Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. P-7318-BIH

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ONA

PROPOSED CREDIT

IN AN AMOUNT EQUIVALENT TO SDR 53.2 MILLION

(US$72 MILLION EQUIVALENT)

TO

BOSNIA AND HERZEGOVINA

FORA

SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT

June 1, 1999

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

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CURRENCY EQUIVALENTS(as of June 1, 1999)

Unit of currency: Konvertible Marka (KM), equivalent to 1:1 to Deutsche Mark

I KM=US$0.55

WEIGHTS AND MEASURESMetric System

ABBREVIATIONS AND ACRONYMS

BiH Bosnia and HerzegovinaBFP Budget Framework PaperCAS Country Assistance StrategyCAFAO Customs and Fiscal Assistance OfficeCWS Centers for Social WorkCBBH Central Bank for Bosnia and HerzegovinaDMU Debt Management UnitEBF Extra-budgetary FundEBPAC Enterprise and Bank Privatization Adjustment CreditEU European UnionFRY Federal Republic of YugoslaviaGDP Gross Domestic ProductIDA International Development AssociationIMF International Monetary FundKM Konvertible MarkaMFTER Ministry for Foreign Trade and Economic RelationsMTEF Medium Term Expenditure PlaningMoF Ministry of FinancePHRD Policy and Human Resources Development FundPFSAC Public Finance Structural Adjustment CreditSAI Supreme Audit InstitutionSBA Stand-by ArrangementSFRY Socialist Federal Republic of YugoslaviaVAT Value Added Tax

FISCAL YEARJanuary 1 to December 31

Vice President: Johannes F. LinnCountry Director: Christiaan J. Poortman

Sector Director: Pradeep MitraTask Team Leader: Sebnem Akkaya

BOSNIA AND HERZEGOVINA FOR OFFICIAL USE ONLY

PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT

Credit and Operation Summary

Borrower: Bosnia and Herzegovina

Beneficiaries: Bosnia and Herzegovina, Federation of Bosnia and Herzegovina,Republika Srpska

Amount: SDR 53.2 million (US$72 million equivalent)

Terms: 35 years, including a 10-year grace period

Credit Objectives: To support the establishment of public finance structures and implementation ofreform policies at the State and Entity levels. Specifically, the Credit willsupport: (i) broadening tax policy harmonization and strengthening administrativeco-operation between the Entities to enhance revenue capacity and to encouragefree flow of goods across BiH; (ii) improving revenue and expenditure assignmentswithin the Entities to prevent large differentials in the provision of public services;(iii) initiating reforms to develop an affordable, efficient, and equitable social safetynet; (iv) developing a comprehensive budgetary strategy aimed at improving fiscalefficiency and control; (v) establishing audit institutions and procedures to improvetransparency and accountability in public sector operations; and (vi) strengtheningcountry-wide policy coordination in external debt management, includingdeveloping a policy framework for sub-Entity borrowing.

Credit Description: The Credit will be lent to the State of Bosnia and Herzegovina which will in turnonlend in the amount of US$42 million to the Federation and US$30 milliontoRepublika Srpska, on the same terms as the IDA Credit. The Credit will bedisbursed in three tranches for budgetary and balance of payments support toBosnia and Herzegovina. Release of tranches will be linked to policyconditionality as agreed during the negotiation of the Credit.

Benefits: The implementation of the proposed operation will help BiH consolidate thepublic finance reforms began under the PFSAC, substantially strengthenprospects for continued fiscal stability, enhance sustainability of the structuralreform process, and reintegrate the economy. The reform program will promotefree flow of goods between the Entities and improve tax revenue collection bycompleting harmonization of major tax structures, strengthening administrativeco-operation and revenue distribution. It will facilitate development of a morerobust intergovernmental system, which is supportive of the Entities'stabilization and structural reforms and which will improve efficiency andcoverage of public sector services. By pursuing essential policy and institutionalreforms in budget planning and execution, the operation will help the Entitiescorrect the medium-term imbalance between revenues and expenditures and setappropriate priorities for public outlays. The proposed reform program will alsoimprove medium-term financial viability and targeting of the pension system,initiate design of an equitable and sustainable social safety net system, and

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

ii

ensure a certain level of equalization in the provision of health services throughdevelopmen-t of an efficient health insurance system in both Entities. Byinstituting sound auditing procedures, it will significantly enhance transparency,efficiency and accountability of public service operations. Establishment of aneffective and integrated public finance structure will help BiH conduct soundmacroeconomic management, reduce cost to economic transactions, and achieveextemal creditworthiness. By supporting the development of a public sectorwhich is more suitable to a market economy, the operation will also contribute toprivate sector development, employment creation and poverty reduction.

Risks: The Credit faces two major risks. First, there will be risks associated with BiH'sprocess of reconciliation, as has been demonstrated so far since the signing of theDayton Accords in December 1995. Several measures supported by the proposedCredit are subject to intense political debate within the country-and, moreparticularly, between the different ethnic groups-thus creating a potential fornonrimplementation of the agreed measures and/or reversal of the adoptedreforms. Particular among them are the harmonization of the Entity tax policies,pension reform in the Entities, especially unification of the Federation pensionfunds, and reform of intergovernmental financial relations, particularly in theFederation. To mitigate these risks, the Bank requires the upfront fulfillment ofconditionalities whenever possible and will work closely with the IMF, the USTreasuky and others to jointly promote the implementation of the reform agenda.The Bank also agreed with the BiH governments to set up working groups onkey reform areas and maintain close co-ordination with the existing ones topromote consensus. The Bosnian authorities' strong commitment and success inimplementation of equally difficult set of policy measures under the firstoperation has shown that obstacles created by low political tolerance can actuallybe mitigated.

A second risk is that the Government's administrative and institutional capacitywill be insufficient to handle the complexity of the budgetary and auditingreform actions envisaged in the PFSAC II. The Government is cognizant of thisrisk, and its program is designed to minimize its administrative burden, byappropriate phasing of the measures and application of the technical assistancewhere needed. Certain essential technical assistance activities have already beenfinanced by PHRD grants. The bulk of the technical assistance requirementswould have to be carried through grant financed technical assistance (TA)programs and/or parallel donor financed TA to augment the limited localcapacities.

Poverty Category: Direct impact on poverty will be achieved through provision of more adequateresources for social protection programs, and improved targeting and distributionof social benefits.

Rate of Return: Not Applicable

Map: IBRD 28578R

Project ID Number: BA-PE-55432

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BOSNIA AND HERZEGOVINA

PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT

CONTENTS

1. INTRODUCTION ............. 1

II. ECONOMIC OUTLOOK AND FINANCING REQUIREMENTS . . 2A. Macroeconomic Performance and Policy Framework .2B. Macroeconomic Prospects .3C. Exte rnal Financing Requirements .3

III. BACKGROUND AND ISSUES IN PUBLIC FINANCE .4A. Dayton Rules on Public Finance Structure .4B. Issues and Strategy in Public Finance Reform .5

IV. PUBLIC FINANCE REFORM PROGRAM .. 5A. Reforming and Harmonizing Tax Policies and Coordinating Tax Collection .5B. Reforming the Intergovernmental Finances within the Entities .8C. Reform of Social Safety Net .14D. Reforming the Budgetary Management System .18E. Establishing Auditing Procedures and Institutions .21F. Strengthening Debt Management Capacity .23

V. THE PROPOSED CREDIT .. 25A. Rationale for Bank Involvement .. 25B. Credit Amount and Borrower .25C. Credit Design.25D. Administrative Arrangements .. 26E. Disb-ersement.26F. Monitoring Arrangements and Tranche Release Conditions .26G. Environmental Assessment Requirements .. 28H. Benefits and Risks .. 28

VI. RECOMMENDATION ................... 29

ANNEX I Policy MatrixANNEX II Letter of Development PolicyANNEX I Health Finance Reform ProgramANNEX IV Statistical Annex

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORSON A PROPOSED

SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT (PFSACII)IN THE AMOUNT EQUIVALENT TO SDR 53.2 MILLION

TO BOSNIA AND HERZEGOVINA

1. I submit for your approval the following report and recommendation on a proposed Credit to Bosnia andHerzegovina (BiH) in the amount of SDR 53.2 million (US$72 million equivalent) to help finance a Second PublicFinance Structural Adjustment Operation. The proposed Credit would be on International DevelopmentAssociation (IDA) terms, with a 35-year maturity, including a 10-year grace period. This operation is the third in aseries of adjustment operations designed to support the Government's program of structural reforms. It is thesecond operation that focuses on public finance reform. The proposed Credit would continue support begun byIDA under previous operations, and would underpin the country's fiscal reform program during FY99-00. TheCountry Assistance Strategy (CAS) and the progress report were discussed by the Board of Directors, in July 1997and August, 1998, respectively. The most recent economic report on BiH (Bosnia and Herzegovina-From Recoveryto Sustainable Growth) was published in May 1997. A Public Expenditure Review was completed in October 1997.

