Colombia - Second Programmatic Fiscal and Institutional Structural Adjustment Loan Project

Documentof The WorldBank FOROFFICIALUSEONLY ReportNo. 27068-CO INTERNATIONALBANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENTFORA PROPOSED SECONDPROGRAMMATICFISCALAND INSTITUTIONALSTRUCTURAL ADJUSTMENTLOAN INTHEAMOUNTOFUS$lSO MILLION FOR THE REPUBLICOF COLOMBIA OCTOBER 23,2003 Colombia-Mexico Country ManagementUnit Poverty Reduction and EconomicManagement Unit LatinAmerica and the Caribbean Region This document has arestricted distribution and may be usedby recipients only inthe performance of their duties. Its contents may not be otherwise disclosed without World Bank authorization.  REPUBLICOF COLOMBIA-FISCAL YEAR January 1-December 31 CURRENCY EOUIVALENTS (as of 20 February 2003) CurrencyUnit = Peso 2,903.00 Pesos = US$1 0.92Euros = US$1 WEIGHTS AND MEASURES Metric System CAS Country AssistanceStrategy IDF InstitutionalDevelopmentFacility CFAA CountryFinancialAccountability JMF IntemationalMonetaryFund Assessment ISS Instituto de SeguridadSocial(SocialSecurity CGN ContadurfaGeneralde laNaci6n Institute) (Accountant General's Office) IVA Impuestoa1Valor Agregado (Value-addedtax) CONFIS Consejo Superior de PolfticaFiscal LIL LeamingandInnovationLoan (Superior Council of FiscalPolicy) MAFP Modemizaci6nde la AdministracidnFinanciera CONPES ConsejoNacionalde Politica Econ6micay Pdblica(Public FinancialManagementProject) Social(NationalCouncil of Economicand MDGs MillenniumDevelopment Goals SocialPolicy) MHCP Ministerio de Hacienday Crkdito Pdblico (Ministry CPAR Country ProcurementAssessmentReport of Financeand PublicCredit) CSR Commission for State Reform MU Ministerio del Interior y Justicia (Ministry of Interior DAFP DepartamentoAdministrathodelaFunci6n andJustice) Pliblica (Public ServiceAdministrative MTEF MediumTermExpenditureFramework Department) NFPS Non-FinancialPublic Sector DIAN Direcci6nde Impuestosy Aduanas OBC Organic BudgetCode Nacionales(NationalDirectorateof Taxes PHRD Policy andHumanResourcesDevelopment andCustoms) PLaRSSAL ProgrammaticLaborReform and SocialSector DNP DepartamentoNacionalde Planeach Adjustment Loan (NationalPlanningDepartment) PRAP Programade Renovaci6nde la Administracidn FIAL ProgrammaticFiscaland Institutional Pdblica(Public Administration RenovationProgram) Adjustment Loan SENA ServicioNacionalde Aprendizaje (NationalTraining FNR FondoNacionalde Regalias (National Service) Royalty Fund) SIIF SistemaIntegradode Informaci6nFinanciera FRL FiscalResponsibilityLaw (IntegratedFinancialInformationSystem) GDP Gross Domestic Product SINERGIA SistemaNacionalde Evaluaci6nde Resultados lBRD IntemationalBank for Reconstructionand (EvaluationSystemfor Public Management) Development TAL Technical AssistanceLoan ICBF Instituto Colombian0deBienestarFamiliar VAT Value-addedTax (ColombianFamily Welfare Institute) IDB Inter-AmericanDevelopmentBank IBRD Vice President: Davidde Ferranti Chief Economist: Guillermo Perry Director, LCSPR: ErnestoMay Sector Manager, LCSPS: RonaldE. Myers CountryDirector: IsabelM.Guerrero LeadEconomist: JoaquinA. Cottani Task Manager: Mario F.Sanginks Sr. Counsel andCountryLawyer: EduardoBrito This operation was prepared by a World Bank team composed of MessrsMmes. Del Villar, Leytbn, Mosqueira, Rojas, Sangin&, and Solana (LCSPS), Gonzhlez and Webb (LCSPE), Romhn (LCOPR), and Uribe (Consultant). The team was led by Mr. Sanginks (LCSPS) and worked under the general guidanceof Mr.RonaldMyers (Sector Manager, LCSPS), Mr. Ernesto May (Director, LCSPR), andMrs.IsabelGuerrero(Director,LCClC).  FOROFFICIAL USEONLY COLOMBIA SECONDPROGRAMMATIC FISCAL AND I?NTITUTIONAL STRUCTURAL ADJUSTMENT LOAN(FIAL) LOANAND PROGRAM SUMMARY Borrower: Republic of Colombia 1 Implementipg Ministry of Finance; NationalDepartment of Planning Agkncies: PovertyCategory: Not Applicable Amount: US$l50million Terms: Fixed-Spread Loan (FSL) in US Dollars with semestral Payment Dates for interest and commitment charges due on May 15 and November 15, and with the following Amortization Schedule, during the life of the Loan: PaymentDate Installment Share 15-NOV-2009 10% 15-NOV-2010 10% 15-NOV-2011 10% 15-NOV-2012 10% 15-NOV-2013 10% 15-NOV-2015 10% 15-NOV-2016 10% 15-NOV-2017 10% 15-NOV-2018 10% 15-NOV-2019 10% The Borrower also chose a grace period of 5.5 years and a total repayment term of 16years. Further, the Borrower opted to keep all the conversion options (currency conversions, interest rate conversions and capskollars) in the Loan Agreement. For interest rate conversions, the Borrower chose an Automatic Rate Fixing(ARF) every six (6) months. CommitmentFee: 0.85% on undisbursed loan balances for first four years and 0.75% on undisbursedloan balancesthereafter. , Front-EndFee: 1% of the loanamount Objective: The government's fiscal and institutional reform agenda is supported by the Bank through the series of four single-tranche Fiscal and Institutional Adjustment Loans (FIAL). The objectives of this series of loans are two: first, to promote reforms addressing fiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of public services and This document has a restricteddistributionandmay beusedby recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed  establish the institutional basis for higher efficiency and accountability in public expenditure. The specific objectives of the FIAL program are to: (i) increase tax revenue and reduce distortions in the tax system; (ii) modernize the tax administration; (iii)promote the development of a sound fiscal responsibility legal framework; (iv) reduce losses and generate revenues through improved asset management; (v) prevent massive losses to the State from judicial claims; (vi) improve budget management with modem tools and legal reforms; (vii) develop incentives for efficiency gains in subnational entities; (viii) strengthen the public sector procurement system; (ix) improve performance through management contracts for agencies; and (x) support a coherent and comprehensive reform implementation process. Description: This secondloan of the programwill focus on the followingelements: (i) issuance of all legislation to regulate the application of the tax reform law; (ii) further improvements in tax administration, including specific audit targets and the implementation of integrated tax-customs audits; (iii)approval of an official budget reform strategy; (iv) Congressional approval of an improved 2004 Annual Budget Law; (v) presentation to popular vote of the Constitutional referendum; (vi) issuance of a new policy for legal defense of the state; (vii) presentation to Congress of reforms to the public procurement law; (viii) approval of an official asset managementpolicy and the achievement of specific revenue targets; (ix) signature of management contracts with two government agencies; and (x) enactment of a Fiscal Responsibility Law. Benefits: The key benefits expected from the program are: (i) an average annual contribution to total fiscal revenues of 1.4 percent of GDP from 2003 to 2006; (ii)an average annual contribution to a reduction in current expenditures of 1.6 percent of GDP from 2003 to 2006: (iii) increased reliability and transparency in medium-term fiscal planning and a framework for more realistic budgeting: (iv) a public expenditure system more closely linked to results; (v) improved targeting of public expenditure toward public policy priorities; (vi) a more transparent, simpler, and institutionally robust system of public sector procurement; and (vii) a more efficient andcost-effective use of the assets of the public sector. These achievements would translate directly into fiscal sustainability, improved quality and coverage of public services, and improved governance and transparency. Risks: The most important risks faced by the program are: (i) the challenges faced by the government stemming from the overall political context, in particular the internal conflict and violence associated with illegal drug activity, which could negatively impact the continued implementation of the program; (ii) possible attempts at derailing the reform process by special interest groups affected by it; (iii)the weakening of the government's overall policy agenda by the non-approval of the Referendum; and (iv) the deterioration of the fiscal and macroeconomic environment. Project Identification Number: PO83905  REPUBLICOFCOLOMBIA SECOND PROGRAMMATIC FISCALAND INSTITUTIONALSTRUCTURAL ADJUSTMENT LOAN (FIAL 11) Table of Contents I INTRODUCTION . .................................................................................................. 2 I1. CONTEXT OFTHE OPERATION ..................................................................... 2 ............................................................2 B. FISCAL ANDIr\iSTITUTIONAL ISSUES A. RELEVANTSOCIOECONOMIC BACKGROUND .........................................................................5 I11 THEGOVERNMENT'S REFORMPROGRAM 8 I V THE FISCALAND INSTITUTIONALREFORMPROGRAM .. .............................................. ...................... 9 A. OVERVIEW ............................................................................................................... B. COMPONENTS OF THEPROGRAM ........................................................................... 9 17 V . THE SECONDFISCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN (FIAL 11) ............................................................................... 34 A. LOAN ............................................................................................... B. FIDUCIARY POLICIES DESCRIPTION ............................................................................................. 34 C. ENVIRONMENTAL 36 36 D. BENEFITS ............................................................................................................... ASPECTS .................................................................................... 37 E. RISKS ..................................................................................................................... F. SOCIALIMPACTOFTHEREFORMS .......................................................................... 39 40 ANNEX I LETTER OF DEVELOPMENTPOLICY TO THEWORLDBANK ANNEX 11 INTERNATIONAL MONETARY FUNDRELATIONS NOTE .. .......................43 ANNEX 111 POLICY MATRIX 56 ANNEX IV COLOMBIA AT GLANCE .. ..............................54 ........................................................................................ ............................................................................. 69 FiscalDeficit 1994-2002 ........................................................................................ Figures Figure 1. 4 Figure 2. 4 Figure 3. Timeline of ChangesinTax Policy.......................................................................... Colombian Debt Spreads ......................................................................................... Figure4. Accumulated Fiscal Cost of Contingent Liabilities Against the State ..................... 18 25 Table 1. Table 2. ExpectedAggregate Impact of the FIALReforms .................................................. Division of Responsibility for ProgramComponents .............................................. 10 15 Table 3. 16 Key Measuresofthe 2002 Tax Reform (Law 788) ................................................. Sources of TechnicalAssistance for FIALProgram................................................ Table 4. 19 Table 5. 20 Table 6. Tax Revenue. FirstSemesterComparison. 2002-2003 ........................................... 34 Table 7. Reforms Supported by the FIAL ............................................................................. Public Sector FiscalBalances, Scenario with Reforms (2001-2006) ...................... 38   INTERNATIONAL BANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT A PROPOSED INSTITUTIONALLOANFISCAL FOR SECOND PROGRAMMATIC AND STRUCTURAL ADJUSTMENT TO THE REPUBLICOF COLOMBIA I. INTRODUCTION 1. Colombia, a country of 43 million inhabitants with a history of sustained economic growth and fiscal stability, reached the end of last decade with an almost unprecedented economic contraction and high levels of civil unrest. Facing a difficult fiscal outlook and popular disappointment with the peaceprocess, President Alvaro Uribe took office in August 2002 on a platform of restoring security, fighting corruption, and delivering sustained economic growth. In its first year the Uribe administration has embarked on a path of fiscal prudence, ambitious public sector reform, and determination to end the 40-year armedstruggle that makes Colombia one of the most unsafe countries inthe hemisphere.' 2. The backbone of the public sector reform process i s the Progruma de Renovacio'n de Zu Administrucio'n Pu'bZicu (PRAP), led by the National Planning Department (DNP) and based upon Presidential Directive 10 of October 2002. This program has so-called "vertical" reforms, which are basically sector- or entity-specific institutional restructuring actions that seek to reduce excess public sector employment and enhance quality and cost-effectiveness of public services; and "horizontal" reforms, which encompass cross- sector issues of public administration, such as asset management, procurement, and others. This modernization effort is coupled with substantial reforms in fiscal management, led by the Ministry of Finance and Public Credit (MHCP). These include a substantive tax reform, amajor overhaul of the tax administration, budget reform, andthe enactment of fiscal responsibility regulations. Together, these measures add up to a broad package meant to lay the foundations for improved service delivery and sustained fiscal balance. 3. During the second semester of 2002, the government agreed with the multilateral banks that the public sector reform process would be supported by structural adjustment loans from both the International Bank for Reconstruction andDevelopment (IBRD) and the Inter-American Development Bank (IDB). The Bank focused on the issue of fiscal rigiditiesthat make the implementation of public policy extremely difficult, bothfromthe revenue perspective and through the achievement of efficiency gains in the "horizontal" elements of the reform process. The IDB, on the other hand, focused its adjustment lendingon the "vertical" elements of reform, and some horizontalelements not covered by the Bank, and is also preparing an investment operation to support the policy reforms. 4. On March 18, 2003, the Bank approved the first Fiscal and Institutional Adjustment Loan (FIAL) to supp`ort the government's reform efforts. This first single- tranche structural adjustment loan, in an amount of US$300 million, laid out the The approval rating of the current administration has remained high. The latest polls indicate that 70 percentof Colombianshavea favorable imageof the President, and hisjob approval rating is 64 percent.  principles of a programmatic operation that would total an estimated US$900 million and would conclude inFY 2006. This programhas two objectives: First, to promote reforms addressingfiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The focus of the reform program will gradually shift from tax and fiscal responsibility at the beginning, to expenditure and public expenditure reform in the later stages. 5. This Program Document presents the second loan of the FIAL program (FIAL 11) for an amount of US$lSO million in a single tranche. Each of the loans in the FIAL program has a particular thrust within the overall scope of the reform; while FIAL Iwas heavily weighted toward tax policy as the initial and most urgent effort toward fiscal sustainability, the primary emphasis of the proposed FIAL I1i s on establishing the legal and normative framework of the key elements of public sector reform, including procurement, royalty transfers, and fiscal responsibility, and the implementation of management contracts with two government agencies and the definition of the budget reform strategy. FIAL I11 is expected to focus mainly on the results of the tax administration efforts, the operation of a framework of legal defense of the State, new asset management legislation, and the effective implementation of the mandates of the procurement and fiscal responsibility laws. The fourth and final FIAL IV will emphasize the full implementation of the tax reform, the enactment of the budget reform, the expansion o f the management contracts scheme, additional performance management tools, and the overall evaluation of the reformprocess. 6. As shown later in this document, progress in the reform program has been satisfactory, andthere havebeensignificant accomplishments derived from the first FIAL loan. Most notably, the government has enacted a substantial tax reform package that i s expectedto yield an additional 1percent of GDP inrevenue this calendar year, as well as the initial steps of several key initiatives of public sector reform. The FIAL IIloan is well synchronized with the accomplishments to date, and sets the stage for further reforms duringthe remaining three years of this government's administration. 11. CONTEXT OFTHE OPERATION A. RELEVANT SOCIOECONOMIC BACKGROUND 7. Macroeconomic Performance. During 1998-2002, the economy suffered from stagnation, but today confidence inthe economy i s slowly returning, as signs of recovery and growth continue. The economy grew by 3.3 percent in the first semester of 2003, which i s the biggest gain inGDP in five years, and i s expected to grow by about 2.5 to 3 percent this calendar year and by 3 to 3.5 percent in 2004. Although the unemployment rate fell from 16percent inthe first quarter of 2003 to 14 percentin the second quarter of the same year, it remains to be seen whether the economy i s now firmly established on a path of growth and stability. Total investment now stands at about 14 percent of GDP, with private investment under 6 percent, which will not sustain significant growth. While 2  government consumption grew by two thirds between 1994 and 2002, household consumption remained basically unchanged. Inflation declined in 2002, assisted by sluggishdemand, and was about 6 percent, andi s expectedto be about the same in2003. 8. Colombia's exports increased in the first semester of 2003 relative to the same semester in 2002. This increase can be explained mostly by carbon exports. While the country's nontraditionalexports, mainly manufactured goods and cut flowers, performed well in recent years and now amount to over half of total merchandise exports, the appreciation of the peso and the economic slowdown in the United States, Venezuela, and other Andean countries affected them negatively in the first semester of 2003. Increasing imports have, however, maintained a deficit in the trade balance. The total external current account had a deficit of about 2.1 percent of GDP inthe first semester of 2003. 9. Fiscal Performance. Over the past half-decade, new realities have emerged in Colombia's fiscal domain, including significant deficits and large future fiscal liabilities. The rapid expansion of the public sector over the previous decade, from spending one- fourthof GDP in 1990to over one-third of GDP today, combined with growing pension and other liabilities, has led to significant and persistent structural deficits. As public spending rapidly outstripped the sector's revenue-generating capacity, much of the fiscal deficit was financed with debt, both domestic and external. Today, total public sector debt in Colombia is over 50 percent of GDP. The deficit of the consolidated public sector for 2002 was 3.6 percent of GDP, largely due to election-year spending, higher military outlays, and a weakening of the social security institutions. For security spending, the current administration estimates that it will need an additional 1percent of GDP per year. 10. Nevertheless, the Uribe Administration has stressed its commitment to continue the fiscal adjustment efforts of the previous administration. On December 20, 2002, Congress approved a strong tax package estimated to increase tax collections by close to 1 percent of GDP in 2003 and rising in the next two years. The fiscal deficit for the Combined Public Sector i s expected to come down to 2.5 percent of GDP in 2003 and about 2.3 percent in 2004. As a precaution, the Government requested a Stand-By Agreement from the International Monetary Fund (IMF). The first review of the Stand- By Arrangement was satisfactorily completedon June 11, 2003. All performance criteria and structural benchmarksfor end-2002 and end-March2003 havebeen met. 11. Congress passed two key structural reforms: a pension reform (Law 797, January 2003) to address the looming deficits of the social security sector, Colombia's largest future fiscal liability, and a labor reform to increase flexibility in Colombia's rigid labor market. An overhaul of the public administration sector i s well underway. Additionally, Telecom was liquidated and Cajanal and Caprecom were massively reformed. In June 2003, the Government of Colombia (GOC) was finally successful in passing through Congress a reform of the Znstituto de Seguridad Social (Social Security Institute, ISS), which includes the separation of health service provision and financing. In late June Congressapproveda fiscal responsibility law. 3  Figure 1:FiscalDeficit 1994-2002 (Percentage of GDP) 40% 23 Source: Superior Council for FiscalPolicy (CONFIS). 