Report No. 25033-POL Poland Toward a Fiscal Framework for Growth A Public Expenditure and Institutional Review January 21, 2003 Poverty Reduction and Economic Management Sector Unit Europe and Central Asia Region Document of the World Bank Cutrrency amid Eqmvalenmt UraiDs (Exchange Rate Effective as of January 17, 2002) Currency Unit = ZLOTY (PLN) US$1.00 = 3.80 zloty MFnscd Yean January 1 to DecembeT 31 Weights annd Iegun res Metric Syst -fi X CRA NYMS AND ABLRE WA TO$NS AIDS Acquired Immnune Deficiency Syndrome NDB Notional Defined Benefit ALMP Active Labor Market Policy NDC Notional Defined Contribution AMA Agricultural Marketing Agency NECARD National Extension Center for Agriculture and AoPF Act on Public Finance Rural Development APA Agricultural Property Agency NEI Netherlands Economic Institute ARMA Agency for Restructunng and Modernization NIS Newly Independent States of Agriculture OECD Organization for Economic Cooperation and CAP Common Agriculture Policy Development CEE/CEEC Central and Eastern Europe OFE Open Pension Funds CG Central Government PAYG Pay-as-you-go CIT Corporate Income Tax PEM Public Expenditure Management CPI Consumer Price Index PFRON National Fund for the Rehabilitation of DRG Diagnosis Related Group Disable People EBFs Extrabudgetaiy Funds PISA Program for International Student Assessment ESA European System of Accounts PIT Personal Income Tax EU European Union Phare Pologne et Hongrie: Actions pour la EUROSTAT European Union Statistical Office Reconversion Economique FTE Full Time Equivalent PKP National railways FY Fiscal Year PLN Polish New Zloty GDDKia General Directorate of Public Roads POP Persistent Organic Pollutant GDP Gross Domestic Product PSE Produce Support Estimate GUS National Statistical Office R&D Research and Development HIT Health Systems in Transition REER Real Effective Exchange Rate HIV Human Immunodeficiency Virus SA Social Assistance IALS International Adult Literacy Survey SAI Supreme Audit Institution IFI Intemational Financial Institution SAPARD Special Action Program for Agriculture and IMF International Monetary Fund Rural Development IUT Institut Universitaire de Technologie SME Small and Medium Enterpnse ISPA Instrument for Structural Policies for Pre- SWE Supported Work Establishment Accession TFR Total Fertility Rate KRUS Old Age and Disability System for Farmers TPE Total Public Expenditure LG Local Governments TSE Total Support Estimate LOT Polish National Airline UMTS Universal Mobile Telecommunications MARD Ministry of Agriculture and Rural System Development UNUS Health Insurance Supervisory Agency MoES Ministry of Education and Sports VAT Value Added Tax MoF Ministry of Finance VET Vocational Education and Training MoH Ministry of Health WHO World Health Organization MoL Ministry of Labor WIBOR Warsaw Inter Bank Offer Rate MPC Monetary Policy Council ZUS Old Age and Disability System MTEF Medium Term Expenditure Framework Vice President: Johannes F. Linn Country Director: Roger Grawe Sector Director: Cheryl Gray Sector Leader: Bernard Funck Task Team Leaders: Asad Alam and Jos Verbeek Preface The objective of this report is to assess the status of public expenditures and develop recommendations to promote fiscal stability and growth in Poland. This work was requested by the Government of Poland at the end of 2001. The analysis and recommendations contained herein are based on the findings of several World Bank missions to Poland during 2002. The report contains a detailed review of the macroeconomic context and imperatives for fiscal reform, the incentives for informed policymaking and good budgeting embedded in the expenditure management system, and the key expenditure policies that emerge. The report builds on the detailed policy matrices provided to the Government in January and March of 2002, as well as the draft budget management report provided in July 2002. The Bank team was comprised of: Mukesh Chawla and Marzena Kulis (health), Sue Berryman and Dorota Holzer-Zelazewska (education), Ryszard Petru and Michal Rutkowski (social protection), Elena Kastlerova, Robert Kietlinski (transport), Mark Lundell and Ryszard Malarski (agriculture), Barbara Letachowicz, Piotr Krzyzanowski, and Anil Markandya (environment), Jos Verbeek and Marcin Sasin (macroeconomic), Anwar Shah (intergovemmental fiscal relations), and Asad Alam, William Dorotinsky, and Angapudi Premchand (budget management). Alison Panton and Rosario Hablero provided excellent assistance with document processing. Marta Michalska was invaluable with mission arrangements. The work was initiated under guidance of Michael Carter, Country Director, and Kyle Peters, Sector Manager and with Pradeep Mitra as Sector Director and completed under direction of Roger Grawe, Country Director, Bernard Funck, Sector Manager, and Cheryl Gray, Sector Director. The lead adviser for the report was Lajos Bokros. The peer reviewers were Luca Barbone and Anand Rajaram. This report has benefited from the comments from colleagues within the Bank, in particular from Helga Muller, Maureen Lewis, Eva Molnar, Joseph Goldberg, Armin Fidler, and Chris Hall. In addition, the report benefited from comments received from colleagues at the EU, IMF, and OECD. The Bank team is grateful to all government and non-government officials who cooperated with the work of the team. These include the various working groups established by the Government, the Public Finance Committee of the Sejm, senior officials of the Ministry of Finance and other line ministries, regional and municipal governments, the supreme audit institution, the National Bank of Poland, and the various autonomous agencies as well as researchers from local think tanks. In particular, the team is grateful to Mrs. Wasilewska-Trenkner, Deputy Minister of Finance, and Plenipotentiary for Public Finance Reformns, for her support, coordination of the work, and substantial engagement with the Bank team. TABLE OF CONTENTS EXECUTIVE SUMMARY ................................................i 1. THE STRATEGIC SETTING .................................................1 Introduction .................................................1 Macroeconomic Context .................................................2 Key Issues in Public Finance .................................................8 2. THE PUBLIC EXPENDITURE MANAGEMENT SYSTEM ............................................ 19 Introduction ................................................ 19 POLAND'S BUDGET SYSTEM IN PERSPECTIVE ................................................ 20 KEY ISSUES AND REFORM OPTIONS ................................................ 22 Fragmentation of the Budget ................................................ 22 The Disconnect Between Policy Formulation and Budgeting .............................................. 27 The Lack of Performance Orientation ................................................ 32 Gaps in the Accountability Framework ................................................ 35 Conclusions ................................................ 36 3. OPTIONS FOR EXPENDITURE POLICY REFORMS .39 SOCIAL PROTECTION .39 The Transition Experience .40 Key Issues and Reform Options .42 Disability Pensions .44 Old Age and Disability System for Farmers (KRUS) .45 Social Assistance .46 Active Labor Market Programs .48 Sickness Benefits .50 Supporting Work of Disabled .51 Conclusions .53 HEALTH .53 Introduction .53 Health Status .53 Expenditures on Health Care in Poland, 1996-2002 .54 Recent Health Sector Reforms in Poland .57 Key Issues and Reform Options .58 Equity .62 Financing .63 Demographic Challenges .64 Conclusions .64 EDUCATION .65 Structure and Financing of Poland's Education System .65 Key Issues and Reform Options .69 Quality of Education .74 Equity .75 Conclusions .78 ENVIRONMENT .78 Introduction .78 Environmental Improvements During the 1990s .79 Government Policy Objectives for the Environment .81 Profile of Spending Programns on the Environment .............................................................. 81 Key Issues and Reform Options .................................................................. 82 Conclusions .................................................................. 88 AGRICULTURE AND RURAL DEVELOPMENT ................................................................ 88 Introduction .................................................................. 88 Sectoral Overview .................................................................. 89 Trends in Current Expenditures .................................................................. 91 Key Issues and Reform Options .................................................................. 95 Conclusions .................................................................. 97 TRANSPORT .................................................................. 98 Introduction .................................................................. 98 Railways .................................................................. 103 Conclusions .................................................................. 104 ANNEX 1 .................................................................. 105 Inter-Govermment Fiscal Relations ........................ .......................................... 105 REFERENCES .................................................................. 112 LEST O˘ 'F TA]BLES Table 1.1: Selected Economic Indicators, 1996-2002 .............................................................. 3 Table 1.2: Economic Indicators in Selected Countries, 1995-2002 ............................................... 4 Table 1.3: Savings Investment Balances (1999-2002) and Deficit Trends (1999-2003) ....................... 7 Table 1.4: Required Primary Surpluses to Stabilize Public Debt to GDP Ratio Under Alternative GDP Growth and Real Interest Rate Scenarios ...............................................................8 Table 1.5: Different Fiscal Scenarios and their Impact on Public Debt Dynamics (2003-6) ................. 11 Table 1.6: Sensitivity Analysis .................................................................... 11 Table 1.7: Estimated Net Contributions to Poland by EU ........................................................ 12 Table 1.8: General Government Expenditures by Economic Classification, 1995-2001 ....... .............. 14 Table 1.9: General Government Expenditures by Functional Classification, 1995-2001 .................... 15 Table 3.1: Social Expenditures in Poland in 1989-2000 (% of GDP) .......................................... 38 Table 3.2: Social Security Contributions in Selected OECD Countries ........................................ 39 Table 3.3: Demographic Impact on Pension Expenditures ....................................................... 40 Table 3.4: Labor Fund Expenditures on Labor Market Programs, 1996-2002 ............................... 46 Table 3.5: Effectiveness of Selected ALMPs, 1996-2001 ....................................................... 47 Table 3.6: Selected Labor Programs: Maximum Reimbursement Rates ...................................... 47 Table 3.7: Number of Sick Leave Days Annually, 1997-2001 .................................................. 48 Table 3.8: Cost of Support of Disabled, 1997-77 (% of GDP) .................................................... 50 Table 3.9: Health Status Indicators - Poland Compared with Other Countries ................................ 51 Table 3.10:Efficiency and Access lndicators, Selected Countries (various years: 1995-97) . . 56 Table 3.11 :Public and Total Educational Expenditures as a Percent of GDP and of Total Public Expenditures by Year, 1995-2001 .................................................................... 63 Table 3.12:Public Education Expenditures by Level and Type of Education as a Percent of GDP and of Total by Year, 1995-2000 ........................................................... 64 Table 3.13:Expenditures Per Student by Level of Education Relative to Limit Cost for Primary Education (1998) .................................................................... 64 Table 3.14:Monthly Expenditures on Education per Enrolled Household Member by Consumption Quintile and as a Percent of Total Household Expenditure, 2000 ................................. 66 Table 3.15 :Trends in Student/Teacher Ratios by Level of Education and Year of Public Schools and Regional Comparators ......................................................................... 68 Table 3.16:Trends in the Use of Labor and Capital for Public Primary Schools in Urban and Rural Areas, 1990-91 to 1999-2000 ......................................................................... 68 Table 3.17:Polish and OECD Net Enrollment Rates .............................................................. 71 Table 3.1 8:Highest Level of Education Completed for 25-64 year old Populations for Poland and OECD, 1999 ......................................................................... 72 Table 3.19:Public Education Expenditures per Enrolled Household Member by Consumption Quintile (PLN per month) ......................................................................... 73 Table 3.20:Enrollment Rates by Type of Secondary and Tertiary Education and Consumption Quintile for Ages 7-24, 2000 ......................................................................... 74 Table 3.21 :Urban vs. Rural Enrollment Rates by Type of Secondary and Tertiary Education and Consumption Quintile for Ages 7-24 ................................................................. 74 Table 3.22:Population at Age 15 and Older by Highest Level of Education Completed, 1998 ............ 75 Table 3.23:Pollution Efficiency of Poland and Selected CEE, NIS, and OECD Countries ................. 76 Table 3.24:Environment Sector Expenditures, 1995-2000 ...................................................... 79 Table 3.25 :Funding of the EU Acquis Communautaire Program 2002-2006 (MnQvn ) ........................ 81 Table 3.26:Estimate of Agriculture Support, 1998-2000 ......................................................... 91 Table 3.27:Situation in Road Infrastructure, 1999 ................................................................ 93 Table 3.28:General Government Expenditures on the Transport Sector, 1994-2001 ........................ 96 Table 3.29:Projected Road Expenditures on the National Network, 2002-2005 .............................. 96 Table 3.30:Recent Trends in Railway Transport, 1997-2002 ................................................ ... 98 LIST OF FIGURES Figure 1.1: Fiscal and Monetary Development...................................................................... Figure 1.2: Size and Composition of Government Expenditures ................................................ 14 Figure 2.1: Current Disconnected Policy and Budget Process ................................................... 27 Figure 2.2: Policy and Budget: Toward and Integrated Process ................................................ 29 Figure 3.1: Composition of Social Protection Expenditures, 1995 and 2000 .................................. 39 Figure 3.2: Social Security Contributions Dividing Risks ........................................................ 39 Figure 3.3: Disability Cash Benefits as a Percentage of GDP ................................................... 42 Figure 3.4: Farmers' Pension Expenditures, 1990-2-1 (% GDP) .............................................. 43 Figure 3.5: Distribution of Social Benefits by Consumption Deciles ........................................... 45 Figure 3.6: Sickness Benefits Expenditures in % of GDP ........................................................ 48 Figure 3.7: Expenditures on Health (as % of GDP) ............................................................... 52 Figure 3.8: Real Expenditures by Use of Health Care, 1996-99 ................................................. 53 Figure 3.9: Breakdown of Public Expenditures by Use of Healthcare, 1996-99 ............................... 54 Figure 3.10:Out of Pocket Household Expenditures on Health (monthly in Zlotys), 2000 .................. 60 Figure 3.11 :Trends in Share of Fee-Paying in Public Tertiary Education, 1990-2001 ........................ 65 Figure 3.12:Projected Demographic Trends by Level Specific Ages for 2002-2020 (2002=100) ........... 67 Figure 3.13:Distribution of Ownership of Agricultural Land ..................................................... 87 Figure 3.14:Agriculture Budget as % of GDP and Expenditures ................................................ 89 Figure 3.15:Distribution of Expenditures .......................................................................... 89 Figure 3.16:Dynamics of Agricultural Budget (Thousand PLN) ................................................. 90 Figure 3.17:Rail Employees/Km .......................................................................... 98 Figure 3.18:Condition of Road Network, 1999 ..................................................................... 99 LEST ˘DF BOXES Box 1.1: Causes of Fiscal Detenoration in 2001 ................................................................... 6 Box 1.2: Public Debt Limits ...................................................................... 9 Box 1.3: Definitions of Public Sector and Public Debt ........................................................... 10 Box 2.1: Variable Accountability Arrangement for Special Funds and Agencies ............................ 23 Box 2.2: The Annual Budget Formulation Process in Poland ................................................... 28 Box 2.3: Strengthening Investment in Poland ..................................................................... 30 Box 3.1: The National Fund for the Rehabilitation of Disabled Persons (PFRON) .......................... 49 Box 3.2: Diagnosis Related Group (DRG) ...................................................................... 58 Box 3.3: Ecological Funds ...................................................................... 79 Box 3.4: Roles and Responsibilities ...................................................................... 91 LEST1$ (D)F ANNEX TABLES Annex 1-Table 1: Functional Composition of Local Expenditures, by Level of Local Government 2000 ...................................................................... 104 Annex 1-Table 2: Local Government Sources of Revenue in Poland, 2000 (in Percent) .105 EXECUTIVE SUMMARY 1. Poland is on the threshold of membership of the European Union (EU). This would mark a major accomplishment along the path of transition to a market economy, a process that Poland embarked upon 12 years ago. Integration with the European market offers significant opportunities for accelerated growth and improvement in living standards. Poland's current economic situation has significant strengths and weaknesses. In particular, the realization of low inflation is a major achievement. Yet, this has been accompanied by economic stagnation and high unemployment. In recent years, economic growth has slowed in Poland, averaging only I percent in 2001 and a projected 1.2 percent in 2002. The slowdown has brought to the fore the fiscal pressures within the budget. Indeed, the main threat to the potential recovery arises from the deteriorating fiscal situation. The overall balance of the general government has deteriorated from a negative 2.8 percent of GDP in 2000 to minus 5.3 percent of GDP in 2001 (and a projected -6.6 percent of GDP in 2002). Public debt has risen from 42.3 of GDP m 2000 to a projected 49.8 percent of GDP in 2002. 2. The economic slowdown and structural weaknesses in the rules and incentives underpinning budget management have also contributed to growing fiscal imbalances since the end of 2000. To fully exploit the opportunities that EU accession offers, Poland needs to ensure an open and competitive economy and a stable macroeconomic environment. For this, it is of critical importance that Poland continues to vigorously implement social and structural policy reforms to strengthen the prospects for growth and fiscal stability. Towards this end, Poland needs to consolidate and restructure its public finances, strengthen budget management, and better leverage EU financing. 3. This reports examines those social and structural reform issues that affect or are affected by the stance of public finance. First, it reviews Poland's economic performance with a focus on its macroeconomic policy mix, public debt sustainability issues, and developments in public finance and expenditure composition. It highlights the need to tighten fiscal policy as a means to further rebalance the macroeconomic policy mix and to reverse unfavorable debt dynamics. It also points out that Poland's public sector is relatively large for its income level and that social protection and assistance related expenditures have been a major source of this situation. Another important point is the need to enhance the developmental impact of expenditures. In particular, investment in physical infrastructure has been relatively neglected during the last decade in favor of expenditures on social programs and consumption. Fiscal consolidation has also been hampered by over-indexation of social expenditures. 4. Second, the report examines the extent to which the current budgetary outcomes are the result of weaknesses in the incentive arrangements for good budgeting. The report suggests significant reforms in budget processes as a pre-requisite for sustainable improvements in public finances. In particular, pnority areas for government action include measures to consolidate the budget to ensure a comprehensive picture of public finances and effective cash management; to strengthen the performance orientation of the budget through the introduction of a Medium-Term Expenditure Framework and incentives at ministenal and local govermnent levels for improved public service delivery; and to strengthen ex post internal and external audit systems. These improvements would provide policymakers with the requisite institutional tools for better-informed decision-making that would provide them with he best chance of achieving Poland's developmental objectives. 5. Third, the report examines the options for expenditure cuts and restructuring necessary for fiscal sustainability, given that the full implementation of expenditure management reforms will take time and Poland's adjustment needs are immediate. In particular, the report discusses those sectoral programs that could potentially: (i) provide significant savings to the budget (social protection); (ii) contribute to Poland's human and physical capital; (iii) unlock the growth potential of underutilized factors of production in agriculture and Poland's rural areas; and (iv) improve the country's living conditions through upgrading its environmental standards as agreed with the EU. Each of these sections identifies needed social and/or structural reforms that have a direct expenditure impact or that lead to a more effective and efficient use of the resources allocated to it. 11. MacIroeconomic Comtext of FAscal Poley 6. FiscaR Sustgnablity. The observed fiscal deficits in Poland are not merely cyclical but to a large extent structural in nature. The estimated structural deficit widened from 2.7 percent of GDP in 2000 to 4.0 percent of GDP in 2001. The discipline of the EU's Growth and Stability Pact, which requires budgets to be structurally in balance and cyclical deficits to be limited to 3 percent of GDP, provides a useful benchmark for policy convergence. The imperatives of the country's public finances, especially as its public debt rises close to the constitutional ceiling of 60 percent of GDP, implies that the overall general govemment net borrowing requirement needs to be reduced. A reduction of the fiscal deficit of around 3.5 percent of GDP in 2003 is needed to maintain the debt to GDP ratio below 50 percent, which is the first threshold as defined in the Act on Public Finance. 7. A return to the sound macroeconomic policies of the early transition years, combined with a hard budget constraint for enterprises, would enable the economy to re-emerge from the current slowdown more competitively. Fiscal consolidation and the reduction of overall deficits should make further monetary easing a real possibility while at the same time reversing the unfavorable public debt dynamics. 8. There are several policy options for the Govemment that, if implemented, can reduce the size of the required expenditure retrenchment, and help ease the fiscal problem. First, the financial benefits from EU accession can be maximized in the near term. While this would require the strengthening of administrative capacities to assist with the effective absorption of pre- and post-accession funding, net additional EU funds can increase by 0.5 percent of GDP in the first years of accession to close to 1.0 percent in 2006. Ensuring that these additional funds are primarily used to replace own funding would reduce the need for expenditure retrenchment by a similar amount. 9. Second, the Government could generate additional privatization revenues. In 2002, the Government estimated its holdings in companies to amount to PLN140 billion or 19 percent of GDP that suggests significant opportumities to generate privatization revenues and reduce the debt burden. Privatization revenues are estimated at a mere 0.5 percent of GDP in 2002 and planned at 0.9 percent of GDP in the draft 2003 budget. If the Government would increase privatization revenues to 1.5 percent of GDP annually (starting in 2003), debt dynamics would be much more favorable and less adjustment in non-interest expenditures would be necessary in the short run. 10. Third, Poland needs to reduce its revenue losses through tax expenditures that are estimated at around 8.5 percent of GDP in 2000.1 The foregone revenues from VAT only were in the order of 6.7 percent of GDP or PLN45.7 billion zlotys. Recovenng part of these foregone revenues would strengthen the primary balance and obviate the need for additional expenditure retrenchment. ' See OECD (2002). 11. Notwithstanding the above, significant expenditure cuts will likely be necessary over the short- to medium-term to ensure fiscal sustainability. For instance, significant possibilities for expenditure savings exist primarily in social protection through better targeting and rationalization of programs (see discussion below). Similarly, in agriculture and rural development, a sizeable proportion of current budgetary obligations can be shifted to EU sources with EU accession, and EU transfers can be better leveraged for rural development. 12. In addition, the Government needs to actively manage its fiscal risks to prevent a recurrence of fiscal imbalances. The pnmary source of fiscal risk arises from the use of public guarantees and delayed payment of contributions to the second pillar of the pension system. The use of state guarantees to allow firms and public bodies to acquire credits or to receive them at reduced interest rates has increased sharply smce 1999 from an average 0.3 percent of GDP annually during the 1990s to a permissible level of guarantees for FY03 to PLN23 billion or 3 percent of projected GDP. To further improve its ability to systematically analyze its own solvency and sustainability of its macroeconomic policy framework over various time horizons, the Government should develop a balance sheet of public financial assets and liabilities as well as of its tangible non-financial assets. Strengthen Fiscal Sustainability . -_P.Rt., V PWtjCY RtCOMNENDA v - E , SEQUENCIN & VISC IMPULCA- JNS8 Rebalance macroeconomic policy by tightening Sequencing: prepare legal amendments and revise fiscal policy so as to facilitate a reduction of real 2003 budget; interest rates and put public debt dynamics on a Fiscal implications: Depending upon policy sustainable footing by maintaining a debt to GDP combination chosen, fiscal adjustment of up to 3.5% ratio below 50 percent. of GDP needed in 2003, increasmg to over 5.0% of GDP if delayed to 2004; Medium term: Primary balance of general government needs to be maintamed at 0.5% of GDP. Prepare for financial consequences of EU Fiscal implications in short term: Net benefit membership. estimnated at 0.5-1.0% of GDP. Generate additional privatization revenues Fiscal implications in short term: one to one decline m public sector borrowing requirements. Limit recourse to contingent fiscal liabilities to carry Fiscal implhcations: Contingent liabilities can out public policies. potentially increases public debt by approximately 4% of GDP. Develop a balance sheet of the Government's Fiscal implications: imnproved decision-making with financial liabilities and assets, and of tangible non- respect to solvency and sustainability. financial assets. 13. Improve the Growth Impact of Fiscal Policy. The size of Poland's public sector is relatively large for its income level. A smaller public sector would provide greater space for private sector development and promote growth. The burden of fiscal adjustment will have to be borne initially by expenditures; but once the debt has been put on a sustainable trajectory, reductions in the tax burden can also be considered. 14. It is also clear that Poland's expenditure programs are heavily tilted towards recurrent expenditure programs and that the country has lacked the needed investment to upgrade its infrastructure and to improve its environmental standards. Even though EU funds will contribute to the financing of these much needed investments, such action would require a shift in public expenditures from current expenditures - social transfers and expenditures on goods and services-towards investments and would require significant contributions from the budget. This, in turn, would require improvements in public expenditure management, which is further elaborated upon in the next section. iii 15. The current web of high tax expenditures, inter-enterprise debts, and high payroll taxes distorts incentives for growth. Focusing tax relief on one particular sector, although beneficial for that particular sector, means that potential government revenues are foregone, and that future generations as well as other sectors and/or inputs in production (e.g., labor) will be taxed more heavily. A review of the current tax system seems appropriate with a view to enhancing the transparency of the system. For instance, the reduction in tax expenditures and hardening of budget constraints can be complemented by a reduction in payroll taxes. While its fiscal impact over time may be budget neutral, this would strengthen incentives for employment and facilitate a much-needed reduction in unemployment. [mimp rove the G;row˘2tn JEImact lT Fiscal Policy Reduce the size of the public sector. Sequencing: Prepare necessary legal amendments and regulations in early 2003 and prepare 2004 budget using new legal and regulatory framework; Fiscal implications: Reduce expenditures by 3.5% in 2003 and limit expenditure growth well below GDP growth and reduce taxation from then on; Growth implications: positive. Promote a greater developmental orientation of Sequencing: Prepare necessary legal amendments and ublic expenditures. regulations in early 2003 and prepare 2004 budget Decrease the level of tax expenditures in a budget using new legal and regulatory framework. neutral manner by reducing payroll taxes. Fiscal implications: budget neutral implementation; I Growth implications: positive. liii. Poland's Public Expeinditure Management System 16. The current budgetary outcomes reflect, in part, the weaknesses in the incentive environment provided by the rules and processes underlying budget formulation and execution. While addressing this incentive framework has to be an ongoing process of reform over several years, a start needs to be made today. The priority areas for Govemment action are discussed below. 17. ConsoUldate the IBudget. A clear and comprehensive picture of the state of public finances is fundamental to effective management of the public purse. Incomplete and partial infornation leads to fragmentation and precludes appropriate decision-making during budget formulation and execution. It is generally expected that a government budget's scope would be coterminous with the total operations of a govemment and would include all instruments of fiscal policy. Such a comprehensive coverage is necessary to facilitate the formulation of fiscal policies and the judicious use of fiscal instruments, such as taxes and expenditures, sales and purchase operations, lending and borrowing, and guaranteeing transactions. 18. An important issue in Poland is the existing "'fragmentation" in the budget management system. This "fragmentation" takes place primarily through four areas-the large number of extrabudgetary funds and agencies, the inadequate integration of cash and debt management, the exclusion of foreign aid from budget coverage, and the inadequate treatment of fiscal risk. Consolidating the budget would facilitate comprehensiveness, and would aid the development of appropriate fiscal policies as well as a judicious use of fiscal instruments. iv Consolidate the Budget PRXOY&YfPOLtCY RECOMAENkAt10ANS - SEQUECIQ& CAl IXYHQNS ' Consolidate the budget by including all public Sequencing Prepare necessary legal amendments and revenues and expenditures, and subjecting all regulations in early 2003 and prepare 2004 budget using budget funds to uniform standards of budget the new rules. scrutiny and legislative oversight. Economic Implication: improved transparency and Unify accounts of state budget entities into a accountability of budget process. Single Consolidated Fund (Treasury Single Account), and shift away from practice of "actual release" of funds to "release of authority" to spend. Include and integrate foreign aid into the budget so that the same appropriation process covers it as domestically funded expenditures. Include in the annual budget an explicit statement of the Government guarantees provided and to be provided, its recipient, amounts, purposes, fees (if any) and the risks taken into account in the formulation of the annual budget. 19. Link Policy Formulation with Budgeting. Policy formulation in Poland is largely disconnected from the budget process, undermining the incentives for the economy, efficiency, and effectiveness of budgeting. Moreover, many of the policy normatives are embedded in laws. While these provide greater stability for the policy environment, they also limit the flexibility governments need to have to adapt policies to changing circumstances, needs, and priorities, and substantially increase the transactions cost of making the required policy changes. 20. Instituting a Medium-Term Expenditure Framework (MTEF) within which annual budget needs are assessed would enable discussion and evaluation of the links between economic objectives, policy options and trade-offs, allocation of resources, and expected results. A key component of such a framework would be multi-year fiscal aggregates-the overall macroeconomic and fiscal policy parameters-which would serve as a basis for the annual budget process. - Better Link Policy Formulation with Budgeting Institute a Medium-Term Expenditure Framework Sequencing: Prepare for implementation in early 2003; within which annual budget needs are assessed. phased actual implementation of full MTEF itself; First steps should include (i) strengthening the Economic Implications: unproved transparency and process of macro forecasting; (ii) preparing and accountability of budget process and a more efficient adopting a fiscal policy paper; and (iii) linking use of public resources. policy formulation explicitly with the budget formulation timeline. Undertake fundamental reviews of key sectors in a Sequencing: use of the instrument should be coordinated phased manner. with introduction of MTEF and consolidation of EBFs and agencies; Economic implications: improved and more efficient resource use. 21. To address the continuing of new policy commitments during the fiscal year and the fiscal rigidity from mandated legal policy commitments, the Government should undertake fundamental reviews of selected ministries, extrabudgetary funds (EBFs) and/or agencies so that a view could be taken of policies to be continued, modified, or abandoned, and/or on the appropriate organizational form though v which public services are to be delivered. This would also help rationalize the number of EBFs and autonomous agencies over time. 22. Strengthen the Performance Orientation of gIhe Budget. The dominant culture of mere compliance with law with respect to inputs alone, rather than of performance or delivery aspects, is particularly pernicious and makes the system inadequate. There are three sets of issues here that need to be addressed. First, the budget classification is input-based and does not easily provide for performance evaluation. Input-based expenditure data that come up from line ministries and other spending units are relied upon mainly to ensure that wages and pension payments are met fully. The budget classification does not reveal the purpose of the funds appropriated. Therefore, the Govemment should develop within each ministry a program classification of spending, which fully integrates investment projects and allows for a shift towards performtance oriented budgeting. This should create the potential to make delivery units responsible for service delivery and accountable for results. 23. Second, the limited revenue autonomy at the local level and the lack of appropriate national service standards for public services do not provide adequate incentives to local governments for service delivery. With Poland's accession to the EU, the role of local governments will come into even sharper focus as agents for the speedier integration of the Polish economy with the rest of Europe. Thus, both to serve Polish citizens better and to enhance the international competitiveness of Poland, inter- governmental fiscal relations need to be strengthened as an aid to better government. Incentive mechanisms therefore need to be strengthened along the following lines: (i) enhance local revenue means to strengthen local accountability; (ii) link public service delivery performance with the way fiscal transfers are determined; and (iii) introduce separate fiscal capacity equalization programs for various population sizes and types of local govemments. Stfien then Performance Orientation iE;**kiCe Ri2=' +- - S - - EQICG & _FSCAL1 WUCATIONS Develop within each ministry a program Sequencing: Prepare necessary legal amendments and classification of spending that fuHly integrates regulations in early 2003 and prepare 2004 budget investment projects and allows for a shift towards using the new program classification; performance oriented budgeting. Fiscal implications: better resource use should allow for savings. Strengthen incentive mechanisms for service Sequencing: Phased inmplementation over 1-3 years; delivery at the local level by (i) enhancing local Fiscal implications: small positive benefits, but revenue means to strengthen taxpayer potentially large benefits in quality of public services. accountability; (ii) linking public service delivery performance with the way fiscal transfers are determined; and (iii) introducing separate fiseal capacity equalization programs for various population sizes and types of local governments. Improve information available on program Sequencing: Prepare necessary legal amendments and efficiency during budget preparation and execution regulations in early 2003 and execute 2004 budget by (i) expanding the scope of functional autonomy using the new framework; given to budget units; (ii) strengthening the internal Fiscal implications: better resource use should allow controls within budget units, and (iii) selectively for savings. Introducing performance orientation and accountability measures for services. 24. Third, the information available on program efficiency during budget preparation and execution is insufficient. The responsibilities of the budget units during the budget implementation phase are limited to complying with the budget law and to keep spending on inputs within the approved budget estimates. Previous experience shows that while the budget units have been largely successful in these endeavors, this has been at the cost of program efficiency. The directions of improvement envisaged in vi this regard comprise the pursuit of specific objectives in three areas: (i) expanding the scope of functional autonomy given to the budget units; (ii) strengthening the intemal controls within the units, and (iii) selectively introducing performance orientation and accountability measures for public services. However, such changes will necessarily need to be consistent with the requirements of macroeconomic stabilization, the development of systems of intemal control, and the needs of central agencies for financial information for overall fiscal monitoring. 25. Strengthen the Accountability Framework. The current accountability framework is primarily geared towards compliance with laws and financial probity. This relies upon the preparation of annual accounts, and the publication by the Supreme Audit Institution of its investigative reports and an annual report. The Public Finance Law puts emphasis on the pursuit of violations of fiscal discipline and on the imposition of penalties by the persons appointed to look into the violations, but not on achieving the Govemment's objectives in financial management and the delivery of goods and services. As to promote moves towards greater functional autonomy and accountability, while ensuring adequate safeguards for the attainment of economy, efficiency, and effectiveness in the use of public resources, the extemal audit would require that public accounts be certified by the audit agency and subjected to legislative scrutiny. Streng hen the Accountabilty Framework A`f8 PRiORITY POLICY RECOMMEiNDATIONS' % . - r} S U Develop unified accounting standards for Sequencing: Prepare necessary legal amendments and Government. regulations in early 2003 and execute 2004 budget Require supreme audit institution to authenticate using the new framework; public accounts. Fiscal implications: positive. Expand the scope of accountability to include performance. M. Options for Expenditure Policy Reforms 26. Opportunities exist to reform expenditure policies in such a way as to promote fiscal stability, strengthen the competitiveness of the economy, and provide a stronger basis for future growth. The reform of social protection, perhaps, provides the best chance to reduce expenditure pressures and generate budgetary savings over both the short and medium term. This would also pave the way for reducing the excessive payroll tax, which is a drag on new hiring and job creation in the formal economy. Other sectoral reforms, for instance in health and education, are more likely to be budget neutral in the aggregate, though they have important implications for improving human capabilities and strengthening the comipetitiveness of Poland in an integrated Europe. Finally, structural reforms in agriculture, environment, and transport offer the greatest potential for accessing EU funds, converging to EU standards, and promoting economic integration. None of these reforms are, however, easy. They will require strong and sustained Government commitment over the medium term. Public support will also need to be mobilized through an effective communication strategy to explain to the Polish citizens the costs and benefits of the various options and the policy trade-offs inherent therein. 27. Social Protection. A major contributory factor to fiscal pressures in Poland is social protection expenditures. In 2000, these accounted for 20 percent of GDP, equivalent to 45 percent of general government expenditures. This makes the Polish system one of the most expensive among the OECD countries, and undermiines Poland's competitiveness. Relatively high replacement rates of benefits and extensive system leakages create disincentives for work. At the same time, high social protection expenditures mcrease the costs to employers of hiring workers and undercut potential job and wage growth. While any deep restructuring of the system would require a careful evaluation of social protection programs, with special emphasis on whether they are actually reaching the poor and needy in vii Poland's society, there are several policy areas in which the Government can proceed imrnediately in order to reduce the fiscal burden of these programs. 28. Old Age Pensions. Poland spends about 6 percent of GDP on old age pensions. The old age pension system was substantially reformed in 1999 with the switch from the single pillar defined benefit pay-as-you-go (PAYG) system to a multi-pillar defined contribution system for those under the age of 50. Those older than 50 remained under the PAYG system with generous entitlements. The implementation of the new pension system however, has not proceeded as originally planned. Implementation problems with the identification of participants and therefore the inability to assign individual contributions to contributors have harmed the credibility of the much needed and otherwise well-designed reforms. 29. In addition, and partly as a result of system problems in identifying all contnbutors, the Government has, on several occasions, delayed transferring funds to ZUS to be passed on to the privately managed pension funds. This has resulted in a cumulative debt by the Government to these pension funds of PLN7 billion or 0.9 percent of GDP as of the end of 2002. Although, the Social Security System Act of 1999 clearly identifies the procedures in such cases, including penalty interest to be paid by the Government, payment delays disrupt the functioning of the new system, harm the credibility of the reform effort, and create unnecessary additional cost to the budget in the forrn of penalty interest estimated at PLN1 billion a year. Therefore, the Government should speed up the information technology component and transfer back-payments to ZUS to be passed on to the open pension funds so as to regain credibility and reduce the accruing of penalty interest. 30. While the PAYG system provides generous security, it still places a burden on public expenditure, adversely affects labor market efficiency, provides unequal gender treatment, and provides perverse incentives to combine work with early retirement. To improve the functioning of the PAYG system, the Government should consider unifying the retirement ages for both sexes, raising the early retirement age, and further tightening the ability to combine work with the receipt of early retirement benefits. While the last two recommendations would provide savings to the budget in the short term, the first recommendation would provide savings in the long run and would improve equity of the system. SochAg liroectdonm: Old Age Pemsonas Speed up the information technology component of Fiscal implhcations: Potentially reduces expenditures the pension reform. by PLNI billion. Transfer back-payments of the Governmenmt's contribution to the second pillar to DFE. Unify the retirement age for both sexes. Sequencing: Prepare necessary legal amendments in early 2003 and execute 2004 budget using the new framework, Fiscal implications: savings can be expected only in the long run. Raise early retirement age for both sezes. Sequencing: Prepare necessary legal amendments in early 2003 and execute 2004 budget using the new framework; Fiscal implications: savings could be about 0.4 percent of GDP annually. Discourage combining worlk with early retirement Sequencing: Prepare necessary legal amendments in under the old PAYG system. early 2003 and execute 2004 budget using the new fiamework; Fiscal implications: potential savings cannot be assessed, as no data collection is currently undertaken on people working and receiving early retirement benefits. viii 31. Disability Pensions. Poland spends around 4 percent of GDP annually on disability pensions. This is 2 percent of GDP more than the average OECD country and 1.2 percent more than Norway, which is the second highest spender in the OECD on disability pensions. Important and urgent measures would be to provide only term disability pensions and to re-examine all current beneficiaries with a certified permanent disability pension, starting with the youngest as was done, for example, in the Netherlands. Social Protection: Disabili Pensions ' PIORIrY. POLicy.REcoMMENDATioNs SEQUEN~ING & CSCAL IMPLICATIONS Limit disability benefits to term disability. Sequencing: Prepare necessary legal amendments m early 2003 with implementation to take place in 2004- 2005; Fiscal implications: every 10 percent decline of the stock of disabled would result in 0.34 percent of GDP declme m spending. 32. Old Age and Disability System for Farmers (KRUS). Poland is the only transition country with a separate system of social insurance for farmers. A characteristic feature of the Polish system of farmers' social insurance is that benefits paid out by KRUS are almost in their entirety financed through a state budgetary subsidy, which amounts to 2 percent of GDP. Only a small component, "Contribution Fund," is fully paid from contributions by insured farmers. In the agriculture sector (see also below) a bi-modal pattern of land ownership has become apparent as agricultural land owned by farmers with more than 15 hectares has doubled from 20 to 40 percent, while the share of small, 1-2 hectares, farrns has hardly changed between 1995 and 2000, clearly indicating further commercialization and consolidation of farm businesses. At the same time, all farmers are covered by KRUS and are exempt from income tax, which also means that there is no systematic recording of farm incomes. Social Protection: Old Age and Disability System for Farmers <'P;utiiOR PTl.itRRCOMMNDATIONS eSEQUENCING & FisCALAMPLCAT6IONS9.r'- Phase in income taxes in agriculture. Sequencing: Prepare necessary legal amendments in early 2003 with implementation to take place in 2004- 2005; Fiscal implications: budget neutral. Switch large farmers from KRUS to ZUS; utilize Sequencing: Prepare necessary legal amendments in the availability of CAP direct payments to phase out early 2003 with implementation to take place in 2004- KRUS and to soften impact of changes on farmers. 2005; CAP direct payments effective upon EU accession. Fiscal implications: Positive. Savings from shifting farmers to ZUS estimated at 0.1% of GDP annually. Utilization of CAP direct paymnents (upon EU accession) would lead to one-to-one substitution for budget expenditures leading to savings of around 0.5% ._________________________________________ of G D P annually. 33. With the upcoming EU accession, the Government is well placed to undertake a systematic overhaul of KRUS. While the reform must be devised and implemented carefully, a starting point has to be to change the whole philosophy of social insurance of people employed in agriculture and to use EU funding available under CAP to moderate the impact of the reforms. A first step in a new social insurance system for people employed in agriculture should introduce income tax for all those working in agriculture. This would permit the division of farmers into those who are small and cannot afford to pay taxes and those who are large and can. The latter should be treated the same way as other self-employed people. A second step would be to switch this latter group of large farmers from the KRUS to the ZUS system, which could potentially increase contributions to the two systems jointly by roughly PLN750 ix million annually. At the same time, availability of CAP direct payments to farmers would help to compensate for the changes m KRUS. 34. Social Assistance. The Polish social assistance system is extremely complex. In addition, evidence from household budget surveys indicates that targeting needs to be improved. This is particularly the case for family and housing benefits. Henceforth the Government should redesign the social assistance system with a view to limiting or concentrating the currently large number of programs. It should also further tighten eligibility for social assistance programs, while redesigning the overall social assistance system so that leakages, which are estimated at around 02-0.3 percent annually, are reduced significantly. Socl Jffrolecifolni: Sochia AssAstaimce PlUOF'SGez-J. l - f l. r. .. - a[U v .'; .|'V SFt' '¶- .1'4,~ R EN. f f;.s.CA PCAoN Contract out the delivery of active labor marrket Sequencing: Undertake necessary adjustments during programs. 2003 with implementation to take place in 2004; Add re-employment bonuses. Fiscal implications: budget neutral. Separate sources of funding of active and passive labor market programs. 37. It is also important to put the financing of active labor market programs on a more equitable footing. Therefore, defining separate sources of funding for active and passive labor market programs would reduce competition between programs, especially during periods of rising unemployment. The x proposed option is that passive labor market programs would continue to be funded by the payroll tax, albeit at a lower rate, while active programs would receive funding from general revenues. 38. Sickness Benefits. In the 1990s, the number of sick leave days rose steadily, imposing rising fiscal and economic costs. Notwithstanding the introduction of several appropnate and partly effective measures to curb the rising sick leave related expenditures, the number of sick days is still above the OECD average, and benefits (especially long-term) are relatively generous in comparison with most of the OECD countries. Therefore, additional measures should be introduced. For short-term sickness, the replacement rate should be lowered from the current 80 percent to 70 percent, while the waiting penod is simultaneously expanded beyond five days. Benefits should also be calculated on the basis of the remuneration of the last 12 months and not 6 months, as is the case now. For the long-term sick, the 100 percent benefit should be reduced to a level lower than that for the short-term sick, in line with intemational practice. The introduction of a waiting period for those who are sick for less than 5 days probably does not go far enough to fully discourage people from the inappropriate use of sick leave or to discourage medical doctors from prescribing longer sick leaves. Social Protection: Sickness Benefits -* -'..SIORrY PQLIC1REiC.MME$ATIONS SEQUEIN],* &F SCAISAMuCATImNS77 Lower replacement rate for short term and long Sequencing: Prepare necessary legal amendments in term sick. early 2003 with imnplementation to take place in 2004; Fiscal implications: savings of 0.05% of GDP Expand waiting period beyond 5 days of sickness. Sequencing: Prepare necessary legal amendments in early 2003 with implementation to take place in 2004. Fiscal implications: small positive. 