Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7318-BIH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ONA PROPOSED CREDIT IN AN AMOUNT EQUIVALENT TO SDR 53.2 MILLION (US$72 MILLION EQUIVALENT) TO BOSNIA AND HERZEGOVINA FORA SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT June 1, 1999 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (as of June 1, 1999) Unit of currency: Konvertible Marka (KM), equivalent to 1:1 to Deutsche Mark I KM=US$0.55 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS BiH Bosnia and Herzegovina BFP Budget Framework Paper CAS Country Assistance Strategy CAFAO Customs and Fiscal Assistance Office CWS Centers for Social Work CBBH Central Bank for Bosnia and Herzegovina DMU Debt Management Unit EBF Extra-budgetary Fund EBPAC Enterprise and Bank Privatization Adjustment Credit EU European Union FRY Federal Republic of Yugoslavia GDP Gross Domestic Product IDA International Development Association IMF International Monetary Fund KM Konvertible Marka MFTER Ministry for Foreign Trade and Economic Relations MTEF Medium Term Expenditure Planing MoF Ministry of Finance PHRD Policy and Human Resources Development Fund PFSAC Public Finance Structural Adjustment Credit SAI Supreme Audit Institution SBA Stand-by Arrangement SFRY Socialist Federal Republic of Yugoslavia VAT Value Added Tax FISCAL YEAR January 1 to December 31 Vice President: Johannes F. Linn Country Director: Christiaan J. Poortman Sector Director: Pradeep Mitra Task Team Leader: Sebnem Akkaya BOSNIA AND HERZEGOVINA FOR OFFICIAL USE ONLY PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT Credit and Operation Summary Borrower: Bosnia and Herzegovina Beneficiaries: Bosnia and Herzegovina, Federation of Bosnia and Herzegovina, Republika Srpska Amount: SDR 53.2 million (US$72 million equivalent) Terms: 35 years, including a 10-year grace period Credit Objectives: To support the establishment of public finance structures and implementation of reform policies at the State and Entity levels. Specifically, the Credit will support: (i) broadening tax policy harmonization and strengthening administrative co-operation between the Entities to enhance revenue capacity and to encourage free flow of goods across BiH; (ii) improving revenue and expenditure assignments within the Entities to prevent large differentials in the provision of public services; (iii) initiating reforms to develop an affordable, efficient, and equitable social safety net; (iv) developing a comprehensive budgetary strategy aimed at improving fiscal efficiency and control; (v) establishing audit institutions and procedures to improve transparency and accountability in public sector operations; and (vi) strengthening country-wide policy coordination in external debt management, including developing a policy framework for sub-Entity borrowing. Credit Description: The Credit will be lent to the State of Bosnia and Herzegovina which will in turn onlend in the amount of US$42 million to the Federation and US$30 millionto Republika Srpska, on the same terms as the IDA Credit. The Credit will be disbursed in three tranches for budgetary and balance of payments support to Bosnia and Herzegovina. Release of tranches will be linked to policy conditionality as agreed during the negotiation of the Credit. Benefits: The implementation of the proposed operation will help BiH consolidate the public finance reforms began under the PFSAC, substantially strengthen prospects for continued fiscal stability, enhance sustainability of the structural reform process, and reintegrate the economy. The reform program will promote free flow of goods between the Entities and improve tax revenue collection by completing harmonization of major tax structures, strengthening administrative co-operation and revenue distribution. It will facilitate development of a more robust intergovernmental system, which is supportive of the Entities' stabilization and structural reforms and which will improve efficiency and coverage of public sector services. By pursuing essential policy and institutional reforms in budget planning and execution, the operation will help the Entities correct the medium-term imbalance between revenues and expenditures and set appropriate priorities for public outlays. The proposed reform program will also improve medium-term financial viability and targeting of the pension system, initiate design of an equitable and sustainable social safety net system, and This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. ii ensure a certain level of equalization in the provision of health services through developmen-t of an efficient health insurance system in both Entities. By instituting sound auditing procedures, it will significantly enhance transparency, efficiency and accountability of public service operations. Establishment of an effective and integrated public finance structure will help BiH conduct sound macroeconomic management, reduce cost to economic transactions, and achieve extemal creditworthiness. By supporting the development of a public sector which is more suitable to a market economy, the operation will also contribute to private sector development, employment creation and poverty reduction. Risks: The Credit faces two major risks. First, there will be risks associated with BiH's process of reconciliation, as has been demonstrated so far since the signing of the Dayton Accords in December 1995. Several measures supported by the proposed Credit are subject to intense political debate within the country-and, more particularly, between the different ethnic groups-thus creating a potential for nonrimplementation of the agreed measures and/or reversal of the adopted reforms. Particular among them are the harmonization of the Entity tax policies, pension reform in the Entities, especially unification of the Federation pension funds, and reform of intergovernmental financial relations, particularly in the Federation. To mitigate these risks, the Bank requires the upfront fulfillment of conditionalities whenever possible and will work closely with the IMF, the US Treasuky and others to jointly promote the implementation of the reform agenda. The Bank also agreed with the BiH governments to set up working groups on key reform areas and maintain close co-ordination with the existing ones to promote consensus. The Bosnian authorities' strong commitment and success in implementation of equally difficult set of policy measures under the first operation has shown that obstacles created by low political tolerance can actually be mitigated. A second risk is that the Government's administrative and institutional capacity will be insufficient to handle the complexity of the budgetary and auditing reform actions envisaged in the PFSAC II. The Government is cognizant of this risk, and its program is designed to minimize its administrative burden, by appropriate phasing of the measures and application of the technical assistance where needed. Certain essential technical assistance activities have already been financed by PHRD grants. The bulk of the technical assistance requirements would have to be carried through grant financed technical assistance (TA) programs and/or parallel donor financed TA to augment the limited local capacities. Poverty Category: Direct impact on poverty will be achieved through provision of more adequate resources for social protection programs, and improved targeting and distribution of social benefits. Rate of Return: Not Applicable Map: IBRD 28578R Project ID Number: BA-PE-55432 iii BOSNIA AND HERZEGOVINA PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT CONTENTS 1. INTRODUCTION .............1 II. ECONOMIC OUTLOOK AND FINANCING REQUIREMENTS . . 2 A. Macroeconomic Performance and Policy Framework .2 B. Macroeconomic Prospects .3 C. Exte rnal Financing Requirements .3 III. BACKGROUND AND ISSUES IN PUBLIC FINANCE .4 A. Dayton Rules on Public Finance Structure .4 B. Issues and Strategy in Public Finance Reform .5 IV. PUBLIC FINANCE REFORM PROGRAM ..5 A. Reforming and Harmonizing Tax Policies and Coordinating Tax Collection .5 B. Reforming the Intergovernmental Finances within the Entities .8 C. Reform of Social Safety Net .14 D. Reforming the Budgetary Management System .18 E. Establishing Auditing Procedures and Institutions .21 F. Strengthening Debt Management Capacity .23 V. THE PROPOSED CREDIT ..25 A. Rationale for Bank Involvement ..25 B. Credit Amount and Borrower .25 C. Credit Design.25 D. Administrative Arrangements ..26 E. Disb-ersement.26 F. Monitoring Arrangements and Tranche Release Conditions .26 G. Environmental Assessment Requirements ..28 H. Benefits and Risks ..28 VI. RECOMMENDATION ................... 29 ANNEX I Policy Matrix ANNEX II Letter of Development Policy ANNEX I Health Finance Reform Program ANNEX IV Statistical Annex REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT (PFSACII) IN THE AMOUNT EQUIVALENT TO SDR 53.2 MILLION TO BOSNIA AND HERZEGOVINA 1. I submit for your approval the following report and recommendation on a proposed Credit to Bosnia and Herzegovina (BiH) in the amount of SDR 53.2 million (US$72 million equivalent) to help finance a Second Public Finance Structural Adjustment Operation. The proposed Credit would be on International Development Association (IDA) terms, with a 35-year maturity, including a 10-year grace period. This operation is the third in a series of adjustment operations designed to support the Government's program of structural reforms. It is the second operation that focuses on public finance reform. The proposed Credit would continue support begun by IDA under previous operations, and would underpin the country's fiscal reform program during FY99-00. The Country Assistance Strategy (CAS) and the progress report were discussed by the Board of Directors, in July 1997 and August, 1998, respectively. The most recent economic report on BiH (Bosnia and Herzegovina-From Recovery to Sustainable Growth) was published in May 1997. A Public Expenditure Review was completed in October 1997. I. INTRODUCTION 2. The proposed PFSAC II builds on BiH's achievements to date in establishing both the Dayton-mandated common institutions and the governance structure in its two constituent Entities: The Federation of Bosnia and Herzegovina (Bosniac-Croat Federation) and Republika Srpska. With a marked improvement in progress toward structural policy reforms since 1998, many critical institutions and policies are now in place. These include the central bank and national currency; a legislative and regulatory framework for the banking sector and for enterprise privatization; a uniform customs tariff and trade regime; financing means and mechanisms for the common institutions; a legislative framework for budget management; and an institutional and legislative framework for debt management. Significant progress has also been achieved in removing barriers to the movement of goods and people within the country, including initial steps towards harmonization of tax systems across the Entities. These reforms have been supported by two World Bank adjustment operations (the PFSAC and the proposed Enterprise and Bank Privatization Structural Adjustment Credit) as well as by an International Monetary Fund (IMF) Stand-by Arrangement. 3. Sustaining and broadening the positive developments of the past year is the key challenge BiHfaces for continued rapid reconstruction and growth in the medium term. Structural policy reforms must be accelerated if BiH is to increasingly rely on its own resources and institutions in designing and implementing the policies required for long-term development. The proposed PFSAC II aims to assist BiH to meet this challenge by supporting further progress in institution-building and policy reforms in the following areas: (i) broadening tax policy harmonization and strengthening administrative co-operation between the Entities to enhance revenue capacity and to encourage free flow of goods across BiH; (ii) improving revenue and expenditure assignments within the Entities to prevent large differentials in the provision of public services; (iii) initiating reforms to develop an affordable, efficient, and equitable social safety net (iv) developing a comprehensive budgetary strategy aimed at improving fiscal efficiency and control; (v) establishing audit institutions and procedures to improve transparency and accountability in public sector operations; and (vi) strengthening country-wide policy coordination in external debt management, including developing a policy framework for sub-Entity borrowing. II. ECONOMIC OUTLOOK AND FINANCING REQUIREMENTS A. Macroeconomic Performance and Policy Framework 4. Macroeconomic Performance. The combination of prudent economic policies and large-scale donor assistance has yielded impressive results in Bosnia and Herzegovina. Economic growth has averaged about 40 percent in real terms each year since 1995. Inflation has fallen progressively, and is currently running at single digit rates on a country-wide basis. There has been a significant increase in real per capita consumption for most households. Many schools and health clinics have reopened, and the main infrastructure networks have been largely rehabilitated. Commerce and production are picking up with the help of donor-financed lines of credit. External debt rescheduling has been successfully completed with both London Club and Paris Club creditors, significantly reducing the debt inherited from the former SFRY. The London Club agreement provided for a 73 percent reduction in the net present value of outstanding debt, including arrears; and the Paris Club agreement provides for debt rescheduling on Naples terms or a 67 percent reduction in the present value of the debt. Regularization of relations with remaining creditors, including the resolution of issues related to outstanding foreign claims on non-government creditors, is expected to be completed by the end of this year. 5. Despite the rapid economic recovery, reflecting the extremely depressed level of post-war economic activity, GDP is still only at about 40 percent of its prewar level and living standards for many Bosnian families remain low. Measured unemployment, which fell sharply during the initial years of economic recovery, appears to have stagnated at around 35 percent-very high even by the standards of transition economies. Due to the later start to donor assistance and economic recovery, and limited integration with the international economy, incomes are lower in Republika Srpska than in the Federation. Although aid flows to Republika Srpska accelerated following the election of a moderate government in January 1998, its close economic integration with the Federal Republic of Yugoslavia makes it particularly vulnerable to the ongoing conflict there (see paras. 9-10 below). 6. The Macroeconomic Policy Framework. Maintaining the macroeconomic stability that has been achieved to date requires sustained prudent fiscal management by the authorities, further progress in institution building and transition reforms, and continued international financial and technical assistance. The basic underpinnings for this policy framework are provided by an IMF Stand-by Arrangement (SBA) that was approved in June 1998. 7. The principal elements of the SBA program are: (i) use of a fixed exchange rate as a nominal anchor through the currency board arrangement; (ii) limiting the fiscal deficit of the consolidated public sector to levels compatible with available sources of foreign financing and avoiding borrowing by all levels of government from the domestic banking system and non-bank public; (iii) avoiding any significant accumulation of new domestic arrears, especially in wage and social security payments; and (iv) continuation of large scale external assistance on concessional terms. Structural elements of the program include customs tariff reform and trade liberalization, consolidation of the fiscal institutions of the State and the Entities, and reform of the payments system. The program also contains important elements of the agenda for banking reform and enterprise privatization and restructuring. The first review of the SBA has been delayed but is now expected to be successfully concluded shortly. The authorities have recently requested that the SBA be converted later this year into an Enhanced Structural Adjustment Facility (ESAF) arrangement, which would provide a medium-term framework for macroeconomic policies and continued IMF assistance. 8. The government's reform efforts have also been supported through adjustment lending by the World Bank. The Bank's first non-emergency adjustment operation, the PFSAC (SDR 46.2 million, approved in June 1998) assisted the Bosnian authorities in implementing key public finance reforms in 1998. These reforms were instrumental in improving the consistency between State and Entity budgets, establishing a transparent and predictable funding mechanism for the State budget, setting the legislative framework for budget management, 2 establishing a legal and institutional framework for debt management, initiating the harmonization and reform of Entity tax systems, and initiating reform and re-organization of Entity pension systems. The PFSAC was fully implemented and disbursed in less than a year providing a sound basis for the proposed follow-up operation, PFSAC II, to broaden public finance reforms. In addition, a second adjustment operation, the Enterprise and Bank Privatization Adjustment Credit (EBPAC), is being presented to the Board together with the proposed PFSAC II. The EBPAC would support the government's efforts in initiating bank and enterprise privatization through privatization of small and medium-sized enterprises, bank restructuring and support for a deposit insurance scheme. Tile proposed PFSAC II and EBPAC are both highly complementary to the SBA/ESAF. B. Macroeconomic Prospects 9. Prospects for Growth. Continued stabilization, institution-building and reform efforts are essential in the coming years to ensure sustainable recovery and growth. However, the fluid political environment adds a certain degree of unpredictability, and risk, to Bosnia's future economic performance. The ongoing conflict in the Federal Republic of Yugoslavia (FRY) is having an important impact on economic developments in Bosnia and Herzegovina, notably Republika Srpska. The main channels for this impact include reduced trade, investment and economic activity, and higher unemployment. The fiscal position of both Entities has come under pressure from lower tax revenues and higher public spending to deal with increased domestic social needs and new refugees. 10. Despite the disruptions from the crisis in FRY, the Bosnian authorities have pledged themselves to press forward with their economic reform programs. Under a scenario of continued policy reform, and assuming that the crisis in FRY stops in the coming months, simulations indicate that after 1999 GDP growth would return to its gradual path of deceleration from the very high postwar rates to rates more normally associated with open and dynamnic economies (see Table 1). As in the recent past, growth and employment generation in the next few years would be stimulated, to a large extent, by donor-financed activities. Subsequently, however, consistent with anticipated declines in donor assistance for the reconstruction program, achieving balance of payments viability and creditworthiness will require a sizable reduction in domestic absorption. This reduction will have to come from public sector investment in light of the current very considerable reconstruction-driven levels of public investment. At the same time, an effort will be required to offset this reduction in public investment by completing structural reforms, in particular, to attract private capital and increase investment efficiency. Recurrent public expenditures would actually be expected to increase modestly, in line with the need to strengthen social safety nets and to make appropriate provision for the operation and maintenance of new investments. Consequently, enhanced revenue performance would be critical to ensure medium-term fiscal sustainability. With these assumptions, Bosnia and Herzegovina's GDP should reach about two-thirds of its prewar level by the mid-2000s, bringing living standards in Bosnia much closer to the average of transition countries in Central and Eastern Europe. C. External Financing Requirements 11. Exceptional external financial assistance has made a major contribution to Bosnia and Herzegovina's balance of payments. In addition to generous humanitarian assistance, the international community made commitments during 1996-98 of US$4.2 billion, mainly on a grant basis, for Bosnia's reconstruction and peace implementation activities. As of end-1998, total disbursements of grants and loan aid were estimated at about US$2.8 billion. The Donor Conference held in May 1999, which was the last to be held in support of the Priority Reconstruction Program, produced total pledges of US$1.05 billion. With the commitment of these pledges, the external financing requirement of the US$5.1 million Priority Reconstruction Program would be met. Over the next several years, disbursements of donor funds committed for the Priority Reconstruction Program will provide a substantial share of Bosnia's external financing. 12. Allowing for the impact of the crisis in FRY, Bosnia and Herzegovina's total external financing requirement in 1999 is estimated at US$1.4 billion. As in recent years, this financing requirement consists mostly of reconstruction costs and debt service obligations. After taking into account anticipated reconstruction 3 assistance and other identified official and private flows (including planned disbursements from the proposed PFSAC II and EBPAC), there would be a residual financing gap of about US$60 million in 1999 which is expected to be closed within the next few months. Table 1: Selected Key Economic Indicators V, 1996-2005 Estimated Projected 1996 1997 1998 1999 2000 2001 2002 2005 Gross Domestic Product GDP(US$ million) 2741 3423 4082 4533 5333 6262 7090 9080 Real GDP growth (%) 69 30 18 8 14 14 10 5 Investment (% of GDP) 41 42 38 33 33 32 28 25 Public 24 24 20 16 13 11 7 2 Private 17 18 18 17 20 21 21 23 Consumption(%ofGDP) 118 105 99 92 87 84 82 78 Public Sector Balances Expenditures (% of GDP) 78 56 52 48 48 47 44 40 Revenues (%ofGDP) 51 31 32 31 35 36 37 38 Deficit (-)(%of GDP) -27 -25 -20 -17 -13 -11 -7 -2 Extemal Financing (%of GDP) 27 23 20 17 13 11 7 2 Balance of Payments Financing Requirements (USS million) 2333 2006 1683 1423 1289 1247 1022 587 o/wCurrentAccountDefici' 1528 1710 1397 1079 1035 990 743 361 o/w Debt Service (scheduled) 575 386 227 195 204 207 229 175 o/w Increase in Foreign Exchange Reserves 230 -90 59 150 50 50 50 50 Financing Sources (USS million) 2333 2006 1683 1362 1188 1196 972 587 o/w Unrequited Current Official Transfers 558 422 190 94 45 45 20 7 o/w Donor Financing 3l 1707 750 983 968 711 700 500 200 o/wFDlandOtherPrivateFlows 0 0 100 60 162 185 230 280 o/wArrears Clearance andDebt Relief -125 306 172 63 47 38 25 1 1 o/w Others 194 528 238 178 224 228 197 88 Remaining Financing Gap (USS million) 0 0 0 61 101 50 50 0 External Debt Total Extemal Debt4' (in % of GDP) 137 127 71 72 68 64 60 55 Debt service(in%oftotal exports) 66 35 9 8 8 7 6 5 1/ Data refers to estimates for all Bosnia and Herzegovina unless otherwise stated. 21 Excluding interest and official transfers. 3/ Including use of IMF resources, other budgetary/balance of payments support. and fnancing for reconstruction. 4/ Reduction of debt stock in 1998 reflects debt rescheduling with London Club and Paris Club creditors. Source: Official data, Bank and IMF staff estimates. HI. BACKGROUND AND ISSUES IN PUBLIC FINANCE A. Dayton Rules on Public Finance Structure 13. The Dayton Accords provide a broad framework for building a new governance structure in BiH. Under the Accords, BiH is a sovereign state consisting of two Entities, the Federation of Bosnia and Herzegovina and Republika Srpska, with a State government responsible for international relations and inter-Entity coordination. Key economic institutions and policies envisaged at the State level include a central bank (organized as a currency board in its first six years) and a new currency, customs and trade policies, international financial relations (including servicing of international debts and debt management) and coordination in telecommunication and transport. Unless mandated otherwise by the State Parliament, the State does not have the capacity to tax or collect customs duties on its own. The budgetary needs of the State are to be met in the proportions of two thirds by the Federation and one third by Republika Srpska. 4 14. The Entity governments have exclusive responsibility in their respective territories over defense, intenal affairs (including police), environmental policies, economic and social sector policies (such as agriculture, industry, and health), refugees and displaced persons, reconstruction programs and justice, tax, and customs administration. To carry out these responsibilities, each Entity retains ownership of the taxes collected in its territory. The two Entities, however, have different fiscal structures. The Federation has a three-tier fiscal system: the Federation government, cantons, and municipalities, with major responsibilities resting with the cantons. Republika Srpska has a two-tier structure: the Republika Srpska government and municipalities, with very limited local fiscal authority. 15. Despite considerable progress to date in establishing the Dayton-mandated public finance structure at the State and the Entity levels, much remains to be done in building a framework for sustainable fiscal management. In the Federation, the customs, tax and the payments systems were reintegrated; tax policies were broadly unified and significant progress has been achieved in establishing canton-level fiscal administration. Nevertheless, co- ordination between Entity and local governments remains weak. Consequently, separate policies and practices still continue within the fiscal structure of the Federation. The Republika Srpska initiated basic fiscal reforms only last year and, therefore, its fiscal system still operates along the lines of the former SFRY system. At the State level, the institutional and legislative framework envisaged by the Dayton Accords began functioning last year, although there have been, and will continue to be, ups and downs. The establishment of the central bank and the introduction of a national currency, common customs tariff policies, and a State budget along with clear financing arrangements were among the key factors that made this possible, while providing the basis for initial co-ordination between the Entities in key areas of economic management. For BiH to start functioning as a unified State, however, these initial efforts toward policy harmonization and coordination will have to be deepened and strengthened. B. Issues and Strategy in Public Finance Reform 16. Bosnia and Herzegovina is at a critical juncture on its road to sustainable economic growth. Sound public finances will be critical to the credibility and, hence, sustainability of the structural reform process and robustness of the supply response. Strengthened fiscal capacity is also the cornerstone on which creditworthiness must be built. In order to achieve further progress in establishing such a viable medium-term fiscal management strategy, BiH faces the following major tasks over the next twelve to eighteen months: (i) strengthening domestic resource mobilization, including through better policy and administrative co-ordination both between and within the Entities; (ii) introducing strategic public resource allocation, including through investmnent planning; (iii) improving revenue and expenditure assignments at different levels of government and, hence, provision of public services within the Entities; (iv) creating a fiscally viable social safety net with a greater focus on poverty alleviation in the transitional period till the resource base of the system is strengthened to allow provision of more comprehensive social assistance; (v) establishing institutional and regulatory frameworks for improving transparency and accountability of government finance; and (vi) strengthening country-wide policy coordination in external debt management, including developing a policy framework for sub-Entity borrowing. IV. PUBLIC FINANCE REFORM PROGRAM A. Reforming and Harmonizing Tax Policies and Coordinating Tax Collection Current Situation 17. Significant progress has been made to date in reforming tax policies and strengthening tax administration within the Entities. Harmonization of tax systems across the Entities has also been initiated. Reforms supported by the first PFSAC, improved the tax system across Bosnia and Herzegovina by: (i) reducing exceedingly high tax burdens; (ii) initiating the process of creating tax structures that would facilitate the free flow of goods between the Entities and international trade; and (iii) rationalizing the public sector's size and role in the economy. 18. The Federation Government has simplified its sales tax structure. It has further reduced the combined wage tax and contribution rates and hence the burden on labor; broadened the wage tax base to include some non-wage 5 benefits, such as per diems and allowances; reduced the profits tax rate; and developed a global income tax. With assistance from the EU, the government has also developed a reform program to improve tax collection by strengthening the coordination between the Federation Tax and the Customs Administrations. As part of this program, a Fiscal Administration Board was formed to coordinate the activities and to enhance the transfer of information between the Financial Police, Customs Administration, and Tax Administration. 19. The Republika Srpska has also achieved progress towards reducing the.wage tax by reducing the pension and health contribution rates and the wage withholding tax. Similarly, sales and profit tax rates were significantly reduced. In conjunction with these measures, the Ministry of Finance took several initiatives to maintain revenues, including significant improvement in the inspection capacity for better enforcement and widening the tax net. These efforts successfully resulted in increased revenue collection despite the implementation of significant rate cuts. 20. The Entities began implementing the State-set common customs and trade policy. As a result, tarif rates were simplified and unified, with an average effective rate of about 8 percent applying across the country for most imports. Significant progress was made towards eliminating both special customs agreements with Croatia and Yugoslavia and protective tariffs that are preventing full harmonization of the tariff system across the country. In an effort to broaden harmonization of the tax systems, the Entities have also began harmonizing their sales and excise tax systems by adopting similar tax bases and by collecting revenues at the same point in the distribution process. 