Document of The World Bank FOR OFFICIAL USE ONLY Report No: 26040 IMPLEMENTATION COMPLETION REPORT (TF-23344; TF-23282; IDA-32580) ON A CREDIT IN THE AMOUNT OF SDR53.2 MILLION (US$72 MILLION EQUIVALENT) TO BOSNIA AND HERZEGOVINA FOR A SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT JUNE 2, 2003 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective jUNE 2, 2003) Currency Unit = Konvertible Marka KM = US$ 0.60 US$ = 1.67KM FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS CAS Country Assistance Strategy CEM Country Economic Memorandum ESW Economic and Sector Work EU European Union GDP Gross Domestic Product ICR Implementation Completion Report IDA International Development Agency LDP Letter of Development Policy LSMS Living Standards Measurement Survey OHR Office of the High Representative PFSAC Public Finance Structural Adjustment Credit PFSAC II Second Public Finance Structural Adjustment Credit PRSP Poverty Reduction Strategy Paper RS Republika Srpska TA Technical Assistance SDR Special Drawing Rights Vice President: Johannes F. Linn Country Manager/Director: Orsalia Kalantzopoulos Sector Manager/Director: Cheryl W. Gray Task Team Leader: Saumya Mitra BOSNIA-HERZEGOVINA PFSAC 2 CONTENTS Page No. 1. Project Data 2. Principal Performance Ratings 3. Assessment of Development Objective and Design, and of Quality at Entry 4. Achievement of Objective and Outputs 5. Major Factors Affecting Implementation and Outcome 6. Sustainability 7. Bank and Borrower Performance 8. Lessons Learned 9. Partner Comments 10. Additional Information Annex 1. Key Performance Indicators/Log Frame Matrix Annex 2. Project Costs and Financing Annex 3. Economic Costs and Benefits Annex 4. Bank Inputs Annex 5. Ratings for Achievement of Objectives/Outputs of Components Annex 6. Ratings of Bank and Borrower Performance Annex 7. List of Supporting Documents Project ID: P055432 Project Name: PFSAC 2 Team Leader: Saumya Mitra TL Unit: ECSPE ICR Type: Core ICR Report Date: June 9, 2003 1. Project Data Name: PFSAC 2 L/C/TF Number: TF-23344; TF-23282; IDA-32580 Country/Department: BOSNIA AND HERZEGOVINA Region: Europe and Central Asia Region Sector/subsector: Central government administration (50%); Other social services (13%); Compulsory pension and unemployment insurance (13%); Health (12%); Sub-national government administration (12%) Theme: Tax policy and administration (P); Public expenditure, financial management and procurement (P); Other accountability/anti-corruption (P); Social risk coping (S); Decentralization (S) KEY DATES Original Revised/Actual PCD: 01/21/1999 Effective: Appraisal: 03/30/1999 MTR: Approval: 06/24/1999 Closing: Borrower/Implementing Agency: GOVERNMENT OF BOSNIA AND HERZEGOVINA/MIN. FIN. BH; GOVERNMENT OF BOSNIA AND HERZEGOVINA/MIN. FIN. FEDERATION Other Partners: STAFF Current At Appraisal Vice President: Johannes F. Linn Johannes F. Linn Country Director: Orsalia Kalantzopoulos Christiaan J. Poortman Sector Manager: Cheryl W. Gray Pradeep K. Mitra Team Leader at ICR: Saumya Mitra Sebnem Akkaya ICR Primary Author(s): Saumya Mitra; Jean-Luc Bernasconi; Irina Smirnov 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome:S Sustainability:L Institutional Development Impact:H Bank Performance:S Borrower Performance:S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The overall objective of the Public Finance Structural Adjustment Credit-II was to help create the conditions for sustainable economic growth through a strengthening of public finances. Reform of public finances was seen as vital to establishing the credibility of policies to undertake successfully the transition to a market economy, complete the recovery from the conflict of 1992-95, and lay the basis for a robust private sector supply response. Strengthened fiscal capacity was also the cornerstone on which country creditworthiness was to be built. The specific objectives of the public finance reform programme supported by PFSAC-II were: (i) strengthened domestic resource mobilization, through improved policy and administrative coordination both between and within the Entities of Bosnia and Herzegovina -- the Federation of Bosnia and Herzegovina and Republika Srpska; (ii) the introduction of strategic public resource allocation, including through investment planning; (iii) the improvement of revenue and expenditure assignments at different levels of government and, hence, more efficient provision of public services within the Entities; (iv) the creation of a fiscally viable social safety net with a greater focus on poverty alleviation in the transitional period till the resource base of the system was strengthened to allow provision of comprehensive social assistance; (v) the setting up of institutional and regulatory frameworks for improving transparency and accountability of government finance; and (vi) the strengthening of country-wide policy coordination in external debt management, including developing a policy framework for sub-Entity borrowing. The Reform Strategy Context. The project's objective was framed in the context of the need to build Dayton-mandated institutions in public finance at both the level of the state and its two constituent entities and to strengthen public finance policies so as to reap gains in efficiency on both the revenue and expenditure sides. It also built upon the achievements of the first Public Finance Structural Adjustment Credit (1998-99) under which basic public finance policies and institutions had been established. Under the Dayton peace settlement (December 1995), Bosnia and Herzegovina was organised as a highly decentralised country. The responsibility of the sovereign state was limited to international relations and inter-Entity coordination. Its economic powers were confined to operating a central bank (organized as a currency board) with a new currency, setting customs and trade policies, conducting international financial relations (including servicing of international debts and debt management) and coordination in telecommunication and transport; no tax-raising powers were provided. In contrast, the Entity governments had exclusive responsibility in their respective territories over practically all matters of public policy (except, as noted above, those of the State) and public administration; specifically in the economic sphere, over taxation, customs administration, and all public spending. The Entities themselves were considerably decentralised -- the Federation particularly so with a three-tier fiscal system: the Federation government, cantons, and municipalities, with major expenditure responsibilities resting with the cantons; the - 2 - RS had a two-tier structure: the entity government and municipalities, with limited local fiscal authority. Achievements by project initiation. In the first three years of peace (1996-98), Bosnia and Herzegovina made rapid progress in the reconstruction of its economy and infrastructure. It also took strides towards fulfilling the Dayton framework for setting up public institutions and putting in place economic policies designed to progress to a market economy. Donor engagement in the form of funds for investment and technical assistance was massive and there was intense external engagement also in providing political guidance and support to the State and Entity governments. By mid-1999, when PFSAC-II was approved, key institutions and policies were in place. The central bank was functioning highly efficiently and had issued a convertible national currency in a liberal regime for external payments; legislative and regulatory frameworks for the banking sector and for bank and enterprise privatization were in place; a liberal trade regime had been enacted, with a low, uniform customs tariff. Specifically on public finances, the financing means and mechanisms for the institutions of the State had been agreed, a legislative framework for budget management and an institutional and legislative framework for debt management were functioning at the level of the State and the Entities, steps towards a reform of pension systems had been initiated, and first measures towards harmonization of tax systems across the Entities had been taken. These public finance reforms were supported by PFSAC-I. Significant progress has also been achieved in removing barriers to the movement of goods and people within the country. The reform vision. Strengthened public finances were seen as a key instrument for ensuring the viability of Bosnia and Herzegovina in several senses. First, there was the need to build up a sense of nationhood and national unity through supporting the state, improving inter-Entity cooperation and creating a common restriction-free economic space throughout the land. Second, large efficiency gains were envisaged through improvements in tax policies, tax administration and tax harmonisation between the Entities as well as by raising standards in the provision of essential public services, notably health and pensions, and in ensuring their sustainability. Third, the enhancement of transparency and accountability through budget system, audit, and debt management reforms was designed to increase public confidence in governance and to fight corruption. The reform vision encompassed paving the way for a self-sustaining government sector that would rely on its own resources and institutions in designing and implementing the policies required for long-term development as donor support was gradually wound down. Moreover, an efficient and light system of taxes, a liberal customs regime, efficient provision of needed public goods, and Entities working in