39. Supporting Work for the Disabled. The support for work for the disabled is financed through a variety of tax breaks and direct and indirect support mechanisms to enterprises. These are channeled through Supported Work Establishments and the National Fund for Rehabilitation of Disabled Persons (PFRON), which is an extrabudgetary fund. The design of the current system makes it impossible to track the flow of funds while the revenue generated by the quota-levy system is independent of the actual needs of the disability programs. In addition, the wage subsidy provided under the program makes up for more than the productivity differential, encouraging enterprises to hire minimally disabled, minimum wage workers. To tackle these issues, the Government should integrate PFRON back into the budget ensuring that it has a full picture of all its financial flows (and improving the comprehensiveness and transparency of its own budget), phase out the quota-levy system while developing a system that is based upon rewards and productivity differentials instead of punishment, and strengthen the capacity at the local level to execute support programs for disabled workers. Social Protection: Supportng Work For the Disabled P.. ORr POLJc*EQ*MEDA1UONS. SE7UENC &IIScAL TI JNS -'7 Ensure that all funds pass through the budget. Sequencing: Prepare necessary legal amendments in Phase out the quota - levy system. early 2003 with implementation to take place in 2004; Replace PFRON with direct appropriations to local Fiscal implications. positive. governments. 40. Health Care. Despite various reforms in the health sector during the 1990s, substantial scope remains for reforms aimed at preventing excessive growth in demand and costs, encouraging more efficient use of resources, improving equity of access, and making the financing of the sector more sustainable. Poland spent 6.4 percent of GDP on health in 2001, of which about 71 percent was public expenditures and the remaining 29 percent was private expenditures. These amounts have remained more or less steady over the period 1997-2001 and are, as a percentage of GDP, comparable to other EU countries. While Poland's health status compares favorably with the health status of other EU accession xi countnes, it does not compare as favorably with the health status of the people of countries already belonging to the EU. 41. Efficiency. Further improvements in efficiency can be accomplished by allowing health facilities to compete with each other for business from sickness funds that should not feel obliged to support any particular facility. The renewed accumulation of debts by health service providers, in particular, tertiary health service providers (after a clearance of their debts with the 1999 reforms) is extremely worrisome as it indicates that the reforms did not change the incentives for improvements in efficiency. The introduction of the new health insurance system only temporarily eased the position of providers. To solve the issue of the accumulation of new debts by hospitals, the Government should, in the short run, enforce a hard budget constraint on hospital managers so as to provide the necessary incentives for accountability and financial discipline. Over the more medium term, the Government needs to think about a strategy for further reducing the number of hospitals and hospital beds through a system of hospital consolidation with a well-defined strategy for closures. This would also require the development of bankruptcy procedures to facilitate the enforcement of hard budget constraints and improve financial discipline in the public sector health care facilities. 42. In addition, the Government should consider additional measures for improving incentives to contain costs in the sector by linking services provided to compensation and thus ensunng that the "money follows the patient," which would promote the most cost-effective means of production and delivery. Basing reimbursement levels for drugs on the use and pricing of generic drugs, and introducing control triggers and benchmarks for monitoring drug use, would help contain the excessive growth in the cost of drugs. IBestlii Care: Ef!ciency Introduce meaningful competition among Dnealth Sequencing: Prepare necessary legal amendments in service providers, so as to allow for hospital early 2003 with implementation to take place in 2004 consolidation, bankruptcies, and financial and Coordinate implementation with measures to link accountability. hospital payments and services, and redistribute resources according to population needs; Economic implications: better resource use within the sector. Fiscal implications: potentially large as increases in hospital debts are estimated at PLN 1.5 billion a year. Reform hospital payments so as to establish direct Sequencing. Prepare necessary legal amendments in linkage with nature and scope of patience services early 2003 with irnplementation to take place and ensure that "money follows the patient". immediately; Fiscal implications: potential savings of PLNI billion of hospital expenditures. Promote use of generic drugs, where they eznst, and Sequencing: Prepare necessary legal amendments in rationalize prescription practices. early 2003 with implementation to take place immediately; Fiscal implications: potential savings of PLN1.5 billion. 43. Financing. The health insurance system has done well in recent years insofar as collection of premiums is concerned. There remains, however, a serious problem with the recording of premium collections in ZUS, and in the case of almost one-third of all contributors, it is difficult to identify to which sickness fund they belong. Currently, this is remedied imperfectly during the course of the year through special norm-based reallocations from the Ministry of Health, typically towards the end of the fiscal year. However, this implies that individual sickness funds face financing shortfalls during the xii course of the year, and have to resort to debt financing to meet this shortfall. Therefore, the Government should contemplate the introduction of a commonly shared and unique identification number, should force better coordination among ZUS, UNUS, and other agencies for sharing of information, and should design and implement an IT system that allows individualized tracking of premium contnbutions. 44. In order to strengthen the financing of health care and promote provider choice and competition, the Govermment should also consider establishing the enabling legal and regulatory framework for supplemental health care insurance. Health Care: Financing PIUOIPT1 POLICY RECOMMENDATIONS - SEQUENIGG&Fis4CALbirLCATIONS-> - Eliminate inefficiencies in the recording of Sequencing: Prepare necessary legal amendments and collections and redistribution of premiums. mechanisms 2003 with implementation to take place soon thereafter; Fiscal implications: potential savings of PLNO.5 _________________________________________billion. Consider supplemental health insurance scheme Sequencing: Prepare necessary legal amendments in with co-payments. early 2003 with implementation to take place immediately; Fiscal implications: savings depend on amount of co- I payment. 45. Equity. In the absence of accurate estimates of utilization and of costs, it is difficult to assess the equity impact of public expenditures on health. However, an examination of the structure of the equalization formula that redistributes part of the premium collections and of the burden of out-of-pocket expenditures on health care suggests that equity is not a major problem in the health sector in Poland. Nevertheless, improvements in the link between resource allocation and population needs can be made and an effort to eradicate informal payments should be undertaken. The former can be accomplished by amending the algorithm used for the equalization of inmurance premiums to include provisions to redistribute resources based upon population needs and utilization, in addition to the adjustments for age and income that are presently available. The latter requires the adoption of a multi-pronged strategy, which should include: (i) improving the incentive framework by ensuring that both the demand for, and supply of, such payments is curtailed; (ii) addressing the culture of acceptance in the existing system by educating people that side payments between public employees and citizens are unacceptable and would not be tolerated; and (iii) establishing a system of oversight and accountability for all health providers, and ensuring swift punishment for transgressors. Health Care: Equity -2 'rPRIORITYPOLICY RECOMMENDATIONS 7N- SEUEN CtG 'ISCL AnONSX Redistribute resources according to population Sequencing: Prepare necessary legal amendments in needs and health care utilization. early 2003 with implementation to take place immediately; Fiscal implications: more equitable resource use. Institute mechanisms to eradicate informal Implications: increased credibility of public healthcare payments. system and reform effort. 46. Education. Significant education sector reforms have been undertaken during the transition; however, Poland's education system is not yet positioned to meet the needs of a modern market economy or to fully exploit the potential of EU integration. Relative to OECD benchmarks, the sector is well funded with public expenditures on education accounting for about 6 percent of GDP, which is almost 14 percent of total public expenditures. It is useful to look at educational reforms along three thematic areas: the efficiency, quality, and equity of the education system. The need for reallocating expenditures is xiii accentuated by demographic shifts in the cohorts of school age population that necessitate changes in the allocation of resources to different levels of education. 47. Efficiency. Improving efficiency, in particular dealing with inefficiencies at the primary school level and the under-funding of secondary education, depends critically on addressing the role of the state and the incentives embedded in intergovernmental arrangements. Currently, the Govermnent lacks an internally consistent policy framework, partly because it is constrained by a lack of accurate and timely information, but also because it has inadequate analytical capacities. To better define the role of the state in the education sector, a combination of measures should be implemented that focus on (i) setting a limited number of policy objectives in collaboration with stakeholders; (ii) gathering, analyzing, and publishing information on performance; (iii) setting quality standards, and (iv) ensuring access by the poor at all levels of education through appropriate targeting of expenditures. 48. Additionally, the Government should improve the incentives for action at the local level by revising the intergovernmental financing framework. First, a rationalization of the subvention formula that shifts away from reliance on historical expenditure patterns towards output standards, which are predictive of good learning, should be undertaken. Second, the Govermment should increase the flexibility for local governments to reallocate funds from primary to secondary education to accommodate the demographic bulge of secondary school students. Third, the Government should create incentives for local governments to capitalize on the demographic trends by consolidating primary schools. This could be assisted by (i) developing a competitive grants program to "sweeten" the merger of schools and make it more acceptable for parents and local governments, and/or (ii) evaluating the possibility for the Ministry of Education to absorb the costs of severance pay for redundant teachers. To help implement such a cornprehensive reform strategy, a national public relations campaign is also needed to explain the benefits of reforms to the public. 49. Quality of Education. Poland performs extremely well in terms of the average years of completed schooling, a key indicator of quality. In fact, it outperforms the average for OECD countries at each level, except preschool. The number of years of education that the average five-year-old Pole can expect to complete over his/her lifetime is only slightly below the average for the OECD as a whole. Despite these high enrollment rates, several quality issues emerge. First and foremost, Poland's performance is relatively low on intemational learning assessments. Second, differentiation in student performance among Poland's secondary schools accounts for the bulk of the variation in student performance compared to the OECD average. The program type that accounted for most of the inter-school variance was the basic vocational program, which is particularly popular in rural areas. This also explains, in large part, the difference in educational attainment between rural and urban areas. Third, Poland has relative low completion rates among tertiary students. 50. Measures that are recommended for improving the quality of education are for the Ministry of Education to put in place incentives for the kuratoria and the gminas to work together to improve learning outcomes. Actions that would help in this regard are: ensuring that schools and students have clear and measurable performance targets, publishing the learning performances of Poland's students relative to these targets (and as measured by external assessments), and strengthening the joint accountability of local govemments, school principals, and kuratoria staff for improving students' learning outcomes. 51. To tackle the quality differentiation issues at the secondary school level, the Government should continue with the implementation of the 1999 reforms in this area and should put in place a more unified system of secondary education. To improve the completion of post-secondary education, the Government should design and implement a unified system (such as the IUT system of France or the American community college system). The unified system should have certain characteristics, such as being accessible to both secondary education graduates and non-graduates, offering different mnixes of short- xiv term and longer-term instructional programs depending upon market need, and having governance and financing arrangements that encourage rapid programmatic responses to changes in skill demands. Education PRIORITY POLICY RECOMMEN*AM|ON * SEQUENCIG iv Strengthen Ifficiency Redefine the role of the state in a decentralized Sequencing: Phased implementation over the next 1-5 environment. years; Revise the intergovernmental financing framework Fiscal implications: small savings in the medium to support output-based standards, expenditure term; reallocation towards secondary schools, and primary Economic implications: better resource use. school consolidation. I Enhance Quality Link the kuratoria and gminas in a strategy to Sequencing: Phased implementation over the next 1-3 improve the quality of education. years; Reduce the differentiation in student performance Fiscal implications. budget neutral; improvements at the secondary level. should be made within existing budget limits; Replace the multiple postsecondary systems with a Economic implications: increased quality should lead unified system. to improved human capital indicators. Improve Equity Use a multi-pronged strategy to address the "rural Sequencing: phased implementation over the next 1-5 problem". years; Fiscal implications budget neutral; improvements should be made within existing budget limits; Economic implications: better resource use and ______________________ improved human capital attainment in the rural areas. Reduce the public subsidy for private schools. Sequencing: Prepare necessary legal amendments and mechamsmns during 2003 with implementation to take place soon thereafter; Fiscal implications: small savings. 52. Equity. Unfair learning opportunities matter because human capital affects poverty by affecting the individual's employment opportunities and wages. Since the education of the parents affects the educational achievements of their children, less education in the parental generation can fuel intergenerational cycles of poverty. Poland's labor markets also increasingly allocate employment opportunities and wages according to variations in human capital, as measured by years of education. 53. Total public expenditure on education per enrolled household member slightly favors the poorer quintiles as evaluated using the household survey for 2000. Poorer farnilies are larger and have a higher average number of children enrolled per household than wealthier families. However, public expenditure by consumption quintile differs by level of education. At the primary level, expenditures are pro-poor. At the lower and upper secondary level expenditures are relatively even across quintiles, while at the tertiary level, expenditures are biased against the poor as the wealthiest quintile benefits almost seven times more than the poorest quintile. This is primarily because households with enrolled members from the wealthiest quintile have almost six times the number of tertiary enrollments as their counterparts from the poorest quintile. The expenditure pattern does not differ between urban and rural areas. However, the public policy of subsidizing private schools does not benefit the poor and is not defensible on equity grounds. Therefore, the public subsidy equal to 100 percent of average public unit cost at primary and lower and upper secondary school should be reduced. 54. Given the learning disadvantage for rural students, a multi-pronged strategy to address this should be designed and implemented. Several elements of such an approach have already been discussed: financing arrangements that roughly equalize gminas' abilities to top up the subvention and that increase xv the funds for under-funded secondary education; a proactive government role in promoting equity of learning opportunity; reducing the differentiation within the secondary system that leads to greater variance in learning outcomes; linking the kuratoria and gminas in a strategy to improve the quality of education; and providing incentives for rural gminas to let them keep the resources saved from rationalizing their school network if they plow their savings back into strengthening educational quality. 55. Environment Even though Poland has been doing quite well with respect to the use it makes of its natural environment, it has a long way to go before it can reach EU levels of efficiency. Poland's public expenditures on environmental-related investments are equivalent to 1 percent of GDP. While the country has witnessed major improvements in its natural enviromnent during the past decade-more recently as a result of a switch to cleaner and more efficient methods of production and consumption- EU accession poses a huge challenge in terms of the efficiency of public investments related to the environment. It also challenges the country's ability to use EU funds and provide the needed counterpart funds from private or IFI sources. 56. To attract private mvestment the Government should create an enablng environment for the private sector to step in. Data suggest that Poland lags behind most other EU candidate countries in terms of private ownership and control of environment-related economic activities. Hence, where it is appropriate (e.g., waste management, district heating), commercialization/privatization should facilitate moving environmental-related investments out of the public sector. The Government should prepare a strategy paper which investigates not only ways in which private funds can be mobilized but also evaluates current bottlenecks to private participation in the financing of environmental projects (e.g., city authorities are unwilling to accept private financing because of a loss of state subsidy for the utility if it is operated as a private entity). 57. The main vehicle for public expenditures on the environment as well as the main source of financing are the local ecological funds and the environmental fund operating under the auspices of the Ministry of Environment. Given that each of these institutions lacks the state-of-the-art techniques to assess the effectiveness of its investments, a comprehensive evaluation of the effectiveness of environmental-related (public) expenditures is impossible. In addition, environmental fees and charges in Poland are high in companson with other EU candidate countries as well as EU member states, and because of the country's regional structure, there is excessive fragmentation. . Environment PIOuIoTY POLICY RECOMMIXATPONS- ? . ,fl _ Create an appropriate environment for private and Sequencing: Prepare necessary legal amendments and MI participation, the latter where cost-effective, mechanisms during 2003 with implementation to take with respect to (co-) financing of environmental- place soon thereafter; related investments and promote further private Fiscal implications: initially small savings, but with investments by expanding private sector ownership more and more private participation large positive and control. savings possible; Economic implications: better resource use. Improve effectiveness and priority setting of public Sequencing: Prepare necessary legal amendments and expenditures by (i) consolidating local ecological mechanisms during 2003 with implementation to take funds; (ii) increasing flexibility in expenditure place soon thereafter; allocations; (iii) preparing and using methods and Fiscal implications: positive; procedures to assess cost-effectiveness and priority Economic implications: better resource use. setting of environmental investments. I__ 58. This requires action in three areas. First, local ecological funds (below the voivodship level) should be consolidated at the national and voivodship levels and their present structure of financing and expenditures should be reviewed. As noted earlier, in addition to increasing the effectiveness of public xvi spending, this would make it easier to raise counterpart funding and would improve the comprehensiveness and transparency of the budget. Second, flexibility should be increased in the expenditure allocations between items. Some flexibility in reallocation, which would nevertheless respect the broad intent of the Ministry of Fmance, would be very helpful in reducing local financing constraints on environmental investments. Third, assessing should be begun of the cost effectiveness and priority setting mechanisms of different projects and programs. This has to be carried out at the national, voivodship, and local (powiat and gmina) levels. Procedures for evaluating environmental projects have reportedly been "worked out" jointly with the European Commission and international financial institutions. The implementation of these procedures, however, is still lacking. With the exception of the National Fund, the EcoFund, and a few regional funds, most funds do not even collect the data required for sound project appraisal. Funds usually support projects irrespective of their financial viability. 59. Agriculture and Rural Development. For Poland's agriculture to exploit its comparative advantage with the EU, urgent structural reforms are needed. Public expenditures in the rural sector in Poland are equivalent to 3 percent of GDP and are focused on two main policy objectives: the improvement of productivity in the agricultural sector and the achievement of panty of rural income with urban income levels. The main policy instruments used are price and input subsidies, including interest rate subsidies and loan guarantees, and transfers from the budget to cover almost 90 percent of the rural pension fund obligations under the KRUS system. 60. The emphasis on these instruments leaves insufficient expenditure available for agricultural extension and rural infrastructure programs which could be more successful than input and output subsidies at improving agricultural productivity. The current mix of instruments also fails to provide sufficient focus on the creation of off-farm employment in rural areas. For this reason, the Government should shift sectoral expenditures towards employment and productivity-enhancing areas. Specific areas for such increases are: non-farm employment generation, agricultural research and development, extension services, and irrigation, drainage, and land improvements. Clearly, cuts in other programs will have to be found. The specific areas of cuts are: expenditures on market intervention, gradual elimination of current input and credit subsidies, and expenditures on KRUS. 61. Looking ahead, the fundamental challenge is to ensure that Polish agriculture emerges as a serious competitive player in the EU markets with a primary focus on improving productivity. There are four EU programs from which Poland would benefit: (i) SAPARD. About l A.4 billion from the EU and state contribution to the SAPARD budget are expected to be expensed over the 2003-06 period; (ii) Price Support. If accession proceeds as planned, price support to Polish agriculture would rise by about E250 million annually (or about PLNI billion). These price increases are mainly for poultry, beef, and milk, with the prices of pork and grains experiencing a decline. From the time of accession, however the charge of most of these expenditures will be transferred to the EU budget, relieving Polish public finances accordingly; (iii) Farmers' Compensations. Direct payments to farmers, which were an issue of keen debate between Poland and the EU, can reach, in the years 2004-06, respectively a maximum of 55, 60, and 65 percent of the payments granted to farmers of the current EU member states. The EU budget will finance 25, 30, and 35 percent from the direct payment program of CAP. Poland has the option to top up CAP payments out of its own resources by redirecting EU structural funds originally set aside for rural development, (about E500 million) or general government revenues. In the light of prevailing fiscal conditions, the govemment would be wise not to avail of this flexibility; and (iv) Rural Development, Structural, and Cohesion Funds. Some of the structural and cohesion funds could also be targeted on rural development, which is expected to lead to disbursement of El.8 billion (PLN8 billion) annually over 2004-2006 excluding rural development funds used to increase direct aid to farmers. 62. The issues outlined above and the EU resources available require the development and implementation of a coherent and well-defined agriculture and rural development policy that can improve xvii productivity and create jobs in rural areas, thereby putting Polish agriculture on a firm competitive footing in the EU and enhancing rural incomes. Policy recommendations that can move the country toward this goal are to restructure rural sector expenditures towards employment and productivity enhancing areas and uses EU funding to replace domestic funding to the maximum extend possible given the current budget situation and the level of value-added produced by the sector. Specific areas that should be considered are: non-farm employment generation, agricultural research and development, extension services, and irrigation, drainage, and land improvements. Clearly, cuts in other programs will have to be found to meet EU co-financing needs. The specific areas of cuts are: expenditures on market intervention and the KRUS program. As the CAP will be paid from the EU budget, the current expenditures on market intervention from the Polish budget could be largely discontinued, with the likely exception of the PLN400 million spent annually on the pork sector (which is not supported under the CAP). Similarly, the gradual elimination of current input and credit subsidies could potentially yield up to PLN2.0 billion. 63. A similarly large source of savings to be reprogrammed could come from the KRUS program. This could amount to PLN950 million annually. The availability of direct payments from the EU as income transfers should facilitate the reform of KRUS. First, it would compensate the farmers, at least partially, for the changes in KRUS eligibility critena and premiums as proposed above. If the direct payments were distnbuted equally among the farmers, the farmers remaining in KRUS would be wholly compensated for the increase in KRUS premiums, and the larger farmers graduating into ZUS would be about 70 percent compensated. If direct payments were distributed to farmers on a per hectare basis (this would eventually reach about US$80/ha per year), then the degree of compensation of smaller farmers would be less, with the large farmers wholly compensated for the increased cost of pension contributions associated with moving from the KRUS system to the ZUS system. Second, as income transfers, these payments would be decoupled from the levels of production of one or another agricultural commodity produced by a given farmer. This, overall, would tend to distort agricultural prices less (compared to international market prices) and would cause less economic inefficiency and less costs to the budget, as surpluses to be disposed of through export subsidies would also be less. 64. All in all and assuming (as this report recommends) that a one to one substitution between EU direct payments and KRUS outlays can be achieved, EU accession will create the opportunity to bring down the burden of agricultural expenditures that are to be domestically financed from the current 3.5 percent of GDP to 2.6 percent of GDP. Even further reduction is possible through financing some of the remaining 2.6 percent through EU funds available. Agriculture & Rural Development PRIORITYPOL1CY RFCOmwNDAnoN&S - .1 , N S Restructure rural sector expenditures towards Sequencing: Eliminate non-CAP compliant employment aid productivity enhancing aress and expenditure progrms in 2003. Fund remaining use EU funds to replace domestic funds to the programs from the EU budget after accession maximum extend possible. Fiscal implications: 0.5 percent of GDP. Utilize the availability of CA1P direct payments to Sequencing: Prepare necessary legal amendments in phase out KRUS. early 2003 with implementation to take place in 2004- 2005; CAP direct payments effective upon EU accession. Fiscal implications: Positive. Utilization of CAP direct payments (upon EU accession) would lead to one-to-one substitution for budget expenditures leading to savings of around 0.5% of GDP annually. 65. Transport. Improvements in Poland's transport system have not kept pace with the demand changes of the economy. Public expenditures on transport account for 2.1 percent of GDP. Roads and railways account for more than 90 percent of total transport expenditures. The road sector development is xviii lagging behind the explosion in demand, while the railway volumes have dropped due to the collapse of heavy industry, increasing competition from the road sector, and declining service performance. 66. Road Transport. Key challenges in roads come from the rapid increase in motorization and the drastic shift in the modal split. Over the past decade, the demand for road transport has grown radically, owing to the unprecedented growth of passenger car ownership. The number of vehicles in Poland has increased from 9 million to about 14 million since 1990. Annual average daily traffic on international roads has doubled during the last ten years. The supply side, however, has not kept pace. The road sector has been a victim of under-investment in maintenance and modernization. As a result, the roads are mostly congested, slow, polluted, and unsafe. 67. Major investments in high priority road infrastructure, including motorways, are clearly required as Poland's economy continues its growth and as it prepares for accession to the EU. However, the cost of such a program, which is part of the Government's overall economic strategy for Poland, will be very high: starting from US$1 billion per year in 2002 (about 0.5 percent of GDP) to almost US$3 billion in 2005 (about 1.4 percent of GDP). Past experience points to significant problems with absorption capacity in the sector and hence there is an immediate need to scale up the Government's effort to increase Poland's implementation capacity, as expenditures are planned to increase more than threefold. This will require shifts in expenditure composition and improvements in the efficiency of the use of the funds allocated for maintenance and construction. The latter will be facilitated through a EU-mandated rationalization of the system of user charges. 68. An important element underpinning the Government's road improvement program is a consistent system for setting spending priorities, based upon rigorous economic criteria. Among other things, the Government needs to put in place institutional arrangements that (i) produce a balanced program for maintenance, upgrading, and new road investments, which produces value for money; (ii) permit the setting of priorities in the form of a five-year rolling program; (iii) set appropriate design standards, in particular for individual road links; and (iv) prepare a road safety program for inclusion in the overall road development program. Currently, the system used to set priorities does not adequately use economic criteria. It uses physical intervention levels, which also appears to result in design standards for new works that seem too high. The creation of a more professional road agency, modeled, for example, on the UK, Latvia, or New Zealand systems, which is able to operate along more commercial lines and which is responsible for the above identified tasks, would assist this much needed institutional development. In addition, the five-year rolling program should result in a multi-year funding request and allocation that reflects the sector's needs and the priority that the Govermment assigns to the sector and is fully integrated into the above proposed MTEF. Road Transport >* S RiORi POUCN-RNCMIENDATIONS SEQUENNG-&; fJCAL LCADioNS. -JyT R Increase road expenditures as planned, not only for Sequencing: Prepare necessary policy changes in 2003 new roads but also for road maintenance. with implementation to take place soon thereafter; Improve system efficiency through a EU-mandated Fiscal implications: expenditure increases needed, but reorganization of user charges. are included in Government strategy; Develop institutional capacity for priority setting, Economic implications: large impact expected not only road administration, and safety by creating a through reduced direct transport cost but also through smaller, more professional road agency able to improved safety. operate along lines that are more commercial. 69. Rail Transport. Although progress has been made with regard to preparing the railway sector to adapt to the demands of a market economy, the sector remains loss making and its overall performance remains mixed, partly because of remaining price distortions and inadequate operational performance. Additional action is therefore needed on several fronts. First, to improve efficiency and performance xix more effective management techniques should be applied. Commercialization and possible changes in the ownership structure of railway companies would help accomplish this. Second, the newly established framework for contracting, which decentralizes not only contracting but also subsidy decisions to regional governments, lacks adequate resources to be implemented effectively. Third, to generate additional revenue, the railway company (PKP SA) should be able sell its surplus (real estate) assets. However, clear ownership has not always been established and therefore has delayed the sale. Fourth, and partly related to the above, is the need to develop a local capacity for train operations. As pnvate participation in train operations is being prepared for, significant capacity development will be needed at the regional and municipal levels as these governments become responsible for regional and suburban passenger services. Rai Tirnaspor IFIRI!(EDIR PCLU21 4it;1Z3sQ7D ,'$jsTg SQTC $ NTM7.>7G & cATE. Ik>MMCAIIONG Develop effective management mechanisnns through Sequencing: Prepare necessary policy changes in 2003 commercialization and possible changes in the with implementation to take place soon thereafter; ownership structure of railway companies Fiscal implications: small positive; Allocate adequate resources for implementing the Economic implications: better resource use and more newly established legal framework for contracting. competitive rail sector not only in freight services but Utilize excess railway ezeess assets to generate also with respect to passengers. financing. IDevelop local level capacity for train operations. Conclusions 70. The Govemment has three broad objectives for expenditure reforms: strengthening of budgetary control and discipline, conformity with EU requirements, and promotion of fiscal decentralization. There are no inherent trade-offs between these three objectives, which can be mutually supportive in a proper institutional environment. Indeed, the objective of fiscal decentralization provides a real opportunity for developing political coalitions with local governments which would emerge as a significant group of "winners" if recent discussions within the Government to strengthen local revenue means, and improve local incentives for better public service delivery and accountability, come to fruition. Many recommendations require a change in current practice and, to be fully effective, may require changes to legal statutes also. 71. While the recent widening of fiscal deficits reflects, in part, counter-cyclical fiscal policy in the wake of the economic slowdown, this deterioration of the fiscal position also raises questions about the credibility of the budget process. Weaknesses in the incentive arrangements for good budgeting are central to the fiscal problems facing Poland today. Notwithstanding the progress made in budgetary reforms in several areas, significant weaknesses remain in the current system that limit the attainment of efficiency, economy, and effectiveness in the use of public resources. 72. The recommendations made in this report would, if implemented, establish transparent and objective rules and procedures for budget planning and formulation. They would also help to broaden Government, parliamentary, and public understanding of the aggregate fiscal constraint, the fiscal implications of policy trade-offs, and the benefits from shifting focus from the overly formalistic compliance with budget law and inputs alone to the timely delivery of quality public goods and services. They would also serve.to strengthen the competitiveness of the economy, and would provide a stronger basis for future growth. The growing recognition in the Government and the country of the need to address the structural fiscal imbalance, and to seek systemnic solutions to these issues, provides a "window of opportunity" for the Government to accelerate the implementation of these public finance reforms. xx 1. THE STRATEGIC SETTING INTRODUCTION 1.1 Poland is on the threshold of membership in the European Union (EU). This would mark a significant event on the path of transition to a market economy, a process that Poland embarked upon 12 years ago. Integration with the European market offers significant opportunities for accelerated growth and improvement in living standards. Poland's current economic situation has significant strengths and weaknesses. In particular, the realization of low inflation is a major achievement. Yet this has been accompanied by economic stagnation and high unemployment. The economic slowdown and structural weaknesses in the rules and mcentives underpinning budget management have also contributed to growing fiscal imbalances since the end of 2000. To fully exploit the opportunities that EU accession offers, Poland needs to ensure an open and competitive economy and a stable macroeconomic environment. For this purpose, it is of critical importance that Poland continues to vigorously implement key social and structural reforms to strengthen its prospects for growth and fiscal stability. 1.2 This report examines those social and structural reform issues that affect or are affected by the stance of public finance. Chapter 1 reviews Poland's economic performance with a focus on its macroeconomic policy mix, public debt sustainability issues, and developments in public finance with a general analysis of expenditure composition. It highlights the need to tighten fiscal policy as a means to rebalance the macroeconomic policy mix and to reverse unfavorable debt dynamics. It also points out that Poland's public sector is relatively large compared with its income level and that social protection and assistance related expenditures have been a major source of this situation. Another important point identified here is the need to expand the developmental impact of expenditures, as (in particular) investment in physical infrastructure has been seriously neglected during the last decade in favor of expenditures on social programs and consumption. In addition, fiscal consolidation has been hampered by the over-indexation of social expenditures and the embedding of these expenditures into law. The resulting unfavorable debt dynamics could partly be contained if the Government were to speed up the faltering privatization process. 1.3 The question arises as to what extent the weak budgetary outcomes are the result of inadequacies in the budget processes. To that end, Chapter 2 investigates the incentives for good budgeting and suggests significant reformns in budget processes as a prerequisite for sustainable improvements in public finances. In particular, priority areas for govemment action include measures to consolidate the budget to ensure a comprehensive picture of public finances and effective cash management; to strengthen the performance orientation of the budget through the introduction of a Medium-Term Expenditure Framework and incentives at ministerial and local govermment levels for improved public service delivery; and to strengthen ex post intemal and external audit systems. The Government should also present a more comprehensive sustainability picture of the public sector by consolidating extrabudgetary funds and agencies and by developing a balance sheet of public sector financial liabilities and assets and of its tangible non-financial assets. These improvements would provide policymakers with the requisite institutional tools for better-informed decision-making that would provide them with the best chance of achieving Poland's developmental objectives. 1.4 While the full implementation of expenditure management reforms will take time, Poland's needs are urgent. Measures need to be implemented now to reform sectoral expenditure policies and put Poland on a sustainable fiscal path. Chapter 3 discusses those sectoral programs that could potentially (i) provide significant savings to the budget (social protection); (ii) contribute to Poland's human (health and education) and physical capital (transport); (iii) unlock the growth potential of underutilized production factors in agriculture and Poland's rural areas (agriculture and rural development); and (iv) improve the country's living conditions through upgrading its environmental standards as agreed with the EU. Each of these sections identifies the necessary social and/or structural reforms that would have a direct expenditure impact or would lead to a more effective and efficient use of the resources allocated to the sector. MACROECONOMIIC ˘CONTEXT 1.5 The remainder of this chapter contains a review of Poland's economic performance. Its main recommendations are the following: (a) Rebalance maciroeconomic polcy by dghtemimg fiscal policy so as to faciltte a reductiom of real interest rates aind put public debt dynamics oin a sustatimabEe footing. A return to the sound macroeconomic policies of the early transition years combined with a hard budget constraint for enterprises would enable the economy to reemerge from the current slowdown more competitively. Fiscal consolidation and the reduction of overall deficits should make further monetary easing a real possibility while at same time reversing the unfavorable public debt dynamics. Net public borrowing requirements need to be reduced by around 3.5 percent of GDP to ensure fiscal sustainability. This could be accomplished by a combination of expenditure retrenchment, the substitution of domestic funding for expenditure programs by EU funding, and the increasing of privatization revenues; (b) Prepare for the flnamicial coinsequences of IEJ membershp. Maximizing the economic and financial benefits of EU accession in the near term will require the strengthening of administrative capacities to assist with effective absorption of pre- and post-accession funding. (c) Reduce the size of the public sector. The size of Poland's public sector is relatively large compared with its income level. In addition, the size of Government can hamper further private sector development. Given the current size of the deficit and the already high revenues, the burden of fiscal adjustment will have to be borne primarily by expenditures; (d) Promote a greater development orientatlmon nm publi expenditures. This would require a shift in public expenditures from current expenditures -- social transfers and expenditures on goods and services -- towards investments in physical capital; (e) De˘crease the level of tam expenditures. A review of the current tax system seems appropriate and should have as an aim decreasing tax expenditures. This should allow for a significant reduction in taxes that affect labor so as to promote more labor friendly business and to facilitate a much-needed reduction in unemployment; (f) Limit recourse to contingent fiscal labiles to carry out pubei polcies. In recent years, the use of public guarantees to provide financial support to public enterprises has increased sharply. These contingent liabilities risk saddling current and future generations with excessive tax burdens and undermining economic competitiveness; 2 (g) Develop a balance sheet of the Government's rtnancial liabilities and assets, and of tangible non-financial assets. This would assist the Government in its ability to think more systematically about its own solvency and the sustainability of its macroeconomic policy framework over various time honzons. Table 1.1: Selected Economic Indicators, 1996-2002 Annual Data 1996 1997 1998 1999 2000 2001 _2002_ Real Economy GDP Growth (constant prices) 6.0 6 8 4.8 4.1 4.0 1.0 1 3 Share of Private Sector in GDP 66.7 69 2 70.9 71 9 71 8 Domestic Demand Growth (constant prices) 9.7 9 2 6 4 4.8 2 8 -1.7 0 8 Gross Domestic Fixed Investment Growth (constant prices) 19.7 21 7 14.2 6.8 2.7 -9.8 -7.2 Employment (end of penod, in thousands) 15,103 15,315 15,335 14,573 14,540 14,043 13,888' Share of Private Sector in Employment 68.2 70.7 72.3 72.2 73.2 Unemployment, Registered (end of period, %) 13.2 10.3 10.4 13.1 15.1 17.4 18.1 Labor Productivity in the Business Sector (year-on-year, % change) 6 1 4.0 9.2 6.4 3.9 of which though changes in Employment (year-on-year, % change)3 -1.5 -1.5 4.0 1.8 2 7 Puiblic Finances General Government Revenues (% of GDP) of which 43.0 42.3 41.1 41 3 39.7 40.4 39.9 Tax Revenues including Social Secunty (% of GDP) 36 1 35.3 34.6 33.8 33.1 32.3 Central Government Revenues (% of GDP) 24.7 24.0 22.9 20.5 19.8 19 5 19 3 as percentage of planned 98.3 102.1 98.1 97.4 96.3 87.2 General Govemment Expenditures (% of GDP) 46.1 45.2 43.6 44.5 42.8 45.7 46.6 Central Government Expenditures (% of GDP) 28 1 26 6 25.2 22.5 22.1 24.0 24.6 as percentage of planned 98.7 98 2 97.4 97.4 96 6 93.2 General Govemment Deficit (% of GDP) -3.1 -2.9 -2.5 -3.2 -3 1 -5.3 -6.7 General Govemment Primary Deficit (% of GDP) 0.6 0 6 0.7 -0. 1 -0.4 -2.3 -3 0 General Govemment Financing Requirements4 (% of GDP) -3.1 -2 9 -2 5 -3.2 -3.2 -5.6 -7.1 Central Govemment Deficit (as % of GDP) -3.3 -2.6 -2.4 -2.0 -2.3 -4.5 -5.3 Total Public Debt (% of GDP) 47.9 46.9 42.9 45.7 42.3 43 2 49.8 Public Sector Debt (excl. risk weighted guarantees) (% of GDP) 47.9 46.9 42.9 44.4 40.9 41.9 48 2 State Treasury Debt (% of GDP) 47.9 46.9 42.9 43.0 39.0 39.3 44.8 Guarantees counted as part of Public Debt (% of GDP) 0.0 0.0 0.0 1.3 1.4 1.3 1.6 Total Outstanding Guarantees (% of GDP) 5.1 4.5 3.6 3.2 2.9 4.1 3.8 Prices, Wages, and Interest Rates Inflation CPI (end of period, year-on-year, % change) 18.5 13.2 8.6 9.8 8.5 3.6 0.8 Inflation PPI (end of period, year-on-year, % change) 11.2 11.5 4.8 8.1 5.6 -0.4 2.2 Real Wage Increase (period average, year-on-year, % change) 5.9 3.3 4.7 1.0 2.5 2.4 Gross nominal monthly wage (USS period average) 324.2 324.8 352.8 427.8 435.7 499.6 522.9 NBP Refinancing rate (end of period, %) 26.0 28.0 21.0 21.5 24.0 16.5 9.75 Real 3 months WIBOR (period average, %) I 5 9.0 9.5 7A4 8.6 10.6 6.1 Lending rate (penod average, %) 26 1 25.0 24.5 17.0 20 0 18.4 12.2 Real Effective Exchange Rate' (end of penod, % change) 6.1 -0.4 4.5 -1.0 13.0 11.1 -9.5 Nominal Exchange Rate (PLN/USS, end of period) 2 88 3.52 3.50 4.15 4.14 3 99 3.84 Nominal Exchange Rate (PLN/Euro, end of penod) 3 60 3.87 4.09 4.17 3.85 3.52 4.02 External Developments Exports of Goods & Services Growth (constant prices) 12.0 12.2 14.3 -2 6 23.2 9.3 4 0 Import of Goods & Services Growth (constant pnces) 28.0 21.4 18.5 1 0 15.6 -1.5 2 0 Trade Balance (% of GDP) -8.8 -11.5 -11.9 -11.9 -11.0 -8.0 -8.3 Current Account Balance (% of GDP) -1.0 -3.0 -4 4 -7.5 -6.3 -4.1 -3.6 FDI (inflow, % of GDP) 1.9 2.1 3.2 4.2 5 3 4.0 2 7 Reserves as months of imports of goods 5.9 6.1 7.2 7.1 6.7 6.3 6.8 Extemal Debt (% of GDP) 33.0 34.5 37.3 42. 2 44.1 40.2 40.6 il World Bank Staff estimates, annual estimates or latest observation- 2/ Based on Labor Force Data: 2002 figue as of end of 3d quarter. 3/B ased on OECD calculations (See OECD 2002). an increase indicates a reduction in employment; 4/ Includes borrowing requircments for compensation payments to pensioners due to inflationary erosion of pensions in the early 1990s 5/ INS-IMF ReeR, increase indicates appreciation, Sources. GUS, NBP, OECD, IMF and Bank Staff estimates 3 Table 1.2: Econmomic lindicators in Selected Counmtries, 1995-2OO2 GDP per Poverty Head capita (ppp count index (< based) GDP Growth $4.30/day) Unemplo ment (LFS definition) 2000 1996-2000 2001 2002' 1997/98199 1996 2000 2001 Poland $ 9,000 5.1 1.0 1.3 18.4 13.0 16.1 18.4 Czech Republic $ 13,780 1.3 3.3 2.7 0.8 8.7 8.8 8.0 Hungary $ 11,860 4.0 3.8 3.5 15.4 7.0 6.4 5.7 Slovak Republic $ 11,040 3.8 3.3 4.0 8.6 16.2 18.6 19.4 Slovenia $ 17,310 4.3 3.0 2.5 0.7 7 6 7.0 5.7 Estonia $ 9,340 4 9 5.0 5.3 19.3 12.3 13.8 12.4 Latvia $ 7,090 4.7 7.7 5.5 34.8 14.5 14.2 13.1 Lithuania $ 7,150 3.3 5.9 5.0 22.5 14.1 15 6 16.5 Public Expenditures General Government Deficit (% CPI Index CPI Inflation (period average, % (% of GDP) of GDP) (1995 =100) change) 2000 1996-2000 2001 2002' 2000 2000 2001 2002 Poland 42.8 -3.0 -5.3 -6.6 182.0 10.1 5 5 3.4 Czech Republic 44.3 -2.5 -5.3 -9.1 138.6 3.9 4.7 3.0 Hungary 46.2 -2.7 -3.3 -9.4 201.8 9.8 9.2 5.4 Slovak Republic 43.1 -3.4 -3.1 -7.4 148.4 12.0 7.3 4.2 Slovenia 44.2 -0.9 -1.6 -2.9 148.5 8.9 8.4 6.5 Estonia 38.1 -1.1 0.4 1.5 159.1 4 0 5.8 3.6 Latvia 38.8 -1.2 -2.1 -1.5 140.2 2.6 2.5 2.0 Lithuania 32.9 -4.7 -1.9 -1.5 145.2 1.0 1.3 1.3 Credit to Foreign Debt Current Account Balance (% private sector Nominal Interest rate (Money (% of GDP) of GDP) I% of GDP) Market rate 2001 1996-2000 2001 2002' 2001 1995 2001 2002' Poland 39.4 -4.4 -4 1 -3.6 25.3 25.8 16.2 7.7 Czech Republic 38.5 -4 4 -4.6 -4.6 42.2 10.9 4.7 2.9 Hungary 65.1 -3.9 -2.1 -2.9 33.5 28.0 9.8 9 7 Slovak Republic 55.5 -5.5 -8.6 -8.6 26.2 9.8 7.8 8.3 Slovenia 36.1 -1.3 -0 4 -0.3 40.0 12.2 6.9 5.3 Estonia 11.8 -7.6 -6.1 -10.0 30.1 4.9 4.9 5.0 Latvia 38.3 -6.5 -10.1 -8.0 23.2 22.4 5.2 4.0 Lithuania 43.9 -9.8 -4.8 -6.2 11.7 26.7 3.4 3.5 I/AlI figures for 2002 are World Bank staff estimates Sources: GUS, Word Development Indicator (WDI) Data base, IFS and World Bank Staff estimates 1.6 Macroeconnonmc Performnnance. The start of Poland's transition in 1990 was marked by exceptionally difficult macroeconomic conditions, which included high inflation, a large legacy of external debt, and a high black market foreign exchange premium. Saddled with a large part of the enterprise sector that was considered "value subtracting," Polish policymakers took huge rnsks by making the zloty convertible, fixing the exchange rate and lowering import barriers. As a consequence, Poland was virtually unique among the large front-running European transition countries in having an unbroken growth record after the initial output collapse (see Table 1.1). The main factors behind this performance were a macroeconomic environment that was conducive to growth and which allowed a gradual decline in inflation, as well as a combination of hard budget constraints for enterprises, a competitive real exchange rate, and a post-privatization governance structure that allowed business, in particular small and medium size enterprises, to flourish. 1.7 Compared to economic developments in other EU accession countries (see Table 1.2), Poland stood out as a star performer during most of the last decade. This performance was largely explained by the bold reform policies that Poland embarked upon at the beginning of the transition process, and the ability of its private sector to recognize the extraordinary opportunities created by those policy actions. 1.8 Poland's successes during the early years of transition were however aided by relatively easy access to social safety net programs for redundant workers. Indeed, the rationalization of the overly 4 generous social assistance network of the communist era was not tackled with the same vigor as the market-oriented reforms. This shortfall in the early reform program is a key factor behind Poland's current dilemma of large (structural) deficits and the relatively large size of its public sector. It has also contributed to the crowding out of public investment and therefore has limited Poland's long-term growth potential. 1.9 The macroeconomic environment deteriorated progressively at the end of the last decade. Following the Russian crisis of 1998, the loss of export markets in the East- amounting to around 3 percentage points of GDP- triggered a new round of enterprise restructuring to curtail falling profitability. This time, the resulting improvements in productivity were brought about in large part by reducing employment. This has led, together with increased numbers of newcomers to the labor market due to the baby boom of the early 1980s, to significant increases in unemployment. As of December 2002, over 3.1 million people were unemployed or 18.1 percent. Figure 1.1: Fiscal and Monetary Developments Real Effective Exchange Rate 1.0- Structural Deficit (0Aof GDP) (1996M1=100) 140.0- -5.0 90.0 1996 1997 1998 1999 2000 2001 CDD(D 0 0 10StructuraliDefkit *Cyciical Deficit oHeadIine deficit |- -4- 'z 0j 0 -.g -3 i i NjEg E Real 3 Months Wibor Monetary Condition Index for 14.0 2.5 Polanda 12.0 2.0 10.0 l 1 5 -Ti Easlng 1 0.0 -4 0- ~ ~ ~ ~ ~ ~ ~ ~ 0 6.0 ~~~~~~~~~~~~~~~0.0 45.0--. 2.0 1.199 7 . .. . .. ,0 ,..,,,.,.,,,,in.,,,,,.-2.0 -2.0 -2 5 -- CDCD CDCD D CDCD (DO 00000 CD( coDCDCDCD(D CDOCDOCDO -D -D -D (D *D CD CD CD 0s 0s M 0 0 0D co tO to co o CD O O O C o 0)0) -4-4 - (DCD (DO 0 -~~~~~-0)N)N)4 -4 0C 00CD CO CDCO O0 (3 Stutua De ict n Oyfta De 'Ic Fladin de ict 9 F. E m m T.< Kj _ mj_S _s_ --4-.-4~~~~~~~~1 4 4- 4-4 4 - a. The Monetary Condition Index is calculated as a weighted average of the change in the real exchange rate and the real 3 months WIIBOR: MCI(t) = a REER(t) + (1-a) Real WIBOR(t), with a derived from the equation: a std(REER) (1- a) std(Real WIBOR), where std( stands for standard deviation. Sources: OECD (structural deficit), NBP (WIBOR), GUS (inflation), and IMF (REER). 