Argentina - Provincial government finances (Vol. 1 of 2) : Main report

Repot No. 81 76AR Argentina Provincial Government Finance Study (In Two Volumes) Volume I April 3, 199C Latin America and the Caribbean Region Country Department IV FOR OFFICIAL USE ONLY . ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ . ..I \\A~~~~~~~~~~~~~ I. - Doctnet of the World Bank This d&~tment has 'a' istrlcied distribution and may be used by recipientW. ,only in the perfomunane of their ofricial duties. its cnt"nt may not othewwlse be disclosed without World Bank authorization. '01- _ _ _  Currency Equivalents Due to the extremely high rates of inflation in Atgentina, all monetary units are expressed in US dollars of July 1988. Argentine currency is transformed into Australes of this date using a weighted average of the Consumer Price Index for Buenos Aires (50 percent) and the Wholesale Price Index of INDEC (50 percent) arnd, then, into dollars using the average exchange rate of the "mercado financiero" for July 1988 (USSI a 12.28 Australes). The rate of the "mercado finanioero" was slightly above that of the "mercado paralelo" for this month. Fiscal Year January 1 - December 31 Glossary of Abbreviations and Acronyms CFI Federal Investment Council (Consejo Federal de Inversiones) FAP Financial Action Plan FIDEI Special Fund for Electrification of the Interior (Fondo Especial para Bletrificacion del Interior) FIEL Foundation for Latin American Economic Studies (Fundacion de Investigaciones Economicas Latinoamericanas) FMIS Financial Management Information System FONAVI National Housing Fund (Fondo Nacional de la Vivienda) GDP Gross Domestic Product GPP Gross Provincial Product INDEC National Institute of Statistics and Censuses (Instituto Nacional ' Estadistica y Censos) IMF International Monetary Fund OB Output-Oriented Budgeting PBS Provincial Planning and Budgeting System TPI Transfers for Provincial Investments  FOk OFFICIAL USE ONLY PREFACE This country sector work is part of a broad program of economic and sector work for Argentina developed by the World Bank. As such, it is closely related to, and has been supported by, complementary studies addressing important national issues. Most promiaent among these other, related studies are the 1989 Country Economic Memorandum (Reforms for Price Stability and Growth, which contains a chapter summarizing the preliminary findings of the present study), Tax Policy for Stabilization and Economic Recovery, and the Energy Sector Study. These reports have been issued dur:ing the later stages of preparation of the present report, and the latter has benefitted significantly from the interchange of ideas and information among colleagues involved in these other studies. This report is based partially on the findings of a mission that visited Argentina from July 15 (seven days after the inauguration of the new Government) through August 1, 1989. The mission comprised the following members: James Hicks (Mission Leader); David Vetter (Public Finance); Lubomir Ficinski (Expenditure Planning and Execution); Humberto Petrei (Budgeting); and Barbara Nunberg (Personnel Policies and Practices). Prior to the mission, extensive field work, coordinated by Mr. Vetter, was undertaken by Alfredo Perazzo and Guillermo Diaz. These consultants visited the six case study Provinces (Buenos Aires, Chubut, Cordoba, Salta, Santiago del Estero, and Santa Fe), and collected detailed financial data that previously had not been available in a central place. Their final report (May 1989) provided invaluable support to the mission. This report, together with the individual reports of the other mission members, were used by Messrs. Hicks and Vetter in writing the present report. The mission also visited the Provinces of Buenos Aires, Cordoba, La Pampa, Neuquen and Santa Fe, primarily for investigation of budgeting procedures, tax administration, personnel procedures, and expenditure planning and execution. Preliminary findings of the mission were discussed with officials of the National Secretaria de Hacienda, with very useful exchanges of ideas. Another mission, comprised of Messrs. Hicks, Vetter and Ficinski, visited Argentina December 7-18, 1989 to discuss a preliminary version of this report with authorities of the Ministry of Economy. These officials informed the mission that they were in agreement with the report's findings and recommendations, but proposed some improvements in presentation, all of which were incorporated in the present version. In addition, the mission visited the Province of Mendoza to see its innovative budgeting system. A great debt of gratitude is due the national officials, that supported the missions, as well as the authorities and staffs of the This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Provlncos of Buenos Aires, Chubut, Cordoba, La Pampa, Mendoza, Neuquen, Salta, Santa Fe, and Santiago del Estero; without their cooperation and support, this report would not have been possible. I I  TABE OF CONTENTS VOLUE I CUTIVE SUIOIARY . . . . . . . . . . . . . . . . . . . . . . i-xv I. INTRODUCTIOE . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. Importance of the Study . . . . . . . . . . . . . . . . . . . . 1 B. Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . 4 C. Interfaces with Other Bank Studies and Limitations . . . . . . 5 D. Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 E. Methodology and Sources of Data . . . . . . . . . . . . . . . . 8 II. OIERVIEW OF TEE PROVINCES IN ARGENTINA'S PUBLIC SECTOR . . . . . 13 A. International Comparisons of Fiscal Decentra'ization . .. 13 B. Four Types of Transfers from the Central Government . . . . . . 13 C. Fiscal Federalism in Argentina . . . . . . . . . . . . . . . . 15 D. The Revenue Sharing Law of 1987 .... . . . ....... . . 19 E. Summary and Recommendations ..... . . . ........ . . 28 III. PROVINCIAL REVENUES . . . . . . . . . . . . . . . . . . . . . . 33 A. Provincial Own-Source Revenues ... . . . . ...... . . 33 B. Comparative Performance on Current Revenues . . . . . . . . . . 38 C. The Efficiency of Revenue Collection . . . . . . . . . . . . . 43 D. Recommendations for Increasing Provincial Revenues . . . . . . 50 S. Simulation of Total Impact of Improved Tax Collection . . . . . 54 IV. PROVINCIAL EXPENDITURES . . . . . . . . . . . . . . . . . . . . 57 A. Current Expenditures . . . . . . . . . . . . . . . . . . . . . 57 B. Capital Spending . . . . . . . . . . . . . . . . . . . . . . . 64 C. Comparative Evaluation of Expenditures . . . . . . . . . . . 64 D. The Distribution of Expenditures by Functional Categories . . . 65 E. Distribution of Benefits from Public Expenditures . . . . . . . 67 F. Increasing the Efficiency and Equity of Resource Allocation . . 67 V. PROVINCIAL DEFICITS AND SOURCES OF CREDIT . . . . . .. . . 72 A. The Rapid Rise of the Provincial Fiscal Deficit . . . . . . . . 72 B. Financing the Provincial Deficit . . . . . . . . . . . . . . . 75 C. Recommendations ............. ..... .... . . 79 VI. BUDGETING, EXPENDITURE PLANNING AND IMPLEMENTATION . . . . . . . S1 A. A Normative Introduction ....... .. .. .. .. .. . . 81 B. Assessment of the Current Situation: Budgeting . . . . . . . . 82 C. An Assessment of the Current Situation: Expenditure Planning 86 D. Assessment of Current Situation: Project Execution and Procurement . . . . . . ..89 E. An Agenda for Improving Expenditure Planning and Budgeting . . 92  VII. A STIATEGY FOR PROVINCIAL FISCAL RF0ORU) AND EXPENDITURE EFFICIEDCY . