Documentof TheWorldBank FOROFFICIAL USEONLY ReportNo. 36274 TR - INTERNATIONALBANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSEDLOAN INTHEAMOUNT OFEURO403 MILLION TO THEREPUBLICOFTURKEY FORA PROGRAMMATICPUBLICSECTOR DEVELOPMENTPOLICYLOAN(PPDPL) June 5,2006 PovertyReductionandEconomicManagementUnit HumanDevelopmentSector Unit Turkey CountryUnit EuropeandCentralAsia Region This documenthas a restricted distribution andmay be usedbyrecipients only inthe performanceof their official duties. Itscontentsmay not otherwise be disclosedwithout World Bank authorization. TURKEY GOVERNMENT - FISCAL YEAR January 1-December 31 CURRENCYEQUIVALENTS (Exchange Rate Effective as of May 31,2006) Currency Unit New TurkishLira (YTL) US$ 1.00 1.5600New TurkishLira(YTL) YTL 1.00 US$O.64 WEIGHTSAND MEASURES Metric System ABBREVIATIONAND ACRONYMS ASCUS Agriculture Sales CooperativeUnions BEEPS BusinessEnvironment and EnterprisePerformanceSurvey BRSA Banking Regulationand Supervision Agency CAR Capital Adequacy Ratio CAS Country AssistanceStrategy CBRT Central Bank of Republic of Turkey CIT CorporateIncomeTax CCT Conditional Cash Transfers CEM Country Economic Memorandum CFAA Country Financial Accountability Assessment CPI ConsumerPrice Index DFIF SupportPrice Stabilization Fund DIS Direct Income Support EBA Execution andBankruptcy Act EBFs ExtraBudgetary Funds EGDPL Employment GenerationDevelopment Policy Loan ES EmekliSandigi (PensionFund) EU EuropeanUnion FDI ForeignDirect Investment FIRST Financial SectorReformand StrengtheningInitiative FX ForeignExchange FOREX ForeignExchangeMarkets GDP Gross Domestic Product GDPA GeneralDirectorate of Public Accounting GFS GovernmentFinancial Statistics GNP Gross National Product GRECO Group of States Against Corruption HPC HighPlanningCouncil HTP Health Transition Project IACB Internal Audit Coordination Board IBRD International Bank for Reconstruction and Development IMF InternationalMonetary Fund LDP Letter of Development Policy M&E MonitoringandEvaluation MOF Ministry of Finance MOH Ministry of Health MOLSS Ministry of Labor and Social Security MTFP MediumTermFiscal. Plan MTP MediumTermProgram NAO National Audit Office NBFI Non-Bank Financial Institutions NGO Non-Governmental Organization OECD Organization for Economic Cooperationand Development PASB Public Accounting StandardsBoard PEIR Public Expenditure and Institutional Review PEM Public ExpenditureManagement PER Public Expenditure Review PFMC Public FinanceManagementand Control PFPSAL ProgrammaticFinancial andPublic SectorAdjustment Loan PHRD Populationand HumanResourcesDevelopment PIP Public InvestmentProgram PIT PersonalIncome Tax PMS PerformanceManagementSystem PPDPL ProgrammaticPublic SectorDevelopmentPolicy Loan PPA Public ProcurementAgency PRA Presidencyof RevenueAdministration RDA Regional Development Agency SA1 Supreme Audit Institution SBA Stand-by Arrangement SCT SpecialConsumptionTax SDIF SavingsDeposit InsuranceFund SDR SpecialDrawingRights SEE State-ownedEconomic Enterprises SHCEK Social Services& ChildProtection Organization SMES Small and Medium Scale Enterprises SPA SpecialProvincialAdministration SPO State PlanningOrganization SRMP Social RiskMitigation Project SSA Social Security Administration SSK SosyalSigortalar Kurumu(Social Security Institute) SYDGM Directorate Generalof Social Assistanceand Solidarity SYDV Social Solidarity Foundation TCA Turkish Courts of Accounts TESEV Foundation for Economic andSocial Studies TODAIE Turkish MiddleEastPublic Administration Institute TURKSTAT Turkish Statistical Institute UAP Urgent Action Plan UHI Universal Health Insurance UHF Universal Health InsuranceFund UNCITRAL UnitedNations Commission onInternational TradeLaw VAT Value Added Tax WPI World Bank Institute YTL New Turkish Lira Vice President: ShigeoKatsu Country Director: Andrew Vorkink SectorManagers: CarlosFelipe Jaramillo - Amp Banerji SectorDirectors: Cheryl Gray - CharlesGriffin Task TeamLeaders: RodrigoA. Chaves- John Innes REPUBLICOFTURKEY PROGRAMMATICPUBLICSECTOR DEVELOPMENTPOLICYLOAN(PPDPL) TABLEOFCONTENTS I INTRODUCTION . .............................................................................................................................. 1 I1 . MACROECONOMICCONTEXT ................................................................................................... 3 OVERVIEW............................................................................................................................................ 3 RECENTECONOMIC DEVELOPMENTS INTURKEY .................................................................................. 4 MACROECONOMIC AND DEBT OUTLOOK SUSTAINABILITY ................................................................ 12 I11 . THE GOVERNMENT'SPROGRAM ............................................................................................ 17 IV. BANKSUPPORTTO THEGOVERNMENTSTRATEGY ........................................................ 20 LINKMCAS...................................................................................................................................... 20 COLLABORATIONWITH THE ImAND m E RDONORS 22 RELAT~ONSH~P OTHERBANKOPERATIONS TO .................................................................................... ...................................................................... 23 LESSONS .............................................................................................................................. 24 LEARNED ANALYTICAL UNDERPINNINGS ............................................................................................................ 25 V. THE PROPOSEDPPDPL ............................................................................................................... 27 OPERATIONJUSTIFICATION ................................................................................................................. 27 PROGRAMMATICFRAMEWORKOPERATION DESCRIPTION AND ........................................................... 27 POLICY AREAS SUPPORTEDBYTHEL OAN ........................................................................................... 31 COMPONENTI: SUSTAINING AN ENABLINGMACROECONOMICFRAMEWORK ...................................... 31 COMPONENT11:SOCIAL SECURITYAND SOCIAL ASSISTANCE REFORM .............................................. 32 THESOCIAL SECURITYSYSTEM.......................................................................................................... 32 PENSIONPARAMETERS ........................................................................................................................ 33 ADMINISTRATIVEREFORM THESOCIAL SECURITY SYSTEM OF UNIVERSAL HEALTH INSURANCE ( ~ 1 ) .............................................................................................. ........................................................... 37 39 SOCIAL ASSISTANCE REFORM ............................................................................................................ 42 COMPONENTIII:PUBLICFINANCIAL EXPENDITURE AND MANAGEMENT REFORM............................ 44 BACKGROUND ..................................................................................................................................... 44 THEPFMCLAW 45 COMPONENT Iv:................................................................................................................................. PUBLIC ADMINISTRATION AND GOVERNANCE REFORM BACKGROUND ..................................................................................................................................... 49 .......................................... 49 REFORM OFLOCAL ADMINISTRATIONS............................................................................................... 50 REGIONALDEVELOPMENT .................................................................................................................. 56 THEFIGHTAGAINSTCORRUP~ION ...................................................................................................... 57 POSSIBLEFUTURE LOAN -PPDPL I1 ................................................................................................... 59 PROGRAM GOALSANDEXPECTED OUTCOMES .................................................................................... 61 VI. OPERATIONIMPLEMENTATION ............................................................................................. 64 POVERTY ANDSOCIALIMPACTS .......................................................................................................... 64 IMP.MENTATION. MONITORING. EVALUATION AND .......................................................................... 66 FIDUCIARY ASPECTS ........................................................................................................................... 67 DISBURSEMENTAUDITING.......................................................................................................... AND 68 ENVIRONMENTAL ASPECTS ................................................................................................................. 69 RISKSANDRISKMITIGATION .............................................................................................................. 71 ANNEXES ANNEX 1:LETTEROFDEVELOPMENTPOLICY (LDP) ANNEX 2: PPDPLPROGRAM POLICYMATRIX ANNEX 3: FUNDRELATIONSNOTE ANNEX 4: COUNTRYAT A GLANCE ANNEX 5: THE PENSIONSYSTEMFOLLOWINGTHE 1999REFORMS ANNEX 6: BUDGETANDPUBLICFINANCIALMANAGEMENTREFORMS ANNEX 7: PUBLICADMINISTRATION AND GOVERNANCEREFORM ANNEX 8: PUBLIC EXPENDITURESONHEALTH: CURRENTLEVELS, PROJECTIONSANDSUGGESTED COST-CONTAINMENTMEASURES Map# IBRD33501 The ProposedLoanwas preparedby a team consisting of RodrigoChaves (ECSPE), John Innes(ECSHD) as team leaders, Mediha Agar (ECSPE), Andrina Ambrose (LOAG1); Seda Aroymak (ECSPS); Enis Baris (ECSHD), Dilek Barlas (LEGEC), Pinar Baydar (ECCU6), Jeanine Braithwaite (ECSHD), MukeshChawla (ECSHD), Peter Dewees (ESCSD), Amitahba Mukherjee (ECSPE), Zafer Mustafaoglu (ECSPE), hand Rajaram(PRMPS), Gary Reid (ECSPE), Anita Schwarz (ECSHD), Kamer KarakurumOzdemir (ECSPE), Sanjay Vani (ECSPS), Mathew Verghis(ECSPE), Izzet Yildiz (ECSPE). Peer reviewers: Christian Baeza (LCSHS), Robert Holzmann (HDNSP), Sanjay Pradhan (PRMPS), Michal Rutkowski(MNSHD) LOANAND PROGRAMSUMMARY REPUBLICOFTURKEY PROGRAMMATICPUBLICSECTORDEVELOPMENTPOLICY LOAN (PPDPL) macroeconomic framework; (b) reforming substantially the country's social protection system, which covers social security, universal health insurance (UHI), and social assistance, (c) continuing the ongoing process of upgrading the financial controls and expenditure management of public resources, and (d) improving the administration and governance of the public sector. The program supported by the Loan contains actions, milestones, and expected results in each of the above four broad areas of policy. Accordingly, the PPDPL has been designed around four components which, in turn, contain conditions, triggers, and indicators critical to achieving the objectives of the government's program as well as to measuring implementationprogress andresults achieved. The first component supports the maintenance of the macroeconomic framework which has underpinned Turkey's recovery after the 2001 crisis as well as the ongoing sustained episode of rapid economic growth that began in2002 and continues to date, The second component focuses on improving the quality of fiscal adjustment by addressing the growing deficits in the social security system through (a) parametric reforms of pensions and (b) structural improvements in the institutional and administrative framework for the provision of social security benefits and social assistance. This component also supports universal access to health services while deploying actions to increase the efficiency and contain the cost of health services funded by the state. The third component supports continued implementationand broadening of the structural and institutional reforms of the public financial management and budget systems that the World Bank began supporting under the Programmatic Financial and Public Sector Adjustment Loan (PFPSK) series of loans. The fourth component supports improving the administration and governance of the public sector through actions required to reduce regional disparities, promote decentralization, and combat corruption at all levels of the public sector. An enabling macroeconomicframework will continue to be an important underlying driver for the sustainedgrowth experiencedby Turkey since 2002. Bringing the social security system to actuarial medium term sustainability while continuing to improve the legal, institutional and systemic structures of public expenditure management (PEM) will enable improved fiscal adjustment and will create the fiscal space required for the state to undertake important expenditures in areas such as infrastructure. In addition, this action is widely expectedto increase the credit ratings of Turkey's long term debt, which would reduce the cost of servicing suchdebt -creating, therefore, further fiscal space. The reformed social protection system will provide comprehensive insurance against old age, poverty, illhealth, and more effective social assistance to the poor. Better focused regional development efforts and moreeffective provision of public servicesat the local level will assist in reducing large regional disparities, improving local service delivery and allowing for a more effective utilization of pre-accessionfunds from the EuropeanUnion (EU). The design and early implementation of systemic approach to suppor! ongoing anti-corruption efforts will assist in reducing this obstacle tc economic and social development. On the external front, the current account deficit continues to be a majoi cause for concern, as it stood at about 6.4 percent of gross nationa product (GNP) (US$ 23 billion) in 2005. In the absence of policj adjustment, it i s expected to widen further in 2006. The increasein tht imported energy bill alone is anticipatedto account for an estimated 1.' percentagepoint of GNP increase of the current account deficit relativt to 2005. Other risk factors include financial market perceptions and hence public debt sustainability, spillovers from global liquidity tightening, or ai eventual emerging market crisis. These factors would affect Turkey': macroeconomic situation because of the still large debt to GNP ratio although this ratio has decreased and is expectedto continue to decreasc rapidly. Additionally, the reform program contains actions, most notabl: parametricreformof the pension system, which haveproven difficult, i not impossible, to implement in a large number of other countries - whether developed or developing. The approaching elections schedulec for late 2007 mightmake overall reformeffort moredifficult. PO17052 INTERNATIONALBANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENTFORA PROPOSEDPROGRAMMATICPUBLICSECTORDEVELOPMENTPOLICYLOAN (PPDPL)TO THE REPUBLICOFTURKEY I. INTRODUCTION 1. Turkey i s well into a new stage of public sector reform aimed at addressing the second generation challenges imposed by the economic crises of 2000 and 2001. In reaction to these crises, there has been a strong fiscal adjustment with significant primary surpluses in each year thereafter. The fiscal adjustment has been accompanied by ongoing implementation of a comprehensive long term government program to modernize the institutions and procedures of public sector management. Nonetheless, the quality of fiscal adjustment needs to be improved . and there i s a need to address additional public sector reform challenge, most notably in social security, governance and decentralization. 2. Consequently, the authorities have designedand adopteda program of sustainedmedium- term legal, institutional, and structural developments aimed at promoting growth and improving social conditions. The PPDPL will support policy actions within the overall program in four connected areas, namely: (a) sustaining the current enabling macroeconomic framework; (b) reforming the country's social protection system which consists of social security, health insurance and social assistance; (c) continuing the on-going process of upgrading the public financial managementandbudget reforms; and (d) improvingthe administration and governance of the public sector. 3. The government andthe Bank staff agreedthat Bank support will follow a programmatic approach. This decision was made because this approach recognizes the fact that the government has adopted a well specified medium-term program which needs to remain flexible in view of the ongoing dynamic process of EU accession negotiations. Priorities within the overall public sector reform program may change as EU negotiations advance and so may the preferences regarding the specific subjects of Bank support within the wider government program. 4. In addition, a series of two annual operations is advisable because there is a need for follow-up actions in the social security reform area and on fiscal sustainability and efficiency issues of pension, health and social assistance reforms. For instance, the fiscal authorities might need to include actions to curtail growing health costs that may result from administrative decisions of sector agencies. The need for these actions will only become known during 2006 andpossibly 2007. 5. The portion of the wider government program to be supported by the first loan contains a coherent set of actions, milestones, and expected results ineach of the above four areas of policy action. Accordingly, the PPDPL was designed to have four components containing conditions and triggers for the second loan supporting future actions envisioned by the program which are critical to achieving its objectives as well as indicators for measuringprogress inimplementation andresults achieved. Consistent with a programmatic approach and with the Country Assistance 1 Strategy (CAS), the PPDPL will be followed by a proposed PPDPL II(US$ 400 million) in FY07 6. The first component of PPDPL supports the maintenance of the macroeconomic framework which has underpinnedTurkey's recovery after the 2001 crisis as well as the ongoing sustainedepisode of rapideconomic growth that beganin2002 andcontinues to date. 7. The second component focuses on improving the quality of fiscal adjustment by addressing the deficits in the social security system through (a) parametric reforms of pensions and (b) structural improvements in the institutional and administrative framework for the provision of social security benefits and social assistance. This component also supports universal access to health services to the population while promoting actions to increase the efficiency and control the costs of the health system. 8. The thirdcomponent supports continued implementation and expansion intonew areas of the structural and institutional reforms of the public financial management and control systems that the Bank began supporting through the series of PFPSALloan series. 9. The fourth and last component supports improving the administration and governance of the public sector through actions required to reduce regional disparities, improve local administrations, andcombat corruption at all levels of the public sector. 10. The Bank has provided analytical and financial support to the government's program through extensive economic and sector work, as well three previous PFPSALs of which PFPSAL III,thelastloaninthesequence,isscheduledtocloseonJune30,2006. ThePFPSALs supportedreforms inthe financial andpublic sectors. The Bank is currently preparing a parallel programmatic series of development policy loans aimed at assisting Turkey create more and better jobs for its population. These two Employment Generation Development Policy loans (EGDPL) are under preparation and they will support actions in (a) reforming labor market regulations, (b) improving the business environment, (c) increasing private sector access to investment capital, and (d) facilitating the adoption of technology and upgrading workers skills. Itis expectedthat EGDPLIwill bepresentedto the BoardofExecutive Directors for approval in early FY07. 11. Right at the outset it should be noted that the reform program supported by the PPDPL series of loans contains policy actions, most notably the parametric reform of the pension system, which have proven difficult, if not impossible, to implement ina large number of other countries -whether developed or developing- where the actuarial balancesof the pay as you go systems are fiscally unsustainable. Aware that these reforms are vital to both long-term fiscal stability and modernization of the economy including convergence with the EU, the authorities managed to undertakethese politically difficult reforms - notwithstanding that a general election is expected to take place in2007. This i s clear evidence of the ownership andcommitment to the program. 2 11. MACROECONOMICCONTEXT OVERVIEw 12. Commitment of the government to sound economic policies since 2001 and determined implementation of its reform program has placed the Turkish economy in a good position to embark on a sustained path of faster economic growth. Substantial progress has been achieved in reducing inflation and real rates of interest, improving public finances, restructuring the financial sector, improving the business environment, and reforming the public sector. In particular, strong fiscal discipline helped lower inflation and inflationary expectations and improve debt sustainability. Thus, stability has been restored, predictability has improved and market confidence has increased. The Stand-By Arrangement (SBA) with the International Monetary Fund (JM.F), and the ongoing process of EU accession, i s expected to provide an anchor for the continuation of the reform processin the years ahead, and contribute to increasing Turkey's growth potential andimproving convergenceto the EUaverageincome level. 13. The recovery following the 2001 crisis has been remarkable. The Turkish economy rebounded very strongly andhas been one of the fastest growing economiesinthe world over the last four years. Annual growth averaged 7.8 percent during 2002-2005. The rapid increase in real per capita income helped Turkey achieve faster convergence with higher income countries. Inflationcame down to single digits in 2004 for the first time in 35 years and further decelerated to 7.7 percent in 2005, greatly facilitating the reduction in interest rates. However, two key challenges remain, namely that (a) high unemployment continues to persist, at 10.3 percent in 2005 despite strong growth for three consecutive years and (b) the current account deficit reached 5.2 percent of the GNP in 2004 and widened further to 6.4 percent of GNP in 2005, in partcausedbyhigher,imported energy billdue to increasesinthe priceof oil derivatives. 14. Resolute fiscal consolidation has been the cornerstone of the economic program. The public sector primary balance moved to a surplus of 7.1 percent of GNP by 2004, and over 6 percent in 2005, from a deficit of 1.6 percent in 1999. These primary surpluses have lead to a reduction of gross public debt from 106 percent of gross domestic product (GDP) in 2001 to 77 percent in2004, and an estimated71percent in 2005. 15. Monetary policy has focused on implicit inflation targeting, facilitated by fiscal consolidation and the introduction of a floating exchange rate regime. Progress has been achieved in restructuring the financial sector, improving the business environment, and reforming the public sector. Key markets have been liberalized and regulatory capacity in the economy has been strengthened. Turkey has thus strengthened its position as a functioning market economy, although further reforms are needed to secure resilience and strengthen the capacity of the economy to cope with competition inthe EUsingle market. 16. On October 3, 2005, accession negotiations with the EUwere formally launched, which has provided Turkey an anchor for continuing reform, economic stability, and accelerated growth. The EU accession negotiations provide impetus for deepening and broadening the reforms required for Turkey's convergence to the EUaverage income per capita. This process will be self-reinforcing, as accelerated income convergence would enhance prospects for Turkey's eventual membership. The benefits however are contingent on the quality of the policy 3 framework, efficient and effective public management, and maintaining the reform momentum, The task will be even more demanding for Turkey, requiringmore intense andfocused efforts on effective compliance with the EUAcquis. Table 1:KeyEconomicIndicators ActualY Prog. 31 2000 2001 2002 2003 2004 2005 2005 MAINMACRO INDICATORS GNP Growth 6.3 -9.5 7.9 5.9 9.9 7.6 6.0 CPIInflation(Dec-Dec) 39.0 68.5 29.7 18.4 9.3 7.7 6.0 Nominal InterestRate 38.0 99.1 63.5 44.1 24.9 16.2 13.2 Real ex-ante Interest Rate 41 -9.5 35.5 30.3 30.2 15.4 8,3E 8.1 UnemploymentRate 6.5 8.4 10.3 10.5 10.3 10.3 n.a. UnitWage Index(1997=100) 102.8 71.1 72.9 85.8 96.1 108.3 n.a. PUBLIC SECTOR Primary Balance(% GNP) 2.6 5.1 4.2 6.3 7.1 6.5 6.5 Overall Deficit (% GNP) 13.3 16.7 12.5 9.6 4.8 1.4 0.4 Net Public Debt (% GNP) 11 57.1 90.5 78.5 70.4 63.5 55.8 50.1 of which net external debt (% GNP) 19.1 37.7 32.3 22.1 17.5 8.5 4.3 Privatization ($ bn) 1.9 1.6 0.5 0.4 1.7 4.0 9.1 EXTERNALBALANCE Current accountbalance (% GNP) -4.9 2.3 -0.8 -3.4 -5.2 -6.4 -7.2 Exports (fob, $ bn) 51 30.7 34.4 40.1 51.2 67.0 76.9 82.8 Tourism ($bn) 7.6 8.1 8.5 13.2 15.9 18.2 19.1 External Debt (% GNP) 58.9 78.7 71.3 61.2 53.7 46.9 48.2 CBT ForeignExchange Reserves($ bn) 23.2 19.8 28.1 35.2 37.6 52.4 63.0 Memo GNP (TL quadrillion) 125.6 176.5 275.0 356.7 428.9 486.4 547.9 Y T W S D ExchangeRate (annual average) 0.6239 1.2223 1.5041 1.4967 1.4218 1.3410 1.3392 11Includes the government securities issuedto recapitalize the SDIF andstate banks. 21Government figures as adjustedby IMFandWB estimates. 31WB and IMFprojections 41Average of monthly nominal interest ratedivided by 12-month aheadinflation 5nncludes shuttle trade E:Estimate Source: Government, IMFand WB estimates. RECENTECONOMIC DEVELOPMENTS INTURKEY 17. The GNP growth rate in 2005 reached 7.6 percent exceeding expectations for the fourth straight year (Table 1). As a result, averagereal growth in2002-2005 was almost 8 percent. The major contributing factors were private consumption, private investment, and export growth. A noticeable change from the past rapid growth episodes was that growth mainly came from the private sector, while public sector consumption and investment expenditures were heavily constrainedby tight fiscal policies. GDPper capita at current dollars exceededUS$5,000 for the first time inTurkey's history, andtotal GDPreachedUS$363.3 billion in2005. 18. A simple comparison of the two year sub-periods of 2002-03 and 2004-05, indicates the increasing importance of the growth in private investment (Table 2). Surging exports immediately after the crisis, recovering private consumption and stock buildingin the economy have caused annual average growth rates around 7 percent during the first two years of the 4 recovery period (2002-03). The growth of private investment during this period was also at par with the rate of GDP growth, whereas its contribution was less significant relative to private consumption due to the smaller share of private investment in the GNP. The annual average growth rate acceleratedto 8.2 percent during the last two years (2004-05), as private investment started to increase at higher pace and its contribution to growth was comparable to the contribution of private consumption which accounts for a much larger share in the GDP. Although the strong increase in domestic demand was partly counterbalanced by the slowdown in stock building, total domestic demand was robust during the second period of recovery. Domestic demand grew faster than real GNP in 2003-2005, causing a broadening of the current account deficit. Consumption Investment Final GDP Total Private Public Total Private Public Net Exp Dom. Demand Dom. Demand Annual Average Growth(percent) 1990-2000 4.1 4.4 4.2 5.3 5.4 6.5 2.8 4.8 4.6 2002-2005 7.5 6.3 6.8 1.4 15.6 19.7 3.7 9.3 8.5 2002-2003 6.9 4.0 4.3 1.4 4.3 6.8 -1.9 11.4 4.1 2004-2005 8.2 8.6 9.4 1.5 28.1 34.1 9.5 10.4 13.1 Contributionto Growth (annual average, percentagepoints) 1990-2000 4.1 3.4 3.0 I 0.5 1.6 1.4 0.3 -1.1 4.8 4.6 2002-2005 7.5 4.8 4.7 0.1 3.8 3.6 0.2 -3.2 9.9 8.2 2002-2003 6.9 3.0 2.9 0.1 0.9 1.0 -0.1 -2.I 8.8 3.9 2004-2005 8.2 6.2 6.1 0.1 6.1 5.7 0.5 -3.5 11.3 12.0 19. In May 2006, there has been global volatility in the prices of equities, bonds, foreign exchange markets (FOREX), and commodities which affected all emerging markets including Turkey. While Turkey was not disproportionately affected compared to other countries, some domestic developments occurred prior to this global volatility had an intensifying effect in local markets. 20. The nature and magnitude of the macroeconomic risks resulting from these recent events will ultimately depend on the depreciation of New Turkish Lira (YTL) with respect to the Euro and the US dollar following the reestablishment of normalcy in global markets. If the current level of depreciation in YTL i s sustained, it would have a negative impact on pace of the disinflation and on public debt. However, a positiveimpact on price competitiveness and exports andtherefore on current account balancewould also be expected. 21. A comprehensive analysis of the possible effect of this recent foreign exchange (FX) volatility on key economic variables has not been conducted as it is not obvious at this stage whether the current move i s permanent or would be reversed. In this context, the projections in the document do not reflect the impact of this recent volatility. However, early estimations indicate that such effects are unlikely to be large inmagnitude. Due to the flexible exchange rate regime and a decline in currency substitution, the pass through of YTL depreciation to inflation has declined in recent years'. A World Bank public debt sensitivity analysis indicates that a 10 According to a recentCBRT study (2005), the pass throughcoefficient has fallen from63 to 33 and the study 5 percent permanent depreciation in YTL would increasethe public debt stock between 2.4 to 2.7 percent of GNP in 2006-depending on the behavior of interest rates. On the external front, however, a 5 percent real effective exchange rate depreciation is expected to reduce current account deficit to GNP ratio between0.9 percentage points to 1.6 percentage points depending on the elasticity of exports and imports. 22. Preliminary data indicate that the economy continues to grow in 2006 although at a smaller rate than in 2005. The official estimate of 5 percent growth for the whole year is expected revised to 6 percent. On the demand side, growth i s being driven by private sector consumption, public and private investment, and exports; while on the supply side, industry, trade, transportation andcommunication sectors are the key drivers. 23. Inflation in 2004 fell to single digits for the first time in more than 30 years and further decelerated in 2005. Consumer Price Index (CPI) inflation fell from 9.3 percent in 2004 to 7.7 percent in 2005 (below the target rate of 8 percent), as a strong YTL helped keep the disinflation process on track. Continued slack in the labor market and rising productivity have kept inflationary pressures low despite the surging economy and rising oil prices and inflation expectations have remained stable. As of January 1, 2006 the Central Bank of the Republic of Turkey (CBRT) introduced formal inflation targeting. According to the implementation framework announced by the CBRT, the inflation targeting approach adopted allows for reasonable flexibility, by attaching an uncertainty band of plus or minus two percentage points aroundthe headline CPIprogram target of 5 percent. However, although fiscal consolidation has laid the groundwork for explicit inflation targeting, continued fiscal discipline i s key for successful implementation, since policy inconsistency i s the main risk of failure in inflation targeting regimes. In this context, flexibility seems to be the preferred option in the implementation of inflation targeting, until the fiscal program i s more firmly established and external imbalances are reduced. In 2006, first quarter inflation came within the CBRT's pre- announced +/-1 inner band. However, monthly CPI inflation of 1.34 percent in April 2006 was higher than the market expectations of 0.43 percent. As of April, the annualized CPIinflation of 8.8 percent i s higher than the program value that is consistent with the end-year target, yet falls within the +/-2 percentagepoints band. 24. Fiscal performance has remained strong since 2002. In 2004, the primary surplus exceeded the target of 6.5 percent of GNP for the first time with stronger than expected receipts of the corporate income tax (CIT) and value addedtax (VAT) andover-performance of the State- owned Economic Enterprises (SEES) in their contribution to primary surplus. Primary expenditures were in line with expectations. In 2005, the primary surplus was realizedabove 6 percent of GNP and the overall deficit has declined to below 2 percent of GNP. The fiscal performance showed no deterioration in the first four months of 2006 as the primary surplus of the central government budget amounted to 35 percent of the annual target for 2006. 25. The net public debt to GNP ratio fell from 70 percent in 2003 to 64 percent in 2004 due to declining real interest rates, strong fiscal performance, the recovery of economic growth and the continued appreciation of the real exchange rate. The end 2005 net public debt declined to impliesthat a permanent 10percentlira weakening, everythingelse the same, would resultinan extra 3.3 percent inflation within the next two years following the depreciation. 6 55.8 percent of GNP. With increasing capital inflows and growing appetite for the Turkish government paper, the Treasury hadno problem in servicing the debt. The average maturity of new debt increased from 15 months in 2004 and to over 27 months in 2005. More encouragingly, Treasury was able to issue YTL 27.7 billion of 5-year floating rate bonds (FRNs) in2005, Another YTL 14.7 billionof 5-yearFRNshavebeenissuedduring2006 as of May. 26. CBRT occasionally intervenes in the FX market to dampen what are deemed to be excessive volatility in the exchange rate. The CBRT intervened directly in the markets by buying foreign currency and restarted its currency buying auctions immediately after December 17, 2005. Credit growth has been particularly strong, and the process of reverse currency substitution has continued with foreign currency deposits falling to 35 percent of total deposits at the end of 2005, from 57 percent in 2002 and 43 percent in 2004. With strong growth and financial deepening, base money grew by close to 50 percent inreal terms in2005. Interest rates on treasury bills continued to fall, particularly after December 2004, reaching 14.2 percent at end-2005. The markets sentiment was encouragedby the formal start of the negotiations with the EUon October 3, 2005 and the CBRT moped up the excess foreign currency in the markets. Interest rates hovered slightly below 14percent in early 2006 but recent global volatility caused the ratesto go up to 16percent towards the endof May 2006. 27. On the external front, the current account continues to be a cause for concern; deteriorating from a surplus of 2.3 percentin 2001 to a deficit of 6.4 percent in 2005. The strong recovery in the Turkish economy following the 2001 financial crisis, the appreciation of YTL resulting from reverse currency substitution and large capital inflows, and the surging oil prices have all contributed to the deterioration of the current account. 7 -1,524 -8,036 -15,604 -23,091 `radeBalance -26,728 -10,065 -15,495 -22,087 -34,373 -43,147 olw Exports f.0.b. 27,775 31,334 36,059 47,253 63,167 73,390 Textile andClothing 10,03 1 10,341 12,148 14,995 17,338 18,658 Machinery, Electric-Electronic andVehic 5,853 7,262 8,881 12,802 18,585 21,933 Machinery andEquipment 1,439 1,617 2,117 3,159 3,965 4,928 Electric-Electronic 1,787 2,041 2,632 3,168 4,459 5,081 Vehicles 2,627 3,605 4,132 6,474 10,161 11,924 olw Imports c.i.f. (by BEC) -54,503 -41,399 -51,554 -69,340 -97,540 -116,537 Capital Goods -11,365 -6,940 -8,400 -11,326 -17,397 -20,341 IntermediateGoods -36,O 10 -30,301 -37,656 -49,735 -67,549 -81,666 ConsumptionGoods -6,928 -3,813 -4,898 -7,813 -12,100 -13,962 Others -199 -344 -600 -466 -493 -567 Memo:Ener~yImports* -9,529 -8,339 -9,204 -11,575 -14,407 -21,231 ;ervices 11,366 9,132 7,879 10,504 12,784 13,964 olw Tourism 5,923 6,352 6,599 11,090 13,364 15,280 ncome -4,002 -5,000 -4,556 -5,557 -5,637 -5,744 hrrent Transfers 4,774 2.993 2.436 1.027 1,127 1,468 demo: hrrent Account (% of GNP) -4.9 2.3 -0.8 -3.4 -5.2 -6.4 kade Balance (% of GNP) -13.3 -7.0 -8.5 -9.3 -11.4 -11.9 iource: TURKSTAT, CBRT 28. The current account deficit startedto expand significantly in2003, reaching US$8 billion or 3.4 percent of GNP (see Table 3), driven by recovery andthe pent-up demand, reflected inthe high growth inthe consumption goods imports. The Government took active measuresin May 2004 including reduction in tax credits for automobile purchases and raising taxes on consumer credit, however these measures had a limited impact on import demand. In2004, the growth of consumption goods somewhat moderated, while the increase in intermediate goods and especially capital goods imports accelerated. Although export growth was also strong, it lagged behindimports and the deficit widened to US$15.6 billion, or 5.2 percent of GNP, in 2004. 29. Strong growth in 2005 has been associated with increasing imports of capital and intermediate goods. As the trade balance further worsened in 2005 (despite the moderation in the automobile imports) to about US$43 billion, the current account deficit hit US$23 billion, or 6.4 percent of GNP. The increase came as a result of imports growth outpacing exports (Figure l.a shows the contribution of exports and imports to the current account changes over 2001- 2005). The export coverage of imports declined from around 69 percent in January 2005 to around 62 percent in December 2005. On a more positive note, the contributionof consumption goods imports declined and the increasein the capital and intermediate goods (of about US$ 17 billion) was the main factor behind the growing trade deficit (see Figure 1.b). While the trade deficit did not improve in the first three months of 2006, exports showed signs of recovery in 8 March, 2006. Furthermore, the depreciation of the YTL, if sustained, could improve trade balances. Figure 1.a Breakdownof the changeinCurrent Account 1 Figure 1.b Breakdownof the changeinImports(c.i.f.) 60% Balance I 40% 20% 0% -20% -40% -60% -80% J i 2001-02 2002-03 2003-04 2CQ4-05 2001-02 2002-03 2003-04 2004-05 1m~~ports .Imports nother 30. An important factor contributing to the widening CAD has beenthe appreciation of YTL due to increasedcapital inflows. Since 2002, the real exchange rate appreciated substantially and as Table 4 shows that the trade-weighted real exchange rate soaredto a level significantly higher (appreciated) than pre-2001 crisis level. The trade weighted real exchange rate appreciatedby 48 percent on a cumulative basis compared to 2001 and 16 percent compared to pre-crisis level in 2000. Although part of the appreciation might be due to a correction in the exchange rate of a possible overshooting after the crisis and another part due to strong labor productivity growth, large capital inflows as well as reverse currency substitution have also played a significant role. The appreciation of the currency has diminished the external competitiveness gained with the large depreciation duringthe crisis. Table 4: RealEffectiveExchange Rate, 1999-2006 1999 2000 2001 2002 2003 2004 2005 2006* ReelEffective ExchangeRate(1) 127.3 147.6 116.3 125.4 140.6 143.2 171.3 171.9 (1): A trade weighted, 1995=100 *April 2006 Source: CBRT 31, Turkey aims at achieving convergence with the EU average income levels. The recent robust growth rates and the rises in per capita income have accelerated convergence with the average per capita income in the EU. The past experience of successful former accession countries shows that sustained high growth rates together with productivity driven real appreciations are two important sources of convergence. In order to further accelerate convergence, Turkey needs higher investment ratios to sustain high growth rates for a prolonged period, which could increase the current account deficit, as well as productivity driven gradual real appreciation of its currency. In this context, it i s important to keep the current account at sustainable levels which requires prudent macroeconomic policies in place and depends on the amount of Foreign Direct Investment (FDI) and other long term capital flows. Productivity increasesto sustainreal appreciation i s important for maintaining the external competitiveness. 9 32. The recent upsurge in consumer credit has also contributed to the strong domestic demand and the widening in the current account deficit. Bank credit to the private sector rose significantly in2004 and 2005 and this trendhas continued inearly 2006 (Table 5). Table 5: Private Credit 1999 2000 2001 2002 2003 2004 2005 2006* Percentof GNP Total Bank Credits 24.6 24.3 22.3 14.7 16.5 20.5 26.7 Percentof Total Bank Credits Total Bank Credits 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 -Privatesector Credits 84.2 87.1 83.0 84.5 87.1 90.2 93.6 94.2 -Consumer Credits 11.1 22.1 12.5 16.3 21.8 29.9 34.7 36.3 *February 2006 Source: CBRT 33. Energy imports accounts for another significant part of the deterioration in the current account. Turkey is heavily dependent on energy imports and rising oil prices have severely affected Turkey's external balances. The price of crude oil paid by Turkey increased from 22.7 dollars per barrel in 2001 to 59 dollars per barrel in early 2006. Consequently, energy imports comprising oil and natural gas increased from 8 billion dollars in 2001 to 20 billion dollars in 2005 (Table 6). The non-oil current account deficit has also widened substantially after 2001 due to robust domestic demand and real appreciation of YTL. The deterioration inthe non-oil current account amounted to almost 9 percentage points of GNP since 2001. However, the bulk of this deterioration came in the first two years of the recovery as non-oil current account deficit stabilized around 1percent of GNP in the last two years. The ratio of the change in the current account to the change in the GNP indicates that surging oil prices have been a driving force behindthe deterioration inthe current account. BOP(Million USDollars) 2000 2001 2002 2003 2004 2005 Current Account -9821 3392 -1524 -8036 -15604 -23091 Oil Imports* -8721 -7829 -8326 -10545 -13075 -19527 Non-oil CurrentAccount -1100 11221 6802 2509 -2529 -3564 Non-oil CtW/GNP(%) -0.5 7.8 3.7 1.1 -0.8 -1.0 CA.DIGNP(%) -4.9 2.3 -0.8 -3.4 -5.2 -6.4 Won-Oil CADIAGNP(%) -27.5 14.0 3.5 -3.2 -4.9 ACALVAGNP(%) -8.3 -3.1 -11.1 -19.5 -31.5 34. The financing of the current account deficit has not been a problem partly because the share of long-term capital and non-debt creating flows continues to increase, In 2004, about 53 percent of total net inflows (excluding IMF credits and official reserves) were in the form of 10 short-term flows. This share dropped to 41 percent in 2005, and to 18 percent in the first three months of 2006, which i s a healthy sign. Non-debt creating flows such as FDI,equity flows, and net errors and omissions covered some 75 percent of the current account deficit in 2005. In particular the FDI inflows (on a cash basis) reached a historical high of US$ 9.7 billion (2.7 percent of GNP)in 2005. On a commitment basis, FDIis estimated at almost US$ 20 billion in 2005, of which the great majority (72 percent) i s related to privatization of SEESand sales of Savings Deposit Insurance Fund (SDIF) assets. FDIrelated to acquisitions in the private sector accounts for the rest of commitments. On a cash-flow basis, however, FDI, originating from private sector acquisitions accounts for more than half of the inflows in 2005, consistent with an increasing appetite for Turkish companies and a significant rise in foreign interest in the Turkish banking sector. 35. Although the share of short term inflows in total inflows declined, there i s the potential risk for reversal of these inflows if a sudden change in the market sentiment occurs either as a result of domestic factors or an external shock. The comparatively high level of private and public external debt underscores the risk of a significant depreciation in the currency. However, there are some mitigating factors that make the economy more resilient to such shocks. In contrast to the pre-2001 crisis period, a flexible exchange rate regime i s in place and an independent CBRT has established strong credibility over the past few years. The official reservesof the CBRT rose from around U S $ l 9 billion in2001 to US$52.4 billion in 2005. The official reserves stood at 5.2 months of imports in 2005. The reserves increased further to US$ 61billion as of May 31, 2006. 36. In the long term, sustainability of the current account is going to be helped .by the following: (a) increased confidence level, mostly due to continued macroeconomic stability and positive developments on the EU relations front, i s likely to improve the structure of capital flows, towards more long-term financing including FDI; and (b) continued fiscal discipline through a highprimarybudget surplusto ensureneededmobilization of domestic savings for the financing of investment. 37. 2005 represents a milestone in the history of privatization in Turkey. The Privatization Administration completed the ever biggest privatization, Turk Telekom, in July 2005, raising US$6.6 billion for a sale of 55 percent shares of the company.2The total amount of privatization deals in 2005 is expected to yield close to US$ 26 billion (not including sales by the SDII;), although some of the sales are still in the legal process. B y comparison, only US$9.4 billion of privatization deals was realized in the whole period 1986-2004. All these developments signal a strong confidence in the Turkish economy and confirm the government's commitment to the privatization program. Continuing efforts of privatization will help reduce public debt and, combined with greater green-field FDI, will be particularly helpful in financing the widening current account deficit-especially in a context where short-term capital flows to emerging market economiesmay dry upwith increasinginterest ratesininternational capital markets. The total amount will be paid infive annual installments and only an amount of 1.3 billion dollars was received in 2005. The strongprivatization progresscontinued with big ticket items, such as the state refinery TUPRAS and the steel companyEregli Demir Celik. 11 38. Unfortunately, the impressive economic growth didnot reduce the overall unemployment rate. Despite the strong growth performance for the four consecutive years in a row, unemployment remained high at 10.3 percent in 2005. In urban areas however, the unemployment rate declined to 12.7 percent, close to one percentage point, while the unemployment of youth declined by more than 2 percentage points to 22.8 percent. Although the rate of increase inemployment in services, industry and construction sectors was significant, employment in the agriculture sector declined by 907,000 over this period as workers left agriculture to look for employment in more productive sectors. Given the strong labor force growth andthe potential for an increasein participation rates, Turkey needs to grow at very high rates to simply keep unemployment from rising. 39. Turkey's economic program i s supported by an IMF SBA. In May 2005, the IMF approved a three-year, special drawing rights (SDR) 6.66 billion (about US$ 10 billion) SBA to support Turkey's economic and financial program through May 2008. The overriding goals of the new program are to create conditions for sustainedgrowth that will raise living standards and reduce unemployment; facilitate convergence towards the EU economies; and bring about an orderly exit fromIMFsupport. 40. The program's macroeconomic framework i s centered on achieving high and sustained growth of around 5 percent each year. Inflation was targeted at 8 percent for 2005, and it was realized at 7.7 percent. The program envisions low single digit inflation by 2008 - the endof the program. The program also envisages a reduction in the government's net debt ratio by a further 10percent of GNP. 41. A combined first and second review and an amount of SDR 1.1billion (about US$ 1.6 billion) credit disbursement have been completed under the new SBA. The last IMFmission in May 2006 concluded that Turkey's economy continues to perform well. On this basis, discussions on the third and fourth reviews of the IMF SBA have been completed and it i s expectedthat the IMFBoardwill consider these reviews inJuly 2006. Growth has moderated in line with program assumptions, inflation i s in single digits, and the public debt burden i s being reduced steadily. The authorities' adherenceto prudent macroeconomic policieshasplayed a key rolein supporting these developments. ~CROECONOMICOUTLOOKANDDEBT SUSTAINABILITY 42. The recently achieved macroeconomic stability and strong fiscal performance have helped the building of confidence in the economy, which in turn resulted in a reduction in the risk premiumattachedto the Treasury's cost of borrowing. Going forward, financial markets are likely to rely increasingly on the twin anchors of the EUand the IMFprogram as indicators for continued progress with the reform program, and over the long term, convergence towards the EU. 43. Accordingly, the current benign international liquidity conditions, the approval of the successor IMF SBA in May 2005, the formal initiation of negotiations between the EU and The projectionspresentedinthis section are madeby the World Bank. 12 Turkey in October 2005, and recent credit rating and outlook upgradesby credit rating agencies havebeen key drivers inthe improved market sentiment towards Turkey. 44, Because the credibility of the Government's program i s consolidated, Turkey could sustain the growth rates of around 5 percent (Table 7 )envisagedinthe IMFprogram. However, for faster convergence with the EU, Turkey aims at sustaining higher growth rates at 6 to 7 percent. Onthe demand side, confidence indicators are strengthening and lower interest rates are providing a stimulus to private investment and consumption. Despite strong domestic demand and the increase in oil prices, the disinflation process still remains on track, albeit with a slower path of decline after the developments in early 2006. The strong growth in private investment expenditure in2004 and 2005, and strong industrialproductiongrowth inthe last quarter of 2005 are indicative of the improvedprospects for sustainedgrowth and employment generation. Table 7: SelectedMedium-term MacroeconomicIndicators 2001 2002 2003 2004 2005 2006 21 2007 21 2008 21 GNP Growth -9.5 7.9 5.9 9.9 7.6 6.0 5.0 5.0 CPI Inflation 68.5 29.7 18.4 9.3 7.7 6.0 4.0 4.0 NominalInterest Rate 99.1 63.5 44.1 24.9 16.2 13.2 11.8 10.9 RealInterestRate I/ 35.5 30.3 30.2 15.4 8.3 8.1 7.5 6.7 Current Account (billion $) 3.4 -1.5 -8.0 -15.6 -23.1 -29.4 -29.1 -27.9 Exports (f.0.b.) 34.4 40.1 51.2 67.0 76.9 82.8 90.8 99.3 Imports(f.o.b.1 -38.1 -47.4 -65.2 -90.9 -109.6 -123.2 -131.6 -138.9 Capital Account (billion $) -14.6 1.2 7.1 17.7 43.8 42.9 30.5 30.5 FDI 2.8 0.9 1.2 2.0 8.6 14.4 6.9 7.2 OverallBalance (billion $) -12.9 -0.2 4.1 4.3 23.2 14.5 1.4 2.6 1)Computedas the average of the monthly auctionrates deflated by 12-monthaheadCPIinflation 2) The years 2006,2007 and2008 are WB staff estimates. Source: Government,IMFand WB estimates. 45. The interest rate path will be critical to the success of the program. Risinginterest rates affect growth prospects, increase the debt burden and make fiscal adjustment more difficult and hence less credible. The disinflation process that supports real interest rates reduction has continued throughout 2005. The CBRT continued cutting the overnight rates, reducing it to 13.5 percent in December 2005. Further declines will have to be underpinned by structural reforms strengtheningmarket confidence inlong-run fiscal sustainability. 46. As confidence consolidates and government crowding out is reduced, real interest rates are projected to continue declining over the period 2006-2008. The favorable effect on the macroeconomic outlook would work through several channels. First, it would directly stimulate consumption and investment. Second, it would improve the debt dynamics, thereby facilitating fiscal adjustment while increasing the credibility of the reform program. Third, as confidence in the policy framework grows, risk margins would narrow and foreign and domestic investment wouldrise. 47. Government i s committedto maintaining a tight fiscal stance in the 2006 budget and the pre-accession economic program submitted to the EU. The primary surplus has been the cornerstone of Turkey's recovery from crisis since 2001, and sustaining a credible fiscal program will be important to retain market confidence and to further reduce the debt. Improving the quality of fiscal adjustment will be crucialinensuring its sustainability. 13 48. The external position is projected to stay strong, with the overall balance declining from the peak of US$ 23.2 billion surplus (supported by strong capital inflows) in 2005 to US$ 14.5 billion in 2006, before moderating to an average of US$ 2 billion in 2007-08. The current account deficit i s projected to increase slightly from the 6.4 percent of GNP in 2005, to 7.2 percent in2006, and decline gradually thereafter. While exports (fob, includingshuttle trade) are projectedto increase from almost US$77 billion in2005 to about US$99 billion in2008, strong consumption and investment growth could boost imports by even a higher amount. Given the improved FDI inflows (and commitments in 2005) and the EU negotiations process in place since October 2005, m>I i s projected to reach US$ 14.4 billion in 2006 and then moderate to slightly above US$7 billion a year over 2007-2008. 49. The specific factors underlying the medium-term projections that the economy wilt grow by 6 percent in 2006 and about 5 percent annually in the 2007-2008 period include: (a) strong external anchors-supporting enhanced confidence in the policy framework; (b) improved macroeconomic stability and continued decline in interest rates-which would stimulate private investment and consumption demand; (c) stronger export performance-which would permit faster import and output growth; and (d) strong external inflows, including FDI. Under this scenario, fiscal adjustment would yield a permanent reduction in the public sector borrowing requirement from 1.4 percent of GNP in 2005 to a surplus of almost 1.6 percent in 2008. This will underpin the projected stabilization of the net public debt stock to GNP ratio below 50 percent of GNP by 2007. The programmed fiscal adjustment would also support the continuation of the strong disinflationary process during the medium-term. Increasing oil prices as well as a creep in global inflation are potential external risks to the projecteddisinflation path. I Table 8: BaselineDebtDynamics 1 PublicDebtForecasts(in % of GNpf I 2000 2001 2002 2003 2004 2005 2006 2007 2008 Gross Debt Stock 68.2 107.5 93.6 83.4 77.4 71.6 65.5 60.7 55.9 GrossDomestic Debt Stock 43.1 71.1 56.3 56.4 54.5 52.9 49.3 46.6 43.2 Net Debt Stock 57.1 90.5 78.5 70.4 63.5 55.8 50.1 45.6 41.2 NetDomesticDebt Stock 38.0 52.8 46.2 48.3 46.0 47.3 45.7 43.0 39.6 Domestic InterestPayments 2.l 14.9 23.0 15.9 14.8 11.7 8.0 6.5 5.8 5.0 DomDebt Arrmrtization 12.9 25.5 24.7 24.3 29.2 27.6 19.4 18.2 15.5 PSBR 31 13.3 16.7 12.5 9.6 4.8 1.4 0.4 -0.5 -1.6 MacroeconomicIndicators 2000 2001 2002 2003 2004 2005 2006 2007 2008 NominalInterestRate (a) I 38.0 99.1 63.5 44.1 24.9 16.2 13.2 11.8 10.9 CPIInflation(%, DeclDec) 39.0 68.5 29.7 18.4 9.3 7.7 6.0 4.0 4.0 RealInterestRate I/ -9.5 35.5 30.3 30.2 15.4 8.3 8.1 7.5 6.7 Depreciation(DedDec) 24.4 114.3 13.5 -14.6 -3.8 0.1 2.9 1.o 1.o REER( D d e c ) 13.7 -23.6 10.9 34.6 10.4 4.5 0.0 0.0 0.0 GNP growthrate (a) 6.3 -9.5 7.9 5.9 9.9 7.6 6.0 5.0 5.0 primary Balance(% of GNP) 2.6 5.1 4.2 6.3 7.1 6.5 6.5 6.5 6.5 14 50. Publicdebt sustainability." The net public debt to GNPratio, which fell from a highof 90.5 percent in 2001 to 63.5 percent in 2004, has further declined to 55.8 percent at the end of 2005 (Table 8). In gross terms, the debt to GNP ratio stood at 71.6 percent at end 2005. The assumptions in the programmed trends for the key macroeconomic parameters result in further steady decline in the gross public debt to GNP ratio, falling below 60 percent in 2008. Realization of this outcome hinges on sustained growth, continuous fiscal adjustment (a primary surplus of 6.5 percent of GNP), stable exchange rates and a favorable external environment. While the strong YTL has underpinnedthe fall ininflation and decline inthe public debt to GNP ratio, the extent of the exchange rate appreciation and current account deficit that have accompanied growth in economic activity, have generated additional sources of macroeconomic risk. 51. A sensitivity analysis of the public debt dynamics demonstrates the central role of credible policies to build confidence and deepen the fiscal adjustment. Even though the level and the structure of Turkey's public debt have improved, Turkey remains exposed to risks. The short average maturity of the domestic debt leads to high monthly rollover requirements. FX exposure i s another important determinant. Turkey's crisis responseprogram has featured debt swaps by the Treasury to eliminate the excess open FX position of the banks, together with increased FX and FX-linked borrowing. As a result, the share of FX and FX-linked debt (including both external and domestic debt) in the total public debt stock has decreased sharply but still representsa significant share (Table 9). Moreover, a highproportion of domestic debt is in FRNs (as of end-2005, 54.6 percent of the consolidated budget domestic debt stock is in FRNs)which entails exposureto interest rate movements. Table 9: ConsolidatedBudgetTotal Debt (Share of total) 2001 2002 2003 2004 2005 TRL 44 42 54 58 62 FX-Linked 56 58 46 42 38 Source: Treasury 52. To illustrate the risks, a low-case scenario can be formulated where fiscal performance goes off track and the primary surplus undershootsthe programtargets for 2006-08 and does not exceed 3 percent of GNP. As a result, real interest rates could be in the 15 percent range, Le., well above the projected program path. The growth momentum would be expected to falter under the burdenof sustainedhighrealinterest rates with growthfalling to 3 percent per year, A slowdown in the growth rates and deterioration in the public debt dynamics could lead to renewed capital account outflows and exchange rate instability, which would exacerbate the impact on the debt burden. Under these conditions, the decliningtrend in the public debt burden couldbe interrupted. This sectionsummarizesthe extensivework on public debt sustainability presentedinthe 2006 Turkey: Country Economic Memorandum(CEM). 