5 IBox 1.1: Causes of Fiscal Deterioration ilm 2001 The deterioration in the fiscal situation in 2001-from a Table 1: Composition of General Govommont Doficit 2000 2001 2001 2001 deficit of 2 8 percent of GDP in 2000 to 5.3 percent of GDP in in Billion PLN Actual Bud2ot Rev0sod Actual 2001 (against a planned 2.9 percent of GDP}-is wholly CGRevenues 1357 1611 1525 1405 CG Expendlitures 151 1 181 6 185 5 172 9 attributable to the growth in expenditures (see Table 1). In ow Transfers to OFE 76 144 91 8726 particular, this is completely attributable to the increases in the Deficit of CG -154 -20.5 -33.0 -32.4 Deflict of LG -3 1 -3 1 -4 8 -3 1 deficits of the Central Govemment and its extra budgetary Health Funds 07 0-0 0-0 0-5 funds, which increased by 2.3 percent of GDP and 0.5 percent OtherEFs -06 7 0 7 '33 2 3 6 of GDP respectively. Local government budget deficits Gonoral Govt Deflcit -17 7 .23.0 -40 9 -381 remaed largely unchanged. CG Expenditures 22 1% 22 9% 25 1% 24 0% ow Transfers to OFE 11% 18% 12% 12% The growth in deficits was largely driven by growth in pre- 1Defcitof CG -22% -2.0% .4.5% -4.5% Deficit of LG-0 5% -0 4% -0 6% -O 4% determined expenditures which accounted for 93 percent of Health Funds 0 1% 00% 00% 0 1% the expenditure growth (see Table 2). The large proportion of OtherEoBFs -01% 00% .04% -05% these predetermined expenditures-65 percent of central Genoral Gov't DeficIt -20% *2 9% *5 5% -5 3% government expenditures in 2001-made it difficult to cut memo 6850 7937 739 728 expenditures when, during the course of the year, it became Source MoF. IMF and WorldBank staff estimates clear that the ambitious revenue targets were unlikely to be met. Most of these expenditures are embedded into sectoral laws. Moreover, some expenditure categories-e.g. pensions, education transfers to Local Government, and expenditures on roads-are linked to expected revenues or expected increases in macroeconomic indicators as reflected in the original budget law. Therefore, if revenues and the macroeconomic indicators are significantly over estimated, as turned out to be the case in 2001, Table 2. Centrai Governmuent Egxpeaditre: the budget deficit would increase correspondingly. [This points to Control Govommont 19D9 1 2000 1 2001 1 2001 the need to reevaluate the way these expenditure categories are nominal Actual I Actual I BudAosL Actual determined (see chapter I and 2 for recommendatons).] With Expondltumsa (PLN bin) 130 4 151.1 181. ''172 fr(e eomedtos. PredetemIned 805 923 1155 1127 2001 being an election year, political factors also likely affected Regular 57 9 58 8 66 1 602 NomInal growth 5 .2% 20.2% 5a160 budget decisions, including optimistic economic forecasting. Predetemined 14 6% 25 1% 22 1% Regular 1 6% 12 5% 2 4% Source MoF and World Bank staff estmates The planned growth m expenditures would still have been affordable if growth and revenue estimates for 2001 had been realized. As it turned out, the 2001 budget was based upon optimistic macroeconomic assumptions (see Table 3). Nominal GDP was projected to grow by 12.3 percent-in line with market expectations at that time-but the actual nominal increase was only 5.2 percent. This contributed significantly to the PLN20.6 revenue shortfall (relative to budget estimates) in the Central Government budget. The collapse of domestic demand meant that import-related revenues, as measured by custom duties and VAT from imports, declined by PLN6.3 billion compared to their initial estimate. The drop in excise taxes was a combination of a much lower oil price than projected and the economic slowdown which caused a drop in demand for transport and gasoline consumption. This Tcble3: CentralGovernmett:revenneprojection, octnai, and ahertfa[Li caused a loss in revenues of PLN4.3 billion. Actual CIT and =Geoic.t 19ralo*00 1 2000 1 200 t revenues from profits also short, relative to target, by nm in Actual 25.0 Bu3t57 Aict40o5 2Shorftalm PLN4.3 billion. This was largely due to lower growth VAT domtelcgooad. 163 139 j8a1 163 4: _ outcome. Better macroeconomic forecasting and a custsm importVAT 38 0 42 9 47 0 40 ° °3 (21 CIT 15 19 7 12 43 14) considered assessment of market risks to the forecast could P3T 2 1 23 2 34 22 III have obviated some ofthe fiscal pressures that subsequently Othren 82 118 187 181 l1 developed (see chapter 2 for recommendations in this area). :eRouleMOFan~dWertaBank staff ess,nates 5 0 0 1.10 The creation of an independent Monetary Policy Council (WPC) in 1999 led to a stronger focus on inflation control. When inflation rebounded during 1999 and 2000 into double digits, the MPC progressively tightened monetary policy by raising its refinancing rate to a peak of 24.0 percent in August 2000. Real lending interest rates increased to over 13 percent during 2001, up from around 10 percent during 1999-2000. As a consequence, and in combination with possible over-investment during the high growth years of 1996-99, domestic demand (in particular investment) declined significantly starting in the second half of 2000. While inflation had indeed declined impressively to 0.9 percent (year-on-year) as of end-November 2002, so had GDP growth. 1.11 While monetary policy tightened during the second half of 2000, fiscal policy eased considerably during 2001. Indeed, the budgetary consequences of the unfavorable economic dynamics that emerged at 6 the end of 2000 were not adequately recognized (see Box 1.1: Causes of Fiscal Deterioration in 2001). The Central Government budget for 2001 was based on optimistic revenue projections as well as on one- offs such as an increase in income from the Natlonal Bank of Poland and the sale of UMTS licenses. These temporary increases in revenue were, however, used to finance permanent expenditures, and therefore further complicated the 2002 budget situation. As a consequence, and even though amendments to curb expenditures were introduced, the Central Government's deficit increased significantly from a planned 2.6 percent to 4.5 percent of GDP in 2001. 1.12 These fiscal developments led to a significant deterioration in the government's non-interest deficit and its savings-investment balance despite continuation of the long-term trend of inadequate levels of public investment. Before 2001, current revenues and recurrent expenditures were roughly in balance, (i.e. net government borrowing covered investment outlays). By 2001, however, a substantial share of net govemment borrowing was financing government recurrent expenditures; the erosion was caused completely by the deterioration of the Central Government's financial situation. This has continued m 2002 and the proposed budget for 2003 shows little sign of improvement (see Table 1.3), indicating difficulties with tightening fiscal policy and adjusting its composition. 1.13 Headline general government deficit widened from 2.8 percent in 2000 to 5.3 percent in 2001, while the structural deficit (general government deficit corrected for business cycle effects) worsened from 2.7 percent of GDP in 2000 to 4.0 percent of GDP in 2001 (see Figure 1.1). The proposed budget for 2003 foresees a small reduction in the overall general government financing requirement to 6.6 percent of GDP from an estimated 7.1 percent for 2002 (see Table 1.3). Table 1.3: Savings Investment Balances (1999-2002) and Deficit Trends (1999-2003) as percentage of GDP 1999 2000 2001 2002 _ in billions PLN 1999 2000 2001 2002' 20032 Foreign Savings 7 5 6 3 4.1 3.6 Non-interest Deficit 1.0 -0.2 16.3 21.9 19.3 Interest Payments 19.0 18.5 21.7 27.1 29 0 Government Balance -3.4 -3 1 -5.3 -6.6 General Government Deficit 20.0 18.3 38.0 49.0 48.3 Government Savings -0 2 0 1 -2.3 -3.6 Compensation for o w Central Government 1 2 -I 2 -3.6 -4.1 Non-increasing of Pensions 0 0 3.4 2.5 3 5 3.3 Government Investment 3 2 3.2 3.1 3.0 Net Financing Requirements 20.0 21.7 40.5 52.5 51.6 % ofGDP 3.3 32 5 6 7 1 6.6 Rest of the Economy -4.1 -3.2 1.3 3.0 Pnvatization Receipts 13.3 26 5 6 5 3.6 7 4 Savings 19.1 20.1 21 5 22 3 Net Public Sector Investment 23.2 23 3 20 2 19.2 Borrowing Requirements 6.7 -4.8 34.0 48.9 44.2 Savings (excl. changes in stock) 18.2 18 5 19 8 21.8 % of GDP 1.1 -0 7 4.7 6 6 5 6 1 / MoF and World Bank staff estimates. 2/ Based on draft 2003 budget and World Bank staff estimates. Sources GUS, IMF, and Bank Staff estimates. 1.14 This "tight monetary and loose fiscal" policy mix crowded out investment and moderated the potentially expansionary effect of fiscal policy. Recent monetary developments in 2002 point toward an easing of monetary conditions with the MPC lowering its interest rates by cumulative 1,400 basis points; at the same time, the appreciation of the euro has stabilized the appreciating zloty. Nonetheless, real interest rates remain hlgh at around 6 percent compared to 3 percent in the euro area. The monetary easing is likely to help growth prospects. While the balance of risks is against the re-emergence of mflationary pressures, this needs to be watched carefully. 1.15 A persistence of tight monetary and expansionary fiscal policies can, over time, cause chronic macroeconomic imbalances and adversely affect public debt dynamics. The experiences of Russia (1998) and Turkey (2001) illustrate that the key requisite for a desirable rebalancing of macroeconomic policy is to tighten fiscal policy so as to facilitate the reduction of real interest rates and to maintain confidence in the government, and to do this m the context of strengthened, pragmatic, and transparent policy coordination. Given Poland's relatively large size of government, much of the adjustment will need to 7 fall on public expenditure. A progressive reduction in the deficit should make further interest rate cuts possible, and ease external pressures. 1.16 To begin tackling the widening fiscal imbalances, the Government announced a fiscal rule that would limit central govemment expenditure growth to "CPI+1%" in 2001. It is apparent that an expenditure rule for the whole of Government would have been a more appropriate approach to fiscal consolidation. The introduction of a fiscal rule has the clear advantage of signaling to investors and the MPC, the Government's intention with regard to fiscal policy. The "CPI+1%" rule was never expanded to the whole of the Government and was abandoned during the 2003 budget preparation for a deficit targeting mechanism, which is to bnng the General Government deficit within Maastricht criteria in 2005 (i.e., below 3 percent of GDP). KEY JISSUES EN IPUBL1C IFNANCE 1.17 There are several key issues in public finance, which are discussed below. 1.18 IFiscaR Susitainabity. The consequence of the favorable macroeconomic conditions during the early years of transition and of debt work-outs with various debtors in particular the Paris and London Clubs, resulted in a State Treasury debt to GDP ratio that declined to less than 39 percent of GDP by 2000. Poland's Constitution caps public debt-to-GDP ratio at 60 percent. The Act on Public Finance defines additional rules to preclude this from happening by triggering adjustment mechanisms to be implemented by different levels of govemment when public debt levels reach 50 and 55 percent of GDP (see Box 1.2: Public Debt Limits). The current economic slowdown and the inability of the Government to tighten fiscal policy have led to rapid increases in State Treasury and public indebtedness and public debt is estimated by the authorities to amount to 49.8 percent by the end of 2002. To stabilize Poland's public debt at a level below 50 percent net public sector borrowing requirements will need to be reduced by 3.5 percent of GDP in 2003. 1.19 To accomplish this, while taking into account the already high levels of taxation and the relatively TalbRe 1.4: Rleqinkred Pirimary Suirpluses to large size of Govemment, the Government has in the Statbilze PubiDc ID)ebt to GDP Iatiio unGCdelr short run basically three instruments at its disposal: (i) Aftermative GD]P Girowtli an]d IReal expenditure retrenchment; (ii) EU transfers; and (iii) limterest Rate Scenarios privatization revenues. Reducing poorly targeted 2002 social expenditures alone could potentially save the Ratio of public debt to GDP 49.8 budget 3.4 percent of GDP (see Chapter 3 for details). Long-term real output growth 4.0 Another option is to use increased EU funding (see Primary balance to GDP -3.0 Table 1.7) to replace domestic funding for expenditure Primary balances to GDP necessary programs. For example, domestic funding of KRUS to stabilize the public debt ratio for a benefits could be replaced by direct payments from the real interest rate that exceeds the real EU's CAP. Another option is use EU funding for growth rate by: +0.5 percent 0.25 infrastructural investments that are currently funded g +.Spercent 0.5 by other public resources. Domestic funding +1.0 percent 0.50 requirements could, henceforth, be reduced by another +3.0 percen 1.50 0.2 percent of GDP in 2003, and once the country is a Source: World Bank Staff estimates. full member of the EU in 2004, this reduction could increase progressively to over 2 percent of GDP (see also Chapter 3 for details). In addition, privatization revenues have been far below potential and planned amounts in 2002. An increase by 0.5 percent of GDP should be within the possibilities of the Government, given the large number of companies still in state hands and the state's holdings in partly divested companies. Hence, a reduction of net borrowing 8 requirements by 3.5 percent in 2003 through a combination of measures identified above should be feasible Box 1.2: Public Debt Limits Poland's constitution does not allow the Public Debt to GDP ratio to exceed 60 percent, i.e., the Constitution forbids taking any obligations after which Public Debt to GDP ratio exceeds 60 percent. The act on Public Finance gives not only the definition of Public Debt,' but also the rules which are to ensure that thls constitutional limnit will not be breached. For that purpose, it specifies these thresholds at which specific actions have to be taken: * Public Debt to GDP greater than 50 percent, but not higher than 55 percent of GDP. In tis case: i. The Council of Ministers has to prepare a State Budget for the following year in which the budget deficit of the State as a ratio to its revenues cannot exceed the budget deficit as a ratio to its revenues of the current year; il. The same rule applies to Local Governments. * Public Debt to GDP greater than 55 percent, but less than 60 percent of GDP. In thus case, the Government is expected to undertake several actions: i. The Council of Ministers has to prepare a State Budget for the following year in which the deficit of the State will be consistent with a falling State Treasury Debt to GDP ratio; ii. Local Governments will have to reduce their deficit limit as calculated under the previous rule by multiplying this limut by the coefficient R. R is equal to (0.6-Public Debt to GDP)/0.05; iii. The Council of Ministers is to prepare and present to the Sejm a fiscal consolidation plan, which will lower the Public Debt to GDP ratio. * Public Debt to GDP reaches 60 percent of GDP. In this case, the Government is forced to further restrain fiscal policy by: i. Placing a complete ban on issumg new Government guarantees during the current as well as in the subsequent fiscal year; ii. The Council of Ministers is to prepare and present to the Sejm a fiscal consolidation plan, which will lower the Public Debt to GDP ratio below the 60 percent limit; iii. The Council of Ministers has to prepare a balanced State Budget for the subsequent fiscal year; iv. Local Governments as well have to prepare balanced budgets. See Box 1.3: Definitions of Public Sector and Public Debt. 1.20 To address whether Poland's current policies are sustainable in the longer term, it is relevant to investigate the required primary surpluses the Government will have to generate to stabilize its public debt-to-GDP ratio under different growth targets and real interest rate trajectories and to compare them with their current levels. To be able to keep public indebtedness just below 50 percent of GDP, Poland will have to generate a primary balance surplus of between 0.25 to 1.5 percent of GDP, depending on the difference between Poland's long-term growth potential and the expected long-term real interest rate. Given that the primary balance stood at a negative 3.0 percent in 2002, these calculated targets would indicate a need to reduce the primary deficit between 3.25 percent and 4.5 percent of GDP to accomplish a long-term sustainable fiscal situation (see Box 1.3: Definitions of Public Sector and Public Debt).2 The sustainability exercise points out clearly the macroeconomic dilemma that the current macreconomic policy entails: higher (equilibrium) real interest rates, given a country's growth potential, require larger primary surpluses and henceforth larger expenditure reductions. 2 It is important to note that these simulations assume that in the long run Poland's economy is fully aligned with the economy of its foreign creditors as measured by a constant real exchange rate and no remaimng differential between domestic and foreign interest rates and that the gap between the real interest rate, and the real growth rate remams constant as well. 9 3ox 1.3: Deflnidoios of Pubic Sector and ?ubec DeCbt This box explains the definition of the Public Sector or General Government and Public Debt as stated in the Act of 26 November 1998 on Pubhc Finances (AoPF) and the difference between these definitions as stated in ESA95. The definition of Public Sector includes extrabudgetary funds and agencies, but excludes state owned enterprises, state banks, and commnercial-law comnpanies/agencies. As such, it includes 16 voivodships, 315 Powiats, and 2,489 gminas. On the central or state level, there are 3 social security funds, 11 other (EBFs), 15 state agencies, and one sectoral health fund. On the regional level, there are 16 sickness funds and over 3,000 extrabudgetary funds and agencies mostly operational in agricultural and environmental protection. The AoPF presents in Article 9 and 10 the two definitions of public indebtedness: one related to debt of the State Treasury (Ministry of Finance) and one related to the Public Sector as defined in the Act. The definition of Public Debt includes: 1. issued securities for cash liabilities, 2. drawn credits and loans, 3. accepted deposits, 4. payable commitments: a) of budgetary units, b) resulting from laws and court decisions, extended guarantees, and other. The definition of debt of the State Treasury used as an input in the determination of public debt includes 1) liabilities that have arisen from fimancing State budget deficits 2) the sum of risk adjusted guarantees issued by the State Treasury. The latter definition excludes liabilities of lower levels of governments as well as extrabudgetary funds. The risk of guarantees issued by the State Treasury is assessed using a "point scoring systemn", which has been developed by the MoF itself and which resembles similar systems of commercial banks as well as standardized procedures and rules of risk assessment. The ESA95 manual on Government Deficit and debt definition of the Public Sector or General Government includes all institutional units of the central state and local government, and social security funds, which are other non-market producers whose output is intended for individual and collective consumption, and mainly financed by compulsory payments made by units belonging to other sectors, and/or all institutional units principally engaged in the redistribution of national income and wealth. The definition of public sector debt or general government debt includes: 1) currency and deposits, 2) securities other than shares, including financial derivates, 3) loans, 4) shares and other equity (if any), 5) insurance technical reserves (if any). The main difference between the two definitions is the treatment of guarantees and of the ESA95 inclusion in the General Government sector of open pension funds (OFE). This reduces the public debt amounts as calculated under the ESA95 definition as the sum of risk adjusted guarantees issued by the public sector are not included and the debt to the OFEs of the Polish Government are netted out. Note that EUROSTAT still has to agree to these proposed adjustments, in particular the latter. See Table 1 for quantification. Table 1. Public Debt (1999-2001) Public Debt definition 1999 2000 2001 Total Public Debt (A oPF) 45.7 42.3 43.2 Public Debt (AoPF excluding rish weighted 44.4 40.9 41.9 guarantees) General Government Debt (ESA95) 42.6 38.9 38.7 10 1.21 Alternative Fiscal Scenarios. Evaluating different short-term fiscal scenarios can provide an understanding of the need and magnitude of the aggregate fiscal adjustment of the primary balance and the consequences of each scenario for public debt dynamics. For this purpose, two scenarios are simulated for the 2003-06 period: (i) a "deficit target" scenario; this scenario is to bring the General Govemment deficit below 3 percent of GDP by 2005 through expenditure cuts (i.e., within Maastrncht critena) facilitating EMU entry; and-(ii) a scenario with constant ratios of non-interest expenditures and revenues to GDP for the 2003-06 period (i.e., without significant fiscal consolidation). Table 1.5: Different Fiscal Scenarios and their Impact on Public Debt Dynamics, (2003-6) Primary Surplus 1 2003 2004 2005 2006 Debt to GDP ratios 1 2003 2004 2005 2006 Scenano (i) -2.6% -1.1% 0.2% 0.3% Scenario (i) 1 53.5% 54.2% 53.1% 52.2% Scenario (ii) 1-2.6% -2.6% -2.6% -2.6% Scenaro (ii) ' 53.5% 559% 57.6% 59.2% Deficit reduction scenario (i) Underiving main macr-economic assumptions General Govemment Deficit 6.1% 4.5% 3.4% 3.5% GDP growth 3.5% 4.9% 5.2% 5.2% Revenues 40.7% 40.7% 40.9% 41.3% Real effective interest rate 3.5% 3.0% 2.8% 2.7% Expenditures 468% 45.2% 43.9% 44.2% Exchange rate deprecation 1.0% 1.0% 1.0% 1.0% Source: World Bank Staff 1.22 The results of the simulations are shown in Table 1.5, together with the main underlying macroeconomic assumptions for the period 2003-06. The deficit target scenario will require the government to reduce the primary deficit by 3 percent of GDP between 2003 and 2005. Although this reduction will generate primary surpluses by 2005, it will not keep the public debt ratio from breaching the first debt limit threshold of 50 percent in 2003 nor will it facilitate a return of the public debt ratio to below this first threshold. To keep the debt from rising above the 50 percent limit, an up-front reduction in the primary deficit of 3.5 percent is necessary. However, this would allow higher expenditure growth in the years thereafter and therefore could allow much needed increases in investment expenditures from 2004 onwards, given, of course, that the cuts have been made primarily in current expenditure programs. Postponing the return to a debt-to-GDP ratio of below 50 percent of GDP to 2004 would entail an additional 1.5 percent of GDP expenditure adjustment. 1.23 Scenario (ii) puts the path of public debt on a Table 1.6: Sensitivity Anal s collision course with the constitutional limit of 60 se,ana is 12003 2004 2005 2006 percent shortly after 2006, which will then require Growth 25% 30% 30% 30% percent , ~~~~~~~~~~~~~~rnwySupn-- -scenarlo .2 6% .1 0% 0 4% 04% even larger expenditure adjustments, inflicting much DebttoGDP rab Scenano 0) 540% 555 U3% U51% X . ~~~~~~~~~~~~~~Scenario (6) 54 0% 57 3X N.0% OM>% harm to the Government's programs and its Real Effect" lntoreS rat 40% 38% 38% 37% well its own ~ ~ ~ ~ ~ Pmy upt5 Semrf = 3 0 %07% 08% beneficiaries as well as its own credibility. Scnnaru () 535% 5422% 531% 521% Exchn laleBnl Scannarioo(I) 53 5% 560% 5%60. 1% rate ~gee05.n"jt!5o 50% 350%_ 50% 50% 1.24 Undoubtedly, much of the results of each of isceraNo (i) .2 5% -10% 03% 04% the simulated scenarios depends on the projected ° lSceario(i) 541% 571% 594% 61.8% macroeconomic framework, which in itself depends Source: World Bank staff estimates on many economic events that are uncertain. It is therefore useful for illustrative purposes to simulate how sensitive the results as presented in Table 1.5 are with respect to less favorable economic developments. This is to make it possible to analyze the downside risks of a less favorable macroeconomic environment and to estimate the impact on the needed fiscal adjustment. Table 1.6 shows the results for primary surpluses in the case of scenario (i) and for public debt to GDP ratios for both scenarios, with respect to lower GDP growth, higher domestic interest rates, and lager nominal depreciation of the zloty.3 3 In each illustrative case the deficit for 2003 is lirnited to the nominal PLN amount as presented in the draft budget for 2003 (i.e., PLN48.3 billion). Scenario (ii) keeps the levels of non-interest expenditures as a ratio to GDP the same as in the scenarios presented in Table 1.5 except for the adjustment needed to keep the 2003 deficit limited to PLN48.3 billion. This means that actual expenditures are increased by the additional costs generated by higher debt 11 1.25 It is immediately clear that the results of the simulations presented in Table 1.6 are particularly sensitive to GDP growth. A GDP growth of 2.5 percent for 2003 and 3 percent thereafter, will cause the second debt limit of 55 percent to be breached in both scenarios and will put scenario (ii) on a path of reaching the constitutional limit in 2005. Higher nominal interest rates and a slightly higher depreciation of the zloty also put additional pressure on the public debt-to-GDP ratios. The constitutional limit will be reached in scenario (ii) in 2006 if no corrective measures are taken. 1.26 A macroeconomic scenario of lower growth, higher interest rates, and a more sharply depreciating currency could materialize if indeed much needed expenditure rationalization would not be undertaken as part of the 2004 budget preparations. This would signal a continuation of an expansionary fiscal policy and an inability to reform public finance. If it would also jeopardize further monetary easing, then a weaker economy with higher interest rates and less foreign capital inflows is a likely outcome. In such a scenario, it is a realistic possibility that the constitutional limit will be breached no later than 2005. Hence, rebalancing macroeconomic policy, by progressively reducing the fiscal deficit and therefore facilitating further reductions in real interest rates should be given a high priority. 1.27 Opportunities and Chalenges of EU-Accession. 'The forthcoming accession to the EU and subsequently the implementation of the Acquis Communautaire over the coming years will require additional expenditures and investrnents in several sectors of the economy (e.g., environment, agriculture and infrastructure) and will also limit subsidies to other sectors such as coal and steel. Before accession, Poland has received support through the so-called Pre-Accession funds: PHARE, SAPARD, and ISPA.4 Although conmmitments from these funds will cease at the point of accession, disbursements are expected to continue until at least 2006 (see Table 1.7). Table 1.7: Estimated Net Contributions to Poland by EU % of GDP~ 2002 200 2004 2000 2000 1.28 The funds available on accession -- 0Pr22 20 20 00 Structural Fund, Cohesion Fund, and funds SPAARD 01 0 1 01 01 01 coming from the Common Agriculture Policy 4IARE o 0.2 03 02 02 02 (CAP) will require co-financing in larger A M'kfts 01 02 02 amounts than the Pre-Accession funds and will fm RI Dev 003 04 0 4 . Sbual F 0 S 10 1 l require prepayment in the case of direct IMM 01 02 0 3 payments under the CAP. In addition, Poland 'In'sM T0t 01 21 24 will have to pay its contribution to the EU budget PoNa 03 0.5 15. 2.5 26 from the moment of accession, which will M "SduI dfn*2IW3IA2W 03 05 07 2 13 amount to about 1.25 percent of GDP annually. Source: EU. UKIE. World Bank Staff estirnates One of the main challenges that previous accession countries have faced was to be able to generate enough projects eligible for EU financing in the early years of membership. This has often led to a situation in which new member states were net contributors to the EU budget even though they were granted reduced contribution rates to the EU budget. The current candidate countries have been assured by the EU Commission that each new member state during its first year(s) of membership would receive on a net basis no less than the amount it received the year before membership. 1.29 Nevertheless, Poland might be confronted with transitional financial difficulties that may result in an increase in indebtedness. This could be caused through a combination of factors. First, the planned EU contributions to Poland are defined as budgetary commitments for payments and are based on service payments. Scenario (i) simulates in each case the needed primary balance to reach the deficit reduction as shown in table 1.5, (i.e., to reach 4.5 percent in 2004 and 3 percent thereafter). 4 PHARE stands for Pologne et Hongrie: Actions pour la Reconversion Economique; SAPARD stands for Special Action Program for Agriculture and Rural Development; and ISPA stands for Instrument for Structural Policies for Pre-Accession. Each of these programs assists the candidate countries of Central Europe in their preparations for joining the European Union. 12 disbursement profiles that might turn out to be too optimistic for the new member states to realize as they find it difficult not only to prepare enough quality projects but also to mobilize the needed amounts of co- financing. Second, direct aid under the CAP will have to be pre-paid by the Government and will be reimbursed only the next fiscal year. Delayed disbursements and prepayments of direct aid to farmers could result in a cash drain of between 0.5 and 1.0 percent of GDP, leading to an equivalent increase in indebtedness during the initial years of EU membership. In such an event, contingency measures should be prepared to ensure that such a possible delay in the absorption of EU funds would not lead to a permanent increase of government debt. Therefore, the Government should without delay put in place a framework that would assist the involved institutions during the preparation and implementation of EU supported activities as to ensure that Poland can absorb the available funds in a timely manner. 1.30 Privatization Revenues. Evidently, if the Government could generate additional pnvatization revenues, then the public debt situation might be less threatening. In 2002, the Government estimated its holdings in companies to amount to PLN140 billion. Henceforth, there would appear to be significant opportunities to reduce the debt burden by increasing privatization revenues. Privatization revenues are estimated at a mere 0.5 percent of GDP in 2002 and planned at 0.9 percent of GDP in the draft 2003 budget. If the Government would increase privatization revenues to 1.5 percent of GDP annually starting in 2003, debt dynamics would be much more favorable and less adjustment in non-interest expenditures would be necessary in the short run. Notwithstanding this positive impact on Poland's debt stock of increased privatization revenues, long-term debt sustainability would still require the primary surpluses to be generated as presented in Table 1.4. 1.31 The preparation of a balance sheet of the Government's financial liabilities and assets, including tax and social security payment arrears, and of tangible non-financial assets, would assist the Government in thinking more systematically about its own solvency and about the sustainability of the macroeconomic policy program over vanous time horizons. When this information is shared with Parliament, it would also greatly improve the accountability and enhance the transparency of the overall fiscal situation. Such a balance sheet would be an important input in the evaluation of the sustainability of the Government's fiscal policy, as it would be a key component of the Government's medium term and intertemporal budget constraint. It is important to construct such a balance sheet of net financial liabilities and net tangible assets using market values and imputed forward-looking valuations based on realistic assumptions of future cash flows to the budget. Basing the valuation of tangible assets on current reproduction or replacement costs would most likely lead to excessive optimism about the status of public finance, as replacement costs are likely to be significantly m excess of the present discounted value of the future cash flows they can be expected to generate. 1.32 Size of Government. The size of government, as proxied by total public expenditures, is relatively high for Poland in comparison with other countries with similar levels of per capita income (see Figure 1.2). This becomes a concern if one takes into account that public expenditures as a proportion of GDP tend to be higher. in richer countries than in poorer ones.5 Therefore, the Government should make an effort to reduce its size by evaluating the appropriateness, effectiveness, and efficiency of its expenditure programs with the objective of consolidating and decreasing the size of government to be in line with its relative income level. In addition, Poland spends a large component on those sectors that are expected to grow proportionally even more when its income increases, in particular social protection and welfare (see Figure 1.2). Reducing the size of the public sector would also free up much-needed resources for pnvate sector development. 5 This is due to the fact that when countries become more affluent their populations demand a wider range of services, of a higher quality, especially in health care, but also in education, social protection, and welfare. 13 Figure 1.2: Size and Composition of Government Expenditures GDP per capita and Public Bcpenditures ai "Uly and we (% d fDtal Oxpndlbire and net 50 - (2000 data or most recent) Fra Nd l a 45 q*e * Bei __-- _ r 0C oPd 4Dab _- =[- r b eta .2 eBr cLintI A li lL l .Gb 2s- ye ec3 d&; cgS |( 40 Lbni S 2 5 If!k20O 0 10000 20000 30000 40000 GM per capita In ppp terms Source World Development Indicators 2001 and ECSPE Public Expenditure database. 1 33 Economic Classiflcation of Expenditures. Three key findings emerge from Table 1 8). First, relative to its comparator countres, Poland spends too much on current consumption expenditures Transfers to households and nonprofit organization account for almost 20 percent of GDP, which is higher than the 13 percent spent by the other seven EU accession countnes Second, Poland spends too little on public investment. At just above 7 percent of total expenditures, or 3.3 percent of GDP, this is far less than other EU accession countnes' average of 12 5 percent of expenditures or 5 4 percent of GDP. Not surpnsmgly, this has left Poland with one of the least developed road and telecommunications networks (see Chapter 3) in the region, harnpering transportation and the absorption of information Table 1.8: General Government Expenditures by Economic Classification, 1995-2001 General Government 200j1 2a00 tW5e20g 1995-2000 1995-2000 EU Accession.7? EU-15' Share Share Share Share Share Share Share Share Share Share of GDP of Tota I cGDP of Total of GDP of Total of GOP of Total of GDP of Total By Economic Classification M fj) .L M).. J . {M) 1% ) (%) (%) Total Expenditure 45 3100 0 431 100 l 44 0 100 0 43 8 100 0 49 0 100 0 Curnnt Expendltur. 42 0t 92 7 40 0 92 9 40 8 92 7 381 87 5 45 0 91 a Expendltura on Goods & Servlcss 17 5 38 7 16 6 38 8 15 8 36 0 18 38 4 20 3 41 4 Wages Salarles 74 164 72 16Ea 74 168 76 176 107 21 8 Other Purrhases ofGoods S Services 10 1 22 3 9 4 21 _ 84 4 19 2 9 0 20 7 9 6 19 6 lntsremt Payments 3 0 _ 87 2 7 83 3 34 7 8 3 3 7 5 4 7 96i Other Domestic 25 5 6 21 4 8 2 7 61 Abroad 0 5 _ 12 080 15 _ a8 18a Subsidies IL Oth*r Current Transfers 21 4 47 3 20 7 48 0 21 5 48 9 18 1 4161 10 3 3731 Subsldles i 5 3 4 0 9 21 1 a 4 0 3 4 7 9 Transfers to Oth,er Levels of National 00 0 00 0 0 0 0 0 18 41 a To Households 8 Nonprofit Institutions 199{ 43 9 19 7 45 8 19 7 44 8 128 29a 4 Abroad 0 _ 1 _ 01 01 0 2 0 0 01 0 i 1 Capital Exponditue 31 73 3 31 71 3 2 7 3 5 4 125 4 0 82 1t EU Accession-7 includes Czech Republic, Hungary, Slovak Republic, Slovenia, Estonia, Latvia and Llthuania, but excludes Potand 21 EU 15 Includes all cufrent European Union member countIes Sources GUS. GFS. Ministry of Finance and ECSPE Public Exeonditure database technologies. Thlird, Poland spends much less on subsides than the other EU accession countnes-I 5 percent of GDP in 2001 compared with 3 4 percent of GDP for the EU accession countries However, public expenditure data may not reveal the true picture, as Poland has an elaborate system of guarantees 14 and tax expenditures that supplies support mostly to state enterpnses. The Government has also on several occasions pledged holdings of state owned or partly privatized firms as collateral for commercial banks to provide working capital to the steel sector or to re-capitalize state banks. The latter takes place outside of the budget system, m a non-transparent manner, and without appropriate parliamentary oversight. 1.34 Functional Classification of Expenditures. A look at the functional classification of government expenditure provides further insights into the sources of expenditure pressures (see Table 1.9). First, expenditures on social security and welfare consume the largest share of the budget, equivalent to about 20 percent of GDP or 44 percent of expenditures in 2001. This is about 40 percent higher than comparable expenditures for the other EU accession countries (even though total expenditures are only slightly higher). Second, expenditures on human capital investments in health and education are equivalent to about 10.5 percent of GDP or 23 percent of the budget. These are broadly comparable to the EU accession countries, though Poland spends relatively less on health and relatively more on education. Table 1.9: General Government Expenditures by Functional Classification, 1995-2001 General Govemment 22001 2000 1995-1999 1995-2000 1995-2000 Share Sha Sh Share Share Share Share EU Accession-7 _ EU-15 of GOP of Total of GDP of Total of GDP of Total of GDP of Total of GDP of Total By Functional Classification Of G P%) (%) (%) (%) (%) (%) (%) Total Expenditure 45 3 100.0 43.1 100 0 44.0 100.0 43.5 100.0 49 0 100.0 General Public Services 2.5 5 5 2.5 5.8 2 4 5 4 3.1 7.2 Defense 1.3 2 8 1.4 3.2 1.6 3.5 1.4 3.3 2 0 4.1 Public Order & Safety 1.9 4.1 1 9 4.3 1.8 4 1 1 9 4 5 = Education 6 3 13.8 5.9 13.7 5.5 12.7 4.9 11.3 5.3 10.8 Health 4.3 9.5 4 2 9 8 4.6 10 3 5 5 12.6 6 6 13.5 Social Secunlt & Welfare 20 1 44 4 18 7 43 4 20.2 45.6 14 3 32 9 Housing & Community Amenities 2 6 5.7 3 0 6.9 3.7 8 2 2.2 5 1 Recreation, Cultural & Religious Affairs & Services 0 9 1 9 08 1.8 0.8 1 1.1 26 Economic Servces 3.6 8.0 2.9 6.7 3 0 6 7 5 7 131 Interest 3 0 6.7 2.7 6.3 3.4 7 8 3 3 7.5 47 96 Misc. (Incd. adjustment for employer contnbutions at the same leyel) -1.1 -2.5 -0 8 -1 9 -2.9 -6 2 -0.1 -0 21 1/ EU Accession-7 includes Czech Republic, Hungary, Slovak Republic, Slovenla, Estonia, Latvia and Lithuania, but excludes Poland. 2/EU 15 includes all current European Union member countries Sources. GUS, GFS, Ministry of Finance and ECSPE Public Expenditure database. 1.35 State Guarantees. The use of state guarantees to allow firms and public bodies to acquire credits or to receive them at reduced interest rates has increased sharply since 1999. Throughout the 1990s, guarantees were extended at an average 0.3 percent of GDP annually. In 2000, the limit specified in the budget law was increased threefold to PLN10 billion, indicating an increased intention to channel resources to preferred sectors using this policy instrument. The amount set in the budget law for new guarantees during FY02 is PLN29 billion or 4 percent of this year's GDP. However, the draft budget law for 2003 has reduced the permissible level of guarantees for FY03 to PLN23 billion or 3 percent of projected GDP. 1.36 During the 1995-2001 penod, 43.6 percent of state guarantees were allocated to the transport sector.6 Other main beneficiaries were the financial sector (23.7 percent) and the energy sector (9.5 percent). As of December 31, 2001, the amount of outstanding guarantees equaled PLN29.7 billion or 4.1 6 Of the given guarantees to this sector, 39 percent was for the national airline (LOT), as insurance prerriiums increased dramatically after the Septemnber 1 I terronst attacks in New York (N.Y.) and Washington (DC). Twenty- nine percent was allocated to the national railways (PKP) and most of the remainder was issued to cover a loan for road construction. 15 percent of GDP. Of this amount, 31 percent was allocated to firms in the transport sector, 16 percent to banks, 13 percent to the railway company, 13 percent to companies in the energy sector, and 9 percent to the road sector. Although procedures are well defined in the AoPF, there is evidence (see OECD 2002) that some of the standard rules are being circumvented, most notably the rule of limiting the guarantee to 60 percent of the total credit taken. 1.37 The Government definition of public debt (see Box 1.3: Definitions of Public Sector and Public Debt) deals quite appropriately with loan guarantees and its risk-weighted valuation is quite apt. The transparency of this evaluation and the process of extending such guarantees could, however be improved. Applying the insights from "value at risk" methodologies developed for the private sector, especially if there are low-probability events for which it would be useful to make some budgetary allowances in advance, could result in further improvements to the treatment of such contingent liabilities. 1.38 In addition, the Government should consider specifying each individual guarantee in the budget law instead of one all-encompassing appropriation. Improving the transparency of the process through which companies can apply would strengthen public and parliamentary oversight and scrutiny. Such procedures would also help limit the ability to use this instrument to substitute for budgetary expenditures, given that this policy instrument is used with increasing frequency to support sectoral interventions or to promote large-scale policy initiatives. Where it is difficult a priori to identify the individual beneficiary of a guarantee, the Government should identify in the budget law the total amount of guarantees that would be allocated to support a (sectoral) policy. 1.39 The Burden of PFro-determiniedl Expendituires. In 1999, 58 percent of budget expenditures were non-discretionary; by 2002, this had increased to over 65 percent. While some degree of embedding expenditures in laws and its indexation is warranted for the effective implementation of priority expenditures, the pre-determination of the budget imparts structural rigidities, which limit fungibility and constrain budgetary reallocation. The further fragmentation of the budget (see Chapter 2 for further discussion) also constrains the ability of the state to effectively manage its public finances. 1.40 Tax IExpendtiiires. Furthermore, a disproportionately large amount of government revenue is being lost on tax expenditure. The OECD estimated in its 2002 Economic Survey that total tax expenditures amounted to around 8.5 percent of GDP for 2000 and states that inter-enterprise debts also represent a mechanism by which enterprises have been supported. The forgone revenues from VAT were in the order of 6.7 percent of GDP or PLN45.7 billion zlotys for 2000 alone. EU accession-related negotiations with regard to the chapter on taxation have recently been reopened after having been closed provisionally in the spring of 2002, with the specific purpose of obtaining a transition period until 2008 for raising the VAT rates on construction services. Focusing tax relief on one particular sector, although beneficial for that particular sector, means, given total Government outlays, that in future, other sectors and/or inputs in production (e.g., labor) will be taxed more heavily. Given the large amount of tax expenditures (see also Cavalcanti and Li [2000]), a proper review of the current tax system seems appropriate and should be aimed at decreasing tax expenditures. This should be applied in such a way that the net budget revenue effects are neutral and therefore should allow for a significant reduction in taxes that affect labor, in order to promote more labor friendly production across the whole economy and to facilitate a much-needed reduction in unemployment. Conclusioms 1.41 Poland faces significant fiscal challenges. These challenges arise from different sources: EU accession, which not only requires the reduction of overall deficits but also the reallocation of expenditures toward infrastructure upgrading, and the strengthening of budget management; the demands of growth, which requires the restructuring of expenditure policies, particularly in the social sectors; the 16 changes in demographics, which suggest an increasing burden of disability and survivor pensions, health and old age care, and lower percentage of the working age population; and the challenge of ensuring the effective delivery of public services. 1.42 Responding to these challenges requires actions along various dimensions. Such actions include the imperative to control the size of the public sector and reduce the overall size of the govemment deficit. Only by reducing the deficit can public debt dynamics be put on a sustainable path and can further reductions in interest rate be achieved without risking a re-emergence of inflation. Fiscal discipline also needs to be strengthened by limiting the state recourse to public guarantees and tax expenditures as altemative means for financing public policy choices. In addition, the reallocation of public expenditures away from consumption and toward public investment is needed in order to strengthen the developmental orientation of the budget. 17 18 2. THE PUBLIC EXPENDITURE MANAGEMENT SYSTEM INTRODUCTION 2.1 While the recent growth in deficits reflects, in part, countercyclical fiscal policy in the wake of the economic slowdown, this detenoration of the fiscal position raises questions about the credibility of the budget process. Weaknesses in the incentive arrangements for good budgeting are central to the fiscal problems facing Poland today. Notwithstanding the progress made in budgetary reforms in several areas, significant weaknesses remain in the current system that limit the attainment of efficiency, economy, and effectiveness in the use of public resources. 2.2 Some recent improvements in the public expenditure management (PEM) system include a modem budget law, improved macroeconomic forecasting capacity within the Ministry of Finance, enhanced budget transparency (for instance, with the publication of budget documents on the internet), and the recent initiation of intemal control and intemal audit capacity development. While many of the features of Poland's PEM system are common to former socialist economies, they also reflect common weaknesses! Additional budgetary reforms are needed to gain the full benefit of economic reforms and to align the budget process with the needs of the Polish govemment and its citizens. In particular, the budget needs to define clear goals for the delivery of public goods and services and to indicate how progress against these goals will be measured. 2.3 The assessment below the performance of Poland's budget system is based on the extent to which the system promotes three key objectives: (i) aggregate fiscal discipline - allowing budgets to be set consistent with a realistic macroeconomic framework and a sustainable fiscal program, and brought in on target; (ii) allocative efficiency - requiring that resource allocations reflect the policies and priorities of the Government's program; and (iii) technical efficiency - requiring that resources are utilized efficiently and effectively for the purpose for which they have been allocated. Additionally, the budget process is examined in terms of its comprehensiveness, accuracy, annuality, authoritativeness, and transparency.8 These principles need to be met if the PEM system is to serve as an effective tool for ' Some of the common features are: a cash-based budget system; an input-oriented budget formulation system built around budget normatives (set outside of the budget process); a one-year budget planning horizon that does not provide a framework for evaluating multi-year policy or expenditure commitments (new or existing); a decentralized payment system, with significant responsibility for accounting and propriety resting with line ministries; and the absence of a formal Treasury system, a consolidated Treasury fund, and integrated cash and debt management functions. 8 Conprehensiveness means that all revenue and expenditure, and all government agencies, are included in the budget; all government agencies are integrated into the public expenditure management system. Accuracy means that actual transactions and flows are recorded. Annuality means that the budget covers a defined period of time (e.g., one year). Authoritativeness refers to spending being carried out only as authorized by law. Transparency refers to information on spending being publicly available, on a timely basis, in an understandable or common fornat. 19 formulating and implementing budget policies, evaluating budget outcomes, and holding agencies accountable for results.9 2.4 Prionty areas for improvement are the following: (a) Consofidate the budget by inciuding all publec revenues 2aid expenmditures, and subjecting alD budget funds to uniforim standards of budget scrininay amd legAslaDtve oversight. A clear and comprehensive picture of the state of public finances, as opposed to the current fragmentation, is fundamental to the effective management of the public funds. This would facilitate the formulation of fiscal policies as well as a judicious use of fiscal instruments. (b) Develop Link Policy Formulatioin with budgetnng. This would require the Medium Term Expenditure Framework within which annual budget needs are assessed. This would make possible the discussion and evaluation of links between economic objectives, policy options, and trade-offs, allocation of resources, and expected results. A key component of such a framework would be multi-year fiscal aggregates-the overall macroeconomic and fiscal policy parameters-which would serve as a basis for the annual the budget process. The Government should also undertake fundamental reviews of key sectors in a phased manner. This would not only help rationalize the number of EBFs and autonomous agencies over time but would also address the current fiscal rigidities resulting from mandated legal policy commitments (or over-indexation of the budget). (c) Strengthen incentives at the ministeirial gaind local governmment levels for impiroved pubfic service delivery and accountability. In a departure from current practices, a start should be made by: developing the performance orientation of selected expenditure programs; strengthening the revenue autonomy of local governments to ensure better matching between their revenue means and expenditure needs; expanding the scope of the functional autonomy of the spending units; and shifting from an administrative culture of compliance with law to one of cost-effective provision of public services. Such changes will necessarily need to be consistent with the requirements of macroeconomic stabilization, the development of systems of internal control, and the needs of central agencies for financial information for overall fiscal monitoring. (d) Strengthen the accou˘ntabUity framework This would promote the move toward greater functional autonomy and accountability, while ensuring adequate safeguards for the attainment of economy, efficiency, and effectiveness in the use of public resources. A key measure would be to require that public accounts are certified by the audit agency and subjected to legislative scrutiny. ?PGLAND'S 1BEUlDGIETl SYST1IEM 1N IPERItSPECTIfRIVE 2.5 The budget system in Poland has undergone several changes during recent years, particularly in the 1990s. Several of these measures have been taken, or are being taken, to put the system in conformity with the practices of the EU so that the admission requirements can be fully met. The key features of the existing system are given below. 2.6 Legislation. The Public Fmance Law of 1998 basically govems the systems in operation at both the central and local government levels. This Law specifies several fiscal rules to ensure fiscal solvency See Schick, Allan, A Contemporary Approach to Public Expenditure Management, IBRD, 1998. p. 4. 20 and liquidity at both the central and local levels. These rules are: (i) outstanding central government public debt cannot exceed 60 percent of GDP; (ii) the ratio of debt service to revenues for local governments is to be maintained below 15 percent; and (iii) the ratio of debt to revenues for local governments cannot exceed 60 percent. The Public Finance Law also lays out the framework governing the coverage of the budget, the roles of the budgetary units (departments and agencies), submission of the budget to the Sejm (legislature), and related aspects. 2.7 In principle, the Sejm has, the final control of the public purse in that it has the power to revise or alter revenue estimates and expenditure programs as long as the government-proposed nominal deficit levels are maintained. The Public Finance Committee of the Sejm, which includes representatives of all parties, can conduct public hearings on the budget proposals. The President has the power to veto the budget as proposed by Sejm, which then may be subjected to extended negotiations between the President and the Sejm. 2.8 The legal framework also provides for an independent audit agency, known as the Supreme Chamber of Control that supports the Parliament's oversight function. The Supreme Chamber has a long tradition in Poland, and its charter was revised and enacted in the form of comprehensive legislation in 1994. 2.9 Fiscal Transparency. Following the example of other European countries, the Polish authorities have been making continuous efforts to disseminate information on the fiscal status of the government. Budgets are published and are also available on web sites. Similarly, data on public debt and intentions on future debt to be raised (annual debt plans) are available on the web site. With the gradual growth of electronic technology, it is likely that there will be extended use of this window for the dissemination of fiscal data and analysis and for public access to this information. 2.10 Budgetary Decision-Making. The Govemment has periodically undertaken the exercise of making fiscal projections over an extended period, and macroeconomic models support these exercises. The Public Finance Law enjoins the Minister of Finance to prepare a three-year fiscal strategy document so that annual decisions may be taken within a medium-term framework. There is a Cabinet subcommittee that is entrusted with the task of reviewing proposed capital expenditures. As noted above, the Sejm may alter both in spirit and substance the budget proposals of the Govemment, and capital spending is one area of active Sejm attention. The focus of the discussions, however, is on the state or central government budget deficit excluding off-budget items and without full information on subnational spending. This has resulted in sub-optimal decisions that have a negative impact on the general govermment budget. 