Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 27068-CO

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT FOR A PROPOSED

SECOND PROGRAMMATIC FISCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN

IN THE AMOUNT OF US$lSO MILLION

FOR

THE REPUBLIC OF COLOMBIA

OCTOBER 23,2003

Colombia-Mexico Country Management Unit Poverty Reduction and Economic Management Unit Latin America and the Caribbean Region

This document has a restricted distribution and may be used by recipients only in the performance o f their duties. I t s contents may not be otherwise disclosed without World Bank authorization.

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CAS CFAA

CGN

CONFIS

CONPES

CPAR CSR DAFP

DIAN

DNP

FIAL

FNR

FRL GDP lBRD

ICBF

IDB

REPUBLIC OF COLOMBIA-FISCAL YEAR January 1-December 3 1

CURRENCY EOUIVALENTS (as of 20 February 2003) CurrencyUnit = Peso

2,903.00 Pesos = US$1 0.92Euros = US$1

WEIGHTS AND MEASURES Metric System

Country Assistance Strategy Country Financial Accountability Assessment Contadurfa General de la Naci6n (Accountant General’s Office) Consejo Superior de Polftica Fiscal (Superior Council of Fiscal Policy) Consejo Nacional de Politica Econ6mica y Social (National Council of Economic and Social Policy) Country Procurement Assessment Report Commission for State Reform Departamento Administratho de la Funci6n Pliblica (Public Service Administrative Department) Direcci6n de Impuestos y Aduanas Nacionales (National Directorate of Taxes and Customs) Departamento Nacional de Planeach (National Planning Department) Programmatic Fiscal and Institutional Adjustment Loan Fondo Nacional de Regalias (National Royalty Fund) Fiscal Responsibility Law Gross Domestic Product Intemational Bank for Reconstruction and Development Instituto Colombian0 de Bienestar Familiar (Colombian Family Welfare Institute) Inter-American Development Bank

IDF JMF ISS

IVA LIL MAFP

MDGs MHCP

MU

MTEF NFPS OBC PHRD PLaRSSAL

PRAP

SENA

SIIF

SINERGIA

TAL VAT

Institutional Development Facility Intemational Monetary Fund Instituto de Seguridad Social (Social Security Institute) Impuesto a1 Valor Agregado (Value-added tax) Leaming and Innovation Loan Modemizaci6n de la Administracidn Financiera Pdblica (Public Financial Management Project) Millennium Development Goals Ministerio de Hacienda y Crkdito Pdblico (Ministry of Finance and Public Credit) Ministerio del Interior y Justicia (Ministry of Interior and Justice) Medium Term Expenditure Framework Non-Financial Public Sector Organic Budget Code Policy and Human Resources Development Programmatic Labor Reform and Social Sector Adjustment Loan Programa de Renovaci6n de la Administracidn Pdblica (Public Administration Renovation Program) Servicio Nacional de Aprendizaje (National Training Service) Sistema Integrado de Informaci6n Financiera (Integrated Financial Information System) Sistema Nacional de Evaluaci6n de Resultados (Evaluation System for Public Management) Technical Assistance Loan Value-added Tax

IBRD Vice President: David de Ferranti Chief Economist: Guillermo Perry Director, LCSPR: Ernesto May Sector Manager, LCSPS: Ronald E. Myers Country Director: Isabel M. Guerrero Lead Economist: Joaquin A. Cottani Task Manager: Mario F. Sanginks Sr. Counsel and Country Lawyer: Eduardo Brito

Th is operation was prepared by a World Bank team composed o f MessrsMmes. Del Villar, Leytbn, Mosqueira, Rojas, Sangin&, and Solana (LCSPS), Gonzhlez and Webb (LCSPE), Romhn (LCOPR), and Uribe (Consultant). The team was led by Mr. Sanginks (LCSPS) and worked under the general guidance of Mr. Ronald Myers (Sector Manager, LCSPS), Mr. Ernesto May (Director, LCSPR), and Mrs. Isabel Guerrero (Director, LCClC).

FOR OFFICIAL USE ONLY COLOMBIA

SECOND PROGRAMMATIC FISCAL AND I?NTITUTIONAL STRUCTURAL ADJUSTMENT LOAN (FIAL)

LOAN AND PROGRAM SUMMARY

Borrower:

Implementipg Agkncies:

Poverty Category:

Amount:

Terms:

Commitment Fee:

Front-End Fee:

Objective:

Republic o f Colombia 1

Ministry o f Finance; National Department o f Planning

Not Applicable

US$l50 million

Fixed-Spread Loan (FSL) in U S Dollars with semestral Payment Dates for interest and commitment charges due on May 15 and November 15, and with the following Amortization Schedule, during the l ife o f the Loan:

Payment Date Installment Share

15-NOV-2009 10% 1 5-NOV-20 10 10% 15-NOV-2011 10% 15-NOV-2012 10% 15-NOV-20 13 10% 15-NOV-20 15 10% 15-NOV-2016 10% 15-NOV-2017 10% 15-NOV-2018 10% 1 5-NOV-2019 10%

The Borrower also chose a grace period o f 5.5 years and a total repayment term o f 16 years. Further, the Borrower opted to keep all the conversion options (currency conversions, interest rate conversions and capskollars) in the Loan Agreement. For interest rate conversions, the Borrower chose an Automatic Rate Fixing (ARF) every six (6) months.

0.85% on undisbursed loan balances for f i rst four years and 0.75% on undisbursed loan balances thereafter. ,

1 % of the loan amount

The government’s fiscal and institutional reform agenda i s supported by the Bank through the series o f four single-tranche Fiscal and Institutional Adjustment Loans (FIAL). The objectives o f this series o f loans are two: first, to promote reforms addressing fiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision o f public services and

This document has a restricted distribution and may be used b y recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed

Description:

Benefits:

Risks:

establish the institutional basis for higher efficiency and accountability in public expenditure.

The specific objectives o f the FIAL program are to: (i) increase tax revenue and reduce distortions in the tax system; (ii) modernize the tax administration; (iii) promote the development o f a sound fiscal responsibility legal framework; (iv) reduce losses and generate revenues through improved asset management; (v) prevent massive losses to the State from judicial claims; (vi) improve budget management with modem tools and legal reforms; (vii) develop incentives for efficiency gains in subnational entities; (viii) strengthen the public sector procurement system; (ix) improve performance through management contracts for agencies; and (x) support a coherent and comprehensive reform implementation process.

This second loan of the program wi l l focus on the following elements: (i) issuance o f all legislation to regulate the application o f the tax reform law; (ii) further improvements in tax administration, including specific audit targets and the implementation of integrated tax-customs audits; (iii) approval o f an official budget reform strategy; (iv) Congressional approval of an improved 2004 Annual Budget Law; (v) presentation to popular vote o f the Constitutional referendum; (vi) issuance o f a new policy for legal defense o f the state; (vii) presentation to Congress o f reforms to the public procurement law; (viii) approval o f an official asset management policy and the achievement o f specific revenue targets; (ix) signature o f management contracts with two government agencies; and (x) enactment o f a Fiscal Responsibility Law.

The key benefits expected from the program are: (i) an average annual contribution to total fiscal revenues o f 1.4 percent o f GDP from 2003 to 2006; (ii) an average annual contribution to a reduction in current expenditures of 1.6 percent o f GDP from 2003 to 2006: (iii) increased reliability and transparency in medium-term fiscal planning and a framework for more realistic budgeting: (iv) a public expenditure system more closely linked to results; (v) improved targeting o f public expenditure toward public policy priorities; (vi) a more transparent, simpler, and institutionally robust system o f public sector procurement; and (vii) a more efficient and cost-effective use o f the assets o f the public sector. These achievements would translate directly into fiscal sustainability, improved quality and coverage o f public services, and improved governance and transparency.

The most important r isks faced by the program are: (i) the challenges faced by the government stemming from the overall political context, in particular the internal conflict and violence associated with illegal drug activity, which could negatively impact the continued implementation o f the program; (ii) possible attempts at derailing the reform process by special interest groups affected by it; (iii) the weakening o f the government’s overall policy agenda by the non-approval o f the Referendum; and (iv) the deterioration o f the fiscal and macroeconomic environment.

Project Identification Number: PO83905

REPUBLIC OF COLOMBIA SECOND PROGRAMMATIC FISCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT

LOAN (FIAL 11)

Table of Contents

I . INTRODUCTION .................................................................................................. 2 CONTEXT OF THE OPERATION ..................................................................... 2

A . RELEVANT SOCIOECONOMIC BACKGROUND ............................................................ 2 B . FISCAL AND Ir\iSTITUTIONAL ISSUES ......................................................................... 5

I11 . THE G O V E R N M E N T ’ S REFORM PROGRAM .............................................. 8 I V . THE FISCAL AND I N S T I T U T I O N A L REFORM PROGRAM ...................... 9

A . OVERVIEW ............................................................................................................... 9 B . COMPONENTS OF THE PROGRAM ........................................................................... 17

A D J U S T M E N T LOAN (FIAL 11) ............................................................................... 34

I1 .

V . THE SECOND F I S C A L AND INSTITUTIONAL STRUCTURAL

A . LOAN DESCRIPTION ............................................................................................... 34 B . FIDUCIARY POLICIES ............................................................................................. 36 C . ENVIRONMENTAL ASPECTS .................................................................................... 36

F . SOCIAL IMPACT OF THE REFORMS .......................................................................... 40

D . BENEFITS ............................................................................................................... 37 E . RISKS ..................................................................................................................... 39

ANNEX I . LETTER OF DEVELOPMENT POLICY TO THE WORLD BANK ....................... 43 ANNEX 11 . INTERNATIONAL MONETARY FUND RELATIONS NOTE .............................. 54 ANNEX 111 . POLICY MATRIX ........................................................................................ 56 ANNEX I V . COLOMBIA AT GLANCE ............................................................................. 69

Figure 1 . Figure 2 . Figure 3 . Figure 4 .

Table 1 . Table 2 . Table 3 . Table 4 . Table 5 . Table 6 . Table 7 .

Figures Fiscal Deficit 1994-2002 ........................................................................................ 4 Colombian Debt Spreads ......................................................................................... 4 Timeline o f Changes in Tax Policy .......................................................................... 18 Accumulated Fiscal Cost o f Contingent Liabilities Against the State ..................... 25

Expected Aggregate Impact of the FIAL Reforms .................................................. 10 Division of Responsibility for Program Components .............................................. 15 Sources o f Technical Assistance for FIAL Program ................................................ 16 Key Measures ofthe 2002 Tax Reform (Law 788) ................................................. 19

Reforms Supported by the FIAL ............................................................................. 34 Tax Revenue. First Semester Comparison. 2002-2003 ........................................... 20

Public Sector Fiscal Balances, Scenario with Reforms (2001-2006) ...................... 38

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED SECOND PROGRAMMATIC FISCAL AND

INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF COLOMBIA

I. INTRODUCTION

1. Colombia, a country o f 43 mill ion inhabitants with a history of sustained economic growth and fiscal stability, reached the end o f last decade with an almost unprecedented economic contraction and high levels o f c iv i l unrest. Facing a difficult fiscal outlook and popular disappointment with the peace process, President Alvaro Uribe took office in August 2002 on a platform of restoring security, fighting corruption, and delivering sustained economic growth. In i t s first year the Uribe administration has embarked on a path of fiscal prudence, ambitious public sector reform, and determination to end the 40-year armed struggle that makes Colombia one o f the most unsafe countries in the hemisphere.’

2. The backbone of the public sector reform process i s the Progruma de Renovacio’n de Zu Administrucio’n Pu’bZicu (PRAP), led by the National Planning Department (DNP) and based upon Presidential Directive 10 of October 2002. This program has so-called “vertical” reforms, which are basically sector- or entity-specific institutional restructuring actions that seek to reduce excess public sector employment and enhance quality and cost-effectiveness of public services; and “horizontal” reforms, which encompass cross- sector issues o f public administration, such as asset management, procurement, and others. This modernization effort i s coupled with substantial reforms in fiscal management, led by the Ministry of Finance and Public Credit (MHCP). These include a substantive tax reform, a major overhaul of the tax administration, budget reform, and the enactment of fiscal responsibility regulations. Together, these measures add up to a broad package meant to lay the foundations for improved service delivery and sustained fiscal balance. 3. During the second semester of 2002, the government agreed wi th the multilateral banks that the public sector reform process would be supported by structural adjustment loans from both the International Bank for Reconstruction and Development (IBRD) and the Inter-American Development Bank (IDB). The Bank focused on the issue of fiscal rigidities that make the implementation o f public policy extremely difficult, both from the revenue perspective and through the achievement of efficiency gains in the “horizontal” elements of the reform process. The IDB, on the other hand, focused i t s adjustment lending on the “vertical” elements of reform, and some horizontal elements not covered by the Bank, and i s also preparing an investment operation to support the pol icy reforms.

4. On March 18, 2003, the Bank approved the f i rs t Fiscal and Institutional Adjustment Loan (FIAL) to supp‘ort the government’s reform efforts. Th is f i rs t single- tranche structural adjustment loan, in an amount o f US$300 million, laid out the

The approval rating of the current administration has remained high. The latest polls indicate that 70 percent of Colombians have a favorable image o f the President, and his j ob approval rating i s 64 percent.

principles o f a programmatic operation that would total an estimated US$900 mill ion and would conclude in FY 2006. This program has two objectives: First, to promote reforms addressing fiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of public services and establish the institutional basis for higher efficiency and accountability in public expenditure. The focus of the reform program will gradually shift from tax and fiscal responsibility at the beginning, to expenditure and public expenditure reform in the later stages.

5. This Program Document presents the second loan o f the FIAL program (FIAL 11) for an amount of US$lSO million in a single tranche. Each of the loans in the FIAL program has a particular thrust within the overall scope of the reform; while FIAL I was heavily weighted toward tax policy as the initial and most urgent effort toward fiscal sustainability, the primary emphasis of the proposed FIAL I1 i s on establishing the legal and normative framework of the key elements of public sector reform, including procurement, royalty transfers, and fiscal responsibility, and the implementation of management contracts with two government agencies and the definition o f the budget reform strategy. FIAL I11 i s expected to focus mainly on the results o f the tax administration efforts, the operation of a framework o f legal defense of the State, new asset management legislation, and the effective implementation o f the mandates o f the procurement and fiscal responsibility laws. The fourth and final FIAL I V wil l emphasize the full implementation of the tax reform, the enactment of the budget reform, the expansion o f the management contracts scheme, additional performance management tools, and the overall evaluation of the reform process.

6. As shown later in this document, progress in the reform program has been satisfactory, and there have been significant accomplishments derived from the first FIAL loan. Most notably, the government has enacted a substantial tax reform package that i s expected to yield an additional 1 percent o f GDP in revenue this calendar year, as well as the initial steps of several key initiatives of public sector reform. The FIAL II loan i s well synchronized with the accomplishments to date, and sets the stage for further reforms during the remaining three years of this government’s administration.

11. CONTEXT OF THE OPERATION

A. RELEVANT SOCIOECONOMIC BACKGROUND

7. Macroeconomic Performance. During 1998-2002, the economy suffered from stagnation, but today confidence in the economy i s slowly returning, as signs o f recovery and growth continue. The economy grew by 3.3 percent in the first semester o f 2003, which i s the biggest gain in GDP in five years, and i s expected to grow by about 2.5 to 3 percent this calendar year and by 3 to 3.5 percent in 2004. Although the unemployment rate fell from 16 percent in the first quarter of 2003 to 14 percent in the second quarter of the same year, i t remains to be seen whether the economy i s now firmly established on a path of growth and stability. Total investment now stands at about 14 percent o f GDP, with private investment under 6 percent, which w i l l not sustain significant growth. While

2

government consumption grew by two thirds between 1994 and 2002, household consumption remained basically unchanged. Inflation declined in 2002, assisted by sluggish demand, and was about 6 percent, and i s expected to be about the same in 2003.