15 Table 10. Turkey: External Financing Requirementsand Sources, 2000-2008 (Inbillions ofU.S. dollars) Actual Projection 51 2000 2001 2002 2003 2004 2005 2006 2007 200s ross financing requirements 39.9 39.0 37.6 47.3 61.9 86.7 97.9 112.3 120.2 Current accountdeficit (excluding official tra 10.0 -3.2 2.0 8.3 15.9 23.7 30.2 29.7 28.5 Amortization ondebt securities 1.7 2.1 2.7 3.9 3.8 3.4 2.6 3.7 3.7 Of which: Public sector 1.4 2.0 2.3 3.8 3.8 3.1 2.6 3.7 3.7 Deposit money banks 0.4 0.0 0.4 0.2 0.0 0.4 0.0 0.0 0.0 Medium and long-termdebt amortization 13.8 14.3 13.6 14.9 14.5 16.7 17.9 28.1 35.0 Of which: Public sector 11 3.6 3.6 3.0 3.2 3.2 3.3 3.1 3.4 3.3 Private sector 7.9 8.9 9.0 10.3 10.1 11.1 13.8 18.0 23.6 Deposit moneybanks 2.3 1.9 1.6 1.4 1.2 2.4 1.O 6.7 8.1 Short-termdebt amortization 14.3 25.8 19.3 20.1 27.7 42.9 47.2 50.9 53.0 Public sector(net)ll -1.0 1.o 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Tradecredits 24 20.2 17.9 17.8 22.4 31.4 46.0 49.5 52.8 55.0 Banks and other private (net) 4.9 6.9 1.5 -2.3 -3.7 -3.1 -2.3 -1.9 -2.0 vailable financing 39.9 39.0 37.6 47.3 61.9 86.7 97.9 112.3 120.2 Foreign direct investment(net) 0.1 2.8 0.9 1.2 2.0 8.6 14.4 6.9 7.2 Portfolio flows 3.4 -1.7 4.2 7.8 13.2 18.1 9.5 9.3 9.3 Public sector 7.5 2.1 3.3 5.3 5.8 6.5 5.5 5.5 5.8 Deposit moneyhanks 0.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Private sector(net) -4.6 -3.8 0.9 2.5 7.5 11.6 4.0 3.8 3.5 Mediumandlong-terndebt financing 18.1 13.2 15.8 14.1 20.6 30.2 37.5 44.2 51.0 Of which: Public sector 11 3.4 3.2 2.9 0.7 1.7 0.5 2.7 3.0 2.0 Private sector 12.8 9.2 11.5 11.9 15.4 21.0 26.8 30.5 37.0 Deposit moneybanks 1.9 0.9 1.3 1.4 3.5 8.8 8.0 10.7 11.9 Short-termtradecredits, currency and deposit 17.9 13.2 15.9 23.0 27.9 49.9 49.1 52.7 54.7 Official transfers 0.2 0.2 0.5 0.3 0.3 0.6 0.8 0.6 0.6 Other 31 -2.8 -1.7 0.1 5.0 2.3 2.4 1.o 0.0 0.0 Net reserves(+/-= decreaselincrease) 3.0 12.9 0.2 4.1 -4.3 -23.2 -14.5 -1.4 -2.6 Accumulation of gross reserves -0.4 2.7 -6.2 4.0 -0.8 -17.8 -10.8 1.o -0.8 IMF(net) 3.4 10.2 6.4 -0.1 -3.5 -5.4 -3.7 -2.4 -1.7 Purchases 3.4 11.3 12.5 1.7 1.2 2.4 3.6 2.7 0.9 Repurchases -0.1 -1.1 -6.1 -1.7 -4.7 -7.8 -7.3 -5.1 -2.7 Total External Debt 118.5 113.6 130.2 145.0 162.2 170.1 197.2 216.9 237. d w Short-term Debt 28.3 16.4 16.4 23.0 32.6 38.2 44.0 48.1 52. Total External DebtlGNP 58.9% 78.7% 71.3% 61.2% 53.7% 46.9% 48.2% 50.1% 50.9' Debt ServiceRatio 41 37.2% 41.9% 38.1% 35.1% 27.2% 26.4% 27.0% 33.2% 36.4' I/Generalgovernmentand Central Bank of Turkey. 24 Series reflects gross flows of short term tradecredits, and stocks of credits to the banking sector. 31Errors andomissions. 4/ Interestplus medium- andlong-term debtrepaymentsas percentof current account receipts(excluding official transfers). 51World Bank ource: CBT, IMFandWB estimates. 3. Externalfinancing and debt. Turkey has to deal with an external financing challenge over the medium-term which relatesto both the magnitude andthe composition of this financing. Annual financing requirement increased from US$ 47.3 billion in 2003 to 61.9 billion in 2004 and US$ 86.7 billion in 2005 (Table 10) as a result of the widening current account deficit and the amortization of short-term trade credits. Assuming that imports will stay at high levels as a result .of strong growth and macroeconomic stability, trade credit i s expected to continue increasing, which puts pressureon the gross financingrequirement for 2007-08. Turkey needs to generate enough medium and long term capital inflows to: (a) finance an annual current account deficit of close to US$30.2 billion in2006, and an averageof US$29.1 billion in2007-2008; (b) service sizeable long term loan repayments despite easing out of repayments to the IMF; and (c) keep the short-term debt inflows at prudent levels. Given the improvement in the financing of the current account deficit, through historically high FDIand longer term financing, Turkey is expected to be able to manage these high levels of external financing requirements in the mediumterm. Moreover, the improving level of CBRT gross reserves (over US$ 52 billion at end 2005) could provide some additional cushion in case of a severe external shock. The stock 16 of external debt reachedUS$ 170billion at the end of 2005 (of which US$38 billion short term), equal to about 46.9 percent of GNP, which represents a decline from the 2004 value of 53.7 percent. Looking ahead, the extent to which Turkish banks and enterprises will be able to rollover their external obligations and attract new financing on favorable terms will remain an important determinant for the program. 54. The IMF SBA in place, the government's macroeconomic policy framework, and the striking improvement in macroeconomic indicators presented above and reflected by recent increases in Turkey's credit ratings, support that, while significant risks remain, the current macroeconomic framework is adequate for the purposesof the PPDPL. 111. THEGOVERNMENT'SPROGRAM 55. Turkey's economic policy and reform program i s made of a number of separate, yet consistent among themselves, documents. The long-term agenda i s articulated in the 23-year National Development Plan (2001-23). The initial priorities of the current administration were spelled out in the Urgent Action Plan (UAP) published on January 3, 2003 and in the 59" Government Program presented to Parliament on March 18, 2003. Updates to the economic program are approved by the Cabinet of Ministers in the form of annual programs. The current one i s for 2006 andwas published inthe Official Gazette on October 17,2005. 56. Turkey also produces an annual EU Pre-Accession Economic Program which details short and medium term policy actions and structural reform priorities related to EU accession. The 2005 Pre-Accession Program which covers the 2006-2008 period was adopted by the High Planning Council (HPC) in November 2005. In addition, the country i s implementing an economic program supported by an IMF SBA which is expected to run until 2008, includes a government Letter of Intent. These policy documents are consistent among themselves. 57. Key long-term development goals include transforming the country's economic and social structure in order to become an influential regional economic power, raising the level of health and education in the society, improving income distribution, strengthening scientific and technological capacity, enhancing effectiveness in infrastructure services and protecting the environment. The vision that Turkey has for itself is of a modern and secular participatory democracy, fully integratedin the European community, playinga critical role inits region, with an export-oriented, technology-intensive production structure. Turkey sees the EU accession process as an important opportunity for harmonization with international norms andstandards. 58. Turkey's development agenda i s centered on four major themes: (a) sound macroeconomics and governance; (b) equitable human and social development; (c) attractive business climate and knowledge; and (d) strong environmental management and disaster mitigation. (a) Sound Macroeconomics and Governance: In the past, chronic instability has prevented Turkey from realizing its full growth potential. Over the past two decades and prior to the current periodof stability, Turkey's economy hadremained vulnerable and plagued by persistent fiscal imbalances, chronically high inflation, and sharp swings in the business cycle. Earlier attempts to stabilize the economy fell short, and high growth hadnever been sustained for long. 17 The government recognizes that consolidating the current macroeconomic stability and strengthening public sector governance requires action on: (i)continued effective implementation of structural fiscal policies to ensure permanent fiscal adjustment; (ii) carrying out the recently adopted medium-termprogram to improve the transparency and efficiency of PEM; (iii) furthering broad-based institutional reforms to improve the quality of public sector governance; (iv) embarking on a judicial reform program based on a comprehensive judicial sector assessment; and (v) improving the mechanisms for service delivery including through a process of decentralization. (b) Equitable Human and Social Development: Human development is critical for Turkey's ambitions for EUaccession, global competitiveness and reduction of inequality. Sustaining high growth and modernizing the role of the state are key strategic objectives for Turkey, but none of them may be fully achieved or sustained without improving the country's human capital. Currently, educational attainment of the Turkish population and labor force is by far the lowest of all Organization for Economic Cooperation and Development (OECD) countries. Raisingthe educational qualifications of the population is a crucial requirement for improved labor productivity and employment growth in Turkey. It is also critical for making the country more competitive in the global economy and to meet the goal of EU accession. The following activities emerge as priorities: (i)continuing the reform of the education sector by strengthening the curriculum of secondary and tertiary education with the objective of linkingthe curricula to labor market requirements and expanding and upgrading the skills base of the country; (ii) advancing the reform of the health sector to make it more equitable and efficient; (iii) continuing the reform of the social security system as a natural complement to the broader public sector reform program; (iv) monitoring and assessing poverty and vulnerability for effective poverty reduction; (v) promotingthe social inclusionof disadvantagedgroups such as women, youth and the elderly; and (vi) removing the constraints currently affecting the Turkish labor market (formal andinformal sector). (c) Attractive Business Climate and Knowledge: Turkey is addressingthe unfinished agenda of financial sector reform. The first phase of financial sector reform following the 2001 crisis addressed the urgent banking sector priorities including upgrading the regulatory and institutional framework of the bankingsector to international levels, restructuring and clean up of the private banking sector, and the financial and operational restructuring of the state banks. A degree of short-term stability has been achieved in the banking sector, and the emphasis is now on consolidation and sustainability of the remaining reforms, focusing primarily on institutional strengthening and independence of the Banking Regulation and Supervision Agency (BRSA) andthe SDIF, privatization of the state banks, reform of the deposit insurance regime, and sales of nonperforming assets heldby the SDIF. On a more strategic level, however, development of a broader and deeper financial sector i s essential for sustained financial stability and economic growth. It is therefore timely for the Government and the private sector to broadentheir focus to encompass diversifying the financial system beyond banking, along with a balanced set of incentives for complementary development of banking and non-bank financial institutions (NBFI) and markets. This will be essential to improve real sector access to a wider range of modem financial products and services; to improve access to finance for a broad range of economic agents, including small and medium scale enterprises (SME), micro-enterprises and low income earners; and to reduce the systemic risks in the financial sector through diversification. Completion of the reform agenda inthe banking sector and development of well- 18 regulated non-bank financial intermediation are key elements for sustainableeconomic recovery. The critical medium-term priorities for promoting private sector development include: (a) completing the process of reforming the banking and financial sector; (b) addressing constraints to S M E growth; (c) accelerating privatization and removing barriers to FDI; (d) improving the governance of the transport sector to reduceits fiscal burden andimprove its competitiveness; (e) continuingthe restructuring and privatization of public utilities coupled with sector reform; (f) following up on the agricultural sector reform implemented under the previous CAS; and (8) implementing the reformprocessinherent inthe EUAcquis Communautaire. (d) Strong Environmental Management and Disaster Prevention: Turkey i s highly vulnerable to natural disasters, especially earthquakes and floods. In 1999, the Marmara earthquakecaused extensive loss of human life andlarge economic costs, pointingto the needto improve disaster prevention and emergency preparedness. High priority needs to be given to reducing the impact of future earthquakes affecting Istanbul and, specifically, to saving lives and mitigating the social and economic impacts that can be expected to occur. Special emphasis should be attached to strengthening the region's emergency management capabilities, including planning, public education, and conducting region-wide emergency exercises. Seismic strengthening of Istanbul's most critical facilities (hospitals, emergency facilities) and major lifelines would assure that the essentialinfrastructure of the region would continue to function in the aftermath of a major earthquake. More broadly, Turkey needs a coherent approach to environment protection, otherwise and like other developing countries, it faces the risk of allowing its economic growth to result in unacceptabledepletion of water, forestry, bio-diversity and air quality. As part of the EU accession process, Turkey is required to enhance its environmental standards and compliance mechanisms, and the EU is taking the lead in supporting this effort. Complying with the EUenvironmental directives i s a major challenge for Turkey, and requires significant increases in environmental investments over a long period of time. Appropriate management of the environment i s also fundamental to the Government's poverty reduction objectives since there could be a relationship between poverty and environmental degradation. Reversing the trends of environment degradation i s a long-term agenda, requiringinstitutionaland cultural changes, it i s important to concentrate on key priority areas: (i)strengthening the country's capacity for emergency preparedness; (ii) further making progress in adopting EU environment standards; and (iii) introducing sound practices for air, water, solid waste andforestry management. 59. As reflected in the CAS (see next section), the government and Bank have agreed that this proposed operation will support four key components of the Turkey's broader overall program, namely (a) maintaining the currently enabling macroeconomic framework; (b) reforming substantially the country's social security and assistance system; (c) continuing the ongoing process of upgrading the public financial management and budget systems; and (d) improving the administration and governance of the public sector. These components were chosen in view of the close relationship among themselves, their strong relationship to the CAS objectives, and the quality of the diagnosis and analytic underpinnings for prescribing policy action resulting from thejoint work of the government andthe Bank. 19 IV. BANKSUPPORTTOTHEGOVERNMENTSTRATEGY 60. The Board of Executive Directors discussed the FY04-06 CAS for Turkey on November 6, 2003. In November 2005, the Board received a Progress Report taking stock of the implementation of the CAS, setting out some adjustments to reflect Turkey's preparation for EU membership, and extending the CAS period by another fiscal year through FY07. The Progress Report left the strategic framework of the Bank's involvement inTurkey largely unchanged, but appropriate refinements were introduced to addressemerging issues. 61. The objective of the CAS has been to help Turkey implement fundamental reforms to reduce economic vulnerability and achieve high and stable growth, and continue the process of addressing long neglected social and environmental problems. In providing this assistance, the CAS Progress Report envisages two series of development policy loans. Public sector reforms will be supported through the proposed PPDPL and PPDPL 11. A proposed series of two EGDPLs are being preparedunder four pillars focusing on policies aimed at improving: (a) the investment climate; (b) the functioning of the financial sector, including continued banking sector reform; (c) performance of the labor market; and (d) labor productivity through technology adoption andupgradedskills. 62. The CAS Progress Report includes a number of measures constituting benchmarks closely monitoredby the Bank. Satisfactory progressin their implementation allows the Bank to move ahead with the corresponding two development policy loans, provided the high case CAS triggers have been met -which, as presentedin Box 1below, i s the case. The following are the benchmarks envisioned underthe Progress Reports andtheir current status. Establishment of the Universal HealthInsurance Fund(UHIF)and Social Security Institution that merges three social security systems. This action is supported under this proposed PPDPL and constitutes aprevious conditionfor presenting the Loan to the Bank's Board of Executive Directorsfor approval. Change inthe unemployment insurance system to improve access to benefits for unemployed workers and easing contribution requirements in a fiscally sustainable way. This action is expected to be supported under theproposed EGDPL series underpreparation. Implementation of severance pay and fixed-term contracting reforms to encourage employment and labor market flexibility. This action is expected to be supported under the proposed EGDPL series underpreparation and is expectedto be a conditionfor presenting either the EGDPL Z or ZZ, depending on on-going discuss~onswith the authorities, to the Bank's Board of ExecutiveDirectorsfor approval. Introductionof a new mortgage finance legislation that would enable the further expansion of equitable and sustainable mortgage markets, contributing to growth in the construction industry and related employment. This action is expected to be supported under the proposed EGDPL series under preparation. A drajl mortgage law has been prepared with 20 technical assistance from the World Bunk and the Financial Sector Reform and StrengtheningInitiative (FIRST). Thedrap was endorsed by the Cabinetof ~inistersand s u b ~ i ~ e dthe Parliamentfor approval. to Box 1: Status of HighCase Triggers MACROECONOMIC b Implementation of a satisfactory macroeconomic framework consistent with the Country Performance Indicators ncluded inthe CAS Matrix. Macroeconomic indicators will be monitoredon a quarterly basis. 1 A satisfactory macroeconomic framework, consistent with the Country Performance Indicators, has been maintained. Performance has exceeded expectations. A new 3-year SBA has been in placefrom May 2005. D~cusswnson #e third andfourth IMF SBA reviews were completed in May 2006 and the IMF Board datefor the release of the associated `rancheshas been setfor July 2006. (seeAnnex 3) STRUCTURAL m Sustainedsatisfactory implementation of public sector reforms, including: 9 budgetreformstoimprovetransparencyandeffectivenessofpublic expenditures; 9 taxreformstoimproveefficiency andequity, andpromote growth; and 9 public liabilitymanagementreforms to managefinancialandfiscalrisks. D Public sector reforms are beingsatisfactorily ~plemented,including: 9 (i) the enactment of the Public Finance Ma~gementand Control (PFMC) Law that harmonizes and modernizes budgetary practice across the general government and whose ~ p l e m e n ~ t i orequires concerted action at all n levels of government; (ii) the rolling-out of government financial statistics (GFS) budget classification in the consolidated budget and most of the special budget institutions; (iii) introduction of accrual accounting in all consolidated budget institutions; and (iv) e l ~ i ~ t of accountsrelated to closed Extra-budgetary Funds; w n P continued tax policy reform to improve efficiency and equity of the tax system including a drajl law on CIT submitted to Parliament and preparationsfor a new Personal Income Tax(PIT) law; and enactment of a new Law on the RevenueAdminist~twn; 9 maintenanceof a strongmiddleofice for riskmanagementinthe Treasury. All of the second tranche conditions of the public sector part of the PFPSAL III have been met including early satisfactory ~p1ement~'on of the new Agriculture FrameworkLaw which was enactedon April 25,2006. . 0 Sustained satisfactory implementation of regulatory reforms, privatization and liberalization of the energy and telecommunications sectors; and of the agriculture reform program designed to replace indirect subsidies with direct income support (DIS) andpromote the developmentof agriculture markets. e The release of the second tranche of the Economic Reform Loan confirms that triggers related to the sustained ~ p 1 e m e n ~ ' oofnregulatory reforms, privatization and l ~ e r a l i ~ t i o nthe energy and telecommunicationssectors and the of agricuuUralreform program have been met. 0 Sustainedsatisfactory implementationof financial andprivate sector reforms, including: 9 continuedindependenceandfurther strengtheningoffinancial marketsregulatoryagencies; 9 completionofprivatizationofstatebanks; 9 passageofanamendedBankruptcy LawandrevisedCommercialCode; 0 There has been somewhat slowerprogress in the area of financial sector reform supported by the PFPSAL III, in particular in state bankprivatizatio~.However,there has been recentprogress in several areas. 9 Independence of the financial markets regulatory agencies has been preserved, and further ins~utionai s ~ e n ~ h e n i nofgBRSA and SDIF is underway. 9 Vakiflank conducteda very successfulIPO in thefall of 2005, and Ziraat and Halk have been substa~ll) restructured in terns of stafing and branch networks in preparation for their privatization. The authorities have engagefi privatizationadvisors to sell Halk. Due to their large size and impact on the market, the Governmentplans to sequence thc privatization of Ziraat ajler the initial steps to privatize Halk. The release of the PFPSAL 111 second tranche will bc consideredsatisfactory for meeting the high casetrigger relatedtothefinancial sector. 9 The Execution and BankruptcyAct (EBA) has been amended and supportirrg regulations have been issued The CommercialCodehas been amended to simplify proceduresfor setting up a company;a new CommercialCodehas beer drajled. 0 Design andimplementationof the next phase of a comprehensivesocial security reform. 9 A comprehensivereform of the social security system is underway.The i n s ~ usocial~security reform la^ ~ l unifyingthe threesocial security schemes was enacted on May 20,2006. The Social Securityand UHI law is re-approved by the Parliament by June. SOCIAL e Maintenanceof public expenditure targets for health, education andsocial protectionas agreedwith the Bank. 21 Aggregatesocial expendituresreached agreed targetswith a slight dvjerence in education. 1 COLLABORATIONWITH THE IMFAND OTHERDONORS 63. The IMF and World Bank teams have collaborated closely in Turkey, and standard working arrangements broadly follow the guidelines for enhanced Bank-Fund collaboration. This has includedparticipation of Bank staff inmeetings with government of the Fund'sprogram review missions, and IMF staff invited to key Bank review meetings and meetings with government, The IMFhas taken the lead inmacroeconomic stabilization and the World Bank in social and structural areas, with close collaboration in structural areas that have a particular impact on macroeconomic stability. The IMFhas particularly valued the work undertaken by the Bank on the fiscal analysis of pension reform and u)-II as well as the assistance to the Government in planning the implementation of these reforms. The Bank's dialogue and conditionality has maintained consistency with the macroeconomic framework endorsed by the m. 64. The Bank has taken the lead in structural areas where both institutions have conditionality including bankruptcy reform, corporate sector restructuring, social security reform, regulatory and market reforms in telecommunications and energy, agriculture reform, andprivatization. The Bank is also inthe leadin areas such as health, education, infrastructure, governance and environmental management. The Fund takes the lead in macroeconomic stabilization including macro-fiscal policy, monetary policy, exchange rate policy and financial stability andrisk management. 65. The work on public sector management and governance has focused on strengthening PEM system while maintaining fiscal discipline. The IMFhas taken the lead in the short-term measures needed for the fiscal adjustment such as incomes policy, urgent revenue and expenditure measures, and budget monitoring and reporting. The Bank has taken the lead in assisting government on the medium-term PEMstrategy, rationalization of the public investment program (PIP), public procurement reform, accounting reform, and public liability management. Public employment policy, medium-term tax strategy, anti-corruption strategy and civil service reform are further areas of Bankinvolvement. 66. Inaddition, the Bank hastaken the leadinreformof the legal framework andregulations for bank supervision, the institutional development of the BRSA and SDIF, and the structural reforms required to guide the restructuring and improve the governance of the state banks, as well as work on NBFI. The IMFhas taken the lead in assessing the soundness of the banking system and where there was an immediate fiscal impact such as the re-capitalization of the state banks, the closing of insolvent banks, andthe privatebank recapitalization scheme. 67. The ongoing EU accession process has generated increased demand for the Bank's services in Turkey. In this context, the Bank accelerated completion of a new CEM on EU accession, in close collaboration with the European Commission, The World Bank Institute (WBI) is complementing the CEM efforts with relevant institutional and leadership knowledge transfer activities designed to improve the ability to identify, analyze, sequence and implement policy decisions related to EU accession. For instance, the Bank assisted the government in 22 organizing two EU leadership seminars where the relevant accession experiences of current members were sharedwith the highestlevels of Turkishgovernment. 68. The Bank has coordinated closely with the EUits advice on the public procurement law and follow up technical assistance to the Public Procurement Agency (PPA) established under the law. The new public procurement law moves Turkey towards compliance with EU directives. The social security reforms envisaged under the program supported by this Loan are inconformity with the EuropeanSocial Model, andwill help Turkey bothkeep on track interms of Copenhagencriteriabut also move fo,mard interms of meetingthe Lisbon agenda. 69. The EU itself i s providing support for the Turkish Employment Agency (ISKUR) and may also assist with finance for the informatics needs of the social security system. The Bank's assistance on public debt management issues has been oriented towards EU practices and the Maastricht criteria. The Bank i s coordinating its dialogue on financial management issues with the EU, and the law on PFMC is consistent with EU standards on internal control. The EUi s preparing to support additional institution-building initiatives under the public sector reform program including support for peer review and twinning arrangements for the Turkish Court of Accounts (TCA) and support for the Ministry of Finance (MOF). mLATI0NSHIPTO OTHERBANKOPERATIONS 70. Turkey's public sector reform programsince 2000 has includedPEMreform, tax policy and administration reform, public liability management and governance reform. Lending support was through the Economic Reform Loan (2000) and the three PFPSALs - PFPSAL I (July 2001), PFPSAL I1 (April 2002) and PFSPAL 111 (June 2004). PPDPL is the next programmatic series supporting reforms inTurkey's public sector as a continuation of the public sector reform agenda envisaged under the PFPSAL program. Financial sector reform components of the PFPSAL program have been integrated into the proposed EGDPL series. PFPSAL program has progressedsuccessfully since its inception in 2001 and is expected to be completedbefore the Boardpresentation of the PPDPL. 71. The PPDPLreforms will be buttressed by the labor markets, financial markets, business climate, and knowledge, innovation, and skills reforms under the proposed EGDPL series. These reforms are aimed at increasing employment in the formal sector by generating new jobs but also by reducing the incidence of informality in the economy. Increased formal sector employment and the implied reduction in the incidence of informality will significantly complement the fiscal sustainability objectives of the social security reforms supported by PPDPL. 72, The PPDPL has strong linkages with a number of other Bank-financed investment projects. The HealthTransition Project (HTP)approved inJune 2004 supports a comprehensive health sector reform program that will improve the cost-effectiveness of the health care system so that the introduction of UHIsupported by this operation can become fiscally sustainable. The Social Risk Mitigation Project (SRMP), approved in September 2001, i s already supporting the strengthening of the social assistancesystem and will support some of PPDPLreforms; a process which will deepen by the proposed follow-on Social Development and Employment Promotion Project (SDEP). Likewise, the Privatization Social Support Project (PSSP) series (PSSP, 23 approved inDecember 2000 andPSSP11in June 2005) i s providingthe necessary social support to ensurethe continued highly successfulprivatization program. LESSONSLEARNED 73. The lending relationship betweenTurkey and the World Bank dates back to 1950, when the Bank made its first loan to Turkey shortly after the country became a new member. The Bank has been active in virtually all sectors and has conducted a great amount of analytical and advisory services. Obviously, there i s a great deal of experience and lessons learned in this relationship, the most relevant of which, from the perspective of this Loan, are summarized in a recent Country Assistance Evaluation (CAE) assessing the outcomes of the World Bank`s assistanceto Turkey during the period July 1, 1993 to June 30,2004. The Bank`s 2005 Review of World Bank Conditionality constitutes another source of lessons learned relevant to development policy loans to Turkey. 74. These lessons learned have been reflected in the design of the PPDPL program as follows. First, in Turkey the Bank must bundle its analytical work and policy dialogue with lending to achieve program effectiveness. The 1993-2004 CAE found that little formal economic and sector analysis was carried out up to the late 1990s but that thereafter economic and sector analysis has become a larger part of the Bank's program which has increasedprogram effectiveness materially. As detailed below, the PPDPLprogram has been designedon the basis of a substantial amount of analytical work. Because of current benign international liquidity conditions, Turkey i s currently able to borrow from financial markets at terms to maturity longer than Bank loans and at the lowest spreads -also relative to Bank loans in history. Thus, the Bank's ability to persuasively advise the government on program design depends largely, if not exclusively at the moment, on the quality of its analytical work and policy dialogue capability - key elements insupporting program ownership. Inthis latter regard, the CAE also found that the policy dialogue has been closer and more effective with the increased management focus on Turkey that resulted from greater decentralization of Bank decision-making to Ankara and the increased role of the Country Office in program monitoring and implementation. The PPDPL program i s beingmanaged from the Country Office with input from staff basedin headquarters, as required. 75. Disbursement conditions under development policy loans should be few and focused on only those actions critical for achieving the results sought under the program. The Bank's adjustment anddevelopment policy loans inTurkey have seen a dramatic decreaseinthe number of disbursement conditions. For example, the Economic Reform Loan (ERL) was fully disbursed (in 2004) after four years after Board approval. One reason for this long implementation period i s that this loan had about 40 disbursement conditions. Since the approval of the ERL, development policy loans in Turkey have been increasingly focused on critical actions, PPDPL has only six core conditions and four crucial triggers have been establishedfor movingforwardwith the preparation of PPDPLII. 76. Related to the above, in Turkey there i s a need to strike a delicate balance between critical disbursement conditions (predictability of the program) and flexibility of expected prior actions (triggers). The PPDPL program attempts to reach this balance by including between 6 and 10 disbursement conditions for each of the two loans in the program-which obviously will 24 be completed before Board presentation, but only four triggers to move forward with the appraisal and negotiations of the second loan prior to submitting it to the Executive Board of Directors for approval. This design recognizes the fact that the government has adopted a well specified and EU accession anchored mediumterm program but which needs to remain flexible in view of the unpredictable timing of public sector reform needs that may result from the on- going dynamic process of EU-accession negotiations. Priorities within the overall public sector reform program may change as EUnegotiations advance and so may the preferences regarding the specific subjects of the Bank support within the wider government program. The design still allows transparent progress reviews and predictability as the program moves to the secondphase because the policy matrix contains numerous non-core actions included that will act as implementation milestones. Naturally, the disbursement conditions for the second Loan under the PPDPL series will need to have sufficient substantive content. In other words, these conditions will need to be critical enough to the objectives of the program to justify the second loan. 77. Country ownership i s fundamental for the program supported by this series of loans as evidenced by the political difficulty entailed by the disbursement conditions for the first loan under the series. As in other countries, the Bank has fully recognized the importance of country ownership in Turkey. This recognition meant that a large portion of the preparation effort of PPDPL was devoted to assessing and assisting in building ownership of the actions envisioned under the program - most notably social security reform. For instance, the Bank spent significant resources providing technical inputs (particularly in health and pension reforms) to key domestic reforms leaders for their use in their own policy dialogue with local constituencies on the urgency of reforminglocal constituencies. 78. Finally, a central lesson learned in Turkey and elsewhere i s that it i s impossible to implement a meaningful development program under volatile macroeconomic conditions and that inflation is a tax that affects primarily the poor. Therefore, the strong fiscal performance demonstratedin the past two years, which i s fully consistent with the objectives of the CAS, and the spirit of the broad public sector reform program should remain an integral part of program and loan design. ANALYTICAL UNDERPINNINGS 79. The World Bank has provided considerable analytical support to Turkey's public sector reform program through three CEMs (2000, 2003, 2006), Country Procurement Assessment Report (200l), Country Financial Accountability Assessment (CFAA, 2001) and Public Expenditure and InstitutionalReview (PEIR, 2001) and Municipal Sector Review (2004). The Bank has been providing technical assistance in developing the government's technical capacity to runpension reform option simulations for several years. Inaddition, a report on costing UHI was provided in 2004. A Joint Poverty Assessment Report was completed in August 2005. A labor market study was finalized and a new Programmatic CEM Series has been launched, of which the first CEM was concluded in 2006. A Public Expenditure Review (PER) i s underway to provide further analytical underpinnings for PPDPL 11. Figure 2 summarizes the linkages betweenthe reformprogram, analytical work and operational support. 25 V. THEPROPOSEDPPDPL OPERATIONJUSTIFICATION 80, The loan will support major policy actions to reform the social security system which, if left unreformed, would be the most important source of future fiscal and macroeconomic imbalances in Turkey. Containing the growth of the social security deficit i s essential for the long-run sustainability of public finances. If implemented as enacted, the reform will bring the social security system to fiscal sustainability which is essential to the stable macroeconomic framework Turkey needs to implement its long-run development program, including completing accessionnegotiations with the EUsuccessfully. 81. Comparable parametric reform of the pension system has proven politically difficult, if not impossible, to enact in other countries -whether developed or developing and where the actuarial balances of the pay as you go system are fiscally unsustainable. Aware that these reforms are vital to both long-term fiscal stability and modernization of the economy including convergencewith the EU, the authorities managedto undertakethese politically difficult reforms -notwithstandingthat ageneralelection isexpectedto takeplacein2007 andthat thereform might be unpopular with some organized groups. These events are clear evidence of ownership of and commitment to the program. World Bank support for these policy actions i s warranted as recognized in the CAS Progress Report, which envisions social security reform as one of the benchmarksunder the enhancedhighcase. 82. The government has demonstrated a strong commitment to fiscal discipline and macroeconomic stability as evidenced by the large primary surpluses in the past years and ensuing reduction in the ratio net public debt to GDP, the much better management of the domestic public debt, the dramatic decrease in inflation and real rates of interest -outcomes that have beenrecognizedby the main credit ratingagencieswith better ratings. 83. The additional features of the PPDPL program represent the Government's plan and commitment to continue implementing second-generation structural reforms needed to consolidate the fiscal adjustment and improve the quality of public service delivery. The authorities continue to address the weaknesses in public financial management that contributed to the boom-bust cycles of the Turkish economy in the past. Much of the fiscal adjustment has been in areas that had been off-budget and in quasi-fiscal activities that helped perpetuate fragmented and non-transparent PEM. Thus, efforts to bring about fiscal savings through social security reform needto be accompaniedby further actions inorder to ensure the highest possible effectiveness of public resources. The ambitious and comprehensive nature of the package of actions and the need to sustain reform momentum in the public sector warrant support from the international community through the PPDPL. PROGRAMMATICFRAMEWORK OPERATIONDESCRIPTION AND 84. As summarized in Figure 2, the proposed loan is an integral part of World Bank analytical and financial support to the government's comprehensive program of sustained medium-term legal, institutional, and structural policy actions to consolidate and improve fiscal 27 adjustment, modernize the institutions and procedures of public sector management and service delivery. 85. PPDPL is the first of two loans supporting a programmatic approach which recognizes that the government has adopted a well specified and EU accession anchored MTP but which needs to remain flexible in view of the unpredictable timing of public sector reform needs that may result from the on-going dynamic process of EU-accession negotiations. Priorities within the overall public sector reformprogram may change as EUnegotiations advance and so may the preferences regarding the specific subjects of Bank support within the wider government program. 86. The PPDPL will support policy actions in four connected components, namely: (a) maintaining the currently enabling macroeconomic framework; (b) reforming substantially the country's social security andassistancesystem; (c) continuing the on-going process of upgrading the financial controls and expenditure management of public resources; and (d) improving the administration and governance of the public sector. 87. The actions and milestones in each of these four components are fully consistent with Turkey's long term economic policy and reform program (see Section IV) as virtually all of the loanconditions andmilestones havebeen adoptedby Parliament, the Council of Ministers andor have been specifically included in (a) the Annual Program approved by the Council of Ministers for 2006 as published in the Official Gazette in October 2005 and (b) the annual EU Pre- Accession Economic Program which details short and mediumterm policy actions and structural reform priorities related to EUaccession, as adopted by the HPC in November 2005. Table 11 presents the specific mapping between the actions and milestones in PPDPL and corresponding decisions by Parliament, the Council of Ministers and items in the Annual Plan and the EUPre- Accession Economic Program. 88. Table 11also presents the conditionality and milestones for PPDPL, their current status, andprogressto be achievedby BoardPresentation. Table 11: Proposed PPDPLConditions and Milestones within the Government's Program PPDPL Current Status, and Location in Government Conditions andMilestones Program (Core disbursement conditions are inbold) The government has maintained a satisfactory status: macroeconomicframework The macroeconomicframework is satisfactory. Discussionsonthe thirdand fourth IMFstand-by reviews were completed inMay 2006 and it is expected that the IMFBoard will approvethese reviews inJuly 2006. Annual Program2006 andPre-AccessionEconomic Program2005 28 Table 11:ProposedPPDPL Conditionsand Milestoneswithin the Government's Program PPDPL Current Status, and LocationinGovernment Conditionsand Milestones Program (Core disbursementconditionsare inbold) Satisfactory social security and UHI legislationwith the Status: following -components has been adopted by the Parliamentapprovedthe Social Security andUHIdraft Parliament: (a) parametric reform for the pension law on April 22,2006. The Parliament overrode a system that wilf ensure the system's long term presidentialveto by approving the "Social Security and sustainability, (b) establishment of a UHI system which UniversalHealth InsuranceLaw" (Law No. 5510) on will provide accessto health insurancefor allcitizens. May 31,2006 -which is exactly the same law approved 3nApril 22,2006. Annual Program2006: social inclusion measure2.1 and 2.3; healthmeasure4. A satisfactory law aimed at reforming the administrative Status: dimensions of social security by unifying the existing The "Social Security Administration (SSA) Law" (No. three socialsecurity schemes hasbeenenacted. 5502) was approvedby Parliament on May 16,2006 and publishedinthe Official GazettedatedMay 20,2006. Annual Program2006: social inclusion measure2.1 A satisfactorysocial assistancereformlaw aimedat status: increasingthe effectivenessand targetingof the social A draft of the law hasbeenprepared. A series of assistancesystemthrough coordination of social assistance consensusbuildingworkshops has beeninitiated. policies hasbeendrafted andthe process of consensus building initiated. Annual Promam2006: social inclusionmeasure 3.1 A satisfactoryactionplanfor implementing efficiency Status: enhancingreforms inthe health systemhas beenadoptedby A satisfactoryplanfor implementing efficiency the relevantagencies. These reforms include: (a) enhancingreforms is inplace. A pilot for family pharmaceuticaland medical devicesagency, (b) family medicine andreferral systems isbeing implementedin medicine andreferral systems, (c) greater autonomy of one province and Ministry of Health (MOH) hasplans to hospitalsand (d) strengthened population health facilities. extendit to another 10provinces once the training is done. Hospital consolidation is completed andall Social Security Institute (SSK) hospitals havebeentransferred to MOH. Annual Program 2006: social inclusionmeasure2.4; health measure5,6,7,8. A satisfactory quantitative framework for monitoring health status: expenditures as well as a plan for containing unexpected A quantitative framework for tracking and monitoring increases in health costs are under implementation by the public expenditureson health is inplace. An action plan correspondingentities involvedinthe sector. for monitoring and managingexpenditureson pharmaceuticals,one of the maindrivers of health expenditures, is inplace. 2005 Pre-AccessionEconomic Program. 29 Table 11:Proposed PPDPLConditions and Milestones within the Government's Program PPDPL Current Status, and LocationinGovernment Conditions and Milestones Program (Core disbursement conditions are inbold) A satisfactory action plan for implementing the law on status: reforming the administrative dimensions of social security A satisfactory actionplanfor streamliningthe has been prepared and is under implementation. The plan idministrative dimensionsof the unified social security includes actions aimed at: (a) consolidating of electronic systemis inplace. The processof merger of electronic records of the existing social security institutions; (b) recordsof the existing social security institutions has developing personnel policies for the unified social security begun, which includesthe integration of identity institution and creating a core cadre of staff; (c) establishing numbersof beneficiaries.Unifiedpersonnelpolicies are financial management and claims adjustment systems; (d) inplaceandanactionplanhasbeendrawn upfor acore integrating identity number systems across social security cadreof staff. An action planhas beenadoptedfor institutions; (e) establishing a systemof periodic monitoring claims management and the fundamentalprinciples of for patient utilization and access to health services; and (f) strategic business and financial managementhavebeen consolidation and integration of the different positive drug incorporated.The consolidation and integration of the lists across social security institutions. different druglists has beencompleted. Annual Program2006: social inclusion measure2.2. A medium term economic framework has been issuedby the Status: Council ofMinisters. The mediumterm economicprogram was issuedby the Councilof MinistersonMay 31,2005. A mediumterm fiscal plan(MTFP) to guidebudget status: formulation hasbeenissuedby the HPC. The MTFP was issuedby the HPC on July 2,2005. A centralgovernment budget law consistentwith the status: MTFPhasbeenenacted andisbeingimplemented The Budget Law was enactedon December27,2005. satisfactorily. The budgetreport to Parliament includesthe projected status aggregate expendituresand revenuesof revolvingfunds and The 2006 Budget Law was enactedwith sufficient extra-budgetaryfunds for the period 2006-2008 . informationon the aggregate expenditureandrevenue projections of revolving funds andextra budgetary funds for the Deriod2006-2008. Implementation of GFS budget classification has been status: extendedto all generalgovernmentinstitutions. The 2006 budgetsfor all general governmentinstitutions havebeenpreparedbasedon the GFS budget classifications and are being implemented accordingly. Detailed financial statistics of the revolvingfunds are status: publishedon aquarterly basis. The MOFhas startedpublishing quarterly data on revolving funds sincethe first quarter of 2005. The PFMC law has been satisfactorily implemented in status: key areas including comprehensive budget coverage, The PFMCLaw was enactedonDecember 12,2003 and abolishment of central ex-ante controls and amended inDecember2005 to eliminate expected accountability inPEM. implementationproblems. The implementationprogress hasbeensatisfactory. Regulations related to the following issues have been status: published: (a) internal and ex-ante financial controls, (b) All of these regulations have beenpublished inthe working principles for strategy development units (c) official gazette. working principles for the Internal AuditCoordinationBoard 30 Table 11:ProposedPPDPLConditionsand Milestoneswithin the Government's Program PPDPL Current Status, andLocationinGovernment Conditionsand Milestones Program (Core disbursementconditionsare inbold) (IACB), and (d) working principles for accountingofficers. Annual Program2006. A tax expenditureframework to promotefiscal Status: accountability andtransparencyhas beenestablishedwhich Issuedas an annex of 2006budget law. includes a list of main tax expendituresand provide a preliminary estimateof tax expendituresinthe 2006 budget (as an annex) for the 4 maintaxes: PIT, CIT, VAT, SCT. A law on the establishment of regional development Status: agencies (RDAs) has beenenacted. Law no. 5449 onthe establishmentof development agencies was enactedinJanuary 2006 Local administrations laws have beenenacted, including: Status: (a) Municipalities Law (no. 5393) was enacted in (a) Municipalities Law; (b) Metropolitan Municipalities July 2005), (b) Metropolitan Municipalities Law Law; and (c) Special Provincial Administrations (SPAs) (no.5216) was enacted inJuly 2004, (c) SPAsLaw (no. Law. 5302) was enactedinMarch2005. Restructuring of debt and receivables of the municipalities Status: Out of the 3,225 municipalities, about 75 percent that haverequesteda restructuring is underway and has been haverequestedrestructuring of their debt and completed for more than three quarters of those receivables, of which about90 percenthave successfully municipalities. completedthe restructuring process as of end May 2006. A satisfactory draft law on the Revenues of Status: A satisfactory draft law on the Revenuesof Municipalities andSPAshasbeenprepared. Municipalitiesand SPAs has beenprepared. POLICY AREASSUPPORTED BY TIIE LOAN COMPONENTI:SUSTAINING AN ENABLING MACROECONOMIC FRAMEWORK 89. Over the last few years, the Turkish economy has been among the fastest growing economies in the world. Inflation has fallen to single digits for the first time in more than two decades, and macroeconomic vulnerabilities have been significantly reduced. Underlying this recovery from the crisis has been a macroeconomic framework that has featured a tight fiscal policy while protecting the social sectors from across-the-board cuts, a flexible exchange rate and significant reform in the financial sector which reduced aggregate risks. Despite this very real progress, the comparatively large public debt stock and high roll-over rates imply risks arisingfrom existing vulnerability to exogenousshocks (see details inSection II). 90. The challenge for the authorities i s to minimizethe impact that these risks might have, in case they were to be realized, on growth, employment, and poverty -among other key variables. Therefore, the government and the Bank have agreed that maintaining a satisfactory macroeconomic framework should be a conditionfor disbursing PPDPL. 31 91. In assessing whether the corresponding macroeconomic framework condition has been met, Bank staff will use its projections of Turkey's medium-term macroeconomic outlook to judge the sustainability of its fiscal program, balanceof payments, and associateddebt dynamics. These projections have been made using a macroeconomic consistency model which focuses mainly on (a) fiscal and debt sustainability risks, (b) balance of payment vulnerabilities, (c) monetary andexchangerate risks, and (d) financial sectorrisks. 92. Bank staff will also take into consideration the views of the IMF and will regard the presence and status of the IMF program in place since May 2005 as an additional element to conclude that Turkey's macroeconomic policies are likely to be sustainable over the medium term. COMPONENT11: SOCIALSECURITYAND SOCIALASSISTANCEREFORM 93. Strong fiscal performance has been the cornerstoneof the economic program since 2001. Between 1999 and 2005, the primary balance of the Consolidated General Government (CGG), , increased from a negligible primary surplus of 0.5 percent of GDP in 1999 to a surplus of 6.1 percent in 2005. One vital public policy issue regardingTurkey's on going and future economic programs is whether such strong fiscal adjustment i s sustainable andor represents an optimal public policy in view the process of EU accession and the existing economic and political circumstances inthe country. 94. Sustainability of fiscal adjustment i s particularly important as Turkey will need to create the fiscal space in the budget for public expenditures arising from important public policy objectives and the EUaccessionprocess which would be the case, for example, as (a) education expenditures need to increase with the growth rate of the school-age population and the increasing enrolment rates at the secondary level and (b) regional development policy objectives imply significant additional infrastructure investment inthe less developedregions. 95. In view that the transfers from the budget to cover the deficit of the social security institutions (pensions and health services) were equivalent to 4.8 percent of GDP in 2005 and that such deficit will increase rapidly if the absence of reform, continued fiscal adjustment clearly requires action to address the structural imbalances in the social security system -which currently originate largely from (a) deficits in the pay-as-you-go pension system (PAYGO), (b) deficits inthe provisionof publicly financed health services, and (c) unexploitedefficiency gains in the operation of the social security institutions. A brief description of the policy challenges for the authorities, policy actions required to meet them, the World Bank's recommendations as well as of the measures to be undertaken under the program supported by the loan follow. Annex 11provides additional detailed information on these issues. THESOCIAL SECURITY SYSTEM 96. Turkey's social protection system i s administered by three separate social security institutions. Registration with one of the three determines eligibility for pensions, health insurance, and unemployment insurance. The majority of the insured labor force falls under the SSK which covers private and public sector workers. The Emekli Sandigi (ES) system covers 32 state employees with civil servant status. Finally, the self-employed and farm workers are covered by Bag-Kur -the third scheme.' Health insurance coverage i s provided by the above three institutions to the same groupingsof employees. 97. Overall, only 47 percent of the employed workers i s contributing to one of three social security systems, with the bulk of the coverage in SSK. Of the 47 percent of the employed workers covered, 48 percent are registered inSSK, 22 percent eachinES and inBag-Kur, and an additional 8 percent in the farmers' scheme under Bag-Kur. The total number of contributors to all systems i s around 11million. Figure3: PensionSystemDeficits Before andAfter Passageofthe 2006 Law 1% 0% -1% -2% -3% -4% -5% -6% -7% -8% 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 Source: PROSTprojections produced by Bankstaff year -+-Base Case +RefonnCase PENSION PARAMETERS 98. The key public policy issue in the Turkish pension system i s ackof fiscal sustainability (Annex V describesthe existing system andprovides details on its lack of sustainability). Figure 3 shows the projected fiscal situation of the PAYGO pension system under the existing pension parameters (base case scenario) and under the alternative scenario of the parametric reforms supportedby this loan. The figure clearly indicates that under the base case the pension system's deficit will hover around 3 percent of GDP until the mid-2020s and will increase rapidly thereafter. In contrast, implementation of the parametric reform supported by the Loan will 'There i s a small noncontributory pension scheme available to those who reach age 65 and have no means of support. This system is administered by ES, but is exclusiveiy financed by general budgetary transfers as beneficiaries do not contribute to the system. Finally, various groups of workers are covered by separate occupationalschemes which inmost cases are voluntary and additional to the existing public schemes 33 prevent the deficit from increasing and will bringthe system to fiscal sustainability, defined as a deficit of lessthan 1percent of GDP, on or about 2038. 