2.11 Payments, Accounting, and Reporting. For the most part, govemment financial transactions are in the form of cash or checks. There is a defined framework for the implementation of the budget. Agencies or budget units are expected to submit financial plans indicating their needs for the fiscal year, including the seasonality factors. On this basis, the Ministry of Finance releases funds (for each ten-day period of the month) to the agencies, which then make arrangements for disbursements as needed. The agencies have selective authority to transfer resources among chapters but cannot increase, within the total budget, the outlays on any chapter by more than 5 percent without MoF approval. A Consolidated Treasury Fund is also planned to be implemented from 2003. A good deal of progress has also been made in the area of reporting. The Central Bank reports the current balances in all the accounts more than once every day. The whole process is being converted into an online system, and from 2003 the MoF will have access to the Central Bank records electronically. Monthly reports are compiled and reported to the MoF by the agencies. The reports from local governments and extrabudgetary funds, however, take more time. 21 2.12 llnternEal FiMnaancall Managemennt and Controls. In the event of a substantial discrepancy between revenues and outlays during the fiscal year, the Cabinet is empowered to block (suspend implementation of) some projects and programs to contain spending. All budget organizations work within the ambit of the Public Finance Law. They have the responsibility to oversee the day-to-day management of receipts and disbursement of funds. At the end of the year, the budget organizations are permitted to carry over funds to the next year if financed by foreign aid. Recently, there has been legislation to appoint internal auditors as a step in the direction of strengthening internal control systems. These efforts have not yet become operational. 2.13 Fiscal l)nisciplne. The Public Finance Law contains several provisions relating to the violation of fiscal discipline and associated liabilities and penalties, and to the authorities entrusted with the task. Failure to establish receivables or overstepping the scope of budgetary authorization are, for example, some of the violations that invite the application of rules of liability. 2.14 Technical ]Infrsrastrancture. Steady progress has been made in the use of computer technology in both the central agencies and departments, to process the financial transactions and to compile accounts and related periodic reports. 2.15 But the existence of the above institutions, systems and operational procedures do not in themselves guarantee an effective and smooth running budget and expenditure management machinery. The key weaknesses and areas for improvement are discussed in detail in the following sections. KllEY E$UES AND REFORM OP G0NS FRAGMENTATION OF THIE 3BUIJDGET 2.16 A clear and comprehensive picture of the state of public finances is fundamental to effective management of the public purse. Incomplete and partial information leads to fragmentation and precludes appropriate decision-making during budget formulation or execution. It is generally expected that a government budget's scope would be coterminous with the total operations of a government and would include all instruments of fiscal policy. Such a comprehensive coverage is necessary to facilitate the formulation of fiscal policies and the judicious use of fiscal instruments, such as taxes and expenditures, sales and purchase operations, lending and borrowing, and guaranteeing transactions. 2.17 An important issue in Poland is the existing "fragmentation" in the budget management system. This fragmentation takes place primarily in four ways-the large number of extrabudgetary funds and agencies, the inadequate integration of cash and debt management, the exclusion of foreign aid from budget coverage, and the inadequate treatment of fiscal risk. 2.18 The Large Number of Eitralbidgetary Funmds and Bundget Agenmees. A large number of extrabudgetary funds (EBFs) and public sector agencies limit effective budget and expenditure management (see Box 2.1). In Poland there are 14 extrabudgetary funds as well as a large number of autonomous agencies, budgetary establishments, and ancillary budgetary enterprises discrepancy that fragment the budget process. '° Some of the fragmentation derives from the budget law itself, which provides for these various institutions. Not only do these institutions contribute to unnecessary administrative overheads, they also introduce avoidable rigidities and inefficiencies (for instance, separate bank accounts and lack of consolidation of public funds), multiple practices of fiscal accounting and reporting, and different accountability structures. 0 OECD (2002) reports 300 budget establishments and 400 ancillary budgetary enterpnses. 22 2.19 There are four key issues here: (a) While the rationale for some of the EBFs is clear-such as health insurance and pensions-the justification for others is not clear. Some activities may need separate arrangements (e.g., financial intermediation, health and social insurance), because their operations need to be conducted differently from those of government departments. Box 2.1: Variable Accountability Arrangements for Special Funds, and Agencies Poland has a large array of public sector institutions, for both the financing and the administration of public sector activity. These institutions have different governance, accountability, and public finance treatments, and it is not clear what benefits or advantages are gained from the different institutions or different budget treatments. The various types of currently authorized institutions include: Budget Entities: entities wholly financed from the public budget and subject to the reporting and financial control regime of the budget law. Surplus funds may not be carried over, but must be returned to the budget. Financial plans of budget entities are collected and published in an attachment to the budget for information purposes. These are not independent legal entities, and can be created or abolished at the will of the governing body (e.g., line mninistries). These exist for national and subnational governments. Schools are an example of a budget entity. Auxiliary Units: subsidiary units of budget entities usually established for adrministrative separation from the budget entity, where the activity is of a different character from core budget entity activities. Auxiliary units sell goods and services to their parent body at cost. and may carry forward half of their working capital. Examples of auxiliary units include publishing or printing offices, building maintenance, recreation facilities, and casinos and bakeries for the Ministry of Defense. Special Funds: another subsidiary activity of budget entities, established where special financing characteristics exist. Prior to 2000, special funds were obligated to return surpluses to the budget at year-end, but no standing rule is currently in place. Financial plans and declaration of assets are not made public. For example, the Ministry of Finance maintains a special fund for bonus funds to pay additional remuneration to staff. Budget Establishments: self-financing activities, as through user fees. They are not separate legal entities, and can be created by ministers, heads of offices, voivods, etc. They can obtain funding from the budget. Emnployee training centers and agricultural service centers are examples of this organizational form. Appropriated (or Extrabudgetary) Funds: created by the Councils of Ministers or People's Councils prior to 1990, at national and local levels, these funds have been grandfathered into continued existence in the current budget law. They are not included in the Budget. Some new funds have been created since 1990, such as the Agricultural Social Insurance Funds, the Arts Promotion Fund, and the Social Insurance Fund. These are accounts for financing purposes, and were technically accountable to a parent ministry or authorized governing body. Each governing body is responsible for determining financial management standards for funds under their purview. Financial plans are included in the budget for informational purposes only. Statutes authorizing individual funds in some cases authorize direct borrowing of the entity from commercial banks. Funds retain surpluses, and may invest in securities. Colleges: educational entities with their own unique legal status and financial activities. Artistic and cultural entities: unique entities created by the authority of local authorities or the Minister of Culture. They are not included in the budget, even for information purposes, and it is unclear to whom they are accountable. Many had been appropriated funds prior to 1990. Agencies: entities established by order of the President of the Council of Ministers or Parliament. Agencies are not in the budget, though the direct budget support they receive may be in the budget. Some government body is designated as the supervisory body for the agency. Financial plans for agencies vary, with some going to the supervisory institution, and some directly to the Sejm. In some cases, these financial plans need prior approval of the supervisory body before implementation, and in other cases, they do not. Generally, financial oversight of agencies is less than for appropriated funds, and has led to the preference for this organizational form. Even where little direct budget support is received, some agencies manage significant levels of state assets. The first agency created, the State Treasury Agricultural Property Agency, manages former collective farms, covering 15 percent of Poland's terrtory. 23 (b) EBFs are not uniformnly subject to the same standards of budgetary oversight, reporting, auditing, and transparency. Only EBF summary balance sheets are included as appendices to the budget when it is sent to Parliament. (c) For autonomous agencies, there are no standards or guidelines on how they should be used and when or what the expected benefits are. Autonomous agencies are proposed by spendmg ministries; a list of all such proposals is prepared by the MoF and submitted to the Cabinet for approval. While Cabinet approval is an important practice, there is no objective set of criteria or standards for evaluating autonomous agency proposals. Nor are there any ex post reviews of autonomous agencies to evaluate whether they have fulfilled their mission, achieved the intended objectives, or generated externalities. (d) The extensive spread of autonomous agencies contributes to a culture that is inimical to the pursuit of coherent fiscal policies. Several agencies may adopt an "enclave" approach, retaining their resources while governments are borrowing funds to finance their activities. Some of the agencies may have their own sources of revenues. Thus, the large number of such agencies contributes to excessive fragmentation and to the pursuit of diffuse policies. Provision of functional autonomy to these agencies could frequently be at the expense of overall budget discipline, and diverse practices of accounting and budgeting could contribute to the serious erosion of legislative oversight. 2.20 In order to address the resulting fragmentation of the budget, the Government needs to consider the following: (a) Careful scrutiny should be made of all existing EBFs and autonomous agencies to determine which should be retained and which transferred to general budget activity. Criteria should be developed for reviewirng and assessing proposals establishing any new EBF. The criteria for inclusion or exclusion from the budget are basically two: (i) is the EBF or agency pursuing an activity that is naturally considered as an instrument of fiscal policy? and (ii) are the operations of the agency contributing to additional value, net of cost? Such a review, supported by the fundamental review discussed further on, should contribute to an improved coverage of the budget and thus to a more coherent fiscal policy."I (b) Those EBFs that are retained should be subject to at least the same degree of accountability, reporting, auditing, and transparency as on-budget operations. 12 Common standards of budget discipline and related legislative oversight need to be adopted. This requires: (i) displaying the financial data of the EBFs in the budget documentation and developing aggregate general government budgets for policy discussion and decision- making; (ii) subjecting all EBFs and agencies to the same accounting and reporting standards as the rest of government; and (iii) developing systems for evaluating the performance of EBFs and agencies against their legally defined objectives. In this connection, a study needs to be conducted to review the experience to date with these various institutional forms, develop evaluation criteria, and to evaluate the lessons learned. " A separate piece of work, outside the scope of this study, should develop a detailed framework for evaluating EBFs in Poland. 12 World Bank (2001). 24 (c) The necessary legislation for reforming the EBFs needs to be enacted.'3 This should include a framework goveming their budgets, borrowing powers, financial management practices, and accounting standards as well as channels of accountability. (d) Before new autonomous agencies are created, it might be valuable to require a clear report on why the agency is being created, what benefit is expected, how this would be measured, what the baseline for the mdicator is, what performance targets would be, and why normal governmental status is not sufficient. Moreover, it would be useful to insert into the agency's charter a statement of the need for a performance contract, with an independent assessment of performance after two to three years of operation, and with the provision that the entity automatically loses its autonomous status at the end of four years, at which time it must be re-proposed for autonomous status. The forced re- proposal of autonomous agencies provides a regular opportunity for policy-level review of these instruments.'4 2.21 Fragmented Cash and Debt Management. While the MoF has a firm grip on the aggregate cash management of the state budget, there are efficiency gains, which can be achieved from better- integrated cash and debt management. Currently, after the approval and legislative passage of the budget, the budget units furnish the MoF with their financial plans for the year, and their "harmonograms" which indicate their cash needs. This enables the Ministry to ascertain the seasonal ebb and flow of the outflows, and to match them to the extent possible with similar developments in the inflows and with the plan for the mobilization of debt resources. Information on the intent regarding debt is posted on the website of the MoF. The present practice has, however, a few major procedural rigidities. But these can easily be avoided and a more efficient cash management system can be instituted. These are: (a) On the basis of the harmonograms, funds are directly released into the accounts of the budget units, although such a physical transfer involves, in general, mobilization of debt resources. (b) Extrabudgetary funds maintain their accounts with the commercial banks, which again are not taken into account in the determination of the borrowing requirements. This, and the preceding feature, contributes to a situation where the government is engaged in borrowing even when some liquid resources are available in its broader portfolio. (c) The releases are made, following a very old convention that predates the central planning days, in terms of ten-day periods, which contributes to additional rigidity in the system. 2.22 Cash management needs to recognize certain fundamental premises. First, the cash resources, even when physically held by the units, belong to the whole government. The principle of cash unity has to be respected. Second, to the extent that the separate accounts are contributing to the above types of problem, the situation can be resolved, as has been the case on the revenues side, with the creation of a single consolidated fund, but with separate subset of virtual accounts (and no physical balances) as integral parts thereof. Third, the releases may be made in the form of ceilings up to which the budget units can draw money without separate physical cash balances. In other words, the sub-accounts of the consolidated funds are the ones to which the amounts paid out are debited. 2.23 In the light of the above considerations, the following steps may be considered for strengthening cash and debt management: 3 Draft legislation which moves in this direction has been pending for some time. :4 A separate piece of work that should be undertaken is the development of a framework for Poland to asses current and screen future proposed agencies. 25 (a) A single consolidated fund (alternatively called the Treasury Single Account) should be established, from which all budgetary transactions will be carried out. The budget units would maintain sub-accounts within this consolidated fund. Work is under way within the Government and the Central Bank to introduce such a single account from January 1, 2003. (b) Releases should be made in terms of ceilings up to which the budget units may engage in spending transactions. In view of the absence of separate physical balances, the total balances of the consolidated fund would indicate the net cash position (inflows-outflows adjusted for foreign aid balances). (c) In determining the overall borrowing requirement, the extrabudgetary units may be authorized to invest their short-term liquid surpluses in government paper. This would enable the Government to determine the amount to be financed by the captive funds, and the funds to be borrowed from the public. (d) With a view to providing greater flexibility to the budget units, even if it is marginal, the release authority may be issued for the month as a whole. 2.24 lincomnplete Coverage oT Foreignm Ald. In the existing system, projects and programs funded by foreign sources are shown in the form of an informational statement appended to the budget, but are not included in the budgetary estimates of expenditures or financing. The prevalent view within Government is that since this funding is included in the budget document presented to the legislature, it should be considered as a part of the budget itself. However, the system does not operate as if this were the case. Foreign aid is not part of the appropnation process of the legislature, although counterpart allocations, met from local sources, are included in the budget (albeit separately appropriated). 2.25 This needs to be rectified. There are at least three compelling reasons why this change should be undertaken. First, in the medium term, when Poland becomes a member of the EU, there is a greater likelihood that the quantum of foreign aid would be stepped up substantially. Second, as the level of foreign aid is increased, there could be a greater need for the allocation of funds in domestic currency. This requires an integrated consideration of the foreign and local funds. Third, the maintenance expenditures on completed foreign-aid projects would also increase over the years. For purposes of transparency and clarity, the source of funding (as is required for EU projects) may also be identified. Such a display in the budget would facilitate an integrated consideration of the role and contribution of foreign aid, while rendering clarity to the members of the legislature and the conmmunity. 2.26 [lladequate T1reatnmeit of Flscal llsks. The budget provides an incomnplete coverage of fiscal risks.'5 Macroeconomic risks are addressed reasonably well during budgetary fornulation and, with greater stability of key nominal variables; this is reportedly less of a problem now. The picture is less favorable with respect to the treatment of micro risks. In the current system, the annual budget law sets the limits on the guarantees that may be provided during the year. No information is provided on the risk of outstanding guarantees, nor is any indication given as to whether the nsks or the potential contingent liabilities have been adequately financed. Similarly, in the case of subsidies (such as those administered by the Ministry of Infrastructure), the budget estimates show the limits up to which the facilities may be funded. Any excess over the limit is either considered as an arrear (to be adjusted later, if at all) or as an issue that has to be solved from internal resources by the providing agency (e.g., railways). I5 The macro risks include the changes in the macroeconomic assumptions relating to the growth rates of GDP, exchange rates, unemployment (for social safety net spending), interest rates, and rates of inflation. The micro risks, for which the budget should be prepared, relate to the contingent liabilities arising, for instance, from government guarantees, and to the hidden subsidies, now met from the respective sources provided by the state-owned enterprises. 26 2.27 Fiscal risk management should be integral to the budget. Two specific measures for strengthening its coverage are: (a) As a step toward better coverage of potential contingent liabilities, the annual budget should contain an explicit statement of the government guarantees provided, the list of the recipients, amounts, purposes, guarantee fees, if any, and the risks taken into account in the formulation of the annual budget. (b) Similarly, a statement should be appended about the subsidies and the underlying assumptions of the budget estimates. THE DISCONNECT BETWEEN POLICY FORMULATION AND BUDGETING 2.28 Policy formulation in Poland is currently disconnected from the budget process, undermining the incentives for economy, efficiency, and effectiveness in budgeting. Moreover, many of the policy normatives are embedded in laws. While these provide greater stability for the policy environment, they also limit the flexibility governments need to have to adapt policies to changing circumstances, needs, and priorities, and substantially increase the transactions cost of making the required policy changes. As a result, even though sectoral policies are the pnmary responsibility of the sector ministries (e.g., education policy in the Ministry of Education), spending ministries have become mere administrators of laws and programs, rather than managers of policy and programs. 2.29 Key issues in this area are the following: (a) The budget is primarily intended to allocate available funds to existing commitments and programs, rather than to serve as a vehicle for rationalizing policy, objectives, and resources, or for seeking the most efficient expenditures for a given set of objectives. This leads to the apparent absence of substantive policy analysis and discussion of options throughout the budget process (see Figure 2.1). This is an historical artifact of the socialist era, and occurs along both process and organizational lines. Consequently, sector ministries generally have little incentive to economy and efficiency, to question whether their own programs should be continued or reorganized, and invite discussion of whether the current mode of implementation is the most effective (e.g., autonomous agency, subvention to non-governmental public organizations, etc.). The natural tendency of the ministries then is to expand resources devoted to the sec.tor and themselves. Figure 2.1: Current Disconnected Policy and Budget Process Policy Process Budget Process The policy process 1 ~tOCC55 !2awNormaciesu generally 'a proceeds outside O . the budget including policy \ Lanual Efldget - decisions. laws_i and associated r- Syste'abzatto - norniative rules ) The budget is a staffing and rinance function. organitzation of rilhng up the iinistries .,lsting programs 27 '- with ailablc revenues 27 (b) The expenditure implications of policies are not fully developed within Government. Professional bodies and line ministrnes develop normatives for the sectors, and these are enacted in laws. These normative laws form the basis for program operation and budget requests. Line ministries, outside the budget cycle, are responsible for enacting decrees that detail the organizational structure and staffing needs of the ministry in order to carry out the laws within its jurisdiction. (c) Capacity for policy analysis or development within Govemrnment is also limited and varies among the different Govermment ministries and departments. (d) The process of budgetary decision-making is essentially geared to the short-term: a single fiscal year (see Box 2.2). In reality, however, fiscal policies and related individual measures take place on a continuum. Most of them have to be carried from one year to another to reach fruition. However, as the decision-making focuses only on the immnediate short term, several discontinuities arise, as is the case with mvestment budgets. B3oz 2.2: TRne Annual lBudget Fornnulatdon Pirocess nn Poland In the current system, the process of formulating the annual budget for the next year starts soon after the budget of the current year is approved. In several cases, this means that the budget units start collecting budgetary data from their subordinate units by the end of March and submit to the Ministry of Finance. The review takes place in the Ministry of Finance, and the consideration of the proposals go through an iterative process within the central govermment; during July-August, firm ceilings within which budget estimates have to be prepared are issued to the budget units. In general, the budget guidance is provided to protect the indicated level of the budget deficit. In some years, as has been the case with the preparation o the budget for 2002, additional guidance may be given to the effect that additional spending proposals should be undertaken only if additional revenues materialize. The estimates achieved from the budget units are then consolidated, and a finished product is submitted to the legislature by end-September, as is required under the Law. The budget is then processed through the legislative committees, and all other aspects remaining valid, the final budget, with the approval of the President, would be ready for implementation by January 1. (e) The orientation of decision-making is firmly anchored in the level of the deficit. But even in this regard, there has been avoidable ambiguity in that several concepts of the deficit-such as the nominal deficit, the economic deficit, the structural deficit, and the deficits for different levels of general government-have emerged during recent years. Since the policy anchor is rooted in the deficit levels, two avoidable problems have emerged. First, the estimates of revenue have become manipulable in both the executive and legislative wings of government. During the period 1998-2001, there was been a growing bias toward inflating revenue estimates, as discussed earlier. Further, in the legislative wing there have been instances where the estimates of revenue have been raised merely to accommodate proposals for increased outlays while being within the levels of deficit. (f) The estimates of expenditure contain a good deal of slack. The budget units seek to provide such a slack so that the tempo of their activities can be maintained even when the monthly allotments by the MoF are short-issued. This slack continues from one year to another, as the primary emphasis of the review of the MoF is the continuation of the previous year's level of expenditures adjusted for the level of estimated inflation. The two different approaches have contributed to a situation in which outlays are continued, not necessarily because of any demonstrated need, but because they have been there during previous years. This approach of institutionalized incrementalism has contributed to the neglect of the pursuit of economy and efficiency. 28 (g) Over time, the budget has become overly indexed, with onerous expenditure obligations from existing policies, many embodied in legislation. These contribute to budgetary rigidity and to the little flexibility in annual policy making and budget-making. The benign neglect of this issue has contributed to growing problems in containing the growth of current expenditures. (h) The responsibility of the budget units is limited under the law to the spending of the amounts provided in the budget. Underspending in such a context may even be considered an indication of prudence. In reality, the administrative culture of compliance with the law over performance or program outcomes, which permeates all levels of government, has contributed to the neglect of service delivery or accountability for results. This narrow approach is distinctly out of step with the developments in other European countnes and with the legitimate expectations of a civic and democratic society. 2.30 The general integrated concept toward which the Polish policy formulation processes should move can be summarized in Figure 2.2. This can be undertaken along the following lines: Figure 2.2: Policy and Budget: Toward an Integrated Process The budget process serves to bnng together the objectives and policies of government with laws, means of inplementation, and The integrated available resources policy is reflected in the budget proposal Poices considered outside the budget process are considered with reference to government objectives for the resources (affordability) and nmeans of implementation (a) Macro economic forecasting needs to be strengthened. As noted above, macroeconomic forecasting has been somewhat optimistic on the revenue side. A good practice in the current process of Polish macro forecasting is the sharing of estimates with private sector and academic groups for vetting before advancing the forecast for Government discussion. The forecast is released publicly with the budget, but without direct comparison with other forecasts or identification of and explanation for the assumptions. And, whereas technical forecasts of GDP and revenues should generally be the purview of technical experts, the current Polish process allows for the political adjustment of GDP and revenue figures. To strengthen the transparency of the process and remforce the objectivity of estimates, it might be useful to include the published forecasts of key economic variables underlying the budget estimates, and include them in a table that compares the Govemment forecasts to major private and public sector forecasts (domestic and intemational) of the same variables, and with the explanation of the Govemment assumptions. 29 (b) The Government should adopt an annual fiscal policy paper detailmg a multiyear macro- fiscal framework. The Ministry of Finance should prepare this early in the budget process, setting the overall macroeconomic, and fiscal policy parameters for the budget. Major threats and challenges to the budget over the medium term should be discussed. As an integral part of the fiscal policy paper, clarity should be provided on the concept of deficit used and its implications for fiscal policy. Also important would be the development of a balance sheet for general and central government, showing assets and liabilities comprehensively. This is particularly important given the large off-budget assets that may also be pledged as collated in guarantees and loans. The fiscal policy paper should be the subject of cabinet discussion and approval. This would not only help to educate policy officials on the impact of policy decisions on the economy and finances. By facilitating a consensus in the Cabinet, all Cabinet members would better understand the basis for the budget and would be more inclined to adhere to the policies that they agreed to. The fiscal policy paper itself would be amended to reflect Government decisions, and could then be released with the budget, or even in advance of the budget. 16 (c) Policy formulation needs to be linked explicitly to budget formulation. To this end, it is appropriate that budgetary policies are formulated in the context of a rolling Medium- Term Expenditure Framework (MTEF). As a part of this approach, expenditure estimates will need to be prepared each year, for the next budget year as well as for the following two years. The legislative appropriation action would, however, be limited to the annual budget. In the preparation of the forward estimates, a distinction should be made between: (i) the future financial implications of current or existing policies; (ii) outlays on new projects and programs, including allocations from domestic counterpart funds (see Box 2.3); (iii) foreign aided projects and programs; and (iv) contingent liabilities, such as the assumption of guarantees and associated risks. In addition, a small notional contingency may be retained to meet unforeseen situations. A key input into the MTEF would be the multi-year fiscal aggregates and Government policy from the fiscal policy paper. From these multi-year indicative spendmg allocations for each sector or ministry would be derived. These sectoral targets would be distributed to spending ministries at the start of the annual budget process, and ministries would be expected to prepare their requests within the ceilings. By prioritizing spending within a ceiling, ministries have more incentive to review current spending programs, assess effectiveness or whether the programs fit government priorities, and make trade- offs among sectoral policies and programs. Analyzing ministry budget requests is also made easier if the requests differentiate between the cost of continuing programs and activities and new spending requests or proposals. The development of the MTEF should be accompanied by a broadening of sectoral policy discussion beyond the confines of government. The policy issues for sectors can be published in "white" papers for general public reaction. The scrutiny of a wider variety of stakeholders can expose costs and benefits not readily apparent within the Government. The Government would still take its decision, and would need to explain or justify its position, but the expanded scrutiny from outside would improve the quality of the options presented for decision as well as the quality of decisions themselves. Moreover, a broader dialogue can enhance the sustainability of reforms, promoting greater public awareness and understanding of policy challenges, and thereby cultivating broader political support for (and minimizing opposition to) policy reforms. 6Such a paper could be based on Chapter 3 of Poland's EU Pre-Accession Economic Program. 30 Box 2.3: Strengthening Investment Budgeting in Poland Investment budgeting in Poland has special characteristics and issues that deserve special treatment. This is particularly important given the possibilities for leveraging large EU inflows. There are several critical issues with respect to investment budgeting. The threshold for defining investment expenditures is very low-namely, investments over 3,500 zlotys (equivalent to less than $900). The process for requestmg investment projects is separate from that for current expenditures, and does not take place within the framework of a comprehensive, programmatic approach around the objectives of the program. There are no capital budgeting standards or guidelines that require cost-benefit analysis or multi-year capital and recurrent costing for proposals. If this information did exist, it would form the basis of Ministry justification of budget requests and would allow the Mmistry to evaluate its proposal in light of its multi-year sectoral ceiling, and also to evaluate the proposals for multi-year implications. Capital investments suffer from inefficiencies in their implementation. Systematic evidence on this is not available, but the anecdotal evidence is highly suggestive. Capital funding is highly varied from year to year, and in some cases only enough funds are provided to keep the project "active." The result is waste of resources, failure to complete projects in a timely manner, and failure to gain the benefits of capital spending in time to benefit program operations or further government objectives. Given the above issues, the Ministry of Finance should undertake reforms to the capital budgeting process. Some areas for improvement are: (i) The threshold limit for inclusion into the investment budget is too low and should be revised upwards to better capture outlays that provide long-term benefits to the society. (ii) A detailed investment planning process should be installed in the government. This should enable a specification of the criteria for public funding, and a techmcal as well as economic appraisal of the projects. The initial submission by budget units should reflect these basic steps. * Investment priorities need to be determined taking into account priority economic programs, multiyear capital and recurrent costs, and available multiyear financing from own and external sources. * An objective system of investment planning should be introduced based on the role of the state, whether the project should be publicly financed or not, and efficient project selection upon cost- benefit analysis of competing choices. * The selection of capital projects should be vetted by the Ministries of Economy and Finance. * Consistent with the above, a multi-year pipeline of projects should be developed and costed out on an annual basis. * To the extent possible, agreement should be reached with the legislature about the magnitude of investment outlays, and the list of projects to be included in the annual budget. In particular, investment projects should be financed from the budget only if they belong to an approved list of sound investments as compiled above, and new investments should be adequately funded for timely completion. (iii) Investment budgeting should be fully integrated into the MTEF and the annual budget process. To that end, the rolling MTEF should be utilized to ensure the affordability of the project pipeline and for the selection of projects to be financed under the annual budget. In tum, the annual budget should indicate for each project the estimated total cost to completion, previous outlays, annual outlays proposed and sources of finance when funded by donors. The domestic component of outlays should be indicated. Where projects have been completed, the maintenance outlays should be indicated. Finally, a complementary reporting should be developed to track the implementation performance. (d) To address the issue of the continuing policy commitments and the fiscal rigidity they contribute to annual policymaking, two measures need to be taken: (i) The Government should undertake, either through its own apparatus or through contractual services, a fundamental review of selected agencies (budget units and autonomous agencies) so that a view could be gained of the policies to be continued, the policies to be modified, and the policies to be abandoned; and 31 (ii) As an integral part of the annual budget process, the budget office should identify areas where economy measures would be appropriate, taking into account the findings of the intemal and extemal audit offices. (e) In submitting the budget to the legislature, it is appropriate that a budget memorandum is prepared containing the following elements: (i) There should be a fiscal policy statement containing the objectives of the budgeting assumptions, changes from the forward budget estimates, and the basis of revenue and expenditure estimates in comparison with similar estimates prepared by intemal financial institutions, regional organizations, and local think tanks. (ii) The document should also identify the specific guarantees to be given and their limits, as well as tax expenditures provided during the previous year, their nature, and first generation impact on revenues. After approval by the legislature, a summary statement indicating the changes made by the legislature, and their impact should be prepared for intemal use and for the information of the community. THE LACK OIF PERFORMANCE (GRUENTATION 2.31 Budgeting in Poland lacks performance orientation. The dominant culture of compliance with law with respect to inputs alone, to the exclusion of performance or delivery aspects, is particularly pernicious. There are at least three sets of issues here. 2.32 Bundget Classication. The budget classification is input-based and does not provide for performance evaluation. Input-based expenditure data that come up from line ministries and other spending units are relied upon mainly to ensure that wages and pension payments are met fully. The existing classification, which is largely inherited from the days of central planning and is common to several Central European countnes and countries of the former Soviet Union (some of them have moved over to a new system that reflects the current international practices), envisages the division of transactions into sections (at the apex level, and therefore approximately equivalent to functions), divisions (administrative or budget units), and chapters (programs), which are then subdivided into items or paragraphs, or standardized objective classifications (such as salaries and wages, purchase of goods and services, etc.). The classification, at the level of chapters, is a mix of programs and organizational units. 2.33 There are two specific issues with respect to budget classification: (a) The current classification illustrates the items on which moneys are spent but does not reveal the purpose or destiny of the funds appropriated. It is necessary that this should be streamlined with the chapters reorganized to provide a link between the objectives of the unit and the purposes of the allocated funds. (b) The budget classification is also uneven across ministries, with some masking the objectives to which the funds will be put rather than enhancing program assessment.'7 2.34 Budget classification could be improved in the following ways: 17 For example, in the Ministry of Education there are three codes: Code 38 for higher education, which is 95 percent of their budget; code 30 is for non-higher education, at 4 percent of the budget; and code 25, physical education and sports, is at I percent of the budget. 32 (a) As an aid to budget transparency, as well as to the assessment of effectiveness of ministry policies and programs, it is useful to develop within each ministry a program classification of spending. Programs are groupings of related activities that support a common objective, and frequently correspond to organizational units within ministries (e.g., within a ministry of health, a program might be food safety, which might include activities such as food inspections, and regulation of food additives, all of which are under the direction of an agency for food safety). (b) Investment projects should be fully integrated into this program classification. This would strengthen the links between policies and investment projects and would facilitate investment planning and management. (c) A start should be made to shift toward perfornance-onented budgets so as to test the potential of making the units responsible for services and accountable for results. 2.35 Inadequate Local Government Incentives for Public Service Delivery. Most public services are rendered at local government levels'8. This requires a detailed and additional depth assessment of the incentive framework within the current arrangements. However, a preliminary look at the examination suggests that the lack of local revenue autonomy and service standards has distorted the incentives for aligning public service systems to local preferences and needs, and for improving local efficiency and accountability. There are three issues requiring attention: (a) Local revenue means do not match their expenditure needs. Financing local expenditures by unconditional transfers enhances autonomy while weakening taxpayer accountability. (b) The monitoring of local govemment service delivery performance is weak and there is no focus on incentives and accountability for results. (c) The use of a common equalization standard for all govemments introduces spatial inequity. For example, the municipal equalization program uses an average of all municipalities (small or large, rural or urban) in calculating the standard. Furthermore, for lack of adequate data, the calculation of the standard is based on collected revenues with minor adjustments for potential revenues. 2.36 With Poland's accession to the EU, the role of local govemments will come into a sharper focus as agents for the speedier integration of the Polish economy with the rest of Europe. Thus, both to serve Polish citizens better and to enhance the international competitiveness of Poland, inter-govemmental fiscal relations need to be strengthened as an aid to better government. Therefore, incentive mechanisms need to be strengthened along the following lines: (a) Local revenue means need to be enhanced to strengthen local accountability. There are several options here that the Govemment should consider. These include the following actions: (i) Eliminate tax sharing for the personal income tax and the corporate income tax. Reduce central tax rates and allow flat supplementary tax rates on a central govemment tax base for personal income to all levels and for corporate income to voivodship only. (ii) As an interim measure, in transition to market value assessments for property taxes, allow property tax rates to vary by tax zone/location. 18 See Annex 1 for a brief description of inter-government fiscal relations. 33 (iii) Expand the base of the tax on motor vehicles to include all personal and commercial vehicles. (iv) Improve agricultural tax to reflect true potential yields. (v) Allow direct payments of grants in-lieu of taxes by central government entities to local governments. (vi) Limit extrabudgetary funds (as discussed earlier). (b) Incentive mechanisms for public service delivery need to be strengthened in the way fiscal transfers are affected. Options for reform here are to reformulate road, education, and health transfers as performance-oriented transfers (see Chapter 3). (i) Criteria for allocation to local governments and secondary distribution to all public and private providers need to be simplified. (ii) Service delivery access and performance measures for the continuation of transfers should be established. (iii) Transparent performance monitoring and client satisfaction surveys can be utilized. (iv) There can also be provisions to deal with performance failures. (c) There is a need to introduce separate fiscal capacity equalization programs for various population sizes and types of local govermments. Further attempts could be made to include all revenue bases in a full tax base equalization. In addition, ceilings and floors could be introduced to avoid large yearly fluctuations in entitlements. 2.37 hmaidequate MFunaimel anlid Pirogiram Maimagenmennt. During budget preparation and execution, little is known about program efficiency. The responsibilities of the budget units during the phase of budget implementation are limited to complying with the budget law and to keep spending on inputs within the approved budget estimates. Previous experience shows that while the budget units have been largely successful in these endeavors, it has been at the cost of program efficiency 2.38 There are three issues that involve internal financial and program management: (a) An effective internal control and audit system has yet to be developed in Poland. In September 2001, an amendment to the Public Finance Law established a Public Internal Financial Control system, which has come into effect from January 1, 2002. However, this is yet to be functionally operational. The Government envisages the development of a cadre of functionally independent internal auditors in each spending unit, reporting simultaneously to the agency head as well as a General Internal Auditor in the Ministry of Finance. The latter will be responsible for the development and harmonization of methodology relating to financial management and internal audit. (b) In canrying out their expenditures, the spending units have very few incentives to secure economies in outlays or procure efficiency. In fact, their only legal requirement is that they spend the moneys appropriated for them. This arises from a lack of operational autonomy, and from little responsibility, legally or otherwise, for the delivery of services. (c) Spending units have limited freedom in shifting (when considered appropriate), budget outlays from one budget category to another. This problem is further exacerbated in the current situation, in that the categorization of chapters and paragraphs may, in some cases, be considered to be too detailed, and therefore to be a limitation for operational efficiency. 34 2.39 The movement toward improvement envisaged in this regard comprise the pursuit of specific objectives in three areas: (a) The development of the intemal audit function needs to be accelerated. It is best to start with basic training in auditng and systems analysis to support the core function of internal audit. Once these audits are operating well, then it might be advisable to add high-order tasks, such as program evaluation or intemal management consulting. The internal auditors, once they are in place after appropriate training, should be required to formulate programs and annual reviews that are in conformity with the areas of economy identified as part of the Fiscal Policy Paper. In due course, links should be established between the internal auditor's work and the annual budget review. Through linkage to the annual budget review, the audit affords a useful tie to resource allocation decisions and policy discussions, as well as monitoring whether internal and extemal audit recommendations are being implemented. (b) It is necessary to review the ways in which the purposes of financial controls may still be achieved without any major erosion of the control now exercised. Should the control emphasize inputs or provide flexibility for provision of services? In this regard, the needs of budget units would be different. While, to some extent, the proposed revision of the classification could provide some additional freedom, it is necessary to review, in consultation with the spending units and the legislature, the extent to which further delegation of financial powers could be made consistent with the needs of accountability, financial reporting, and macroeconomic management. (c) As an integral part of this effort, it is also necessary to review the question of whether the duration of some appropriations should be extended. In the present system, carryover of the unspent amounts is permitted for bnef and specified periods with the approval of the Cabinet and the Public Finance Committee of the legislature. This procedure is adequate and should be continued. However, in regard to the investment outlays, it would be appropriate to review, the feasibility of multi-year appropriations, with the approval of the legislature, in tandem with the implementation of the three-year rolling medium-term expenditure framework. GAPS IN THE ACCOUNTABILITY FRAMEWORK 2.40 The current accountability framework is primarily geared toward compliance with laws and financial probity. This approach relies on the preparation of annual accounts and the publication by the Supreme Audit Institution (SAI) of its investigative reports and an annual report. More emphasis is placed in the Public Fmance Law on the pursuit of violations of fiscal discipline and on the imposition of penalties by the persons appointed to look into the violations than on achieving the Government's objectives in financial management and the delivery of goods and services. 2.41 Financial accountability is a critical foundation of government. Certain elements missing in the present framework are: (a) The annual accounts submitted by the Government (which are consolidated by the MoF and approved by the Cabinet) do not conform to accepted accounting principles. (b) Although the Supreme Audit Institution audits the public accounts, it does not certify them. Having the SAI review records and detect errors is valuable, but it is a technical approach that leaves both the SAI and the users of audit agency reports without a clear basis for assessing the annual accounts. If the audit agency were 35 required to attest or certify that the annual accounts were a fair and accurate representation of the status of public finances, it would have to take a clear stand on that point. This opinion, attached to the annual accounts when sent to Parliament, provides parliamentarians, policymakers, and the general public with a clearer basis for discussion and for taking appropriate action. (c) Poland's SAI has initiated some deeper program and performance reviews, particularly around issues of corruption. These are valuable contributions to strengthening the public finance system and should be continued and expanded. This task would be made easier with the development of budget classifications built around programs and objectives, with output indicators for programs. However, it should be recognized that performance reviews are higher order tasks of some Westem external audit bodies, and do not replace the core functions of external audit bodies. (d) The audit reports are in the public domain but are not consistently taken up or considered by the legislature or by the MoF. While Parliament cannot be required to take up audit reports, members could be encouraged to adopt parliamentary procedures that favor taking up such reports. Moreover, the MoF, in annual budget discussions, should regularly request agencies to report on how they have addressed the findings in the audits, and the MoF should take the audit findings into account when making budget recommendations. Formal Goverrunent or agency responses to audit findings would also be useful. 2.42 Measures to enhance the accountability framework include the following: (a) Efforts need to be made to develop accounting standards for the Government. To this end, an autonomous body comprising members from the corporate and public sectors, as well as from the professional accounts, may be set up. (b) The SAI should be required to certify the public accounts of the Government. (c) The scope of accountability could be expanded to include value for money and performance audits, provided basic audit functions do not suffer, and formal opportunities may be created so that the legislature or its committees can take up the consideration of annual accounts and audit reports. The MoF should incorporate audit findings into its budget recommendations (where the Government concurs), and should follow up with agencies on audit findings. CONCLUSRONS 2.43 Strengthening budget systems would provide better incentives to align resources with policies and performance, would facilitate the process of expenditure restructuring, and would improve budget outcomes. This is at the heart of current problems with achieving aggregate fiscal discipline as well as promoting intersectoral and technical efficiency. The analysis in this report clearly suggests that there are serious deficiencies in the incentive framework for budget management. Indeed, these weaknesses may in large part have contributed to the recent deterioration in the overall fiscal situation as well as the general decline in public service delivery outcomes. 