8. Colombia’s exports increased in the f irst semester o f 2003 relative to the same semester in 2002. This increase can be explained mostly by carbon exports. While the country’s nontraditional exports, mainly manufactured goods and cut flowers, performed well in recent years and now amount to over half o f total merchandise exports, the appreciation of the peso and the economic slowdown in the United States, Venezuela, and other Andean countries affected them negatively in the first semester of 2003. Increasing imports have, however, maintained a deficit in the trade balance. The total external current account had a deficit o f about 2.1 percent o f GDP in the f i r s t semester o f 2003. 9. Fiscal Performance. Over the past half-decade, new realities have emerged in Colombia’s fiscal domain, including significant deficits and large future fiscal liabilities. The rapid expansion of the public sector over the previous decade, from spending one- fourth of GDP in 1990 to over one-third of GDP today, combined with growing pension and other liabilities, has led to significant and persistent structural deficits. As public spending rapidly outstripped the sector’s revenue-generating capacity, m u c h of the fiscal deficit was financed with debt, both domestic and external. Today, total public sector debt in Colombia i s over 50 percent of GDP. The deficit of the consolidated public sector for 2002 was 3.6 percent of GDP, largely due to election-year spending, higher military outlays, and a weakening o f the social security institutions. For security spending, the current administration estimates that i t w i l l need an additional 1 percent o f GDP per year. 10. Nevertheless, the Uribe Administration has stressed i t s commitment to continue the fiscal adjustment efforts o f the previous administration. On December 20, 2002, Congress approved a strong tax package estimated to increase tax collections by close to 1 percent of GDP in 2003 and rising in the next two years. The fiscal deficit for the Combined Public Sector i s expected to come down to 2.5 percent of GDP in 2003 and about 2.3 percent in 2004. As a precaution, the Government requested a Stand-By Agreement from the International Monetary Fund (IMF). The first review of the Stand- B y Arrangement was satisfactorily completed on June 11, 2003. A l l performance criteria and structural benchmarks for end-2002 and end-March 2003 have been met.

11. Congress passed two key structural reforms: a pension reform (Law 797, January 2003) to address the looming deficits o f the social security sector, Colombia’s largest future fiscal liability, and a labor reform to increase flexibility in Colombia’s rigid labor market. An overhaul of the public administration sector i s well underway. Additionally, Telecom was liquidated and Cajanal and Caprecom were massively reformed. In June 2003, the Government of Colombia (GOC) was finally successful in passing through Congress a reform of the Znstituto de Seguridad Social (Social Security Institute, ISS), which includes the separation o f health service provision and financing. In late June Congress approved a fiscal responsibility law.

3

Figure 1: Fiscal Deficit 1994-2002 (Percentage of GDP)

40%

23

Source: Superior Council for Fiscal Policy (CONFIS).

12. The External Environment. Colombia's vulnerability to external shocks has seen some recovery in recent months. Although i t s sovereign debt spreads have improved since the beginning of the year in absolute terms and relative to the emerging market average, Colombia i s s t i l l vulnerable given the uncertainty about the future o f the internal conflict; the passage of the referendum; the problems in Venezuela (the largest market for Colombia's nontraditional exports); and the outlook for the U.S. economy, Colombia's main trading partner. Nonetheless, given i t s floating exchange rate, falling inflation, and adequate international reserves, Colombia should be we l l equipped to deal with moderate external shocks as i t undertakes the fiscal adjustment supported by the proposed program.

Figure 2: Colombian Debt Spreads (EMBI COL vs EMBI+)

818,2002 011912002 ,11112882 ,21,,12002 t11012003 3,1912011 112412003 bi i i210, 1118,2003 * o I $ 1 * e o P

Source: Ministry of Finance and Public Credit.

4

13. Poverty. In Colombia, there has been a close positive correlation among fiscal balance, g rowth , and poverty reduction. During periods of positive growth (and fiscal balance), C o l o m b i a enjoyed substantial declines in poverty (even though inequality increased). Specifically, from 1988 to 1995, as GDP grew on average at about 4.2 percent per year, poverty rates declined from about 65 to 60 percent o f the population. This reduction, and the government’s efforts that helped achieve it, w e r e completely wiped out by the 1998-99 recession. Poverty levels today are not substantially different from what they were in the late 1980s. Although unemployment has dropped from around 15.7 percent last year to 14 percent during the second quarter o f 2003, i t i s yet not clear whether the economy has stabilized to sustain this level. Put differently, the evidence suggests that sustainable growth and fiscal balance have been Colombia’s best social safety net. A fiscal balance program that increases revenue and makes expenditure more efficient, and within prudent l imi ts, i s a sine qua non for Colombia’s attaining the human development Millennium Development Goals (MDGs). 14. Insecurity and Violence. Colombia has captured headlines around the world for its alarming indexes of violence. Since the 1980s, the multidimensional problem of violence has become more widespread and i s exacting an increasing economic and social toll. From 1 9 9 9 to 2002, the number o f attacks on petroleum infrastructure increased by 160 percent, on electric infrastructure by 680 percent, and kidnappings by 126 percent over the average o f the previous 13 years. I t i s estimated that the conf l ic t reduces the annual economic growth rate by at least 2 percent. The conflict places the country in a particularly vulnerable and difficult position; i ts repercussions for the economy and the overwhelming social demand for i t s settlement make peace the paramount priority of the government’s public policy agenda.’ As crucial complements to the direct counterinsurgency measures, the government recognizes the need to sustain fiscal balances and improve the quality and efficiency of public services. 15. In h i s 2003 report to Congress delivered on July 20, President Ur ibe presented encouraging signs that the government’s strategy on democratic security i s yielding positive results. During the f i rst semester o f 2003 there were 24 v io len t attacks on populations, the lowest in 10 years and just over one-third of the number for the f irst semester of 2002; attacks on economic infrastructure are down 58 percent over the same period, and homicides declined by 21 percent and kidnappings by 34.2 percent. Although there i s st i l l significant uncertainty over the evolution of the armed conflict, a n d paramount challenges s t i l l remain ahead, the statistics for the first half o f 2003 could show the beginning of a reversal in the trend toward increased violence that began in the late 1990s.

B. FISCAL AND INSTITUTIONAL ISSUES

16. The fundamental issue that constrains the effective implementation of publ ic policy in Colombia i s the inability of the Government to access the necessary budgetary resources to attend policy priorities. Regardless of the political commitment to promote

’ It has been estimated, for instance, that war-related additional public expenditures w i l l reach 1.5 percent o f GDP by 2006.

5

peace and development, there i s little that can be done without resources. Budgetary shortfalls are clearly not uncommon; fiscal adjustment i s a worldwide reality. However, the nature of the Colombian fiscal imbalance i s particularly complex due to the interplay of insufficient tax revenue, inefficient and rigid expenditure, and the lack o f an adequate legal framework for fiscal responsibility.

17. Some of the key issues that make up the spectrum of constraints to effective public policy that were faced by the incoming Uribe administration in August 2002 are:

18. Insufficient Resources for the Implementation of Public Policy. The Colombian Central Government tax burden has hovered under 20 percent o f GDP for the last few years,2 which was insufficient to undertake the ambitious government agenda, and substantial reforms in both tax policy and administration were required. A Bank- supported tax reform law enacted in December 2002 significantly broadened the tax base and reduced a number of exemptions. I t has already had visible impact on the revenues in the first semester of 2003, although the Constitutional Court challenged some key elements scheduled to go into effect in 2005. Tax administration measures are underway with support f rom the Bank, but most o f the challenges in this area s t i l l l i e ahead and involve efficient information usage, improved auditing, and a revision o f bylaws and regulations.

19. Lack o f a Fiscal Responsibility Framework. Many countries in the region have increased the odds of fiscal sustainability by approving laws that establish certain basic fiscal responsibility guidelines. These guidelines pertain to matters such as debt ceilings, subnational borrowing, medium-term fiscal planning, and reporting and accountability. The lack of such framework at the national level in Colombia made i t diff icult to align expenditures to within affordable and sustainable l imits. In June 2003, the government enacted the Fiscal Responsibility Law, which i s one o f the key benchmarks under the FIAL program.

20. The Colombian public sector lacks the institutional and legal framework to appropriately identify, assess, value, regularize the titling, and if necessary dispose o f assets-particularly real estate-that are part o f i t s capital stock. Not only are unnecessary expenditures generated when assets cannot be easily transferred from one activity to another, but a potential source of capital revenue i s not realized when assets unrelated to public policy priorities cannot be sold. Not having the appropriate mechanisms for asset management costs the public sector hundreds of millions of U.S. dollars.

21, Inordinate Growth of Liabilities against the State. Although reliable estimates s t i l l do not exist, contingent liabilities to the State that arise from legal action could reach as much as 2 percent o f GDP if current trends continue. The legal claims that generate such massive losses to the State have varied origins, including labor or administrative disputes, but the most significant source are contracts in areas such as concessions or public works that have gone into arbitration. Significant efforts need to be invested to strengthen the public sector’s capacity to defend itself, in parallel to an overhaul of the administrative processes (such as procurement) that lead to poorly designed contracts.

Inefficient use of Public Assets.

* Source: Directorate o f National Taxes and Customs (DIAN).

6

22. Inadequate Budgeting. The Colombian budgeting system i s plagued by numerous structural problems that are unquestionably key contributors to the difficulties in policy implementation, such as (a) the large number o f legally mandated expenditure entitlements eliminates the fiscal space needed to accommodate revenue shock or changes in expenditure priorities; (b) a budget structure that i s incompatible with economic, functional, or performance analyses; (c) a Ministry of Finance with limited authority to regulate public expenditure aggregates; (d) complex institutional arrangements that in effect divide the budget process into separate current expenditure and investment processes; (e) budgeting definitions that do not fall under internationally accepted standards; (0 a lack o f instruments to develop a medium-term vision of fiscal policy; and (g) a lack of substantial evaluation of public expenditure results, among others.

23. Inefficient System of Royalty Transfers. The Constitution establishes a rigid system of royalty transfers through the National Royalty Fund (FNR) that does not promote efficiency in their use. In order to obtain higher value-for-money in some of the key areas to which the royalties are directed, such as education, it i s important to improve the targeting mechanisms via constitutional reform if necessary in order to achieve higher impact from limited resources.

24. Complex and Ineffective Public Procurement System. There i s a high fiscal cost associated with an inadequate public procurement system. Not on ly are the costs o f government contracts higher than they would otherwise be, but poorly designed contracts (intentionally or not) find their way directly into litigation and generate large liabilities for the State. The Colombian procurement system i s not only ineffective in overseeing potentially conflictive contracts, but i s also plagued with complexities that raise the cost to bidders and cloud an effective application of modem procurement principles.

25. Lack of Incentives for Performance. The Colombian budget system does not have adequate mechanisms to promote performance at the agency level. Furthermore, the administrative regulations (such as human resource management) are fairly rigid and make i t difficult for public sector managers to be empowered with more flexibility. Under this scenario, i t i s difficult to have a serious system of performance evaluation that carries real consequences for both the agency and the government. Within a n environment of severe fiscal constraints, i t i s imperative to develop instruments to promote enhanced performance in the short term.

26. Past Government Responses. All recent governments have attempted to reverse these negative trends. However, the responses primarily addressed revenue and were partially ineffective with respect to the expenditure side, that is, reform of the public sector. To attempt to deal with excessive spending, previous administrations had launched several public sector reform programs. Yet these in i t ia t ives4ur ing 1992 and 1994, during 1998 and 1999, and in 200O-did not fully reach their desired outcomes. The limited success of these past reforms was primarily due to (a) some reforms, especially those between 1998 and 1999-though explicitly focused o n expenditure reduction-faced legal or political obstacles; and (b) other reforms were not primarily targeted to expenditure reduction or to effectively tackle the inner roots of rigid growth in fiscal transfers or legal claims against the State. After these attempts at reform, the

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Colombian pub l ic sector still requires a significant effort to reduce inefficiencies, align responsibilities, foster transparency, and improve management and accountability.

111. THE GOVERNMENT’S REFORM PROGRAM

27. General Framework: The Estado Comunitario and the Future of the Colombian Public Sector. The idea of Estudo Comuniturio l ies at the heart o f this government’s public sector reform program. The Estudo Comuniturio i s a set o f basic reform guidelines put together and demonstrated in practice by President Uribe at the time he was governor of the department of Antioquia, perhaps the most developed intermediate-level administration in Colombia. Already elaborated and announced during President Uribe’s campaign, the concept of Estudo Comuniturio inspired criteria for the selection of entry points and impact evaluation o f public sector reform under the current administration. Although s t i l l evolving as a guiding concept of public sector reform, the Estudo Comuniturio incorporates and adapts to Colombia a number of widely accepted, contemporary principles of public sector reform that wi l l guide the renovation of the Colombian public sector under the current administration.

28. The concept of the Estudo Comuniturio i s the foundation of the National Development Plan 2002-2006. The fundamental principle underlying the concept is that the State should exist for the service of i t s citizens and not for the benefit o f special interests. The Estudo Comuniturio involves c iv i l society in the attainment o f social objectives; i t i s a modern State where scarce resources are invested wisely and efficiently; and i t i s a decentralized State that stands for regional autonomy with transparency, political responsibility, and community participation.

29. The National Development Plan proposes the development o f the Estudo Comunitario through four basic pillars:

0

0

0

e

30.

Democratic Security. The State must provide security and protection to all Colombians, without political, ideological, religious, or socioeconomic distinctions. Sustainable Development and Employment. Economic growth stagnated during the last few years and unemployment has grown by around 10 percent since 1999. The State must provide the conditions to recover the path to economic growth. Social Equity. The State must ensure that the fruits o f economic growth are enjoyed by all Colombians. Renovation of the State. The State must modernize i t s administration and reform intergovernmental relations. The ultimate goal i s to build a managerial, participatory, and decentralized public sector.

The Estado Comunitario and the Fiscal and Institutional Reform Program. The fundamental purpose o f the Fiscal and Institutional Reform Program i s to liberate resources for the effective implementation of public policy and to generate efficiency and transparency gains that wi l l contribute to fiscal sustainability and the improvement of service delivery. In this sense, the Program i s a necessary condition for the attainment of

8

the goals of the National Development Plan as described above. Democratic Security hinges upon the availability of untied fiscal resources, within a framework of macroeconomic stability, to invest in restoring peace to the country; Sustainable Development requires a sound macroeconomic framework and effective fiscal policy; Social Equity requires ability to deliver improved services to the poor and increase their ability to benefit from economic growth; and the Renovation ofthe State clearly entails efficiency and transparency gains and the necessary institutional strengthening actions to deliver more and better public services in a fiscally sustainable way. The reform program designed to implement this vision involves a wide array of constitutional, legal, and administrative measures that, together, represent the most significant reform effort since the Constitution of 1991.3 3 1. Concept and Structure of the Public Sector Reform Program. The core of the reforms i s contained in two reform packages known as the Tax Reform and the Renovation of Public Administration. These two packages are framed within and supplemented by other government reforms in such a way that the magnitude and expected impact of the former cannot be adequately grasped without reference to the latter. The program i s both coherent with and strengthened by the constitutional and legal reforms courageously undertaken by the current administration, involving a popular referendum scheduled for October 2003, a resubmission of a constitutional reform that was struck down by the Senate in July 2003, a pension reform, the reform of the Central Government structure, and a fiscal responsibility law enacted in June 2003. Al l these reforms have significant fiscal implications and should establish the necessary basis for Colombia’s political reconstruction and economic recovery.

Iv. THE FISCAL AND INSTITUTIONAL REFORM PROGRAM

A. OVERVIEW

32. Objectives of the Program. The Fiscal and Institutional Reform Program i s supported by the Bank through the series of four single-tranche Fiscal and Institutional Adjustment Loans (FIAL). The Bank approved the f i rs t loan of the program in March 2003 for an amount of US$300 mill ion out o f an estimated total of US$900 million for the entire program. This program has two objectives: first, to promote reforms addressing fiscal rigidities necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability; and second, to improve the provision of pub l i c services and establish the institutional basis for higher efficiency and accountability in public expenditure. The focus o f the reform program w i l l gradually shift from tax and fiscal responsibility at the beginning, to expenditure and public expenditure reform in the later stages.

World Bank projects are supporting these reform efforts through a combined package of structural reform projects that include overall rationalization o f public expenditures (including pension and social security expenditures), labor reform, tax reform and tax administration, financial reform, and improvement of health, education, and family services.

9

33.

34.

The specific objectives o f the FIAL program are to:

Increase tax revenue and reduce distortions in the tax system; Modernize the tax administration; Promote the development of a sound fiscal responsibility legal framework; Reduce losses and generate revenues through improved asset management; Prevent massive losses to the State from judicial claims; Improve budget management with modern tools and legal reforms; Develop incentives for efficiency gains in subnational entities; Strengthen the public sector procurement system; Improve performance through management contracts for agencies; and Support a coherent and comprehensive reform implementation process.

Table 1 describes the expected aggregate results of the reforms supported b y the FIAL program.