99. The current and projected deficits are the result of key structural characteristics of the current system, including that (a) there are large numbers of young pensioners in Turkey and, until 2034, current workers could choose to retire at a young age - for instance, 70 percent of pensioners under the systemfor public employees (ES) are below the ages of 58 (female) and 60 (male); (b) contribution periods in Turkey are too short relative to the expected length of the benefit payments -for instance, the system for private sector workers (SSK) requires only 16 years of contributionfor a full pension while pension benefits are expected to be paid34 years to female retirees and 27 years to their male counterparts; and (c) pensions benefits are simply too generous relative to workers contributions where replacement rates of 65-75 percent of gross wages translate into benefits equal to 93-107 percent of net wages while the use of nominal GDP growth for indexing the earnings used to calculate pension benefits results in a wage base 14 percent higher than the final salary ina career of 25 years and24 percent in a career of 40 yeam6 100. While the revenue side of the pension system is affected negatively by limited contribution compliance in the form of a large number of workers who do not participate in the system andof under-reporting of wages, this part of the discussion focuses on parametric reform. The issue of enforcement of social security contributions i s treated below in relation to the institutionaland administrative reform. 101. The challenge for the authorities is to bring about the sustainability of the PAYGO system by complementing now the reform of 1999 supported under the World Bank's Economic Reform Loan. The 1999 reform contributed to sustainability by establishing minimum retirement ages which were absent since 1991.7 However, the 1999reform needsto be phased-in slowly in view of judicial decisions protecting the acquired rights of individuals who were participating in the system in 1999. One consequencei s that the first cohort of workers eligible to retire after the reform could choose to retire as young as 38 years, if female, and 43 if male. Thanks to the 1999 reform, the retirement age will be 58 for female workers and 60 for their male counterparts retiringafter 2034. 102. Inorder to meet the challenge of fiscal sustainability, the authorities have enacted a new Social Security and UHI .law that, among other things, changes and equalizes key pension parameters for all social security contributors so that the set of resultingunified parameters will make the PAYGO system sustainable, where sustainability i s understood as a situation where the deficit as a percentageof GDP has (a) ceased to grow, (b) fallen by approximately 1percentage An additional element inthe system's lack of sustainability is that Turkey, incontrast to a large number of other countries, does not tax income subject to contributions nor pensions benefits when they are received. Either form of taxation would improve the system's fiscal balances. Since average pensions are low in Turkey and there is a high incidence of poverty among pensioners, taxation of pensions will not be considered under the reform program supportedby this loan. As detailed in Annex V, Turkey enacted a parametric reform in 1999 which brought changes such as increasing retirement ages, contribution periods, revising assessmentrules and indexation. The changes didnot turnthe pension systemaroundfor two reasons. First, not.all the planned reforms were implemented. Following a legal challenge, the reforms did not apply to those already working, postponing much of the effect. Second, the system was already so muchout of balancethat it couldnot be mendedby the relatively weak measuresincluded inthe earlier reform. 34 point of GDP relative to the base case in 2016, and (c) decreasedto below 1 percent of GDP by about 2038, if consistently implementeduntilthen. 103. Table 12 presents a summary comparison of the key pension parameters before and after the reform. The parametric reform is rather ambitious, as evidenced by some of its noteworthy features, namely: (a) the reform covers all types of wage earners, from civil servants, to private sector workers, to self-employed, to farm workers -the reform i s comprehensive; (b) incontrast to the previous regime where ES participants had substantially more generous parameters, the new parameters are the same for all groups of employees-the reform brings about public policy fairness to all employees in the country; and (c) if the reform is consistently implemented, fiscal sustainability of the PAYGO system will not depend on future additional reforms -parametric reform has been concluded in that there will be no need for further parametric reform in the foreseeable future. 104. Enactment of the new social security law, establishing the parameters summarized in Table 12, i s one of the core disbursementconditions for PPDPL. Inassessingthat this condition has been met, Bank staff applied the standard PROST (Pension Reform Options Simulation Toolkit) model to these pension parameters. This exercise confirmed that, under conservative assumptions, sustainability will be achieved if these parameters are applied as envisioned in the law. Again, sustainability is understood in this context as a situation where the deficit as a percentage of GDP has (a) ceased to grow, (b) fallen by approximately 1 percentage point of GDP relative to the base case in2016, and (c) decreasedto below 1percent of GDP on or about 2040, if implemented untilthen. 35 Table 12: Turkey: ReformofPAYGOPensionParameters ' Summary comparisonbetweenpensionparametersbeforeandafter reforr ! j 1 AFTERREFORM I " ...... ....................................... ............................................................... " " j I BEFORE i For ! For PARAMETER INSTITUTION , IMPACTON 1 REFORM contributions 'I contributions (BASECASE) , madeupto madein2007 DEFICIT 2007 I and thereafter j&..__,I 1 Accrual rates 1 2.5% (2007 - Yccrualrate ti ....................................... ..Bag-Kur......................... SSK 2.6% : /:1 will remain for Ii " 4................."..."..."".l 1 2.6% 2016) years served Positive, Strong I ........................................... I 3.0% 2.0% (2016- j ES I I prior to2007 1 afterwards) Women: 2036 to 2075: ! SSK ' Women: From RetirementAge i /* " ................................................. " ...............i .................................................... Bag-Kur I Increasefrom40 "_ to 58 II1 Nochange 59 to 65 'ositive - Strong, LongTerm I ' Men: Increase ' Men: From61 ES 1 from44 to 60 1 to 65 Nochannefor Valorization of 1 1i ___- I i .............. ' " SSK -. "" ...""4 ...."l.l" GrowthRateI.I wageseirned ,i CPI+Real i1 ....-.-....... I .......1 CPI+Real before2007. 50% CPI + 50 past wages i.." .......... 2?&K.E-- +-.-" ..I_ 1 Last wage earned.,..: GrowthRate ... I1 Wagesearnedin Positive, Strong 2007 and %Wage / (no valorization thereafter under ES , needed) ' 1 new parameters ji- .........................SSK.............. " ..."-...... "" ._Bag-Kur......... " " -4 1 CPI Positive, Strong 1 thereafter under i ES I1 Increaseof civil servants' wages . new parameters 1 ..................................... " SSK Mixed ; Nochangefor " i "" " ..."... .........l.""."l_. ....................II.l.lii " j . Income "step" , wages earned ~ Base wage I$ Bag-Kur -........ ".l" i_-.___._I_._-_-._ , " ....---.+ I (outof 12) I before2007. subject to i Whole working i Wages earnedin - ., Positive payrolltax 2007 and time i ' ' Last wage earned thereafter under i ES I new parameters 1: 1 Increasefrom 5,000days to j I Ii 7,000days j ,... ........ SSK (14~0years) j " " --.* ........ ....... ............. .....: Positive, "11.1 Number of days Women:20 paid premium No change 25 Years 1 Years / Men: 25 1 Long Term L1. Bag-Kur __ 1 Years "41 jj I Women:20 I -,. I Years / Men: 25 I ES Years Yf=nrq Totalpremium k"." SSK ............... . i ! 33.5%-41% - 41% Rates ti ............. .....".I Bag-Kur I 40% 33.5% - 39% Neutral I ..............".: """ ES ?6% 36% 36 ADMINISTRATIVE REFORMOFTHE SOCIALSECURITYSYSTEM 105. A fragmented social security system consisting of three social security institutions with incompatible databases has facilitated noncompliance which negatively affects the system's revenue as large numbers of employers and workers neither pay their pension contributions nor their health insurance premiums. Many others are widely believedto under-report wages. 106. Inadditionto the 3 percentof GDPdeficitinthePAYGOsystemin2005, the three social security institutions experienced a deficit in the provision of health services of 0.8 percent of GDP. The deficit was coveredby direct transfers from the general budget to ES, SSK, andBag- Kur. 107. The fragmentation of the system i s a key culprit of low collection rates and implied limited access to benefits. It i s estimated that less than half (about 47 percent) of workers contribute to the system. On the benefit side, only 29 percent of the population over the age of 65 is receiving an old age pension from any of the public schemes. Of that 29 percent, about half receive pensions from SSK, 18 percent from ES, 30 percent from the self-employed scheme in Bag-Kur, and only 5 percent from the farmers' scheme inBag-Kur. 108. Access to health services is, in practice, not limited to contributors because a large number of ineligible (non-contributing) individuals obtain services. It i s estimated that up to 20 million people could receive services without paying premiums to one of the three funds. Reasons behind the high levels of access by non-contributors include that: (a) in all the funds, eligibility of an individual provides access to herlhis immediate family - inthe case of Bag-Kur, for example, there are only 0.5 million fully paidup members while some 9.2 million people are estimated to be eligible for health services; (b) it is easy to gain access to health care using another person's insurance record; and (c) health care providers are generally reluctant to refuse care. Inaddition, 12million "green-cards" have beenissued to poor uninsured people to provide basic health coverage. Record-keeping is so poor that current estimates of the uninsured population range from 6 million (MOH and Ministry of Labor and Social Security - MOLSS) to 22 million (National Health Accounts). While the MOH records the number of new applicants for greencards andissuanceof new greencards, it maintains norecords of renewals. 109. To a large extend, revenue collection problems arise from the lack of one central data base covering the entire working age population and the consequent inability to check an individual's reasonsfor non payment. Havingthree systems that talk to each other wouldbe one way to tackle this issue, but bringingtogether all the pension funds andhealth systems data bases into one national data base i s a necessary condition to improve collections as it would permit tracking and bringingto account any working age individual experiencing long periods of non- payment.* Naturally, unification itself i s not sufficient to improve revenue collection. It will put the new institution in a better position to identify non payers and to enforce payment but Unification itself could improve revenue collection but significant changes are also neededregarding inspection and enforcement procedures. The World Bank will support action in this other complementary fronts under the proposedEGDPL series of Loan which is expectedto contain conditions on actions aimed at decreasing informality inTurkey, including inspectionandenforcementof social security contributions. 37 collection rates will only improve if changes are also made to the inspection and enforcement procedures. 110. In recognizing these issues and in addressing the dual policy challenge of reducing deficits and increasing access to pensions and health services, the authorities have taken actions to unify the existing three social security institutions by creating a single pension entity and a UHIF. The single pension fund will integrate collection of pension contributions and health premiums as well as payment of pension benefits. The UHFwill manage other financial flows inthe health sector, includingpremiumspaidby the budgeton behalf of the poor, andthe health expenditures of civil servants. The World Bank will support the policy action of merging the existing social security institutions by making enactment of satisfactory legislation to that end a core disbursement condition of this Loan. This law has been approved by the Parliament and published inthe Official Gazetteof May 20,2006. 111. Naturally, there are practical problems in amalgamating the current three systems into a new single system. The three information technology platforms are not compatible and a new system onto which the existing data from the three systems could be transferred needs to be developed. The new system will need to (a) accept all current pension fund members from the three funds into one single system with one single unique personal identifier -which should be used for pensions, health and if possible tax; (b) accept monthly contributions from all working age members of the population; (c) identify those individuals who cease to pay (for whatever reason); and (d) notify everyone of working age of their yearly contributions that are recorded andthe effect that this has on their pension andhealth entitlements. 112. The creation of the UHF will also place a significant burden on the information requirements of the health care system. Entitlement to health care under the new health system (see below for further details) will be limited to those who are (a) registered in the new system, (b) have made a minimumof one month contribution, and (c) are currently fully paid up at the time of the treatment, but with the important provision that the government will pay the premiums of the verifiable registered poor. Effective enforcement of these conditions will require doctors, hospitals, clinics, and pharmacies to have access to the database. It also requires health care providers to decide whether to provide a service which should be recorded and could be appealedagainst at a later date. 113. To function effectively, the UHIF needs, among other things: (a) a comprehensive and updated data base with all individuals of working and pension age, including status of contributions paid and in arrears; (b) income test facilities for those among the poor who wish to be declared eligible for the state to pay their contributions; and (c) online access to the data base on the part of health service providers to confirm that individuals seeking services are up to date on their contributions and, thus, eligible to receive services. 114. The authorities and Bank staff are keenly aware there are significant benefits resulting from unifying the social security system but that obtaining such benefits entails major implementation challenges. Accordingly, the PPDPL contains two conditions related to the unification of the system. The first condition i s enactment of the enabling legislationto unifythe system. The second condition i s the development and adoption of a satisfactory, time-bound, plan with clear performance indicators for implementing the administrative dimensions of 38 unifying the social security systems. The plan contains actions aimed at, inter alia: (a) consolidating of electronic records of the existing social security institutions; (b) developing personnel policies for the unified social security institution and creating a core cadre of stafc (c) establishing financial management and claims adjustment systems; (d) integrating identity number systems across social security institutions; and (e) establishing a system of periodic monitoring for patient eligibility, utilization, and access to health services. In view of the forward looking nature of this condition, diligent implementation of the planhas beendesignated as a trigger for movingforward with PPDPLII, the secondloan expected underthe program. UNIVERSAL HEALTH INSURANCE (UHI) 115. As part of the broader social security reform, legislation has been enacted to introduce u)-TIwhich is a key element in the UAP adopted by the government in January 2003. On the basis of risk pooling and social solidarity, participation in UHIwill be mandatory for virtually the entire working age population as well as the elderly. 116. The public policy objectives behind the introduction of UHIinclude (a) improving the quality of access to health services by the poor who, as explained before have access to health services on a uneven and very likely erratic manner (e.g., only in emergency situations) and (b) putting on a normal footing the somewhat chaotic access to health insurance where large numbers of ineligible (non-contributing) individuals obtain services -regardless of their income levels. 117, From a public sector management point of view, fiscal affordability of UHIis the key challenge. The key dimensions of this challenge follow. 118. The UHIF will act as an insurance agent for services under the new UHI system. Revenue will come from premiums corresponding to 12.5 percent of the wage base for workers and a similar contribution form the self-employed -which are equivalent to the premiums charged by ES, SSK, and Bag-Kur currently. The government will identify those who are too poor to contribute to the system and will cover their contributions with resources targeted to this purposeby the budget. 119. Given that there is no change in premium levels in moving from the old system to UHI, increases in revenue will need to come from improved enforcement of social security contributions. The assumption that more people will voluntarily pay health insurance premiums seems rather optimistic because large numbers of non-contributors currently have access to health care even if they are not entitled to it. There is no apparent reason why this situation should change. The possibility to improve collections originates from the new centralized and complete data base of working age individuals. Nonetheless, the authorities and the Bank have been rather cautious in the analysis of UHI by assuming that informality levels will remain constant. 120. On the cost to the budget, it is conceivable that the introduction of UHIwill not have a large cost impact because a large portion of the populationhas some degree of access to health insurance schemes including existing programs for the poor. Nonetheless, under UHI all working age individuals will be required to register and would be expected to either pay 39 premiums or demonstratethat they meet the requirements for the state paying on their behalf. A scenario where the cost of Uf-IIfor the budget will rise materially i s possible if people whose premiums will be paidby the state (i.e,, the poor) join at a faster rate than people who will pay their own premiums. Again, in being conservative, the projections of UHI budgetary costs summarized inFigure4 are basedon the assumptionthat the poor, whose premiumswill be paid bythe budget, willjoin at afaster ratethan contributing participants. Figure 4: HealthInsuranceDeficit I , 121. Figure4 presentsestimates of the incremental future costs of UHItakinginto account key aspects, namely: (a) changes inutilization of health services by the already insuredas they adjust to new boundaries of coverage; (b) utilization patterns of the newly insured; (c) changes in expenditures following efficiency improvement measures following the introduction of UHI; (d) changes in expenditures following the introduction of new provider payment methods; and (e) changes inhealthexpendituresfollowing demographic changes over the years. 122. The figure indicates that in the first year of the introduction of UHI (2007), the incremental deficit would be about 0.1 percent of GDP annually until about 2020 after which health sector reforms start generating savings relative to the base case. These estimates have been overtaken by events in that in 2005 the transfer of SSK hospitals to the MOH led to increasedcosts and health service utilizationcausing an unexpected spike of 0.3 percent of GNP. Public expenditures on health have also risen in the first quarter of 2006. These expenditures, excluding the MOHand universities budget, are expected to increaseby over 15 percent year-on- year in2006 (ifno reforms or cost-saving measuresare introduced). 123. The increaseinhealth expenditures i s almost entirely explained by increased spending on hospitals and pharmaceuticals,andwithin these categories, by increase inthe quantity of number of medical services andnumber of prescriptions for drugs. The increaseinquantity is essentially explained by two factors: (a) increase in coverage and access, effectively covering the entire population of the country; and (b) change of behaviors of medical providers in MOH hospitals which now might have incentives to provide more services. Additional measures are requiredto contain these costs and will be supported under the proposed PPDPL and ongoing HTP (see below). 40 124. Since the increase inhealth expenditures is almost entirely driven by increaseinquantity, it is requiredthat any soundlonger-term strategy on cost-containing measurestakes into account quantity. The principal measure to control quantity i s the introduction of co-payments for outpatient visits as such visits normally cause a prescription for drugs for which there i s a co- payment currently. co-payments for visits will come into effect on January 1, 2007 when the new PensionsandUniversal HealthInsuranceLaw will becomeeffective. 125. As mentioned above, the introduction of UHI, supported with health reform measures that increase systemic efficiency, i s projected to lead to cost savings over the next 20 years relative to the cost of UHIwithout additional reforms, Without the health sector reforms the introduction of UHIwill lead to increasedexpenditures on health by the government in the next 20 years. As Figure4 shows, at the current rates of utilization, the health insurance deficit inthe base case (with UHI but without accompanying reforms) will by 2020, outstrips the health insurance deficit with UHIand reforms. Government spending on health with UHlbut without systemic reforms will, however, be fiscally unsustainable. To make UHI fiscally sustainable, UHImustbeaccompaniedbyreformstomakethehealthsystemmoreefficientasisdiscussedin the next paragraph. In addition, there must be strong enforcement that services will be provided only to those who pay their UHFpremiums,or to the poor whose premiums will be paid by the state, with a robust mechanism for identificationof the poor. 126. Inorder to ensure the sustainability of UHI,Government has committeditself underthis Loan to two policy actions, The first action is aimed at effectively implementing efficiency enhancing reforms in the health system that will bring about cost savings, including: (a) establishment of a national pharmaceutical and medical devices agency; (b) introduction of family medicine as the organizational model for primary health care services; (c) harmonization MOH hospitals for greater autonomy (as of January 2005, all SSK hospitals were transferred to the MOH); and (d) strengthening population health facilities including disease surveillance, maternal and child health and prevention and control of diseases. All of these measures, supported under the World Bank financed HTP, are expected to lead to a more efficient and modem healthcaresystem for Turkey. 127. The authorities are implementing a satisfactory quantitative framework for monitoring health expenditures and a contingent action plan for containing health costs. The action plan envisions taking actions (as needed) such as: (a) reducing the range of reimbursable drugs (Le., difference betweenoriginal and closest generic) from 30 percent to 22 percent of price of generic drugs; (b) rationalizing the price of generics and original drugs; (c) combining MOFISSWBag- KurLES positivelreimbursable lists of drugs; (d) reassessingand possibly reducingthe number of drugs on the positive list; (e) improving medical audit of pharmaceuticals to reduce errors and misuse in prescriptions. In addition, the authorities are analyzing all potential sources of additional savings such as the feasibility of revisingthe price of MOH outpatient services. The M O H and MOLSS have already established a strong foundation for these measures buy setting up a similar rigorous pharmaceutical dispensing and expenditure monitoring system. With the assistance of the HTP, a rigorous hospital expenditure monitoring system will be established in the middle of 2007 which will allow careful scrutiny of all hospital bills and charges to permit reducing expenditures. 41 Table 13: Projected Transfers to Social Security institutions for Pensionsand Health Insurance (percent of GDP) Base Case' Reform Case Health Health Pensions insurance Total Pensions insurance Total 2007 3.4 0.7 4.1 3.2 0.8 4.0 2008 3.4 0.8 4.2 3.1 1,o 4.1 2009 3,3 0.9 4.2 2.9 1.I 4.0 2010 3.3 1.o 4.3 2.8 1.3 4.1 2011 3.2 1.1 4.3 2.7 1.2 3.9 2012 3.2 1.2 4.4 2.6 1.3 3.9 2013 3.2 1.3 4.5 2.6 1.5 4.1 2014 3.2 1.4 4.6 2.5 1.6 4.1 2015 3.2 1.6 4.8 2.4 1.7 4.1 2016 3.2 1.7 4.9 2.3 1.8 4.1 2017 3.2 1.8 5.0 2.3 1.9 4.2 2018 3.1 2.0 5.1 2.2 2.0 4.2 2019 3.1 2.1 5.2 2.1 2.1 4.2 2020 3.1 2.3 5.4 2.0 2.2 4.2 2021 3.1 2.4 5.5 1.9 2.2 4.1 2022 3.1 2.6 5.7 1.8 2.3 4.1 2023 3.1 2.7 5.8 1.8 2.3 4.1 2024 3.1 2.9 6.0 1.7 2.3 4.0 2025 3.1 3.1 6.2 1.6 2.3 3.9 These vroiections do not indude: (a) the additional costs of the 2005 hosvital transfer and (b) abo& 0 7 percentof GDPas of2005 correspondingto benefitspaidtoklderly people, war veterans, andother beneficiaries. Source: WB staff calculations. 128. Finally, and as indicated in Table 13, Turkey needs to rely in the short-term projected savings from the pension reforms to compensate for the increased costs of introducing UHIso that the combined pension and health insurance deficit starts to decline from the beginning of implementation. To show its commitment to fiscally sustainable social security reform, the government has committed under a SBA with the IMF to (a) capping the combined social security institution costs to the central government budget at 4.5 percent of GDP, and (b) maintaining primary surplus at 6.5 percent of GDP. These macroeconomic performance conditions complement the structural actions envisioned to be implementedunder PPDPL. SOCIALASSISTANCE REFORM 129. The social assistancesysteminTurkey is weak andfragmented, although some important progress has been made over the last 4 years in strengthening the programs, targeting and increasing the financing. Social assistance takes many guises, coming through a variety of ministries and agencies even including the Ministry of Defense. The main programs however are the basic ES pension for the uninsured elderly over 65 (discussed under pensions, and therefore not discussed further here), the activities and programs of the General Directorate of Social Assistance and Solidarity (SYDGNI) andthe services provided by the Social Services and Child Protection Organization (SHCEK). 42 130. The SYDGM, which was established in the early 1980s, has one of the last few Extra- budgetaryFundsdrawing revenuesfrom as diverse fields as income taxltraffic fineshroadcasting tariffs, has made significant progress in improving the basic social safety-net over the last 4 years. Spending about YTL 1.4 billion in 2006 (or some 0.3 percent of GNP)it has introduced a Conditional Cash Transfer (CCT) program which reaches the poorest 2.3 million children providing a monthly benefit to their mothers as long as they are either receiving adequate medical care (pre-school age) or else staying in school (school age up to 18). Beyond this, the SYDGM has a strong focus on promoting income-generation opportunities for the poor to develop sustainablelivelihoods. SHCEK i s responsible for the provisionof social services to the poor including to the disabled, abandoned children, youth in difficulty and the indigent elderly. The problem is that social policy itself i s scattered across a plethora of institutions with only weak coordination. Financing for the key programs of the SYDGM is not assured due to the reliance on an extra-budgetary fund. SHCEK's capacity to deliver cost-effective social services at the local level uniformly throughout the country is limited. Social assistance itself, and the eligibility thereunto, are not adequatelyintegrated into the social security system. 131. Recognizing these problems, the government has been working on drafting a revised social assistance law. This law aims to develop a coherent and coordinated social policy. Under this arrangement, the MOLSS would be given the overall authority for developing social policy. Services would be provided through the SYDGM (which would be both a social assistance benefits payment agency with its 931 subsidiary foundations which reach out to all provinces and districts and an agency to promote sustainable livelihoods amongst the poor) and social services themselves would be provided through a range of agents such as SPAS,municipalities and non- governmental organizations (NGOs). The government's intention i s to modernize these benefit systems and services, bringingthem up the level of the EUand meetingthe CopenhagenCriteria of EU accession, whilst ensuring that all measures are fiscally sustainable. Such i s the complexity in attaining this, that there is a need for very strong stakeholder building across the many government entities involved, NGOs, local government, trade unions and citizen groups. This has madethe progresson draftingthe requisite legislation lengthyandproblematic. 132. The Bank is fully supportive of these measures by the government as it has been working on these issues over the last decade. The SRMP (FY02) has built up the poverty targeting capability, institutional capacity and income-generation program of the SYDGM. However, this has all taken place in a very fragmented, and thus inefficient, overall environment, where in addition, Turkey, despite statements in the constitution to the contrary, has no unified social policy. The Bank fully endorsesthe government inits strivings towards a coherent social policy, a coordinated social assistance system which i s well targeted to the poor and yet i s fiscally sustainable, Such a set of measures are difficult to develop, and hence require more time to develop the necessaryconsensusandformulate them adequately. 133. The PPDPL series is the ideal instrument to support such a process. Recognizing the difficulties, and thus time required, as well as the more urgent agenda of stopping the fiscal deficit caused by the existing pensions system and preventing a further one due to the introduction of UHI,both the Bank and the government have agreedthat PPDPL should be the period of consensus building to develop such a draft law which deals with these issues. The MOLSS has draftedsuch a law and has commenced the process of consulting stakeholders and building up consensus within the government. Thus, it is expected that under PPDPL11a law 43 giving more coherence to social policy through coordinated social assistance and strengthened poverty targeting will be submittedto Parliament. COMPONENT111: PUBLICFINANCIAL EXPENDITURE AND MANAGEMENT REFORM BACKGROUND 134. The importance of public financial and expenditure management issues could not be stressed enough in Turkey. A fragmented budget and ineffective accountability mechanisms combined with other structural weaknesses in public sector management permitted large fiscal imbalances to develop which ultimately contributed to the crises in 1994 and 2001. A fragmented budget outside the control of public sector authorities made fiscal discipline and the management of fiscal risks close to impossible. Multiple layers of inspections and internal controls were ineffective and provided incentives for agencies to establish off-budget flows to evade controls, further fragmentingthe budget. Extensive off-budget activities made it difficult to estimate, let alone manage, the full extent of government financing and expenditures.' 135. Since 2001 there has been significant progress in terms of fiscal transparency and accountability. Turkey has made its legislation on public procurement, financial management and financial control broadly consistent with best international standards. A PPA has been established; most extra budgetary funds have been integrated into the budget; the number of off- budgetrevolving funds has been considerably reduced through consolidation; the duty losses of state banks accounted in a more transparent manner; and creation of new duty losses without appropriation inthe budget becameforbidden by law. 136. PFMC Law (No. 5018), enactedinDecember 2003 and amendedin2005 provides a new legal framework for modern PEM and accountability. In replacing the previous budget and public accounting law (enacted in 1927), the PFMC articulates a modem view of performance- oriented public sector management. The PFMC law: (a) comprehensively defines public revenue and expenditure of the general government; (b) introduces a medium term approach to fiscal strategy and budget preparation to improve aggregate fiscal management and budget prioritization; (c) proposes agency-level strategic planning and performance-related budgeting applicable to the entire general government; (d) requires ministries and departments to set performance goals and prepare ex-post accountability reports for Parliamentary and public scrutiny; (e) delegatesfinancial control andinternal audit responsibilities to spending agencies in line with EU standards; and (f) strengthens government accountability by extending the scope andmandateof external audit by the TCA to the entire general government. 137. Notwithstanding the impressive record since 2001, continued progress in the quality of public sector management needs effective implementation of the PFMC law. This is the fundamental policy challenge at the moment in the area of public financial and expenditure management for the authorities. PPDPL recognizes the achievements accomplished by the authorities in implementing this law. Accordingly, the policy matrix for the loan includes two core disbursement conditions and nine milestones related to implementation of the PFMC law. 'Underlying public sector structural and management issues were analyzed in the 2000 and 2003 CEMs and the 2001PEIR. 44 The milestones were reached leading to the disbursement conditions having been met. The paragraphs that follow provide a brief analysis of the substantive implications of these milestones andjustify thejudgment madeby the Bank in deeming the core conditions as met (for details, please see Annex II). THEPFMCLAW 138. ~mp~ementutionregulations. In view of the complexity and momentous changes entailed by the PF'MC, the period since the enactment of the law in late 2003 was needed to prepare a large body of supporting regulations and guidelines. Thus, the policy matrix for the loan recognizes as an important milestone that key implementation regulations of the PFMC law been published and are now in force. These regulations include: (a) internal audit standards; (b) working principles for financial services unit; (c) working principles for the IACB; and (d) working principles for internal auditors". The publication of these regulations represents a substantial milestone under the government's program and i s recognized as such in the policy matrix for the loan. 139. Medium term flamework for budgeting. There has also been significant progress in linkingpublic policy planningand allocating resourcesthrough the budget with the preparation of a Medium-Term Program (MTP). The policy-planning-budgeting linkage i s being strengthenedfurther through the parameters includedinthe MTP. The MTP was adopted by the Council of Ministers and published inthe Official Gazette in May 2005. It sets out a three year (2006-2008) macro-economic framework with macro targets consistent with the SBA with the IMFwhile layingout the public policypriorities infive development areas andthe key sectorsof the economy. 140. The credibility of the budget preparation process has further improved in view of the MTFPwhich complements the MTP for the 2006 budget. The preparation and adoption by the HPC of an MTFPhas reinforced fiscal discipline andmanagementby providing the basis for an improved strategic allocation of budgetary resources to policy priorities. Starting with the 2006 budget preparation, the Government began implementing a MTFP for central government agencies. The MTFF provided indicative institutional expenditure ceilings for the central government agencies, as per economic classification and basedon the medium term expenditure framework. 141. The MTFP and the MTP represent significant milestones in public management in Turkey. The policy matrix of the PPDPL recognizes them as such. From an impact point of view, the bottom line i s that the 2006 central government budget law enacted by Parliament i s fully consistent with the macro and fiscal frameworks contained inthe MTP and MTFP. Among loThe December2005 amendmentof the PFlMClaw mergedthe functions of the financial services with those of the strategy development units. l1The five development areas covered inthe MTP are (a) improving human resources and employment generation, (b) social inclusion and the fight against poverty, (c) enhancing the competitivenessof enterprises, (d) regional development and reduction in regional development disparities and (e) good governance. The nine main sectors included in the MTP are (a) education, (b) health, (c) environment and urban infrastructure, (d) science and technology, (e) agriculture, (f) manufacturing industry and mining, (g) energy, (h) transportation and communication, and (i) tourism. 45 other things, Turkey confirmed its commitment to continue tight fiscal policy, as evidenced by a primary surplus of 6.5 percent of GNP. Enactment and satisfactory implementationof a budget law consistent with the MTFP and MTP was considered to be a key action required to achieve the program's objectives in linkingthe budgeting with policy planning. Accordingly, this action was designatedas a core disbursementcondition for PPDPL-which has been met. 142. Expanding budget coveruge. As mentioned above the government's program is keenly focused in achieving a comprehensivebudget framework. This objective i s welljustified inview of past experience in Turkey where non-transparent government expenditures created fiscal imbalances that contributed to economic crises. A number of important milestones have been accomplished in terms of improving the classification and reporting of fiscal activities and in integrating extra-budgetary items into the budget. With the implementation of the PFMC law in 2006, a new general government budget definition has been introduced. This new definition which i s consistent with international best practice covers (a) central government budget institutions (total of 143), (b) social security institutions' budgets (4 includingthe unemployment insuranceagency), and (c) local administrations budgets (around 3,225). Moreover, the coverage of the central government budget has been considerably expanded as 45 new institutions were included in the central government budget (Le. sum of general budget, special budget and regulatory and supervisory institutions). As a consequence of these actions, the Parliament i s now able to review total expenditures of the central government. 143. Better definition and comprehensive coverage of the budget represents a milestone inthe government's program which i s recognized as such inthe matrix of policy actions for PPDPL. 144. Reducing the number and increasing the transparency of off-budget activities and revolvingfunds. There has been a drastic reduction in the number and amount of off-budget institutionsand activities. Only a Support Price Stabilization Fund (DFIF) and five extra extra budgetary funds (EBFs) (Social Solidarity Fund, Defense Fund, Promotion and Publicity Fund, Saving Deposits InsuranceFund, and Privatization Fund) remaininTurkey today from a total of more than 60 such funds prior to the beginning of the implementation of this program. All others have been legally extinguished and their previously earmarked revenues and expenditures have been integrated into the budget since 2004 -an action supported under the PFPSAL program. Theexpenditures of the remaining EBFs'*havebeen stable at 0.8-0.9 percent of GNPin2003-05 andis projectedto decline to 0.6 percent of GNPin2006. 145. Rationalization and reform of revolving funds, which represent another form of off- budget activity, is well under way. Through consolidation, the number of revolving funds was reduced by about two thirds from about 2,650 in mid-2001 to around 1,000 by end 2005. The amended PFMC Law confirms the government's commitment to restructuring all revolving funds by the end of 2007. As an interimmeasure, the MOF publishes financial statistics for the revolving funds on a quarterly basis since 2005 -which represents another important milestone aimed at bringing transparency of fiscal balances in Turkey and, as such, acknowledged in the matrix of policy actions. `'Excludingthe SavingDeposit InsuranceFund. 46 146. A related milestone achieved under the program and also recognized in the matrix of policy actions for the loan is that the Parliament is, for the first time, informed about the expected aggregate fiscal position of the remaining revolving funds. This information i s provided as an annex to the budget proposal for the central government. It includes all proposed expenditures and revenues of institutions outside the central government (i.e. social security institutions, local administrations, EBFs and off-budget revolving funds). This milestone also contributes greatly to fiscal transparency but equally importantly, allows a policy debate at the Parliament about the allocation of an important share of public resources. 147. Recognizingtax expenditures. Another important milestone in the process of achieving full fiscal transparency and accountability inTurkey has been the establishment of a framework to list and disclose the amounts of tax expenditures -as properly recognized in the policy matrix for this loan. 148. To have a comprehensive budget process, OECD governments increasingly estimate the forgone revenue cost of tax expenditures and publishtax expenditure accounts as part of budget processes. Turkey has an extensive array of tax expenditure provisions, particularly in the income tax structure. Fiscal management as well as effectiveness of tax expenditures could be significantly enhanced if tax expenditures were accounted for and explicitly brought into the budget process. Incorporating tax expenditures in government accounts and budget process results intax policies being subjectedto scrutiny thus leadingto improvedtax policies. 149. Completing the development of tax expenditure accounts and incorporation of tax expenditures in budget reporting will require considerable work over an extended period. As a first step in this direction, the MOF has included a list of tax expenditures and its estimated amount for the 2006-2008 as an attachment to the budget. Since this is the first year, coverage was limited to the main taxes: PIT, CIT, VAT and special consumption tax (SCT).I3 As indicated inAnnex VI, tax expenditures from these four taxes constitute about six percent of the total central government budgetrevenues between 2006 and 2008 period. 150. Functional c ~ s s i ~ c ~of* oexpenditures. Turkey lacked the functional classification of n government expenditure recommended by the IMF's Manual on GFS and which is essential for policy analysis of expenditure. This situation has been addressedby the government's adoption of functional budget classification in line with GFS (version of 2001) and by parallel amendments to the chart of accounts for all entities forming part of the general government. While GFS classification has been applied since the 2004 Budget for consolidated budget agencies, the expansion of GFS to the rest of the general government began with the preparation of the 2006 budget andits execution. 151. Other key di~ensionsof the implementation of the PFMC Law. In addition to the above milestones explicitly recognized in the matrix of policy conditions for this Loan, there are a number of areas where there has also been material progress in implementing PFMC law, which is obviously a rather comprehensive and multifaceted framework. These additional areas cover (a) decentralized ex-ante financial control, (b) an accrual-based accounting system, (c) I3The World Bank hasbeenprovidingtechnicalassistance on tax expenditures to the MOF within the contextof the CEM/ PER. 47 consolidated reporting requirements for the general government; and (d) an official body for settinggovernment accounting standards 152. Beginningfrom January 2006, the ex-ante financial control authority has been transferred to the line agencies thus eliminating the role of the TCA in the budget execution process. Centralized financial controls exercised by the MOF were also abolished in 2006, andtransferred to the line agencies starting from 2006. Financial services units, which will undertake financial controltogether with ex-ante control function, are beingestablished since January 2006 for entire general government institutions. Budgeting and accounting responsibility for special budget agencies has been transferred from MOF to the respective agencies. The outcome of this action should be more effectiveness and clearer accountability inbudget implementation. 153. To provide centralized oversight mechanism over now dispersedinternal audit functions, the PFMC law requires a central IACB to be attachedto the MOF. This boardwould set internal audit standards, organize training for internal auditors, and provide quality assurance in respect of internal audit work carried out by line ministry internal audit units. The Board has been established and the secondary legislation on its working principles and rules was issued in the Official GazettedatedOctober 8,2005. 154. In the last few years, Turkey has endeavored to reform the public accounting system. This began with the introduction of an automatedon-line accounting system, called Say2000i,in more than 1,500 accountancies spread across the,country, capturing receipts and payments as they are made. Because the database i s linked through a central server, all transactions are immediately available, and the system i s capable of producing periodic financial statements without the delays that typify decentralized accounting systems. In addition, Turkey has switched from a cash-basedto an accrual method of accounting. Since annual budgets are cash- based, the General Directorate of Public Accounting (GDPA) in the MOF has devised an intricate method for accounting entries that keeps track of both the cash-based and accrual entries. 155. In conclusion, one of the core disbursement condition of the PPDPL under this component requires satisfactorily implementation of the PFMC law in key areas including comprehensive budget coverage, abolishment of central ex-ante controls, increased transparency through accrual based accounting and accountability in PEM. The summary presented above indicates that there has been sufficient substantial progress in implementing key aspects of the law by, for instance: (a) requiringthat a mediumterm strategy be the framework for determining fiscal aggregates and linking sector budgets to policy priorities; (b) expanding budget coverage to all central budget entities; (c) expanding the GFS economic and functional budget classification to the entire general government; (d) delegating more responsibility and accountability to spending agencies through reformingthe internal control regime and abolishing central-level ex-ante control; and (e) improving accounting through implementation of accrual- based accounting through the entire general government. On this basis, the core condition has been deemedas met. 48 COMPONENT Iv: PUBLICADMINISTRATION AND GOVERNANCE REFORM BACKGROUND 156. Decentralization, or the transfer of authority and responsibility for public functions from the central government to subordinate or quasi-independent government organizations or the private sector, covers a broad range of concepts. Political, administrative, economic and fiscal decentralization, have different characteristics, policy implications and conditions for success. All these factors needto becarefully consideredwith acomprehensive approach. 157. One of the core components of decentralization is fiscal decentralization which can be defined as the transfer of expenditure responsibilities and revenue assignments to lower levels of government. If the local governments are to carry out decentralized functions effectively, they must have adequate revenues-raised locally or transferred from the central government-as well as the authority to make expenditure decisions. Among the many expected benefits of decentralization are improved service delivery, improved resource allocation and improved participation by localresidentsindecision-making. 158. However, decentralization i s not a panacea and it may bring some problems as well. A major risk that could arise from fiscal decentralization is the increasedfiscal pressure, It i s often politically difficult to impose hard-budgetconstraints at the local level and the local governments might have a tendency to rely on the center's bailout. For example, some countries, including Brazil and China, experienced macroeconomic problems when tax bases were decentralized without a clear assignmentof expenditures to the level of government that receives the revenues. Others, including Argentina and Mexico, ran into problems because sub-national governments accrued unsustainable debts and had to be bailed out by the central government. Governments faced problems when the decentralized expenditure responsibilities were not matched by revenue assignments. This led to unperformed services and to unsustainable sub-national deficit^.'^ It is therefore crucial to recognize these potential risks and ensure a match between expenditure responsibilities and revenues at each level of government and create institutional mechanisms that will enforce ahardbudget constraint between levels of government. 159. Turkey initiated a comprehensive public administration reform process in 2003. The public policy objective of the reformi s to establish a more participatory, transparent, accountable public sector which respects human rights and freedoms, and provides high quality public services on a timely, efficient and equitable manner, In the past, growing and centralized public administration which lacked a strategic view contributed to increasing budget deficits. It was insufficientinmeetingcitizens' expectations and had lost their confidence becauseof ineffective governance. 160. There had been previous attempts to achieve these objectives but they were timid and piecemeal. The current reform design is comprehensive and has a well defined strategy. The Prime Ministry, which i s the leading and coordinating agency in this reform process, established the objectives and principles of the reform in a report titled "Change Management in Public l4World Bank Institute Working Papers, Decentralization Briefing Notes, 1999. 49 Administrations" 15. Basedon a review of the role of the state and global state of the art inpublic administration policies, processes, and practices; the report identifies the main elements that are required for an effective restructuring of the public sector as: (a) a new public administration framework, (b) a better central administration, (c) more effective local administrations and (d) other new arrangements, the main component of which i s civil servicereform. 161. The World Bank supports the objectives and direction of the government's broad reform agenda related to public administration and governance. This section examines the subset of specific actions to be supportedthrough the PPDPLLoan in three broad areas namely: (a) local administration reform; (b) regional development initiatives; and (c) the anti-comption agenda, as follows (see Annex I1for details). The section that follows on future loans under the program presentsoptions for further World Bank support to the government's broader agenda. REFORMOFLOCAL ADMINIST~TIONS 162. National development depends significantly on local level growth and service delivery, Achieving these objectives in Turkey will require (a) overcoming large economic and social disparities across regions and among urban and rural areas; (b) modernizing the fiscal, political, and administrative framework in which central and local governments operateI6; and (c) enhancing collaboration between local administrations, the central government and stakeholders. Obviously, well functioning local administrations represent a key ingredient to achieving more even local level growth and better service delivery. The following are a few examples of the obstacles that needto be overcome in order to improve the functioning of these administrations. 163. Turkey's rapidly growing urbanization i s placing increasing demands on financing of, and access to, basic public services. Urbanization, especially in large cities, has been creating increasing pressure on services providedby central and local governments. For example, school construction i s a central government responsibility. However, inurban areas, municipalities own the plots of land where schools can be constructed; since they are not necessarily obliged to construct schools, they may choose to use such lands in other revenue-generating ways. Better coordination of policies andallocation of responsibilities is required. 164. Increasing demands for public services due to high rate of urbanization have so far been addressed by assigning the responsibility for basic urban services and allocating increasing amounts of central government funds to municipalities but maintaining traditional central government administrative control measures. Little could be expected from this strategy going forward because, among other reasons:l7(a) the long-standing practice of meeting the growing service demands with increased allocations from the central budget has become unsustainable due to fiscal pressures; (b) the system of heavy reliance on budgetary transfers and borrowing through Treasury guarantees does not provide incentives for fiscal discipline; (c) traditional administrative control has become increasingly ineffective to oversee, influence, and guide l5Thange ManagementinPublic Administrations", TurkishRepublic, Prime Ministry, October 2003 InTurkey, the term `local government' includes metropolitan municipalities (16), municipalities (3,209), SPAS (81), localgovernmentunions and villages. l7Turkey Municipal SectorReview, October 2004. 50 Turkey's large and growingurban sector; and (d) the role of the private sector inthe delivery and financingof urban services has beenminimal. I Table 14: Distribution of Municipalities inProvinces, Districts and Towns by Sizeof Population Population Group Number of Municipalities To TotalPopulation % 0-2,000 396 12,7 631 272 2,001-5,000 2 56,3 5.089.434 17,7 5,001-10,000 457 14,6 3.080.282 10,7 10,001-20,000 239 797 3.261.014 11,4 20,001-50,000 161 52 4.963.214 17,3 50,001-100,000 73 2 3 5.100.328 17,8 100,~0-250,000 36 192 5.451.588 19,O 250,001- 3 071 1.104.855 399 Source: Ministry of Interior, July 2003 165. The preponderance of small settlement units is another key challenge. As Table 14 shows, 80 percent of the municipal population lives in municipalities with a population of more than 5,000 (yet these comprise only 31 percent of the total number of municipalities): municipalities with a population of less than 5,000 make up 69 percent of all municipalities, but their population comprises only 20 percent of the total municipal population. This distribution creates fiscal problems such as inadequate revenue capacity of small municipalities and high average cost of service provision. Addressing this issue will require that either the population scale of municipalities be changed or service associations be established to overcome problems of service scale. 166. The acute need for a reform of the local administrations i s also evident inthe results of a satisfaction survey conducted by Foundation for Economic and Social Studies (TESEV) in 2004. TESEV conducted a citizen satisfaction survey on central and local service provision inselected 20 provinces across the country. While the central administration score improved considerably in 2004 compared to 2000, the local administrations' score stagnated. The citizens' trust for local administrations came out at the lowest level in the public sector and 73 percent of the interviewed statedthat there i s a needfor reformingthe local administrations. 167. The examples above testify to the need for a comprehensive reform of local administrations with the ultimate objective of improving the efficiency and quality of service delivery. In view of the initial status of the system, a gradual (yet comprehensive) reform process needed to be launched Turkey. To that end, Turkey has enacted several laws whose provisions were either missingor inadequate in the previous legal framework for restructuring intergovernmental relations and promoting regional development. The enactment of these laws was a critical necessary pre-condition for triggering the implementation process of the reform which ultimately will cause the desired results on the ground at the local level. 168. The PPDPL recognizes the criticality of a new modern legal framework, Accordingly, enactment of a package of four new laws under the government program from 2004 to 2006 has been designatedas a core disbursement condition inthe policy matrix of the loan. The following are the individual laws in the package of required legislation: (a) Metropolitan Municipalities Law (no.5216, enactedinJuly 2004;, (b) SPA Law (no. 5302, enactedin March 2005); (c) Local 51 Administration Unions Law (no.5355, enacted in May 2005); and (d) Municipalities Law (Law no. 5393 adopted inJuly 2005). 169. The administrative arrangements for local level cover change in legislative framework, establishment criteria for local administrations, and organizational changes. The legal framework for municipalities has been modernized as part of the public administration reform program. The Municipalities Law has modernized the organizational structures, duties and authorities, working and service methods, human resource management and fiscal structures of municipalities. The minimum population threshold to establish a municipality has been increasedto 5,000 from the previous 2,000. The law facilitates mergers and amalgamations, and expands the duties and authorities of municipalities. Starting from January 2007, municipalities with less than 2,000 population will be abolished and converted into villages if they can not increasetheir populations through mergers and amalgamations with other municipalities. 