21. Despite this progress, significant additional reforms of tax policies and administration are essential to improve tax collection and to create an environment conducive to growth and private sector expansion in Bosnia and Herzegovina. In particular, greater effort is needed to broaden and accelerate the process of harmonization of the Entity tax systems and to establish strong administrative coordination between the Entity tax administrations. Rapid progress on these fronts is crucial for minimizing tax avoidance and for minimizing harmful tax competition as well as encouraging the free flow of goods between the Entities. Issues and Plans in Tax Reform 22. Building on the achievements to date in reforming the tax system, the most urgent challenges the tax policy in BiH faces include: (i) incorporating all Entity specific tariffs into the State customs law and eliminating all implicit tariffs imposed by the Entities; (ii) completing hannonization of the sales and excise tax structures between the Entities; (iii) developing a revenue distribution system between the Entities to limit tax competition; and (iv) developing adequate cooperative arrangements between the tax administrations in the Entities. 23. Harmonization of Entity tax system& The explicit tariff structures in BiH were rationalized and harmonized with the passage of the State Customs Law in mid-1997. Nonetheless, full implementation of the Law has been prevented by continued imposition of two kinds of Entity-set tariffs: (i) protective tariffs on certain commodities, including many agricultural goods; and (ii) implicit tariffs, whereby the Entities impose differential excise tax rates on domestic- and foreign- produced commodities, which effectively operate as tariffs. To develop a joint approach for eliminating the protective tariffs, the Entities established a Committee composed of representatives of the State and the Entity Ministries of Trade in mid-1998. The Committee has both identified the list of items on which additional customs tariffs will be temporarily applied during 1999 and selected uniform rates. The State Council of Ministers adopted the list and the rates in March 1999. Likewise, the Tax Working Group has started developing a similar approach to eliminate the implicit tariffs. To achieve this, the Group must focus on setting identical rates for excise taxes on domestic and imported commodities in the Entities by bringing the excise tax rates on imported commodities down to rates imposed on domestic goods. This approach will ensure that all differential taxes are accounted for in the special tariffs enacted by the Council of Ministers. It will, at the same time, harmonize the excise tax rates on domestically produced goods between the Entities. 24. For full harmonization of the customs system, the Federation and Republika Srpska must also eliminate their special trade arrangements with Croatia and FRY, respectively, which effectively exempts most imports from 6 customs tariffs and subjects these commodities to domestic rather than foreign excise tax rates. Both Entities have recently taken a decision to this end and are presently adjusting their customs system for initiating implementation bv June 1999. Finally, in order to complete the harmonization of the sales tax system, the Entities must align the sales tax rates. The existing differences in the sales, excise and customs tax rates create strong incentives for tax avoidance through purchasing (either by wholesalers or consumers) in the low tax Entity. Elimination of most rate differences is crucial to limit such avoidance and to encourage free trade. The Entities intend to achieve significant progress towards this end by the end of 1999. 25. Improving revenue attribution rules between the Entities. The problems arising from varied tax structures between the Entities are exacerbated by the existing attribution rules, which result in sales and excise tax revenues remaining where they are collected--e.g. excise taxes are collected at import or manufacture; sales taxes on all excisable goods are collected where the first sale occurs. There are several critical problems inherent in the existing system that prevents the growth of economic relations between the Entities. These include: first, incentives for harmful tax competition, as each Entity has the potential to attract economic activity by undercutting the sales and excise taxes imposed in the other Entity; second, inequity in the distribution of tax revenues between the Entities, since sales and excise tax revenues do not accrue to the Entity where consumers live; third, creation of disincentives for trade between the Entities, as they receive the excise and sales taxes on commodities obtained from any location except from the other Entity. As trade between them grows, the Entities are increasingly concerned about implications of the existing attribution rules. To improve the system, the Entities need to develop a mechanism that would ensure maximum revenue collection while providing the revenues to the Entity where the commodities are to be consumed. This is best accomplished by collecting the revenues at the point of import or manufacture and passing them from the collecting Entity (where manufacture or import occurs) to the consuming Entity (the Entity of destination) through a mechanism which would ensure that revenues are paid to the proper Entity, such as introducing tax stamps. The Tax Working Group mentioned in para.23 is developing a joint approach to resolve the attribution problems. 26. In the medium-term, the Bosnian authorities will have to consider ways to collect sales tax revenues within a system entailing fewer complications than the existing system. A value added tax (VAT) could constitute such an alternative. The VAT system would not only generate more revenues, and close opportunities for evasion, but would also further the alignment of the BiH's tax system with European norms. Both Entities are considering exploring the VAT's potential and analyzing how it could be structured within and across the Entities. In addition, the Entities also recognize the need for developing a highly coordinated tax administration as a precondition for the introduction of the VAT. 27. Strengthening administrative co-ordination between the Entities. Co-ordination between the two Entities on tax and customs administration remains limited thereby opening opportunities for tax evasion. As a result, the Entity tax administrations are unable to fully audit transactions and tax returns that involve both Entities; they are unaware of many transactions between firms across the Entities. The Entities are considering improving administrative co-operation, and to this end have recently initiated a dialogue under the EU's supervision. Nonetheless, initial arrangements will only provide a limited degree of cooperation. Effective elimination of the potential for tax evasion, introduction of new attribution rules for revenue allocation between the Entities, and eventually a VAT system all require strong administrative cooperation. The best way to achieve this is developing an information sharing system between the tax administrations in the two Entities. Actions to be Supported by PFSAC II 28. The proposed operation will support the continued development and implementation of tax reforms, with a particular emphasis on harmonization of tax policies and coordination of tax collection across Entities. Prior to Boardpresentation, the Federation and Republika Srpska will have (i) started implementation of the State-set tariff surcharges by eliminating their respective protective tariffs; (ii) eliminated special trade agreements with Croatia and Yugoslavia; (iii) equalized the excise tax rates on domestic and imported goods so that all differential taxes are accountedfor in the tariff surcharges enacted by the State Council of Ministers; and (iv) established a Working 7 Group to develop a plan for coordination between the two tax administrations. Additionally, it is also expected that preparation of a plan to allocate the sales and excise taxes between the Entities in a more equitable and administratively feasible way will have been initiated. 29. Prior to the second tranche release, the Federation and Republika Srpska will have (i) completed the harmonization of sales tax system by reducing differences in sales tax rates; (ii) submitted to their Parliaments amendments to their sales and excise tax legislation on inter-Entity allocation of the sales and excise taxes; and (iii) adopted a plan to strengthen the coordination between their Tax Administrations in a way to ensure effective implementation of the new inter-Entity allocation rules for the sales and excise taxes. 30. By the third tranche release, the Federation and Republika Srpska will have started the implementation of (i) new legislation on inter-Entity allocation of sales and excise taxes; and (ii) administrative co-ordination necessaryfor effective implementation of the new legislation on inter-Entity allocation of sales and excise taxes. 31. The technical assistance, which has been provided through the previous operation and during the preparation of this Project, will continue during implementation. In particular, the Bank will assist and advise the Entity Governments in: (i) examining the revenue attribution rules and developing acceptable arrangements to ensure that the revenues are allocated in an equitable and administratively feasible manner; (ii)strengthening the administrative coordination; and (iii) modernizing the tax systems, particularly through development of a VAT system. Financing for the technical assistance is being provided through Policy and Human Resources Development (PHRD) grants. B. Reforming the Intergovernmental Finances within the Entities Current Situation 32. Under the Dayton Accords, major government budgetary responsibilities are divided among the four levels of government: the State, the Entities, the cantons (in the Federation) and the municipalities. The design of the intergovernmental fiscal system assigns limited economic and fiscal management responsibility to the State and provides significant autonomy to the Entities. The Entities have different fiscal structures. In the Federation, canton level administration is being developed as the major instrument of government to accommodate different demands for services and to allow for greater local control over setting services. A more centralized structure is operating in Republika Srpska. Unless otherwise mandated by the State Parliament, the budgetary needs of the State are to be met in the proportions of two thirds by the Federation and one third by Republika Srpska, with the Entities having ownership of the taxes collected in their territories. 33. Since mid-1997, the State and the Entity Governments have intensified their efforts to establish Dayton- mandated budgetary financing arrangements. With assistance from the Bank under the first PFSAC, the 1998 budgets set the stage for the formulation and implementation of mutually consistent budgets across all three Governments. This was made possible by establishing both clear financing arrangements and a transfer mechanism between the Entity and the State govermnents. These arrangements have substantially improved stability and transparency of financial relations between the three governments, and provided the State with regular funds to undertake its administrative functions and to meet external obligations. 34. Progress in establishing the cantonal governance structure has continued in the Federation including considerable, though uneven, progress in integrating the administrative structure in the two ethnically mixed cantons. At present, all cantons have basic fiscal management and legislature structures in place and they are all fully operative. The revenue and expenditure assignments, since 1997, have generally followed the structure laid out in the new Federation Constitution. Revenues are distributed using a pure tax assignment system. Customs and excise tax revenues and, starting mid-1998, profit taxes on certain large firms (such as the electric and telephone companies) are assigned to the Federation Government and the remainder of the revenues, mainly from sales, profits, and wage taxes, are assigned to the cantons and municipalities. Combined, cantons and municipalities 8 collect more than 60 percent of Federation-wide revenues with the municipalities' share averaging about 20 percent of the revenues from the canton taxes. 35. The Federation Government has relatively little service delivery responsibility-4imited primarily to defense and social assistance for veterans and their families. Together these services account for a large proportion of Federation spending (more than 60 percent in 1998). Service delivery for functions such as health, education, housing, social assistance and police is primarily a cantonal responsibility, with each canton determining the relative role of the canton versus the municipalities. Generally, municipalities deliver preschool education, some social assistance, culture, sports, and utility services that are provided through off budget companies. Despite the Federation's success in significantly improving the sales tax revenue allocation between cantons during 1998, per capita service provision capacity varies widely across cantons. At present, except for a very minimal ad-hoc Federation pool, there is no mechanism to improve horizontal equity in access to basic public services across cantons nor to account for externalities in service delivery. 36. The Republika Srpska Government undertakes almost all service delivery--with municipalities primarily responsible for utility services, also generally provided by off budget companies. Tax revenues are collected at the central level of which about 10 percent (mainly from sales, wages and profit taxes) are allocated to municinalities through a system similar to the one between the Federation cantons and municipalities. The revenue allocation has been improved since 1997 to provide certain municipalities with a slightly higher share of tax revenues, depending on their characteristics. The allocation of revenues is higher for those municipalities that are on the border, have high social problems, have significant damage from the war, or have large numbers of refugees. These adjustments constitute a step towards eliminating financial imbalances at the local level. The government is currently developing a new decentralization strategy. Issues and Plans for Reform of Intergovernmental Finance 37. Because of the Federation's more complicated structure, issues in intergovernmental finance remain relatively more significant in the Federation than in Republika Srpska. Despite the appearance of clear rules in revenue and expenditure assignments in the Federation, a series of specific issues remain to be addressed for ensuring provision of minimum services across the Federation and for enhancing the public sector's operational efficiency. The key issues include: (i) improving the allocation of revenues across the Federation; (ii) strengthening the legislative structure to prevent exemptions or concessions against another level of government's tax bases; (iii) enhancing local revenue capacity and clarifying local autonomy to implement local taxes; (iv) developing mechanisms to effectively finance and deliver services with geographic spillovers; and (v) improving the emerging health finance system to ensure Entity-wide provision of basic health services. In Republika Srpska, a greater attention must also be given to maintain an efficient intergovernmental system which requires a careful analysis of the emerging decentralization strategy. 38. Improving revenue attribution rules within Federation. Existing arrangements in the allocation of revenues between the cantons result in a relatively wide range of revenues on a per capita basis (about 5:1 in 1998). Despite improving the revenue allocation since 1998, attribution of sales taxes on excisable commodities to the first buyer's location results in disproportionately greater per capita revenues in those cantons with high economic activity and cantons where importing is concentrated. Similar deficiencies exist in the current allocation of profits tax revenues to the headquarters canton, in cases where companies operate in more than one canton. In the absence of any Federation mechanism to address current disparities in fiscal resources available to the cantons, low activity locations are able to deliver fewer services. To improve the revenue distribution, the Federation government needs to develop mechanisms for (i) improving revenue allocation rules to ensure that greater revenues are allocated to the place of destination; (ii) redistributing some limited tax revenues; (iii) altering sharing rules between jurisdictions in cases where some component of the taxable activity takes place in more than one jurisdiction. 39. As in the case of inter-Entity allocation of sales and excise tax revenues (discussed in para.25), changes to the attribution rules within the Federation require a mechanism that would maximize revenue collection while 9 providing more equitable distribution of revenues across cantons. Both of these objectives could be achieved by collecting taxes at the import or manufacturing stage and by allocating them according to a formula that would constitute a good proxy for the distribution on a destination basis. Tax evasion in the Federation could be significantly minimized by collecting sales and excise taxes at import or manufacture-e.g. revenue collection is estimated to improve by about one-fourth if only sales taxes evasion on imported excisable commodities could be reduced. Reduction of evasion would, in turn, allow all cantons to receive higher revenues. The Federation government, in co-ordination with cantons, is currently exploring options--including the approach described above-- for improving sales and excise tax revenue allocation and it intends to formulate an approach for implementation in the next year. 40. Improving the allocation of profit taxes in the Federation requires a comparatively different approach. Under the existing system, frms operating in multiple cantons make no contribution toward financing the delivery of services in cantons where they have branches, despite benefiting from public services offered in these cantons. This creates disparities in access to resources. It also provides an incentive for the cantons to compete for businesses by cutting taxes. A set of situs rules could be developed to improve revenue sharing arrangements between cantons. However, such sharing mechanisms entail significant administration and compliance costs. These costs can best be avoided by collecting the profit taxes at the Federation level. Since this would mean a reduction in the revenues provided to cantons, such a shift must be made along with a set of expenditure responsibilities. The Federation has already initiated revenue re-allocation in October of 1998 by transferring to itself ownership of the profit tax revenues from many large firms--representing about one-half of profit tax collections. Expenditure assignments were, however, maintained, creating additional pressures on already tight canton finances. The problems associated with both profit tax revenue allocation and with those expenditures that have a Federation-wide impact, but presently assigned to cantons without clear financing arrangements-such as higher education and tertiary health care-could be eliminated by re-assigning the profit taxes to the Federation, along with responsibility for such services. 41. Enhancing andprotecting revenue capacity in the Entities. Both the tax base and the tax rate for most of the important taxes in the Federation--including sales, wages, profits-are determined at the Federation level. Since uniform rates and bases will be more difficult to achieve with devolved control, administrative and compliance efficiencies arise from Federation control over most taxes and bases. To safeguard cantonal revenues, however, the cantons must be protected from the Federation's exempting taxpayers or narrowing the base for taxes assigned to cantons. At present, the sales tax law allows the Federation to reduce sales tax rates for periods of up to six months by decree-the decrees are, however, renewed every six months. Based on this provision, the Federation has granted an increasing number of exemptions from the canton sales tax base in recent months. Similarly, payroll taxes were reduced for certain groups; autos produced in Sarajevo are being subjected to lower tax rates, and a portion of the profit tax revenues was shifted from cantons to the Federation. Furthermore, there has been a rapid increase in the number of duty free shops in the Federation where no sales tax is collected and where excise tax rates have been lowered. Transactions at such open, informal markets have also created significant opportunities for evasion. While failing to stimulate economic activity in any significant way, tax exemptions worsen financial imbalances at each level of government. To address this problem, Federation needs to introduce several measures including: (i) allowing changes on the tax bases and rates, only if provided under the existing laws and through a Parliamentary act; (ii) eliminating the existing tax exemptions; and (iii) adopting measures to effectively control duty-free shops and ensure that transactions at such establishments are limited to authorized persons. In Republika Srpska, practice of tax exemptions/relief to date has been comparatively limited and the above stated principals should guide the tax policy in the future. 42. In addition, the Federation tax system needs to be adjusted to establish appropriate incentives for cantons and municipalities to increase revenue collection. The existing system does provide cantons with the majority of Federation-wide tax revenues, but allows them little capacity for varying their revenue structure to meet the different preferences of their citizens. To provide cantons and municipalities with a reasonable flexibility over revenue instruments, while retaining a coherent and easy-to-administer tax structure, cantons could be allowed to 10 exert a limited control over tax rates and fees. The Federation must, ho sever, continue to maintain control over the tax bases. This could be achieved by legislating minimum tax rates and hence limiting the degree of tax competition between the cantons and municipalities. Although maximum rates could also be established, competitive pressures between the cantons will generally make establishment of such rates unnecessary. 43. The portfolio of potential taxes available to augment local government finance, particularly in municipalities, includes property-based taxes. These taxes are currently imposed as excise taxes on property in both Entities, though to a limited extent. Both Entities are considering gradually expanding the existing system toward a traditional property tax. The information and administrative infrastructure associated with the existing property based taxes in both Entities provide a sound basis for developing a broader approach to property taxation. Successful development of a property tax system will require cooperation between the finance, cadastral and tax administration offices of the Entities' local governments. 44. In the Federation, almost all tax revenues collected by the FTA are intended for the cantons and municipalities, since Federation-owned taxes (i.e. customs and excise taxes on imports) are collected by the customs administration. Advantages in terms of lower operational costs, coordination of administration, and uniform practices all argue strongly in favor of the administration at the Federation level. For the efficient operation of this system, however, it is also important that the cantons feel the Federation is making a good faith effort to collect revenues. At present, the cantons suggest that revenue collection can be enhanced if the FTA becomes more responsive to local concerns and follows up more vigorously on cantonal information and input. There is also a tendency by some cantons to establish cantonal tax administrations. To improve tax collection and to forestall this tendency, the Federation must strengthen the coordination between local FTA branches and the cantonal Ministry of Finances. Another step in improving tax collection is to develop and implement a plan to merge the Financial Police with the Tax and the Customs Administrations. While substantially improving use of limited resources, this would ensure that taxpayers are confronted with coordinated audits and administrative activities. A similar approach to reform the revenue collecting institutions is also needed in RepublikaSrpska. 45. Improving public service delivery in Federation. The Federation faces the challenge of preventing the large differences in access to fiscal resources across cantons from being translated into large differentials in the supply of public services. This is particularly important for those public services with major externalities to the Federation as a whole--e.g. education and health--which are broadly assigned to the cantons in the Federation. To date, progress has been slow in developing efficient mechanisms for delivering and financing education and health services. Measures are now urgently required for developing these mechanisms, particularly for improving the provision of health care within the Federation. 46. Services with Geographic Spillovers Under the existing system, the respective roles of the Federation and cantons in the provision of tertiary health care and higher education services remain to be determined. These two services are currently being delivered and largely financed by selected cantons, but the benefits are received by residents from many cantons. The present system entails both equity and efficiency problems since: (i) one canton's residents finance services for other cantons; and (ii) in the presence of geographic externalities, cantons are likely to under-provide these services since they would fail to adequately account for the benefits received by other areas in the Federation. There is also a risk of creating incentives for establishing university faculties and more sophisticated health care services in every canton. Assigning tertiary health care and higher education services to the Federation could effectively address the weaknesses of the present system. The additional revenues that the Federation needs for providing these new service responsibilities could be obtained by shifting the profit tax revenues from cantons to the Federation-actually a large portion has already been recently assigned to the Federation without any adjustment in canton responsibilities (see para. 40). A first step in shifting higher education and tertiary health care services to the Federation involves developing an effective service delivery framework. In the case of higher education, this includes determining locality, governance structure and financing arrangements. A similar framework needs to be developed for tertiary health care within a broader health care reform as presented below. 11 47. Health care finance in Federation. The Federation Health Care Law envisages a canton-based health insurance system, financed by payroll tax contributions. Recognizing that such a system will lead to undesirable small risk pools, it also provides for the creation of a Federation level health insurance fund, responsible for certain joint health care functions. To date, progress in establishing this system has been modest. Cantonal health insurance funds were to be created by February 1998, but only three cantons have established such funds. Several canton'- rontinue to deposit health care contributions in the general canton budget and use a portion of these funds for financing other services. Health contributions in the Croat-majority cantons continue to go into a single fund. As for the Federation level structure, the Federation Health Insurance Fund was established, and its Director was appointed in December 1998. Nonetheless, both services to be provided by the fund and financing sources have yet to be specified. 48. The effectiveness of this system in reducing the existing wide variations across cantons in access to health services, and in enhancing the overall health service delivery in Federation, critically depends on the design of the Federation level Health Insurance Fund. The Fund is expected to undertake a major responsibility in: (i) ensuring that all eligible residents of the Federation have access to basic health care services; (ii) financing services with Federation-wide benefits, such as eligible tertiary care services and highly specialized services that can only be delivered effectively in a limited number of locations for a larger risk pool; and (iii) providing technical and managerial assistance in operation of the cantonal health insurance funds, including centralized procurement of medical supplies. 49. To effectively undertake these functions, the Fund must have a strong overall administrative role within the health care system as well as sufficient financing resources. The resource base of the Fund is currently envisaged to constitute no less than one-fifth of the total health contributions. Furthermore, in order to facilitate the progress towards rapid implementation of new health care system, the Federation government also needs to determine an affordable package of basic health care services that will be provided across the Federation, with options for additional services to be financed at the cantonal level. The technical work towards this has been initiated (with the assistance from the World Bank under ongoing health projects) with a focus on determining the most cost-effective basic package of health services along with management tools and incentives to promote their effective provision and usage. The Federation is considering taking the actions necessary to complete the establishment of cantonal insurance funds and to specify the parameters of the Federation insurance fund before the end of this year so that health contributions can start flowing into the cantonal insurance funds and the Federation insurance fund can start operating in the new fiscal year. (see Annex III, for more detailed presentation of the health finance reform program) 50. Strengthening intergovernmental finance in Republika Srpska. Over the past months, the Republika Srpska government has prepared draft legislation on local management that proposes to decentralize the governance structure by creating an intermediate set of governments in the form of districts. The legislation calls for creation of eight such districts that would be responsible for roads, communications, secondary education, and regional health care. The districts are to be financed mainly by a percentage of tax revenues raised in their jurisdictions. Under the new structure, municipalities will retain their responsibilities for utilities, local roads, culture, education, sport, health and social protection based on the existing revenue sharing arrangements with the central government. The draft legislation lays out a very general structure. Therefore, the proposed operational relationship between the governments as to whether the districts would be de-concentrated arms of the Entity government or more independent governments-as cantons in the Federation-remains unclear. In the former case, the proposed structure could enhance administrative efficiency; in the later case it could create the same type of equity and efficiency problems that exist in the provision of particularly social services in the Federation. The Republika Srpska authorities agree that a more coherent structure needs to be designed, with a focus on enhancing the administrative efficiency. They have asked the World Bank to continue providing its assistance in this area under the proposed PFSAC II. 12 51. Health care finance in Republika Srpska. The health care system in the Republika Srpska is being financed mainly by payroll taxes. There are also transfers from the general budget to finance health contributions of certain unemployed populations, such as refugees and demobilized soldiers. The government is currently in the process of adopting a new Health Insurance Law with a focus on (i) improving the financial viability of the system through promotion of cost-effectiveness and efficiency in public health service delivery; and (ii) developing a solidarity system, as in the case of the Federation, ensuring equal access to the basic package of health care services across Republika Srpska as well as financing eligible tertiary health care services. The definition of the basic package of health care services is, in turn, crucial in achieving the government's objectives stated in item (i) above. To this end, as in the case of Federation, the use of management tools and incentives to influence the behaviors of service providers and consumers is essential. Another important challenge is to implement incentives and sanctions to improve collection. The government is considering addressing this challenge by developing guidelines which would establish: (i) procedures for improving transparency in budgeting and usage of health contributions; (ii) incentives/sanctions to improve collection; (iii) procedures for strengthening coordination between the central fund and its branch offices; and (iv) prototypes of contracts to guide the purchasing of health services. Actions to be Supported by PFSAC II 52. The proposed operation will support the authorities' efforts in developing a sustainable intergovernmental fiscal structure across BiH by focusing on the key issues described above. As an initial step in this direction, by Board presentation, both the Federation and Republika Srpska will have either eliminated or agreed to eliminate existing tax relief and exemptions with a specified expiration date, including those exemptions granted to duty-free shops, unless providedfor by international treaties or under their tax legislation, by allowing them to expire at the end of their current term. Additionally, it is expected that preparation of a plan to (i) improve allocation of sales taxes on excisable commodities and profit taxes in the Federation; (ii) shift responsibility for higher-education to the Federation Government along the lines described in para. 46; and (iii) determine the key operating features of and establish the respective Health Insurance Funds in Federation will have been initiated. It is also expected that the draft legislation on local management in the Republika Srpska will have been revised to design an efficient decentralization strategy. 