close economic cooperation to create the environment for private investment were also envisioned. Much remained to be done in building a framework for sustainable fiscal management. In the Federation, the customs, tax and the payments systems continued to be fragmented reflecting the war-time division on ethnic lines, but a start had been made in unifying tax policies and progress has been achieved in establishing canton-level fiscal administration. However, co-ordination between Entity and local governments was weak. In summary, fragmented policies and practices largely continued within the fiscal structure of the Federation. The Republika Srpska had barely - 3 - initiated basic fiscal reforms. At the State level, the institutional and legislative framework envisaged by the Dayton Accords had begun to function, but cooperation between the Entities in key areas of economic management was absent or weak. For Bosnia and Herzegovina to start functioning as a unified State these initial efforts toward policy harmonization and coordination needed to be deepened and strengthened. Therefore, the key challenge faced by the country was deepening structural reforms in public finances. The Credit aimed to assist the authorities in meeting this challenge by supporting further effort in institution-building and policy reforms in (i) broadening tax policy harmonization and strengthening administrative co-operation between the Entities; (ii) improving equity in the provision of public services; (iii) developing an affordable social safety net; (iv) improving fiscal efficiency and control; (v) establishing audit institutions; and (vi) strengthening country-wide policy coordination in external debt management. Macroeconomic Framework The economic recovery of Bosnia and Herzegovina since the end of the war has been impressive and has been accompanied throughout by solid macroeconomic performance. The institution of a currency board arrangement underpinning a convertible local currency ensured monetary stability and a low rate of inflation; currently inflation is around zero. The requirement to balance budgets on a cash basis (excluding donor financing) imparted fiscal discipline. Discipline in public finances has also been assisted by a radical strengthening of the banking regulatory regime and by the privatisation of banks and closure of inadequately capitalised ones. As a result, substantial re-monetization of the economy has taken place. Small enterprise privatisation is all but complete. The trade and customs regime has been liberal and progress on market-oriented structural reforms has taken place, if at too slow a pace. Internal formal and informal restrictions on the free movement of goods, capital and labour across the entities have been removed, and inter-entity commerce has boomed. - 4 - 1997 1998 1999 2000 2001 2002 Real GDP Growth (% p.a.) Actual /Est 36.60 15.60 9.60 5.50 4.50 3.80 Est./Projected .. .. 8.00 14.00 14.00 10.00 Real Export Growth (% p.a.) Actual /Est 78.00 40.00 13.00 6.00 3.20 4.37 Est./Projected .. .. 14.00 15.00 14.00 14.00 Fiscal Balance (%of GDP) Actual /Est (25.00) (20.00) (9.10) (10.00) (5.80) (4.30) Est./Projected .. .. (17.00) (13.00) (11.00) (7.00) Current Account Balance (% of GDP) Actual /Est (47.00) (37.00) (8.20) (12.50) (15.50) (19.00) Est./Projected .. .. (25.00) (20.00) (15.00) (10.00) Gross External Debt (% of GDP) Actual /Est .. 64.70 68.20 64.60 53.30 47.20 Est./Projected .. .. 72.01 68.10 63.61 60.49 Inflation (% p.a.) Actual /Est 10.00 3.00 3.40 5.10 3.10 0.30 Est./Projected .. .. .. .. .. .. Generous donor financing of the reconstruction and public investment budget has been instrumental in supporting economic growth. After GDP growth averaging over 60 per cent in the first two post-conflict years, growth slowed to 10 per cent in the late 1990s and has recently been averaging around 4 per cent. External debt write-offs of around 70 per cent in net present value terms from both bilateral and commercial creditors have freed up resources for internal spending. As donor support has taken the form of grants, external debt indicators remain comfortable: total external debt service in relation to exports of goods and non-factor services ranges at 8-10 per cent. This encouraging macroeconomic performance has taken place with the support of IMF arrangements since the end of the conflict. At PFSAC-II approval, Bosnia and Herzegovina was in the middle of a two-year standby arrangement for SDR94 million. Upon the expiry of this successful arrangement, a 15 month standby for SDR68 million was agreed and Bosnia and Herzegovina remains in compliance with its undertakings under the arrangement. Macroeconomic performance has also been underpinned by public finance reforms (described earlier) under Bank credits and Fund programmes, by improvements in the climate for investment and by privatisation -- also part of Bank support. In addition, the country has received copious technical assistance from the Bank, the Fund and bilateral partners in practically all spheres of the economy. Despite the record of continued macroeconomic stability, pursuit of structural reforms, and large scale donor assistance, job creation remains the Achilles' heel of the economy and poverty is widespread. Growth has dented unemployment insufficiently -- the rate of unemployment remains around 40 per cent; adjusted for informal sector activities, unemployment is, perhaps, of the order of 20 per cent. The LSMS study shows that 20 per cent of the population are poor. The poor are disproportionately present in small towns and villages and long term displaced persons and refugees are at significantly higher risk. At high risk are also the young, the poorly educated, and - 5 - families with only one earner. Over the medium term, macroeconomic vulnerabilities will arise as the country faces the challenge of supplanting external support (with a winding down of extraordinary donor assistance) with domestic resources, whilst reducing the extremely high share of public expenditures in GDP (around 60 per cent) and also trimming the tax burden (around 50 per cent) that is required to release resources to the private sector. Both these ratios are excessive by any standards and are not consistent with macroeconomic stability over the medium term. Some of the adjustment will be assisted by the termination of the reconstruction-type investments, but a strong effort at expenditure reduction will, nonetheless, be required to preserve macroeconomic stability and keep debt indicators within prudent bounds. Indeed, Bosnia and Herzegovina faces the twin challenges of sharply cutting public spending whilst raising the quality of public spending. A sharp reduction in spending on wages and goods and services is required hand in hand with civil service reform to reduce the public sector payroll and direct staff to high priority managerial activities. Defence and veterans expenditures are also far too high. Room will also have to be found for normal investment in public goods, adequate operations and maintenance, for making good some implicit or contingent liabilities of the government, and possibly for social assistance. Moreover, expenditure demands will arise from one-time (but significant) costs associated with accelerated refugee returns, military demobilisation, and downsizing public enterprise operations. The major gains in the quality, i.e., efficiency and equity, in public spending will have to come in the social sectors. Unit costs in education (extremely high by international comparisons) need to be reduced through reforms and the cost of social spending (health, education, social assistance, pensions) will have to be kept within the resource envelope, whilst significant efficiency and equity gains will have to be sought. Greater private sector participation in service delivery and privatisation of large enterprises and utilities are required to support medium term fiscal adjustment. These actions will reduce pressures on public spending, while tax revenues can be expected to benefit from efficiency improvements. The reforms supported by PFSAC-II have set the stage for the medium term fiscal adjustment task. Clarity and Realism of Objectives The PFSAC-II was undertaken under the aegis of FY98-99 Country Assiatance Strategy (CAS), as updated by the July 1998 CAS Progress Report (IDA/R98-111). In their Policy Statement of mid-1998, the authorities identified their highest priority as the reduction of unemployment through the pursuit of (i) macroeconomic stability; (ii) public finance reform; and (iii) private sector development. The CAS was designed to support these objectives and it identified inter-entity cooperation as key to driving the implementation of the development agenda. The CAS Progress Report elaborated on the then-planned PFSAC-II, focussing on the contribution discipline in public finances would make to the overall structural reform programme. The project as approved and implemented was fully in line with the CAS. - 6 - The project objectives were articulated clearly and were of central relevance to Bosnia and Herzegovina's objective of consolidating economic recovery. The expectations for the achievement of project objectives were realistic. The objectives were precise in their formulation and the relationships to their supporting reform components were clearly explained. The links to the overarching public policy goals -- strong, self-sustained private sector led growth leading to a fall in unemployment -- were delineated and discussed in project documents. Nevertheless, the project could have provided a better