Table 1: Expected Aggregate Results of the FIAL Reforms Objective I Expected Resalt

Promote reforms addressing fiscal rigidities 1 Average annual contribution to total fiscal revenues of necessary to attain the substantial fiscal adjustment underlying sustainable macroeconomic stability.

1.4 percent of GDP from 2003 to 2006; Average annual contribution to a reduction in current expenditures of 1.6 percent o f GDP from 2003 to 2006.4 Increased reliability and transparency in medium-term fiscal planning and a framework for more realistic

0

0

I budgetinn. Improve the provision of public services and establish the institutional basis for higher

A public expenditure system more closely linked to results;

efficiency and accountability in public expenditure.

0

0

0

Improved targeting of public expenditure toward public policy priorities; A more transparent, simpler, and institutionally robust system o f public sector procurement; More efficient and cost-effective use of the assets of the D u b k sector.

35. Achievements under FIAL I. FIAL I supported a successful package of reform measures, including (a) enactment of a tax reform law; (b) implementation o f important tax administration measures such as increased withholding at the source and improved information exchange with banks; (c) enactment of a law authorizing a Constitutional referendum that, among other things, reforms the royalty transfer system; (d) enactment of Law 790 that strengthens the Ministry of Interior and Justice’s Directorate of Judicial Defense; (e) issuance o f Decree 2170 improving the public procurement system; (f)

Including the overall effect of the referendum. Without the referendum this average i s approximately 0.7 percent per year for the same period. Additionally, some Bank data not yet reviewed with the Government were used for the estimate of the impact on expenditures.

10

creation of a commission for asset management; and (g) selection of two pilot agencies for the implementation of a management contracts scheme.

36. Changes in the FIAL Program Since the Approval of FIAL I. The program has not undergone substantial changes since the approval o f the first operation. The structure of t he program and both the general and specific objectives remain unchanged, although the policy matrix has undergone a process of clarification and streamlining while still ful ly reflecting the scope of the reform program. On the contrary, the matrix has been strengthened by the establishment o f specific quantitative targets in some components that in most cases go beyond those established originally, and reflect the strong pace of the reform program led by the Government.

37. Of the subset of prior actions for FIAL I1 that have been defined as a trigger^"^ in the FIAL I document, there have been three components where the sequence and measurement of the reforms have been changed:

0 Budget Reform. The original FIAL matrix called for the presentation of the Organic Budget Code to Congress as for FIAL 11. However, the political environment surrounding the .referendum, coupled with the potentially controversial nature of the Code (primarily because i t seeks to reduce politically attractive permanent expenditure entitlements and revenue earmarks), has forced the government to take a more cautious and deliberate process of presentation of the bill to Congress. This wi l l now take place before FIAL 111 goes to the Board, while the approval of a policy document outlining the elements of budgetary reform wi l l be approved for FIAL I1 and the Organic Budget Code approved for FIAL IV.

Tax Administration. The original FIAL matrix called for the operation of an integrated tdcustoms taxpayer current account system for the largest taxpayers during 2003. However, DIAN adopted a new information technology strategy during th is year that calls for the development o f a platform that will provide integrated accounts for al l taxpayers, but which w i l l not be ready until mid-2004. This new strategy i s being supported and partially financed through the Bank- financed Public Financial Management Project I1 (MAFP 11). Therefore, the original policy action has been removed from FIAL I1 and introduced into FIAL 111 with a broader coverage.

0 Asset Management. The original FIAL matrix used revenue targets to measure the progress of the asset management program. Following expert advice, the program now measures this with both institutional development indicators and coverage in terms o f assets by the asset management system, wh i l e the revenue targets have been discarded.

0

The triggers defined for this operation are a subset of the policy matrix and are prior actions that need to be fulfilled for the approval of this loan by the Bank. They have been identified as the key elements of the reform process and serve as guideposts of the progress o f the program. As part of the prior actions, these triggers are included in the loan agreement and are part o f the package o f policy measures that sustain the loan. As this i s not standard practice in programmatic lending, special authorization was received from the Legal Department.

11

38. Expected Results under FIAL 11. The measures supported b y FIAL I1 are expected to y ie ld important results, including (a) issuance o f all legislation to regulate the application of the tax reform law; (b) further improvements in tax administration, including specific audit targets and the implementation o f integrated tax-customs audits; (c) approval of an official budget reform strategy; (d) Congressional approval o f an improved 2004 Annual Budget Law; (e) presentation to popular vote of the Constitutional referendum; (0 issuance of a new policy for legal defense o f the state; (g) presentation to Congress o f reforms to the public procurement law; (h) approval of an official asset management policy and the achievement of specific revenue targets; (i) signature of management contracts with two government agencies; and (i) enactment o f a Fiscal Responsibility Law.

39. Foreseen Results of FIAL I11 and IV. FIAL I11 i s expected to focus primarily on the following key policy actions: (a) achievement of specific targets of the tax reform; (b) unification of taxpayer accounts; (c) presentation o f the Organic Budget Code to Congress; (d) full implementation of revised royalty transfer scheme; (e) establishment of the institutional arrangements of the procurement system; (f) evaluation of the pilot management contract scheme; and (g) full implementation of the Fiscal Responsibility Law. FIAL I V wi l l focus on actual results from the tax policy and administration measures and the approval of the Organic Budget Code, implementation of medium-term budgeting, extension of the management contract scheme, and the effective implementation of the procurement, fiscal responsibility, asset management, and legal defense policies.

40. Overall Assessment of the Reforms. The Government has shown a high level of commitment and resiliency in pursuing the objectives o f the reform, which i s largely based upon the President's campaign platform and his initial presidential directives for public sector modernization.6 During the f i rst year of the Uribe Administration, the executive has worked with Congress for the enactment o f over 100 laws, including major reforms in tax policy, pensions, labor, fiscal responsibility, and most important, the approval to present a referendum to the population with significant measures for fiscal sustainability and reduction in the levels o f cor r~p t ion .~

41. The tax reform supported by FIAL I (and i t s full regulation by FIAL 11) has shown important results and statistics show that revenue has increased according to expectations. Nonetheless, the government i s s t i l l considering further measures to raise revenue while observing international best practices in tax policy. To complement the tax reform and as a prelude to the upcoming budget reform, Congress approved the Fiscal Responsibility Law, which sets out important principles for fiscal sustainability and transparency. Expenditure-side reforms of the kind supported by the FIAL are more complex and some of them show results only in the medium or long term; however, some indicators that show that the reform process i s on track are the following: (i) The

On July 26th, President Uribe held his first live, televised cabinet meeting where the Ministers presented reports on their accomplishments to date. Most of the objectives o f the FIAL, notably in taxation, budgeting, procurement, and fiscal responsibility, were explained and discussed at length.

The Constitutional Court recently ruled that most of the questions in the referendum are constitutional, including all related to the FIAL. Shortly afterward, the Government set the date of October 25" for the vote.

12

government has taken the overhaul o f i ts budgeting system very seriously and has obtained assistance from the Bank, the IMF, and other entities in the design of a new budget law; (ii) The 2004 Budget Bill was submitted to Congress and approved incorporating substantial improvements in terms of medium-term planning and the provision o f useful information for fiscal analysis; (iii) Strategies have been defined and institutional arrangements established to oversee areas such as asset management, legal defense of the state, and public sector procurement; (iv) A novel management system i s being piloted to enhance accountability for results; and (v) A referendum to consult the population on key issues involving fiscal, political, and institutional issues has been scheduled for October 25.

42. The FIAL Program within the Bank’s Country Assistance Strategy (CAS). Under i ts objective of achieving fast and sustainable growth, the CAS approved in December 2002 indicates that, “The main objective o f the IBRD’s strategy in terms of the macroeconomic framework would be to support Colombia’s continued fiscal adjustment, including the quality of the adjustment, as key for achieving faster and sustainable growth. To support this, the IBRD, in close collaboration with the IMF and the IDB, w i l l prepare a Programmatic series of Fiscal and Institutional Adjustment Loans (total US$900 million) to support fiscal adjustment, including reforming the tax system, strengthening the tax administration, implementing a fiscal responsibility law and reforming the public sector.” The CAS scheduled the first loan of the program for FY03 in the amount of US$300 million, followed by two loans o f US$l50 mi l l ion each in FY04 and FY05, and a final US$300 mill ion loan in FY06.

43. Linkage between the Programmatic Fiscal and Institutional Adjustment Program and other Bank Operations and Activities. The proposed Programmatic series of Fiscal and Institutional Adjustment Loans to support public sector reform and fiscal adjustment i s the core of the Bank’s support to the reform efforts of the government, and wi l l provide the basis upon which complementary policy-based operations wil l be developed. These include support to the financial sector in the form o f Programmatic Financial Sector Adjustment Loans (FY03 and FY04) that aims to promote the development of a well-functioning financial system that can provide adequate services to all segments of the productive sector and the population at large. In addition, building on the achievements o f the Financial Sector Adjustment Loan (FYOO), it w i l l address the remaining agenda to ensure the health and financial sustainability of the banking system and to foster capital markets development.

44. The anticipated Sustainable Development Sector Adjustment Loan (FY05) w i l l support the mainstreaming of the environment in practically a l l infrastructure sectors, including water and sanitation, energy, transport, and disaster management. The tools for mainstreaming environment include policy setting, strategic environmental assessments, land use planning @lanes de ordenamiento territorial), permits and licensing, environmental regulation, economic and fiscal instruments, social impact analysis and valuation, assessment and linkage with global environmental goals, participation a n d conflict-resolution mechanisms, and development o f sector-environment indicators l inked to health impacts. These tools are currently being used in most sectors, however, this operation aims to enhance effectiveness and impact by providing a more rational

13

application based on priority-setting and institutional analysis (how the environmental management institutions set priorities, receive budgets, and function).

45. The FIAL program shares some areas of mutual interest wi th the Programmatic Labor Reform and Social Sector Adjustment Loan (PLaRSSAL) approved by the Bank during the second quarter of FY2004. The task teams have worked in coordination, and the two main areas of interaction are (a) Management Contracts for Government Agencies. Both programs seek to improve the efficiency and effectiveness o f Colombian Family Welfare Institute (ICBF) and the National Training Service (SENA). The FIAL approaches t h i s issue through the creation o f a new instrument for improving management that can then be replicated to other entities and sectors. PLaRSSAL, on the other hand, i s concerned with the substantive impact of the managerial reforms on quality and coverage of service delivery.8 (b) Incentives for Efficiency Gains. This FIAL component has the objective of introducing incentives that promote the use of results- based management to improve efficiency and effectiveness of fiscal transfers to the subnational levels, particularly in the education sector, and wi l l support the presentation of the referendum to popular vote which includes a provision to assign 56 percent of the National Royalty Fund to education projects exclusively to increase school attendance in vulnerable groups. Other quantitative and qualitative sector-specific outcomes and indicators are considered in the PLaRSSAL.

46. In addition, the FIAL program i s highly interrelated with the current Public Financial Management Project II (MAFPII), aimed at strengthening budgeting, tax administration, public investment management, procurement, and results management. This Bank-financed Technical Assistance Loan (TAL), in implementation since August 2001, i s the most important source of technical assistance funding for the implementation of the FIAL policy actions. Although i t was approved before the FIAL discussions began, i t s objectives are fully consistent with the FIAL policy matrix. The components that are within i t s scope and are receiving assistance are tax policy, tax administration, budgeting, and procurement. Support for management contracts for government agencies and the monitoring of the overall reform process also fall within i t s scope, and technical assistance w i l l be made available shortly.

47. Complementarities with other Institutions’ Operations. The IDB i s preparing an investment operation of approximately US$18.3 million, designed to support the implementation of the overall reform program and specific support to asset management, legal defense of the State, and information technology. Both task teams are working in close coordination since the IDB’s components of asset management and legal defense of the state wi l l support and be consistent with the FIAL’s policy matrix. This loan i s expected to go to the IDB’s Board o f Directors during the last quarter of 2003.

48. Institutional Assessment. The FIAL program i s being executed b y the Ministry of Finance (MHCP) with the support of the National Planning Department (DNP). MHCP wi l l ensure the full execution o f the policy measures and “triggers” established in the program. These activities wi l l be carried out in close coordination with DNP.

In other words, the FIAL i s concerned with the success of the “instrument,” whereas the PLaRSSAL i s concerned with the “substance” of the reforms in ICBF and SENA.

14

49. Given the size and relative complexity of the program, the General Vice-Minister of Finance, working closely wi th the Deputy Director of DNP, will be responsible for the strategic management of the program. These two agencies have the consensus-building capacity and political, technical, and operational support required to assume this responsibility. Both are part o f CONFIS, participate actively in Congressional debates and Cabinet meetings, and serve as counterparts to the IMF and other multilateral agencies as representatives of the Finance Minister and the Director of DNP. In addition, the Vice-Minister of Finance and the Deputy Director of DNP are responsible for the execution of MAFP-TI[ and i t s respective institutions. They w i l l be capable o f establishing synergies and synchronizing the parallel development of MAFP-11 and

50. The strategic management of the program will involve the fol lowing actions: (a) being the interlocutor of the national government with the Bank; (b) supporting and managing the fulfillment of the policy actions of the various program components; (c) coordinating the development o f the planned actions and reforms with those responsible within the various entities; and (d) compiling and sending the technical, legal, and administrative information required for the execution o f the policy measures of the program.

5 1. To assume the responsibility o f coordination and follow-up of FIAL-11, an inter- ministerial working group has been established within MHCP, comprising all agencies and entities involved in the program, including MHCP, DNP, the M in i s t r y of Social Protection, the Ministry of Justice and the Interior, SENA, and ICBF. Each of these entities has designated one high-level professional as a representative to this inter- ministerial working group, and as the one directly responsible for program components. Table 2 outlines how responsibility for each of the program components has been divided.

FIAL-II.

Legal Defense of the State Public Sector Procurement Asset Management Public Sector Reform Monitoring and Evaluation of State Reform Fiscal Resoonsibilitv Law

and ICBF Ministry o f Justice and Interior (Vice-Minister) DNPLegal Advisory Group DNPLnfrastructure Department DNPPublic Administration R e f o r m Program DNP/SINERGIA and MHCP/CONFIS MHCPRechnical Vice-Minister

52. For the development o f the duties required for the strategic management of the program, the Vice-Minister of Finance has the support of expert professionals within the Superior Council o f Fiscal Policy (CONFIS) and within the general directorates o f Macroeconomic Policy, Taxes and Customs (DUN), Public Credit, Budget, and the Treasury. For the development of the duties that correspond to DNP, DNP has the

15

support of valuable professionals in the directorates of the Public Administration Reform Program, Infrastructure, Social Development, Justice and Defense, External Credit, and Results Evaluation.

53. As part of the planned measures in FIAL-11, the government has developed a system for monitoring and evaluating state reform, and has announced monitoring indicators for public sector reform progress on the DNP website. The DNP, through the Evaluation System for Public Management (SINERGIA) (for components o f Asset Management, Legal Defense of the State, Procurement, Management Contracts, and Management of the Reform Process) and MHCPKONFIS (for components o f Tax Reform, Tax Administration, Fiscal Responsibility, Budget Reform, Incentives for Efficiency Gains, and Management of the Reform) wi l l follow up and evaluate results of FIAL-II. The results of FIAL-I1 wi l l comprise part of the findings of the government's National Development Plan for 2002-2006. The government has the mandate to follow up in terms of effectiveness, productivity, and efficacy, and the results o f the follow-up and evaluation w i l l be reported to the Bank by means of periodic reports.

54. Technical Assistance. Many of the technical assistance requirements o f several key components-particularly tax administration, budgeting, and procurement-as well as the financial management or evaluation features of other components, w i l l be partially or fully provided by the MAFPII project, currently in execution. In addition, the Government and the IDB are considering including technical assistance support for other FIAL components-particularly asset management and legal protection o f the State- under an IDB-TAL project currently under preparation. Moreover, the GOC and the Bank are exploring complimentary grant financing through Institutional Development Facilities (IDFs) or Policy and Human Resources Development grants (PHRD) to support the reform process. Table 3 summarizes the technical assistance arrangements.

Table 3: Sources of Technical Assistance for the M A L Program Component t Source(s) I status

Tax Reform I MAFP I1 (IBRD) I In execution

55. Fiscal Commitments. Within i t s macroeconomic framework, the government signed a new Stand-By loan with the IMF in the amount o f SDR1.5 b i l l ion for the next two years (see Annex 11-Fund Relations Note). Achieving the structural benchmarks of

16

the agreement will constitute an overarching pol icy condition for the FIAL. Some of the targets of the IMF-backed program for 2003 are a Combined Public Sector deficit of 2.5 percent of GDP, a current account deficit o f 0.8 percent of GDP, and an inflation rate between 5 and 6 percent.

