BOSNIA AND HERZEGOVINA   Public Expenditure Reforms in BIH: Moving from Aid Dependency to Fiscal Self-Reliance World Bank March 4, 2003

Outline of the Presentation The case for expenditure rationalization Salient features of public expenditure in BIH from four points of analysis: What? Where? Who? How? Some suggested priorities for reforms

Macroeconomic achievements Robust post-conflict economic growth performance (25% p.a.between 1996-2002) Anchors of macroeconomic stability: the currency board and recent fiscal stabilization… … resulting in low inflation and confidence in the domestic currency Some progress in structural and administrative reforms: financial sector, tax administration, expenditure management

Outstanding macroeconomic challenges Although still positive, economic growth has been rapidly fading Export performance remains subdued, resulting in an important current account gap (about 20 % of GDP) Employment growth remains subdued Pace of structural reforms directly aimed at stimulating supply responses of the economy has been uneven and altogether slow (privatization, business environment, public sector and corporate governance, rule of law)

The macroeconomic case for fiscal adjustment

Is public spending too high in BIH? Current size of public expenditure is beyond sustainability: Realistic (and desirable) resource availability Transition to private-sector led growth Comparison with size of Government in other transition economies (above 55% in BIH vs. 35%-40% in most first-tier accession countries and below 30% in OECD) Recurrent accumulation of arrears (esp. at the local level) suggests that current size is not affordable

Constraints to expenditure rationalization Additional pressures on public finances are likely in the period ahead: Unpredictability of the decline of aid flows Need to alleviate tax burden on the economy New expenditure pressure points: institution/ capacity-building, possible adjustment costs after public sector downsizing, public investment needs,… Fiscal risk: contingent liabilities, quasi-fiscal operations, deferred deficits (esp. at the local level) Rigidities in expenditure and complex intergovernmental arrangements

Salient Features of Public Expenditures: 1. On what are resources spent?

Public Sector Spending in Wages and Salaries Public sector spending on Wages and & Salaries (W&S) is disproportionately high in BiH Public Sector Spending in Wages and Salaries Sources: Official data & staff estimates for BiH; WB data sources. Source: Official data & staff estimates for BiH; WB data sources.

Tensions in recurrent spending Wages and salaries crowd out spending on operations and maintenance: Ratio of wage to non-wage spending is high in BIH, particularly in the FBIH:

Salient Features of Public Expenditures: 2. Where do the resources go?

Defense expenditure remains large Spending on defense is above average, although recent demobilization should bring it down by about 1-1.5% of GDP Within the defense sector, the weight of W&S is particularly disproportionate (between 70% and 80%, NATO average: 40%) Further rationalization of spending and improvements in reporting and financial discipline Spending on public order and safety appears equally large. Urgent need to undertake sectoral expenditure review.

Social Transfers BIH has, on aggregate, an extensive transfer program with one of the most generous benefit system for war veterans in Europe (3-4% of GDP): urgent need to tightly define entitlements The short-term agenda for pensions: maintain financial stability while improving collection performance Outside veteran benefits and social security, social protection benefits are very low As a consequence, the transfer system appears to be regressive with the most needy being left out or insufficiently targeted

Social expenditures Education spending is high and inefficient: High unit costs and low student-teacher ratios (esp. vocational, tertiary); Fragmented provision of higher education Input-based financing carries wrong incentives Low allocative efficiency: poverty incidence among vocational training graduates, low enrollment in general secondary Wide disparities in per pupil spending leads to access inequality of education Complex intergovernmental assignments disrupt service provision at the local level

Social expenditures (cont.) Health care financing remains fragile: First wave of reforms successful in establishing relatively stable, although very fragile, health insurance funds; pooling of catastrophic risk in the Federation Fundamental problem of mismatch between entitlements and collected resources remains acute leading to high (and regressive) out-of-pocket financing and unregulated private sector delivery High burden on payroll taxation characterized by poor enforcement of collection , numerous exemptions, and unreliable financing for disadvantaged groups (pensioners, unemployed, self-employed, refugees, IDPs) Network of providers is marked by fragmentation, overlap, mismatch between services provided and needs, and soft budget constraints System bias against preventive and primary health care

Salient Features of Public Expenditures: 3. Who spends the resources? Significant vertical fiscal pressures on the State and the municipalities because of their very limited own revenues as a source for financing their current responsibilities—e.g. in 2001 the State’s own revenues could cover less than 30% of its operational expenditures, and in 2000 the municipalities’ estimated own revenues could cover only about one-quarter of their expenditures in both Entities Significant horizontal fiscal pressures in both Entities because present large revenue disparities at the sub-Entity level severely impeding low activity location’s service capacity and/or risk potentially larger fiscal imbalances

Key issues in fiscal decentralization Define the role of the State (including its revenue base) in the context of institution building, economies of scale, and regulatory harmonization Revenue and expenditure assignments: putting order in the “house” with the equitable delivery of quality public services as the ultimate objective Vertical / horizontal policy coordination (1) Stress regulatory function in the view of the SES: environmental standards, CRA, Power RA, SBS, Customs, VAT (Admin., Structure,…), quality standards (e.g. education), policy coordination/monitoring (e.g. data consolidation needs). (2) Address vertical/horizontal imbalances, (3) Fiscal self-reliance is not only financial, it also implies self-reliance on the formulation and implementation of coherent budget policies in the country (consistency of legislations, policy coherence, conflict resolution, accountability)

Salient Features of Public Expenditures: 4. How are the resources managed? Strategic programming and budget preparation: episodic initiatives remain to be institutionalized Budget execution and reporting: progress on treasury system, FMIS, recording, accounting Public procurement needs major reform Internal controls & audits: redefine their role in the expenditure cycle Supreme audit institutions and external oversight: promising first steps but lack of follow-up Rules of transparency and integrity yet to be enforced

Conclusion: the triple challenge of expenditure reform 1. Rationalization of total public expenditure as to decrease its share in the economy: no other alternative to accommodate financially sustainable, private sector-led growth 2. Increased efficiency and equity of expenditure so that it can have an impact even within the hard budget constraint 3. Transparency and good governance in the management of public resources with a view to raise its efficiency but also to regain trust of taxpayers, beneficiaries, financiers, entrepreneurs and investors

Some suggested priorities for reforms Strategically manage expenditure rationalization rather than be subjected to it  critical need to complete strategic budgeting process (PRSP/MTEF) Institutionalize fiscal policy coordination: State/Entities, Entities/Sub-entity Address the issue of civil service reform and wage bill containment Further rationalize excessive spending (defense, veteran benefits)

Some suggested priorities for reforms In core public services, restructure expenditure to realize efficiency gains under an assumption of overall spending freeze Intensify policy debate on intergovernmental fiscal relations Limit and manage fiscal risk: eliminate soft spots in the budget constraint, strictly adhere to financial stability principles for extra-budgetary funds,… Establish track record in strengthening fiduciary framework (e.g. public procurement) and governance (e.g conflicts of interest, anti-corruption)