sense of the priorities within the objectives and the related reform components. Clearly, not all objectives were of equal weight or value; moreover, the trade-offs between them could have been more explicitly identified. Similarly, a discussion might have been provided of, for example, why reform steps in health were included but not education in social sector reforms, though education faced equally serious problems and project preparation had studied the education sector. The documentation should also have elaborated on the medium term fiscal constraints faced by Bosnia and Herzegovina and built them in into the design. The high degree of relevance of the project can be seen from the fact that the Policy Statement of the authorities of the State and the Entities had considered the PFSAC-II supported reforms as a key pillar. The sound realism of the objectives arises from the achievements of the earlier operation, PFSAC-I that was fully complied with and disbursed within one year. The authorities had already taken some of the key actions prior to Board presentation of PFSAC-II and had continued to demonstrate their commitment to following through. Critical among these actions were entity implementation of State-set tariffs and elimination of special trade agreements of each, entity equalisation of excises on domestic and imported goods, rationalisation of tax exemptions, design of Federation legislation on pension fund unification, establishment of entity working groups on budget system reforms, and, by project effectiveness, design of entity legislation on setting up audit institutions. The project was also prepared and appraised at a time of significantly improving inter-entity cooperation, notably in the fiscal field, and a strong, coordinated donor effort to provide political and financial incentives for bolstering cooperation. The reform agenda supported by the operation was ambitious in its scope covering diverse elements within public finances and the timetable for project implementation was equally ambitious. This tight timetable imparted an internal discipline to maintain the reform momentum on a wide front, but, in the event, the totality of reforms needed an additional year for completion. Looking at the overall reform achievements, a period of three and a half years to complete successfully a wide-ranging and ambitious reform agenda such as the one supported by PFSAC-II clearly cannot be faulted as being too long; indeed, it stands up well to international comparison. Evaluation of Benefits and Risks The major benefits of the operation were identifed as the consolidation of the public finance reforms began under the PFSAC-I, thereby substantially strengthening the prospects for continued fiscal stability; adding to the sustainability of the structural reform process; and the reintegration of the economy. The reforms would 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. They would facilitate development of a robust intergovernmental system and improve efficiency and coverage of public - 7 - sector services. Medium-term imbalance between revenues and expenditures would be corrected and public outlays would reflect priorities more closely. Benefits would also arise from improvements in the financial viability and targeting of the pension system, the design of an equitable and sustainable social safety net, and greater equity in the provision of health services in both Entities. Finally, the institution of sound auditing procedures was expected to enhance accountability of public service operations. These envisaged benefits have been realized. As noted, fiscal stability was maintained, overall tax revenues rose and tax administration was strengthened, but, clearly, there is a major task of medium term fiscal adjustment that lies ahead. The reforms supported by PFSAC-II were key to the entire structural reform programme as given in the Policy Statement of the authorities of mid-1998; without these measures, other reforms relating to private sector development and privatisation and social sector modernisation would have foundered for lack of fiscal stability. These measures were also central to the re-integration of the economy and the creation of a common economic space free of distortions, unwarranted tax competition, and losses in revenues owing to lack of inter-entity cooperation. Finally, they served an important political economy objective in fostering the conditions for inter-entity dialogue on economic policy matters and providing a vehicle for Bank, IMF and donor engagement to reward growing cooperation. An evaluation of the component-specific benefits of the project is contained in the next section. The project identified two major risks, (i) those associated with the country's process of ethnic reconciliation and (ii) those arising from low administrative and institutional capacity within the governments. The project contained elements that were politically sensitive in view of the inter-ethnic differences of views on the division of the role of the state and the entities and, in the case of the Federation, differences in views on the degree of integration of delivery of public goods. Thus, questions such as the need to harmonise tax rates and systems across entities, to put pensions on a fiscally sustainable footing, and, in the Federation, the unification of pension funds and reform in intergovernmental financial relations were contentious. The project sought to mitigate this risk by insisting on up-front actions and on encouraging the consensus-building process through joint actions (e.g., common working groups). Donors were also energised to provide the technical assistance required and the political pressure to support reforms. It was noted that the success of PFSAC-I had required strong commitment and cooperation by the different authorities, and this augured well for the successor project. The second risk was largely addressed through a programme of carefully phased technical assistance from the Bank, Fund and bilateral donors. 3.2 Revised Objective: Not applicable. 3.3 Original Components: 1. Harmonisation of tax policies and coordinating tax collection. 2. Reform of intergovernmental finances within the entities. 3. Reform of the social safety net. - 8 - 4. Modernisation of the budget management system. 5. Establishing auditing procedures and institutions. 6. Strengthening debt management capacity. 3.4 Revised Components: Not applicable 3.5 Quality at Entry: The quality of entry of PFSAC-II is assessed as satisfactory as the project (i) addressed the key priorities of the governments in public finance reform; (ii) was fully consistent with the CAS and the updated Progress Report; (iii) incorporated attentively lessons learned from its predecessor project, particularly on the careful sequencing of reforms, the support required to build consensus, and the need for intensive Bank and other donor engagement in TA, supervision and coordination; and (iv) was designed on the basis of extensive analytical work -- CEM, PER as well as on the individual project components and of institutional capacities and needs --, and the project design also reflected implementation constraints and risks and provided for appropriate flexibility of response. Moreover, the project was prepared with the full participation of the Entity governments and the governments displayed a high level of commitment. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: The overall outcome of the project is judged to be satisfactory in that key objectives were met and the development impact is rated to be substantial. Despite the difficult political environment during project implementation and the risks posed by the political sensitivity of the reform components and weak institutional capacity, the components achieved their goals. Inter-entity harmonisation of tax policies and systems was implemented as envisaged with the outcome of higher revenue yields, greater efficiencies and reduced distortions. Intergovernmental financial reforms have clarified the attribution of revenues and improvements in public service delivery have taken place. Pension funds are financially sustainable and more efficiently administered. Reforms in budget management and the establishment of the audit system have led to clear results: gains in transparency and accountability, closer relationship between priorities of public policy and budgets. Finally, the entities have adopted improved external debt management systems resulting in more secure budget control and oversight, but the guidelines relating to sub-entity borrowing are still to be implemented. The achievements under the operation are likely to be sustainable for a number of reasons. First, the project has been an instrument for deepening the inter-entity dialogue on public finance and has created the policy and institutional conditions for a closer integration of the economy through fiscal reforms. Second, far reaching improvements in tax administration, social service delivery, budget management and accountability affect public welfare tangibly and enjoy popular support. This makes reversion unlikely. Third, the authorities maintain their support for overall structural reforms and a follow up adjustment credit in support of measures to ensure medium term fiscal sustainability and achieve efficiency gains in public spending is envisaged (CAS, 2002). - 9 - Nevertheless, the experience of Bosnia and Herzegovina has shown that though changes in laws and regulations and administrative systems are often difficult enough, the fundamental test of the durability of reforms lies in implementation. Formal reform measures can often be obtained through political pressures or financial incentives from donors, but real ownership can be elusive. PFSAC-II has done a credible job in the ownership battle, and its three tranche structure provided incentives for ownership and performance. Yet, the implementation of some key components or elements of its components is at a nascent stage and strong political support will be required for success. A formidable implementation challenge remains that will have to be addressed by new governments that have just taken office. 