I. INTRODUCTION

2. The proposed PFSAC II builds on BiH's achievements to date in establishing both the Dayton-mandatedcommon institutions and the governance structure in its two constituent Entities: The Federation of Bosnia andHerzegovina (Bosniac-Croat Federation) and Republika Srpska. With a marked improvement in progress towardstructural policy reforms since 1998, many critical institutions and policies are now in place. These include thecentral bank and national currency; a legislative and regulatory framework for the banking sector and forenterprise privatization; a uniform customs tariff and trade regime; financing means and mechanisms for thecommon institutions; a legislative framework for budget management; and an institutional and legislativeframework for debt management. Significant progress has also been achieved in removing barriers to themovement of goods and people within the country, including initial steps towards harmonization of tax systemsacross the Entities. These reforms have been supported by two World Bank adjustment operations (the PFSACand the proposed Enterprise and Bank Privatization Structural Adjustment Credit) as well as by an InternationalMonetary Fund (IMF) Stand-by Arrangement.

3. Sustaining and broadening the positive developments of the past year is the key challenge BiHfaces forcontinued rapid reconstruction and growth in the medium term. Structural policy reforms must be accelerated ifBiH is to increasingly rely on its own resources and institutions in designing and implementing the policiesrequired for long-term development. The proposed PFSAC II aims to assist BiH to meet this challenge bysupporting further progress in institution-building and policy reforms in the following areas: (i) broadening taxpolicy harmonization and strengthening administrative co-operation between the Entities to enhance revenuecapacity and to encourage free flow of goods across BiH; (ii) improving revenue and expenditure assignmentswithin the Entities to prevent large differentials in the provision of public services; (iii) initiating reforms todevelop an affordable, efficient, and equitable social safety net (iv) developing a comprehensive budgetarystrategy aimed at improving fiscal efficiency and control; (v) establishing audit institutions and procedures toimprove transparency and accountability in public sector operations; and (vi) strengthening country-wide policycoordination in external debt management, including developing a policy framework for sub-Entity borrowing.

II. ECONOMIC OUTLOOK AND FINANCING REQUIREMENTS

A. Macroeconomic Performance and Policy Framework

4. Macroeconomic Performance. The combination of prudent economic policies and large-scale donorassistance has yielded impressive results in Bosnia and Herzegovina. Economic growth has averaged about 40percent in real terms each year since 1995. Inflation has fallen progressively, and is currently running at single digitrates on a country-wide basis. There has been a significant increase in real per capita consumption for mosthouseholds. Many schools and health clinics have reopened, and the main infrastructure networks have beenlargely rehabilitated. Commerce and production are picking up with the help of donor-financed lines of credit.External debt rescheduling has been successfully completed with both London Club and Paris Club creditors,significantly reducing the debt inherited from the former SFRY. The London Club agreement provided for a 73percent reduction in the net present value of outstanding debt, including arrears; and the Paris Club agreementprovides for debt rescheduling on Naples terms or a 67 percent reduction in the present value of the debt.Regularization of relations with remaining creditors, including the resolution of issues related to outstanding foreignclaims on non-government creditors, is expected to be completed by the end of this year.

5. Despite the rapid economic recovery, reflecting the extremely depressed level of post-war economicactivity, GDP is still only at about 40 percent of its prewar level and living standards for many Bosnian familiesremain low. Measured unemployment, which fell sharply during the initial years of economic recovery, appearsto have stagnated at around 35 percent-very high even by the standards of transition economies. Due to thelater start to donor assistance and economic recovery, and limited integration with the international economy,incomes are lower in Republika Srpska than in the Federation. Although aid flows to Republika Srpskaaccelerated following the election of a moderate government in January 1998, its close economic integrationwith the Federal Republic of Yugoslavia makes it particularly vulnerable to the ongoing conflict there (see paras.9-10 below).

6. The Macroeconomic Policy Framework. Maintaining the macroeconomic stability that has beenachieved to date requires sustained prudent fiscal management by the authorities, further progress in institutionbuilding and transition reforms, and continued international financial and technical assistance. The basicunderpinnings for this policy framework are provided by an IMF Stand-by Arrangement (SBA) that was approvedin June 1998.

7. The principal elements of the SBA program are: (i) use of a fixed exchange rate as a nominal anchorthrough the currency board arrangement; (ii) limiting the fiscal deficit of the consolidated public sector to levelscompatible with available sources of foreign financing and avoiding borrowing by all levels of government fromthe domestic banking system and non-bank public; (iii) avoiding any significant accumulation of new domesticarrears, especially in wage and social security payments; and (iv) continuation of large scale external assistanceon concessional terms. Structural elements of the program include customs tariff reform and trade liberalization,consolidation of the fiscal institutions of the State and the Entities, and reform of the payments system. Theprogram also contains important elements of the agenda for banking reform and enterprise privatization andrestructuring. The first review of the SBA has been delayed but is now expected to be successfully concludedshortly. The authorities have recently requested that the SBA be converted later this year into an EnhancedStructural Adjustment Facility (ESAF) arrangement, which would provide a medium-term framework formacroeconomic policies and continued IMF assistance.

8. The government's reform efforts have also been supported through adjustment lending by the World Bank.The Bank's first non-emergency adjustment operation, the PFSAC (SDR 46.2 million, approved in June 1998)assisted the Bosnian authorities in implementing key public finance reforms in 1998. These reforms wereinstrumental in improving the consistency between State and Entity budgets, establishing a transparent andpredictable funding mechanism for the State budget, setting the legislative framework for budget management,

2

establishing a legal and institutional framework for debt management, initiating the harmonization and reform ofEntity tax systems, and initiating reform and re-organization of Entity pension systems. The PFSAC was fullyimplemented and disbursed in less than a year providing a sound basis for the proposed follow-up operation,PFSAC II, to broaden public finance reforms. In addition, a second adjustment operation, the Enterprise and BankPrivatization Adjustment Credit (EBPAC), is being presented to the Board together with the proposed PFSAC II.The EBPAC would support the government's efforts in initiating bank and enterprise privatization throughprivatization of small and medium-sized enterprises, bank restructuring and support for a deposit insurancescheme. Tile proposed PFSAC II and EBPAC are both highly complementary to the SBA/ESAF.

B. Macroeconomic Prospects

9. Prospects for Growth. Continued stabilization, institution-building and reform efforts are essential in thecoming years to ensure sustainable recovery and growth. However, the fluid political environment adds a certaindegree of unpredictability, and risk, to Bosnia's future economic performance. The ongoing conflict in the FederalRepublic of Yugoslavia (FRY) is having an important impact on economic developments in Bosnia andHerzegovina, notably Republika Srpska. The main channels for this impact include reduced trade, investment andeconomic activity, and higher unemployment. The fiscal position of both Entities has come under pressure fromlower tax revenues and higher public spending to deal with increased domestic social needs and new refugees.

10. Despite the disruptions from the crisis in FRY, the Bosnian authorities have pledged themselves to pressforward with their economic reform programs. Under a scenario of continued policy reform, and assuming that thecrisis in FRY stops in the coming months, simulations indicate that after 1999 GDP growth would return to itsgradual path of deceleration from the very high postwar rates to rates more normally associated with open anddynamnic economies (see Table 1). As in the recent past, growth and employment generation in the next few yearswould be stimulated, to a large extent, by donor-financed activities. Subsequently, however, consistent withanticipated declines in donor assistance for the reconstruction program, achieving balance of payments viability andcreditworthiness will require a sizable reduction in domestic absorption. This reduction will have to come frompublic sector investment in light of the current very considerable reconstruction-driven levels of public investment.At the same time, an effort will be required to offset this reduction in public investment by completing structuralreforms, in particular, to attract private capital and increase investment efficiency. Recurrent public expenditureswould actually be expected to increase modestly, in line with the need to strengthen social safety nets and to makeappropriate provision for the operation and maintenance of new investments. Consequently, enhanced revenueperformance would be critical to ensure medium-term fiscal sustainability. With these assumptions, Bosnia andHerzegovina's GDP should reach about two-thirds of its prewar level by the mid-2000s, bringing living standards inBosnia much closer to the average of transition countries in Central and Eastern Europe.

C. External Financing Requirements

11. Exceptional external financial assistance has made a major contribution to Bosnia and Herzegovina'sbalance of payments. In addition to generous humanitarian assistance, the international community madecommitments during 1996-98 of US$4.2 billion, mainly on a grant basis, for Bosnia's reconstruction and peaceimplementation activities. As of end-1998, total disbursements of grants and loan aid were estimated at aboutUS$2.8 billion. The Donor Conference held in May 1999, which was the last to be held in support of the PriorityReconstruction Program, produced total pledges of US$1.05 billion. With the commitment of these pledges, theexternal financing requirement of the US$5.1 million Priority Reconstruction Program would be met. Over the nextseveral years, disbursements of donor funds committed for the Priority Reconstruction Program will provide asubstantial share of Bosnia's external financing.