170. Inaddition, the managementof districts hasbeenstrengthened, They are associatedwith the municipality, and an organic link for coordination has been established. Mayors' remuneration has been increased. New institutions such as the City Council have been introduced, and there is much greater emphasis on participation and transparency (discussed in more detail below). The law attempts to strengthenmunicipal effectiveness in service provision, including greater authority on urban development and planning. While the laws provide more flexible and effective human resource policies, they also impose greater discipline on municipal personnel expenditures andborrowing. 171. Analogous changes have also been made to the legal framework for Metropolitan Municipalities. The Metropolitan Municipality Law expands the boundaries and functions, with the objective of more efficient and effective service delivery, New criteria have been defined to establish a metropolitan municipality, namely: (i) the level of economic and social development of the municipality shall be appropriate; (ii)the population shall be at least 750,000; and (iii) the municipality shall cover at least 3 districts. 172. PPDPL supports policy action on intergovernmental fiscal relations, particularly in the legal framework for fiscal decentralization and inthe restructuring of the outstanding debts and resolution of arrears of large metropolitan municipalities - where there i s ample room for improving the current system. 173. Enforcing hardbudget constraints among local administrations requires clear expenditure assignments, formula-based transfer systems, local revenues, prudent sub-national borrowing rules, and good financial reporting. The authorities are focusing on the following priority areas: 0 Expanding local administration budget coverage and moving to a consolidated (unified) budget approachto include all local administration fiscal units; 0 Strengthening the policy-planning-budgetinglinkage at the municipal level, and adopting amediumterm approachto expenditure prioritization; 0 Applying international accounting standards to local administrations, including a gradual introduction of accrual accounting; 0 Moreintensive external audit andgradual application of performance audits; and 0 Addressing personnel managementissues andcontrollingpersonnel costs. 52 174. The central government fulfils many functions in the unitary Turkish state: as a result, the fiscal weight of local governments inTurkey i s still relatively light, but this may understate their emerging role and future impact. Primary general government expenditures, in 2005, accounted for close to 35 percent of GDP, of which central government expenditures constituted about 15 percent andlocal administrations 4.4 percent. 175. Table 15 displays the expenditure assignments for central and local administrations based on the new legislative framework. 176. The new legislative framework adopted under the program transfers or delegates a number of new responsibilities to the local authorities. This gradual transfer of expenditure responsibilities to lower tiers of government i s expected to continue. Obviously, the trend will necessitate revisiting the revenue assignments as well because it i s clear that the revenues available to the lower tiers of government are inadequate to finance the provision of services for which local administrations will be increasingly responsible for. 177. As part of delegating more responsibility to the local administrations, the rural services function was transferred to the provinciallevel from the central government in2004. The gradual transfer of expenditure responsibilities to lower tiers of government i s expected to continue which will have implications for revenueassignmentsas well. Table 15: Expenditure Assignments between Centre and Local Administrations 21The role of the centre is more focusedon the highways, andthe local administrations has aclear cut divisions basedontheir mandatearea. 31The governmentis preparing adraft law on social services which will transfer the role of the centre to the 53 178. The current revenue assignments and authorities of the country's local administrations are currently defined in numerous laws," which makes the system confusing and disperse. Nonetheless, local administration revenuesinTurkey couldbe summarized inthree categories: (a) Tax revenues, comprising the share from central government tax revenues, and other tax revenues such as from real estatetax, environmental cleaning tax, charges. (b) Non-tax revenues which include various elements such as contribution shares to expenditures, enterprise revenuesandborrowing. (c) Other revenues, including special aid and extraordinary funds. 179. Local administrations' main revenue source i s the transferred share of taxes from the central government. The share of central tax revenues transferred to local governments is increasing but still low, comprising less than 2 percent of GNP in 2003. Local administrations derive 45 percent of their total revenues (and 75 percent of their tax revenue) from the central government. Tax revenues comprise about 60 percent of local administration total revenues; 36 percent of their total revenues are derived from non-tax revenues. Revenue collection from taxes such as the real estatetax, andthe environmental cleaning tax is quite trivial, 180. Although the current system for central government transfer is simple and i s based on objective criteria that provide stability and predictability of municipal revenues, there is a need for reformingit becauseit has severaldrawbacks, including: (a) Population-based revenue sharing discriminates against local administrations with lower populations. (b) The large share of central transfers in municipalities' revenues de-links taxation and spending. It weakens, therefore, taxpayer accountability. Municipalities spendthe money largely raised by the central government and shy away from the pains associated with raising and justifying taxes locally. (c) The transfers are not normally usedto strengthen service orientation at the local level. Local service delivery performance i s not monitoredas part of public oversight. The financial transfers are also not concerned with actual service delivery as at least 85 percent of transfers are handed over to municipalities whether they actually provide services or not. (d) The equalization element in the current transfer system lacks an explicit standard. The equalization that takes place i s entirely a by-product and depends on the difference between the distribution of tax collection andpopulation. (e) A five percent of in-province tax revenues transferred to the metropolitan municipalities creates different treatment between metropolitan cities and other.large cities. As a city can only Chief among these are the Municipality Income Law (no. 2464 of 26 May 1981), the Property Tax Law (no. 1319 of 29 July 1970), the Law on General Budget Tax Revenue Distribution to Municipalities and City Private Administrations (no. 2380 of February 2, 1981), the Metropolitan Municipality Law and other laws such as law nos. 277 and 5237 of 15 July 1963. 54 be declared a metropolitan area by an act of Parliament, there are no clear criteria that would enable other cities to qualify for this transfer. 181. Weak local administration administrative capacity inmajor tax administration functions - registration, collection and audit (enforcement) - seems to constitute the binding constraint on improving local administration revenue performance. In addition, the true extent of own source revenue arrears i s not known with certainty. These administrative shortcomings appear to be compounded by incentive problems: in some cases political executives are concerned that increases in local revenue collections could prove politically costly. As a result, there i s little incentive for local administrations to strengthen collection of own-source revenues. Local administrations continue to remain dependent on their share of revenue from the central government, andmunicipalefforts to enhancecollection of own source revenues are inadequate. 182. Local administration own-source revenues could be significantly increased through local administrative measures to increase collection of own source revenues", and central government actions to assist local administrations. The authorities are examining ways to provide incentives to local administrations, including through restructuring the system of intergovernmental transfers, to strengthen assessment andcollection of own source revenues. 183. On the basis of the above description of some of the shortcomings in the system, the authorities have come to realize that there is a need to take action inreforming the entire system for intergovernmental fiscal relations. The programsupportedby the loan recognizes the need to draft a new comprehensive law to regulate local administration revenues. Accordingly, action in preparing such a draft has been included as a core disbursement condition in the policy matrix for PPDPL. 184. A draft law on SPASand Municipal Revenues has been prepared by the authorities and reviewed by Bank staff who found the draft as satisfactory in view that the draft (a) seeks to reach horizontal and vertical revenue equalization between the central government and within local administrations; (b) includes performance in service provision as a criterion; (c) provides incentives to local administrations to increase collection of own source revenues; and, (d) strengthens fiscal discipline at local level. Moreover, the draft law contains a formula-based system that takes these factors into account and will increase transparency, diminish central control over local governments, ensure minimumlevels of service provision, and encourage the effective use of resources. 185. Further evidence of the importance of reforming the system of inter-governmental fiscal relations is given by the recurrent need to restructure the borrowings and arrears of local administrations. In the most recent restructuring exercise, still under way, eight out of sixteen metropolitan municipalities' debts and receivables were restructured by a Reconciliation Committee established under law. Out of the 3,225 municipalities, about 75 percent have requested restructuring of their debts and accounts receivable, of which about 90 percent have successfully completed the restructuring process as of end May 2006. Obviously, allowing local l9E.g. through collection-based incentives for local government revenue assessors and collectors, enforcement action against delinquent filers and payers, taxpayer registration drives, regular cleaning of taxpayer registries, investing in information technology, improving the quality and quantity of audits, and strengthening taxpayer services. 55 administrations running up arrears to other public and private entities and restructuring them periodically i s bad public policy. The policy softens hard budget constraints and creates moral hazard problems. Nonetheless, a stock of arrears built under the old system would limit the scope of implementation of the new SPASand Municipality Revenuelaw when enacted. Thus, there i s a need to clear the existent debt delinquency in the system. Consequently, the policy matrix for the PPDPLrecognizes the restructuring of debt and receivables of the municipalities that haverequesteda restructuring i s underway. REGIONALDEVELOPMENT 186. Regional development i s a well justified key public policy concern of policy makers in Turkey, due to both: reasons of domestic equity and convergence with EU averages. For instance, the income level, on PPP per capita basis, in the most developed region in Turkey i s only a third of the lothmost developed region in the EU25, while the income level in the least developed region of Turkey i s about a thirdof that inthe least developedregioninthe EU25". 187. The start of negotiations with EU had focused the country on the importance of addressingthe issueof regional development disparities inthe context of national convergenceto the EUaverage income. A number of development programs are in place in the context of EU- Turkey Financial Cooperation which aim at reducing regional discrepancies and enhance efficiency in the design and implementation of Turkish regional development policy in line with the EU. 188. Inaddition to the actions aimedat devolvingincreasing levels of authorityto regional and local level - the ongoing local administration reform discussed above, Turkey i s also taking action to addressthe challenge of regional development by establishing development agencies. 189. Law No. 5449 on the Establishment of RDAs was adopted in January 2006. The law provides the framework for establishing development agencies chargedwith assisting sustainable regional development as means to reduce regional disparities and contribute to overall national development. The law provides the duties, powers and coordination structures for such agencies. Their functions include: (a) strengthening cooperation between the public and private sectors, including NGOs; (b) ensuring efficient and appropriate use of resources allocated to local development; (c) triggering local economic potential; and (d) stimulate investment through financial and other support services -with these functions being conducted in a manner consistent with national development policies and priorities. The State Planning Organization (SPO) i s designatedby law to be the national level coordination body for the agencies. 190. One key positive aspect of the new law i s that it provides transparency and accountability inthe functioning of the RDAs. Resources. The law provides resources from a variety of sources (Article 19) which include transfers from the central government and local administrations (formula based on population, level of development and performance), official development assistance including EU funds, own revenues from agency activities, funds from chambers of Turkey 2006 AnnualProgram 56 industry and commerce in the region, grants and aids and carry-over of previous year revenues. 0 StafJing. Article 18 provides for RDAs to have expert personnel and support personnel, employed according to the labor legislation -as opposedto career civil servants. Support personnel are envisagedto perform secretariat, public relations, archiving, administrative, finance and personnel services, and shall not comprise more than twenty percent of the total number of agency personnel. 0 Measures toprevent conflict of interest. Members of the agency's decision-making body, the Executive Board, are prohibited from disclosing any information about the agency that may be favor them or others. This prohibition remains after members leave the Board. 0 Transparency. Publication of activities, programs, budgets, and implementation reports are mandatory so as to inform the public about agency activities and resources (Article 21). 0 Internal Audit. Employment of an internal auditor i s mandatory for each agency. The executive boardhasthe flexibility to determine personnel salaries and allowances, 191. The authorities are planningto establish RDAs. In addition, a Regional Development Strategy i s under preparation. Subsequent to the preparation of this central level strategy, each region will then prepareits own Development Strategy. Finally, basedon these strategies, action plans will also be prepared to identify priorities and measures in promoting the region's economic development. 192. There have beenno results on the ground deriving from Law 5449 yet. Nonetheless, this enabling law together with its connected planning and commitments for future action represent positive moment in the right direction to solve on of the most pressing economic and social problems in Turkey, namely large regional disparities. Accordingly, these actions, particularly the adoption of the Law, are acknowledged in the matrix of policy conditions for PPDPL as a milestone inthe implementation of the program supported by PPDPL. THEFIGHTAGAINST CORRUPTION 193. Corruption is well recognized by the authorities as an important obstacle to economic and social development inTurkey andelsewhere. Corruption deters investment, spurs inequality and threatens macroeconomic stability. Corruption also reduces the effectiveness of the public administration and erodes the rule of law. Corruption is a cross cutting issue which plagues the relationship between the public and private sectors as well as civil society. Combating corruption must be, therefore, an integral part of the public administration reform program supportedby the PPDPLseries of loans. 194. Turkey has been attacking corruption through several means, especially after the 2001 crises when the issue became an important subject in the public discussion. A national strategy to enhance transparency and good governance in the public sector was published inMarch 2002 under the title "A Transparent and Ckan Turkey: Together Hand in Hand". The objective of the strategy was to provide a comprehensive framework for improving governance andreducing 57 political influence. The strategy establishedpriorities and benchmarks. It sought to empower andenergize public opinion to fight corruption. 195. The basic elements and actions of the strategy were reflected in the UAP adopted by the current administration in 2003. A ministerial committee for enhancing transparency and improving good governance was established in March 2003, under the leadership of a State Minister. A technical committee chaired by the Prime Minister's Inspection Board provides support to the ministerial committee. The committee benefits from an EU-funded project that supports the establishment of an anti-corruption unit within the Prime Ministry and aims to increasethe capacity of key institutions for combating corruption. 196. A number of substantiveactionsenvisionedin UAPhavebeen implemented. The law on "Freedom of Information for Citizens" was enacted in October 2003. The implementation regulations for the law were published in April 2004. The law enables citizens to monitor the performance of the public sector. Inthis context, citizens are able to request information on-line from public agencies (through their websites). A Prime Minister's decree issued in January 2006, requires all public institutionsto provide an annual summary report on the implementation of the Law on Freedom of Information. Also, a law on the establishment of an Ethics Board for civil servants was enacted inJune 2004, Subsequently in September 2004, the Ethics Boardwas established and in April 2005, the regulation on the Code of Conduct for civil servants was issued. 197, Further, the new Penal Code contains provisions concerning bribery, trading in influences, abuse of power, and embezzlement. It also provides for more severe sentencing for corruption-related crimes.21 The Code also introduces the concept of liability of legal persons in cases of corruption and contains provisions concerning corruption inpublic procurement. 198. There have been additional reforms in broader issues such as public procurement and public financial management and budget reform (discussed in the previous section). These reforms are instrumental in improving overall transparency and accountability inthe governance of the public sector. 199. Turkey has alsojoined the ranks of the international community infightingcorruption by ratifying many of the international conventions on the subject, including the Civil and Criminal Law Conventions of the Council of Europe (2003 and 2004), the OECD Convention on Combating Bribery of Foreign Officials (2003), and the UN Convention against Transnational Organized Crime (2003). The UNConvention against Corruptionwas signedby Turkey in 2003 and was ratified by the Parliament in May 2006. Turkey became a member of Group of States Against Corruption (GRECO) inJanuary 2004. 200. Although corruption has not beeneradicated inTurkey, there i s reliable evidence that the strong action of the current government i s yielding positive results. For example, Transparency International's Corruption Perception Index for 2005 ranked Turkey 66* (out of a total of 159 countries) compared to the rank of 77th in 2004 (out of a total of 146). The Business Environment and Enterprise Performance Survey (BEEPS) conducted by the World Bank and 2005 EuropeanCommissionProgressReportonTurkey. 58 the EBRD22captures the views of entrepreneurs and business executives about taxes, macroeconomic and government policies, corruption, anticompetitive practices and financing costs. Turkey showed significant improvement between 2002 and 2005 in many aspects of the survey, including reducing red tape, improving its business environment, and reducing corruption. Obviously, the survey also indicates that there is room for improvement in subjects like customs, businesspermits and taxes. 201. The authorities and Bank staff realize now that the broad policy actions have been taken, fight against corruption will becomeincreasingly difficult which requires a more comprehensive view and refined strategies to continue making progress on the matter. It has become apparent that continued fight against corruption requires a clear assessment of the most urgent actions to reignite the initial impetus of this administration. Unfortunately, there is no obvious action plan. The program supported by PPDPLrealizes, therefore, that Turkey needs to complete a detailed diagnostic to design the strategy required to continue tackling corruption so as to maintain increasingly more positive performance levels as measured by reliable indicators such as Transparency International Indexes and the Bank's BEEPS. POSSIBLE FUTURE LOAN -PPDPL I1 202. Following PPDPLthe authorities and Bank staff will consider whether to present to the Board of Executive Directors a second loan (PPDPL 11) for approval. The 2005 CAS Progress Report envisions that PPDPLI1will be for an amount equivalent to US$400 million. 203. PPDPL I1 is expected to support the implementation of the second phase of the government's medium-term program of legal, institutional, and structural policy actions to consolidate fiscal adjustment and modernize the institutions and procedures of public sector management and service delivery. Accordingly, PPDPL 11will also support actions in four components, namely: (a) maintaining the currently enabling macroeconomic framework; (b) reformingsubstantially the country's social security and assistancesystem; (c) continuingthe on- going process of upgrading the financial controls and expenditure management of public resource; and (d) improvingthe administration and governance of the public sector. 204. More specifically, Table 16 presents a list of policy actions, milestones that are in the government program and which could be supported under PPDPL11. The table also presents (in bold) the indicative triggers agreed by the government as key program indicators to justify movingto PPDPL11. 205. Symmetrically with PPDPL, the second loan i s expected to have between six and eight prior actions which obviously will be completed before Boardpresentation. The authorities and Bank staff have agreed to designate four of these potential prior actions as triggers to move forward with the appraisal of the second loan prior to submitting it to the Executive Board of Directors for approval. The remaining prior actians will be selected during the appraisal of the Loan. 22The BEEPScoversall countriesof the Central andEasternEurope, the former Soviet UnionandTurkey. The objective of the,surveyi s to evaluatethe constraintson investment andprivate sector growth. 59 206. Selection of four triggers among the expected prior actions recognizes the fact that the government has adopted a well specified and EU accession anchored MTP but which needs to remain flexible in view of the unpredictable timing of public sector reform needs that may result from the on-going dynamic process of EU-accession negotiations. Priorities within the overall public sector reform program may change as EU negotiations advance and so may the preferences regarding the specific subjects of Bank support within the wider government program. 207, The design still allows transparent progress reviews and predictability as the program moves to the second phase because the policy matrix contains numerous non-core actions included that will act as implementation milestones. Naturally, the 10 or so disbursement conditions for the second loan under the PPDPL series will need to have sufficient substantive content, in other words these conditions will needto be critical enough to the objectives of the program to be supported with the second loan. In seeking authorization to negotiate, the loan team will need to obtain agreement from Bank Senior Management on the substantive content andbalanceof the remainingprior actions. Table 16: Board Conditions,Milestones,andTriggers under PPDPLI1 * (Triggers are inBold) ComDonent I.SustainineMacroeconomicStabilitv The governmenthas maintained a satisfactorymacroeconomic framework. Component 11. Social Security and Social AssistanceReform The socialsecurity andUHIlaw has beenimplementedas enactedin2006 inorder to ensure the fiscal sustainability of the social security and UHI systems where sustainability will be measured by a combineddeficit not exceeding4.5 percentof GNP. An agreed action plan for implementing the law on reforming the administrative dimensions of social security has been satisfactorily implemented as evidencedby the achievement of key benchmarks and milestonesinthe plan. Implementation of the plan resultedin (a) consolidatedelectronicrecordsof the previous sociai security institutions, (b) personnelpoliciesfor the new social security institution and a core cadre of staff; (c) established financial management and claims adjustment systems, (d) integrating identity number systems; (e) a system of periodic monitoring for patient utilization and access to health services; and (f) unique positivedrug listsfor all participants inthe new socialsecurity institution. A satisfactory social assistance reform law aimed at increasing the effectiveness and targeting of the social assistance system through close coordination of social assistance policies has been submitted to the Parliament. An agreed action plan for implementing efficiency enhancing reforms in the health system has been satisfactorily implemented by the relevant agencies, including the SSA, the UHIF,and the MOH. Outcomes of the plan include (a) accreditation of sufficient service providers, (b) well functioning family medicine and specialistreferral systems and (c) sufficient autonomy of hospitals. Legislationdetermining and regulating the payment of health insurancepremia by the governmentfor the poor under UHIis inplace and isbeingimplemented. There has been satisfactory continuous implementation of the quantitative framework for monitoring health - expendituresas well as a plan for containing unexpectedincreases inhealth costs. I 60 - Component111.Budgetand PublicFinancial Management Reform Implementationof fiscal policies has beenconsistent with the MTFP issuedin2006. The central government PROGRAMGOALS AND EXPECTED OUTCOMES 208. The goals of the program are summarized in the first column of Table 17, the expected program outcomes in the immediate years after PPDPL I1are identified in the second column, and the contribution of the program to CAS objectives are presentedinthe thirdcolumn. 209. It should be noted, however, that the program's key outcomes will need quite some time to be realized -in the case of parametric pension reform the outcome of fiscal sustainability will take a number of generations to be obtained. In other cases, there will be significant lags betweenthe realization of outcomes andthe ability to monitor them-such i s likely to be the case of having well functioning RDAs and the ability to measure substantial development at the regional level. Therefore, an effort has been made in finding short-term outcomes that could be measured during program implementation and which would be proxies for the longer-term outcomes soughtby the program andwhich, for its very nature, couldbe achieved quickly. 210. The fact that the key long term public policy outcomes will be ultimately realized well beyond the time frame of the program does not reduce their importance -on the contrary it attest 61 to the urgency to start immediately. Accordingly, continued progress towards meeting the ultimate longterm goals of the program will be monitored through any future CAS. 211. The program would make a significant contribution to the objectives set inthe 2003 CAS and its 2005 Progress Report of (a) making the economy more resilient to crises that disproportionately affect the most vulnerable; (b) contributing to sustainable economic growth that i s critical to pull many of the poor out of poverty; (c) promoting human development to create opportunities for the poor, make access to health more equitable and the social protection system more efficient; and (d) reducing regional differences by improving the delivery of and access to services, andcreatingjobs in disadvantagedareas. Table 17: Expected Program Outcomes and Contribution to CAS Objectives Program Areas andGoals Expected ProgramOutcomes Contribution of Program to CAS Following Disbursement of Objectives PPDPL11 ~ SustainingMacroeconomic Stability Long-term macroeconomic stability. The targets of the macroeconomic Contributesto assistingTurkey in program have been met, including reducingeconomic vulnerability. (a) single digit inflation rates, (b) economic growth of at least 5 percent, (c) declining real interest rates (d) a combined social security systemdeficit of at most 4.5 percent of GNP, including the deficit of UHI* SOC d Security and Social AssistanceRe rm At a minimum to arrest the deficits The social security deficit as a Contributesto making the economy of the social security institutions in percentageof GDP has (a) ceased to moreresilient to crisesthat the immediate term and to reduce grow and (b) the actuarial projected disproportionately affect the most them over the long term to bring deficit has fallen by approximately 1 vulnerable. about the sustainability of fiscal percentagepoint relative to the base balances necessary for macro case in2016 and decreasedto below stability and to create the fiscal 1percentofGDPby2040. space for implementing Turkey's developmentagenda. The main credit rating agencies have upgradedTurkey's long term ratings by one notch on the basis of the improved long term fiscal sustainability. The resulting better assessment of country risk by investors has entailed reductions in Turkey's spread relative to JP Morgan's index for emerging markets. To improve the fiscal sustainability Pension parameters are the same for Contributes to makingthe social of the social security system but, all major groups of employees (a) security more equitable and equally important, improve its equity public servants, (b) wage earners in streamlines serviceprovisiondoing andefficiency. the private and public sectors, and away with arbitrary differences in (c) the self-employed. In addition the provisionof health care by UHIhas beenextended to the entire extendinghealthinsurancecoverage population. to 100percentof the population ina fiscally sustainablemanner. 62 A satisfactory quantitative Us0contributes to moreefficient framework for monitoring health 'esource utilization and efficiency in expenditures is in place and will he delivery of health services in allow ascertaining that the social iospitals needs to be improved. security deficit including UHI will Systemic changesinthe health not exceed4.5 percentof GNP. ;ector target improvementsin nanagementandorganizationof iealth services. Budg andPublicFinancialManagement1 form Improve the government's ability to Fiscal policies have been consistent Zontributes to making the economy estimateand managepublic finances with the MTFP which ensures sound more resilient to crises that lack of which contributed to past fiscal policies. lisproportionately affect the most crises. vulnerable, The central government is applying Contributes to reshaping the role of standards issued by the Accounting the state in the economy and to Standards Board and its financial breaking the vicious circle of an statements have been preparedin an unsustainablylarge public sector and accrualbasis. inadequate public sector management leading to ever There is a complete list of tax increasingpublic indebtedness. expenditures and an accurate estimate of their costs with a proper functional classification. The GFS budget classification covers the entire general government. I Pub AdministrationandGovernanceR 3rm Promote regional development to Satisfactory progress towards Contributes to reducing regional reduce regional income disparities establishmentof RDAs. differences by improving the through redefining the delivery of and access to services, responsibilities and strengthening and creating jobs in disadvantaged the financial position of local areas administrations as well as creating institutions charged with developing specific regions. To develop and set in motion the The public is fully aware of the Contributes to implementing public implementation of the long-term government's long -term strategy to sector reforms with special emphasis strategy that systematically and combat corruption and there is a on Turkey's anti-conuption strategy. progressively attacks the problem of clear allocation of responsibility which complements key fiduciarq corruption and which requires the among institutions to implement the work. commitment and participation of actionsinthe strategy. government, citizens and the private sector. The strategy will strengthen on going activities also supported under the program such as public financial management and accountability reforms. 63 VI. OPERATIONIMPLE~NTATION POVERTY AND SOCIAL IMPACTS 212. Povertv. The PPDPL program will contribute substantially to a long-term positive impact on poverty in Turkey, as it i s designed to increase the effectiveness and coverage of the social security system and social safety-net. Turkey has made little progress inreducing poverty over the period 1994-2002, with overall poverty rates of 27 percent, although extreme poverty i s very small at less than 1.4 percent of the population in 2002 as evidenced in the Joint Poverty Assessment Report (JPAR, FY06). Recent strong economic growth over the period 2002-2005 i s estimatedto have reduced overall poverty rates down to 23-25 percent on the assumption of no changes in income distribution. The actual situation i s being analyzed by the Bank now that the more recent householdincome and expenditure survey data have become available This analysis will be further updated under the Regional Poverty Update (FY06). Under any realistic scenario, it is this large number of people in poverty and vulnerable to poverty who constitute one of the largest and most important economic and social challenges for Turkey. 213. This very low rate of extreme poverty is reflective both of Turkey's income and the importance of the informal social safety-net, where neighbors and extended family members will generally help those in dire straits. However, with migration, reduced family sizes (reflective of the significant reduction in fertility rates in Turkey) urbanization and modernization, the traditional informal social safety-net has started to break down as has been demonstrated from the results of qualitative poverty analysis undertaken in the context of the preparation of the PPDPL. Thus over time, the formal social safety-net (of which the social security system is by far the largest part) has become increasingly important to help families and individuals in social risk management and the prevention of poverty. Unfortunately, the share of the population covered by the formal social security system has declined over time, as job creation has taken place in the informal sector, due to the high costs of compliance with formal social security requirements in the formal sector. Over 50 percent of the working population i s not covered under the social security system, a proportion which i s bigger among the lower age cohorts. The reforms under the PPDPL aim to address these issues by strengthening the social security system, ensuring its long-term fiscal sustainability, reducing the costs of compliance, extending coverage and ensuring that social assistance receives adequate financing and i s targeted more effectively. 214. The Government's social security reforms, supported here by the PPDPL are bold and comprehensive. The reforms will have a direct positive and continuing impact on the poor and vulnerable by: (a) extending health insurance to the entire population, thus helping in the management and mitigation of health risks and (b) providing a more equitable and more sustainable pension system, increasing coverage and ensuring continued provision of income support for the elderly. 215. Gender. The reforms supported by the PPDPL program should have a positive impact on women. Women will benefit disproportionately from the introduction of UHI, where those currently uncovered (estimated at between 6 and 22 percent of the population) will be provided with full basic health coverage for the first time. Currently those without formal coverage, and many of those with Green Card coverage, receive rudimentary or even no basic health care, 64 although critical health conditions are invariably treated by hospitals even when the patient has no coverage. This results in many simple health problems escalating to more acute conditions. Although there i s little evidence of the uninsured beingrefused care, there are clearly increases in female morbidity and a general lack of efficiency resulting from this very imperfect system. Extendingimproved quality ante-natal and other health care services to all women through UHI will result in a major welfare gain and help Turkey to meet its Millennium Development Goals on infant andmaternal mortality. 216. Similarly, strengthening the social assistancesystemwill help all poor families. This will reduce the extreme pressures which fall on poor women in managing the family and ensuring that children bothreceive basic adequate nutrition andcan affordto attend school. Integration of social policy formulation, as envisaged under the PPDPL program, will go a long way to improving the effective social inclusionof women, the disabled, as well as children and youth in difficulty. 217. Inthe case of pension reform, the issues are more nuanced and complex. Currently in common with many countries, women working in the formal sector effectively gain a significantly greater rate of return on their pension contributions, both because of an earlier retirement age and greater longevity. While it i s true that the pension reforms will compress the difference between males and females, they will not eliminate them. However, the important counterfactual here i s that without the reforms, the entire pension system in Turkey could become unsustainable fiscally, thus totally eliminating any pro-female impact that the system currently provides. 218. Stakeholder analysis. The PPDPL reforms contribute to a pro-poor development agenda. However, from a political economy perspective, compared to the counterfactual, some privileged groups (e.g. civil servants) are likely to lose relatively. UHIwill extend the benefits of modem health care services to the poorest 20 percent of the population. However, there might be some resistanceto the complementary health sector reforms, which are a pre-requisite for the introduction of affordable UHI,from the medical professional community to the development of family medicine, improved control and rationalization of pharmaceuticals expenditures, and the autonomization of hospitals. A stronger social assistance system will benefit the poorest 10-20 percent of the population, warding off extreme poverty (which as noted is actually very low at 1.8 percent of the population). Moreover, the entire agenda of the reform in improving government service delivery, although it will benefit the entire population, i s likely in reality to benefit women and families the most, as they tend to be more frequent users of local services, when adequate services are available. 219. While the policies in UHIand social assistance largely represent a win-win situation, in the field of pension reform and labor market policy there will be some losers. In the field of pensions, although it i s extremely difficult to reduce the existing stock of acquired rights, and such attemptsinthe past have beenblockedby the Constitutional Court, the pension reformmust of necessity reduce future acquired rights for all those in the system. This i s the necessary price which mustbepaidinorder to have apensionsystem sustainable for all. 220. Great skill will be required by the Government in presenting the case for reforms in pensions, emphasizing both the medium to long term advantages, the short -term advantages to 65 the poor, and that they are part of a wider citizen friendly government reform. Stakeholder consultations with the support of a population and human resources development (PHRD) grant and a sound public information campaign (prepared under the same PHRD) are essential in this regard. 221. Participation. Many of the reforms that are to be supported under PPDPL were envisaged in the Government's UAP. At that time, social security reform, tax reform, public expenditure and financial management reforms, service delivery andjob creation were all listed as beingpart of the Government agenda. 222. Government implemented a program of consultation around the social security reform. The SSA in the MOLSS i s responsible for the design and consultation of the reform. To build consensus within the Government, a steering committee for the reforms was established during the technical preparations. 223, A White Paper was prepared and sharedwith key stakeholders on July 29, 2004. These stakeholders include unions representing private sector, state employees and civil servants, the pensioner's society, and chambers of commerce. The stakeholders provided their comments at an intensive series of meetings over the period since September 2004. The general reaction to the proposed reforms in social security was overall positive although some groups expressed concerns as expected. IMPLEMENTATION,MONITORING,EVALUATION AND 224. The Under-secretariat of the Treasury will be responsible for coordinating actions among other concerned ministries and agencies. A number of other agencies are involved in the implementation of the public sector reform program being supported by the PPDPL program includingthe PrimeMinistry,SPO, MOF, MOLSS, Ministryof Interior andTCA. 225. As part of the PPDPLpreparation process, the Bank has discussedwith both the MOLSS and the SSA the development of an ongoing monitoring and evaluation (M&E) process of the social security reforms to ensure adequate feedback from beneficiaries to policy-makers. This qualitative feedback mechanism will complement the ongoing quantitative poverty monitoring which is undertaken annually (and continuously) since 2002 by the Turkish Institute of Statistics, supported by the SRMP loan and which would be supported also by the HTP. M&E i s traditionally a weak area within the Turkish social sector ministries, but there i s a strong understanding of the need to strengthen such mechanisms. The Bank has worked to strengthen bothquantitative andqualitative monitoringmechanismsinthe SYDGM, MOH, SHCEK andthe Ministry of National Education, The system for the MOLSS and SSA are supported under the HTP. 226. Bank staff will focus on the impact outcomes of the program and the adjustments that need to be made to the operation as it evolves, to take into account the latest country developments, stakeholder support, and feasible options for realizing the intended development goals. The review will be largely basedon the monitoring indicators (benchmarks) and the goals of the program. At the same time, the overall status of the government's program will be 66 monitoredto determine whether country conditions and the specific conditions of the proposed operation have been met. FIDUCIARY ASPECTS 227. Modernization of Turkey's system of public financial accountability in line with international standards is an urgent PEM priority. As detailed in the August 2001 CFAA, some of the basic building blocks are in place: an established legal framework; reliable, albeit fragmented, accounting processes; regular reporting of financial results; an apparently independent Supreme Audit Institution(SAI), the TCA, which reports to Parliament; a relatively open system of accountability andplenty of skilled personnel. However, deeper analysis reveals significant problems and lack of systemic coherence. Complex institutional relationships, multiple sources of public funds, heavy emphasis on ex ante controls and inadequatereporting to the legislature reduce transparency and weaken financial management. Accounting and procurement legislation have not kept up with evolving international standards. Similar to the budget, the audit systemi s fragmented with many bodies besides the TCA carryingout activities analogous to external inspection andaudit. Expected outcomes of the program will correct many of these shortcomings. 228, Accounting. Efforts to upgrade the public accounting system are steadily gaining momentum after years of limited progress. The suy2OOOi automated accounting system is operational in virtually all of the approximately 1,500 sites of the MOF's GDPA across Turkey. Under this internet based system, the MOF's central accounting data base contains data on all individual transactions wherever they occur in the system. The initiative to introduce modified accrual accounting in compliance with GFS requirements i s making progress. Turkey has consciously switched from cash-based to an accrual basis of accounting. Since the annual budgets are cash-based, the GDPA in the MOF has devised an intricate method for accounting entries that keeps track of both the cash-based and accrual entries. Cash-based budget outturns are therefore easily distinguished from accrual-basedexpenditures. The PFMC has replaced the public accounting law (No. 1050) and provided MOF with permanent authority to issue budget coding and accounting standards for all general government agencies. The MOF has issued a new framework for the accrual-based chart of accounts. It i s harmonized with the economic classification of the newly adopted GFS budget classification system. A new chart of accounts enabled the MOF to compile financial statements consistent with the 2001-GFS budget cla~sification.~~Article 49 of the PFMC law mandates that accounting be harmonized with the international standards and standardsbe issuedby aPublic Accounting StandardsBoard (PASB), which i s to be established as the general government's sole standard-setting authority. The PASB will be under the MOF comprised of representatives from the TCA, SPO, MOF, Treasury, and other agencies. 229. Procurement. Turkey has moved decisively to upgrade its public procurement legislation and practices in line with international standards. The new public procurement law was enacted in January 2002. The new law is based on the United Nations Commission on International Trade (UNCITRAL) model and moves Turkey inthe direction of compliance with 23The GDPA will only be compiling the financial statements for the generalgovernment. The Department of Statisticsis responsiblefor compiling GFS-compliant financial statistics. 67 EU standards. The independent PPA established by law to oversee public procurement and ensure enforcement of the new procurement standards is fully operational. The Government is working on new procurement legislation for SEESin the public utilities sectors consistent with the relevant EUdirective. 230. Auditing. Effective financial accountability requires extensive modernization of Turkey's public audit system. The objectives are two fold: (a) clarify institutional responsibilities, promote improvements in audit quality in line with international standards and support the shift from ex-ante controls to ex-post monitoring in harmony with the efforts to improve operational performance; and (b) expand the scope of TCA audits to cover the entire general government including local administrations, autonomous agencies, social security institutions, remaining extra-budgetary funds and revolving funds, with the overall objective of transforming the TCA into an effective state audit institution. These objectives have been facilitated by enactment of the PFMC law and will further be supportedthrough enactment of the new TCA law. With regardto audit quality, the law clarifies the roles and responsibilities of the line agencies, the MOF and the TCA. The PFMC law established a framework for decentralizing internal audit to the line agencies in line with EU requirements. It discontinued the TCA's to discontinue involvement in budget execution and focused on ex-post audits, including performance audits. With regard to the transformation of TCA, the new law will: (a) include all general government agencies under TCA's annual audit; (b) subject TCA's own accounts to external audit with reports submitted to the Parliament; and (c) expand the scope of TCA audits to cover the entire general governmentz4. As with any major institutionalreform, the transformation of TCA into a modem state audit institution must be carefully designed to build consensus with the public administration. The TCA i s committed to undertake internal reforms to align its institutional structure with international standards for state audit institutions, to upgrade its audit capabilities, and to reach consensus with the other government audit bodies on implementation of the reform. A draft action plan for the TCA's internal reform has been preparedand will be improved, includingthrough a peer review by auditors fromother European state audit institutions. The action plan is expected to be adopted by the Government and TCA after the enactmentof the TCA law. DISBURSEMENT AUDITING AND 231. Disbursementand ImplementationArrangements. The proposed loan will follow the Bank's disbursementprocedures for development policy loans. The untied balance of payments support will be disbursed against satisfactory implementation of the program and not tied to any specific purchases and no procurement requirements will be needed. Upon approval of the loan and notification by the Bank of Loan effectiveness, the Government will submit a withdrawal application. The IBRD will deposit the proceeds of the loan with the CBRT, which will form part of the official FX reserves at the request of the Undersecretariat of Treasury. The government will utilize the proceeds of the loan in foreign currency for either foreign debt servicing or for crediting the local currency equivalent into the treasury single account for financing budgeted expenses. Prior to that, the borrower will pay a front-end fee amounting to 1.0 percent of the loan amount from its own resources. If, after deposit in this CBRT account, 2.4The TCA audit mandatedoes not cover the audit of the Parliament. The Parliament will be audited by an independent audit committee. 68 the proceeds of the loan are used for ineligible purposes (for example, to finance items imported from nonmember countries or goods or services on the IBRD standard negative list), the IBRD will require the borrower to either: (a) return that amount to the account for use for eligible purposes; or (b) refundthe amount directly to the IBRD, in which case the IBRDwill cancel an equivalent un-disbursedamount of the loan. 232. Accounts, Auditing and Closing Date. The administration of this loan will be the responsibility of the Under-secretariat of Treasury. The government will maintain accounts and records, or ensure that such items are maintained, showing that loan disbursements were in accordance with provision of the Loan Agreement. Such accounts and records will be maintained in a form acceptable to the Bank. The IMFhad conducted a safeguards assessment of the CBRT in April 2002 and determined that, while number of measures was taken to strengthen the CBRT, such as the conduct of a quality external audit and the preparation of financial statements according to International Financial Reporting Standards (IFRS), there remained a number of vulnerabilities that neededto be addressed. The assessment recommended reorganization of the internal audit function, expansion of the role of the audit committee, publication of IFRS financial statements, and reconciliation of program monetary data with the audited financial statements, including an audit of the treasury component. Since then CBRT has taken a number measures including reconciliation of monetary data with audited financial statements and its audit by the independent auditor, publication of annual audited financial statements and the independent auditors report, reorganization of internal audit function, including the adoption of a new charter and the appointment of the head of the internal audit department. The audit reports by independent auditors on the financial statements of the CBRT for the year 2004, 2003 and 2002 provided a clean audit opinion. Past audits and generally positive assessment by the IMF indicate that there are no strong reasons for asking additional safeguards such as audit of deposit account. As a result of the above, no audit will be necessary underthis loan. The closingdate of the loan will be September 30,2007. ENVIRONMENTAL ASPECTS 233. Because of the nature of the policy actions supported under the program and the substantial long-term positive impact on poverty which i s envisaged as a result of PPDPL, this operation in unlikely to have any significant negative effects on the environment. Having said this, it is useful to characterize some of the potential environmental risks associated with expectedpolicy reforms. 234. PEM. Public sector reform programs of the type supported by PPDPL embrace expenditure frameworks, budget transparency, accountability, better financial management, and improved service delivery. The overall emphasis on improving governance and quality of spending and enhancing the transparency with which resources are allocated should improve environmental spending along with other forms. Thus, in principle, these reforms will be positive for environmental institutions, unless fiscal contraction falls disproportionately on such institutions, which i s not envisaged under PPDPL. 235. Tax reform. The impacts of tax reforms, which focus on institutional improvements, automation, transparency, compliance, and taxpayer services are expected to be environmentally 69 neutral, or positive to the extent that increasedtax revenuescan be usedto finance environmental institutions andinvestments. 236. Extending social protection. Improved coverage of the pension and health insurance systems i s expectedto have a greater impact on the urban formal wage sector, perhapsincreasing the incentive for rural workers to seek formal urban wage employment, increasing the burdenon urban services, and contributing to urban environmental problems. Conversely, there could be reduced environmental degradation inrural areas becauseof rural-to-urban migration. 237. Turkey's environmental priorities are outlined in various strategy documents focused on several areas including Turkey's National Report on Sustainab~eDevelopment (2002) prepared for the Johannesburg Summit, the environmental chapter of Turkey's NationaZ Program for the Adoption of theAcquis (2001), andthe National ~nviron~entalAction Plan (1998). A number of sectoral strategies complement these national reports, such as the Nutrient ReductionAction Plan (2002) which focuses on efforts to reduce agricultural waste runoff to the Black Sea; the National Forest Program (2004), which considers the scope for improving forest management; and the National Strategy and Plan of Action on Biodiversity (2001) which outlines Turkey's commitments as a signatory to the Convention on Biodiversity. 238. Inurban areas, Turkey's environmental challenges are primarily associated with air and noise pollution, industrial waste management, waste water management, sanitation, and access to clean water, complicated by the burden of providingurban housing and services to accommodate the growing number of rural-to-urban migrants. Specifically, urban pollution management i s emerging as a critical concern becauseof the need for heavy investments inmanaging municipal drinking water supplies, and urban and solid waste to comply with the EU environmental directives. Turkey has been taking important steps to improve implementation and enforcement of environmental legislation. In 2006, for example, regulations on environment inspection, monitoring, and enforcement were upgraded. Various measuresare now inplace to ensure there i s decentralized regulatory capacity to take on these tasks, 239. In rural areas, environmental degradation is most profoundly felt amongst upland communities where soil loss and deforestation have reduced the agricultural sector's productive capacity. Around 15 percent of Turkey's population i s found in forested areas, where the incidence of poverty i s highest amongst households with the least access to grazing lands, In rural areas, Government i s investing heavily in forestation and erosion control on the one hand, while promotingthe adoption of improved livestock breeds and fodder management systems to reducepoverty rates in uplandcatchments, on the other. Rural income generating strategies, such as beekeeping, organic farming, horticulture, and so on feature prominently in the programs of the Ministry of Agriculture and Rural Affairs and the Ministry of Environment and Forests. Watershed rehabilitation features strongly in these initiatives, Pilot community-based protected area management schemes are underway in several national parks and protected areas. These efforts are aligned with revisions to legislation to improve the institutional and legal framework for nature conservation. 