4.2 Outputs by components: 1. Harmonization of tax policies and coordinating tax collection -- rated satisfactory. At project initiation, the Entities had differing sales and excise tax rates and structures, differing customs tariffs and trade practices, excise taxes differed as to origin of goods, tax collection was poorly coordinated and excise taxes collected at the wholesale level were not passed on to the destination of the consumer. There were, thus, powerful incentives for wasteful tax competition, distortions were created within one country from varying tax rates and tax practices, revenue attribution was not related to the point of final consumption, and tax avoidance or evasion was facilitated. It was clear that sustained and efficient growth could not take place under such highly distorted fiscal conditions. Supported by the project, the authorities undertook to harmonize tax systems and rates, to simplify and apply the state-mandated external tariff system, to abolish discriminatory trade practices (including customs arrangements of the Federation with Croatia and of the RS with Yugoslavia), to agree on allocation of tax revenues based on destination of goods, and to strengthen cooperation between tax administrations so as to make the reformed system effective. During project implementation, the district of Brcko was declared to be under international supervision and its separate tax system had to be provided for within the project. It is a major achievement of the project that this ambitious set of reforms was fully achieved. These actions were politically sensitive as they lay at the heart of the the issue of the autonomy of entities as prescribed in the Dayton accords and nationalist-oriented politicians were not eager to cooperate with one another. Progress in achieving these reforms was fitful, slower than expected, and required strong interventions from donors. Today, sales and excise tax rates are fully harmonised, no differential excise tax rates exist, a common external tariff and trade regime is applied, revenue attribution follows the destination principle and there is encouraging cooperation between the customs, excise and tax authorities. These achievements have required not only legislative changes, but the setting up of mechanisms for inter-entity allocation of sales and excise tax revenues and coordination of tax administrative practices and information sharing. These achievements were facilitated by an intensive provision of TA by the Bank (including through donor financed programmes) and directly by donors. The implementation of the inter-entity allocation mechanism is at a very early stage and will have to be carefully monitored to ensure its effective functioning. The implementation of the allocation mechanism for one important excisable product, tobacco, is proceeding satisfactorily. One - 10 - significant weakness of the harmonised tax system arises from the uneven implementation of its provisions relating to the import of fuel products in the special district of Brcko that is under international supervision. As this causes substantial losses in revenues for both entities, addressing this lacuna is a matter of urgency. Further and continuous work will also be required to improve inter-entity tax administration cooperation and information exchange with the important purpose of fighting tax-related fraud. Through its achievements on harmonisation and building up of tax administration capacity, the project has created the conditions for the eventual introduction of VAT, notably through building up skills in tax administrations and by the institution of tax rebate systems that are an essential building block for a VAT system. Experience in other countries has shown that preparations for the introduction of VAT have to be done with great care and typically require several years. The tax administration capacity can be built on for this purpose. It will be important to avoid a rushed introduction of VAT and to introduce it within an administrative structure that enjoys the full confidence and support of the state and entity governments and the populace as a whole. Otherwise, the risks of substantial revenue losses and a slippage from the achievements of the PFSAC-II supported reforms will be too great. The project was well designed to satisfy the outcomes under this component and clear performance indicators were set out as tranche release conditions. 2. Reforming intergovernmental finances within the entities -- rated satisfactory. In the Federation, efficiency in intergovernmental finances was hampered by an unbalanced allocation of revenues across the cantons as sales taxes on excisable goods and profits taxes were assigned to the point of collection and not related to destination of goods or the location of production. Further, tax exemptions were awarded with little rationale, outside legislative authority, and local revenue capacity was unduly restricted. Public service delivery with geographic spillovers needed to be financed on a sustainable and equitable basis, particularly in health. In the RS, action needed to be taken on tax exemptions and policies developed on improving efficiency in health care finance and service delivery. Significant progress has been recorded in all these areas of action. Both entities rationalised tax exemptions and eliminated those outside the law. In the Federation, the government opted for moving the attribution of sales taxes on excisable commodities as well as its collection to the retail level. This also led to harmonised points of collection between the entities. However, the change in point of collection to retail has led to significant revenue losses. Although the eventual introduction of VAT will automatically solve the level of collection problem, consideration is being given in the intervening period to moving the collection to the importer/manufacturing level (as has been done for the tax on tobacco). Such a change, if undertaken, would have to be followed by a mechanism to attribute the revenues to the local (canton) level. Local revenue capacity has been strengthened by abolishing duty free privileges (except at the airport for outbound passengers) and by reducing ad hoc tax exemption awards. In the Federation, cantonal health funds today channel contributions in a transparent manner and offer equitable access for health services to all ethnic groups. However, the administrative - 11 - unification of the health funds in one mixed-ethnic canton (the Mostar canton) has only just taken place (having been greatly delayed for political reasons) and judgement as to its proper functioning must be awaited; financial unification had taken place a year earlier. The cantonal system has been supplemented by the creation of a Federation Health Insurance Fund funded by both the Federation budget and cantonal health insurance revenues to finance certain tertiary expensive health services, thereby reducing wide variations across cantons in access to such services. Data from the first quarter of 2003 show that KM8.4 million were placed in this fund as transfers from the cantons. It would clearly be desirable to even out existing wide variations also in primary and secondary services and consideration should be given in the future to widening the remit of the insurance fund. A pre-condition for this further reform is a strong improvement in compliance with the payment of contributions within certain poorly performing cantons -- an objective of the proposed Social Insurance Technical Assistance Credit. In the RS, rules have been put into place for strengthening control over the collection of health contributions and policy steps taken to focus expenditures on priority services, such as primary health care and the basic health package. Nevertheless, the degree of evasion and non-payment of contributions remains serious. Greater budgetary support for health spending will be required. 