53. Before the second tranche release, on the revenue side. (i) both the Federation and the Republika Srpska will have eliminated all those tax and duty exemptions that are without a specified expiration date and that are not provided for under their tax legislation or by international treaties, and adopted measures to effectively control duty-free shops and ensure that transactions at such establishments are limited to authorized persons; and (ii) the Federation Government will have amended its sales and excise tax legislation for improving collection and allocation of sales tax on excisable goods between the cantons. In addition, the Federation is expected to adopt measures to enhance local revenue capacity and to clarify local autonomy to implement local taxes. On the expenditures side: (i) the Federation will have established cantonal health insurance funds; (ii) the Federation Government will have determined and adopted responsibilities and financing sources for the Federation Health Insurance Fund in line with principles described in paras. 48-49 above; and (iii) Republika Srpska will have adopted guidelines to improve administrative efficiency in health service delivery and the collection of heath contributions. It is also expected that measures to shift responsibility for higher education to the Federation and decisions for sources of financing are taken. 54. Before the third tranche release, on the revenue side, the Federation will have started the implementation of the new collection and allocation system for sales tax on excisable goods between the cantons. On the expenditure side, the Federation Government will have adopted amendments to the Law on Health Care on service responsibilities and financing sources for the Federation Health Insurance Fund. During the preparation and implementation of the proposed project, both the State and the Entities are expected to continue implementing the State finance mechanism. The technical assistance which has been provided through previous operations and during the preparation of this operation will continue through implementation. The focus of the assistance will be on (i) supporting the design of new models to improve revenue and expenditure assignments in both Entities as 13 described in the above paragraphs; (ii) developing a more comprehensive property tax system in both Entities; and (iii) strengthening the tax administration capacity in both Entities. C. Reform of Social Safety Net 55. Fundamental reforns in the existing social protection programs for the elderly, the poor, the sick, the war veterans and their families are needed in BiH in order to balance resources with the needs of poverty alleviation, as donor assistance is being phased out. The proposed operation supports the Entities' efforts to develop a fiscally viable social safety net system. (i) Reforming Pension System Current Situation 56. Rising wages and employment over the last three years, and hence the rising pension tax base, brought about a significant increase in pension revenues of the three pension funds presently operating in BiH--two separate schemes in the Federation, covering Bosniac-majority areas (the Sarajevo Fund) and Croat-majority areas (the Mostar Fund), and a Republika Srpska scheme. Despite the resulting parallel increase in benefits, benefit levels remain less than one third of their pre-war levels in the Federation and less than one fifth in the Republika Srpska. The cause of the financial strain is the high ratio of pensioners to contributors, which is presently at about 0.8:1 across the three funds. This ratio will be even higher when the number of contributors is adjusted downward to account for some firms and the military both of which accumulated arrears in contributions to pension funds. 57. All three funds operate on a pay-as-you-go basis-i.e. current contributions are paid out as benefits in the same period. Each fund, however, pays pensions according to a different formula, reflecting differences in their response to the post-war financial situation, which does not allow for the payment of pensions according to the pre- war formula. In the Mostar Fund, earmarked revenues are divided by the number of pensioners resulting in a flat benefit, zero balance as well as highest minimum pensions in BiH. In the Sarajevo Fund, until the passage of the Federation Pension Law in 1998, the pre-war formula was used to calculate pensions but roughly half of this amount was actually paid out and the difference between the actual and statutory benefits was considered to be a debt owed to pensioners. The new legislation, consistent with the first PFSAC reforms, declared all future benefit payments final, precluding the possibility for further arrears. The Republika Srpska Fund pays pensions according to a formula which gives higher pensions to those with more education-as a proxy for pre-war higher earnings. It operates with significant transfers from the budget since earmarked contribution revenues are not sufficient to cover outlays. In both the Republika Srpska and the Sarajevo Funds, the present distribution of benefits results in relatively wide range of pensions (5:1). The situation is especially difficult for those with below average pensions, especially in the Republika Srpska where average benefits (75 DM) are about half of those in the Federation (150 DM), reflecting large differentials in average wages. 58. The new Federation Pension Law mentioned above has several positive features which should lead to some reduction in medium term pension spending pressures. It reduces future new pensions; restricts eligibility in the medium term via provisions on the assessment base and retirement age; brings post retirement indexation more into line with material resources of the funds; and most importantly, equates actual with legal pension payments in the Sarajevo Fund as indicated above. Moreover, it creates both a Federation-wide framework for social policy by forcing the two Federation funds to operate under one Federation-wide law, and a Federation Pension Agency with a mandate to begin the process of re-integration of the pension system. To this effect, it calls for preparation of a follow-up legislation deternining the new organizational structure. Nevertheless, significant additional reforms are needed to improve the finances of the Federation funds. A similar set of pension reforms is also urgently needed in Republika Srpska. 14 Issues and Plans for Reforming Pension System 59. At present, BiH faces three challenges in pension policy: First, financial constraints need to be addressed in a more systematic way by aligning benefit levels with the realities of future revenues and demographics. Second, the most destitute pensioners need to be better protected by rising minimum pension levels through adjustments to the distribution of benefits. Finally, a medium-term strategy needs to be designed for introducing long overdue comprehensive pension reforms over the next couple of years. In the case of the Federation, dealing with the third challenge requires rapid progress in reintegration of the Federation pension system, without which in-depth pension reform is impossible. 60. In both Entities, pension funds determine the benefit levels in an ad-hoc manner with a short-term focus (see para.57 above). While the present approach served as a means to bridge the pre- and post-war pension systems, it is incompatible with the objective of achieving financial sustainability over the medium term. This can only be achieved by redefining benefit rules so that promises will be aligned with projected resources. This approach could be phased in gradually but should lead to a financial balance over a reasonable time period. In the meantime, policies that might exacerbate the present situation must be avoided. For example, the recent tendency in Republika Srpska to raise statutory benefit levels for current and future pensioners must be avoided; even at current benefit levels, the system operates through significant budgetary transfers. Any adjustments to the benefits must be validated by realistic projections about resource availability-the Republika Srpska authorities have asked the World Bank to assist in this area under the proposed PFSAC II. In the case of the Federation, while the new Federation pension legislation prevents the future accumulation of arrears, the benefit formula still needs to be adjusted to reflect the realities of future resources. More importantly, introduction of a realistic benefit formula must precede the merger of the two Federation funds to ensure the financial viability of the new, unified Federation pension system. 61. Given the low average pension and the significant number of low-level pensioners in both Entities, an important short-term objective of pension policy must be to protect the most destitute pensioners. Achieving this requires a temporary policy in which the lowest pensions are increased relatively more generously when revenues are increased, until reaching a reasonable subsistence level. Giving higher priority to financing an adequate minimum within the pension system has been a policy followed by many countries during times of severe financing constraints. This approach should, in turn, compress the present wide range of pensions in both Entities and, hence, result in more equitable distribution of limited pension revenues. 62. Further pressures to pension finances would come from special military benefits in both Entities. In the Federation, special lower contribution rates, along with a more generous benefit formula for the military has already created financial strains. While the new Federation Pension Law envisages the development of financing modalities for special military benefits through separate legislation, preparation of the legislation has been delayed A rapid resolution of the financing issues for military is critically important for preventing cumulating financial imbalances in the new Federation pension system. This can be done by calculating the additional liability caused by the special benefits, and either earmarking revenues to cover them in a transparent manner and/or reducing the special benefits. Several special benefit schemes for military also exist in Republika Srpska, where budgetary transfers provide supplementary financing. The Government is considering expanding these schemes by providing special pension benefits for veterans and their families. In order to improve the financial viability of the pension system, Republika Srpska must also develop a financing strategy for special benefits and must avoid providing additional benefits for veterans through the pension system. Finally, both Entities must refrain from providing contribution relief or exemptions from pension contributions. In general, any special support program should be financed from available revenues in a systematic and transparent manner. 63. The decentralized state of public pension provision in the Federation presents another important challenge. Advantages of economies of scale in administration and ease in labor mobility suggest a unified Federation pension system to cover the relatively small Federation population. As indicated in para.58 the new Federation Pension legislation establishes a timetable for drafting separate legislation that would resolve this difficult issue. As a first 15 step towards this end, a new Federation Pension Agency, consisting of representatives from both pension funds, was established in January 1999 and assigned with the task of drafting this legislation by June 1999. The next step must be implementation of a merger of the two funds by the end of 1999. This task involves introducing, alongside, measures aimed at achieving fiscal sustainability and an adequate safety net described in paras. 60-62 above. Finally, within the same timetable, it is also important to design a mechanism to retire all outstanding claims (e.g., unpaid contributions from enterprises and the military, as well as unpaid pensions) prior to the establishment of the new, Federation-wide pension fund. The authorities have asked the World Bank to continue providing its assistance in this area under the proposed PFSAC II. tA4. In thc medium term, more comprehensive pension reforms will have to be considered in BiH. Reform options such as the introduction of privately managed pensions will have to be studied carefully. The governments of both Entities have asked the World Bank to continue providing technical support in designing a comprehensive pension reform. Such reform would, in due course, be supported by future structural adjustment operations. Actions to be supported by PFSAC II 65. The proposed operation will support the Entity govermments' efforts to design and implement pension policies that will contribute to attaining fiscal sustainability, better targeting of the most vulnerable pensioners and unification of pension policies and administration in the Federation. Continuing dialogue between the Entity governments and the Bank is expected in both designing short-term pension policy and preparing medium-term reform. Prior to Credit effectiveness, Entities will have prepared a report on actuarial projection of each Entities' pension finances and distribution of pension income. In addition, the Federation Pension Agency will have submitted to the Federation Government the draft legislation on the merger of the two pension fund. It is also expected that both Entities will have initiated the actuarial estimate of additional cost of special benefits for the military. 66. Before the second tranche release, (i) the Republika Srpska Parliament will have adopted amendments to pension legislation, defining both a new benefit formula and eligibility criteria conducive to a long run balance in its pension finances; and (ii) the Federation Parliament will have enacted the legislation creating the new unified Federation Pension Fund and introducing both a benefit formula and eligibility criteria conducive to a long run balance in its pension finances. These pieces of legislation should be under implementationby the time of the third tranche release. Additionally, it is also expected that by the time of the second tranche release: (i) explicit financing and badgeting rules for special military benefits and contributions will have been developed and unviable schemes will have been eliminated; (ii) adjustments to the benefit formula for provision of a reasonable minimum benefit will have been made; and (iii) existing exemptions for social insurance contributions will have been eliminated, and measures prohibiting provision of exemptions unless provided for by existing legislation will have been taken. By the time of the third tranche release, both Entities are expected to have initiated their comprehensive pension reform strategy. The technical assistance, which has been provided through previous operation and during the preparation of this operation, will continue through implementation in all of the key areas presented above. (ii) Reforming Veteran's Benefits and Other Social Protection Programs Current Situation 67. Bosnia and Herzegovina's pre-war social protection system was among the most sophisticated in Eastern Europe. During the war, the system financially collapsed and fragmented across BiH and it largely remains so today. In addition to the pension system, only veterans' benefits and a few other social programs, mainly providing poverty relief, can be funded at present. Budgetary transfers for veterans' programs, and donor assistance for the other programs, provide the main funding source. Social assistance programs are generally the responsibility of cantons in the Federation, except for veterans' programs, for which the Federation shares financial responsibility. In Republika Srpska, the structure is more centralized at the Entity level. In both Entities, municipal Centers for Social Work (CSW) administer the implementation of programs that provide poverty relief, mainly by managing 16 foreign-financed programs, as domestically-financed programs are very limited. As with the other social sectors, the system of social assistance today faces the dual challenge of overcoming low levels of financing capacity and lack of an effective governance framework. Measures are now urgently required to improve the provision of social assistance in both Entities and reintegrate the system in the Federation. Issues and Plans in Reforming Veteran' Benefits and Other Social Protection Programs 68. Reforming veteran's benefits prograsn. Over the last year, both Entities prepared legislation on their respective veterans' benefits schemes, covering both war veterans and their families. The Republika Srpska enacted its legislation while the Federation legislation awaits Parliamentary approval. The legislation of both Entities reveals two major weaknesses. First, the incongruity between available resources and promised benefits are not adequately addressed, a pattern likely to be reinforced by the indexation rules tying benefits to average wage growth. The best way to address these problems is, as in the case of pensions, redefining benefit rules so that promises will be aligned with projected resources; and tying benefit adjustments to the availability of resources. Second, an overly complex schedule of benefits was created, with ten levels of disability including very minor physical impairment. This adds to the administrative costs of the system and creates a very large beneficiary pool into perpetuity. Furthermore, by including annual benefits for those with minor disabilities, the program also reduces the funds that would otherwise be available for the seriously handicapped and their families. These weakness could be addressed by a combination of policy measures, including reducing the number of benefit categories; separating discrete, one-time compensation programs and permanent entitlement programs, e.g. paying one-time benefits to those with minor disabilities; and improving targeting of resources to the neediest cases. 69. The analysis necessary to design such policies, however, requires data and information on the number and composition of beneficiaries in each Entity. Such data and information is not only limited but also not readily available at present. As a first step towards addressing this critical issue, both Entities are currently gathering existing data and information. Both are expecting to complete aggregation and analysis by May 1999. This must be followed by the development of a more systematic data collection, analysis and monitoring capacity in both Entities with the assistance from donors. 70. Subsequently, an integraticn strategy must be developed for veterans' programs in the Federation, both on the policy and the administrative level. This would help minimize the administrative costs associated with multiple schemes in a small Entity, and resulting savings could be passed back to beneficiaries. It would also help harmonize benefit levels across the Federation. The ongoing work towards unification of the pension system constitutes a sound model to follow in developing such a strategy. 71. Reforming other social protection programs. The development and institutionalization of a new social protection system is urgently needed in BiH, where foreign humanitarian support-a major resource base since the end of the war-has been gradually diminishing. The immediate challenge is to provide poverty relief during the initial transition period, before in-depth reformn of the system is possible. This requires (i) improving targeting methods to direct available resources to the most needy; and (ii) strengthening the existing institutional base for more effective provision of poverty relief. It also involves identifying existing programs and beneficiary coverage by consolidating the available information, which *is currently scattered because of local implementation of programns. This process has already begun with the ongoing efforts to re-define the beneficiary identification card for accessing CSW assistance and to link the databases between the CSW across each Entity. 72. Further steps must be taken to provide the CSWs with adequate resources, both to run the most critical assistance programs and to enable them to finance their basic administrative expenditures. At present, financing for CSWs is primarily the responsibility of cantons in the Federation and the municipalities in Republika Srpska. This creates a potential for translating current large differences in local fiscal resources into large differentials in the provision of social assistance especially in places where foreign assistance is relatively limited. Given the extremely tight domestic finances in both Entities, in the near term, such pressures could be contained only by (i) 17 continued strong donor assistance; and (ii) collaborative efforts of the donors and the authorities to direct available resources to places with lowest social assistance capacity. 73. A permanent approach for addressing present weaknesses in financing and governance capacity will, however, need to be urgently developed before the humanitarian assistance is phased out. In order to provide a sound basis for this exercise, a comprehensive poverty analysis, built on a household income and expenditure surveys, will have to be undertaken. Key decisions will have to be made on the target level of social assistance, criteria for eligibility etc. and other policies with fiscal implications. Critical choices will also have to be made regarding both the administrative structure and the financing modalities of the new system. In making these choices, efficiency and equity issues will have to be properly addressed in the Federation. The Statistics Institutes in both Entities recognizes the importance of household survey research and considers initiating the survey work with the assistance from donors including the Bank. Subsequently, in light of the survey results, the Entities are considering to review and revise the ongoing work. to develop legislative framework for the social assistance strategy. Actions to be Supported by PFSAC II 74. The proposed operation will support the Entity governments in designing and implementing an affordable social protection strategy, with an emphasis on targeting the most destitute groups. Continuing dialogue between the governments and the Bank is expected in designing short-term social protection policy and in preparation for medium-term reform. Such medium-term reform efforts would, in due course, be supported by future structural adjustment operations. Prior to the second tranche release, both Entity Governments will have submitted to the Bank a comprehensive analysis of beneficiaries for their respective veteran's programs. It is also expected that the preparation of the household income and expenditure surveys be initiated in both Entities. D. Reforming the Budgetary Management System Current Situation 75. During 1998, both Entities have made significant progress in both establishing the legal basis for the budget process and in strengthening basic budget procedures and organizational structures. The new Entity laws on the "Principles of the Budget" have been adopted, which codifies the set of budget reforms supported under the first PFSAC. The coverage and comprehensiveness of the budgets have been extended by including external cash grants, general budgetary borrowing and related expenditures into the budget. Necessary provisions have been included in the new budget laws thereby extending this system to incorporate capital budgets, including externally financed projects. Initial general frameworks have been adopted to govern domestic and external local government borrowing. Significant progress has been made towards introducing new and improved budget classification systems which creates uniform standards across central and local governments and initiates comprehensive expenditure reporting. Accounting systems have been improved, including adoption of a regulatory framework for commitments reporting. New procurement regulations have been adopted to establish a system that promotes open competition and transparency. Furthermore, an agreement has been reached to establish treasury systems as part of the overall payment system reform. 76. Despite these substantial achievements, much remains to be done in both Entities to consolidate well functioning budget systems that can carry out the main budgeting functions of aggregate fiscal discipline, strategic resource allocation and efficient resource use. The Bosnian authorities recognize these shortcomings, and intend to address them through continued reform of the budgetary processes and institutions. Issues and Plans in Reforming the Budget Management 77. Further progress in reform of budgetary processes is essential for developing a comprehensive budgetary strategy that will contribute to more efficient budget planning and execution systems in BiH. Once established,.this 18 system would also further improve transparency and accountability in government policies and strategies. The most urgent reforms in order to improve the budget planning are: (i) introducing strategic budget preparation; (ii) reintegrating recurrent and capital budgets; and (iii) strengthening institutional capacity. In addition, each government should establish a treasury department to ensure better budget execution, better control as well as better evaluation of budget outcomes. 78. Reform of Budget Planning Processes. There are three major weaknesses in the existing processes for budget preparation. First, the linkage between budgets and government policies and strategies is not strong. Second, the donor-financed investment program, a relatively large portion of the total public resource envelope in BiH, is separated from the remainder of the budget. Third, the medium-term perspective in the planning of government expenditure programs is weak. Consequently, the government has very little capacity to develop both expenditure policies and priorities consistent with resource constraints and, more generally, with a macroeconomic framework within which the budget operates. This shortcoming is demonstrated by existing budgeting practices, whereby line ministries submit budget estimates that are considerably in excess of available resources; the subsequent cutbacks during the allocation process negate much of the initial budget preparation work. More importantly, the lack of capacity to set the appropriate balance between capital spending and recurrent spending undermines not only the government's ability to meet operations and maintenance costs but also its ability to maintain fiscal stability once donor assistance is phased out. In the Federation, the highly decentralized local structure poses additional problems in linking resource allocations to broader Entity level policies, in ensuring an equitable distribution of public sector resources, and in establishing a clear rationale for the distribution of aid financing. 79. Systemic weaknesses in budget planning are reinforced by institutional deficiencies in both Entities. In each Entity, the MoF currently has a very limited economic policy and forecasting role; responsibility for external aid is located outside of the MoF. Policy and programming capacities within line ministries are poorly developed, and where they do exist, they tend to be located in donor-supported project implementation units (PIUs), or specialized institutes. Finally, in the Federation, relationships between the respective Federation and cantonal line ministries remain unclear, and co-ordination between the two in budget planning is weak. 80. Addressing the weaknesses in budgetary planning in BiH will, therefore, require developing a two-pronged strategy. The first part involves developing a comprehensive budget strategy, consistent with government's macroeconomic and sectoral policies and integrating capital and recurrent budgets. To this end, a medium-term expenditure framework (MTEF), supportive of such an integrated approach to budgetary planing, must be developed. The second part involves strengthening the institutional capacity and establishing a cooperative approach for budget planing. This entails, consolidating and developing core expenditure planning functions within the MoFs; developing sector-wide policy and programming functions within the line ministries; and establishing working groups involving representatives of relevant institutions. Under the proposed Credit, an agreement on the framework of budgetary reforms in these areas has been reached, and preliminary work has been initiated by both Entities. 