12. Allowing for the impact of the crisis in FRY, Bosnia and Herzegovina's total external financingrequirement in 1999 is estimated at US$1.4 billion. As in recent years, this financing requirement consistsmostly of reconstruction costs and debt service obligations. After taking into account anticipated reconstruction

3

assistance and other identified official and private flows (including planned disbursements from the proposedPFSAC II and EBPAC), there would be a residual financing gap of about US$60 million in 1999 which isexpected to be closed within the next few months.

Table 1: Selected Key Economic Indicators V, 1996-2005

Estimated Projected

1996 1997 1998 1999 2000 2001 2002 2005Gross Domestic Product

GDP(US$ million) 2741 3423 4082 4533 5333 6262 7090 9080Real GDP growth (%) 69 30 18 8 14 14 10 5Investment (% of GDP) 41 42 38 33 33 32 28 25

Public 24 24 20 16 13 11 7 2Private 17 18 18 17 20 21 21 23

Consumption(%ofGDP) 118 105 99 92 87 84 82 78

Public Sector BalancesExpenditures (% of GDP) 78 56 52 48 48 47 44 40Revenues (%ofGDP) 51 31 32 31 35 36 37 38Deficit (-)(%of GDP) -27 -25 -20 -17 -13 -11 -7 -2Extemal Financing (%of GDP) 27 23 20 17 13 11 7 2

Balance of Payments

Financing Requirements (USS million) 2333 2006 1683 1423 1289 1247 1022 587

o/wCurrentAccountDefici' 1528 1710 1397 1079 1035 990 743 361o/w Debt Service (scheduled) 575 386 227 195 204 207 229 175o/w Increase in Foreign Exchange Reserves 230 -90 59 150 50 50 50 50

Financing Sources (USS million) 2333 2006 1683 1362 1188 1196 972 587o/w Unrequited Current Official Transfers 558 422 190 94 45 45 20 7

o/w Donor Financing 3l 1707 750 983 968 711 700 500 200o/wFDlandOtherPrivateFlows 0 0 100 60 162 185 230 280o/wArrears Clearance andDebt Relief -125 306 172 63 47 38 25 1 1

o/w Others 194 528 238 178 224 228 197 88

Remaining Financing Gap (USS million) 0 0 0 61 101 50 50 0

External Debt

Total Extemal Debt4' (in % of GDP) 137 127 71 72 68 64 60 55

Debt service(in%oftotal exports) 66 35 9 8 8 7 6 5

1/ Data refers to estimates for all Bosnia and Herzegovina unless otherwise stated.

21 Excluding interest and official transfers.

3/ Including use of IMF resources, other budgetary/balance of payments support. and fnancing for reconstruction.4/ Reduction of debt stock in 1998 reflects debt rescheduling with London Club and Paris Club creditors.

Source: Official data, Bank and IMF staff estimates.

HI. BACKGROUND AND ISSUES IN PUBLIC FINANCE

A. Dayton Rules on Public Finance Structure

13. The Dayton Accords provide a broad framework for building a new governance structure in BiH. Underthe Accords, BiH is a sovereign state consisting of two Entities, the Federation of Bosnia and Herzegovina andRepublika Srpska, with a State government responsible for international relations and inter-Entity coordination.Key economic institutions and policies envisaged at the State level include a central bank (organized as a currencyboard in its first six years) and a new currency, customs and trade policies, international financial relations(including servicing of international debts and debt management) and coordination in telecommunication andtransport. Unless mandated otherwise by the State Parliament, the State does not have the capacity to tax or collectcustoms duties on its own. The budgetary needs of the State are to be met in the proportions of two thirds by theFederation and one third by Republika Srpska.

4

14. The Entity governments have exclusive responsibility in their respective territories over defense, intenalaffairs (including police), environmental policies, economic and social sector policies (such as agriculture, industry,and health), refugees and displaced persons, reconstruction programs and justice, tax, and customs administration.To carry out these responsibilities, each Entity retains ownership of the taxes collected in its territory. The twoEntities, however, have different fiscal structures. The Federation has a three-tier fiscal system: the Federationgovernment, cantons, and municipalities, with major responsibilities resting with the cantons. Republika Srpska hasa two-tier structure: the Republika Srpska government and municipalities, with very limited local fiscal authority.

15. Despite considerable progress to date in establishing the Dayton-mandated public finance structure at theState and the Entity levels, much remains to be done in building a framework for sustainable fiscal management. Inthe Federation, the customs, tax and the payments systems were reintegrated; tax policies were broadly unified andsignificant progress has been achieved in establishing canton-level fiscal administration. Nevertheless, co-ordination between Entity and local governments remains weak. Consequently, separate policies and practices stillcontinue within the fiscal structure of the Federation. The Republika Srpska initiated basic fiscal reforms only lastyear and, therefore, its fiscal system still operates along the lines of the former SFRY system. At the State level, theinstitutional and legislative framework envisaged by the Dayton Accords began functioning last year, although therehave been, and will continue to be, ups and downs. The establishment of the central bank and the introduction of anational currency, common customs tariff policies, and a State budget along with clear financing arrangements wereamong the key factors that made this possible, while providing the basis for initial co-ordination between theEntities in key areas of economic management. For BiH to start functioning as a unified State, however, theseinitial efforts toward policy harmonization and coordination will have to be deepened and strengthened.

B. Issues and Strategy in Public Finance Reform

16. Bosnia and Herzegovina is at a critical juncture on its road to sustainable economic growth. Sound publicfinances will be critical to the credibility and, hence, sustainability of the structural reform process and robustness ofthe supply response. Strengthened fiscal capacity is also the cornerstone on which creditworthiness must be built.In order to achieve further progress in establishing such a viable medium-term fiscal management strategy, BiHfaces the following major tasks over the next twelve to eighteen months: (i) strengthening domestic resourcemobilization, including through better policy and administrative co-ordination both between and within the Entities;(ii) introducing strategic public resource allocation, including through investmnent planning; (iii) improving revenueand expenditure assignments at different levels of government and, hence, provision of public services within theEntities; (iv) creating a fiscally viable social safety net with a greater focus on poverty alleviation in the transitionalperiod till the resource base of the system is strengthened to allow provision of more comprehensive socialassistance; (v) establishing institutional and regulatory frameworks for improving transparency and accountabilityof government finance; and (vi) strengthening country-wide policy coordination in external debt management,including developing a policy framework for sub-Entity borrowing.

IV. PUBLIC FINANCE REFORM PROGRAM

A. Reforming and Harmonizing Tax Policies and Coordinating Tax Collection

Current Situation

17. Significant progress has been made to date in reforming tax policies and strengthening tax administrationwithin the Entities. Harmonization of tax systems across the Entities has also been initiated. Reforms supported bythe first PFSAC, improved the tax system across Bosnia and Herzegovina by: (i) reducing exceedingly high taxburdens; (ii) initiating the process of creating tax structures that would facilitate the free flow of goods between theEntities and international trade; and (iii) rationalizing the public sector's size and role in the economy.

18. The Federation Government has simplified its sales tax structure. It has further reduced the combined wagetax and contribution rates and hence the burden on labor; broadened the wage tax base to include some non-wage

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benefits, such as per diems and allowances; reduced the profits tax rate; and developed a global income tax. Withassistance from the EU, the government has also developed a reform program to improve tax collection bystrengthening the coordination between the Federation Tax and the Customs Administrations. As part of thisprogram, a Fiscal Administration Board was formed to coordinate the activities and to enhance the transfer ofinformation between the Financial Police, Customs Administration, and Tax Administration.

19. The Republika Srpska has also achieved progress towards reducing the.wage tax by reducing the pensionand health contribution rates and the wage withholding tax. Similarly, sales and profit tax rates were significantlyreduced. In conjunction with these measures, the Ministry of Finance took several initiatives to maintain revenues,including significant improvement in the inspection capacity for better enforcement and widening the tax net. Theseefforts successfully resulted in increased revenue collection despite the implementation of significant rate cuts.

20. The Entities began implementing the State-set common customs and trade policy. As a result, tarif rateswere simplified and unified, with an average effective rate of about 8 percent applying across the country for mostimports. Significant progress was made towards eliminating both special customs agreements with Croatia andYugoslavia and protective tariffs that are preventing full harmonization of the tariff system across the country. Inan effort to broaden harmonization of the tax systems, the Entities have also began harmonizing their sales andexcise tax systems by adopting similar tax bases and by collecting revenues at the same point in the distributionprocess.