240, The EU.is providing assistance to the government to build capacity for environmental management, regulation, enforcement and monitoring, as well as for developing revised legal instrumentsfor nature conservation. Inaddition, it is providing support for the establishment of 70 the Regional Environment Center, with the objective of providing training and capacity building of civil society groups. RISKS RISKMITIGATION AND 241. Vulnerability to financial crises. There has been significant improvement in many vulnerability indicators since the 2001 crisis including for example that (a) the cost of borrowing has been declining, (b) the composition of public debt has improved, (c) debt management practices progressed considerably, and (d) debt-to-GNP ratios are expected to decline further. The evaluation of these variables is explained indetail inthe February 2006 CEM. Nevertheless, the comparatively highdebt stock andrelatively short maturities mean that the economy remains vulnerable to a "sudden stop" in financing. As of end 2005, the share of foreign currency debt (38 percent) and floating rate debt (31 percent), and the average maturity of fixed rate debt (28 months) mean that sharp exchange and interest rate fluctuations could cause some risks. The growing current account deficit adds to financing needs. The short term nature of much of the private capital flows underscoresthe risks of a reversal inmarket sentiment, 242. Mitigating these risks requires maintaining the confidence of domestic and foreign financial market participants. Increasingly, such confidence is basedon continued progress with the "twin anchors" of EU accession and the IMF program. Markets appear to be treating EU accession and the WD;program as guarantors of maintenance of a sound economic program and, over the long term, convergenceto the EU. Following the decision by the European Council to open accession negotiations with Turkey in December 2004 there have been changes in the structure of capital flows with maturities lengthening, FDIi s increasing, andinterest rates falling. Smooth progress with the accessionprocess and the IMFprogram i s likely to allow the economy to absorb other external risks such as tightening of global liquidity, As the government's reform program gains a track record and credibility, the link to the anchors are likely to become less important and financial market participants will focus on the reform programitself. 243. Underlyingthe importance attachedto the process of EUaccession andthe WIF program i s the recognition that they imply continued progress with the much improved macroeconomic framework and structural reforms that began after the crises in200012001. The floating exchange rate regime introduced in 2001 has increased the economy's ability to absorb shocks, Systemic risks in the bankingsector have been addressed, the state banks have been re-capitalized, and the open FX position of the banking sector has moved close to balance. CBRT independence and the regulatory bodies for banking, energy, telecommunications and public procurement are helping to de-politicize economic management in line with international and EUnorms. Fiscal adjustment has shifted the primary fiscal balance from deficit to surplus and the legal framework for better fiscal managementis beinggradually put inplace. 244. External factors. The favorable global environment for emerging markets has been important `for Turkey's recovery. An important external risk i s the possibility of a slowdown in the EU accession process. A change in global liquidity conditions, for example stemming from higher interest rates in the US, the Euro area, and Japan remains an important external risk factor. A crisis in another emerging market could leadto self-fulfilling fears of contagion. The mitigating factor for bothEUaccessionrisks and global financing risk will be for the authorities to move forcefully on their program of structural reforms so as to convince markets that Turkish 71 fundamentals are sound. Geo-political events in the neighboring region may affect Turkey negatively through increased risk aversion by market participants (Le., higher spreads) and oil prices - as the country i s a net energy importer and the price of energy affects the current accountnegatively. 245. Banking Sector. Since 2002, there has been a major shift in banking assets from government paper to credit to the private sector. The source of bank profits has shifted from trading and treasury revenue to profits from net interest revenue in the loan and deposit business. The tighter fiscal policy, as well as confidence inthe reform process for EUcandidacy, has made the speculative trading business less attractive inbothcurrency andinterest rate positioning. 246. The shift toward domestic credit therefore would seem to have two positive benefits: the banking system should have become less susceptible to market risks that accompany international debt crises - mainly rapidly rising real interest rates and falling exchange rates - and financial deepening improves the prospect for development. However, the change in bank portfolios has increased credit risk when, if left unchecked, may have negative consequences. There are, however, several factors mitigatingthe probability of a crisis. Turkey has experienced the failure of major individual banks without experiencing a systemic run. The inter-bank market is very small implying individual bank problems are unlikely to be transmitted to the systemas a whole. 247. Nevertheless the expansion of the credit portfolio leaves the banking system potentially vulnerable to a substantial increase in domestic interest rates because borrowers that are solvent at current interest rate levels may be unable to meet interest and principal payments at substantially higher rates. In addition, a few banks are yet to acquire the experience and techniques required to rapidly expand consumer credits safely. In addition, banks may become vulnerable to the impact of troubles in financial markets outside the banking system duringdebt crises. 248. Political, legal and implementation risks. Policy makers are well aware of the importance of keeping on track with both the EU accession process and the IMF program. However, the public sector reform program faces legal, political and implementation risks that can undermine the achievement of the goals of the program without necessarily triggering a financial crisis. To mitigate this risk of significant political opposition to social security reform, the Government conducted a process of consultation and comments were actively sought from social partners. 249. Following the approval by the Parliament of the Social Security and UHILaw on April 19,2006, the President vetoed 15 articles of the law on the core parametric changes of the reform and sent it back to the Parliament for re-discussion. After the veto, the Government re-affirmed its commitment to re-approve the law without any amendments and sent it back to President "as is." Parliament re-approved the law on May 31, 2006. According to the Turkish Constitution, the law has now to be signed by the President within 15 working days from the day the re- approved law i s submitted to the President as the Parliament approved the vetoed law without amendments. However, and as any other law in Turkey, this one could also be challenged in front of the Constitutional Court. 72 250. Implementation of major public reforms needs strong coordination and monitoring. Public sector reforms, by the nature of the issues they address, tend to be cross-cutting and take time to implement. They therefore are particularly demanding of strong high level leadership that provides a clear vision of the objectives, makes pragmatic mid-stream adjustments to adapt to changed circumstances, and ensures effective coordination across government. The Public Debt and PFMC laws spearheadedthe public sector reforms in part to address concerns about recurring fiscal crises. Several new laws have been enacted in the recent past and others are reportedly in the process of being enacted. Therefore, strong coordination i s required to ensure the consistency of the reform. 251. For example, the enactment of the Omnibus Law has createdconcerns that the provisions of the law run counter to the intention (as stated in the PFMC law approved by Parliament) to improve fiscal transparency andto ensure that policy decisions are subject to consideration inthe context of a medium-term fiscal strategy that restrains expenditure commitments. Given the importance to Turkey of maintaining the credibility of these major reforms, the importance of strong and effective coordination that minimizes such conflict cannot be overemphasized, 252. Implementation of the PFMC law itself presents a major challenge. Beyond the introduction of a more transparent and accountable approach to public resourcemanagement, the P M C law envisages a substantial change in the public internal financial control framework and devolves financial management authority and responsibility to line agencies. The framework requires creation of new organizational structures such as internal auditors, financial controllers, andfinancial service units. 253. Implementation of the PFMC law across the local administrations needs to be properly phasedin. The PFMC law i s applicable to the central government as well as local governments comprising 81 SPAs and more than 3,200 municipalities. Some of the SPAs and several municipalities are relatively very small to command adequate resources to establish the new institutional structures such as financial controllers and internal audit. The law envisages a uniform implementation schedule across the general government irrespective of the size and or capacity of the agencies to implement the law. This poses an enormous implementation risk as smaller municipalities may choose to either ignore the provisions that they consider expensive to implement or implement the provisions focusing on the form rather than substance. 254. A mitigating factor for the coordination risk is the increased reliance on EU technical assistance. For example, the MOF has started to receive technical assistance from the Netherlands Ministry of Finance to assist with "secondary legislation regarding the budgetary process (according to the Maastricht Criteria), the strengthening of the institutional framework for an improved budget process and more efficient budget policy." The French Ministry of Finance is to provide advice and assistanceinthe areas of ex-ante controls, internal audit, and IT systems. The TCA, the SAI, has made arrangements (again via an EU financed twinning project) to receive technical assistance and training from the U.K.'s National Audit Office (NAO) and peer review from the Spanish SAI. But at the end of the day, these will not be substitute for the neededleadership within Turkey. 255. The social security reform also requires both strong institutions, close collaboration amongst them, for the reforms to be successful. Moreover, the introduction of UHI alone 73 without the concurrent complementary reforms in strengthening the health referral system, rationalizingpharmaceuticalsprocurement and providingmore autonomy to hospitals to increase their efficiency, could lead to the un-affordability of UHI from a fiscal point of view. Fortunately the government i s well aware of these risks and is from the beginning giving as muchintentionto institutional issues as to the policy design itself. It is already startingto unify the pension systemsin a sequentialbasis, starting with unifying the data bases. This progressive or stealthy integration will very much facilitate a final formal unification. The SYDGM is already being strengthened, with the support also of the SRMP, to take on a more effective social safety-net role. As noted previously, all the complementary reforms inthe health sector i s being piloted in Duzce, whilst a major start has already been made in rationalizing the public procurement of pharmaceuticals. Bank investment loans are in place to support institution and complementary reforms in pensions and UHI(HTP), social assistance (SRMP) and labor market (PSSP 11and the EU). However, the experience of increased health expenditures in 2005 demonstrates the fiscal risks inherent inthe health system and the need for the Government to be both vigilant in monitoring such expenditures and in introducing tougher administrative measuresto controlpharmaceutical expenditures. 256. There have been some rumors about early Parliamentary elections and the risk that the Government may resort to populist policies. However, the Government has made very clear public statementsthat there will be no early elections and the elections will take place inthe Fall 2007 as scheduled. At the same time, the Government remains committed to the economic program as evidenced by the completion of the 3rdand 4h IMFstand-by arrangement reviews in May, with an expected Board date in July 2006. Economic populism concerns are inconsistent with the Government just passing a most politically controversial reform-a comprehensive reformof the social security system, and maintaining consistently tight fiscal policy stance. Table 18: RiskAssessmentTemplate for LendingOperations Risk Factors Description M~gationmeasures Rating " Rating priorto "of mitigation residual risks (1) (2) (3) (4) (5) Country and sector factors Macroeconomic policy framework Comparatively highdebt levels Strong fiscal adjustment 3 2 and risingcurrent accountdeficit underpins createfinancing risk. macroeconomic program. ProspectsofEU accessiontalks and renewedFundprogram. Increasingshare of non- debt creating capital inflows. Flexible exchange ratecould mitigate a sharp exchange rate correction. Sectorpolicies and institutions Reformfatigue as elections EUnegotiations.IMFand 3 2 74 approach. WB programs are in place. Political stability and governance Single party hascreatedmost Government has been 2 2 stable governmentinyears. careful to managethe Nonethetess, political tensions political tensionsand couldappear as the 2007 avoid confrontation. electionsapproach. Borrower and other official Governmentis keento retain and Bank conditionality 2 2 ownership be seen to retain ownershipof consistsof actions already social security andpublic sector takenor envisagedto be reform. taken soon. Institutional capacity (project The merger of the three social Government has createda 3 2 agency and country) security institutions will be small team that is challenging. PEMreforms now managingthe processof needto be extendedto local integration. Bank support administration level. is coming through a Implementationof the component of a decentralizationreformcould be companion health project. challenging. EUsupportis available for the PEMreforms. Government is actively engaged ininstitutional capacity building in collaboration with the EU and other donors. Externalfactors Economic (market) developments Risks of contagion from The authorities remain 3 3 emerging market crisis. US, committed to high EuropeanCentral Bank and Bank primary surplusesto ofJapanmonetarypolicy reduceoutstandingdebt. tightening. Geopolitical tension CBRT policy inthe regioncouldbevery independenceguaranteed disruptive, including increased by law. riskaversionand substantially higher energy prices. Socialandenvironmentalfactors Compliance with Bank safeguard policies where applicable Country sociallenvironmental No particular risks identified 2 2 protectionsystems beyond the general socialtenvironmental risks. Fiduciary factors Compliancewith Bank fiduciary guidelines Country public financial accountability systems Despite significant progressinthe StrongBank involvement 2 2 overall framework, generalrisks inprocurementand remain. financial management, together with harmonization with EU, 75 Internal and otherfactors Staff skills (including stability in A largecross sectoralteam has Active efforts to ensure a 2 2 assignment) been working with Government strongteam. for two years. Supervisionresources One trancheoperation. Subsequentoperation is 1 1 adequately funded Other factors Overallrisk The program supportsrisky Governmenthas strong 3 2 second generationreforms. ownership, EUaccession process provides strong externalanchor. aRating on four-point scale accordingto probability of occurrence and magnitudeof adverse impact where 4 represents high riskwhile 1representslow risk. 76 Annex I Page 1of 10 REPUBLIC OF TURKEY PRIMEMINISTRY The Undersecretariat o f Treasury Ref B.02.HM.O.DEI.01.05 - 01 .01.02.201W29995 Ankara, June 5,2006 Mr.PaulWolfowitz President The World Bank Washington DC 20433 U.S.A. Dear Mr.Wolfowitz, 1. The commitment o f the Government to implement sound economic and structural policies in the last three years has resulted in economic stability and high growth. Having established macroeconomic stability and increased confidence that are critical to sustaining high growth rates, we are in a better position to unlock Turkey's potential for growth and facilitate faster convergence to the EU. Our aim i s to secure sustained high growth while generatingemployment for Turkey's young populationandensuringsocial inclusion. We have also made great progress inimplementinga wide rangingstructural adjustment program. 2. To consolidate the current macroeconomic stability and strengthen public sector governance, we are dedicated to maintaining our strong macroeconomic policies and continuing and further expanding and deepening our public sector reform efforts. Three of the key components o f our public sector reform agenda are: (i) Security and Social Social Assistance Reform, (ii) Public Financial and Expenditure Management Reform and (iii) Public Administration andGovernanceReform. 3. In this context, we request World Bank support for our program by approving the Programmatic Public Sector Development Policy Loan (PPDPL) program and the disbursement o f the EUR 403 million (on standard IBRD terms for Turkey) for the first PPDPL. We are confident that the reforms detailed inthis Letter merit full support from the World Bank andthe international community. I.SustainingMacroeconomicStability 4. Favorable macroeconomic outcomes in2005 strengthenedthe prospects for sustained growth. The annual growth in 2005 was 7.6 percent, higher than the target o f 5 percent, representing the fourth consecutive year inwhich the target i s surpassed. Inflation (CPI) fell to 7.7 percent, below the target o f 8 percent. Since the credibility ofthe Central Bank (CBRT) i s now firmly established, with the inflation target being undershot for 4 years in a row and the inflationary expectations well aligned with targets, the CBRT has formally launched an explicit inflation targeting regime on January 1, 2006. Interest rates on Treasury bonds declined to an average o f 16.2 percent, from the 2004 level o f almost 25 percent. Favorable borrowing conditions as reflected inthe lower real interest rates and longer maturity together Annex I Page 2 of 10 with sizeable primary surplus helpedbringthe gross public debt burdendownto an estimated 71 percent o f GNP, from the 2001 peak o f above 100 percent. While the current account deficit widened further in2005 to an estimated6.4 percent o f GNP, there was no difficulty in the financing o f this deficit, as for example the FDI inflow in 2005 reached a record higho f US$ 9.7 billion. CBRT gross international reserves stood at US$ 52 billion at end-2005, an increase o falmost 40 percent with respectto 2004. 5. Our commitment to maintaining fiscal discipline has been instrumental in achieving the favorable macroeconomic performance. Following the 2004 primary surplus o f about 7 percent, impressive fiscal performance continued in 2005 with a primary surplus over 6 percent. We have met the first Maastricht criteria in advance of EU membership, as the overall deficit for the public sector declined to below 2 percent in2005. In2006, we expect a further improvement which is likely to be reflected in close to zero balance for the public sector. 11. Social Securityand SocialAssistance Reform 6. The Government fully recognizes the urgency o f a comprehensive social security system reform package. The biggest challenge we face i s the lack o f sustainability of the pension system. Towards this goal, we have prepared a set o f legislations to overhaul the social security system andbringthe system to balance inthe long term. The two keypieces in the package, namely Social Security InstitutionalLaw no: 5502 was enactedon May 20,2006 and Social Security and Universal Health Insurance Law no: 5510 was adopted by the ParliamentonMay 31,2006. 7. Parametric Reform. The current reform is designed to bringabout the sustainability o f the system in the long run. The parametric law will unify the key pension parameters for all social security contributors leading to a situation where the deficit as a percentageo fGDP has (a) ceased to grow by 2007, (b) fallen by approximately 1percentagepoint o fGDP relative to the base case in 2016, and (c) decreased to below 1 percent of GDP in OF about 2040, if consistently implementeduntilthen. By fully implementingthe reform, we seek to ensure the fiscal sustainability ofthe social security reform, includingUHI. 8. Administrative Reform. Realizingthat the fragmentation o f the social security system i s the key reason behind low collection rates and implied limited access to benefits, we have initiated, through the enactment o f enabling legislation, (i)the unification o f the three social security institutions, Emekli Sandigi, SSK and Bag-Kur into a single pension fund and (ii) establishment of a universal health insurance fund (UHF).The single pension fund will integrate collection of pension contributions and health premiums as well as payment o f pension benefits, The UHIF will manage other financial flows inthe health sector, including premiums paid by the budget on behalf o f the poor, and the health expenditures of civil servants. 9. The merging of the existing systems will inevitably bring about compatibility problems for the information technology platforms o f the three systems. Therefore, the new system will need to be one onto which the existing data from the three systems could be transferred. Similarly, the effective functioning of the UHF will need, among other things: (a) a comprehensive and updated data base with all individuals of working and pension age, including status of contributions paid and inarrears, (b) income test facilities for those among Annex I Page3 of 10 the poor who wish to be declared eligible for the state to pay their contributions, (c) online access to the data base on the part of health service providers to confirm that individuals seeking services are upto date on their contributions and, thus, eligible. 10. Towards successfblimplementationo fthe recently enactedsocial security institutional reform law, we have already preparedandwill implementa time bound actionplanwith clear performance indicators for implementingthe administrative dimensions o f unifjmgthe social security systems. The plan contains actions aimed at, among others: (a) consolidation o f electronic records ofthe existing social security institutions; (b) developing personnelpolicies for the unified social security institution and creating a core cadre o f staff; (c) establishing financial management andclaims adjustment systems; (d) integrating identitynumber systems across social security institutions; and (e) establishing a system o f periodic monitoring for patient eligibility, utilization, andaccess to health services. 11. Universal Healtlz Insurance (UHQ).The major public policy objective for the Government is to improve the quality of access to health services by the poor, while at the same time rationalizingthe access to health services. The introductionof a UHIscheme does not only pursue these policies but at the same time responds to the public finance challenge o f capping the risingdeficits o fthe public health care systeminthe longterm, althoughthe fiscal affordability o fUHIis a key challenge itself. 12. The newly establishedUHFwill act as an insurance agent for services under the new UHIsystem. Revenue will come from premiums correspondingto 13.5 percent of the wage base for workers and a similar contribution from the self-employed -which are equivalent to the premiums charged by ES, SSK, and Bag-Kur currently. The Government will identify those who are too poor to contribute to the system and will cover their contributions with resourcestargetedto this purpose bythe budget. Onthe revenue side, since there i s no change inpremium levels inmoving from the old system to UHI, increases inrevenue will need to come from improvedenforcement o f social security contributions. 13. On the expenditure side, it could be expected that the introduction o f UHIwill not have a large cost impact because a large portion o f the population has some degree o f access to healthinsuranceschemes including existingprograms for the poor. 14. To ensure sustainability o f the UHI, the Government has designed two policy actions. The first action, supported also by the Bank financed Health Transformation Project, aims at effectively implementingefficiency enhancing reforms inthe health system that result in cost savings. These reforms include: (a) establishment of a national pharmaceutical and medical devices agency; (b) introduction o f family medicine as the organizational model for primary health care services; (c) harmonization o f state hospitals for greater autonomy; and (d) strengthening population health facilities including disease surveillance, maternal and child health andprevention andcontrol o fdiseases. 15. The second policy action is the commitment by the Government to implement a satisfactory quantitative framework for monitoring health expenditures as well as a contingent action plan for containing unexpected increases in health costs. The action plan envisions taking actions (as needed) such as (a) reducing the range of reimbursable drugs @e., difference between original and closest generic) from 30 to 22 percent o f price o f generic drugs; (b) rationalizing the price of generics and original drugs; (c) combining Annex I Page4 of 10 MOF/SSKBag-Kur/ES positivelreimbursable lists of drugs; (d) reassessing and possibly reducing the number of drugs on the positive list; e) improving medical audit of pharmaceuticals to reduce errors and misuse inprescriptions. Inaddition, we are analyzing all potential sources of additional savings such as the feasibility of revising the price o f MOH outpatient services 16. Social Security and Social Assistance. The Government is determined to achieving a fiscally sustainable social security system by (a) capping the combined social security system deficit including UHI at 4.5 percent of GNP and (b) maintaining primary surplus at 6.5 percent of GNP. 17. Going forward, we intend to consolidate these reform efforts to overhaul Turkey's social security and assistance systems and achieve fiscal sustainability. The following will be among the key actions we planto take inthis context: The social security and UHIlaw will be fully implemented as enacted in2006 to ensure the sustainability ofsocial security reform includingu)-II. An action plan for implementing the law on reforming the administrative dimensions of social security will be implemented as evidenced by the achievement o f key benchmarks and milestones inthe plan. Implementation o f the plan is expected to result in (a) consolidated electronic records of the previous social security institutions, (b) personnel policies for the new social security institution and a core cadre o f staff, (c) established financial management and claims adjustment systems, (d) integrating identity number systems, (e) a system of periodic monitoringfor patient utilization and access to health services, and (f) unique positive drug lists for all participants in the new social security institution. A satisfactory social assistance reform law aimed at increasing the effectiveness and targeting of the social assistance system through close coordination of social assistance policies will be submitted to the Parliament with a view to start implementation as soon as possible. Legislation determining and regulatingthe payment of health insurance premia bythe government for the poor under UHIwill be inplace. An agreed action plan for implementing efficiency enhancing reforms in the health system will be implemented by the relevant agencies, including the Social Security Administration, the Universal Health Insurance Fund, and the Ministry of Health. Outcomes of the plan are expected to include (a) accreditation of sufficient service providers, (b) well functioning family medicine and specialist referral systems and (c) sufficient autonomy of hospitals. A satisfactory quantitative framework for monitoring health expenditures will be in place as well as a contingent action plan for containing unexpected increases in health costs that would be adopted by the corresponding entities Annex I Page 5 of 10 involvedinthe sector as part o f our commitment to ensure fiscal sustainability o f entire social security system. 111.PublicFinancialandExpenditureManagementReform 18. We continue our progress towards full implementation o f the landmark Public Financial Management and Control (PFMC) Law (enacted in December 2003). This law provides a new legal framework for modem public expenditure management and accountability and introduces a performance-oriented public sector management. Since enactment, we have prepared many o f the required supporting regulations and guidelines. While the full implementation o f the law i s expected by end-2007, implementation in key areas started in 2006 including in the areas o f budget coverage and classification, budget processes, accounting and accountability. A key set o f regulations, representing an important milestone, have been published and are now in force, including on: (a) procedures and principles for internal and ex-ante financial control, (b) working principles for strategy development unit, (c) working principles for the Internal Audit Coordination Board (IACB), and(d) working proceduresandprinciples for accounting officers. 19. PFMC Law. Implementation of the PFMC law is progressing satisfactorily including inthe key areasof abolishment ofcentral ex-ante controls andpublic accountability inpublic expenditure management. As the centralized ex-ante financial controls exercised by the TCA was abolished in 2005 and that o f MOF in 2006, the authority was transferred to the line agencies starting fiom 2006. Strategy development units, which will undertake financial control together with ex-ante control function, are being established since January 2006 for entire general government institutions. Budgeting and accounting responsibility for special budget agencies has been transferred fiom MOF to the,respective agencies. The outcome of this action should bemore effectiveness and clearer accountability inbudget implementation, e 20. To better link public policy planning and allocation o f resources through the budget, we introduced a medium-term expenditure framework for central government agencies inthe 2006 budget preparation cycle. The Council o f Ministers issued in May 2005, the medium term program for 2006-08 which establishes the macroeconomic fi-amework and macroeconomic targets for 2006-08. Based on and consistent with the medium-tern program, the medium-tern fiscal plan was issued inJuly 2005 by the HighPlanning Council and lays out the medium-term fiscal aggregates and sets institutional ceilings by economic classification. Medium-termbudgetingframework i s a tool for strengthening the linkbetween our policies and the budget while also improving the credibility o f the budget preparation process. The medium-term fiscal plan will provide a strong basis for improving strategic allocation o fpublic resourcesinaccordance with our priorities. 21. The 2006 central government budget, consistent with the medium-term fiscal planwas enacted inDecember 2005. As reflected inthe budget figures (which targets about 5 percent o f GNP for the central government primary surplus), the Government is committed to maintaining the public sector primary surplus o f 6.5 percent o f GNP and policy implementationi s hlly consistent with the mediumterm fiscal plan. 22. The Government's program is also aimed at achieving a comprehensive budget fiamework. Towards this goal, the 2006 budget expanded the budget coverage to all central budget entities. Inaddition, with the implementation o fthe PFMC law in2006, a new general Annex I Page 6 of 10 government budget definitionhas been introduced, which is consistent with international best practice and covers: (a) central government budget institutions (total of 143), (b) social security institutions' budgets (4 includingthe unemployment insurance agency), and (c) local administrations budgets (around 3,225). Moreover, the coverage o f the central government budget has been considerably expanded as 45 new institutions were included in the central government budget(i.e. sum o f generalbudget, special budget andregulatory and supervisory institutions). 23. We continue to rationalize the off-budget activities by reducing the number and increasingthe transparency o f extra budgetary funds andrevolvingfunds. Only 5 of the more than 60 extra-budgetary funds (Social Solidarity Fund, Defense Fund, Promotion and PublicityFund, Saving Deposits InsuranceFund, and Privatization Fund)remainas, we have, with support under the PFPSAL program, closed all others and moved their previously earmarked revenues and expenditures into the budget starting in 2004. The number o f revolving funds was also reduced from about 2,650 in mid-2001 to around 1,000 by end- 2005. The Government i s committed to restructuring all revolving funds within general government by the end o f 2007. Inorder to bringtransparency o f fiscal balances, the MOF has been publishing quarterly financial statistics for the revolving funds since 2005. In addition, projected fiscal balances o f the revolving funds are provided as an annex to the budgetproposal for the central government. 24. Although the GFS consistent economic and functional classification has already been applied for consolidated budget starting with the 2004 budget, it was extended to cover the rest of the central government and social security institutions inthe 2006 budget preparation. This is expected to significantly improve the policy analysis o f public spending. Reporting has also been improved as the projected aggregate expenditures and revenues o f revolving funds and extra-budgetary funds for 2006-08 have been submitted to the Parliament during the central government budget approval process. 25. As part o f our efforts to enhance fiscal transparency and accountability, we have initiated efforts to establish a framework to identify and monitor tax expenditure. It is well recognized that Turkey has an extensive array o f tax expenditure provisions, particularly in the income tax structure. As a first attempt to account for tax expenditures, we included, as an annex to the budget, the estimated cost o f tax expenditures for 4 main categories: personnel income tax (PIT), corporate income tax (CIT), value added tax (VAT) and special consumptiontax (SCT) between2006 and2008. 26. As a continuation o f our public sector reform program, we will continue ongoing process o f upgrading the financial controls and expenditure management of public resources. .Towards this end, we intendto take several actions includingthe following: (i) We will continue to implement fiscal policies that are consistent with the mediumterm fiscal planissuedin2005 andthe 2006 budgetlaw without major deviation from the expenditure andrevenue parameters inthe law. (ii) The Accounting Standards Board will issue accounting standards for the central government. Annex I Page 7 of 10 Financial statements for the 2006 central government budget will be prepared on anaccrual basis. We will effectively monitor tax expendituresthrough (a) completing the list o f tax expenditures, (b) refiningthe cost estimate of these expenditures, and (c) providinga functional classification o ftax expenditures. The PFMC Law will be implemented to secure the law's ability to bringabout bestpractice o fpublic financial controls and expenditures management. An adequate framework for public accountability will be establishedthrough approval by the parliament o f the new TCA law which empowers the TCA to audit entire general government and to carry out financial and performance audits. The link between the resource allocation process and actual investmentneeds (particularly new investment needs due to arise inthe EU alignment process) will be improved through, among other actions, an assessment o f the actual needs for maintenance expenditure for the existing capital o f the actual stock andastronger selectionprocessfor publicinvestments. IV. PublicAdministrationandGovernanceReform 27. One o f our core public policy objectives is to establish a more participatory, transparent, accountable public sector which respects human rights and freedoms and provides high quality public services on a timely, efficient and equitable manner. Turkey's recent past has been characterized by increasing budget deficits that were a by-product o f a growing and centralized public administration which lacked a strategic view and ineffective governance. Following a review o f the role o f the state and global state o f the art inpublic administration policies, processes, and practices; the Government identified the main elements in required for an effective restructuring o f the public sector as: (a) a new public administration framework, (b) a better central administration, (c) more effective local administrations and(d) other new arrangements, the main component ofwhich i s civil service reform. In 2003, the Government has initiated a comprehensive reform with a view to modernize Turkey's public administration system. Inwhat follows, this letter of development policy discusses the three main elements o f this reform process, for which we request the World Banksupport throughPPDPL.28. 28. Local Administrution Reform. The sustainability o f the strong growth performance in Turkey experienced in the last 4 years depends critically on a more evenly distributed growth at local level and improved service delivery. Local administration reform plays a central role in achieving these objectives. Key policy challenges in this respect include: (a) overcoming large economic and social disparities across regions and among urban and rural areas; (b) transformingthe fiscal, political, and administrative framework inwhich central and local governments operate; and (c) enhancing engagement with local administrations and stakeholders. 29. One o fthe mainreasonsunderlyingthe need for a reform isthe unsustainable increase in the budget allocations from the central budget arising from the rapidly growing Annex I Page8 of 10 urbanization which creates increasing demand for services. The delivery and financing of the increased amount of services, on the other hand, have only been marginally met bythe private sector. Inaddition, the system ofheavy reliance on transfers from the center does not provide incentives for fiscal discipline, Moreover, the administrative control has become increasingly more difficult to effectively maintain. As a result, it became inevitable to embark on a comprehensive reform o f the local administrations with the ultimate goal o f improving the efficiency and quality o f service delivery. 30. We have enacted a package o f four laws to establish a new and modem legal framework for local administrations. The following are the individual laws inthe package o f requiredlegislation: (i) MetropolitanMunicipalities Law (no.5216, enacted inJuly 2004), (ii) Special Provincial Administrations Law (no. 5302, enacted in March 2005), (iii) Local Administration Unions Law (no.5355, enacted in May 2005), and (iv) Municipalities Law (Law no. 5393 adopted in July 2005). Through these laws, the legal framework for municipalities hasbeenmodemized. 31. The Municipalities Law has modernized the organizational structures, duties and authorities, working and service methods, human resource management and fiscal structures o f municipalities. The minimum population threshold to establish a municipality has been increasedto 5,000 from the previous 2,000. Inaddition, the management of districts has been strengthened. The law attempts to strengthen municipal effectiveness in service provision, including greater authority on urbandevelopment andplanning.While the laws provide more flexible and effective human resource policies, they also impose greater discipline on municipal personnel expenditures and borrowing. Analogous changes have also been made to the legal fiamework for Metropolitan Municipalities. The Metropolitan Municipality Law expands the boundaries and functions, with the objective o f more efficient and effective service deliveryand establishes new criteriato establish a metropolitan municipality, namely, (i) levelofeconomicandsocialdevelopmentofthemunicipalityshallbeappropriate,(ii) the the population shall be at least 750,000 and, (iii) municipality shall cover at least 3 the districts. 32. The new system introduced by these laws, involves delegation o f a number o f responsibilities to the local authorities. In order to ensure consistency between the cost o f deliveringthe services and revenue assignments, we have revisited the revenue structures o f the local administrations. The Government has drafted a law on Special Provincial Administration and Municipal Revenues with a view to: (a) reach horizontal and vertical revenue equalization among central government and within local administrations; (b) include performance in service provision as a criterion; and (c) provide incentives to local administrations to increase collection o f own source revenues. The draft law also contains a formula-based system that takes these factors into account and will increase transparency, reduce unpredictability and arbitrariness, diminish central control over local governments, ensureminimumlevels o f service provision, andencourage the effective use o fresources. 33. The need for reforming the intergovernmental fiscal relations is also evident in the growth o f the arrears o f local administrations. Implicit local administration financing also occurs through creation o f arrears to other entities, most troublingly in respect o f social security contributions. Inaccordance with the municipalities' law, a reconciliation committee has been established to manage the restructuring o f municipalities' and affiliated companies' Annex I Page9 of 10 debt. As of May 2006, eight out of sixteen metropolitan municipalities' debts andreceivables were restructured by the committee. Out of the 3,209 municipalities, about 75 percent have requested restructuring o f their debt and receivables, o f which about 90 percent have successfully completed the restructuring processas o f endMay 2006. The aim o fthis exercise i s to bring municipalities on a firm footing for taking on new and expanded revenue and expenditure assignments andestablish fiscal sustainability. 34, Regional Development. Regional Development is one of our key policy challenges, especially in light o f our objectives to achieve more equitable economic development and accelerate convergence with the EU average income. The income level, on PPP per capita basis, inthe most developed region inTurkey is only a thirdo fthe 1Oth most developedregion inthe EU25, while the income level inthe least developedregionofTurkey is about athird o f that in the least developed region in the EU 25. In addition to actions under the local administration reform discussed above, a significant step in addressing regional development issues has been the enactment o f Law no. 5449 on the Establishment of Regional Development Agencies (RDAs) in January 2006. The law provides the framework for establishing development agencies chargedwith assisting sustainableregional development as means to reduce regional disparities and contribute to overall national development. The law provides the duties, powers and coordination structures for such agencies. Their functions include (a) strengthening cooperation between the public and private sectors, including NGOs; (b) ensuringefficient and appropriate use o fresources allocated to local development; (c) triggering local economic potential, and (d) stimulate investment through financial and other support services -with these functions being conducted in a manner consistent with national development policies and priorities. The State Planning Organization (SPO) is designated by law to be the national level coordination body for the agencies. One key positive aspect of the new law is that it provides transparency and accountability in the functioning ofthe RDAs. 35. A RegionalDevelopment Strategy isunderpreparation. Subsequentto the preparation o f this central level strategy, each region will then prepare its own Development Strategy. Finally, based on these strategies, action plans will also be preparedto identify priorities and measuresinpromotingthe region's economic development. 36. Fight Against Corruption. The Government recognizes that, as in many countries around the world, corruption is an obstacle to economic and social development in Turkey Although corruption has not been eradicated inTurkey, international indicators from different surveys point to an improvement in the level and perception o f corruption, as for example evident in Transparency International's Corruption Perception Index and the Business Environment and Enterprise Performance Survey(BEEPS) conducted by the World Bank and the EBRD. 37. The Government took a number o f substantiveactions that have been envisaged inthe UrgentAction Plan. The first one o fthese actions was the enactment o fthe law on "Freedom o f Information for Citizens" in October 2003. This was followed by publication o f the implementation regulations inApril 2004. Another action was the enactment o fthe law on the establishment of an Ethics Board for civil servants was in June 2004. Subsequently in September 2004, the Ethics Board was established and in April 2005, the regulation on the Code of Conduct for civil servants was issued. Further, the new Penal Code contains Annex I Page 10 of 10 provisions concerning bribev, trading ininfluences, abuse o f power, and embezzlement and provides for more severe sentencing for corruption-related crimes. The Code also introduces the concept of liability o f legal entities in cases o f corruption and contains provisions concerning corruption inpublic procurement. 38, Inthe mediumterm, we will continue with policies to improve public administration and governance. Towards this goal, the Government plans include measures such as the following: (i) We will implement the law on the Establishment o f Regional Development (RDA) Agencies by diligently (a) publishing of implementingregulations on the role o f RDAs, use o f f'unds, personnel policy and management, budgetary and accounting standards, performance measurement criteria and audit o f the RDAs(b) satisfactory progressinestablishment ofRDAs. (ii) We will adopt a law on Special Provincial Administration and Municipality Revenues, andstart implementationthrough secondarylegislation. (iii) A strategy to combat corruption will be prepared and made public, its institutional responsibilities will be clearly assigned and its implementation will start. 39. We are committed to maintaining the macroeconomic stability and fiscal discipline. We also believe that the policies andactions described inthe letter are adequateto achievethe objectives o f the public sector reform encompassing social security and social assistance, public financial and expenditure management and public administration and governance components. The Government is committed to meeting all the conditions agreed with the Bank for Board presentation of the PPDPLprogram and release of the PPDPL 1. We also standready to take additional measures, ifnecessary, to ensure the continuation and success o f our reform program supported by the PPDPL series. Inthis regard, we may consult with the Bank as the Program unfolds. n3 a 0 fi .I m wL MDo e .C L d L f 1 0 2 H v1 3 c, 0 L P e, s * 0 B0 4LE1 V h c. .I E 8 v1 I U v) 3 CL 0 h P Q) E a c Q) CI v1 20 Y al 2 n VI s U 0 -2E1 L 0 h .I CI tz 43 v) 1 Y v) Annex I11 Page1of 4 TheWorldBank-IMFRelations (as ofJune 5,2006) Bank-FundCollaboration 1. The World Bank and IMF teams have worked in close collaboration in Turkey, and standard working arrangements broadly follow the guidelines for enhanced Bank-Fund collaboration, The IMFhas taken the lead in macroeconomic stabilization and the World Bank in social and structural areas, with close collaboration in structural areas that have a particular impact on macroeconomic stability. Background 2. After the collapse of the 2000 exchange rate-based disinflation program and the floating of lira in February 2001, the banking system experienced heavy losses, inflation soared and the economy contracted by nearly 10 percent. Public debt climbed to over 90 percent of GNP in 2001, partly owing to the costs of bank restructuring, After the crisis, the Turkish government introduced a three-year economic program backed by a SBA with the IMF and series of programmatic loans from the Bank and since then, strong fiscal consolidation and disinflation efforts have laidthe basis for a rapid andpowerfulrecovery. 3. Turkey has concluded the last Fund-supportedprogram covering the periodof 2002-2004 successfully and the impressive outcome has laid solid foundations for the new program. These reforms have delivered a decisive break with Turkey's history of high and variable inflation, and low and volatile growth. 4. Highprimary surplusescontributedto bringingpublic debt on a sustainableanddeclining path. The net debt-to-GNP ratio declined to 64 percent in 2004 andthe market risk premiumon Turkish debt fell significantly. The net public debt-to-GNP ratio is projected to be around 56 percent in 2005. The adherence to a strict monetary program under the floating exchange rate regime helped establish the CBRT's credibility and facilitate a dramatic decline in real interest rates as confidence recovered. In this environment, real GNP grew by about 8 percent on average during the periodof 2003-2005, and it i s projected to grow by 6 percent in 2006. At the same time, inflation has fallen to single digits in 2004 for the first time in the last 35 years, and further declinedto 7.7 percent in2005, below the annualtarget of 8 percent. 5. Leaving the favorable developments aside, the Turkish economy faces a number of risks as well. The strong economic recovery, the appreciation of YTL and risingoil prices have also ledto widening current account deficit which continue to remain a source of concern. The high size of the government debt, its short maturity, and its currency composition is also a major source of vulnerability. For the medium term, the authorities' main challenge i s to implement policies that achieve the goals of sustained growth and low inflation. With the start of the EU accession negotiations, the alignment with the EU Acquis and rapid income convergence to the EUaveragesnow constitute further challenges. Annex I11 Page 2 of 4 The new SBA for Turkey 6. The Executive Board of the IMFapproved a three-year, SDR6.66 billion (about US$ 10 billion) SBA in May 2005 to support Turkey's economic and financial program through May 2008. An amount equivalent to SDR 555.17 million (about US$ 837.5 million) made available immediately. The Boardalso approved a one-yearextension of Turkey's repurchaseexpectations totaling SDR 2.52 billion (about US$ 3.80 billion) arising in 2006. A combined first and second reviews and an amount of SDR1.l billion (about US$ 1.6 billion) credit disbursementhave been completed under the new SBA until now. In May 2006, an IMF mission within the context of the Third and Fourth Reviews of the program concluded that Turkey's economy continues to perform well. The reviews are expectedto be approved by the IMFBoardin July, which would cause disbursementof about 1.3 billion SDR (around US$ 1.9 billion). 7. The overriding goals of the new program are to create conditions for sustained growth that will raise living standards and reduce unemployment; facilitate convergence towards the EU economies; and bring about an orderly exit from Fund support. To achieve this, the program aims to: Deal effectively with short-term macroeconomic challenges and, in particular, reduce the current account deficit to more sustainablelevels. Secure permanently lower inflation, by retaining the floating exchange rate, preserving central bank independenceunder formal inflationtargeting. Further improve the government debt position more sustainable through continued sizable primary surpluses, shifting towards longer debt maturities, and underpinning the fiscal adjustment with structural fiscal reforms. e Improve Turkey's net FX reserve position and strengthen its resilience to unexpected external developments. 0 Maintain financial sector stability by further improving the supervisory and regulatory framework, accelerating asset recovery andrestructuring statebanks. 0 Implement a structural reform agenda that enhances Turkey's growth prospects, lowers unemployment, and improves the investment climate. 8, The program's macroeconomic framework i s centered on achieving high and sustained growth of around 5 percent each year. Inflation was targeted at 8 percent for 2005, declining to the low single digits by the end of the program. The program also envisages a 5 percentage point decline in the overall fiscal deficit that should help reduce the government's net debt ratio by a further 10percentof GNP. 9. Growth has moderated in line with program assumptions, inflation i s in single digits, and the public debt burden i s being reduced steadily. The authorities' adherence to prudent macroeconomic policies has played a key role in supporting these developments. The main challengeto the economic outlook i s the widening current account deficit, which has been driven Annex I11 Page3 of 4 by increasing oil prices and strengthening of YTL. The authorities' response to the current account developments-a strong 2006 budget, a gradual easing of monetary policy, and stepped- upreserve accumulation-has been appropriate. The CBRT's cautious approach to interest rate cuts i s appropriate given a more challenging inflation outlook in 2006. In this context, the CBRT's adoption of formal inflationtargetingi s welcome. Areas inwhich the World Bankleads 10. The Bank has taken the lead in structural areas where both institutions have conditionality including bankruptcy reform, corporate sector restructuring, social security reform, regulatory and market reforms in telecommunications and energy, agriculture reform, and privatization. The Bank i s also in the lead in areas such as health, education, infrastructure, governanceandenvironmental management. Areas inwhich the Fundleads 11. The Fund takes the lead in macroeconomic stabilization including macro-fiscal policy, monetary policy, exchangerate policy andfinancial stability andriskmanagement. Areas of shared responsibility 12. The work on public sector management and governance has focused on strengthening PEMsystemwhile maintaining fiscal discipline. The Fundhas taken the lead in the short-term measures needed for the fiscal adjustment such as incomes policy, urgent revenue and expenditure measures, and budget monitoring and reporting. The Bank has taken the lead in assisting government on the medium-term PEM strategy, rationalization of the PIP, public procurement reform, accounting reform, and public liability management. Public employment policy, medium-term tax strategy, anti-corruption strategy and civil service reform are further areas of Bankinvolvement. 13. The challenge facing Turkey inthe financial sector has beento addressthe bankingcrisis andputtinginplace an appropriate legal and regulatory framework that would minimize the risk of future crises. The Bank has taken the lead in reform of the legal framework and regulations for bank supervision, the institutional development of the BRSA and SDIF, and the structural reforms required to guide the restructuring and improve the governance of the state banks, as well as work on NBFI. The Fund has taken the lead in assessingthe soundness of the banking system and where there was an immediate fiscal impact such as the re-capitalization of the state banks, the closing of insolvent banks, and the private bank recapitalization scheme. On the state banks agenda and resolution of private banks the Fundand Bank have worked closely as a team. The Bank intends to continue its support for financial sector reform in Turkey including the development of the NBFIfor which a major study has recently beenconcluded. Annex 111 Page4 of 4 Current Status of the IMPSBA Review Discussionson Turkey's IMFSBA Conclude Successfully PressReleaseNo. 06f107, May 23,2006 14. Mr. Hugh Bredenkamp, the IMF Senior Resident Representative in Turkey, issued the following statementinAnkara today: 15. "An International MonetaryFundmission, ledby hrenzo Giorgianni, today successfully concluded discussions on the third and fourth reviews under Turkey's SBA and agreed ad referendumon a draft Letter of Intent. 16. "Against the backdrop of vigorous economic growth in Turkey, led by strong domestic demand, the current account deficit has continued to widen and the pace of disinflation has slowed. These developments highlight the need to adhere strictly to the government's fiscal policy framework, andfor acautious monetary policy stance. 