81. The new system for budget planing and preparation would work as follows. There will be three building blocks of the MTEF. The first one is the macroeconomic framework, which would provide the basis for projecting resource base and expenditure allocations as well as the context against which key budget issues could be analyzed. Initially, it would be based on the IMF/World Bank framework. In time, as the economic forecast and analysis capacity within the MoFs is built up, it would increasingly reflect the MoFs' own analysis. The second building block is the sector strategy framework, which would establish overall government policy objectives for the sect6r as well as strategic program areas and financing requirements within the sector, consistent with overall govermnent resource constraints. This would, in turn, help determine the strategic shifts in inter-sectoral resource allocations and provide the basis for monitoring and evaluating sector program outcomes. The third building block would be sectoral expenditure plans, covering both recurrent and investmnent allocations and the related financing. Initially, this would require a major exercise to incorporate externally financed projects within the Entity budgets. In the 19 Federation, the MTEF would also incorporate cantonal expenditure plans, with an emphasis on enhancing the linkages between cantonal expenditure plans and the Federation-wide sector strategies and the macroeconomic framework. 82. The time horizon for the MTEF will be three years, within which the MTEF would be revised and "rolled forward" each year. The MTEF will be prepared during the first half of the year in the forn of a "Budget Framework Paper" (BFP); it will be approved by the respective Entity Cabinets. The BFP will then provide the strategic framework and resource ceilings for the subsequent preparation of the annual Budget. With the assistance from the World Bank, the Entities have already initiated the work towards preparation of the first BFP. To facilitate this, each Entity has established both a BFP Working Group and Sector Working Groups (SWG). Initially, the SWGs was formed for a limited number of pilot sectors (including health, education and transport in the Federation, and transport, education, and agriculture in Republika Srpska) which will be the focus of the initial BFP. Both Entities plan to finalize their respective draft BFPs for submission to their Cabinets by June 1999. The Entities also initiated work towards integrating externally financed public expenditures into the BFP and the budgets. Finally, as a first step towards strengthening economic policy and analysis capacity in their respective MoFs, both Entities intend to establish a macroeconomic forecasting unit within the MoF. 83. Reform of Budget Execution Systems. Establishing a treasury system at both State and the Entity levels is the single most urgent reform for improving budget execution in BiH. Under the present system, the Entity payment bureaus undertake a treasury-like function independently of the MoFs. Consequently, the MoFs have very weak financial planning and control capacity. There is also very little cash management, and the execution of the State and the Entity budgets largely follows the annual plans with substantial revisions during the course of the year. The treasury, when established, will maintain the exclusive authority for transfer and spending, and hence, it will substantially improve budget control and cash management capacity at all levels of government. 84. In the face of the ongoing efforts to abolish, by the end of 2000, the payments bureau system in BiH, the Bosnian authorities recognize the need for rapid progress towards establishing the treasury system. The Entity budget system laws provide the legal basis for the establishment of the treasury system. The initial modeling work towards the establishment of the State Treasury System began in 1998 with the assistance from the IMF and the US Treasury; the Entities are now considering initiating a similar process with the assistance from the World Bank, IMF and the US Treasury. To achieve this, all three governments are intending to complete, by early 2000, the transfer of accounts to the Treasury Ledger for all budget institutions, prepare the centralized payments system and Treasury Single Account, develop the system of commitment reporting, and complete staffing of the treasury department for operation starting mid-2000. Actions to be Supported Under PFSAC n 85. The proposed operation will support the design and implementation of MTEF and Treasury systems to support a better integrated, better managed, more transparent and more accountable system of public financial management in BiH. During the period of PFSAC II implementation, the program will focus on the following: (i) improving the preparation process and strategic orientation of the Entity budgets by preparing an initial BFP as a basis for the year 2000 annual budget; (ii) imnproving the budget coverage by incorporating externally financed public sector expenditures into the BFP and the budget; (iii) establishing the institutional framework for the development of a medium term budget planning process; and (iv) initiating the design of an appropriate treasury system for the Entities. In this context, by Board presentation, both Entities will have established the BFP Working Group to co-ordinate the preparation of the initial BFP and will have drafted the initial BFP. In addition, it is expected that establishment of Sector Working Groups for undertaking sector reviews and preparing sector strategy framneworks be initiated in both Entities. 86. By the time of the second tranche release, both Entities will have (i) incorporated capital projects in the year 2000 budget plans, including those which are externally funded; (ii) established macroeconomic fiscal analysis andforecasting units in their respective MoFs; and (iii) finalized the initial BFP and obtained approvalfrom their 20 respective Cabinets. By the time of the third tranche release, (i) both Entities will have adopted a strategy and timetable to integrate external aid management ffnctions; (ii) both Entities will have revised the BFP to guide the year 2001 budget and submitted it to their respective Cabinets; and (iii) the State and the Entities will have begun operating with Single Treasury Account and manage budget execution through Treasury Ledger Account. 87. Thereafter, implementation of budget reform should be continued in the following areas: (i) further strengthening of policy and programming capacities in the MoF and the line ministries for systemic preparation of a three year BFP; (ii) extending sector policy and strategy reviews to all sectors and developing sector strategy frameworks; (iii) strengthening the State and the Entity treasury systems. The technical assistance provided through previous operation and during the preparation of this operation will continue through implementation. Continued reforms to consolidate and broaden the proposed PFSAC II program would, in due course, be supported by future structural adjustment operations. E. Establishing Auditing Procedures and Institutions Current Situation 88. The existing public sector institutional framework in Bosnia and Herzegovina lacks an audit function. As a result, there is no comprehensive system to promote transparency and accountability in public sector performance and provide legislative bodies with the necessary infornation to exercise control over the executive. To address this problem, the first PFSAC program supported the establishment of external auditing institutions as one key reform element in strengthening both public finances and the performance of the public sector in the country. Following extensive discussions with govermment authorities at all levels, the initial work focused on the development of appropriate government audit models. This phase was concluded at the end of 1998, resulting in a proposal on the organizational and functional framework of the external audit system. It was also uniformly agreed that International Association of Supreme Audit Institutions (INTOSAI) standards form the basis for the audit system in Bosnia and Herzegovina. Building on the initial proposal, the Bosnian authorities are now considering completing the design of the audit system and establishing the organization structure before the end of 1999. The authorities have asked the World Bank to continue providing assistance under the proposed PFSAC II. 89. In addition to the external audit functions, there is a need to strengthen the internal audit functions in both Entities and at the State level. Currently, each of the two Entities MoFs has an Inspection Unit, which possesses the functions of internal control. In addition, the Entity payments bureaus undertake a quasi-audit in review of their respective transactions. A more systematic and harmonized approach is needed in order to establish effective internal audit procedures. This will enable government agencies to exercise managerial control within their organizations and to prepare analysis and reports to management on their systems, practices and organization, as well as compliance with budgetary and accounting requirements. Issues and Plans for Instituting Auditing Procedures and Practices 90. Institutionalizing exdernal auditing. The most critical aspect in designing an external audit system in BiH was to determine a feasible organizational structure that would enable several layers of largely autonomous governments to undertake sound audit functions within their jurisdictions while at the same time ensuring consistency of standards, methodology and quality across all levels of govermment. The Bosnian authorities have recently agreed on an organizational structure that would meet these requirements. This entails: (i) establishing a Supreme Audit Institution (SAI) in each Entity and at the State level for carrying out external audit functions of respective central and local government activities and organizations; (ii) establishing a National Coordinating Committee (NCC), comprising the State and Entity Auditor-Generals, for setting audit standards, for ensuring consistency of standards, methodology and quality, for assigning audit responsibility for activities that extend across the Entities and/or the State, and for determining representation on international bodies. The NCC will be chaired by the State Auditor-General and meet according to a fixed schedule on at least a quarterly basis; (iii) appointing the State and the Entity Auditor-Generals through a Parliamentary act for a fixed and non-renewable term. In March, 21 the authorities initiated the process of establishing the SAIs by forming a Working Group comprising the representatives of the State and the Entities, including cantons in the Federation. The group, with the World Bank assistance, is responsible for the various steps leading to the creation of th,e SAIs, starting with the preparation of the legal framework. 91. The objective of the external audit in both Entities and the State will be to carry out (i) compliance audit tG ensure that all legal and regulatory requirements have been met, or report any failures; (ii) certification audit in the form of a report on the financial statements, and (iii) performance audit (value for money) to measure the performance of individual public institutions with regard to efficiency, economy and effectiveness. The external audit by the SAIs will embrace all government activities and organizations that are partially or wholly owned, controlled or funded by public sources or that are provided by an external organization on loan or grant basis. As is true elsewhere, maintaining independence and ensuring operational integrity are key to effective operation of SAIs. To prevent political or other unwanted interference, SAIs will be constitutional bodies reporting on their activities to their respective Parliaments at the State, Entity and Canton levels. However, due to relatively longer process of amending the constitution, they will commence operation under legislation for a transitional period. Their budgets will be charged items on respective government budgets. In the case of the Federation, the cantons will also contribute to the cost of the Federation SAI, on the basis of a fee determined by the size of audit work to be performed on their behalf. The authorities expect each SAI to prepare the first audit reports before the end of 1999. 92. Institutionalizing internal auditing In conjunction with the ongoing work to develop extemnal auditing system, there is a need to institutionalize internal auditing at all levels of government. The best approach would be to start this process within the Entity Ministries of Finances, including cantons in the Federation, and then to gradually expand it into other public institutions and the State Ministry of Finance once it is established. This could be most efficiently done by re-organizing the existing Inspection Units with internal control functions, as Internal Audit Units with proper internal auditing capacity reporting to the Minister of Finance. The new Entity organic budget laws provide the Ministers of Finance with such legal authority by giving them responsibility for the accounting and supervision of revenues and expenditures. The same applies to the canton Ministers of Finance in the Federation. In the initial stage, the Internal Audit Units must be responsible, at a minimum, for compliance audit to improve the control and management of budgetary expenditures. Gradually, internal auditing must be broadened to include operational efficiency and effectiveness. In the process of developing the external and internal auditing function, special attention must be given to ensure that the two functions would reinforce, rather than duplicate, each other. The Entities intend to follow the above presented strategy to bring the work on the internal auditing up to comparable speed with that of the external auditing. Actions to be supported by the PFSAC H 93. The proposed operation will support the development of a strong auditing capacity in BiH. As an initial step in this direction, prior to Credit effectiveness, the State, the Federation and Republika Srpska will have (i) submitted draft legislative framework and budgets for their SAIs to their Parliaments; and (ii) appointed their Acting Auditor-Generals. The legislative framework and budgets will be adopted by the State and Entity Parliaments by the time of the second tranche release and will be under implementation by the time of the third tranche release. In addition, by the time of the second tranche release, the State and the Entity Parliaments will have appointed Auditor-Generals for their SAls. It is also expected that during this timetable, the authorities will (i) prepare and process necessary amendments for establishing SAIs as constitutional bodies during 2000; and (ii) introduce necessary measures to strengthen the regularity and institutional framework for internal auditing. 94. The Bank has been providing technical assistance to support the authorities in their efforts and will continue this assistance under the PFSAC II. It is also expected that parallel, donor-financed assistance will be provided during PFSAC II implementation, particularly to support the establishment and operationalization of the SAIs. The technical assistance will (i) assist and advise the SAls in developing planning capabilities, designing audit systems and strengthening operational effectiveness; (ii) support the SAIs in the development of software tools, procurement 22 of office equipment, and formal and on the job training of staff; and (iii) assist the State and the Entity governments in strengthening the regulatory and institutional framework for internal auditing. F. Strengthening Debt Management Capacity Current Situation 95. During 1998, Bosnia and Herzegovina made significant progress towards building its public debt management structure, which was supported by the World Bank through the first PFSAC. The Entity Laws on external debt, consistent with each other and with the State Law on External Debt, were adopted by both Entities. Debt management units (DMU) were established in the State Ministry for Foreign Trade and Economic Relations (MFTER), as well as in each of the two Entities' MOF's. The London Club and Paris Club Agreements on the rescheduling of BiH's external debt to commercial banks and official creditors, respectively, were concluded, thereby wiping out a large part of the debt inherited from the SFRY. An automatic and transparent debt servicing system was established, substantially improving the regularity of debt service payments; a comprehensive foreign debt tracking system was established in the State MFTER. A Protocol on information sharing between the State, the Entities and CBBH was signed by the four parties to regularize and streamline the exchange of debt-related information between various debt management agencies. An Agent Agreement was signed between the State MFTER and the CBBH that acts as the debt servicing agent of the State. Furthermore, in the Federation, progress was achieved in building the capacity of Entity MOFs and commercial banks to manage the credit riskarising from different forms of borrowing, with extensive assistance from international donors. 96. Both Entities made their first steps to regulate the sub-Entity borrowing, whereby local governments are allowed to borrow only externally for investment purposes within a certain limit. At present, however, few local governments and municipalities have the technical and fiscal capacity to carry the debt burden; neither the State nor the Entities possess mechanisms to monitor and supervise borrowing at the lower levels of government. To date, few local governments have contracted any external borrowings. The present time is opportune for establishing a comprehensive debt tracking system in the BiH to foster fiscal discipline. Issues and Plans for Strengthening Debt Management Capacity 97. The borrowing activity in BiH is currently low due to severely limited financing capacity; a large proportion of the reconstruction needs continue to be financed by international aid flows. In the medium-term, however, as aid-flows and concessional financing diminishes, alternative sources of external finance, including borrowing from capital markets, will be a more significant option in financing the reconstruction and development needs. BiH's access to such external financing will be determined, to a large extent, by the effectiveness and the prudence of its borrowing arrangements. Developing a strong external debt management capacity, therefore, remains to be an important challenge for the Bosnian authorities. This requires continued improvements to the institutional setup and reforms to strengthen both borrowing policies and policy coordination between governments, including the development of a policy framework for sub-Entity borrowing. 98. As mentioned above, substantial progress was made during 1998 in creating the legal and institutional setup for external debt management. Further steps must now be taken to develop policy-making, credit-analysis and monitoring functions in the State and Entity DMUs that would promote fiscally prudent borrowing operations. This includes broadening Entity DMU's mandate to manage their debt portfolio, not merely to execute debt service transactions. They must be able to track and control borrowing by lower levels of government and enterprises and evaluate sub-Entity debt for its sustainability. It also includes broadening information sharing and policy co- ordination arrangements between the State and the Entities to improve the quality and the coverage of the information used for sovereign decision-making. To develop a co-ordinated approach in addressing these issues, both the State and the Entities intend to develop "Guidelines" for public sector borrowing building on the present legislative framework. The Guidelines will establish (i) a comprehensive debt reporting system; (ii) strong and transparent selection, budgeting and supervision procedures for loans and guarantees; and (iii) procedures for 23 borrowing policy coordination. The authorities have asked the World Bank to continue providing its assistance in this undertaking under the proposed PFSAC II. 99. Reporting procedures are already well established for State and Entity borrowing. These must be extended to cover debt liabilities of sub-Entity governments, public enterprises, and utilities as well as liabilities of public agencies that have separate budgets such as social security funds. As the first step in this direction, debt databases must be created in each Entities' MoF's (in DMU's) and compulsory reporting procedures must be introduced for all public sector borrowing. The Entity MoF's must share such data with the State MFTER. For comprehensive debt reporting, the CBBH must also establish a similar database and reporting procedures for private sector debts. Debt data reconciliation should be regularly conducted between the State MFTER and CBBH. Once the State and Entity Treasuries are created, such reporting flows could be streamlined thereby simplifying data reconciliation. 100. The Guidelines must enforce ceilings on the amount of annual borrowing allowed by a sub-Entity government as specified in the Entity Budget System Laws. To this end, the guidelines must establish (i) reporting requirements with sufficient detail on terms and purpose of loans to enable the authorities to prepare reliable debt service projections and to control the fiscal risk; (ii) budgeting procedures that will allow for tracking the real value of obligations outstanding; (iii) monitoring criteria that will help track the utilization of loan proceeds and the progress of the project. They should also include transparent appraisal and approval procedures in order to prevent instances of connected borrowing (sub-Entity borrowing from the commercial banks that they either own or control) and market loans (short-term sub-Entity borrowing from local commercial banks, usually for liquidity management purposes, often with extensions of maturity). Finally, the guidelines must establish clear procedures for the issuance of State and Entity guarantees concerning external borrowing of sub-Entity governments and enterprises (as allowed by the existing legislation) while prohibiting the issuance of guarantees by sub-Entity governments for certain duration. 101. Furthermore, policy-coordination needs to be strengthened between the State and the Entity DMU's in order to harmonize borrowing plans with the country's ability to service its external debt. The separation of borrowing, debt servicing responsibility, and fiscal authority in BiH creates potential for a free riderproblem. As a result, irresponsible or mistaken borrowing decisions on the part of Entity or sub-Entity governments as well as public agencies, may jeopardize the borrowing ability not only of the Entity concerned, but the other Entity and the State. Coordination of borrowing strategies would limit the free rider problem and, hence, enhance the creditworthiness of all borrowers, both public and private. The State Debt Law provides for the establishment of a high-level Debt Advisory Committee, with representation from all State and Entity agencies involved in managing external debt of BiH. For this purpose, the Interagency Working Group--originally constituted to ensure the consistency and transparency of debt information--should gradually assume the functions of piloting the country's debt strategy. Actions to be Supported by PFSAC II 102. The proposed operation will support the authorities' efforts in strengthening the countrywide debt management capacity by (i) assisting the DMU's in further clarifying their mandates in debt monitoring and policy formulation; (ii) supporting the introduction of comprehensive reporting and consistent data reconciliation procedures; and (iii) assisting and advising the Bosnian authorities in developing and implementing Guidelines for prudent borrowing operations and policy co-ordination. By the time of the third tranche release, the State and the Entities will have initiated the implementation of the Guidelines. The technical assistance, which has been provided both through the previous operation and during the preparation of this operation, will continue through implementation. 24 V. THE PROPOSED CREDIT A. Rationale for Bank Involvement 103. The Bank Group's assistance strategy for FY98/99--as outlined in both the Country Assistance Strategy dated July 31, 1997 and the progress report dated August 6, 1998--aims to assist BiH in moving from immediate postwar reconstruction towards sustainable recovery and growth. The key objectives of this strategy are: (i) strengthening the institutions of macroeconomic management; (ii)initiating structural reform measures, particularly in privatization and banking reforms; and (iii) carrying forward physical reconstruction of the country. 104. Particular emphasis will be placed on support for developing economic institutions and policies. Key among these efforts are reforms in fiscal management, including, inter alia, rationalization in the assignment of revenue and expenditure responsibilities, sound budget and external debt management, improved transparency and accountability in the use of public sector resources and the establishment of a sustainable social assistance framework for the most vulnerable. As noted in the CAS, the FY98/99 program includes two public finance reform operations. The proposed PFSAC II is the second of these two operations. The first operation, PFSAC, was successfully implemented, and its second and final tranche disbursed in December 1998. The PFSAC II is designed to help BiH deepen and expand the reform measures in public financial management initiated under the PFSAC. B. Credit Amount and Borrower 105. The proposed IDA credit, in an amount equivalent to US$72 million (SDR 53.2 million), will be bnt to Bosnia and Herzegovina (the State) for a period of 35 years, including a 10-year grace period, on standard IDA terrns. The State will onlend, through subsidiary agreements, US$42million equivalent of the Credit proceeds to the Federation and US$30 million equivalent of the Credit proceeds to Republika Srpska, on the same terms as the IDA Credit. The beneficiaries would be Bosnia and Herzegovina (the State), the Federation and Republika Srpska. Co-financing on grant terms is expected to be offered by the Government of Netherlands. Funding for technical assistance required for the preparation of this operation is being provided through two PHRD grants. C. Credit Design 106. The proposed Credit would provide quick-disbursing funds for fiscal and balance of payments assistance in support of the government's efforts to reform public finance institutions and policies. The main elements of the program supported by this operation include: (i) broadening tax policy hannonization and strengthening administrative co-operation between the Entities to enhance revenue capacity and to encourage free flow of goods across BiH; (ii) improving revenue and expenditure assignments within the Entities to prevent large differentials in the provision of public services; (iii) initiating reforms to develop an affordable, efficient, and equitable social safety net; (iv) developing a comprehensive budgetary strategy aimed at improving fiscal efficiency and control; (v) establishing audit institutions and procedures to improve transparency and accountability in public sector operations; and (vi) strengthening country-wide policy coordination in external debt management, including developing a policy framework for sub-Entity borrowing. In view of the critical importance of establishing a functioning fiscal system for the entire country, this operation puts its main emphasis on assisting the Bosnian authorities to harmonize policies, and to strengthen policy co-ordination both within, and between the Entities as well as between the State and the Entities. Conditionality (as specified in section F below) is mostly linked to intergovernmental financial relations, the tax system, budgetary management and institutional aspects required for the functioning of the country as a unified State. Other substantive reforms discussed in the previous sections, particularly regarding the social safety net, are clearly important for the operation of an efficient public finance system in the longer term. The Bank intends to support these reforms through future structural adjustment operations. 25 D. Administrative Arrangements 107. The State MFTER is responsible for overall administration of the Credit on behalf of Bosnia and Herzegovina, the borrower. Each Entity's Ministry of Finance is responsible for administering the pre-allocated amount of funds of the Credit. Based on discussions with government authorities, it is understood that the counterpart funds of the proposed Credit would be used to support fiscal expenditures of the State and Entity governments, in particular, contributions of the Entities to the 1999-00 State budget for debt service obligations, essential social expenditures such as pension payments, and minimum income support, as well as costs related to institution-building efforts in the areas of budget management, external audit, tax administration and health finance. E. Disbursement 108. The Credit will be disbursed in three tranches to the deposit account of the State at the Central Bank of Bosnia and Herzegovina (CBBH). The entire amount of all three disbursements will be transferred from the State's Deposit Account to the budgetary accounts of the Entities in the CBBH. The first tranche (US$28million equivalent, with a Federation share of US$16 million and a Republika Srpska share of US$12million) would be available upon Credit effectiveness. The second tranche (US$24 million equivalent, with a Federation share of US$14 million, and a Republika Srpska share of US$10 million) and the third tranche (US$20 million equivalent, with a Federation share of US$12 million, and a Republika Srpska share of US$8 million, respectively) would be available upon satisfactory review by IDA of the implementation of the adjusttnent program as a whole and the fulfillment of the specific second and third tranche conditions as described in the following section. F. Monitoring Arrangements and Tranche Release Conditions 109. Implementation of the policy program will be monitored by a Committee composed of the representatives of the State MI TER and the Entity Ministries of Finance. With input from participating ministries/institutions, the Committee will have responsibility for monitoring and evaluating progres.- mider the various components of the program. IDA will monitor implementation with the help of the Committee's reports, and through supervision missions. Specific conditions for Board presentation of the Credit, Credit effectiveness and second and third tranche release of the Credit are presented below and in the policy matrix in Annex I. (i) Reforming and Harmonizing Tax Policies and Coordinating Tax Collection Board Presentation a) Entities to implement the State-set tariff surcharges. b) Entities to eliminate special trade agreements with Croatia and Yugoslavia. c) Entities to equalize the excise tax rates on domestic and imported goods. d) Entities to establish a Working Group to develop a plan for coordination between the two tax administrations. Second Tranche Release a) Entities to complete the harmonization of the sales tax systems by reducing differences in sales tax rates. b) Entities to submit to their Parliaments amendments to their sales and excise tax legislation on inter-Entity allocation of the sales tax on excisable goods and excise taxes. c) Entities to adopt a plan to strengthen the coordination between their Tax Administrations, including an information sharing system. Third Tranche Release a) Entities to implement new legislation on inter-Entity allocation of sales and excise taxes. b) Entities to implement new arrangements for administrative co-ordination, including an information sharing system. 