Argentina - Public finance review : from insolvency to growth

Report No. 10827-AR Argentina: Public Finance Review From Insolvency to Growth February 11, 1993 Country Operations Division Country Department IV Latin America and the Caribbean Region FOR OFFICIAL USE ONLY M 1'~ It.1& 1-'i~. V IANl 1.fI:V LW4 T'S)Y ~ k G3 | AIJ;;h(-1r: D11SAW} AlitA'~~IHI;, rJ Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIVALFNTS Currency Unit - Peso EXCHANGE RATE A$1.00 = US$I.00 FISCAL YEAR January I - December 31 ABBREVIATIONS AFJP Pension Funds Administradoras de Fondos de.lubilaci6n y Peisiontes AGP P,rt Authority Administraci6n General de Puertos AyEE Water and Electric Company Agua y Energia Ele&trica ANA National Customs Admibistration Administraci6n Nacional de Adwuias ANSSAL National Administration of Health Insurance Administraci6n Nacional de Seguiros de Salud ATN Discretionary Treasury Grants Aportes del Tesoro Nacional BANADE National Development Bank Batnco Nacional de Desarrollo BCRA Central Bank Banco Central BHN National Housing Bank Batnco Hipotecario Nacionad BIC Investment and Growth Bonds Bonos de Inversion y Crecimiento BICE Bank of Investment and External Trade Banco de Inversiones y Comercio Externo BOCE Economic Consolidation Bond Bonos de Consolidaci6n Econ6mica BOCON Consolidation Bonds Bonos de Consolidaci6n BONEX External Treasury Bonds Bonos Externos del Tesoru CNEA Atomic Energy Commission Comisi6., Nacional de Energia At6mowica CONAE National Commission for Space Activities Comisi6n Nacional de Actividades Espaciales CONFER National Committee of Radio Telecommunications Comite National de Radio y Telecoutunicaciones CONFESA Federad Health Council Coosejo Federal de Salud CONICET Nationad Couicil on Science and Technology Consejo Nacional de Ciencia y Tecuologia CRM Monetary Regulatiou Account Cuenta de Regulaci6n Monetaria DGI General Tax Board Direcci6u Generad de Impositiva DNCFP Federal Commission of Provinces Direcci6n Nacional de Cousejo Federad de Provincias DGFM General Directorate for Military Factories Direcci6n General de Fdibricaciones Militares DNC National Highway Board Direccidn Nacional de Carreteras DNRP Provincial Tax Boards Direcci6n Nacionad de Recaudaci6n Provincial DVP Provincial Highways Departments Direcci6n de Vialidad Provincial ENADEP National Sports Agency Ente Nacional de Deportes ENATUR National Tourism Agency Ente Nacional de Turismo ENTel National Telephone Company Empresa Nacion;a de Telecomunicaciones FIEL Foundation for Latin America Economic Research Fundaci6n de Investigaciones Econ6micas Latinoamericana.s FONAVI National Ilousing Fund Fondo Nacional de Vivienda GdE Nationa Gas Company Gas del Estado GPP Gross Provincial Product Producto Bnrto Provinciad IAF Institute for Fmancial Aid to Retired lastituto para Ayuda Financiera ad Personal Military Personnel Militar Retirado INAP National Institute of Public Administration Instituto Nacional de Administraci6n P1balica INDER Reinsurance lnstitute Institutos de Reaseguros INOS National Institute of Social Insurance Instituto Nacional de Seguro Social INSSJP Institute of Health Insurance for Retirees Instituto de Seguro de Salud para Jubilados and Pensioners y Pensionados IPV Provincial Housmg Institutes Instituto Provincial de Vivienda MERCOSUR Southern Common Market Mercado Comuu del Star MHSA Ministry of Health amd Social Action Ministerio de Salud y Acci6n Social NFPS Non-Financial Public Sector Sector Piiblico No-Financiero NPS National Pension System Sistema Nacional de Pensiones NPV Present Net Value Valor Actual Neto OSN National Sanitation Company Obras Sanitarias de la Naci6n PAMI Program of Integral Medical Care Programa Integral de Ctuidados Medicos PAN National Food Program Programa Nacional de Alimentaci6n PAYG Pay-As-You-Go Sistema de Reparto QRs Quantitative Restrictions Restrictiones Cuantitativas SEGBA Electricity Company of the Province Servicios Electiicos del Gran Buenos Aires SICE Secretary of Commerce and Industry Secretaria de Industria y Comercio Exterior SIDE National Intelgence System Sistema de Inteligencia del Estado SIPRI Stockholm International Peace Research Institute Instituto Internacional Stockhohno de Paz e lnvestigaci6n SOFI French Customs Administration Administraci6n Francesa de Aduanas SVOA Secretary of Housing Secretaria de Vivienda VAT Value-Added Tax lupimesto ad Valor Agregado YPF State Oil Company Yacimientos Petroliferos Fiscales  FOR OmCIL USE ONLY COUNTRY DATA - ARGENTINA MONEY,CREDITANDPRICES 1980 1985 1t88 1989 1990 1991 1992gW (Mon Peaos; end ofpaod) Mbony ad Quai Money 0.0008 0.6 24 298 5,593 1Z726 20.570 Donestic Bank Credt to Pui4cSoctor 0.0002 0.7 28 1,442 15853 17,437 17.378 Doenwrc B* Creat to PiteSeotor 0.0008 1.0 18 307 4,77 14243 19.013 MoneyandOuas Moneyeas%of GDP 22.3 14.2 29.2 11.7 10.9 10.3 13.4 WOeI Pd11cIex (1985=100) 0.0673 133 3,156 173,153 1,555,570 Z439.141 Z604.846 Amial perctede chnes In: General Wholesae P1ea OIaex 57 384 432 5,388 798 57 7 Banl Credt to Pmo Sector 70 377 527 5,009 999 10 0 Ban*CredattoPrheteS$ctor 109 372 285 1,914 1,119 199 33 BALANCE OF PAYMENTS 1980 1985 1990 1991 1992W MERCHANDISE EXPORTS (Averge 19881991) (USS Mion) uSS Mh %o ctTe Esrta of Goods. NFS 10,765 10,242 14,953 14,753 14.95 Agricual goods df 2.631 27.6 lIs ocfGoods,NFS 14.024 5.AM 7,057 11,779 17,584 Autat. goods of ogdc. o1g.e / 4,354 45.7 ReOce BSance (3.259) 4.351 ,896 2,976 (Z,29) lMend. of In shl origfi v2551 26.8 TotalMeraade s Eqpofs 9.535 100.0 Interest Payments (net) (947) (4,879) (5,724) (4.930) (3,679) Other Fedor Paymnec (net) e/ (584) (425) (479) (868) (953) EXTERNAL DEBT (as of Dec.31. 1992) W USS Meh Net Ctrreit Trenas 23 0 71 0 (49) Balanco on Crrt Accownt (4.767 (953) 1.7(4 (,822) (7.310) Totel Dita Outtnding & D wAsed (DOD) 73,167 IRRD 3.037 Cted Investenant 788 919 1,668 2.481 2.441 IDB and Oew Muilalterel 3.697 IMF 2.882 ota M&LT Loam (net) 3,400 .78t (9t9) 128 (250) slaterals 10.481 Disbursements 5.809 7.564 - Bonds 8.683 Amot,on 2,409 4.778 Conerwdal Bras h 44.386 OtwerCaplt (net) bt -2217 -881 345 1,757 7,806 DESTSERUICE RATIO, 1992 Il 44.8% Change In Net Res s ( * Increse) 2796 (1.871) (R,8a) (2,704) (2,087) Interest aenilce ratIo (% ot expods G&NPS) 19.8% Ioss Resnves (end y 6.,743 4,801 6,010 9.093 11.,80 IBRROIDA LENDING, DECEMBER31. 1992(Mkm. USS) RATE OF EXCHANGEY' tBRD IDA 1980 102 oteedg & Dftursod 3,037 Urdnbtsed - USS 1.00 -A$O.00000018 US81.00.AS0.9906 Ou_ Ingledc Undsoned AS 1.00-US55.SSS5SS AS 1.00 USS .105 e/ Dlrec rUerenert ncorme pka other teator erdee Incomne. b/Vc deos oit-tenn calpal net t eMFfacue, chne In arres, and lon cOnentot. c/ tnctud, vabtio end OFWer a$ nert. dt BCRA categores 1. 11, and III: IvcAoc d oether rnol aprodueta; agtad*n lt a: ts ald oth. e/ CRA categodes IV, VIII. and Xt: I.e. rmnad0wed food, bevees end tobacco, w. ftus and reated Produc: testes and dobng. / Al other rmnfadured goode caes. of Pfenwteye _fle. hW dncie idal nmkets. pvate non.earateed. shoert ten and pobic sedor Qtflndog ddt I Anno,tlon end Inttures parenat on nedurn, nd leong4mr (MLT) dctI as a peraettap of eort of GSNFS. Exds aren; ndcleds re_ahelg of datlM Y Pdod everp In opeos. I 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.  This report is based on missions which visited Argentina in November 1991, March 1992 and October 1992. The main mission comprised the following members: Richard Newfarmer (IMission Leader, Macro, Public Finance) Daniel Artana (Industrial Promotion, Subsidies, and Provincial Finance Nicole Ball (Military Expenditures) Egbert Gerken (Social Security) Shahrzad Gohari (Education and Health) Daniel Hewitt (Military Expenditures) Felipe Lurain (Public Investment) Roberto Manrique (Presidency and Military Expenditures) Jacques Morisset (Revenues, Public Enterprises, Central Bank, Macroconsistency) Philip Musgrove (Education and Health) Victor Thuronyi (Direct Taxes) Jaime Vasquez-Caro (Tax Policy and Administration) Mario Vicens (Monetary Policy and Macroconsistency) Matthew Vogel (Budget Analysis, Statistical Annexes, and Projections) The mission also benefitted from contributions from Raul Auzmendi (Transport), James Hanson (Extemal Debt), Antonio Martin del Campo (Budget Processes), Nelson de Franco (Power), Oscar Libonatti (Fiscal Accounts), John Stoddart (zlydrocarbons), and David Vetter (Provinces). Atejandro Izquierdo helped p-epare the Statistical Annexes and graphs. James Hanson provided valuable comments. Diane Bievenour and Mila Divino provided secretarial support. The mission also produced a companion report on provincial public finmnce, Argentina: Towards a New Federalism (June 1992), World Bank.  Table of Contents Page No. EXECUTMVE SUMMARY .................................... i-xvii PAr I - INTRODUCTION CHAPTER 1. FINANCLAL INSTABILITY AND PUBLIC FINANCES ... ....... 1 A. Public Sector Deficits, Inflation, and Slow Growth ................. 1 B. Main Problems in Public Finance: 1970-89 ...................... 6 C. Post-1989 Structural Reforms in Public Finance ................... 12 CHAPTER 2. THE ARGENTINE PUBUC SECTOR ..................... 24 A. Concepts and Definition ................................. 24 B. Revenues and Expenditures by Level of Government ................ 28 C. Budget Expenditures by Function: The National Administration ... ...... 31 PART I - REVENUES CHAPTER 3. FEDERAL REVENUES AND TAX POUCY ................ 37 A. Revenue Problems ..................................... 37 B. Tax Policy: Toward Greater Efficiency ....................... 40 C. Remaining Issues ..................................... 45 D. The August 1992 Agreement with Provinces ..................... 49 E. Recommendations .................................... 50 CHAPTER 4. TAX ADMINSTRATION ............................ 54 A. Tax Administration: Ovemrl Evaluation .54 B. Enforcement and Tax Expenditures .......................... 56 C. Administrative Developments: DGI, Customs and Social Security .61 D. Recommendations .67 CHAPTER 5. HEALTH ...................................... 69 A. Overview ......................................... 69 B. Federal Expenditures in 1992 ............................. 71 C. The Role of Health Insurance Funds (Obras Sociales) ............... 74 D. Prospects and Recommendation for Reform ..... ................ 77  -2 - PART m - EXPENDITURES CHAPTER 6. EDUCAflON . ................................... 83 A. Principal Eduvation Issues ............................... 83 B. The Level and Structure of Expenditure in Education .............. 84 C. University Education .......... ......................... 89 D. Policy Options for Reformn ............................... 90 CHAPtER 7. MILTARY EXPENDITURE .......................... 93 A. Introduction ......................................... 93 B. Military Expenditures in 1984-1990 ......................... 94 C. Personnel, Wages, Allowances, and Pensions ................... 96 D. Overview of Military Expenditure: 1991-1992 ................... 98 E. Personnel Retrenchment Policy Options ....................... 99 F. Facilities, Assets and Operations .......................... 102 G. Conclusions ....................................... 103 CHAPTER 8. THE PRESIDENCY ........... .................... 107 A. Presidency Expenditures .......... .................... 107 B. Recommendations .................................... 111 CHAPTER 9. PUBLIC ENTERPRISES ........ .................... 115 A. Background . ...................................... 115 B. The Menem Administration Strategy ........................ 117 C. Recommendations .................................... 122 CHAPTER 10. PROVINCLAL GOVERNMENTS ...................... 124 A. Introduction ....................................... 124 B. Evolution of Provincial Government Deficits ................... 125 C. Provincial Government Revenues .......................... 125 D. Provincial Government Expenditures ....................... 129 E. Recommendations .................................... 133 CHAPTER 11. SOCIAL SECURITY (PENSION INSURANCE) .... ........ 140 A. Overview ....... 140 B. The Failure of the National Pension System ...... ............. 141 C. Restoring a Viable Pension System ...... ............ ..... 147 D. Cleanirg Up the Old System ............................. 152 E. Managing the Medium-Term Transition .......... ............. 156 F. Recommendations .............................. 160  -3- CHAPTER 12. PUBUC ENVESTMENT ........................... 162 A Capita! Stock ad Recant Trends in Investment ................. 162 B. Recent Trends in Public Investment ........................ 164 C. Public Investment Programming Mechanism and Project Selection ..... 166 D. Public Investment--1992 and Beyond ....................... 167 E. Recommendations ............. 175 CHAPTER 13. THE CENTRAL BANK AND QUASI-EXPENDITURE ........ 179 A. The Quasi-Fiscal Deficit ............................... 179 B. Sources of Financing of the Public Sector .................... 181 C. Strengthening Monetary Authority .......................... 187 D. Recommendations .................................... 190 PART IV - PUBLIC FINANCE TOWARD THE YEAR 2000 CHAPTER 14. PUBLIC FINANCE AND THE FUTURE OF PRICE STABILITY .. 193 A. Macroeconomic Projections .............................. 194 B. Sustainabflity of the Fiscal Balance ........................ 199 C. Savings from Recommended Reforms ........................ 203 D. Conclusion . ........................................ 208 ANNEXES Annex 1.1 Subsidies to the Private Sector Annex 2.1 The Public Sector: Budgeting Concepts and the Stmcture of the Federal Govenument Annex 4.1 A Simplified Approach to Measuring Tax Effort Annex 4.2 Highlights of Tax Legislation Under the Menem Administration Annex 7.1 Military Facilities, Restructuring and Announced Actions Annex 13.1 The Sources of Financing of the Combined Public Sector: A Macroconsistency Framework Annex 14.1 General Description of the Projections STATISTICAL APPENDIX ,, .w^ ,I . I r  SUMMARY OF MAJOR POLICY RECOMMENDATIONS A. Overview * u~e Years of Progress 1. The Menem Admii-istration assumed office in July 1989 after a decade of crisis in public finances tha; had culminated in hyperinflation. The new team inherited weak public institutions accustomed to deficit spending and reliance on the inflation tax. Claims on the state's resources were far greater than its capacity to mobilize resources--meaning the Argentine state was insolvent. Dependence on the inflation tax had caused the macreeconomy to become progressively more unstable by shrinking the monetary base to levels that made it impossible to control inflation with even small fiscal gaps. 2. In response to the crisis, the Menem Administration enacted a series of structural reforms in its first 42 months that progressively recast the foundations of public finance. The Government undertook difficult-to-reverse reforms in the legal framework, institutions, and policies. These involved restructuring the state through reforms in revenue mobilization to increase the quantity and quality of tederal revenues and expenditure reforms that have redrawn the boundaries of the national government and private sector. Expenditure reforms included an administrative reform to reduce the size and scope of government and improve control over expenditures, a new federalism that made revenue-sharing with the provinces transparent and decentralized selected expenditures, and an extensive program of privatizations and asset sales to end irreversibly subsidies through public entities and facilitate new private investment. Finally, the Government has also attempted to delink the nonfinancial public sector from the source of inflationary finance through reforms of the Central Bank. 3. The results have been impressive: revenues increased, expenditures declined, and the noninterest balance moved into sustainable surplus for the first time in decades. Aggregate expenditures have not fallen more as a share of GDP because increases associated with automatic transfers to the provinces and social security offset expenditure reductions elsewhere. The transfers have helped to alleviate (at least initially) latent structural deficits in social security and the provinces as well. Progress in controlling inflation was not smooth--in part because institutional weaknesses took time to redress, and because small errors of macroeconomic management superimposed on small and skittish financial markets quickly were amplified into runs on the currency. Nonetheless, the underlying fundamentals in public finance improved steadily, as the combined deficit of the public sector fell from 10.5 percent of GDP in 1989 to a projected slight surplus in 1992. The macroeconomy has become more stable and the economy is now in its third year of strong expansion. The Challenges Ahead 4. Maintaining balance in public finances is an essential prerequisite for continued price stability and economic expansion. This idea is now broadly accepted among Government officials at all levels and the public at large. Nonetheless, weaknesses in the structural underpinnings of public finance remain in social security,  - ii - provincial finances, health insurance, and defense expenditures--and these pose medium- term threats to fiscal balance. Maintaining the intensity of the reform effort--with their implied sacrifices--in an environment of price stability, growth, and fading memories of hyperinflation is the challenge now facing the Government. Moreover, if economic growth should slow, then tax growth will decline and demands for wage increases, new subsidies, and public spending may intensify. 