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 A. Design Criteria for the Strategy . . . . . . . . . . . . . . . 103 B. Instruments and Actions Required for Strategy Implementation . 105 MAP: IBRD 20450 VOLUME II: ANNEXES AND STATISTICAL APPENDIX INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . I ANNEX CHAPTER I. OVERVIEW OF THE PUBLIC FINANCE DATA AND REPORTING PROCEDURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 A. Government Structure for P-ovision of Public Services . . . . . 2 B. The Availability of Data ............. . ... 2 C. The Reporting System for Provincial Public Finance Data . . . . 4 E. Transfers from the Central Government . . . . . . . . . . . . . 8 F. Rationale for Inter-governmental Transfers . . . . . . . . . . 11 ANNEX CHAPTER II. SOCIO-ECONOMIC STRATIFICATION OF THE PROVTNCES . 13 A. The CFI Stratification of Provinces . . . . . . . . . . . . . . 13 B. Population, Product and Poverty by Province and CFI Group . . . 14 ANNEX CHAPTER III. FIELD IORK IN THE PROVINCES . . . . . . . . . . 16 STATISTICAL APPENDIX.. ................. 18 TABLE OF CONTENTS . . . . . . . . . . . . . . . . . . . . . . . . . 18 Tables 1 - 26  ARGENTINA PRovW"CIAL GovC NNNST FNANMR STuDY 3XSCUTXM SUARY 1. Reducing the public sector deficit is of fundamental importance for success of Argentina's medium-term adjustment program, and to address the underlying structural problems and sources of instability in its economy. There have been three major sources of this deficit: (a, the Central Government itself, including the official banking and finance entities, as well as social security; (b) the public sector enterprises; and (c) the provincial governments. 2. Successful implementation of the medium-term adjustment program must include, of course, measures to adequately address all three sources of this deficit. In the past, only the Central Government and public enterprises have received priority analysis regarding their roles in creating excessive public sector deficits. Increasingly, however, it has been recognized by national and provincial authorities that the provincial governments cannot be ignored in the national adjustment program, as the provinces have become the largest, and fastest growing, contributors to the consolidated public sector deficit. 3. Thus, despite its fundamental importance to macroeconomic policy formulation and implementation, provincial public finance generally has not received the attention that its importance in national fiscal policy requires. This is partly because the provinces are difficult and costly to study, in that they are numerous (22), institutionally complex, extremely heterog',neous by almost any indicator, and spatially dispersed. Furthermore, there are not even adequate up-to-date data on provincial public finance. 4. While provincial expenditures rose rapidly over the 1970-86 period,- reaching over 11.2 percent of GDP in i986, total own-source provincial revenues actually dropped from a high of 5.6 percent of GDP in 1980 to only 5.0 percent of GDP in 1986. The total fiscal deficit of the provinces in 1986 before transfers from the central government was 6.2 percent of GDP (about US$4 billion), much higher than the public 1/ For a description of the distribution of service delivery responsibilities by level of government, see V 'lume II, Annex Chapter I, Section A.  - Li - sector enterprises and social security combined.a/ After transfers, the provinces showed a slight fiscal surplus, but at the expense of helplng transform the natioral administrations before transfer surplus of 5.4 percent of GDP into a fiscal deficit of 4.6 percent of GDP after transfers. Preliminary data indicate that the situation has deteriorated significantly since 1986. P. A prime contributor to these skyrocketing provincial deficits was the perverse incentives that prevailed in national/provincial relationships before the implementation of the Revenue Sharing Law in 1988, in which provincial financial mis-management generally was rewarded by ad hoc transfers from the Central Government or by subsidized loans from the Central Bank. Before implementation of this new Revenue Sharing Law, transfers predominantly were discretionary grants from the Secretaria de Hacienda that were neither transparent nor predictable. Also, the Central Bank has provided rediscounts or overdrafts for the Provincial Banks to meet the liquidity crisis caused by their deficit financing to the provincial governments. These provincial/national financial practices have contributed to unsustainable public sector fiscal and quasi-fiscal deficits, and their continuation would undermine national efforts to attain price stability and to proaote sustainable economic development. 6. 'though the necessity of bringing irresponsible provincial deficits under control is of utmost and urgent concern, the role of the provinces in promoting Argenti . s economic development musz not ne neglected. The provinces are increasingly important providers of public services, especially for education and health. Expenditures of Argentina's provincial governments in 1986 amounted to 11.2 percent of GDP (or US$7.8 billion) with investments accounting for 2.6 percent of GDP (US$1.6 billion). The new Government's strategy of decentralization should substantially increase this importance. 7. The primary objective of this sector study is to assist the Government of Argentina in identifying and implementing appropriate measures that will result in an effective and equitable reduction in the Provinces' contribution to excessive, consolidated public sector deficits. Tc meet this objective the study seeks to go beyond the documentation of how much provincial financial management has deteriorated. It also seeks: (a) to identify relationships and incentives that explain why this crisis has developed; and 2/ All transfers under the ad hoc revenue sharing agreements during 1984- 86 are treated as grants to the provinces, as the criteria used in their distribution were neither predictable nor transparent. See para. 2.04 for a discussion.  - iII - (b) to recommend to the Government a strategy for provincial fiscal reform and improved expenditure efficlency. 8. Chapters I and II present a description of the study's scope and methodology, as well as an overview of the provinces in Argentina's public sector. Chapters IZI-V provide analysis of provincial revenues, expenditures and sources of deficit financing. chapter VI assesses provincial practices regarding budgeting, expenditure planning and impl.Aentation, and Chapter VII recommends a strategy for provincial fiscal reform and improved expenditure efficiency. This Sumarary presents the principal conclusions reached in this study, itu recommended strategy for improvement, and finally an estimate of the potential pay-off to result from implementation of the proposed strategy. A. Principal Conclusions 9. A k;sic conclusion of this study is that there is a streng gentiral consensus at both the central and provincial government levels on the need for fundamental reforms in the financial relationships between the Central and Provincial Governments. Reforms in intergovernmental financial relationships are an integral part of the strategy outlined below, and the key to their success is political commitment at both provincial and central levels. At the provincial Level, there is an enormous potential for improved financial management, and these