 3. Annual income form improved management of public assets averages US$60 million in the 2003-2006 period. 4. The annual operating expenses of the public sector fall by about US$280 million, on average, in the 2003-2006 period. The Acto Legislativo sets a 2 percent ceiling on the real growth rate of transfers from the national to sub-national government. The Acto Legislativo also sets a 1.5 percent ceilng on the real rate of growth of government operating expenses. 5. Annual savings averaging US$400 milion in the 2002-2005 period result from improved legal defense of the State. 149. Social Impact Colombia's social conflict constitutes one of the most determining elements of its fiscal and public sector reform requiremenits and prospects. The government has successfully established a climate of dialogue and understanding backed by determined application of its laws to contain social movements within the constitutional order. It has worked in close collaboration with Congress and political parties to enact substantial reforms that hacl been impossible to achieve in previous administrations. Moreover, the government is inviting the population at large to vote on a referendum that will substantially amend the constitution. The government also offers a package of vertical and horizontal reforms of the public sector airmed at enhancing 44  Annex 1: Letter of Development Policy transparency and accountability, citizen participation in public affairs, public administrative efficiency, and higher coverage and quality of service delivery. 150. This project intends to ensure the feasibility and sustainability of this package of reforms by strengthening the fiscal capacity and the adequacy of government actions, while simultaneously minimizing risks in the government's comprehensive, multi-sector reforms. If this package is successfully implemented and maintained after the change of administration, Colombia should have a public sector that is more responsive to citizen demands, accountable, and participatory. For the broader citizenry it can be expected that the reforms will contribute to better service delivery and a more transparent form of government. 151. The public sector reform process includes the elimination of at least 40,000 jobs in the central administration, of which 30,000 will come from the elimination of the posts of employees who reach retirement during the next few years, and the rest from the elimination of staffed positions. All staff deemed redundant will receive the legally established severance package, and those who are not legally entitled to removal benefits (such as temporary or directly appointed staff) will receive at least one year's salary as severance. In addition, all those who lose their employment will be entitled to participate in a retraining and career counseling program. Finally, the government has indicated its commitment to the protection of vulnerable groups and will ensure that single mothers without job alternatives, the handicapped, and those about to reach retirement age will not be removed. 152. The social impact of the program will be closely monitored jointly by the borrower and the Bank. Assessments will measure the family income effect and the overall poverty and inequality effect on the basis of the country's household surveys. 153. Poverty Impact The proposed FIAL will contribute to poverty reduction at all levels. First, it will help protect the macroeconomic framework of the country by reducing the likelihood of widespread government fiscal crises. This is important since, as noted, the Bank's analysis shows that negative macro shocks are the most important cause of poverty increases in Colombia. Second, the various proposed sectoral reforms which FIAL would support should sustain economic recovery, consolidate economic growth in the medium and long term, and reduce poverty. It also bears repeating that economic growth continues to be the major source of poverty reduction and social stability in Colombia. 154. Third, the FLAL will also ensure that through the fiscal strengthening program, in particular the tax reforms, more resources will become available to help ensure the allocation of adequate public resources to social programs and reduce the insecurity that affects particularly those that lack the resources to protect themselves. This is especially pertinent for education and health, facilitating the provision of public services for the poor. Fourth, the FIAL supports measures to improve the efficiency and coverage of these services, benefiting the poor directly. This is to be achieved through better budgeting, the results agreements and their evaluation, and more transparent procurement. These together should ensure that essential public services are more efficiently available to those who could not otherwise obtain them on their own. 45  Annex I: Letter of L)evelopment Policy G. RisKis 155. The proposed program carries considerable risks. With regard to internal risks, the first is that the overall political context, including the conflict and violence associated with illegal drug activity, could escalate, which would negatively impact the implementation of the program. Although Colombia is deeply committed to ending the violence that has plagued the country for decades, and has obtained the pledge of the