12. The External Environment. Colombia's vulnerability to external shocks has seen some recovery in recent months. Although its sovereign debt spreads have improved since the beginning of the year in absolute terms and relative to the emerging market average, Colombia is still vulnerable given the uncertainty about the future of the internal conflict; the passage of the referendum; the problems in Venezuela (the largest market for Colombia's nontraditional exports); and the outlook for the U.S. economy, Colombia's main trading partner. Nonetheless, given its floating exchange rate, falling inflation, and adequate international reserves, Colombia should be well equipped to deal with moderate external shocks as it undertakes the fiscal adjustment supported by the proposedprogram. Figure 2: Colombian Debt Spreads (EMBICOL vs EMBI+) 818,2002 011912002 ,11112882 ,21,,12002 t11012003 3,1912011 112412003 biii210, 1118,2003 *oI$1*eoP Source: Ministry of Financeand Public Credit. 4  13. Poverty. In Colombia, there has been a close positive correlation among fiscal balance, growth, and poverty reduction. During periods of positive growth (and fiscal balance), Colombia enjoyed substantial declines in poverty (even though inequality increased). Specifically, from 1988 to 1995, as GDP grew on average at about 4.2 percent per year, poverty rates declined from about 65 to 60 percent of the population. This reduction, and the government's efforts that helped achieve it, were completely wiped out by the 1998-99 recession. Poverty levels today are not substantially different from what they were in the late 1980s. Although unemployment has dropped from around 15.7 percent last year to 14percent during the second quarter of 2003, it i s yet not clear whether the economy has stabilized to sustain this level. Put differently, the evidence suggests that sustainable growth and fiscal balance have been Colombia's best social safety net. A fiscal balance programthat increases revenue andmakes expenditure more efficient, and within prudent limits, i s a sine qua non for Colombia's attaining the humandevelopment Millennium Development Goals(MDGs). 14. Insecurity and Violence. Colombia has captured headlines around the world for its alarming indexes of violence. Since the 1980s, the multidimensional problem of violence has become more widespread andis exacting an increasing economic and social toll. From 1999 to 2002, the number of attacks on petroleum infrastructure increased by 160 percent, on electric infrastructure by 680 percent, and kidnappings by 126 percent over the average o f the previous 13 years. It i s estimated that the conflict reduces the annual economic growth rate by at least 2 percent. The conflict places the country in a particularly vulnerable and difficult position; its repercussions for the economy and the overwhelming social demand for its settlement make peace the paramount priority of the government's public policy agenda.' As crucial complements to the direct counterinsurgency measures, the government recognizes the need to sustain fiscal balances and improvethe quality and efficiency of public services. 15. In his 2003 report to Congress delivered on July 20, President Uribe presented encouraging signs that the government's strategy on democratic security i s yielding positive results. During the first semester of 2003 there were 24 violent attacks on populations, the lowest in 10 years and just over one-third of the number for the first semester of 2002; attacks on economic infrastructure are down 58 percent over the same period, and homicides declined by 21percent and kidnappings by 34.2 percent. Although there i s still significant uncertainty over the evolution of the armed conflict, and paramount challenges still remain ahead, the statistics for the first half of 2003 could show the beginning of a reversal in the trend towardincreased violence that began in the late 1990s. B. FISCAL AND INSTITUTIONALISSUES 16. The fundamental issue that constrains the effective implementation of public policy in Colombia i s the inability of the Government to access the necessary budgetary resources to attend policy priorities. Regardless of the political commitment to promote 'Ithas been estimated, for instance, that war-related additional public expenditures w i l l reach 1.5 percent of GDP by 2006. 5  peace and development, there i s little that can be done without resources. Budgetary shortfalls are clearly not uncommon; fiscal adjustment i s a worldwide reality. However, the nature of the Colombian fiscal imbalance is particularly complex due to the interplay of insufficient tax revenue, inefficient and rigid expenditure, and the lack of an adequate legal framework for fiscal responsibility. 17. Some of the key issues that make up the spectrum of constraints to effective public policy that were faced by the incomingUribe administration inAugust 2002 are: 18. Insufficient Resources for the Implementation of Public Policy. The Colombian Central Government tax burdenhas hovered under 20 percent of GDP for the last few years,2 which was insufficient to undertake the ambitious government agenda, and substantial reforms in both tax policy and administration were required. A Bank- supportedtax reform law enactedin December 2002 significantly broadened the tax base and reduced a number of exemptions. It has already had visible impact on the revenues in the first semester of 2003, although the Constitutional Court challenged some key elements scheduled to go into effect in2005. Tax administration measures are underway with support from the Bank, but most of the challenges in this area still lie ahead and involve efficient information usage, improved auditing, and a revision of bylaws and regulations. 19. Lack of a Fiscal ResponsibilityFramework. Many countries inthe regionhave increased the odds of fiscal sustainability by approving laws that establish certain basic fiscal responsibility guidelines. These guidelines pertain to matters such as debt ceilings, subnational borrowing, medium-term fiscal planning, and reporting and accountability. The lack of such framework at the national level in Colombia made it difficult to align expenditures to within affordable and sustainable limits. In June 2003, the government enacted the Fiscal Responsibility Law, which i s one of the key benchmarks under the FIALprogram. 20. Inefficient use of Public Assets. The Colombian public sector lacks the institutional and legal framework to appropriately identify, assess, value, regularize the titling, and if necessary dispose of assets-particularly real estate-that are part of its capital stock. Not only are unnecessary expenditures generated when assets cannot be easily transferred from one activity to another, but a potential source of capital revenue i s not realized when assets unrelated to public policy priorities cannot be sold. Not having the appropriate mechanisms for asset management costs the public sector hundreds of millions of U.S.dollars. 21, Inordinate Growth of Liabilities against the State. Although reliable estimates still do not exist, contingent liabilities to the State that arise from legal action could reach as much as 2 percent of GDP if current trends continue. The legal claims that generate such massive losses to the State have varied origins, including labor or administrative disputes, but the most significant source are contracts in areas such as concessions or public works that have gone into arbitration. Significant efforts need to be invested to strengthen the public sector's capacity to defend itself, in parallel to an overhaul of the administrative processes(such as procurement) that leadto poorly designed contracts. * Source: Directorate of National Taxes and Customs (DIAN). 6  22. Inadequate Budgeting. The Colombian budgeting system i s plagued by numerous structural problems that are unquestionably key contributors to the difficulties in policy implementation, such as (a) the large number of legally mandated expenditure entitlements eliminates the fiscal space needed to accommodate revenue shock or changes in expenditure priorities; (b) a budget structure that is incompatible with economic, functional, or performance analyses; (c) a Ministry of Finance with limited authority to regulate public expenditure aggregates; (d) complex institutional arrangements that in effect divide the budget process into separate current expenditure and investment processes; (e) budgetingdefinitions that do not fall under internationally accepted standards; (0 a lack of instruments to develop a medium-term vision of fiscal policy; and (g) a lack of substantial evaluation of public expenditure results, among others. 23. Inefficient System of Royalty Transfers. The Constitution establishes a rigid system of royalty transfers through the National Royalty Fund (FNR) that does not promote efficiency intheir use. Inorder to obtain higher value-for-money in some of the key areas to which the royalties are directed, such as education, it is important to improve the targeting mechanismsvia constitutional reform if necessaryinorder to achieve higher impact from limitedresources. 24. Complex and Ineffective Public Procurement System. There i s a high fiscal cost associatedwith an inadequate public procurement system. Not only are the costs of government contracts higher than they would otherwise be, but poorly designed contracts (intentionally or not) find their way directly into litigation and generate large liabilities for the State. The Colombian procurement system is not only ineffective in overseeing potentially conflictive contracts, but is also plagued with complexities that raise the cost to biddersand cloud an effective application of modemprocurement principles. 25. Lack of Incentives for Performance. The Colombian budget system does not have adequatemechanisms to promote performance at the agency level. Furthermore, the administrative regulations (such as human resource management) are fairly rigid and make it difficult for public sector managers to be empowered with more flexibility. Under this scenario, it is difficult to have a serious system of performance evaluation that carries real consequences for both the agency and the government. Within an environment of severe fiscal constraints, it i s imperative to develop instruments to promote enhancedperformance inthe short term. 26. Past Government Responses. All recent governments have attempted to reverse these negative trends. However, the responses primarily addressed revenue and were partially ineffective with respect to the expenditure side, that is, reform of the public sector. To attempt to deal with excessive spending, previous administrations had launched several public sector reform programs. Yet these initiatives4uring 1992 and 1994, during 1998 and 1999, and in 200O-did not fully reach their desired outcomes. The limited success of these past reforms was primarily due to (a) some reforms, especially those between 1998 and 1999-though explicitly focused on expenditure reduction-faced legal or political obstacles; and (b) other reforms were not primarily targetedto expenditurereduction or to effectively tackle the innerroots of rigidgrowth in fiscal transfers or legal claims against the State. After these attempts at reform, the 7  Colombian public sector still requires a significant effort to reduce inefficiencies, align responsibilities, foster transparency, and improve management and accountability. 111. THEGOVERNMENT'S REFORMPROGRAM 27. General Framework: The Estado Comunitario and the Future of the Colombian Public Sector. The idea of Estudo Comuniturio lies at the heart of this government's public sector reform program. The Estudo Comuniturio is a set of basic reform guidelines put together and demonstrated in practice by President Uribe at the time he was governor of the department of Antioquia, perhaps the most developed intermediate-level administration in Colombia. Already elaborated and announced during President Uribe's campaign, the concept of Estudo Comuniturio inspired criteria for the selection of entry points and impact evaluation of public sector reform under the current administration. Although still evolving as a guiding concept of public sector reform, the Estudo Comuniturio incorporatesand adapts to Colombia a number of widely accepted, contemporary principles of public sector reform that will guide the renovation of the Colombian public sector under the current administration. 28. The concept of the Estudo Comuniturio i s the foundation of the National Development Plan2002-2006. The fundamental principle underlying the concept is that the State should exist for the service of its citizens and not for the benefit of special interests. The Estudo Comuniturio involves civil society in the attainment of social objectives; it i s a modern State where scarce resources are invested wisely and efficiently; and it i s a decentralized State that stands for regional autonomy with transparency, political responsibility, and community participation. 29. The National Development Plan proposes the development of the Estudo Comunitario through four basic pillars: 0 Democratic Security. The Statemust provide security andprotection to all Colombians, without political, ideological, religious, or socioeconomic distinctions. 0 SustainableDevelopment and Employment. Economic growth stagnated during the last few years and unemployment has grown by around 10percent since 1999. The Statemustprovide the conditions to recover the pathto economic growth. 0 Social Equity. The State must ensure that the fruits of economic growth are enjoyed by all Colombians. e Renovationof the State. The Statemust modernize its administrationand reform intergovernmental relations. The ultimate goal is to builda managerial, participatory, anddecentralized public sector. 30. The Estado Comunitario and the Fiscal and Institutional Reform Program. The fundamental purpose of the Fiscal and Institutional Reform Program is to liberate resourcesfor the effective implementation of public policy and to generate efficiency and transparency gains that will contribute to fiscal sustainability and the improvement of service delivery. Inthis sense, the Programis a necessary condition for the attainment of 8  the goals of the National Development Plan as described above. Democratic Security hinges upon the availability of untied fiscal resources, within a framework of macroeconomic stability, to invest in restoring peace to the country; Sustainable Development requires a sound macroeconomic framework and effective fiscal policy; Social Equity requires ability to deliver improved services to the poor and increase their ability to benefit from economic growth; and the Renovation ofthe State clearly entails efficiency and transparency gains and the necessaryinstitutional strengthening actions to deliver more andbetter public services inafiscally sustainableway. The reformprogram designed to implement this vision involves a wide array of constitutional, legal, and administrative measures that, together, represent the most significant reform effort since the Constitutionof 1991.3 31. Concept and Structure of the Public Sector Reform Program. The core of the reforms is contained in two reform packages known as the Tax Reform and the Renovation of Public Administration. These two packages are framed within and supplemented by other government reforms in such a way that the magnitude and expected impact of the former cannot be adequately grasped without reference to the latter. The program i s both coherent with and strengthened by the constitutional and legal reforms courageously undertaken by the current administration, involving apopular referendum scheduled for October 2003, a resubmission of a constitutional reform that was struck down by the Senate in July 2003, a pension reform, the reform of the Central Government structure, and a fiscal responsibility law enacted in June 2003. All these reforms have significant fiscal implications and should establish the necessary basis for Colombia's political reconstruction and economic recovery. Iv. THEFISCAL INSTITUTIONALREFORMPROGRAM AND A. OVERVIEW 32. Objectives of the Program. The Fiscal and Institutional Reform Program i s supported by the Bank through the series of four single-tranche Fiscal and Institutional Adjustment Loans (FIAL). The Bank approved the first loan of the program in March 2003 for an amount of US$300 million out of an estimated total of US$900 million for the entire program. This program has two objectives: first, to promote reforms addressingfiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The focus of the reform program will gradually shift from tax and fiscal responsibility at the beginning, to expenditure and public expenditure reformin the later stages. World Bank projects are supporting these reformefforts through a combined package of structural reform projects that include overall rationalization o f public expenditures (including pension and social security expenditures), labor reform, tax reform and tax administration, financial reform, and improvement of health, education, and family services. 9  33. The specific objectives of the FIALprogram are to: Increase tax revenueand reducedistortions inthe tax system; Modernize the tax administration; Promote the developmentof a soundfiscal responsibility legal framework; Reducelosses and generaterevenuesthrough improvedasset management; Prevent massivelosses to the State fromjudicial claims; Improve budgetmanagementwith moderntools and legal reforms; Develop incentives for efficiency gains insubnational entities; Strengthenthe public sector procurementsystem; Improve performance through management contracts for agencies; and Support acoherent andcomprehensivereformimplementation process. 34. Table 1describes the expected aggregate results of the reforms supported by the FIALprogram. Table 1: Expected AggregateResultsof theFIALReforms Objective I ExpectedResalt Promotereforms addressingfiscal rigidities 1 Average annual contribution to total fiscal revenuesof necessary to attain the substantialfiscal 1.4 percent of GDP from 2003 to 2006; adjustmentunderlying sustainable 0 Average annualcontribution to a reduction in current macroeconomic stability. expenditures of 1.6 percentof GDP from 2003 to 2006.4 0 Increasedreliability and transparency in medium-term I fiscal planningand a framework for more realistic budgetinn. Improve the provision of public services and A public expenditure system more closely linked to establishthe institutional basis for higher results; efficiency and accountability in public 0 Improved targeting of public expenditure toward expenditure. public policy priorities; 0 A more transparent, simpler, and institutionally robust systemof public sector procurement; 0 More efficient and cost-effective use of the assets of the Dubk sector. 35. Achievements under FIAL I.FIAL Isupported a successful package of reform measures, including (a) enactment of a tax reform law; (b) implementation of important tax administration measures such as increased withholding at the source and improved information exchange with banks; (c) enactment of a law authorizing a Constitutional referendum that, among other things, reforms the royalty transfer system; (d) enactment of Law 790 that strengthens the Ministry of Interior and Justice's Directorate of Judicial Defense; (e) issuance of Decree 2170 improving the public procurement system; (f) Includingthe overall effect of the referendum. Without the referendum this average is approximately 0.7 percent per year for the same period. Additionally, some Bank data not yet reviewed with the Government were usedfor the estimate of the impact on expenditures. 10  creation of a commission for asset management; and (g) selection of two pilot agencies for the implementation of a managementcontracts scheme. 