improvements do not reuaire complicated or technically difficult initiatives. Rather, dramatic improvements may be attained from quite simple reforms in provincial revenue and expenditure planning, budgeting and administration. These reforms were not adopted In the past due to the perverse incentives in the system of intergoverimental transfers (para. 5), as well as inadequa';e controls of rediscounting by provincial banks. National Goverment officials have expressed a firm commitment to the elimination of these perverse incentives, and provincial government officials have expressed strongly their desire for increased financial and political autonomy. Sustainable increases in provincial autonomy will require, however, significant improvements in provincial financial management. The primary areas for potential improvement are summarized below. Increasin@ Revenues 10. There is a very wide margin for increasing provincial tax and non-tax revenues by increasing the efficiency of billing and collection procedures. Just the most basic improvements in these collection and billing procedures could increase revenues significantly, as well as reduce the inequities resulting from "free-riding" by those who are not billed and by evaders. 11. Eventually, tax reform should eliminate the considerable overlap of provincial taxes with those at the national and municipal  - iv - levels. In the meantime, the three levels should increase cooperation in the administration of these taxes. 12. The case studies done in six provinces show that improved billing and collection procedures (e.g., better cadastres, information systems and management techniques) could substantially increase provincial tax revenues without raising nominal rates. Where feasible and cost effect've, billing and collection should be privatized (e.g., as in the collection of delinquent property taxes in the province of Santa Fe). After privatizing as much as is deslrable and possible, any additional qualified staff necessMr3' for adequate tax administration should be recruited, if possible through reallocation and training of existing provinciai personnel (thereby not increasing payroll expenditures), or, as a last resort, by new hiring. Improved fiscal performance would require not only better billing arEd more aggressive collection, but also improvements in the quality of services that should help increase the willingness to pay taxes and fees. 13. Rough estimates based un "reasonable" improvements in tax administration, without any nominal increases in tax rates or changes in legislation, would produce a total increase in tax revenues of 38 percent (US$461 million, or about 0.5 percent of GDP) for five of the provinces studied. 14. Billing and collection of non-tax revenues tend to be even less efficient than for tax revenues. There is a clearly a need for greater emphasis on cost recovery for public services through user fees and tariffs. This is especially true for the water companies which often require con-tant transfers from the provincial governments. Water is rarely metered, and both billing and collection procedureG are often monumentally inefficient. Users perceive the fees to be unfair, as they are not based on actual consumption. Also, consumers may not respond to increases in tariffs (such as the very high ones of July 1989) by reducing consumption. For all of these reasons, the water companies often represent a kind of "black hole" in provincial public finance. Reducing Bxpenditurms and Increasing Their Efficiency 15. Expenditures for the general administrations of all provinces and the Federal Capital rose from 7.5 percent of GDP in 1970 to 11.2 percent of GDP (or about US$8 billion) in 1986. The data from the case studies show that expenditures increased by over seven percent in 1987, even though total revenues declined. 16. The driving force in the increase of current expenditures was clearly personnel, but transfers to municipalities and other entities were also important. Provincial public employment in only the general administration increased by over 230,000 (34 percent) in all provinces during the 1983-86 period, to 913,000 in 1986.  17. Clearly, provincial personnel policies constitute a priority area of reform not only because personnel expenditures represent a sizeable portion of total provincial expenditures (an average of 46 percent between 1981 and 1986), but also because personnel administration systems in the provinces studied showed serious deficiencies in management capacity, resulting in inefficiency and diminished incentives to performance. 18. A program to improve the management of provincial public personnel systems should include several policy measures. First, the data base needs to be strengthened. Most fundamental is the implementation of a public employee census to determine the number and profile of government personnel. Second, the links betweer the personnel management system and the payroll system should be strengthened, so that cross-checking between the two systems can be used to identify ghost workers or double employment. Any gaps between these two systems should be analyzed and closed. 19. Where high employment, low salaries and wage compression are acute, a careful strategy of rationalization should be developed, with cost estimates for its implementation. inmployment reduction and the redistribution of resulting salary savings to decompress the wage structure and increase incentives to professional levels should be a goal in some cases. 20. Rationalization and control of transfers could produce important savings for provinces. Discretionary grants to municipalities should be redqc-3d and/or replaced with automatic revenue sharing and matching grants tied to improved fiscal effort and efficiency. Transfers to public enterprises should be reduced to a minimum by improving their efficiency and encouraging full cost recovery, as well as by priva-ization. Laws regulating pension funds and other transfers to individuals should be reviewed and administrative procedures tightened to discourage abuses. 21. Basic improvements in orqanization and management of provincial governments, direct and indirect administration, could save much time and money for both the government and those needing services. 22. Direct subsidies should be transparent and clearly targeted to the lowest income families. The provinces should emphasize provision of those services which tend to go to lower income groups, such as basic education. gproving Fiscal Planning, Budgeting and Execution 23. Most provincial budgets currently are definitely not useful instruments for the programming, management, control ar. -luation of public expenditures, because: they lack an adequate strategy for handling inflation; the budget offices are under-staffed and under- equipped, as well as politically weak; the methodologies are deficient;  - vi - coverage is incompletal reporting is slow and not pertLnenti and control is merely legallstic.- The lack of an adequate strategy for dealing with inflation leads to a number of important distortions in the budgetary process, LncludLng, the approval of the budget during or even after the fiscal year, serLal budgeting and discontinuitles in budget execution. 