3. Reform of the social safety net -- rated satisfactory. The pension systems of both the entities provided for benefits inconsistent with demographics and with projection of revenues based on the applied contribution rates. Moreover, the distribution of benefits needed to be tilted towards the most destitute pensioners by a rise in minimum pensions. Finally, the distinct ethnically-based pension funds in the Federation needed to be merged so as to create the conditions for a viable unified pension system with equitable benefits. The veteran benefits programme in both entities, likewise, was unbalanced as to entitlements and available resources and over-complicated in its administration. Legislative pension reforms in both entities, supported by the project, have resulted in financial discipline by relating benefits to available resources and redefining benefit rules and indexation formulae in accordance with projected revenues. Financial transparency and accountability in the use of resources has been established. The divided pension funds in the Federation have been unified. This has paved the way for strengthened financial viability of the system by simplifying contribution collection and enhancing confidence in the fairness of the system. The unification will result in greatly enhanced labour mobility in the Federation and will do much to promote post-war ethnic reconciliation. However, the information systems that underlie the fund have not so far been unified and action must be taken urgently to this end. The pension fund should also agree on a settlement of its arrears to the cantonal health funds. Steps are being taken to devise reform of the veteran benefits system, and this reform will be supported by the forthcoming Second Social Sector Adjustment Credit. The RS pension fund system is functioning smoothly with no recurrence of payment arrears that were experienced in mid-2002, but the level of pensions (related so as to balance with the cash contributions flowing into the fund) remains extremely low and enforcement action is required to reduce the current high rates of non-payment of contributions. - 12 - More generally, in both entities, compliance with the paying of pension and health fund contributions is less than satisfactory, legal action is not taken against non-compliers, and procudures and systems, including IT, are inadequate to ensure coordination and information exchange between the various ministries of finance, pensions and social funds and tax administrations. The proposed Social Insurance Technical Assistance Credit is being designed to address these shortcomings. 4. Reforming the budget management system -- rated satisfactory. The weaknesses identified in the budget management system related to insufficient linkages between public policies and priorities and the budget; lack of integration of the recurrent and capital budgets; and absence of a medium term planning perspective. In addition, budget execution systems at entity and canton levels were fragmented and weak in controls. Both entities have taken great strides towards addressing these weaknesses in a impressive performance. Strategic multi-year budgetting systems and processes have been introduced with links between budget planning and macroeconomic and sectoral policies. In this context, the preparation of medium term expenditure frameworks has been a critical step, and one that facilitates the eventual preparation of poverty reduction strategy papers. But implementation is at an early stage in both entities, and the effective translation of sector priorities and the making of inter-sector choices in spending priorities into the budget still remains to be achieved. In the entities, inter-ministerial working groups have developed expenditure policy and strategy frameworks for a series of pilot sectors and a pilot exercise is underway in two cantons of the Federation. This will be a highly important task for the near future. Capital and recurrent budgets are integrated. In the Federation, cantons have also carried out similar reforms. The integration of budgets will be replicated by the authorities at the State level as part of ongoing preparations for a full PRSP. Significant progress has been made towards enhancing the coverage of capital expenditures in the Entity budgets, including externally financed capital projects. This process has also led to notable improvements in the external financing databases, which are administrated by aid coordination units. More recently, the entities have also taken the decision to strengthen their role in the management of external financing. Progress has also been made at the State level; however, the fragmentation of donor coordination responsibility between two ministries of the State will complicate management. Finally, a major step towards improving budgetary control and transparency was achieved with the establishment of a treasury system at the State and the Entity levels. 5. Establishing auditing procedures and institutions -- rated highly satisfactory. At project initiation, Bosnia and Herzegovina lacked an audit capability. The challenge lay in designing an external audit system that would permit the autonomous layers of government to undertake sound audits, whilst ensuring consistency of standards and quality across all the layers. The reform strategy entailed establishing a Supreme Audit Institution in the State and each entity to carry out compliance audits (relating to legal and regulatory requirements), certification audits (financial) - 13 - and performance audits (value for money), with a National Coordinating Committee, comprising State and entity auditor-generals, being responsible for ensuring consistency. Appropriate safeguard provisions relating to the independence of the institutions was to be made. Furthermore, the strategy called for the institutionalization of internal audits at all levels of the government, with entity and canton ministries of finance playing a leading role. This component has been fully implemented. Supreme Audit Institutions function at the State and entity levels and have developed considerable capacity to undertake external audits. Compliance and certification audits are being conducted, training of staff is under way for performance auditing expected to be introduced in about two years. Progress has been made towards establishing internal auditing, initially, certification audits, with compliance and performance to follow, in the entities and in one of the cantons. A comprehensive technical assistance programme is in place to support development of this work. This progress is impressive but it needs to be supported by proper follow-up of the auditors' reports by competent authorities in the State and the entities in terms of enacting reforms and enforcing sanctions in the event of breaches of the law. Moreover, especially with both the entities, independence appears to be tenuous and attempts have been made to apply political pressure on auditors. Parliamentary organs would need to be vigilant to ensure that the audit institutions are permitted to function with effectiveness. 6. Strengthening debt management capacity -- rated satisfactory. Within the debt management institutions of the State and the entities -- which had been set up under PFSAC-I --, the need to develop policy-making, credit analysis and monitoring functions, in particular the tracking and control of borrowing by sub-entity levels of government, public enterprises, utilities and public agencies, was addressed by this component of the project. Specifically, the strategy provided for the adoption and implementation of guidelines for borrowing intended to ensuring accurate reporting of debt, strong, transparent criteria for contraction, budgeting and supervision of loans and guarantees, and procedures for coordination. The guidelines and the associated coordination framework has been developed and adopted by both entities to the benefit of debt management and policy coordination between the entity and sub-entity levels. These guidelines are being translated into public borrowing legislation (consistent with the existing state law). The entity governments need to ensure that sub-entity borrowing is fully in compliance with the guidelines. 4.3 Net Present Value/Economic rate of return: Not applicable. 4.4 Financial rate of return: Not applicable. 4.5 Institutional development impact: The project has made a high contribution in a number of spheres to institutional development in Bosnia and Herzegovina and has greatly improved the ability of the country to make effective use of its human and financial resources. This achievement has been facilitated by the large volume of - 14 - technical assistance put in place by the Bank, the Fund and bilateral donors. In the tax area, the administrations of the entities have been strengthened, institutional cooperation fostered, and systems improved. The budget planning and management system has been developed virtually from scratch, single Treasury systems built and training provided to staff. Furthermore, within the state and the entities, external debt management capacity has been deepened with the adoption of modern methods. The pension reforms leading to sustainable systems, the unification of the Federation funds, and the institution of the entity level Health Insurance Fund in the Federation are powerful examples of institutional development in social service delivery. The establishment of Supreme Audit institutions at the State and entity levels, coordination mechanisms, the introduction of internal audit practices and capabilities at the State, entity and sub-entity levels, together with a large programme of training for staff, is expected to result in a significant boost to the efficient use of human and financial resources within the governments. In sum, the establishment of governance structures, together with appropriate tools for management, in all components of the project reflects the subatantial institutional development impact of the operation. 