36. Changes in the FIAL Program Since the Approval of FIAL I.The program has not undergone substantial changes since the approval of the first operation. The structure of the program and both the general and specific objectives remain unchanged, although the policy matrix has undergone a process of clarification and streamlining while still fully reflecting the scope of the reform program. On the contrary, the matrix has been strengthened by the establishment of specific quantitative targets in some components that in most cases go beyond those established originally, and reflect the strongpace of the reformprogram ledby the Government. 37. Of the subset of prior actions for FIAL I1that have been defined as a trigger^"^ in the FIAL Idocument, there have been three components where the sequence and measurement of the reforms have beenchanged: 0 Budget Reform. The original FIAL matrix called for the presentation of the Organic Budget Code to Congress as for FIAL 11. However, the political environment surrounding the .referendum, coupled with the potentially controversial nature of the Code (primarily because it seeks to reduce politically attractive permanent expenditure entitlements and revenue earmarks), has forced the government to take a more cautious and deliberate process of presentation of the bill to Congress. This will now take place before FIAL 111goes to the Board, while the approval of a policy document outlining the elements of budgetary reform will be approved for FIALI1and the Organic Budget Code approved for FIALIV. 0 Tax Administration. The original FIAL matrix called for the operation of an integrated tdcustoms taxpayer current account system for the largest taxpayers during 2003. However, DIAN adopted a new information technology strategy during this year that calls for the development of a platform that will provide integrated accounts for all taxpayers, but which will not be ready untilmid-2004. This new strategy is being supported and partially financed through the Bank- financed Public Financial Management Project I1 (MAFP 11). Therefore, the original policy action has been removed from FIAL I1and introduced into FIAL 111withabroadercoverage. 0 Asset Management. The original FIAL matrix used revenue targets to measure the progress of the asset management program. Following expert advice, the program now measures this with both institutional development indicators and coverage in terms of assets by the asset management system, while the revenue targets havebeendiscarded. The triggers definedfor this operation are a subset of the policy matrix and are prior actions that needto be fulfilled for the approvalof this loan by the Bank. They have beenidentifiedas the key elementsof the reform process and serve as guidepostsof the progressof the program. As part of the prior actions, these triggers are includedinthe loan agreement and are part of the package of policy measuresthat sustainthe loan. As this is not standard practice in programmatic lending, specialauthorization was received fromthe LegalDepartment. 11  38. Expected Results under FIAL 11. The measures supported by FIAL I1are expectedto yield important results, including (a) issuance of all legislation to regulate the application of the tax reform law; (b) further improvements in tax administration, including specific audit targets and the implementation of integrated tax-customs audits; (c) approval of an official budget reform strategy; (d) Congressional approval of an improved 2004 Annual Budget Law; (e) presentation to popular vote of the Constitutional referendum; (0issuanceof a new policy for legal defense of the state; (g) presentation to Congress of reforms to the public procurement law; (h) approval of an official asset management policy and the achievement of specific revenue targets; (i) signature of management contracts with two government agencies; and (i) enactment of a Fiscal Responsibility Law. 39. ForeseenResultsof FIAL I11and IV. FIAL I11is expected to focus primarily on the following key policy actions: (a) achievement of specific targets of the tax reform; (b) unification of taxpayer accounts; (c) presentation of the Organic Budget Code to Congress; (d) full implementation of revisedroyalty transfer scheme; (e) establishment of the institutional arrangements of the procurement system; (f) evaluation of the pilot management contract scheme; and (g) full implementation of the Fiscal Responsibility Law. FIAL IV will focus on actual results from the tax policy and administration measures and the approval of the Organic Budget Code, implementation of medium-term budgeting, extension of the management contract scheme, and the effective implementation of the procurement, fiscal responsibility, asset management, and legal defensepolicies. 40. OverallAssessment ofthe Reforms. The Government has shownahighlevel of commitment and resiliency in pursuing the objectives of the reform, which i s largely based upon the President's campaign platform and his initial presidential directives for public sector modernization.6 During the first year of the Uribe Administration, the executive has worked with Congress for the enactment of over 100 laws, including major reforms in tax policy, pensions, labor, fiscal responsibility, and most important, the approval to present a referendum to the population with significant measures for fiscal sustainability and reduction inthe levels of corr~ption.~ 41. The tax reform supported by FIAL I(and its full regulation by FIAL 11) has shown important results and statistics show that revenue has increased according to expectations. Nonetheless, the government is still considering further measures to raise revenue while observing international best practices in tax policy. To complement the tax reform and as a prelude to the upcomingbudget reform, Congress approved the Fiscal Responsibility Law, which sets out important principles for fiscal sustainability and transparency. Expenditure-side reforms of the kind supported by the FIAL are more complex and some of them show results only inthe mediumor long term; however, some indicators that show that the reform process i s on track are the following: (i) The On July 26th,President Uribe held his first live, televised cabinet meeting where the Ministers presented reports on their accomplishments to date. Most of the objectives of the FIAL, notably in taxation, budgeting, procurement, and fiscal responsibility, were explained and discussedat length. The Constitutional Court recently ruled that most of the questions in the referendum are constitutional, including all related to the FIAL. Shortly afterward, the Government set the date of October 25" for the vote. 12  government has taken the overhaul of its budgeting system very seriously and has obtained assistance from the Bank, the IMF, and other entities in the design of a new budget law; (ii) The 2004 Budget Bill was submitted to Congress and approved incorporating substantial improvements in terms of medium-term planning and the provision of useful information for fiscal analysis; (iii) Strategies have been defined and institutional arrangements established to oversee areas such as asset management, legal defense of the state, and public sector procurement; (iv) A novel management system is being piloted to enhance accountability for results; and (v) A referendumto consult the population on key issues involving fiscal, political, and institutional issues has been scheduledfor October 25. 42. The FIAL Program within the Bank's Country Assistance Strategy (CAS). Under its objective of achieving fast and sustainable growth, the CAS approved in December 2002 indicates that, "The mainobjective of the IBRD'sstrategy interms of the macroeconomic framework would be to support Colombia's continued fiscal adjustment, including the quality of the adjustment, as key for achieving faster and sustainable growth. To support this, the IBRD, inclose collaboration with the IMF and the IDB, will prepare a Programmatic series of Fiscal and Institutional Adjustment Loans (total US$900 million) to support fiscal adjustment, including reforming the tax system, strengthening the tax administration, implementing a fiscal responsibility law and reforming the public sector." The CAS scheduled the first loan of the program for FY03 in the amount of US$300 million, followed by two loans of US$l50 million each in FY04 and FY05, and a final US$300 million loan inFY06. 43. Linkage between the Programmatic Fiscal and Institutional Adjustment Program and other Bank Operations and Activities. The proposed Programmatic series of Fiscal and Institutional Adjustment Loans to support public sector reform and fiscal adjustment i s the core of the Bank's support to the reform efforts of the government, and will provide the basis upon which complementary policy-based operations will be developed. These include support to the financial sector inthe form of Programmatic Financial Sector Adjustment Loans (FY03 and FY04) that aims to promote the development of a well-functioning financial system that can provide adequate services to all segments of the productive sector and the population at large. Inaddition, building on the achievements of the Financial Sector Adjustment Loan (FYOO), it w i l l address the remaining agenda to ensure the health and financial sustainability of the banking system and to foster capital markets development. 44. The anticipated Sustainable Development Sector Adjustment Loan (FY05) w i l l support the mainstreaming of the environment in practically all infrastructure sectors, includingwater and sanitation, energy, transport, and disaster management. The tools for mainstreaming environment include policy setting, strategic environmental assessments, land use planning @lanes de ordenamiento territorial), permits and licensing, environmental regulation, economic and fiscal instruments, social impact analysis and valuation, assessment and linkage with global environmental goals, participation and conflict-resolution mechanisms, anddevelopment of sector-environment indicators linked to health impacts. These tools are currently being used in most sectors, however, this operation aims to enhance effectiveness and impact by providing a more rational 13  application based on priority-setting and institutional analysis (how the environmental management institutions set priorities, receivebudgets, and function). 45. The FIALprogram shares some areas of mutual interest with the Programmatic Labor Reform and Social Sector Adjustment Loan (PLaRSSAL) approved by the Bank during the second quarter of FY2004. The task teams have worked in coordination, and the two main areas of interaction are (a) Management Contracts for Government Agencies. Bothprograms seek to improve the efficiency and effectiveness of Colombian Family Welfare Institute (ICBF) and the National Training Service (SENA). The FIAL approaches t h i s issue through the creation of a new instrument for improving management that can then be replicated to other entities and sectors. PLaRSSAL, on the other hand, is concerned with the substantive impact of the managerial reforms on quality and coverage of service delivery.8 (b) Incentives for Efficiency Gains. This FIAL component has the objective of introducing incentives that promote the use of results- based management to improve efficiency and effectiveness of fiscal transfers to the subnational levels, particularly in the education sector, and will support the presentation of the referendum to popular vote which includes a provision to assign 56 percent of the National Royalty Fundto education projects exclusively to increase school attendance in vulnerable groups. Other quantitative and qualitative sector-specific outcomes and indicators are considered inthe PLaRSSAL. 46. In addition, the FIAL program is highly interrelated with the current Public Financial Management Project II (MAFPII), aimed at strengthening budgeting, tax administration, public investment management, procurement, and results management. This Bank-financed Technical Assistance Loan (TAL), in implementation since August 2001, i s the most important source of technical assistancefunding for the implementation of the FIAL policy actions. Although it was approved before the FIAL discussions began, its objectives are fully consistent with the FIAL policy matrix. The components that are within its scope and are receiving assistance are tax policy, tax administration, budgeting, and procurement. Support for management contracts for government agencies and the monitoring of the overall reform process also fall within its scope, and technical assistancewill be made available shortly. 47. Complementaritieswith other Institutions'Operations. The IDB is preparing an investment operation of approximately US$18.3 million, designed to support the implementation of the overall reform program and specific support to asset management, legal defense of the State, and information technology. Both task teams are working in close coordination since the IDB's components of asset management and legal defense of the state will support and be consistent with the FIAL's policy matrix. This loan is expectedto go to the IDB's Boardof Directors duringthe last quarter of 2003. 48. InstitutionalAssessment. The FIALprogram is being executedby the Ministry of Finance (MHCP) with the support of the National Planning Department (DNP). MHCP will ensure the full execution of the policy measures and "triggers" established in the program. These activities will be carried out inclose coordination with DNP. In other words, the FIAL is concerned with the success of the "instrument," whereas the PLaRSSAL is concernedwith the "substance" of the reformsinICBFand SENA. 14  49. Given the size and relative complexity of the program, the General Vice-Minister of Finance, working closely with the Deputy Director of DNP, will be responsible for the strategic management of the program. These two agencies have the consensus-building capacity and political, technical, and operational support required to assume this responsibility. Both are part of CONFIS, participate actively in Congressional debates and Cabinet meetings, and serve as counterparts to the IMF and other multilateral agencies as representatives of the Finance Minister andthe Director of DNP. In addition, the Vice-Minister of Finance and the Deputy Director of DNP are responsible for the execution of MAFP-TI[ and its respective institutions. They will be capable o f establishing synergies and synchronizing the parallel development of MAFP-11 and FIAL-II. 50. The strategic management of the program will involve the following actions: (a) being the interlocutor of the national government with the Bank; (b) supporting and managing the fulfillment of the policy actions of the various program components; (c) coordinating the development of the planned actions and reforms with those responsible within the various entities; and (d) compiling and sending the technical, legal, and administrative information required for the execution o f the policy measures of the program. 51. To assume the responsibility of coordination and follow-up of FIAL-11,an inter- ministerial working group has been established within MHCP, comprising all agencies and entities involved in the program, including MHCP, DNP, the Ministry of Social Protection, the Ministry of Justice and the Interior, SENA, and ICBF. Each of these entities has designated one high-level professional as a representative to this inter- ministerial working group, and as the one directly responsible for program components. Table 2 outlines how responsibility for each of the program components has been divided. and ICBF Legal Defenseof the State Ministry of Justice andInterior (Vice-Minister) Public Sector Procurement DNPLegalAdvisory Group Asset Management DNPLnfrastructure Department Public Sector Reform DNPPublic Administration ReformProgram Monitoring and Evaluation of State Reform DNP/SINERGIA andMHCP/CONFIS FiscalResoonsibilitv Law MHCPRechnical Vice-Minister 52. For the development of the duties required for the strategic management of the program, the Vice-Minister of Finance has the support of expert professionals within the Superior Council of Fiscal Policy (CONFIS) and within the general directorates o f Macroeconomic Policy, Taxes and Customs (DUN), Public Credit, Budget, and the Treasury. For the development of the duties that correspond to DNP, DNP has the 15  support of valuable professionalsin the directorates of the Public Administration Reform Program, Infrastructure, Social Development, Justice and Defense, External Credit, and Results Evaluation. 53. As part of the planned measures in FIAL-11, the government has developed a system for monitoring and evaluating state reform, and has announced monitoring indicators for public sector reform progress on the DNP website. The DNP, through the Evaluation System for Public Management (SINERGIA) (for components of Asset Management, Legal Defense of the State, Procurement, Management Contracts, and Management of the Reform Process) and MHCPKONFIS (for components of Tax Reform, Tax Administration, Fiscal Responsibility, Budget Reform, Incentives for Efficiency Gains, and Management of the Reform) will follow up and evaluate results of FIAL-II. The results of FIAL-I1will comprise part of the findings of the government's National Development Plan for 2002-2006. The government has the mandate to follow up in terms of effectiveness, productivity, and efficacy, and the results of the follow-up and evaluation will be reportedto the Bank by meansof periodic reports. 54. Technical Assistance. Many of the technical assistance requirements of several key components-particularly tax administration, budgeting, and procurement-as well as the financial management or evaluation features of other components, will be partially or fully provided by the MAFPII project, currently in execution. In addition, the Government and the IDB are considering includingtechnical assistance support for other FIAL components-particularly asset management and legal protection of the State- under an IDB-TAL project currently under preparation. Moreover, the GOC and the Bank are exploring complimentary grant financing through Institutional Development Facilities (IDFs) or Policy andHumanResourcesDevelopment grants (PHRD) to support the reform process. Table 3 summarizes the technical assistancearrangements. Table 3: Sourcesof Technical Assistancefor the M A L Program Component Source(s) status Tax Reform tIMAFPI1(IBRD) IIInexecution 55. Fiscal Commitments. Within its macroeconomic framework, the government signed a new Stand-By loan with the IMF in the amount of SDR1.5 billion for the next two years (see Annex 11-Fund Relations Note). Achieving the structural benchmarks of 16  the agreement will constitute an overarching policy condition for the FIAL. Some of the targets of the IMF-backed program for 2003 are a Combined Public Sector deficit of 2.5 percent of GDP, a current account deficit of 0.8 percent of GDP, and an inflation rate between 5 and 6 percent. 56. Although fiscal performance has remained within the framework of the IMF agreement through the first semester, there i s widespread expectation that the year-end deficit will b e above 2.5 percent of GDP. This will be fueled by several factors, among them the seasonality of expenditures and a supplemental budget to be considered by Congress that includes unforeseen debt payment obligations, pensions, a n d the cost of the referendum. An IMF mission will review the progress in the agreement during the last week of October. B. COMPONENTSOFTHEPROGRAM 57. Tax Policy. Colombia gets its fiscal revenue from three main sources-oil royalties, customs duties, anddomestic taxes. The value of oil revenues depends largely on world market factors beyond the government's control, although there i s scope for reform of how these revenues are allocated and shared between different levels of government.' Customs revenues have generally declined over recent years, with trade liberalization, andthis trend shouldcontinue for the sake of economic development. The main opportunity for increasing revenues comes from domestic taxation, which i s also an important area for reducingeconomic distortions and administrative complexities. For the last 15 years the value o f oil revenues has also suffered from attacks on the pipelines. 