26 (ii) Reforming the Intergovernmental Finances within the Entities Board Presentation a) Entities to eliminate existing tax relief and exemptions with a specific expiration date, unless provided for under their respective tax legislation or by international treaties and including those exemptions granted to duty-free shops, by allowing them to expire at the end of their current term. Second Tranche Release a) Entities to eliminate all tax and duty exemptions without a specified expiration date and that are not provided for under their respective tax legislation or by international treaties, and to adopt measures to effectively control duty-free shops and ensure that transactions at such establishments are limited to authorized persons. b) Federation to adopt amendments to its tax legislation to improve collection and allocation of sales tax on excisable goods between the cantons. c) Republika Srpska to develop and adopt guidelines to improve administrative efficiency in health service delivery and the collection of health contributions. d) Federation to establish cantonal health insurance funds and adopt service responsibilities and financing sources for the Federation Health Insurance Fund. Third Tranche Release a) Federation to implement the new collection and allocation system for sales tax on excisable goods between the cantons. b) Federation Government to adopt amendments to the Law on Health Care regarding service responsibilities and financing sources for the Federation Health Insurance Fund. (iii) Reform of Social Safety Net Credit Effectiveness a) Entities to prepare a report on actuarial projection of their pension finances and their pension income distribution. b) The Federation Pension Agency to submit to the Federation Government the draft legislation on the merger of the two pension funds. Second Tranche Release a) Republika Srpska to adopt amendments to pension legislation on benefit forrnula and eligibility criteria. b) Federation to adopt amendments to pension legislation on the financial and administrative unification of the Federation Pension Fund and new benefit formula and eligibility criteria. c) Entities to submit to the Bank a comprehensive analysis of beneficiaries for their veteran's programs. Third Tranche Release a) Federation to implement amendments to its pension legislation. b) Republika Srpska to implement amendments to its pension legislation (iv) Reforming the Budgetary Management System Board Presentation a) Entities to establish the BFP Working Group to co-ordinate the preparation of the BFP and to draft the initial BFP. Second Tranche Release a) Entities to incorporate capital projects in the year 2000 budget plans including those which are externally funded. b) Entities to establish macroeconomic analysis and forecasting units in their respective MoFs. c) Entities to complete the initial BFP and to obtain approval from their Cabinets. Third Tranche Release a) Entities to adopt a strategy and timetable to integrate their external aid management function. 27 b) Entities to revise the BFP, to guide the year 2001 budget, and to submit it to their Cabinets. c) Entities and State to operate with Single Treasury Account and manage budget execution through Treasury Ledger Account. (v) Establishing Auditing Procedures and Institutions Credit Effectiveness a) State and Entities to submit draft legislative framework and budgets for their SAIs to their Parliaments. b) State and Entities to appoint their respective Acting Auditor-Generals. Second Tranche Release a) State and Entities to adopt the legislative framework and budgets for their SAIs. b) State and the Entity Parliaments to appoint Auditor-Generals for their SAIs. Third Tranche Release a) State and Entities to operationalize their SAIs. (vi) Strengthening Debt Management Capacity Third Tranche Release a) State and Entities to implement Guidelines goveming public sector borrowing and policy co-ordination. G. Environmental Assessment Requirements 110. In accordance with the Bank's Operational Directive on Environmental Assessment (OD4.01, Annex E), the proposed operation has been placed in Category "C" and does not require an environmental assessment. H. Benefits and Risks 111. Benefits. The implementation of the proposed operation will help BiH consolidate the public finance reforms began under the PFSAC, substantially strengthen prospects for continued fiscal stability, enhance sustainability of the structural reform process, and reintegrate the economy. The reform program will promote free flow of goods between the Entities and improve tax revenue collection by completing harmonization of major tax structures, strengthening administrative co-operation and revenue distribution. It will facilitate development of a more robust intergovernmental system, which is supportive of the Entities' stabilization and structural reforms and which will improve efficiency and coverage of public sector services. By pursuing essential policy and institutional reforms in budget planning and execution, the operation will help the Entities correct the medium-term imbalance between revenues and expenditures and set appropriate priorities for public outlays. The proposed reform program will also improve medium-term financial viability and targeting of the pension system, initiate design of an equitable and sustainable social safety net system, and ensure a certain level of equalization in the provision of health services through development of an efficient health insurance system in both Entities. By instituting sound auditing procedures, it will significantly enhance transparency, efficiency and accountability of public service operations. 112. Establishment of an effective and integrated public finance structure will help BiH conduct sound macroeconomic management, reduce cost to economic transactions, and achieve external creditworthiness. By supporting the development of a public sector which is more suitable to a market economy, the operation will also contribute to private sector development, employment creation and poverty reduction. 113. Risks. The Credit faces two major risks. First, there will be risks associated with BiH's process of reconciliation, as has been demonstrated so far since the signing of the Dayton Accords in December 1995. Several measures supported by the proposed Credit are subject to intense political debate within the country-and, more particularly, between the different ethnic groups-thus creating a potential for non-implementation of the agreed measures and/or reversal of the adopted reforms. Particular among them are the harmonization of the Entity tax policies, pension reform in the Entities, especially unification of the Federation pension funds, and reform of 28 intergovernmental financial relations, particularly in the Federation. To mitigate these risks, the Bank requires the upfront fulfillment of conditionalities whenever possible and will work closely with the IMF, the US Treasury and others to jointly promote the implementation of the reform agenda. The Bank also agreed with the BiH governments to set up working groups on key reform areas and maintain close co-ordination with the existing ones to promote consensus. The Bosnian authorities' strong commitment and success in implementation of equally difficult set of policy measures under the first operation has shown that obstacles created by low political tolerance can actually be mitigated. 114. A second risk is that the Government's administrative and institutional capacity will be insufficient to handle the complexity of the budgetary and auditing reform actions envisaged in the PFSAC II. The Government is cognizant of this risk, and its program is designed to minimize its administrative burden, by appropriate phasing of the measures and application of the technical assistance where needed. Certain essential technical assistance activities have already been financed by PHRD grants. The bulk of the technical assistance requirements would have to be carried through grant financed TA programs and/or parallel donor financed TA to augment the limited local capacities. VI. RECOMMENDATION 115. I am satisfied that the proposed Credit complies with the Articles of Agreement of the Association, and I recommend that the Executive Directors approve it. James D. Wolfensohn President by Sven Sandstrom Attachments Washington, D.C. June 1, 1999 29 SCHEDULE A BOSNIA AND HERZEGOVINA PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT TIMETABLE OF KEY PROJECT PROCESSING EVENTS 1. Time taken to prepare: three months 2. Project prepared by: Government with IDA assistance 3. Identification Mission: November 1998 4. Preparation Mission January/February 1999 5. Appraisal Mission: April 1999 6. Negotiations: May 1999 7. Planned Board Presentation: June 1999 8. Planned Effectiveness: July 1999 9. Expected Project Completion: Not applicable 10. Relevant SAR: Not applicable 30 SCHEDULE B Page 1 of 2 STATUS OF BANK GROUP OPERATIONS IN BOSNIA AND HERZEGOVINA A. STATEMENT OF BANK LOANS a' (As of May 24,1999) US$ Million Loan Fiscal (Less Cancellations) No. Year Borrower Project Loan Undisbursed Loans/Credits/Grants IBRD O 4038-BOS 1996 Bosnia and Herzegovina Consolidation Loan A 28.6 0.0 4039-BOS 1996 Bosnia and Herzegovina Consolidation Loan B 284.9 0.0 4040-BOS 1996 Bosnia and Herzegovina Consolidation Loan C 307.1 0.0 Total 620.6 0.0 Of Which: Repaid 24.9 Total Now Held by the Bank: 595.7 TFBH' (Under Disbursement) TF-024030 1996 Bosnia and Herzegovina Emergency Recovery Credit 45.0 0.0 TF-024031 1996 Bosnia and Herzegovina Emergency Farm Reconstrucbon 20.0 0.0 TF-024032 1996 Bosnia and Herzegovina Emergency Water Supply 20.0 0.0 TF-024033 1996 Bosnia and Herzegovina Emergency Transport 35.0 1.8 TF-024034 1996 Bosnia and Herzegovina Emergency District Heating 20.0 0.0 TF-024035 1996 Bosnia and Herzegovina Emergency War Victims Rehabilitation 5.0 0.0 TF-024040 1996 Bosnia and Herzegovina Emergency Education Reconstruction 5.0 0.0 Total 150.0 1.8 IDA 2897-BOS 1996 Bosnia and Herzegovina Emergency Educabon Reconstruction 5.0 0.0 2896-BOS 1996 Bosnia and Herzegovina Emergency War Vicbms Rehabilitation 5.0 2.6 2902-BOS 1997 Bosnia and Herzegovina Emergency Housing Repair 15.0 0.0 2903-BOS 1997 Bosnia and Herzegovina Emergency Power Reconstruction 35.6 0.2 2904-BOS 1997 Bosnia and Herzegovina Emergency Public Works and Employment 10.0 0.8 2905-BOS 1997 Bosnia and Herzegovina Emergency Landmines Clearance 7.5 0.0 2906-BOS 1997 Bosnia and Herzegovina Emergency Demobilization and Reintegrabon 7.5 0.5 2914-BOS 1997 Bosnia and Herzegovina Transition Assistance Credit 90.0 0.0 N001-BOS 1997 Bosnia and Herzegovina Emergency Industry Re-Start Guarantee 10.0 0.0 N002-BOS 1997 Bosnia and Herzegovina Emergency Microenterprise/Local Inibtatives 7.0 0.4 N003-BOS 1997 Bosnia and Herzegovina Essenbal Hospital Services 15.0 3.7 N032-BOS 1998 Bosnia and Herzegovina Transport Reconstructon II 39.0 6.7 N035-BOS 1998 Bosnia and Herzegovina Education Reconstruction II 11.0 2.7 3028-BOS 1998 Bosnia and Herzegovina Reconstruction Assistance Project 17.0 4.8 3029-BOS 1998 Bosnia and Herzegovina Emergency Natural Gas 10.0 0.4 3070-BOS 1998 Bosnia and Herzegovina Emergency Pilot Credit (RS) 5.0 2.7 3071-BOS 1998 Bosnia and Herzegovina Power iI 25.0 25.0 N040-BOS 1998 Bosnia and Herzegovina Forestry 7.0 6.2 3090-BOS 1998 Bosnia and Herzegovina Public Finance I (Structural Adjustment) 63.0 0.0 3191-BOS 1999 Bosnia and Herzegovina Local Development 15.0 15.0 3020-BOS 1999 Bosnia and Herzegovina Basic Health 10.0 10.0 Total 409.6 81.7 The status of these projects is described in a separate report on all Bank/IDA financed projects in execution, which is updated twice yearly and circulated to the Executive Directors on April 30 and October 31. Consolidation Loans A, B, and C were approved on June 13, 1996 and becamne effective on June 14, 1996. Trust Fund for Bosnia and Herzegovina. Page 2 of 2 B. STATEMENT OF IFC INVESTMENTS (As of March 31, 1999) Gross Commitments ------US$ Million------ Fiscal Year Obligor Type of Business Loan Equity Total 1977 Tvomica Kartona I Ambalaze Cazin Timber, Pulp and Paper 3.65 0.00 3.65 1985 Sour Energoinvest Industrial Equipment and Machinery 8.53 0.00 8.53 1997 Horizonte BiH Enterprise Fund SME Investment 0.00 1.93 1.93 1997 Microenterprise Bank Microcredit 0.00 0.57 0.57 1997 Sarajevska Pivara Beverage Manufacturing 3.89 0.00 3.89 1998 SEF Akova Abbatoir, Meat Packing and Processing 2.08 0.00 2.08 1998 Wood Agency Credit Line Furniture and Other Wood Products 13.69 0.00 13.69 1998 SEF Lignosper Fumiture Manufacturing 2.27 0.00 2.27 1999 SEF Kupex Industrial and Consumer Services 2.46 0.00 2.46 Total Gross Investments 36.57 2.50 36.57 Participations, Cancellations, Terminations, Exchange Adjustments, Repayments, and Arrears (Principal Only) 13.01 0.00 13.01 Total Commitments Now Held by IFC 36.57 2.50 36.57 Total Undisbursed 14.20 1.54 14.20 Total Outstanding 22.37 0.96 22.37 SCHEDULE C Page 1 of 2 Bosnia and Herzegovina at a glance /19 B"osia furope& ______ POVERTYancuSOCIAL and Central LOW- Heozegovina Asia Incom Development diamond* 1 998 Population, mid-year (mlins) ..4.2 476 2,048. Life expectancy GNP per capit (Atla method, US$), 92 2,320 350 GNP (A4la method US$ bIio) 3.9 1,108 722 Avera se annual growth, 1091-97 Population (%/) 0.1 .2 2.1 GN Labor force (%) 0.3 0.5 2:3 GPGross per primary Most recent estimate (1atet year 'available, 199147) r capita enrollment Povry( fppltion below national povetly Mie)* Urban poulatior (% offtal poplatIon)42 67 28 Life expectancy at birt la~ 60 59 Infant mrtality (per 1,000 live bIts)~ 1's 25 78 Child malnutrition (% of children under 5) I* * Access to safe water Access to safe watert (%of popu1ation) 71 IllliteracyN( of popultion age 15)47 Gross primary enrollment (% of coo-g popultn)9 91 - Bsi n ezgvn Male . ~~~~~~~~~~~~~~~~~100' Low-income group KEY ECONOMIC RATJIOS and LONG-TERM TRENDS. 1978o 1988 197 1998 Economic ratios* Gross domestic investment/GDP . ... 42.0 380Trd Exports of~ goods and servicealGOP .. . 29.3 33~5Trd Gross domestic ssavngslGQP . , . 49 1 . Gross national savingelGOP i.. . 1. 0,4 Current account batanclGOp .. ,. 41.0 .-27.8 Domestic Interest paymentslGDp. . 6.7 2.7 Investment Total debt/GDP . . 128.3 705 Savings Total debt servcleprts . .38 Present valUe of debtlGDP .. . 9.8 Present value of debtlexpprts . . . . 178 8 Indebtedness 10764 1987-97 109 1997 19 (average annual grWth) GDP. ., . 69.1 29.5 1, -Bosnia and He,zegovina GNP per capita . . 74.0 301 1 .4 Low-income group Exports of goods and services . . 99.3 57,7 34.7 __________________ STRUCTURE of the ECONOMY 1976 1986 1997 1998 Growth rates of output and investment I%) (% of GDP) 200 Agriculture .. ..... IndustryI Manufacturing .o Services 50 Private consumption . ... .92 93 94 99 99 97 98 General government consumption .. . GDI 0--GDP Imports of gGods and services . .. 76.1 70.2 (average anual growth)1976486 1987-97 1997 1998 Growth rates of exports and imports 1%) Agriculture . ..200 Industry . ... * ISO Manufacturing Services 0 50 Private consumption . General government consumption .. . . . Gross domestic investment . .. 61.2 10.2 92 93 94 95 99 97 99 Imports of goods and services . .. 31.7 3.7 -Exports -0-Imports Gross national product.. ._____________________ Note: 1997 data are preliminary estimates. The diamonds show four key indicators in the country (in bold) compared with its income-group average, If data are missing, the diamond will be incomplete. Page 2 of 2 Bosnia and Herzegovina PRICES and GOVERNMENT FINANCE 1976 1986 1997 1998 Inflation (%) Domesfic prices (% change) 115 Consumer prces .. .. 110 ImplicitGDPdeflator .. .. 11.2 3.1 100 Government funance ss (% of GDP, includes current grants) go Current revenue . ... ..92 93 94 ss srd 97 go Current budget balance - GDP deflator -O--CPI Overall surplus/deficit .. .._.._.. TRADE 1976 1986 1997 1998 Expot and Import bvels (US$ millions) (US$ millions) Total exports (fob) .. .. 575 817 3,000 Commodity I .. .. 2,500 Commodity 2 2,000 Manufactures .. Total imports (cif) .. .. 2,333 2,573 1,500- Food 1.000 Fuel and energy .. .. .. .o0 Capital goods .. F. .. . 91 92 93 94 ss srd 97 rza Export price index (1995=100) .. Import price index (1995=100) -I . Exports 11 Imports Terms of trade (1995=100) .. .. .. .. BALANCE of PAYMENTS (US$ millions) 1976 1986 1997 1998 Current account balance to GDP ratio (%) Exports of goods and services .. .. 1,002 1,367 0 I . Imports of goods and services .. .. 2,606 2,864 s o 92 93 94 95 9s 97 9a Resource balance .. .. -1,604 -1,498 Net income .. .. -228 -109 -15 Net current transfers .. .. 772 480 -20 l Current account balance .. .. -1,060 -1,127 -2I Financing items (net) .. .. 971 1,158 -30 - Changes in net reserves .. .. 89 -31 -ss Memo: Reserves including gold (US$ millions) .. Conversion rate (DEC, locabUS$) .. EXTERNAL DEBT and RESOURCE FLOWS 1976 1986 1997 1998 (US$ millions) Composition of total debt, 1998 (US$ millions) Total debt outstanding and disbursed .. .. 4,392 2,879 IBRD . .. 596 581 IDA .. .. 291 433 A:581 Total debt service .. .. 385 123 E: 822 IIRD .. .. 35 35 IDA .. .. 2 3 Composition of net resource flows Official grants .. .. 574 727 Er: 433 Official creditors .. .. 431 363 Prvate creditors .. .. -107 -75 Foreign direct investment .. .. 0 100 I77 Portfolio equity .. .. 0 0 D.988 World Bank program Commitments .. .. 77 100 A - IBRD E - Bilateral Disbursements .. .. 111 142 B - IDA D - Other multiateral F - Pnvate Principal repayments .. .. 0 0 C - IMF G - Short-termn Net flows .. .. 111 142 Interest payments . .. 37 38 Net transfers .. .. 74 104 Development Economics 5/11/99 ANNEX I Page I of 9 BOSNIA AND HERZEGOVINA SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT - POLICY MATRIX (Items in italic and bold are conditions for tranche releases) 1. Maintaining a Stable Macroeconomic Framework Monetary Policy * Maintaining policies conducive * Has restored and maintained * Maintain currency board * Continued satisfactory * Continued satisfactory to monetary stability. monetary stability since 1995; principles and abstain from implementation of the implementation of the * Established countrywide extending credits to the public monetary policies. monetary policies. operational structure for the sector or the banking system. central bank; introduced the new national currency. * Modernizing the payments * Developed a comprehensive * Initiate the implementation of * Continued satisfactory * Continued satisfactory system and liquidating payment two-year reform strategy to be the reform program. implementation of the reform implementation of the reform bureaus across BiH. implemented through end- program program 2000. Fiscal Policy * Maintaining a fiscal policy * Has maintained budgets * Balance budgets on a cash * Continued satisfactory * Continued satisfactory consistent with the monetary balanced on a cash basis and basis; abstain from borrowing implementation of the fiscal implementation of the fiscal policy and overall structural abstained from borrowing from from the nonbank and banking policies. policies. reform strategy. the domestic banking sector. sector; and prevent accumulation of arrears. * Established clear arrangements * Continued satisfactory * Continued satisfactory * Continued satisfactory for the financing of the State implementation of the State implementation of the State implementation of the State budget, including an automatic finance mechanism. finance mechanism. finance mechanism. transfer mechanism between the Entity and the State Governments. 11. Reforming and Harmonizing Tax Policies and Coordinating Tax Collection * Broadening and accelerating * Entities began implementing * Entities to inplement the State- * Entities to conplete the * Implement; the process of harmonization of the State-set common custom set tariff surcharges; harmonization of sales tax the Entity tax systems; and and trade policy; * Entities to elininate special system by reducing differences establishing strong * Entities began harmonizing trade agreements with Croatia in sales tax rates; administrative co-ordination their sales and excise tax and Yugoslavia; between the Entity tax systems by adopting similar tax * Entities to equalize the excise administrations. bases and by harmonizing the tax rates on domestic and collection point in the inported goods; distribution process; ANNEX I Page 2 of 9 POIJCY AREAS AND ocerves AofHlVEMdlwr/MPAws M-v9 sudS PRORTG!*BQAR MER& OR I SEcOND: MEA.IS PRIMI TOfiE >TSD ALiwDYt'r c PSENATtOM . n . DBUR T __ _ _ _ _ __ _ _ _ _ _ (JU E I~99 ) (0 CE BE : .......5_P) (J O NE 2000O) * Entities both strengthened their * Entities to establish a Working * Entities to adopt a plan to * Entities to Implement new own tax administration and Group to develop a plan for strengthen the coordination arrangementsfor initiated a dialogue, under the coordination between the two between their Tax administrative co-ordination, EU's supervision, for tax adninistrations. Adninistrations, including an including an information improving administrative co- information sharing system. sharing system, operation with each other. * Improving revenue attribution * Entities to submit to their * Entities to implement new rules between the Entities. Parliaments amendments to legislation on inter-Entity their sales and excise tax allocation of sales and excise legislation on Inter-Entity taxes. allocation of the sales tax on excisable goods and excise taxes. * Tax Working Group to initiate * Entities to complete proposals the work on value added tax for introduction of VAT system (VAT) system. III. Reforming the Intergovernmental Finances within the Entities Federation * Improving revenue attribution * Improved the revenue * Begin preparing a plan to * Adopt changes to the tax * Implement the new collection rules within the Federation. allocation between cantons by improve allocation of (i) sales legislation to improve and allocation systemfor sales attributing sales tax on taxes on excisable goods by collection and allocation of taxes on excisable goods excisable commodities to the ensuring greater revenues to be sales taxes on excisable goods between cantons. first buyer's location. allocated to the place of between cantons. destination; and (ii) profit taxes by re-defining the assignment and/or distribution rules between the cantons and the Federation * Strengthened the co-ordination * Eliminate/agree to elininate * Eliminate all tax and duty * Enhancing and protecting between the Tax (FTA) and existing tax relief and exemptions without a specified revenue capacity across Customs Administration (FCA) exemptions with a specific expiration date and that are Federation. and enhanced the information expiration date, including not providedfor under tax sharing arrangements between those granted to duty-free legislation or by international the FTA, FCA and the shops, unless providedfor treaties; and adopt measures Financial Police. under tax legislation or by to effectively control duty-free international treaties, by shops and ensure that allowing them to expire at the transactions at such end of their current term. establishments are limited to authorized persons. ANNEX I Page 3 of 9 * Initiate preparation of a * Adopt and implement; * Implement; proposal to clarify local autonomy to implement local taxes; * Design an approach to * Adopt and implement. gradually expand the existing, excise tax-based, property tax system toward a traditional property tax; * Agree, based on reform * Develop a plan to strengthen * Adopt and implement; proposals developed with the the co-ordination between the EU-CAFAO's assistance, on a local branches of the FTA and strategy to merge Financial the cantonal MoFs. Police with the FTA and FCA and initiate implementation. Improving public service . Basic governance structure has * Initiate preparation of a * Adopt the proposal; * Implement; delivery and preventing large been established across proposal to shift responsibility differentials in the supply of Federation including adoption for higher education to public services between of the Law on the revenue and Federation, determining cantons. expenditure assignment. locality, governance structure Certain areas (e.g. health, financing sources and defense, social welfare), modalities. however, left with less clear assignment. Adopted laws on health * Establish cantonal health insurance and health protection. insurance funds; * Deternine and adopt services * Federation Government to responsibilities andfinancing adopt amendnents to the Law soarces for the Federation on Health Care regarding Health Insurance Fund. service responsibilities and financing sonrces for the Federation Health Insurance Fund * Refrain from providing * Refrain from providing * Refrain from providing contribution relief or contribution relief or contribution relief or exemptions from heath exemptions from health exemptions from health contributions; contributions; contributions; ANNEX I Page 4 of 9 PoLicy ARiAS AN ORJECrIVYS Ac m rIMESu MEASURES PRIOR T BOARD ME t SRESPRIOR TOT'H SECOND. MLASuRES PRiOR h O fWR THIRD AL...AV :.R.Oi.EP PRESENTATION T"W..I&. sM3NT TAKCHEDISBUlSftMENr :._ _ __ _ _ __ _ _ _ . . M . . . . . . . . . . ( M. .... ,, JuN 1 9 ) ( . E cg~ a 19 9 ) (JuN E2 000) Republika Srspka Enhancing and protecting * Improved tax inspection * Eliminate/agree to eliminate * Eliminate all tax and duty revenue capacity. capacity for better enforcement. existing tax relief and exemptions without a specified exemptions with a specific expiration date and that are expiration date, including not provided for under tax those granted to duty-free legislation or by international shops, unless providedfor treaties; adopt measures to under tax legislation or by effectively control duty-free international treaties, by shops and ensure that allowing them to expire at the transactions at such end of their initial ternm establishments are limited to authorized persons. * Agree, based on reform proposals developed with the EU-CAFAO's assistance, on a strategy to merge Financial Police with the FTA and FCA and initiate implementation * Design an approach to * Adopt and initiate gradually expand the existing, implementation; excise tax-based, property tax system toward a traditional property tax. * Strengthening health care * Develop and adopt guidelines * Adopt and implement. finance by increasing to improve administrative transparency in resource efficiency in health service allocation and enhancing the delivery and collection of health expenditure accounting. health contributions. * Refrain from providing * Refrain from providing * Refrain from providing contribution relief or contribution relief or contribution relief or exemptions from heath exemptions from heath exemptions from heath contributions; contributions; contributions; * Designing an effective * Prepared draft legislation on * Review and revise the draft * Submit the proposed legislation a Adopt and implement. decentralization strategy. local management that legislation with a view to to the Rcpublika Srspka proposes to decentralize the enhance administrative Government. government structure. Proposed efficiency by clearly defining operational relationship the role of the proposed between the governments, intermediate governments however, remained unclear. accordingly. ANNEX I Pag 5 of 9 nh. Establishing Efficient and Equitable Social Safety Net (i) Pension Reform * Achieving longer-term fiscal * Federation Government passed * Entities to prepare a report on * Entities to adopt amendments * Entities to implement sustainability and improving a new legislation to (i) prevent actuarial projection of their to pension legislation on anendments to their pension targeting of the most destitute accumulation of pension pensionfinances and their benefitformula and eligibility legislation. pensioners by (i) redefining arrears; (ii) gradually increase pension inconme distribution. criteria; benefit rules to align promised the retirement age; and increase benefits with the projected the minimum service period * Entities to adopt a temporary * Implement; resources; and (ii) increasing required for retirement; and scheme to increase lowest lowest pensions more (iii) tighten eligibility criteria; pensions more generously until generously until reaching a * The Management Board of reaching a reasonable reasonable subsistence level. Bosniac Pension Fund subsistence level. improved targeting by flattening the benefit payments; Republika Srspka restricted eligibility and prevented systemic accumulation of pension arrears. * Entities to begin developing, * Entities to adopt explicit * Implement; based on actuarial projections, financing and budgeting rules a financing scheme to improve for special military benefits and the sustainability of the special contributions and to eliminate military benefits; unviable schemes; * Entities to refrain from * Entities to refrain from * Entities to refrain from providing contribution relief or providing contribution relief or providing contribution relief or exemptions from pension exemptions from pension exemptions from pension contributions; contributions; contributions; * Reintegration of the Federation * The new Federation pension * Federation to begin designing a * Federation to adopt and pension system. legislation created a Federation mechanism to retire all implement this mechanism wide framework for pension outstanding claims (including prior to the establishment of policy and established a both unpaid contributions and the new unified Federation timetable for design and pensions); Pension Fund; adoption of the new organizational structure; * Federation established a * The Federation Pension * Federation Government to * Implement; Federation Pension Agency to Agency to submit to the adopt legislative changes for design and implement a re- Federation Government the financial and administrative integration strategy. drafi legislation on the merger merger of the two pension of the two pension funds. funds alongside with the changes to the benefit formula and eligibility criteria. ANNEX I Page 6 of 9 PoutcYv M&ARS o OwEcvfs ACHl*WEMENT1MEASURES MEASURESWKIUORT BOADo MiFsuR sPaTotsusICoNa MEASVREPRIOI rouin* ThaRzD ALRvAnVJ1NThOOUC90 PMUSENTAION TTYci8E 1ANCilEV M WU IW g~~~~~~~~~~~~~~~JN _9~ (DKIWE t9..) : ^.aM=(JU)NKt- * Comprehensive medium-term * Entities to begin developing pension reform. proposals for medium-term reforms, including privately managed pensions. (ii) Other Social Protection Programs * Achieving longer-termn fiscal * Entities drafted a new * Entities to initiate a survey of * Entities to subndt to the Bank * Implement; sustainability, improving legislative framework for the beneficiaries under veteran a conprehensive analysis of govemance as well as targeting veteran's benefits scheme. programs; beneficiariesfor their of the veteran's benefits and Benefit formula and eligibility veteran 's programs; other social protection criteria, however, are still not programs by (i) redefining compatible with realities of * Entities to begin preparing a * Entities to adopt (i) new benefit * Implement benefit rules to align promised future resources and objective report on actuarial projection of rules to align veteran's benefits benefits with the projected of protecting the most destitute. their veteran's finances; with projected resources; and resources; (ii) re-defining the (ii) new indexation rules to link eligibility criteria and benefit adjustments to the improving distribution rules to availability of resources. channel adequate resources to * Entities to re-define benefit * Implement. most needy; and (iii) re- categories, including through organizing the administrative reducing their number, structure, designing one-time compensation programs, and improving targeting; * Entities to re-define the * Entities to finalize the process beneficiary identification cards. of linking databases on * Entities to initiate a beneficiary profiles in their comprehensive review of respective CSWs; and, existing social welfare subsequently, complete the programs, including review of social welfare composition of beneficiaries programs. and financing sources. * Entities to review the CSWs budgets and provide each CSWs with adequate financing for basic administrative expenditures and for most critical assistance programs. * Reintegration of the Federation * Federation to begin developing * Federation to adopt the * Adopt and implement. veteran's benefits system. a re-integration proposal for proposal and begin drafting veteran's programs along the necessary legislative lines of the pension system. amendments. ANNEX I Page 7 of 9 F rgW..,,,,/,, gC fV.. . Developing a comprehensive * Both Entities are in the process * Entities to determine a * Entities to initiate the survey; * Entities to complete the survey; medium-term social protection of developing legislative timetable and begin preparing a * Entities to begin developing a * Entities to finalize the draft strategy. frameworks for their respective comprehensive poverty new social protection strategy, proposal for submission to the social assistance system. analysis built on a household focusing on target level of Government. expenditure and income survey. assistance, eligibility criteria, administrative structure and the financing modalities. V. Reforming the Budgetary Management System * Improving budget planing * Established legal basis for the * Entities to establish the BFP * Entities to complete the initial * Entities to revise the BFP to processes by developing: budget process and Working Group to co-ordinate BFP and to obtain approval expand its time-horizon to (i) a comprehensive multi-year strengthened the basic budget the preparation of the BFP from their Cabinets. threeyears and guide theyear budget strategy (MTEF) procedures and organizational and to start the preparation of 2001 budget and submit it to consistent with government's structures. the initial BFP; their Cabinets. macroeconomic and sectoral * Improved budget classification policies and integrating capital and adopted a uniform budget * Entities to establish Sector * Entities to extend sector * Entities to extend Sector and recurrent budgets; classification in the Federation; Working Groups in selected Working Groups and policy Working Groups to cover main (ii) strengthening the * Improved coverage of revenues sectors and to prepare sector work to cover at least two more sectors and initiate sector institutional capacity and and expenditures and initiated policy and strategy sectors compared to the initial policy and strategy reviews to establishing a cooperative commitments reporting; frameworks; composition; develop sector strategy approach for budget planning. * Began including external frameworks; budget support and related expenditures in the budget. * Entities to establish formal * Entities to incorporate capital * Entities to adopt a strategy and procedures for co-ordination projects in the year 2000 timetable for integrating their between the MOF and Aid Co- budget plans including those external aid management ordination Units; which are externally funded functionL * Entities to begin modifying existing databases by recording aid disbursements more systematically * Entities to initiate work to * Entities to establish * Entities to operationalise establish macroeconomic macroeconomic analysis and macroeconomic analysis and analysis and forecasting units forecasting units In their forecasting units; in each Entity MoF. respective MoFs; * Entities to determine the pilot * Entities to initiate work to sector ministries for establish policy and establishing policy and programming units in pilot program units and their sector ministries. functional organizations. ANNEX I Page 8 of 9 POLICY ARiAS ANDOBWE6rEivS ACHvIKVME*/MNSURES MWVREfPOR'TO B0M MwRJI=PORmo TO ThSEOND MzaIsPRI TOi UE7W ALuREADY bmOCED ORRSNTATION TR c II'Zm 7RANCHE DisBBWtSMmNr .