2.44 The lack of progress on the budget management reforms relative to other economy-wide and institutional reforms derives from three sources: (i) the progressive improvement in the overall macroeconomic environment, at least as measured by falling nominal budget deficits (up to 2000) and low inflation, which induced a sense of complacency in both fiscal policy and institutional issues; (ii) the 36 fragmentation of the budget, which-with its attendant variations in the requirements for budgetary and legislative oversight, accounting, and financial reporting-has now created various strong vested interests in maintaining the status quo; and (iii) the weak stimulus for institutional reforms in this area from domestic political institutions. However, there is a growing recognition of the need to address the structural fiscal imbalance, and to seek systemic solutions to these issues. This provides a window of opportunity for the Government to initiate institutional reforms to strengthen budget management. 2.45 The recommendations made in this section would, if implemented, establish transparent and objective rules and procedures for budget planning and formulation, and thereby would limit the scope for ad hoc changes in the budget. They would also help to broaden Government, parliamentary, and public understanding of the aggregate fiscal constraint, the fiscal implications of policy trade-offs, and the benefits that would accrue from shifting the focus from compliance with the budget law to the timely delivery of quality public goods and services. 37 38 3. OPTIONS FOR EXPENDITURE POLICY REFORMS 3.1 Opportunities exist to reform expenditure policies in such a manner as to promote fiscal stability, but also to strengthen the competitiveness of the economy and provide a stronger basis for future growth. Social protection reform affords the best opportunity to reduce expenditure pressures and to provide some budgetary savings over both the short and the medium term. This would also pave the way for reducing the excessive payroll tax, which is a drag on new hiring and job creation in the formal economy. Other sectoral reforms, for example, in health and education, are more likely to be budget neutral in the aggregate, though they have important implications for efficiency and equity as well as for the future competitiveness of Poland in an integrated Europe. Yet structural reforms in agriculture, the environment, and transport offer the greatest potential for accessing EU funds, converging to EU standards, and promoting economic integration. None of these reforms, however, is easy and each would require strong and sustained Government commitment as well as an effective communication strategy to inform citizens about the costs and benefits of various options as well as the policy trade-offs inherent therein. SOCIAL PROTECTION 3.2 A major contributing factor to fiscal pressures in Poland is social protection expenditures. In 2000, these expenditures amounted to 20 percent of GDP, accounting for 5 percent of general government expenditures. While many programs have benefited from past reforms, there is substantial scope for improving them so as to contain rising costs and reduce the fiscal burden, to improve poverty targeting, and promote incentives for work. 3.3 The Polish social protection system is one of the most expensive among OECD countries, undermining Poland's competitiveness. Relatively high replacement rates of benefits and extensive system leakages create disincentives for work. At the same time, high social protection expenditures- partly driven by demographic trends-increase the costs to employers of hiring workers, and undercuts potential job and wage growth. While any deep restructuring of the system would require a careful evaluation of social protection programs, with special emphasis on whether they are actually reaching the poor and needy in Poland's society, this review highlights that there are specific directions in which the Government needs to move urgently in order to reduce the fiscal burden. 3.4 In particular, the review highlights the following factors: (a) The cost of old age pensions needs to be reduced. This would require equalizing pension age for both sexes, raising early retirement age, and limiting possibility of combing work with early retirement. (b) The eligibility criteria for disability pensions need to be tightened. Disability pensions need to be limited to term disability. (c) Social insurance in agriculture needs to be substantially reformed. The Government needs to scale down KRUS and move toward a system that maintains incentives for work and inter-sectoral job mobility, while providing adequate social insurance. 39 (d) Cross inndexation of benesnts shouEd be phansed out. This would ease pressures on the growth of non-discretionary expenditures. THiE TRANSff>ON EXPERIENCE 3.5 Poland, like other countries in Central and Eastern Europe, began the process of transformation from a centrally planned economy to a market economy with a relatively well-developed system of social security. While the newly introduced market rules led to the introduction of new programs to protect workers from new risks (such as passive and active labor market programs), the old programs were not reformed, which led to an excessive use of benefits under these programs. In particular, expenditures on old age and disability pensions increased rapidly. While the growth of social protection expenditures may have helped to ease the social costs in the early years of transition, it has led to the double burden on high fiscal and labor costs, both of which undermine Poland's growth potential. 3.6 Social protection expenditures include expenditures on social insurance programs (such as pensions, and sickness, disability, unemployment, and other benefits) and non-insurance-based social welfare programs (such as social assistance). An analysis of expenditure data reveals several interesting trends (see Table 3.1). First, most of the increase in social protection expenditures took place in the early years of transition. Second, the largest growth areas were old age and disability pensions. The main increase took place in 1991, when the number of new pensioners was fivefold the previous rate. This flow of new pensioners occurred as people took early pensions to avoid unemployment. This increased the stock of pensioners. At the same time, the implementation of pension reforms, especially the introduction of private pension funds, led to an increase in the contribution rate by 7 percentage points. Third, there was a twofold increase in expenditures on social assistance. Fourth, the composition of social protection expenditures remained largely unchanged between 1995 and 2000 (see Figure 3.1). Old age pensions account for 43 percent of these expenditures followed by disability pensions at 24 percent. Various benefit programs (mcluding unemployment benefits) account for 27 percent while social assistance programs account for only 6 percent of social protection expenditures Table 3.1: Social Expemditures in Poland iin 1909 - 2000 (% of GDOP) 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 200D TOTAL 11.5610.80 17.19 19.67 19.69 20.37 19.81 19.28 18.81 18.15 18.11 17.40 Old age pensions (ZUS) 3.06 3.25 5.22 6.18 6.26 6.55 6.48 6.39 6.43 6.40 6.42 6.26 Disability (ZUS) 2.42 2.38 3.21 3.63 3.64 3.82 3.74 3.62 3.62 3.57 3.56 3.3 Id age pensions (KRUS) 0.84 1.04 1.39 1.45 1.47 1.59 1.52 1.44 1.39 1.32 1.26 1.1 Disability (KRUS) 0.36 0.43 0.59 0.67 0.72 0.84 0.85 0.84 0.85 0.83 0.82 0.7 Survivors 1.12 0.58 1.48 1.81 1.85 1.99 1.98 1.98 2.00 1.98 1.99 1.95 Family benefits 2.71 1.90 2.51 2.43 2.04 1.67 1.43 1.34 1.30 1.28 1.20 1.23 Sickness benefit, occupational ijury and disease 0.67 0.12 0.29 0.40 0.53 0.67 0.61 0.70 0.74 0.85 0.78 0.5 Unemployment 0.64 1.60 1.87 1.92 1.96 2.05 1.93 1.44 0.91 0.94 1.0 ocial Assistance 0.25 0.36 0.81 1.16 1.17 1.18 1.08 1.05 1.04 1.03 1.13 1.06 Source: The World Bank, SCT Social Expenditure Statistics in the Transition Countries - POLAND 40 Figure 3.1: Composition of Social Protection Expenditures, 1995 and 2000 to08 1995 1.06 1 06 2000 a Old age pensions (ZUS+KRUS) i;2 05 0 7 43 0 Disability (ZUS+KRUS) 0 61 1.~~23 4 OSurvivors 8 00 98\ | 13 Famly benefits \,, ij/ 1.95 u - \ ! 1 DSickness benefit, occupationalinjury 1 9 8 v v v and disease Unemployment 4 5 9 4 15 ESocial Assistance Source: MoF, and World Bank Staff estimates. 3.7 Contributions. Both the employer and the Table 3.2: Social Security Contributions employee pay social security contributions. For old age in selected OECD countries as a and disability pensions, the contributions are divided equally between the employer and the employee at percentageofgrosswages. 16.25 percent. The employee pays sickness Contribution contributions, while the employer pays work injury US 14 contributions. From the total contributions, 12.22 percent is transferred to the notionally defined Ireland, UK 16 contribution (NDC) and pay-as-you-go (PAYG) Spain 28 pension systems and 7.30 percent to open pension Sweden 30 funds. When labor fund contributions (2.45 percent) Gernany 34 and workers social benefit fund contributions (0.08 Czech Republic 35 percent) are added, then the payroll tax in Poland Slovak Republic 37 equals 39 percent, one of the highest percentages in the Hungary 38 region and therefore increase the costs of labor (see Netherlands 39 Figure 3.2 and Table 3.2). Poland 39 Source: OECD 2001 3.8 Cross Indexation of Benefits. The indexation mechanism in Poland is defined by Figure 3.2: Social Security Contributions law, which states that pension indexation cannot Dividing Risks as levied on gross pay be lower than 20 percent of the expected real wage growth. This formula applies to all types of pensions (old age, disability, and also farmers 2.45%1.62% pensions). Although the Govermment recently put forward a proposal to change the indexation 12.22% formula from ex ante to ex post, many benefits 19. are cross-indexed which means that any increase 13.00% 7.30% of the minimum wage (which is the base for many other social benefits) automatically leads to an increase in other social expenditures. This increases the burden of non-discretionary |DDeablilty SlIckne:s s Work InJury expenditures on the budget. The phasing out of cross-indexation would ease this growth of non- Source: Government discretionary expenditures. 41 3.9 Demographic Challenges. Although Poland's population size is not expected to change drastically over the comng decades, its age profile will change substantially, as Poland's fertility remains low and life expectancy continues to increase. These demographic trends will have pronounced effects on pension-related expenditures. The pension reform initiated by the Government in 1999 will allow Poland to save on its expenditures on old age pensions over the next few decades (see Table 3.3). However, the system of disability pensions and survivor benefits remained basically untouched for the last few years and as a consequence expenditures on these programs are expected to rise from an already excessive 4.9 percent of GDP for 2000 to over 7.5 percent in Table 3.3: Demographic Dmpact on Pension Expenditures 2050. This has the consequence that once old % of GDP 200( 201dJ202dJ203d204c 205M age pension expenditures stabilize at around 9 Pension Expenditures 10.9 9.7 9.9 9.6 9.2 9.71 percent of GDP after 2040; total expenditures on Old age 6.0 5.3 4.5 3.1 2.1 2.1 pensions will start to increase again because of Disability and survivor 4.9 4.4 5.5 6.5 7.1 7.6 claims on benefits through the disability and Soure- Chlon-Dorninczak, A. survivor pension programs. 1KEY JSSUES AND REFORM PTIMONS Old Age Peznsion$ 3.10 The old age pension system was substantially reformed in 1999 with the switch from the PAYG system to a multi-pillar system. Those under the age of 50 at the time of the reforms were covered by the new system, while those older then 50 were covered by the old one. The old system is based on a defined benefit principle, with generous entitlements. The average actual retirement age is very low, at 54 for women and 59 for men, while the regular retirement age is 60 and 65, respectively. The reformed part consists of two defined contribution pillars, of which the first is based on a notionally defined contribution (NDC) principle, while the second is funded and managed by private pension funds. 3.11 The implementation of the new pension system, however, has not proceeded as originally planned. Implementation problems with the identification of participants, and as such the inability to assign individual contributions to contributors, have harmed the credibility of the much needed and otherwise well-designed reforms. In addition, and partly instigated by the identification issues mentioned, the Government has delayed transferring funds to ZUS to be passed on to the privately managed pension funds on several occasions. This has resulted in a cumulative debt by the Government to these pension funds of PLN7 billion or 0.9 percent of GDP as of today. Although, the act on the social security system of 1999 clearly identifies procedures in such cases, including penalty interest to be paid by the Government, it disrupts the functioning of the new system, harms the credibility of the reform effort, and creates an unnecessary additional cost to the budget in the forrn of penalty interest. 3.12 While the PAYG system provided generous security, it also placed a heavy burden on public expenditures. Along with the demographic changes, this necessitated the pension reforms. Public expenditures on old age pensions increased from 3 percent of GDP in 1989 to 6.5 percent in 1995 while the average pension increased from an already high level of 60 percent of the average income in the late 1980s to about 70-80 percent in the 1990s. However, reforms have also brought their own budgetary cost, as the implicit cost of the unfunded system was made explicit. Part of the social security revenues- about 1.5 percent of GDP annually - was transferred to finance the second pillar. The costs of the multi- pillar system were accompanied by modifications to the CPI pension indexation rule, which led to a decrease in the replacement rate, as well as a decrease in the pension expenditure ratio to GDP (from 68.3 percent in 1996 to 61.8 percent in 2001). 3.13 Notwithstanding these changes, there are several key issues in the current system, including the following: 42 (a) The low retirement age under the old part of the system is one of the main causes of the high public spending. The actual average retirement age is much lower than that in most OECD countries. The low actual retirement age also leads to discriminatory gender practices, as women retire early. (b) The perverse incentives for combining work with early retirement leads to higher public spending. Under the non-reformed old age pension scheme, early retirement is subsidized. This would not be an issue if the early retirement'9 pensions were actuarially fair and reflected actual contributions. Given the subsidy for early retirement in the non- reformed notional defined benefit system (NDB), this creates perverse incentives to take early retirement. Even though limitations in additional earnings were introduced, in practice this arrangement continues to encourage earlier retirement with simultaneous retention of work. Earlier retirement implies an increase of public expenditure for old age pensions with a simultaneous reduction of receipts from contributions. (c) Different retirement ages for men and women in the NDC system implies significant pension differentiation. Though the first pension under the new system will be paid out in 2009 for women and in 2014 for men, different retirement ages would result in lower pensions for women, since they contribute for shorter periods and receive benefits for longer periods. (d) Weak follow through with regard to the implementation of the pension reforms initiated in 1999. The delay with the implementation of the information technology component of the reform has hindered the overall implementation of the multi-pillar pension reform. It has indirectly also led to a delay of passing on by the Government of their contribution to the second pillar. 3.14 Recommendations. To improve the financial viability of the pension system and to reduce its costs to the budget and society, key recommendations are as follows: (a) Unify the retirement age for both sexes. This would eliminate the existing gender bias. (b) Raise the early retirement age for both sexes. This could be done by half a year every year or by one year every second year until it reaches the normal retirement age. This approach has been adopted, for example, in the Czech Republic and in Lithuania. Approximate savings could be about 0.4 percent of GDP annually. (c) Tighten benefit payments. The payment of benefits should be suspended when the individual takes up work upon earlier retirement. (d) Speed up the information technology component of the pension reform. This should make possible the full identification of individual accounts, should facilitate timely transfers to the open pension funds (OFE), and should improve the credibility of the reform program. (e) Transfer back payments of the Government's contribution to the second pillar to OFE. For the new pension system to be fully credible and operational, the Govemment itself should be seen as supporting its operations and therefore should transfer its part of the second pillar contributions without further delay. 19 Earnings in excess of 70 percent of the average wage and lower than 130 percent caused a proportional lowering of the old age pension, while earnings in excess of the 130 percent threshold resulted m the suspension of payment of the old age benefit. 43 IDISABLITeY PENSIONS 3.15 The disability pension system for employees is of a social insurance type. It is a defined benefit system with the same formula as that for old age pensions but with a 30 percent reduction. The amount of disability pensions as a share of GDP is very high in comparison with other countries in transition, as well as OECD countries (see Figure 3.3). At the same time, the number of disability pensioners is also very high.20 The main cause of extremely high expenditures on disability pensions is the stock of disabled, which arose from the use of extremely liberal criteria for granting disabilities in early 1990s. The law on disability pensions was amended in 1997, limiting the possibility of permanent disability pensions (which were granted until this time) and tightening the eligibility criteria. The Government recently introduced new eligibility rules which have resulted in a drop in the inflow of disability pensions for the first time in years. However, the existing beneficiaries were not reviewed. Figure 3.3: Disability Cash Benefits as a Percentage oF GDIP 4.5 - 3 98 4- 3.5- 3 2.81 2.5 -2.39 2 ~~~~~~~~~~~~1 81 1 87 1.95 1.9721 1 32 13416-- 1.5 1 04 0991087- 3550~~~~ 74 032 0 50 i 0.5 0.1 0 -~~oc - ) DC 0 - - L CD C Z -U 0 CD CD !P~~~ ~ ~~. CD CD V3 N (D 0 C 0 0 CD = a CD z. 8 = 8 3 3 iX D a g z O. C. _. an C C cD a) Ca CD C CDC ii C, C ~~~~~~~~~~~~~~~~mCD 0 W 0~~~~~~~~~~~~ ~~~~~~ o C, cn Source: OECD 2001 3.16 Recommendations. The key recommendation is: o Limit disabliAty benefits to term disabiity. Only term disability pensions should be provided. That would mean the re-examination of all persons with certified permanent disability, starting from the youngest, as for example; it was done in the Netherlands. To give a sense of the magnitude of possible savings - every 10 percent decline of the stock would 20 The dimensions of disability in Poland are greater than in most other countries, even when taking into account the differences in definition (e.g., where disability pensioners are treated as retirees). It should be noted that the presented figures exclude disability pensions paid out through KRUS, which amount to an additional I percent of GDP. 44 result in 0.34 percent of GDP decline in spending. In the Netherlands, when similar measure were implemented for beneficiaries younger than 40, the stock decline by almost 30 percent. OLD AGE AND DISABILITY SYSTEM FOR FARMERS (KRUS) 3.17 Poland is the only transition country with a separate system of social insurance for farmers. A charactenstic feature of the Polish system of farmers' social insurance is that benefits paid out by KRUS are almost entirely financed through a state budgetary subsidy. Only a small component, the "Contribution Fund," is fully paid from contributions by insured farmers. Most of the benefits under KRUS are for old age pensions and for farmers' disability (see Figure 3.4).2I It is for those two programs that the state subsidy is given. Figure 3.4: Farmers' Pension Expenditures, 1990 - 2001 (% GDP) 3 2.5 2 1 IS 1991 1992 1993 1994 1995 19 1997 1998 1999 2XW 2901 a farmers old-age Ofarmers disabilh! Ofarmiers survvor l Source: KRUS. 3.18 There are four key issues with respect to the old age and disability pension system for farmers: (a) The large number of small farms and the low rural incomes limit the potential for higher contributions. According to the 1996 General Agricultural Census, about two- thirds of the rural population lives on individual farms, of which over 50 percent are smaller than 5 ha. Incomes from these small farms are so low that it is difficult to generate contribution rates similar to those paid by self-employed persons in urban areas. Out of roughly 1.6 million contributors to KRUS, only about 100,000 are in farms with 1- 2 ha. Approximately 3.9 percent of their cash income goes toward KRUS premium. (Those in farms under I ha are already ineligible for KRUS.) (b) Large farmers pay relatively less. Large farmers who have higher incomes pay the same low contributions as other farmers and are not obliged to pay personal income tax. About 350,000 are on farms of more than 15 ha. The share of cash income which these contributors pay to meet the KRUS premium is only 3.4 percent. Clearly, those farmers with over 15 ha have sufficient capacity to pay the minimum ZUS premium, which would be about an additional 10 percent of cash income. (Farms with hired labor already 21 This system was planned in 1978 as a system that would also support agricultural production and curb further diversification of farms. The definition of the KRUS system includes subsidies from the state budget. All the farmers pay an equal contnbution at 30 percent of the lowest old age pension in the employee system. The contribution is not dependent on the area of a farm or the sales volume. Regular retirement age is 60/65 (F/M), but there are early retirement provisions that could be chosen by men at the age of 60 and women at 55 if they had been covered by social insurance for 120 quarters and had discontinued farming activity. The insured person has the right to receive a permanent disability pension when he/she is irreversibly incapable of working on a farm, even though he/she would be able to take up other wage-earning work. The number of pensioners is about 2 million people. 45 pay these ZUS premia for their workers.) The lack of records on farm incomes also makes it difficult to assess which farmers can afford to pay a contribution. (c) The system of social insurance of farmers has features that are closer to the socnal assistance system than to the socal insurance system. Such a structure is appropriate for farmers and their families who in no way would be able to save for future old age pensions. However, it is not appropriate for persons who would be able to save. The generalized subsidy to the rural population imposes a serious fiscal cost. Moreover, the more attractive benefit-cost ratios of the farmers' old age and disability pensions encourage farners to remain in farming. (d) There are other system features that distort incenutves in the agricuRtural sector. For example, the linking of eligibility for KRUS benefits to agricultural land holdings discourages rural dwellers from looking for off-farm employment opportunities, distorts the proper functioning of the agricultural land market, and discourages land consolidation. This can only undermine agncultural reform, and perpetuate rural unemployment and poverty. 3.19 Recommendatioms. The reforming of KRUS is an imperative, but one which has to be devised and implemented carefully. A starting point must be the changing of the whole philosophy of social insurance for people employed in agriculture. Some of the key measures that would support this are the following: (a) Phase in imcome taxes im agricuRture. The key starting point for a new philosophy of social insurance for people employed in agriculture would be introduction of income tax for those working in agriculture. This would permit the division of farmers into those who cannot afford to pay taxes and those who should be treated the same way as self- employed. (b) Refoorm the ]KRUTS system. The switch of large farmers from the KRUS system to the ZUS system would increase contributions to the two systems jointly by roughly PLN750 million annually. A similar, but grandfathered, phase-out of contributors in farms of 1-2 ha would save the two systems about PLN200 million annually. It is reasonable to exclude this group from KRUS, as less than 10 percent of the income of these families is actually from farming. For farmers who would continue under KRUS (those on farms of 2-15 ha), the premiums should be raised to increase the cost coverage from the current 10 percent to at least 15 percent (as was the target originally set when KRUS was established). As about 450,000 curTent contributors would be moved out of KRUS, the remaining 1.15 million would see an increase of about 100 percent in their KRUS contributions (or about PLN600 per year each) to reach the 15 percent coverage level. SCIIAL ASI sTANcE 3.20 Social assistance provides assistance based on income and functional cnteria.22 The income category established that the income per person could not be higher than 90 percent of the minimum old age pension. The functional criterion defined the circumstances that should be taken into account when allocating social assistance benefits. There is no minimum guaranteed income principle. In the initial period, the implementation of social assistance reforms was not fully consistent. Fragmentary solutions were implemented, which were not always cohesive. The role of temporary benefits clearly increased-- from less than 20 percent of all expenditures in 1990-91 to nearly 50 percent in 1993-with the raising of the income threshold and loosening of the benefit criteria. 22 Linking the two criteria--income and functional--serves to counteract the exclusiveness of the income criterion. 46 3.21 The Polish social assistance system is extremely complex. Evidence from household surveys supports the fact that targeting also needs to be improved (see Figure 3.5). Even though the bulk of benefits are received by the poorest consumption decile, richer deciles receive family benefits. Takhng the second decile as a poverty line, benefits that are received by the higher deciles can treated as indicative of incorrect targeting. This can also be seen particularly with respect to housing allowances. Other programs, such as temporary assistance, are relatively well targeted. Figure 3.5: Distribution of Social Benefits by Consumption Deciles 1.00- 0.90 - 0.80 - 0.70- 0 60 _ 2 3 4 5 ____________ __ _ __ 1 *AIimonyfrom AllmonyFund 0 04 0 01 00o1 000 001 0 00 0 00 0 00 0 00 0 00 0 03 EDOtherS Abenefit 0 02 0 01 0 00 0 00 0 00 0 00 0 00 0 00 0 00 0.00 0.01 *S Abenefntforpregnant womenf o 000 O 000 000 0.00 O000 O 000 O 000 O 000 O 000 O 000 O 000 gTemporaryS A benefit 0.03 00o1 00o1 00 000 0o .00 00 0.0 000 o 000 001 *Permanent S Abenefnt 006 0 02 0 01 0 011 0 01 0.00 0 01 0 00 0 00 0 00 0 05 EDHousing allowance 0 03 0 02 0.02 0.01 0 01 0 01 0 00 0 00 0 00 0 00 0 06 Child ralsiig benefit 0 02 0 01 0 01 0 01 0 01 0 01 0 00 0.00 0 o O00 000 005 0Nurslng allowance 0 02 0 01 0 01 0 01 0 01 0 01 0 01 0.00 0 00 0 01 0 05 *§Family allowance 0 08 0 07 0 05 0 05 0 04 0 03 0 03 0 02 0.01 0 01 0 24 0Farmerdisablliypeflslon 0 iS 0 06 0 04 0 03 0 03 0.02 0 01 0 02 0.01 0 01 017 QFarnmerold age penslon 0 45 01lO 007 006 0 04 0 02 0 02 0 02 0 01 002 0 28 Source: Household Budget Survey, 2000; Bank Staff calculations 47 3.22 Recommendation. The two key recommendations are the following: (a) Ratfionalize the social assistance progrram. As a priority, the Government should redesign the entire social assistance with a view to limiting or concentrating the currently large number of programs. It would make the system transparent and simple. (b) ll mprove targedng. Along with the implementation of the above recommendation, the targeting effectiveness of family allowances and housing allowances should be improved. Eligibility for these allowances should be limited to lower income households, which are the true target group of such assistance. ACTIvE LABOR MARKET IP'ROGIRAMS 3.23 Labor market programs are considered by many to be the first line of defense against unemployment. These programs include retraining; public works; intervention programs; graduate programs; loans; special programs; and employment services. In 2001, the country spent over 1 percent of GDP on these programs, reaching out to over 1 million people (see Table 3.4). However, most of these expenditures were on account of passive labor market programs. Table 3.4: Labor IFund Expendftures on Labor Ma5rket Progranims, 1996-2002 1996 1997 199$ 1999 2000 2001 2002p Total expenditure (PLN million) 7,418 6,778 5,011 5,776 6,922 8,343 10,046 Passive Programs (%) 86.0 76.7 60.0 67.0 71.0 76.0 74.8 Unemployment benefits 86.0 70.3 46.3 47.0 40.3 35.0 33.0 Pre-retirement benefits and 0.0 6.4 13.7 20.0 30.8 41.0 41.8 allowances ActivePrograns(%) 13.1 21.7 31.5 25.3 28.1 9.7 11.0 Training 1.2 1.7 2.2 1.8 0.2 0.5 1.3 Intervention Works 3.7 4.7 7.1 4.7 2.7 1.3 1.0 Public Works 2.1 6.2 6.7 3.6 0.9 1.2 0.4 Graduate Programs 1.7 2.5 4.9 5.1 1.6 2.0 2.0 Loans 1.1 2.6 4.3 4.0 6.6 0.8 2.6 Youth Programs 3.1 4.0 6.3 5.5 2.9 4.1 3.5 Other Active Programs 0.2 0.1 0.2 0.6 1.5 0.6 0.2 Other expenditure (%) 0.8 1.7 8.4 7.7 12.6 14.0 14.2 Sources: National Labor Office, and Ministry of Finance (draft budget law) and World Bank staff estimates. 3.24 The key issues are the following: (a) The level of expemditures. While this level of spending is comparable to those of other countries in the region,23 the increase in unemployment has renewed the debate about these programs. While labor market programs can make a difference to facilitating the transition out of unemployment, especially for people most likely to be caught in unemployment traps (less-skilled workers, youth, the disabled, and people in high unemployment areas) there is a fine line between providing income support and discouraging job search. The effectiveness of labor market programs should be 23 Data for the late 1990s indicate that Poland's level of spending on labor market programs as a share of GDP is slightly lower than the EU average (1.2 percent), comparable to Hungary (1.1 percent), and higher than the average for the OECD countrnes (0.8 percent). Furthermore, the level of spending is much higher than the spending levels in the Czech Republic (0.37 percent) and Estonia (0.2 percent). 48 measured, therefore, against their ability to reach a balance between providing a safety net and at the same time facilitating the transition back to employment. (b) The effectiveness of expenditures. Under the oversight of the National Labor Office, the effectiveness of active labor market programs is measured against two indicators: the unit cost of the program per participant and the percentage of participants finding a job after the program (see Tables 3.5 and 3.6). The figures suggest that training was the most effective program, with declinig unit costs and more than 40 percent of participants finding a job after participation in the program. Intervention works and graduate programs came next, with high rates of after program job placement and declining unit costs, albeit from a slightly higher level. These three programs compare favorably with public works, which had higher unit costs and much lower after program job placement rates. (c) The financing of active labor market programs. Active labor market programs are currently financed from payroll contributions to the Labor Fund. This contributes to the high taxes on labor and also unnecessarily squeezes the active labor market programs during an economic downturn when passive labor market payouts are higher and contributions are less. Table 3.5: Effectiveness of Selected ALMPs, 1996-2001 _1996 1997 1998 1999 2000 2001 Unit % Unit % Unit % Unit % Unit % Unit % Costs Finding Costs Finding Costs Finding Costs Finding Costs Finding Costs Finding PLN Job PLN Job PLN Job PLN Job PLN Job PLN Job Tramiing 1,076 55.5 825 49.0 780 51.8 768 50.6 776 49.1 1,116 44.5 Intervention Works 1,982 50.6 1,822 56.8 2,366 64.1 1,624 65.1 1,171 66.4 2,371 67.8 Public Works 1,436 8.2 2,764 7.1 3,153 11.8 2,746 13.2 2,601 14.2 3,403 13.3 Fraduate Programs 4,519 0.0 1,252 68.9 1,750 72.7 1,748 57.1 1,919 50.7 2,494 49.7 Source: National Labor Office Table 3.6: Selected Labor Programs: Maximum Reimbursement Rates' Reimboursement Reimbursements Program Amount (PLN)2 (% of minimum wage) Intervention programs 527 75.0 Public works 1,653 236.0 Graduate programs 527 75.0 1/ One month of full-time work. 2/lncludes salary and social insurance contributions Source: National Labor Office 3.25 The above indicators provide some measure of the cost effectiveness of the programs, but they are unable to capture either deadweight losses or substitution effects. Independent evaluations of Polish labor market programs indicate that, even when deadweight losses are accounted for, the ranking of labor market programs is not very different from the ranking that results from the analysis of the two indicators provided by the National Labor Office, although there are some important qualifications. For example, 49 earlier research using quasi-expenmental methods24 indicates that intervention programs (26 percent increase in the probability of ever findmg a normal job), loans for the self-employed (29 percent), and retraining (12 percent) are the most effective programs for raising the participants' chances of getting into a regular job. The same however cannot be said for employment services, which had no measurable impact, and public works, which showed a negative impact on participants' future employment 25 opportunities. 3.26 Recommedzations. Three measures for improvement are the following: (a) Contract out the deDlvery of sacdve Dlbor market programs. This should allow decentralization to proceed without sacrificing economies of scale in the delivery of labor market programs, since one provider can meet the needs of more than one powiat. (b) Add lre-employmenit bonuses. The experience in some OECD countries26 indicates that combining job search assistance with re-employment bonuses significantly reduces the average duration of unemployment. One way of implementing this recommendation is to allow unemployment benefit recipients who find a job within the first six months of unemployment to keep a share of what they were entitled to receive during this period. (c) Separate sources of fubnding. Defining separate sources of funding for active and passive labor market programs would reduce competition between programs, especially during periods of rising unemployment. The proposed option is that passive labor market programs continue to be funded by the payroll tax, albeit at a lower rate, while active programs receive funding from general revenues. SiCKNESS IBENEFITS 3.27 In Poland, sickness benefits for the first 32 days are paid by employers, and after that from social Figuire 3.6: Sickmess IBeneilts security. Sickness benefits are equivalent to 80 percent Xupeunture in % of GDI? of salary for up to 90 days and then are 100 percent. oo Benefits can be topped up in collective agreements 075 /0 between employers and employees, and 100 percent of 071 the benefit level is applied when sickness is work related or due to pregnancy. 6064 0.6 3.28 In the 1990s, the number of sickness days rose a55 steadily (see Table 3.7), imposing nsing fiscal and 05 9 economic costs. This led to the adoption of a law in 044 1999 that introduced control over doctors and a system 045 for monitoring sick pay prescriptions. Notwithstanding 04 o. I 19 m some reduction in expenditures-- about 0.3 percent of Souim: 199 p1C 0 GDP-- the number of sick days is still above the OECD ___ average, and benefits (especially long-term benefits) are relatively generous in comparison with most of the OECD countries. 24 The quasi-experimental method consists of assessmg the irnpact of the program on employment and earnings by comparing active labor market program participants with the most similar person from the unemployment register of the same labor office who did not participate in one of these programs. See O'Leary (1998) 25 It reduced the chances of ever getting into a normal job ever by 5 percent and by 8 percent during the observed ,eriod. 26 Japan, Korea, and the United States. 50 3.29 What is important to emphasize is that countries that offer 100 percent replacement rate for the fiTst weeks of sickness apply a so-called "waiting pernod" mechanism, which means that the sick person does not receive benefits for the first few days of sickness. This measure was recently implemented; however it only affects those who are sick for fewer than five days. However, this could also perversely encourage doctors to prescribe more than five days of sick leave. Table 3.7: Number of Sick Leave Days AnnuaUy, 1970-2001 1970 1975 1980 1985 1990 1995 1997 1998 1999 2000 2001 Sick leave 1,038 1,465 2,270 2,415 2,445 2,153 2,302 2525 2,287 1,686 1,551 (number of days in 47 29 67 63 44 83 16 94 93 19 85 thousands) Sick leaves per 1 insured 9.4 11.0 16.2 17.2 17.3 16.7 17.6 19.9 17.6 12.8 12.0 Source. ZUS. 3.30 Recommendations: (a) Lower the replacement rate. For short-term sickness, the replacement rate should be lowered from the current 80 percent to 70 percent; benefits need to be calculated on the basis of the remuneration of the last 12 months, and not 6 months, as is the case now. For long-term sickness, the 100 percent benefit should be reduced to a level even lower than the short-term rate, in line with international practice. (b) Expand waiting period beyond 5 days of sickness. Firstly, it would prevent perverse behavior to prescribe longer sick leaves and secondly could further rationalize the system. SUPPORTING WORK OF DISABLED 3.31 There are two main programs designed to encourage the employment Box 3.1: The National Fund for the Rehabilitation of of people with disabilities: the quota- Disabled Persons (PFRON) levy system and Supported Work Establishments (SWEs). Quotas levied The National Fund for the Rehabilitation of Disabled Persons from enterprises with a work force of (PFRON) is an extrabudgetary fand intended to support the from nterriseswitha wor fore of employmnent and rehabilitation of people with disabilities. The less than 6 percent of disabled persons main functions of PFRON are assistance in the fmiancing of: give revenues for a special employing disabled persons, various rehabilitation programs, extrabudgetary fund (PFRON) to assist and other subsidies and investments of projects having to do the employment of disabled people (see with disabled people. PFRON is financed directly from Box 3.1). payments made by enterpnses. Some of the payments are levies paid under the quota-levy system by enterprises that do not 3.32 The former system of sheltered employ at least 6 present workers with disabilities. Supported workshop cooperatives was transformed Work Establishments (SWEs' make other payments (to) PFRON (starting in 1991) into a mixture of instead of paying certain taxes to the national Treasury. SWEs cooperatives and pnvate sector are subject to mnany tax relieves, of which VAT exemptions are Work the most important (SWEs do not pay VAT up to the limnit businesses called Supported WES (threefold salary times number of disabled), and above this limit Establishments (SWEs). S - the equivalent of VAT is sent to PFRON. The social security employ 40 percent or more workers with contribution is financed by PFRON and by the state. Currently, disabilities, of which 10 percent are there are about 4,000 SWEs. 27 These businesses are sometimes called Protected Workplace Enterprises or Sheltered Workshops. PFRON seems to prefer Supported Work Establishments, and that is the term used here. 51 required to be severely disabled. Employers with over 25 employees must pay a penalty to PFRON if less than 6 percent of their workforce is disabled. The penalty for failing to meet the quota is equal to one half of one average wage for each employee with disabilities. The VAT exemption surplus is another source of revenue originating in the SWEs. SWEs do not pay the VAT to the central government; instead, they keep an amount equal to three times the lowest remuneration for each full time disabled employee. The difference between this amount and the remaining VAT total is paid to PFRON. 3.33 The key issues here are as follows: (a) The current system mnakes At impossible to track the flow of funnds. Even Govemment authonties cannot determne exactly the cost to the budget of the tax diversion. Further, the amount of the revenue generated through the quota-levy and tax exemption system is independent of the actual needs of disability programs. (b) A wage subsidy may be an appropriate way to Devel the pDaying field for workers whose disabiDlties reduce their productivity as compared with workers without disagbildtes. Yet, the argument in favor of a wage subsidy extends only to making up the productivity differential, not to reimbursing the entire wage of the worker with disabilities. The particular wage subsidy seems to have been designed in a way that encourages SWEs to hire the minimally disabled minimum wage workers. This does not serve well the objective of "mainstreaming" the hiring of workers with disabilities. (c) The current quota system provides a disincentive to hiring. Most of the employers with more then 20 workers do not achieve the 6 percent quota, with a majority not employing any workers with disabilities. Employers consider the levy to be another wage tax that adds another 3 percent to the cost of labor. Tgable 3.8: Cost of Support of Disabled, 1997-99 (% of GDIF3 1997 1998 1999 Costs of PFRON' 0.96 0.90 0.82 Loss of budgetary revenues to SWE2 0.31 0.29 0.28 1/ Total of tax relieves (includmg local taxes), direct and indirect support to SWEs, deduction from PFRON levies by other firms; R/ Total of tax relieves (VAT, CIT, PIT Source: IMF 3.34 Recommendations. Measures to address the issues with disability are the following: (a) Ensunre that aDD funds pass thDroungh the budget. This would mean that SWEs pay the corporate profits tax, VAT, and other taxes exactly like other profit-making enterprises. Expenditures of public funds to encourage the employment of workers with disabilities would then be appropriated as part of the normal budget process. (b) Phase out the quota - nevy system. The quota-levy system still exists in over half of the EU countries, but other countries are moving away from it. The United Kingdom abandoned its quota system and the Netherlands gave up on a planned system. Ireland and Belgium have limited their system to the public sector. Countries in Europe and North America rely more on anti-discrimination legislation. An alternative to the use of quotas would be the development of a policy of reward rather than punishment. (c) Replace 1I"IFRON with direet approprinatons to local governmmemts. Powiats and voivodships would receive direct appropriations for disability programs (perhaps together with a strengthened Office of the Plenipotentiary for Persons with Disabilities). 52 CONCLUSIONS 3.35 Social protection expenditures have become a significant fiscal burden and a source of disincentives for work. While the government undertook many attempts to reform this area, fundamental reform occurred only in the old age pension system. There is an urgent need to continue reforms in social protection, especially in the field of farmers' pensions, disability pensions, and the system of protecting work for the disabled. By lowering the ratio of social protection expenditures, the fiscal space can be created for investment expenditure, required for EU accession. It would be important as well to lower the high payroll taxes, which would help reduce labor costs in Poland and promote job creation and growth. HEALTH INTRODUCTION 3.36 Various reforms in the health sector dunng the 1990s have sought to protect and improve the health status of Polish citizens. However, substantial scope for further reforms remains aimed at preventing excessive growth in demand and costs, encouraging more efficient use of resources, improving equity of access, and making the financing of the sector more sustainable. This section analyzes the structure and trends in health sector expenditures and then identifies key reform issues and options. The main areas recommended for further consideration by the Polish Government are the following: (a) Improve hospital financial management. Measures under this recommendation would require shifting to a system of reimbursing hospitals in a way that ensures a direct linkage between compensation and services provided to the patient; introducing case-mix payment systems for payments to hospitals; and containing hospital debts by imposing hard-budget constraints; and strengthening incentives for hospital consolidation. (b) Strengthen equity of access. While substantial improvements have been made in recent years, additional measures in this area should target the elimination of informal payments which hurt the poor more than others; and the reform of the system of fiscal transfers to link resources explicitly with population needs and health care utilization. (c) Strengthen the financing of health care. The primary measure in this area is to address the inefficiencies in the collection and redistribution of premiums so as to improve allocations among health funds. This may no longer remain an issue if current Government proposals to merge the sickness funds into a National Health Fund are adopted. Consideration should also be given to developing the legal and regulatory framework for supplemental health care insurance, as in many other OECD countries. (d) Prepare for demographically related shifts in the composition of- health expenditures. Poland's rapidly aging population will place increasing pressure on old age care and age related health expenditures. Taking into account the demographic structure of Poland over the next 50 years and its current overall level of health and old age care expenditures, expenditures in these areas should be expected to increase in the order of 2-2.5 percent of GDP. HEALTH STATUS 3.37 The health status of the people of Poland compares favorably with the health status of the people of several EU accession countries, though not as favorably with the health status of the people of countries belonging to the EU (see Table 3.9). Standardized death rates - 993.4 per 100,000, all causes - are toward the lower range for the EU accession countries, but about 50 percent higher than the EU 53 average. Life expectancy in Poland of 73.4 years is within the range of life expectancy in the accession countries, but lower than the life expectancy in EU countries. The infant mortality rate in Poland of 8.9 per 100,000 also compares well with most accession countries but is higher than the EU average of 5.2. The incidence of tuberculosis at 31.5 per 100,000 is below the median for the accession countries but more than double the EU average of 12.3. Table 3.9: Ilealtlin Status lEndicators-Polaimd Conmpanred with Other Countries Standardized Death Life TB Incidence Rates, per 100,000, all Expectancy Infant Mortality per 100,000 AIDS per causes (2000) Rate (1999) (1999) 100,000 (2001) Slovenia 832.7 75.8 4.6 21.4 0.35 Hungary 1192.6 70.8 8.4 35.1 0.27 Czech Republic 911.0 74.9 4.6 15.6 0.13 Estonia 1095.1 71.0 9 5 50.8 0.21 Slovak Republic 1057.8 72.1 8.6 20.4 0.07 Poland 993.4 73.4 8.9 31.5 0.26 Latvia 1150.9 70.2 11.3 77.7 0.98 Lithuania 980.0 72.4 8.7 75.7 0.19 Bulgaria 1134.9 71.5 14.6 42.9 0.19 Romania 1160.9 70.6 186 116.2 2.49 EU ave. (1997) 690.12 78.1 5.2 123 2.27 Sources: WHO, Health for All Database, 2001; Country data are for the year 1999, while the EU average is for the year 1997. The HIV-AIDS data are for the year 2001. EXPENDITURES ON HIEALTH CARE EN PIOLAND,9 2996&20022 3.38 Poland spent 6.4 percent of GDP on health in 2001, of which about 70 percent were public expenditures. These expenditures have remained more or less steady over the period 1997-2001. Compared with other European countries, Poland spends a moderate amount of GDP on health (see Figure 3.7). 3.39 Public expenditures on health care comprise expenditures by Sickness Funds (from 1999 onward), and state and local government budgetary allocations. Expenditures incurred over and above the budgetary allocations and collections of Sickness Funds remain uncovered and are deemed financed by "debts" in the public domain.29 Private expenditures on health care comprise direct out-of-pocket payments on health care. 3.40 Total expenditures on health care in Poland (in real 2001 prices) increased from an average of 40 million zlotys per year in 1996-97 to an average of 45 million zlotys per year during 1998-2000 (Figure 3.9). With the introduction of social health insurance in 1999, state budgetary allocations on health care dropped Trom PLN26 billion in 1998 to PLN2.7 billion, with the drop in the share of the state budget more than made up by the Sickness Funds. Real expenditures on health care by the Sickness Funds (2001 prices) increased from PLN26.2 billion in 1999 to PLN28.3 billion in 2001. The planned outlay for 2002 is 29.5 billion zloty (at 2001 prices). 28The seven-year period 1996-2002 cuts across two different fimancing regimes: budgetary from 1996-98, and social insurance from 1999 onward. While complete data are available for the period 1996-99, disaggregated budget data are not available for 2000-02. Private expenditure data are also not available for 2001-02. 29There is a particular problem in the treatment of debts. Debt figures as announced for each year are cumulative figures, representing total end-of-year debts. For the purposes of this calculation, debts for each year are obtained as the difference between the current end-of-year debt figure and the previous year's end-of-year debt figure. 54 Figure 3.7: Expenditure on Health (as % of GDP) Croatia Slovenia Slovak Rep. Czech Rep. Hungary L atvia Estonia Lithuania Poland Russia Belarus Romania Turkey Ukraine Bulgaria _1 0 3 6 9 12 ToA Public expenditure on heafth as % of GDP b Total health care expenditure as % of GDP Sources- World Development Report, 2001 (GDP data); Emi Suzuki, personal correspondence (Health Expenditure data); OECD Health Database 2001. 3.42 With the introduction of social health insurance in 1999, the share of expenditures on outpatient and inpatient (or secondary) care increased substantially. As Figure 3.9 shows, the share of outpatient expenditure increased from about 16 percent for each of the years preceding the introduction of health insurance to over 19 percent in 1999. The share of expenditure on inpatient care followed a similar pattem, rising from 29 - 32 percent annually during 1996-98 to over 40 percent in 1999.3' 3.43 At the same time, however, the share of university hospitals (tertiary services) fell from 7-8 percent annually during 1996-98 to 2.5 percent in 1999.32 Overall, the share of expenditures on inpatient services increased from around 36 percent in 1998 to about 43 percent in 1999. During this period, the share of investments also fell by half, from 11 percent in 1997 to 5.6 percent in 1999.33 Expenditures on 30There is a particular problem in the treatmnent of debts. Debt figures as announced for each year are curnulative figures, representing total end-of-year debts. For the purposes of this calculation, debts for each year are obtained as the difference between the current end-of-year debt figure and the previous year's end-of-year debt figure. 3' Approximately half of the debt is incurred in hospital care. Computed with this adjustment, the share of expenditure on hospital services increases to 39.8 percent in 1996, 41.6 percent in 1997, 42.7 percent in 1998, and 43.0 percent in 1999. 32 This refers to the highly specialized procedures financed from the state budget. Sickness Funds financing for tertiary care institutions is tncluded in the category "hospitals." 33 In the absence of data on investments after 1999, it is difficult to conclusively detennine the reasons for the low allocations for investments. 55 pharmaceutical products constitute a significant share of total health expenditures and have been nsing every year. Expenditures on pharmaceutical products went up from 23 percent in 1994 to 29.5 percent in 1999. In comparison with other countries, Poland spends a disproportionately higher percentage of total health expenditures on drugs. For instance, the share of expenditures on drugs in total health expenditures was 25 percent in the Czech Republic, 20 percent in Romania, 17 percent in the United Kingdom, and 13 percent in Germany.34 IFigure 3.8: Rlleal Expeindituires onm leIEah Care, 1996-2002 50,000 50,000 . 40,000 - 40,000 o 30,000 30,000 20,000 20,000 o 10,000 10,000 1996 1997 1998 1999 2000 2001 2002 Sickness Funds State Budget [ Local Govt. Budget Debt ~Total Public Expenditures - - - Total Private Expenditures Total Expenditures Source: MoH (Health Statistics, National Health Accounts), GUS, MoF, and UNUS. 3.44 Real per capita expenditures on health have remained more or less steady during the last seven years, varying in the small range of PLN1,040-1,175 between 1996 and 2001 (at 2001 prices). Of this, real per capita public expenditures increased from about PLN800 to 894 (or by about 12 percent). Private out-of-pocket expenditures account for the balance. RECENT HEALTH SECTO7R RIFORlS RN IFOLAND 3.45 The most significant and far-reaching health sector reforms were initiated in January 1999, when Poland introduced systemic changes in the health sector by thoroughly overhauling health financing, management, and organization. Social health insurance was introduced and the institution of the Sickness Fund (Kasa Chorych) was created. All citizens belong to one of 16 Sickness Funds organized on a regional basis (plus one Sickness Fund for military services), to which mandatory health insurance contributions are paid. Employers transfer a sum currently equivalent to 7.75 percent of employee earnings. The Funds contract with a wide vanety of individual and institutional providers of preventive, ambulatory, specialist, and in-patient care to supply health services for the insured. Some highly specialized procedures under tertiary care are financed directly from the State budget. An equalization fund - financed by a proportion of each Fund's revenues - adjusts for the disparities in income and expenditure in different regions according to a forrnula rnsk-adjusted for age. Individuals, organizations, 34 Cornparative data are from various years during 1996-99. 35 This refers to the highly specialized procedures financed from the state budget. Sickness Funds financing for tertiary care institutions is mcluded in the category "hospitals." 