21. Despite this progress, significant additional reforms of tax policies and administration are essential toimprove tax collection and to create an environment conducive to growth and private sector expansion in Bosniaand Herzegovina. In particular, greater effort is needed to broaden and accelerate the process of harmonization ofthe Entity tax systems and to establish strong administrative coordination between the Entity tax administrations.Rapid progress on these fronts is crucial for minimizing tax avoidance and for minimizing harmful tax competitionas well as encouraging the free flow of goods between the Entities.

Issues and Plans in Tax Reform

22. Building on the achievements to date in reforming the tax system, the most urgent challenges the tax policyin BiH faces include: (i) incorporating all Entity specific tariffs into the State customs law and eliminating allimplicit tariffs imposed by the Entities; (ii) completing hannonization of the sales and excise tax structures betweenthe Entities; (iii) developing a revenue distribution system between the Entities to limit tax competition; and (iv)developing adequate cooperative arrangements between the tax administrations in the Entities.

23. Harmonization of Entity tax system& The explicit tariff structures in BiH were rationalized andharmonized with the passage of the State Customs Law in mid-1997. Nonetheless, full implementation of the Lawhas been prevented by continued imposition of two kinds of Entity-set tariffs: (i) protective tariffs on certaincommodities, including many agricultural goods; and (ii) implicit tariffs, whereby the Entities impose differentialexcise tax rates on domestic- and foreign- produced commodities, which effectively operate as tariffs. To develop ajoint approach for eliminating the protective tariffs, the Entities established a Committee composed ofrepresentatives of the State and the Entity Ministries of Trade in mid-1998. The Committee has both identified thelist of items on which additional customs tariffs will be temporarily applied during 1999 and selected uniform rates.The State Council of Ministers adopted the list and the rates in March 1999. Likewise, the Tax Working Group hasstarted developing a similar approach to eliminate the implicit tariffs. To achieve this, the Group must focus onsetting identical rates for excise taxes on domestic and imported commodities in the Entities by bringing the excisetax rates on imported commodities down to rates imposed on domestic goods. This approach will ensure that alldifferential taxes are accounted for in the special tariffs enacted by the Council of Ministers. It will, at the sametime, harmonize the excise tax rates on domestically produced goods between the Entities.

24. For full harmonization of the customs system, the Federation and Republika Srpska must also eliminatetheir special trade arrangements with Croatia and FRY, respectively, which effectively exempts most imports from

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customs tariffs and subjects these commodities to domestic rather than foreign excise tax rates. Both Entities haverecently taken a decision to this end and are presently adjusting their customs system for initiating implementationbv June 1999. Finally, in order to complete the harmonization of the sales tax system, the Entities must align thesales tax rates. The existing differences in the sales, excise and customs tax rates create strong incentives for taxavoidance through purchasing (either by wholesalers or consumers) in the low tax Entity. Elimination of most ratedifferences is crucial to limit such avoidance and to encourage free trade. The Entities intend to achieve significantprogress towards this end by the end of 1999.

25. Improving revenue attribution rules between the Entities. The problems arising from varied tax structuresbetween the Entities are exacerbated by the existing attribution rules, which result in sales and excise tax revenuesremaining where they are collected--e.g. excise taxes are collected at import or manufacture; sales taxes on allexcisable goods are collected where the first sale occurs. There are several critical problems inherent in the existingsystem that prevents the growth of economic relations between the Entities. These include: first, incentives forharmful tax competition, as each Entity has the potential to attract economic activity by undercutting the sales andexcise taxes imposed in the other Entity; second, inequity in the distribution of tax revenues between the Entities,since sales and excise tax revenues do not accrue to the Entity where consumers live; third, creation ofdisincentives for trade between the Entities, as they receive the excise and sales taxes on commodities obtained fromany location except from the other Entity. As trade between them grows, the Entities are increasingly concernedabout implications of the existing attribution rules. To improve the system, the Entities need to develop amechanism that would ensure maximum revenue collection while providing the revenues to the Entity where thecommodities are to be consumed. This is best accomplished by collecting the revenues at the point of import ormanufacture and passing them from the collecting Entity (where manufacture or import occurs) to the consumingEntity (the Entity of destination) through a mechanism which would ensure that revenues are paid to the properEntity, such as introducing tax stamps. The Tax Working Group mentioned in para.23 is developing a jointapproach to resolve the attribution problems.

26. In the medium-term, the Bosnian authorities will have to consider ways to collect sales tax revenues withina system entailing fewer complications than the existing system. A value added tax (VAT) could constitute such analternative. The VAT system would not only generate more revenues, and close opportunities for evasion, butwould also further the alignment of the BiH's tax system with European norms. Both Entities are consideringexploring the VAT's potential and analyzing how it could be structured within and across the Entities. In addition,the Entities also recognize the need for developing a highly coordinated tax administration as a precondition for theintroduction of the VAT.

27. Strengthening administrative co-ordination between the Entities. Co-ordination between the two Entitieson tax and customs administration remains limited thereby opening opportunities for tax evasion. As a result, theEntity tax administrations are unable to fully audit transactions and tax returns that involve both Entities; they areunaware of many transactions between firms across the Entities. The Entities are considering improvingadministrative co-operation, and to this end have recently initiated a dialogue under the EU's supervision.Nonetheless, initial arrangements will only provide a limited degree of cooperation. Effective elimination of thepotential for tax evasion, introduction of new attribution rules for revenue allocation between the Entities, andeventually a VAT system all require strong administrative cooperation. The best way to achieve this is developingan information sharing system between the tax administrations in the two Entities.

Actions to be Supported by PFSAC II

28. The proposed operation will support the continued development and implementation of tax reforms, with aparticular emphasis on harmonization of tax policies and coordination of tax collection across Entities. Prior toBoardpresentation, the Federation and Republika Srpska will have (i) started implementation of the State-set tariffsurcharges by eliminating their respective protective tariffs; (ii) eliminated special trade agreements with Croatiaand Yugoslavia; (iii) equalized the excise tax rates on domestic and imported goods so that all differential taxes areaccountedfor in the tariff surcharges enacted by the State Council of Ministers; and (iv) established a Working

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Group to develop a plan for coordination between the two tax administrations. Additionally, it is also expected thatpreparation of a plan to allocate the sales and excise taxes between the Entities in a more equitable andadministratively feasible way will have been initiated.

29. Prior to the second tranche release, the Federation and Republika Srpska will have (i) completed theharmonization of sales tax system by reducing differences in sales tax rates; (ii) submitted to their Parliamentsamendments to their sales and excise tax legislation on inter-Entity allocation of the sales and excise taxes; and (iii)adopted a plan to strengthen the coordination between their Tax Administrations in a way to ensure effectiveimplementation of the new inter-Entity allocation rules for the sales and excise taxes.

30. By the third tranche release, the Federation and Republika Srpska will have started the implementation of(i) new legislation on inter-Entity allocation of sales and excise taxes; and (ii) administrative co-ordinationnecessaryfor effective implementation of the new legislation on inter-Entity allocation of sales and excise taxes.

31. The technical assistance, which has been provided through the previous operation and during thepreparation of this Project, will continue during implementation. In particular, the Bank will assist and advise theEntity Governments in: (i) examining the revenue attribution rules and developing acceptable arrangements toensure that the revenues are allocated in an equitable and administratively feasible manner; (ii)strengthening theadministrative coordination; and (iii) modernizing the tax systems, particularly through development of a VATsystem. Financing for the technical assistance is being provided through Policy and Human ResourcesDevelopment (PHRD) grants.

B. Reforming the Intergovernmental Finances within the Entities

Current Situation

32. Under the Dayton Accords, major government budgetary responsibilities are divided among the four levelsof government: the State, the Entities, the cantons (in the Federation) and the municipalities. The design of theintergovernmental fiscal system assigns limited economic and fiscal management responsibility to the State andprovides significant autonomy to the Entities. The Entities have different fiscal structures. In the Federation, cantonlevel administration is being developed as the major instrument of government to accommodate different demandsfor services and to allow for greater local control over setting services. A more centralized structure is operating inRepublika Srpska. Unless otherwise mandated by the State Parliament, the budgetary needs of the State are to bemet in the proportions of two thirds by the Federation and one third by Republika Srpska, with the Entities havingownership of the taxes collected in their territories.

33. Since mid-1997, the State and the Entity Governments have intensified their efforts to establish Dayton-mandated budgetary financing arrangements. With assistance from the Bank under the first PFSAC, the 1998budgets set the stage for the formulation and implementation of mutually consistent budgets across all threeGovernments. This was made possible by establishing both clear financing arrangements and a transfer mechanismbetween the Entity and the State govermnents. These arrangements have substantially improved stability andtransparency of financial relations between the three governments, and provided the State with regular funds toundertake its administrative functions and to meet external obligations.