24. There are some changes that should be adopted immediately to improve the budgetLng procees. Firet, a more systematic way of dealing with inflation must be adopted. Second, the central and decentralized budget offices should be strengthened by: givlng them greater authority in budget preparation, improving their information systems and up- grading their personnel. Finally, the annual budget should be part of a medium term expendlture plan. 25. There are several approaches that may deal effectively with inflation during budget formulation and execution. The Province of Mo.ndoza employs a very sophisticated strategy (See Box 6.1 at the end of Chapter 6). As the budget is expressed in physical as well as monetary units, the Mendoza budget office can continually adjust budget allotments to current prices, using actual market prices. However, it approves expenditures only if revenues are sufficient to cover them. Thie equilibration of expenditures and revenues does not require approval of the legislature. The opposite of this strategy could also be used: expenditures could be adjusted monthly or quarterly by the rise in revenues, but witda an option for review by the legislature, if total real expendltures rise or decllne by a percentage defined in the law. For example, the legislature could speclfy that it would have the option to review the budget, if totsl real expenditures were 20 percent higher or lower than those predicted for the time period. Yet another option would be to approve contingency measures for each of these eventualities as part of the budget. 26. Investment planning for new projects tends to be haphazard, and there is virtually no p'anning for preventive maintenance in most provinces. Project identification, evaluation and selection should be improved by adopting more rigorous methodologies and strengthening the responsible entities. Preventive maintenance plans should be elaborated and implemented. 2;. Improvements in project execution procedures could cut at least 15 percent in the construction cost of civil works and 10 percent in goods and services expenditures with no loss in quality. The potential savings for all provinces in 1986 are estimated at about USS230 million in construction and at US$95 million in goods and services for a total of US$325 million (about 0.5 percent of GDP). These estimates exclude provincial public enterprises. 3/ The Province of Mendoza is a notable exception. See para. 6.59.  - vii - 28. To lower the cost of new investments, the provinces should: improve procurement procedures, abolish "Buy Argentina" and "Buy Province" legislation, reduce design errors and changes, improve the methodology for adjusting prices for inflation, and establish an information system about projects and costs. For example, simple improvements in procurement procedures, such as adopting the lowest evaluated price for bid evaluation, could reduce current and capital expenditures by at least 10 percent, or about US$400 million. Also, elimination of "buy .rgentina" and "buy province" legislation would not only lower costs, but also help to modernize industry by stimulating competition. Strategies for maximizing the impact of public expenditures on private investment should be developed. Provinces should analyze their comparative advantages for different kinds of activities (i.e., those that they could stimulate without subsidies), such as in the primary sector as well as in industry and tourism. Possible forward and backward linkages should also be explored. For example, the highest priority might be irrigation, which could in turn produce demands for processing of the increased production,. as well as for inputs. Ways of informing the private sector of these cpportunities should be developed. S. The Proposed Strategy for Reform 29. The need for fiscal reform in the provincial public sector is evident and fully supported by the officials at the national and provincial levels. The objectives of this reform should not be just to reduce the deficit (although this is by far the most urgent), but also to transform the provinces into agents of development which generate surpluses that they can invest wisely to increase total provincial product, thereby augmenting their future tax revenues. 30. To be successful, a strategy for provincial fiscal reform and improved expenditure efficiency must encompass two dimensions: national and sub-national. (a) At the national level, there must be in place a system of intergovernmental transfers (including revenue sharing, matching grants and loans) that are predictable, transparent, financially sustainable, and that provide ir.centives to provincial fiscal autonomy. The granting of credit to the provincial banks by the Central Bank must be rigorously controlled. (b) The sub-national level of the strategy must include the entire sub-national public sector, not only provincial central administrations, but also their indirect administrations, inclu4Lng public enterprises, as well as direct and indirect municipal government administrations. A broad approach to the entire sub-national public sector is necessary because in Argentina's federal system, fiscal reform is only as strong as  - viii - the weakest link in the system. National public sector deficit reduction efforts will fail if provincial government finances are not sound, and these, in turn, will not be sound if provincial enterprises and/or municipalities generate deficits that demand provincial "bail-outs" that eventually work their way up to the Central Bank or the National Secretaria de Hacienda. Desidn Criteria for the Strateoy 31. The criteria for design of the strategy may be grouped in two broad categories: intergovernmental transfers and provincial financial management. Implementation of an improved system of intergovernmental transfers is the responsibility primarily of the Central Government, while responsibility for improved provincial financial management rests with the provinces, although the Central Government may provide valuable assistance to them. A fundamental prerequisite for success in formulating and implementing a strategy for provincial fiscal reform and improved expenditure efficiency is a transparent (sanctioned through legislation and implemented through the budgetary process) and disciplined process for access to credit by the sub-national public sector. Therefore, the Central Bank should continue to maintain strict controls on rediscounts by provincial banks, thereby not allowing its funds to be used by provincial banks to finance their provincial government deficits. Furthermore, prudential regulation is required in many provinces in order to have adequate discipline and control over the provincial banks' operations. Without these disciplinary measures, the detailed proposals presented below will be doomed to failure. 32. The Central Government and Intergovernmental Transfers. The system for the transfer of revenues from the Central to Provincial Governments (and from Provincial to Municipal Governments) should be based predominantly on a revenue sharing system that is legally mandated and formula-driven. This is based on the normative position that a revenue sharing system should provide sufficient revenues to sub- national governments so that, when combined with a reasonable revenue effort by the sub-national governments, these may at least adequately operate and maintain their existing services. The overall system of intergovernmental transfers should provide, therefore, not only a reliable source of revenues to provinces, but also strong incentives to improved provincial revenue performance. Discretionary grants should form a small part of the "pool" of resources flowing from the Central to Provincial Governments, basically limited to providing support in emergencJes such as flooding. New provincial investments should be financed by provincial savings in current account and by responsible borrowing. Given this normative framework, the strategy for provincial fiscal reform should include an intergovernmental transfer system that: (a) is predictable; (b) is transparent;  - ix - (c) provides transfers in sustainable and equitable quantities; and (d) provides incentives to provincial fiscal autonomy. 