5. Aware of this, the Government has shown its resolve to implement and/or consolidate the ambitious set of reforms already underway. The Government intends to consolidate tLe administrative reform by implementing the recently passed Law of Public Financial Management, by improving control over the wage bill, by seeking passage of the Law of Public Procurement, and by completing the bureaucratic restructuring. Social security :-eform, the linchpin of several other reforms, is intended to provide an adequate and reliable pension to beneficiaries and, by capitalizing the system, create a huge pool of savings available for investment, albeit at transitional cost to the Government. Social security reform also is linked to the reform of direct tares, since income tax collection is central to funding of social securi y from gene-l revenues. Also as part of the social security financing, the Government has proposed changes in federal-provincial fiscal relations, desigrp I to improve the balance between revenue and expenditure responsibilities; it is also encouraging provinces to undertake their cwn adjustment programs. In other areas, the Government has formulated a reform of the health insurance program that would provide universal health coverage, reduce inefficiencies in the health system, and eventually reduce wage taxes, while offering the promise of improved health status and worker productivity. Finally, the Government has also begun a reform of the defense complex, inclhding the privatization of military-run public enterprises, restructuring personnel and revising the use of military facilities. These reforms constitute the basis of future improvements in public finance and will help eradicate the structural deficit and improve the quality of revenue mobilization and expenditures. The Government merits full external support in these efforts. 6. If these reforms are consummated, the public sector accounts are projected to be in approximate balance over the medium term. The remaining small financing gaps toward the end of the decade should be financeable in a world of price stability, low interest rates, steady four percent growth, and continued confidence in economic management. 7. However, public finances have little cushion in the event that favorable economic and policy assumptions do not materialize. First, slower-than-projected growth of output or unexpected increases in inflation may reduce public sector revenues below projected levels; while the revenue problem is no longer structural, the Government still has minimal scope for offsetting adverse events through revenue increases. Second, the process of adjustment has given rise to new uncertrinties that may place unanticipated claims on public resources. The Government needs to increase spending on social services and investment in the near term to rrnprove service delivery. The downsizing of the state has reduced the demand for investment in public goods and services but only partially; the deteriorationt from a decade of neglect requires new and more efficient spending. Third, the proposed new social security regime entails unknown but substantial transition costs. While the near-term costs are to be offset by  - iii - general revenues, changes in the design of the refonn as it makes its way through Congress may increase these costs. Fourth, levels of public sector indebtedness are still high, and fiscal accounts are vulnerable to unanticipated interest rate surges. Finally, the Government is consolidating past arrears to social security recipients, suppliers, and others with claims on the state through issue of as much as US$15-20 billion in new debt (the consolidation bond, BOCON); the service of this debt is capitalized for the first six years, but payments on the order of US$3 billion will be required in the last years of this decade. Although some of this new debt will be canceled with future asset sales, cash payments on the BOCON will come due at exactly the time when payments to commercial banks under the recent debt reduction agreement peak at about US$3 billion. These uncertainties mean that Argentina must not slow the pace of medium-term reforms, and the Government should therefore strive to exceed its current fiscal objectives. 8. With federal revenues approaching historic highs of more than 24 percent of GDP, the main outstanding issues are to improve the neutrality of the tax policy framework and its progressivity. As discussed below, reducing payroll taxes (perhaps as part of the health insurance reform) and broadening the base of the income tax would serve both ends well while at the same time contributing to revenue increases. Tax administration, much inproved in recent years, also holds the Promise of some revenue increases, mainly through vigilant administration of recent controls on costly subsidies to promoted industries. New revenues from these sources could in the future be used to eliminate remaining small taxes and ease rates on main taxes. Finally, provincial tax Policy and administration are potential sources of additional revenues and efficiency. 9. On the expenditure side, the stop-go austerity programs of the 1980s and the post-1989 adjustment program--notably the administrative reform and the privatization program--brought down federal public expenditures to levels that are a tolerable burden on the economy. Public expenditures, equal to 22 percent of GDP at the federal level and 40 percent for all public expenditures, are below the average for the industrial countries, and comparable to middle-income countries. 10. The main problems with expenditures are: (i) to buttress mechanisms that prevent surges in expenditure in the future; (ii) to increase the productivity of aUl public expenditures; and (iii) to reduce the excessive current expenditures of the provinces. Expenditure surges arise from spending corapression, inadequate control of the wage bill and other expenditures, and precarious financing for spending authorities receiving transfers. The administrative reform, by reducing employment in the Federal Government by over 50 percent and increasing wages, has relieved wage compression; the privatization program has had a similar effect. Also, the Government has taken important strides to improve Budget Office's control over cash management, budgeting, and programming. The new Law of Financial Administration, passed in September 1992, wijl establish the legal basis for fiscal control, including expenditure authorization and ex post auditing. Also, regularizing financial relations with the provinces and public enterprises have reduced pressures for discretionary allocations. Nonetheless, important actions remain: full implementation of the control and ex post auditing systems in Financial Administration Law, improved control of the wage bill, and gainLng fiscal control over the health insurance system.  -iv- 11. Sustaining the recovery in the private sector requires a more efficient delivery of publicly supplied goods and services, and a sound macroeconomic and regulatory framework. At the national level, expenditure compression in the 1980s reduced the already-low productivity of public expenditures. While recent employment rductions and privatizations have relieved the compression, only better management and resource allocation across programs can realize potential productivity gains. 12. At the provincial level, spending is nearly twice the noninterest expenditure of the national administration. Current expenditures are excessive and investment is low.' Most provinces, long accustomed to a share of the inflation tax, are only now beginning the adjustment that the Federal Government started three years ago. While provinces are being asked to supply an increasing share of public service, they have received windfall gains in co-participated revenues, and this could reduce the incentive to adjust. For that reason, the Government has last year obtained proportional payment for administration of taxes, an increased share of co-participated taxes for social security, transferred responsibility for secondary education and health to the provinces, and required repayment of rediscounts. Adjustment in the provinces--through reforms of tax systems, administration, and employment practices--is the only way that provinces can begin to provide educational, health and other services more efficiently. Moreover, from a macroeconomic point of view, a slowdown in growth and revenue collection would generate considerable demands to increase transfers unless provincial administrations make headway in implementing their own reforms. The next section elaborates on these themes by summarizing the specific recommendations of this report. B. Policy Options to Consolidate Fiscal Stability 13. Several new policies and reforms, summarized below, could increase the fiscal surplus by an estimated 1.2-1.4 percent of GDP, and provide the cushion necessary to offset contingencies in the medium-term fiscal program. Moreover, the reforms would provide considerable improvement in the quality of public revenue mobilization and productivity of expenditures. This report suggests specific policy initiatives in tax policy and administration, current expenditures, and public investment as well as spending in the social security system, public enterprises and provinces. fhx Policy 14. The tax policy framework over the last two years has produced dramatic improvements in tax collection at the same time that it has evolved into a more efficient system. The Government has markedly increased its -^iance on VAT and reduced the coverage of inefficient taxes, especially those on exports. The system now relies on four modern taxes: the general and uniform VAT, the income/assets tax, import tariffs, and excise taxes on selected final products (notably fuel, cigarettes, and alcoholic beverages). The abolition of the remaining inefficient taxes will be possible as revenues from efficient taxes become compatible with the current public expenditures. The main I Provincial public finances are treated in summary form in this report based on a detailed review in a separate report. See World Bank, Argentina: Towards a New Federalism, June 1992.  v outstanding issues are neutrality with respect to use of capital and labor and the progressivity of the system. 15. The Government is poised to address these issues in the context of its social security and pension funds reforms. One proposal would be to reduce the wage taxes by making some portion of the employers' contribution deductible against the VAT, and thus incrcase social security funding from the VAT and income taxes. This would generate an important incentive for employers to declare social security contributions and help reduce evasion. The burden of the income tax on the middle and lower-middle class would be reduced by raising the minimum monthly taxable income. This proposal would be a salutary step toward reducing the bias against employment, but is only a partial solution. Although the increase in the minimum taxable income will in principle improve the progressivity because of the reduction of taxation on low- income workers, it would effectively narrow the base for the income tax by excluding many mid- and upper-income taxpayers as well. While the annual average income per family is estimated at about US$19,000, the minimum taxable income is above US$20,000. Also, the loss of the wage taxes may require the Government to increase the VAT rate. 16. A more direct way of addressing both the factor bias and progressivity is to explore ways of reducing the wage taxes and increasing taxes on income from capital. Assuming that the social security system is financeable through the elimination of evasion at a 26 percent contribution rate, the Government should consider linking a reform of the health insurance system with a reduction in both the family funds and the health insurance quotas. Contributions to health and family funds account for nearly 24 percent of gross salaries, much higher than nonpension wage taxes in all OECD countries. Health reform--discussed at length in Chapter 5--and more efficient use of the family funds might permit reductions of the payroll taxes by half. 17. At the same time, the Governnent could increase the taxation of income from capital directly through modifications to the corporate and personal income tax. For the corporate income tax, the deduction of interest payments from the corporate income tax should be retained, provided that interest income is taxed at the individual level. At the same time the Government should review the expensing of investment to ensure that the depreciation deduction is consistent with economic rates of depreciation. 18. For the personal income tax, the Government should reintroduce taxation on income from capital, which is now virtually exempt. First, the Governuiin. should disallow the interest deduction; this would allow taxation of the interest earnings. Second, the Govermnent should also institute taxation of at least the real portion of capital gains. Finally, the Government should not raise the already generous minimum threshold on income subject to taxation, but, as tax administration improves, lower it. In addition, the Govermment should eliminate miscellaneous deductions and rview the possibility of taxation of fringe benefits. The effect of these measures would be to broaden the base rather than to narrow it. 19. Reducing the payroll tax through reduction of health funds contributions, which are fully deductible from the base of the personal income tax, will automatically increase the base of the personal income tax. Lower contributions can lead to an  - vi - increase in after-tax wages since a reduction in labor cost leads to an increase in labor demand, which in turn affects positively real wages (and can also reduce unemploy- ment). The positive impact on real wages will be reinforced if a decline in the price level occurs. The price of capital would be positively influenced since labor costs directly affect the production cost of investment goods. Finally, simultaneous reductions in the wage tax, coupled with other reforms in service delivery, will also improve the equity of the tax system. 20. The August 1992 agreement with provinces helps redress the earmarked imbalance between the social security system and other demands on Treasury resources fixed in the coparticipation regime. The package assigns 15 percent of total coparticipateJ tax reveniues !o the social security system, but does not create maximum incentives for provincial governments to adjust. Tax revenues allocated to provinces are projected to increase by nearly US$3.8 billion between 1992 and 1993. The agreement left in place about US$1.5 bilion in transfers other than co-participation, including FONAVI, which are less effective in achieving their stated objectives. Transfers to the provinces other than coparticipation should be considered as an instrument of structural adjustment and in that sense should be linked to improvements in the fiscal performance of the provinces. Tax Administration 21. Reforms in tax administration have been a major cause of revenue improvements to date, and have allowed the Government to gain strong control of revenue streams. Nonetheless, programs to improve control of industrial promotion, internal administration, the tax court, and the customs administration merit priority attention because of their high revenue potential. 