34. Progress in establishing the cantonal governance structure has continued in the Federation includingconsiderable, though uneven, progress in integrating the administrative structure in the two ethnically mixedcantons. At present, all cantons have basic fiscal management and legislature structures in place and they are allfully operative. The revenue and expenditure assignments, since 1997, have generally followed the structure laidout in the new Federation Constitution. Revenues are distributed using a pure tax assignment system. Customs andexcise tax revenues and, starting mid-1998, profit taxes on certain large firms (such as the electric and telephonecompanies) are assigned to the Federation Government and the remainder of the revenues, mainly from sales,profits, and wage taxes, are assigned to the cantons and municipalities. Combined, cantons and municipalities

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collect more than 60 percent of Federation-wide revenues with the municipalities' share averaging about 20 percentof the revenues from the canton taxes.

35. The Federation Government has relatively little service delivery responsibility-4imited primarily to defenseand social assistance for veterans and their families. Together these services account for a large proportion ofFederation spending (more than 60 percent in 1998). Service delivery for functions such as health, education,housing, social assistance and police is primarily a cantonal responsibility, with each canton determining the relativerole of the canton versus the municipalities. Generally, municipalities deliver preschool education, some socialassistance, culture, sports, and utility services that are provided through off budget companies. Despite theFederation's success in significantly improving the sales tax revenue allocation between cantons during 1998, percapita service provision capacity varies widely across cantons. At present, except for a very minimal ad-hocFederation pool, there is no mechanism to improve horizontal equity in access to basic public services acrosscantons nor to account for externalities in service delivery.

36. The Republika Srpska Government undertakes almost all service delivery--with municipalities primarilyresponsible for utility services, also generally provided by off budget companies. Tax revenues are collected at thecentral level of which about 10 percent (mainly from sales, wages and profit taxes) are allocated to municinalitiesthrough a system similar to the one between the Federation cantons and municipalities. The revenue allocation hasbeen improved since 1997 to provide certain municipalities with a slightly higher share of tax revenues, dependingon their characteristics. The allocation of revenues is higher for those municipalities that are on the border, havehigh social problems, have significant damage from the war, or have large numbers of refugees. These adjustmentsconstitute a step towards eliminating financial imbalances at the local level. The government is currentlydeveloping a new decentralization strategy.

Issues and Plans for Reform of Intergovernmental Finance

37. Because of the Federation's more complicated structure, issues in intergovernmental finance remainrelatively more significant in the Federation than in Republika Srpska. Despite the appearance of clear rules inrevenue and expenditure assignments in the Federation, a series of specific issues remain to be addressed forensuring provision of minimum services across the Federation and for enhancing the public sector's operationalefficiency. The key issues include: (i) improving the allocation of revenues across the Federation; (ii) strengtheningthe legislative structure to prevent exemptions or concessions against another level of government's tax bases; (iii)enhancing local revenue capacity and clarifying local autonomy to implement local taxes; (iv) developingmechanisms to effectively finance and deliver services with geographic spillovers; and (v) improving the emerginghealth finance system to ensure Entity-wide provision of basic health services. In Republika Srpska, a greaterattention must also be given to maintain an efficient intergovernmental system which requires a careful analysis ofthe emerging decentralization strategy.

38. Improving revenue attribution rules within Federation. Existing arrangements in the allocation ofrevenues between the cantons result in a relatively wide range of revenues on a per capita basis (about 5:1 in 1998).Despite improving the revenue allocation since 1998, attribution of sales taxes on excisable commodities to the firstbuyer's location results in disproportionately greater per capita revenues in those cantons with high economicactivity and cantons where importing is concentrated. Similar deficiencies exist in the current allocation of profitstax revenues to the headquarters canton, in cases where companies operate in more than one canton. In the absenceof any Federation mechanism to address current disparities in fiscal resources available to the cantons, low activitylocations are able to deliver fewer services. To improve the revenue distribution, the Federation government needsto develop mechanisms for (i) improving revenue allocation rules to ensure that greater revenues are allocated to theplace of destination; (ii) redistributing some limited tax revenues; (iii) altering sharing rules between jurisdictions incases where some component of the taxable activity takes place in more than one jurisdiction.

39. As in the case of inter-Entity allocation of sales and excise tax revenues (discussed in para.25), changes tothe attribution rules within the Federation require a mechanism that would maximize revenue collection while

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providing more equitable distribution of revenues across cantons. Both of these objectives could be achieved bycollecting taxes at the import or manufacturing stage and by allocating them according to a formula that wouldconstitute a good proxy for the distribution on a destination basis. Tax evasion in the Federation could besignificantly minimized by collecting sales and excise taxes at import or manufacture-e.g. revenue collection isestimated to improve by about one-fourth if only sales taxes evasion on imported excisable commodities could bereduced. Reduction of evasion would, in turn, allow all cantons to receive higher revenues. The Federationgovernment, in co-ordination with cantons, is currently exploring options--including the approach described above--for improving sales and excise tax revenue allocation and it intends to formulate an approach for implementation inthe next year.

40. Improving the allocation of profit taxes in the Federation requires a comparatively different approach.Under the existing system, frms operating in multiple cantons make no contribution toward financing the deliveryof services in cantons where they have branches, despite benefiting from public services offered in these cantons.This creates disparities in access to resources. It also provides an incentive for the cantons to compete forbusinesses by cutting taxes. A set of situs rules could be developed to improve revenue sharing arrangementsbetween cantons. However, such sharing mechanisms entail significant administration and compliance costs.These costs can best be avoided by collecting the profit taxes at the Federation level. Since this would mean areduction in the revenues provided to cantons, such a shift must be made along with a set of expenditureresponsibilities. The Federation has already initiated revenue re-allocation in October of 1998 by transferring toitself ownership of the profit tax revenues from many large firms--representing about one-half of profit taxcollections. Expenditure assignments were, however, maintained, creating additional pressures on already tightcanton finances. The problems associated with both profit tax revenue allocation and with those expenditures thathave a Federation-wide impact, but presently assigned to cantons without clear financing arrangements-such ashigher education and tertiary health care-could be eliminated by re-assigning the profit taxes to the Federation,along with responsibility for such services.

41. Enhancing andprotecting revenue capacity in the Entities. Both the tax base and the tax rate for most ofthe important taxes in the Federation--including sales, wages, profits-are determined at the Federation level. Sinceuniform rates and bases will be more difficult to achieve with devolved control, administrative and complianceefficiencies arise from Federation control over most taxes and bases. To safeguard cantonal revenues, however, thecantons must be protected from the Federation's exempting taxpayers or narrowing the base for taxes assigned tocantons. At present, the sales tax law allows the Federation to reduce sales tax rates for periods of up to six monthsby decree-the decrees are, however, renewed every six months. Based on this provision, the Federation hasgranted an increasing number of exemptions from the canton sales tax base in recent months. Similarly, payrolltaxes were reduced for certain groups; autos produced in Sarajevo are being subjected to lower tax rates, and aportion of the profit tax revenues was shifted from cantons to the Federation. Furthermore, there has been a rapidincrease in the number of duty free shops in the Federation where no sales tax is collected and where excise taxrates have been lowered. Transactions at such open, informal markets have also created significant opportunitiesfor evasion. While failing to stimulate economic activity in any significant way, tax exemptions worsen financialimbalances at each level of government. To address this problem, Federation needs to introduce several measuresincluding: (i) allowing changes on the tax bases and rates, only if provided under the existing laws and through aParliamentary act; (ii) eliminating the existing tax exemptions; and (iii) adopting measures to effectively controlduty-free shops and ensure that transactions at such establishments are limited to authorized persons. In RepublikaSrpska, practice of tax exemptions/relief to date has been comparatively limited and the above stated principalsshould guide the tax policy in the future.

42. In addition, the Federation tax system needs to be adjusted to establish appropriate incentives for cantonsand municipalities to increase revenue collection. The existing system does provide cantons with the majority ofFederation-wide tax revenues, but allows them little capacity for varying their revenue structure to meet thedifferent preferences of their citizens. To provide cantons and municipalities with a reasonable flexibility overrevenue instruments, while retaining a coherent and easy-to-administer tax structure, cantons could be allowed to

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exert a limited control over tax rates and fees. The Federation must, ho sever, continue to maintain control over thetax bases. This could be achieved by legislating minimum tax rates and hence limiting the degree of taxcompetition between the cantons and municipalities. Although maximum rates could also be established,competitive pressures between the cantons will generally make establishment of such rates unnecessary.

43. The portfolio of potential taxes available to augment local government finance, particularly inmunicipalities, includes property-based taxes. These taxes are currently imposed as excise taxes on property in bothEntities, though to a limited extent. Both Entities are considering gradually expanding the existing system toward atraditional property tax. The information and administrative infrastructure associated with the existing propertybased taxes in both Entities provide a sound basis for developing a broader approach to property taxation.Successful development of a property tax system will require cooperation between the finance, cadastral and taxadministration offices of the Entities' local governments.