17. "Underscoring their commitment to fiscal discipline, the authorities will adopt measures to ensure that aggregate primaryexpenditures in 2006 do not exceedthe approved budget andto keep the deficit in the social security system within the program ceiling of 4% percent of GNP. These measures, together with the potential for fiscal revenues to overperform, should yield a primary surplus in2006 that exceeds the government's target of 6% percent of GNP. As a further safeguard for the budget, the government has declared that it will not introduce any further reductions or exemptions to the VAT. 18. "The central bank reaffirmed its determination to achieve the targets set out in Turkey's recently-adopted formal inflation targeting framework, andto preservethe floating exchange rate regime, which has shown its resilience inthe face of recent market turbulence. The central bank's net international reservepositioni s expectedto remain comfortably inexcess of program targets. 19. "Other key topics for the reviews included the government's policies to strengthen the finances of the social security system, plans for tax reform and improved tax administration, the implementation of reforms to enhance bank supervision, and the strategy for the state banks. The draft Letter of Intent sets out steps and timetables for moving forward in all these areas. Parliamentary approval of the two landmark social security reform laws was a major achievement, andthe government remains committedto implement these reforms as expected. 20. "The agreement reached with the authorities i s subject to approval by the Management and Executive Board of the Ih4F. In the period ahead, the government intends to implement identified budgetary measures and other policy actions. Providedthat these steps are taken in a timely manner, the IMFExecutive Boardcould meet to consider the completion of the third and fourth reviews in July. Completion of the reviews will enable Turkey to draw immediately an amount equivalent to SDR 1.2 billion (about US$1.9 billion)." Annex IV Page 1of2 Turkey at a glance 4/18/06 Europe& upper- POVERTYandSOCIAL Central middle- Turkey Asia income Dewlopmentdiamond' 2005 Population,mid-year (tniilions) 72.1 473 576 GNI percapita (Atlas method, US$) 4,740 3,300 4,770 Lifeexpectancy GNI (Atlas method, US$ billions) T 341.7 1,557 2,748 Averagaannualgrowth, 199945 Population(%) 1.4 0.0 0.8 Laborforce (%) 2.1 0.5 1.4 GNi Gross per primary Moatrecentestlrnate(latestyear avallable,199405) capita enrollment Poverty (77 ofpopulationbelownationalpover?yline) Urbanpopulation (% of totalpopulati~~ 68 64 73 Lifeeqctancyat birth (years) 70 69 69 Infantmoriaiky(per 1,ooOlivebin'hs) 35 29 23 Childmalnutrition (% ofchildrenunder5) Access to improvedwater source Accesstoan imprwed water sourca(% o~population) 82 91 93 Literacy(% ofpopulationage 1s) 87 97 94 - Grossprimaryenrollment (% ofschooJ-agepopulation) 94 102 106 Turkey Male 98 103 107 U ~ e r - ~ i ~ l eWOUD~ ~ e - l Female 91 101 105 KEYECONOMICRATIOSand LONG-TERMTRENDS 1985 1995 2009 2005 Economicratios* GDP (US$billions) 67.2 169.3 301.9 362.5 GrosscapitalformatiodGDP 16.5 25.5 25.7 24.8 Exportsof goods andServiceSrGDP 15.9 19.9 28.9 27.4 Trade Grossdomestic savingdGDP 21.o 19.9 18.2 GrossnationalsavingslGDP 17.1 24.8 19.9 18.4 T CurrentaccountbalancalGDP -1.5 -1.4 -5.2 -6.3 interest paymenWGDP 2.9 2.5 2.4 2.2 Domestic Capital TotaldebVGDP 38.7 43.6 53.7 46.9 savings formation Totaldebt servicelexports 35.0 27.7 32.6 34.1 Presentvalue of debtlGDP 55.6 48.6 Presentvalueof debifexports 179.8 164.3 Indebtedness 1985-95 1995-05 2w4 2005 200503 (averageannualor&) GDP 4.2 3.2 8.9 7.4 5.0 - Turkey GDP percapita 2.0 1.6 7.5 6.0 3.7 U ~ e r - m i ~ l e -groupe i ~ Exportsof goods andservices 7.4 10.9 12.5 8.5 8.6 STRUCTUREottha ECONOMY 1985 1995 1 Growth of capitaland GDP (%) (% of GDP) 2009 2005 I Agriculture 20.4 16.4 12.9 11.9 40 Industry 27.1 30.0 22.4 23.7 Manufacturing 17.7 20.6 13.9 14.0 Services 52.5 53.5 64.7 64.5 ; Householdfinal consumptionexpenditure 79.1 68.2 66.9 68.7 s o l Generalgov't final consumptionexpenditure 7.5 10.8 13.2 13.1 Importsof goods andservices 19.0 24.4 34.7 34.0 -GCF '-O-GDP 1985-95 199505 1 Growth of (averageannualgrowth) 2009 2005 exportsand Imports(%) c Agriculture 1.3 1.0 2.0 5.7 Industry 5.2 2.4 8.8 8.6 Manufacturing 5.8 3.2 10.1 6.3 Services 4.0 3.4 8.3 6.5 - Householdfinal consumptionexpenditure 3.7 2.4 9.9 8.8 Generalgov't final consumptionexpenditure 3.4 2.6 0.5 2.4 Grosscapitalformation 5.4 3.3 27.4 103 Exports -Imports Importsof goods andservices 9.4 8.6 Note: 2m5 dataare preliminary estimates. Groupdata areto2004. * The diamondsshowfour keyindicatorsin the country(inbold)comparedwith itsincome-group average. If data are missing, the diamondwill be incomplete. Annex IV Page2 of2 Turkev PRICESand GOVERNMENTFINANCE 1985 1995 2004 2005 Domesticprices (% change) 80 Consumerprices .. 88.0 9.3 7.7 80 ImplicitGDP deflator 53.1 87.2 9.9 5.4 40 Governmentfinance 20 (% of GDP,includescurrentgrants) 0 Currentrevenue .. 23.9 40.6 42.3 Currentbudgetbalance -1.2 -2.3 2.7 Overallsurplusldeficit .. -5.1 -4.7 -1.4 TRADE 1985 1995 2004 2005 (US$ mi//ions) Exportandimportlevels(US$ mill.) Totalexports (fob) 8,255 21,636 67,047 76,748 Textiles .. 8,727 18,226 19,599 Processedagriculturalproducts .. 2,160 3,427 4,386 Manufactures 7,262 20,298 59,579 68,737 Total imports@iff 11,344 35,709 97,540 116,537 Food 416 1,678 528 642 Fuelandenergy 3,895 4,578 14,377 21,178 Capitalgoods 3,050 8,215 17,397 20,341 Exportpriceindex(2000=700) 102 128 122 129 Importpriceindex (2000=100) 120 123 122 131 Terms of trade (2000=100) 85 104 100 99 BALANCEd PAYMENTS 1985 1995 2004 2005 (US$mi//ions) Current accountbalanceto GDP(%) Exportsof goodsandservices 11,119 36,575 89,975 102,606 3 T Importsof goodsandservices 12,495 40,107 101,069 121,335 2 Resourcebalance -1,376 -3,532 -11,094 -18,729 1 0 Netincome -1,553 -3,205 -5,637 -5,746 1 Netcurrent transfers 1,916 4,398 1,127 1,468 2 -3 Currentaccount balance -1,013 -2,339 -15,604 -23,007 -4 Financingitems(net) 1,137 7,344 16,428 40,854 5 Changesin net reserves -124 -5,005 -824 -17,847 4 7 Memo: Reservesincludinggold (US$mil/ims) 3,655 23,317 53,785 68,656 Conversionrate (DEC,/ccaWS$) 522.0 45.845.3 ####### 1,344,025 EXTERNALDEBTand RESOURCEFLOWS 1985 1995 2004 2005 (US$mi//ons) :ompositionof 2005 debt(US$ mlll.) Totaldebt outstandinganddisbursed 26.013 73,782 162,240 170,062 IBRD 3,432 4,939 6,153 5,829 IDA 178 130 77 71 Totaldebt service 4,601 11,451 30,483 36,518 IBRD 394 1,278 767 995 IDA 5 7 7 7 Compositionof netresourceflows Officialgrants 100 756 Officialcreditors 424 -1,183 123 53 Privatecreditors 1 801 7,935 5,918 Foreigndirectinvestment(netinflows) 99 772 1,988 8,626 Portfolioequity(netinflows) 0 -147 6,064 10,642 F- 103,314 WorldBank program Commitments 838 162 1,586 2,125 ,i- IBRD E- Bilateral Disbursements 636 422 1.499 461 B- IDA D - Othermultilateral F Private Principalrepayments 159 888 586 761 C IMF - G Short-term -- Netflows 477 -466 913 -300 Interestpayments 240 397 189 241 Nettransfers 237 -863 724 -541 Annex V Page 1of 13 The PensionSystemFollowing the 1999Reforms 1. The' fiscal deficits in the pension system can be traced to laws passed in 1991. The minimumretirement age was abolished, which coupledwith short minimumcontributory periods inSSK of less than 15 years and only slightly longer periods inES and Bag-Kur of 25 years for men and 20 years for women, meant that individuals were able to retire as early as age 34 inSSK and as early as 40 inES and Bag-Kur. While there are 1.2 million persons over the age of 65 receiving pensions, there are 3.1 million personsbelow the age of 65 receiving pensions, with an additional 0.9 million persons at a minimum below the age of 65 receiving disability and survivor pensions. 2. The 1999 reform, supported through the Bank's ERL, sought to remedy this problem by reestablishing a minimum retirement age. However, the reform i s to be phased in extremely slowly, with the retirement age as low as 38 for women and 43 for men for the first cohorts retiring after the reform. The retirement age will eventually be 60 for men and 58 for women, but these ages will not apply to cohorts retiring before 2034. Both the 1991 law and the retirement age aspect of the 1999 reform applied to all three pension systems, although the impact on SSK i s far greater than on the other systems since its shorter minimum contributory periodhadresulted insuch low retirement ages initially. 3. SSK. Employers are required to contribute 11 percent of wage for pensions while employees contribute 9 percent of wage. The total contribution for all social programs i s 15 percent for the employee, with 5 percent for health and 1percent for unemployment insurancein addition to what i s paid for pensions and 21.5 percent from the employer who pays 6 percent for health, 1percent for maternity, 1.5-7 percent for work injury, and 2 percent for unemployment insurance on top of what i s paid for pensions. Relative to even older OECD countries, these contribution rates are quite high. OECD average contribution rates are 19.4 percent of wage for pension and 31.9 percent for all social programsbut include countries such as Canada with rates as low as 6 percent for pensions. The average for Latin American countries which are closer demographically to Turkey than the older OECD countries i s 12 percent contributions for pensionsand 21.6 percent overall. 4. The 1999 law changed most of the SSK benefit parameters, but since the benefits receivedevenby new pensionersconsist of a combination of old system benefits and post-reform benefits prorated by years of service under each system, it i s necessary to describe the benefit structure both pre-reform and post-reform. Pre-reform, benefits used to be 60 percent of the average of salaries from the last 5 years plus 1percent additional for each additional 240 days, with individuals able to retire having contributed for 5,000 days or 13.9 years. In addition, workers had to have been members of SSK for 25 years if male and 20 years if female. A secondretirement option existed whereby workers who hadreachedthe ages of 55 for males and 50 for females couldretire with 54 percent of last salary with only 3600 days of contributions or 10years. Contribution ceilings and floors, and maximumand minimumpensions were adjusted byParliamentinan adhoc fashion, with some periods where the contributionceiling actually fell below minimumwage. Pensionspost-retirement were adjustedby growth incivil servant wages. During periods of crisis, the adjustments could lag inflation considerably, while during boom periods, pensioners did quite well, In addition, in 1984, Parliament had instituted a social assistance payment to all pensioners. The nominal amount of this flat payment was decided AnnexV Page2 of 13 annually by Parliament. By 1996 this flat payment had become so large'that it exceeded the average pension level, completely unraveling any relationship between pensions and contributions. Since 1996, this flat payment was frozen in nominal terms and now i s only about 1percentof pensions, but it is still given to all pensionersincludingthosejust retiring. Box 1:What Went Wrong With the 1999TurkishPensionReforms? Several factors interceded since the 1999 pension reform which has caused the deficits to return higher and faster than originally projected - policy changes, lack of growth in employment and coverage, lower macroeconomic performance,as well as the responseof individuals to the incentivesprovided inthe new system. The policy changes include the ad hoc indexation introduced in 2004 which superseded the automatic inflation indexation of pensions as mandated by the 1999 law for Bag-Kur self-employed and SSK and the introduction of social support payments for all pensionersin2003, which were permanently addedto the pensionbase in 2004 and will be given to all future pensionersas well. Preliminary estimatessuggest that the ad hoc indexation increasedthe deficit by at least 8 percent. The formalization of the 2003 social support payments increased the deficit by an additional 25 percent. The 1999 reforms had also anticipated a large increase'in coverage in line with rapid growth in employment and wages. Institutional reforms in the pension systems would complement the growth in employment by helping to formalize workers, bringing them and their contribution revenue into the pension system. The number of contributors was expected to have risen to 14.3 million in 2004 from 11.1 million in 1999. But, in fact, the institutional reforms never took place. Insteadof rapid growth inemployment and wages, Turkey faced a recession in2001, which depressed employment and wages. As a result, the number of contributors actually fell slightly to 11.0 million with most of the decline in SSK which saw contributors fall from 6.3 million to 5.5 million. This decreasewas balancedby an increaseinpublic sector employment, leaving the total roughly constant. The lack of coverage increases resultedina further 83 percentincrease inthe deficit. Incentives also appear to have been affected by the reform, although these effects are much more difficult to quantify. The reform had been expected to raise revenues by 22 percent in SSK, for example, immediately by raising the ceiling for income subject to contributions to 5 times minimum wage FactorsWhichLedtoWorseningefthe PensionSystem from around average wage. And it did initially. But by 2004, only about 15 percent of workers were claiming wages above average wage, with more than 50 percent declaring only minimum wage. It seems that workers have systematically chosen to under-declare earnings in response to the higher ceilings with the ultimate impact in lower revenues for the social security system, rather than higher. " I 7 ID 1999 Projections 0Disaggregationhncentives 0Worseningof ES Similarly, ES in 1999 contributed to the 0Lackofcoverageexpansion 0Social Support U2004 indexation deficit, but not in a huge way. Today, it represents 30 percent of the overall deficit, while providing pensions to only 13 percent of beneficiaries. Several factorsmay have ledto this change. One factor which may have contributed is that while contributions are collected only on salaries, pensionsare paid on the total remuneration including bonuses. Bonuses go up with seniority. As the pension reform has begun rising retirement ages, individuals gain more seniority causing more of a disparity between the revenue and expenditure side. Health expenditures for retirees which also come out of the same contribution for ES haverisen markedly due to a rapid aging of the civil service. Civil serviceexpansionfrequently occursinbatches which results inchunky civil serviceretirements. Lessons from 1999that havebeenincorvorated into the current design: Annex V Page3 of 13 e Institutional reformis neededto improve enforcement. As the figure indicates, the biggest gap betweenthe 1999 projections and 2003 outcomes comes from the lack of increase in coverage of the social security system. Better enforcement is critical. Although the institutional reforms are expected to take place, projections this time do not assume an increase incoveragerates unlike in 1999. e Labor market reforms to improve the incentivesfor formal sectorjob creation are also important. e The entire system including ES, the institution for civil servants should be included. e Ad hoc changesthat do not follow the law haveimmediate consequencesfor the deficit. 5. Post-reform, the requirements are a little more stringent, with workers required to contribute 7,000 days or 19.4 years for full retirement, although this change is also being phased inslowly for current workers. Fullretirement benefits are 54 percent of lifetime career average, although the average is computed by revaluing the nominal wages by growth in nominal GNP. Workers are still required to belong to SSK for 25 years if male and 20 years if female, and the new minimum retirement ages are being phased in slowly. A partial retirement option is still available, but at the normal retirement ages of 60 and 58, effective immediately. Workers need only 4,500 days of contributions or 12.5 years under this option and will receive 40 percent of their career average salary with 2 percent additional up to a total of 25 years and 1.5 percent subsequently. 6. A major innovation of the new law was the removal of ad hoc adjustments to be replaced by automatic indexation rules. The minimumsalary on which contributions were to be paidwas indexed to nominal GDP growth. The maximum salary on which contributions were to be paid was set at 5 times the minimuminsurable earnings (3 times in the original law, but subsequently raised to 5). Pensions were to be automatically indexed to inflation on a monthly basis. One issue that has arisen from the automatic indexation i s that a discrepancy has arisen between minimum wage and the minimum insurable earnings. Particularly since the 2001 fiscal crisis, minimumwage which is still adjusted on an ad hoc basis has not risen as fast as nominal GNP growth. Thus, minimum insurable earnings are almost 50 percent higher than minimum wage. Employers were currently required by the 1999 law to pay the full contribution, both employer and employee portion, for the difference between the two. InJanuary 2004, it was decided that the government pick up the contributionon the difference for the first 6 months of this year. As of June 2004, the concept of minimum insurable earnings as distinct from minimum wage i s legislatedto disappear. 7. Bag-Kur. Contribution rates are 20 percent for pcnsions and 20 percent for health coverage. As with all systems which cover the self-employed, there i s the perennial problem of evaluating the income earned. Turkey initiated a system of minimum earnings steps which are attributed to individuals regardless of what they actually earn. Most people declare earning level 1 in their first year of contribution and are automatically raised to the next level the following year. This occurs for the first 12 years. Subsequently automatic increases only occur every 2 years. Workers of course have the freedom to declare a higher earning level anytime they choose. The income levels associated with each step are different for the self-employed and the farmers, with the farmers' income substantially below that of the self-employed. Prior to the reform there were only 12 steps, with automatic increasesinthe first 6 years and then only at the worker's discretion beyond that. The nominal earnings level associated with each step is also automatically indexednow to nominal GNP growth. Annex V Page4 of 13 8. However, it should be noted that Bag-Kur has very low collection rates for its contribution revenue. Typically, workers pay very little duringtheir working years if at all. Just prior to retirement, they go to Bag-Kur and pay a lump sum equivalent to the past due contributions with interest and then receive their retirement. Prior to reform, Bag-Kur maintained the same benefit structure for the self-employed and the farmers with each getting 70 percent of the last earning step after 25 years of service at any age and 60 percent of the last earning step after 15 years of service at age 55 for males and age 50 for females. Pensionswere indexed by growth incivil servant wages. A flat social assistancepayment was provided inBag- Kur as well but its nominal amount hadbeen frozen early on and only rose briefly in 1995 and 1996before beingfrozen permanently. 9. The reform only affected the benefit structure for the self-employed. The farmers were allowed to retain their previous structure, but with retirement ages imposed. The self-employed benefit structure became identical to that of SSK, with individuals receiving 65 percent for 25 years of service and45 percent for 15 years of service. Pensionswere basedon the full earnings history (as defined by the steps). Pensions were also now indexed by inflation automatically on a monthly basis. As with SSK, the earnings steps are rising with nominal GNP growth which exceeds the rate of wage growth potentially causing difficulties for workers who do try to comply with the system. 10. ES. ES i s the program which covers civil servants including military personnel. The financing of ES i s somewhat different from the other plans in that health insurance during working years i s not covered by the pension fund. Health insurance during working years is covered directly by the line ministries with whom the civil servants are employed. The pension fund covers only retirement age benefits, pensions and health services during retirement. For this a 36 percent contribution is collected, of which 20 percent comes from the employer and 16 percent from the employee. No distinction i s made between revenue for health or pensions, but in2003, about 30 percent of expenditure came from provision of health services and70 percent was derived directly from pensions, suggesting that about 26 points of the 36 percent contribution finance pensionswith the rest financing health. Another distinction betweenES and the other schemes i s that the basis for contributions and the basis for benefits are different. Contributions are paid on the basis of basic salary. Depending on the grade of the worker, this basic salary may represent as little as 60 percent of the worker's total cash remuneration. When pension benefits are paid, they are paid on the full remuneration, including all the bonuses, etc. Thus, from the initial design, there is both a financing gap in ES and an equity issue, where lower grade workers pay contributions on a larger share of their salary than higher grade workers. 11. While the retirement age change includes civil servants, the 1999 law otherwise left civil servants untouched. Their benefit as always i s 75 percent of last salary, based on all remuneration, with increasesafter retirement indexed to growth incivil servant wages. Infact, it i s slightly more generous than that. If a worker retires from a particular grade, his pension i s tied to the growth in salary for that job. The retirement age change has had almost no impact yet because civil servants had to work a minimumof 25 years for a man and 20 years for a woman before collecting a pension. Since the legalretirement age i s currently about 43 for a manand40 for a woman with the very slow phase-in period, virtually no one is affected by the change yet. Annex V Page5 of 13 12. Non-contributory pension benefits. Turkey also provides a small noncontributory benefit to those over the age of 65 who earn below the level of the benefit. Currently ES pays 1,050,852 noncontributory pensions, of which 207,578 are paid to elderly men (over 65), 424,623 to elderly women, andto 139,046 elderly couples, Inaddition, 48,554 men over the age of 18 with 70 percent or more disability receive benefits, 24,082 women in the same group, and 908 couples. Finally, 136,949 menover the age of 18 with disability of 40-70 percent receive it, 61,313 women, and 7,799 couples. The amount as of March 2004 is only TI, 54.63 million per month for a single person andTL 81.945 million (50 percent more) for a couple. The amount is paid quarterly through banks if in urban areas, but through the post office if in rural areas. The pension amount was initially 67 percent of minimum wage, but i s now about 16 percent. In addition, importantly, the personreceives an identity card which provides outpatient care at state hospitals, but no medicines. Inpatient care i s provided by the hospital itself. The pension, like all pensions inTurkey, i s exempt from all taxes. 13. Voluntary pensions: Turkey began a system of voluntary private pensions run on an individual basis, much as in Latin America, with the first contributions collected in November 2003. The one significant difference from Latin America i s that individuals have to sign a contract pledging monthly, quarterly, semiannual, or annual contributions as opposed to simply making a payment whenever they have the money. However, additional or irregular contributions are also possible. As of end of 2005, there were 714,146 pension contracts, with the total amount invested equal to approximately only US$920 million. Administrative charges are a maximum of 8 percent on contributions, 3.5 percent on assets, and firms are allowed to charge an entrance fee with acap equal to the monthly minimumwage. 14. Contributions are tax deductible for employees up to 10 percent of gross wage, with the maximum tax deductible contribution equal to minimumwage. This i s important since the first lira of earnings i s taxable in Turkey at a 15 percent rate, i.e., no exemptions. At withdrawal, if the savings have remained less than 10 years, they are subject to a 15 percent tax rate. If longer than 10 years, but before the saver reaches retirement age, they are subject to 10percent tax. If the participant is at retirement age with 10 years of savings, 25 percent is completely tax-free, while remaining 75 percent pays 5 percent tax. This seems to be the treatment regardless of whether these are employee or employer contributions. This is treated as a withdrawal and taxed as a lump sum. If it i s annuitized, there i s no further tax on annuity payments, since they are taxed upon withdrawal. 15. On investment, each company has set up at least 3 pension mutual funds with different risk characteristics. At least 24 percent of the contributions must be invested in government bonds or fixed income securities. Upto 15 percent may be invested abroad. Currently, about 80 percent of the investments are invested in government bonds since the real interest rates are so high. There arecurrently 11licensedpension companies, 10of which possess also life insurance license. The remaining i s an affiliate of the OYAK company of the military. A pension monitoringcenter has been set up to allow for the e-supervision and monitoring of the system on a daily basis by the Treasury. The pension products offered by the pension companies can be sold by the personal pension intermediaries. These intermediaries musttake an electronic basec test (e-BEAS), consisting of questions in economics, finance, tax policy related to pensions, public pension systemrules, etc inorder to get a license. Annex V Page6 of 13 16. Issuesin the Turkish Pension System. The obvious main issue in the Turkish pension system is its lack of fiscal sustainability. Figure 1 shows the fiscal situation of the pension system, with overall deficits projected to be 4.5 percent of GNPin 2004 after havinghit a low of 2.57 percent of GNP in 2000. This reflects certain key disequilibria and issues, the most important of which are: a) There are still too many young pensionersinTurkey and they will persist until at least 2034; 62 percent of SSK and a staggering 70 percent of ES pensioners are below the ages of 58 (female) and 60 (male). b) Contributionperiods inTurkey are too low relative to benefit receiptperiods. Typically countries require contribution periods at least double the period of pension receipt. In Turkey, currently SSK requires only 16 years of contribution for a full pension while years of pension benefits are 34 for women and 27 for men. c) Pensions are too generous relative to wages for workers. Workers pay at least 30 percent of their salaries in various contributions and taxes. Replacement rates of 65-75 percent of gross wage translate into benefits equal to 93-107 percent of net wage. On top of that, the use of nominal GNP growth for indexing the earnings usedto calculate pensions results in a wage base 14percent higher than final salary for a 25 year career and24percent higher for a40 year career. d) No taxation on pensions. Almost all countries around the world tax either income subject to contributions or pensionswhen they are received. Turkey does neither. 17. Moreover, there has been some backsliding over pension policy. In January 2004, the Government announced an increase in pensions by 10 percent as of January and by another 10 percent as of July of this year. The said increase i s not presentedby the Turkish authorities as a policy change but rather as a one-off measure only 1 Efgure1: fiscal Deficits ofthe PensionSystem applicable in 2004. 6.00/0I Although the increase may have respectable reasons of 4.5% - fl social policy and political economy, it will also have undesirable consequences. On one hand, the proposed 1.5% measure will increase benefits beyond the 0.0% expected inflation and will, 1994 1996 1998 2000 2002 therefore, further worsen the -eSSK -m- -.l~Emekli Sand@ financial position of the Bag-Kur *Total pension system. On the other hand, such ad-hoc decisions erode the perceived stability of pension legislation and threaten the system with further, unexpectedfiscal shocks. The approved and legally binding text of the proposal was not available during our visit, however, our discussionswith the authorities confirmedthat the increase will not be additional to the statutory indexation. Annex V Page7 of 13 18. A social support payment for pensioners was introduced as a one off measure in 2003. SSK pensioners were each given an additional TL 75 million per month while Bag-Kur pensioners were given an additional TL 100 million per month. In order to maintain the fiscal constraints imposed by the 1999 law, the decision was made to subtract the monthly inflation increases awarded to each pensioner from this lump sum amount. For most SSK pensioners, by midyear (July 2003) the social support payment had disappeared. However, in Bag-Kur, the majority of this payment still existed at year end. This explains the relatively sharp increase in Bag-Kur deficits in 2003. A decision was then made in 2004 that not only were the remaining supplements to be continued and now considered part of the pension base on which indexation increases are computed, but new pensioners in Bag-Kur were also to be given social support payments on par with what existing pensioners in their income ranges were receiving. These social support payments would also be considered part of the pension base and would rise with inflationjust like the normal pension. 19. This measurefurther undermines the 1999 law which attempted to link contributions and benefits. If flat social support payments are provided to pensioners completely unlinked to previous contributions, pensioners essentially obtain their benefits not from their previous contributions but from the political process. In the case of Bag-Kur, these social support payments were often 100 percent or more than the original benefits. So it i s no surprise that Bag-Kur contributors under-declare earnings or refuse to contribute beyond the absolute bare minimum. They expect their pensions to come from the political process not from their contributions. The rise of these social support payments i s particularly troublesome in Turkey where historically the social assistancepayment as noted inparagraph 12had fully overtaken the contributory benefit even inSSK. Need for reform: 20. While SSK i s still slightly below its pre-reform deficit, the large growth indeficits comes from ES which as noted above, had little change in its policy from the 1999 reform. While the picture improves somewhat as the slow retirement age i s phasedin, the life expectancy increases inTurkey overcome the paceof reform andeventually inthe longrun, the deficits increaseto 7 percent of GDP. 21. But along with the non-sustainability of the pension system is the view that pensions are quite meager in Turkey. While seeming to be a contradiction with the non-sustainability, the system provides incentives to encourage individuals to contribute for too few years and retire early so that a small pension i s providedto lots of people rather than focusing on those unable to work for age or disability reasons. As a result, most young retirees continue to work while collecting a pension and then feel the loss of the work income when they truly retire. Life expectancy at retirement i s about 28 years for men and 34 years for women. Thus, the men and women who are currently retiring from SSK with 15-17 years of contributions can be spending almost twice as much time collecting pensions as they do contributing to them. Obviously, a system cannot work this way. Usually pension systems count on contributions from a large group of contributors to sustain a small group of beneficiaries. In SSK, there are not even two contributors per beneficiary and the other systems are even worse. Since most of the younger retirees work, but do not pay contributions, the practice of work without contributions has Annex V Page8 of 13 become ingrained in Turkish society and makes it difficult to combat this more legal form of evasion from the clearly illegal evasion where younger workers also do not contribute. 22. While the retirement age issue i s being addressed in the 1999 reform, albeit at a very slow pace, the number of years required to collect a pension i s only rising from 15 years to 19.4 years. Even at this rate, people will spend as much time or more in retirement than in working and contributing. Inmost countries, people contribute twice or three times as long as they collect benefits, so the Turkish situation i s quite abnormal. On top of that the benefit i s front-loaded. Workers in SSK receive 35 percent for the first 10 years of service, 3.5 percent per year. This drops to 2 percent for the next 15 years of service, resultingin workers who retire with 19 years of service collecting a benefit equal to 53 percent of their average salary. If they work an additional year, they get only 55 percent. It i s not worth the effort for the worker. And if the worker works beyond 25 years, the additional benefit accrual drops to 1.5 percent, removing any incentive for workers to continue contributing beyond 25 years. This needs to be compared with workers in other countries who regularly accrue 35 to 45 years of service. As a result, even as the retirement age increases, workers are going to choose to evade a large part of their working career to avoidthe fairly highemployee contributions (21 percent) and the culture of workers all contributingnever gets established. Benefit systems usually pay 1-2 percent, closer to 1percent per year of service. Even if people are allowedto retire with 20 years of service, if their benefit i s only 20 percent of average salary, they may think twice about retiring as early as possible. 23. Along the same lines, the target replacement rate for 25 years of work in Turkey i s 65 percent of salary. Even the EO, which i s often accused of being overly generous, targets 40 percent replacement after 30 years of contribution. Thus, by international standards Turkey i s overly generous. Comparing Turkish workers with Turkish pensioners, we would still have to conclude that the system i s overly generous. Out of a salary of 100 percent of gross wage, workers pay 9 percent for pensions, 5 percent for health insurance, and 1 percent for unemployment insurance. Minimum wage workers pay in addition 15 percent of salary for income taxes, with higher rates on higher income workers. Thus, the take-home salary of a worker i s only 70 percent of gross wage. Ifthe pension, which i s not subject to income tax, i s 65 percent of gross salary, workers in retirement receive 93 percent of their take-home salary. Duringworking years, workers usually support children andperhapsparents. Duringretirement years, they usually support only themselves, so they require less income. The need for other expenses, like commuting and work clothes, also falls in retirement. Thus, the pensions seem overly generous, bothby Turkish standards andby international standards. 24. The one issue that i s consistent with both the perception of low pensions and the generosity of the system is underreporting of earnings. More than 50 percent of workers in SSK report the minimum insurable earnings. In Bag-Kur through the step system, workers cannot declare the same levelof earnings year after year, but no one voluntarily declares higher earnings than required. If workers are in fact earning substantially more, but together with their employers under-declaring their earnings, they will of course end up with low pensions. The current systemappears to reward this behavior by awarding large pensionsfor minimum years of service. In addition, periodically, the Government grants additional social support payments to pensioners, which are flat amounts per pensioner. Despite the 1999law, the Government didthis in2003, which raisesthe level of pensionsto acceptablelevels without raisingcontributions and Annex V Page 9 of 13 provides the message to workers that it i s okay to under-declare earnings. Pensions will be providedat a reasonable level throughthe political processinany case. 25. In SSK, less than 5 percent of earners earn above the ceiling, so for all intents and purposes, the contribution rate applies more or less to the whole wage base. This has not been true pre-1999. Incidentally, some 50 percent of workers declare minimuminsurable earnings. 26. It has to be notedthat given the large segments of the population not receiving pensions, fiscal resources spent to bail out the pension system which covers primarily upper and middle income individuals end up with a regressive impact on the overall distribution of income, with resources drawn from a broader tax base being usedto support pensions for a narrower tax base. Ideally, a pension system with less than full coverage should be fiscally sustainable through employee and employer contributions alone. 27. Turkey is a young country and should not be experiencing fiscal deficits of the magnitude that it has experienced. Figure 2 shows that Turkey is twice as young as the next youngest OECD country, Ireland, which itself i s twice as young as the oldest OECD country, Italy. F'igure 2: Percentage of Populationover Age 65 inTurkey and SelectedOB.3 Countries 28. Impactof 2006 Law. From a fiscal sustainability perspective, the 2006 law brings the pension system in the long run to fiscal sustainability. However, as with all pension systems which do not adjust benefits to life expectancy changes, as life expectancy continues to rise in the outer years of the simulation period, pension deficits will begin to re-emerge, but these will not be anywhere close to the magnitude of the current deficits and will remain below 1 percent for the remainder of the simulation period. The pension projections below show the fiscal impact of the reform. Annex V Page 10of 13 figure 3: PensionSystemDeficits Before andAfter Passageofthe 2006 Law 1% 0% -1% -2% -3% -4% -5% -6% -7% -8% 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 Source: PROSTprojections producedby Bankstaff year +Base Case --i-RefonnCase 29. The positive achievements of the reform include the substantial fiscal gains as well as the unification of a previously fragmented system. Some of the fiscal gains come from the uniform move to inflation indexation of pensions post-retirement, which i s a substantial achievement. Previously, only SSK and Bag-Kur self-employed pensioners received pension adjustments indexed to inflation by law, although the Government had granted higher increases in recent history. Furthermore, prior to reform, there were strong disincentives for continuing work, with the benefits given for each additional work year much lower than those given for the normal working career. While not necessarily providing incentives for continued work, this new law removes the disincentives, with all work years being given equal credit whether they are below what i s considered a normal working career or not. However, there remain some areas of concern for the longer term future. 30. First, the contribution rates in Turkey are still relatively high by OECD standards, with .- the average OECD contribution rate slightly below Turkey's. Figure 4 shows Turkish contribution rates relative to those in other OECD countries. Retirement ages in Turkey are currently substantially below those in other OECD countries. Only in 2048 will Turkey achieve the retirement ages of most other OECD countries today. Since most OECD countries do not currently have sustainablepensions, more changes will be required in these countries, suggesting that even in 2048, Turkey's retirement age may lag those of other countries. One might argue that Turkey's life expectancy is below that of the other OECD countries, but OECD countries like Mexico are quite comparable to Turkey and still have retirement ages of 65 for both men and women even today. The low retirement ages inTurkey are aresidual from the 1991decision to remove the minimum retirement age entirely and the 1999 decision to reinstate a minimum retirement age very, very slowly. In the 2006 law, the decision was made to keep the 1999 retirement age schedule intact and only impact those joining the covered labor force after the new law goes into force. Butthis results in very low retirement ages for a very long time. Since Annex V Page 11of 13 these young retirees draw pensions for such a long time, once they have retired, it becomes very difficult to reduce expenditures. Flgure 4: ContributionRates inSelectedOEWJDCountries 4 0 , I 35 30 25 20 15 10 5 0 Figure5: RetirernentAges inTurkey Comparedwiththe OED 31. Accrual rates, the benefit paid per year of contribution, are also approaching OECD levels, but have not reachedOECD averages even with the new pension law. Figure 5 shows the accrual ratesinOECD countries. Annex V Page 12 of 13 .-c 3 [: p 2.5 c 0 b 2 h 5a 1.5 s 1 cd 'b 0.5 B @ o 32, A third source of potential savings comes from a reduction in the informalization of the labor force and growth in the number of formal sector contributors and wage base. Currently, almost 50 percent of the contributors in SSK contribute on the basis of minimum wages; most workers in all systems contribute for as few years as possible in addition to those who work entirely in the informal labor force. This behavior is linked with the pension parameters in the Turkish pension system. They are all predicated on the belief that the typical working or contribution life i s relatively short and will remain so and should remain so. In most countries, the typical working life is 40-45 years, and individuals who participate in the labor force contribute for the full working life. InTurkey, the new law stipulates that the full working career will be 25 years, but this is being phased in extremely slowly such that only those who begin work in 2026 will face the 25 year constraint. As a result of the few expected years of contribution, Turkish policymakers need to choose between raising the accrual rate per year of service and the prospect of many people receiving low pensions. If individuals obtain decent pensions with only 20 years of work and contribution, they would have lesser incentives for larger pensions similar to those in other countries. The high accrual rates thus reinforce the behavior that encourages the policymakers to promote the high accrual rates from the beginning. The new law improves the situation in that before, private sector workers earned 3.5 percent accrual rates for their first 10 years of work, which then dropped to 2 percent per year for the next 15 years of work and then to 1.5 percent per year thereafter. Now there is a flat rate for all years of work. Actuarially fair insurance would reward those who work beyond retirement age by approximately 6 percent additional pension per year of delay. 33. Furthermore, even in the new system, there i s the possibility of a partial pension. While the new law stipulates that the new entrant as of 2026 must contribute 25 years before receiving a full pension, partial pensionscan be received with only 15 years of contributions and at an age three years older than the retirement age. But again, the 15 year requirement i s being slowly phased in from the current 12.5 and the previous 10 year requirement. As a result, there i s a relatively large number of pensioners, especially in Bag-Kur where individuals contribute as little as possible, who are receiving very low pensions. The typical response has been to Annex V Page 13of 13 complain through the political process that pensions are too low and to receive some kind of supplement which is equally distributedto those who contributed 10 years as well as to those who contributed 30. These periodic supplements further reinforce the incentives to contribute as little and for as few years as possible. The recent supplements in 2003 more than doubled the pensionsfor Bag-Kurfarmers, causingnot only fiscal stress, but also underminingcompliance. 34. Figure 7 shows the impact of the reform on the level of pension benefits relative to average wage. The fall inpension benefits can be attributed to a number of factors. Figure 7: Average PensionBenefits as % ofAwrage Wage inSSK 35. Conclusions. The 2006 Turkish pension law has made substantial changes and will move Turkey to a fiscally sustainable pension system in the future with a unified labor market which improves labor flexibility and compliance. The remaining agenda involves increasing formalization of the labor force and reducing contribution rates. The law removes many of the disincentives to longer working careers embeddedin previous pension laws. Challenges remain relatedto increasingthe formalization of the labor force. Annex VI Page 1of 16 Budget andPublic Financial Management Reforms Overview 1. The overarching objectives of a budget system, characterized by budget procedures, decision making processes and institutions, are to ensure fiscal discipline, prioritize allocations and improve efficiency and accountability in the management of public resources. A well- functioning budget system enables government to determine a sustainable deficit strategy consistent with price stability, growth and equity objectives. It also ensures that policy makers recognize fiscal constraints and identify priorities for resource allocations and that public financial management practices are such that resources are in fact used to achieve policy objectives, including delivery of public services. 2. The necessary conditions for these outcomes to be achieved by the budget and financial management system are many. A comprehensive budget i s necessary to ensure fiscal discipline. Decisions on policy priorities must recognize budget constraints and be reflected in budget allocations. Budget classifications must be capableof providinginformation for policy-makers to make strategic decisions on expenditure priorities and resource allocation, ensuring that key policy objectives are adequately funded. Transparent and accountable public financial management, reflected in effective budget execution, reliable accounting, timely reporting; robust internal controls and effective external audit, i s necessary to provide the incentives for improvedpublic sector performance and for effective delivery of public services. A robust public accountability system spurs efficiency and effectiveness on the part of public agencies, by supporting the achievement of performance objectives. Effective internal controls and audits discourage waste and fraud while maintainingincentives for innovation or performance-oriented management. 3. A number of assessments of Turkey's budget system in the late 1990s and early 2000 identified fundamental problems with many aspects of the budget and financial management system that taken together were seen to contribute to the repeated fiscal crises and to the deteriorating public sector performances. Followingreforms in debt management, tax policy and administration and procurement that were supported by PFPSAL Iand II, embarked on a Turkey far reaching budgetreforms in 2003 with the enactment of the PFMC Law. A number of aspects of the PI;MC law have been implemented while others remain to be implemented. This chapter provides a retrospective as well as a description of the key issues for the reform agenda and managementinthe next few years. 4. Both international experience and Turkey's own experience indicate that implementation of a major budget and public financial management reform needs strong coordination and monitoring. Because of their impact on the entire government, public sector reforms tend to be cross-cutting, and take time to implement. They require strong high-level leadership for articulating a clear vision of the objectives. Pragmatic mid-stream adjustments must adapt to changing circumstances, and coordination must be effective across government. Weak interagency coordination would pose the inherent risk of provisions being enacted that are inconsistent with or contradict the previous reforms. It is crucial that Turkey maintain the momentum and credibility of these major reforms; so that the need for strong and effective coordination to reconcile conflicts cannot be overstated. Annex VI Page2 of 16 Budget and FinancialManagement IssuesinTurkey- a RetrospectiveView 5. A fragmented budget and ineffective accountability mechanisms compoundedstructural and managementweaknesses inTurkey's public sector andcontributed to large fiscal imbalances and repeated fiscal crises in the 1990s as well as most recently in 2001. This was due to underlying structural weaknesses in the institutional arrangements for the managementof public finances. Fiscal policy was not in control of policy makers since a fragmented budget made difficult both the maintenance of fiscal discipline and the management of fiscal risks. Multiple layers of inspections and internal controls were ineffective but provided incentives for agencies to establish off-budget flows to evade controls, creating further fragmentation in the budget. Extensive off-budget activities made it difficult to estimate and therefore manage the full extent of government finance and e~penditure.~~For example, duringthe crisis of 2001, the elimination of duty loses, budgeting of accumulated past duty loses and the restructuring in the banking sector have caused the net public debt to GNP ratio go up to 90.5 percent in 2001 from 57.1 percent in2000. 6. The 2001 crisis providedthe impetus for policy-makers to address economic, structural, public management and social issues in a comprehensive manner. In response to the crisis, Turkey adopted a new medium-term macro-economic program and launched a renewed structural reform program in December 200126.The renewed program incorporated a three- pronged strategy to achieve macroeconomic stability supportedby improved social cohesion: (a) macroeconomic policies to restore fiscal stability and growth, and aggressively support disinflation process; (b) structural policies and institutional reforms to address financial sector and public sector weaknesses; and (c) enhanced social dialogue with increased emphasis on protecting the most vulnerable groups. Accordingly, public sector reform since 2001has focused on achieving the significant fiscal adjustment required to underpin macroeconomic stabilization, while simultaneously addressing underlying structurallinstitutional weaknesses. There has been significant progressonbothfronts since then, 7. Fiscal adjustment inTurkey hadtwo initial objectives. The first was to generate sufficient primary surplus in order to support a credible macroeconomic framework that would improve financial market confidence, help debt reduction and reduce inflation and interest rates. The second was to undertake structural/institutional reforms needed to address the underlying weaknesses in public financial management that have contributed to the boom-bust cycles that havebeena persistent feature of the Turkisheconomy for some years. 8. Strong fiscal performance has been the cornerstone of the economic program since 2001. Between 1999 and 2005, primary balance of the Consolidated General Government (CGG), increasedfrom a negligible primary surplus of 0.5 percent of GDP in 1999 to a surplus of 6.1 percent in2005.27The CGGborrowing requirement decreasedby 12.5 percentagepoints of GDP 25Underlying public sector structural and management issues were analyzed in the 2000 and 2003 CEMs and the 2001PER. 26Supportedby anIMFSBA andthe Bank's Programmatic andFinancial Sector Adjustment Loans (PFpSALs) 27 Consolidated general government definition used here is from the SPO. For the conversion from the SPO definition to the IMFSBA program definition, pleaserefer to Box *. The definition includes the (a) consolidated budget, (b) social security institutions), (c) a subset of budgetary and extra-budgetary funds, (d) local administrations, and (e) off-budget revolving funds created by public entities. This definition does not include the Annex VI Page3 of 16 between 1999 and 2005, driven by the increase in the primary surplus and the decline of interest payments on public debt. Turkey's public sector-comprising CGG and SEES-achieved an even larger fiscal consolidation in 1999-2005, from a primary deficit of 1.6 percent of GDP in 1999to a primary surplus of over 6 percentin2005.28 9. Reflecting this sound fiscal framework, interest payments and net public debt to GNP ratios have declined significantly. Strong fiscal adjustment helpedTurkey significantly reduceits net public debt to GNP ratio to 55.8 percent in 2005 from 90.5 percent in 2001. Declining debt ratios and lower interest rates-thanks to receding inflation as well as stronger confidence in the ability of the government to restore macroeconomic stability-have led to sharp declines in interest payments on public debt. Interest payments, which hadpeaked at 25.4 percent of GDP in 2001, up from 14.6 percent in 1999, declined to 9.5 percent of GDP in 2005. However, interest payments still representedthe equivalent of 28 percent of total primary expenditures of CGG in 2005. 10. Fiscal consolidation Figure 1:Fiscalbalancesandprimary expendituresandrevenuesof the came primarily from the GeneralGovernment (1999-2005; in % of GDP) revenue side, with heavy reliance on indirect taxes rather than reduction in the primary expenditures. The increase in tax revenues were also facilitated by the strong tax policy reforms of the government supported under the PFPSALs of the Bank. The improvements in tax collection are the immediate result of the first and second direct tax reform packages of 2003 and 2004 designed to simplify and consolidate the direct tax regime as well as minimize geographical, sectoral, and other investment incentives-including rationalizing the benefits in free trade zones in line with OECD standards andinternational best practice. 11. Tax policy reforms to further simplify tax structure, broaden the tax base and align tax policy more closely with the EU are ongoing. A new set of draft legislations on PIT, and CIT was prepared by the Government (a) to streamline the structure of the PIT by unifying the schedules for wage and non-wage income and reducing the number of brackets (b) to broaden the tax base through loweringthe CIT from 30 percent to 20 percent (c) to phase out investment exemptions andallowances. revenues and expenditures of the CBRT and other public depository institutions, 45 non-financial state economic SOEs), eight regulatory and supervisory agencies, and25 out o f a total of 28 special budget institutions listed inthe PFMC Law. (Special budget institutions are public entities established as affiliated or related to a ministry to rovide certain public services. These entitiesreceiverevenuesand are authorizedto spend them.) The IMF's Stand-By Arrangement (SBA) program target of 6.5 percent of GNP primary surplus for 2005-2007, includesprimary surplusof a subset of SOEs together with the generalgovernment.The primary surplus data for the SEESusedherearefromIMFstaff reports. Annex V I Page4 of 16 12. The on-going tax policy reforms have been supported by reforms strengthening the administrative structure. Status of the revenue directorate general was upgraded to a semi- autonomous Presidency of Revenue Administration (PRA) attached to the MOF with the legislation enacted in 2005. In this upgraded structure, PRA's president directly reports to the minister. Along with this upgrade, the functional reorganization of the PRA i s being undertaken which will reorient the PRA from an administrative structure based on individual taxes to a functional structure including taxpayer registration, taxpayer services, collections, audit, legal, information technology, and human resources. Additionally, separating of the policy function from the PRA and setting upthe tax policy unit inthe MOF was completed with a law enactedin February 2006. 13. Considerable improvement has been achieved in the areas of fiscal transparency and. accountability. Turkey has aligned, to a large extent, its legislation on public procurement, financial management and financial control with international standards. A PPA and an office for debt and risk management have been established; most extra budgetary funds integrated into the budget; the number of off-budget revolving funds has been considerably reduced through consolidation; the duty losses of state banks accounted in a more transparent manner; and creation of new duty losses without appropriation inthe budget legally prohibited. 14. The year 2003 marks a definingmoment in modernizing public financial managementin Turkey. The Pf;l\/IC Law (No. 5018), enactedinDecember 2003 and amendedin 2005 provides a new legal framework for modern PEM and accountability (Box 1 explains the amendments introduced in 2005). In replacing the prior 1927 budget and public accounting law, the PFMC articulates a modem view of performance-oriented public sector management. The PFMC law: (a) comprehensively defines public revenue and expenditure of the general government; (b) introduces a medium term approach to fiscal strategy and budget preparation to improve aggregate fiscal management and budget prioritization; (c) proposes agency-level strategic planning and performance-related budgeting applicable to the entire central government; (d) requires ministries and departments to set performance goals and prepare ex-post accountability reports for Parliamentary and public scrutiny; (e) delegates financial control and internal audit responsibilities to spending agencies in line with EU standards; and (f) strengthens government accountability by extending the scope and mandate of external audit by the TCA to the entire general government. 