22. Of these, perhaps the highest tax yield could come from the Government's efforts to control industrial promotion. The program, implemented in November 1992, involves exchanlging self-declared benefits for an audited tax credit applicable against future taxes, cancellation of benefits not yet activated, and careful auditing of existing beneficiaries. The DGI should devote the necessary resources to audit firms that did not pay taxes during the suspension of benefits in the year following the Energency Law; the effort to control provincial firms has achieved only 50 percent of its targeted rate of audit thus far, but could yield revenues of more than US$300 million. In looking to the future, the Government should make permanent the suspension of new industrial promotion benefits, the suspension of which is scheduled to expire in September 1993. 23. The entire reform program of the industrial promotion system will produce large fiscal savings. Estimates of DGI staff suggest that the tax credit substitution program will reduce the fiscal cost of the industrial promotion from US$2.7 billion to US$1.4 billion in 1993. Current Expenditures: The Wage Bill 24. The Government has undertaken an unprecedented administrative reform to downsize and reorganize the Federal Government. Officials reorganized the main ministries and selected decentrlized agencies. Employment in the national  - vii - administration will have fallen from roughly 670,000 in 1990 to under 285,000 by end 1992; of this reduction, 105,000 employees have left the Government and the remainder have been transferred to the provincial governments. Fmployment reductions in the public enterprise sector have been no less dramatic: employment has fallen from 295,000 to almost 50,000. Of this 245,000 reduction, about one-third has been through retrenchment, and the rest via privatization. 25. To complete the reduction program, the Government should: (i) complete the restructuring process for those remaining governmental organizations that have yet to be restructured, including CONICET, CNEA, civilian personnel in the Armed Forces, the national universities, the National Sugar Board, and health insurance funds (obras sociales), which in total would reduce employment by an additional 27,000 positions; (ii) continue to work with the budget office to disaggregate reductions by jurisdiction to ensure proper accounting and budgeting in the future; (iii) realize a special study on reductions, including the preparation of names and identification numbers for the purpose of ensuring that those who leave and receive indemnification will not reenter public service. 26. To complete the reform of the wage payment system and pay scale, the Government must: (i) establish its own computerized registry of civil service and centralize the payment function directly or through the Ministries' accounts in line with the new law of Public Finances, possibly absorbing the staff of the Office of Civil Service into the Ministry of Economy--where it was located before the Military Government of 1976; (ii) implement a computerized check payment system through the banking system to control the wage bill, a measure that might save as much as US$200 million in administrative costs plus additional savings through reduction in wages to nonexistent workers. If the new system is well designed, it will ensure greater accountability and establish firm control over the wage bill. These actions may help reduce further the resources devoted solely to "administration"--amounting to a savings of nearly US$400 million spent through the various ministries. Health and Social Welfare 27. The Government is now beginning to formulate an effective strategy for the social sectors. The Federal Government is a relatively small actor in health compard to the provinces and the quasi-public health insurance funds. Federal outlays for health, housing, and welfare absorb US$800 million of the US$8 billion in noninterest, non-transferrable expenditures--40 percent of the national administration's actual spending. An additional US$1.5 billion are spent as direct transfers from the federal budget--US$l billion is transferred to the provinces through the FONAVI housing program and US$200 million to subsidize the health insurance funds operated by the unions (obras sociales). 28. Health. Most public health expenditures--whose resources flow from the wage tax as well as budgetary allocation--go through the health funds, which represent US$5.6 billion (estimated on the basis of 1986 data, the latest available) compared to federal expenditures of US$745 million by the Federal Government and perhaps US$2.0- 3.5 billion by the provincial governments. Improvement in the efficiency of expenditure in this sector must, therefore, focus on improving the accountability and efficiency of  - viii - the health funds and provinces. A major reform of the social insurance funds could provide both a source of savings in 1993 as well as major improvements in productivity of health care expenditures. 29. The Government has prepared a major reform of the health insurance funds and made its main principles law through a Presidential decree in January 1993. The new program would: (i) allow contributors to choose their own providers; (ii) allow free entry after a transition phase; (iii) require providers to offer a minimum package of health care at a specified price; and (iv) universal coverage with subsidies for indigent individuals (as distinct from current institutional subsidies). This would be combined with close monitoring of both the insurance system and the medical package, including limitations on administrative expenditures. The new system would in effect finance universal coverage by reducing the acknowledged very high costs of administration and waste in the current system. The new program remains to be defined through regulations and institutions but should be created along the lines of the original draft law. 30. A stronger insurance system, such as that contemplated in the recently prepared draft law on obras sociales, would also relieve the federal bureaucracy of major expenditures through the budget for financing the deficits of the insurance funds-- through the ANSSAL (US$217 million in 1992). Remaining expenditures could be focused on core national objectives: vaccinations, preventive medicine, prevention of drug abuse, sanitation regulation, and targeted programs of maternal and child health care. Selected programs, such as the Ministry of Education's Student Health Program (US$48 million) and the Congressional Medical Plan (US$15 million), might be less necessary in the context of a national health insurance program. 31. Other Welfare. The MHSA has welfare programs other than housing (discussed under investment) that collectively amount to US$140 million. These programs should be reviewed for possible reductions in light of the Govemment decision to decentralize expenditure responsibility to the provinces. In addition, other jurisdictions, especially the Ministry of Labor, spend US$240 million on several programs that merit review for effectiveness. Education 32. The Argentine educational system, once among the best in Latin America, has become a shadow of its former preeminence. Entrenching privileges for teachers and granting free admission and education for students beginning in the 1970s interacted with cycles of austerity in the 1980s to produce fiscally eroded public institutions. Under budget pressure, the primary schools were decentralized to the provinces beginning in the early 1970s, where many of the same forces continued at play. The secondary and vocational schools were transferred in 1992 by agreement, with implicit funding from the increase in the co-participated revenues. Quality, salaries, and teaching conditions now vary widely among provinces. 33. After transferring secondary education to the provinces, the Government now spends about US$1.3 billion on education at the federal level, about half of which (US$720 million) is transferred to the federal universities. The largest potential  - ix - efficiency gains in federal spending are therefore to be found at the university level. This spending has not been sufficient to prevent the decline of the quality of public university education in Argentina. Because competing private universities can fulfill much of the demand and because low public tuition tends to be a regressive subsidy-- most graduates are from above-average-income families and go on to earn better-than- average salaries--the Government should consider a program of phased divestiture of the university system. This would allow resources to be concentrated or. subsidies designated for low-income student scholarships at universities and enrichmeni programs for primary and secondary education administered at the provincial level. 34. As an interim policy, the Government should consider the establishment of a combination of user fees (i.e., tuition) and targeted subsidies (i.e., loans and scholarships for low-income, meritorious students) to enhance financing. Adopting a needs-based, targeted student loan program would ensure that low-income students would have access to university education. If the system's 700,000 students were charged a modest tuition of US$100 per term plus US$20 per month (private universities charge US$250-600 for tuition plus US$300-800 month), the Government would mobilize nearly US$300 million in additional funds. Adopting a needs-based, targeted student loan program would ensure that low-income students would have access to university education. 35. At the same Jime, the shift of secondary education to the provinces should facilitate the downsizing or even closure of the Ministry of Education. Selected programs, such as Budget and Education Policy (US$45 million), lThacher Education and Training Programs (US$83 million), the Cultural Budget (US$16 million), Technical Education Council (US$17 million), and Scientific Research (US$42 million), should be reviewed for their effectiveness. 36. In the future, it will be necessary to increase educational spending to pay for the equalization of teacher salaries for secondary education, increase overall pay linked to other productivity measures, improve school materials that are woefully out of date, and rehabilitate deteriorating plant and equipment. These demands will fill on the provinces. This cost could be at least partially offset by reducing the number of teachers, consistent witl reasonable class sizes. At present student-teacher ratios are quite low (about 11) and highly variable across provinces (6-15). Also, paid leaves are excessive and poorly monitored. A structural reform could substantially offset costs of higher wages. Defense 37. Military expenditures absorb the second largest share of the non-interest federal budget, and the largest share of discretionary Treasury expenditures, 32 percent. Military outlays excluding pensions have fallen from over 6.0 percent of GDP in 1980- 81 to less than 2 percent at present, now among the lowest proportions of GDP in the hemisphere. The Government has recognized that Argentina's security environment has improved significantly since 1983. Resolution of long-standing conflicts with Chile, Brazil, and Great Britain, coupled with a reduction in the perceived threat of external support for domestic subversion following disintegration of the Soviet Union, has led  x the Government to take the opportunity to reconsider levels of military spending, and at the same time redirect military spending to more effectively fulfill its function. 38. The Government has identified several imbalances that currently hamper military efficiency to achieve this objective. First, with personnel costs absorbing over 70 percent of the defense budget, the military's operational capacity has been severely curtailed. Second, as the size of the force has decreased since the mid 1980s, the traditional rank pyramid for the Armny, Navy and Air Force has become distorted, with the ratio of officers to enlisted personnel rising substantially. Third, the military pension system is in urgent need of rationalization to remain solvent, to bring it into line with the civilian pension system, and ensure mobility between the defense and civilian systems. Fourth, the facilities operated by the armed forces need to be consolidated and relocated to areas from which they can most effectively defend Argentine territory. On the other hand, wages do not appear to be a problem--military pay is significantly higher than civilian pay, and on a par with other countries when compared to mean incomes at similar grades and length of service. 39. The reform strategy the Govermnent has begun to implement the rationalization of the entire military sector. This includes defense-industry privatization, personnel retrenchment, and facilities consolidation. Thirty defense-related public enterprises are currently being privatized. This exercise will eliminate their substantial losses and allow the Government to retire their associated debt, possibly even producing some revenue. Present plans to reduce civilian Ministry of Defense personnel by 40 percent will restore the ratio of civilian to military personnel that existed prior to 1985 and lead to an estimated annual savings of US$80 million. 40. The Government is also considering retrenchment of military personnel. A decrease in the level of military employees would enable the Ministry of Defense to further lower personnel costs and facilitate the restoration of a more pyramid-shaped personnel structure. Additionally, by using some of the funds to increase operations and maintenance, and possibly making some strategic capital purchases, the Government feels it could achieve the same level of security at a lower annual cost. One way to achieve this is, for example, to implement a program that restored the personnel pyramid existing in 1984; this would entail a 25 percent personnel reduction and would save an estimated US$155 million annually. An important principle for military restructuring is that revenues from asset sales should be used to support the reform process--for the program of restructuring of the defense establishment, severance payments and adjustment assistance, reform for the military pension system, or investments in relocation and enhanced mobility of forces in line with the Govenmment's new strategy--instead of consumed in support of normal current expenditures. Otherwise, when the revenue stream from asset sales ends, the Government will have the same spending levels and no way to support them. In other words, proceeds from asset sales should be used to reduce liabilities or for selected strategic investment consistent with the new defense strategy. Presidency 41. The Presidency has evolved into a major spending entity in the Federal Government, responsible for 14 percent of spending ir. the national administration. The  - xi - Argentine Constitution mandates the existence of no more than 8 Ministries in the National Administration, a limit recently reenforeed with the administrative reform in 1991/92. However, governments have used the Presidency jurisdiction as the sphere of Government where secretariats with Ministerial rank could be established. The four largest units--the Communication Secretariat (responsible for the Public Broadcasting Company), the National lburism Agency, CONICET (the research institute program), and the nuclear power agency (CNEA) are responsible for 80 percent of staff and expenditures in the Presidency. 