33. Provincial Financial Management. Within the natIonal framework described above, the strategy requires that provincial governments adopt financial management practices that promote: (a) provincial financial autonomy; (b) management efficiency; (c) public accountability; and (d) expenditures that support sustainable economic development. Instruments and Actions Required for Strategy ImPlementation 34. Following the framework for strategy design, recommendations for strategy implementation are presented according to the policy instruments and actions to be taken by the Central and Provincial levels of government. Implementation must be actively pursued by both levels if the strategy is to be successful. 35. The recommended policies and actions to be taken at the Central Government level may be summarized in three areas: Revenue Sharing System; Special Transfers for Provincial Investments; and Provincial Financial Management Information System. 36. Revenue Sharing System. Although the current Revenue Sharing system (RSS -- sistema de coparticipacion), regulated under the )ecember 1987 legislation, may be criticized on several grounds, it is a vast improvement over the chaotic transfer system prevailing before it went into effect. To its merit, the current RSS fully meets two of the criteria for intergovernmental fiscal relations set out above, in that it provides shared revenues that are transparent and predictable for both Central and Provincial Governments. The RSS also appears to be fiscally sustainable, given reasonable levels of price stability. In addition, to the extent that all provinces recognize that national revenue sharing will be the only guaranteed intergovernmental transfer to be received from the Central Government, the RSS also provides incentives to provincial fiscal autonomy. However, its equity might be criticized, in that its inter-jurisdictional redistribution of revenues results in a flow of potential resources away from provinces with the greatest number of households with unsatisfied basic needs. 37. It is recommended, therefore, that the basic RSS currently in place not be changed in the near-term. As part of the continual evaluation of the system, however, it also is recommended that the Central Government implement a system for monitoring the efficacy of the system, taking into account the criteria noted above (predictable, transparent, sustainable, equitable, and promoting provincial fiscal autonomy). Basic inputs for monitoring and evaluation of the RSS could be provided by the Provincial Financial Management Information System,  described below. Especially important is the evaluation of the fiscal impacts resulting from decentralizing the responsibility for the provision of public services to sub-national governments, such as the recent transfer of responsibility for secondary educatlon to the provincees. This continuing evaluation should also cover the relative efficiency of different levels of governments in the provision of public services, according to their different characteristics (e.g., population size, per capita product, etc.) It is very important, however, that the continual evaluation of the RSS, and eventual changes to improve it, not be done solely on the basie of provincial financial management; rather, it should be made in the broader context of national fiscal policies for stabilization and economic development. 38. Special Transfers for Provincial Investments (TPI). The RS should be considered primarily as resources designated to meet provincial recurrent expenditures. Creation of a new system of matching grants, the TPI, is recommended, and it would be designed to meet three basic needs: (a) to immediately provide strong national incentives to provincial fiscal autonomy; (b) to provide financing for capital improvements programs in the near-term for those provinces that generate current account savings; and (c) to promote, in the medium- and long- term, the transition of the financing of provincial capital investments from earmarked, segmented sources of funding to competitive, non- segmented financing through domestic financial markets. 39. Several alternatives for providing resources for the TPI may be considered. First, ending the industrial promotion regime would eliminate a national fiscal drain estimated conservatively at 3.5 percent of GDP, or close to US$2.5 billion, per year (see Chapter II, Section D). The provinces should develop new strategies for regional development that would not require the subeidies of industrial promotion--that would move with market forces rather than against them. This would involve identifying provincial comparative advantages in sectors that could attract significant private investment. A part of the fisoal gain to be received by ending the industrial promotion regime could be allocated to the TPI. As an alternative, or complement, to the above, the TPI could be funded by the "pooling" of approprlate "special purpose" funds presently transferred to provinces as current and capital grants (discretionary, earmarked transfers) such as FEDEI, the nutrition and tobacco funds, etc. Together, these funds (excluding the Housing Fund, FONAVI, which is considered a loan fund and reported "below the line") have amounted to almost one percent of GDP, or about US$600 million per year, and they are transferred to provinces on an ad hoc baseis, without regard to their financial performance. An alternative to combining all of these funds into one new fund via legislation could be to allocate their resources as matching grants in accord with improvements in fiscal efficiency via executive orders. 40. Initially, the TPI could be included as a line-item in the national budget, with clear regulations for use of TPI funds.  - xi - Strong incentives to promote provincial fiscal autonomy would be provided through strict criteria for provincial access to the TPI. Access to TPI grants would be limited to those provinces that have in place a Financial Action Plan (see para. 49) that has resulted in current account savings (without grants) at least during the preceding quarter. Access to the TPI only after a province has begun to generate current savings would provide not only a strong incentive for these savings, but also an incentive for provinces to improve their financial reporting systems. 