56. Although fiscal performance has remained within the framework o f the IMF agreement through the first semester, there i s widespread expectation that the year-end deficit w i l l b e above 2.5 percent of GDP. This will be fueled by several factors, among them the seasonality o f expenditures and a supplemental budget to be considered by Congress that includes unforeseen debt payment obligations, pensions, a n d the cost of the referendum. An IMF mission wil l review the progress in the agreement during the last week of October.

B. COMPONENTS OF THE PROGRAM

57. Colombia gets i ts fiscal revenue from three main sources-oi l royalties, customs duties, and domestic taxes. The value of oil revenues depends largely on world market factors beyond the government’s control, although there i s scope for reform of how these revenues are allocated and shared between di f ferent levels of government.’ Customs revenues have generally declined over recent years, with trade liberalization, and this trend should continue for the sake of economic development. The main opportunity for increasing revenues comes from domestic taxation, w h i c h i s also an important area for reducing economic distortions and administrative complexities.

Tax Policy.

For the last 15 years the value o f oil revenues has also suffered from attacks on the p ipe l i nes .

17

Figure 3: Timeline of Changes in Tax Policy Total Income 1990-2002

(‘76 GDP)

16

14

12 n :: 10

6

4 1 , , , 1

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Previous rounds of tax reform, particularly in 1974 and 1986, l e f t the country with 58. a fundamentally sound array of taxes at the national level-on value added, corporate, and personal income. The two aspects of the income tax are largely integrated by exempting dividends from taxation as personal income and giving all corporate forms equal tax treatment. Prior to 2003, capital gains were not taxed at the individual level, which had the advantage o f avoiding double taxation of retained earnings (matching the non-taxation o f distributed earnings and further integrating the business and individual tax systems), but had the disadvantage of reducing revenue and offering opportunities for tax avoidance through schemes to convert current income into capital gains.

59. Aside from the major reforms, however, the tax laws have suffered frequent changes that reduced revenue collection and introduced distortions by granting preferential treatment to special interests or, alternatively, increased revenue and intensified distortions by raising the rates on activities already being taxed. Figure 3 shows the recent timeline of changes in tax policy and revenue. Now, the new government of Colombia has an electoral mandate to raise more tax revenue, and the challenge i s to do so in a way that reduces privileges and distortions.

60. The enactment of Tax Reform Law 788 in December 2002 brought together some of the key policy actions geared to the modernization of Colombian tax policy. This law (a) eliminates exemptions and expands the tax base for the value-added tax; (b) establishes a new ceiling on the wage exemption for the personal income tax, and reduces incentives for non-taxed compensation to employees; and (c) phases out the corporate income tax exemption for capital gains from sales of stock, mutual funds, and real estate, and for profits from previously privileged corporate forms, contracts, funds, or bonds. On a tax-by-tax basis, the 2002 tax reform included the measures shown in Table 4.

Key Policy Actions Undertaken.

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Table 4. Key Measures of tbe 2002 Tax Reform (Law 788) Tax I Key Effects

Value-Added I A large number of previously exempted or excluded goods and services wil l be Tax

Personal Income Tax

Corporate Income Tax

Other National Taxes and Contributions Subnational Taxes

subject to the V A T at 7 percent from 2003, rising to 10 percent in 2005 Mobile phone rate established at 20 percent Rate on automobile sales wi l l be unified at 25 percent from the current range of 20 percent to 35 percent Collection of VAT on al l capital goods with a 3-year rebate or credit for registered firms making further sales Reduction o f the wage tax exemption from 30 percent to 25 percent with a ceiling of Co1$16 million in monthly wages, and reduction of tax exemptions, tax credit, and non-taxed income for the personal income tax Phase-out of exemptions for capital gains from sales of stock, mutual funds, and real estate, and for profits from a variety of previously privileged corporate forms that often served as tax shelters Reduced access to the special tax regime (20 percent rather than the standard 35 percent) 10 percent special surcharge for 2003, to be lowered to 5 percent in 2004 Does not eliminate the distortionaryfinancial transactions tux implemented in 1999; however, it closes some loopholes for transactions in the real economy and allows exemptions for some interbank transactions not meant to be taxed Rationalizes departmental and district taxes on alcoholic drinks Increases the gasoline tax surcharge transferred to subnational governments by 5

0

percent

61. The Government has moved ahead quickly in the preparation and approval of a large number o f decrees that regulate the implementation of Law 788. Among the most important issued to date are those on dispute resolution, declaration of assets held abroad, inflation adjustment of inventories, closing loopholes to the financial transactions tax, revisions to the value-added tax, VAT exemptions for exporters, taxation of rental property, and determining and imposing penalties.

62. Remaining Challenges. In addition to completing the issuance of regulations for the tax refom, the government w i l l be implementing actions in 2004 that were foreseen in Law 788. These mainly involve reducing the exemptions in the corporate income tax law and reducing from 10 to 5 percent the surcharge on the corporate tax base rate, both of which should improve the overall investment climate and reduce distortions.

19

Table 5: Ta EE INTERNAL TAXES

Income Tax VAT

EXTERNAL TAXES Customs External VAT

GMF (0.3%) TOTAL

9,311 5,763 3,548 2,376 944 1,43 1 682

12,369

9.47 5.86 3.61 2.42 0.96 1.46 0.69 12.58

10,924 6,694 4,230 2,979 1,018 1,960 750

14,653

10.0 6.1 3.9 2.7 0.9 1.8 0.7 13.4

1,613 93 1 682 603 74

5 29 68

2,284

0.54 0.27 0.27 0.31

0.34 -0.01 0.84

-0.03

Source: Ministry of Finance and Public Credit.

63. The provision of Law 788 that established a 2 percent VAT starting in 2005 on previously untaxed goods and services such as basic foodstuffs, health, education, and transportation was recently challenged and rendered unconstitutional by the Constitutional Court because i t violated the principles o f progressive taxation. The expected annual collection from this measure was 800 billion Colombian pesos (approximately US$280 million, for 2005), which the government wil l need to raise through alternative measures. Some of the options being considered are a 3 to 4 percent VAT on certain previously exempt goods while maintaining the exemption on certain services, such as health and education, or a progressive pensions tax. Therefore, fiscal sustainability wil l require an additional round of tax reform in the future, with content and schedule yet undetermined.

64. Expected Outcomes. These measures w i l l expand the VAT tax base from about 41 percent o f consumption in 2002 to about 59 percent by 2005," a major achievement. Regarding the corporate income tax, the phase-out of exemptions w i l l reduce them from 70 percent of potential revenue in 2003, to 50 percent in 2004, to 20 percent in 2005, and to 0 percent in 2006. An increase in subnational revenues by one-fifth i s expected. Preliminary estimates by the authorities indicate that tax collections would increase by about 1 percent of GDP in 2003 as a result of the tax package, rising to 1.2 percent o f GDP in 2004 and to 1.7 percent of GDP in 2005. Table 5 shows the observed increase in tax revenues comparing the f i rs t semester o f 2002 with the f i rs t semester of 2003.

65. Tax Administration. Even the best policy reforms would realize their goals o f greater revenue yields with fewer distortions only i f there are improvements in tax administration. This remains a major weakness in Colombia, where tax revenues are substantially below what the rates and the tax base would normally suggest.

66. The VAT and income taxes each collect only a little over 5 percent of GDP. The National Directorate o f Taxes and Customs (DIAN) i s the entity responsible for tax and customs administration. Some o f the most important areas where the tax administration needs improvement are:

.

lo Assuming that the 2 percent VAT gets restored or replaced by an equivalent measure.

20

0 Revision of the relationship with the banking system in order to standardize information flows and reduce the period during which funds are held by banks (now 14 days); Improved coverage of withholdings of interest income on individuals, now only at 7 percent and from large accounts only; Increased integration between the areas of internal revenue and customs, especially in processes such as auditing and information management; Reduced costs of enforcing compliance.

0

0

0

67. Key Policy Actions Undertaken. The DIAN has undertaken a major modernization effort and i s working hard to meet the revenue targets for 2003.'' I t has established regulations to reduce the threshold o f interest income revenue to be withheld at the source, enhanced reporting by financial institutions, established a p lan to collect tax debt, and defined indicators to monitor customs processes in Bogota and Medellin. I t has improved the cross-referencing of information with financial institutions, audited a majority of the large taxpayers that were brought into the new tax regime, established performance indicators for tax administration, and carried out over 200 integrated audits (taxes and customs), which i s well above the commitment in the policy matrix. The MHCP wi l l present to Congress a draft law to regulate the penalization o f tax evasion. Furthermore, DIAN has increased i t s auditing activities dramatically and has embarked on an ambitious modernization effort with the support o f the Govemment of Spain and the Bank. 68. Remaining Challenges. Many challenges to tax administration st i l l l ie ahead, In the medium term, DUN knows i t needs to make significant efforts in systems development, and reengineering of processes and procedures, and that improved regulations of and relationships with the banking system are necessary, which are in turn expected to yield a reduction in administrative costs per peso collected of 10 percent, a collection o f 75 percent of potential revenue from previously exempted corporate income taxes, and marked improvements in a broad set o f performance indicators. These w i l l be accomplished with the support o f FIAL I11 and IV. 69. Fiscal Responsibility. The fiscal situation in Colombia reflects the extent of excess demand on the State, i t s inability to meet those demands, and the urgency of achieving sustainable balances. A sound fiscal framework i s essential for the national security effort, for the social programs that sustain the State's legitimacy, and for the protection o f common citizens against the ravages of inflation. Achieving that w i l l require, among other things, institutional reform o f the formulation of macroeconomic policy, and close monitoring and control to meet short- and long-term fiscal targets.

70. Behind the unavoidable fiscal arithmetic b y which spending in excess of revenue has led to deficits and the accumulation of debt in Colombia, there l i e budgeting a n d fiscal management procedures that gave rise to the unsustainable fiscal tendencies. Colombia has given increasing attention, therefore, to changing i t s rules o f the game for fiscal policy at al l levels of government. Until recently, the Constitution and legal rules for budgeting and treasury have done l i t t le to restrain Central Govemment deficits a n d

In the televised cabinet meeting, DIAN announced that it had collected over 99 percent of the revenue target set for the first seven months o f 2003, which was COPI7,582,000 million.

21

debt, and in some ways they encouraged them. For example, vigencias futuras make commitment for future expenditure and the allowance for arrears based on ad hoc promises for future payment of current expenditures.

71. In the 1990s, the new Constitution broadened political participation, increased spending impulses, and weakened the tax base o f the national government (automatically sharing i t with subnational governments), all o f which compromised overall fiscal prudence. T h e Acto Legislativo (constitutional reform) o f 2001 sought to put ex ante limits on some of the spending impulse coming from transfers to subnational governments.

72. Despite these reforms, the national government believes that at all levels of government there remains too much discretion affecting fiscal deficits and not enough assurance o f fiscal sustainability. DNP evidence to this effect i s the fact that Central Government expenditures have increased steadily from 9.4 percent of GDP in 1990 to 20.8 percent of GDP in 2002.

73. The Colombian Congress approved a Fiscal Responsibility Law (FRL) in June 2003 that sets the stage for fiscal sustainability. After several rounds o f revisions and consultations with the Bank, the bill was enacted into law. The bill had been discussed within the government and Congress since the previous administration, and it came through Congress without any ad hoc amendments or cumbersome transition clauses. The FRL contains rules for fiscal stability, transparency and macroeconomic consistency, fiscal discipline, and subnational debt l i m i t s that reinforce and expand the measures previously taken with Law 617. The Law contains rules for (a) setting fiscal targets linked to debt sustainability and primary balance for the Non-Financial Public Sector (NFPS); (b) publication o f the financial plan; (c) annual reports of fiscal results to Congress; and (d) the obligation to include the fiscal impact and source o f financing within any new law that affects taxes or expenditures.

74. Remaining Challenges. The key challenge in relation to fiscal responsibility w i l l be the full application o f the FRL in 2004, including the issuance of regulations. The main new work w i l l be the development of a Multiyear Fiscal Framework (Marc0 Fiscal Multi-Anual) and the accompanying reports, which are due for the first time in summer 2004 but have been advanced in the presentation of the 2004 annual budget bill to Congress. As this i s developed and the complexities become apparent, the government wi l l at the same time develop and then issue the regulations. Here the issues of calculation of contingent and floating debt wi l l be spelled out-the format for reporting them, linkage of the Multiyear Fiscal Framework with the stipulations o f the Organic Budget Law (to be submitted to Congress by then), and the regulation o f subnational debt. 75. Asset Management. Public Asset Management i s the institutional framework used by the public sector to account for, administer, allocate, maintain, use, and dispose of government assets. Currently, the existing information on public real estate assets i s deficient, incomplete, and unreliable. l2 Furthermore, the administration of public real

Key Policy Actions Undertaken.

~

l2 For example, current figures on public asset inventories reflect the unreliable information systems used. Of the 302 entities at the national level, only 187 report information about their asset inventory to the Contaduria General de la Nacio'n (CGN). Additionally, most entities report incomplete information.

22

assets has been focused on precarious registration procedures and deficient conservation and maintenance of the properties. I t i s in many cases unknown whether the asset i s up to date in terms of legal contingencies, accounts payable, and so forth. Additionally, the high cost of normalizing assets has caused a significant proportion of public assets to have legal problems. This situation implies unnecessary public expenses and a high opportunity cost. The new framework w i l l create the rules, regulations and organizational practices-both formal and informal-for an efficiency-driven asset management policy.

76. Some agencies have accumulated a varied array o f properties and other assets, which with unclear legal status and economic value, incomplete registration, and irregular control, do not constitute a solid basis to apply professional management criteria. Moreover, there are no standardized procedures, centralized control, o r incentives for efficient asset management. The complex legal framework i s an additional burden because i t does not recognize market principles, nor does it provide adequately for discretionary managerial actions. As a result of al l these factors, asset management i s inefficient, and there i s a substantial accumulation of idle assets.

77. Key Policy Actions Undertaken. A government team for asset management was set up by DNP to lead the reforms in this area, prepare a National Council of Economic and Social Policy (CONPES) document defining the government pol icy in this matter, and to carry out a short-term asset sale and savings program meant to generate approximately US$10.5 million in capital revenue. The CONPES document has been approved and provides the initial framework and procedures for standardized, coherent, and efficient asset management.

78. Remaining Challenges. DNP wil l be the agency in charge o f implementing the directives contained in the CONPES document. This i s crucial since at present no entity in the Central Government i s in charge o f asset management, and standard policies and procedures have to be developed from scratch. The scope of this initial work also includes the operational planning for the elaboration of consolidated inventories (wi th verification o f title, possession, value, and accounting registration), the request to entities of the Central Government to report on their current asset stock, and the realization of savings and revenues in the short term o f approximately US$9 million.

79. Subsequent actions include (a) the formal establishment of a centralized unit in charge of the coordination of the more substantial reforms, the development of manuals of policies and procedures, provision o f technical assistance and overall guidance to other participating agencies, and management of a database system; and (b) development o f a more flexible and open-minded approach to concessions, leasing, privatization, outsourcing, and so forth, and the publication o f the inventory of assets owned by each agency, increasing transparency and accountability. The new approach wil l have four main pillars:

Contribution to Public Investment in Social Proaams: Priority wil l be given to the identification of idle public real estate assets that can be transferred to the national social housing program. DNP wil l work together w i t h the Ministry o f Housing and Environment in the design and development of a legal and financial scheme that wi l l speed up the transformation process of idle publ ic real estate

0

23

0

0

a

80.

assets into social housing projects. This will help to achieve the government’s targets in the reduction o f the existing housing deficit (1.5 m i l l i on units). More specifically, social programs such as land reform, primarily €or victims of violence, w i l l be addressed. Urban Renovation: The state has a large m o u n t of nonproductive assets that could be used by local municipalities and districts for urban renovation projects. Real Estate LeasindRents: Public real estate assets generating revenues can be packaged and sold in capital markets. Sales: The existing legal framework l imi ts the selling process of public assets. In this regard, legal reforms have to be submitted to Congress to approve innovative outsourcing schemes for the implementation of commercial strategies to dispose of assets. This includes the contribution of idle public property to private real estate projects as a means to speed up the sale and generate value in the process. These schemes have proven successful in social housing programs at the municipal level (Metrovivienda) and could be adapted to serve the Central Government’ s objectives . Protecting the State against the Extraordinary Growth of Legal Claims.