42. A close examination of these agencies suggests unnecessarily high employment levels in the central administration and decentralized agencies in light of the new role of the state. The Presidency has been relatively untouched by the administrative reform, and overll employment levels are virtually the sarne as before the reform began. Since this is a jurisdiction that most needs reform, the Government should apply the same principles of downsizing to the Presidency that were applied thmughout the rest of the public sector. Specifically, for the largest executing units, the Government might consider: (i) eliminating the Communications Secretariat and establishing a Directorate of Communications under the new General Subsecretariat of the Presidency; eventually, the National Service of Radio Telecommunications could be privatized, removing 950 positions from public sector accounts; (ii) rationalizing the National Iburism Agency and establishing a new National Directorate also under the jurisdiction of the Ministry of Economy, thereby eliminating 500 positions; and (iii) privatizing CONICET and the Miguel Lillo Foundation, resulting in the abolition of 5,589 positions from the public sector budget, since research and development activities could be undertaken in public and private universities. 43. Finally, the nuclear power company (CNEA) should be restructured into business and research units for privatization and transferred out of Presidency. Two possible business units (power production and heavy water) could be established under the Secretariat of Electric Energy in the Ministry of Economy until privatization is completed. Privatization would lead to an eventual public sector savings of US$850 million. The rationalization of the Presidency jurisdiction could result in net savings of US$570 million. Public Enterprises 44. Public enterprises accounted for 25 percent of total public spending in Argentina as late as 1990, but the privatization program has aleady shrunk this to 17 percent. The Government's program of privatization of public enterprises has produced enormous benefits. Among them are capital revenues o support the transition to a sustainable public finance position, relief from investment demand in the sector, an end to pricing distortions, and macroeconomic shocks associated with political pricing. Assuming that the privatization program is completed as scheduled, resources for the Government are at estimated between US$4-5 billion in 1992, somewhat higher than official projections, which do not take into account the privatization of Encotel, Puertos A.G., OSN, and Gas del Estado. The program, if maintained on schedule, will also facilitate reductions in transfers from the federal budget.  - xii - 45. Capital revenues from asset sales are to be used in the program to cancel liabilities. It is essential that the Government maintain this policy and avoid using asset sales to finance current expenditures. Because of the debt consolidation (discussed below), the indebtedness of the Government will increase in 1993 despite the debt reduction agreement with commercial creditors. Therefore, any one-time extraordinary revenues through asset sales should be used to reduce debt. 46. Budget transfers amount to US$2 billion annually and should be phased down in accordance with the privatization and enterprise restructuring schedule. In 1993, transfers should be scaled down to less than US$800 million--virtually all to the remaining segnients of the railways and Yacyreta--and to less than US$400 million in 1994, nearly all to Yacyreta. Special effort should be devoted to reductions in railway transfers, since they are economically inefficient and costly. 47. A prerequisite for economic success in privatization is the enactment of a clear regulatory framework, es-jecially for pricing, in those sectors not subject to the discipline of price competition from competing sellers. In particular, output prices must be fixed according to their international production costs and not only according to the evolution of the benefits of the formerly public firm. Finally, the new Law of Procurement, submitted to Congress in January 1993, would establish the basis for a long-term, non-discriminatory regime for the entire public sector. Provincial Finance 48. Provinces account for about one-third of public spending in Argentina. Though preliminary estimates suggest the provinces collectively will be in fiscal balance in 1991, in the past they have been major sources of deficit in the consolidated public sector accounts. The Government has undertaken major efforts to improve the federal fiscal structure, and reduce the incentives to spend without regard to revenues. Several problems exist that can prevent the new federalism from realizing its full potential. First, imbalances between current and capital spending within provincial finances are becoming evident; provincial real current expenditures jumped by 41 percent between 1982 and 1990, while capital expenditures dropped by 25 percent. Second, the large rise in coparticipated taxes and the large federal-provincial transfers have reduced the fiscal urgency to reform as new revenues absolve provinces of the political cost of raising taxes; for example, in 1992, the provinces will be able to spend an estimated US$500 million more than in 1991, over and above the cost of transferred secondary education and health. A third problem is the inefficiency of provincial and municipal tax systems, characterized by distortionary taxes, poor tax administration, and pooI' use of the revenue potential of local tax bases. Finally, provincial governments financed more than 60 percent of their deficits in 1990 with loans through the provincial banks, and reforns initiated do not go far enough to ensure that the provincial banks will not again become a source of deficit finance and macroeconomic instability during the next economic downturn. 49. Federal Framework. Tb maintain the incentive to adjust in the context of the present primary distribution in the Revenue Sharing Law, one option is to improve the distribution of the marginal incrases that result from improved federal tax administration or new revenue measures at the federal level. This would require seekimi-  - xiii - an accord to reduce the marginal transfers from future improvements and/or seeking to transfer additional expenditures to the provinces with projected "windfall" gains from marginal increases from future federal revenues. This is the strategy the Government has followed to date. Another option is to recast the US$2.2 billion of noncoparticipated transfers in the budget. The largest of these include the FONAVI housing program (US$900 million), special aid to Buenos Aires and Tierra del Fuego (two programs totalling US$300 million), the Tobacco Fund (US$100 million), and the National Highway Fund (US$100 million). With the agreement of the provinces, some or all of these resources might be consolidated into a program of block grants to be disbursed in proportion to current savings performance of provinces and/or to reimburse the cost of agreed reforms, such as severance payments to redundant workers or provincial social security reforms. This fund could be supplemented with: (i) incremental improvements in aggregate coparticipated resources; and (ii) loan proceeds from international financial institutions. A fund of US$2.0-3.0 billion could provide a powerful incentive to adjust current expenditures and revenues and provide a continuing source of much needed investment at the provincial level. The fund would be administered by a project execution unit established in the budget office; the unit would calculate the net present value, and would disburse against projects meeting the test of a positive net present value. 50. Revenues. The Government should also work with the provinces to: (i) transfer to the provinces the tax administration system now in operation at the DGI, including the computerized control of the largest taxpayers, cross-checks with DGI regional offices and accounts, and improved collections of sales and land taxes; and (ii) revamp the tax policy framework to eliminate inefficient taxes. 51. Expenditures. Provinces will be the main agents providing public services in the future. Their efficiency in doing so will have a profound effect on the long-term growth rate of Argentina. The most pressing need is a comprehensive administrative reform to reduce public employment similar to that designed at the national level to reduce employment and raise average salaries as well as a review of the allocation of human and fiscal resources to service delivery. Social Security 52. Social security spending, after accounting for 12-14 percent of spending of the nonfinancial public sector during most of the 1980s, is projected to increase to 21 percent by 1992. This represents increases in the pensions themselves, as well as payment of a larger share of accrued pensions in lieu of accumulating arrears. The August 1992 agreement with the provinces ended the accumulation of arrears by increasing paid pensions with the use of co-participated resources. The new system would create an integrated pension system for workers, comprised of a public new minimum pension for all workers, a transitional pension for retired workers and those about to retire, and a capitalized, privately-managed system. The move to a capitalized system can, if properly managed and financed, restore credibility to the social security system. 53. The most important issue is that the Govermment create sufficient fiscal "space" to finance the decade-long transition to a fully capitalized system. This entails  - xiv - planning for an increased deficit in the social security system (before general revenues) to about US$5-7 billion annuaUly in 1994-97. In 1993, general revenues more than covered the system's deficit because that share of the wage tax going to the capitalized system would not take effect (and therefore be lost to the public system) until 1994, the date of implementation. As of that time, however, general revenues of US$5-7 billion are needed in 1994 and beyond, if the deficit is not to be increased. This suggests that at least the 15 percent of coparticipated revenues temporarily allocated to social security in 1993 be continued. 54. Moreover, the annual system deficit could turn out to be US$1-$2 billion higher than the Government's present projections, depending on several possible adverse developments during the passage of the law and the transition-phase implementation: unfinanced pension increases, slow progress in controlling evasion (and therefore a slower decline of the dependency ratio), and overly generous treatment of workers during the transition with insufficient years of contribution, who might otherwise have to delay retirement until age 70. Since the financing is so dependent on general revenues, changes to the reform package that increase benefits could easily destabilize public finances. 55. Policies to Reinforce the Reform. To address the risks mentioned above, the Government should: (i) protect the new system against demands that it raise benefits for pre-reforn pensioners beyond levels mandated by the old laws; (ii) resist demands for raising the compensatory pension above levels established in the December modification of the draft law; (iii) lower the average level of pension insurance from about 70 percent of the average wage to 55-65 percent--levels common in Western Europe; (iv) resist pressure for weakening the rules for the transition to higher minimum years of contribution and age at retirement; instead, allow workers not qualifying under the rules to retire at age 65 or later with actuarially fair deductions from their pensions; (v) strengthen the audit program for disability pensions; (vi) further strengthen social security collections through systematic cross-checks with the DGI; (vii) extend mandatory affiliation to all economically active, including provincial and municipal public employees; at a minimum require provincial and municipal schemes to adopt the same criteria as to minimum years of contribution and age at retirement. 56. Pension Fund Investments. The Government must design investment rules for the pension funds that will ensure the security of these resources, as the pension funds (as opposed to the pension system) will accumulate a large surplus in their first two decades of growth. These funds will produce investible resources of about US$3 billion annually in this decade. An important step is taken in the present draft law, which prohibits any minimum investment requirements in particular instruments (notably Government paper); requiring the funds to invest in financing the deficit of the rest of government would have reduced confidence in the performance of the funds. 57. Confidence in the private pension fund scheme also depends on a coherent set of rules, and on the credible policing of the rules by a professional supervisory body free of conflicts of interest and political intervention. The draft law, however, lacks rules on the composition of the superintendency, and a recent agreement between the Government and the unions would staff the superintendency with representatives from the state, the unions, employers, and the affiliates rather than a professional management l q . I  -xv - and staff which is accountable to the Executive or Congress. This armangement might undermine confidence that all AFJPs will be held to the strict standards of the law including application of the ultimate sanction, i.e., revocation of the AFJP license and transfer of the pension fund to other AFJPs. A weak superintendency risks that the state guarantee for a minimum fund performance will be called. Therefore, the Government should establish a professional superintendency for AFIPs. Public Investment 58. After nearly two decades of decline, public investment in Argentina is at historic lows. Though public investment averaged about 10 percent of GDP in the 1970s, it now has fallen to under 5 percent. The privatization program has reduced the demand for public investment and opened many sectors to private investment--notably, telecommunications, hydrocarbons, and transportation. Under private stewardship, these sectors may become dynamic, even leading sectors in Argentina. These facts, however, do not mitigate the need for new investment in those sectors remaining in the public domain--including highways, energy (for the near term), and social infrastructure. 59. Although the Government of Argentina has made progress in the planning of public investment, with the appearance of public investment plans for both 1991 and 1992, the process of capital budgeting can be greatly improved, thereby increasing the efficiency of public investment. A serious shortcoming in the public investment process is the absence of a consistent mechanism of project evaluation that can guide investment decisions of the authorities. Out of more than 20 investment projects of over US$5 million identified, economic evaluations exist for only a handful. The government is now strengthening its technical group to establish the capacity to conduct proficient economic evaluations, including the calculation of relevant social prices to be used in all these evaluations. 60. Several principles should guide this process. FYst, all investments should undergo an economic evaluation. Second, no project with a negative net present value at social prices should be carried out; having a positive net present value at social prices is a necessary, but not sufficient condition to go ahead with an investment project. In Argentina, where the public sector faces significant financial constraints, it may be impossible to finance all projects with a positive net present value. Thus, thirn, a project ranking is needed. Resources would then be allocated from the highest ranked project down, until resources are fully and efficiently allocated. Recent improvements in investment planning now establish the basis for a multi-year program that would establish out-year priorities for budgetary funding. 