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: None. 5.2 Factors generally subject to government control: The reform programme supported by the project was stretched out over a 3 1/2 year period, which is an entirely reasonable period given the depth of the reforms, but which was, nonetheless, a year beyond that envisaged under the operation. Progress in taking the policy and institutional reform measures was hindered by frequent changes in governments (following elections) during the life of the project. It was also handicapped by protracted decision-making by the various tiers of the government; the project may have under-estimated this difficulty. Inter-entity cooperation was often less than full-hearted, especially at the beginning; as a result, the agreement on the mechanism for tax attribution and eventual revenue sharing was delayed. Part of the delay can also be attributed to the need to make provision in mid-project implementation for the special circumstances of Brcko district in project design once that district was placed under international supervision. Also for reasons of inter-entity tensions, delays took place on agreeing to common policies on and then implementing reforms related to budget systems and external debt management. Ethnic tensions within the Federation led to slow preparation for the plan for unification of the pension funds and then to the implementation of the plan. For similar reasons, the operation of cantonal health funds in mixed-ethnic cantons as well as the implementation of the Health Insurance Fund were delayed. These difficulties were compounded by weak human and institutional capacities. Preparatory work for much of the reforms took longer than envisaged and required intensive externally- supported TA. There was a tendency on the part of the RS pension fund and the Sarajevo fund to - 15 - back-track on agreed rules for pension adjustments that dissipated the reform momentum. The State and entity ministries of finance generally took a strong leadership role in project implementation, often with very few dedicated and technically equipped staff. Project performance improved as technical capacities were being gradually built up and as inter-entity dialogue developed and cooperation improved. A major factor responsible for the successful completion of the ambitious set of reforms was the dedication of the authorities, as represented by entity prime ministers and ministers of finance, to their programme as outlined in the Policy Statement of 1998; it was this commitment that overcame the difficulties outlined above. 5.3 Factors generally subject to implementing agency control: Not applicable as government is the implementing agency. 5.4 Costs and financing: The IDA financed cost of the project amounted to SDR53.2 million (US$72 million equivalent at the time of Credit approval), of which SDR31 million was onlent to the Federation and SDR22.2 million to the RS. The Netherlands provided co-financing in the amount of US$27 million, of which US$8 million was allocated to the State and US$9.5 million to each of the Entities; and Switzerland provided cofinancing in the amount of US$3 million equivalent, divided equally between the Entities. The substantial cofinancing of PFSAC-II amounting to over 40 per cent of the IDA contribution is notable. 6. Sustainability 6.1 Rationale for sustainability rating: The sustainability of the reforms supported by the project is judged to be likely. First, the policy and the institutional measures taken under the project will greatly enhance the viability of public finances, thereby creating the conditions for the furtherance of structural reforms on a broad front to the benefit of prospects for self-sustained growth. All levels of the government -- State, entities and sub-entity units -- benefit from the strengthening of policies and systems. Second, the project has been an important vehicle for fostering inter-entity cooperation, and the dialogue between the entities has deepened in the course of the project. This has made clear the benefits to be obtained from cooperation and the creation of a single economic space, the elimination of wasteful and distortive tax competition and restrictions on the movements of goods and factors of production; and also the high costs that will be associated with any possible attempt at reversion. Third, the public is benefitting tangibly from sustained, regular pension payments, more assured health care that is also more sustainably financed, greater accountability and transparency in all levels of the government brought about through budget system reforms and the new audit capabilities in an environment that was widely held to be highly corrupt. The greater assurance in the availability of, and equity in, the allocation of public goods and the diminution of the possibilities of malfeasence will help to maintain the public support for these reforms. Fourth, the continuing commitment of the authorities to a continuation of the public finance reform agenda is evidenced by their support for the recommendations of the recent Public - 16 - Expenditure and Insittutions Study and their interest in the proposed follow-up operation, the Economic Management Adjustment Credit, focussing on reforms to ensure medium-term viability in public finances (CAS Progress Report, 2002). Finally, external political and economic support on reforming public finances and fighting corruption, helping establish the standards that the country will be required to fulfil to qualify for the stabilisation and association agreement with the EU and the demonstrated determination at State and entity government levels to progress to an ever closer relationship to the EU, and the continued conditioning of donor financial support to progress in structural reforms remain powerful bulwarks of sustainability. Nevertheless, the authorities will need to remain vigilant to a number of vulnerabilities that sustainability faces. Sustainability will depend to an important degree on the steadfastness and quality of implementation. This report has identified a number of areas where implementation is still in its infancy, and tough political and technical challenges lie ahead. One source of vulnerability is the proposed introduction of VAT, which is highly desirable in itself, but which requires meticulous preparation, adequately paced timetable for introduction, and which should be levied and administered in a form that enjoys the support of all the people of the country. Otherwise, the risk of a substantial haemorrhage of revenues will be great. Another is the need for the new governments to brief themselves fully as to the lessons from the reforms and to stick closely to the implementation path. A third arises from the simultaneous challenge of pareing down the public sector to create the room for private sector led growth, whilst raising the quality of public spending. A fourth can be found is the inadequate levels of pension payments and the basic health care package (especially in Republika Srpska), which are unlikely to be tolerated for long by society. Hence there is the need for continued TA to strengthen local capability and introduce new ideas. The close engagement of the Bank, Fund and donors will remain vital. In turn, the state and entity governments will have to deepen cooperation and accept greater accountability. 6.2 Transition arrangement to regular operations: Not applicable. 7. Bank and Borrower Performance Bank 7.1 Lending: The Bank's performace is rated as satisfactory. The project identification was on target as it addressed a central plank of the authorities' reform objectives and was fully consistent with the thrust of the CAS. The Bank assisted the authorities closely in the design of the project and careful attention was paid not only to the key policy and institutional changes, but also to the necessary technical assistance required. The design covered the essential policy variables under public finance reform. The team was large, staffed with the right mix of skills, experienced in prior work on Balkan or post-conflict countries, and, indeed, many members had worked on PFSAC-I. Substantial continuity of staff was maintained. The design work had been supported by a recent CEM, recent PER, and by reform-specific - 17 - technical studies. Both preparation and appraisal were staff intensive with close involvement of the state and entity level counterparts; some bilateral donors were also consulted. The appraisal covered an assessment of the commitment of the authorities, evaluation of project implementation capacities and need for additional technical support, and the design of the project, while clearly ambitious, was kept parsimonious so as to maximise the prospects for implementation. There was close rapport with the Fund team working on the parallel standby arrangement. The project, as noted earlier, paid careful attention to the lessons learned from the PFSAC-I operation. 7.2 Supervision: Project supervision is rated as satisfactory. It was intense with missions from HQ taking place every 3-4 months (at times in combination with ESW tasks) and with an economist in the resident mission tracking developments closely. Supervision was greatly helped by the task manager being unchanged throughout the project; indeed, she had also managed PFSAC-I. Supervision missions highlighted developments (or lack thereof) clearly to the authorities, both at meetings and in written aide-memoirs, covering the issues in detail. Missions worked closely as partners with government representatives and with providers of TA; indeed, close coordination with donors to ensure uniformity of advice and proper coverage of TA needs was an important aspect of supervision. Supervision reports reveal the early and proactive detection of incipient problems, creative approaches to possible solutions, and a high quality of advice given to the client. Supervision reports were followed up by communications and missions from the country director and resident representative. The contribution of supervision missions to the building of consensus and the furthering of economic dialogue between the entities and between ethnic groups in the Federation as well as its technical support was valued by the authorities and helped develop project sustainability. 