41. The TPI would provide much-needed resources for capital expenditures in those provinces that have demonstrated the financial capacity to properly operate and maintain their existing service delivery facilities and obligations. This matching capital grant transfer mechanism should not be considered a permanent facility, however. Rather, it should be a transitory mechanism necessary to provide incentives and support1 to the necessary structural changes in the financial relationship between the central and Provircial Governments.A- 42. Thus, the TPI should be viewed as an initial step, moving away from supporting provincial expenditures with national deficit financing, and toward the provinces eventually financing their investments with their own savings and with borrowing obtained through the national financial markets. Currently, however, Argentina's financial markets are unstable and segmented, and they are not efficiently mobilizing domestic savings and allocating resources. Therefore, in the near-term, the TPI's key role would be to provide incentives for provinces to become savers, thereby reducing sub-national government pressures on the consolidated public sector deficit. Combined with deficit-reducing measures by the Central Government and its public enterprises, the TPI would therefore contribute to the macroeconomic conditions necessary for the financial sector to perform more efficiently. 43. As Argentina's financial markets attain acceptable levels of domestic savings mobilization and of efficient resource allocation, the TPI could be phased out, with the provinces thereafter competing for funds in non-segmented financial markets. 44. In summary, the proposed TPI would be guided by four general principles: (a) access to the TPI by provinces would be voluntary; 4/ One example of such a transitory measure was approved by the Congress in December 1989: it defines the sources of revenues and also clear regulations for their allocation among provinces, including the exclusion of provinces failing to undertake measures to reduce their fiscal deficits.  - xii - (b) access to TP1 grants would be competitive, with those provinces making greater financial management improvements (generating greater current account surpluses) being eligible to receive more from the TPI; (c) the quantity of funds allocated to the TPI, as well as the conditions for transfer of these funds to provinces, would be consistent with the national strategy for development and strengthening over time of national financial markets; and (d) TPI grant financing would be available only for expenditures that are part of a provincial budget that has been accepted by a national authority on the basis of its verification that the expenditures are directed to operations that are economically efficient, financially sustainable and institutionally manageable (see discussion of the Provincial Planning and Budgeting System, PBS, para. 52). 45. Financial Management Information System. In order to provide data essential to macroeconomic policy formulation, as well as to monitor provincial progress toward fiscal autonomy, it is recommended that the Central GoverAment move immediately to establish a Provincial Financial Management Information System (FMIS). Baseline date for the FMIS would be provided by the provinces through their Planning and Budgeting Systems (PBS, para. 52). Initially, the PBS would be the Financial Action Plan to initiate the process, but a more comprehensive expenditure planning and budgeting system would be implemented over time. The PBS would be the key instrument for the planning, programming and control of provincial revenues and expenditures. It also would be the primary instrument for analysis of provincial eligibility for the TPI resources, in that it would provide information on the economic efficiency and financial sustainability of the provincial plans. 46. The FMIS would serve tso key functions. First, it would provide the Central Government with a necessary input for national fiscal policy. Also, it would provide the base on which to identify provincial needs for technical assistance for improved financial management, and to design such assistance programs. Very useful experience in the design and implementation of such information systems currently is available in the five provinces (Buenos Aires, Cordoba, La Pampa, Neuquen and Santa Fe) that are implementing the Bank financed Municipal Development Project (Loan 2920-AR), where municipal financial management information systems are being developed at the provincial level. The experience with the new budgeting system in the Province of Mendoza is also most interesting, showing how much can be done when there is a strong commitment to fiscal reform. 47. A prerequisite for making the FMIS useful, as well as all the other measures recommended for implementation at the Central Government level, is adequate institutional capacity to manage the overall process  - xiii - for restructuring provincial government financial management. There are several options for strengthening the Central Government's capacity to overview the provincial development process, with this process including (a) dimensioning and regulating the TPI, (b) development and analysis of the F1IS (including monitoring the performance of the RSS), and (c) review of PBSs. One option would be to strengthen the national Ministry of Economy's in-house capacity; another would be to contract with an appropriate technical assistaqce entity, either a public institution (such as a university or CFI ), or a private organization (such as FIEL, the Fundacion Mediterranea, or a consulting firm). Because of the transitory nature of the TPI and of national scrutiny of the PBSs, some contracting of outside support to the Central Government may be the preferred option. In any case, however, a "baseline", permanent strengthening of the Ministry of Economy would be necessary to ensure adequate linkages between the proposed FMIS and macroeconomic fiscal policy. Similar institutional support and strengthening would be required in the provinces in order to implement the recommendations for provincial government actions described below. 48. At the Provincial Government level, it is recommended that the provinces undertake the following to implement the strategy for fiscal reform and improved expenditure efficiencys begin immediately to formulate Financial Action Plans; and initiate the design of Provincial Planning and Budgeting Systems. 49. Financial Action Plans. Provincial PAPs would be the first step in moving toward provincial financial autonomy. They would be comprised of preliminary annual budgets for a three to five year period. The FAPs would emphasize measures that may be taken immediately to improve performance, without the need for detailed studies or information systems. After the reform process is initiated under a FAP, more comprehensive measures could be undertaken through permanent Provincial Planning and Budgeting Systems as the FAP is phased out. The main objective of the FAP is to identify simple measures that should increase revenues and control expenditures so that the province may produce a current account surplus to be used for investments and to amortize loans. 50. On the revenue side, simple improvements in billing and collection procedures would have considerable pay-offs. On the expenditure side, the FAP would present the province's plans for reducing expenditures and increasing their efficiency, and it would initiate their implementation. Three general areas appear to be particularly important: personnel, procurement and investment design / CFI (Consejo Federal de Inversiones) is a rather unique public institution that is financed by a percentage of total provincial revenue sharing, and its Board of Governors is comprised of the Governors of all the provinces. Thus, it is national in scope, but provincial in focus.  - xiv - and execution. Personnel is by far the largest and fastest growing expenditure category in most provinces. 