36 In the absence of data on investments after 1999, it is difficult to conclusively determine the reasons for the low allocations for investments. 37 Cornparative data are from various years during 1996-99. 56 and other legal entities pay health insurance premiums, which are collected by ZUS or by KRUS. The employees and individuals working under agency or assignment contracts, and the uniformed services employees,38 pay their premiums directly to the branch sickness fund. The premiums collected by ZUS and KRUS are then transferred to the Sickness Funds. Figure 3.9: Breakdown of Public Expenditures by Use of Health Care 1996-99 45 0% 40 0% 350% Outpabent 300% Hospital University 25 0% Clinics -Dnigs 20 0% . . . Investments --Debt 15.0% 100% 5 0% 00% I.w - 1996 1997 1998 1999 Source: MoH and MoF. 3.46 The introduction of social health insurance not only brought about significant changes in the organization and flow of funds in the health system (with the primary financing role being picked up by the Sickness Funds, as discussed above), it also changed the incentive system for service providers. Prior to the reforms, almost all physicians were paid on a salary basis, and hospitals were given an annual budgetary allocation. With the reforms, primary care providers came to be paid on the basis of a per enrollee capitation fee, while outpatient specialist care came to be paid on a fee per service basis. The level of the capitation fee and the specialist fee differ from one Sickness Fund to another, and are influenced by the range of services and obligations set in the contracts. Finally, most hospitals came to be reimbursed on the basis of a fixed amount per admission per department, irrespective of the type of stay or the severity of the illness. Again, the rates and formulas varied with Sickness Funds. 3.47 Many achievements have been recorded in the two years following the introduction of social health insurance. The reform has generally done well in bringing about a desirable change in utilization patterns, by encouraging primary care visits and reducing use of specialist services. Changes in the utilization of hospital services also show an improvement in 1999 compared with the previous year. The changes in the 1999 utilization patterns and rates are a result directly of the conscious policies of contracting being followed by the insurance fund, and indirectly of the new provider incentives that have been introduced following social health insurance. Paying primary care physicians on the basis of capitation, often making them fund-holders for specialist care as well, introduced incentives for primary care physicians to reduce referrals and increase their own efforts. Strict implementation of the policy on 38 Employees of Army, Police, State Defense, and other uniformed services. 39 Employees of Army, Police, State Defense, and other uniformed services. 57 referrals and the limited number of contracts for specialist services ensured that the utilization of specialist services remained low. Paying hospitals on a reducing scale vis-a-vis the number of patient days introduced incentives for hospitals to reduce the length of stay. 3.48 At the same time, however, the health sector reforms have not always been received well by the public or by many of the providers themselves. Some of the reasons for the widespread discontent with the reforms have to do with: (i) long waiting lists for specialist, dental, and emergency services following a huge drop in the number of services contracted; (ii) uncertainty and confusion in the minds of patients related to procedures governing choice, access, utilization and the benefit package; and (iii) insufficient transparency in the functioning of the health insurance funds. The poor financial situation of some health facilities added to the general confusion and the impression that the health reforms had failed to arrest the ever-growing debts. 3.49 Along with the health financing reformns, the Ministry of Health launched a program of restructuring health services provision. Recognizing that the costs of health care provision would increase with aging populations, new medical technologies, and increased patient expectations, the Ministry of Health initiated a three-pronged strategy to bring about a rationalization of health care service delivery and provision: (i) reducing the number of medical and non-medical health care personnel, (ii) effecting organizational changes in inpatient care and (iii) effecting organizational changes in primary and emergency care. The major thrust of the Ministry of Health's plan was to increase access and introduce cost-containment measures. The three-year restructuring plan is being carried out in cooperation with, and with the participation of, a number of stakeholders in the system. Regional and local governments play an important role in defining regional and local health policies and in co-financing specific programs. Sickness Funds provide the necessary infornation and cooperate in the preparation of regional health policies. Professional associations participate in the preparation of the restructuring programs and provide opinions on the regional and local strategies. 3.50 The initial results of the program indicate some success. More than 90,000 medical and non- medical personnel have been laid off from public health care facilities since the introduction of social health insurance. In supporting the retrenchment, the Ministry of Health has provided funds to public health care facilities for redundancy packages for medical and non-medical staff. As regards organizational changes in inpatient care, the Ministry of Health has supported the development of new health care facilities, the consolidation of existing health care facilities, the consolidation of wards within hospitals, the centralization of services at the regional level, and privatization initiatives. The main objective of the reorganization of inpatient care has been to ensure access to hospital care and at the same time liquidate unnecessary hospital beds. In the process, alternative forms of care (day care centers, nursing homes, palliative care facilities) have been developed. Finally, as regards organizational changes in primary and emergency care, the Ministry of Health has supported the upgrading of primary and emergency care facilities and the purchase of equipment. XEY IISSUES AND RJEFORM PTCONS 3.51 There are three major sets of issues with respect to improving health services in Poland. These relate to the efficiency of the health care system and of the public expenditures on it, to equity and to access to health care, and to the financing of the sector. These issues are discussed below. Effoeocy 3.52 Recent health sector reforms in Poland have included a number of organizational and management measures aimed at improving overall efficiency. While some of these reforms have produced results in the direction desired, others have not. Efforts to restructure and downsize health 58 facilities have been generally successful, and the number of hospital beds has been significantly reduced and a large number of hospital staff has been laid off. Similarly, hospital autonomy has proceeded rapidly, with almost all hospitals enjoying a large degree of autonomy with respect to personnel and financing decisions. 3.53 Table 3.10 presents some efficiency and access indicators for selected countries. Between 1995 and 1999, the number of hospital beds and average length of stay was reduced significantly. The number of hospital beds per 1,000 persons fell from 6.3 beds in 1995 to 5.3 in 1999, a reduction of almost 20 percent. Similarly, hospital length of stay fell from 10.8 days to 9.3 days durng this penod. Improvements in staffing have been modest, with the number of physicians falling slightly, from 2.4 to 2.3 per 1,000 persons, but that of nurses has been significant, from 5.6 to 5. Table 3.10: Efficiency and Access Indicators, Selected Countries (various years: 1995-97) Country Hospital beds per 1,000 ALOS Occupancy Physicians per Nurses per 1,000 population rate 1,000 population population Spam 3.1 8.5 76.4% 4.2 4.6 Norway 3.3 6.5 81.1% 4.1 18.4 Netherlands 3.4 8.3 61.3% 2.5 9.0 Denmnark 3.6 5.6 81.0% 2.9 7.2 Croatia 4.0 9.6 88.2% 2.3 4.7 France 4.3 6.0 75.7% 3.0 5.0 Slovenia 4.6 7.9 75.4% 2.3 6.8 Poland (1995) 6.3 10.8 85.2% 2.4 5.6 Poland (1999) 5.1 9.3 85.2% 2.3 5.1 Belgium 5.2 7.5 80.6% 3.9 10.8 Hungary 5.8 8.5 75.8% 3.6 3.9 Estonia 6.0 8.8 74.6% 3.0 6.2 Austria 6.4 7.1 74.0% 3.0 5.3 Czech Republic 6.5 8.8 70.8% 3.0 8.9 Slovak Republic 7.1 10.3 77.9% 3.5 7.1 Germany 7.1 11 76.6% 3.5 9.6 Sources: For Poland: Central Statistical Office (GUS, 2000): "Basic Data on Health Care in 1999", published in Warsaw in 2000. On Poland's Bed Occupancy Rate: Ministry of Health Official Statistics published at the MoH web site. For other countries: Health Systems in Transition (HIT) reports, various years. 3.54 While Poland still has many more beds than such countries as Denmark, the Netherlands, Norway, and Spain, it is doing significantly better than several countries in Eastern and Central Europe, for example, Slovakia, the Czech Republic, and Estonia. The average hospital length of stay in Poland in 1999 was on the high end, but was a marked improvement from the position in 1995. In terms of number of physicians and nurses, Poland's numbers were average even before the restructuring initiative was taken up. 3.55 Reform measures that have been less successful include those associated with increasing the role of competition and market forces, and with cost-containment. These issues are discussed below. (a) There is little or no competition among health service providers. In theory, health facilities compete with each other to get business from the Sickness Funds; in practice, however, the Sickness Funds have been supporting nearly all health-providing facilities. Tough decisions to let the inefficient units close down have not been taken, and competition between health facilities is not especially marked. Similarly, while there have been some efforts to contain the growth of institutions producing tertiary health care, these have been largely piecemeal. Finally, while a number of new institutions have 59 been created to support social health insurance, they have not been very effective either in providing leadership and guidance, or in supervising and monitoring the Sickness Funds. (b) Itaceintives to encourage cost-containment have anot been adequate. Cost containment has not been the focal point of reforms at the different levels of health care: (i) For outpatient care, physicians are paid on the basis of a fixed capitation fee per enrollee for all outpatient services, regardless of the extent and nature of treatment sought. Since physicians participating in this scheme bear most of the risk of treating a patient, they are likely to be conservative in the amount of health care they provide, and are more likely to over-refer patients to costlier specialist care. This often becomes a beneficial arrangement for both the physician and the patients, who prefer specialist care even if the primary care physician can equally well provide the required treatment. This, however, increases the costs to the health system since specialist care is relatively more expensive. (ii) For hospital care, hospital managers have not faced proper incentives for reducing costs and improving financial management. The system of paying per bed-day encourages longer hospital stays, thus providing perverse incentives for cost increases among the providers. For acute hospital care, as well, Poland has not satisfactorily been able to reorient service provision from this relatively expensive type of care to lower levels of care. (iii) For medicines, the normal practice of using brand name drugs even when much cheaper generic drugs are available not only keeps health costs high but also leads to the increased growth of pharmaceutical costs (because brand name drug inflation is generally higher than that for generic drugs). (c) Debts conminue to accumulate. Reflecting the system's inefficiencies, debts continue to accumulate in the sector. As a percentage of total public expenditures on health, end-of- year debts in Poland fell from 5.4 percent in 1996 to 2.7 percent in 1997, but increased fivefold in 1988 to 13 percent.40 The introduction of health insurance only temporarily eased the position in 1999, but by the end of 2000, these debts again shot up to about 3 percent of public expenditures on health (or about 1 billion zlotys or US$250 million). The debt problem highlights not only shortcomings in the allocation of resources and in the flow of financing within the system, but also the characteristics of reform which were aimed at stabilizing resources rather than shifting the incentives for improvements in efficiency, in the affordability of the health system, and in the quality of care. 3.56 Recommendations. Consistent with the objectives of health reforms in Poland, additional measures need to be considered in order to strengthen the efficiency aspects of the system. (a) lintroduce meandngful compeddion amoEng hieaelth service providers. Health facilities need to compete with each other for business from the Sickness Funds, which should not be obliged to support any facility. Inefficient units unable to compete with others in the market should be allowed to close down and other facilities should be permitted to take over their clientele. 40 In 1998, pharmacies accounted for more than 50 percent of all debts in the health system. See Council of Ministers Statement of State Budget Expenditure, for the periods January 1, 1996 to December 31, 1996, January 1, 1997 to December 31, 1997; and January 1, 1998 to December 31, 1998. 60 (b) Establish a direct linkage between hospital payments and patient services. Linking services provided to compensation and ensuring that the "money follows the patient" will promote the most cost-effective means of production and delivery. Theory and international experience suggest the use of prospective payments for inpatient care (see Box 3.2). Prospectively determined payments for a set of services deemed necessary by established clinical protocols to treat a particular diagnosis rely on the fact that services associated with a particular treatment are reasonably predictable and can be bundled into a group to which a monetary value can be attached. Such payment mechanisms discourage excessive use, since the hospital generates surplus by carefully employing its resources and controlling lengths of stay. (c) Strengthen incentives for hospital consolidation. Over the medium term, the Government needs to think about a strategy for further reducing the number of hospitals and hospital beds through a system of hospital consolidation with a well-defined strategy for closures. This would also require the development of bankruptcy procedures to facilitate enforcement of hard budget constraints and improve financial discipline in public sector health care facilities. In the short run, this requires enforcing a hard budget constraint on hospital managers so as to provide the necessary incentives for accountability and financial discipline. Box 3.2: Diagnosis Related Group (DRG) A widely known prospective payment system is the Diagnosis Related Group (DRG). Developed to classify treatments according to the resource costs of its treatment, DRGs employ a complete and consistent coding system of patient-level information obtained from medical records to establish and cost bundles of appropriate inputs for one or more diagnosis-based treatments. Typically requiring about 10-20 data items per discharge over a few years, the DRG system provides a valuable tool not only for reimbursing hospitals but also for overall planning and resource management. There is no inconsistency in employing DRGs in a system subject to global payment linuts. In fact, retaining global budgets is perhaps sensible, at least in the short run, to ensure that hospital expenditures are contained within defined limits. A DRG-based system by itself will not necessarily promote efficient use of resources. Hospital care providers and managers need the flexibility and tools to actively manage their resources and redirect their use, and ensure that cost-savings in the treatment of one case are passed through the entire system. Short of this, the introduction of DRG will only bring about piecemeal changes. (d) Extend the system of family medicine to cover 100 percent of the population. The introduction of family medicine in Poland - a system in which physicians provide health services for the whole family, treating common illnesses across such medicine domains as internal medicine, gynecology, pediatrics, prevention, and health propagation - has been synonymous with both enhanced patient satisfaction and cost containment. Currently, this covers only 30 percent of the population, mostly in the urban areas; this needs to be extended to cover 100 percent of the population. (e) Promote the use of generic drugs, where they exist, and rationalize prescription practices. This is essential to contain the growth of prescription costs, particularly since this is the largest item of private expenditures. One method could be to set reimbursement levels for drugs based on the use and pncing of generic drugs, and to establish control triggers and benchmarks for monitoring unnecessary and excessive prescriptions. 61 EQUETY 3.57 In the absence of accurate estimates of utilization and of costs, it is difficult to assess the equity impact of public expenditures on health. However, an examination of the structure of this equalization formula that redistributes part of the premium collections and of the burden of out-of-pocket expenditures on health care suggests that equity is not a major problem in the health sector in Poland. This is discussed below. 3.58 Equaflzation of [Resources. Part of the funds collected by ZUS and KRUS are subject to "equalization" based on the principles of equity and solidarity.' The guiding principle of this equalization is that if financial resources are distributed on the basis of need, with equal resources being allocated for equal need, it will be followed by a fair distribution of personnel, drugs and supplies, all of which together will lead to an equitable delivery system. In accordance with the provisions of the Health Insurance Law, the Sickness Funds retain 80 percent of their collection and set aside the remaning 20 percent for redistribution and "equalization" across all funds. The equalization algorithm redistributes funds on the basis of allocations adjusted by the age distribution of the Fund's population. Since the elderly (over 60 years-of age) consume more health care, and providing health care to them is more expensive, the equalization algorithm considers a 2.4 times larger allocation for the elderly population. The algorithm also uses an adjustment by income, but allows the Funds to retain some of their income advantage. In practice, the equalization formula effectively transfers funds out of the richer funds to the poorer funds.4' 3.59 Out-of-pocket Payments. Out-of-pocket payments have emerged as an important source of health care financing and take two forms: formal co-payments and informal out-of-pocket payments. Formal co-payments were almost non-existent prior to the transition, reflecting the constitutional guarantee to free health care for all citizens, but now apply to many services, such as dental care, and to pharmaceuticals and medical prosthesis and have assumed significant proportions over time. Informal payments, in cash or in kind, made by patients or others on behalf of the patients to public health care providers for health services received or expected to be received, existed even during socialist times, and are all-pervasive even now. 3.60 An analysis of the 2000 Household Budget Survey shows that Figure 3.10 Out-of-Pocket Household Expenditures on an average Polish household spent 0 Health (monthly, In zlotys), 2000 about PLN82.7 on health (or PLN26 16 5- per capita), equivalent to about 4.5 140 percent of its total expenditure (see e s 120 4 '- Figure 3.10). Overall, total private 80- 3 - expenditure on health amounted to o 60_. 2 co PLN12,279 million a year, equivalent 40 [- n 1 to 1.8 percent of GDP. On average, 20 '1h1H II 0 urban households spent a little more 1 2 3 4 5 6 7 8 9 10 than rural households in absolute Consumpntio Dscbes terms (PLN88 versus 73 per month) l Monthly Household Expenditure on Health but about the same in relative terms -0˘Share In Total Household Expenditures (4.6 percent versus 4.4 percent of total Sources: Household Budget Survey, 2000; staff calculations 41 There is transfer of funds from the richer funds, such as Dolnoslaska (Wroclaw), Mazowiecka (Warsaw), Slaska (Katowice), and Branzowa (the Special Fund for Railway, Army, Police, etc.) to the poorer ones, of which the largest beneficiaries are Podkarpacka (Rzeszow), Swietokrzyska (Kielce), Podlaska (Bialystok), Lubuska (Jelenia Gora), and Warmnnisko-Mazurska. 62 household expenditures). Expenditures on drugs and medicines constitute 60-80 percent of total out-of- pocket health expenditures of a household, and medical consultations account for another 15 percent. 3.61 The analysis also shows that there is a positive correlation between living standards, as measured by equivalent consumption, and health expenditures-that is, the higher the standard of living, the higher the health expenditure. Thus, richer households spend considerably more on health care than the poorer ones; in terms of the share of total household expenditures, the differences range between 3 and 5 percent. These payments cover both formal co-payments and informal payments. 3.62 There are two issues which emerge from the above analysis: (a) Inadequate links between resource allocation and population needs. There is no provision in the algorithm in its present form for redistributing resources according to population needs and health care utilization other than as predicted by age, which only captures about 25 percent of the variation in use. (b) The presence of informal payments. While it is not possible to unbundle out-of-pocket payments into formal and informal payments, the latter have potentially far-reaching implications for everyone in the country's health care system. By their very nature, informal payments are unauthorized and contribute to the general environment of corrupt practices and the growth of a parallel health care financing system. Variously referred to as "envelope payments" or "gray payments" in Poland, informal payments introduce perverse incentives in the health system and compromise Government efforts to improve efficiency, accountability, and equity in the public sector. The non-transparent and discretionary nature of informal payments has adverse effects on equity and access to health care, with the more vulnerable segments of the population having to pay disproportionately large amounts for the health services that should otherwise be available free of charge. 3.63 Recommendations. There are two measures that the govemment can undertake to address the remaining equity issues in the sector. (a) Redistribute resources according to population needs and health care utilization. The algorithm used for the equalization of insurance premium collections needs to be amended to include provisions to redistribute resources based on population needs and utilization, in addition to the adjustments for age and income that are presently available. (b) Institute mechanisms to eradicate informal payments. Solutions to this problem are not easy.42 A multi-pronged strategy needs to be adopted. This strategy should include: (i) improving the incentive to reduce the demand for, and supply of, such payments; (ii) addressing the culture of acceptance in the existing system by educating people to the fact that side payments between public employees and citizens undermine the health system; and (iii) establishing a system of oversight and accountability for all health providers, and ensure swift punishment for transgressors. FINANCING 3.64 The health insurance system has done well in recent years insofar as the collection of premiums is concerned. In 1999, the Sickness Funds expected to collect PLN20 billion, against which the actual collection was PLN18.8 billion, or 94.2 percent of the target. Collections improved significantly in 2000, and against a target of PLN21.9 billion, the actual collection was PLN23.4 billion, or 107 percent. 42 Lewis, Maureen (2000), "Who Is Paying for Health Care in Eastem Europe and Central Asia?" World Bank. 63 Collections also exceeded the target in the first six months of 2001, with PLNI3.2 billion, or 103 percent, collected. 3.65 There remains, however, a serious problem with the recording of premium collections in ZUS, and in the case of almost one-third of all contributors it is difficult to identify to which Sickness Fund they belong. Currently, this is remedied imperfectly durng the course of the year through special norm- based reallocations from the Ministry of Health, typically toward the end of the fiscal year. However, this implies that individual Sickness Funds face financing shortfalls during the course of the year and have to resort to debt financing to meet this shortfall. 3.66 Recommendations. Following from the above analysis, there are two measures that need to be considered. (a) EDliminate kneffncienices Ani the recordinng of colectaons and the redlistrilbuton of preniunns. This would require the use of a commonly shared and unique identification number, better coordination among ZUS, UNUS, and other agencies for the sharing of information, and the implementation of systems that allow individualized tracking of premium contributions. (b) Consider a suppemenmtaDn heaeth insurgance scDneme. In order to strengthen the financing of health care and promote provider choice and competition, the Government should consider establishing the enabling legal and regulatory framework for supplemental health care insurance in addition to, and without options to opt out of, the compulsory social health insurance system. IDIEMORAPHIC CHALLENGES 3.67 It is clear from age profiles for public expenditures on health and elderly care that expenditures are concentrated at the end of the age distribution. Although a simple combination of age-related expenditure profiles with future demographic projections gives only a basic view of the impact of aging on health and old age care expenditures, it nevertheless can help to identify the pressures caused by demographic changes on public expenditures. Estimates presented below show that Poland's rapidly aging population will place increasing pressure on these categories of expenditures. Taking into account the demographic structure of Poland over the next 50 years and its current overall level of health and old age care expenditures, expenditures in these areas should be expected to increase in the order of 2-2.5 percent of GDP between today and 2050. 43 3.68 A prudent recommendation, therefore to would be the following: o IPrepare for demographic related shfts Ain the compositionn of Dhealth expendituires, as Poland's rapidly aging population will place increasing pressure on old age care and age-related health expenditures. (CONCLUSNONS 3.69 In order to address the existing problems in the health sector, and to consolidate the gains made, several changes need to be brought about on many fronts, but most urgently with regard to improving the 43 For a detailed discussion of the methodology and consequences for EU member states, Economic Policy Committee (2001), "Budgetary Challenges Posed by Aging Populations: The Inipact of Public Spending on Pensions, Health and Long-term Care for the Elderly and Possible Indicators of the Long-term Sustainability of Public Finance. 64 efficiency of resource use. Key expenditure areas that need immediate attention are hospitals and pharmaceuticals, which combined account for almost 75 percent of total health expenditures. Cost containment in hospitals can be effected by introducing case-mix payment systems and ensuring that hospital managers face a hard budget constraint. Linking services provided to compensation and ensuring that "the money follows the patient" would promote the most cost-effective means of production and delivery. As far as delivery of health services is concemed, the reform measures should concentrate on extending the family physician system to cover 100 percent of pnmary care, and instituting a system of heavy penalties to dissuade violation of the referrals system. And finally, in the area of organization and management, there is an urgent need to reduce the number of hospitals and hospital beds through a system of hospital consolidation with a well-defined strategy for closures. This would also require the development of bankruptcy procedures to facilitate the enforcement of hard budget constraints and improve financial discipline in the public sector health care facilities. EDUCATION 3.70 The education sector accounts for about 6 percent of GDP and almost 14 percent of total public expenditures. The sector has already made significant reforms during the transition years. However, it is not yet positioned to meet the needs of a modern market economy or to exploit the full potential of EU integration. As this section argues, if certain actions are taken, critical reforms can probably be executed within the current overall envelope for public spending in the education sector. Some of the important measures to be undertaken are as follows: (a) Reduce inefficiencies in the sector. These measures include redefining the role of the state in a decentralized service delivery environment, revising intergovernmental fiscal relations in order to provide incentives for local reforms that are consistent with national objectives, and shift resources to secondary location in line with the demographic changes. (b) Improve the quality of education. These measures include linking quality assurance with financing and operations, reducing the differentiation at the secondary level, and unifying the multiple post-secondary systems. (c) Reduce inequities in the sector. In particular, a multi-pronged strategy is needed to address the relative disadvantage of rural children and to reduce the public subsidies of preferences of the wealthy for private schools. STRUCTURE AND FINANCING OF POLAND'S EDUCATION SYSTEM 3.71 The current structure of the system consists of preschool; six years of primary education; three years of lower secondary education; between two and four years of upper secondary education, depending on the student's program; modular vocational/technical postsecondary programs of six months to two years in length; and tertiary education of two types: academic and higher vocational. Significant curricular branching occurs at the secondary level. The options are the three-year academic ("general") lycee; 14 three-year vocational/technical programs ("profiled lycee"), with local governments, teachers, students, and parents at a given powiat choosing which subset of the 14 will be offered at the secondary schools in that powiat; four-year technical secondary schools; and two-year or three-year basic vocational programs." "Graduates of all but the basic vocational programs are defined as secondary school graduates, and graduates of the technical secondary schools also receive the certificate of technician. Secondary school graduates can, if they wish, stand for the matura examination that controls entrance into tertiary education. Whether or not they have taken the 65 Table 3.11: Public aDd Total Education ExpeDnditures S n IPerceit of GDP and of Total lublic Expendituires by Year, 1995-2001 Year Public and Private Expenditunre on Education as a Public Education as a Percent of GDl? IPercent of Total Public Public Expenditure PFrivate Expendgtere Toeal Expenditure (TPE) 1995 4.85 n.a. n.a. 12.0 1996 5.05 n.a. n.a. 12.8 1997 5.16 n.a. n.a. 13.1 1998 5.01 n.a. n.a. 13.4 1999 4.92 n.a. n.a. 14.0 2000 5.00 0.9' 5.9 14.5 2001 6.3 n.a. n.a. 13.8 OECD (1998) 5.30 0.7 6.0 12.9 1/ Staff calculations based on Central Statistical Office Household Budget Survey for 2000. Sources: Ministry of Finance; Table B4.1 OECD, 2001. 3.72 Overal Expeniditures. Relative to OECD benchmarks, Poland's education sector is well funded. (See Table 3.11). At about 6 percent of GDP-and about 14 percent of total public expenditures- Poland's public expenditures on education are higher than the OECD average. Total private expenditures on education totaled 0.9 percent of GDP in 2000, slightly higher than average private expenditures for the OECD. 3.73 Alocations among Educational LeveRs. Poland's public allocations by educational levels are comparable to those for the OECD (see Table 3.12). In 2000, Poland spent 72 percent on primary and secondary education, 18 percent on tertiary education, and 10 percent on preschool education. Table 3.12: Public Educamion Expemditures by Level gnd Type of Educatioin as a Percent Of GDP and of otalo by Year, 1995-2000' Level of Education Percent of Total Eduscation Ezpenditures Allocated by 1998 Compiarisons Level 1995 1996 1997 1990 1999 2000 PolandZ ODECD2 Preschool 10.8 10.3 9.9 10.0 10.1 10.1 10.0 9.6 Primary Education 51.2 50.1 50.5 50.5 47.0 41.1 Lower Secondary, NA NA NA NA 1.9 8.4 Upper Secondary 21.2 21.7 21.7 21.8 21.5 22.9 72.3 69.3 Academic 5.3 5.6 5.8 6.1 6.2 7.0 VET 15.9 16.1 15.9 15.7 15.2 15.8 Tertiary 16.8 17.9 17.9 17.7 19.6 17.6 17.7 21.2 1/ These exclude expenditures not allocated by level, such as extracurricular activities, teacher training, transport of students, and administrative costs of the MoES, dormitories, and correctional facilities. In 2000 teacher trainmng constituted 0.4 percent of total education expenditures; other expenses not allocated by level, 10.3 percent. 2/ The Poland and OECD percents are public expenditures on education net of the share going to tertiary institutions for research and development activities. 3/ In 1999, Poland split the eight-year primary school into the six-year primary school and three year lower secondary school. Source: Ministry of Fmance; Tables B4.1 and B6.3, pp. 100 and 118, OECD 2001. 3.74 Local Govermnmemt PMnancing. Gradual fiscal decentralization has meant that local governments are funding an increasing share of expenditures. By 2000, the state's (central) share was 27 percent of its 1995 share. Gminas assumed financing responsibility for preschools in 1990 and for primnary education matura examination, they can enter post-secondary school. Graduates of basic education can enter post-secondary education or take the matura only if they graduate from a "second chance" two year supplementary technical high school or academuc lycee program. 66 in 1996. In 1999, powiats assumed the financing for upper secondary education. The state continues to finance tertiary education almost entirely. By 1999 gminas financed about 25 percent of all public expenditures on primary and lower secondary education from "own revenues"~-in other words, on average they topped up the education subvention and earmarked grants from the central level by 25 percent. 3.75 Relative Unit Costs. Although Poland's expenditures by level are comparable to the OECD averages, the demographic structure and enrollment rates by level are not. As a result, the average unit cost for preschool is about double that for the OECD (see Table 3.13). The average unit cost for upper secondary is lower than that for primary education, contrary to OECD patterns and business logic. The unit cost for tertiary education is not significantly higher than the OECD's. Table 3.13: Expenditure Per Student' by Level of Education Relative to Unit Cost for Primary Education, (1998) Level of Education Poland Average OECD Preschool 1.84 0.91 Lower Secondary See footnote 2 1.29 Upper Secondary 0.96 1.34 Tertiary 2.85 2.30 1/ Expenditure per student is calculated in U.S. dollars converted using purchasing power parities. It includes public and pnvate institutions. 2/ In 1998 "primary education" in Poland included primary and lower secondary education. The unit cost for this combined level is the reference cost for other levels in Poland. Source: OECD, 2001, Table Bl.l, p.67. 3.76 Recurrent and Capital Expenditures. Recurrent expenditures account for more than 90 percent of education expenditures, similar to OECD levels. Within recurrent expenditures, data suggest that wages and salaries may be crowding out operations and maintenance expenditures. 3.77 At all levels of pre-tertiary education, Poland spent from 7 to 11 percent more of its recurrent expenditures on staff than OECD countries. The national minimum salaries of Poland's teachers at the nominated and diploma levels as a percent of GDP per capita are about the same as the averages for teachers in the OECD after 15 years of experience. As a share of average public sector wages in Poland, the average teacher's salary in 2001 ranged from 63 percent for a probationary teacher to 116 percent for a diploma teacher. Salaries also vary considerably by gminas since wealthier gminas can top up teacher salaries, sometimes by significant amounts. 3.78 Interviews with a few gmina and powiat staff indicated that maintenance expenditures are about one-third of the amount needed. Nationally, maintenance expenditures are relatively stable except for secondary VET, where they have declined. Since this budget line includes equipment repair, maintenance expenditures for this type of education should be higher than for other types. Even accounting for the fact that textbooks are privately financed except for government textbook subsidies for poor children, expenditures for textbooks and learning materials are low. Interviews with gmina and powiat staff indicated that teaching materials are underfunded. Utility costs are relatively low, but there is no indication of utility arrears, of poorly heated schools, or of school closures during the coldest winter months because they cannot be heated. Capital expenditures for lower secondary education were higher than the OECD average for primary and secondary education because gminas were constructing gymnasia to house the newly established lower secondary level of education. Capital shares for academic and VET secondary education and for tertiary education were lower. 3.79 Private Provision. There has been a positive trend in the private provision of education. By 2000-01 private schools represented one-fifth of academic secondary schools, two-fifths of adult education schools, and over three-fifths of institutions at the post-secondary and tertiary levels. Private 67 enrollments increased between 1996 and 2000 from 3.8 to 8 percent of total enrollments. By 2000-01 they were 32 percent of total tertiary enrollments. Figure 3.11: Trends in Share of Fee-Paying Studenits iim Public Terfary Educatiom, 1990-2001 % 90 76.6 75.8 80 74 j 67.5 70 . 6. 5 57.5d 55.7 54.7 53.7 53.4 53.7 60 ____-_-__ 50- 40 _ 30- 20 5 1 6.f4 23.4 24.2 10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 OFree of charge paying l Source: Ministry of Education 3.80 Local govermnents pay significant subsidies to all private schools except at the tertiary level.45 Although the law guarantees free tertiary education from public institutions, cost recovery at this level is increasing through a distinction between "day" and "evening" students. The former are free; the latter pay fees. Between 1990 and 2000, the share of students enrolled in public tertiary institutions that paid fees increased from almost one-quarter to almost one-half (see Figure 3.11). The importance of student fees also increased; in 1995, 11 percent of the total resources of public tertiary institutions came from student fees; by 2000, this had doubled to 22 percent. 3.81 Private Payments. Private payments include fees for private schools, for public universities for "evening" students, for private tutoring, and for public preschools (primarily for food). Except for the poorest families, families pay for textbooks at all levels of education. In 2001 the average cost per child was PLN232-about US$57, and at the gymnasium level the cost can increase to over PLN400-about US$100-per child (Herczynski and Bialecki, 2002). Since Poland's teachers can choose from at times as many as 10 alternative textbooks to use in their classes, it is difficult to use second-hand book markets and textbook rental schemes to reduce the costs of textbooks to families. Using standard textbooks approved by the local teachers' council for fixed periods of time could solve this problem. 45 For preschool they pay, per capita, 75 percent of the average unit cost in the gmina 's public preschools. Since the gminas receive no subvention from the central government for preschool services, these subsidies are paid entirely out of the gmina 's "own income." Primary, lower secondary, and upper secondary non-public institutions that are "accredited" by the MoES2 receive, per capita, 100 percent of the average unit cost in the gmina 's or powiat's public schools. Subsidies for non-public schools at these levels of education are included in the subvention from the central government to local governments. However, private schools receive the average unit cost that consists of the subvention and local government top up. Since students m the post-secondary programs are past the compulsory age for education, local governments pay 70 percent of the average public unit cost for students in non-public post- secondary programs. These subsidies are included in the central subvention. Non-public tertiary institutions receive no public subsidies. 68 Table 3.14: Monthly Expenditures on Education per Enrolled Household Member by Consumption Quintile and as a Percent of Total Household Expenditures, 2000 Budget Category Zlotys per month per enrolled household member by consumption quintile 1 2 3 4 5 Average Total Education 10 19 26 38 80 34 Textbooks, Materials 6 10 12 15 20 13 Services (School Fees, Private Lessons) 4 8 14 23 59 21 Education as Percent of Total Household Expenditures 2.2 3.1 3.4 3.9 4.8 3.9 Source: Calculations by Irena Topinska, from Central Statistical Office Household Budget Survey (2000). 3.82 Income and monthly educational expenditures are positively related, as are income and the percent of total household consumption allocated to education (see Table 3.14). The highest income quintile pays eight times the amount per month for education per enrolled household member as the poorest quintile. Education as a share of average total household expenditures for the wealthiest quintile is more than twice that of the poorest quintile. Figure 3.12: Projected Demographic Trends by Level-Specific Ages for 2002- 2020 (2002 = 100) 120 _ - -- - gro ___ -tR 80 _ 70 _- [L- S oo0 0 3 0D 0 0 0 0~ 0 0 0 0 0 0 0 0 ( 0 M) C.) .0. Cs c ) -4 CO CD 0 - M) C;) v0 U 0 CO (D 0 - -- 3-5 kindergarten *-6 'zero' year -*-- 7-13 primary - -14-16 gymnasium - 1N 17-19 lyceum -- 20-24 tertiary TOTAL 3 - 24 Source: Central Statistical Office Population Projection Data KEY ISSUES AND REFORM OPTIONS 3.83 The efficiency of factor use, the quality of education, and equity constitute unresolved problems in the sector. These are discussed below. Factor Efficiency 3.84 Poland's school-age demographics frame Poland's efficiency challenges and opportunities. Poland's total fertility rate46 is well below replacement, having declined from an average of 2.0 births per woman in 1990 to 1.3 births per woman in 2000. As a result, the school age population (2-24 years of 46 Total fertility rate (TFR) is defined as the theoretical number of children that would be bom to a woman in the course of her reproductive years if subject to the rate of births at each age observed in a given year. 69 age) has been declining since 1990. By 2010, the sector, relative to 2000, is projected to face a 22 percent decline in the school-age population across all levels of education; and by 2020 a 28 percent decline is projected. The baby "booms" and "busts" hit different levels of the system at different times (see Figure 3.12). 3.85 These demographic changes could turn into a significant savings dividend if the Government can adjust inputs to capture the savings associated with smaller cohorts. For example, the 1998 unit cost of a primary school student in 1998 was US$1,496. If all those who were 7-14 years old in 1998 had been enrolled, the cost for the 4.9 million children would have been US$7.4 billion. In 2010, the 7-14 year old cohort is projected to decline to 3.1 million children. Using 1998 unit costs, this smaller cohort translates into a savings of US$2.7 billion. 3.86 These trends have led to the emergence of critical efficiency issues in the sector, and are reflected in various indicators. Three issues-the growing mefficiencies at the primary level, the relatively low teaching loads across all levels of education, and the underfunding of secondary education-are particularly important, as discussed below. (a) Ilacreasing ineffncienctes at the pmnnniry scdool Revel. Several indicators suggest increasing inefficiencies in the use of resources at the primary school level. First in terms of student/teacher ratios, Poland fares relatively well at all levels except for primary education, where Poland's ratios are low relative to the OECD or regional neighbors47 (see Table 3.15). International evidence suggests that Poland could increase its student/teacher ratios without endangering students' learnmng outcomes.48 This is true for both rural and urban primary schools (see Table 3.16). Second, student-classroom and student-school ratios have also been declining during the 1990s, which suggests increasing scale inefficiencies (see Table 3.17).49 The decline in student-classroom and student-school ratios indicates that there has not been consolidation of classrooms and schools at rates commensurate with the falling enrollment numbers. Third, while rural primary schools have generally less efficient school and classroom sizes, it is the urban schools in which the declines in scale economies have been larger. For instance, the average school size for urban schools in 1999-2000 was only 50 percent of the 1990-91 level.50 (b) Reialavely low teachLimg loads. At the primary and secondary levels, fulltime teachers have an average annual load of 641 instructional hours. This is below the average loads in OECD countries in 1999.51 47 National data on numbers of teachers are for fulltime teachers, not fulltime equivalents (FTEs). If Poland had had the Czech Republic's student/teacher ratio at the primary level in 2000-01, it would have needed 87,152 fewer public primary school teachers. 8 The OECD's Program for International Student Assessment (PISA) of 15 year old students indicates that average OECD student/staff ratios are inefficient, at least at the secondary level. PISA shows that learning increases as student/teacher ratios increase, peaking at 25 students per teacher and declining steadily after ratios of 25:1 (OECD 2001a, figure 8.5, p.203). 49 Controlling on family socio-econonic status, PISA shows a non-linear relationship between student learning performance and school size (OECD 2001a). Student performance increases as school size increases up to 1,000 students, with performance declining above 1,000 students. PISA assessed the learmng of 15 year olds, and this relationship may not generalize to younger students. 50 This is in part because grades 7 and 8 in the old primary schools were shifted to lower secondary schools. 5' These were: 801 hours for primary education, 716 hours for lower secondary education, 662 hours for academic secondary education, and 692 hours for secondary VET. 70 3.87 Underfunding of secondary education. Contrary to business logic, 52 by 1998 Poland had unit costs for upper secondary education that were only 62 percent of the average OECD unit costs for this level relative to primary education (see Table 3.15). Incentive arrangements embedded in intergovernmental financing arrangements are partly responsible for the lack of action to address these issues. Table 3.15: Trends in Student/Teacher Ratios by Level of Education and Year for Public Schools and Regional Comparators Level of Educatioa Poland 1999 Average 1996 1998 2000 OECD Czech Hungary Slovak Average Republic Republic Preschool 13.3' 12.8' 12.0' 15.4 19.5 11.8 10.4 Primary 15.5 14.9 14.3 18.0 23.4 10.9 19.6 Lower Secondary NA 21.72 16.9 15.2 16.2 10.9 13.5 General Secondary 20.4 20.3 21.0 Basic VET 20.6 22.2 19.2 14.1 13.1 10.6 13.6 Secondary VET 17.1 17.6 17.7 Post Secondary 25.5 22.8 22.4 15.7 15.3 12.1 10.3 Tertiary 11.7 13.9 15.7 16.2 14.8 1/ Although the data distinguish enrollments in public versus private preschools, the data for preschool teachers combine public and private teachers. Enrollments in non-public preschools as a percent of total enrollments were 3 percent in 1996 and 4 percent in 2000. 2/ Data for 1999 Sources: Polish data: Central Statistical Office; comparator data- Table D5.1, p. 243, OECD, 2001. Table 3.16: Trends in the Use of Labor and Capital for Public Primary Schools in Urban and Rural Areas, 1990-91 to 1999-2000 Ratios 1990-91 1995-96 1999-2000 Urban Rural Urban Rural Urban Rural Student/Teacher 18.7 13.3 18.1 13.8 16.9 13.9 Student/Classroom 36.7 18.4 30.4 17.0 25.4 16.0 Student/School 711 127 626 134 362 118 Source: Appendix A, p.53, Levitas and Herczynski, 2001. 3.88 Recommendations. Solving the efficiency problems identified here depends on addressing the role of the state and the mcentives embedded in intergovernmental financing arrangements that affect efficiency and educational service delivery. The principal recommendations are the following: 52 Both secondary academic and vocational education and training (VET) require more highly educated and specialized teachers, more laboratories, and more extensive libraries than prirnary or lower secondary education. Given that Poland has a greater share of upper secondary students enrolled in VET than the average for the OECD (two-thirds versus about 50 percent on average for OECD countries), the low ratio of upper secondary unit costs to those for primary education is even more troubling. 53 Current intergovernmental financing arrangements mean that local governments cannot remedy this situation unless the g?nina has powiat nghts that let local governments top up the central subvention for secondary schools more easily. However, even in these cases, the gmzna and the powwat have separate budgets and separate councils that allocate resources. Whether the gmina uses its resources to top up the subvention for schools under the powiat depends on goodwill and cooperation between the two levels of administration. Freestanding powiats have to rely almost entirely on the central subvention to pay for secondary education. Ninety-three percent of their budgets consists of subventions and targeted subsidies from the central budget, the other 7.5 percent coming from I percent of the PIT (personal income tax) collected in the powiat and interest on deposits. By contrast, an average of 52.5 p1ercent of gmina income derives from own income. 4These were: 801 hours for primary education, 716 hours for lower secondary education, 662 hours for academic secondary education, and 692 hours for secondary VET. 71 T[bRle 3.17: Polish aDnd OECDID2 Net EInrollmeint Rates Level of Education 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 OECD Rates (1999-00) Preschool (Ages 3-6) 45.3 46.8 47.9 49.6 49.9 50.2 60.0 (4 years and under) Primary Education' 97.2 97.4 98.0 98.1 98.3 98.6 97.7 Total Secondary, of which 80.1 80.8 81.2 82.0 83.0 84.0 76.9 Academuc Secondary 25.9 21.8 28.1 29.5 31.4 33.5 48.7 Secondary VET 27.0 27.9 28.7 29.5 30.3 31.0 7.1 Basic Vocational 27.2 25.9 24.4 23.0 21.3 19.5 19.8 Post Secondary 4.2 4.6 4.6 4.7 4.6 4.4 NA2 Tertiary Education 17.2 19.3 22.2 25.4 28 0 30.6 20.7 Expected Years of Education3 16.0 16.7 1/ In the school year 1999-2000 primary education was reduced to six years and a lower secondary cycle of three years introduced. As of 1999-2000 the enrollment rates for primary education are in fact the rates for the primary and lower secondary grades. 2/ Poland's post-secondary education is comnparable to ISCED 4C (non-tertiary, post-secondary) programs in the OECD. For methodological reasons the OECD does not calculate net enrollment rates for this type of education. 3/ Expected years of education are calculated excluding children under five years of age. Source: Poland data: Central Statistical Office; OECD data: tables C1.l, C1.2, and C2.1, OECD, 2001. (a) Redeflne the role of the state in a decentraflzed environmeint. Efficiency issues will not be addressed unless the role of the state in a decentralized environment is clarified. Currently, the Govermnent lacks an internally consistent policy framework, is constrained by a lack of accurate and timely information, and has inadequate analytical capacities. These problems can be addressed by undertaking the following: (i) Setting a limited number of mutually consistent policies for the sector in collaboration with the sector's stakeholders. (ii) Making changes in the structure and financing of the system, especially by using targeted financing as incentives for local governments to move in particular directions, and by establishing a strong analytical capacity in the Ministry of Education. 55 Both secondary academic and vocational education and training (VET) require more highly educated and specialized teachers, more laboratories, and more extensive libraries than primary or lower secondary education. Given that Poland has a greater share of upper secondary students enrolled in VET than the average for the OECD (two-thirds versus about 50 percent on average for OECD countries), the low ratio of upper secondary unit costs to those for primary education is even more troubling. 56 Current intergovernmental financing arrangements mean that local governments cannot remedy this situation unless the gmina has powiat rights that let local governments top up the central subvention for secondary schools more easily. However, even in these cases, the gmina and the powiat have separate budgets and separate councils that allocate resources. Whether the gmina uses its resources to top up the subvention for schools under the powiat depends on goodwill and cooperation between the two levels of administration. Freestanding powiats have to rely almost entirely on the central subvention to pay for secondary education. Ninety-three percent of their budgets consists of subventions and targeted subsidies from the central budget, the other 7.5 percent coming from 1 percent of the PIT (personal income tax) collected in the powiat and interest on deposits. By contrast, an average of 52.5 percent of gmina income derives from own income. 