7.3 Overall Bank performance: Satisfactory. Borrower 7.4 Preparation: The borrower preparation is rated satisfactory. All levels of the government were closely involved in preparation through working groups and they provided ideas for design of project components. The borrower governments took actions to satisfy Board presentation conditions, some of which involved the preparation or passage of legislation. The borrower demonstrated firm commitment to its reform programme and to its financial relationship with the Bank. 7.5 Government implementation performance: Government implementation is rated satisfactory. The authorities stayed the course on macroeconomic stability and remained in full compliance with Fund standby arrangements. Implementation actions were generally taken as agreed or as sequenced, albeit often with considerable delays. Clearly, frequent changes in government following elections hampered implementation. Some of the implementation weaknesses arose from the unavoidable political sensitivities associated with the project; others from inadequate technical capacity -- these factors have been discussed earlier. Nevertheless, the delivery of such a far-reaching set of reforms within a 3 1/2 year period is commendable. The implementation experience has led to the realization of the gains to be reaped from cooperation, from fiscal modernisation, all of which has set the stage well for follow-up operations. It remains vital that the encouraging start to - 18 - implementation is maintained in the months ahead as the new institutions (inter-entity transfer of tax revenues, external debt management, broadening internal audits, developing the budget framework, pension and health funds operating under disciplined rules) will doubtless face challenges. 7.6 Implementing Agency: See above 7.7 Overall Borrower performance: Rated satisfactory. 8. Lessons Learned * In a post-conflict environment of weak governance and still festering ethnic tensions, a firm commitment by the top State and entity leaderships to the reform programme and associated policy measures is vital to success. Moreover, the dedication of a core team of political and technical leadership amidst elections and changing ministerial cabinets greatly assisted in keeping reforms on track. * Inter-entity and ethnic cooperation requires a careful, often slow, process of consensus building, realization of "win-win" solutions, and is facilitated by external mediation. Technical working groups supported by Bank teams or other donor teams and external political or financial incentives from the OHR and donors are critical to achieve agreement on reforms. * A clear vision and a clear supporting strategy for public finance reforms was important to success. The project followed logically from PFSAC-I, represented continuity, and is to be followed by another adjustment credit. Careful linkages of reforms and their sequencing is critical, especially when different actors that are required to coordinate (State, entities, sub-entities) are involved. * TA has to be planned and linked to project implementation from the project design stage where local capacity is so weak. * All this, in turn, requires careful spadework, reform blueprint, technical studies. Bank work and TA was of importance. It requires deep institutional knowledge and experience of the country or region and of post-conflict conditions. The skilled Bank team and the continuity of its composition won credibility and led to success. * In the weak governance environment and with politically sensitive reforms, intensive supervision is vital. Supervision has to be pro-active and fully engaged at the political and working levels and directed at finding solutions. Resident mission played an important supporting role. * Partnerships with the Fund and with bilateral donors has leveraged up the impact of all parties, with each playing a lead role in a specialised field. * The passing of legislation and the setting of reform-supporting institutions, difficult though - 19 - they are, represent only the first step to final outcomes of higher growth and greater efficiency in public finances. The quality and steadfastness of implementation are vital factors. The authorities and all their donor partners, especially the Bank, will have to remain vigilant to the sources of vulnerabilities in implementation and respond promptly to emerging problems. 9. Partner Comments (a) Borrower/implementing agency: In relation to the PFSAC II Implementation Completion, we consider the implementation satisfactory, as the Credit was used by the BiH for the intended purposes. Although in the post-war period significant improvements have been achieved, especially in the following areas: - infrastructure reconstruction, - strengthening of the domestic currency and, consequently, low inflation rate, - removing inter-entity barriers for movement of goods, people and capital, - beginning of the market reforms through trade liberalization and creation of single economic space, and - beginning of the enterprise and bank privatization, etc., Bosnia and Herzegovina is still facing great difficulties, major ones being reflected through high unemployment rate of 40%, poverty rate of 20% and still large numbers of refugees and displaced persons. Under such circumstances, PFSAC II focused on the structural reform program in the area of public finance, so the funds provided under the credit assisted Bosnia and Herzegovina to strengthen public finances, this being a precondition for creation of the sustainable economy of a country. The credit assisted in mobilization of public resources in all areas by improving, on one hand, the coordination of financial and administrative links between the BiH's two entities, and, on the other hand, those within each entity. The proceeds of the Credit have helped BiH to implement: - reform and harmonization of the tax policies in the entities, as appropriate legislation has been adopted in this area, - reform of financing of and harmonization of health care in the entities, - pension system reform (merger of PIO and MIO in the Federation of Bosnia and Herzegovina, appropriate legislation has been passed in RS, so pensions in both entities are being disbursed within the available resource envelopes), - reform of the Budget Management Systems at both the State and the entity levels, - strengthening of the debt management capacity at both the State and the entity levels, - reform of the budget execution system, and - establishment of the appropriate audit institutions in Bosnia and Herzegovina, to - 20 - perform public finance audits. PFSAC II also served the purpose of fulfillment of BiH assistance program ­ CAS, through: - strengthening of the Bosnia and Herzegovina's macroeconomic stability, - strengthening of the public finances, and - private sector development. Inter-entity cooperation in all the areas was crucial for implementation of all these reforms, and the cooperation was significantly strengthened by and through the implementation of PFSAC II. Bosnia and Herzegovina continues its efforts to stay on the path of establishment of the single economic space and creation of the road to sustainable economic development. We were happy to have had this credit to assist us in our endeavor. We hope that the new three-year CAS will assist Bosnia and Herzegovina with the additional IDA loan funds, to speed up Bosnia and Herzegovina's transition process, as we are aware that we are still at the beginning of this process. (b) Cofinanciers: (c) Other partners (NGOs/private sector): 10. Additional Information - 21 - Annex 1. Key Performance Indicators/Log Frame Matrix Outcome / Impact Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate Promoting free flow of goods between the Entity governments have taken legislative and Satisfactory implementation of the measures Entities and improving tax revenue collection administrative steps to these ends. continues. by incorporating all Entity specific tariffs into the State Customs Law and eliminating all implicit tariffs imposed by the Entitis as well as special trade agreements. Promoting free flow of goods between the Legislative and administrative actions have The implementation of the harmonised tax Entities and improving tax revenue collection been taken in all these areas, but actual structures continues satisfactorily, and that of by both harmonizing the sales and excise tax implementation of inter-entity allocation of the allocation of inter-entity taxes has begun. structures and developing a revenue sales and excise taxes is still to be effected. distribution system between the Entities. Improving revenue and expenditure These actions have been fully taken. The implementation of the actions continues assignments within the Entities by improving to be satisfactory. the allocation of sales tax revenues to the local governments, and financing and delivery of services with geographic spillovers, particularly in health. Designing an equitable and sustainable These actions have been taken with two The merged Federation system has begun to pension system by aligning pension benefit gaps, (i) the merged Federation system was operate satisfactorily. RS took measures to levels with the realities of future revenues; to begin functioning and (ii) RS pension restorre sustainability to its pension system. adjusting the pension benefit formula for contribution rules were not satisfactory as provision of a reasonable minimum benefit; they raised insufficient amounts to finance and integrating Federation pension systems. pension