Litigation against the State has a substantial fiscal impact in Colombia, much above known impacts for other countries. Typically, lawsuits against the State arise from poorly drafted contracts, which leave space for litigation regarding the interpretation of rights and obligations. Since 1994, the number o f cases filed has increased enormously, and their outcomes have contributed negatively to the current fiscal crisis. In the last four years, actual payments due to formal first instance judicial or arbitration decisions against the State exceeded US$145 mi1li0n.l~ This amount alone i s cause for serious concern, but reflects only the flow of actual payments made; estimates show the accumulated stock of contingent liabilities growing at an alarming speed. I f this trend continues, i t i s estimated that b y 2006, liabilities due to judgments against the State w i l l represent approximately 2 percent of GDP (see Figure 4).14

81. This scenario i s aggravated by the fact that the State cannot afford to honor on time all compensatory payments. An extremely high rate of penalty interest (up to 30 percent per year) i s applied, creating a “snowball effect” in the State’s liabilities. This allows ample margin for unethical practices, as creditors “prefer” to be paid late and benefit from a very attractive return on their accounts receivable.

l3 Based on data from MHCP, before the decision o f the appeal level. Note that a single case s t i l l pending decision, Telecom, could generate compensation payments of up to US$282 million, adding great fiscal ’‘ Sources: Contraloria General de la Nacidn; Contaduria General de la Nacidn. These figures have not been independently verified by the Bank, DNP, or the Ministry of Finance.

ressure that i s not sustainable in the short term.

24

Figure 4. Accumulated Fiscal Cost of Contingent Liabilities Against the State

8000

1995 1996 1997 1998 1999 2000 2001 2002(e)

Sources: Contralon’a General de la Republica, Contadun’a General de la Nacibn, and World Bank

82. Regardless o f the complexity of the situation, three distinctive elements can be identified as the main reasons for this problem. First, there seems to b e a web of c i v i l servants, contractors, judges, attorneys, and so forth engaged in coordinated corrupt practices that materialize in such things as reciprocal favors o f poorly drafted contractual agreements, fake accusations and claims, high compensation payments, and intentional “erroneous” decision^.'^ Second, the Colombian State has a weak capacity to defend itself in court. The private sector i s better equipped to retain expert legal advice, and therefore their claims are exerted with much more rigor. Third, the legal framework encourages the State to act passively with respect to demands and claims from individuals. In labor and contracting legal issues, the State recognizes certain rights of counterparts, but in doing so, compromises i ts own position.

83. The Ministry of Finance, the Planning Department, and the Ministry of Interior and Justice are especially concerned with the fiscal threat that originates from a weak legal and judicial performance of the State. These government units, with the support o f sector ministries, the Procuraduria, the Contraloria, and the Consejo de Estudo, are committed to elevating the institutional capacity of the State to protect itself from legal claims as a precondition for an effective reform.

84. The objectives of strengthening legal protection o f the State are (a) to reduce negligence and corruption in the management o f state affairs, including labor and commercial contracts; (b) to reduce fiscal impact o f judicial and arbitration decisions against the State by seeking compensation from responsible officers or third parties; (c) to strengthen the state capacity to prepare, monitor, and control large investment contracts and labor relations with a view to prevent contractual disputes; (d) to anticipate and prevent state responsibility for infringement of basic rights; and (e) to foster a better

l5 This appears to have happened, for example, in the recent decisions against the State for the cases of Foncolpuertos and Termorrfo.

25

investment climate through enhancement o f transparency, predictability, and responsibility in state contractual and extra-contractual relations.

85. Key Pol icy Actions Undertaken. The immediate objective o f the government i s to improve i ts legal protection through the institutional strengthening of the Ministry of Interior and Justice’s (MIJ) Directorate of Legal Defense. As part of L a w 790, which pushed the agenda of public sector modernization and gave the President special authority to restructure the Executive Branch, Congress approved a specific clause for strengthening the MIJ’s roles and responsibilities in legal defense and mandated the implementation of an information system to track and raise alerts regarding lawsuits. Consequently, the Directorate of Legal Defense i s carrying out a detailed diagnosis and typology of the related issues, causes, and costs to produce policy guidelines to be approved officially by the government.

86. Remaining Challenges. The enactment o f Law 790 and the groundwork being carried out by the MU i s just the beginning of a lengthy process o f strengthening legal defense, and i ts actual impact on the budget may not be seen for years. The MIJ needs a highly qualified cadre of staff to carry out the mandates of the law (including the obligation to coordinate the defense of all claims above 2,000 monthly minimum salaries, or approximately US$235,000). An effective reduction in the fiscal cost of claims also requires a coordinated effort with the sources of the dispute (such as the procurement process), and with other agencies of control and oversight. The overall diagnosis and strategy was approved as a CONPES document and became official government policy. The information system mandated by the law i s also o f high importance to ensure prompt action when required.16

87. Budget Management. Colombia’s planning and budgetary process i s a complex interplay of various entities operating under diverse rules and procedures. I t produces the National Development Plan, the Financial Plan, the National Investment Plan, the Annual Investment Operative Plan, and the Budget. Theoretically, they are fully consistent with one another, but in practice they differ among themselves. Budget law figures are actual appropriations instead of expenditure caps, which consequently limit the scope for expenditure control during the budget year. Furthermore, the budget process does not produce reliable revenue estimates.

88. Over the years, many Colombian interests have successfully won permanent budget entitlements or revenue earmarks. This has served to circumvent resource constraints and to reduce the scope for government decisionmaking and good fiscal policy. I t has also crimped the mobilization of funds for new programs. This problem has been recognized and acknowledged b y the Colombian authorities since i t was f i rst pointed out by the 1980-8 1 Presidential Commission for Inter-Government Fiscal Relations. However measures to attenuate i t have been too weak or short-1i~ed.l~

l6 The technical assistance required to achieve the long-term objectives o f legal protection o f the State w i l l be provided by an IDB-funded TAL, currently in preparation and scheduled for approval in late-2003. l7 Cf. Bird, R. M., 198 1, Colombia. Inter-govemment Fiscal Relations. Harvard University, International Tax Program. The Presidential Comisidn de Gasto Pliblico of the early 1990s produced a report o f similar category.

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89. Other deficiencies in the system include the absence of suitable controls over budget outcomes. Instead of having effective “checks,” Colombian budgeting i s too process oriented. This has hampered the tracking of such important elements as stability, effectiveness, and efficiency. In addition, Congress lacks the technical capacity to properly analyze budget information.

90. Thus, the challenge i s to initiate a transformation o f the budget system through several fronts: first, to introduce greater flexibility by restricting earmarking o f revenues, permanent expenditure entitlements, and the use of forward budgeting; second, to establish effective controls over expenditure aggregates; third, to develop tools for improved medium-term budgetary planning; and fourth, to make the budgetary process more policy focused and accountable for results. This wi l l not be an easy task. Besides the inertial tendencies to maintain existing practices, the vested interests that have gained power on budget decisions wi l l resist giving it up.

91. Reform wi l l require sustained changes in rules and procedures to make budget decisions according to policy priorities (allocative efficiency), performance and results (productive efficiency), and available resources. This would affect how Central Government and sectoral authorities decide on what should be done, how i t i s going to be achieved, and who i s responsible for it. I t would also affect subnational governments to the extent that national rules and practices are also applicable to regional and local governments. The new rules also call for mechanisms to hold policymakers and managers accountable for planned outputs and outcomes to be delivered in a timely fashion.

92. Key Policy Actions Undertaken. The f i rst attempt by the Government to rationalize the budgetary system was contained in a proposal for constitutional reform (Acto Legislativo) that would have given the MHCP the authority to regulate budget execution within fiscal targets, in contrast with the current system where the budget creates mandatory and inflexible entitlements. Although the Lower House approved the proposed reform, it was struck down b y the Senate.” Therefore, virtually all the policy actions needed to reform the structure o f the budgetary system st i l l lie ahead. However, i t should be noted that the 2004 budget document, which was presented to Congress on July 2gth, was a significant improvement over previous budgets because i t included a medium-term fiscal outlook, the calculation o f tax expenditures and contingent liabilities, and a presentation by functions that integrates current and capital expenditures.

93. The road map toward budget reform was approved as a CONPES document. This in itself i s an important achievement because it shows consensus within the Executive Branch over the objectives o f the reform, something rather difficult considering that several ministries benefit from budgetary rigidities and that restoring control over expenditure aggregates to the Ministry o f Finance places greater pressure on them to use their budgets within clearly established guidelines.

On July 20, the Government resubmitted a variant of the Acto Legislativo to Congress, including proposals to allow the annual budget law to modify earmarked revenues and modify laws that generate public expenditure, and prohibiting the creation of new earmarked revenues. However, i t s theoretical approval by Congress would take approximately one year.

27

94. ChaEZenges Ahead. The government has determined that substantial reforms in the budgetary process are essential to restore i t s capacity to implement fiscal policy within a framework of macroeconomic stability. A number of key policy actions lie ahead which, when taken together, constitute an important package of reforms that w i l l restore flexibil i ty to budgetary management and strengthen the policymaking capacity of the Executive Branch. These include:

Pursuing a Medium-Term Expenditure Framework (MTEF) adjusted to the Colombian legal and political constraints. This document must propose aggregate fiscal targets for a multiannual period (in conjunction with the FRL), identify key strategic and policy issues, and propose sectoral allocations. Once these sectoral priorities and activities are identified by line ministries and decentralized agencies, i t would be possible to carry out a cost assessment o f total requirements within each sector. This medium-term perspective would also serve other purposes: i t would provide reliable figures to evaluate possibilities o f budget cuts from the standpoint of output impact rather than the more traditional input perspective, and would clarify the need to evaluate legal entitlements in the light of sectoral objectives and priorities, and how to shift resources when priorities change.

Ensuring Consistency between Current and Capital Expenditures. Over decades, the processes of assigning current and capital expenditures by the Ministry o f Finance and DNP, respectively, have resulted in two almost autonomous budgets. This resulted in, among other things, an inability to effectively analyze the current expenditure consequences of public investment. The authorities will act to ensure coherence between current and capital spending.

Greater Transparencv and Accountability for Outcomes. This element of the strategy calls for simplifying budgetary information in order to make it easier to understand and available for public use. This proposal goes hand in hand with the government's initiatives to launch a website with comprehensive fiscal information based on S I I F outcomes, and wi l l require the immediate implementation of a communication program to convey to the public the present budget figures. The bond between results and budget allocation i s an important area for improvement.

Review of Entitlements and Earmarked Revenues. To promote flexibility in public expenditure, the GOC needs to undertake a process of review of expenditure entitlements and earmarked revenues, and define the necessary legal and administrative measures to introduce greater f lexibil i ty into budget management.

Budgeting and Accounting Classifications Using International Standards. Different government levels have been reluctant to unify accounting and budgeting classifications, instead using nonstandard accounting practices. The strategy aims at unifying budgeting and accounting bookkeeping according to international standards in time for the FY2006 budget.

28

95. These reforms, and others critical to the modernization of the public expenditure cycle, will be introduced through two primary vehicles: first, a new, more comprehensive and coherent Organic Budget Code (OBC); and second, the annual budget laws, which should incorporate the requirements of both the revised OBC and the recently approved Fiscal Responsibility Law. Between them, the Government should achieve substantial improvements in the budgeting process in order to introduce greater flexibility, accountability, and macro-fiscal consistency.

96. Development of Incentives for Efficiency Gains. Service delivery in Colombia, as in many other countries, has long emphasized inputs over outcomes. The traditionally centralized public sector management tended to distance public managers even further from the outcomes achieved by the interventions of their programs, yielding mediocre public services at unreasonably high costs. I t was hoped that decentralization would be a strategy to reverse this tendency, and since the mid-1980s a shift of resources and decision making authority to local government has occurred. But decentralization has not fully reached i t s objectives, and i t s level of implementation varies among the regions. The transfer of powers has resulted in blurred responsibilities in a number of sectors, which further undermines accountability.

97. The government has shown commitment toward introducing incentives to promote the use of results-based management to improve efficiency and effectiveness o f fiscal transfers at the subnational levels, particularly in the education sector. Given the fact that the fiscal decentralization scheme in Colombia establishes mandatory transfers to both departments and municipalities and that the Central Government has no authority to condition those transfers on performance, they have become one of the most important sources of budgetary rigidity. Transfers for education, for instance, represent about 7.5 billion pesos per year (12 percent o f the total budget).

98. The government’s strategy to overcome this situation or, at least, introduce results-oriented criteria and incentives to impact such rigidities consists of two measures: (a) the approval of Law 715 that changes the current supply-based transfer system for education based on the number of teachers in a certain region, to a new demand-based system based on the number of students attending school; and (b) reallocation of the 5 6 percent of the National Royalty Fund (FNR) currently spent on improperly planned and often inappropriate investments to finance exclusively education projects aimed at increasing school attendance of children in vulnerable groups.

99. Key Policy Actions Undertaken. Law 715, approved in December 2001, establishes new distribution criteria to go into effect in 2004, but it has already worked as an effective incentive to increase student enrollment across the country. Of course, such powerful incentives imply not only the sound objective o f encouraging students to attend school, but also the risk o f fraud by entities reporting excessively high numbers o f students to receive high transfers. Strong policies to improve control and audit systems are being developed by the Ministry of Education, and are expected to be operating by 2004.

100. Remaining Challenges. Improved targeting o f the resources of the FNR i s a n important element that remains to be achieved. Although the FNR does not represent a significant amount of resources compared to unconditioned transfers (1.5 percent), it can

29

constitute an additional incentive to subnational governments in order to promote the national pr ior i ty o f reducing deficits in school attendance. Such reallocation implies reforms to the Constitution, because the FNR i s regulated at that level. A referendum to approve such a constitutional amendment along with other fiscal and polit ical reforms has been approved by Congress and was recently authorized b y the Country’s Constitutional Court. The referendum wi l l take place in late October 2003. 101. Demonstrating i t s commitment to the reform, the Government has already initiated the FNR reallocation exercise by including, in the 2003 Budget, appropriations of 31.6 percent of these resources to projects meeting the criteria established by the Ministry of Education in the spirit of the pursued constitutional reform. This was possible through a decision by the Comite‘ Nacional de Regalias, a national and sub- national government joint committee that currently has oversight authority over that part of the FNR. As a result of this particular exercise, about 30,000 new students from vulnerable groups wi l l be enrolled this year, in addition to the regular enrollment rate. I t i s estimated that the total reallocation of royalties could duplicate such results.

102. In the event that this provision of the referendum i s not approved, it i s the commitment of the government that at least the 31.6 percent of the FNR wi l l continue to be allocated to projects to increase educational coverage, as in 2003, in order to make the results achieved to date irreversible and to expand them, depending on financial resources. This “Plan B” wi l l certainly have less impact than the reforms proposed in the referendum, but i t reflects what i s feasible within the current constitutional framework. 103. Strengthening Public Sector Procurement. Contracting and procurement with clear and transparent rules i s critical for making efficient choices in buying goods and services, and averting corruption in the process. In Colombia, inefficiencies in public contracts are due to a large extent to the legacy o f traditional patronage systems in the State, and to a dispersed and highly diversified legal framework. 104. Currently, a variety of laws and regulations govern public procurement, with frequent overlaps and omissions, and a proliferation o f regimes and exceptions. This debilitates monitoring and protects both buyers and vendors of services f rom being accountable to each other, providing much opportunity for corruption. Moreover, no central agency i s in charge of promoting reform and determining rules that could introduce more transparency and efficiency in the procurement process. Overly complex and superfluous procedures, such as the registry o f contractors, thus st i l l prevail, partly because the use of modern information technology i s relatively weak and state agencies are not well equipped to use it. Contract management and planning i s poor, and only large and experienced agencies show good practices. Procurement methods need to be redefined, standardized, and made more expeditious. There should be a better distribution of contract risk. Strategies for handling and successfully concluding the legal claims should also be established. Finally, civil society does not yet play a significant supervisory role, which further undermines accountability and transparency.

105. Key Actions Undertaken. The government has taken important init ial steps in this direction, notably Decree 2 170 that strengthens transparency and objectivity in procurement. Although this instrument only became effective on January 1, 2003, i t s impact i s already being felt. The requirement o f advertising bidding opportunities and

30

bidding documents on the web has been well received by both the p r i va te sector and government of f ic ia ls. Another development welcome by government agencies and state companies has been the introduction of “reverse auctions’’ for the procurement of large volumes of standard goods. Although, i t is s t i l l too early to tell, several government institutions h a v e successfully used this tool with meaningful reductions o f price. On the other hand, S o m e agencies complain that the shopping procedures introduced under the Decree have lengthened the procurement process of standard goods, which i s not necessarily bad, given the considerable discretion for the use of shopping under Law 80. I t i s expected that the new law amending Law 80 will, on one hand, firm up provisos included in the Decree, and on the other, correct shortcomings.

