Argentina - Provincial finances study : selected issues in fiscal federalism (Vol. 1 of 2) : Main report

Report No. 15487-AR Argentina Provincial Finances Study Selected Issues in Fiscal Federalism (In Two Volumes) Volume l: The Main Report July 12, 1996 Public Sector Management & Private Sector Development Division Country Department I Latin America and the Caribbean Regional Office Document of the World Bank  Currency Equivalents Currency Unit: Peso US$1 = ARG$1 Fiscal Year January 1 to December 31 ABBREVIATIONS AND ACRONYMS ATN Aportes Tesoro Nacional, Transfers of National Treasury CAS Country Assistance Strategy CFI Coparticipacion Federal de Impuestos EFCB Emergency Financial Control Board FEDEI National Electric Development Fund FIEL Foundation for Latin Amercian Economic Research FONAVI National Housing Fund GDP Gross Domestic Product GO General Revenue Bond IDB Interamerican Development Bank MAC Municipal Assistance Corporation MCBA Municipalidad de Buenos Aires NBI Unsatisfied Basic Needs PEM Public Expenditure Management  ARGENTINA PROVINCIAL FINANCES STUDY Selected Issues In Fiscal Federalism Preface This report is based on the findings of a mission that visited Argentina between January 29 and February 9, 1996. The mission comprised Maria Freire (task manager and main author), LAIPS; David Rosenblatt, LAICO; Richard Bird, University of Toronto; David Grossman, University of Columbia; and Benjamin Darche, University of California. Mario Salinardi (consultant) contributed with three provincial case studies. The mission is grateful to the Argentine authorities for their collaboration, in particular to Messrs./Mmes Juan Antonio Zapata, Juan Vega, Tereza Iturre (Ministry of Interior), Jorge Baldrich, Ricardo Sosa, Carlos Fernandez and Juan Sanguinetti (Ministry of Economy) and the Ministers of Economy and respective staff of the provinces of Buenos Aires, Mendoza and Santa Fe. We also acknowledge the collaboration of our colleagues in FIEL and Universidad de la Plata who provided challenging ideas and new points of view. The World Bank's Resident Mission provided logistic support. The report was produced under the supervision of Gobind Nankani, Director, Paul Meo, Division Chief, Public Sector Modernization and Private Sector Development, and Danny Leipziger, Lead Economist, Country Department I, Latin America and the Caribbean Region. The peer reviewers for this task were James Hicks and Vincent Gouarne. The final draft of this report was discussed with the Government in June 1996.   ARGENTINA PROVINCIAL FINANCES STUDY Table of Contents Volume 1: Main Report Preface Executive Summary Page No. 1. Introduction 2. Fiscal Performance of Argentina's Provinces 1990-1995 The Organization of the State .4 Fiscal Performance of Argentine Provinces .5 Variations across Provinces .8 Policy Agenda and Structural Reforms .13 3. Restructuring Fiscal Federalism in Argentina .22 Introduction .22 Provincial Taxation ..23 Revenue Sharing and Intergovernmental Transfers .29 Conclusions .42 4. Towards a New Incentive Framework of Financial Discipline .42 Introduction .42 Financial Management Tools .42 Strengthening Provincial Fiscal Management .43 Standard Control Mechanisms 45 Fiscal Emergency Control Mechanisms .45 Access to Long-Term Financing for Capital Investment .46 5. Provincial Financial Capacity- A Comparative Assessment .48 Analytical Framework .48 Results: Scoring .50 A Simulation Model to Project Provincial Fiscal Performance .53 Provincial Debt Reporting System .56 Annexes: Statistical Appendix Map  Text Tables: 2.1 Argentina: Federal Allocation of Responsibilities ................... .................. 4 2.2 Expenditures by Sector and Government Level, 1980-94 ......................... 5 2.3 Argentina Provinces: Fiscal Performance ................................................ 6 2.4 Annual Growth and Composition of Expenditures ................. ................. 7 2.5 Contribution of Advanced and Other Provinces to Fiscal Imbalance ........ 9 2.6 Argentina Provinces: Selected Indicators ................................................. 10 2.7 Adjustment in Current and Capital Expenditures, 1995 .............. ................ 12 2.8 Argentine Provinces - Adjustment Simulations ........................ ................ 15 2.9 Argentine Provincial Finance - Adjustment Program ................. ................. 17 3.1 Tax Collections by Level of Government and Type of Tax, 1994 ......... ...... 26 3.2 Public Sector Tiers and Vertical Imbalance ............................................... 29 3.3 Argentina: Transfers to Provinces, 1995 .................................................. 34 3.4 Per-Capita Transfers and Total Equalization, 1995 ............... ................. 37 3.5 Secondary Distribution - Simulation Scenarios ......................... ................ 40 5.1 Indicators for Financial Capacity Evaluation .............................................. 49 5.2 Indicators of Financial Capacity, 1995 ...................................................... 51 5.3 Final Scores of Financial Capacity Indicators ............................................ 