__ _ __ _ _ __ _ ___ . ... !.. . .... _ . . :. JU E c ........ :, , , ) ........ .. ,,, ...I ) * Strengthening budget control * Entities adopted the legal basis * Entities and State to adopt * Entities and State to adopt the * Entities and State to operate and cash management capacity for the establishment of the regulations on the Treasury new systems and begin with Single Treasury Account by establishing a treasury treasury system; Department identifying preparing required reports. and to manage budget system at the State and the * State initiated the process of functional responsibilities. execution through Treasury Entity levels. developing a model for * Entities and State to begin LedgerAccounts. establishing a treasury system; developing systems for cash * Agreement reached on the management budget execution, gradual transfer of government accounting and reporting. accounts in the Payments Bureaus to Entity Treasury Ledger Accounts. VI. Establishing Auditing Procedures and Institutions * Promoting transparency and * Agreed on the organizational * State and Entities to submit * State and Entities to adopt the * State and Entities to accountability in public sector structure, mandate and a work draft legislativeframework legislativeframework and operationalize their SAls. performance and providing plan for establishment of the and budgetsfor their SAIs to budgetsfor their SAIs. legislative bodies with the Supreme Audit Institutions their Parlianents; * State and the Entity necessary information to (SAls) and established a * State and Entities to appoint Parliaments to appoint exercise control over the Working Group to initiate the their respective Acting Auditor-Generalsfor their executive. technical work towards this Auditor-Generals. SAIs. end. X State and Entities to adapt audit * Sate and Entities (including standards, promulgate cantons in the Federation) to regulations and prepare training begin preparing and publishing manuals; audit reports. * Entities to initiate preparation of Constitutional amendments for establishment of their SAls * Strengthening internal audit * Began developing a strategy to * Entities to develop a plan to re- * Entities to adopt and implement * Entities to adopt a timetable for procedures within public strengthen internal audit organize the Inspection Units the plan for establishing gradually expanding internal institutions by developing a procedures. within their MoFs as Internal Internal Audit Units in their auditing to include operational more systematic and Audit Units with proper MoFs, responsible, at efficiency and effectiveness harmonized approach to internal auditing capacity minimum, for a compliance and initiate implementation; internal audit function. reporting to the Minister of audit; Finance. * Entities to expand the process * Entities to adopt and initiate to develop a similar approach implementation. for strengthening the internal audit function in other public institutions. ANNEX I Vil. Strengthening Debt Management Capacity Strengthening debt * Created legal and institutional * Develop a plan to strengthen * Adopt and implement. * Implement; management capacity to framework for external debt policy-making, credit analysis enhance the efficacy and management; and monitoring functions in the effectiveness of the external * Established a comprehensive State and the Entity DMUs; borrowing and to facilitate the foreign debt tracking system in reintegration of BiH into the the State MFTER; * Initiate preparation of * State and Entities to adopt the * State and Entities to international capital markets. * Adopted a Protocol on Guidelines to govern the public Guidelines; inplement the Guidelines; information sharing between sector borrowing, including at the State, the Entities and the the Sub-Entity level, * Create debt databases in each * Create a Debt Advisory CBBH; establishing: (i) a Entity DMU and introduce Committee at the State level, * Entities adopted a general comprehensive debt reporting compulsory reporting with representation from the framework to govern Sub- system; (ii) transparent procedures for all public sector Entity DMUs, to co-ordinate Entity borrowing. selection, budgeting, and borrowing (including, Sub- borrowing strategies between supervision procedures for Entity governments, public different levels of loans and guarantees; and (iii) enterprises and utilities, extra- governments. procedures for borrowing budgetary fund etc.) policy co-ordination. ANNEX II Second Public Finance Structural Adjustment Credit to Bosnia and Herzegovina May24, 1999 Mr. J. Wolfensohn President World Bank 1818 H Street NW Washington, D.C. 20433 U.S.A. LETTER OF DEVELOPMENT POLICY Dear Mr. Wolfensohn: As you know, Bosnia and Herzegovina (BiH) has been experiencing continuing economic and social recovery since the signing of the Dayton/Paris Peace Agreement in December 1995. While living standards are still low for many families and economic activity is still at about 40 percent of the prewar levels, the reconstruction effort has already yielded significant results, as reflected by increased production and trade, reduced unemployment, restored services, and improved infrastructure. Our progress toward building Dayton-mandated common institutions and the governance structure in the Entities, as well as implementing structural policy reforms, has also gained momentum, particularly since 1998. Many critical institutions and policies are now in place. These include: the central bank and national currency; a legislative and regulatory framework for both the banking sector and for enterprise privatization; a uniform customs tariff and trade regime; financing means and mechanisms for the common institutions; a legislative framework for budget management; and an institutional and legislative framework for debt management. These achievements not only made it possible for State institutions to begin functioning last year but also provided the basis for initial co- ordination between the Entities in key areas of economic management. We have also achieved significant progress in removing barriers to the movement of goods and people within the country, including initial steps towards harmonization of tax systems across the Entities. Sustaining and broadening the positive developments of the past year is the key challenge BiH faces for continued rapid reconstruction and growth in the medium term. This challenge has been increased substantially by the crisis in Kosovo. Nevertheless, we intend to accelerate structural policy reforms with an emphasis on preparing BiH to increasingly rely on its own resources and institutions in designing and implementing the policies required for long-term development. Public finance reform is a key element of this strategy and the cornerstone for achieving further progress in institution-building, in strengthening fiscal capacity, and in achieving robust supply response in the economy. Specifically, over the next twelve to sixteen months we intend to: * broaden tax policy harmonization, encourage inter-Entity trade, and strengthen administrative co- operation between the Entities by eliminating Entity-specific protective and implicit tariffs and special trade agreements with Yugoslavia and Croatia, by improving tax revenue attribution rules between the Entities, and by establishing information sharing arrangements between the Entity Tax Administrations; * improve revenue and expenditure assignments within the Entities by adopting measures to strengthen collection and distribution of local revenues and to improve provision of public services with geographic spillovers and Entity-wide impact, particularly health care services; * create a fiscally viable and equitable social safety net by aligning pension and veteran benefits with the realities of available resources, by improving distribution of benefits to better protect the most needy, by initiating the design of a sound social protection system and, in the case of the Federation, by integrating the Bosniac and Croat social safety net systems; * develop a comprehensive budgetary strategy by introducing strategic public resource allocation, reintegrating current and capital budgets, strengthening institutional capacity and coordination in budget planing and execution, and introducing treasury function; * establish audit institutions and procedures to improve transparency and accountability in public sector operations; * strengthen country-wide policy coordination in extemal debt management, including developing a policy framework for sub-Entity borrowing. Reforming and Harmonizing Tax Policies and Coordinating Tax Collection We have taken significant steps to date in reforning tax policies and strengthening tax administration within the Entities. The Federation Government has simplified its sales tax structure, further reduced the combined wage tax and contribution rates and hence the burden on labor. It has broadened the wage tax base to include some non-wage benefits, such as per diems and allowances; reduced the profits tax rate, and developed a global income tax. With assistance from the EU-CAFAO, the Federation Govemment has also developed a reform program to improve tax collection by strengthening the coordination between the Federation Tax and Customs Administrations. In Republika Srpska, the wage tax was also reduced through a reduction in the pension and health contribution rates and the wage withholding tax. Similarly, sales and profit tax rates were significantly reduced. In conjunction with these measures, the Ministry of Finance took several initiatives to maintain revenues, including significant improvement in the inspection capacity for better enforcement and widening of the tax net. These efforts successfully resulted in increased revenue collection despite the implementation of significant rate cuts. We have also initiated policy harmonization and administrative cooperation between the Entities for mutual benefits. Both Entities began implementing the State-set common customs and trade policy for most imports. In an effort to broaden harmonization of the tax systems, the Entities have also begun harmonizing their sales and excise tax systems by adopting similar tax bases and by collecting revenues at the same point in the distribution process. Further progress in coordination of tax policies and tax administration between the Entities is critical to avoiding harmful tax competition and tax evasion, as well as for encouraging the free flow of goods between the Entities. To this end, our near-term priorities are: (i) incorporating all Entity specific tariffs into the State customs law and eliminating both implicit tariffs imposed by the Entities and special trade agreements with Croatia and Yugoslavia; (ii) completing the harmonization of the sales and excise tax structures between the Entities; (iii) developing a revenue distribution system between the Entities; and (iv) developing adequate cooperative arrangements between the tax administrations in the Entities. Efforts are underway to implement these priorities. 2 Harmonization of Entity tax systems. Over the last several months, the Tax Working Group (composed of representatives from both Entities) and the State and Entity Ministries of Trade have started developing a joint approach for eliminating the Entity-set protective and implicit tariffs. Regarding the protective tariffs, with the assistance from the OHR, we identified the list of items on which additional customs tariffs will be applied during 1999 and selected a set of uniforn rates. The State Council of Ministers adopted the list and the rates in March 1999. Both Entities are in the process of adjusting their system for implementation of the new rates and expect to initiate the implementation by no later than mid- May 1999. Regarding the elimination of the implicit tariffs, with the assistance from the US Treasury and the ORR, the Tax Working Group is continuing to work on setting identical rates for excise taxes on domestic and imported commodities in the Entities. This approach will ensure that all differential taxes are accounted for in the additional tariffs enacted by the Council of Ministers. It will, at the same time, harmonize the excise tax rates on domestically produced goods between the Entities. Both Entities expect to adopt the new and harmonized excise tax rates by no later than June 1999. Additionally, in an effort to further limit tax avoidance and to encourage the free flow of goods across BiH, we intend to complete the harmonization of the sales tax system between the Entities by aligning the sales tax rates by the end of 1999. We recognize that for full harmonization of the customs system, Federation and Republika Srpska must also eliminate their special trade arrangements with Croatia and Yugoslavia, respectively. These arrangements effectively exempt most imports from customs tariffs and subject them to domestic, rather than foreign, excise tax rates. A decision towards elimination was taken by both the Federation and Republika Srpska in mid-May 1999. Both Entities are currently adjusting their customs system for implementation of State-set common customs rates for trade with Croatia and Yugoslavia by no later than June 1999. Improving revenue attribution rules between the Entities. As trade between the Entities grows, there is also the immediate need to address the taxation of inter-Entity sales. The existing inter-Entity tax revenue attribution rules result in sales tax revenues on excisable goods and excise tax revenues remaining where they are collected. Consequently, they create incentives for harmful tax competition, result in inequitable inter-Entity revenue distribution and discourage free trade between the Entities. To improve the system, we will develop a mechanism that would ensure maximum revenue collection while providing the sales tax revenues on excisable goods and excise tax revenues to the Entity where the commodities are to be consumed. Accordingly, revenues shall be collected at the point of import or manufacture and passed from the collecting Entity (where manufacture or import occurs) to the consuming Entity (the Entity of destination) through a mechanism which would ensure that revenues are paid to the proper Entity, such as introducing tax stamps. The Tax Working Group has begun developing the rules and the operating principles of the new attribution system and will subsequently determine the necessary amendments to the Entity Sales and Excise Tax legislation. By December 1999, both Entities will have submitted to their Parliaments the amendments to their legislation on inter-Entity allocation of the sales and excise taxes. Both Entities will have implemented these amendments by no later than March 2000. We intend to deepen, in the next two years, reform of the sales tax system by introducing a value added tax system (VAT). The VAT system would not only generate more revenues, reduce the administrative complications of the existing sales tax system and close opportunities for evasion, but it would also further the alignment of our tax system with European norms. Both Entities are considering analyzing how VAT system could be structured within and across the Entities over the next six to eight months, and both Entities are developing a proposal for submission to their Governments by no later than June 2000. Strengthening administrative co-ordination between the Entities. At present, due to very limited co- ordination, the Entity tax administrations are unable to fully audit transactions and tax returns that involve both Entities; they are unaware of many transactions between firms across the Entities. We recognize that effective elimination of the potential for tax evasion, introduction of new attribution rules for revenue 3 allocation between the Entities, and eventually a VAT system all require strong administrative cooperation between the Entities revenue collection agencies. As a first step in this direction, the Entities have established a Working Group to study ways for improving administrative cooperation. The Group will develop a plan to strengthen information sharing arrangements and coordination between the Entity Tax Administrations so as to ensure effective implementation of the new inter-Entity allocation rules for the sales and excise taxes. By December 1999, both Entities will have completed and adopted this plan and both will have begun implementing it by no later than March 2000. Reforming the Intergovernmental Finances within the Entities Under the Dayton Accords, major government budgetary responsibilities are divided among the four levels of government: the State, the Entities, the cantons and the municipalities. The design of the intergovernmental fiscal system assigns limited economic and fiscal management responsibility at the State level but significant autonomy at the Entity level. The Entities have different fiscal structures. In the Federation, canton level administration is being developed to allow for greater local control for setting service levels. A more centralized approach is operating in Republika Srpska. Due to the Federation's more complicated structure, issues in intergovernmental finances are relatively more significant in the Federation than in Republika Srpska. Since mid-1997, we intensified our efforts to establish Dayton-mandated budgetary financing arrangements between the State and the Entities. In 1998, we established both clear financing arrangements and a transfer mechanism between the Entity and the State governments. Based on this system, we have begun formulating and implementing mutually consistent budgets across all three Governments. These arrangements have substantially improved stability and the transparency of financial relations between the three governments, and provided the State with the resource base to undertake its administrative functions and to meet external obligations. We will continue to fully implement these arrangements during both the current fiscal year and in the future. Progress in establishing the cantonal governance structure has continued in the Federation, including considerable, though uneven, progress in integrating the administrative structure in the two ethnically mixed cantons. At present, all cantons have basic fiscal management and legislative structures in place. Since 1997, the revenue and expenditure assignments have generally followed the structure laid out in the new Federation Constitution. The Federation Government has achieved some improvement in the sales tax revenue allocation between cantons by re-defining, in late 1997, the collection point for the sales tax revenues. Likewise, the Republika Srpska Government has, since 1997, improved the revenue allocation to provide certain municipalities with a higher share of tax revenues, depending on their characteristics. The allocation of revenues is higher for those municipalities that are on the border, have high social problems, have significant damage from the war, or have large numbers of refugees. These adjustments constitute a step towards eliminating financial imbalances at the local level. Over the next sixteen months, we will deepen our reform efforts to support the development of a sound intergovernmental financial system in both Entities. Specific issues we intend to address in the Federation involve enhancing both revenue collection and distribution, and provision of minimum service levels, particularly in health. In the Republika Srpska, we are working on a decentralization strategy aimed at creating a more efficient intergovernmental system and health finance reform. Improving revenue attribution rules within Federation. Existing arrangements in the allocation of revenues between the cantons result in a relatively wide range of revenues on a per capita basis (about 5:1 in 1998). Our initial attempt to address this issue by attributing sales taxes on excisable commodities to the first buyer's location in October 1997, while improving overall revenue allocation between cantons, resulted 4 in disproportionately greater per capita revenues in those cantons with high economic activity and cantons where importing is concentrated. Similar deficiencies exist in the current allocation of profit tax revenues to the headquarters canton in cases where companies operate in more than one canton. To further improve the revenue allocation rules between cantons, we have agreed on developing a mechanism that will ensure allocation of greater revenues to the place of destination while maximizing revenue collection. This mechanism will be operated by collecting sales taxes on excisable commodities at the import or manufacturing stage and by allocating them according to a formula that constitutes a sound proxy for the distribution on a destination basis and that yields additional revenues for all cantons. As demonstrated by the forms of sales tax evasion to date, collecting sales taxes at import or manufacture will significantly minimize tax evasion, which, in turn, will allow all cantons to receive higher revenues. The Federation MoF, in co-ordination with the cantonal MoFs, plans to finalize the design of the mechanism by September 1999 and, subsequently, to draft the associated amendments to the sales and excise tax legislation. By December 1999, the Federation Parliament will have adopted these amendments for implementation starting January 2000. Likewise, we will consider improving allocation of the profit taxes in the near future by re-defining the allocation rules between the Federation and cantons, along with those expenditures that have a Federation-wide impact, but are presently assigned to cantons without clear financing arrangements, such as higher education. Enhancing and protecting revenue capacity in the Entities. Both the tax bases and the tax rates for most of the important taxes in the Federation--including sales, wages, and profits--are determined at the Federation level due to associated administrative and compliance efficiencies. We recognize, however, that the cantonal revenues must be protected from the Federation's exempting taxpayers or narrowing the base for taxes assigned to cantons and re-assigning revenues/expenditures unilaterally. To this end, we intend to take the following steps over the next eight months: as a first step, we will allow existing tax relief and exemptions, including those exemptions granted to duty-free shop, with a specific expiration date to expire, unless the exemptions are specifically provided for by either international treaties or the existing tax laws; as a second step, we will, eliminate, by December 1999, those tax and duty exemptions that are without a specified expiration date and that are not provided for by either international treaties or the existing tax laws, and will adopt measures to effectively control duty-free shops and ensure that transactions at such establishments are limited to authorized persons; as a third step, we will require Parliamentary acts for any changes to cantonal tax bases and rates. In Republika Srpska, practice of tax exemptions/relief to date has been comparatively limited and the above stated principals will be guiding the tax policy in the future. On the administrative side, to improve the tax collection both in the Federation and Republika Srpska, we plan to reform and transform the revenue collecting institutions in each Entity and improve coordination between local tax administration offices and the cantonal Ministry of Finances in the Federation. Our aim is to ensure that taxpayers are confronted with coordinated audits. The new, re- organized administrative system will have begun operating in the near future. In addition, we plan to adjust the Federation tax system, both to establish appropriate opportunities for cantons and municipalities to increase revenue collection, and to allow them a reasonable capacity to meet the differential preferences of their citizens. To this end, we will adopt, by December 1999, legislation that will establish the cantonal capacity to set minimum tax rates so as to limit the degree of tax competition between the cantons and municipalities. We further plan to gradually expand our currently limited property tax system toward a traditional property tax system in order to augment local government finance, particularly in municipalities in both the Federation and Republika Srpska. This work will also involve establishing cooperation between finance, cadastral and tax administration offices of the Entities' local governments. Strengthening intergovernmental finance in Republika Srpska. Over the past months, we have begun developing a new local management strategy which aims to decentralize the governance structure 5 by creating an intermediate set of governments in the form of districts. We are envisaging the creation of eight such districts that would be responsible for roads, communications, secondary education, and regional health care. The districts will be financed mainly by a percentage of tax revenues raised in their jurisdictions. We are currently in the process of developing the legislative framework for this new system which will be finalized by the end of 1999. We recognize that operational relationship between the governments needs to be clearly laid out in the legislation with a focus on enhancing the administrative efficiency. To achieve this, we will restrict the role of districts to be de-concentrated arms of the central government and will legislate their responsibilities accordingly. Improving public service delivery in the Entities. We recognize the need for developing efficient mechanisms for delivering and financing education and health services in both Entities, particularly in the Federation due to its decentralized governance structure. Our priority in the case of education services is to address the present weaknesses in higher education services in the Federation, which are currently being delivered and largely financed by selected cantons, although the benefits are received by residents from many cantons. To this end, we plan to develop, by the end of 1999, a clear service delivery framework involving a re-definition of respective responsibilities of the Federation and cantons in higher education. In the case of health services, we have already begun designing a strategy to establish an effective governance framework and to improve both collection and usage of health care resources in both Entities. An important integral element of our strategy is to ensure that all eligible residents will have access to basic health care services, with a particular emphasis on designing the most cost-effective basic health package in each Entity. Building on these principals, each Entities' Ministry of Health has prepared, with the assistance from donors (including the World Bank, World Health Organization, EU-PHARE and the Government of United Kingdom), policy papers laying out their health care reform strategy in the medium-term. Both Entities have also initiated technical studies to facilitate the design of specific policy measures and mechanisms to achieve the objectives of their reform strategy. These studies include: (i) preparation of a comprehensive "Health Account" in each Entity covering both public sector revenues and expenditures in health, and private, out-of-pocket health spending; (ii) determination of the most cost-effective basic package of health services in each Entity along with management tools and incentives to promote their effective provision and