106. On October 20, 2003, the Government approved a CONPES document establishing t h e guidelines for improving public sector procurement. This document describes the need for simplifying the system o f various parallel procurement regimes, the introduction of efficiency considerations into the procurement process, and the establishment of a government entity responsible for the oversight of public sector procurement’ 9 .

107. Remaining Challenges. Although Decree 2 170 has introduced improvements in the procurement process, i t s cornerstone-the Organic Procurement Law (Law SO>- remains a major obstacle to substantive reform. Law 80 coexists with a large number of other laws and regulations that have an impact on the procurement process with major overlaps and omissions, muddling the regulatory framework and opening opportunities for corruption and fraud. The overall regulatory framework must be simpl i f ied and L a w 80 needs to b e substantially improved to become effective, in coordination with the guidelines of the CONPES document.

108. Earlier this year, the Government sent to Congress Bill 007/2003 amending L a w 80. The bill was drafted with considerable input from the private and pub l i c sectors. I t includes a number of positive amendments to Law 80 and establishes an electronic procurement information system. An important proviso making a government agency responsible for public procurement was dropped from the bill, but was la te r reintroduced at the request of the Government. Further down the line, the government w i l l need to implement the institutional arrangements defined in the revised Law 80, issue subsidiary regulations, and restructure the national registry o f bidders. The bill be ing considered i s fully consistent with the recently approved CONPES document, even though the customary process i s that the CONPES document gets approved before the bil l i s submitted to Congress. 109. Management Contracts for Government Agencies. Although the Colombian public sector i s rich in sophisticated tools for evaluation and monitoring, such as SINERGIA, the government’s performance monitoring system, the rigidities of the budgetary, human resource management, and administrative systems have made i t virtually impossible to match real incentives to institutional performance. Particularly in an environment of severe fiscal constraints, i t i s important to obtain the highest value-for- money in order to fulfill social demands and effectively implement publ ic policy. Since

,

l9 The consultancy requirements for the modernization o f the procurement process are fully funded by the Bank’s Public Financial Management Project 11 (MAFP 11).

3 1

i t i s not feasible to establish a comprehensive performance budgeting system in the short term, the Government requires a mechanism to introduce incentives for performance, at least on an agency-by-agency basis.

110. Key Actions Taken. The Government has implemented on a pilot basis a new instrument to both improve mechanisms for performance evaluation and provide incentives to independent or decentralized agencies in order to promote efficiency and better service delivery. The idea of introducing management contracts i s in line with the objective o f overcoming expenditure rigidities in those agencies that have their own funding sources but no incentives to provide good service.

1 1 1. Management agreements are, in essence, written agreements between Central Government entities (Ministries of Finance, of Social Protection, and the National Department of Planning) with oversight authority over a particular sector where independent or quasi-independent public agencies operate, and one or more o f those agencies. These agreements specify performance targets for the agency such as increased service coverage, improved quality and higher cost-effectiveness, and the consequences of achieving or not achieving the targets. The government has selected two major social protection decentralized agencies, ICBF and SENA, which are also targets o f policy commitments under the Bank’s PLaRSSAL, to spearhead this strategy. These two agencies have signed management contracts with the Central Government entities and constitute a pi lot exercise to be expanded in the future.

112. The National Service for Training (SENA) i s a 40-year-old agency that provides technical education to defined groups of the population in order to qualify the labor force and provide adequate sk i l l s for young people seeking their f i rs t job, and for older workers. SENA’s services are funded through a mandatory contribution f rom workers all over the country, which i s automatically discounted from private and public entities’ payrolls. Currently, SENA’s budget accounts for 0.82 percent of the total national budget. The Colombian Institute for Family Welfare (ICBF) i s a national agency that provides basic health (nutrition) services for the most vulnerable children and other groups under special risk. I t i s also an old agency (35 years) that enjoys its own revenues from mandatory contributions paid by private and public employers. ICBF’s annual budget accounts for about 1.56 percent o f the total national budget.

113. Each agency had agreed to an ambitious four-year strategic plan with the new Ministry of Social Protection. N o incentives, however, were offered in order to seriously promote changes in the administration. To fill this gap, management agreements have been signed between the Ministry o f Finance, the National Planning Department, the Ministry of Social Protection, and the agencies involved, as a key complement to the reform and modernization strategies in both entities. This instrument should provide the incentives to generate the desired virtuous cycle that promotes administrative efficiency, financial independence, and service improvements for their beneficiaries.

114. One common issue that was identified by these agencies i s the way in which the Ministry of Finance authorizes the use o f their “own” resources. Given fiscal constraints, these agencies are limited in the amount they can spend from the resources they collect, by the so-called espacio fiscal (fiscal yield). This policy contributes to balancing the aggregate fiscal accounts, but provides a wrong and perverse incentive to the agencies

32

that have no motivation to improve revenue generation and, thus, expand or improve service delivery. The key incentive to be introduced into the management agreements by the Ministry of Finance i s an increase in the fiscal yield based on (a) reaching service delivery goals under the strategic plan (particularly those agreed under PLaRSSAL), and (b) increasing revenue collection. This new scheme w i l l connect budget allocation decisions with service delivery achievements and revenue collection efficiency, transforming the perverse scheme into the correct way to provide incentives.

1 15. Remaining Challenges. The signature on the management contracts with I C B F and SENA is just the first step in a process meant to generate greater efficiency and accountability for outcomes in public service delivery. The performance of these agencies vis-&-vis the contracts wi l l have to be measured, and if appropriate, the incentives should be introduced into the 2005 budget. Frequent monitoring of the agreements wi l l be necessary to ensure their proper enforcement and the accumulation of lessons learned for a future expansion of the model to other public agencies. If this model i s successful in ICBF and SENA, the government intends to expand it to at least six more agencies by the end of i t s term.

116. Management of the Public Sector Reform Process. Reforming the State is a complex undertaking that challenges any government’s capability. This i s also true for Colombia as i t carries out i t s ambitious reform program. Putting in place adequate institutional arrangements, securing the necessary technical expertise, assembling implementation teams, ensuring political support during al l phases o f the reform, and carrying out meaningful and useful evaluations and assessments of the process have a l l been challenges for the leaders o f the reform.

117. Gaining the acceptance o f political actors i s key for successful reform. Initially, this role i s being played by the National Commission for Economic and Social Policy (CONPES) as the principal planning commission. Over the course of the reform, however, there wil l be the need to guide the process on a more continuous basis to avoid the danger of loss o f political momentum. Not all participating ministries are equally affected by or interested in the state reform process, so much specificity wi l l be gained from working only with the most relevant ones by creating a specialized commission in addition to CONPES. This core Commission for State Reform (CSR) has already been established, composed o f the Ministry of Finance, the Planning Department, and the Departamento Administrativo de la Funcidn Pu’blica (DAW, the department in charge o f the c iv i l service).

118. The fundamental guidelines for the overall reform process have b e e n defined in a CONPES document entitled, “Program for the Renovation o f the Public Administration,” which further develops the reform guidelines established in Presidential Direct ive 10, and formally establishes them as government policy.

1 19. Remaining Challenges. Transforming political priorities and goals in to effective application i s the challenge that underlies technical coordination of the process. The DNP wi l l tackle this by regularly incorporating into i t s work the advice of top experts in state reform, initially for the crafting of general government policy. In the medium term, this should be complemented by a group of seasoned experts to consult independently.

Key Actions Taken.

33

Equally important i s the establishment or continuing support of technical task teams in both DNP and each of the ministries and agencies subject to reform.

120. The evaluation of the reform, including the definition of meaningful indicators both at the aggregate and component levels, has advanced and SINERGIA has taken the leadership o f th is effort. A report on the “evaluability” o f the sector-specific objectives has been prepared and certain baseline indicators are in the process o f being defined, quantified, and published. However, the collection, processing, and analysis o f information for this purpose wi l l likely be a complex challenge.

V. THE SECOND FISCAL AND INSTITUTIONAL STRUCTURAL ADJUSTMENT LOAN (FIAL 11)

A. LOAN DESCRIPTION

121. This operation i s proposed as a single-tranche loan to be ful ly disbursed in November or early December 2003, and i s linked to, among other things, regulation o f the tax reform law, significant improvements in tax administration, the official definition of a budget reform strategy, presentation of the referendum to popular vote, issuance o f CONPES documents establishing the policies for legal defense of the State, asset management and the overall public sector reform framework, presentation to Congress o f changes to the procurement law, and the signature o f management contracts with ICBF and SENA. The detailed legal and regulatory reforms required as part o f the proposed second loan are shown in Table 6.

third calendar quarter, prior to Loan initial disbursements, has not exceeded 75% of the overall deficit limit in said budget. The Borrower has issued the necessary executive decrees to regulate the application of Law 788 of 2002. The Borrower, through DUN, has: a) developed and implemented software to cross reference information with financial institutions to ensure that interest reported by them match interest reported by taxpayers; b) audited at least 50% of large taxpayers (as defined in Article 562 of the Borrower’s tax code) affected by the new taxes; c) established and published indicators of the cost and time required for tax filing compliance by taxpayers, and d) has carried out at least 80 integrated tax and customs audits. The Borrower has approved CONPES document number 3252 dated October 20,2003, that outlines the strategy for national central government budget reform, including, inter alia: (a) the elimination or reduction of permanent entitlements and earmarked revenues; (b) the regulation of the use of forward budgeting; and (c) the establishment of controls over expenditure aggregates. The Borrower’s Executive Branch has submitted to the Borrower’s Congress and said Congress has approved, the 2004 budget bill of law, to approve the Borrower’s 2004 public budget, to include, inter alia, (a) medium term fiscal outlooks; (b) the calculation o f tax expenditures and contingent liabilities; and (c) the presentation by functions of the Borrower’s government sector, integrating current and capital Borrower’s government expenditures.

2o See definition of “trigger” in Section IV-A All these prior actions, triggers included, have been fulf i l led satisfactorily prior to Board distribution o f this document.

34

The Borrower has submitted to popular vote the provision of the Referendum that reallocates royalty transfers to educational services. The Borrower’s Ministry of Education has issued a resolution (Resolution Number 277103, dated February 17, 2003, to establish the eligibility criteria to allocate economic resources generated from the application of Law 21 for the benefit of public education infrastructure projects in the Borrower’s territory. The Borrower has approved CONPES document number 3250, dated October 20,2003, establishing, inter alia, the new policy for legal defense of the state, including legal reform if necessary. The Borrower has approved CONPES document number 3249, dated October 20,2003, establishing, infer alia: (a) the principles that apply to govemment public procurement, (b) the creation of a new agency or the assignment to an existing agency of public sector procurement responsibilities, and (c) the definition of a strategy for developing and implementing e-procurement. The Borrower has proposed to its legislature modifications to the bill of law amending L a w 80 that incorporate the recommendations of CONPES, including, inter alia: (a) common principles for public procurement; (b) introduction of economic considerations into the public procurement process; and (c) institutional framework for public procurement. The Borrower has approved CONPES document number 3251, dated October 20,2003, establishing the basic principles and strategic planning for Asset Management, including, infer alia: (a) the institutional framework for Asset Management; (b) management information systems for Asset Management; and (c) adequate ru les and procedures for Asset Management. The Borrower, through MHCP and DNP, has signed pilot management agreements w i t h SENA and ICBF. Borrower has approved CONPES document number 3248 dated October 20,2003, establishing the overall strategy of public sector reform and a recommendation to design indicators on public sector productivity and effectiveness. The Borrower has developed a monitoring and evaluation system for the state reform process with indicators of productivity and effectiveness and has widely publicized it, including i t s publication through DNP’s web site. The Borrower has enacted Law Number 819 o f 2003 that regulates, inter alia: (a) the annual presentation of (i) a medium-term fiscal framework with deficit targets linked to debt sustainability; (ii) a report of fiscal results to congress (including all debt and contingent liabilities), and (iii) a financial plan that includes measures to fully compensate for any fiscal slippage in the previous year; (b) restrictions on future spending obligations of national and sub-national governments; and (c) the obligation to include the fiscal impact and source of financing within any new national law that affects taxes or expenditures.

122. Triggers for the Third Operation. A subset of the policy actions for FIAL 111 described in this operation’s Policy Matrix has been identified as the key benchmarks that w i l l demonstrate progress in the reform program, and i t s fulfillment will be required before presentation of the third operation to the Board. These triggers are:

0 Borrower has presented to Congress a new Organic Budget Code which substantially reduces budgetary rigidities and enhances the role of the Ministry of Finance and Public Credit in regulating public expenditure aggregates.

0 Borrower has implemented the policies and actions for legal defense established in the CONPES document in the Ministry o f the Interior and Justice and in the Ministry of Finance and Public Credit.

Borrower has established a new governmental agency with the responsibility for establishing common guidelines, evaluating and monitoring public sector procurement, or has assigned this function to an existing agency.

Borrower has established and begun the operation o f the government agency responsible for asset management.

0

0

35

0 Baseline and a subset o f progress indicators for monitoring progress and final goals of the reform process are applied to the reforms achieved to date and are disseminated countrywide.

123. Loan Amount. The proposed (US$150 million) loan in the form o f a fixed spread, U.S .-dollar-denominated loan would be made to the Republic of Colombia. Disbursements under the proposed program would be made to an account (depository account) of the Republic o f Colombia, established at the Banco de la RepLibZica for this purpose. This loan would have a single tranche of US$l50 million, expected to be disbursed in late November or early December 2003.

B. FIDUCIARY POLICIES

124. Procurement and Financial Administration. A Country Financial Accountability Assessment (CFAA) i s currently being prepared and an init ial draft i s under internal discussion. Although the scope of the CFAA regarding financial management i s significantly broader than the scope o f the FIAL’s budget component (which i s focused primarily on eliminating rigidities), the recommendations o f the draft CFAA being discussed are consistent with the FIAL. An enrichment of the FIAL policy matrix for loans III and IV based on CFAA recommendations wi l l be considered once the CFAA i s finalized and a plan of action i s agreed with the government. Moreover, the financial management team wi l l advise with regard to audit of the depository account at the Central Bank. Regarding procurement, a Country Procurement Assessment Report (CPAR) was prepared in March 2001 and i t s key recommendations are part o f the reforms to the procurement system that are part o f the proposed Policy Matrix.

125. Some o f the key preliminary conclusions o f the CFAA which are relevant to the context of the FIAL program focus on the following areas: (a) an overall weakness o f the financial management processes which cannot adequately enforce budgetary constraints; (b) a fragmented payments system; (c) the need to develop subsidiary systems to the Integrated Financial Information System (SIIF) to fulfill information requirements for appropriate decisionmaking; (d) deficiencies in the information provided by the budget oversight agencies; (e) inadequate budgetary classification structures; and (f) insufficient and inadequate legislative oversight of the public expenditure process, among others.

C. ENVIRONMENTAL ASPECTS

126. Being a structural adjustment program, the environmental provisions of OD8.60 apply to this operation and, consequently, an environmental rating i s not required. However, there i s one issue regarding the tax reform supported by the program that needs to be addressed. Law 788 eliminated the capital gains (or “occasional gains”) tax exemption for individuals involuntarily selling their property to the State for public works (through eminent domain), creating a conflict with the Bank’s po l icy on involuntary resettlement that mandates fair net compensation to the seller. Through the elimination of this tax exemption, the seller now faces a net patrimonial loss. A joint proposal on the

36

reestablishment of fair net compensation w i l l be prepared for the next loan of the program in close collaboration with the government.

D. BENEFITS

127. Fiscal Adjustment. The reform program supported by the FIAL I1 would put the NFPS accounts on a more sustainable path. Each of i t s proposed measures carries fiscal implications, which are singled out in the government’s projections, through 2006, shown in Table 7. The reforms are projected to improve the overall balance of the Non- Financial Public Sector by 1.7 percent of GDP in 2003, and b y over 3 percent of GDP in the following years, relative to the alternative scenarios without reforms. Reform of tax policy and tax administration make the largest projected contribution, with the effects o f the referendum and the pension reform contributing most of the rest of the savings. When combined with the constitutional referendum, the vertical reforms, and the pension and labor reforms just approved by Congress, the impact of the whole reform package i s projected to reach 2.8 percent o f GDP in primary surplus.