52 5.4 Change in Ranking of Provinces, 1991 and 1995 ....................................... 53 5.5 Creditworthiness Matrix - Scores of Indicators and Final Ranking ............. 55 Statistical Appendix Table 1: Provincial Public Accounts, 1991-96 (Millions of Pesos) Table 2: Provincial Public Accounts, 1991-95, 1995 Constant prices Table 3: Gross Financing Needs, 1991-95 Table 4: Net Financing Needs, 1991-95 Table 5: Current Balance as % of Current Revenues 1991-95 Table 6: Operating Balance, 1991-95 Table 7: ATN as % Total Revenues, 1991-95 Table 8: Provincial Primary Deficit, 1991-95 Table 9: Debt Service as % of Current Revenues, 1991-95 Table 10: Personnel plus Debt Service as % Current Revenues Table 11: Structure of Current Expenditures, as % of Current Revenues, 1991-95 Table 12: Personnel Expenditures as % Net Revenues, 1991-95 Table 13: Provincial Employment, Personnel Expenditures and Average Wages, 1991-95 Table 14: Provincial Selected Indicators Table 15: Provincial Revenues, 1995 Table 16: Provincial Debt, Estimates, 1995 Table 17: Argentina Provinces - Adjustment Simulations Table 18: Simulation of Secondary Distribution according to Capitation and Equalization Formula  Table 19: Total Equalization in Argentina Provinces, 1995: Table 20: Indicators of Financial Capacity, 1995 Table 21: Indicators of Financial Capacity, 1995 - Number of Standard Deviations from Average Table 22: Final Scores of Financial Capacity Indicators Table 23: Final Ranking of Provinces According Creditworthiness Indicators Volume H - Technical Annexes 1. Restructuring Fiscal Federalism in Argentina 2. A Walk through Argentina's Fiscal Federalism System 3. Strengthening the Institutional Framework 4. Financial Capacity - A Comparative Assessment   Executive Summary i Executive Summary 1. Argentine provincial finances are under considerable stress. The country has undergone fundamental political and economic changes and the system established during the inflationary 1980s does not fit today's circumstances. A symptom of this mismatch is the emergence of fiscal deficits in most provinces. The overall provincial deficit -- which had improved after the stability program from 1.4% of GDP in 1990 to 0.2% in 1992 -- has deteriorated since, rising to 1.2% of GDP in 1995. Borrowing and outstanding debt have increased, payment arrears have accumulated and the provinces are delaying the payment of essential expenditures. The situation concerns the Argentine authorities for it affects the country's overall fiscal effort and creates severe political tensions in a federal country. 2. Argentina's public sector is highly decentralized. Sub-national governments are responsible for 45% of public sector expenditures, a share that is higher than in many Latin American countries. In 1994, the Argentine provinces financed 97% of basic education, 92% of health and 84% of welfare outlays. On the revenue side, provinces collect only 18% of the public sector revenues. Own-source revenues cover 37% of provincial expenditures. The gap between expenditures and revenues is filled by transfers and shared-revenues. 3. The roots of the provincial troubles go back at least 20 years, when high inflation rates together with reliance on centrally collected revenues and lack of budget discipline led to continued fiscal deficits. With the Convertibility Plan, the revenue situation improved significantly. Between 1990 and 1995, provincial revenues went up 37% in real terms, with own-source revenues taking the lead (54% growth during the same period). However, expenditures also adjusted quickly -- in part due to additional decentralization of social services -- pushing the overall deficit to previous levels. Personnel expenditures expanded 37% in real terms, primarily due to higher real wages. Provincial pension funds -- insufficiently financed and with generous benefits -- contributed to a fifth of the provincial deficits. 4. By the end of 1995 the situation was unsustainable. With the decline in economic activity, as Argentina confronted the "Tequilla effect" (GDP fell 4.4% in 1995), provincial revenues dropped 6% in real terms and despite some expenditure cuts, the fiscal deficits persisted. Out of twenty four provinces, only four generated savings to finance investment. The few capital expenditures made were financed partly by earmarked transfers (43%) partly by borrowing. In many instances, transfers from the central government were mortgaged to pay due debt service. Arrears accumulated and several provinces resorted to issuing their own script as a form of payment. 