usage; and (iii) completion of a survey on public evaluation of and expectations from the health care system in the Entities to increase the responsiveness of the system to the needs of the population. In addition, with the support from the Bank's Basic Health Project, we plan to develop new incentive mechanisms for improving efficiency in remuneration of health service providers in the near future. While the above stated overall objectives of the health care reform are similar across Entities, the content of reform differs between the Entities, reflecting differences in their governance and legislative structure. In the Federation, as presented in the 1997 Health Insurance Law, we envisage a canton-based extra-budgetary health insurance system (cantonal funds), financed by payroll tax contributions for health. Recognizing that such a system will lead to undesirable small risk pools, we also envisage the creation of a Federation level health insurance fund (Federation fund), responsible for certain joint health care functions. We have begun building this new institutional structure both at the cantonal and the Federation level, but the progress to date has been limited. Only three cantons have established their funds so far. As a result, several cantons continue to deposit their health contributions in the general canton budget and to use a portion of these funds for financing other services. Our important priority during 1999 is completing, before the end of the year, the establishment of the cantonal funds, and ensuring that the health care contributions will flow into these funds in all cantons starting in January 2000. As for the Federation level structure, we established the Federation Health Insurance Fund and appointed its Director in December 1998. Another important priority for 1999, is to prepare the conditions for smooth operation of the Federation fund in the near future. To this end, we have already begun formulating, in coordination with the cantons, the functional responsibilities of the Federation 6 fund and its financing modalities. We recognize that the design of the Federation fund is critically important in reducing the existing wide variations across cantons in access to health services, and in enhancing the overall health service delivery across the Federation. Therefore, we have agreed that the Federation fund will undertake the following major responsibilities: (i) ensuring that all eligible residents of the Federation have access to basic health care services; (ii) financing services with Federation-wide benefits, such as eligible tertiary care services and highly specialized services that can only be delivered effectively in a limited number of locations for a larger risk pool; and (iii) providing technical and managerial assistance in operation of the cantonal health insurance funds, including centralized procurement of medical supplies. Regarding financing of the Federation fund, we have agreed that its resource base will be derived from total payroll tax contributions for health; specifically, we are envisaging assigning up to one-fifth of the total health contributions to the Federation fund. Building on the above stated principles, by December 1999, we will have specified the functional responsibilities and the share of the Federation fund in total health contributions. Based on this final framework, we shall have drafted, by February 2000, the required amendments to the Federation Health Insurance Law on the responsibilities and financing sources of the Federation fund. By no later than April 2000, the Federation Government shall have adopted these amendments to the Federation Health Insurance Law for operation of the Federation Health Insurance Fund starting from mid-2000 onwards. In Republika Srpska, the health care system operates within a more centralized structure, including the Republika Srpska Public Health Insurance Fund and its four regional branches. The system is being financed mainly by payroll tax contributions for health. The government finances health contributions of certain unemployed populations, such as refugees and demobilized soldiers, from the general budget. During 1999, we are aiming to adopt a new Health Insurance Law in Republika Srpska with a focus on (i) improving the financial viability of the system through promotion of cost-effectiveness and efficiency in public health service delivery; and (ii) developing a solidarity system, as in the case of the Federation, ensuring equal access to the basic package of health care services across Republika Srpska as well as financing eligible tertiary health care services. In addition, we plan to develop, by December 1999, guidelines to promote efficient operation of the Republika Srpska Public Health Insurance Fund and its four regional branches. The guidelines will establish: (i) procedures for improving transparency in budgeting and usage of health contributions; (ii) incentives/sanctions to improve collection; (iii) procedures for strengthening coordination between the central fund and its branch offices; and (iv) prototypes of contracts to guide the purchasing of health services. Reform of Social Safety Net Reforming Pension System. Rising wages and employment over the last three years, and hence the rising pension tax base, brought about a significant increase in pension revenues of the three pension funds presently operating in BiH -- two separate schemes in the Federation, covering Bosniac-majority areas (the Sarajevo Fund) and Croat-majority areas (the Mostar Fund), and a Republika Srpska scheme. Despite the resulting parallel increase in benefits, however, benefit levels remain less than one third of their pre-war levels in the Federation and less than one fifth in the Republika Srpska. The cause of the financial strain is the high ratio of pensioners to contributors, which is presently at about 0.8:1 across the three funds. At present, all three pension funds operate on a pay-as-you-go basis -- i.e. current contributions are paid out as benefits in the same period. Each fund, however, pays pensions according to a different fortnula: in the Sarajevo Fund, until the passage of the Federation Pension Law in 1998, the pre-war formula was used to calculate pensions but roughly half of this amount was actually paid out, and the difference between the actual and statutory benefits was considered to be a debt owed to pensioners. The new legislation declared all future benefit payments final, thereby precluding the possibility for further systemic arrears. In the Mostar Fund, earmarked revenues are divided by the number of pensioners resulting in a flat benefit, zero balance as well as highest minimum pensions in BiH. The Mostor Fund is currently in the process of adopting a new formnula similar to that of the Sarajevo Fund in accordance with the 7 harmonization principals of the new Federation Pension Legislation. The Republika Srpska Fund pays pensions according to a formula which gives higher pensions to those with more education-as a proxy for pre-war higher earnings. It, however, operates with significant transfers from the budget since earmarked contribution revenues are not sufficient to cover outlays. The existing pension schemes face several challenges in the short term. First, owing to financial difficulty, both the Republika Srpska pension fund and the Sarajevo pension fund in the Federation have been late for several months in making payments to pensioners. Second, despite the rapid increase in the average pension level for some parts of the country, a significant number of the pensioners in both the Federation and Republika Srpska still receive pensions that are below the minimum required for subsistence living. Third, the pension finances are largely being managed according to principles we developed during the war-period in order to cope with the severe financial difficulties; a more comprehensive pension strategy needs to be developed and gradually introduced. We recognize that, in the case of the Federation, dealing with the third challenge requires rapid progress in reintegration of the Federation pension system, without which in-depth pension reforn is impossible. The immediate challenge that we face is to address the financial constraints in a more systematic way. To achieve this, we plan to redefine benefit rules with the aim of aligning the benefit levels with the realities of future revenues and demographics. This approach shall be phased in gradually, with the objective of attaining a financial balance over a reasonable time period. In the meantime, pension funds shall give special attention to validating adjustments to the benefits by realistic projections about resource availability. In the case of the Federation, while the new Federation pension legislation prevents the systemic accumulation of arrears, the benefit formula still needs to be adjusted to reflect the realities of future resources. As a first step in redefining the benefit formula, by June 10, 1999, we will have prepared a report on actuarial projection of each Entities' pension finances. Based on this analysis, we will develop, during the second half of 1999, a new benefit formula and an eligibility criteria conducive to a long run balance in Entity pension finances. By the end of 1999, we will have adopted the necessary amendments to Entity pension legislation in order to introduce this new system in 2000. Another immediate challenge we face is to improve the targeting of the most destitute pensioners in the short-term. In both the Republika Srpska and the Sarajevo Pension Funds, the present distribution of benefits results in relatively wide range of pensions (5:1). Given the low average perisions (about 75 DM in the Republika Srpska and 150 DM in the Federation), the situation is especially difficult for those with below average pensions. We plan to improve the distribution of benefits through a temporary policy whereby the lowest pensions shall be increased relatively more generously when revenues are increased, until reaching a reasonable subsistence level. To this end, we aim to prepare a report on distribution of pension income by June 1999. Based on this analysis, we intend to adjust, by the end of 1999, the benefit formula for provision of a reasonable minimum benefit starting in 2000. We recognize that further pressures to pension finances would come from special military benefits in both Entities. In the Federation, special lower contribution rates, along with a more generous benefit formula for the military has already created financial strains. While the new Federation Pension Law envisages the development of financing modalities for special military benefits through separate legislation, preparation of the legislation has been delayed. Similarly, several special benefit schemes for the military exist in Republika Srpska, where budgetary transfers provide supplementary financing. The resolution of financing issues for the military by the end of 1999, is priority in both Entities in order to prevent cumulating financial imbalances in their new pension systems. To this end, by no later than the end of 1999, we shall calculate the additional liability caused by the special benefits and develop a transparent financing strategy, involving either earmarking revenues and/or reducing the special benefits. We further plan to support the viability of the new system by eliminating tax relief or exemptions from payroll tax for pensions. 8 As indicated above, the decentralized state of public pension provision presents another important challenge in case of the Federation. An initial step to address this problem was taken last year through the adoption of the new Federation Pension Law. The Law created both a Federation-wide framework for social policy by requiring the two Federation funds to operate under one Federation-wide law, and a Federation Pension Agency with a mandate to begin the process of re-integration of the pension system. As a further step towards re-integration, a new Federation Pension Agency, consisting of representatives from both pension funds, was established in January 1999 and assigned with the task of drafting this legislation by April 1999. By early June, the ongoing work to prepare this draft will have been finalized; the draft will have been submitted to the Federation Government by no later than June 10, 1999. The Federation intends to take further steps toward the actual merger of financial and administrative aspects of the two funds during the second half of 1999; it intends to adopt, by the end of 1999, the necessary legislative changes for creating the new, Federation-wide pension system alongside measures aimed at achieving fiscal sustainability and an adequate safety net described in above paragraphs. The Federation further plans to design a mechanism to retire all outstanding claims (e.g., unpaid contributions from enterprises and the military, as well as unpaid pensions) prior to the establishment of the new, Federation-wide pension fund. Building on the above mentioned actions, we plan to extend our reform efforts, in 2000, by developing a medium-term strategy for introducing comprehensive pension reforms over the next couple of years. It should be noted that the new Federation Pension Law, has already introduced several positive features which would lead to some reduction in medium term pension spending pressures. For examples it reduces future pensions, it restricts eligibility in the medium term via provisions on the assessment base and retirement age, and it brings post retirement indexation more into line with material resources of the funds. Most importantly, it equates actual with legal pension payments in the Sarajevo Fund. Nevertheless, we recognize that additional medium-term reforms must be studied both in the Federation and Republika Srpska, including the introduction of privately managed pensions. Reforming Veteran's Benefits and Other Social Protection Programs. During the war, our social protection system financially collapsed and fragmented across the country; it largely remains so today. In addition to the pension system, only veterans' benefits and a few other social programs, mainly providing poverty relief, can be funded at present. Budgetary transfers for veterans' programs, and donor assistance for the other programs, provide the main funding source. Social assistance programs are generally the responsibility of cantons in the Federation, except for veterans' programs, for which the Federation shares financial responsibility. In Republika Srpska, we have a more centralized structure at the Entity level. In both Entities, municipal Centers for Social Work (CSW) administer the implementation of programs that provide poverty relief, mainly by managing foreign-financed programs, as domestically-financed programs are very limited. As with the other social sectors, the system of social assistance today faces the dual challenge of overcoming low levels of financing capacity and establishing a new and effective governance framework. In addition, the Federation faces the challenge of integrating its fragmented social assistance system with an emphasis on establishing an efficient and equitable system. Veteran's Benefits Programs. The immediate challenges in this area are achieving fiscal sustainability, improving targeting of the most handicapped and their families, and re-integrating the policies and administration across the Federation. Over the last year, both Entities have made initial efforts to address these issues and have drafted legislation on their respective veterans' benefits schemes. We recognize that these pieces of legislation needs to be strengthened to: (i) more adequately address the incongruity between available resources and promised benefits; (ii) improve the indexation rules, which currently tie benefits to average wage growth; and (iii) simplify the present schedule of benefits with an emphasis on increasing the funds available for the seriously handicapped and their families and reducing the administrative costs of the system. 9 The analysis necessary to design such policies requires data and information on the number and composition of beneficiaries in each Entity which at present is limited. Additionally, in the case of the Federation, beneficiary information is contained in separate databases for Croat- and Bosniac-majority areas; the Federation Veteran's Directorate's access to such information has thus far remained limited. As a first step towards addressing these critical issues, both Entities are currently intensifying their efforts to gather data and information. Both will have completed aggregation and analysis by no later than July 1999. Subsequently, Entities plan to redefine benefit rules to align promises with projected resources and to tie benefit adjustments to the availability of resources. They also plan to address the weakness in the definition of the benefits system by a combination of policy measures. These measures include reducing the number of benefit categories; separating discrete, one-time compensation programs and permanent entitlement programs, e.g. paying one-time benefits to those with minor disabilities; and improving targeting of resources to the neediest cases. In addition, the Federation, building on the ongoing work towards unification of its pension system, plans, by the end of 1999, to develop an integration strategy for veterans' programs, both on the policy and the administrative level. It is expected that this will help minimize the administrative costs associated with multiple schemes and will harmonize benefit levels across the Federation. Reforming other social protection programs. In the face of gradually diminishing foreign humanitarian support, our main resource base for social assistance, the development and institutionalization of a new social protection system in BiH is another near-term challenge that we are facing. Our immediate concern is to sustain poverty relief before in-depth reform of the system is possible. To this end, we plan to improve targeting methods to direct available resources to the most needy and to strengthen the existing institutional base for more effective provision of poverty relief. We have already begun identifying existing programs and beneficiary coverage by consolidating the available information which is currently scattered due to local implementation of programs. This process involves re-defining the beneficiary identification card for accessing CSW assistance, and establishing and subsequently linking the databases between the CSW within each Entity. We further plan to improve the CSWs resource base to enable them both to run the most critical assistance programs and to finance their basic administrative expenditures. As mentioned above, at present, financing for CSWs is primarily the responsibility of cantons in the Federation and the municipalities in Republika Srpska. We recognize that this creates a potential for translating differences in local fiscal resources into differentials in the provision of social assistance. Given our extremely tight domestic finances, in the near term, such pressures could be contained only by (i) continued strong donor assistance; and (ii) joint efforts with donors to direct available resources to places with the lowest social assistance capacity. Our medium-term strategy is to develop a permanent approach for addressing present weaknesses in financing and governance capacity before the humanitarian assistance is phased out. In order to provide a sound basis for this exercise, we first intend, with the assistance from donors including the World Bank, to undertake a comprehensive poverty analysis, built on household income and expenditure surveys. Building on this analysis, we subsequently intend to determine key aspects of our social assistance strategy, including the target level of social assistance, criteria for eligibility etc. and other policies with fiscal implications, as well as the administrative structure and the financing modalities of the new system. In light of these studies, ongoing work in both Entities to develop the legislative framework for the social assistance strategy will be further reviewed and revised. Reforming the Budgetary Management System During 1998, we made significant progress in establishing the legal basis for the budget process and in strengthening the budgetary organizational structures. The new Entity laws on the "Principles of the 10 Budget," encompassing a set of key reforms, have been adopted. The coverage and comprehensiveness of the budgets have been extended by including external cash grants, general budgetary borrowing and related expenditures into the budget. Necessary provisions have been included in the new budget laws thereby extending this system to incorporate capital budgets, including externally financed projects. Initial general frameworks have been adopted to govern domestic and external local govermment borrowing. Other achievements to date include: (i) significant progress towards introducing new and improved budget classification systems to create uniform standards across central and local governments and initiate comprehensive expenditure reporting; (ii) improvements to the accounting systems, including adoption of regulatory framework for commitments reporting; and (iii) adoption of a rew procurement regulations to establish a system that promotes open competition and transparency. As a further aspect of reform efforts aimed at improving fiscal efficiency and controt we anticipate developing a comprehensive budgetary strategy that will contribute to more efficient budget planning and execution systems in BiH. We expect that once established, this system would substantially enhance strategic public resource allocation, ensure efficient resource use and further improve transparency and accountability in government policies. Reform of Budget Planning Processes. We have identified several areas in budget planning, which call for initiating actions. Chief among these are: (i) strengthening the linkage between budgets and govermment policies and strategies; (ii) integration of the donor-financed investment program -- a relatively large portion of the total public resource envelope in BiH -- into the budget; (iii) introduction of a medium- term perspective in the planning of government expenditure programs; and (iv) strengthening the economic policy and forecasting function in the Entity MoFs and policy and programming capacities within line ministries as well as co-ordination between the MoFs and the line ministries in budget planing. To address these issues, we have agreed on a comprehensive reform program, covering budgetary planning processes and institutions, and initiated implementation in March 1999. The program has two main elements. The first element involves developing an integrated approach to budgetary planning and preparation in the form of a medium-term expenditure framework (MTEF). The MTEF will have three building blocks: * The first one is the macroeconomic framework, which will provide the basis for projecting resource base and expenditure allocations as well as the context against which key budget issues could be analyzed. Initially, we will base it on the IMFl/World Bank framework. In time, as the economic forecast and analysis capacity within the MoFs is built up, it will increasingly reflect the MoFs' own analysis. Both Entities have already initiated development of macroeconomic frameworks to guide their budget preparation for the next year; * The second building block is the sector strategy framework, which will establish our overall policy objectives for the sector as well as strategic program areas and financing requirements within the sector, consistent with overall resource constraints. This will, in turn, help us determine the strategic shifts in inter-sectoral resource allocations and provide the basis for monitoring and evaluating sector program outcomes. As an initial step in this direction, both Entities have identified a limited number of pilot sectors and have established Sector Working Groups to develop the initial strategy framework in these pilot sectors (including health, education and transport in the Federation; and transport, education, and agriculture in Republika Srpska). We are planning to gradually expand the sector strategy frameworks to cover all the main sectors by mid-2000; * The third building block will be sectoral expenditure plans, covering both recurrent and investment allocations and the related financing. We recognize that, initially, this would require a major exercise to incorporate externally financed projects within the Entity budgets. Nevertheless, we perceive this exercise as a major instrument to enhance, not only our capacity to set the appropriate balance between capital spending and recurrent spending, but also our 11 ability to maintain fiscal stability once donor assistance is phased out. As a first step in this direction, we have already started modifying existing databases by recording aid disbursements more systematically. By the end of 1999, we will have incorporated capital projects in the year 2000 budget plans, including those which are externally funded. The time horizon for the MTEF will be three years, within which the MTEF would be revised and "rolled forward" each year. The MTEF will be prepared during the first half of the year in the form of a "Budget Framework Paper" (BFP); it will be approved by the respective Entity Cabinets. The BFP will then provide the strategic framework and resource ceilings for the subsequent preparation of the annual Entity budgets. In the Federation, the MTEF would also incorporate cantonal expenditure plans, with an emphasis on enhancing the linkages between cantonal expenditure plans and the Federation-wide sector strategies and the macroeconomic framework. We have already initiated the work towards preparation of the first BFP in each Entity. To facilitate this, each Entity has established both a BFP Working Group and Sector Working Groups (SWG). Initially, the SWGs were formed for the above indicated pilot sectors which will be the focus of the initial BFP. Both Entities intend to finalize draft BFPs for submission to their Cabinets by June 1999, with an emphasis on guiding the subsequent preparation of the 2000 budget. Likewise, by June 2000, we will have revised this initial BFP to expand its time horizon to three years and submitted it to the Entity Cabinets in preparation for the 2001 budget cycle. The second element of our reform program involves strengthening the institutional capacity and establishing a cooperative approach for budget planing. This entails: consolidating and developing core expenditure planning functions within the MoFs; developing sector-wide policy and programming functions within the line ministries; and establishing planing working groups involving representatives of relevant institutions. As indicated in the above paragraphs, we have already begun implementing these institutional aspects of the reform program. Cooperation between Entity MoFs and aid coordination units is being strengthened, and a strategy and timetable for integration of aid management function will have been adopted by no later than June 2000. In addition, by December 1999, Entities will have established a Macroeconomic Forecasting Unit within their MOFs. By June 2000, we plan to extend the Sector Working Groups to all main sectors and establish policy and programming units in the pilot sector ministries involved in the 1999 BFP exercise. Reform of Budget Execution Systems. In order to improve public sector cash management, to increase control over public sector resources and to enhance fiscal transparency, we intend to move rapidly towards establishment of a treasury system. This will move parallel to our efforts to modernize the payments system and reorganize the payments bureau functions. At the State level, a program for development of treasury functions has already been prepared. Accordingly, we intend to begin operation of centralized payments, a Single State Treasury Account and State Treasury Ledger Accounts by the end of 1999. At the level of the Entities, the new budget system laws provide the legal basis for establishing the treasury system. However, the two Entities begin this task from different budgetary systems and initial institutional arrangements for public sector payments. Therefore, the speed and content of reform will differ from case to case. In the Federation, a significant proportion of treasury functions are currently undertaken by the financial section of the Department of Mutual Services, which will be transferred to the Ministry of Finance before the end of 1999. In the meantime, to initiate the establishment of a treasury department, the Federation shall adopt, by June 1999, regulations on the responsibilities of the treasury department, begin recruitment of staff and begin to develop procedures to transfer accounts from the Payments Bureau to the Treasury ledger. By December 1999, the Federation shall have completed the transfer of accounts to the Treasury Ledger for all Budget Institutions, prepared the centralized payments system and Treasury Single Account, developed the system of commitment reporting and completed staffing of the treasury department for operation starting from January 2000. 