61. Power. The annual investment budgets for 1992 of Atucha II and Pichi Picun Leufu were US$395 million and US$146 million, respectively. lbken together, the two absorb over 20 percent of the total investment budget of the national government (including central administration, special accounts, decentralized agencies and public enterprises), which was US$2.6 billion for 1992. Both of these projects have negative net present values at any discount mate over 12 percent. In the case of Pichi Picun Leufu, the Government contributions are very small and given the favorable conditions of fnancing, it should be completed. The completion of Atucha II should be postponed if financing cannot be obtained; as long as counterpart funds are scarce, any financing  - xvi - scheme for its completion should include the minimum Government contribution during the 1993-94. 62. Housing. The PONAVI housing program also appears uneconomical. Although no benefit-cost evaluation is available, there is good reason to believe that its NPV would be negative at reasonable discount rates. The program absorbed over US$900 million of resources in the budget for 1992 and has some serious flaws. An attractive and feasible option may be to phase out the program over the next two to three years. These funds have a high component of government saving, mainly because the FONAVI program does not attract any outside financing. 63. Possible savings from these measures would amount to some US$1.4 billion, and could be used for investments in road maintenance, acceleration of Yacyreta and Piedra de Aguila hydropower projects, and increased investments in worthwhile provincial health and education projects. Central Bank 64. Since the conversion of short-term domestic debt into 10-year BONEX bonds in January 1990, the Government has moved vigorously to shut off the sources of finance to the nonfinancial and financial public sector through the monetary program. The trade financing facilities were closed and the function transferred to the new trade bank, Bank of International Trade (BICE). Second, financing the social security system through the OPP account has been ended. Third, debt service on the public debt held by the Central Bank is now charged to the Treasury. Fourth, rediscounts to the industrial bank (BANADE) and the Housing Bank (BHN) were gradually closed between 1987 and 1990, and net rediscount flows to the other public banks have been negative since these banks are repaying the emergency infusion of liquidity they received during the January 1991 run on the austral. 65. These events have set the stage for improving the legal framework of the Central Bank and strengthening it as an institution. The passage of the new Central Bank Charter in September 1992 was a milestone in the creation of a modern monetary authority; the highest priority for Argentina is to implement the new Charter. The Charter provides the monetary authority with substantial independence, proscribe rediscounts--except for emergencies, and then only for limited periods against a pledge of the borrower's capital--and legally prohibits lending to the nonfinancial public sector. This is a necessary complement to the Law of Convertibility. 66. Administration and Management. Management should revamp the structure of the Board of Directors to relieve them of operational line responsibilities. As it stands, Board members play both roles of supervising the President and carrying out his mandate. This dilutes rsponsibility and compromises the advice a Board member must give its President. The Government should use the opportunity presented by the Charter to appoint people of stature in the financial community and invest them with the responsibility of ensuring that the goals of the Charter are faithfully attained by the President and his management. Management must also devote special attention to tasks that have a high cost if not handled properly and immediately, most notably the reconciliation of the balances with external creditor banks.  - xvii - 67. Accounting. Many changes carried out in recent years have significantly improved the Centiul Bank's accounting svstem. In particular, the recalculation of ,he end-1989 balance sheet and the elimination of forced investments and of the Monetary Regulacion Account helped to simplify the accounting system. Nevertheless, the present system is still severely deficient. Reconstitution of the accounting system must move in parallel with the reorganization process. The reconstitution of the accounting system rnust also be carried out with a view to ensuring that it generate the appropriate statistics for the Central Bank's new responsibilities in a timely way. The Central Bank's operations must be defined precisely along with the specific ways and means by which data will be entered into the accounting system. Specific personnel would then be responsible for recording designated transactions. The fundamental question is whether the present system can be salvaged or if the system should be entirely replaced. Along these lines, it is noteworthy that an external audit of Centml Bank accounts will be required by the new Charter. 68. Liquidation Function. The Government in September 1992 modified the Financial Entities Law to require that all future liquidation of bankrupt financial institutions be handled directly by the court system. This leaves on the on-going liquidations with the Central Bank, many of the liquidations are more than a decade old, yet are still time-consuming and costly. The Central Bank should accelerate efforts to finish the process as soon as possible. 69. Superintendency. Consistent with the new Charter of the Central Bank, the Government should: (i) consolidate the reform of the Superintendency of Banks by ensuring greater administrative independence and enactment of its upgraded salary and organizational structure; (ii) assign responsibility for issuing norms pertaining to banking regulation; and (iii) assign responsibility for the timely publication of financial indicators, including the balance sheets and income statement information as well as portfolio classification of banks. Also, (iv) the management relations between the Certral Bank and the Superintendency should be made clearer and more predictable; (v) more enforcement power should be uttributed to the Superintendency; and (vi) instruments used to evaluate commercial bank activities should be revised. Of particular concern is the need to reduce the incentives for large banks to take too many risks (too- big-to-fill policy). One possibility may be to tie bank supervision more directly to the amount of bank capital. Well-capitalized banks would be allowed to be the most diversified in financial services, since increasing the bank's own capital requirements is probably the most effective way of reducing moral hazard incentives. C. Conclusions 70. The Menem administration his made the most impressive progress in improving Argentina7s growth prospects of an; recent administration. It has done so by improving the fundamentals of public finance. These efforts have brought price stability within reach, and with it the possibility of enjoying sustained high economic growth. The next three years, however, will be as critical as the last three years. As the experience of other countries in the hemisphere has shown, only persistent, resolute and unrelenting pursuit of fiscal stability and efficient policies can realize a country's growth potential. Argentina has shown itself willing to pursue this course. I I I . , Ior. 11l *11.4 I 'l i - ' I . - 1 ,I .  CHAPIER 1. FINANCIAL INSTABILITY AND PUBLIC FINANCES A. Public Sector Deficits, Inflation, and Slow Growth I. Imbalances in public finance have been central to Argentina's prolonged economic decline. Once among the world's most prosperous economies, Atgentina has experienced slow economic growth since the 1940s. During the 1970s, the country's long-term growth rate slowed, and in the 1980s the country suffered from its longest period of stagnation in the century (Figure 1.1). Savings and investment rates fell precipitously from the 1970s until 1989 (Figure 1.2). Argentines, responding to the unstable macroeconomic environment, increasingly saved and invested abroad, labor productivity feUl, and poverty worsened. The value of the currency plummeted as the price level increased, and the ratio of public debt to GDP rose to nearly 100 percent. Figure 1.1 Figure 1.2 GOP Growth: Long Torm Trend Investment and envlng 1970-92 (Averago of Period) .o. Opp a 3csm go a~~~~~~~~~~~~~~l 16 , rwo m | ftUW4 SDl"?U 1mS0S4 mu.,,... jew,... 1670 1676 loe Ste 181 is" is" 16612  -2- 2. Underlying this economic Figure 1.3 performance were several macroeconomic Qobd Plscal Dofolt an Intlan and institutional distortions that marifested themselves in chronic public sector deficits and endemic inflation (Figure 1.3). Public . sector deficits in the late 1970s ranged from A 5-14 percent of GDP, and in the early 1980s surpassed 15 percent of GDP. Central Bank J losses, difficult to calculate in 1980-83, undoubtedly pushed the combined deficit to over 20 percent of GDP. After the return to constitutional democracy in 1983, public demands to control inflation were translated ,.,, 10 . .1.73 1979 199 1905 1.... 1992 into four major stabilization programs. All - - - of them failed to eradicate inflation, and a" Onk " oa each ended in. a more virulent inflation than the preceding one. The main reason for these failures was the inability of the Government to redress rapidly and permanently the structural deficit of the public sector. 3. The origin of the structural deficit was traceable to the post-war organization of the economy. Economic policy from the 1940s was used to propagate rules favoring the interests of successive private groups with access to power, and political competition drove the expansion of the state and the proliferation of implicit subsidies. By the early 1980s, public expenditures as a share of GDP surpassed 55 percent. Implicit subsidies to unionized labor took the form of high wages, guaranteed employment, and rigid rules governing hiring and dismissals. Subsidies to industry were embodied in highly protected markets, tax exemptions through special promotion regimes, subsidized credit (or even effective grants since many loans were not collected), subsidized inputs from public enterprises, and high, noncompetitive prices on sales to public enterprises. Housing contractors and selected middle class home buyers benefitted from enormous public subsidies through earmarked taxes and effective grants through the Housing Bank (BHN). Ibbacco growers benefitted from special taxes, as did the sugar growers, the merchant marine, and other small interest groups. Consumers, mainly in the urban middle classes, enjoyed below-cost tariffs from public enterprise and lax collection practices. Provincial governments could avail themselves of costless credit from the provincial banks, which the Central Bank reimbursed. The military enjoyed expanding budgets, especially in 1976-82, as well as management perquisites in state companies. By 1987-89, subsidies through the budget, tax exemptions, agricultural regulations, public enterprise tariffs, and central bank rediscounts were estimated to amount to some US$7 billion' roughly 8 percent of GDP. 4. The growth of the state and concomitant rents and subsidies were financeable during the late 1970s largely because of high private savings after the 1975/76 stabilization, and then the expanding Eurodollar market with low or even negative international interest rates. This permitted the Government to run debt-financed 1 See Annex 1.1 "Subsidies to the Pdvate Sector."  -3- deficits of 7-8 percent of GDP with rates of inflation between 200-300 percent annually for the second half of the 1970s. However, the sudden rise in real international interest rates and the abrupt end to voluntary foreign commercial bank credit in the early 1980s provoked a financial collapse, and placed additional pressure on the economy. The economy was forced to divert domestic savings into foreign interest payments. After the public sector took over much of the private debt in 1980-82, the larger public interest bill onily exacerbated the existing structural public deficit. 5. The public sector had difficulty extracting more resources from the private sector, since the ever-greater share of the combined public sector borrowing requirement had to be financed through the domestic financial system and, eventually, money creation (Figure 1.4). The private sector, in an effort to avoid the inflation tax, gradually withdrew its resources from the financial system and reduced its holdings of currency; this, together with the effects of inflation on real revenue collection, made the macroeconomy progressively more unstable in the 1980s, and weakened the instruments of monetary policy (Figure 1.5). Even though the level of the deficit fell from near 20 percent of GDP in the early 1980s to an average of about 10 percent in 1987-89, the base of the inflation tax had shrunk because efforts to reduce the deficit were not fast or permanent enough to convince the private sector that its savings in domestic currency would not be taxed by inflation. Inflation became high and unpredictable, and thus became the main impediment to the recovery of private savings and investment. The decade ended with two episodes of hyperinflation in 1989. Figure 1.4 Figure 1.5 Fbimnl of Om PUble Seor DOf Ratio ot Ml to ODP (Ca8hBt 10 EEICOW Ma eCWd . .. .. . .. .. .. .. . . .. . O e4 -N I@ UPe HO UN* 1990911I2re "R was s I  -4 - Macroeconomic Problems Confrcnting the Menem Administration 6. When the Menem administratiotn assumed office, it confronted three macroeconomic problems grounded in public finance. First, the economic team inherited public institutions that for years had incentives favoring spending uWthout incentives to mise revenues. The national administration, enjoying access to Central Bank financing for its bonds and resorting to arrears, had a reduced incentive to collect taxes. Other levels of government--the decentralized agencies, public enterprises, the social security system, and provinces--were not subject to effective budget constraints and were usually able to push their deficits back onto the Treasury and ultimately the Central Bank. Many public enterprises had evolved into nonaccountable fiefdoms, and the Treasury covered deficits through direct transfers and progressive assumption of their liabilities. Public banks were able to draw on rediscounts from the Central Bank. The capacity of the social security system to collect and record properly its revenues from high wage taxes diminished and it had little incentive to reform because it relied progressively more on earmarked taxes, central bank financing, and arrears to pensioners. Provinces, relying on revenue-sharing and special grants from the Federal Government, were able to increase expenditures, especially on employment and generous social security benefits; when federal transfers proved insufficient to finance expenditures, these governments borrowed from their provincial banks, whose deficits had been historically covered by the Central Bank. The private health insurance funds, which administered a compulsory public tax that collectively amounted to 3-4 percent of GDP, had no accountability to the public at large or minimal accountability to their beneficiaries. These institutional arrangements had important corollaries: the lack of responsibility, based on the absence of public accountability, manifest itself in decreasing revenues and ever weaker controls on spending. 