5. At the end of 1995, provincial debt was estimated at US$14.9 billion, of which US$1.1 billion was multilateral debt; $1.2 billion to $1.5 billion was floating debt. Reported debt service is relatively low (11% of current revenues on the average) but this reflects the large proportion of non-contractual debt and the quasi-automatic roll-over of  1) Executive Summarv due debts. Partial evidence and case studies shows that short term debt constitutes more than 50% of the financial debt and that interest rates in 1995 were above 18% a year. 6. While the provincial per capita debt was $430 in 1995, high compared with $400 in the average of the US states, there are large differences among the provinces. Per capita debt ranges from $2,200 in La Rioja (almost twice per capita provincial total revenues) to $50 in San Luis. At present, there are almost no limits on provincial borrowing and provincial creditworthiness plays no role in establishing borrowing terms. The provinces can use their unconditional transfers (coparticipation funds) as collateral for commercial and investment borrowing. The state-owned Banco de la Nacion executes the guarantees appropriating the coparticipation funds to pay due debt service. This makes provincial lending an attractive business for domestic banks, although many provinces have overcommitted those funds and have found themselves in serious fiscal trouble. 7. The central government has helped the most distressed provinces on a case-by- case basis through discretionary non-reimbursable grants. The most important are the Aportes del Tesoro Nacional (ATN) which increased from $68 million in 1990 to $600 million in 19951. This situation is not desirable. ATN's are highly discretionary, tend to be politically biased and undermine efforts to improve efficiency and accountability of provincial management. Differences in Provincial Performance and Adjustment Needs 8. Argentina's provinces vary widely in size, economic potential and fiscal performance. Broadly speaking, five provinces (traditionally classified as the advanced ones --the province of Buenos Aires, the Municipality of Buenos Aires, Cordoba, Mendoza and Santa Fe) represent 70% of the country's GDP, 60% of total provincial borrowing and have thus a key role in the aggregate provincial fiscal situation. In 1995, of these five provinces, two were in balance -- the province of Buenos Aires and the Municipality of Buenos Aires. Santa Fe, Mendoza and Cordoba were facing current balance deficits, which together represented 20% of the aggregated provincial current deficit of $1.4 billion. 9. For analytical purposes, the report classifies the provinces according to recent fiscal indicators -- current and overall fiscal balance, debt service/current revenues and debt stock/current revenues. Provinces are then classified into (i) moderately balanced (unbalanced) -- if current fiscal balance is less (greater) than 10% of current revenues; (ii) in too much debt if the debt service/current revenues is greater than 15% and if the debt stock/revenues is greater than 60%. In these lines the provinces can be classified as follows. * The first group includes seven provinces whose fiscal situation is stable or could be stable with a small fiscal adjustment. This group includes San Luis, This includes the Transfers allocated by the Ministry of Interior and the Ministry of Economy.  E,xecutive Summary ii La Pampa (traditionally well managed provinces), the city of Buenos Aires, the province of Buenos Aires (all with surplus in the current account) and Santa Fe, Salta and Neuquen. The last three provinces had deficits of about 5-9% in the current account. The structure of the expenditures of Salta and Neuquen shows a disproportionally high share of personnel outlays indicating the need to reduce this item by 30% and 20% respectively. * The second group -- provinces with serious fiscal problems -- includes Santa Cruz, San Juan and Tierra del Fuego. In 1995, their current deficits reached 21%, 37% and 53% of their current revenues, respectively. In order to ease this problem, these provinces would need to reduce current expenditures by 27% in the case of San Juan and 35% in the case of Tierra del Fuego. * The third group includes two provinces -- Mendoza and Cordoba -- with debt ratios well above the limits and problems in serving the debt. Early 1996, Cordoba had 33% of its coparticipation funds retained to pay debt service; Mendoza about 40%. The ratio of debt/revenues is high -- 93% in Mendoza, 80% in Cordoba. In both cases, debt service and personnel expenditures absorb more than 80% of their revenues. - The fourth group includes eleven provinces with both fiscal and debt service difficulties. Table 2.6 in the main report shows the situation of these provinces that account for 10% of the country's GDP but one third of the provincial debt. The worse cases include La Rioja, Rio Negro, Jujuy, Formosa (despite a wide program of reform), Corrientes and Misiones. Debt stock is larger than annual revenues and the current deficit is above 20%. For most of these provinces, a reduction in personnel outlays between 25% and 40% would be necessary to restore fiscal discipline. A simulation exercise indicates that La Rioja would need to reduce current expenditures by 50% and personnel expenditures by 73%. Catmarca and Rio Negro would need to cut personnel outlays by around 40%; Chaco and Formosa more than 25%. 10. The "best performers" shared a similar structure of expenditures in the last five years: personnel expenditures averaged less than 60% of the net revenues (current revenues less transfers to municipalities); debt service was low and the ratio of outstanding debt over revenues did not exceed 40%. The city of Buenos Aires was the exception. 