17  Figure 3: Timeline of Changes inTax Policy Total Income 1990-2002 (`76 GDP) 16 14 :: 12 n 10 6 4 1 , , , 1 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year 58. Previous rounds of tax reform, particularly in 1974and 1986, left the country with a fundamentally sound array of taxes at the national level-on value added, corporate, and personalincome. The two aspects of the income tax are largely integrated by exempting dividends from taxation as personalincome and giving all corporate forms equal tax treatment. Prior to 2003, capital gains were not taxed at the individual level, which hadthe advantageof avoiding double taxation of retained earnings (matching the non-taxation of distributedearnings and further integrating the business and individual tax systems), buthadthe disadvantageof reducing revenue and offering opportunities for tax avoidance through schemes to convert current income into capital gains. 59. Aside from the major reforms, however, the tax laws have suffered frequent changes that reduced revenue collection and introduced distortions by granting preferential treatment to special interests or, alternatively, increased revenue and intensified distortions by raising the rates on activities already being taxed. Figure 3 shows the recent timeline of changes in tax policy and revenue. Now, the new government of Colombia has an electoral mandate to raise more tax revenue, and the challenge is to do so ina way that reducesprivileges anddistortions. 60. Key Policy Actions Undertaken. The enactment of Tax Reform Law 788 in December 2002 brought together some of the key policy actions geared to the modernization of Colombian tax policy. This law (a) eliminates exemptions and expands the tax base for the value-addedtax; (b) establishes a new ceiling on the wage exemption for the personal income tax, and reduces incentives for non-taxed compensation to employees; and (c) phases out the corporate income tax exemption for capital gains from sales of stock, mutual funds, and real estate, and for profits from previously privileged corporate forms, contracts, funds, or bonds. On a tax-by-tax basis, the 2002 tax reform included the measuresshown inTable 4. 18  4. Key Measuresoftbe 2002Tax Reform(Law 788) Tax ITable Key Effects Value-Added I A large number of previously exempted or excluded goods and services will be Tax subject to the VAT at 7 percent from 2003, risingto 10percent in2005 Mobile phone rate established at 20 percent Rate on automobile sales will be unified at 25 percent from the current range of 20 percent to 35 percent Collection of VAT on all capital goods with a 3-year rebateor credit for registered firms making further sales Personal Reduction of the wage tax exemption from 30 percent to 25 percent with a ceiling Income Tax of Co1$16 million inmonthly wages, and reduction of tax exemptions, tax credit, and non-taxed income for the personal income tax Corporate 0 Phase-outof exemptions for capital gains from sales of stock, mutual funds, and IncomeTax real estate, and for profits from a variety of previously privileged corporate forms that often served as tax shelters Reducedaccess to the special tax regime (20 percent rather than the standard 35 percent) 10percent special surcharge for 2003, to be loweredto 5 percent in2004 Other National Does not eliminate the distortionaryfinancial transactions tux implemented in Taxes and 1999;however, it closes some loopholes for transactions inthe real economy and Contributions allows exemptions for some interbank transactions not meant to be taxed Subnational Rationalizes departmental and district taxes on alcoholic drinks Taxes Increasesthe gasoline tax surcharge transferred to subnational governments by 5 percent 61. The Government has moved ahead quickly in the preparation and approval of a large number of decrees that regulate the implementation of Law 788. Among the most important issued to date are those on dispute resolution, declaration of assets held abroad, inflation adjustment of inventories, closing loopholes to the financial transactions tax, revisions to the value-added tax, VAT exemptions for exporters, taxation of rental property, and determining and imposing penalties. 62. Remaining Challenges. In addition to completing the issuance of regulations for the tax refom, the government will be implementing actions in 2004 that were foreseen inLaw 788. These mainly involve reducing the exemptions inthe corporate income tax law and reducing from 10 to 5 percent the surcharge on the corporate tax base rate, both of which should improve the overall investment climate andreducedistortions. 19  EE Table 5: Ta INTERNALTAXES 9,311 9.47 10,924 10.0 1,613 0.54 IncomeTax 5,763 5.86 6,694 6.1 931 0.27 VAT 3,548 3.61 4,230 3.9 682 0.27 EXTERNALTAXES 2,376 2.42 2,979 2.7 603 0.31 Customs 944 0.96 1,018 0.9 74 -0.03 ExternalVAT 1,431 1.46 1,960 1.8 529 0.34 GMF(0.3%) 682 0.69 750 0.7 68 -0.01 TOTAL 12,369 12.58 14,653 13.4 2,284 0.84 Source: Ministry of FinanceandPublicCredit. 63. The provision of Law 788 that established a 2 percent VAT starting in 2005 on previously untaxed goods and services such as basic foodstuffs, health, education, and transportation was recently challenged and rendered unconstitutional by the Constitutional Court because it violated the principles of progressive taxation. The expected annual collection from this measure was 800 billion Colombian pesos (approximately US$280 million, for 2005), which the government will need to raise through alternative measures. Some of the options being considered are a 3 to 4 percent VAT on certain previously exempt goods while maintaining the exemption on certain services, such as health and education, or a progressive pensions tax. Therefore, fiscal sustainability will require an additional round of tax reform in the future, with content and schedule yet undetermined. 64. Expected Outcomes. These measures will expand the VAT tax base from about 41 percent of consumption in 2002 to about 59 percent by 2005," a major achievement. Regarding the corporate income tax, the phase-out of exemptions will reduce them from 70 percent of potential revenuein2003, to 50 percent in 2004, to 20 percent in 2005, and to 0 percent in 2006. An increase in subnational revenues by one-fifth i s expected. Preliminary estimates by the authorities indicate that tax collections would increase by about 1percent of GDP in 2003 as a result of the tax package, rising to 1.2 percent of GDP in 2004 and to 1.7 percent of GDP in2005. Table 5 shows the observed increase in . tax revenuescomparing the first semester of 2002 with the first semester of 2003. 65. Tax Administration. Even the best policy reforms would realize their goals of greater revenue yields with fewer distortions only if there are improvements in tax administration. This remains a major weakness in Colombia, where tax revenues are substantially below what the rates and the tax base would normally suggest. 66. The VAT and income taxes each collect only a little over 5 percent of GDP. The National Directorate of Taxes and Customs (DIAN) is the entity responsible for tax and customs administration. Some of the most important areas where the tax administration needs improvement are: loAssumingthatthe 2 percentVAT getsrestoredor replacedby anequivalent measure. 20  0 Revision of the relationship with the banking systeminorder to standardize information flows andreducethe period during which funds are held by banks (now 14days); 0 Improvedcoverageof withholdings of interest income on individuals, now only at 7 percent andfrom large accounts only; 0 Increasedintegration betweenthe areas of internal revenue and customs, especially inprocesses such as auditing and informationmanagement; 0 Reducedcosts of enforcing compliance. 67. Key Policy Actions Undertaken. The DIAN has undertaken a major modernization effort and is working hard to meet the revenue targets for 2003.'' It has establishedregulations to reduce the threshold of interest income revenue to be withheld at the source, enhancedreportingby financial institutions, establisheda plan to collect tax debt, anddefined indicators to monitor customsprocesses inBogotaand Medellin. It has improved the cross-referencing of information with financial institutions, audited a majority of the large taxpayers that were brought into the new tax regime, established performance indicators for tax administration, and carried out over 200 integrated audits (taxes and customs), which is well above the commitment in the policy matrix. The MHCP will present to Congress a draft law to regulate the penalization of tax evasion. Furthermore, DIAN has increased its auditing activities dramatically and has embarked on an ambitious modernization effort with the support of the Govemment of Spain and the Bank. 68. Remaining Challenges. Many challenges to tax administration still lie ahead, In the medium term, DUN knows it needs to make significant efforts in systems development, and reengineering of processes and procedures, and that improved regulations of andrelationships with the banking system are necessary, which are in turn expected to yield a reduction in administrative costs per peso collected of 10 percent, a collection of 75 percent of potential revenue from previously exemptedcorporate income taxes, and markedimprovements in a broad set of performance indicators. These will be accomplished with the support of FIALI11and IV. 69. Fiscal Responsibility. The fiscal situation in Colombia reflects the extent of excess demand on the State, its inability to meet those demands, and the urgency of achieving sustainable balances. A sound fiscal framework i s essential for the national security effort, for the social programs that sustain the State's legitimacy, and for the protection of common citizens against the ravages of inflation. Achieving that will require, among other things, institutional reform of the formulation of macroeconomic policy, and close monitoringand control to meet short- and long-term fiscal targets. 70. Behindthe unavoidable fiscal arithmetic by which spending in excess of revenue has led to deficits and the accumulation of debt in Colombia, there lie budgeting and fiscal management procedures that gave rise to the unsustainable fiscal tendencies. Colombia has given increasing attention, therefore, to changing its rules of the game for fiscal policy at all levels of government. Until recently, the Constitution and legal rules for budgeting and treasury have done little to restrain Central Govemment deficits a n d In the televised cabinet meeting, DIAN announced that it had collected over 99 percent of the revenue target set for the first seven months of 2003, which was COPI7,582,000 million. 21  debt, and in some ways they encouraged them. For example, vigencias futuras make commitment for future expenditure and the allowance for arrears based on ad hoc promisesfor future payment of current expenditures. 71. In the 1990s, the new Constitution broadened political participation, increased spending impulses, and weakened the tax base of the national government (automatically sharing it with subnational governments), all of which compromised overall fiscal prudence. The Acto Legislativo (constitutional reform) of 2001 sought to put ex ante limits on some of the spending impulse coming from transfers to subnational governments. 72. Despite these reforms, the national government believes that at all levels of government there remains too much discretion affecting fiscal deficits and not enough assurance of fiscal sustainability. DNP evidence to this effect is the fact that Central Government expenditures have increased steadily from 9.4 percent of GDP in 1990 to 20.8 percent of GDP in2002. 73. Key Policy Actions Undertaken. The Colombian Congress approved a Fiscal Responsibility Law (FRL) inJune 2003 that sets the stage for fiscal sustainability. After severalrounds of revisions andconsultations with the Bank, the bill was enacted into law. The bill had been discussed within the government and Congress since the previous administration, and it came through Congress without any ad hoc amendments or cumbersome transition clauses. The FRL contains rules for fiscal stability, transparency and macroeconomic consistency, fiscal discipline, and subnational debt limits that reinforce and expand the measures previously taken with Law 617. The Law contains rules for (a) setting fiscal targets linkedto debt sustainability and primary balance for the Non-Financial Public Sector (NFPS); (b) publication of the financial plan; (c) annual reports of fiscal results to Congress; and (d) the obligation to include the fiscal impact and source of financing within any new law that affects taxes or expenditures. 74. Remaining Challenges. The key challenge in relation to fiscal responsibility will be the full application of the FRL in 2004, including the issuance of regulations. The main new work will be the development of a Multiyear Fiscal Framework (Marc0 Fiscal Multi-Anual) and the accompanying reports, which are due for the first time in summer 2004 but have been advanced in the presentation of the 2004 annual budget bill to Congress. As this i s developed and the complexities become apparent, the government will at the same time develop and then issue the regulations. Here the issues of calculation of contingent and floating debt will be spelled out-the format for reporting them, linkage of the Multiyear Fiscal Framework with the stipulations of the Organic Budget Law (to be submitted to Congress by then), and the regulation of subnational debt. 75. Asset Management. Public Asset Management is the institutional framework used by the public sector to account for, administer, allocate, maintain, use, and dispose of government assets. Currently, the existing information on public real estate assets i s deficient, incomplete, and unreliable.l2 Furthermore, the administration of public real ~ l2For example, current figures on public asset inventories reflect the unreliable information systems used. Of the 302 entities at the national level, only 187 report information about their asset inventory to the Contaduria Generalde la Nacio'n(CGN). Additionally, most entities report incomplete information. 22  assets has been focused on precarious registration procedures and deficient conservation and maintenance of the properties. Itis inmany cases unknownwhether the asset is up to date in terms of legal contingencies, accounts payable, and so forth. Additionally, the high cost of normalizing assets has caused a significant proportion of public assets to have legal problems. This situation implies unnecessary public expenses and a high opportunity cost. The new framework will create the rules, regulations and organizational practices-both formal and informal-for an efficiency-driven asset management policy. 76. Some agencies have accumulated a varied array of properties and other assets, which with unclear legal status and economic value, incomplete registration, and irregular control, do not constitute a solid basis to apply professional management criteria. Moreover, there are no standardized procedures, centralized control, or incentives for efficient asset management. The complex legal framework i s an additional burdenbecauseit does not recognizemarketprinciples, nor doesitprovide adequatelyfor discretionary managerial actions. As a result of all these factors, asset management i s inefficient, andthere is a substantial accumulation of idle assets. 77. Key Policy Actions Undertaken. A government team for asset management was set up by DNP to lead the reforms in this area, prepare a National Council of Economic and Social Policy (CONPES) document defining the government policy in this matter, and to carry out a short-term asset sale and savings program meant to generate approximately US$10.5 million in capital revenue. The CONPES document has been approved and provides the initial framework and procedures for standardized, coherent, and efficient asset management. 78. Remaining Challenges. DNP will be the agency in charge of implementing the directives contained in the CONPES document. This is crucial since at present no entity in the Central Government is in charge of asset management, and standard policies and procedures have to be developed from scratch. The scope of this initial work also includes the operational planning for the elaboration of consolidated inventories (with verification of title, possession, value, and accounting registration), the request to entities of the Central Government to report on their current asset stock, and the realization of savings and revenuesinthe short term of approximately US$9 million. 79. Subsequent actions include (a) the formal establishment of a centralized unit in charge of the coordination of the more substantial reforms, the development of manuals of policies and procedures, provision of technical assistance and overall guidanceto other participating agencies, and management of a database system; and (b) development of a more flexible and open-minded approach to concessions, leasing, privatization, outsourcing, and so forth, and the publication of the inventory of assets owned by each agency, increasing transparency and accountability. The new approach will have four mainpillars: 0 Contribution to Public Investment in Social Proaams: Priority will be given to the identification of idle public real estate assets that can be transferred to the national social housing program. DNP will work together with the Ministry of Housing and Environment in the design and development of a legal and financial scheme that will speed up the transformation process of idle public real estate 23  assets into social housing projects. This will help to achieve the government's targets in the reduction of the existing housing deficit (1.5 million units). More specifically, social programs such as land reform, primarily or victims of violence, will be addressed. 0 Urban Renovation: The state has a large mount of nonproductive assets that could be usedby localmunicipalities anddistricts for urbanrenovation projects. 0 Real Estate LeasindRents: Public real estate assets generating revenues can be packaged and sold incapital markets. a Sales: The existing legal framework limits the selling process of public assets. In this regard, legal reforms have to be submitted to Congressto approve innovative outsourcing schemes for the implementation of commercial strategies to dispose of assets. This includes the contribution of idle public property to private real estate projects as a means to speed up the sale and generate value in the process. These schemes have proven successful in social housing programs at the municipal level (Metrovivienda) and could be adapted to serve the Central Government's objectives . 80. Protecting the State against the Extraordinary Growth of Legal Claims. Litigation against the State has a substantial fiscal impact in Colombia, much above known impacts for other countries. Typically, lawsuits against the State arise from poorly drafted contracts, which leave space for litigation regarding the interpretation of rights and obligations. Since 1994, the number of cases filed has increased enormously, andtheir outcomeshave contributed negatively to the current fiscal crisis. Inthe last four years, actual payments due to formal first instancejudicial or arbitration decisions against the State exceeded US$145 mi1li0n.l~ This amount alone i s cause for serious concern, but reflects only the flow of actual payments made; estimates show the accumulated stock of contingent liabilities growing at an alarming speed. If this trend continues, it i s estimated that by 2006, liabilities due to judgments against the State will represent approximately 2 percent of GDP (see Figure 4).14 81. This scenario i s aggravated by the fact that the State cannot afford to honor on time all compensatory payments. An extremely high rate of penalty interest (up to 30 percent per year) i s applied, creating a "snowball effect" in the State's liabilities. This allows ample margin for unethical practices, as creditors "prefer" to be paid late and benefit from a very attractive returnon their accounts receivable. '` l3Based on data from MHCP, before the decision o f the appeal level. Note that a single case still pending decision, Telecom, could generate compensation payments of up to US$282 million, adding great fiscal ressure that is not sustainable in the short term. Sources: Contraloria General de la Nacidn; Contaduria General de la Nacidn. These figures have not been independently verified by the Bank, DNP, or the Ministry of Finance. 24  Figure 4. AccumulatedFiscalCostof Contingent LiabilitiesAgainst the State 8000 1995 1996 1997 1998 1999 2000 2001 2002(e) Sources: Contralon'a Generalde la Republica,Contadun'aGeneral de la Nacibn,and WorldBank 82. Regardless of the complexity of the situation, three distinctive elements can be identified as the main reasons for this problem. First, there seems to be a web of civil servants, contractors, judges, attorneys, and so forth engaged in coordinated corrupt practices that materialize in such things as reciprocal favors of poorly drafted contractual agreements, fake accusations and claims, high compensation payments, and intentional "erroneous" decision^.'