15. Beginningfrom 2006, the PFMC has startedto be implemented in key areas. The interim period since the enactment of the law in late 2003 has been utilized to prepare implementation, incliding the preparation of supporting regulations and guidelines. The full implementation of the law is expected by the end of 2007. The implementation legislations on the key areas have been published, including (a) procedures and principles regarding internal control and ex-ante financial control (b) regulation on selecting internal auditor candidates, their training and certification, (c) working proceduresand principles of strategy development units which includes the financial services function, (d) working procedures and principles of internal audit coordination board and (e) regulation on the assignment, supervision, authorities and working procedures and principles of accounting officers. The regulation on working procedures and principles of internal auditors has been submitted to the Prime Ministry for their approval and publication. Annex VI Page5 of 16 New ReformAgenda Supported by the PPDPL 16. With the enactment of the 2006 budget, Turkey entered anew era inbudget and financial management. The 2006 budget i s the first one prepared and to be implemented according to the provisions of the new PFMC law. Although full implementation of the PFMC is expecteduntil the end of 2007, with the 2006 budget PFMC law has been satisfactorily implemented in key areas, such as (a) improving budget processes to enable a mediumterm fiscal strategy to guide fiscal aggregates and enable sector budgetsto be linkedto policy priorities, (b) expanding budget coverageto all central budget entities, (c) expanding the GFS consistent economic andfunctional budget classification to entire central budget entities and social security institutions, (d) delegating more responsibility and accountability to spending agencies through reforming the internal control regime and abolishing central-level ex-ante control, (e) improving accounting through implementation of accrual-based accounting through the entire general government (f) strengthening government accountability to the Grand National Assembly by extending the scope and mandate of external audit by the TCA to the entire general government. In addition, the government has sought to improve the effectiveness of its public investments through rationalization of ongoing projects andimprovedprocessesfor prioritization. LinkingPolicy-Planning and Budgetingthrough a MediumTermBudget: At the Central Level: Improved Credibility of the Budget PreparationProcess 17. The preparation and political endorsement of an MTFP i s expected to reinforce fiscal discipline and management as well as providing the basis for improved strategic allocation of budgetary resources to priorities. Starting from 2006 budget preparation, the Government initiated medium term expenditure framework for general government agencies and indicated indicative institutionalexpenditure ceilings for the central government agencies, both economic and functional classification, based on the medium term expenditure framework. The government has been receiving technical guidance and support for this new approach from the Ministry of Finance of the Netherlands. 18. Relative to the pre-2001 situation, there have been steady improvements in budget preparation including better central guidance to the line ministries on budget preparation. The framework for these actions was established under the PFPSAL by a W C decision issued in June 2001 to accompany the Prime Minister's Budget Call. The HPC decision provideda macro- fiscal framework for the preparation of the 2002 budget. It established indicative ceilings for recurrent and investment budgets for ministries and line agencies, based on an indexation formula applied to the actual budget allocations that each ministry and line agency received in 2001. As a further step, the Prime Minister's Budget Call for the 2003, 2004 and 2005 budgets included individually specified indicative ceilings for each ministry and line agency, based on the 2002 budget preparation experience. 19. The policy-planning-budgeting linkage i s being strengthened further through top down budget formulation announcedby the MTP and the MTFP in 2006 budget. The MTPwhich was issuedinthe Official Gazette dated May 31,2005 as a Council of Ministers' Decision (COM) set out a three year (2006-2008) macro-economic framework. Macro economic targets for 2006- Annex VI Page6of 16 2008 set out in the MTP were consistent with April 2005 SBA with the IMF.29The MTP provided policies and priorities in five development areas and nine main sectors. 30 In addition, the MTFP was issued in July 2, 2005 as a HPC decision and laid out medium term fiscal aggregates and institutional ceilings by economic classification consistent with the MTPS3l Moreover, the 2006 central government budget approved by the Parliament i s consistent with the macro and fiscal framework of the MTP and MTFP.The Government confirmed its commitment to continue with the primary surplus of 6.5 percent of GDP for the entire public sector through approval of 2006 central government budget which targets a primary surplus of about 5 percent of GDP. The remaining primary surplus of 1.5 percent of GDP i s expected to be secured from the rest of the public sector, inline with the INII;fiscal projection. Table 1:Comparisonofthe MTFPAppropriationCeiling with the Approved2006-Budh GeneralandSpecial (YTL million) BudgetInstitutions MTFPInstitutional Ceiling 160,143 Adjustments (-)Net impactof the institutions includedlexcluded after the MTFP 3,676 (+)Treasurycontribution 7,652 (+)Revenuetransfer for local admin. and fund 14,119 (+) Social, Cultural andHealthappropriation included inthe Universities' budget 350 MTFPComparableOverall Ceiling 178,589 Approved Budget 181,460 (percent increase) 1.6 Source: MOF, staff calculation. 20. Fiscal aggregates of the 2006 central government budget approved by the Parliament are inlinewith the aggregatefiscal ceilingprovided by the MTFP.The total appropriation envelope provided for the general and special budget institutions in the MTFP was YTL 160.1 billion. This amount reaches YTL 178.6 billion after the adjustments required to make MTFP data comparable with the approved budget allocation. The approved budget allocation of YTL 181.5 billion, therefore, reflects only a small, 1.6 percent, overrun compared to the indicative MTFP ceiling (Table 1). This small increase resulted mainly from including revenue surpluses of the regulatory entities inthe general budget. 29 Another implicit underlying factor for determining the macro economic framework for has been convergence with the Maastricht criteria of the EU. The 2005 Pre-accessionEconomic Program document states that securing price stability, reducing the public sector deficit and debt to GDP ratios must be priorities if the macro-economic olicies are to convergewith the Maastricht criteria. Five development areas covered in the MTP are (a) improving humanresourcesand employment generation, (b) social inclusion and the fight against poverty, (c) enhancing the competitiveness of enterprises, (d) regional developmentand reduction inregional developmentdisparities and (e) good governance. And the nine main sectors included in the MTP are (a) education, (b) health, (c) environment and urban infrastructure, (d) science and technology, (e) agriculture, (f) manufacturing industry and mining. (g) energy, (h) transportation and communication, (ix) tourism. 31The MTFPprovided aggregate fiscal balances for the entire central governmentinstitutions. Whereas, institutional ceilings were provided only for general and special budget institutions excluding the regulatory and supervisory institutions inline with the PFMC law. Annex VI Page7 of 16 21, While the linkage between the policy-planning and budgetting has improved drammatically through medium-term budgeting approach supported by top-down policy and fiscal formulation in 2006, more efforts are requiredfor further improvements. Although 2006 was the first year of implementation, the achievements in linking the policieslpriorities with the budget has beenquite satisfactory. However, further improvements can be achievedthrough; a Ensuring that the MTP's sectoral classi~cationis appropriately translated into the budget~nctionalclassification: The sectoral breakdown provided in the MTP is not consistent with the functional classification of the budget Due to inconsistent classifications of the MTP and the budget, it is difficult to follow the link between the policies envisaged in the MTP and the related budget allocations. Mapping specific sectoral categories of the MTP priorities into the functional categories of the budget would allow the government to easily translate MTPdecisions into budget allocations. 0 Supporting policy objectives with required measures: Policies and priorities defined in the MTP are too generic and do not provide sufficient guidance for line agencies to translate these policies into their budget proposals. A detailed policy matrix defining prioritieslpolicies accompanied by a set of measures together with their cost estimates and implementation timetables could provide better guidance for the line agencies. 0 Rationalizing the number of policy f o ~ u l ~ t i odocuments: Currently, there are n too many documents that can be treated as the basis of policy f~rmulation.~~ The Government should consider merginglconsolidating some of these documents for a simplified policy guidance structure so as to eliminate confusion for the line agencies, reduce the workload of the key central agencies, and diminishthe risk of inconsistencies among these documents. At institutional Level: improvingcapacity 22, The 2001 PER noted that the institutional processes for policy formulation and management, both in ministries and at the level of the Council of Ministers, were weak and had been neglected due to the highturnover of governments. Thus in addition to the strengthening of "top-down" processes for setting medium term fiscal strategy, reforms would also have to strengthen "bottom-up" processes to improve policy formulation planning and performance at agency level. It i s important to ensure that both the capacity of ministries and departments to propose policies in line with strategic objectives i s strengthenedand a more disciplined process for policy decision making by the Council of Ministers is established. The PFMC law underlines the need for such institutional capacity strengthening by requiringthat the fiscal implications of new policies be estimated andpolicy decisions be made consistent with the MTFP. 33 Policy formulation in2006 was basedon the following list of documents preparedby the central agencies: i)2006 annualprogram(SPO), ii)genera1economic targetsand investments2006 (SPO), iii)2005 Pre-AccessionEconomic Program (SPO), iv) MTP (SPO), v) MTFP (MOF). Additionally, the ninth Development Plan, the Rural DevelopmentPlan, and the Regional Development Plan will be includedinthe list starting next year. Annex VI Page 8 of 16 I 4 I 5 1 General Directorateof Highways I HacettepeUniversity 6 I DenizliSPA 7 Iller Bank 8 Kayseri Metropolitan Municipality 23. The PFMC law requires ministries to undertake a strategic planning exercise and performance budgeting in order to clarify policy goals as well as objectives and to prepare budget requests consistent with performance goals. The SPO has issued guidelines for strategic planning in key line ministries and departments. In July 2003, the HPC issued a decision announcing the launch of the strategic planning initiative on a pilot basis in eight agencies representing various parts of general government (Table 2). The Government launched these pilot cases in 2004 to test the guidelines developed by SPO and MOF for strategic planning and performance related budgeting respectively. 24. With the guidance and support from SPO, these eight agencies are expected to finalize their strategic plans during 2006 with a view to reflecting these plans in the 2007 Budget. The SPO is considering an evaluation of the pilots before rolling-out the strategic planning implementation. Based on the experiences on these pilots, a phasedprogram to expand strategic planningto the rest of the government will be prepared and implemented. The SPO has prepared a draft secondary legislation which envisages a phased approach to expand strategic planning through the endof 2010. 25. Inorder to have a smooth transition period, the Government establishednew institutional structures. The MOF and SPO established new departments to undertake the piloting activities, provide training, and better respond to the newly defined structure. The performance based budgeting department in the MOF and the strategic planning department in the SPO were established in 2004 and 2005, respectively. The experience of the pilots demonstrates both the difficult challenge posedby these agency level reforms andthe need for coordination and careful design inimplementation of performance basedbudgeting. It i s particularly difficult to undertake major performance reforms in a context where the financial control and managementreforms are being implemented with resulting environmental changes and uncertainties. Thus the main challenge for the government i s to draw lessons from the pilot cases to design further stages of the reform, includingconsideration of the appropriate pre-conditions for such reform. 26. Unlike the phased approach adopted at the central level, the Government has decided on an accelerated implementation of strategic planning at the local administrations starting from 2006. The decision appears to have been largely motivated by political imperatives rather than prudentreformplanconsiderations.This initiative was partof the Government's decentralization reform efforts, which i s expectedto leadto an efficient allocation of resources at the local level, - -a key to improve public service delivery. The Metropolitan Municipalities Law (no: 5216, enacted in July 2004), the Municipality Law (no: 5393 enactedin July 2005), and SPA law (no: Annex VI Page9 of 16 5302, enacted in February 2005) require all the local administrations with more than 50,000 populations to prepare their strategic plans within a year after the effectiveness of these laws. Therefore total of 286 local administrations are required to complete their strategic plans by July 2006. 27. As noted there are a number of issues which needto be worked out by the Government for a sound implementation of the strategic planning and performance budgeting initiatives. Timing andsequencingis acritical issue. Technical andhumanresourcecapacity will be another one of the major challenges for the implementation of strategic planning at the local level. Furthermore, due to the transitional approach at the central level, the lack of link between central level strategic plans and local level ones will be another major challenge. Moreover, coming up with a provincial level strategic plan which was not foreseen by the legislation will be an additional complication for the government given that all municipalities, SPA and metropolitan municipalities will preparetheir own strategic plans without appropriate linkage and sequencing. Expanding Budget Coverage 28. Inline with the government's strategy to achieve comprehensive budget framework for supporting sound fiscal management, a number of steps have been taken to improve the classification and reporting of fiscal activities of the general government and to integrate extra- budgetary items into the budget. 29. Better Budget Definition: Adaptation of new budgetary definitions helped Turkey converge with the international practice. A new general government budget definition has been introduced with the implementation of the PFMC in 2006. This definition encompassing the previous definition of entire consolidated budget institutions covers (a) central government budget institutions (total of 143), (b) social security institutions' budgets (4 including the unemployment insurance agency), and (c) local administrations budgets (around 3,225). 30. Improved Comprehensiveness of the Budget: Moreover, the coverage of the central government budget approved by the Parliament has been considerably expanded. With this expansion, 45 new institutions were included in the central government budget (i.e. sum of general budget, special budget and regulatory and supervisory institutions). With this structure, the Parliament enablesto review the total expenditures under the central government. 31. There has been a drastic reduction in the number and size of off-budget institutions and activities since 2001. All budgetary funds, with the exception of the DFWlinked to the reform of the agriculture sales cooperative unions (ASCUS), and all but five EBFs (Social SolidarityFund, Defense Fund, Promotion and Publicity Fund, SDIF, and Privatization Fund) were eliminated by legislation in 2000 and 2001. Furthermore, system of earmarked revenues and expenditures associatedwith the closed EBFs has been mostly integrated into the budget since 2004 -an issue supportedunderthe PFPSALprogramof the Bank. 32. Rationalization and reform of revolving funds, which represent another form of off- budget activity, is under way. Through consolidation by agency, the number of revolving funds was reduced from about 2,650 in mid-2001 to around 1,000 by the end 2005. The amended PFMC Law confirms the government's intention to restructure all revolving fund within general Annex VI Page10of 16 government by end-2007. As an interim measure, the MOF is publishingthe financial statistics for the revolving funds on aquarterly basis since 2005. 33. The original plan for the revolving funds was to close them down until the end of 2007. However, the Government revised its plan and amended the PFMC in 2005 so as to initiate restructuring of the revolving funds rather than abolishing, The MOF stated its intension that mainly for the sectors other than education and health, restructuring still means the closure of the revolving funds. For the restructuring of revolving funds inthe health andeducation sector, MOF requested the Bank's technical support. Under the upcoming PER, the alternatives for the revolving funds inthese two sectors is plannedto be analyzed. 34. Together with the extended coverage of the central government budget, the transparency of the general government improved through informing the Parliament about aggregate fiscal magnitudes. The proposed expenditures and revenues of institutions outside the central government (Le. social security institutions, local administrations, EBFs and off-budget revolving funds) have been submitted to the Parliament as an annex to central government budget proposal. Therefore, the Parliament has been informed of the expected aggregate fiscal positions of these institutions. 35. Reporting tax expenditure estimates in budget proposal to Parliament:To have a more comprehensive budget process, governments in OECD countries over recent decades have been estimating revenue cost of tax expenditures, publishing tax expenditure accounts and including estimated tax expenditures in the budget processes. Tax expenditures represent a major share of the discretionary expenditures for a government. While a complete set of tax expenditures has yet to be calculated, Turkey has an extensive array of tax expenditure provisions, particularly in the income tax structure. Fiscal management as well as effectiveness of tax expenditures could be significantly enhanced if tax expenditures were accounted for and explicitly brought intothe budget system. Incorporating tax expenditures in government accounts and budget process would result in the tax policies being subjected to more careful scrutiny thus leading to improvedtax policies. 36. Development of tax expenditure accounts andincorporation of tax expenditures inbudget reportingrequires considerable work over extendedperiod. The work can broadly be dividedinto three major stages. First, capacity to estimate ex-post tax expenditures for completed financial years needs to be developed. Second, a common understanding about the meaning, classification andimplication of tax expenditure accounts needsto be developed across stakeholdersinside and outside the government. Third, capacity to forecast tax expenditures along with tax revenues needs to be developed. 37. As a first attempt inthis direction, the MOFhas includeda list of tax expenditures andits estimated amount for the 2006-2008 as an attachment to the budget. Since this i s the first year, the coverage of this study was limited to major items in the four main tax legislations: PIT, CIT, Annex VI Page11of 16 VAT and SCT.34As can be seen from the Table 3, the projected amount constitutes more than five percent of the total central government budgetrevenuesover the 2006-2008 period.35 Table3: TotalProjectedTax Expenditures,2006-2008 (YTL million) 2006 2007 2008 CIT (Law no: 5422) 5,393 5,918 6,430 PIT (Law no: 193) 2,533 2,845 3,128 VAT (Law no: 3065) 437 479 521 SCT (Law no: 4760) 230 237 244 Total 8,592 9,479 10,322 Memo item Central governmentrevenues 160,938 178,517 180,641 Tax expendituresas a shareof central governmentrevenues (percent) 5.34 5.31 5.7 1 ImprovedBudget Classification 38. A functional classification of expenditures is now in place for all parts of government, excludinglocal governments. Untilrecently, Turkey didnot have the functional classification of government expenditure that i s recommended by the IMF's Manual on GFS and which i s essential for policy analysis of expenditure. This situation has been addressed by the government's adoption of functional budget classification in line with the GFS 2001 and by parallel amendments of the chart of accounts for all entities forming part of the general government. The GFS classification, including the ten sector functional classification has been applied in the 2004 Budget for consolidated budget agencies. The expansion of the GFS to the rest of the general government has startedto be implementedwith the 2006 budget. DelegatingResponsibility and Accountability to the LineAgencies 39. The new PFMC law introduced modem accounting framework, includinga decentralized ex-ante financial control, an accrual-based accounting system, consolidated reporting requirements for the general government; and it established an official body for setting government accounting standards. 40. Decentralization of financial control to line agencies: Starting from January 2006, most of the ex-ante financial control authority has been transferred to the line agencies thus eliminating the role of the TCA in the budget execution process. Centralized ex-ante financial controls exercised by the TCA and MOF were abolished in 2005 and 2006, respectively, and transferred to the line agencies starting from 2006. Financial services units, which will undertake financial control together with ex-ante control function, are being established since 34The World Bank has beenprovidingtechnical assistanceon tax expendituresto the MOFwithinthe context of the CEMfPER. 35The data does not represent the total amount of the tax expenditures. Itcoversonly tax expendituresunder the four main tax legislations. Annex VI Page12of 16 January 2006 for entire general government institutions. Budgeting and accounting responsibility for the special budget agencies has been transferred from MOF to the respective agencies. The transitional arrangements envisioned in the PFMC require current budget and accounting personnel of the MOFworking invarious line agenciesto assume the new positions inthe newly established financial services units -such transitional arrangements facilitate orderly implementation of new requirements, 41. Internal Audit: With devolution of the authority andresponsibility to spending agencies, the need has increased for a modern internal audit organization that can assure the head of the spending agency on the soundness of the internal control system. The PFMC Law requires each public administration to establish an internal audit unit within its administration. The law envisions a decentralized internalaudit model inwhich internal auditors report to the headof the administration. Full implementation of the new internal control framework i s yet to be completed. Successful implementation of it would require consistent management support and extensive training in addition to development of new systems and procedures. A key challenge now i s to operationalize internal audit function and find a right balance by avoiding duplication andoverlap with the work of inspectors, who would continue to work intheir current positions. 42. To provide centralized oversight mechanism over dispersed internal audit function, the law requires a central IACB to be attached to the MOF. This board would set internal audit standards, organize training for internal auditors, and provide quality assurance in respect of internal audit work carried out by line ministry internal audit units. The Board has been established and the secondary legislation on its working principles and rules was issued in the Official GazettedatedOctober 8,2005. 43. The MOF has created three new departments to prepare secondary legislation and to implement the PFMC Law. These are FinancialControl Department, Internal Audit Department, and Financial Management Department. The financial control department i s responsible for preparing secondary legislation in the area of financial controls. The internal audit department is developing secondary legislation in the area of internal audit, and it also serves as a secretariat for the IACB. The financial management department is responsible for work in the area of performance budgeting. 44. The MOFis receiving technical assistance from the French Ministry of Finance under an EU-financed twinning project. The project covers ex-ante controls, internal audit, and information technology systems. The project was expected to provide diagnostic assistance in internal financial control; help in setting up new institutions, such as IACB; trainingof staff; and provision of computer-assisted audit tools. The project began in March 2005 and is expected to finish in August 2006. An evaluation of the project should be undertaken to plan any required follow-up. Improving the Public AccountingSystem 45. In the last few years, Turkey has made systematic and conscious efforts to reform the public accounting system. These efforts began with the introduction of an automated on-line accounting system, called Say2000i, in more than 1500 accountancies spread across the country, capturing receipts and payments as they are made. Because the database i s linked through a Annex VI Page13of 16 central server, all transactions are immediately available, and the system i s capable of producing periodic financial statements without the delays that typify decentralized accounting systems. A commendable aspect of the automatedaccounting systemi s that it was developed completely by MOF in-house IT department without outside technical and financial assistance. The system covers the entire general budget institutions (Chart Iof the PFMC Law), majority of the Special Budget Institutions (Chart 11), and Regulatory and Supervisory Agencies (Chart III).36 The Say2000i systemdoes not extend to local governments, such as SPASandmunicipalities. 46. Turkey has switched from cash-based to accrual basis of accounting. Since annual budgets are cash-based, the GDPA in the MOF has devised an intricate method for accounting entries that keeps track of cash and accrual entries. Accounting Standards, while facilitating comparison of performance across agencieslministries, enable preparation of useful financial statements essential not only from budget management perspective but also for decision making. Article 49 of the PFMC law mandates that accounting be harmonized with the international standards and the related standards be issued by a PASB, --established as the general government's sole standard-setting authority3'. The PASB will be under the MOF and will comprise representatives from the TCA, SPO, MOF, Treasury, and other agencies. PASB now needs to issueAccounting Standardsto be usedfor preparingconsolidatedfinancial statements. EffectiveExternal Audit 47. The objectives of reforms in external audit are: (a) to extend the mandate of TCA to the non-financial public sector including entire general government (b) to end TCA's ex-ante involvement in budget execution; and (c) to transform TCA into an effective SA1 able to carry out audits inaccordance with international standards. An effective SA1is an essentialelement in the accountability chain inthe public sector and these reforms would enable TCA to become an effective SA1 and strengthen the public sector accountability. A part of these objectives have already been achieved by enactment of the PFMC law, which enables TCA to carry out audits of all budget executing institutions including Presidency, and removes the requirement of TCA's ex-ante involvement in the budget execution, which could hinder independence and objectivity of an audit institution. The PFMC Law also requires auditing by TCA of the accountability reports prepared by line ministries. In order to ensure consistency with the PFMC law and to bring the working of the TCA in line with international best practice, TCA has prepared a new draft TCA law. The new law aims at significantly altering the existing TCA law in several respects- it envisages extension of TCA's mandate to cover the general government institutions (inline with the PFMC law) andthe SEES,and to certain other bodies which usepublic funds38. Second, the draft law clearly defines the types of audits that TCA can carry out including financial audits and performance audits in addition to compliancelregularity audit. The new law, which should be enacted soon, will have a profound impact on the working of the TCA by 36There are only 7 institutions which are not covered by the Say2000i yet due to technical difficulties. These are Turkish Standards Institute, Turkish Patent Institute, KOSGEB, Telecommunication Agency, BRSA, Tobacco Agency, andPunishmentand Prison Institutions 37The secondary legislation of the formation, duties and working principals of the PASB was issued inthe Official azetteinMay 2005. However, the appointmentof the boardmembersis yet to be done. !?' Currently, HighBoard Audit (YDK) audits SOEs, which is directly under the prime minister's office. TCA has no authority to audit the SOEs. Annex VI Page14 of 16 enhancing the emphasis on financial and performance audit compared to the current focus on compliance audits andjudicial work, although the new law retains the court of accounts. 48. The PFPSAL program has supported the external audit reforms up to drafting of a new legal framework. The PPDPL program proposes to support the full implementation of these reforms. The TCA will continue to receive technical advice from the Bank and from the U K s NAO through an 18-month twinning project financed by the EU. The twinning project is assisting TCA in developing internationally recognized audit standards consistent with EU guidelines, revamping the organization structure, and training of staff in financial and performance audits. As part of this project, TCA will also undergo a peer review process to be conductedby the SpanishSAI. 49. While awaitingthe enactment of the new law, the TCA together with the twining partner has begun working on the implementation plan for successfully implementing the new law. The Bank will play an important role in this exercise, by offering technical assistance in the areas needing support, and advice inpreparing secondary legislation. Rationalizationof PIP 50. Increasing efficiency of public investment spending will be crucial because of substantial increase in investment needs that may arise during the EU accession process. The Government recognizes the expected expenditure pressure on the PIP in the 2006 Annual Program. The program additionally underlines two major problems in the PIP. First, the lack of adequate resource allocation to current investment needs, and second inefficiencies in using these allocations. These two issues can be addressed through (a) rationalization of the existing as well as new investment projects; (b) improving quality of feasibility studies leading to better prioritization and improved completion of projects; (c) enhanced M&E; (d) strengthening capacity for project preparation, implementation and M&E units in public agencies, (e) linking allocation of maintenanceappropriation with the existingcapital stock, 51. The Government has announcedthat its effort towards improving the quality of PIP will continue in the 2006 Annual and Investment Program. In the 2006-2008 annual investment program guidelines, the government confirmed its commitment to further reducing the average PIPcompletion time, one of the quality indicators, from an estimated6.6 years in2005 to 5 years by 2008. Further, tlie 2006 investment allocation envisages an average completion time of 5.5 years (see Table 4). The reduction in completion times alone does not certainly ensure the rationalization of the PIP. Structural measures are bound to complement the rationalization of the investment stock, by enhancing managementof the public investments. Annex V I Page15 of 16 Table 4 :Public Sector Investment, 1996-200611 (current prices,million YTL) Number ~ o t aValue l Total Expenditure AverageTime by the end of Initial Investment Investment of Completion Projects of ofprojects previousyear Allocation 21 (in 9%of GNP) 31 1998 5556 34,084 9,657 2,135 2,378 4.4 10.4 1999 5458 57,126 17,380 3,560 3,649 4.7 10.2 2000 5321 86,219 26,125 5,905 6,183 4.9 9.2 2001 41 5047 142,919 45,885 7,167 7,570 4.3 12.5 2002 4414 166,797 66,021 10,590 12,223 4.4 8.5 2003 3851 187,110 80,372 12,464 10,386 2.9 7.6 2004 3555 196,113 86,766 11,978 11,625 2.7 8.1 2005 2627 206,684 84,03 1 16,174 15,875 3.3 6.6 2006 2525 200,391 86,512 17,522 5.5 11Excludeslocaladministrations. Y 2004figure is provisional. 2005figure isprogramprojection. 31Average time of completion is calculated as the amount oftime required to finishupthe remaining stock completely, assumingthat no other projects are taken into the investment program inthe followingyears and an appropriation and expenditure is ma 41Includes supplementarybudget allocation ofYTL 280million andYTL 555 millionfrom Law 3418 revenues. 52. Going forward, it i s critical to take necessary measures to address the above problems. 2006 Annual Program lists several opportunities that could help in improving the efficiency of the PIP, including increased public resources for investments, increased EU funds strategic planning tool -which i s currently beingpiloted, increasedprivate participation and the ongoing decentralization efforts. While it i s important to increase the stock of public capital with a strategic view, it i s also important to secure appropriate allocations for operation and maintenance of the existing capital stock. This i s an important requirement not only for improving the quality of services, but also for restricting the cost of the projects. Available figures indicate that total maintenance expenditures declined from 0.4 percent of GNP in 2000- 2001 to 0.2 percent in 2003-0439.Appropriation for maintenance expenditures declined for the transportation, education and health sectors. Such reductions in O&M expenses should be avoided since they are not sustainable as they reduce the efficiency and growth. It i s therefore advisableto provide for maintenanceneedsto minimize the decay of the public capital stock. 39The total maintenanceexpenditure is estimated as the sum of the small amounts of expenditure recorded in the recurrentbudget and the expenditure that is part of the investment budget. There is a potential drawback for using the latter series. It is obtained by extracting from the investment program database those projects having as part of its title or characteristics, words like maintenance, repair, renovation. However, other projects that do involve a maintenancecomponent are not picked up by this method if the names or characteristicsspecified inthe database do not involve the relevant words. General Directorate of State Highways is reported to have many projects involving maintenancework. As morereliable andrefined databecomes available, the data could be updated. Annex VI Page 16of 16 Box 1:Amendmentsto the PFMCLaw The Government amendedthe PFMClaw inDecember22,2005 with law no. 5436. The mainmotivationbehindthis amendment was to clarify some of the terminology usedinthe law, thus eliminating some of the foreseen implementation problems.The most importantfeatures of the amendment canbe explained as follows. Change inthe Coverage: As aresult of this amendment, there havebeensome changes in the list of the chart I,I1and111. Table x, provides a summary of these changes. Court of JurisdictionalDisputes Chart I Ministry of Justice (Chart I) HighCouncil for Elections Chart I MinistryofJustice (Chart I) General Directorateof MintandStamp Printing House Chart I Treasury Near and Middle-East Labor Training Center Chart I1 MOLSS (Chart I) Center of Researchon Ataturk Chart I1 Presidencyof Ataturk Culture, lanmage andHistory (PACLH) StructuralChanges: 0 The financial control officer positions havebeeneliminated andthe authority for ex-ante control has beenmovedto the Financial Services Unitsingeneral. 0 As is the case for regulatory andsupervisory institutions, the Parliament andthe TCA will submit their budgetsdirectly to the Parliament, with acopy given to the MOF. 0 The Parliament's external audit will beundertakenby an independentaudit commission as is the case for the TCA. 0 Revenue surplus of the regulatory and supervisory institutions will be transferred to the generalbudget on a quarterly, rather than annual,basis. The revolving funds, which were scheduledto be closedby the endof 2007, will now be restructured within the same timetable. Annex VI1 Page 1of 22 PublicAdministrationandGovernanceReform 1. Turkey initiated a comprehensive public administration reform agenda in 2003 with an aim to have a participatory, transparent, accountablepublic sector which respects human rights and freedoms and provides high quality public services on a timely, efficient and equitable manner. The need for reform was a result mainly of the inability of the current legal, institutional and personnel structure of the public administration to adapt to the global and domestic developments. A growing and increasingly more centralized public administration lacking a strategic view resulted in increasing budget deficits, was insufficient in meeting citizens' expectations, and had lost the confidence of the citizens as a result of ineffective governance. 2. In contrast to the earlier reform efforts which were piecemeal, current reform design is comprehensive and has a well defined strategy aimed at addressing the problems of the current system. The Prime Ministry, which i s the leading (and also coordinating) agency in this reform process, established the objectives and principles of the reform in a 2003 report titled "Change Management inPublic Administrations" 40.Based on a review of the role of the state andrelated global improvements in public administration policies, processes, practices, the report identifies the main elements of restructuring the public sector as, (i)a new public administration framework, (ii)restructuring of the central administration, (iii)restructuring of the local administrations and (iv) other new arrangements, the main component of which i s civil service reform. 3. Decentralization, or the transfer of authority and responsibility for public functions from the central government to subordinate or quasi-independent government organizations or the private sector, covers a broad range of concepts. Political, administrative, economic and fiscal decentralization, have different characteristics, policy implications and conditions for success. A11thesefactors needto be carefully considered with acomprehensive approach. 4. One of the core components of decentralization i s fiscal decentralization which can be defined as the transfer of expenditure responsibilities and revenue assignments to lower levels of government. If the local governments are to carry out decentralized functions effectively, they must have adequate revenues-raised locally or transferred from the central government-as well as the authority to make expenditure decisions. Among the many expected benefits of decentralization are improved service delivery, improved resource allocation and improved participation by localresidentsindecision-making. 5. However, decentralization i s not a panacea and it may bring some problems as well. A major risk that could arise from fiscal decentralization i s the increasedfiscal pressure. It is often politically difficult to impose hard-budget constraints at the local level and the local governments might have a tendency to rely on the center's bailout. For example, some countries, including Brazil and China, experienced macroeconomic problems when tax bases were decentralized without a clear assignment of expenditures to the level of government that receives the revenues. Others, including Argentina and Mexico, ran into problems because sub-national governments "Change ManagementinPublic Administrations", T.R. PrimeMinistry,October2003 Annex VI1 Page2 of22 accrued unsustainable debts and had to be bailed out by the central government.4' Governments faced problems when the decentralized expenditure responsibilities were not matchedby revenue assignments. This led to unperformed services and to unsustainable sub-national deficits. It is therefore crucial to recognize these potential risks and ensure a match between expenditure responsibilities and revenues at each level of government and create institutional mechanisms that will enforce a hardbudget constraint betweenlevels of government. 6. The World Bank supports the objectives and direction of the government's broad reform agenda related to public administration and governance. This section examines the subset of specific actions to be supported through the PPDPL Loan in three broad areas namely (a) local administration reform, (b) regional development initiatives, and (c) the anti-corruption agenda, as follows. 1. LocalAdministrationReform 7. National development, economic growth and poverty alleviation hinge on improved sub- national growth and service delivery. Achieving these objectives often requires overcoming economic and social disparities across regions, and among urban and rural areas; transforming the fiscal, political, and administrative framework in which central and local go~ernments~~ operate; and enhancing engagement with sub-national governments and stakeholders. Many governments have adopted a three-pronged approach to local government modernization and reform: improving intergovernmental fiscal relations; strengthening local government fiscal, financial and administrative structures; and developing the functional and accountability systems that make local governments work. Many governments have also discovered that rapid decentralization can leadto problems such as maintaining fiscal balance nationally (as increasing resources are transferred to sub-national levels) and unsustainable deficits by sub-national governments. 8. Turkey's rapidly growing urbanization is placing increasing demands on financing of, and access to, basic public services. Urbanization, especially in large cities, has been creating increasing pressure on services providedby central and local governments. For example, school construction i s a central government responsibility. However, in urban areas, municipalities own the plots of land where schools can be constructed; since they are not obliged to construct schools, they chooseto use such lands inother revenue-generating ways. 9. Increasing demands for public services due to high rate of urbanization have so far been addressed by assigning the responsibility for basic urban services and allocating increasing amounts of central government funds to municipalities, and maintaining traditional central government administrative control measures. This strategy has not been enough to adequately meet increasing demands for services for several reasons:43(a) the long-standing practice of meeting the growing service demands with increased allocations from the central budget has become unsustainable due to fiscal pressures, (b) the system of heavy reliance on budgetary 41 World Bank Institute Working Papers, Decentralization Briefing Notes, 1999. 42 In Turkey, the term `local government' includes metropolitan municipalities (16), municipalities (3209), SPAS (81), local governmentunions and villages. 43 Turkey municipal sector review, October 2004. Annex VI1 Page 3 of 22 transfers and borrowing through Treasury guarantees did not provide incentives for fiscal discipline, (c) traditional administrative control has become increasingly ineffective to oversee, influence, andguide Turkey's large and growing urban sector, (d) the role of the private sector in the delivery and financing of urban services has been minimal and (e) the EUaccession process brought up significant investment requirements for Turkey to meet EUstandards in the areas of water, wastewater and solidwaste treatment. 10. The preponderance of small settlement units is another key challenge (see table below). It creates fiscal problems such as inadequate revenue capacity of small municipalities and high cost of service provision. This requires that either the population scale of municipalities be changed or service associations be establishedto overcome problems of service scale. The main reason for concentration of population in large municipalities, and at the same time increase in the number of small municipalities, i s continuous migration to large municipalareas while at the same time small settlement units are being continuously transformed into municipalities. As the table shows, 80 percent of the municipal population lives in municipalities with a population of more than 5,000 (these comprise 31percent of the total number of municipalities): municipalities with a population of less than 5,000 make up 69 percent of all municipalities, but their population comprises only 20 percentof the total municipal population. I Table 1: Distribution of Municipalities inProvinces, Districts and Towns by Size of Population Population Group Number of Municipalities 70 TotalPopulation 76 0-2,000 396 12,7 631 2 2 2,001-5y000 2 56,3 5.089.434 17,7 5,001-10,000 457 14,6 3.080.282 10,7 10,001-20,000 239 7,7 3.261.014 11,4 20,001-50y000 161 52 4.963.214 17,3 50,001-100,000 73 2 3 5.100.328 17,8 100,000-250,000 36 1 2 5.451.588 19,O 250,001- 3 0,l 1.104.855 3,9 Source: Ministry of Interior,July 2003 11. The acute need for a reform of the local administrations i s also evident in the results of a satisfaction survey conducted by TESEV in 2004. TESEV conducted a citizen satisfaction survey on central and local service provisionin selected 20 provinces across the country. While the central administration score improved considerably in 2004 compared to 2000, the local administrations' score stagnated. The citizens' trust for local administrations came out at the lowest level in the public sector and 73 percent of the interviewedstated that there i s a need for reformingthe local administrations. 12. Several factors have converged in recent years to forge a trend to devolve some authorities and responsibilities to local administrations. Key among these are: (i) EU the accession process, (ii) increasing public pressure for basic services, (iii)regional and local demands for participation in their own development, (iv) higher public expectations for government performance, (v) the global competitive environment, and (vi) other regional and global trends. The ultimate objective of the reform i s to improve the efficiency and quality of service delivery by providing selected local services at the local level. A gradual local administration reformprocess is under way inTurkey. Annex VI1 Page4 of22 13. Turkey has enacted several laws to restructure intergovernmental relations and promote regional development: (i) the MunicipalitiesLaw (Law no, 5393 adopted in July 2005), (ii) the Metropolitan Municipalities Law (no.5216, enactedin July 2004), (iii) SPASLaw (no. 5302, the enacted in March 2005), (iv) the Local Administrations Unions Law (no.5355, enacted in May 2005) and (v) the RDAsLaw (no.5449, enactedinJanuary 2006). A. LocalAdministration Structures 14. Legal Framework. The administrative arrangements for local level cover change in legislative framework, establishment criteria for local administrations, and organizational changes. The legal framework for municipalities has been modernized as part of the public administration reform program. The Municipalities Law has modernized the organizational structures, duties and authorities, working and service methods, human resource management and fiscal structures of municipalities. The minimum population threshold to establish a municipality has been increased to 5,000 from the previous 2,000. The law facilitates mergers and amalgamations, and expands the duties and authorities of municipalities. Starting from January 2007, municipalities with less than 2000 population will be abolished and converted into villages if they can not increase their populations through mergers and amalgamations with other municipalities. 15. Inaddition, the managementof districts has been strengthened. They are associatedwith the municipality, and an organic link for coordination has been established. Mayors' remuneration has been increased. New institutions such as the City Council have been introduced, and there is much greater emphasis on participation and transparency (discussed in more detail below). The law attempts to strengthenmunicipaleffectiveness in service provision, including greater authority on urban development and planning. While the laws provide more flexible and effective human resource policies, they also impose greater discipline on municipal personnelexpenditures andborrowing. 16. Analogous changes have also been made to the legal framework for Metropolitan Municipalities. The MetropolitanMunicipality Law expands the boundaries and functions, with the objective of more efficient and effective service delivery. New criteria have been defined to establish a metropolitan municipality, namely, (i) level of economic and social development the of the municipality shall be appropriate, (ii)the popuIation shall be at least 750,000 and, (iii) the municipality shall cover at least 3 districts. For Istanbul and Kocaeli, the metropolitan municipalityboundary i s coterminous with the provincialboundary. 17. PersonneE Issues: Local administration personnel comprise three main groups: civil servants, workers (permanent and temporary) and contracted personnel. Personnel expenditures comprise the highest expenditure item for municipalities. Their share in total municipal expendituresi s about 32 percent for the period 1994-2002 according to TURKSTAT. This share i s above the legal ceiling of 30 percent. Effective management of local administration personnel, especially in the case of municipalities and metropolitan municipalities, i s constrained in the absence of a modern legal framework for public personnel. Local administrations do not have specialist human resource management personnel. However, although the law mandates that primary and permanent local services are to be performed by civil servants, such activities have been known to be performed at times by workers and even by temporary workers. Some Annex VI1 Page 5 of 22 municipal services are privatized, and sometimes municipalities employ personnel through the companies they own. 18. A modem legal framework for public personnel would greatly aid local administrations in setting policy for, managing, and competitively paying, their personnel. In addition, an effective establishment control mechanism (which would help local administrations to manage, monitor and control their public personnel) would greatly facilitate the transparency and control of personnel expenditures. B. IntergovernmentalFiscal relations 19. Inmost countries, the appropriate assignment of expenditure responsibility, revenuesand intergovernmental transfers change as economic, demographic, institutional and politicallgovemance structures evolve. While some systems provide localjurisdictions the ability to expand responsibilities to adjust to changing needs, others are more constraining, limiting local expenditure functions to only a demarcatedlist. 20. Fiscal Decentralization. Enforcing hard budget constraints among local administrations requires clear expenditure assignments, formula-based transfer systems, local revenues, prudent sub-national borrowing rules, and good financial reporting. The authorities are focusing on the following priority areas: 0 Expanding local administration budget coverage and moving to a consolidated (unified) budget approachto include all local administration fiscal units; 0 Strengthening the policy-planning-budgeting linkage at the municipal level, and adopting a mediumterm approachto expenditure prioritization; Applying international accounting standards to local administrations, including a gradual introduction of accrual accounting; More intensive external audit andgradual application of performance audits; and i Addressingpersonnelmanagementissuesandcontrollingpersonnelcosts. I Table 2: Primary Expenditures Breakdownof General Government (% of GNP) 1999 2000 2003 2005' General GoveimmentIf II 33.7 II 32.8 33.2 34.5. ConsolidatedBudget 16.2 ~ LacalAdministration 3.7 10.7 11.0 Revolving Funds 2.0 1.9 Extrabudgetary Funds 3.0 2.7 1.2 1.o 0.7 0.7 0.6 0.0 0.0 0.0 0.0 0.0 0.1 0.1 1lExcludingRegulatoryand SupervisoryInstitutions 212005RealGNP growthis estimatedas 6 percent 21. ExpenditureAssignments: The central government fulfils many functions inthe unitary Turkish state: as aresult, the fiscal weight of local governments inTurkey is still relativelylight, but this may understate their emerging role and future impact. Primary general government expenditures, in 2005, accounted for close to 35 percent of GNP, of which central government AnnexVII Page6of22 expenditures constituted about 15 percent and local administrations 4.4 percent, However, the figure for local administrations does not include the expenditures of all municipal economic enterprises and hence may understatethe true fiscal weight of local administration^^^. 22. The first fundamental step in the design of intergovernmental fiscal relations is a clear assignment of functional responsibilities among different tiers of government. Municipal functions are being gradually adjustedin line with subsidiarity, though local administrations are still assigned limited responsibilities even after the enactment of recent laws which have somewhat redefined their responsibilities. Inmetropolitan municipalities, the legal personality of sub-provincial municipalities has been preserved, but some rights, duties, revenues and services have been assigned to the metropolitan municipality. The objective was to move towards standard levels of service provision, reap economies of scale, and providelmanage city services inharmony with nationalplans andpolicies. Table 3: ExpenditureAssignments betweenCentralandLocalAdministrations s are delivering those servicesthrough semi-autonomousutility companies. 23 The core municipal services have traditionally comprised transportation, water and waste water, and solid waste management. The municipalities in most cases produce and deliver the services themselves, while they also have the option to use the private sector for the delivery of services. In metropolitan municipalities, water and wastewater management i s carried out 44The figures include water, sewerage, natural gas and public transportation companiesbelonging to local administrations. Annex VI1 Page7 of 22 through the semi-autonomous utility companies attached to the metropolitan municipalities. While solid waste collection and construction and maintenance of secondary and tertiary roads are the responsibility of the district municipalities, waste transfer and disposal and construction and maintenance of the main roads are the responsibility of metropolitan municipalities. Table 3 displays the expenditure assignments for central and local administrations based on the new legislative framework. 24. The municipalities can also work with Iller Bank (Bank of Provinces) to help plan, procure, finance, and implement an investment program. Iller Bank also provides technical assistance on land-use plans, and design and construction of water supply and wastewater managementsystems, on an as neededbasis. 25. The new legislative framework transfersldelegates a number of new responsibilities to the local authorities. However it also clearly states that the local administrations should prioritize their responsibilitieslfunctions based on their revenues and capacities which reflect the concerns about the lack of sufficient capacity to fulfill increasedlevel of expenditure assignments. 26. As part of delegating more responsibility to the local administrations, the rural services function was transferred to the provincial level from the central government in 2004. This gradual transfer of expenditure responsibilities to lower tiers of government is expected to continue: this will have implications for revenue assignmentsas well. 27. heal A d ~ ~ n ~ s Revenues.n It is not clear inTurkey whether revenues are adequate ~ a ~ o to finance the provision of services for which local administrations are responsible. The revenue assignments and authorities of Turkey's local administrations are currently defined in numerous laws45.Local administration revenues inTurkey fall into three categories: a. tax revenues, comprising the share from central government tax revenues, and other tax revenuessuch as from real estatetax, environmental cleaning tax, chargesetc.; b. non-tax revenues which include various elements such as contribution shares to expenditures, enterprise revenues andborrowing; and c. other revenues, which include special aidand funds 28. The central government collects taxes and transfers shares at specified rates to local governments. Tax revenues are first pooled; thereafter a certain percentage i s transferred to local governments according to population and origin46. From the "pool", 6 percent goes to municipalities, and 1.12 percent to provincial special administrations allocated on the basis of population. Metropolitanmunicipalities receive 5 percent extra share from taxes collected inthe provincial center (increased from the previous 4.1 percent). The Council of Ministers i s authorized to increase this rate twofold or reduce it to the legal limit. In addition, 35 percent of the 6 percent transferred to lower level municipalities i s further transferred to relevant 45Chief amongthese are the Municipality Income Law (no. 2464 of 26 May 198l), the Property Tax Law (no. 1319 of 29 July 19701, the Law on General Budget Tax Revenue Distribution to Municipalities and City Private Administrations (no. 2380 of February 2, 198l), the MetropolitanMunicipality Law and other laws such as law nos. 277 and 5237 of 15 July 1963. 