72 (iii) Publishing credible information on the performance of the system. This should include filling in the "missing" data in the OECD's Education at a Glance (2001) and publishing an Annual Statistical Report Card on Polish Education.57 (iv) Assurng educational quality through standard setting and enforcement-for example, curricular leaming standards and skill and knowledge standards for teachers, and using the feedback from assessments such as PISA to frame an attack on learning problems that mobilizes local governments, the kuratoria, and financing and other policy instruments. (v) Continuing to protect the interests of the poor at all levels of education through the appropriate targeting of public education expenditures. (b) Revise the intergovernmental financing framework. The primary objective here is to improve the incentives for local level action, consistent with national objectives. Several measures can be taken in this regard: (i) Rationalize the current subvention formula. This requires a shift from histoncal expenditure patterns toward output standards that are predictive of good leaming. (ii) Improve the flexibility for local governments to reallocate funds from primary to secondary education. (iii) Reduce the funding differences between rural (and poor) and urban gminas. Even though rural gminas contribute smaller amounts (3 percent in 2001 as against 39 percent m Warsaw), their contributions constituted a larger share of their meager budgets (45 percent compared with 30 percent for urban gminas).58 These inequities will undermine the Govermment's strategy to close the gap between urban and rural students in educational attainments. (iv) Create incentives for local governments to capitalize on the demographic bonus by consolidating schools, especially in those rural areas that are already struggling with inefficient schools. Initiatives that would be helpful include the following: * Develop a competitive grants program to "sweeten" the merger of schools for parents. The grants should be used to create a single consolidated school with observably richer learning resources than those in the closed schools. This grants program should include an agreement between the MoES that the gmina or powiat will plow its downstream savings from the consolidation of schools into continued quality improvements for the school. * Cost out the possibility of the MoES, instead of local govemments, absorbing the costs of severance pay for redundant teachers. (c) Implement a political strategy that includes a national public relations campaign. This is essential to inform the public of the costs and benefits of education reform. For instance, with respect to school consolidation, a key element of the strategy should be to stress that savings, if any, would remain at the local level for re-investment into the school system. This is the only way to offset the political challenge of consolidating schools and reducing the number of teachers. 57 This could include data prepared for the OECD and other data of particular interest to the stakeholders of education-for examnple, the educational participation, completion, and learning outcomes of rural versus urban students. 58 See Levitas and Herczynski (2001). 73 QUALTY OF EDUCATiON 3.90 How well does Poland's education system position its graduates to obtain jobs at wages that support families? Is it adjusting to labor supply/demand shifts? Are its graduates well placed to exploit the economic opportunities and challenges of Poland's entry into the EU? 3.91 Poland is performing extremely well in terms of the average years of completed schooling, a key indicator of quality. In fact, it is outperforming the average for OECD countries at each level, except preschool (Table 3.17). The number of years of education that the average five-year old-Pole can expect to complete over his/her lifetime is only slightly below the average for the OECD as a whole. 3.92 Despite these high enrollment rates, several quality issues emerge. (a) RelativeRy low perornmance onm internafional learning assessmnits.59 On the International Adult Literacy Survey (LALS), 75 percent of Polish 16-65 year olds performed below the level required to function competently in a modem workplace. On the Program for International Student Assessment (PISA), Poland's 15 year olds ranked twenty fourth out of 31 OECD and non-OECD countries in literacy and mathematics and twenty-first in science. lDiffereniationm among Poland's schooDs. This accounts for the bulk of between-school variation in student performance over the OECD average.60 The program type that accounted for most of the inter-school variance was the basic vocational program.6' The effects of differentiated schools on students' acquisition of the skills and knowledge needed in modem workplaces raise serious questions about the structure of Poland's secondary system. In countries with differentiated program or school types, the clusterng of students with particular socio-economic characteristics is greater than in systems where the curriculum does not vary significantly between schools. Students from poorer families tend to choose or be directed to programs or schools with less demanding study programs. This socio-economic clustering effect compounds the effects of less demanding programs for this reason: the impact of the overall social background of a school's intake on student performance is greater than the impact of the individual student's social background. Thus, students from a lower socio-economic background attending schools in which the average socio-economic background is high tend to perform much better than when they are enrolled in a school with a below-average socio- economic intake. (b) ReRaltivey Dower rates of tertary completere. Relative to the OECD, Poland has a smaller percent that have completed only primary or lower secondary education, a much higher percent that have completed some forn of secondary education (academic, vocational, basic vocational), and only half the OECD share of tertiary completers (see Table 3.18). A large share of secondary completers have completed only the two year basic vocational program that focuses less on building and reinforcing the higher order cognitive and foundation skills required by modem workplaces. f~~~~~~~~~~~~~~~~~~~~~~~~ 59 Care needs to be taken in interpreting these tests as they both measure respondents' ability to manipulate information to solve problems in the real world, not their academic skills per se, or their mastery of a specific school curriculunL 60 Discounting the differences between school and program types reduced the between-school variation in student gerformance for Poland from 67 to 14 percent over the OECD average. 1 At the time of the PISA administration students had been in the basic vocational program for only a few months. Thus, the "tracking" of students that preceded entry into the basic vocational program, not the program itself, seems more responsible for the score results. 74 (c) Disconnect between quality assurance and financing and operations. The sector's functions of quality assurance (the kuratoria) and financing and operations (the gminas and powiats) are currently de-linked. Teachers and headmasters are accountable to two bosses (the gmina and the kuratoria) that are not collaborating closely. Quality assurance functions are split up in peculiar ways-for example, the headmaster and gmina/powiat approve teacher promotions up to the point of "certified" teacher; the kuratoria approves the last promotion on the career ladder. The kuratoria may hold headmasters responsible for activities for which the gmina has no money. Table 3.18: Highest Level of Education Completed for 25-64 Year Old Population for Poland and OECD, 1999 Country Primary/Lower Secondary Basic Vocational Secondary Tertiary Poland 22 24 43 11 OECD Average 36 4 39 22 Source: Table A2. la, p.43, OECD, 2001. 3.93 Recommendations. Three measures are recommended to improve educational quality. (a) Link the kuratoria and gminas in a strategy to improve the quality of education. While the distinct functions of these different players can remain, a productivity focus needs to structure their relationship. Their shared objective should be to identify the best mix of inputs relative to learning outcomes, using intemational and Polish empirical evidence-for example, the PISA finding on the relationship between learning outcomes for older children and student/teacher ratios. For this to take place, the MoES should put in place an incentive framework that produces strong cooperation between the kuratoria and local governments. Several measures that would help in this regard are and the following: (i) Ensure that schools and students have clear and measurable performance targets. (ii) Publish the learning performances of Poland's students relative to these targets, as measured by external assessments. (iii) Strengthen the joint accountability of local governments, school principals, and kuratoria staff for improving students' learning outcomes. (b) Reduce the differentiation at the secondary level. In light of the PISA results, Poland needs to move to a secondary education system that is less differentiated. It should start by shifting toward uniform capitation funding. (c) Replace the multiple post-secondary systems with a unified system. Possible models could be the IIJT system of France or the American community college system. The unified system should have certain characteristics, such as being accessible to both secondary education graduates and non-graduates, offering different mixes of short-term and longer-term instructional programs depending on customer need, and having governance and financing arrangements that encourage rapid programmatic responses to changes in skill demands. EQUITY 3.94 Unfair learning opportunities matter for Poland. Since the education of the parents affects the educational achievements of their children, less education in the parental generation can fuel 75 intergenerational cycles of poverty. Poland's labor markets increasingly allocate employment opportunities and wages according to variations in human capital, as measured by years of education. 3.95 Pro-poor publc education expenditures. Total public expenditures on education per enrolled household member slightly favor the poorer quintiles (see Table 3.19). Poorer families are larger and have a higher average number of children enrolled per household than wealthier families. However, public expenditure by consumption quintile differs by level of education. At the primary level, expenditures are pro-poor. At the lower and upper secondary level, expenditures are relatively even across quintiles, while at the tertiary level, expenditures are biased against the poor as the highest income quintile benefits almost seven times more than the poorest quintile. This is primarily because households with enrolled members from the wealthiest quintile have almost six times the number of tertiary enrollments as their counterparts from the poorest quintile. However, the expenditure pattern does not differ between urban and rural areas. Table 3.19: Public Education Expeunditures per Enmroled IHiouseDnoEd Member by Comsumptionn Quinmtile (PLN per mointh) Level of Education Consumption Quintile All (poorer >> richer) Households 1 2 3 4 5 Education Total 254 246 240 236 229 242 Preschool Prinary 149 126 117 107 92 120 Lower-Secondary 28 28 27 25 25 27 Basic Vocational 27 16 15 9 5 15 Secondary General 12 19 20 26 31 21 Secondary Vocational 28 37 35 30 21 30 Post Secondary 2 3 4 4 3 3 Tertiary 8 17 23 35 54 26 Average # ofenrolledpersons per household 2.04 1.79 1.69 1.59 1.47 1.72 1/ Data not reliable. Source: Calculations by Irena Topinska, based on Central Statistical Office 2000 Household Budget Survey 3.96 Public policy on subsidizing private schools also does not benefit the poor. Public subsidies for students in private institutions-100 percent of average public unit cost at primary and lower and upper secondary education-that are, in turn, free to charge fees, subsidize the preferences of wealthier families for private education. This is not defensible on equity grounds. 3.97 No signaificant disadvantage for girls. In 2000-01, there were no significant gender differences in enrollments in pre-tertiary education. Girls constituted 48.7 percent of those enrolled in primary and lower secondary education and 49.7 percent of those enrolled m upper secondary education. They were significantly over-represented in academic secondary education (62.7 percent); somewhat under- represented in secondary VET (45.8 percent); and significantly under-represented in basic vocational education (33.8 percent). They were over-represented at the post-secondary level (65 percent) and at the tertiary level (57 percent). 3.98 Despite the pro-poor pattern of education expenditures and the reasonable gender composition of enrollments, there are two important equity issues in Poland's education system. (a) Lower access for poor chfldren. At the ages that correspond most closely to upper secondary and tertiary education (15-18 years of age and higher), those from the poorest quintile trail all other quintiles in enrollment rates. Enrollment rates after age 18 are 76 strongly related to the consumption quintile, with the poor being only 30 percent as likely as the wealthiest quintile to be enrolled in academic secondary education and only 17 percent as likely to be enrolled in tertiary education (see Table 3.20). Table 3.20: Enrollment Rates by Type of Secondary and Tertiary Education and Consumption Quintile for Ages 7-24, 2000 Type of Enrollment Consumption Quintile All Poorest 2 3 4 5 Households Basic Vocational 36.3 23.1 21.6 11.6 8.0 22.4 Acadenuc Secondary 19.0 30.2 37.5 48.4 62.7 36.0 Vocational Secondary 38.8 51.3 49.5 45.8 30.7 44.1 Post Secondary 2.6 4.4 4.8 5.3 2.9 4.0 Tertiary Total 11.4 21.7 33.4 44.9 66.5 34.8 Source: Calculations by Irena Topinska, based on Central Statistical Office 2000 Household Budget Survey. (b) Relative disadvantage for rural children. While neither rural residence nor consumption quintile affects enrollment rates for primary education, both affect enrollment rates for upper secondary education and tertiary education with the effects on tertiary enrollment rates being particularly strong (see Table 3.21). Given the relationship between enrollment in basic vocational programs and PISA scores and the higher enrollment rates in these programs in rural areas, it can be assumed that, on average, rural students lag behind urban students in their acquisition of the skills and knowledge needed in modem workplaces. The rural population is also disadvantaged in terms of the level of education attained (see Table 3.22). Since family educational achievements strongly affect the achievements of the children (e.g., OECD, 2001a), rural children start with a disadvantage. Those of aged 15 years and older are much less well educated than the urban population (see Table 3.22). About 60 percent of the rural population are farmers. Especially after Poland joins the EU, the number of farm workers can be expected to decrease dramatically, since EU and Polish experts estimate that only about 14 percent of Poland's farms will be economically viable under the full liberalization of agricultural markets associated with EU membership (Levitas et al., 2001). Those that leave farming will need levels of human capital that let them create SMEs in rural areas or allow them to migrate successfully to urban labor markets. However, Poland's farmers now have lower levels of human capital than their EU counterparts. The LALS showed that Polish farmers tested on average 40 percent below other occupational groups in Poland; the OECD gap was 10 percent. Table 3.21: Urban versus Rural Enrollment Rates by Type of Secondary and Tertiary Education and Consumption Quintile for Ages 7-24, 2000 Typeof Consumption Quintile All Enrollment Poorest 2 3 4 5 Households Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural Basic Vocational 33.5 38.7 20.9 26.0 20.3 23.7 11.6 19.7 5.6 16.6 18.4 28.7 Academic 26.6 13.1 36.0 22.7 39.8 25.5 54.6 33.6 67.9 42.7 44.6 22.6 Secondary Vocational 38.5 39.3 49.7 53.2 48.1 51.8 42.0 55.2 30.7 47.8 41.8 47.7 Secondary Post Secondary 3.8 1.8 4.7 4.0 4.7 5.1 6.2 3.1 3.3 1.1 4.5 3.1 Tertiary Total 14.6 9.2 26.3 16.0 14.1 20.5 51.5 27.8 72.9 38.4 44.9 18.4 Source: Calculations by Irena Topinska, based on Central Statistical Office 2000 Household Budget Survey. 77 3.99 Recommendataon. The key equity issue is how to close the gaps in human capital between urban and rural students and between poor and less poor children. Since poor children are more apt to live in rural areas, solving one of these problems will mitigate the other. The recommendation is: U Use a multi-pronged strategy to address the "rural probRem." Several elements of such an approach have already been discussed: financing arrangements that roughly equalize gminas' abilities to top up the subvention and that increase the funds for underfunded secondary education; assuming a proactive role in protecting equity at the center; reducing the differentiation within the secondary system that leads to greater vanance in learning outcomes; linking the kuratoria and gminas in a strategy to improve the quality of education; and cutting "deals" between the MoES and rural gminas to let them save money by rationalizing the school network and plowmg their downstream savings back into education quality. Table 3.22: IPopulation at Age 15 amd Gldelr by HBighest Level o3 Eduiectonm Completed, 199g8. Level of Education Total Urban Rural Primary or Incomplete Primary 33.4 31.2 44.6 Basic Vocational 25.7 24.6 28.0 Secondary (Academic and VET) 28.4 30.9 14.2 Tertiary 8.2 13.1 3.2 Source: Central Statistical Office. CONCLUSDONS 3.100 Poland's human capital stock is a key factor that will determine whether the country and its citizens can take full advantage of EU membership. Although the broad budget implications of the recommendations made here are unlikely to generate significant fiscal savings over the short to medium termn, by strengthening the human capabilities and the comnpetitiveness of the economy, they are likely to promote longer-term growth and fiscal stability. ENVURlONM1ENT INTRODUCTEON 3.101 As with all the countries of Eastern Europe, Poland began the transition to a market economy with a production structure that was inefficient in its use of energy and natural resources. The resulting ambient environment was heavily polluted, with all the media - air, soil, and water - in a considerably worse condition than in its neighbors to the West. It is now nearly 12 years since the first non-communist government was sworn in and during that time the country has witnessed major improvements in its natural environment. Most pollutants have declined, initially as a consequence of the decline in output but more recently as a result of a switch to cleaner and more efficient methods of production and consumption. 3.102 Even though Poland has been doing quite well with respect to the use it makes of its natural environment, it has a long way to go before it can reach EU levels of efficiency. Given its commitments to achieve EU membership in the next three years or so, this poses a huge challenge in terms of environmental-related investments. Key policy interventions that are needed are listed below: (a) IPromote private investments by enhanchng private ownership and control A broad array of initiatives is needed, including options to commercialize or privatize (where appropriate), to rationalize local municipal services, to level the playing field for public and private operators, and to strengthen monitoring and enforcement. 78 (b) Strengthen the effectiveness of public expenditures. This requires consolidating local ecological funds, increasing the flexibility of shifting expenditure allocations between items, instituting systems for cost-benefit analysis, and reviewing the present structure of financmg and expenditures. (c) Establish clear investment priorities. These should be consistent with the overall goals of efficiency in public and private investment in this sector. (d) Leverage additional financing. These funds can help supplement scarce own budget resources for the necessary investments. For this, the Govemment not only needs to better leverage IFI flows, but also develop a strategy for mobilizing private sector resources. ENVIRONMENTAL IMPROVEMENTS DURING THE 1990S 3.103 Between 1993 and 1999, Poland achieved an increase in energy efficiency of 67 percent and a water pollution efficiency gain of 31 percent (see Table 3.23). In absolute terms, Poland's water pollution efficiency is similar to that of other "advanced" accession countries, such as the Czech Republic and Hungary, and more than double that of the NIS countries of Moldova and Ukraine, in fact, more than three times that of Ulkaine. However, it is still one-third to one-sixth that of the OECD group, and well below that of the EU countries such as France, Greece, and the United Kingdom. Table 3.23: Pollution Efficiency of Poland and Selected CEE, NIS, and OECD Countries PPP /lKg of Organic Water Pollutant I 1980 1993 1999 Country Group CEE C _ _ _ _ _ _ _ _ _ _ _ Bulgaria 463 1,056 1,0 84 Czech Republic . 1,822 2,351 Hungary 805 1,619 2,052 Latvia _ 773 1,870 Poland - 1,666 2,183 Romania 816 2,384 1,043 NIS M oldova 732 808 Ukraine 1,149 828 OE CD _ _ _ _ _ _ _ _ _ _ _ France 2,05 3 5,017 1232,329 Germany 4,282 6 ,67 Greece 3, 5,8 8 8 United Kingdom 1,451 4,2 071 6 006 USA 2,954 7,409 9,693 PPP S/Kg Oil Equivalent 1980 1990 1999 Country Group CEE C Bulgaria 09 1 7 2 3 Czech Republic 2.8 3.5 Hungary 2.0 3 3 4 6 Latvia 6 6 4 1 Poland 2 1 3 5 Romania 1 6 2 3 3 8 NIS Ukraine 1 3F12 O E CD OECD _ ~~~~~~~ ~~~France 2 9 4.31 5 3 Greece 4 8 5 L 6 0 United Kingdom 2 5 4 4 5.81 USA 16 2.9 3.91 Source: World Bank, World Development Indicators 3.104 Air Quality. During the last ten years considerable efforts have been made to reduce emissions of different gases (SO,, NO,, particles etc.) into the atmosphere. Reductions in budgetary subsidies to some of the most polluting industries, along with a shift to market-based prices, has encouraged energy 79 efficiency. Environmental policy has also advanced the introduction of end-of-pipe mitigation of pollution as well as, to a lesser extent, the adoption of cleaner technology. By this means, the country has managed to achieve a real growth in GDP of 56 percent between 1991 and 2001 while actually reducing emissions of CO2, SO02 NO, and particles. While this is commendable, it is with respect to Poland's aspirations as a member of the EU that the performance remains weak. For example, emissions of C02 in Poland are about 1, 180 Kg/I, 000 US$ of PPP/GDP, compared with a EU15 average of about 420. Comparable figures for SO2 are 710 and 130, and 360 and 180 for NO,<62 Thus Poland has a considerable way to go before it achieves EU levels of efficiency with respect to these pollutants. Table 3.24: Environment Sector Expeinditures, 1995-2000 By Rinstituiom % fD Total 1995 1996 1997 1998 1999 2000 Own Resources (Enterprises and Gminas) 32.0 n.a. 47.0 50.2 46.2 53.4 Budget Resources 5.0 n.a. 7.6 6.4 5.2 5.4 State 5.0 n.a. 3.0 2.6 2.0 2.2 Voivodshup 18.0 n.a. 2.8 2.1 1.4 1. Poviat n.a. 0.0 0.0 0.2 Gminas n.a. 1.8 1.7 1.8 1.4 Foreign Resources 5.0 n.a. 3.8 7.3 5.9 3.9 Ecological Funds (loans, credits, grants) 40.0 n.a. 16.9 16.2 24.6 20.0 Local Financial Institutions (Banks) - n.a. 16.5 12.5 12.9 11.7 Other Resources - n.a. 8.1 7.4 5.2 5.6 TOTAL 100 n.a. 100 100 100 100 As Percentage of GDP 1.0 1.6 1.6 1.6 1.4 1.0 As Percentage of Gross Capital Formation 5.5 7.6 6.6 2.9 5.5 7.6 Budget Resources as % of Total Government Expenditure 1.61 n.a. 0.98 1.01 1.24 0.64 By Media Air and Climate Protection 53.4 58.5 50.9 51.5 47.1 36.8 Waste water and water protection 36.6 35.2 40.6 38.0 43.9 50.9 Municipal waste watertreatment 34.8 15.8 17.4 14.7 17.1 17.7 Sewerage and rainfall drainage na. 15.7 18.1 17.4 20.4 29.0 Water supply n.a. 0.4 0.7 0.5 1.6 0.7 Solid waste management, soil & groundwater protection 9.5 5.9 6.9 9.1 8.2 9.9 Protection of biodiversity 0.2 0.1 0.0 0.1 0.1 0.1 Nature & landscape conservation 0.0 0.1 0.0 0.1 0.1 0.0 Noise & vibration control 0.3 0.2 0.3 0.4 0.2 0.7 Protection against radiation 0.0 0.0 0.0 0.0 0.0 0.0 Other 0.0 0.0 1.2 0.9 0.6 1.7 TOTAL 100 100 100 100 100 100 As Percentage of Gross Capital Formation 5.5 7.6 6.6 6.5 5.5 3.8 As Percentage of GDP 1.0 1.6 1.6 1.6 1.4 1.0 Source: GUS and Ministry of Environment 62 Data are taken from Peszko and Lenain (2001) and are for 1997 or the latest year available after that. 80 3.105 Water Quality. For water pollution, progress has been less rapid. In 1991 Poland had few wastewater treatment facilities, either at the industrial or at the community level. Some progress has been made since then; water withdrawal declined 21 percent between 1990 and 1998 and the percentage of the population connected to a sewerage system and the percentage whose sewerage goes to a treatment plant have gone up. Nevertheless, water quality is still well below EU levels. Whereas in Poland around 55 percent of the population is connected to public sewerage and about 45 percent of collected sewage is treated, the comparable figures in Germany are 95 percent and 90 percent, respectively. 3.106 Other Indicators. While air and water emissions have mostly declined, the same cannot be said of some of the other indicators of environmental quality. The number of cars, for example, has increased fourfold since 1990, with negative impacts on air quality in congested areas. Increases have also been observed in household wastes and m the use of packaging. Although this is still below EU levels in respect of these indicators, Poland also does not have the investment in capital and infrastructure to deal with the problems that arise from these sources. The vehicle fleet, for example is still older than in the EU and investment in adequate waste disposal and recycling facilities is well below EU levels. GOVERNMENT POLICY OBJECTIVES FOR THE ENVIRONMENT 3.107 The focus on EU accession is clearly reflected in the State Ecological Policy document, which was adopted by the Parliament on August 23, 2001. The policy is couched in terms of sustainable development and identifies a number of strategic issues (e.g., shaping macroeconomic and sectoral policies to come closer to sustainable development, and ensuring public access to information). It also seeks to "assure harmonization of ecological policy with the scope and direction of EU ecological policy." EU accession issues also heavily influence implementation issues. The short-term policy goal is focused on preparation for EU accession, with priority within that being given to areas where environmental quality is having serious impacts on health and where improved environmental disaster emergency and recovery systems are needed. The medium term goal is to make significant improvements in environmental conditions in the framework of EU ecological regulations and standards as well as international conventions, and to provide further institutional strengthening in the sector. The long-term goals are to establish sustainable development as a solid basis for all state economic and social policies and, in this context, to improve the rational use of natural resources. PROFILE OF SPENDING PROGRAMS ON THE ENVIRONMENT 3.108 Any discussion of public expenditures needs to be undertaken in the context of total expenditure needs, much of which are being met from private sources. Public expenditures are met primarily through the ecological funds (see Box 3.3), but also through direct budgetary support. An examination of expenditures-public as well as private-reveals several interesting facets: (a) After increasing over 1990-97, total environmental expenditures have fallen in real terms by 38 percent over 1998-2000 (see Table 3.24). As a percentage of GDP, this is equivalent to a decline from 1.6 percent in 1997-98 to 1 percent in 2000. (b) Both capital and current expenditures on the environment are increasingly being undertaken by enterprises using their own resources. (c) There is a marked shift in the pattern of environmental expenditures. The share of own resource environmental expenditures by enterprises has gone up from 32 percent in 1995 63 Data are taken from Peszko and Lenain (2001) and are for 1997 or the latest year available after that. 6 Data are taken from Peszko and Lenain (2001) and are for 1997 or the latest year available after that. 81 to 53 percent in 2000, while other sources have been falling. In particular, even though a significant portion of total expenditures (16-24 percent) comes from the ecological funds (whose expenditures are part of the consolidated budget, but which operate as relatively independent entities, with access to earmarked funds), their share has halved from 40 percent in 1995 to 20 percent in 2000. Foreign resources remain small at 4-7 percent of total expenditures. Box 3.3: Ecological lFunds The system of ecological funds is made up of I national fund, 16 regional funds and 2,500 municipal funds. In addition, there is a special EcoFund, which manages debt-for-environment swaps. In total, they had access to PLN 2.1 billion in 1999 and PLN 1.3 bilhon in 2000 (E520 million and E325 million, respectively). Despite the big decline in 2000, the funds remain the largest among all the CEE/NIS countries. They are a major source of funding for a range of projects including environmental education, afforestation, end-of-pipe investment, and R&D in new abatement technologies. The funding takes mainly the form of grants, but also includes loans and a mixture of the two depending on the activity. Expenditures by these funds are closely tied to their main source of income - pollution charges and fines paid by enterprises and municipalities. In the post-1989 fiscal reform period, the municipal and powiat ecological funds have shifted from being extrabudgetary to being part of the consolidated budget. (d) This decline in environmental expenditures in absolute as well as relative terms is quite recent. Annual environmental investment taken over the longer period of 1990-1997 more than doubled in real terms (Table 3.26). 65 (e) During the transition, there has been a shift of expenditures toward air protection and away from water and waste management. Air and water dominate total expenditures. From 1995 to 1999 air protection was the largest item, but prior to that water-related expenditures were the highest.66 The component with the largest decline was "solid waste management, soil and ground water protection" (down from 21 percent in 1990 to 10 percent in 2000). KEY ESSUES ANID REIFORM lIPfIIfONS (a) Declidmng Puublic Expenditure onn the Einvironnimment aumd the ChalneDnge of EU Accessioa. The recent decline in environmental expenditure from budgetary sources is a matter of concern, in spite of the fact that non-budgetary resources are increasing and their potential has yet to be fully realized. The main reasons are: (i) there are some areas of expenditure which are essential for effective environmental management and which can only be provided for by the public sector, and (ii) the expected public sector expenditures required to meet the EU Accession agreements are high and will increase. Public sector expenditures are essential to ensure compliance with a changing domestic legislative framework, compliance with growing international environmental obligations (e.g., conventions on Climate Change, Persistent Organic Pollutants (POPs), Basle 65 The definition of environmental is relatively narrow, referring mainly to end-of-pipe installations. It is estimated that the total level of all expenditures on all partly or wholly motivated environmental investments, including modernizations, technology process changes, fuel switching, etc., is perhaps twice as much.(Zylicz, 1998). The definition used in Poland is, however, consistent with that reconunended by the OECD (1996, 1998). 66 A similar change can be observed in other CEE countries, where the air pollution intensity of production has declined sharply (Zylicz and Lehoczki, 1994). What is not clear, however, is whether the extent of the shift is justified on welfare grounds. 67 In addition to covering expenditures in the areas identified above, budgetary resources are also used to fund some large wastewater treatmnent projects when other sources are not available for this purpose. There are some special funds managed by the Ministry of Environmnent specifically for this purpose. 82 Convention on Transport of Hazardous Substances, European Sulfur and Nitrogen Protocols), monitoring of environmental trends, and participation in and contribution to strategic environmental assessments of sectoral policy reforms carried out by other ministnes.68 While these may not involve large sums, there are indications that these areas are inadequately funded. Table 3.25: Funding of the EU Acquis Communautaire Pro ram: 2002-2006 (E millions) 2001 2002 2003 2004 2005 2006 TOTAL * Program: Quality of Water State 404.0 499.0 540.6 540.6 600.0 629.7 8,321.0 Non-State Domestic 53.3 65.9 71.4 71.4 79.2 83.2 2,961. External 222.7 275.1 298.0 298.0 330.8 347.1 2,725.0 Total 680.0 840.0 910.0 910.0 1,010.0 1,060.0 14,007.0 lPPC State 48.2 48.2 65.9 74.7 82.7 86.7 632.0 Non-State Domestic 496.8 496.8 679.1 770.3 852.3 893.3 6,515.0 External 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total 545.0 545.0 745.0 845.0 935.0 980.0 7,147.0 Quality of Air State 0.4 0.4 0.3 0.2 0.2 0.2 10.3 Non-State Domestic 571.1 576.2 354.0 310.4 294.2 232.2 13,329.7 External 0.6 0.6 0.4 0.3 0.3 0.3 14.5 Total 572.2 577.3 354.7 311.0 294.7 232.6 13,354.5 Waste Management State 143.0 228.7 499.5 550.5 550.9 551.3 5,272.0 Non-State Domestic 148.1 236.8 517.3 570.1 570.5 570.9 5,459.3 External 50.5 80.7 176.3 194.3 194.5 194.6 1,860.8 Total 341.5 546.2 1,193.1 1,314.9 1,315.9 1,316.8 12,592.1 Other State 0.5 2.3 46.4 45.5 52.5 51.9 257.0 Non-State Domestic 0.1 0.4 7.6 7.5 8.7 8.6 42.4 External 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total 0.6 2.7 54.0 53.0 61.2 60.5 299.4 Total State 596.1 778.6 1,152.6 1,211.6 1,286.4 1,319.8 14,492.3 Non-State Domestic 1,269.4 1,376.1 1,629.5 1,729.7 1,804.9 1,788.1 28,307.4 External 273.8 356.4 474.7 492.7 525.5 542.0 4,600.3 Total 2,139.3 2,511.2 3,256.8 3,433.9 3,616.8 3,649.9 47,400.0 (7 Total expenditures will take place over the period to 2015 and beyond for air quality xpenditures. ource: Ministry of Environment 6 In addition to covering expenditures in the areas identified above, budgetary resources are also used to fund some large wastewater treatment projects when other sources are not available for this purpose. There are some special funds managed by the Ministry of Environment specifically for this purpose. 69 The expenditure estimate range is from E25-Eso billion. The figure of E47 billion is partly higher because the costs of the new directives (2001/80 and 2000/59) have been included. The cost of implementing the directives according to the state of 3 .XII.1999 is about E37 billion, which is almost exactly the middle of the above range. '°EDC, 1997, Peszko and Lenain, 2001. 83 The total cost of meeting the EU accession requirements is estimated at around Ł47 billion, (see Table 3.25)7'. A range exists partly because of cost uncertainties but more because costs depend on what control measures are used and what pricing policies are in place72. Lower costs may be possible if the Government pursues least cost investment strategies and increases efficiency in the implementation of the required measures. What is more important from the medium term fiscal perspective than the total cost is the expected cost over the next five years or so. According to govemment estimates, the total costs will rise from Ł2.5 billion (PLNIO billion) in 2002 to Ł3.6 billion (PLN 14.4 billion) in 2006. Of the total costs from 2001 to 2006, about half will come from non- state domestic expenditures, about 14 percent from external public sources (mainly ISPA, SAPARD and other EU funds), and about 35 percent from domestic public finances. It is this last estimate, which implies annual expenditures from all levels of government and from the ecological funds of Ł780 million (PLN3.1 billion) in 2002, rising to Ł1,300 (PLN 5.2 billion) in 2006, that is the issue of concem. State expenditures plus expenditures from the ecological fimds on the environment totaled PLN1669 million in 2000 (see Table 3.27). Data for 2001 are not available but projected expenditures for 2002 are 85 percent higher than the 2000 figure. Even allowing for errors in the estimation of the annual expenditures by source, it is almost certain that the required level is too high and will not be met this year. Furthermore, the required levels of expenditure from state sources rise sharply in the years 2003-2006, and Poland will find it very difficult to achieve these levels of expenditure on the environment that the Government itself has projected, unless it undertakes a deliberate effort to tap EU structural funds for that purpose, and programs expenditures so that they meet eligibility criteria for such funding. (b) Lack of Adequate Counteirpart IFimmancimig. Another reason to be concerned about the level of public spending on the environment is the fact that EU funds for environmental investment (ISPA, SAPARD, and other funds to which Poland has access as an accession candidate country), which will be made available in greater amounts over the next few years, have to be matched by local counterpart funds, which are currently inadequate and are a constraint on the amount of external financing. As the level of investment required for environmental improvements has been increasing, so have the available resources from the EU. For example, between 1998 and 2001, the total amount available from PHARE and ISPA sources was about PLN71 million. In 2002 alone, ISPA allocated of PLN434 million for Poland, and once Poland is a member of the EU, the amount available will increase further by a factor of three or four. As ISPA regulations only allow up to 75 percent of total capital costs to be funded from that source, the demand for local counterpart funds will increase very rapidly. Presently the Government has no clear strategy for raising this amount of local counterpart financing. 71 The expenditure estimate range is from E25-C50 billion. The figure of Ł47 billion is partly higher because the costs of the new directives (2001/80 and 2000/59) have been included. The cost of implementing the directives according to the state of 31 .XII. 1999 is about Ł37 billion, which is almost exactly the middle of the above range. 72 EDC, 1997, Peszko and Lenain, 2001. 73 In addition to covering expenditures in the areas identified above, budgetary resources are also used to fund some large wastewater treatment projects when other sources are not available for this purpose. There are some special funds managed by the Ministry of Environment specifically for this purpose. 7 The expenditure estimate range is from E25-E50 billion. The figure of Ł47 billion is partly higher because the costs of the new directives (2001/80 and 2000/59) have been included. The cost of implementing the directives according to the state of 31 .XII. 1999 is about E37 billion, which is almost exactly the middle of the above range. 7 EDC, 1997, Peszko and Lenain, 2001. 84 (c) Effectiveness of Public Expenditures, Especially Ecological Funds. Are the expenditures organized to provide effective services in a cost-efficient manner, particularly the ecological funds? What changes will be needed in the system of public financing of expenditures once Poland is a member of the EU? There are several issues here. (i) The ecological funds and the Ministry of Environment special funds provide large levels of investments but lack the use of state-of-the-art techniques to assess cost effectiveness and to estimate the social benefits of different investments. At a less sophisticated level, there is no comprehensive information on the extent to which different projects are subsidized. The instruments used include direct grants, soft loans, "green equity" investments, interest rate subsidies on semi- commercial loans, etc. The "subsidy equivalent" to each party is rarely calculated, making any cost effectiveness exercise very difficult to achieve. (ii) The financing of ecological funds needs to be reconsidered. The ecological funds are financed through the earmarking of revenues from pollution charges and fines. These are already among the highest in the CEE and higher than in most OECD countries. The scope for generating additional revenues from them is therefore not a viable option. Indeed, even the current system of environmental finance will come into question after accession has been achieved. Since other EU member states do not impose such high charges, enterprises in Poland have already begun to complain about the lack of a "level playing field." Hence, one of the questions that will need to be addressed in the near future is how to reorganize their financing. (iii) There is excessive fragmentation of ecological funds, and some consolidation is required. Although Poland has one of the more centralized systems of environmental funds in the CEE (a larger share goes to the national fund than anywhere else), the existence of more than 2,800 local funds is not cost-effective. Studies have shown that the efficiency of spending at the municipal level is much lower than at higher administrative levels (Choromanski, 1995). The problem is largely due to "low expertise and small scale of revenues" (Zylicz, 1998). The Ministry of Environment has proposed the "elimination" of these funds below the voivodship level. In this case, alternative financing arrangements will have to be instituted. (iv) Presently allocations to specific line items are described in great detail by the Ministry of Finance, which constrains the ability of the Ministry of Environment to re-allocate its expenditures according to changing circumstances. 3.109 Recommendations. It is clear from the above that a proper resolution of the above issues requires action on several fronts. Some of the more important measures that need to be taken are the following: (a) Promote further private investments by enhancing private sector ownership and control. The evidence suggests that Poland is behind some of the other accession candidate countries in terms of private ownership and control. For instance, at the end of 2000 only two municipal landfills and two waste water treatment plants were partially owned and operated by strategic private investors, whereas in the Czech Republic and Slovakia most of the landfill capacity (more than 20 sites) is operated and owned by private sector companies. In Hungary, seven municipal water companies and eight waste management facilities are privately owned and their investment financed by large foreign 85 companies. In Slovenia, at least 12 municipalities have privatized the provision of communal services. There are several initiatives that the Government can undertake: (i) PrAvatize/commnercialie where appropiriate. There is other evidence that the scope for moving some investments out of the public budget is quite large.76 The success of such a strategy can be pursued through the routes of privatization and commercialization in the areas of district heating, power generation, and waste management. Commercialization has been successfully adopted in Poland in the power generating sector, which allows investment in pollution control equipment to come from commercial loans, backed by power purchasing agreements between the commercialized generating units and the state electricity authority. The same strategy could be extended to more municipalities dealmg with water supply and wastewater, and other sectors77 (for further discussion see Markandya, 2002). (ii) Rationmalize local municipal services. Many of the utilities currently providing services are too small to make cost-effective investments or manage operations in an efficient manner. The financing arrangements, moreover, militate against this, to the extent that soft loans from suppliers and ISPA grants support the status quo. Direct pressure from the central government is needed to overcome this bias and to resist the loss of political patronage that it will imply. (iii) Level the paynyag fTeldl. Private and public facilities should face uniform enforcement of environmental requirements and subsidies. Numerous experts and commercial banks have reported cases where city authorities are unwilling to accept private financing because of a loss of subsidy for the utility if it is operated as a private entity. (iv) Strentheni monitorring. The increased level of private sector activity implies a greater effort by the state to ensure compliance. This in turn requires investment in capital equipment for monitoring and testing, etc. Funding for this can be obtained from ISPA, if the demands can be bundled to meet the E5 million threshold. (v) Develop a strategy paper. The Government should prepare a strategy document that will examine ways in which private sector funds can be mobilized. Following the preparation of this strategic document, a revised and detailed breakdown of expenditures for a rolling five-year period should be prepared. (b) lmpirove the effeedvenness of publie epenaditures. This requires action in the following three areas: (i) Conisoldate local ecoRogical ffunds (below the voWvodshAp level) at the nationaR and voivodsh!p Revels. As noted earlier, in addition to increasing the effectiveness of public spending, this would make it easier to raise counterpart 76 A Czech study showed that as much as half of the "big-ticket" items could be shifted out of the public budget under certain assumnptions (World Bank, 1999). 77 Although it is successful in taking the direct investment cost off the budget, this approach suffers from the problem that the borrowing is, invariably, guaranteed by the government and therefore forms part of the consolidated national debt. There is also the issue in such cases of subsidies to these enterprises through working capital and loans from state-owned banks, given at below commercial rates. To the extent that these practices prevail (and they are still quite common), the institutional mechanism of commercialization for taking environmental costs off budget will still leave some budgetary burden. 86 funding. The immediate action that should be taken is to make some estimates of: (i) the likely savings in management costs; (ii) the potential increase in available counterpart funds as a result of this measure; and (iii) the transfers to local entities that need to be made to enable them to fulfill their other essential functions that were being subsidized by the ecological funds. (ii) Increase flexibility in the expenditure allocations between items. Some flexibility in reallocation, which would nevertheless respect the broad intent of the Ministry of Finance, would be very helpful in reducing local financing constraints on environmental investments. (iii) Start assessing the cost effectiveness of different projects and programs. This has to be done at the national, voivodship, and local (powiat and gmina) levels. Procedures for evaluating environmental projects have reportedly been "worked out" jointly with the European Commission and the intemational financial institutions. The implementation of these procedures, however, is still lacking. With the exception of the national fund, the EcoFund and a few regional funds, most funds do not even collect the data required for sound project appraisal. Funds usually support projects irrespective of their financial viability. (iv) Review the present structure of financing and expenditures by the funds. This review should include: (i) The appropriateness of earmarking pollution fees to the funds and the sharing rules for the fees between different levels of funds (ii) The appropriateness of levying new charges on enterprises or on consumers to replace the high pollution charges78 (iii) How to increase the effectiveness and accountability of the programs and ensure that they are consistent with national and regional environmental objectives (iv) The establishing of a balance between the need for decentralization to better serve local priorities and consolidation to increase the efficiency of administration (v) An evaluation of the role of funds as loan institutions and investors in equity in private firms while at the same time they are being used to manage public funds. (c) Establish investment priorities consistent with the overall goals of efficiency in public and private investment in this sector. While the target expenditures for EU accession are unlikely to be met fully, there may be some scope for a (common) agreement with the EU to accept some reductions in expenditures, based perhaps on lower levels of treatment/compliance with some directives if it can be shown that: (i) the investment is seriously uneconomic (perhaps because the size of the community it serves will decline dramatically in the next few years); or (ii) the "savings" in costs from 78 While in the medium term this reform of environmental finance is essential, the structure of pollution fines and charges and their earmarking for ecological funds need to be retained for the inumediate future. The case for this is primarily based on the urgent need for local finance to meet environmental accession-related expenditures and the lack of any practical alternative. Of course this does not exempt the funds from being cost efficient and focused. There is quite a lot that can be done in that regard and some of the key measures are discussed below. 87 reducing the attainment level by a small percentage will allow more plants to be built and a higher overall contribution to be made to meeting the ambient environmental goals.79 A second area where the issue of consistency in policy goals arises concerns the recormmendations in the reforms in agriculture and rural development, especially with respect to changes in agricultural subsidies. There will clearly be implications of these reforms for the environment, some of which could be positive (promotion of organic agriculture) and others negative (increased use of pesticides). These in turn will have implications for environmental expenditures. These linkages need to be established so that the medium term expenditure plans reflect the relevant changes. (d) Redairect enviironmnentnl expenditure so that it meets eligibity criteria Tolr IEU strunctural fTinds iiiauciang. CONCLUSXONS 3.110 Public sector expenditures on the environment in Poland, which were rose from 1990 to 1997, went into a decline in the last three years for which data are available. While this decline has been compensated in part by an increase in private sector expenditures, total expenditures overall have fallen, during a time when greater spending is needed in the light of the EU accession driven investment program. More budgetary funds need to be provided to the environmental sector, especially where the recent cuts have comnpromnised the country's capacity in the areas of environmental compliance, regulation, and policymaking. 3.111 At the same time, the Government should make a serious attempt to increase non-state expenditures for the environment. This requires fundamental policy reforms that would promote private ownership and control in key sectors. Public sector financing also needs reform. In particular, the current system needs to be replaced by one that more closely mirrors the financing arrangements in non-transition OECD countries, where expenditures on the environment are either from the budget or from the private sector. In the short term, however, the ecological funds need to be retained so that they can provide part of the urgently needed financing to meet the Environmental acquis in a timely fashion. But this should not preclude initiating reformns that consolidate the number of ecological funds and increase the efficiency with which they operate. AGCRIIJLTrURE AND RJRAL DEVEL(D?MIENT ENTRODUC'TION 3.112 Public expenditures in the rural sector in Poland are focused on two main policy goals: the improvement of productivity in the agricultural sector and the achievement of parity of rural income with urban income levels. The main policy instruments used are price and input subsidies, including interest rate subsidies and loan guarantees, and transfers from the budget to cover almost 90 percent of the rural pension fund obligations under the KRUS system. The emphasis on these instruments leaves insufficient expenditure available for agricultural extension and infrastructure programs which could be more successful than input and output subsidies at improving agricultural productivity. The current mix of instruments also fails to provide sufficient focus on the creation of off-farm employment in non- agncultural sectors. 3.113 Key recomrnendations are the following: 79 It is well known that the marginal costs of meeting standards rise with the standards themselves, and this holds particularly strongly in the area of wastewater treatment. 88 (a) Restructure rural sector expenditures toward job and productivity enhancing programs areas and use EU funding to replace domestic funding to the maximum extent possible. Funds need to move away from programs such as input and credit subsidies and the government contnbutions to KRUS toward non-farm employment generation, agnculture research, development and extension services, and imgation, drainage, and land improvements. Expenditures for off-farm employment promotion could increase significantly from the EU structural funds, but replacmg domestic funding with EU funding should be done to the maximum extent possible given the current budget situation and the level of value-added produced by the sector; government co- financing obligations can be best met through savings from current programs. (b) Invest in a modern land cadastre system. With investments as low as US $100 million, a vast base of potential collateral could be tapped to unlock access to credit and provide opportunities for new investment in the rural sector. (c) Seek to use EU direct payments for income transfers to farmers. This would help compensate farmers for the changes in KRUS eligibility criteria and premiums while also decoupling them from levels of production of specific crops. SECTORAL OVERVIEW 3.114 The contribution of agriculture, forestry, and hunting to GDP has been falling steadily since 1990, resulting primarily from the lack of growth in agricultural production volume but also from of declines in prices for agricultural and food products over the period. The decline in production volume resulted from demand reductions in the early 1990s as well as the restructuring of former state farms, whose production share fell quickly during the mid-1990s. In turn, the restructuring of state owned farm holdings led to the exclusion of some marginal farmland from agricultural use but to more rational use of the remaining land by the new private cultivators. 3.115 As a result, in the late 1990s the share of agriculture in valued added fell from about 7 percent in 1995 to just over 3 percent by 2000. However, gross agricultural output has been more or less stable and the share of agriculture in overall employment has been more or less constant at 26-27 percent. However, the most alarming development in the late 1990s in rural employment was the fall in rural non- agricultural employment, which declined by 200,000-300,000 over 1998-2000. This non-agricultural employment accounts for almost 40 percent of rural employment (when estimates for the informal sector are included). 