44. In the Federation, almost all tax revenues collected by the FTA are intended for the cantons andmunicipalities, since Federation-owned taxes (i.e. customs and excise taxes on imports) are collected by the customsadministration. Advantages in terms of lower operational costs, coordination of administration, and uniformpractices all argue strongly in favor of the administration at the Federation level. For the efficient operation of thissystem, however, it is also important that the cantons feel the Federation is making a good faith effort to collectrevenues. At present, the cantons suggest that revenue collection can be enhanced if the FTA becomes moreresponsive to local concerns and follows up more vigorously on cantonal information and input. There is also atendency by some cantons to establish cantonal tax administrations. To improve tax collection and to forestall thistendency, the Federation must strengthen the coordination between local FTA branches and the cantonal Ministry ofFinances. Another step in improving tax collection is to develop and implement a plan to merge the FinancialPolice with the Tax and the Customs Administrations. While substantially improving use of limited resources, thiswould ensure that taxpayers are confronted with coordinated audits and administrative activities. A similar approachto reform the revenue collecting institutions is also needed in RepublikaSrpska.

45. Improving public service delivery in Federation. The Federation faces the challenge of preventing thelarge differences in access to fiscal resources across cantons from being translated into large differentials in thesupply of public services. This is particularly important for those public services with major externalities to theFederation as a whole--e.g. education and health--which are broadly assigned to the cantons in the Federation. Todate, progress has been slow in developing efficient mechanisms for delivering and financing education and healthservices. Measures are now urgently required for developing these mechanisms, particularly for improving theprovision of health care within the Federation.

46. Services with Geographic Spillovers Under the existing system, the respective roles of the Federation andcantons in the provision of tertiary health care and higher education services remain to be determined. These twoservices are currently being delivered and largely financed by selected cantons, but the benefits are received byresidents from many cantons. The present system entails both equity and efficiency problems since: (i) onecanton's residents finance services for other cantons; and (ii) in the presence of geographic externalities, cantons arelikely to under-provide these services since they would fail to adequately account for the benefits received by otherareas in the Federation. There is also a risk of creating incentives for establishing university faculties and moresophisticated health care services in every canton. Assigning tertiary health care and higher education services tothe Federation could effectively address the weaknesses of the present system. The additional revenues that theFederation needs for providing these new service responsibilities could be obtained by shifting the profit taxrevenues from cantons to the Federation-actually a large portion has already been recently assigned to theFederation without any adjustment in canton responsibilities (see para. 40). A first step in shifting higher educationand tertiary health care services to the Federation involves developing an effective service delivery framework. Inthe case of higher education, this includes determining locality, governance structure and financing arrangements.A similar framework needs to be developed for tertiary health care within a broader health care reform as presentedbelow.

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47. Health care finance in Federation. The Federation Health Care Law envisages a canton-based healthinsurance system, financed by payroll tax contributions. Recognizing that such a system will lead to undesirablesmall risk pools, it also provides for the creation of a Federation level health insurance fund, responsible for certainjoint health care functions. To date, progress in establishing this system has been modest. Cantonal healthinsurance funds were to be created by February 1998, but only three cantons have established such funds. Severalcanton'- rontinue to deposit health care contributions in the general canton budget and use a portion of these fundsfor financing other services. Health contributions in the Croat-majority cantons continue to go into a single fund.As for the Federation level structure, the Federation Health Insurance Fund was established, and its Director wasappointed in December 1998. Nonetheless, both services to be provided by the fund and financing sources have yetto be specified.

48. The effectiveness of this system in reducing the existing wide variations across cantons in access to healthservices, and in enhancing the overall health service delivery in Federation, critically depends on the design of theFederation level Health Insurance Fund. The Fund is expected to undertake a major responsibility in: (i) ensuringthat all eligible residents of the Federation have access to basic health care services; (ii) financing services withFederation-wide benefits, such as eligible tertiary care services and highly specialized services that can only bedelivered effectively in a limited number of locations for a larger risk pool; and (iii) providing technical andmanagerial assistance in operation of the cantonal health insurance funds, including centralized procurement ofmedical supplies.

49. To effectively undertake these functions, the Fund must have a strong overall administrative role within thehealth care system as well as sufficient financing resources. The resource base of the Fund is currently envisaged toconstitute no less than one-fifth of the total health contributions. Furthermore, in order to facilitate the progresstowards rapid implementation of new health care system, the Federation government also needs to determine anaffordable package of basic health care services that will be provided across the Federation, with options foradditional services to be financed at the cantonal level. The technical work towards this has been initiated (with theassistance from the World Bank under ongoing health projects) with a focus on determining the most cost-effectivebasic package of health services along with management tools and incentives to promote their effective provisionand usage. The Federation is considering taking the actions necessary to complete the establishment of cantonalinsurance funds and to specify the parameters of the Federation insurance fund before the end of this year so thathealth contributions can start flowing into the cantonal insurance funds and the Federation insurance fund can startoperating in the new fiscal year. (see Annex III, for more detailed presentation of the health finance reformprogram)

50. Strengthening intergovernmental finance in Republika Srpska. Over the past months, the RepublikaSrpska government has prepared draft legislation on local management that proposes to decentralize the governancestructure by creating an intermediate set of governments in the form of districts. The legislation calls for creation ofeight such districts that would be responsible for roads, communications, secondary education, and regional healthcare. The districts are to be financed mainly by a percentage of tax revenues raised in their jurisdictions. Under thenew structure, municipalities will retain their responsibilities for utilities, local roads, culture, education, sport,health and social protection based on the existing revenue sharing arrangements with the central government. Thedraft legislation lays out a very general structure. Therefore, the proposed operational relationship between thegovernments as to whether the districts would be de-concentrated arms of the Entity government or moreindependent governments-as cantons in the Federation-remains unclear. In the former case, the proposedstructure could enhance administrative efficiency; in the later case it could create the same type of equity andefficiency problems that exist in the provision of particularly social services in the Federation. The RepublikaSrpska authorities agree that a more coherent structure needs to be designed, with a focus on enhancing theadministrative efficiency. They have asked the World Bank to continue providing its assistance in this area underthe proposed PFSAC II.

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51. Health care finance in Republika Srpska. The health care system in the Republika Srpska is being financedmainly by payroll taxes. There are also transfers from the general budget to finance health contributions of certainunemployed populations, such as refugees and demobilized soldiers. The government is currently in the process ofadopting a new Health Insurance Law with a focus on (i) improving the financial viability of the system throughpromotion of cost-effectiveness and efficiency in public health service delivery; and (ii) developing a solidaritysystem, as in the case of the Federation, ensuring equal access to the basic package of health care services acrossRepublika Srpska as well as financing eligible tertiary health care services. The definition of the basic package ofhealth care services is, in turn, crucial in achieving the government's objectives stated in item (i) above. To thisend, as in the case of Federation, the use of management tools and incentives to influence the behaviors of serviceproviders and consumers is essential. Another important challenge is to implement incentives and sanctions toimprove collection. The government is considering addressing this challenge by developing guidelines whichwould establish: (i) procedures for improving transparency in budgeting and usage of health contributions; (ii)incentives/sanctions to improve collection; (iii) procedures for strengthening coordination between the central fundand its branch offices; and (iv) prototypes of contracts to guide the purchasing of health services.

Actions to be Supported by PFSAC II

52. The proposed operation will support the authorities' efforts in developing a sustainable intergovernmentalfiscal structure across BiH by focusing on the key issues described above. As an initial step in this direction, byBoard presentation, both the Federation and Republika Srpska will have either eliminated or agreed to eliminateexisting tax relief and exemptions with a specified expiration date, including those exemptions granted to duty-freeshops, unless providedfor by international treaties or under their tax legislation, by allowing them to expire at theend of their current term. Additionally, it is expected that preparation of a plan to (i) improve allocation of salestaxes on excisable commodities and profit taxes in the Federation; (ii) shift responsibility for higher-education to theFederation Government along the lines described in para. 46; and (iii) determine the key operating features of andestablish the respective Health Insurance Funds in Federation will have been initiated. It is also expected that thedraft legislation on local management in the Republika Srpska will have been revised to design an efficientdecentralization strategy.

53. Before the second tranche release, on the revenue side. (i) both the Federation and the Republika Srpskawill have eliminated all those tax and duty exemptions that are without a specified expiration date and that are notprovided for under their tax legislation or by international treaties, and adopted measures to effectively controlduty-free shops and ensure that transactions at such establishments are limited to authorized persons; and (ii) theFederation Government will have amended its sales and excise tax legislation for improving collection andallocation of sales tax on excisable goods between the cantons. In addition, the Federation is expected to adoptmeasures to enhance local revenue capacity and to clarify local autonomy to implement local taxes. On theexpenditures side: (i) the Federation will have established cantonal health insurance funds; (ii) the FederationGovernment will have determined and adopted responsibilities and financing sources for the Federation HealthInsurance Fund in line with principles described in paras. 48-49 above; and (iii) Republika Srpska will haveadopted guidelines to improve administrative efficiency in health service delivery and the collection of heathcontributions. It is also expected that measures to shift responsibility for higher education to the Federation anddecisions for sources of financing are taken.