^ Second, the Colombian State has a weak capacity to defend itself in court. The private sector i s better equipped to retain expert legal advice, and therefore their claims are exerted with much more rigor. Third, the legal framework encourages the State to act passively with respect to demands and claims from individuals. In labor and contracting legal issues, the State recognizes certain rights of counterparts,but in doing so, compromises its own position. 83. The Ministry of Finance, the Planning Department, and the Ministry of Interior and Justice are especially concerned with the fiscal threat that originates from a weak legal andjudicial performance of the State. These government units, with the support of sector ministries, the Procuraduria, the Contraloria, and the Consejo de Estudo, are committed to elevating the institutional capacity of the State to protect itself from legal claims as apreconditionfor an effective reform. 84. The objectives of strengthening legal protection of the State are (a) to reduce negligence and corruption in the management of state affairs, including labor and commercial contracts; (b) to reduce fiscal impact of judicial and arbitration decisions against the State by seeking compensation from responsible officers or third parties; (c) to strengthen the state capacity to prepare, monitor, and control large investment contracts and labor relations with a view to prevent contractual disputes; (d) to anticipate and prevent state responsibility for infringement of basic rights; and (e) to foster a better l5This appears to have happened, for example, in the recent decisions against the State for the cases of Foncolpuertosand Termorrfo. 25  investment climate through enhancement of transparency, predictability, and responsibility in state contractualand extra-contractual relations. 85. Key Policy Actions Undertaken. The immediate objective of the government i s to improve its legal protection through the institutional strengthening of the Ministry of Interior and Justice's (MIJ) Directorate of Legal Defense. As part of Law 790, which pushed the agenda of public sector modernization and gave the President special authority to restructure the Executive Branch, Congress approved a specific clause for strengthening the MIJ's roles and responsibilities in legal defense and mandated the implementation of an information system to track and raise alerts regarding lawsuits. Consequently, the Directorate of Legal Defense i s carrying out a detailed diagnosis and typology of the related issues, causes, and costs to produce policy guidelines to be approvedofficially by the government. 86. Remaining Challenges. The enactment of Law 790 and the groundwork being carried out by the MU is just the beginning of a lengthy process of strengthening legal defense, and its actual impact on the budget may not be seen for years. The MIJ needs a highly qualified cadre of staff to carry out the mandates of the law (including the obligation to coordinate the defense of all claims above 2,000 monthly minimumsalaries, or approximately US$235,000). An effective reduction in the fiscal cost of claims also requires a coordinated effort with the sources of the dispute (such as the procurement process), and with other agencies of control and oversight. The overall diagnosis and strategy was approved as a CONPES document and became official government policy. The information systemmandatedby the law is also of highimportance to ensure prompt action when required.16 87. BudgetManagement. Colombia's planning andbudgetary process is a complex interplay of various entities operating under diverse rules andprocedures. It produces the NationalDevelopment Plan, the Financial Plan, the National Investment Plan, the Annual Investment Operative Plan, and the Budget. Theoretically, they are fully consistent with one another, but in practice they differ among themselves. Budget law figures are actual appropriations instead of expenditure caps, which consequently limit the scope for expenditure control during the budget year. Furthermore, the budget process does not produce reliable revenueestimates. 88. Over the years, many Colombian interests have successfully won permanent budget entitlements or revenue earmarks. This has served to circumvent resource constraints and to reduce the scope for government decisionmaking and good fiscal policy. It has also crimped the mobilization of funds for new programs. This problem has been recognized and acknowledged by the Colombian authorities since it was first pointed out by the 1980-8 1 Presidential Commission for Inter-Government Fiscal Relations. However measuresto attenuate it have been too weak or short-1i~ed.l~ l6The technical assistancerequired to achieve the long-term objectives of legal protection of the State will be provided by an IDB-funded TAL, currently inpreparation and scheduled for approval in late-2003. l7 Cf. Bird, R. M., 1981, Colombia. Inter-govemment Fiscal Relations. Harvard University, International Tax Program. The Presidential Comisidn de Gasto Pliblico of the early 1990sproduced a report of similar category. 26  89. Other deficiencies in the system include the absence of suitable controls over budget outcomes. Instead of having effective "checks," Colombian budgeting is too process oriented. This has hamperedthe tracking of such important elements as stability, effectiveness, and efficiency. In addition, Congress lacks the technical capacity to properly analyze budgetinformation. 90. Thus, the challenge i s to initiate a transformation of the budget system through several fronts: first, to introduce greater flexibility by restricting earmarking of revenues, permanent expenditure entitlements, and the use of forward budgeting; second, to establish effective controls over expenditure aggregates; third, to develop tools for improved medium-term budgetary planning; and fourth, to make the budgetary process more policy focused and accountablefor results. This will not be an easy task. Besides the inertial tendencies to maintain existing practices, the vested interests that have gained power on budgetdecisions will resist giving it up. 91. Reform will require sustained changes in rules and procedures to make budget decisions according to policy priorities (allocative efficiency), performance and results (productive efficiency), and available resources. This would affect how Central Government and sectoral authorities decide on what should be done, how it is going to be achieved, and who i s responsible for it. It would also affect subnational governments to the extent that national rules and practices are also applicable to regional and local governments. The new rules also call for mechanisms to hold policymakers and managers accountable for planned outputs and outcomes to be delivered in a timely fashion. 92. Key Policy Actions Undertaken. The first attempt by the Government to rationalize the budgetary system was contained in a proposal for constitutional reform (Acto Legislativo) that would have given the MHCP the authority to regulate budget execution within fiscal targets, in contrast with the current system where the budget creates mandatory and inflexible entitlements. Although the Lower House approved the proposedreform, it was struck down by the Senate." Therefore, virtually all the policy actions neededto reform the structure of the budgetary system still lie ahead. However, it should be noted that the 2004 budget document, which was presented to Congress on July 2gth, was a significant improvement over previous budgets because it included a medium-term fiscal outlook, the calculation of tax expenditures andcontingent liabilities, and a presentationby functions that integrates current andcapitalexpenditures. 93. The road map toward budgetreform was approved as a CONPES document. This in itself is an important achievement because it shows consensus within the Executive Branch over the objectives of the reform, something rather difficult considering that several ministries benefit from budgetary rigidities and that restoring control over expenditure aggregates to the Ministry of Finance places greater pressure on them to use their budgetswithin clearly establishedguidelines. On July 20, the Government resubmitted a variant of the Acto Legislativo to Congress, including proposals to allow the annual budget law to modify earmarked revenues and modify laws that generate public expenditure, and prohibiting the creation of new earmarked revenues. However, its theoretical approval by Congress would take approximately one year. 27  94. ChaEZenges Ahead. The government has determined that substantial reforms in the budgetary process are essential to restore its capacity to implement fiscal policy within a framework of macroeconomic stability. A number of key policy actions lie ahead which, when taken together, constitute an important package of reforms that will restore flexibility to budgetary management and strengthen the policymaking capacity of the Executive Branch. These include: Pursuing a Medium-Term Expenditure Framework (MTEF) adjusted to the Colombian legal and political constraints. This document must propose aggregate fiscal targets for a multiannual period (in conjunction with the FRL), identify key strategic and policy issues, and propose sectoral allocations. Once these sectoral priorities and activities are identified by line ministries and decentralized agencies, it would be possible to carry out a cost assessment o f total requirements within each sector. This medium-term perspective would also serve other purposes: it would provide reliable figures to evaluate possibilities of budget cuts from the standpoint of output impact rather than the more traditional input perspective, and would clarify the need to evaluate legal entitlements in the light of sectoral objectives and priorities, and how to shift resources when priorities change. EnsuringConsistencybetween Current and Capital Expenditures. Over decades, the processes of assigning current and capital expenditures by the Ministry of Finance and DNP, respectively, have resulted in two almost autonomous budgets. This resulted in, amongother things, an inability to effectively analyze the current expenditure consequences of public investment. The authorities will act to ensure coherencebetweencurrent and capital spending. Greater Transparencv and Accountability for Outcomes. This element of the strategy calls for simplifying budgetary information in order to make it easier to understand and available for public use. This proposal goes hand inhand with the government's initiatives to launch a website with comprehensive fiscal information based on SIIF outcomes, and will require the immediate implementation of a communication program to convey to the public the present budget figures. The bond between results and budget allocation i s an important area for improvement. Review of Entitlements and Earmarked Revenues. To promote flexibility in public expenditure, the GOC needs to undertake a process of review of expenditure entitlements and earmarked revenues, and define the necessary legal and administrative measures to introduce greater flexibility into budget management. Budgeting and Accounting Classifications Using International Standards. Different government levels have been reluctant to unify accounting and budgeting classifications, instead using nonstandard accounting practices. The strategy aims at unifying budgeting and accounting bookkeeping according to international standardsintime for the FY2006 budget. 28  95. These reforms, and others critical to the modernization of the public expenditure cycle, will be introduced through two primary vehicles: first, a new, more comprehensive and coherent Organic Budget Code (OBC); and second, the annualbudget laws, which should incorporate the requirementsof both the revised OBC and the recently approved Fiscal Responsibility Law. Between them, the Government should achieve substantial improvements in the budgeting process in order to introduce greater flexibility, accountability, and macro-fiscal consistency. 96. Developmentof Incentivesfor EfficiencyGains. Servicedelivery inColombia, as in many other countries, has long emphasizedinputs over outcomes. The traditionally centralized public sector management tended to distance public managers even further from the outcomes achieved by the interventions of their programs, yielding mediocre public services at unreasonablyhighcosts. It was hoped that decentralization would be a strategy to reverse this tendency, and since the mid-1980s a shift of resources and decision making authority to local government has occurred. Butdecentralization hasnot fully reached its objectives, and its level of implementation varies among the regions. The transfer of powers has resulted in blurred responsibilities in a number of sectors, which further underminesaccountability. 97. The government has shown commitment toward introducing incentives to promote the use of results-basedmanagement to improve efficiency and effectiveness of fiscal transfers at the subnational levels, particularly in the education sector. Given the fact that the fiscal decentralization scheme in Colombia establishes mandatory transfers to bothdepartmentsand municipalities and that the Central Government has no authority to condition those transfers on performance, they have become one of the most important sources of budgetary rigidity. Transfers for education, for instance, represent about 7.5 billion pesos per year (12 percent of the total budget). 98. The government's strategy to overcome this situation or, at least, introduce results-oriented criteria and incentives to impact such rigidities consists of two measures: (a) the approval of Law 715 that changes the current supply-based transfer system for education based on the number of teachers in a certain region, to a new demand-based system based on the number of students attending school; and (b) reallocation of the 56 percent of the National Royalty Fund (FNR) currently spent on improperly planned and often inappropriate investments to finance exclusively education projects aimed at increasing school attendance of children in vulnerable groups. 99. Key Policy Actions Undertaken. Law 715, approved in December 2001, establishes new distribution criteria to go into effect in 2004, but it has already worked as an effective incentive to increase student enrollment across the country. Of course, such powerful incentives imply not only the sound objective of encouraging students to attend school, but also the risk of fraud by entities reporting excessively high numbers of students to receive high transfers. Strong policies to improve control and audit systems are being developed by the Ministry of Education, and are expected to be operating by 2004. 100. Remaining Challenges. Improved targeting of the resources of the FNR is an important element that remains to be achieved. Although the FNR does not represent a significant amount of resources compared to unconditioned transfers (1.5 percent), it can 29  constitute an additional incentive to subnational governments in order to promote the national priority of reducing deficits in school attendance. Such reallocation implies reforms to the Constitution, because the FNR i s regulated at that level. A referendum to approve such a constitutional amendment alongwith other fiscal and political reforms has been approved by Congress and was recently authorized by the Country's Constitutional Court. The referendumwill take placeinlate October 2003. 101. Demonstrating its commitment to the reform, the Government has already initiated the FNR reallocation exercise by including, in the 2003 Budget, appropriations of 31.6 percent of these resources to projects meeting the criteria established by the Ministry of Education in the spirit of the pursued constitutional reform. This was possible through a decision by the Comite`Nacional de Regalias, a national and sub- national government joint committee that currently has oversight authority over that part of the FNR. As a result of this particular exercise, about 30,000 new students from vulnerable groups will be enrolled this year, inaddition to the regular enrollment rate. It i s estimatedthat the total reallocation of royalties could duplicate such results. 102. In the event that this provision of the referendum is not approved, it is the commitment of the government that at least the 31.6 percent of the FNR will continue to be allocated to projects to increaseeducational coverage, as in2003, in order to make the results achieved to date irreversible and to expand them, depending on financial resources. This "Plan B"will certainly have less impact than the reforms proposed inthe referendum, but it reflects what is feasible within the current constitutional framework. 103. Strengthening Public Sector Procurement. Contracting and procurement with clear and transparent rules i s critical for making efficient choices in buying goods and services, and averting corruption in the process. In Colombia, inefficiencies in public contracts are due to a large extent to the legacy of traditional patronage systems in the State, andto a dispersed andhighly diversifiedlegal framework. 104. Currently, a variety of laws and regulations govern public procurement, with frequent overlaps and omissions, and a proliferation of regimes and exceptions. This debilitates monitoring and protects both buyers and vendors of services from being accountable to each other, providing much opportunity for corruption. Moreover, no central agency i s in charge of promoting reform and determining rules that could introduce more transparency and efficiency in the procurement process. Overly complex and superfluous procedures, such as the registry of contractors, thus still prevail, partly because the use of modern information technology i s relatively weak and state agencies are not well equipped to use it. Contract management and planning i s poor, and only large and experienced agencies show good practices. Procurement methods need to be redefined, standardized, and made more expeditious. There should be a better distribution of contract risk. Strategies for handling and successfully concluding the legal claims should also be established. Finally, civil society does not yet play a significant supervisory role, which further undermines accountability andtransparency. 105. Key Actions Undertaken. The government has taken important initial steps in this direction, notably Decree 2170 that strengthens transparency and objectivity in procurement. Although this instrument only became effective on January 1, 2003, its impact is already being felt. The requirement of advertising bidding opportunities and 30  bidding documents on the web has been well received by both the private sector and government officials. Another development welcome by government agencies and state companies has been the introduction of "reverse auctions'' for the procurement of large volumes of standard goods. Although, it is still too early to tell, several government institutionsh a v e successfully used this tool with meaningful reductionso f price. On the other hand, Some agencies complain that the shopping procedures introduced under the Decree have lengthened the procurement process of standard goods, which is not necessarilybad, given the considerable discretion for the use of shopping under Law 80. It is expected that the new law amending Law 80 will, on one hand, firm up provisos included inthe Decree, and on the other, correct shortcomings. 106. On October 20, 2003, the Government approved a CONPES document establishing t h e guidelines for improving public sector procurement. This document describes the need for simplifying the system of various parallel procurement regimes, the introduction of efficiency considerations into the procurement process, and the establishment of a government entity responsible for the oversight of public sector procurement'9. 107. Remaining Challenges. Although Decree 2170 has introduced improvements in the procurement process, its cornerstone-the Organic Procurement Law (Law SO>- remains a major obstacle to substantive reform. Law 80 coexists with a large number of other laws and regulations that have an impact on the procurement process with major overlaps and omissions, muddling the regulatory framework and opening opportunities for corruption and fraud. The overall regulatory framework mustbe simplified and Law 80 needs to be substantially improved to become effective, in coordination with the , guidelines of the CONPES document. 