128. As official projections, they are necessarily on the optimistic side, in particular, assuming prompt effects o f the pension reforms and a low estimate of military spending.*l Given the weight of longer-term reforms, the package of measures supported by the FIAL I1 would prevent-and reverse-an otherwise unsustainable debt and debt- service accumulation, while also protecting social sector expenditures and vulnerable groups. The Combined Public Sector deficit o f 4 percent of GDP would b e cut almost in half by 2006. If no reforms were implemented or if these reforms were seriously delayed, the NFPS would remain on an unsustainable path, and probably spiral into protracted, increasing deficits. Instead, as a result of the reform program, the public sector’s debt path i s changing significantly, putting the public-debt-to-GDP ratio on a more manageable path.

~

*’ The projections on savings due to a reduction o f the transfers to the pension system are based on the reform passed this year and to an update on i ts database which revealed a multi-affiliation problem, where a number of affiliates contributing to private pension funds should have been contr ibuting to the ISS. Solving that problem wi l l bring additional income to the government, but does not ye t make the ISS completely solvent.

37

otal Revenues Current Revenues

Tax Revenues of which : Reforms of Tax Policy and Administration

Non-Tax Revenues Property Income Operational Surplus of Public Enterprises

Other of which: Public Asset Management

otal Expenditure and Net Lending Current Expenditures

of which: Effect of Referendum Wages and Salaries

of which: elimination Of posts for vacancies and retirees Goods and Services and Other

Interest Extemal Intemal

Transfers to Private Sector of which ; Savings Due to Legal Defense of the State of which ; Pension Reform

Other

Capital Expenditure

of which: Reform of Law 80 (for contracting) and on-line govemment Fixed Capital Formation, cash basis

Transfers Net Lending Statistical Discrepancy

on financial public sector balance 'uasi-fiscal balance ogafin balance et cost of financial restructuring lverall balance lverail Financing

lemorandum item: entral Government Fiscal Balance FPS Primary Balance, with reforms FPS Primary Balance, no reforms lebt Stock

ource: Minisuy of Finance, IMP and World Bank Estimates

29.6 29.6

19.2

10.4 1.3 4.2 4.8

33.3 24.9

7.5

3.5 5.0 2.3 2.8 9.8

-0.9

8.3

8.2 0.1 0.1 0.2

-3.5 0.7 0.2 -0.7 -3.3 3.2

-5.7 1.5 1.5

29.8

20.9 I .2 8.9 0.8 3.1 4.4 0.0

32.1 24.8 -1.2 6.5 -0.1 3.1 5.0 2.3 2.7 10.2 0.0 -0.4

0.0

7.3

-0.2 7.2 0.1 0.0 0.0

-2.3 0.4 0.3 -0.5 -2.1 2.1

-4.0 2.7 -0.4

29.4

20.6 1.7 8.8 0.7 3.1 4.4 0.0 31.4 24.1 -0.8 6.5 -0.2 3.0 4.8 2.3 2.5 9.9 -0.1 -0.9

0.0

1.3

-0.4 1.2 0.1 0.0 0.0

-2.0 0.3 0.3 -0.5 -1.9 2.0

-2.6 2.8 -1.2

29.2

20.6 1.9 8.6 0.6 3.6 4.4 0.0 31.1 23.8 -0.8 6.5 -0.2 2.9 4.1 2.2 2.5 9.1 -0.1 -1.3

0.0

7.3

-0.4 1.2 0.1 0.0 0.0

-1.9 0.3 0.3 -0.5 -1.8 1.9

-2.4 2.8 -1.8

129. Improved Quality and Coverage of Public Service Delivery. The program is designed to encourage improvements in public sector delivery through a variety of instruments, including (a) performance-based incentives for accessing resources for education at the subnational level; (b) management contracts with two key government agencies (ICBF and SENA), developed to encourage the achievement o f the ambitious goals of their strategic plans; and (c) the introduction of elements of accountability for results in the new budgeting legal framework. Furthermore, there should be important indirect effects on service delivery from all other elements of the program, including

38

more efficient asset management at the agency level and improved procurement processes.

130. Improved Governance and Transparency. A number of studies have identified the capture of the State by special interests as one of the most damaging elements of corruption.22 State capture can come about through “legal” mechanisms, such as the passage of laws that create permanent expenditure entitlements or tax exemptions for certain interest groups that carry enough political or economic weight to lobby effectively. These dimensions o f state capture are confronted directly by the measures supported by the program. First, the tax reform supported by FIAL I had as one o f i ts explicit objectives the elimination of tax exemptions, in order to broaden the base and remove distortions. Second, the budget reform has also among i t s explicit objectives the rationalization of permanent expenditure entitlements and stricter guidelines for forward budgeting (which has been used to “reserve” space in future budgets often without justification). Overall, the program i s expected to have a significant positive impact on governance and the reduction of state capture.

E. RISKS

13 1. The proposed program carries considerable risks. With regard to internal risks, the first i s that the overall political context, including the conflict and violence associated with illegal drug activity, could escalate, which would negatively impact the implementation of the program. Although Colombia i s deeply committed to ending the violence that has plagued the country for decades, and has obtained the pledge of the international community to support this endeavor, the conflict could s t i l l intensify during the next few years. The FIAL supports reforms that wil l help liberate resources to address the country’s priorities during transition from the conflict to the postconflict era. The FIAL will also support introduction o f institutional reforms that would help consolidate peace and stability during the postconflict era.

132. Second, due to the internal conflict the government may be unable to endure prolonged social disruptions and resistance from major interest groups (such as teachers and health sector unions) that could derail the reform agenda and lead to more social and political instability. The government i s reducing this risk by working with political parties, Congress, the Judiciary, and independent auditing and control agencies in the formation o f a broad-based state coalition that ensures continuity of reforms within the public sector. The program supported by the proposed loan promotes the joint effort o f all branches of the Colombian state, private capital, and civ i l society through built-in participatory, consultation, and other consensus-building mechanisms. Consensus- building instruments have been incorporated in each one o f the proposed components and in the overall management of the reform process. I f successfully applied, consultation and evaluation should be sufficient to mobilize government and nongovernment institutions in support of the reforms, and overcome resistance from particular interests that have previously captured the State.

22 “Corrupcidn, DesempeAo Institucional y Gobemabilidad” (Corruption Perception Survey); Bog&, Colombia, World Bank, 2002.

3 9

133. The referendum approved by Congress in December 2002 and authorized b y the Constitutional Court in July 2003 contains several key reforms and wil l be placed before the people on October 25th, 2003. There i s o f course the risk that the referendum approved by Congress w i l l not be supported by the population. The government i s already planning on substitute measures in case the referendum i s not approved by the people. Those substitute measures would include (a) gradual elimination o f some special pension regimes through legal reform and collective bargaining, (b) law reform proposals and administrative measures to ensure expenditure cuts and additional tax revenues with a fiscal effect that i s at least equivalent to the expected impact of the current expenditure freeze, and (c) the national government putting pressure on subnational governments that currently receive royalty transfers to concentrate their project proposals in the education sector. I t should be noted, however, that the referendum i s directly related to part of one component o f the FIAL (Incentives for Efficiency Gains), so a defeat of the referendum would not be catastrophic for the overall program or threaten i t s continuation.

134. Third, through external or internal shocks, the fiscal situation may deteriorate, which would jeopardize the macroeconomic situation. The World Bank program and that of the IMF and IDB are intended to lessen this risk by demonstrating active, visible support of the government’s proposed fiscal and public sector adjustments. The macroeconomic situation may also be weakened b y external factors such as regional political or economic instability or further deterioration of the terms o f trade. On balance, consequently, the FIAL i s judged to be a “high-risk, high-return” program. Therefore, it will be essential to maintain a close working relationship with the client, and to provide ample, ongoing dialogue and assistance during the implementation period. To this end, the parallel T A L (MAFPII) w i i l provide an important opportunity for the Bank to closely accompany the program. The supervision activities of MAFPII w i l l be a fundamental vehicle to maintain frequent coordination with the Government counterparts. All these reflect the belief that, because this program would form the core o f the Bank’s interventions in Colombia, i t s successful implementation wi l l be critical.

F. SOCIAL IMPACT OF THE REFORMS

135. Colombia’s social conflict constitutes one of the most determining elements o f i t s fiscal and public sector reform requirements and prospects. The Government has successfully established a climate of dialogue and understanding backed by determined application o f i t s laws to contain social movements within the constitutional order. I t has worked in close collaboration with Congress and political parties to enact substantial reforms that had been impossible to achieve in previous administrations. Moreover, the Government i s inviting the population at large to vote on a referendum that wi l l substantially amend the Constitution. The government also offers a package o f vertical and horizontal reforms of the public sector aimed at enhancing transparency and accountability, citizen participation in public affairs, public administrative efficiency, and higher coverage and quality of service delivery.

136. This program intends to ensure the feasibility and sustainability o f this package of reforms by strengthening the fiscal capacity and the adequacy o f government actions,

40

while simultaneously minimizing risks in the government’s comprehensive, multisector reforms. If t h i s package i s successfully implemented and maintained after the change of administration, Colombia should have a public sector that is more responsive to citizen demands, more accountable, and more participatory. For the broader citizenry it can b e expected that the reforms w i l l contribute to better service delivery and a more transparent form of government. 137. The public sector reform process includes the elimination of at least 40,000 jobs in the central administration, of which 30,000 w i l l come from the elimination of the posts of employees who reach retirement during the next few years, and the rest from the elimination of staffed positions. All staf f deemed redundant wil l receive the legally established severance package, and those who are not legally entitled to removal benefits (such as temporary or directly appointed staff) w i l l receive at least one year’s salary as severance. In addition, all those who lose their employment wil l be entitled to participate in a retraining and career-counseling program. Finally, the government has indicated i t s commitment to the protection o f vulnerable groups and w i l l ensure that single mothers without job alternatives, the handicapped, and those about to reach retirement age w i l l not be removed.

138. In addition to the reduction in public sector employment, there are other measures in the government’s reform agenda that have an unquestionably negative effect on the country’s lower-income groups. The most evident i s the introduction of the VAT on a l l previously exempt goods and services, including basic foodstuffs, education, health, and transportation, which has a higher proportional impact on the poor. The broadening o f the VAT base i s in line with international best practices in tax policy, but i t s impact on the poor should be mitigated through focalized expenditure, at least in the short run.

139. In order to compensate for the social impact o f the fiscal adjustment and the effects of the armed conflict in depressed areas of the country, the government has bolstered its social protection network. One o f the main programs of this network i s the Red de Apoyo Social-RAS, which for 2003-2005 i s expected to disburse over US$500 million with the support of the Bank and the IDB.23 The largest component o f the RAS i s Fumilius en Accidn which provides a cash subsidy to 350.000 low income families in the form of a monthly $20 nutrition grant per family subject to regular visits by children under 7 to health centers and a $3-$6 subsidy per child to promote school attendance in both elementary and secondary education. Government expenditure on this program doubled between 2002 and 2003 and total expenditure on the social protection network reached 0.5 percent of GDP. The government i s committed to sustaining this level o f investment through end-2006.

140. Although the FIAL measures may have a short-term negative effect on unemployment and distribution of income (albeit mitigated through substantial social expenditure), the long-term effect w i l l be unquestionably pro-poor. First, it will he lp protect the macroeconomic framework of the country by reducing the likelihood of widespread government fiscal crises. This i s important since, as noted, the Bank’s

23 BIRF-7017 (Empleo en Accidn Program, U S $100 million), BIRF-7050 (Familias en Accidn Program, US $150 million) and IDB-1280/OC-C0 (Red de Apoyo Social Program, U S $270 million).

41

analysis shows that negative macro shocks are the most important cause of poverty increases in Colombia. Second, the FIAL wi l l also ensure that through the fiscal strengthening program, in particular the tax reforms, more resources w i l l become available to help ensure the allocation o f adequate public resources to social programs and reduce the insecurity that affects particularly those that lack the resources to protect themselves. This i s especially pertinent for education and health, facilitating the provision of public services for the poor. Third, the FIAL supports measures to improve the efficiency and coverage of these services, benefiting the poor directly. This i s to be achieved through better budgeting, the results agreements and their evaluation, and more transparent procurement. Together these should ensure that essential public services are more efficiently available to those who could not otherwise obtain them on their own.

141. Monitoring Arrangements. The Government, with the support of the Bank, has defined a strategy to monitor the social impact of the policy measures of the FIAL program. The f i rs t step consists of the construction of a detailed hypothesis on the social, poverty, and income distribution impacts of the individual components o f the reform program, expanding i t to the aggregate level, and factoring in the mitigating measures being undertaken through incremental social expenditure. Once this hypothesis i s defined, the required monitoring inputs identified (such as the household survey and other statistical data), and the cost of carrying out this exercise i s measured, DNP and MHCP intend to carry out periodic reviews and assessments. I t i s expected that for FIAL 111, the DNP w i l l have completed the hypothesis, identified data sources, and carried out a preliminary exercise on impact measurement.

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Annex I

(Translated from Original in Spanish)

REPUBLIC OF COLOMBIA

MINISTRY OF FINANCE AND NATIONAL PLANNING DEPARTMENT

LETTER OF DEVELOPMENT POLICY TO THE WORLD BANK

Bogoth, October 20,2003

43

Annex I

Bogoti, October 20,2003

Mister JAMES D. WOLFENSOHN President WORLD BANK Washington, D. C.

Dear Mr. Wolfensohn:

Since the beginning of the Administration of President Uribe-Velez in August 2002, the expansion o f the World Bank program for Colombia (CAS) and the important disbursements o f the loan program by the development multilateral agencies have been one o f the most overwhelming evidences of support to the country. The Wor ld Bank and the Inter-American Development Bank (IDB) have impeccably observed the commitments acquired with the country and have contributed to the recovery o f confidence on the stability of the Colombian economy and the reestablishment o f i t s access to the markets. This evidence of confidence has been of primordial importance for the performance of an ambitious plan of reforms, a good portion of which was already approved by the Congress o f the Republic and i s under implementation process.

We are pleased to present you in the attached document, an update of the Political Letter we submitted to the Bank in the month of January this year for the development o f the f i rs t Fiscal and Institutional Programmatic (FIAL-I) loan. In this update we present you the recent evolution of the economic condition of the country and, within such context, a synthesis of the purposes and the content of the policies and reforms we have already started.

The Government recognizes that some risks may threat the suitable implementation o f the program, including an insufficient support to the economic initiatives included in the Referendum, a higher volatility of the outside markets and an unanticipated increase of the security expense. Knowingly, the Government has identified a number o f contingency measures designed for protecting the program. Such measures include additional taxes and an early implementation of some of the measures discussed in this document.

Finally, the Government i s committed to the program presented in this document and i t i s also pleased to approve the accompaniment and the financial support of the Wor ld Bank.

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In attention to the measures taken and implemented, the Government i s thankful for their quick consideration by the Bank's Directors of the second fiscal and institutional programmatic loan. The Government i s at the disposal o f the Bank's technical teams in order to prepare a joint definition of future loan programs in the extent the reforms included in this program with the Bank are consolidated.

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I. The Context and the Macroeconomic and Security Situation

A. THE GENERAL CONTEXT

1. Colombia has reached a considerable macroeconomic stability since the 1998 - 1999 crisis, in spite of the worsening of the violence. Fiscal consolidation has progressed, inflation has been reduced and the financial system i s showing signs o f strength.

2. With an interruption in the middle of the year 2002, these achievements allowed the country to gain access to the international markets of credit and guaranteed the stability o f the exchange rate. In the middle of the year 2002, within an environment of regional instability, the spreads of sovereign bonds increased considerably and the peso devaluated in consequence. This situation was aggravated by an increase in the fiscal deficit and an unprecedented deterioration of the armed conflict, as a result of the events occurred during the peace processes o f the time.

3. Confronting an adverse regional environment and enormous fiscal problems, some important budgetary cut offs were approved for the year 2003, a one-time net worth tax was established and the Congress approved a package o f tax and control measures without precedents. Some decrees addressed to cut expenses, benefits or subsidies were also issued: the rate for the Tax Refunding Certificate (CERT) was reduced to zero, and non obligatory benefits at territorial level and the vacancies that had not been filled since July 2002 were suppressed too. In a parallel manner, the Government started to design and establish an ambitious program to reduce and restructure the public administration.