54. Before the third tranche release, on the revenue side, the Federation will have started the implementationof the new collection and allocation system for sales tax on excisable goods between the cantons. On theexpenditure side, the Federation Government will have adopted amendments to the Law on Health Care on serviceresponsibilities and financing sources for the Federation Health Insurance Fund. During the preparation andimplementation of the proposed project, both the State and the Entities are expected to continue implementing theState finance mechanism. The technical assistance which has been provided through previous operations andduring the preparation of this operation will continue through implementation. The focus of the assistance will beon (i) supporting the design of new models to improve revenue and expenditure assignments in both Entities as

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described in the above paragraphs; (ii) developing a more comprehensive property tax system in both Entities; and(iii) strengthening the tax administration capacity in both Entities.

C. Reform of Social Safety Net

55. Fundamental reforns in the existing social protection programs for the elderly, the poor, the sick, the warveterans and their families are needed in BiH in order to balance resources with the needs of poverty alleviation, asdonor assistance is being phased out. The proposed operation supports the Entities' efforts to develop a fiscallyviable social safety net system.

(i) Reforming Pension System

Current Situation

56. Rising wages and employment over the last three years, and hence the rising pension tax base, broughtabout a significant increase in pension revenues of the three pension funds presently operating in BiH--two separateschemes in the Federation, covering Bosniac-majority areas (the Sarajevo Fund) and Croat-majority areas (theMostar Fund), and a Republika Srpska scheme. Despite the resulting parallel increase in benefits, benefit levelsremain less than one third of their pre-war levels in the Federation and less than one fifth in the Republika Srpska.The cause of the financial strain is the high ratio of pensioners to contributors, which is presently at about 0.8:1across the three funds. This ratio will be even higher when the number of contributors is adjusted downward toaccount for some firms and the military both of which accumulated arrears in contributions to pension funds.

57. All three funds operate on a pay-as-you-go basis-i.e. current contributions are paid out as benefits in thesame period. Each fund, however, pays pensions according to a different formula, reflecting differences in theirresponse to the post-war financial situation, which does not allow for the payment of pensions according to the pre-war formula. In the Mostar Fund, earmarked revenues are divided by the number of pensioners resulting in a flatbenefit, zero balance as well as highest minimum pensions in BiH. In the Sarajevo Fund, until the passage of theFederation Pension Law in 1998, the pre-war formula was used to calculate pensions but roughly half of thisamount was actually paid out and the difference between the actual and statutory benefits was considered to be adebt owed to pensioners. The new legislation, consistent with the first PFSAC reforms, declared all future benefitpayments final, precluding the possibility for further arrears. The Republika Srpska Fund pays pensions accordingto a formula which gives higher pensions to those with more education-as a proxy for pre-war higher earnings. Itoperates with significant transfers from the budget since earmarked contribution revenues are not sufficient to coveroutlays. In both the Republika Srpska and the Sarajevo Funds, the present distribution of benefits results inrelatively wide range of pensions (5:1). The situation is especially difficult for those with below average pensions,especially in the Republika Srpska where average benefits (75 DM) are about half of those in the Federation (150DM), reflecting large differentials in average wages.

58. The new Federation Pension Law mentioned above has several positive features which should lead to somereduction in medium term pension spending pressures. It reduces future new pensions; restricts eligibility in themedium term via provisions on the assessment base and retirement age; brings post retirement indexation more intoline with material resources of the funds; and most importantly, equates actual with legal pension payments in theSarajevo Fund as indicated above. Moreover, it creates both a Federation-wide framework for social policy byforcing the two Federation funds to operate under one Federation-wide law, and a Federation Pension Agency witha mandate to begin the process of re-integration of the pension system. To this effect, it calls for preparation of afollow-up legislation deternining the new organizational structure. Nevertheless, significant additional reforms areneeded to improve the finances of the Federation funds. A similar set of pension reforms is also urgently needed inRepublika Srpska.

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Issues and Plans for Reforming Pension System

59. At present, BiH faces three challenges in pension policy: First, financial constraints need to be addressed ina more systematic way by aligning benefit levels with the realities of future revenues and demographics. Second,the most destitute pensioners need to be better protected by rising minimum pension levels through adjustments tothe distribution of benefits. Finally, a medium-term strategy needs to be designed for introducing long overduecomprehensive pension reforms over the next couple of years. In the case of the Federation, dealing with the thirdchallenge requires rapid progress in reintegration of the Federation pension system, without which in-depth pensionreform is impossible.

60. In both Entities, pension funds determine the benefit levels in an ad-hoc manner with a short-term focus(see para.57 above). While the present approach served as a means to bridge the pre- and post-war pensionsystems, it is incompatible with the objective of achieving financial sustainability over the medium term. This canonly be achieved by redefining benefit rules so that promises will be aligned with projected resources. Thisapproach could be phased in gradually but should lead to a financial balance over a reasonable time period. In themeantime, policies that might exacerbate the present situation must be avoided. For example, the recent tendency inRepublika Srpska to raise statutory benefit levels for current and future pensioners must be avoided; even at currentbenefit levels, the system operates through significant budgetary transfers. Any adjustments to the benefits must bevalidated by realistic projections about resource availability-the Republika Srpska authorities have asked theWorld Bank to assist in this area under the proposed PFSAC II. In the case of the Federation, while the newFederation pension legislation prevents the future accumulation of arrears, the benefit formula still needs to beadjusted to reflect the realities of future resources. More importantly, introduction of a realistic benefit formulamust precede the merger of the two Federation funds to ensure the financial viability of the new, unified Federationpension system.

61. Given the low average pension and the significant number of low-level pensioners in both Entities, animportant short-term objective of pension policy must be to protect the most destitute pensioners. Achieving thisrequires a temporary policy in which the lowest pensions are increased relatively more generously when revenuesare increased, until reaching a reasonable subsistence level. Giving higher priority to financing an adequateminimum within the pension system has been a policy followed by many countries during times of severe financingconstraints. This approach should, in turn, compress the present wide range of pensions in both Entities and, hence,result in more equitable distribution of limited pension revenues.

62. Further pressures to pension finances would come from special military benefits in both Entities. In theFederation, special lower contribution rates, along with a more generous benefit formula for the military has alreadycreated financial strains. While the new Federation Pension Law envisages the development of financing modalitiesfor special military benefits through separate legislation, preparation of the legislation has been delayed A rapidresolution of the financing issues for military is critically important for preventing cumulating financial imbalancesin the new Federation pension system. This can be done by calculating the additional liability caused by the specialbenefits, and either earmarking revenues to cover them in a transparent manner and/or reducing the special benefits.Several special benefit schemes for military also exist in Republika Srpska, where budgetary transfers providesupplementary financing. The Government is considering expanding these schemes by providing special pensionbenefits for veterans and their families. In order to improve the financial viability of the pension system, RepublikaSrpska must also develop a financing strategy for special benefits and must avoid providing additional benefits forveterans through the pension system. Finally, both Entities must refrain from providing contribution relief orexemptions from pension contributions. In general, any special support program should be financed from availablerevenues in a systematic and transparent manner.

63. The decentralized state of public pension provision in the Federation presents another important challenge.Advantages of economies of scale in administration and ease in labor mobility suggest a unified Federation pensionsystem to cover the relatively small Federation population. As indicated in para.58 the new Federation Pensionlegislation establishes a timetable for drafting separate legislation that would resolve this difficult issue. As a first

15

step towards this end, a new Federation Pension Agency, consisting of representatives from both pension funds, wasestablished in January 1999 and assigned with the task of drafting this legislation by June 1999. The next step mustbe implementation of a merger of the two funds by the end of 1999. This task involves introducing, alongside,measures aimed at achieving fiscal sustainability and an adequate safety net described in paras. 60-62 above.Finally, within the same timetable, it is also important to design a mechanism to retire all outstanding claims (e.g.,unpaid contributions from enterprises and the military, as well as unpaid pensions) prior to the establishment of thenew, Federation-wide pension fund. The authorities have asked the World Bank to continue providing its assistancein this area under the proposed PFSAC II.

tA4. In thc medium term, more comprehensive pension reforms will have to be considered in BiH. Reformoptions such as the introduction of privately managed pensions will have to be studied carefully. The governmentsof both Entities have asked the World Bank to continue providing technical support in designing a comprehensivepension reform. Such reform would, in due course, be supported by future structural adjustment operations.