11. Among the causes for the provincial fiscal crisis, institutional factors played a major role: (i) lack of budgetary discipline inherited from he hyperinflationary years; (ii) mandated service transfers; (iii) inadequate rules with respect to accounting, reporting, and transparency; (iv) lagging institutional adjustment from the prevailing irresponsible budgeting practices of the hyperinflation years. In addition, the rapid and unexpected rise in provincial revenues with the Convertibility Plan in the early 1990s led to unwise expenditure increases that could not be sustained when the boom broke.  iv Executive Summary 12. In addition, the incentives at the central level may have been favorable to provincial overspending. During the inflationary years, central government financing was almost automatic, and provincial bail outs were the rule. After the Convertibility Plan, the situation changed towards greater discipline. However, increasing discretionary transfers from the center together with the unlimited use of transfers as collateral to commercial borrowing and current deficit financing have had a negative influence on provincial fiscal discipline. Provincial structural adjustment. 13. With the Convertibility Plan, the Federal Government promoted structural reforms in the provinces through two wide-range policy agreements (Federal Fiscal Pacts, 1992 and 1993). The provinces agreed to (i) improve own-resource mobilization, (ii) reform the structure of the provincial taxes and eliminate a series of distortionary taxes, (iii) modernize the provincial public administration and deregulate the provincial economy, (iv) privatize public enterprises (including the provincial banks), and (v) transfer the provincial public employees pension fund to the national streamlined pension fund. In exchange, provincial governments were ensured minimum floors in the revenue-sharing allocation which would compensate provincial revenues from possible declines in own- source revenues associated with the economic reforms. 14. Progress has been achieved in many of those areas, notably in the privatization of the provincial banks and the deregulation of provincial economic activities. Progress in achieving fiscal adjustment has lagged. In 1995, many provinces reduced substantially their spending in goods and services and in the early part of 1996, severe personnel cuts were being planned. In addition, many provinces have realized the effort that is required and have accepted to transfer to the central government their pension funds, in spite of the political difficulties that had to be faced. The provincial pension funds contributed to about one-third of the provincial current deficit. It is expected that the ongoing transference will contribute to improve the fiscal accounts in a sustainable way. 15. Achieving sustainable fiscal accounts is a priority for the central government. A major problem is the size of the provincial debt and the lack of capacity of many provincial governments to service their debt obligations. The central government has began preparing with selected provinces adjustment programs aimed at debt restructuring-cum- fiscal adjustment. These programs would include refinancing of the existing provincial debt with central government instruments so as to lengthen the maturity and lower the current interest rate. The provincial governments would agree to implement fiscal adjustment programs over three years with clear fiscal targets aimed at reaching a sustainable fiscal balance. Details on the financing of this package are being worked out by the Government of Argentina. 16. Provincial fiscal adjustment is urgent. For most of the provinces, adjustment must come from expenditure reduction since the potential for revenue increases is limited. The size of the adjustment varies across provinces. However, to be successful, provincial  Executive Summary v reforms must include a reform in the incentive structure both at the provincial level -- adoption of reform programs to ensure a self-sustained financial situation in the medium term; rationalization of expenditures, especially public sector employment -- and at the central level, to remove the moral hazard of having the central government guaranteeing provincial debt, widen provincial tax powers and improve the design of the inter- governmental transfer system. Provincial Reform Programs 17. Provincial reform should contain the following elements: * Fiscal objectives, strategy and timetable to reach them. The objectives should include at least a current account balance, a ceiling in the debt/revenue ratio; and a sustainable debt service/current revenue ratio. Medium and long-term financial scenarios would establish limits on aggregate spending and help to quantify the need to reduce expenditures. * Public expenditure reviews (notably in the social sectors, which account for most of the expenditures) would be carried out to prioritize expenditure programs and avoid cuts in essential items. * Privatization of public enterprises and utilities is a