46 The following taxes are excluded from the pool: petroleum excise; 28 percentof vehicle excise; 60 percent of tobacco& alcohol, the specialcommunications tax; and the tax on gamesof chance. Annex VI1 Page8 of 22 metropolitan municipalities. Tax revenues of municipalities other than those transferred from the central government comprise real estate tax collected under Law no.1319, and other municipalrevenues collected under Law no. 246447. Table 4: Revenue BI akdownoi Adlr (% of GNP) 1999 2000 2003 'otal Revenues 3.7 3.8 4.1 4.2 Tax Revenues 2.0 2.1 2.3 2.0 2.5 ConsolidatedBudgetTransfers 1.6 1.8 2.0 1.5 1.9 Municipality 1.5 1.6 1.8 1.4 I.7 SpecialProvincial Administration 0.2 0.2 0.2 0.2 0.2 Own Sources 0.4 0.4 0.4 0.4 0.6 Municipality 0.4 0.3 0.3 0.4 0.6 SpecialProvincial Administration 0.0 0.0 0.0 0.0 0.0 Non-Tax Revenues 1.2 1.1 1.2 1.1 1.5 Municipality 1.o 1.o 1.o 0.9 1.4 SpecialProvincial Administration 0.2 0.1 I 0.2 0.2 0.1 Others 0.5 0.5 0.5 0.4 0.2 Municipality 0.1 0.1 0.1 0.1 0.2 SoecialProvincial Administration 0.4 0.4 0.4 0.4 0.0 'Municipalities and Special Provincial Administrations ;ource: Fiscal Decentralization: A New Approach to Alleviate Poverty and Regional Disparities (2005), by :.Emil B.Kerimoglu, B.Neyapti, andH.Yilmaz, UNDP, Tesev Publications. 29. Local administrations' main revenue source i s the transferred share of taxes from the central government. The share of central tax revenues transferred to local governments is increasing but still low, comprising less than 2 percent of GNP in 2003 (see Table 4). Local administrations derive 45 percent of their total revenues (and 75 percent of their tax revenue) from the central government. Tax revenues comprise about 60 percent of local administration total revenues; 36 percent of their total revenues are derived from non-tax revenues. Revenue collection from taxes such as the real estate tax, and the environmental cleaning tax i s quite trivial. 30. Sho~comingsofthe current tax revenue transfer system. Although the current transfer system has simple and objective criteria that provide stability and predictability of municipal revenues, it has several drawbacks. (i) Population-basedrevenue sharing discriminates against local administrations with lower populations. For municipalities with a population of more than 500,000, the main revenue sources are tax revenues and shares from the central government. However, the significance of these sources diminishes as the population decreases. 47 Comprising Announcement and Advertisement Tax, Entertainment Tax, Communications Tax, Electricity and Gas ConsumptionTax, Fire Insurance Tax, Environmental Cleaning Tax, Charges, and Contributionshares. Annex VI1 Page9 of22 De-coupled taxation and spending. The large share of central transfers in municipalities' revenues de-links taxation and spending and thereby weaken taxpayer accountability. Municipalities spend the money largely raised by the central government and shy away from the pains associated with raising and justifying taxes locally. There i s little incentive to exploit own revenue bases. Local taxes and duties remain at a low level and are almost exclusively set and controlledby the centre. De-coupled transfers and services. The transfers are not usedto strengthen service orientation at the local level. Local service delivery performance i s not monitored as part of public oversight. The financial transfers are also not concerned with actual service delivery because more than 85 percent of transfers are given to municipalities regardless of whether they actually provide services or not. Equalization objective not defined. The equalization element in the current transfer system lacks an explicit standard. The equalization that takes place i s entirely a by-product of depending on the difference between the distribution of tax collection andpopulation. Itis not clear to what extent the transfers meet any specific objective, such as allowing various municipalities to provide reasonably comparable levels of public services at comparablelevels of taxation. Differential treatment. The 5 percent of in-province tax revenues transferred to the metropolitan municipalities creates different treatment between metropolitan cities and other large cities. As a city can only be declared a metropolitan area by an act of Parliament, there are no clear criteria that would enable other cities to qualify for this transfer. 31. Own-source revenues. Weak local administration administrative capacity in major tax administration functions - registration, collection and audit (enforcement) - seems to constitute the binding constraint on improving local administration revenue performance. The principal problems appear to be: (a) the prevalence of stop filers, non-filers, and late filers; (b) limited availability of taxpayer services; (c) distorted performance incentives and low professional qualifications of staff; and (d) inadequate support from and coordination with national government agencies. In addition, the true extent of own source revenue arrears i s not known with certainty. The administrative shortcomings appear to be compounded by incentive problems: in some cases political executives are concerned that increases in local revenue collections could prove politically costly. As a result, there is little incentive for local administrations to strengthencollection of own-source revenues. Local administrations continue to remain dependent on their share of revenue from the central government, and municipal efforts to enhance collection of own source revenues are inadequate. Local administration own- source revenues could be significantly increased through local administrative measures to increase collection of own source revenues4*, and central government actions to assist local administrations. The authorities are examining ways to provide incentives to local 48 E.g. through collection-basedincentives for LGUrevenue assessors and collectors, enforcement action against delinquent filers and payers, taxpayer registration drives, regular cleaning of taxpayer registries, investing in information technology, improvingthe quality andquantity of audits, and strengthening taxpayer services. Annex VI1 Page10of 22 administrations, including through restructuring the system of intergovernmental transfers, to strengthenassessment andcollection of own source revenues. 32. Policy-makers are in agreement that the local administration revenuesneedrestructuring. The draft RevenuesLaw i s an important step inthat direction. However, the fact that the draft is still being continuously revised reflects the complexity of the problem. Representatives of both central and local governments seem to agree that restructuring the intergovernmental transfer system should seek to reach horizontal and vertical revenue equalization between governments; include performance in service provision as a criterion; and provide incentives to local administrations to increase collection of own source revenues. A formula-based system that takes these factors into account, it i s argued, will increase transparency, reduce unpredictability and arbitrariness, diminish central control over local governments, ensure minimum levels of service provision, andencouragethe effective use of resources. 33. Local Adminis~r~*onBorrowing and Arrears. When local administrations borrow foreign funds to meet their financing needs, they create contingent liabilities. Local administrations' sovereign guaranteed foreign borrowing increased rapidly in the nineties, with the debt stock risingfrom US$ 890 million (1990) to thrice this level in 1998, before starting to decline. Borrowing by local administrations is regulated by Law no. 4749, enacted in 2002, and as of the third quarter of 2005, their foreign debt stock declined to US$ 869 million. Law no. 4749 also provides priority (over investment expenditures) to local administration appropriations to finance foreign debts, and provides for establishing a debt payment account to which local administrations are required to allocate part of their revenues to finance their debts. Domestic borrowing takes place from the Bank of Provinces and domestic financial institutions.Borrowing limits have been set by Law no. 5393. 34. Implicit local administration financing also occurs through creation of arrears to other entities, most troublingly in respect of social security contributions. Local administrations routinely run up arrears to other public and private entities, and these debts and receivables are periodically restructured, softening the hard budget constraints and creating a moral hazard problem. In the most recent restructuring exercise, still under way, eight out of sixteen metropolitan municipalities' debts and receivables were restructured by a Reconciliation Committee established under law. Out of the 3,225 municipalities, about 75 percent have requestedrestructuring of their debt andreceivables, of which about 90 percent have successfully completed the restructuring processas of endMay 2006. C. ServiceDelivery and Central Government Oversight 35. Transparency, participation and accountability: Although local administration laws offer sufficient scope, the extent of actual implementation by local administrations of transparency, participation and accountability provisions is uneven and varies across the country. The authorities believe that much more needs to be done to strengthen awareness of the new legal provisions for transparency, participation and accountability, and to monitor the implementation of the relevant provisions. 36. As part of the effort to strengthen local administration performance and accountability, the Ministry of Interior is developing service standards for local administrations. Designed to Annex VI1 Page 11of22 assist local governments in prioritizing obligatory services to their citizens, they can provide measurableindicators to assess whether local administrations are infact delivering such services. At the macro level, they can assist the central government in determining overall financing requirements for local administrations in the delivery of basic services. Local administrations can use such standards to guide planning and budgeting, and in evaluating their overall performance. 37. Although such standards should ideally be outcome-oriented, it may be necessary to begin with measuresmore closely related to outputs. Such standards could be set nationally and made applicable to all local administrations, acknowledging that different jurisdictions may require different time periods to achieve them. Because the standards are linkedto obligatory functions, the central government has the responsibility to ensure that local governments are able to meet them. It would be desirable to limit such standards to a narrow list of obligatory functions, recognizing the potential fiscal implications of expansive lists. Clearly, however, the ability of various local administrations to achieve such standards will vary considerably depending on local revenues, capacities andconditions. Box 1:PerformanceManagement Systems(PMSs) InternationalExperience - A quick reviewof the local governmentPMSs of five countries49disclosessome common lessons. All the systems emphasize building strong links between measurement of the past, management of the present, and planning for the future. Key lessonslearnt include: (i)Zncrementallchangeinrespons~ilityandaccountabilitypatternshasbeenfoundtobemoreeffective and s u s ~ i ~ bineinducingindividuals to change performancebehavior than large systemic shifts. (ii)Successful interventionsfocused onratingpetfomance of specificfunctions of local~minis~a~ns, rather than emphasizing anoverall comparativeranking of the administrative units themselves. (iii) qualityPMSmustberesu~s-o~ented,goodsystemwillbelimitedtoafewcriticalindicators,butwith A A sufficient detail at appropriate levels so that staff can be held accountable for assessing their levels of accomplishmentand making decisionson what changes are neededto improve performance. To be useful for benchmarking, a PMS should provide information that measures qualitytsatisfaction and quantitytequity, together with unit costs. The system must be designed and operated with a high degree of accuracy, consistency and integrity while ensuring that both cost and complexity of survey operation are appropriate to locally prevailing conditions. (iv) Even the best PMS are severely limited in their ability to influence change: indicator data are merely the `tip of the iceberg'. PMS data do not explain why performance outcomes have been achieved and the information provided by formal assessment systems is always being supplemented by informal intelligence gathering carried out by elected representatives. Given the limitations of data, quality of data collection and analysis, and potential politicization of the survey process, using such numbers as a means to compare the performanceof local administrations at any given point intime should be done with caution. It is more useful to monitor trends over time andto allow local administrations to assess their immovement over time. 38. Measuring and managing local administration performance5' assumes importance in the context of accountable and transparent local administration functioning. In addition, (a) local administrations seeking to access additional financing from the private sector and the central .^ 4yMalaysia, Indonesia,UnitedKingdom, Australia and Canada. 5o Performance management is defined as the regular assessment and improvement of the results (outcomes) and efficiency of services or programs. Annex VI1 Page 12of22 government need to be able to demonstrate that their performance can be assessed in an accountable and transparent manner, incorporating feedback from service users and leading to measurable change in performance; and (b) the proposed fiscal decentralization law proposes somewhat greater fiscal autonomy for local administrations; this will necessitatea PMS that can influence local administration behavior in improving service delivery through more accountable, efficient andequitable utilization of resources. 39. Changes in the Central Government Oversight System. The central government has been exercising considerable control over Turkey's municipalities mainly through the Ministry of Interior and the provincial and district governors. The central government oversight relies largely on ex-ante controls and emphasizes the center's obligation to ensure compliance with laws. The control measures fall under three categories - administrative, budgetary, and financial. As evidenced by the increasing financial arrears, the traditional reliance on ex-ante controls has become increasingly ineffective as the urban economies have become too large and complex for the center to control directly. Further, the oversight system is not outcome oriented andfails to provide informationabout municipalperformance and actual service delivery. 40. The local administration reformweakenedthe firm administrative control over decisions, transactions and works of local administrations. The new oversight function aims to ensure integrity of the administration and coordination in public services. Oversight functions more in the form of ajudicial recoursemechanism are promoted. a Ratification system of local council's decision and budget has been removed. The previous practice of obtaining approvals of the prefect for some council decisions has been abandoned. Instead, prefect may appeal to administrative judiciary against council decisions they find unlawful. 0 The approval period required for internal borrowing i s removed for amounts below a certain threshold. Internal borrowing not exceeding 10 percent of budget revenues may be authorizedby council decisions. 0 Approval and visa procedures formerly required for the organizational establishment and the creation of cadres have been abandoned. 0 Local administrations are now empowered to establish direct correspondence with the central government, previously maintained through the governorship. 41. Changes in the Control System. The excessive control mechanism over local administrations based on compliance audits was replaced with a modern approach aiming at prevention of mistakes. The new approach entails training and guidance, and expanding good practices. Internal control procedures are to be carried out by controllers, the councils, the audit committees and senior managers. The TCA will initiate performance and financial audit and the Ministry of Interior will perform external control on other administrative decisions and transactions. Furthermore, an efficient public scrutiny will be made available with the disclosure of council decisions andcommission reports of local administrations. 42. Capacity Constraints. The uneven institutionalcapacity across local administrations has been exposed by two specific challenges that now confront local administrations -- the mandatory preparation of strategic plans by local administrations and the looming challenge of Annex VI1 I Page13of22 accessingand absorbing EUstructural funds. Several challengesconfront the authorities as they raceto buildcapacity: i. Changingthemindsetsoflocaladministrationelectedandappointedpersonnelisa longterm processandresults inthe short term are unlikely; ii. Attractingandretainingscarcetechnicalskillssuchasstrategicplanning,budgeting, human resource management, accounting, fiscal policy, revenue administration, ... formulation of performance standards; 111. As regional development policy and processes are put into place (see next section), there i s likely to be a growing need for skills such as investment promotion, credit screening, project preparation and appraisal; and iv. Movingfrom a centralized to a more decentralized participative transparent model of local administration will also require the acquisition of new skills including working more closely with civil society andNGOs 43. The SPO and Ministry of Interior are addressing the capacity gap through: (a) the SPO budget for capacity-building pilots; (b) an EU-financed and Ministry of Interior-implemented local administration capacity-building program; and (c) additional EU resources (about 19 million Euro) which will be earmarked to strengthen capacity in the soon-to-be-established (regional) development agencies (see Section 11). 11.RegionalDevelopment 44. Regional development51i s a concern of policy makers in many countries. In some cases these concerns focus on long-standing areas of rural poverty. In others, they focus on cities adversely affected by industrial restructuring. Governments have respondedto these concerns by attempting to stimulate economic growth in these locations. Many such efforts involve costly programs of infrastructure investment and subsidies to private firms. Some are ineffective. Some are actively harmful to the national economy as a whole. Governments pursue a variety of objectives under the rubric of regional development. The primary objective of regional development i s often poverty reduction. In the EU, this i s couched in terms of `convergence'. Elsewhere it i s expressedas the problemof laggingregions or one-industry towns. The aim is to addresspoverty in situ by revivingthe economies of specific geographical areas. 45. In Turkey, two factors play a role in the recent regional development policies; (i)EU regional policies and (ii) government's tendency to devolve authority to local level - or the the ongoing local administration reform discussed in section Iabove. A comparison of the NUTS2 level regional per capita income levels shows large discrepancies between Turkey and the EU 25, The income level, on PPPper capita basis, inthe most developed region inTurkey i s only a third of the 1 0 most developed region inEU25, while the income level inthe least developed ~ region i s about a third of the least developed region in EU2552. The start of negotiations with EUbrought to the forefront the importance of addressing the issue of regional discrepancies, as well as the issue of convergenceto the EUaverage income. A number of development programs 51`Regional development' is defined here as any effort by the public sector to stimulate economic development in specific geographicalsubunitsof Turkey. 522006 Annual Program, figures refer to 2002. Annex VI1 Page14 of22 are in place in the context of EU-Turkey Financial Cooperation which aim at reducing regional discrepancies and enhance efficiency in the design and implementation of Turkish regional development policy inline with the EU. 46. One of the ways through which Turkey is addressing the challenge of regional development is by establishing development agencies. Law no. 5449, adopted in January 2006 provides a framework to establish development agencies for sustainable regional development and to minimize regional disparities. The law outlines the duties, powers and coordination of such agencies. Their stated role i s to (a) strengthen cooperation between the public sector, the private sector and NGOs; (b) ensure efficient and appropriate use of resources; (c) activate local potential, and (d) provide investment support through financing and support services. This i s to be done in tune with national development principles, policies and priorities. The national level coordination of the agencieswill be done by the SPO. 47. The law provides for transparent andaccountableagency functioning. Resources. The law provides resources from a variety of sources (Article 19). These comprise transfers from the central government and local administrations (based on a formula comprising population, level of development and performance), official development assistanceincluding EUfunds, own revenues from agency activities, funds from chambers of industry and commerce inthe region, grants and aids and carry-over of previous year revenues. a Staffing. Article 18 provides for the agency to have expert personnel and support personnel, employed according to the labor legislation. Support personnel are envisaged to perform secretariat, public relations, archiving, administrative, financial and personnel services, and shall not comprise more than twenty percent of the total number of agency personnel. Measures to prevent conflict of interest for members of the executive board, the agency's decision-making body (Article 10): both during and after their terms of office, members are prohibited from disclosing any confidential information about the agency and any other confidential information they have acquired, nor can they exploit such informationintheir own favor or of others'. a Tran~parency.Publication of activities, programs, budgets, and implementation reports are mandatory, so as to inform the public about agency activities and resources (Article 21). InternaE Audit. Employment of an internal auditor is mandatory for each agency. The executive board has the flexibility to determine personnel salaries and allowances. 48. The authorities need to prepare several secondary legislations (and guidelines in certain areas) for the implementation of the law, including in the areas of auditing and control, administrative andfinancial issues, performance and human resources. Most of these regulations have recently been drafted. The authorities are planning to establish RDAs as set out in the law. In addition, a Regional Development Strategy is under preparation. Subsequent to the preparation of this central level strategy, each region will then prepare its own Development Strategy. Finally, based on the strategies, action plans to be prepared will identify priorities and measuresinpromoting the region's economic development. The role and potential impact of the Annex VI1 Page15 of 22 development agencies will be known better once the regulationsto the Law on these agencies are drafted. 49. The mainchallenges surrounding regional development are: Theproblem of the `missingmiddle' and the role of development agencies. Turkey's strong central administration, its increasingly assertive municipalities and metropolitan municipalities, and the relative decline over time of provincial special administrations have together created a vacuum at the intermediate level of government -the problem of the `missing middle'.53Development agencies' roles and functions relative to those of SPAs and other public entities at the intermediate level will be clearer once the functioning of the pilot development agencies i s evaluated. S ~ e n ~ h e n i n glocal-provincial-national planning linkages: positive role of developmentagencies. The SPO's expertise and experience in national level planning is unquestioned. At the local level, municipalities are now required to prepare strategic plans within a defined timeframe. However, local administration capacity i s a key con~traint.~~ Policy makers are aware of the potential positive role that development agencies can play in strengthening the planning linkages between different tiers of government, and in providing capacity-building technical support to municipal and provincial authorities in respect of their planning activities (Article 5.a). The challenge will be to staff the agencies adequately and establish a coordination mechanism that will ensure consistency between the local level strategic plans and development agencies' programs andpractices. Project impzementation. It i s not clear whether the agencies will execute projects themselves, or finance projects to be executed by local administrations, chambers and private entities. The wording of the framework law i s quite broad, as it should be: development agencies can "use, or allow others to use, the funds allocated to agencies" within the framework to be provided by the SPO (Article 5.f read with Article 4.2.c). Although development agencies will be private law entities, the funds that are likely to be used by municipalities and SPAs through the development agencies will have to be consistent with the PEM system. Follow-up regulations under preparation are expected to clarify these issues. Financing infras~uctureinvestments, incl~dingpotential EU-financed investments. The wording of the law is broad enough to permit agencies to finance investment projects, and for EU structural funds to flow through these agencies (Articles 5.k and 19.b). However, whether this will actually happen, and if so from when, is not yet clear. However, there i s a larger issue relating to regional infrastructure investments, of which EU-financed infrastructure investments i s an example. Empirical evidence from other 53The draft "Public Administration Framework Law" provides to SPAScomplete and exclusive authority on issues that are consideredthe prime responsibility of local governments. 54 An EUfundedtechnical assistanceproject is aimedat particularly at providingtechnical and material supportfor establishmentand functioning of RDAs with the broad objective of promoting efficiency indesigning and implementationof regional developmentpolicies. Annex VI1 Page 16 of22 countries suggests that EUstructural funds have clearly spurred a great deal of activity. During the most recently completed phase of Objective 155structural funding (1994- 1999), 4,104 km of highways and 31,844 km of other roads were constructed or upgraded. This construction has temporarily boosted the local economy though the 'expenditure of funds from outside the region.56 But aggregate data suggest that these efforts have had little impact on regional economic disparities. Regional convergence within individual member states of the EUcame to a virtual halt just after the structural and cohesion policies were intr~duced.~~ Gamier reports that regional disparities have, in fact, widened within EUmember The authorities may consider commissioning specific analytical work to examine these issues in the context of the establishment and role of development agencies. A c c ~ ~ ~ Theuoperation and~activities of these agencies have been excluded from ~ ~ ~ Z ~ . the PFMC Law and the Procurement Law (Article 27) suggests that they will not spend public money themselves. If so, the reason for such exclusion from these basic accountability and transparency laws i s clear. If not, however, it raises questions as to why public resources flowing through these entities will not be subject to the same accountability andtransparency requirements as other public resources, 111.Anti-Corruption Agenda 50. Corruption i s an important obstacle to economic and social developments across all countries, as corruption may deter investment, spur inequality and erode macroeconomic stability. Corruption has also beenfoundto reduce the effectiveness of public administration and erode the rule of law. Corruption i s an interdisciplinary issue and combating corruption can not be separatedfrom public administration reform. 51. According to international indicators, Turkey ranks more favorably interm of the level of corruption in 2005 compared to earlier. Transparency International's Corruption Perception Index, for example, ranksTurkey as 66th(out of a total of 159countries) compared to the rank of 77thin2004 (out of a total of 146). In.addition, the BEEPSjointly conducted by the World Bank and EBRD59,provides information about the views of entrepreneurs and business executives about taxes, macroeconomic and government policies, corruption, anticompetitive practices and financing costs. Comparing the results with the results of the 2002 survey, Turkey has significantly improved in many aspects of the survey, such us reducing red tape, improving its business environment and reducing corruption. However the survey also shows that there i s roomfor improvement insubjects like customs, businesspermits andtaxes. 52. Turkey has been addressing the issue through several measures, especially after 2001 when the issue came more forward in the public agenda. A national strategy to enhance 55Definedas regions with per capita GDPs less than75 percentof the EUaverage. 56Bradley, John. op. cit. 57Boldrinand Canova, op.cit. Notethat disparities among the individual member states of the EUnarrowedduring this period. 58Garnier, C. op, cit. 59The BEEPScoversall countriesof the Central andEasternEurope, the former Soviet UnionandTurkey. The objective of the survey is to evaluatethe constraintson investment and private sector growth. Annex VI1 Page 17of 22 transparency and good governance in the public sector was published in March 2002 under the slogan "A Transparent and Clean Turkey: Together Hand in Hand". The objective of the strategy was to provide a comprehensive framework for improving governance and reducing political influence over the economy which establishes clear priorities and benchmarks, and empowers and energizes public opinion to fight corruption. The basic structure and actions of this strategy was reflected in the UAPof the current government. A ministerial committee for enhancing transparency and improving good governance was established in March 2003, under the leadership of a State Minister. A technical committee chaired by the Prime Minister's Inspection Boardprovides support to the ministerial committee. At the same time, there i s an EU funded project that supports the establishment of an anti-corruption unit within Prime Ministry and aims to increasethe capacity of a numberof key institutions for combating corruption. 53, Among a comprehensive set of substantive actions was the enactment of the Law on "Freedom of Information for Citizens" in October 2003 and the issuance of the follow up regulation on the implementation of the law in April 2004. The law provides an important basis for enabling citizens to monitor the performance of the public sector. In this context, public agencies have provided an opportunity to citizens to request information on-line, through their websites. A Prime Minister's decree issued in January 2006, required all public institutions to provide an annual summary report on the implementation of the Law on Freedom of Information. A law on the establishment of an Ethics Board for civil servants was enacted in June 2004. Subsequently in September 2004, the Ethics Board was established and in April 2005, the regulation on the Code of Conduct for civil servants was issued. Further, the new Penal Code contains provisions concerning bribery, trading in influence, abuse of power and embezzlement and punishes corruption-related crimes more seriously."' The Code also introduces the concept of liability of legal persons incases of corruption and contains provisions concerning corruption in public procurement. In addition, broader reform efforts such as the public procurement reform andpublic financial management andbudget reform (discussed inthe previous section) have also been instrumental in improving transparency and good governance, as well as civil service reform andjudicial reform. 54. Turkey ratified many of the international conventions on anti-corruption including Civil and Criminal Law Conventions of the Council of Europe (2003 and 2004), OECD Convention on Combating Bribery of Foreign Officials (2003) and UN Convention against Transnational Organized Crime (2003). The UNConvention against Corruption was signedby Turkey in 2003 and ratified by the Parliament in May 2006.61Turkey became a member of GRECO in January 2004. Civil Service Reform6' 55. The legal framework currently governing public servants and contract personnel, coupled with institutional arrangements and practices pose a number of challenges to efficient and effective use of personnel within Turkey's public administration. Given the court's "'2005EuropeanCommissionProgressReportonTurkey. The convention was submittedto the Parliament inJuly 2005, was clearedby the related commissions buthas not yet beenapprovedinthe GeneralAssembly. 62This sectionprovidestheWorld Bank's views on civil servicereformissuesinTurkey basedonpublicly available information. Annex VI1 Page 18of22 interpretation of Turkey's Constitution, under the existing Public Personnel Law (of 1965) it i s extremely difficult to adjust staffing composition or levels. Given rapidly advancing technology, as well as a changing role for the state, such staffing rigidity is a serious constraint to effective andefficient use of public resources. Other challenges include (a) institutional arrangementsand practices that (i)fail to focus staff on meeting organizational objectives effectively and efficiently; and (ii) underinvestment inthe human capital of public servants; as well as (b) leadto pay setting rules and practices that (i) to ensure consistency in the competitiveness of public fail servants' remuneration, largely because remuneration i s not concentrated in those elements of pay directly linked to the human capital requirements of the jobs beingperformed, and (ii) make it unnecessarily difficult for the Government to ensurefiscal sustainability of the wage-bill. 56. The draft Law on Public Personnel seeks to address several major objectives that stem from these problems. These include: (i)improving efficiency; (ii) eliminating discrepancies in remuneration across similar positions within the public sector; (iii) it easier to ensure a making fiscally sound wage bill; and (iv) providing competitive opportunities for entry into the public administration. The following paragraphs outline how these proposed reforms will address current problems. 57. Improving efficiency: To improve efficiency this draft law would mandate changes aimed at three broad sub-objectives: (i) it easier to adjust staffing composition when make required; (ii) enhance sources of performance motivation for public personnel; and (iii) facilitate opportunities for public servants to improve their human capital over the course of their careers within the public service. 58. ~ l i m i n ~ . ndiscrepancies in remuneration across similar positions within the public g sector: To accomplish this, this draft proposal would consolidate the legal framework governing salary setting throughout the public sector, so as to: (i) establish seven uniform salary scales, one each for public servants in each of four separate career streams, and public contracted personnel in each of three career streams; (ii) concentrate salary in (a) basic duty salary or wage, and (b) duty difference allocation, thereby concentrating salary in those salary elements most clearly linked to human capital requirements and demands of the position; and (iii) inconjunction with related changes in the Social Security and Universal Health Insurance Draft Law, the proposal would ensure that any elements of remuneration that bring with them social security (pension) rights, also impose commensuratesocial security contribution (premium payment) obligations on the recipient of those elementsof remuneration. 59. Making it easier to ensure afiscally sound wage bill: To address this objective, the proposal would consolidate the legal framework governing salary setting throughout the public sector (as described above) which should (i) make it easier for the MOF to monitor and analyze central government wage bill implications of employment and pay policy proposals or changes ; and (ii) that any elements of remuneration that bringwith them social security (pension) ensure rights, also impose commensuratesocial security contribution(premium payment) obligations on the recipient of those elements of remuneration, thereby reducing perverse incentives to obtain eligibility for such elements of salary, as well as eliminating a fiscally imprudent practice of providing pension benefits not tied to pension contributions. Annex VI1 Page19of22 60, Providing competitive oppo~unitiesfor entry into the Fublic ad~~nistration:To accomplish this, the proposed draft law would continue Turkey's current requirements for standardized examination-based competitive recruitment and selection procedures for both public servants and contracted personnel (Articles 32-33), as well as for promotions (Art. 47). Regulations governing those procedures would be established by the State Personnel Administration (Arts. 33,47). 61. Policy makers do acknowledge some risks and implementation challenges. At least five of the changes proposed to be introduced by the proposed draft law are likely to pose risks and implementation challenged3: ~stablishinglegal distinction between public servants and contractedpersonnel: The text of this draft law which provides a legal basis for permitting non-renewal of contracted personnel contracts has been very carefully drafted, It i s unclear how the Turkish judicial system is likely to rule on challenges to these provisions. The Government has and continues to pay very close attention to the risk of an adverse judicial finding once these provisions are challenged. It does appear virtually certain that these provisions will be challenged. In short, this i s an unavoidable risk and challenge posed by the laudable determination to create a more flexible labor market for an important subset of Turkey's public employees; a challenge that the Government fully recognizes. is missalfor repeated "un~atisfactory~~performance ratings: The current Law on State ~ ~ n c ~ allows termination~ofeemployment for public servantsonly for events such ~ ~ n a ~ ~ as major disciplinary actions, voluntary departure, retirement, death. Poor performance is not grounds for dismissal. An existing regulation does allow termination of employment of a public servant if the public servant's performance is consistently poor. Inparticular, a public servant with a negative employment recordfor two successive years i s required to be transferred to another department; and if helshe receives a negative assessment in the next year, his employment must be terminated. This new draft law would include similar provisions in the Law itself, thereby giving a firmer legal foundation to such requirements. This i s quite sensible. There is a risk, however, that a poorly functioning annual personnel performance evaluation process will make these requirements of little consequence. This i s also an issuefor promotions, Perjimnance bonuses: Performance bonuses are sensibly subject to important restrictions on their magnitudes. Still, as the government is aware from its analysis of this issue andadvice it hasreceived from SIGMA, the EUandothers, it is difficult to get a performance pay system to work as well as one might hope. Inaddition to limiting the magnitudes of such performance bonuses, perhaps the most importantchallenge i s to get the performance evaluation processto work reasonably well. Concentrating salary in basic duty and "duty difference" components: It i s an excellent idea to concentrate salary inbasic duty and "duty difference" components. The current draft law, however, does not uniquely determine what fraction of total remuneration will reflect these two components. The large number of other elements of 63In addition, several other provisions of that draft law pose important risks to one or more of the key reform objectives. These include: step salary increase provisions (Art. 45) and personnel performance evaluation procedures(Article 76). Annex VI1 Page20 of 22 remuneration andleave rights (Articles 3,66-68, Temporary Article 3) could compromise this objective. Careful analysis will be required to assess whether the implementation of these provisions will actually concentrate salary in basic duty and "duty difference" elements of remuneration. Setting basic salary and wage scale index (`(indicators")structure: Because of current significant discrepancies in remuneration for similar positions across institutions, implementation of the more uniform salary structures mandated by this law will require changes in salary relativities. If implementation required no change in the overall wage bill, some staff would see their remuneration rise while others would seeit fall. If,on the other hand, any remuneration decreases are to be avoided, the wage bill would have to rise. This poses difficult trade-offs, of which the Government i s well aware. Managing thefiscal cost of compensation ha~oni~ation. Multiple scenariosare being modeled so that their implications (both for the overall wage bill and for remuneration changes for individual staff) can be adequately understood before adopting a salary structure and implementation plan. In addition, phasingin of the new salary structure i s almost certain to be an important element of the implementation plan. Appropriate design of the reform would be needed so as to minimize its overall budgetary impact, while gradual phaseinwould be advisable so as to spreadout the cost over time. ~ e c r u ~ eandt selection, and promotionsprocedures: The draft law would continue n the examination-based, competitive recruitment and selection procedures as well as similar proceduresgoverning changes in grade (Le., promotions), which were established within the last six years. The draft Law leaves to the State Personnel Administration the responsibility for regulating these processes. It will be important to continuously monitor how well they are working and to make adjustments as necessaryto ensure their integrity i s not compromised. Step salary increases: These are, essentially, basic salary or wage increases based on seniority. Only personnel receiving unsatisfactory ratings in the annual performance review process at least once in any three-year period are excluded from these step pay increases. If the performance evaluation process does not reliably ensure that poor performers receive "unsatisfactory" ratings, these step salary increases will become guaranteed salary increases tied to seniority. Under these circumstances, these step increases will tend to be viewed as entitlements by staff, rather than as a source of motivation. At best, they will motivate staff to avoid flagrant violation of work rules. Moreover, they will pose the additional problem of creating fiscal costs that cannot be easily controlled. Personnel performance evaluation procedures: It is notoriously difficult to get performance evaluation procedures to reliably distinguish between actual performances across staff. Giventhe important role that annual personnelperformance evaluations will play under this new law inpromotions, bonus pay determinations, step increases, as well as for providing a mechanism for terminating non-performing public servants, it is especially important that careful attention be paidto ensuring that Turkey's performance evaluation processes work well. The proposed draft law leaves to the State Personnel Presidencythe task of spelling out detailed personnel evaluation procedures and criteria. It also quite sensibly requires Turkish Middle East Public Administration Institute (TODAIE) to provide an independent assessment of the system established by those Annex VI1 Page21of22 detailed regulations. The one issue that would merit more attention here i s the process itself-and, inparticular, at leastfour dimensions of that process: involving individual staff members in reaching agreements with those who will evaluate them before the beginning of an evaluation periodon how their success in meeting the criteria specified inthe regulations should bejudged - ie., what sorts of evidence will be relevant, requiring input from ~uZtipZe persons in distinct positions to assess the performance of any given staff member (e.g., supervisor, peers, clients); subjecting the evaluator's consolidation of those inputs into a single evaluation to review by hislhersuperior before it i s finalized; and creating some rules or incentives designed to counter the natural tendency for supervisors to give most (if not all) staff the same (high) evaluations (e.g., setting fixed limits on the fraction of "very good" ratings - Le., requiring supervisors to rate their staff on a "curve" - or, alternatively, establishing a formula linking performance ratings to performance bonuses, while imposing a ceiling on total performance payments, and then requiring that each unit's set of performance ratings yield aperformance bonus payment total no greater than that ceiling). Judicial Refom- 62. Significant progress has been made in strengthening the functioning of the judicial system inTurkey since the beginningof 2004. Major milestones include the following: The adoption of the law in2004 for the establishment of the Regional Courts of Appeal One was a major step in addressing the issue of high case-load in the courts and the High Court of Appeals and ensuring a more efficient and effective judiciary. The law became effective in April 2005. The establishment of such courts will not only decrease the workload of the High Court of Appeals, but will enable a substantial reduction in the size of the High Court of Appeals in order to make it better suited to fulfilling its mainfunction, which is to ensure a unity of legal practice an enlighten the interpretation of provisions of legal codes. The establishment of Regional Courts of Appeal i s an important step forward in increasing the speed and efficiency of the judiciary. The Government i s implementing a project with EUfor the physical establishment of the Regional Courts of Appeal, and the project i s progressing as scheduled with training programs for judges, public prosecutors andother staff of the new courts beingprepared. The establishment of the Justice Academy i s another important step to increase the quality of the judicial system and ensure pre-service and in-service training of judges through an independent body. After the initial stage to operationalize the Justice Academy considerable progress has been made in the number of judges trained by the Judicial Academy. All the major laws, such as the Commercial Code and Law of Obligations, are being reviewed and substantially amended to address the needs of the new and advanced 64This sectionprovides the WorldBank`s views onjudicial reformissuesinTurkey basedonpublicly available information. Annex VI1 Page22 of 22 commercial transactions and align the legal system with the EUlegislation. Inorder to bringmore efficiency to the judiciary and reduce the case load of the courts, the Civil Procedural Codei s also undergoing substantial amendments. 63. In order to further advance the fight against corruption, it is necessary to have a clear assessment of the most urgent areas for improvement. Towards this goal, Turkey needs to complete a diagnostic study and design a strategy to tackle the remaining bottlenecks inreducing cormption. An action plan based on this strategy could then be implemented with clear assignments for the responsible institutions. Annex VI11 Page 1of 9 PublicExpendituresOnHealth: Current Levels, Projections And SuggestedCost- Containment Measures 1. Public expenditures on health have risen significantly in 2005 as well as in the first quarter of 2006. Public expenditures on health of social security institutions, Green card and Civil servantsincreasedfrom 13.9 billion YTL in 2003 to 16.2 billion YTL in 2004 (representing an increase of 16.5 percent) and 18.1 billion YTL in 2005 (representing an increase of 11.7 percent). At the same time, MOHand universities budgetexpenditures on health increasedfrom 3.3 billion YTL in 2003 to 3.9 billion YTI, in 2004 (representing an increase of 18.2 percent) to 5.6 billion YTL in2005 (representing an increaseof 43.6 percent). Figure1:PublicExpendituresonHealth SSI+GreenCard+CivilServants 20 8 4 15 76 cag .I = 5 % V 10 4 5 .I a 3 " 5 2 1 0 0 I 2003 2004 2005 2006 111SSI+GreenCard+CivilServants,Nominal(leftaxis) SSI+GreenCard+Civil Servants, Real, 2005 prices (left axis) GrowthReal, 2005 mices (rightaxis) Annex VI11 Page2 of9 Figure 2: Public Expenditures on Health MOH+Univ Budget 8 , 35 7 30 6 25 ~5 2o P 8 4 8 3 15 2 10 1 5 0 0 2003 2004 2005 2006 2. Total health expenditures increasedfrom YTL 17.2 billion in2003 to YTL 20.1 billion in 2004 (representing an increase of 16.8 percent) and 23.7 billion YTL in 2005 (representing an increase of 17.9 percent). Inreal terms (2005 prices), total health expenditures (including social security institutions, Green Card, Civil Servants, MOHand university budgets) increasedby 6.7 percent in2004 relative to 2003 and9.2 percent in 2005 relative to 2004, Annex VI11 Page 3 of 9 Figure 3: Public Expenditures onHealth Total: SSI+Green Card+Civil Servants+MOH+Univ 30 12 25 10 20 8 l5 P 6~ 4 10 5 2 0 + 0 2003 2004 2005 2006 Table 1:Public Expenditures on Health (YTL billion) 1 SSI+Green Card+Civil Servants, Nominal 13.9I 16.3I 17,9I 20.8 3. The increase in health expenditures in recent years i s almost entirely explained by increasedspending on hospitals and pharmaceuticals, and within these categories, by increase in the quantity of number of medical services and number of prescriptions for drugs. For instance, the number of outpatient visits in MOH hospitals increased from 110 million in 2003 to 130 million in2004, andto 170million in2005. 4. Across the different categories of beneficiaries, the bulk of the increase inexpenditures i s explained by SSK enrollees and Green Card holders. The increase in quantity is essentially explained by two factors: Annex VI11 Page4 of 9 0 Increase in coverage and access, effectively covering the entire population of the country; and 0 Change of incentives facing medical providers inMOHhospitals. 5. The increase in coverage, tantamount to effective introduction of UHI even before the official enactment of the legislation, manifests itself in the increased utilization of services by Green Cardholders and SSK beneficiaries, bothof which have seen animpressive addition inthe consumption of health goods and services course of the last 15 months. 6. In parallel with the take-over of SSK hospitals by MOH, the incentives structure for physicians working in MOHhospitals might have changed as their reimbursementfrom the net collections of revolvingfunds i s linkedto their performance which i s a function of the number of services performed. At the same time, almost all medical tests and diagnostics inM O Hhospitals havebeen outsourced to private parties. While this has resulted inlower unit costs of tests, it has also ledto an increaseinthe number andrangeof available tests. 7. The net result of extending coverage and protection to almost the entire population coupled with changes in economic incentives and extensive outsourcing of services, has been a significant increase inquantity of services delivered. On the positive side, there i s no doubt that these changes have significantly improved access, increased utilization from the earlier low levels, andpractically eliminatedwaiting lists. 8. Inaddition to the realincreaseinquantity of servicesbeingproducedanddelivered, there are concerns that the billing system further exaggerates the number of services provided. There i s no working and effective claim processing system at present, and it i s almost impossible to verify the nature, extent and authenticity of the bills produced and presented by MOHhospitals. The extent of this overstatement and inflation is difficult to establish and ascertain, but there is little doubt that this practice is not uncommon. Projecting HealthExpenditures 9. Just as the 2005 year-end expenditure figures were higher than planned and higher than expenditures recorded inprevious years, public expenditures on health in2006 are also projected to be higher than planned. Public expenditures on health, excluding MOH and universities budget, are expected to increase by over 15 percent year-on-year in 2006 (if no reforms or cost- saving measures are introduced), 9.2 percent in 2007 and 2008 and by 7.2 percent thereafter. Including MOH and universities budget, public spending on health i s expected to increase by 16.5 percent in 2006 compared to 2005. In real terms, total public spending on health i s projectedto increaseby 10.5 percent in 2006 relative to 2005. 10. Percapita public expenditure on health is expected to increase from YTL 326 in 2005 to YTL 374 in 2006, representing an increase of 14.9 percent. Per capita public expenditures on health are projected to increase to 400 YTL in 2007, 450 YTL in 2009, 500 YTL in 2011 and almost 600 YTL in2014. Annex VI11 Page5 of 9 11. Figure 4 presents a summary projection of public expenditures on health between 2006 and 2014, under three scenarios. Table 2 provides the numbers used in the figure. Table 3 presents the MOHand Universities budget spending on health. Figure 4: Projected Public Expenditureson Health (ExcludingMOHand University BudgetExpenditures) 40,000 38,000 36,000 esr 34,000 32,000 30,000 .CI 3 LI 28,000 26,000 24,000 22,000 20,000 2006 2007 2008 2009 2010 2011 2012 2013 2014 +With ReformMeasures +With ReformMeasures and OP/IPPharma Cost Saving -%-NoReformMeasures 12. Key assumptions made by Bank Staff in projecting the reform scenario include (a) outpatient visits will increase at a rate of 5 percent through 2008 and 2.5 percent thereafter; (b) family medicine coverage will increasefrom 1percent of the population in 2006 to 5 percent by 2007 and 50 percent by 2010; (c) as family medicine coverage increases, the ratio of outpatient visits to MOHhospitals will fall from currently 60 percent to 54 percent by 2010 and 53 percent by 2014; (d) hospital occupancy rate will increase from 67 percent to 72 percent by 2011; (e) Annex VI11 Page7 of9 - - '.lo XX @XKL SOL tWLIFA 1 13 :U IGX VL 5OL 'WLIFC 1; E X 1% L1. SCL tU.SJI( 10CU.133M-9SLimt SET v 16. In the medium and longer term, however, cost containment will have to rely on building the system hierarchyby full expansion of family medicine as gate-keeper, reformingthe patient referral system to streamline hospital-based outpatient care, and finally introduce payment mechanisms for providerswhich will replace the current performance-basedpayment of hospital physicians with one which will discourage unnecessaryuse of physician and diagnostic services and introduceincentivesto remainwithin budget. Annex VI11 Page8 of 9 Bag-Kur PHARMA 177.4 22.3 31.2 9.6 17.3 16.9 11.1 -16.4 OTHER 39.1 -0.6 -10.4 35.2 5.8 -9.4 12.4 21.3 TOTAL 110.7 31.8 17.1 8.3 23.7 14.9 8.2 -3.5 BUDGET 28.1 33.9 2.1 16.3 23.6 1.1 -16.0 7.1 GREENCARD PHARMA 77.9 36.0 9.8 84.3 -14.5 82.2 63.1 128.9 TOTAL 343 34.2 3.2 27.2 14.7 15.2 5.8 58.7 HEALTH 22.1 28.9 4.0 9.8 12.9 19.4 9.7 1.8 TOTAL PHARMA 45.3 18.6 20.5 14.3 18.0 10.6 2.1 11.0 OTHER 11.3 3.9 -0.7 20.3 0.5 9.2 13.5 5.2 TOTAL 313 22.2 11.4 12.6' 14.8 14.2 6 3 6.5 Billion YTL 2002 2003 2004 2005 Actual (A) I10,848,717.30 I 15,127,609.65 I 17,429,887.75 19,718,966.71 Projected (P) I10,542,337.80 I 14,224,884.75 I 16,931,840.41 I 19,290,134.29 Actual-Projected (A-P) 306,379.50 902,724.90 498,047.34 428,832.42 (A-P) a~ % ofP 2.91 6.35 2.94 2.22 2005-03 2005-04 2005-05 2005-06 2005-07 BAGKUR 173,967,260.40 161,286,684.89 160,83 1,807.70 160,541,678.94 128,116,307.59 EMEIZI 187,216,095.70 223,514,734.37 235,145,471.23 219,137,189.41 177,284,932.49 SSK 339,765,872.04 326,458,397.48 338,727,329.36 347,893,039.55 309,174,562.87 Annex VI11 Page9 of 9 2005-03 2005-04 2005-05 2005-06 2005-07 BAGKUR 13,920,185 12,699,917 12,327,459 11,992,249 10,266,94 1 EMEUi 13,947,300 18,618,467 19,143,313 16,990,440 14,754,78 1 SSK 29,660,877 27,983,332 27,660,525 27,381,843 25,135,009 2005-03 2005-04 2005-05 2005-06 2005-07 BAGKUR 12.50 12.70 13.05 13.39 12.48 EMEKLi 13.42 12.01 12.28 12.90 12.02 SSK 11.46 11.67 12.25 12.71 12.30 billion ?TL 2006 2007 2008 2009 2010 2011 Health Expenditures 20,710,182 24,384,285 28,085,358 32,154,425 37,358,502 41,729,794 TURKEY PROVINCE CAPITALS* NATIONAL CAPITAL RIVERS TURKEY MAIN ROADS Prut RAILROADS PROVINCE BOUNDARIES* This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information INTERNATIONAL BOUNDARIES shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any endorsement or acceptance of such boundaries. *Province names are the same as their capitals. 26
Groupe de la Banque mondiale · Program Document
Turkey - Programmatic Public Sector Development Policy Loan Project
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