4. The Government i s aware that the sustainability of the public debt should be supported on solid structural reforms and not on optimistic scenarios o f economic growth or on risky hypothesis about the behavior of the exchange rate or the interest rate. Without any doubt, the support o f the World Bank i s essential for the progress o f the reforms. In particular, the support of the Bank i s o f primary importance while the high interest rates the country i s paying nowadays are reduced: almost 25% o f the Central National Government expenditure i s represented by the payment o f interest.

5. During the year 2002, the real growth of GDP was close to 1.7%, inflation was 6.99%, the deficit of the current account remained in levels close to 1.8% o f the GDP and Net International Reserves grew in an approximate amount of US$220 million. For the year 2003, a recovery of the economic growth with stability i s expected: the growth rate w i l l be between 2% and 2.5%, the inflation target is between 5% and 6%, and the deficit in the current account will reduce to 2.5% of the GDP.

6. For the year 2003, the fiscal deficit target was set at 2.5% of GDP. However, undeferable expenses prompted the revision o f this target, now standing at 2.8% o f GDP for the end o f this year. This change was made in consultation and coordination with the IMF.

46

7.

8.

9.

10

In order to reach the fiscal objective, the Government has taken a l l the necessary measures such as the approval of the tax reform. Currently, we are s t i l l expecting the result of the Referendum that includes a tax adjustment component, wh ich i s expected to generate savings for 0.78% of GDP ($1.6 billion) in 2003 and 1.24% of GDP ($3.018 bil l ion) in the year 2004.

B. THE 2002 - 2006 PERSPECTIVES

The macroeconomic scenario for the next four years i s based on a current account deficit that oscillates around 2.1 % of GDP, an investment rate that i s around 14% o f GDP and a domestic savings rate higher than 12% o f GDP. The financing of the capital account wi l l be carried out through the recovery of the direct foreign investment and of the net borrowing of the private sector. The net borrowing of the public sector wi l l continue being important.

The balance of the public sector shows a deficit financed with funds from internal credit (between 2.1% and 1.7% of GDP) and external credit (between 0.3% and 0.4% o f GDP). The gradualness of the adjustment on the excess expenditure that subsists in the public sector wi l l be financed with the savings generated by the adjustment of the private sector. The credibility of the adjustment in the public sector i s given by the scope o f the structural reforms currently in progress.

The fiscal consolidation wi l l continue in the medium term. The economic conditions are expected to improve in 2004, and the actual growth of the GDP i s expected to be higher than 3 percent starting this year. The higher deficit wi l l be financed with direct investment, a continuous support o f multilateral banking, and the access o f the country to the international financial markets. The monetary policy w i l l be addressed to support a moderate reduction of the inflation w i th in an objective inflation scheme and a floating exchange rate.

11. The deficit in the public sector wil l be reduced to 2.5 per cent o f GDP, supported by the measures described above. Although this target i s slightly higher than the one initially established, the commitment o f the Government with fiscal stability i s maintained in such a way that the debt o f the non financial public sector wi l l be reduced below 50 per cent o f the GDP in the medium term. The Government expects that a sustained reduction o f the debt, a continuous improvement o f t he indicators of economic vulnerability and a sound economic management w i l l increase the confidence and allow the Colombian credit qualification to improve and the cost of borrowing to decrease.

12. Within the frame of the macroeconomic policy, the Colombian Government entered into a Stand B y Agreement (SBA) with the IMF for DEG 1,548 million for

47

the next t w o years. One of the main purposes o f the program is the reduction o f the fiscal deficit en two points of GDP through structural reforms in different fronts.

11. The Program of Fiscal and Institutional Adjustment -11

A. OBJECTZVES

13. The Program o f Fiscal and Institutional Adjustment to be financed with World Bank quick-disbursing funds has as i t s objective to continue accompanying the Government of Colombia along the process of fiscal adjustment and the introduction of public management tools that allow a more efficient and transparent assignment and administration of the public funds.

14. In order to meet this objective, the Government has been implementing a group o f structural measures that wi l l allow: an increase in fiscal income through an effective expansion o f the tax base and the elimination of tax exemptions, the progressive flexibility o f the expenditure budget, the introduction of fiscal responsibility principles and their integration to the budgetary system, the strengthening o f transparency in procurement, and the restructuring of public employment. We refer herein to the progress o f each of them:

B. COMPONENTS OF THE PROGRAM

1. Tax Reform and Administration

15. In order to increase income, improve taxation equity and reduce collection costs, Law 788 o f 2002 approved a tax reform. This law eliminates tax exemptions and enlarges the VAT basis and creates a new classification o f salary exemptions, among others. The new measures are expected to increase tax collection around 0.9% of GDP in 2003, 1.2% in 2004 and 1.7% in 2005. To date, the regulatory decrees o f Law 788, 2002 that represent a fiscal impact on tax collection and that should be applied for the operations performed since the first day o f January 2003 have been issued on the matter of value added tax, the assessment to financial movements, withholding taxes and deferred interest for fiscal effects. Some provisions included in Law 788, 2002 are currently in effect and do not require any regulation.

16. In addition to the efforts that on the matter o f the regulation of the tax reform the Government have been performing, the FIAL has accompanied the DIAN (National Tax and Customs Bureau) in i t s efforts of tax administration. The development o f a methodology that allows to obtain, process and use the information related to interests paid and perceived by the tax payers during a determined taxable term i s highlighted. This information w i l l allow the DIAN to develop specific control programs. The issuance of Law 788, 2002 has allowed the DIAN to perform a general control o f those great taxpayers affected by the new taxes. In addition, the new Law wi l l allow the DIAN to sanction those taxpayers who do not observe their tax obligations. The

48

DIAN has also progressed in the establishment of cost and time indicators required by the taxpayers to observe their tax and customs obligations. Such indicators will be published from time to time and wi l l also be part of the DUN internal management programs.

2. Renewal of the Public Administration

17. The Government has continued with i t s actions addressed toward the modernization and rationalization of the public administration, through the merging of ministries (6), the elimination of unnecessary entities and offices, the suppression of some diplomatic bodies, the abolition o f fringe benefits and the elimination of vacancies.

18. The Government has estimated that the savings derived from the implementation of the measures above w i l l increase the GDP from 0.1% in 2003 to 0.6% in 2005. It i s important to highlight that the Congress approved, in the last month of December, a Law that grants special powers to the President of the Republic to carry out the described reforms (such powers allowed the restructuring o f 17 entities).

19. For the dimension of the administration labor force to be suitable, a goal for reducing the operation costs and another goal for increasing the proportion of the officials devoted to the performance o f missionary tasks (70%) have been established.

20. The vertical reforms also provide for the restructuring of at least 20 entities in the decentralized sector, under the premise that their continuance depends upon their financial feasibility. Among the entities subject to restructuring are several regional power companies and a large number of public hospitals; the Colombian Institute o f Social Security (ISS), Telecom and ECOPETROL were already subjected to said process in accordance with the special powers granted by Law 790, 2002.

21. Those reforms considered of transversal type have had important progresses stated herein below:

A policy on the issue o f public procurement i s being prepared, in which the design of a new regulatory and institutional frame for government procurement i s anticipated in order to allow the improvement of process transparency, eliminating the possibility of influencing the selection of the bidders, but which at the same time increases the efficiency (especially at sector level), incrementing i t s impact on the productive sector and generating a reduction of the transaction costs for public entities, as well as a substantial modification of the current practices used in such matter.

The creation of a new governmental strategy addressed to the jur id ical defense o f the Nation i s a basic issue. The Government w i l l prepare a diagnosis that allows to develop a preventive strategy, designing a “quality and protection guaranty

49

system” that includes especial provisions for the high risk sectors (transportation, defense, justice and power, etc.). Alternative mechanisms for the solution o f conflicts wi l l be proposed and the necessary regulatory reforms will be identified. . The design of an integral policy for the productive management o f those assets belonging to the State has allowed to prepare inventories and to define mechanisms for their assessment and juridical righting, and it has also established a timetable for their management. A regulatory framework i s expected to be prepared for the acquisition, registration and use o f new assets b y Government entities. . The establishment o f a result benchmarking and policy follow up system for all the min is t r ies and administrative departments i s promoting the assessment o f the main Government policies and programs, seeking that, as a whole, these aspects make more efficient and transparent the assignment of the funds, improve the efficacy of the policies, the programs and the Country institutions, and allow to present accounts to the citizens. . For the public employment system, a new institutional scheme i s being designed, addressed to the regulation and the administration of an employment policy that centralizes the preparation of a respective policy and the issuance of regulations, and which decentralizes their management, leaving their application in the hands of each entity. Access according to merit, job keeping according to performance and flexibility as for employment termination are the characteristic principles o f the new scheme of public employment in Colombia. . The Government i s establishing the principles that wi l l allow to rationalize the Governmental activity in the regulatory and control bodies, for the purposes o f minimizing the transaction costs for the State, those regulated, supervised and controlled costs, and wi l l establish a single juridical system for the regulatory, supervisory and controlling bodies. . The unification of information systems within the National Public Administration i s being developed through an integral strategy that seeks the acquisition, administration, and use of strategic information, and an adequate institutional scheme. . The strengthening o f electronic Government w i l l allow the incorporation and use of the informatics technology for the development o f operations in Governmental entities, both in their internal activities as well as in their relations with other public and private entities, the citizens and the productive sector. The final purpose i s to facilitate the relations of each citizen with the administration, and to increase the efficiency, transparency and a territorially balanced development o f the State.

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A strategy addressed to eliminate useless procedures seeks to establish a policy frame that allows to rationalize the procedures in public administration, both in its internal operation as well as in i t s relations with the citizens. The Government i s taking actions in order to design and establish projects for procedure rationalization in entities of public administration, according to their benefit / cost relation within the identified projects. The Government w i l l also design a Governmental program in line for rendering services and procedures to entrepreneurs and citizens.

Finally, a cross strategy of internal control attempts to redefine the missionary objectives of internal control in Governmental entities, and for such purpose some actions are being taken addressed to update the inventory of internal procedures in central administration, defining a policy frame for exercising internal control in Governmental entities, establishing a relation between the mentioned policy and the design, application and fulfillment o f the internal transactions and procedures that wil l promote the transparency, efficacy and efficiency of the organization.

22. The effectiveness of the modernization and rationalization actions of Public Administration and the changes in performance in the intervened sectors wi l l be the object o f follow up and assessment actions. With such purpose the respective base lines are currently being drawn, which wi l l be updated along the te rm of the program, and wi l l constitute valuable information for decision making in order to assign budget and to submit accounts within the Government and to the citizens.

3. Fiscal Responsibility and Transparency

23. In July 9 of this year, the Fiscal Responsibility Law was approved. This law seeks to include Colombia within a group o f countries that assume their fiscal problem w i t h responsibility, through the approval of laws that rationalize the fiscal activity and make the public debt sustainable, necessary conditions to generate an economic stability that allows the country to achieve i t s development.

24. This Law seeks the stability o f the public debt, organizing the process o f budgetary planning, in order to make it coherent with the f inancia l and macroeconomic forecasts, allowing the public scrutiny of fiscal situation and widening the debate on fiscal policy through the Congress of the Republic. In order to meet these objectives, the Law provides that the National Government should present before June 15th o f each fiscal year, to the Economic Commissions of the Honorable Congress of the Republic, a Medium Term Fiscal Framework, after being studied and discussed during the first debate of the Budget Annual Law. Th is Framework w i l l include, as a minimum, the Financial Plan, a multi-annual macroeconomic program, the goals o f primary surplus, a report on macroeconomic and fiscal results of the previous fiscal term, an assessment of the m a i n semi-fiscal activities carried out by the public sector, an estimate o f the fiscal cost of the exist ing

5 1

tax exemptions, a l i s t of the contingent liabilities that could affect the financial situation of the Nation, as well as the fiscal cost o f the laws approved in the previous fiscal term. This applies in an equivalent manner to the central Government and to the territorial entities.

25. The L a w also seeks to put on a sound basis the budgetary process o f those practices that have traditionally increased the costs to the Nation. This regulation clarifies the budgetary process and makes i t coherent with sustainable public finances in the short and medium terms. As for forward budgeting requests, their authorization should respond to a serious planning process, coherent with the annual financial plans and, therefore, with the sustainability of the public finances. For this reason, the law grants the CONFIS the competence for granting the authorizations addressed to commit future budgets and includes some restrictions in order to rationalize their use. In first term, it provides that no common future terms may be granted that exceed the term of the Government. However, an option remains of granting exceptional forward appropriations for those projects the CONPES declares as of strategic importance for the country. In second term, the need o f having a minimal appropriation in the current fiscal te rm i s established, in which said authorization i s requested, if dealing with an authorization addressed to compromise common future terms.

26. In line with the objective that the multi-annual analysis guides the expense and public borrowing decisions, the payment capacity o f the territorial entities wi l l be analyzed for the whole period of the loan term and not only for the current term. In addition, the treasury loans are regulated in order to preserve the margin o f the fiscal maneuver the territorial administrations have.

4. Budgetary Reform

27. At this time there i s a preliminary project o f the articles o f reform to the Budget Organic Statute, which i s the product o f the work performed along the last six months and that takes into account the recommendations made by the International Monetary Fund on the issue, and the different conversations held with the Wor ld Bank and the Inter- American Development Bank.

28. The Presidential Message that accompanied the bill of the 2004 budget includes important progresses on the subject o f budget transparency and communication. A reading thereof i s included according to the purpose the public expense seeks, some progress has been achieved in the observance o f the Law o f Fiscal Responsibility including information about the fiscal sustainability in the medium term, contingent liabilities, fiscal cost of tax exemptions, a sensitivity analysis o f the budget to macroeconomic variables and a conversion between the Financial Plan and the budget of the Nation.

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29. On the issue of budgetary classification, Colombia should get close to the international standards, and the first steps have been taken for such purpose. A contract was recently signed in order to carry out both the conceptualization and the implementation of a new system for budgetary classification.

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October 15, 2003

Annex 11 International Monetary Fund 700 19th Street, NW Washington, D.C. 20431 USA

Colombia: Fund Relations Note

On June 1 1,2003 the Executive Board o f the International Monetary Fund (IMF) completed the f i rs t review of Colombia's performance under a two-year, SDR 1.5 bi l l ion (about US$2.1 billion) Stand-By Arrangement, which was approved on January 15, 2003 (see Press Release No. 03/04). The completion of this review enables the release o f SDR 193.5 mill ion (about US$274 million) to Colombia, bringing the total amount available to SDR 580.5 mill ion (about US$822 million). So far the country has not made any drawings under the arrangement.

Background

Under the authorities' program, economic performance has been mostly favorable. The economy grew b y over 3 percent in the f i rs t semester of 2003 led by strong growth in construction and manufacturing. Inflation has declined since April due to falling food prices and stable foreign exchange rate. The combined public sector deficit has remained on track through June 2003. The Banco de l a Repiiblica has kept i t s main refinancing interest rate steady after increasing i t s rates by 200 basis points in early-2003. Congress approved the fiscal responsibility law in June 2003, which was a structural benchmark. The government restructured the state petroleum and telecommunications enterprises, going beyond the steps envisaged in the program.

Executive Board Assessment at the Completion of the First Review

The government of Colombia i s carrying out a strong economic reform program aimed at encouraging faster economic growth and improving social equity. In particular, the government's program focuses on bringing the overall public sector deficit down through a wide range o f initiatives, including several important structural measures such as tax, pension, and labor reforms. A lower fiscal deficit i s essential to reduce gradually the public debt burden, which in turn wi l l ease pressures on interest rates and stimulate growth.

The government i s commended for i t s strong commitment to economic reform. All performance criteria and structural benchmarks for end-2002 and end-March 2003 have been observed. This strong policy implementation has already helped to improve economic performance. The economy showed signs of recovery in the f i rst quarter of 2003, with a slight decline in unemployment and renewed access to international capital markets .

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For 2003, the government i s committed to reducing the overall public sector defici t to 2 ?h percent of GDP, and i s prepared to implement contingency measures, if necessary, to achieve this target. At the same time, the government intends to continue with key structural reforms, including further steps to strengthen expenditure management and modernize public administration. The central bank already raised i t s main refinancing rate and i s committed to taking further measures as necessary to control inflationary pressures.

Colombia's economic reform program has helped reduce the risks to the economic outlook. Nonetheless, the authorities w i l l need to sustain the implementation of the program in order to lay the basis for a durable recovery.

For questions please contact Mr. A. Espejo, Senior Economist, South/Central American I, Western Hemisphere Department, IMF, ext. 37152.

55

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MAP SECTION