way to generate revenues for debt reduction and to achieve efficiency gains in management. Much of the proceeds of prior sales has financed recurrent outlays, rather than retiring outstanding debt. * The provinces should improve expenditure efficiency, by improving staffing productivity -- especially in the social sectors -- and the quality of their management tools, including the budget and planning process. * The provinces should review the assignment of responsibilities and revenues with their municipalities to avoid overlaps and mismatches. * The provinces should develop public expenditure management systems. These PEMs should include (i) budget offices capable of making forecasts of expected revenue and anticipated spending; (ii) budgetary classifications to allow the control on whether the money spent is actually going to the budgeted items and functions; (iii)accounting systems to monitor and control cash flows and to provide needed information on the status of expenditure and revenue; (iv) controls over other commitments even when these do not contribute to additional cash spending in the current year; and (v) mandatory auditing systems.  Vi Executive Summary Control provincial borrowing 18. Argentina's central government has few means to interfere with provincial borrowing, except in the case of foreign loans that need Congressional approval. In the case of domestic borrowing, for which inter-governmental transfers are used as collateral, the loans are registered with the Ministry of Economy and with the Banco de la Nacion. The latter has the authority to deduct any debt payment on guaranteed loans from the main intergovernmental transfer. The Ministry of Economy needs to authorize all provincial loans that use coparticipation funds as a guarantee, but this requirement has been mostly a formal one as most of the loans have been authorized. 19. The following measures would be required: * To improve accountability, the provinces should be asked to present timely, audited reports and undertake periodic expenditure and performance reviews. Grant disbursements would be conditional on these audits and reports. * The present use of co-participation revenue as guarantee to commercial borrowing should be changed to remove the moral hazard of a central government supporting provinces with implicit guarantees of their debt and to stimulate, in the longer run, the development of a private market to finance provincial investment projects. * The present system of registering a creditor's claim on co-participation revenues with the Banco de la Nacion could be replaced by a legal document that would establish a separate " Trustee" with fiduciary responsibility to creditors. The Trustee concept would replace the co-participation guarantee with a legal document that enforces a set of financial rules and fiscal discipline on the province if it wants to borrow. * The central government should provide clear signals that it will no longer bail out provinces which get themselves into trouble. Given the impossibility of bankruptcy proceedings against provinces, reducing this moral hazard will require the institution of credible review/control systems for debt work-outs. * Provinces should have legislation approved to control their own levels of indebtedness and to oblige provincial administration to adhere to fiscal discipline. Examples of the latter would include limitations on borrowing for non-investment purposes, minimum rates of return for investment financed with borrowing, or possibly limits on debt/revenue ratios. Incentive Structure 20. The incentives for reform may come from within the provinces, primarily from constituents holding provincial politicians accountable for their resource management. In Argentina, these incentives are at present generally weak. Because of the high dependence  Executive Summary vii on fiscal transfers, the political costs of provincial expenditures are relatively low -- provincial officials spend proceeds of national taxes and have little incentive to confront provincial taxpayers with the costs of their preferences. This process will change over time but it is in general a long process and more immediate reforms are needed in Argentina today. 21. The incentives for those immediate reforms must come from outside the provinces, essentially from the Central Government. Some key areas should be addressed in priority * Coparticipation. one positive feature of the current system is that the transfers are transparent and predictable. A major problem is that they are very large in relation to provincial own-source revenues and discourage accountability in resource management and spending. Efforts should be made to increase tax powers at provincial level and to devolve some tax authorities to provinces as a way to increase the link between those who benefit from the public services and those who pay. * Discretionary Transfers: ATNs and other discretionary transfers should be subject to hard budget constraint and transparent rules or abolished. This should provide an effective incentive to mobilize provincial resources for desired additional expenditures.