3.116 The agncultural land area in Poland totals about 18.5 million ha with 92 percent used by the private sector. In the late 1990s, agricultural land used by the private sector was fairly stable at 17.0 million ha, but this was a marked increase from the 1990 level, since land leased from the state increased from 0.7 million to about 2.4 million ha (2000). Since the number of agricultural holdings declined from about 2.05 million in 1996 to 1.89 million in 2000, average agricultural land per farm grew from 8.2 to 9.0 ha (in 2000). Moreover, during this process the distnbution of land usage by farm size started to show a more uneven, bi-modal pattern. The share of total agricultural land owned by farmers with more than 15 ha doubled from 20-40 percent, reflecting, in part, the consolidation of larger farms, and the share of 1-2 ha farmers grew slightly as well. At the same time, the shares of agricultural land owned by farmers of 2-5 ha, 5-10 ha, and 10-15 ha dropped continually in the 1990-2000 period. 3.117 There is evidence of farm consolidation at the higher end of the distribution, as the number of farms above 15 ha increased by almost 50 percent since 1990, with the area farmed by this group increasing by 2.7 million ha (see Figure 3.13). At the same time, the number of farms between 2-15 ha fell by almost 400,000 since 1990, and their aggregate area fell by nearly 2.5 million ha. These latter 89 three groups (2-5 ha, 5-10 ha, and 10-15 ha) also have the highest degree (almost 50 percent) of mixed farming (crops and livestock), whereas the smallest fanns and the largest farms are almost 50 percent specialized in the crops sector. In terms of marketed output, the share of the largest farms increased from 39 percent in 1996 to over 45 percent in 2000. The farms with more than 15 ha also have the largest share of family members (over 60 percent) who are between 18-44 years (the so-called "mobile age") and the smallest share of family members "after production" age (men over 65, women over 60). All in all, these are signs of an evolving commercial farming structure. IFigure 3.13: DNstrnibuntio of Owneirship of Agricinltunrsa ILanmd 45% c 40% - 0 35% - .N 30%- 25%- 20% - A Vz_- 1995 %20% 0% 20% 40% 60% 80% 100% 120% Cumulafive Percentage o IF&oms (smllnest to sirgnest) Source: Ministry of Agriculture. 3.118 The primary challenge in agriculture and rural development is how best to enhance farm productivity and generate off-farm employment in the medium to long term. However, the Government also has a social objective: of boosting farm incomes so as to achieve their parity with urban incomes. Indeed, the latter objective is being served through the provision of input subsidies, credit subsidies, and guarantees, agricultural price support, and the KRUS social insurance system that allows low KRUS premiums for participating contributors.80 3.119 However, if farm productivity enhancements require increases in the farm's land-to-labor ratio, then some farms will have to consolidate and retrench farmers, at the direct social cost of those retrenched. As noted above, farm consolidation progressed in the 1990s, and most farmers recognize that this is the future path of agriculture.8' However, in the long run, as urban income per capita continues to grow, it is not feasible to try to maintain parity of rural income with urban income levels through transfer payrments. Rather, the higher income of rural families will need to be achieved most efficiently through go One can estimate the KRUS subsidy by assuming that if the KRUS system had the same ratio of contributors to pensioners as ZUS (roughly 3:1, rather than the current ratio of 0.8) and premiums covered payouts to pensioners, then the premium would have to be 17 billion PLN distributed over 6 million "needed" contributors, or roughly 230 PLN/month. The subsidy is therefore about 180 PLN/month per contributor. 81 Polls of farmers in the late 1990s revealed that only 50 percent wanted to stay in farming and about 45 percent would consider selling their land in order to invest profitably in off-farm enterprises and/or help their children start out in life. 90 off-farm employment; already non-agricultural employment provides the most significant income source for the rural population.2 TRENDS IN CURRENT EXPENDITURES 3.120 Overall expenditure on the agricultural sector has grown from about 20 to 26 billion PLN in the period 1999-2002, increasing from 7 percent of expenditures to about 8 percent of expenditures, equivalent to 3.0 and 3.5 percent of GDP, respectively (see Figure 3.14). At first glance, this appears fairly high in comparison with countries with similar or even higher shares of agriculture in employment and GDP levels, where the range of agricultural expenditure is closer to 1-2 percent of GDP. One of the main reasons for this is that the budget of the Ministry of Agriculture and Rural Development (MARD) includes about 90 percent of subsidy for the payment of pensions of retired (and disabled) farmers under the Agriculture Social Insurance Fund (KRUS, which has been discussed in an earlier section). These expenditures have ranged from 14 to 16 billion PLN over the 1999-2002 period. Without these KRUS expenditures, the agricultural sector budget has indeed increased from 1 percent to 1.3 percent of GDP, close to international comparators. Figure 3.14: Agriculture Budget as % of GDP and Expenditure 8E Without KRUS - 7%- | i ~ Share of GDP M Without KRUS - 5%- l it _ Share of Government 4%- ~~~~~~~~~~Budget 3 Tota I - Share of 3%- ~~~~~~~~GDP *9TotalI- Share of 2% j j 3 ~~~~~~ovmment O% I.Il_2llE ilh 9 Budget 1999 2000 2001 2002 Source: GUS, MoF, and World Bank staff estimates. 3.121 The Polish Government's non-KRUS expenditures in the rural sector focus on a number of development programs aimed at implementing structural transformations in the sector. They are becoming increasingly focused on aspects of EU accession and funded by EU-financed programs. Notable progress has been achieved in the area of regulatory and legal framework adjustments, including the laws applicable to agriculture, the vetennary area, and fisheries. The main rural programs currently in action are: (i) the PHARE programs, which have been providing support to the ongoing preparations for the European integration in the agricultural and rural sectors, mainly in the form of technical assistance, training activities, and experts input; (ii) the annual support program for investment projects in 82 The share of agricultural income is 30 percent and that of transfers is 20 percent, and therefore off-farm emnployment accounts for 50 percent. 91 agriculture, agncultural up-stream and down-stream sectors, rural areas, and agri-food processing, implemented by the Agency for the Restructuring and Modernisation of Agriculture (ARMA); (iii) annual programs of intervention activities on agricultural markets, implemented by the Agricultural Market Agency (AMA); (iv) the SAPARD Operational Program, being prepared for implementation with the co- financing ensured from both pre-accession funds and the national budget; and, (v) the rural Areas Development Program, being implemented with co-financing provided by the World Bank. 3.122 The implementation of these and other agricultural sector expenditures is handled by the MARD and its three main affiliated agencies: the Agricultural Property Agency (APA), ARMA, and AMA (see Box 3.7). SAPARD expenditures in Poland are handled by ARMA but are shown separately as they are additional to ARMA's historical programs. Figure 3.15: Distribution of Expenditures 100% 90% _ 80% -- __ 70% - 1_ EAPA 60% -_ 0 ARMA 40% -MR 30% 20% 10% 0% 1999 2000 2001 2002 Source: MoAg, MoF, and World Bank staff estimates 3.123 In the past four years the organizational distribution of expenditures among the four main budget implementing organizations has shifted in favor of MARD's own (non-KRUS) expenditures and expenditures by APA (see Figure 3.15). The shares of AMA and ARMA have been reduced. For MARD, the main increases have been for fuel subsidies (PLN150 million in 2001), financial support to enterprises in which MARD has ownership83 (PLN150 million in 2002), IFI programs (PHARE expenditures and the World Bank-financed Rural Development Project, averaging PLN220 million in 2001-2002), and subsidies topowiats (PLNI 15 million in 2002). 3.124 For APA, PLN300-400 million is spent each year on debt service on bonds issued to creditors of former state farms (at the time of their liquidation), with another PLN350 mnillion annually for investments in and maintenance of the housing and social assets of former state farms (which continue to be used by their former members). About PLN300 million of APA's increasing revenue (expected to be PLNI.4 billion in 2002) is sent to the national budget. For AMA, total expenditures have declined, with the increase in milk and grain intervention purchases offset by a fall in credit guarantees. Between 80-85 percent of ARMA's expenditures (excluding SAPARD) have been for interest rate subsidies in 1999- 83 In 2000, 16 percent of the food mdustry output was produced by the public sector. This share is 35 percent for the industrial sector as a whole. 92 2002, but these are expected to decline by 20 percent in 2002. Infrastructure mvestments paid for out of ARMA's own budget also fell in 2001-02. However, in 2002, roughly PLN2.3 billion of SAPARD expenditures handled by ARMA are expected to take place. Thus, ARMA handles the largest share of the agricultural budget (not including KRUS). Figure 3.16: Dynamics of Agricultural Budget (PLN thousand) * Administration o Inspection, R&D, and Ad'Asory * Irrigation, Drainage & Land Reclamation * Rural Development Assistance (incl. LACS) l Input Subsidies a Credit Subsidies and Guarantees E Market Interention a Other, including SAPARD 2006 2005 I 2004 2003 2002 2001 2000 I| 1999 I_._.____ - 5,000,000 10,000,000 15,000,000 20,000,000 25,000,000 Source: MoAg, EU, UKIE, and World Bank staff estimates. 3.125 Functional Distribution. The stnikng characteristic of the functional distribution of the agricultural budget (not including KRUS) is that more than half is for input subsidies, credit subsidies, and market intervention purchases, which average PLN3.5 billion annually (see Figure 3.16). Roughly PLN900 million (10-15 percent of the non-KRUS expenditures) is allocated for agricultural support services (inspection services, research and development, farm advisory services). With investment in research and development equal to roughly 1.7 percent of agricultural value added, Poland exceeds low income country and world averages but invests only about 70 percent of the level of comparator countries with similar shares of agricultural GDP in total GDP. Only PLN350 million is allocated for irrigation, drainage, and land reclamation; on a per hectare basis, this is 2-5 times less than budgets for such infrastructure programs in comparable countries. Rural development assistance investments, not including SAPARD funds, have also been quite low, approximately PLN250 million annually. 3.126 These MARD rural development assistance APA investment expenditures are included with PHARE, World Bank, and SAPARD investment expenditures (as the "Other" category). Total investments (not including irrigation, drainage, and land reclamation) averaged about PLN800 mullion annually in 1999-2001. This is less than 10 percent of total non-KRUS agricultural budgetary expenditures and represents a low level for investment expenditures compared with countries with similar size agncultural sectors. Given the expected expansion of the SAPARD program in 2002 (using funds 93 which went unused in 2000-01), the total investment expenditures are to reach PLN3.3 billion in 2002. The other main trends in the 1999-2002 period include: credit subsidies declining from PLN2.1 to 1.6 billion; mput subsidies doubling to over PLN400 million; and market intervention growing 40 percent to PLN1.4 billion. At the same time, KRUS expenditures grew from PLN14. 1 to 16.3 billion. 3.127 Challenges and Opportunities of EU Accession. Looking ahead, the fundamental challenge is to ensure that Polish agriculture emerges as a serious competitive player in the EU markets with a primary focus on improving productivity. Various EU programs are meant to facilitate the transition including the following four programs from which Poland would benefit (see also Box 3.4): (a) SAPARD. About El.4 billion from the EU and state contribution to the SAPARD budget are expected to be expensed over the 2003-06 period. Given a current level of SAPARD linked expenditure (about E250 million), the increase in SAPARD linked expenditures on an annual basis would be about 400 million PLN. (b) Price Support. If accession proceeds as planned (for 2004), price support to Polish agriculture would rise by about E250 million annually (or about I billion PLN). These price increases are mainly for poultry, beef, and milk, with the prices of pork and grains experiencing a decline. From the time of accession however the charge of most of these expenditures will be transferred to the EU budget, relieving Polish public finances accordingly. (c) Fairmers' Compensations. Direct payments to farmers, which were an issue of keen debate between Poland and the EU, can reach, in the years 2004-06, respectively a maximum of 55 percent. 60 and 65 percent of the payments granted to farmers of the current EU member states. The EU budget will finance 25, 30, and 35 percent from the direct payment program of CAP. Poland has the option to top up CAP payments out of its own resources by redirecting EU structural funds originally set aside for rural development, (about E500 million) or general government revenues. In the light of prevailing fiscal conditions, the government would be wise not to avail of this flexibility (d) Rlural Development, Structural, and Cohesioun IFuds. Some of the structural and cohesion funds could also be targeted on rural development, which is expected to lead to disbursement of E1.8 billion (8 billion PLN) annually over 2004-2006 excluding rural development funds used to increase direct aid to farmers. lKEY JISSUES AND Room01EOI M O ITNS 3.128 Several key issues emerged from a careful look at the rural sector. (a) The Low EducaiDon Level in Rural Atreas. As discussed earlier, rural-urban inequalities are significant (see Education section). This is a particularly important obstacle to gaining productive off-farm employment. In addition, opportunities for re- qualification programs such as supplemental short-term courses, job retraining, or consulting services for prospective entrepreneurs, are limited in rural areas. This is a key area that needs strengthening if both the farmers exiting farming and the annual increment to the rural labor force of roughly 50,000 are to qualify for off-farm employment."M 4 GUS projections for 2010 in Population Projection, 1999. 94 Box 3.4: Roles and Responsibilities The Ministry of Agncultural and Rural Development supervises several key govemment agencies with specialized roles and responsibilities. Some of the more important ones, at least from a financial perspective, are the following: Agency for Restructuring and Modernisation of Agriculture (ARMA) is a leading govemmental institution in Poland. ARMA was set up in 1994 and its main activities are related to support for (i) investment in agnculture, agricultural production, agri-food processing and services for the agricultural sector; (6i) measures to create new, permanent jobs for the rural population in non-agncultural sectors; (in) development of technical, production and market infrastructure of rural areas; and, (iv) education with regard to upgrading the qualifications of the rural population, agricultural advisory services, and implementation and dissemination of accountancy in agricultural holdings. Following its accreditation of the European Commission, ARMA is expected to perform the role of the SAPARD Agency wherein the agency will make payments covered by implementation programmes of the CAP accompanying measures. ARMA provides interest rate subsidies on credits to farmers that are provided by banks, direct subsidized loans, and guaranties for repayment of banking loans. Alongside support given to investment projects in agriculture, agri-food industry and services, credits can be granted also for the establishment and furmishing of a farm by young farmers, purchase of agncultural land as well as the creation or furnishing of a farm within the framework of an agncultural settlement programme. The form of assistance provided by ARMA varies depending on the type of undertaking, but regardless of its form, ARMA's expenditures funded from the national budget always supplements the investor's own funds. Agency for Agricultural Markets The AMA is responsible for market intervention in agriculture, focusing on market stabilization and support of farmers' income. The stabilization activities of the ARR apply to pork and beef, wheat, rye, butter, skimmed milk powder (SMP), sugar, potato starch, and occasionally honey and hops. Agricultural Property Agency. The APA was established in 1991. It is responsible for the management, restructuring and privatization of agncultural property of the State Treasury (state-owned farms that were dismantled, the land of the National Land Fund and othet agncultural property) and concentrates on setting up new agricultural holdings and enlargement of existing family farms, as well as on activities to support former employees of state-owned farms and their family members. Since 1998, the APA has been implementing a program of stipends for youngsters from housing estates on the former state owned farms. The main task, (i.e. restructunng and pnvatization of the State Treasury agricultural property) is carred out through its sale or lease. As such, the APA's main income is from revenues from property sales and lease. In order to perform its tasks, the APA has set up II regional branches and 6 subsidiary offices. The list of real estate offered for sale or lease as well as announcements regarding the tenders are placed on information boards in the relevant gmina's office where the real estate is located. When a parcel's estimated value exceeds an equivalent of 1,000 tons of rye (set according to the regulations on agncultural tax) - its offer for sale or lease is published in newspapers having at least voivodship wide circulation. The National Extension Center for Agricultural and Rural Development (NECARD) NECARD is the main organization for agnculture research and extension. It has two subsidianes operating in Cracow and Poznadi, and six regional centers (at Przysiek, Barzkowice, Plofisk, Stare Pole, Radom, and Wroclaw). It also encompasses voivodship agricultural extension centers operating in each province. The NECARD and voivodship extension centers are primarily responsible for: (i) participation in the system of qualifications acquisition and upgrading aimed at farmers and the rural population; (ni) co- operation with research and development units while disseminating and implementing research output in farming practice; (iii) assistance in the course of development and implementation of local and regional rural development programs, particularly those aimed at creating new jobs in non-agricultural sectors of the rural economy; (Iv) dissemination of information on different forms of pre-accession assistance and its effective use; and (v) participation in the Society Information Program on requirements, rules, standards, and procedures in EU-financed rural and agncultural development programs. NECARD's also cooperates with ARMA and has been assigned the task of performing technical and economic assessment of aid applications under the projects to be financed under SAPARD. (b) Farm Unemployment and Under-Employment. Given rural unemployment of 0.7 million and about I million underemployed farmers needing to exit the sector, partially solving these problems by finding employment for half of these people over ten years amounts to generating 85,000 jobs per year. Added to the 50,000 annual increments to the workforce, and assuming that 50 percent of this total will commute to cities; at least 70,000 new jobs annually are needed outside of the agricultural sector in the rural areas. S5 GUS projections for 2010 in Population Projection, 1999. 95 (c) Underdevelopment of laind mortgage institutdons and practices. Currently, when land is taken as collateral, its value is heavily discounted (by as much as 70 percent) as there are large doubts as to the accuracy and well functioning of the title registration and cadastre system. (d) Conitinued Market linterventonos. In terms of policy, government 11able 3.26: Estimate of AgrAcultnure interventions in trade and pricing fell Support, 1990-2000 substantially over the late 1990s. By 1998 1999 2000 2000, policy-related input and output Poland price distortions-as measured by PSE 22 19 7 the Producer Support Estimate (PSE) TSE 2.4 1.8 0.8 and the Total Support Estimate PSE 36 29 34 (TSE)-were much lower than those TSE 1.6 1.6 1.4 of most other transition economies OECD and far lower than those of the EU PSE 33 35 32 and OECD (see Table 3.26). TSE 1.5 1.4 1.3 Other EU Acc 3.129 Despite the positive aggregative picture, PSE 21.7 18.7 16.5 product-specific interventions do take place. TSE 2.9 1.8 1.7 lintervention measures are of the greatest importance PSE is Producer Support Estimate as a percentage of for the pork, grain, and dairy products markets. For total production values TSE is Total Support market stabilization, a price range is fixed in which Estimate as a percentage of GDP and includes all prices are allowed to fluctuate. If the market prices transfers to producers and general non-product- exceed these limits then direct market interventions specific budgetary support to agriculture. exceed hese liits the directmarketSource: 0. Melyukhina, Policy and Non-Policy are made. The ARR supports the minimum price by Sources of Agricultural Price Distrotions: Evidence purchasing at an intervention price somewhat higher from the Measurement of Support in Selected than the minimum price but under a price ceiling Transition Economies, paper submitted for the defined by the Govermment. Since 1997 intervention OECD Global Forum on Agnculture: Agriculture Trade Reform, Adjustment and Poverty; Pans, 23-24 purchases have been carried when their average May, 2002. market pnces during two subsequent weeks remain at _ the level of 90 percent of intervention prices. The ARR can intervene in extemal trade but until 1994 such intervention was mainly in the form of import activities and to a much lesser extent on the export side. In addition, sugar is subject to both price regulation and production quotas (including export quotas). In 2002, sugar export subsidies were estimated at PLN40 million. 3.130 Recommendatdons. The issues outlined above require the development and implementation of a coherent and well-defined agriculture and rural development policy that can improve productivity and create jobs in rural areas, thereby putting Polish agriculture on a firm competitive footing in the EU and enhancing rural incomes. Some policy recommendations that can move the country toward this goal are the following: (a) Restructuare runral sector expeindituires towards empDoymeint and productivity enamincinmg areas and use IE1U funding to replace domestic funding the largest eatend possible. The allocation of funds should be shifted away from rural infrastructure toward currently underfunded areas so as to reach comparator country levels and to position Poland to take advantage of EU structural funds. Replacing domestic funding with EU funding should be done to the maximum extend possible given the current budget situation and the level of value-added produced by the sector. Specific areas for such increases are: non-farm employment generation, agricultural research and development, extension services (by 35 percent to 1.2 billion PLN), and irrigation, drainage, and land improvements (by 100 percent to 700 million PLN). Clearly, cuts in other programs will 96 have to be found to meet EU co-financing needs. The specific areas of cuts are: expenditures on market intervention (currently 1.4 billion PLN) and the KRUS program. As the CAP will be paid from the EU budget, the current expenditures on market intervention from the Polish budget could be largely discontinued, with the likely exception of the 400 million PLN spent annually on the pork sector (which is not supported under the CAP). Similarly, the gradual elimination of current input and credit subsidies could potentially yield up to 2.0 billion PLN. A similarly large source of savings to be reprogrammed could come from the KRUS program. This could amount to 950 million PLN annually, which could help pay for some of the additional expenditures above. (b) Develop a modern land cadastre system. Integration of land and other real estate into a unified cadastre that is updated and accessible electronically and at low cost should be a key priority of the Government. The investments needed in this area could be as low as US$100 million, but would have very high returns if they could improve the security of collateral and bolster the level of credit extended by commercial banks to the agricultural sector. Even then, long-term loans for land acquisition may continue to be a rare phenomenon, since commercial banks have no access to long-term liabilities. However, since the APA has long-term streams of lease payments for land that the private sector rents from it, the APA is well positioned to use these streams to partially guarantee long- term, mortgage backed loans from commercial banks. (c) Phase out KRUS as direct payments are phased in. Using the direct payments from the EU as income transfers would be desirable in two ways. First, it would compensate the farmers, at least partially, for the changes in KRUS eligibility criteria and premiums. If the direct payments were distributed equally among the farmers, the farmers remaining in KRUS would be wholly compensated for the increase in KRUS premiums, and the larger farmers graduating into ZUS would be about 70 percent compensated. If direct payments were distributed to farmers on a per hectare basis (this would eventually reach about US$80/ha per year), then the degree of compensation of smaller farmers would be less, with the large farmers wholly compensated for the increased cost of pension contributions associated with moving from the KRUS system to the ZUS system. Second, as income transfers, these payments would be decoupled from the levels of production of one or another agricultural commodity produced by a given farmer. This, overall, would tend to distort agricultural prices less (compared to intemational market prices) and would cause less economic inefficiency and less costs to the budget, as surpluses to be disposed of through export subsidies would also be less. 73. All in all and assuming (as this report recommends) that a one to one substitution between EU direct payments and KRUS outlays can be achieved, EU accession will create the opportunity to bring down the burden of agricultural expenditures that are to be domestically financed from the current 3.5 percent of GDP to 2.6 percent of GDP. Even further reduction is possible through financing some of the remaming 2.6 percent through other available EU funds. CONCLUSIONS 3.131 The primary challenge in agriculture is how best to enhance farm productivity and generate off- farm employment in the medium to long run. Since farm productivity enhancements require increases in the farm's land-to-labor ratio, the farm consolidation process that has started in Poland will have to accelerate, and agriculture's share in employment will have to fall. However, the Govemment's current emphasis on using agricultural subsidies and price supports to boost rural incomes leaves too little for investment in increasing productivity and promoting off-farm job growth. Thus, the challenge for reforming budgetary expenditures in the rural sector is to shift more of Polish expenditures from subsidies 97 to investments, while providing adequate social support for those who are poorest and least able to exit the agricultural sector. Upon EU Accession, the use of "direct payments" on a per hectare basis will help provide this social support to farmers. Accession to the EU will also facilitate the necessary shift by making rural development, structural, and cohesion funds available to promote the growth of off-farm employment, but to be able to make use of these funds, the Government needs to assure adequate co- financing, both by the public and private sectors. TRllANSIPORTJ fINTRODUCTION 3.132 Public expenditures on transport account for 2.1 percent of GDP. Roads and Table 3.27: Situatdon in R0oad EnfrasteuctuDre, 1999 railways account for no less than 90 percent _ _ Poland EU-AC-7 EU-15 of total transport expenditures. The sector laverage) ( 268 306 3282 is responding to the changmg demands Growth fromn 1990-99 (km, country during transition. Key challenges come average) 11 91 666 from the rapid increase in motorization and Sources: Eurostat and World Develooment Indicators. the drastic shift in the modal split Over the past decade, the demand for road transport has grown radically, owing to the unprecedented growth of passenger car ownership. The number of vehicles in Poland has increased from 9 million to about 14 million smce 1990. Annual average daily traffic on intemational roads has doubled during the last ten years. The supply side, however, has not kept pace (see Table 3.27). The road sector has been a victim of under-investment in maintenance and modernization. As a result, the roads are mostly congested, slow, polluted, and unsafe. At the same time, the collapse of heavy industry and increasing competition from the road sector has led to a significant drop in railway volumes. Lack of restructuring and modem management has initially led to financial troubles and a rapid decrease of the railway's market share. Given the primacy of roads and railways from the expenditure perspective, the key issues and reform options in these two sectors are discussed in detail below 3.133 The main priority actions in roads and railways that would improve the transportation infrastructure are as follows: (a) lEncrease road ezpenditu˘res as plainned, niot only foir new roads but also foDr maintenance, with the backinmg of IEU structuiral and cohDesAoni funds (whDich should be used primairily foDr that puDrpose as wel foir environmmenita1 investments) Funding for roads has to be increased to address the planned expansions as well as to address the huge maintenance backlog. These expenditures need to be planned within a multi-year expenditure framework. (b) Develop an institutional capacity fir priority setting, road admiunstiration, anDd safety. A smaller, more professional road agency, run on commercial principles, needs to be created to deliver the high quality road network that Poland needs. The evaluation system currently used to set the spending priorities, in particular, does not adequately use economic criteria. (c) EnIclude road safety as a critical element of the road infrastructure developmennt programL This would imply adequate financing for such an arrangement, given the public good nature of road safety. (d) Reform railway tiransport This would require the development of effective management mechanisms, through further commercialization and possible changes in 98 ownership structures, adequate public financing for implementing the legal framework for service contracting, and the strengthening of incentives and capacity at the local government level to rationalize regional passenger services. Such a reform program should include the possibility to close down non-profitable lines and the ability for PKP to collect its receivables from its customers irrespective if they operate in the public sector or not. OVERVIEW OF PUBLIC EXPENDITURES ON TRANSPORT 3.134 Total public expenditures on transport are equivalent to 2.1 percent of GDP or 4.5 percent of total expenditures in 2001, up from a low 1.4 percent of GDP 3.2 percent of expenditures in 2000 (see Table 3.28). Of these expenditures, roads account for about 85 percent, followed by railways at around 5 percent. The current level of public expenditures reflects the dominant role of the private sector in the transport sector in Poland. Table 3.28. General Government Expenditures on the Transport Sector, 1994-2001 ___ 1994 1995 1996 1997 1998 1999 2000 2001 ~Transportatlon 1.3% 1.1% 1.2% 1.3% 1.4% 1.3% 1.4% 2.1% Roads |0.9% 0.8% 1.0% 1.1% 1.2% 1.1% 1.2% 1.8% Water Transportation 0 1% 0.1% 0.1% 0.1% % 0.1 0.1% 01% 0 1% Rail, Air. Pipline & Other 0 3% 0.2% 0 2% 0 2% 0.1% 0.1% 0.1% 0.2% Sources: Ministry of Infrastructure and Ministry of Finance. 3.135 A pre-requisite to any expansion in the road improvement program (see Table 3.29) is a consistent system for setting spending priorities, based on rigorous economic criteria. The Government needs to ensure that road spending produces value for money and it also needs to be able to prepare a Table 3.29. Projected Road Expenditures on the National Network, 2002-05 (% Of GDP) 2002 2003 2004 2005 Total 2002- 2005 Classification of Expenditures Total expenditures 0.54 1.07 1.40 1.85 4.87 Of which: Maintenance mcluding rehabilitation 0.16 0.21 0.24 0.25 0.86 Motorways 0.19 0.42 0.60 0.89 2.09 Expressways 0.03 0.10 0.13 0.20 0.46 Strengthening 0.02 0.18 0.26 0.33 0.79 Reconstruction of national roads 0.15 0.16 0.17 0.19 0.66 Sources Of Financing Total financing 0.54 1.07 1.40 1.85 4.87 Of which: Excise tax 0.23 0.25 0.26 0.28 1.03 Other state budget financing 0.02 0.02 0.02 0.02 0.08 Vignette charges 0.07 0.26 0.28 0.29 0.90 lnternational financial institutions 0.12 0.17 0.23 0.21 0.73 SPA 0.03 0.08 0.09 0.04 0.24 Cohesion Fund 0.00 0.00 0.32 0.40 0.71 Privat concessionnaire sources 0.07 0.08 0.12 0.21 0.48 Other sources 0.01 0.21 0.08 0.41 0.70 * GDP of 2002. Source: Govermnent Econormic Prograrn, January 2002. 99 rolling five-year investment program that donors and the EU can support for purposes of further developing the road sector. Among other things, the Government needs to put in place institutional arrangements that (1) produce a balanced program for maintenance, upgrading and new road investments; (ii) permit the setting of priorities in the form of a five year rolling program; and (iii) set appropriate design standards, in particular for individual road links. Currently, the system used to set priorities does not adequately use economic cnteria. It uses physical intervention levels that also appear to result in design standards for new works that seem too high. 3.136 Roads and the Chalenge of EU Accession. Major investments in higher priority road transport infrastructure, including motorways, are clearly required as Poland's economy continues its growth and as it prepares for EU accession. However, the cost of such a program will be very high: starting from US$1 billion per year in 2002 (about 0.5 percent of GDP) to almost US$3 billion in 2005 (about 1.4 percent of GDP). Past experience points to significant problems with absorption capacity in the sector, and hence there is an immediate need to scale up the Government's effort to increase Poland's implementation capacity, as expenditures are planned to increase more than threefold (see Table 3.31). This will require shifts in expenditure composition, even though it can be assumed that the EU will cover up to 75 percent of individual projects. 3.137 Railways in Tiranmsition. Since the start of the economic transformation at the beginning of the 1990s, Poland has been addressing the need to adapt Polish railways to the demands of a market economy and create a competitive railway system. The reform of the Polish State Railways (PKP S.A.) was launched in 2000 by commercializing the company and separating the freight and passenger operators from the railway infrastructure company. Emphasis has been placed on labor restructuring and pre- privatization assistance. The adoption of the new Railways Law strengthened the resolve to pursue the downsizing and restructuring of PKP S.A., and to separate train operations organizationally from infrastructure (track, yards, and signaling), and freight operations from passenger operations. This will allow open access for any operator of freight trains and international passenger trains, a policy now being required by the EU. 3.138 The performance in 2001 was mixed (see Table 3.30). The actual number of staff reductions exceeded the target and led to a cost reduction of nearly PLN500 million. However, the targeted financial recovery was not achieved owing mainly to a 14 percent fall in freight traffic in terns of ton-km (versus. a 2 percent projected fall). Passenger traffic declined by 7 percent (versus. a 9 percent projected fall). Staff productivity (thousand traffic units per staff) remained at the 2000 level of 438. Average revenue per ton-km and per passenger-km remained constant at PLNO.I and PLNO.08, respectively. The lost traffic resulted in a revenue decline of PLN890 million. PKP S.A. attnbuted the steep shrinkage of freight traffic to the sluggish general economy and particularly the shrinking heavy industries. The railways also suffered from the lower-than-expected state budget subsidy in 2001. Table 3.30: Recent T[remds in Rafilway 7ransport, 1997-2002 Railway Traffic Volumes, Level of Staff and Financial Results 1997 1998 1999 2000 2001 2002* Passenger (passenger-kmn million) 25,796 25,652 26,198 24,226 22,461 18,650 Freight (ton-kmn million) 68,632 61,747 55,471 55,562 48,059 44,567 Number of staff(by Decemnber 31) 223,924 211,536 189,929 182,000 169,530 145,000 Net deficit of PKP Group (PLN bln) 0.1 1.3 2.5 2.3 2.2 1.6 * Estimate Source: PKP 100 Figure 3.17: Rail Employees/Km 30 25 20 15 10- 0 R > O 0 a m , i m a cm Source: World Bank Railway database KEY ISSUES AND REFORM OPTIONS Road Sector 3.139 The main current challenges in the road sector in Poland are: (i) to construct road networks (motorways and expressways) and improve road maintenance within an overall appropnate priority setting framework; (ii) to increase road safety; (iii) to implement the management arrangement to ensure that funds are used efficiently and effectively (institutional capacity of road administration); and (iv) to increase revenue mobilization. (a) Low expenditures for _ new roads and road Figure 3.18: Condition of Road Network, 1999 maintenance. Funding for new roads and road Bulgaria maintenance has not Czech Republic kept pace with the Estonia increase in traffic. ithungary Poland has one of the a-a':. = - shortest motorway [ithuania _ oir networks (see Table Ronania _ 3.29) and lowest ratios Slovak Republic of roads in good Sovenia condition (see Figure AVERAGE 3.18). Road 0% 20% 40% 60% 80% 100% expenditures are well I__ below the levels needed Source: NEI Transport Consultants to properly maintain the road network, let alone to construct new roads. A proper evaluation and priority system urgently needs to be developed within a multi-year budget framework, which provides secure and stable financing that reflects the sector's needs and the Government's priorities. At present, out of almost 18.000 km of the national network, 34 percent is in 101 unsatisfactory condition and requires immediate maintenance; only 28.5 percent is in good condition. The total maintenance backlog is estimated at the level of PLN7.8 billion; immediate surface treatment needs are at the level of PLN3.2 billion. In 2002, less than PLNl.0 billion (including state budget allocations together with IFIs loans and EU grant assistance) was allocated-less than one-third of the immediate needs. At the same time, road network users are paying significant amounts of excise tax added to the fuel price while only 12 percent of the total planned excise revenues are allocated to the national road network. The Government's highest priority should be to focus on road maintenance, which is especially important, since main roads are to be strengthened to accommodate trucks up to the EU weight limits. According to the Government's own estimate, the state would need to double allocations for road rehabilitation. (b) llhe wealk innstituiomnal capacity of the road adminastrationi. The existing national road administration (General Directorate of Public Roads - GDDKiA) may not be able to deliver the Government's road infrastructure development program on time and within budget due to prevailing weaknesses in several critical areas. These include managing the detailed engineering works, the bidding process, and the awarding of contracts; supervising of works; managing roads and keeping them open to traffic; managing the traffic flows and dealing with accidents; arranging for the provision of emergency services; and regularly inspecting the roads and carrying out timely maintenance without unduly interfering with traffic.86 (c) Road safety problems. The road safety situation m Poland is not only twice as bad as that in the EU countries, but also lags behind the other EU candidate countries. The economic cost of road accidents in Poland still amounts to about 7 percent of the state budget, or about 2 percent of its GDP (about US$2.5 billion). (d) The need to redirect planned Investmennts to meet structiral funds criteria. In order to exploit the full potential of EU financing for improving its road network, Poland needs to redirect its road investments and generate counterpart funds equivalent to 25 percent of EU funds. 3.140 Recommendations. The Government should work on three important building blocks of a well functioning road administration. These building blocks are: (i) secure and stable financing that reflects the needs of the sector; (ii) an efficient, effective, accountable, and transparent institution to implement the proposed road program; and (iii) a consistent practice of priority setting to ensure that the overall program produces maximum value for money. Therefore, there are four measures that can be adopted while taking into account the severe demands on the road sector and the challenge of mobilizing additional resources. (a) lInmprove system efl1cenmcy thirough reorgainization of the flow of user chsarges. The efficiency of the use of the funds allocated for road maintenance and construction needs to be improved. . In combination with the restructuring of GDDKiA and the securing of additional finance for maintenance, this should ensure that the entire national road network is maintained to a reasonable standard. (b) Create a smaller, moire professional road ageney able to operate along more commercial lines. This could be modeled along the UK, Latvia, or New Zealand systems. The main challenge is how to develop the institutional capacity to deliver high quality road investments. There appears to be a strong case for transformring GDDKiA 86 For example, there is a need to introduce procurement practices that are based on least budget subsidies (negative concessions) instead of the current regulation that a company gets a concession before contract negotiations. 102 into a commercialized institution with oversight ensuring the accountability and transparency of its operation, in particular its procurement methods. (c) Include a road safety component in the road infrastructure development program. This should be financed out of the proceeds from the road users, preferably channeled via National Road Safety Council and allocated by the reformed GDDKiA which would be responsible for financing road safety on the national road network (a similar arrangement exists, for example in New Zealand). All international donors are anxious to ensure that all aspects of road safety are covered in the program. This means that sufficient funds are to be allocated to the secretariat of the National Road Safety Council not only for engineering-the first of the four "e"s of road safety-but also for enforcement, education, and emergency services. In fact, an integrated transport-health-education initiative needs to be undertaken. The present government proposals for road development are quiet about road safety, while users of the premium road network will expect to be offered a "safe" and reliable journey in return for paying the vignette or toll. Since vehicles, using the premium network will be traveling faster, accident rates - and their consequences - are likely to increase unless explicit steps are taken to improve road safety. This means ensuring that there are safe vehicles, safe drivers, and safe infrastructures. (d) Increase alocations for road construction and road maintenance. EU structural and cohesion funds, IFI, and private sources of financing will need to be tapped to provide additional resources for road construction and maintenance. Furthermore, the government could also consider raising the fuel levy. However, any increase in levies should be very clearly linked to improvements in road quality and service, supported by a clear communication strategy. This would ensure that such increases are politically acceptable. The appropriate institutional arrangements, including a multi-year budgeting framework, would also need to be provided (as suggested in (2) above) to ensure that additional resources do indeed translate into improved services. RAILWAYS 3.141 There are two key issues involved in railways: (a) Distortions in pricing. Currently, entry costs for operators are based on average costs, and are among the highest in Europe. There is a need to assess rail infrastructure support policies and access pricing in other European countries (especially EU countries) and develop the approach to be used in Poland. This will be particularly important at the stage in which private-sector participation is invited, as it will be impossible to calculate a joint stock company's value until the cost of infrastructure use is known. (b) Continued problems with respect to operational performance. At the moment, these problems are mostly linked to inadequate maintenance of the existing railway tracks and lack of high-speed lines. The backlog of periodic maintenance of railway tracks is systematically increasing despite of the fact that large amounts of EU assistance and EFI loans are directed to upgrading major lines. 3.142 Recommendations. Notwithstanding the reforms already undertaken, additional action is needed along several fronts, as is listed below: (a) Develop effective management mechanisms. Efficiency and performance improvements need to be sought through commercialization and possible changes in the 103 ownership structure of railway companies. Such a program should include the possibility to close down non-profitable lines and the ability for PKP to collect its receivables from its customers irrespective if they operate in the public sector or not. (b) Allocate adequate resources for ilmplementfng the niewly established legal framework for coumtracting. Resources marked for this project, which also seeks to harmonize contracts at the regional and local levels, has not been allocated. The new system of entering into contracts with the operators of commuter and regional services also transfers fiscal responsibility for subsidies from the national to the sub-national governments. As a result, local governments will need to come up with higher contributions; otherwise, PKP will be forced to close down operations on loss making lines. This may require the institution of PSO agreements to cover all subsidy payments, with the prnciple that PKP shall not operate services when subsidies are not paid. (c) Utflze excess railway excess assets to geinerate flhmancDimg. PKP's assets need to be carefully reviewed and evaluated in order to assign them to the appropriate joint stock company, or be allocated as surplus for disposal. Clear title will need to be developed where surplus assets are to be sold to the private sector or transferred to local authorities. In particular, the disposal or development of non-rail real estate assets should be entrusted to agencies having expertise in real estate development. In any event, proceeds from assets can be used to finance restructuring and rehabilitation, but must not be used to finance continuing subsidies. (d) Develop a local level capacAty for train operationims. As private participation in train operations is being prepared for, significant capacity development will be needed at the regional and municipal government levels as these governments become responsible for regional and suburban passenger services. CONCLUS1ONS 3.143 Improvements in sector efficiency and quality are urgently needed if Poland is to upgrade its road and rail networks. This is needed to reduce the transactions costs in the economy and to promote national competitiveness and growth. Additional revenue needs to be generated from both public and private sources for this effort. This would be helped if there were better linkages between the taxes and levies charged and the improvements in the quality of the road and rail services. Nonetheless, this should be done within the overall public sector budget constraint, which would therefore require savings in other parts of the budget. While some subsidies for rail transport may be needed for social or national reasons, these should be developed in a transparent manner to minimize governance concerns. 104 ANNEX 1 INTER-GOVERNMENT FISCAL RELATIONS 1. Poland is a large unitary state with a 2002 population of over 40 million and having an area of 312,685 square kilometers. The current structure of autonomous local governments was adopted January 1, 1999. According to this structure, Poland is divided into 16 regional governments (voivodships), 60 towns/cities with county status, 305 counties, and 2,489 municipalities (gminas). Most municipalities are quite small in population size, with 23 percent of gminas having a population of less than 5000 inhabitants each and 66 percent of the municipalities having a population below 10,000 each. 2. While local government responsibilities in Poland are delineated, there are some overlapping functions, particularly between the counties and the municipalities as is evident from the description below: (a) Municipalities (Gminas): Nurseries, kindergartens, other pre-school, primary and secondary education, social assistance to elderly and handicapped, homeless and families in crisis, social housing, primary and preventive care and public health, theatres, museums, libraries, parks, sports and leisure, cultural events and heritage conservation, public utilities (water, sewer, electricity, gas, central heating, telephones) waste collection and disposal, street cleaning, cemeteries, environmental protection, local roads, public lighting, public transport, town planning, local economic development, tourism, local police, civil defense, regulations, and electoral rolls. (b) Counties (Powiats): Secondary and technical education, welfare homes, social assistance for elderly, handicapped, homeless and families in crisis, unemployment assistance, protective and curative health, public health, culture and sports, environmental protection, county roads, county planning, land surveys, police and fire protection, civil defense, consumer protection, electoral rolls, and local regulations. (c) Regions (Voivodships): University education, welfare homes, unemployment assistance, health care, drug addition, sports and culture, heritage, environmental protection, natural disasters, regional roads, regional planning, tourism, police, fire protection, civil defense, electoral rolls and regulations. 3. Local Finance. Local governments command roughly one-half of public spending (excluding extrabudgetary funds) in Poland. Other than basic municipal services, basic education and housing are the priority functions for municipalities (see Annex 1-Table 1). For counties, higher education and social Annex 1-Table 1: Functional Composition of Local Expenditures, by Level of Local Government 2000 Function Municipalities Counties Regions Education 36.7 60.0 16.5 Health 6.1 -- 14.9 Social Welfare 9.6 23.0 -- Transport 2.2 7.0 18.8 Housing 21.0 -- Culture 2.8 -- 10.8 Agriculture -- -- 12.6 Administration 9.7 5.0 6.0 ALL 100.0 100.0 100.0 Source: Ministry of Finance. 105 welfare commands a majority of their expenditures. For regions, transportation, education, and health are the major categories of expenditures. 4. Municipalities and cities raise roughly one-half of the revenues from own sources and receive the remaining one-half as central fiscal transfers. Counties and regions on the other hand are primarily dependent upon central fiscal transfers for financing own expenditures (see Annex 1-Table 2). Even for municipalities and cities, significant potential revenues go uncollected due to outmoded methods and outdated assessments. Anmnex 2-Table 2: Local Government Sources of Reveimne an PFohaid, 2000 (jim pereentl) Municipality Type Own Source Fornula Special Grants Total Revenues Grants Municipalities (Gmimas) 52.5 13.7 33.8 100 Counties (Powiats) 7.9 47.7 44.4 100 Cities/towns with county status 48.5 31.2 20.3 100 Regions iovodships) 16.0 37.8 46.2 100 Source: Ministry of Finance. 5. CemtraR-Local Fiseal Tramsfers. Central-local transfers in Poland can be grouped in three categories: (a) tax transfers; (b) formula grants; and (c) special grants. These are discussed below: 6. Tax Tranisfers: The central government returns by place of collection a fraction of revenues from personal and corporate income taxes to local governnents. For regions these tax transfers constitute their predominant source of revenues. The returns are as follows: (a) Municipalities: 27.5 percent of personal income tax revenues and 5 percent of corporate income tax revenues. (b) Mining municipalities: 32.6 percent of personal income tax and 5 percent of corporate income tax. (c) Counties: 1 percent of personal income tax collections. (d) Regions: 1.5 percent of personal income tax revenues and 0.5 percent of corporate income tax revenues. 7. Fo=rmla Gramts: Four major types of formula grants are currently being utilized: equalization transfers; education transfers to municipalities, counties and regions; road transfers to counties and regions; and transport tax compensation transfers for partial abolition of local tax on means of transport and elimination of certain tax preferences. These grant programs are briefly outlined below: (a) EquaRizatlon Tramsfers: Central government provides formula based equalization transfers to municipalities, counties, and regions. Equalization transfers to municipalities attempt to equalize potential per capita revenues up to 76.5 percent of the average for all municipalities. These calculations use adjusted population figures for municipalities to provide additional financing to more populous municipalities. The equalization formula contains a small "Robin Hood" component by which 89 richer municipalities (above 150 percent of the national average) contribute in progressive rates to the pool. A Simnilar design is used for equalization transfers to counties and regions except that the equalization for counties is up to 85 percent of the national average, and for regions, up to 70 percent of the national average. 106 (b) Education Transfers: These comprise 12.8 percent of the state (central) budget. The distribution formula takes into account the type of school, personnel costs, number of scholars, and other available indicators. (c) Road Transfers: The formula uses length and density of road, technical infrastructure, accident rate, and need for road infrastructure development as factors for grant allocation. 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