international community to support this endeavor, the conflict could still intensify during the next few years. The FIAL supports reforms that will help liberate resources to address the country's priorities during transition from the conflict to the post-conflict era. The FIAL will also support introduction of institutional reforms that would help consolidate peace and stability during the post-conflict era. 156. Second, due to the internal conflict the government may be unable to endure prolonged social disruptions and resistance from major interest groups (such as teachers and health sector unions) that could derail the reform agenda and lead to more social and political instability. The government is reducing this risk by working together with political parties, congress, the judiciary and independent auditing and control agencies in the formation of a broad-based state coalition that ensures continuity of reforms within the public sector. The program supported by the proposed loan promotes the joint effort of all branches of the Colombian state, private capital and civil society through built in participatory, consultation and other consensus building mechanisms. Consensus building instruments have been incorporated in each one of the proposed components and in the overall management of the reform process. If successfully applied, consultation and evaluation should be sufficient to mobilize government and non-government institutions in support of the reforms and overcome resistance from particular interests that have previously captured the state. 157. Although President Uribe won the elections with a substantial majority, it is not certain that he will be able to maintain the needed level of support to implement important reforms. Congress could block or alter policy initiatives and/or the Constitutional Court could reverse key reforms. This risk is lessened because the reform program proposed by the Uribe Administration has the support of both major political parties and the government reform program, including initial reform measures, has been fully endorsed by the vast majority of the population. Furthermore, the composition of the Constitutional Court has changed and its recent rulings have been more pragmatic and market-oriented. 158. The Referendum approved by Congress on December 2002 that contains most of these reforms will be placed before the people in 2003. In this connection, and in order to avoid delays in advancing the government's program, most of those reforms that require Congressional approval were included up front -and have been largely approved by Congress-- during the first year in the program. Congressional approval of long- pending reforms such as pensions, tax or labor is by itself an indication of the government capacity to mobilize legislative and country-wide support in favor of reforms that had been impossible to achieve during the previous decade. Besides, the government has put together a dissemination and participation strategy geared to ensure discussion, mobilization and ownership from civil society. 46  Annex 1: Letter of Development Policy 159. There is of course the risk that the Referendum approved by Congress will not be supported by the population. The government is already planning on substitute measures in case the Referendum is not approved by the people. Those substitute measures would include: i) gradual elimination of some special pension regimes through legal reform and collective bargaining; ii) law reform proposals and administrative measures to ensure expenditure cuts and additional tax revenues with a fiscal effect that is at least equivalent to the expected impact of current expenditure freeze, and iii) national government put pressure on subnational governments that currently receive royalty transfers to concentrate their project proposals in the education sector. 160. Third, through external or internal shocks, the fiscal situation may deteriorate, which would jeopardize the macroeconomic situation. The World Bank program, and that of the IMF and IDB, are intended to lessen this risk by demonstrating active, visible support of the government's proposed fiscal and public sector adjustments. The macroeconomic situation may also be weakened by external factors such as regional political or economic instability or further deterioration of the terms of trade. On balance consequently, the FHAL is judged to be a "high-risk, high-return" program. Therefore, it will be essential to maintain a close working relationship with the client, and to provide ample, ongoing dialogue and assistance during the implementation period. To this end, the parallel TAL (MAFPH) will provide an important opportunity for the Bank to closely accompany the program. The supervision activities of MAFPII will be a fundamental vehicle to maintain frequent coordination with the Government counterparts. All these reflect the belief that, as this program would form the core of the Bank's interventions in Colombia, its successful implementation will be critical. 47  Annex!: Letter of Development Policy Annex I (Translated from Original in Spanish) REPUBLIC OF COLOMBIA MINISTRY OF FINANCE AND NATIONAL PLANNING DEPARTMENT LETTER OF DEVELOPMENT POLICY TO THE WORLD BANK BogotA, January 20, 2003 48   Annex 1: Letter of Development Policy Bogot