51. In summary, the FAP involves implementation of the recomendat iLns presented in the Chapters IlU-V of this report (revenues, expenditures and deficit financing), and it would be the first step in implementing a more effective budgeting process in the province' in which the annual budget would be a comprehensive one-year slice of the medium term plan. 52. Provincial Plann4nq and Dudgeting System. After an initial period (about one year) of implementation of the FAP, provinces could then move to implement their PBS. The recommendations of Chapter VI could serve ax guidelines for this, and the experience in Mendoza shows that such reforms are feasible when political commitment is forthcoming. 53. The PBS would be a key tool for provincial planning, budgeting and control. It also would be fundamental for monitoring the effectiveness of provincial management, not only by provincial authorities, but also by the Central Government as it formulates macroeconomic policy and evaluates whether each province is eligible for access to the TPI. Key components of the PBS would include: (a) planning and control of provincial revenues; (b) expenditure priorities, including (i) maintenance and rehabilitation (ii) personnel policies that provide adequate professionalism and performance (iii) new investments, with projects costing greater that an amount agreed with the Secretaria de Hacienda subject to a competent benefit/cost analysis to ensure economic efficiency; (c) reliable projections of total and incremental (with and without a proposed investment) revenues to ensure financial sustainability; (d) strategies for financing investment costs, including own savings and borrowings; and (e) financial and service delivery relationships with decentralized provincial agencies and enterprises, as well as municipalities.  - xv - C. X timated Pay-Off. of the Strateqy 54. 1987 is the latest year for which estimates of executed provincial budgets are available. The overall performance of all provinces may be summarized as follows6/ current account (without grants) deficit -- US$966 million; capital expenditures -- $2,322 million; and overall need for financing -- $2,762 million. Using the 1987 budget estimates for all provinces as a baseline, the impact of different percentage increases in provincial tax and non-tax revenues and of reductions in expenditures may be estimated. Simulations of these improvements provide "orders of magnitude" regarding their results in terms of absolute monetary impact, as well as the resulting improvements (compared to the baseline) on current account savings, with and without grants (i.e., savings and own savings). For example, a relatively modest increase in revenues and decrease in expenditures of 15 percent would transform the 1987 current account deficit (without grants) of almost Us$ one billion (and a need for financing this deficit and capital expenditures of almost US$ three billion) to a current account surplus of USS 164 million and an overall need for financing of US$1.6 million. Increases of revenues and decreases in current expenditures by 25 percent would result in a current account surplus (without grants) of over US$ 900 million, while reducing the overall need for financing to less than US$900 million. 55. This means that improvement at the 25 percent level would enable the provinces to undertake an aggregate capital expenditure program on the order of $1.4 billion, fully financed with current account savings combined with modest capital revenues and existing grant funds. or, provinces could maintain the 1987 level of capital expenditures ($2.3 billion), financed in about equal proportion by current account savings and by long-term borrowings, if available. Improvements of these magnitudes are not unrealistic. They would depend first on the political will to undertake the reform strategy recommended here, as well on technical assistance .n implementing the proposed financial management improvements. 6/ See paras. 7.31 - 7.32.  I. _-NRODUCTION A. RmPortance of the Study In the Context of a Country Strateoy 1.01 Reducing the public sector deficit is of fundamental importance for success of Argentina's medium-term adjustment program, and to address the underlying structural problems and sources of instability in its economy. There have been three major sources of this deficit: (a) the Central Government itself, including the official banking and finance entities, as well as social security; (b) the public sector enterprises; and (c) the provincial governments. 1.02 The provinces have been responsible for thc largest and fastest growing portion of this deficit. While prcvincial expenditures rose rapidly over the 1970-86 period, reaching over 11.2 percent of GDP in 1986, total own-source provincial revenues actually dropped from a high of 5.6 percent of GDP in 1980 to only 5.0 percent of GDP in 1986 (Figure 1.1). The total fiscal deficit of the provinces in 1986 before transfers from the central government was 6.2 percent of GDP (about USS4 billion), much higher than the public sector enterprises and social security combined (Figure 1.2). The provinces showed a slight fiscal surplus, but at the expense of helping transform the national administration's before transfer surplus of 5.4 percent of GDP into a fiscal deficit of 4.6 perceat of GDP after transfers. 1.03 Data from the case studies of six provinces show that their combined fiscal deficit more than doubled in 1987 to US$1.1 billion (1.8 percent of GDP) after transfers, as own-source revenues de7lined and expenditures, erpecially for salaries, continued to rise.- For all 22 provinces and the Municipality of Buenos Aires, the total fiscal deficit in 1987 after trqnsfers was estimated at over US$2.8 billion or about 4 percent of GDP.8 The decline in own-source revenues stems partly from the rise of inflation and the resulting Olivera-Tanzi effect, but also from the increasing inefficiency of the provinces in collecting taxes, as well as the reticence of taxpayers to pay taxes and fees for services of ever deteriorating quality. 1.04 Despite this importance, provincial public finance has not received the attention given to the central government and the public enterprises. There are not even adequate up-to-date data on provincial 7/ For a description of the case study provinces studied, see para. 1.21. 8/ Estimates of the 1987 total fiscal deficit for all provinces and the Municipality of Buenos Aires were made through the proportional expansion of the data obtained in the six provinces surveyed.  5 I' 2| '1 Ii 1, 1 S tt * " o21;t t  . 3 - Table 1.1: ARGENTINA - PUBLIC SECTOR DEFtCIT BY GOVERNNEMTAL LEVELS OR ENTITIES, 1986 (Percent of GDP) Surptus Surptus Before After Transfor Transfer National Adcinistration 5.37 -4.60 Provincial Goveri.nts (a) -6.18 0.07 Pubtlc Sector Enterprises (PSE) -2.20 0.07 Social Security System -1.29 0.15 Total Non-Fiscal Pubtic Sector -4.30 -4.30 Quasi-Fiscal '1.00 Total Deficit -5.30 Source: World Bank, ARGENTINA: REFORMS AND SUSTAINED GROWTH, Cointry Econodc NemorantdL, July 1988. Note: (A) Folloting the Ninistry of Econoay procedure. all revenue sharing under the ad hoc agreeents was considered to be grants (ATN) In this table. For the case study data, transfers made under these ad hoc agreements is considered to be revenue sharing nd, thus, a currwht revenue fiom a national source. public finance. This is partly because the provinces are difficult and costly t.o study, in that they are numerous (22), institutionally complex, extremely heterogeneous by almost any indicator, and spatially dispersed. 