obligations. Developing efficient and transparent budget Appropriate measures have been taken and Policies and measures continue to be in planning system by linking budget institutions are in place, but time will be place, but there is a need to build up preparation with government's needed to effectively internalise the links experience with budget formulation and macroeconomic and sectoral policies; between policies, priorities and budget management. Entities need to ensure that integrating capital and recurrent budgets; and allocations. Moreover, the implementation of guidelines on sub-entity public borrowing are strengthening institutional capacity. guidelines on sub-entity public borrowing was fully enforced. awaited. Output Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate TAX POLICIES AND COLLECTION · Entities to implement the State-set external Achieved. Continued satistactory implementation. tariffs, to eliminate special trade agreements with Croatia and Yugoslavia, to equalize the excise tax rates on domestic and imported goods. · Entities to complete the harmonization of Achieved Continued satisfactory implementation. sales tax system by reducing differences in sales tax rates. · Entities to implement strengthened Achieved Continued satisfactory implementation arrangements for administrative co-ordination, including an information sharing system; · Entities to implement new legislation on To be achieved Implementation initiated. inter-Entity allocation of sales and excise taxes. REFORMING INTER- - 22 - GOVERNMENTAL FINANCES Federation: · Eliminate tax relief and exemptions with a Achieved Continued satisfactory implementation specific expiration date, including those granted to duty-free shops, unless provided for under tax legislation or by international treaties. · Adopt changes to the tax legislation to Achieved Continued satisfactory implementation improve collection and allocation of sales taxes on excisable goods between cantons and implement. · Establish cantonal health insurance funds; Achieved Continued satisfactory implementation establish Federation Health Insurance Fund under secure and clear financing and service responsibilities. RS: · Eliminate all tax and duty exemptions Achieved Continued satisfactory implementation without a specified expiration date and that are not provided for under tax legislation or by international treaties; adopt measures to effectively control duty-free shops and ensure that transactions at such establishments are limited to authorized persons. · Develop and adopt guidelines to improve administrative efficiency in health service Achieved Continued satisfactory implementation delivery and collection of health contributions. SOCIAL SAFETY NET · Entities to adopt and implement Achieved in the Federation, slippage in the Federation - satisfactory implementation; amendments to pension legislation on benefit RS to unsustainable financial position RS has corrected the slippage and formula and eligibility criteria to ensure implementation is now satisfactory sustainability of pension financing. · Federation to adopt and implement merger Merger achieved. Continued satisfactory implementation of the two pension funds alongside with the changes to the benefit formula and eligibility criteria. · Entities to submit to the Bank a Achieved Achieved comprehensive analysis of beneficiaries for their veteran's programs. BUDGET MANAGEMENT SYSTEM · Entities to establish macroeconomic Achieved Maintained analysis and forecasting units in their respective MoFs; to prepare budget framework papers to a time-horizon of three years. · Entities to incorporate capital projects in the Achieved Continued satisfactory implementation year 2000 budget plans including those which are externally funded. · Entities to adopt a strategy and timetable Achieved Maintained for integrating their external aid management function · Entities and State to operate with Single Achieved Continued satisfactory implementation Treasury Account and to manage budget - 23 - execution through Treasury Ledger Accounts. AUDITING PROCEDURES AND INSTITUTIONS · State and Entities to adopt the legislative Achieved Maintained framework and budgets for their Supreme Audit Institutions. · State and the Entity Parliaments to appoint Achieved Maintained Auditor-Generals for their SAIs and to operationalize their SAIs. DEBT MANAGEMENT CAPACITY · State and Entities to implement the Partly achieved Achieved, but entities need to ensure that Guidelines to govern public sector borrowing, guidelines for sub-entity borrowing are fully including at the Sub-Entity level, consisting enforced. of: (i) a comprehensive debt reporting system; (ii) transparent selection, budgeting, and supervision procedures for loans and guarantees; and (iii) procedures for borrowing policy co-ordination. 1End of project - 24 - Annex 2. Project Costs and Financing Project Cost by Component (in US$ million equivalent) Appraisal Actual/Latest Percentage of Estimate Estimate Appraisal Component US$ million US$ million IDA 72.00 72.00 100 Co-financing Dutch Grant 23.00 23.00 100 Swiss Grant 3.00 3.00 100 Total Baseline Cost 98.00 98.00 Total Project Costs 98.00 98.00 Total Financing Required 98.00 98.00 - 25 - Annex 3. Economic Costs and Benefits Not applicable - 26 - Annex 4. Bank Inputs (a) Missions: Stage of Project Cycle No. of Persons and Specialty Performance Rating (e.g. 2 Economists, 1 FMS, etc.) Implementation Development Month/Year Count Specialty Progress Objective Identification/Preparation November 1998 7 1 economist, 3 tax policy specialists, 3 budget specialists December 1998 1 1 budget specialist January 1999 15 1 economist, 4 budget management specialists, 3 audit specialists, 2 debt management specialists, 3 tax policy specialists, 2 pension reform specialists Appraisal/Negotiation April 1999 11 1 economist, 2 tax policy S S specialists, 1 health specialist, 1 pension reform specialist, 2 budget management specialists, 1 treasury system specialist, 1 debt management specialist, 1 audit specialist, 1 veterans benefit sch. May 1999 2 1 economist, 1 legal specialist S S Supervision September 1999 12 1 team leader, 1budget S S management specialists, 1 treasury systems specialist, 1 budget management (fed) specialist, 1 budget management (rs) specialist, 1 budget/macro framework specialist, 1 debt management specialist, 1debt mng.-legal framework specialist, 1tax policy specialist, 1 intergovernmental finance specialist, 1 pension finance specialist, 1 veterans' benefit sch. October 2000 7 1 team leader, 1 treasury S S specialist, 1 pension specialist, 1 public finance special, 1 health sector specialist, 1 program assistant May 2001 6 1 task team leader, 1 treasury S S system specialist, 1 debt management specialist, 1 tax policy specialist, 1 health finance - 27 - specialist, 1budget consolidation specialist May 2001 5 1 task team leader - overall U S supervision, 1 health finace reforms specialist, 1 penison reform specialist, 1 treasury specialist, 1 tax policy specialist ICR 2 1 team leader, 1 S S macroeconomist, 1 research analyst (b) Staff: Stage of Project Cycle Actual/Latest Estimate No. Staff weeks US$ ('000) Identification/Preparation 25.3 117.8 Appraisal/Negotiation 11.1 47 Supervision 96.27 313.9 ICR 8.0 40.0 Total 140 520 - 28 - Annex 5. Ratings for Achievement of Objectives/Outputs of Components (H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable) Rating Macro policies H SU M N NA Sector Policies H SU M N NA Physical H SU M N NA Financial H SU M N NA Institutional Development H SU M N NA Environmental H SU M N NA Social Poverty Reduction H SU M N NA Gender H SU M N NA Other (Please specify) H SU M N NA Strengthening pension and health systems Private sector development H SU M N NA Public sector management H SU M N NA Other (Please specify) H SU M N NA - 29 - Annex 6. Ratings of Bank and Borrower Performance (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory) 6.1 Bank performance Rating Lending HS S U HU Supervision HS S U HU Overall HS S U HU 6.2 Borrower performance Rating Preparation HS S U HU Government implementation performance HS S U HU Implementation agency performance HS S U HU Overall HS S U HU - 30 - Annex 7. List of Supporting Documents Bosnia and Herzegovina - PFSAC II - Initiating Concept Memorandum, January 1999. Bosnia and Herzegovina - PFSAC II - Memorandum for Regional Operations Committee Review Meeting, March 1999. Bosnia and Herzegovina - PFSAC II - Appraisal Mission Back to Office Report, May 1999. Bosnia and Herzegovina - PFSAC II - Negotiations Package, May 1999. Bosnia and Herzegovina - PFSAC II - Board Package (President's Report, Legal Documents), June 1999 Bosnia and Herzegovina - PFSAC II - Project Status Report. (Report ...), Bosnia and Herzegovina - PFSAC II - Supervision: Back to Office Report (BTO), August 1999. Bosnia and Herzegovina - PFSAC II - Supervision: Tax Policy BTO, October 1999. Bosnia and Herzegovina - PFSAC II - Supervision: Pension Reforms BTO, October 1999. Bosnia and Herzegovina - PFSAC II - Supervision: BTO, February 2000. Bosnia and Herzegovina - PFSAC II - Supervision: BTO, September - October 2000. Bosnia and Herzegovina - PFSAC II - Supervision: BTO, May - June 2001. Bosnia and Herzegovina - PFSAC II - Third Tranche Release Memo, IDA/ Bosnia and Herzegovina - Interim Poverty Reduction Strategy Paper ... Bosnia and Herzegovina - Country Assistance Strategy, Report No. 24978, October 2002. Bosnia and Herzegovina - From Aid Dependency to Fiscal Self-Reliance: a Public Expenditure and Institutional Review, Report No. 24297, October 2002. - 31 - - 32 -