108. Earlier this year, the Government sent to Congress Bill007/2003 amending L a w 80. The bill was drafted with considerable input from the private and public sectors. It includes a number of positive amendments to Law 80 and establishes an electronic procurement information system. An important proviso making a government agency responsible for public procurement was dropped from the bill, but was later reintroduced at the request of the Government. Further down the line, the government will need to implement the institutional arrangements defined in the revised Law 80, issue subsidiary regulations, and restructure the national registry of bidders. The bill being considered i s fully consistent with the recently approved CONPES document, even though the customary process is that the CONPES document gets approved before the bill i s submitted to Congress. 109. Management Contracts for Government Agencies. Although the Colombian public sector is rich in sophisticated tools for evaluation and monitoring, such as SINERGIA, the government's performance monitoring system, the rigidities of the budgetary, human resource management, and administrative systems have made it virtually impossible to match real incentives to institutional performance. Particularly in an environment of severe fiscal constraints, it is important to obtainthe highest value-for- money in order to fulfill social demands and effectively implement public policy. Since l9The consultancy requirements for the modernization o f the procurement process are fully funded by the Bank's Public Financial Management Project 11(MAFP11). 31  it is not feasible to establish a comprehensiveperformance budgeting system in the short term, the Government requires a mechanismto introduce incentives for performance, at least on an agency-by-agency basis. 110. Key Actions Taken. The Government has implemented on a pilot basis a new instrument to both improve mechanisms for performance evaluation and provide incentives to independent or decentralized agencies in order to promote efficiency and better service delivery. The idea of introducing managementcontracts i s in line with the objective of overcoming expenditure rigidities in those agencies that have their own funding sources but no incentives to provide good service. 111. Management agreements are, in essence, written agreements between Central Government entities (Ministries of Finance, of Social Protection, and the National Department of Planning) with oversight authority over a particular sector where independent or quasi-independent public agencies operate, and one or more of those agencies. These agreements specify performancetargets for the agency such as increased service coverage, improved quality and higher cost-effectiveness, and the consequences of achieving or not achieving the targets. The government has selected two major social protection decentralized agencies, ICBF and SENA, which are also targets of policy commitments under the Bank's PLaRSSAL, to spearhead this strategy. These two agencies have signed management contracts with the Central Government entities and constitute apilot exercise to be expanded inthe future. 112. The National Service for Training (SENA) i s a 40-year-old agency that provides technical education to defined groups of the population in order to qualify the labor force and provide adequate skills for young people seeking their first job, and for older workers. SENA's services are fundedthrough amandatory contribution from workers all over the country, which i s automatically discounted from private and public entities' payrolls. Currently, SENA's budget accountsfor 0.82 percent of the total nationalbudget. The Colombian Institute for Family Welfare (ICBF) i s a national agency that provides basic health (nutrition) services for the most vulnerable children and other groups under special risk. It i s also an old agency (35 years) that enjoys its own revenues from mandatory contributions paid by private and public employers. ICBF's annual budget accounts for about 1.56 percentof the total national budget. 113. Each agency had agreed to an ambitious four-year strategic plan with the new Ministry of Social Protection. No incentives, however, were offered inorder to seriously promote changes in the administration. To fill this gap, management agreements have been signed between the Ministry of Finance, the National Planning Department, the Ministry of Social Protection, and the agencies involved, as a key complement to the reform and modernization strategies in both entities. This instrument should provide the incentives to generate the desired virtuous cycle that promotes administrative efficiency, financial independence, and service improvements for their beneficiaries. 114. One common issue that was identified by these agencies i s the way in which the Ministry of Financeauthorizes the use of their "own" resources. Given fiscal constraints, these agencies are limitedin the amount they can spend from the resources they collect, by the so-called espacio fiscal (fiscal yield). This policy contributes to balancing the aggregate fiscal accounts, but provides a wrong and perverse incentive to the agencies 32  that have no motivation to improve revenue generation and, thus, expand or improve service delivery. The key incentive to be introduced into the management agreements by the Ministry of Finance is an increase in the fiscal yield based on (a) reaching service delivery goals under the strategic plan (particularly those agreedunder PLaRSSAL), and (b) increasing revenue collection. This new scheme will connect budget allocation decisions with service delivery achievements and revenue collection efficiency, transforming the perversescheme into the correct way to provideincentives. 115. Remaining Challenges. The signature on the management contracts with ICBF and SENA is just the first step in a process meant to generate greater efficiency and accountability for outcomes in public service delivery. The performance of these agencies vis-&-vis the contracts will have to be measured, and if appropriate, the incentives should be introduced into the 2005 budget. Frequent monitoring of the agreements will be necessary to ensure their proper enforcement andthe accumulation of lessons learned for a future expansion of the model to other public agencies. If this model is successful in ICBF and SENA, the government intends to expand it to at least six more agenciesby the endof its term. 116. Management of the Public Sector Reform Process. Reforming the State is a complex undertaking that challenges any government's capability. This i s also true for Colombia as it carries out its ambitious reform program. Putting in place adequate institutional arrangements, securing the necessary technical expertise, assembling implementation teams, ensuring political support during all phases of the reform, and carrying out meaningful and useful evaluations and assessments of the process have all been challenges for the leadersof the reform. 117. Key Actions Taken. Gaining the acceptance of political actors i s key for successful reform. Initially, this role i s being played by the National Commission for Economic and Social Policy (CONPES) as the principal planningcommission. Over the course of the reform, however, there will be the need to guide the process on a more continuous basis to avoid the danger of loss of politicalmomentum. Not all participating ministries are equally affected by or interested in the state reform process, so much specificity will be gained from working only with the most relevant ones by creating a specializedcommission inaddition to CONPES. This core Commission for State Reform (CSR) has already been established, composed o f the Ministry of Finance, the Planning Department, and the Departamento Administrativo de la Funcidn Pu'blica (DAW, the departmentinchargeof the civil service). 118. The fundamental guidelinesfor the overall reform processhave been defined in a CONPES document entitled, "Program for the Renovation of the Public Administration," which further develops the reform guidelines established inPresidentialDirective 10, and formally establishes them as government policy. 119. Remaining Challenges. Transforming political priorities and goals into effective application i s the challenge that underlies technical coordination of the process. The DNP will tackle this by regularlyincorporating into its work the advice of top experts in state reform, initially for the crafting of general government policy. Inthe medium term, this should be complemented by a group of seasoned experts to consult independently. 33  Equally important is the establishment or continuing support of technical task teams in both DNP and each of the ministries and agencies subject to reform. 120. The evaluation of the reform, including the definition of meaningful indicators both at the aggregate and component levels, has advanced and SINERGIA has taken the leadership of this effort. A report on the "evaluability" of the sector-specific objectives has been prepared and certain baseline indicators are in the process of being defined, quantified, and published. However, the collection, processing, and analysis of information for this purposewill likely be acomplex challenge. V. THESECONDFISCALANDINSTITUTIONALSTRUCTURAL ADJUSTMENT LOAN (FIAL 11) A. LOAN DESCRIPTION 121. This operation is proposed as a single-tranche loan to be fully disbursed in November or early December 2003, and i s linked to, among other things, regulation of the tax reform law, significant improvements in tax administration, the official definition of a budget reform strategy, presentation of the referendum to popular vote, issuance of CONPES documents establishing the policies for legal defense of the State, asset management andthe overall public sector reform framework, presentation to Congress of changes to the procurement law, and the signature of management contracts with ICBF and SENA. The detailed legal and regulatory reforms required as part of the proposed secondloan are shown inTable 6. third calendar quarter, prior to Loaninitialdisbursements,has not exceeded75% of the overall deficit limit in saidbudget. The Borrower hasissuedthe necessaryexecutivedecrees to regulate the application of Law 788 of 2002. The Borrower, throughDUN,has: a) developedandimplemented softwareto cross reference information with financialinstitutions to ensure that interest reported by them match interest reported by taxpayers; b) auditedat least 50% of large taxpayers (as defined inArticle 562 of the Borrower's tax code) affected by the new taxes; c) establishedand publishedindicators of the cost and time required for tax filing compliance by taxpayers, and d) has carriedout at least 80 integratedtax and customs audits. The Borrowerhas approvedCONPESdocumentnumber 3252 dated October20,2003, that outlines the strategy for nationalcentral government budgetreform, including, inter alia: (a) the eliminationor reduction of permanententitlementsandearmarkedrevenues; (b) the regulationof the use of forward budgeting; and (c) the establishmentof controlsover expenditure aggregates. The Borrower'sExecutiveBranchhas submittedto the Borrower's CongressandsaidCongresshas approved, the 2004budgetbillof law, to approve the Borrower's 2004public budget,to include, inter alia, (a) medium termfiscal outlooks; (b) the calculationof tax expenditures and contingentliabilities; and (c) the presentationby functions of the Borrower's governmentsector, integratingcurrent and capitalBorrower's government expenditures. 2o See definition of "trigger" inSection IV-A All theseprior actions, triggers included, have been fulfilled satisfactorily prior to Board distribution of this document. 34  TheBorrower has submitted to popular vote the provisionof the Referendumthat reallocates royalty transfers to educationalservices. The Borrower's Ministry of Educationhas issuedaresolution(ResolutionNumber 277103, dated February 17, 2003, to establish the eligibility criteria to allocateeconomicresourcesgeneratedfromthe application of Law 21 for the benefit of public educationinfrastructureprojectsinthe Borrower'sterritory. The Borrower has approvedCONPES documentnumber 3250, dated October 20,2003, establishing,inter alia, the new policy for legaldefenseof the state, including legal reform if necessary. The Borrower has approvedCONPES documentnumber 3249, datedOctober 20,2003, establishing, infer alia: (a) the principles that apply to govemmentpublic procurement, (b) the creationof anew agency or the assignmentto an existingagency of public sector procurementresponsibilities,and(c)the definition of a strategy for developingandimplementinge-procurement. The Borrower hasproposedto its legislature modifications to the bill of law amending Law 80 that incorporate the recommendationsof CONPES, including, inter alia: (a) commonprinciples for public procurement; (b) introductionof economicconsiderationsinto the public procurement process; and(c) institutional framework for publicprocurement. The Borrower has approvedCONPES document number3251, datedOctober 20,2003, establishing thebasic principlesand strategic planningfor Asset Management,including, infer alia: (a) the institutional framework for Asset Management; (b) management information systemsfor Asset Management;and(c) adequaterules and proceduresfor Asset Management. TheBorrower, through MHCPandDNP, hassignedpilot managementagreementswith SENA andICBF. Borrowerhas approvedCONPESdocumentnumber 3248datedOctober20,2003, establishingthe overall strategy of public sector reformandarecommendationto designindicatorson public sector productivity and effectiveness. The Borrower has developeda monitoringandevaluationsystem for the statereformprocess with indicatorsof productivity andeffectivenessandhas widely publicizedit, includingits publicationthrough DNP's web site. The Borrowerhas enacted Law Number819of 2003 that regulates,inter alia: (a) the annualpresentation of (i) a medium-termfiscal framework with deficit targets linkedto debt sustainability; (ii) a report of fiscal results to congress (including alldebt and contingent liabilities), and (iii) afinancial planthat includesmeasuresto fully compensatefor any fiscal slippageinthe previous year; (b) restrictions on future spending obligationsof nationaland sub-national governments; and (c)the obligation to includethe fiscal impact and source of financing within any new national law that affectstaxes or expenditures. 122. Triggers for the Third Operation. A subset of the policy actions for FIAL 111 describedin this operation's Policy Matrix has been identified as the key benchmarks that will demonstrate progress in the reform program, and its fulfillment will be required before presentationof the thirdoperation to the Board. These triggers are: 0 Borrower has presented to Congress a new Organic Budget Code which substantially reducesbudgetary rigidities and enhances the role of the Ministry of Finance and Public Credit inregulating public expenditure aggregates. 0 Borrower has implemented the policies and actions for legal defense established in the CONPES document in the Ministry of the Interior and Justice and in the Ministry of Finance and Public Credit. 0 Borrower has established a new governmental agency with the responsibility for establishing common guidelines, evaluating and monitoring public sector procurement, or has assignedthis function to an existing agency. 0 Borrower has established and begun the operation of the government agency responsiblefor asset management. 35  0 Baseline and a subset of progress indicators for monitoring progress and final goals of the reform process are applied to the reforms achieved to date and are disseminated countrywide. 123. Loan Amount. The proposed (US$150 million) loan in the form of a fixed spread, U.S.-dollar-denominated loan would be made to the Republic of Colombia. Disbursements under the proposed program would be made to an account (depository account) of the Republic of Colombia, established at the Banco de la RepLibZica for this purpose. This loan would have a single tranche of US$l50 million, expected to be disbursedinlate November or early December2003. B. FIDUCIARY POLICIES 124. Procurement and Financial Administration. A Country Financial Accountability Assessment (CFAA) i s currently being prepared and an initial draft is under internal discussion. Although the scope of the CFAA regarding financial management is significantly broader than the scope of the FIAL's budget component (which is focused primarily on eliminating rigidities), the recommendations of the draft CFAA being discussed are consistent with the FIAL. An enrichment of the FIAL policy matrix for loans IIIandIV basedon CFAA recommendations will be considered once the CFAA is finalized and a plan of action i s agreed with the government. Moreover, the financial management team will advise with regard to audit of the depository account at the Central Bank. Regarding procurement, a Country Procurement Assessment Report (CPAR) was prepared in March 2001 and its key recommendations are part of the reforms to the procurement system that are part of the proposedPolicy Matrix. 125. Some of the key preliminary conclusions of the CFAA which are relevant to the context of the FIALprogram focus on the following areas: (a) an overall weakness of the financial management processes which cannot adequately enforce budgetary constraints; (b) a fragmented payments system; (c) the need to develop subsidiary systems to the Integrated Financial Information System (SIIF) to fulfill information requirements for appropriate decisionmaking; (d) deficiencies in the information provided by the budget oversight agencies; (e) inadequate budgetary classification structures; and (f)insufficient andinadequatelegislative oversight of the public expenditure process, among others. C. ENVIRONMENTAL ASPECTS 126. Being a structural adjustment program, the environmental provisions of OD8.60 apply to this operation and, consequently, an environmental rating i s not required. However, there is one issue regarding the tax reform supportedby the program that needs to be addressed. Law 788 eliminated the capital gains (or "occasional gains") tax exemption for individuals involuntarily selling their property to the State for public works (through eminent domain), creating a conflict with the Bank's policy on involuntary resettlement that mandates fair net compensation to the seller. Through the elimination of this tax exemption, the seller now faces a net patrimonial loss. A joint proposal on the 36  reestablishment of fair net compensation will be prepared for the next loan of the programin close collaboration with the government. D. BENEFITS 127. Fiscal Adjustment. The reformprogram supported by the FIAL I1would put the NFPS accounts on a more sustainable path. Each of its proposed measures carries fiscal implications, which are singledout inthe government's projections, through 2006, shown in Table 7. The reforms are projected to improve the overall balance of the Non- Financial Public Sector by 1.7 percent of GDP in 2003, and by over 3 percent of GDP in the following years, relative to the alternative scenarios without reforms. Reform of tax policy and tax administration makethe largest projected contribution, with the effects of the referendum and the pension reform contributing most of the rest of the savings. Whencombinedwith the constitutional referendum, the vertical reforms, and the pension andlabor reformsjust approved by Congress, the impact of the whole reform package is projectedto reach 2.8 percent of GDP inprimary surplus. 128. As official projections, they are necessarily on the optimistic side, in particular, assuming prompt effects of the pension reforms and a low estimate of military spending.*l Given the weight of longer-term reforms, the packageof measures supported by the FIAL I1would prevent-and reverse-an otherwise unsustainable debt and debt- service accumulation, while also protecting social sector expenditures and vulnerable groups. The CombinedPublic Sector deficit of 4 percent of GDP would be cut almost in half by 2006. Ifnoreformswereimplementedorifthesereforms wereseriously delayed, the NFPS would remain on an unsustainable path, and probably spiral into protracted, increasing deficits. Instead, as a result of the reform program, the public sector's debt path i s changing significantly, putting the public-debt-to-GDP ratio on a more manageablepath. *' ~ The projections on savings due to a reduction of the transfers to the pension system are based on the reform passedthis year and to an update on its database which revealed a multi-affiliation problem, where a number of affiliates contributing to private pension funds should have been contributing to the ISS. Solving that problem will bring additional income to the government, but does not yet make the ISS completely solvent. 