7. This situation created a second problem: institutionalizing reliance on the inflation tax ultimately made the fiscal deficit endogenous and explosive. After 1988, the causal chain of fiscal deficits to inflation developed strong feedbacks from inflation to deficits. The first channel was through the well-known Olivera-Thnzi effect; inflation eroded real revenue collections because of lags in colections, a phenomenon that worsened at the higher average inflation rates of the late 1980s because evasion became easier as the currency lost meaning.2 A second channel was through tariffs of public enterprises, which typically fialed to keep pace with inflation. A third channel was the quasi-fiscal deficit of the Central Bank. Ibwards the end of the 1988 and 1989 stabilization episodes, asset holders became more fearful of losses, remonetization slowed, inflation accelerated, and nominal interest rates rose sharply, increasing the interest payments on the liabilities of the Central Bank; this more than offset interest receipts on assets, most of which were unlinked to domestic market rates. Finaly, financial markets, leery of inflation surges, responded to indicators of future inflation-- notably movements in the exchange rate, increases in public enterprise prices, and fiscal deficits--with rapid portfolio shifts against the austral that from time to time reduced the money base by 50 percent in a matter of days. 2 In 1988, for example, Tanzi losses were estimated to be 2.1 percent of GDP. See World Bank, Argentina: Tax Policy for Stabiization and Economic Recovery (8067-AR).  -5- 8. In 1989 these pressures became intense: collection lags mattered more because of higher average inflations, and rapid price increases hung a cloak of opaqueness over tax returns and evasion became pervasive. Public enterprise prices became the indicator of success or failure of a prgram, and so were keep frozen so long that they became sources of deficit. The Central Bank's quasi-fiscal deficit assumed greater importance in the Plan Primavera and Pisn Bunge Born, and financing the Central Bank's deficit became the principal source of money creation after domestic interest rates began to rise at the end of these programs. Finally, by the end of the decade, only professional market players dominated the market, heightening responsiveness of financial markets to increasingly skittish expectations of future inflation, and making the macroeconomy highly susceptible to even minor shocks.3 These problems were especially apparent around the end of each calendar year when the public sector required substantial financing for its heavy end-of-year payments; however, demand for financial assets decreased substantially as individuals closed out their asset portfolios in preparation for vacation. 9. By the advent of the Menem administration, the history of deficits had created the third problem: the state had become insolvent. Claims on state resources were far greater than its capacity to mobilize resources. The high ratio of foreign public debt to GDP (approaching 100 percent in 1989) was only one manifestation of insolvency; others included the unfinanced obligation of the social security system (which was not recorded in the fiscal accounts), estimated to be US$7-10 billion and rising by US$200 milion per month; excessive employment in the public sector with lifetime guarantees; and "acquired rights" granted to beneficiaries of subsidies, including promoted industries with tax credits of 10-15 years' duration. A priority for the Government, therefore, was increasing revenues, reducing flow claims on the Tlrasury-- wage payments and subsidies--as well as restructuring the stock of existing liabilities to foreigners, the financial system, social security recipients, and suppliers. 3 Rudiger Dombusch and Juan Carlos de Pablo formalized these relationships in a model designed to show the relationship betweeo inflation, growth, the budget deficit, and money creation under variots wacroeconomic and financial conditions. The model states: 7r= (OIg-yW/l-ftg); I:50g where ir is inflation, a is the velocity of money under noninflationary circumstances, g is the rate of growth, and P is the response of velocity to the rate of inflation. This equation states that (i) inflation will be less the higher the rate of growth because growth generates a demand for money; (ii) inflation wili be greater the larger the budget deficit; and (iii) the rate of inflation depends on the parameters for velocity; the higher the velocity of money (say, associated with dollarization), the greater will be inflation associated with any level of deficit; similarly, the higher the responsiveness of financial markets and velocity of money to inflation, the greater will be inflation. See Chapter 4 of Deuda Externa e inestabilidad macroeconomica en la Argentina (Buenos Aires: Editorial Sudamericana, 1988), especially pp. 77-79 and Appendix 11.  -6 - B. Main Problems in Public Finance: 1970-89 10. The insolvency problems which the Menem administration encountered were traceable to decades of public sector imbalance. The accounts of the public sector had not been in surplus in three decades.4 The public sector deficit averaged 14 percent of GDP in 1980-84, and fell to 8.9 percent in 1985-89 (Table 1.1). The noninterest or primary balance was in deficit by an average of 9 percent of GDP in the first half of the 1980s, improving to a deficit of 2.2 percent of GDP in the second half. These endemic deficits had their origin in an erosion of revenue capacity and an inability to contain expenditures. Revenues 11. The tax burden as a share of GDP, which had reached 19.5 percent of GDP in 1980, fell to 16 percent in 1989. But more important, this fall was accompanied by an increasing reliance on inefficient taxes that discouraged growth. The Argentine tax system was fairly sophisticated and efficient in the early 1970s; however, tax exemptions were granted for various purposes beginning in 1973. As time passed, inflation, combined with the lack of political resolve to enforce tax laws, progressively eroded the tax structure and administration. The tax system effectively collapsed during the 1989/90 hyperinflations. 12. In an attempt to maintain revenues as the tax system was eroding, the Government began to rely increasingly on inefficient but easily collectable taxes--so- called tax handles. The VAT became riddled with exemptions, primarily for industrial promotion. Revenues from the VAT, which reached a peak of over 5 percent of GDP in 1981, had fallen to under 2 percent in 1989; their contribution to total revenues fell from some 23 percent in 1980-84 to under 15 percent in 1989. The income tax withered to less than one percent of GDP. The tax handles included export taxes, taxes on bank checks, and excessive energy taxes. To complicate matters, the Executive agreed to earmark selected taxes to enlist support from selected regional or special interests when negotiating tax packages through Congress, and these reduced the flexibility of the Treasury to allocate resources. 13. The decline in revenues from efficient taxes (VAT and income taxes) reflected three factors: improper indexing, tax administration and exemptions. Income tax receipts suffered particularly from the inappropriate definition of the inflation adjustments for loss carryovers as well as tax exemptions for income from interest and dividends. Improper indexing of other taxes also lowered real receipts in inflationary times, leading to a procyclical bias in revenue shortfalls. 4 There are difficulties in comparing public sector figures across time, because of variations in accounting. For time series information on fiscal accounts, see FIEL El Gasto Publico en la Argentina, 1960-1988 (Buenos Aires: Fundacion de Investigaciones Economicas Latinoainericanas, 1990).  - 7 - Table 1.1: Argentina - Fiscal Accounts of the Consolidated Public Sector, 1983 - 1992 (Accrual basis, as percent of GOP) 1983 1984 1985 1988 1987 1988 1989 1990 1991 1992e Current Revenue a/ 19.3 22.4 23.1 21.7 20.0 19.1 17.6 17.7 20.4 25.0 Tax Revenue 15.7 19.1 18.7 18.6 17.8 16.8 16.3 16.6 19.1 23.8 DGlandCustomsRevenue 11.0 16.5 15.1 14.6 14.0 12.1 13.0 11.5 13.5 15.9 Social Security Revenue 4.7 2.6 3.6 4.0 3.9 4.7 3.3 5.0 5.7 7.9 Non-tax Revenue 3.6 3.3 4.4 3.1 2.2 2.3 1.3 1.1 1.3 1.2 Current Expenditures 28.0 24.4 25.2 23.5 23.4 23.1 19.9 21.6 21.8 23.7 Personnel 4.8 4.8 4.1 3.6 4.1 4.1 3.4 4.1 3.9 3.6 Goods and Services 2.9 1.9 2.2 2.0 2.1 2.0 1.6 1.4 1.3 1.6 Transfers 14.5 12.7 13.5 14.1 13.8 14.1 11.6 13.1 14.5 16.8 Provinces 7.6 5.9 6.1 6.7 6.6 7.0 6.1 5.7 7.0 8.2 Social Security 6.1 5.6 5.6 5.5 5.1 5.2 3.6 5.7 6.0 8.2 Others 0.8 1.2 1.8 1.9 2.1 1.9 2.0 1.7 1.6 0.4 Interest Payments b/ 5.8 5.0 5.4 3.8 3.5 2.8 3.3 3.1 2.1 1.7 Domestic c/ 0.9 0.8 0.7 0.3 0.5 0.4 0.2 0.5 0.3 0.1 Extemal d/ 4.9 4.2 4.7 3.5 3.0 2.4 3.1 2.6 1.8 1.6 Public Enterprise Non-interest Savings -0.1 0.6 1.0 1.9 1.8 1.0 0.9 1.2 0.3 0.8 Current Revenues 11.0 10.5 13.6 12.1 11.8 12.8 12.8 8.8 6.7 6.0 Current Non-interest Expenditures 11.1 9.9 12.6 10.1 9.9 11.8 11.9 7.6 6.4 5.2 Savings -8.8 -1.4 -1.1 0.1 -1.5 -3.0 -1.4 -2.7 -1.1 2.1 Capital Revenue 0.2 0.2 0.2 0.1 0.1 0.4 0.6 0.2 1.7 1.3 Capital Expenditures 6.8 5.1 4.5 4.4 5.3 6.0 3.9 2.6 2.3 1.7 General Government 2.9 1.6 1.5 1.6 1.7 1.5 1.0 0.8 0.7 1.2 Public Enterprises 3.9 3.6 2.9 2.8 3.6 4.5 2.8 1.9 1.6 0.5 Non-Financial Public Sector Balance -15.4 -6.3 -5.4 -4.2 -6.7 -8.6 -4.7 -5.1 -1.7 1.7 Quasi-fiscal Balance of Central Bank e/ -1.1 -2.5 -2.8 -1.6 -3.4 -1.4 -5.8 -1.0 -0.6 -0.2 Overall Balance -16.5 -8.8 -8.2 -5.8 -10.1 -10.0 -10.5 -6.1 -2.3 1.5 Memo: Primary Surplus -9.6 -1.3 0.0 *0.4 -3.2 -5.8 -1.4 -2.0 0.4 3.4 Operational Primary Surplus f/ -9.8 -1.5 -0.2 -0.5 -3.3 -6.2 -2.0 -2.2 -1.3 2.1 Net Federal Expenditure g/ 36.0 31.4 31.5 27.5 30.2 29.4 28.7 24.0 24.4 24.8 Provincial Revenue, lncl. transfers 11.6 10.4 10.8 11.2 8.0 10.3 9.4 9.0 10.3 13.2 Provincial Expenditure 11.4 11.9 11.4 11.1 12.9 12.3 10.6 13.2 13.5 12.8 Health Funds Expenditures h/ 4.4 4.1 4.3 4.4 4.6 4.7 3.8 3.8 4.2 4.7 Total Non-interest Expenditures 48.4 44.5 46.4 43.1 46.1 48.1 40.7 40.0 39.1 38.2 Total Expenditure, incl. quasifiscal balance of BCRA V 55.3 52.0 54.6 48.5 53.0 52.3 49.8 44.1 41.8 40.1 a/ Includes coparticipated revenues. b/ Interest payments of the enUre Federal Government. c/ Real component of domestic Interest payments for 1983-1991; 1992 is nominal due to return to stability. d/ Accrued interest due. el Real eamings on assets less real Interest costs; IMF definiton, 1983-87; IBRD definiton 1988-1992 (see Ch.13) f/ Primary surplus less capital revenue. g/ Includes non-interest current account of the public enterprises and quasi-fiscal balance (- = expenditure). h/ 1983-1987 from FIEL "Gasto POblico" report (1988); 1988-1992 based on Bank staff estimates. U Gross expenditure of national government, public enterprises, provinces, health funds and quasifscal balance of the Central Bank. Source: Secretary of Finance; Executed Budgets, 1983-1991; Cash Basis, 1992. 1/29/93 10:40AM [BUD92.XLW]BUDCON.XLS  -8 - 14. The capacity to administer efficient taxes eroded with inattention to management and systems development early in the decade and the sharp deterioration in public sector salaries after 1984. The General Tax Office (DGI) had an inadequate tax roll, a low rate of inspections and audits, a low level of efficiency in processing returns, and low rate of collection per audit. In 1989, an audit that cost the DGI on average US$800 produced US$35 in new revenues. The customs administration also became less reliable and effective in the 1980s. 15. The use of tax expenditures in support of industrial activity beginning in the late 1970s was pernicious to revenues. Fiscal incentives for industrial promotion were built around Law 21608 of 1977 to promote industrial investment and supporting the creation of industries in less developed regions of the country. Additional laws expanded the incentives for investment and production in Tierra del Fuego and in four provinces.5 Inadequate control and inspection have led to widespread abuses and tax evasion. The system engendered fiscal losses without significant employment effects. The fiscal cost of the national and regional promotion schemes as well as the scheme for Tierra del Fuego was ectimated to have been as much as 1.0 percent of GDP in 1989. Expenditures 16. Driven by powerful interest groups with minimal accountability to the electorate, total expenditures of the nonfinancial public sector as a percent of GDP increased from a level of slightly less than 30 percent in 1966-70 to a peak of over 55 percent in 1980-83. The stop-go austerity programs of the 1980s produced temporary reversals of these trends, but no sustained reduction. Noninterest expenditures fell by five percentage points of GDP to 1986, only to surge again as mid-term elections approached in late 1987. Expenditures were compressed again in 1988-89--this time by seven percent of GDP--mainly by accumulating arrears in social security and denying resources to the provinces (which in turn accumulated arears with workers and suppliers, and borrowed from their banks). Efforts at stabilization tended to contract those expenditures that were least objectionable politically--investment, the wage bill of the civil service, other public expenditures. The 1980s left public expenditures plagued with both process and composition problems. 17. Process Problems. The inability to control expenditures was the result of: (i) a fragmented fiscal administration with perverse incentives, including proliferation of decentralized agencies, unclear financial relations with the provinces, and overearmarking of revenue streams; (ii) the complete breakdown within the budgetary process; and (iii) the institutional failure to properly control expenditures. Fragmentadon with perverse incentives meant that most public expenditures occurred outside the direct control of the Executive (i.e., the Secretary of Finance), instead residing with the decentralized agencies, special accounts, public enterprises, provinces 5 The fiscal incentives for industrial promotion were awarded through six different instruments: (i) exemption from import duties and VAT purchases on capital goods; (ii) deferral of tax payments by investors up to a certain percentage of the amount invested; (iii) exemption from profit taxes; (iv) exemption from capital taxes; (v) exemption from the VAT; (vi) exemption from the stamp duty; and (vii) exemptions for suppliers of promoted firms.  - 9 - and social security funds. In 1992, for example, the Secretary of Finano;e had direct responsibility for only 20 percent of all spending--and one-quarter of this was interest payments. At the same time, the Federal Government assumed a greater responsibility fcr providing resources, either through taxes or the Centrl Bank. As the various components of government reached the limits of their budgets, they customarily arranged for ad hoc, discretionary bailouts from the central government or Central Bank--financed ultimately from the inflation tax. 18. The budget process itself weakened under the weight of unstable macroeconomic conditions. Cycles of inflation and austerity forced the Tlreasury to manage short-term flows on the basis of the immediate priorities of continually changing quarterly fiscal targets rather than an agreed budget. High and variable inflation soon rendered budgets prepared in nominal terms me-ningless. The budgetary process itself was plagued by several other problems, including the omission from coverage of important sources of expenditures (e.g., public enterprises); absence of budget programming and therefore of a regular programmatic review of public expenditures, oriented towards improved resource reallocation under severe resource constraints; ex- ante and ineffectual control of budget execution; inconsistent accounts and the absence of timely budget processing and therefore weak senior-level monitoring, and unenforceable reporting requirements; the breakdown of the public investment planning process and the absence of a link to the budget. The very institutions of public financial management were inadequate.6 19. In this environment, the expenditure control strategy of the Alfonsin Administration after 1987 was to limit the access of the decentralized public sector to the Treasury and Central Bank--attempting to force each component of government to put itself in balance. Thus, the public enterprises were to have been put in balance by requiring the surplus companies to cross-subsidize the deficit companies, in exchange for taking over the service burden on commercial bank debt; the provinces were taken out of the consolidated public sector accounts with the passage of revenue sharing legislation, and the social security system was to be made financially independent. This strategy necessarily entailed distortions--especially in the cross-subsidies in the public enterprises and in the centrl government absorbing a disproportionate share of the initial expenditure reductions and liabilities of the public sector. This effort ultimately failed--the decentralized components pressed claims to obtain emergency financing via the budget, provincial banks, and even issuance of quasi-money by some provinces. 