12 In Republika Srpska, establishing the treasury function will begin with segregation of the public sector transactions from the operations of the Srpska Development Bank. As an initial step towards this end, Republika Srpska will appoint, in May 1999, a Working Group to develop an action plan for Treasury development. The Group shall finalize the action plan by the end of June 1999. Building on this plan, Republika Srpska shall adopt, by September 1999, regulations on the establishment and responsibilities of the treasury department, begin recruitment of staff, and begin to develop procedures to transfer accounts from the Srpska Development Bank to the Treasury Ledger. By June 2000, Republika Srpska shall have completed the transfer of accounts to the Treasury Ledger for all Budget Institutions, prepared the centralized payments system and the Treasury Single Account, developed the system of commitment reporting and completed staffing of the treasury department for operation thereafter. Establishing Auditing Procedures and Institutions We recognize that establishing a comprehensive audit system is a prerequisite to promoting transparency and accountability in public sector performance and providing legislative bodies with the necessary information to exercise control over the executive. Therefore, we plan to create external auditing procedures and institutions in BiH and to strengthen the regulatory and institutional framework for internal audit function at both the State and the Entity levels. As a first step in this direction, we started, in 1998, designing the organizational and functional framework of the external audit system. The most critical aspect of this work was to determine a feasible structure that would enable several layers of largely autonomous governments in BiH to undertake sound audit functions within their jurisdictions, while at the same time ensuring consistency of standards, methodology and quality across all levels of government. We completed this work in early 1999 and agreed on the following specific arrangements that would meet these requirements: * State and Entities shall establish a Supreme Audit Institution (SAI) for carrying out external audit finctions of respective central and local government activities and organizations. International Association of Supreme Audit Institutions (INTOSAI) standards shall form the basis for the audit system in Bosnia and Herzegovina; * State and Entities shall establish a National Coordinating Committee (NCC), comprising their Auditor-Generals, for setting audit standards, for ensuring consistency of standards, methodology and quality, for assigning audit responsibility for those activities that extend across the Entities and/or the State, and for determining representation on international bodies. The NCC will be chaired by the State Auditor-General and meet according to a fixed schedule on at least a quarterly basis; * The State and the Entity Auditor-Generals shall be appointed through a Parliamentary act for a fixed and non-renewable term; * The objective of the external audit in both the State and the Entities shall be to carry out: (i) compliance audit to ensure that all legal and regulatory requirements have been met, or report any failures; (ii) certification audit in the form of a report on the financial statements; (iii) performance audit (value for money) to measure the performance of individual public institutions with regard to efficiency, economy and effectiveness. • The external audit by the SAIs shall embrace all government activities and organizations that are partially or wholly owned, controlled or funded by public sources or that are provided by an external organization on loan or grant basis. We consider the independence and operational integrity of SAIs as central to their effective operation. To prevent political or other unwanted interference, we shall establish SAIs as constitutional bodies reporting on their activities to their respective Parliaments at the State, Entity and Canton levels. However, due to relatively longer process of amending the constitution, they will commence operation 13 under legislation for a transitional period. Their budgets will be charged items on respective government budgets. In the case of the Federation, the cantons shall also contribute to the cost of the Federation SAI, on the basis of a fee determined by the size of audit work to be performed on their behalf. In March 1999, we initiated the process of establishing the above described framework by forming a Working Group comprising the representatives of the State and the Entities, including cantons in the Federation. The Group is responsible for the various technical steps leading to the creation of the SAIs. Our aim is to adopt the legislative and regulatory framework, establish all three SAIs and appoint the key staff by the end of 1999. To achieve this, we envisage submitting draft legislative framework and budgets for each SAIs to the respective State and the Entity Parliaments and appointing the State and the Entity Acting Auditor-Generals by June 10, 1999. The State and the Entity Parliaments will have adopted these legislative framework and budgets, and appointed Auditor-Generals for their SAIs by August 1999. We will have begun implementing the legislative and the institutional framework starting in January 2000 which will enable the SAIs to start preparing and publishing the audit reports thereafter. During this timetable, we also intend to process necessary amendments for establishing SAIs as constitutional bodies during 2000. In conjunction with the ongoing work to develop an external auditing system, we intend to strengthen the internal audit procedures with a special focus to ensure that the two functions would reinforce, rather than duplicate, each other. Our objective is to develop a framework enabling government agencies to exercise managerial control within their organizations and to prepare analysis and reports to management on their systems and practices as well as compliance with budgetary and accounting requirements. We are considering initiating this process first within the Entity Ministries of Finances, including cantons in the Federation, and then gradually expanding it into other public institutions and the State Ministry of Finance once it is established. To this end, by December 1999, both Entities shall have re- organized the existing Inspection Units with internal control functions, as Internal Audit Units with proper internal auditing capacity reporting to the Minister of Finance. In the initial stage, these Internal Audit Units shall be responsible, at a minimum, for compliance audit to improve the control and management of budgetary expenditures. In the meantime, we will develop a timetable for gradually expanding internal auditing to include operational efficiency and effectiveness and initiate its implementation during the first half of 2000. Strengthening Debt Management Capacity Since 1998, we have made significant progress towards building the public debt management structure. The Entity Laws on external debt, consistent with each other and with the State Law on External Debt, were adopted by both Entities. Debt management units (DMU) were established in the State Ministry for Foreign Trade and Economic Relations (MFTER), as well as in each of the two Entities' MOFs. The London Club and Paris Club Agreements on the rescheduling of BiH's external debt to commercial banks and official creditors, respectively, were concluded, thereby wiping out a large part of the debt inherited from the SFRY. An automatic and transparent debt servicing system was established, substantially improving the regularity of debt service payments; a comprehensive foreign debt tracking system was established in the State MFTER. Other achievements to date include the signing of: (i) a Protocol on information sharing between the State, the Entities and CBBH to regularize and streamline the exchange of debt-related information between various debt management agencies; and (ii) an Agent Agreement between the State MFTER and the CBBH that acts as the debt servicing agent of the State. The Federation and Republika Srpska also made their first steps to regulate sub-Entity borrowing, whereby local governments are allowed to borrow only externally for investment purposes within a certain limit. The borrowing activity in BiH is currently low due to severely limited financing capacity; a large proportion of our reconstruction needs continue to be financed by international aid flows. In the medium- term, however, as aid-flows and concessional financing diminish, alternative sources of external finance, including borrowing from capital markets, will be a more significant option in financing our reconstruction 14 needs. BiH's access to such external financing will be determined, to a large extent, by the effectiveness and the prudence of its borrowing arrangements. Developing a strong external debt management capacity, therefore, remains an important priority for us during the near term. To achieve this, we are planning to improve the institutional setup and to strengthen borrowing policies and policy coordination between governments, including the development of a policy framework for sub-Entity borrowing. As indicated in the above paragraphs, we have already made substantial progress in creating the legal and institutional setup for external debt management at the State and the Entity levels. We intend to further these achievements during 1999 by developing policy-making, credit-analysis and monitoring functions in the State and Entity DMUs that would promote fiscally prudent borrowing operations. This includes broadening Entity DMU's mandate to manage their debt portfolio, not merely to execute debt service transactions. We recognize that to be able to effectively undertake a policy analysis function, the State and the Entity DMUs must be able to track and control borrowing by lower levels of government and enterprises and evaluate sub-Entity debt for its sustainability. To develop such coordinated approach in public sector borrowing, we plan to develop Guidelines building on the present legislative framework. The Guidelines will establish (i) a comprehensive debt reporting system extending existing reporting procedures to cover debt liabilities of sub-Entity governments, public enterprises, and utilities as well as liabilities of public agencies that have separate budgets such as social security funds; (ii) strong and transparent selection, budgeting and supervision procedures for loans and guarantees; and (iii) procedures for borrowing policy coordination. The Governments of the Federation and Republika Srpska will begin implementing the Guidelines starting in the 2000 budgetary year. Through the implementation of the Guidelines, we particularly aim to enforce ceilings on the amount of annual borrowing allowed for sub-Entity governments as specified in the Entity Budget System Laws. To this end, the guidelines shall establish (i) reporting requirements with sufficient detail on tenns and purpose of loans to enable the DMUs to prepare reliable debt service projections and to control the fiscal risk; (ii) budgeting procedures that will allow for tracking the real value of obligations outstanding; (iii) monitoring criteria that will help track the utilization of loan proceeds and the progress of the project. Likewise, the guidelines shall establish clear procedures for the issuance of State and Entity guarantees concerning external borrowing of sub-Entity governments and enterprises (as allowed by the existing legislation) while prohibiting the issuance of guarantees by sub-Entity governments for certain duration. To facilitate the effective implementation of the guidelines, we shall have created, by the end of 1999, debt databases in each Entities' MoFs (in DMUs) and introduced compulsory reporting procedures for all public sector borrowing. The Entity MoFs will share such data with the State MFTER. In addition, we plan to strengthen policy-coordination between the State and the Entity DMU's in order to harmonize borrowing plans with the country's ability to service its external debt. The separation of borrowing, debt servicing responsibility, and fiscal authority in BiH creates potential for a free rider problem which could be limited by coordination of borrowing strategies. This, in turn, would substantially enhance the creditworthiness of all borrowers, both public and private. The State External Debt Law provides for the establishment of a high-level Debt Advisory Committee, with representation from all State and Entity agencies involved in managing sovereign external debt. In 1996, we created a prototype of this Committee which analyzed the consistency of external debt information and prepared for the external debt renegotiations that took place during the past three years. As the relations with external creditors are regularized, we are planning to proceed with the creation of the Debt Advisory Committee in early-2000. The Committee will gradually assume the functions of piloting the country's debt strategy. We hope that the above elaboration of the program for the reform of our public finance systems has clearly expressed our commitment to modernizing our economy and putting it on a sound and 15 sustainable path to growth and prosperity. The continued contribution of the World Bank together with other agencies is an essential part of this difficult endeavor. Mr. Mirsad Kurtovic Minister Foreign Trade and Economic Relations snia and Herzegovina Mr. F ŹBicakcic Mr. Mi:orad Dodik ri5e Minister 7' Prin . M;Q der Fe 0 Rep14ka Sesra Mr. ra Cavic Mr. Novak Kondic Dpep y ister and/ Minister l\ Miryastor R ELeRubeIka Srpska Fede Mstyofnc XXFinance 16 ANNEX III HEALTH FINANCE REFORM PROGRAM Introduction 1. This Annex presents a summary of key issues and objectives for the reform of health sector finance in Bosnia and Herzegovina (BiH). The pre-war system is reviewed in para 2 which is followed by a review of the post-war situation, including legislative framework and support provided by IDA and other donors to Government's reform efforts. The annex concludes with priority tasks to ensure a successful reform of health sector finance. The pre-war situation 2. Estimates of pre-war total health expenditure vary. According to the Federation Ministry of Health (MOH), in 1991 it was about US$245 per capita, or 8.2 percent of GNP'. This was on the high side of the range encountered in the region of Central and Eastern Europe. Until the early 1990's, the health system in BiH was financed through governmental institutions called "self-management communities of interest" (SIZ). These provided health insurance, social security and disability benefits to employees and their families. Insurance revenues were obtained from compulsory contributions from employers and employees (gross salaries), pensions and other personal incomes at an average rate of about 9-12 percent, as well as through contributions paid by farmers. The health sector was already facing a trend of expenditures in excess of revenues before the war. The post-war situation2 3. The total health expenditure was DEM420 million (US$280 million), of which 86 percent was in the Federation. Expenditures exceeded income in both Entities. The actual overspending was larger in the Federation, but was greater in proportion to income in RS. Consolidated overspending was US$11 million. Consolidated expenditures were 7 percent of GDP. Actual expenditures may be higher, the Health Resource Account under-estimated the value of out-of-pocket payments made for private health services and some co-payments in the public sector. Health expenditure per capita has declined from DEM364 (US$245) in 1990 to DEM1 13.5 (US$75) in 1997. 4. Policies, legislation and regulations. For clarity in examining the main issues regarding health care financing and payment mechanisms, it is important to distinguish among the following three: * Revenue generation, structure and efficiency of the proposed finance regime: Health services may be financed largely through general revenues, payroll taxes, user fees, or some combination of all three. The Government of the Federation has already passed a Health Care Law in 1997 (i.e. health insurance legislation), which becomes the practical starting point for discussions and possible amendments. A Health Insurance Law is under preparation in RS. * A politically acceptable and effective system for establishing solidarity based health finance system between cantons in the Federation and regions in the Republika Srspka. This is required Source: Federation Ministry of Health: Strategic Health System Plan (Draft). 1998. 2 Source: Unless otherwise specified, materials contained in this section were obtained from the Health Resource Accounts in Bosnia and Herzegovina - Report of the methodology and results from the pilot year, 1999. It was produced with technical assistance from the U.K. Department for International Development. The data were for 1997. if the poorer cantons or regions are to be able to afford essential health services. It is also a source of political tension. Management of health services within each canton or region. There is a need to examine the statutes, regulations and tools to ensure an effective balance between Entity-level responsibilities for setting policies, standards and guidelines, and cantonal- or regional- level responsibilities for management of services. 5. Health sectorfinance in the Federation. The Federation MOH in 1998 prepared a "Strategic Health System Plan", in consultation with Cantonal MOHs and with support from the World Health Organization. This document identifies in broad terms key health sector goals of universal access, equity and efficiency'. Furthermore, the Federation MOH has issued in December 1998 a more detailed "Policy and Strategy of Health Financing Reform in the Federation of Bosnia and Herzegovina"4. It was prepared with support from EU-PHARE, the World Bank and the Government of the United Kingdom. In this comprehensive document, the Federal MOH specified its commitment and implementation plan for a successful health finance reform, with the following objectives: (i) to establish a uniform health care system in the Federation which will be based on the cantonal organization as opposed to the ethnic one; (ii) to develop a sustainable health finance system by means of health insurance and also by mobilizing all available resources in the community for health care; (iii) to control the expenditures at the macro level; (iv) to develop instruments for the implementation of the health policy objectives through the contracting process; (v) to improve institutional efficiency; (vi) to promote the principles of solidarity; and (vii) to promote pluralism in ownership patterns. In particular, the document has considered the issues of federal solidarity, priority setting in health care, equity, advantages of decentralization and economies of scale. 6. The Federation Law On Health Care of 1997 envisages a canton-based extra-budgetary health insurance system, financed by earmarked payroll tax contributions. Recognizing that such a system will lead to undesirable small risk pools, it also provides for the creation of a Federation level health insurance fund, responsible for certain joint health care functions. To date, progress in establishing this system has been modest. Cantonal extra-budgetary health insurance funds were to be created by February 1998, but only a few cantons have established such funds. Several cantons continue to deposit health care contributions in the general cantonal budget, with a lack of clarity in resource flow and allocation. In some mixed cantons, certain municipalities are covered by cantonal funds other than the one in which they are resident. This is contrary to the 1997 Law On Health Care and the Dayton Accords. As for the Federation level structure, the Federation Health Insurance Fund was established, and its Director was appointed in December 1998. Nonetheless, both the services to be provided by the fund and financing sources have yet to be specified. 7. The effectiveness of this system in reducing the existing wide variations across cantons in access to health services, and in enhancing the overall health service delivery in Federation, critically depends on the design of the Federation level Insurance Fund. The Fund is expected to undertake a major responsibility in: (i) ensuring that all eligible residents of the Federation have access to basic health care services; (ii) financing services with Federation-wide benefits, such as eligible tertiary care services and highly specialized services that can only be delivered effectively in a limited number of locations for a larger risk pool; and (iii) providing technical and managerial assistance in operation of the cantonal health insurance funds, including centralized procurement of medical supplies. 3 Source: Federation Ministry of Health: Strategic Health System Plan 1998 4 Source: Federation Ministry of Health. Policy and Strategy for Health Financing Reform in the Federation of Bosnia and Herzegovina. Sarajevo. December 1998. 2 8. To effectively undertake these functions, the Fund must have an effective lead role for technical support in the health system, as well as sufficient financing resources. The resource base of the Fund is currently envisaged to constitute no less than one-fifth of the total health contributions. The Federation government also needs to determine an affordable package of basic health care services that will be provided across the Federation, with options for additional services to be financed at the cantonal level. The technical work towards this was initiated with assistance from the World Bank under the Health Finance Reform Component of the Essential Hospital Services Project and is being supported by the Health Finance Project of EU-PHARE, and by the Government of the United Kingdom. The Federation is considering taking the actions necessary to complete the establishment of cantonal funds and to specify the parameters of the Federation fund before the end of this year so that health contributions can start flowing into the cantonal funds and the Federation fund can start operating in the new fiscal year. 9. Health care finance in Republika Srpska. The health care system in the Republika Srpska is being financed mainly by payroll taxes, as is the case in the Federation. There are also transfers from the budget to bridge any critical financing gaps for the provision of basic health services. The Republika Srpska government is considering introducing new Health Insurance Law in 1999. The draft statutes include provisions for a "solidarity fund" to promote risk pooling. Coverage of the insured would include a "basic minimum package of services", which is currently being defined, as well as eligible tertiary health services and vertical programs of public health importance. A major challenge is to implement incentives and sanctions to improve collection. 10. The subject of a "basic package" of services needs to be treated with caution in both Entities. Although it was advocated by the World Bank in the 1993 World Development Report, its implementation is fraught with serous risks of failure. From a social and political perspective, the public is highly unlikely to give up what it has theoretically been entitled tofiree of charge. Therefore, the implementation of a system emphasizing health gains through cost-effective services would not be enabled by a mechanistic definition of positive and negative lists of services. It would be enabled by the use of management tools and incentives to influence the behaviors of service providers and consumers. Such tools and incentives would encourage the delivery and use of more cost-effective services through the use of epidemiological information, cost-effectiveness, health technology assessment and business planning, the refinement and use of essential drug lists, rational use of drugs, targeted interventions, as well as a careful introduction of formal co-payments where appropriate. Health Finance Reform 11. The Government of each Entity is working with the World Bank, EU-PHARE and DFID to achieve the objectives of defining sector policy and strategic plans. The near-term objectives include the completion of the following in each Entity: (i) a detailed revenue and expenditure study of the health sector, with the preparation of a National Health Account; (ii) studies on developing approaches to priority setting in health; and (iii) policy documents, strategic plans and indicative timelines for a phased approach to the rationalization of infrastructure and reform of management systems throughout the health sector. 12. The main themes of the ongoing work are as agreed with the Entity Governments under the Essential Hospital Services project [IDA(ITF) Credit Number N003-0 BOS, Document Number T-699 1- BiH, Appendix 12, paragraph 4.3.1.]. Recent major activities include a six-day workshop and study tour to the Netherlands, and a three-day study tour and workshop in Slovenia for technical experts and policy makers from both Entities. The workshops were organized jointly by the EU-PHARE Health Finance Program and the World Bank. Drafts of the policy papers were completed in the Slovenia workshop in the middle of December 1998. At this workshop, Ministers of Health and other representatives of both Entities also agreed to establish a Committee for Inter-Entity Coordination, to address health sector issues 3 where joint work is necessary or desirable. The Basic Health Project, approved by the World Bank on May 4, 1999, will support implementation of incentives and changes in provider payment methods to increase productivity and to control costs in primary care. 13. More specifically, the following are the near-team tasks in support of health finance reform: In order to strengthen the basis for strategic decisions in the health sector, the following will be completed in both Entities by December 1999: (i) A comprehensive Health Account: Each Entity has already completed a Health Account, covering public sector revenues and expenditures. During the second half of CY99, a study of private, out-of-pocket expenditures will be done, to provide a complete Health Account for each Entity. (ii) Studies on feasible approaches to priority setting in health services: This will include considerations of the most effective approach to implementing a basic package of health services in each Entity. It will consider technical and social factors to ensure a successful implementation. Management tools and incentives will be developed to encourage the use of more cost-effective health services and to discourage the use of less cost-effective health services. (iii) A study of public expectations, understanding and perceptions of the health system. This information will enable the health system to be more responsive to the needs of the population. * Preparations are underway for these tasks, with support from the World Bank, the Government of the United Kingdom and the Health Finance Project of EU-PHARE. • By December 1999, in the Federation, establishment of the Cantonal Health Insurance Funds as provided for in the 1997 Law On Health Care. In this regard, the Federation Government and the Cantonal Governments will develop, by September 1999, essential guidelines to facilitate operations of the Cantonal Health Insurance Funds, with reference to: (a) revenue collection from extra-budgetary taxes earmarked for health and (b) transparency in the flow of funds. * By December 1999, in the Federation, development of guidelines to facilitate operations of the Federation Health Insurance Fund, with reference to the following: (i) Solidarity: The objectives are to: (i) ensure that all eligible residents of the Federation have access to basic health services; (ii) cover the costs of eligible tertiary services; and (iii) cover the costs of vertical programs of public health significance, for example, tuberculosis control. (ii) Source of revenues for the Federation Health Insurance Fund: Revenues for the Federation Health Insurance will be derived from payroll taxes. In principle, this could be up to 20 percent of cantonal insurance revenues, as defined in the 1998 "Policy and Strategy for Health Financing Reform in the Federation of Bosnia and Herzegovina", and as agreed during a meeting of representatives of the Federation Ministry of Health, Federation Health Insurance Fund, Cantonal Ministries of Health and Cantonal Health Insurance Funds on April 21, 1999. (iii) Technical and managerial support to be provided by Federation Health Insurance Fund (as the lead agency on health finance) to the Cantonal Health Insurance Funds. This will include centralized procurement of specified medical supplies, to explore economies of scale. 4 Adoption, by the Government of the Federation, of amendments to the 1997 Law On Health Care, to provide a legal mandate for the funding, operations and functions of the Federation Health Insurance Fund. We will ensure that this is achieved by June, 2000. By December 1999, in Republika Srpska, the Government will develop guidelines to enable effective operations of the Republika Srpska Public Health Insurance Fund and the four Regional Branches. Guidelines will establish: (i) procedures for improving transparency in budgeting and usage of health contributions; (ii) incentives/sanctions to improve collection; (iii) procedures for strengthening coordination between the central fund and its branch offices; and (iv) prototypes of contracts to guide the purchasing of health services. 5 ANNEX IV Page 1 of 3 Table 1: Bosnia and Herzegovina - Key Economic Indicators Estimate Projected Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 National accounts (as % GDP at current market prices) Grossdomesticproduct 100 100 100 100 100 100 100 100 100 100 100 Agriculture Industry Services Exports (GNFS)' 20 24 29 33 34 34 35 35 36 36 36 Imports (GNFS) 71 83 76 70 59 54 50 46 43 41 40 Memorandum items Grossdomesticproduct 1867 2741 3423 4082 4533 5333 6262 7090 7731 8386 9080 (US$ million at current prices) Real annual growth rates %, calculated from 1995 prices) Gross domestic product at 69 30 18 8 14 14 10 6 5 5 market prices Real annual per capita growth rates (%, calculated from 1995 prices Gross domestic product at 28 17 7 13 13 9 5 4 4 market prices Balance of Payments (US$m) Exports (GNFS)a 381 658 1002 1367 1541 1816 2162 2498 2796 3044 3293 Merchandise FOB 152 336 575 817 955 1131 1387 1628 1843 2008 2169 Imports (GNFS)a 1334 2278 2606 2864 2659 2863 3124 3234 3358 3460 3596 Merchandise FOB 1082 1882 2333 2573 2397 2586 2826 2935 3051 3152 3278 Resource balance -953 -1620 -1604 -1498 -1118 -1047 -962 -736 -562 -416 -303 Netcurrenttransfers 1002 1094 772 510 311 281 245 210 170 104 37 (including official current transfers) Current account balance -193 -748 -1060 -1127 -896 -879 -831 -640 -504 -424 -350 (after official capital grants) Net private foreign direct 0 0 0 100 60 162 185 200 200 200 200 investment Long-term loans (net) -271 439 12 43 24 117 190 146 144 96 39 Other capital (net, including 578 542 959 1015 944 648 528 390 242 182 161 errors and omissions) Change in reservesb -114 -232 89 -31 -132 -48 -72 -96 -82 -54 -50 (continued) ANNEX IV Page 2 of 3 Table 1: Bosnia and Herzegovina - Key Economic Indicators (Continued) Projected Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Memorandum items Resource balance (% of -51 -59 -47 -37 -25 -20 -15 -10 -7 -5 -3 GDP at current market prices) Real annual growth rates (1995 prices) Merchandise exports 155 78 40 14 15 19 14 10 6 5 (FOB) Merchandise imports S0 40 1I -10 5 6 1 1 0 1 (CIF) Public Sector Balances (as % of GDP at current market prices) Expenditures 36 78 56 52 48 48 47 44 43 42 40 Revenues 29 51 31 32 31 35 36 37 38 38 38 Deficit (-) -7 -27 -25 -20 -17 -13 -11 -7 -5 -4 -2 External Financing 7 27 23 20 17 13 11 7 5 4 2 Others, incl. Arrears 0 0 -2 0 0 0 0 0 0 0 0 Monetary indicators M2/GDP (at current market 21 28 34 .. .. .. .. .. prices) Growth of M2 (%) 9 96 52 .. .. .. .. .. Price indices(1995=100) Implicit GDP deflators (% change) Federation -40.4 9.1 13.7 2.0 .. .. .. .. .. Republika Sirpska 53.1 -35.7 -0.4 9.8 .. .. .. .. .. a. "GNFS" denotes "goods and nonfactor services." b. Includes use of IMF resources. Source: Official data and staff estimates. ANNEX IV Page 3 of 3 Table 2: Bosnia and Herzegovina - Key Exposure Indicators Projected Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total debt outstanding and disbursed (TDO) (US$m)a 3360 3884 4343 2879 3264 3632 3983 4289 4535 4758 4950 Netdisbursements(US$m)' 231 135 211 128 198 198 114 104 88 77 Total debt service (TDS) (US$m)' 513 573 385 122 117 152 151 162 170 177 168 Debt and debt service indicators (%) TDO/XGS' 882 590 433 211 212 200 184 172 162 156 150 TDO/GDP 156 117 127 71 72 68 64 60 59 57 55 TDS/XGS 135 87 38 9 8 8 7 6 6 6 5 Concessional/TDO .. .. .. .. .. .. .. .. IBRD exposure indicators (%) IBRD DS/public DS 14 2 9 29 37 29 30 43 41 39 40 Preferred creditor DS/public DS (%)e 22 3 10 33 62 41 47 78 68 48 45 IBRD DS/XGS 19 2 3 3 3 2 2 3 2 2 2 IBRD TDO (US$m)d 623 596 596 596 596 596 604 594 589 584 560 Share of IBRD portfolio (%) 0.5 0.5 0.5 .. .. .. .. .. IDA exposure indicators (%) IDA DS/public DS .. 0.0 0.5 2.5 3.5 3.2 3.7 3.8 3.9 3.8 4.2 IDA DS/XGS .. 0.0 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.2 0.2 IDATDO (US$m)d .. 191 291 433 533 633 723 803 863 913 913 IFC (US$m) Loans 15 15 8 .. .. .. .. .. Equity and quasi-equity' 0 0 0 .. .. .. .. .. MIGA MIGA guarantees (US$m) 0 0 0 .. .. .. .. .. a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short-term capital. After debt rescheduling. b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d. Includes present value of guarantees. Source: Official data and staff estimates. MAP SECTION IBRD 28578R 16 To Zagreb 1 8 To Osijek TO ZaToZgreb CROATIA To Vinkovci ToPrOsipjek To KI. 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