37  otal Revenues 29.6 Current Revenues 29.6 29.8 29.4 29.2 Tax Revenues 19.2 20.9 20.6 20.6 of which : Reforms of Tax Policy andAdministration I.2 1.7 1.9 Non-Tax Revenues 10.4 8.9 8.8 8.6 Property Income 1.3 0.8 0.7 0.6 OperationalSurplus of Public Enterprises 4.2 3.1 3.1 3.6 Other 4.8 4.4 4.4 4.4 of which: Public Asset Management 0.0 0.0 0.0 otal Expenditureand Net Lending 33.3 32.1 31.4 31.1 Current Expenditures 24.9 24.8 24.1 23.8 of which: Effect of Referendum -1.2 -0.8 -0.8 Wages andSalaries 7.5 6.5 6.5 6.5 of which: elimination Of postsfor vacancies andretirees -0.1 -0.2 -0.2 Goods andServices andOther 3.5 3.1 3.0 2.9 Interest 5.0 5.0 4.8 4.1 Extemal 2.3 2.3 2.3 2.2 Intemal 2.8 2.7 2.5 2.5 Transfersto Private Sector 9.8 10.2 9.9 9.1 of which ; Savings Dueto Legal Defenseof the State 0.0 -0.1 -0.1 of which ; Pension Reform -0.4 -0.9 -1.3 Other -0.9 0.0 0.0 0.0 Capital Expenditure 8.3 7.3 1.3 7.3 of which: Reform of Law 80 (for contracting) andon-line govemment -0.2 -0.4 -0.4 Fixed Capital Formation, cashbasis 8.2 7.2 1.2 1.2 Transfers 0.1 0.1 0.1 0.1 Net Lending 0.1 0.0 0.0 0.0 Statistical Discrepancy 0.2 0.0 0.0 0.0 on financial publicsector balance -3.5 -2.3 -2.0 -1.9 'uasi-fiscalbalance 0.7 0.4 0.3 0.3 ogafin balance 0.2 0.3 0.3 0.3 et cost of financial restructuring -0.7 -0.5 -0.5 -0.5 lverallbalance -3.3 -2.1 -1.9 -1.8 lverailFinancing 3.2 2.1 2.0 1.9 lemorandumitem: entral Government Fiscal Balance -5.7 -4.0 -2.6 -2.4 FPS Primary Balance, with reforms 1.5 2.7 2.8 2.8 FPS Primary Balance, no reforms 1.5 -0.4 -1.2 -1.8 lebt Stock ource: Minisuy of Finance, IMP and World Bank Estimates 129. Improved Quality and Coverage of Public Service Delivery. The program is designed to encourage improvements in public sector delivery through a variety of instruments, including (a) performance-based incentives for accessing resources for education at the subnational level; (b) management contracts with two key government agencies (ICBF and SENA), developed to encourage the achievement of the ambitious goals of their strategic plans; and (c) the introduction of elements of accountability for results in the new budgeting legal framework. Furthermore, there should be important indirect effects on service delivery from all other elements of the program, including 38  more efficient asset management at the agency level and improved procurement processes. 130. Improved Governance andTransparency. A number of studies have identified the capture of the State by special interests as one of the most damaging elements of corruption.22 State capture can come about through "legal" mechanisms, such as the passage of laws that create permanent expenditure entitlements or tax exemptions for certain interest groups that carry enough political or economic weight to lobby effectively. These dimensions of state capture are confronted directly by the measures supported by the program. First, the tax reform supported by FIAL Ihad as one of its explicit objectives the elimination of tax exemptions, in order to broaden the base and remove distortions. Second, the budget reformhas also among its explicit objectives the rationalization of permanent expenditure entitlements and stricter guidelines for forward budgeting (which has been used to "reserve" space in future budgets often without justification). Overall, the program is expected to have a significant positive impact on governance andthe reduction of state capture. E. RISKS 131. The proposed program carries considerable risks. With regard to internal risks, the first i s that the overall political context, including the conflict and violence associated with illegal drug activity, could escalate, which would negatively impact the implementation of the program. Although Colombia is deeply committed to ending the violence that has plagued the country for decades, and has obtained the pledge of the international community to support this endeavor, the conflict could still intensify during the next few years. The FIAL supports reforms that will help liberate resources to address the country's priorities during transition from the conflict to the postconflict era. The FIAL will also support introduction of institutional reforms that would help consolidate peace and stability during the postconflict era. 132. Second, due to the internal conflict the government may be unable to endure prolonged social disruptions and resistance from major interest groups (such as teachers and health sector unions) that couldderail the reform agenda and leadto more social and political instability. The government i s reducing this risk by working with political parties, Congress, the Judiciary, and independent auditing and control agencies in the formation of a broad-based state coalition that ensures continuity of reforms within the public sector. The program supported by the proposed loan promotes the joint effort of all branches of the Colombian state, private capital, and civil society through built-in participatory, consultation, and other consensus-building mechanisms. Consensus- buildinginstrumentshavebeenincorporated ineach one of the proposedcomponents and in the overall management of the reform process. If successfully applied, consultation and evaluation should be sufficient to mobilize government and nongovernment institutions in support of the reforms, and overcome resistance from particular interests that have previously captured the State. 22"Corrupcidn, DesempeAo Institucional y Gobemabilidad" (Corruption Perception Survey); Bog&, Colombia,World Bank, 2002. 3 9  133. The referendum approved by Congress in December 2002 and authorized by the Constitutional Court inJuly 2003 contains several key reforms and will be placed before the people on October 25th, 2003. There is of course the risk that the referendum approved by Congress will not be supported by the population. The government i s already planning on substitute measures in case the referendum i s not approved by the people. Those substitutemeasures would include (a) gradual elimination of some special pension regimes through legal reform and collective bargaining, (b) law reform proposals and administrative measures to ensure expenditure cuts and additional tax revenues with a fiscal effect that i s at least equivalent to the expected impact of the current expenditure freeze, and (c) the national government putting pressure on subnational governments that currently receive royalty transfers to concentrate their project proposals in the education sector. It should be noted, however, that the referendum is directly related to part of one component of the FIAL (Incentives for Efficiency Gains), so a defeat of the referendum would not be catastrophic for the overall program or threatenits continuation. 134. Third, through external or internal shocks, the fiscal situation may deteriorate, which wouldjeopardize the macroeconomic situation. The World Bank program and that of the IMF and IDB are intended to lessen this risk by demonstrating active, visible support of the government's proposed fiscal and public sector adjustments. The macroeconomic situation may also be weakened b y external factors such as regional political or economic instability or further deterioration of the terms of trade. On balance, consequently, the FIAL is judged to be a "high-risk, high-return" program. Therefore, it will be essentialto maintaina close working relationship with the client, and to provide ample, ongoing dialogue and assistance duringthe implementationperiod. To this end, the parallel TAL (MAFPII) wiil provide an important opportunity for the Bank to closely accompany the program. The supervision activities of MAFPII will be a fundamental vehicle to maintainfrequent coordination with the Government counterparts. All these reflect the belief that, because this program would form the core of the Bank's interventions inColombia, its successful implementation will be critical. F.SOCIALIMPACTOFTHEREFORMS 135. Colombia's social conflict constitutes one of the most determiningelements of its fiscal and public sector reform requirements and prospects. The Government has successfully established a climate of dialogue and understandingbacked by determined application of its laws to contain social movements within the constitutional order. It has worked in close collaboration with Congress and political parties to enact substantial reforms that had been impossibleto achieve in previous administrations. Moreover, the Government is inviting the population at large to vote on a referendum that will substantially amend the Constitution. The government also offers a package of vertical and horizontal reforms of the public sector aimed at enhancing transparency and accountability, citizen participation inpublic affairs, public administrative efficiency, and higher coverageand quality of servicedelivery. 136. This program intends to ensure the feasibility and sustainability of this package of reforms by strengthening the fiscal capacity and the adequacy of government actions, 40  while simultaneously minimizing risks in the government's comprehensive, multisector reforms. Ifthis package is successfully implementedand maintained after the change of administration, Colombia should have a public sector that is more responsive to citizen demands, more accountable, and more participatory. For the broader citizenry it can be expectedthat the reforms will contribute to better service delivery and a more transparent form of government. 137. The public sector reform process includes the elimination of at least 40,000 jobs inthe central administration, of which 30,000 will comefrom the elimination of theposts of employees who reach retirement during the next few years, and the rest from the elimination of staffed positions. All staff deemed redundant will receive the legally established severance package, and those who are not legally entitled to removal benefits (such as temporary or directly appointed staff) will receive at least one year's salary as severance. Inaddition, all those who lose their employment will be entitled to participate ina retraining and career-counselingprogram. Finally, the government has indicated its commitment to the protection of vulnerable groups and will ensure that single mothers without job alternatives, the handicapped, and those about to reach retirement age w i l l not beremoved. 138. Inadditionto the reduction inpublic sector employment, there are other measures in the government's reform agenda that have an unquestionably negative effect on the country's lower-income groups. The most evident is the introduction of the VAT on all previously exempt goods and services, including basic foodstuffs, education, health, and transportation, which has a higher proportional impact on the poor. The broadening of the VAT base is in line with international best practices in tax policy, but its impact on the poor shouldbe mitigated through focalized expenditure, at leastinthe short run. 139. In order to compensate for the social impact of the fiscal adjustment and the effects of the armed conflict in depressed areas of the country, the government has bolstered its social protection network. One of the main programs of this network is the Red de Apoyo Social-RAS, which for 2003-2005 i s expected to disburse over US$500 million with the support of the Bank and the IDB.23The largest component of the RAS i s Fumilius en Accidn which provides a cash subsidy to 350.000 low income families in the form of a monthly $20 nutrition grant per family subject to regular visits by children under 7 to health centers and a $3-$6 subsidy per child to promote school attendance in both elementary and secondary education. Government expenditure on this program doubled between 2002 and 2003 and total expenditure on the social protection network reached 0.5 percent of GDP. The government i s committed to sustaining this level of investment through end-2006. 140. Although the FIAL measures may have a short-term negative effect on unemployment and distribution of income (albeit mitigated through substantial social expenditure), the long-term effect will be unquestionably pro-poor. First, it will help protect the macroeconomic framework of the country by reducing the likelihood of widespread government fiscal crises. This is important since, as noted, the Bank's 23BIRF-7017(EmpleoenAccidn Program, US $100 million), BIRF-7050(Familias en Accidn Program, US $150million) andIDB-1280/OC-C0(ReddeApoyo Social Program, US $270million). 41  analysis shows that negative macro shocks are the most important cause of poverty increases in Colombia. Second, the FIAL will also ensure that through the fiscal strengthening program, in particular the tax reforms, more resources will become available to help ensure the allocation of adequate public resources to social programs and reduce the insecurity that affects particularly those that lack the resources to protect themselves. This is especially pertinent for education and health, facilitating the provision of public services for the poor. Third, the FIAL supports measures to improve the efficiency and coverage of these services, benefiting the poor directly. This i s to be achieved through better budgeting, the results agreements and their evaluation, and more transparent procurement. Together these should ensure that essential public services are more efficiently available to those who could not otherwise obtainthem on their own. 141. Monitoring Arrangements. The Government, with the support of the Bank, has defined a strategy to monitor the social impact of the policy measures of the FIAL program. The first step consists of the construction of a detailed hypothesis on the social, poverty, and income distribution impacts of the individual components of the reform program, expanding it to the aggregate level, and factoring in the mitigating measures being undertaken through incremental social expenditure. Once this hypothesis i s defined, the required monitoring inputs identified (such as the household survey and other statistical data), and the cost of carrying out this exercise is measured, DNP and MHCPintendto carry out periodic reviews and assessments. It is expected that for FIAL 111,the DNP will have completed the hypothesis, identified datasources, and carried out a preliminary exercise on impact measurement. 42  Annex I (Translated fromOriginal inSpanish) REPUBLIC OF COLOMBIA MINISTRY OF FINANCE AND NATIONAL PLANNINGDEPARTMENT LETTEROFDEVELOPMENTPOLICYTO THEWORLD BANK Bogoth, October 20,2003 43  Annex I Bogoti, October 20,2003 Mister JAMES D.WOLFENSOHN President WORLD BANK Washington, D.C. Dear Mr.Wolfensohn: Since the beginning of the Administration of President Uribe-Velez in August 2002, the expansion of the World Bank program for Colombia (CAS) and the important disbursementsof the loan program by the development multilateral agencies have been one of the most overwhelming evidences of support to the country. The World Bank and the Inter-American Development Bank (IDB) have impeccably observed the commitments acquired with the country and have contributed to the recovery of confidence on the stability of the Colombian economy and the reestablishment of its access to the markets. This evidence of confidence has been of primordial importance for the performance of an ambitious plan of reforms, a good portion of which was already approvedby the Congress of the Republic andis under implementation process. We are pleasedto present you in the attacheddocument, an update of the Political Letter we submitted to the Bank in the month of January this year for the development of the first Fiscal and Institutional Programmatic (FIAL-I) loan. In this update we present you the recent evolution of the economic condition of the country and, within such context, a synthesis of the purposes and the content of the policies and reforms we have already started. The Government recognizes that some risks may threat the suitable implementation of the program, including an insufficient support to the economic initiatives included in the Referendum, a higher volatility of the outside markets and an unanticipated increase of the security expense. Knowingly, the Government has identifieda number of contingency measures designed for protecting the program. Such measures include additional taxes and an early implementation of some of the measuresdiscussedinthis document. Finally, the Government is committed to the programpresentedin this document and it is also pleasedto approve the accompaniment and the financial support of the World Bank. 44  Inattention to the measures taken and implemented, the Governmentis thankful for their quick consideration by the Bank's Directors of the second fiscal and institutional programmatic loan. The Government i s at the disposal of the Bank's technical teams in order to prepare a joint definition of future loan programs in the extent the reforms included in this program with the Bank are consolidated. 45  I.TheContextandtheMacroeconomicandSecuritySituation A. THEGENERALCONTEXT 1. Colombia has reached a considerable macroeconomic stability since the 1998 - 1999 crisis, in spite of the worsening of the violence. Fiscal consolidation has progressed, inflation has been reduced and the financial system i s showing signs of strength. 2. With an interruption in the middle of the year 2002, these achievements allowed the country to gain access to the international markets of credit and guaranteed the stability of the exchange rate. Inthe middle of the year 2002, within an environment of regional instability, the spreads of sovereign bonds increased considerably and the peso devaluated in consequence. This situation was aggravated by an increase in the fiscal deficit and an unprecedented deterioration of the armed conflict, as a result of the events occurred during the peace processes of the time. 3. Confronting an adverse regional environment and enormous fiscal problems, some important budgetary cut offs were approved for the year 2003, a one-time net worth tax was established and the Congress approved a package of tax and control measures without precedents. Some decrees addressed to cut expenses, benefits or subsidies were also issued: the rate for the Tax Refunding Certificate (CERT) was reduced to zero, and non obligatory benefits at territorial level and the vacancies that had not been filled since July 2002 were suppressed too. In a parallel manner, the Government started to design and establish an ambitious program to reduce and restructure the public administration. 4. The Government is aware that the sustainability of the public debt should be supported on solid structural reforms and not on optimistic scenarios of economic growth or on risky hypothesis about the behavior of the exchange rate or the interest rate. Without any doubt, the support of the World Bank i s essential for the progress of the reforms. Inparticular, the support of the Bank i s of primary importance while the high interest rates the country is paying nowadays are reduced: almost 25% of the CentralNational Government expenditure is representedby the payment of interest. 5. Duringthe year 2002, the real growth of GDP was close to 1.7%, inflation was 6.99%, the deficit of the current account remained inlevels close to 1.8% of the GDP and Net International Reserves grew in an approximate amount of US$220 million. For the year 2003, a recovery of the economic growth with stability i s expected: the growth rate will be between2% and 2.5%, the inflation target is between 5% and 6%, and the deficit inthe current account will reduce to 2.5% of the GDP. 6. For the year 2003, the fiscal deficit target was set at 2.5% of GDP. However, undeferable expenses prompted the revision of this target, now standing at 2.8% of GDP for the end of this year. This change was made in consultation and coordination with the IMF. 46  7. In order to reach the fiscal objective, the Government has taken all the necessary measures such as the approval of the tax reform. Currently, we are still expecting the result of the Referendumthat includes atax adjustment component, which is expected to generate savings for 0.78% of GDP ($1.6 billion) in 2003 and 1.24% of GDP ($3.018 billion) inthe year 2004. B. THE2002 -2006PERSPECTIVES 8. The macroeconomic scenario for the next four years i s based on a current account deficit that oscillates around 2.1% of GDP, an investment rate that is around 14% of GDP and a domestic savings rate higher than 12% of GDP. The financing of the capital account will be carried out through the recovery of the direct foreign investment and of the net borrowing of the private sector. The net borrowing of the public sector will continue beingimportant. 