1.05 A better understanding of provincial government finance is important not only for controlling the fiscal deficit but also for improving the efficiency of Argentina's public sector, because provinces are increasingly impt-tant providers of public services, especially of health and education. The new Government's strategy of decentralization should substantially increase this importance. Expenditures of Argentina's provincial governments in 1986 amounted to 11.2 percent of GDP (or US$7.8 billion). Investments accounted for US$1.6 billion in 1986 (2.6 percent of GDP) of these provincial expenditures, slightly more than the total investments of all public enterprises and about 60 percent more than the central government's investments (including all of its decentralized entities and special accounts).  1.06 It is clear, therefore, that provincial governments cannot be ignored in the efforts to reduce6 the public sector's fiscal deficit and to improve its efficiency. Government's Commitment to and Cooperation with Study 1.07 The economic team of the new Government has assigned top priority to the reform of the public sector enterprises and fiscal reform at the sub-national level. The economic teams of the provinces visited also showed much interest in the study and in a possible Bank lending operation. Thus, at both the national and provincial levels, officials are quite aware of t.he need for fiscal reform and increased provincial financial autonomy, as they realize that tbe central government no longer has the capacity to resolve their revenue problems via discretionary transfers. Provincial officials also expressed the desire for greater political autonomy and freedom from the controls of the Central Government. 1.08 The new Government seems well aware of the fact that fiscal reform at the provincial level is essential in order to maintain the integrity of the Revenue Sharing Law. Until the implementation of this Law in 198b, transfers to the provinces were mostly in the form of discretionary grants. This caused a kind of perverse competition among the provinces to "run up" large deficits in order to get a larger share of the grant "pie". The new revenue sharing law reduces discretionary grants to only one percent of total shared taxes. Both the national and provincial authorities seem quite aware of the importance of maintaining the integrity of automatic distribution criteria set in this law, and also of the impossibility of so doing vnless efforts are undertaken to reduce provincial fiscal deficits. They also realize that this is necessary to reduce pressures for rediscounts to the provincial banks from the Central Bank and the resulting quasi-fiscal deficits. B. Objectives 1.09 The primary objeftive of this sector study is to assist the Government of Argentina in identifying and implementing appropriate measures that will result in an effective and equitable reduction in the Provinces' contribution to excessive, consolidated public sector deficits. A corollary objective is to identify appropriate areas in which the Bank may support improved provincial financial management, so that provinces can generate surpluses and invest them wisely to increase their future economic growth and tax revenues. 1.10 The study's more specific objectives are to identify: (a) specific ways that provincial revenue performance and expenditure efficiency may be improved;  (b) effective incentivea for implementing the above improvements; (c) appropriate, standard provincial hlidgeting ead reporting procedures that may also be used for national financial information systems necessary for macroeconomic planninga and (d) needs for institutional reforms necessary to meet the preceding objectives. 1.11 In addition, the report provides (Volume II) basic data on provincial public finance in a format similar to that widely used by the Bank, as well as information to help in interpreting these data and in understanding the institutional st:rctures of the provinces. The methodological notes and data tables in the Statistical Appendix presented in Volume II are directed primarily to Bank and Argentine staff interested in detailed Interpretatica of the general data or informati;.. at very disaggregated levels. Volume II includes summary tables with highly disaggregated financial data for all 22 provinces and the Federal Capital. In addition, complementary tables, presented in the same format as these summary tables, are available on request for each individual province. These may be quite useful for those interested the analysis of specific provinces and/or of specific sectoral operations. All data also are available on floppy disk. The Statistical Appendix and the supplementa,y tables in the study file will greatly facilitate access to and understanding of these data by those interested in provincial public finance in Argentina. 1.12 Finally, the study file holds additional Methodological Notes used in the preparation of the report, directed to those most interested in replicating or improving on the data series presented in this study. In this sense, these Methodological Notes are a first step in establishing the terms of reference for the continuous updating of a provincial financial management information system (thereby supporting objective (c); also see Chapter VII, paras. 7.18-7.20). C. Interfaces with Other World Bank Studies and Limitations 1.13 Provincial governments are highly open sub-systems within both the public sector and the general economy of Argentina. As such, they are profoundly affected by most fiscal and sectoral policies of the Central Government. For example, energy policy must address the royalties paid by public enterprises to the provinces for extraction of hydrocarbons and uranium, as well as production of hydroelectric power. Industrial development policy must deal with the fiscal loss engendered by the Industrial Promotion Program, which has substantially reduced the "m,-." of resources to be shared among all provinces. National tax policy and the efficiency of tax collection also bear directly on this "mass' of revenue to be shared with the provinces. The fiscal deficits of the provinces can generate quasi-fiscal ones via losses of the provincial banks and eventual "bail outs" by the Central Bank.  - 6 - 1.14 This study focuses on the budgets and financial management of the provinces per se, treating the impacts of national policies as exogenous variables that have or will be covered by on-going research at the Bank (e.g., energy, industrial development, national tax policy, quasi-fiscal deficits, etc.). In other words, the primary focus is on how the provinces may improve their own financial management, rather than those aspects which would require changes in the national revenue sharing system, national tax policy, national sectoral policies for industry and energy, etc. For example, this report will discuss the implications of recent changes in Industrial Promotion on provincial public finance, but will leave the analysis of th4i system and specific recommendations to the ongoing sector work on it.- Similarly, the existing revenue sharing system will also be taken as a given that must be 4ealt with in the broader context of the national tax syitem, as it involves the comparative analysis of the efficiency of different governmental levels tn tax collection.L