6 The institutions of fiscal control were weak. The accounting function (National Accounting Office-CGN) was not fully developed, and accounts were inconsistent because there were no accounting norms for the public sector as a whole; the internal control function--expenditure recording--in the Executive was only effective for public enterprises (General Accounting Office for Public Enterprises-SIGEP) und partially for procurement in the rest of the public sector (National Court of Accounts-TCN); and there was no external auditing because there was inadequate internal control. The control system emphasized formal decisions on an e,x-e basis, instead of following a modern approach, which implied ex-post performance control measured against an approved budget. It also did not separate the three basic functions--accounting, internal registration/control, and external auditing--that have to be independent in a modem institutional structure on control. Finally, the TCN was charged with judicial responsibilities for prosecution of public fraud cases that should be the sole responsibility of the judicial branch.  - 10- However, it did begin a process to regularize accounts and institutionalize fiscal responsibility. 20. Composition Problems (Economic Classification). As austerity programs began to take hold in the late 1980s, the fragmentation of spending authority forced a disproportionate compression on those elements securely in the control of the Treasury--wages, service quality, and investment of the Federal Government. This form of adjustment distorted the composition of expenditures substantially over time as seen through an analysis of expenditures by economic classification. (A functional analysis is discussed below.) The aggregate wage bill and investment fell as a share of the total to make room for a relative increase in interest payments and transfers to nonfederal components of government--namely, the provinces, public enterprises (primarily railways), and social security. 21. The wage bill of the national administration declined from about 4.9 percent of GDP in 1980 to about 3.4 percent in 1989, a period when overall employment in the national administration increased and GDP was contracting. This pattern of adjustment eroded the capacity of the Government to perform its core functions as well as exacerbated existing weaknesses in its budgetary capacity. During the 1980s, the Federal Government increased the number of public emplovees by 36 percent between 1980 and 1990 from about 495,000 to about 670,000 workers (see Annex Tables 3.1-3.7).' By 1990, average real wages had fallen to under 35 percent of their January 1984 levels, the peak for the decade. The salary compression ratio--the ratio of the highest to lowest salary--had fallen to less than 3:1 by February 1990 compared with historical levels of 10-12:1. Provincial public sector employment exhibited the same pattern with even greater distortion. 22. By 1990, the Government could not attract qualified managers and technicians, had limited staff capacity to perform on-going programmatic functions (let alone design and implement broad reforms), and could not adequately monitor policies for compliance and effect. More important, limited human resources were badly deployed across an overextended public sector still designed with a heavily interventionist and market-regulating legal framework. Morale was low, and the average civil servant worked only a few hours a day because of the need for part-time work elsewhere and lack of supervisory control. 23. At the same time, the capacity of the Government to supply its workers with goods and services necessary to perform their duties had fallen: teachers worked without adequate suppliers, hospitals were inadequately supplied and maintained, and maintenance throughout the public sector deteriorated. The balance between non-wage operating costs and wages fell to about 15 percent, down from previous levels of 35 percent in the 1970s. This ratio improved slightly in 1992 because of the general improvement in public finances and administrative reform. 7 In addition, employment in the public enterprises is about 300,000, in the official banks about 33,000, and employment in the provincial governments is estimated at about I million (excluding nonconsolidated municipalities and provincial corporations) (see Annex Table). Also, the military has enlisted personnel of 86,000, paid through the budget.  - 11 - 24. Almost three-quarters of noninterest federal expenditures shown in Table 1.1 were transfers to the provinces, public enterprises, social security and other. Transfers to the provinces were ad hoc and somewhat discretionary during the mid- 1980s, but the coparticipation law enacted in 1988 required the Federal Government to transfer automatically 58 percent of selected taxes to the provinces. This primary distribution formula was significantly higher than at any time in the history of the Republic, and much higher than tie 34 percent prevailing in 1980-84.8 The shift in the tax base toward more efficient taxes also shifted the base in favor of coparticipated taxes. As a result, transfers to the provinces rose from an average of 6.5 percent of GDP in 1983-85 to over 8 percent in 1992. 25. Transfers to the public enterprises were primarily to subsidize the operating losses of several money-losing enterprises, most importantly the railways. For most of the 1980s, enterprises enjoyed considerable autonomy in planning and budgeting, and deficits would be covered by the Treasury; subsidies varied inversely with stabilization programs because most programs froze enterprise tariffs, and managers bargained over the transfers and sought federally guaranteed loans from suppliers that would later revert to the Federal Government to pay. 26. The social security system was massively in deficit throughout the 1980s. This deficit was even larger than that shown in the fiscal accounts because the arrears were not officially recorded or acknowledged until much later (1992). Revenle collections were poorly administered and benefits were generous. Other transfers were military pensions, universities and private education, and the housing program. 27. Public investment during the expenditure compression of the 1980s declined to its lowest level in history. From 5.5 percent in 1983-85, public investment as a share of GDP fell to under 4 percent in 1988. Investment in the Federal Government--roads, schools, hospitals, power--fell especially precipitously since their resources were linked more closely to tax performance. Investment spending in the public enterprises also declined sharply, but in response to their deteriorating savings performance and shrinking borrowing capacity. As a consequence, the quality and quantity of publicly provided goods and services greatly deteriorated. Since 1990, the privatization program has partially relieved the public sector of the pent-up demand for public investment. The Quasi-Fiscal Deficit 28. After its takeover of private debt in 1980-82, the Central Bank assumed the external liabilities of several failed banks as well the expenses of liquidation. In addition, the Central Bank provided subsidized exchange rates for external payments, which added to its losses. After 1985, the Central Bank began to finance the repayment of government bonds, to permit rediscounts to public banks that effectively financed fiscal expenditures (in the form of provincial expenditures or subsidies to housing and industry), and, of lesser importance, to finance an increasing float with the social security system. The Central Bank also absorbed losses associated with trade financing. 8 See World Bank, Towards a New Federalism, May 1992, Chapter 2.  - 12 - All these efforts produced a hugely negative capital position; writing in 1989, the current president of the Central Bank, Mr. Roque Fernandez, estimated the recorded and unrecorded losses of the Central Bank up to 1990 to be about US$67 billion. Annual recorded losses averaged 2 percent of GDP in 1983-86 and 3.5 percent in 1987-89. 29. Financing these quasi-fiscal expenditures required funds. The Central Bank increased demand for its liabilities through ever-higher legal reserve requirements and "forced investments" from the commercial banking system. It also sold its own bonds. These mechanisms in 1987-89 resulted in a substantial debt to the financial system that in itself was destabilizing because of the explosive interest bill. Since its asset portfolio was built on fixed interest loans (many of which were to the Housing and Industrial Banks and were thus nonperforming) and its liabilities composed mainly of forced investments bearing market interest rates, high real interest rates and/or high inflation widened the domestic quasi-fiscal deficit. Towards the end of stabilization episodes based on fixed exchange rates, real interest rates rose as financial markets began to fear devaluations, the interest bill of the Central Bank became an endogenous and destabilizing source of money creation.9 This mechanism eventually led to the coHlapse of the Plan Primavera (August 1988-February 1989), the Plan Bunge Borne (July 1989-December 1989), and ended the Central Bank's capacity to carry out monetary policy. C. Post-1989 Structural Reforms in Public Finance 30. The incoming Menem Administration enacted a series of structural reforms over 30 months that recast the basis of public finance. The Government undertook difficult-to-reverse reforms in the legal framework, institutions, and policies. Gradually, these have begun to change Argentine culture. This process, not unlike a bankruptcy procedure, was characterized by three sets of actions. First, the Government improved revenue mobilization to increase the quantity and quality of federal revenues. Second, it enacted expenditure reforms to reduce the scope and size of government through administrative refiorms that reduced public employment, undertook privatizations to ensure a permanent end to subsidies through public entities, and implemented fiscal decentrlization to make revenue-sharing with the provinces transparent and bring service delivery closer to local constituencies. Finally, the Government is in the process 9 These interest rate rules and the quasi-fiscal deficit generally are analyzed in Chapter 4 of Argemtina: Reforms for Prce Stability and Growh. Washington: World Bank, 1989. See also L. Barbone and P. Beckermnan, "Argentina's Quasifiscal Deficit," October 1988, and P. Beckerman, "Public Sector Debt Distress in Argentina," World Bank, WPS 902, May 1992.  - 13 - of restructuring its liabilities with domestic and foreign creditors to adjust them to serviceable levels. Other reforns have aided the process of activating efficient private investment, notably trade and financial sector reform. '0 Revenue Mobilimtion 31. The Government improved Figure 1.6 revenues by broadening the VAT, extending and TaT R@owRnu its coverage first to all goods in February 1990, and later to services in November 1990. It also adopted an assets tax in 1990. a. The Government also improved the efficiency of the tax administration-- establishing a control system for the latest taxpayers in February 1991 and rebuilding the tax rolls through more than 400,000 site inspections in late 1990. The tax penalty law, adopted by Congress in 1990, provided e v much-needed sanctions for tax non- ! _ n8||| To* .-- "mm" compliance. The tax package of February 1 -1696NN awmmeTtu in..sw, n eM 1991 improved the quality of the revenue | -' mobilization effort because it eliminated many of the so-called tax handles--easy to collect but growth-inhibiting taxes, such as export taxes, taxes on financial transactions, and several low yield taxes. These efforts cumulatively produced dramatic rises in tax collections (Figure 1.6). 10 The fiscal reforms had important antecedents. In retrospect, the mid-term elections of 1987 marked a turning point for public finance. By that time, demand management approaches had failed, the fiscal deficit had mushroomed, and the Plan Austral was unsalvageable. In the last two years of the Alfonsin Administration, the Government took several significant steps down the path of reform later accelerated in the Menem years. It began--slowly at first-to change incentives facing the decentralized public sector. Efforts included the revenue sharing law, which purported to eliminate discretionary transfers to the provinces and was implemented in 1988; the idea was to compel the provinces to live within budget and preempt requests for unbudgeted federal revenues (although the new law entailed a historical high in lost revenues. Second, interest rate liberalization in 1987-88, coupled with the payment of interest on mandatory reserves at the Central Bank, was designed to end the sequestration of resources from the financial system, and improve intermediation by reducing spreads; attaching a cost to reserves would supposedly discipline the Central Bank's practice of increasing reserve requirements to finance the nonfinancial public sector and its own deficit but the cost of interest on the reserves added to the fiscal deficit. Third, the Government ought to end disguised fiscal subsidies via rediscounts to official banks as a way to discipline the provinces, the industry and the housing banks. Fourth, the Government sought to discipline the decentralized components outside the Treasury--social security, public enterprises, and the provinces-by setting up clear mles circumscribing access of these agencies to the federal treasury and to Central Bank finance. Incipient efforts at opening the economy also were begun in 1987/88.  - 14 - Expenditure Reduction and Restructuring 32. Administrative Reform. Because the wage bill dominated expenditures, the Government reduced the federal Figure 1.7 bureaucracy in 1990-92. Federal employment was cut by more than 103,000 Nutlonl Admlnltratlon Employment Le in 1991-92, a total decline of 15 percent since 1990; in addition, 284,000 teachers and health workers were transferred to the provincial governments (Figure 1.7). Rather than simply lay off workers, this Goo I effort was based on a ministerial reorganization that focused on federal -600 X X X Xactivities related to core objectives, and improvements in the civil service system through an improved salary structure and m0o X other efficiency measures. These efforts allowed the Government to increase average salaries, salary dispersion, and still reduce toae 1080 1000 1001 1002 its wage expenditures as a share of GDP and by almost 10 percent in real terms in 1992 (Tkble 1.2). The Government improved its control of public expenditures in earnest beginning in February 1991; one indication was the reduction in spending jurisdictions by more than 50 percent between 1990 and 1992; the number of earmarked accounts fell from 152 in 1989 to 59 in 1992. The Government also enacted a law of Public Financial Administration in September 1992 that will revamp national fiscal accounting, improve expenditure control systems, and establish modern auditing systems for public expenditures."' 33. Public Enterprises. The new Government adopted an accelerated timetable upon taking office in July 1989 for privatization or partial divestiture of nearly all its enterprises. The program's objective was reducing the budgetary burden of the enterprises on the Tleasury, making the firms more competitive, and increasing the volume and efficiency of new investment. The Government sold two television stations, ENTel (US$214 million plus US$5 billion in external debt) and Aerolineas Argentinas (US$260 million plus US$2 billion in external debt). Remaining minority government shares in the new telephone company were sold for US$1.2 billion in early 1992. The Government began a comprehensive restructuring of the petroleum industry--the first in Latin America--by auctioning off areas of YPF (realizing by end-1991 US$1.6 billion in cash). It granted road and railroad concessions to the private sector and restructured the railways, including the privatization of long distance cargo lines, and rduction of 15 percent of the railway's work force. The Government intends to privatize most of the remaining public enterprises in 1992, including shares in the petroleum industry, 11 The World Bank supported reforms of both revenues and expenditures of the Federal Government as well as those of the Central Bank mentioned below with a US$325 million Public Sector Reform Loan (PSRL) (cofinanced by the IDB) and a US$23 million Technical Assistance Loan in July 1991.  - 15 - TABLE 1.2: ARGENTINA - INDICATORS OF ADMINISTRATIVE REFORM: NATIONAL ADMINISTRATION 1N0 1991 1992 Total Reduotio Lay-olft a Tranrfers National Administration Personnel 671,479 581,539 284,215 387.264 103,469 283,795 AdministratIve Reform Program 341,021 267,081 227.677 113,344 90,913 22,43 Central Administration 123,646 87,596 61,276 62,370 39,939 22,43 Decentralted Agenoles 144,600 126,183 123,391 21,209 21,209 Other National Administratlon 72,775 53,302 43,010 29,7W6 29,765 Other Programs 330,458 314,458 56,538 273,920 12,586 261,32 Memo: Armed Forces (A.F.) and Conscripts 131,297 121.946 112,594 18,703 18,703 National Administration and Armed Forces 802,776 703,485 396.609 405,967 i22,172 283,795 Gross lay-olft (exc. tax agencies, Police and A.F.) 121,600 Wages Wage Expendiures (1992 US$ Million) b/ 3,229.49 3,555.16 3,443.05 Wage EpendiRtres (% of GDP) 3.05 2.62 2.23 Implict Average Wage (1992 US$) c/ 4,742 6,320 9,538 Ratlo of Highest to Lowest Salary d/ 3.5 6.0 10.0 Senior Govemment Salary (Percent of Private Sector Equivalent) el 20.0 33.3 74.1 Administation Structure Spending Jurdsdictions 39 30 18 Govemment Agencles 38 38 30 Special Aocounts 93 86 59 Structure of CMI Service SecretarIes 47 36 43 Subsecretarles 99 29 62 National Dirertorates 304 185 187 Source: Ministry of Economy, Presidential Address to Congress (5/1192) and Annex Table 3.1 at Total net lay-ofs. bl Net of indemnnations, preMislons for early retirement and changes In pay-scales; Includes payroll taxes, overUme, 13th month salary and other benefts. cl Estimated considerng Budgeted National Administation Personnel plus Afmed Forces personnel (excluding cocripts; Including health funds till 1992). d/ Data from March 1990, December 1991, March 1992, for SINAPA regime. at Preliminary figures: 1992 are projected.  - 16 - defense industries, the nation's largest Figure 1.8 distributor of electricity Table 1.2 Indicators vm. from Priatiz.lorw of Administration (SEGBA), ports and (US* million) maritime transport, reinsurance, and the g0o0 entire power sector. Capital revenues from privatizations have provided an important . source of transitional finance to the fiscal accounts (Figure 1.8).12 34. Decentralization. The 1000 . Government also sought to restructure fiscal relationships with the provinces. Building noa on the coparticipation law of 1988, which fixed the share of federal revenues o _ _ i _ _ automatically transferred to the provinces at 58 percent, the Government sought to limit macro instability arising from deficits in the provinces. This entail limiting the resources provincial governments could access from their provincial banks by progressively terminating Central Bank lending to provincial banks. It also meant reducing extra-coparticipation transfers through the budget. Finally, it meant transferring classes of expenditures to provincial administration in 1992, notably secondary education and hospitals. 35. The aggregate decline in total public Figure 1.9 spending was mainly owing to the efforts at the federal level in the national PEublo o M of GOP) administration and privatizations. Automatic transfers to the provinces and social security increased in 1991/92 and go thus prevented aggregate expenditures from 40 falling more; but these--at least initially-- helped to alleviate latent structural deficits eo in these areas. Overll, total expenditures to are 15 percentage points of GDP lower than in 1980, and 10 percent lower than in 1983, la the time of return to constitutional democracy (Figure 1.9). Including the 0 w1oo la" MM MY "so 1000Wm1look provinces and health funds, public _ Ada C nt. Mi SZI Ent. b* . expenditures fell from near 60 percent of - ,Itb GDP in the early 1980s to about 40 percent at present. 12 The World Bank supported this effort with the approval of a US$300 million Public Enterprise Reform Loan (PERAL I) and a US$23 million Technical Assistance Loan in February 1991, as well as with the PERAL n of US$ 300 million approved in December 1992.  -17 - 36. Present levels of public Fge 1.10 spending are below the average for the Federal___ev_nue_and_Ex__d_tures industrial countries, and are comparable to t Federal Revenue and Expenditures middle income countries. The average 40 level of Federal Government expenditures for industrial countries was 28.6 percent of K GDP in 1985; middle-income countries \ averaged 27.5 percent. Argentina's S =,*, federal spending was about 25 percent of GDP in 1992. Combined federal and state (provincial) spending in six OECD countries--the US, United Kingdom, F-ance, Germany, Sweden and Japan-- averaged 47 percent in 1985, with a range us of 33 (Japan) to 65 (Sweden).'3 In .Agentina, total public sector spending was *, m ma. 40 percent in 1992. Nonetheless, this conclusion must be somewhat tempered by public expenditures not included in the Argentine numbers--the quasi-fiscal deficit, tax expendituies for industrial promotion, and higher-than-OECD average tariffs. 37. Thken together, the structural measures facilitated an increase in revenues and a decrease in expenditures. On the basis of reforms enacted in 1990, revenues jumped sharply beginning in 1991. Expenditures fell sharply after 1988, especially noninterest expenditures (shown in Figure 1.10 on a net basis). Restructuring Domestic and Fbreign Debt 38. The Government's final step in dealing with its insolvency involved restructuring its financing obligations. The Government had financed its deficit through borrowing from the financial system (US$3.5 billion) and by accumulating arrears to external creditors (US$8 billion), social security pensioners (estimated at US$12-14 billion), and others (US$4 billion). Each of these required major initiatives. 39. Quasi-Fiscal Deficit and Debt with the Fnancial System. Although the Government ended new rediscounts to the housing and industrial banks as well as liberal rediscounts to provincial banks in 1988i, the Central Bank continued money emission to finance the lreasury as well as its own deficit. In the fourth quarters of both 1988 and 1989, the rising interest bill of the Central Bank drove up the donl stic interest bill and widened the deficit, such as occurred with foreign interest payments in the early 1980s (Figure 1.11). In late December 1989, faced with an exploding interest bill, rising Central Bank deficits and the renewed threat of hyperinflation, the Government took the drastic action of converting the domestic, short-term (mainly seven 13 See World Bank, World Developnwmnt Report, 1988, Washington: World Bank, 1988, pp.45-46.  - 18 - Figure 1.11 day), interest-bearing obligations of the Public Sector Primary Surplus Central Bank into US$3.5 billion of 10- and Total Interest 1970-92 year external Treasury bonds (BONEX). es of cap This virtually eliminated the Central Bank's quasi-fiscal deficit and the 0 monetary emission necessary to finance Tots nt it--at the cost of penalizing savers and e erasing confidence in the financial system.14 | 40. External Debt. In April N--a,7hs,o 1988, the Government suspended -Tr1s O ' 1 'S8 19fS, payment on its external debt to commercial creditors. By 1992, it had accumulated US$8 billion in arrears as part of a US$33 billion medium-term commercial bank debt. Public external debt was US$61 billion (Figures 1.12). The Government reinitiated partial payments in June 1990, and established a consistent track record of paying about 25 percent of interest due. At the same time, it allowed external debt to be used in exchange for the sale of assets, which reduced the debt stock by US$7 billion. The measures, together with the progressive improvement in fiscal fundamentals in 1990/91, allowed the Govermment to begin negotiations with commercial banks on a debt reduction deal. In December 1992, Figure 1.12 the Government achieved an agreement mi ,iw a with the banks. The agreement formalizes arrears in a 12-year s uncollateralized bond at LIBOR with a 3- year grace period, after a US$700 million downpayment; it would exchange existing debt for either a collateralized par bond with a fixed interest rate (beginning at 4 percent and rising to 6 percent by the sixth year), or a collateralized discount bond at 65 percent of face value at LIBOR; new collateralized bonds would have a 12 month rolling interest guarantee. The . ml- agreement, although increasing the cash r1 [Fti ID . I payment, will end the accumulation of arrears and provide for debt reduction 14 This is discussed in Chapter 12.  - 19 - similar to Mexico's. Debt service payments would begin at US$1.5 billion in 1993 and rise to US$3.0 billion by the end of the decade."5 41. Arrears to Pensioners and Suppliers. For the last decade, the Government has paid only about half the legally mandated pension owed to social security recipients. Arrearages were not recorded in the fiscal accounts, but are estimated to be US$7-10 billion, and accumulating at a rate of US$200 million per month. Also, the Government accumulated arrears in 1990 with suppliers through the formal suspension of payment for goods and services already provided. In addition, the health funds have arrears with their service providers that will also result in new debt. Finally, the Government, as part of its income tax reform, suspended the poorly designed loss-carry-forward deductions for the corporate income tax, with the agreement to issue some US$1.5-2.5 billion in compensatory bonds. 42. To settle these claims, Congress authorized the Government to issue consolidation bonds (BOCONs) that will have terms or 10 or 16 years (with shorter terms for social security recipients) and a five-year grace period on principal and interest. It is estimated that the Govermnent will have to issue US$15-20 billion. Suppliers and pensioners will have the choice between a bond denominated in local currency with a domestic interest rate and a bond denominated in US dollars at LIBOR. The service of the debt will be capitalized until 1997, but payments on the order of US$3 billion will be required in the last years of this decade. Supporting Sectoral Reforms: Trade and Flnance 43. Trade Regime. After October 1988, the Government began opening the economy to import competition, a process accelerated under the Menem Administration. Quantitative restrictions (QRs) were reduced from about 50 percent of domestic Figure 1.13 production coverage to 7 percent by late UVL WEXTERNAL PROTOTBON 1990 (Figure 1.13); the ad valorem tariff . band was narrowed from 0-115 percent to 0-24 percent, with an average rate of about 18 percent; and the production coverage of industrial export taxes was reduced to 30 f r" percent. In February 1991, the tariff band was reduced further to 0-22 percent, the w Government announced that specific duties would be converted to ad valorem tariffs, ao and the number of tariff rates was reduced to three (i.e., 0, 11, and 22 percent). In October 1991, the statistical tax on exports 0ow W 1 t ; was eliminated through the decree on VW. .w .u.. . deregulation. 15 The financing implications are analyzed in Chapter 13.  - 20 - 44. The deterioration in the tade balance, a consequence of massive capital inflows and fixed convertibility that deprived the Government of the exchange rate instrument, compelled the Government to use commercial policy to achieve an effective devaluation. In October 1992, the Government announced measures to increase the competitiveness of exports in the form of partial tax rebate; on average, rebates would be raised from 8 to 13 percent. The Govermment also decreased slightly the average tariff on imported goods but increased the across-the-board statistical tax from 3 percent to 10 percent. Thus, while nominal average ad valorem taxes fell slightly, the average effective tariff rose from 14.8 percent to 19.8 percmnt. At the same time, it lowered the maximum ad valorem tariff from 35 percent to 20 percent, thus narrowing tariff dispersion. 45. Financial System. The publicly-owned housing and development banks, long subject to political influence and dependent on government financial support, are undergoing major restructuring. The National Development Bank (BANADE) and the National Housing Bank (BHN) closed their branches in March 1990 and reduced their staff by almost 75 percent. The Government is now considering liquidating BANADE and closing BHN's remaining retail functions. The Government also is moving to form a "second-tier" bank that will be managed and ultimately owned by the private sector for its investment needs. Macroecononic Results 46. Fiscal performance has improved notably in the last two years. The primary balance moved into surplus in 1992 for only the second time in the last two decades. The combined deficit fell from 10.5 percent of GDP in 1989 to a projected 0.6 percent surplus in 1992. Automatic transfers to the provinces and social security increased in 1991/92, which prevented aggregate expenditures from falling more; these-- at least initially--helped to alleviate latent structural deficits there as well. Interest costs also declined because of the elimination of the quasi-fiscal deficit and because of the decline in L1BOR. 47. lb change expectations and increase investor confidence so as to lower inflation quickly, the Government enacted the Law of Convertibility, in April 1991. The law guaranteed convertibility of pesos to dollars at US$1:A$1, and effectively proscribed money creation other than through increases in net foreign reserves. The Convertibility program thus disciplined monetary policy and limited the powers of the Government to finance its deficit by inflation.16 The Law markedly reduced the foreign exchange rate risk to investors and the inflation risk to business and labor. 16 The Central Bank still can use rserve requirements as a instrument of monetary policy. It also can affect government dollar-denominated bonds in its reserve backing (though these monetary aggregates are legally limited to less than 10 percent of reserves) through open-market operations to the extent of 'excess" in international reserves or by varying the amount of govermment funds.  - 21 - Figure 1.14 48. As a consequence, the % Deficit and ntlatlon macroeconomic situation improved dramatically. The elimination of the 4 - deficit on the basis of sustainable policies * made it possible to bring inflation down ' (Figure 1.14). As inflation fell, capital returned, and the increased availability of credit produced an economic recovery. The creditworthiness of the Govenmment -o --as reflected in the secondary market , price of private external debt--improved -10 (Figure 1.15). ____ ___ ___ ___ ___ ___ -Owvral PublO - - Inflatlon 49. Most important, the Figure 1.15 program initiated a strong and sustained economic recovery, rising incomes of the of Argentine Debt poor, and new employment creation. .Senthly oton Us ont} Because of the reforms of the public sector and consistent macroeconomic policies, the economy has grown rapidly since 1990. The economic expansion has increased real GDP by more than 15 ao percent (Figure 1.16). At the same time, investment rates have increased and international liquid reserves have more 0 than tripled since 1990, and now back virtually the entire money base. Most 1O0 important, indicators of poverty show substantial improvement. Unemployment e I IeI has fallen to less than 6.9 percent, despite the incoiporation of new workers  - 22 - Figure 1.16 Average Monthly Inflatlon (CPI) and Lquld Reserves and Monetary Labilities Industrla Produotlon Index (USs mficn) Percent (Quarterly) IndeX 80.0 120 14000 70.0 110 12000 Reserve Coverage 60.0 100