9. The balance of the public sector shows a deficit financed with funds from internal credit (between 2.1% and 1.7% of GDP) and external credit (between 0.3% and 0.4% of GDP). The gradualnessof the adjustment on the excess expenditure that subsists in the public sector will be financed with the savings generatedby the adjustment of the private sector. The credibility of the adjustment in the public sector i s given by the scope of the structural reforms currently inprogress. 10 The fiscal consolidation will continue in the medium term. The economic conditions are expected to improve in 2004, and the actual growth of the GDP i s expected to be higher than 3 percent starting this year. The higher deficit will be financed with direct investment, a continuous support of multilateral banking, and the access of the country to the international financial markets. The monetary policy w i l l be addressed to support a moderate reduction of the inflation within an objective inflation scheme and a floating exchangerate. 11. The deficit inthe public sector will be reduced to 2.5 per cent of GDP, supported by the measures described above. Although this target i s slightly higher than the one initially established, the commitment of the Government with fiscal stability i s maintained in such a way that the debt of the non financial public sector will be reduced below 50 per cent of the GDP in the mediumterm. The Government expects that a sustained reduction of the debt, a continuous improvement of the indicators of economic vulnerability and a sound economic management will increase the confidence and allow the Colombian credit qualification to improve and the cost of borrowing to decrease. 12. Within the frame of the macroeconomic policy, the Colombian Government entered into a Stand By Agreement (SBA) with the IMF for DEG 1,548 million for 47  the next two years. One of the main purposes of the program is the reduction of the fiscal deficit en two points of GDP through structural reforms indifferent fronts. 11.TheProgramofFiscalandInstitutionalAdjustment -11 A. OBJECTZVES 13. The Program of Fiscal and Institutional Adjustment to be financed with World Bank quick-disbursing funds has as its objective to continue accompanying the Government of Colombia along the process of fiscal adjustment and the introduction of public management tools that allow a more efficient and transparent assignment and administration of the public funds. 14. Inorder to meetthis objective, the Government hasbeenimplementinga group of structural measures that will allow: an increase in fiscal income through an effective expansion of the tax base and the elimination of tax exemptions, the progressive flexibility of the expenditure budget, the introduction of fiscal responsibility principles and their integration to the budgetary system, the strengthening of transparency in procurement, and the restructuring of public employment. We refer herein to the progress of eachof them: B. COMPONENTSOF THEPROGRAM 1.TaxReform andAdministration 15. Inorder to increaseincome, improve taxation equity andreduce collection costs, Law 788 of 2002 approved a tax reform. This law eliminates tax exemptions and enlarges the VAT basis and creates a new classification of salary exemptions, among others. The new measures are expected to increase tax collection around 0.9% of GDP in2003, 1.2% in2004 and 1.7% in2005. To date, the regulatory decrees of Law 788, 2002 that represent a fiscal impact on tax collection and that should be applied for the operations performed since the first day of January 2003 have been issued on the matter of value added tax, the assessment to financial movements, withholding taxes and deferred interest for fiscal effects. Some provisions included in Law 788, 2002 are currently ineffect anddo not requireany regulation. 16. Inaddition to the efforts that on the matter of the regulation of the tax reform the Government have been performing, the FIAL has accompanied the DIAN (National Tax and Customs Bureau) in its efforts of tax administration. The development of a methodology that allows to obtain, process and use the information relatedto interests paid and perceived by the tax payers during a determined taxable term i s highlighted. This information will allow the DIAN to develop specific control programs. The issuance of Law 788, 2002 has allowed the DIAN to perform a general control of those great taxpayers affected by the new taxes. In addition, the new Law will allow the DIANto sanction those taxpayers who do not observe their tax obligations. The 48  DIANhas alsoprogressedinthe establishmentof cost and timeindicatorsrequiredby the taxpayers to observe their tax and customs obligations. Such indicators will be published from time to time and will also be part of the DUN internal management programs. 2. Renewal of the Public Administration 17. The Government has continued with its actions addressed toward the modernization and rationalization of the public administration, through the merging of ministries (6), the elimination of unnecessary entities and offices, the suppression of some diplomatic bodies, the abolition of fringe benefits and the elimination of vacancies. 18. The Government has estimated that the savings derived from the implementation of the measures above will increasethe GDPfrom 0.1% in2003 to 0.6% in2005. It is important to highlight that the Congress approved, in the last month of December, a Law that grants special powers to the President of the Republic to carry out the described reforms (such powers allowed the restructuring of 17entities). 19. For the dimension of the administration labor force to be suitable, a goal for reducing the operation costs and another goal for increasing the proportion of the officials devoted to the performance of missionary tasks (70%) have been established. 20. The vertical reforms also provide for the restructuring of at least 20 entities in the decentralized sector, under the premise that their continuance depends upon their financial feasibility. Among the entities subject to restructuring are several regional power companies and a large number of public hospitals; the Colombian Institute of Social Security (ISS), Telecom and ECOPETROL were already subjected to said process inaccordancewith the special powers granted by Law 790, 2002. 21. Those reforms considered of transversal type have had important progresses statedherein below: A policy on the issue of public procurement is being prepared, in which the designof a new regulatory and institutionalframe for government procurement i s anticipated in order to allow the improvement of process transparency, eliminating the possibility of influencing the selection of the bidders, but which at the same time increasesthe efficiency (especially at sector level), incrementing its impact on the productive sector and generating a reduction of the transaction costs for public entities, as well as a substantial modification of the current practices usedinsuchmatter. The creation of a new governmental strategy addressedto thejuridical defense of the Nation is a basic issue. The Government will prepare a diagnosis that allows to develop a preventive strategy, designing a "quality and protection guaranty 49  system" that includes especial provisions for the highrisk sectors (transportation, defense, justice and power, etc.). Alternative mechanisms for the solution of .conflicts will be proposedand the necessary regulatory reforms will be identified. The design of an integral policy for the productive management of those assets belonging to the State has allowed to prepare inventories and to define mechanisms for their assessment andjuridical righting, and it has also established a timetable for their management. A regulatory framework is expected to be prepared for the acquisition, registration and use of new assets by Government .entities. The establishment of a result benchmarking and policy follow up system for all the ministries and administrative departments is promoting the assessment of the main Government policies and programs, seeking that, as a whole, these aspects make more efficient and transparent the assignment of the funds, improve the efficacy of the policies, the programs and the Country institutions, and allow to .present accountsto the citizens. For the public employment system, a new institutional scheme is being designed, addressed to the regulation and the administration of an employment policy that centralizes the preparation of a respective policy and the issuance of regulations, and which decentralizes their management, leaving their application in the hands of each entity. Access according to merit, job keeping according to performance and flexibility as for employment termination are the characteristic principles of .the new schemeof public employment inColombia. The Government i s establishing the principles that will allow to rationalize the Governmental activity in the regulatory and control bodies, for the purposes of minimizing the transaction costs for the State, those regulated, supervised and controlled costs, and will establish a single juridical system for the regulatory, .supervisory and controlling bodies. The unification of information systems within the National Public Administration i s being developed through an integral strategy that seeks the acquisition, administration, and use of strategic information, and an adequate institutional .scheme. The strengthening of electronic Government will allow the incorporation and use of the informatics technology for the development of operations in Governmental entities, both in their internal activities as well as in their relations with other public and private entities, the citizens and the productive sector. The final purposeis to facilitate the relations of each citizen with the administration, and to increase the efficiency, transparency and a territorially balanced development of the State. 50  A strategy addressed to eliminate useless procedures seeks to establish a policy frame that allows to rationalize the procedures inpublic administration, bothin its internal operation as well as in its relations with the citizens. The Government is taking actions in order to design and establish projects for procedure rationalization inentities of public administration, according to their benefit / cost relation within the identified projects. The Government will also design a Governmental program in line for rendering services and procedures to entrepreneursand citizens. Finally, a cross strategy of internal control attempts to redefine the missionary objectives of internal control in Governmental entities, and for such purpose some actions are beingtaken addressedto update the inventory of internalprocedures in central administration, defining a policy frame for exercising internal control in Governmental entities, establishing a relation between the mentioned policy and the design, application and fulfillment of the internal transactions and procedures that will promote the transparency, efficacy andefficiency of the organization. 22. The effectiveness of the modernization and rationalization actions of Public Administration and the changes in performance in the intervened sectors will be the object of follow up and assessment actions. With such purpose the respective base lines are currently being drawn, which will be updated along the term of the program, and will constitute valuable informationfor decision makingin order to assign budget and to submit accounts within the Government and to the citizens. 3. Fiscal Responsibility and Transparency 23. InJuly 9 of this year, the Fiscal Responsibility Law was approved. This law seeks to include Colombia within a group of countries that assumetheir fiscal problem with responsibility, through the approval of laws that rationalize the fiscal activity and make the public debt sustainable, necessary conditions to generate an economic stability that allows the country to achieve its development. 24. This Law seeks the stability of the public debt, organizing the process of budgetary planning, in order to make it coherent with the financial and macroeconomic forecasts, allowing the public scrutiny of fiscal situation and widening the debate on fiscal policy through the Congress of the Republic. Inorder to meet these objectives, the Law provides that the National Government should present before June 15thof each fiscal year, to the Economic Commissions of the Honorable Congress of the Republic, a Medium Term Fiscal Framework, after being studied and discussed during the first debate of the Budget Annual Law. This Framework will include, as a minimum, the Financial Plan, a multi-annual macroeconomic program, the goals of primary surplus, a report on macroeconomic and fiscal results of the previous fiscal term, an assessment of the m a i n semi-fiscal activities carried out by the public sector, an estimate of the fiscal cost of the existing 51  tax exemptions, a list of the contingent liabilities that could affect the financial situation of the Nation, as well as the fiscal cost of the laws approved in the previous fiscal term. This applies inan equivalent manner to the central Government and to the territorial entities. 25. The Law also seeks to put on a sound basis the budgetary process of those practices that have traditionally increased the costs to the Nation. This regulation clarifies the budgetary process and makes it coherent with sustainable public finances inthe short andmediumterms. As for forward budgetingrequests, their authorization should respond to a serious planning process, coherent with the annual financial plans and, therefore, with the sustainability of the public finances. For this reason, the law grants the CONFIS the competence for granting the authorizations addressed to commit future budgetsand includes some restrictions in order to rationalize their use. Infirst term, itprovidesthatnocommonfuture terms maybegrantedthat exceedthe termof the Government. However, an option remains of granting exceptionalforward appropriations for those projects the CONPES declares as of strategic importance for the country. Insecond term, the need of having a minimalappropriationinthe current fiscal term i s established, in which said authorization i s requested, if dealing with an authorization addressedto compromise common future terms. 26. Inline with the objective that the multi-annual analysisguides the expense and public borrowing decisions, the payment capacity of the territorial entities will be analyzed for the whole period of the loan term and not only for the current term. In addition, the treasury loans are regulated in order to preserve the margin of the fiscal maneuver the territorial administrations have. 4. Budgetary Reform 27. At this time there is a preliminary project of the articles of reform to the Budget Organic Statute, which is the product of the work performed along the last six months and that takes into account the recommendations made by the International Monetary Fundon the issue, and the different conversations held with the World Bank and the Inter-American Development Bank. 28. The Presidential Message that accompanied the bill of the 2004 budget includes important progresses on the subject of budget transparency and communication. A reading thereof i s included according to the purpose the public expense seeks, some progress has been achieved in the observance of the Law of Fiscal Responsibility including information about the fiscal sustainability in the medium term, contingent liabilities, fiscal cost of tax exemptions, a sensitivity analysis of the budget to macroeconomic variables and a conversion between the Financial Plan and the budget of the Nation. 52  29. On the issue of budgetary classification, Colombia should get close to the international standards, and the first steps have been taken for such purpose. A contract was recently signed in order to carry out both the conceptualization and the implementationof a new systemfor budgetary classification. 53  Annex 11 InternationalMonetary Fund October 15, 2003 700 19th Street, NW Washington, D.C.20431 USA Colombia: FundRelations Note On June 11,2003 the Executive Board of the International Monetary Fund(IMF) completed the first review of Colombia's performance under atwo-year, SDR 1.5 billion (about US$2.1 billion) Stand-By Arrangement, which was approvedon January 15, 2003 (see Press ReleaseNo. 03/04). The completion of this review enables the release of SDR 193.5 million (about US$274 million) to Colombia, bringingthe total amount available to SDR 580.5 million (about US$822million). Sofar the country has not made any drawings under the arrangement. Background Underthe authorities' program, economic performance hasbeenmostly favorable. The economy grew by over 3 percentinthe first semester of 2003 ledby strong growth in construction andmanufacturing. Inflationhas declined since April due to falling food prices and stable foreign exchangerate. The combined public sector deficit has remained on track through June 2003. The Banco de la Repiiblicahas kept its main refinancing interest rate steady after increasing its rates by 200 basis points inearly-2003. Congress approvedthe fiscal responsibility law inJune 2003, which was a structural benchmark. The government restructured the state petroleum andtelecommunications enterprises, going beyond the steps envisaged inthe program. Executive Board Assessment at the Completion of the FirstReview The government of Colombiais carrying out a strong economic reformprogramaimed at encouraging faster economic growth and improving social equity. Inparticular, the government'sprogramfocuses onbringingthe overall public sector deficit down through a wide range of initiatives, includingseveral important structural measures such as tax, pension, and labor reforms. A lower fiscal deficit is essential to reduce gradually the public debt burden, which inturn will ease pressureson interest rates and stimulate growth. The government is commendedfor its strong commitment to economic reform. All performancecriteria and structural benchmarksfor end-2002 and end-March 2003 have beenobserved. This strong policy implementation has already helped to improve economic performance. The economy showed signs of recovery inthe first quarter of 2003, with a slight decline inunemployment and renewed access to international capital markets. 54  For 2003, the government i s committed to reducing the overall public sector deficit to 2 ?hpercentof GDP, andis preparedto implementcontingency measures,if necessary, to achieve this target. At the same time, the government intends to continue with key structural reforms, including further steps to strengthen expenditure management and modernizepublic administration. The central bank already raised its main refinancing rate and i s committed to takingfurther measures as necessary to control inflationary pressures. Colombia's economic reform programhas helped reduce the risks to the economic outlook. Nonetheless, the authorities will need to sustain the implementation of the programin order to lay the basis for a durable recovery. For questions please contact Mr.A. Espejo, Senior Economist, South/Central American I, Western Hemisphere Department, IMF, ext. 37152. 55  4 x       U U   U n U 4 2 e, 0 2D .C --x 0 U YE .3 *h 0 3 2 * 0 C e, % id .5 Ld .5 8 a0 .e E sarr U cd a ar .e  3 3 4 3c  x 0 4c g .3 s3 -$ ta .* S 0 i-) m .* 0 1 a m a s8 I wl 0 wl s G 0 b.  a C   Annex TV Colombia at a glance I/l.uE? 198 174 134 130 zn 315 371 301 ZSfQ @ 69  1961 SDOiJ 27 3 187 22 a 13 B 11 a 13.3 6 2 -5 a BO -6.1 1967 2m 2QQl 3,195 13,115 12.369 1id23 1 TIW I I 36 4 . 5 8 3.083 925 S,lW 5,EIOB 5,199 11,533 12,aa 315 ne 1,428 1,578 134 1 s 3.414 4,469 5 147 249 7 193 299 115 128 118 1961 2Qm 2QO1 4m9 16,624 14832 6,215 14,4W 18.a40 -1,537 1,224 om 427 -2,833 -2,975 249 1.352 2,084 -i,m 358 -1,789 1" 513 2.955 437 -6SB -1.166 B.009 10,265 54 5 2,0133 r? 2,2998 1981 2wx) 4718 34,1181 1 184 1,3P 21 7 1,120 5,171 1111 3m a m 1 1 1 I 7 79 F i!3 453 277 1m 203 1,127 728 a85 1.37e 1,328 D a3 3,380 a 350 6135 23 mi am 77 245 233 174 24 135 85 127 133 11s -1cU 3 70  MAP SECTION