Actions to be supported by PFSAC II

65. The proposed operation will support the Entity govermments' efforts to design and implement pensionpolicies that will contribute to attaining fiscal sustainability, better targeting of the most vulnerable pensioners andunification of pension policies and administration in the Federation. Continuing dialogue between the Entitygovernments and the Bank is expected in both designing short-term pension policy and preparing medium-termreform. Prior to Credit effectiveness, Entities will have prepared a report on actuarial projection of each Entities'pension finances and distribution of pension income. In addition, the Federation Pension Agency willhave submitted to the Federation Government the draft legislation on the merger of the two pension fund. It is alsoexpected that both Entities will have initiated the actuarial estimate of additional cost of special benefits for themilitary.

66. Before the second tranche release, (i) the Republika Srpska Parliament will have adopted amendments topension legislation, defining both a new benefit formula and eligibility criteria conducive to a long run balance inits pension finances; and (ii) the Federation Parliament will have enacted the legislation creating the new unifiedFederation Pension Fund and introducing both a benefit formula and eligibility criteria conducive to a long runbalance in its pension finances. These pieces of legislation should be under implementationby the time of the thirdtranche release. Additionally, it is also expected that by the time of the second tranche release: (i) explicitfinancing and badgeting rules for special military benefits and contributions will have been developed and unviableschemes will have been eliminated; (ii) adjustments to the benefit formula for provision of a reasonable minimumbenefit will have been made; and (iii) existing exemptions for social insurance contributions will have beeneliminated, and measures prohibiting provision of exemptions unless provided for by existing legislation will havebeen taken. By the time of the third tranche release, both Entities are expected to have initiated their comprehensivepension reform strategy. The technical assistance, which has been provided through previous operation and duringthe preparation of this operation, will continue through implementation in all of the key areas presented above.

(ii) Reforming Veteran's Benefits and Other Social Protection Programs

Current Situation

67. Bosnia and Herzegovina's pre-war social protection system was among the most sophisticated in EasternEurope. During the war, the system financially collapsed and fragmented across BiH and it largely remains sotoday. In addition to the pension system, only veterans' benefits and a few other social programs, mainly providingpoverty relief, can be funded at present. Budgetary transfers for veterans' programs, and donor assistance for theother programs, provide the main funding source. Social assistance programs are generally the responsibility ofcantons in the Federation, except for veterans' programs, for which the Federation shares financial responsibility.In Republika Srpska, the structure is more centralized at the Entity level. In both Entities, municipal Centers forSocial Work (CSW) administer the implementation of programs that provide poverty relief, mainly by managing

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foreign-financed programs, as domestically-financed programs are very limited. As with the other social sectors,the system of social assistance today faces the dual challenge of overcoming low levels of financing capacity andlack of an effective governance framework. Measures are now urgently required to improve the provision of socialassistance in both Entities and reintegrate the system in the Federation.

Issues and Plans in Reforming Veteran' Benefits and Other Social Protection Programs

68. Reforming veteran's benefits prograsn. Over the last year, both Entities prepared legislation on theirrespective veterans' benefits schemes, covering both war veterans and their families. The Republika Srpska enactedits legislation while the Federation legislation awaits Parliamentary approval. The legislation of both Entitiesreveals two major weaknesses. First, the incongruity between available resources and promised benefits are notadequately addressed, a pattern likely to be reinforced by the indexation rules tying benefits to average wagegrowth. The best way to address these problems is, as in the case of pensions, redefining benefit rules so thatpromises will be aligned with projected resources; and tying benefit adjustments to the availability of resources.Second, an overly complex schedule of benefits was created, with ten levels of disability including very minorphysical impairment. This adds to the administrative costs of the system and creates a very large beneficiary poolinto perpetuity. Furthermore, by including annual benefits for those with minor disabilities, the program alsoreduces the funds that would otherwise be available for the seriously handicapped and their families. Theseweakness could be addressed by a combination of policy measures, including reducing the number of benefitcategories; separating discrete, one-time compensation programs and permanent entitlement programs, e.g. payingone-time benefits to those with minor disabilities; and improving targeting of resources to the neediest cases.

69. The analysis necessary to design such policies, however, requires data and information on the number andcomposition of beneficiaries in each Entity. Such data and information is not only limited but also not readilyavailable at present. As a first step towards addressing this critical issue, both Entities are currently gatheringexisting data and information. Both are expecting to complete aggregation and analysis by May 1999. This must befollowed by the development of a more systematic data collection, analysis and monitoring capacity in both Entitieswith the assistance from donors.

70. Subsequently, an integraticn strategy must be developed for veterans' programs in the Federation, both onthe policy and the administrative level. This would help minimize the administrative costs associated with multipleschemes in a small Entity, and resulting savings could be passed back to beneficiaries. It would also helpharmonize benefit levels across the Federation. The ongoing work towards unification of the pension systemconstitutes a sound model to follow in developing such a strategy.

71. Reforming other social protection programs. The development and institutionalization of a new socialprotection system is urgently needed in BiH, where foreign humanitarian support-a major resource base since theend of the war-has been gradually diminishing. The immediate challenge is to provide poverty relief during theinitial transition period, before in-depth reformn of the system is possible. This requires (i) improving targetingmethods to direct available resources to the most needy; and (ii) strengthening the existing institutional base formore effective provision of poverty relief. It also involves identifying existing programs and beneficiary coverageby consolidating the available information, which *is currently scattered because of local implementation ofprogramns. This process has already begun with the ongoing efforts to re-define the beneficiary identification cardfor accessing CSW assistance and to link the databases between the CSW across each Entity.

72. Further steps must be taken to provide the CSWs with adequate resources, both to run the most criticalassistance programs and to enable them to finance their basic administrative expenditures. At present, financing forCSWs is primarily the responsibility of cantons in the Federation and the municipalities in Republika Srpska. Thiscreates a potential for translating current large differences in local fiscal resources into large differentials in theprovision of social assistance especially in places where foreign assistance is relatively limited. Given theextremely tight domestic finances in both Entities, in the near term, such pressures could be contained only by (i)

17

continued strong donor assistance; and (ii) collaborative efforts of the donors and the authorities to direct availableresources to places with lowest social assistance capacity.

73. A permanent approach for addressing present weaknesses in financing and governance capacity will,however, need to be urgently developed before the humanitarian assistance is phased out. In order to provide asound basis for this exercise, a comprehensive poverty analysis, built on a household income and expendituresurveys, will have to be undertaken. Key decisions will have to be made on the target level of social assistance,criteria for eligibility etc. and other policies with fiscal implications. Critical choices will also have to be maderegarding both the administrative structure and the financing modalities of the new system. In making thesechoices, efficiency and equity issues will have to be properly addressed in the Federation. The Statistics Institutes inboth Entities recognizes the importance of household survey research and considers initiating the survey work withthe assistance from donors including the Bank. Subsequently, in light of the survey results, the Entities areconsidering to review and revise the ongoing work. to develop legislative framework for the social assistancestrategy.

Actions to be Supported by PFSAC II

74. The proposed operation will support the Entity governments in designing and implementing an affordablesocial protection strategy, with an emphasis on targeting the most destitute groups. Continuing dialogue betweenthe governments and the Bank is expected in designing short-term social protection policy and in preparation formedium-term reform. Such medium-term reform efforts would, in due course, be supported by future structuraladjustment operations. Prior to the second tranche release, both Entity Governments will have submitted to theBank a comprehensive analysis of beneficiaries for their respective veteran's programs. It is also expected that thepreparation of the household income and expenditure surveys be initiated in both Entities.

D. Reforming the Budgetary Management System

Current Situation

75. During 1998, both Entities have made significant progress in both establishing the legal basis for the budgetprocess and in strengthening basic budget procedures and organizational structures. The new Entity laws on the"Principles of the Budget" have been adopted, which codifies the set of budget reforms supported under the firstPFSAC. The coverage and comprehensiveness of the budgets have been extended by including external cashgrants, general budgetary borrowing and related expenditures into the budget. Necessary provisions have beenincluded in the new budget laws thereby extending this system to incorporate capital budgets, including externallyfinanced projects. Initial general frameworks have been adopted to govern domestic and external local governmentborrowing. Significant progress has been made towards introducing new and improved budget classificationsystems which creates uniform standards across central and local governments and initiates comprehensiveexpenditure reporting. Accounting systems have been improved, including adoption of a regulatory framework forcommitments reporting. New procurement regulations have been adopted to establish a system that promotes opencompetition and transparency. Furthermore, an agreement has been reached to establish treasury systems as part ofthe overall payment system reform.

76. Despite these substantial achievements, much remains to be done in both Entities to consolidate wellfunctioning budget systems that can carry out the main budgeting functions of aggregate fiscal discipline, strategicresource allocation and efficient resource use. The Bosnian authorities recognize these shortcomings, and intend toaddress them through continued reform of the budgetary processes and institutions.

Issues and Plans in Reforming the Budget Management

77. Further progress in reform of budgetary processes is essential for developing a comprehensive budgetarystrategy that will contribute to more efficient budget planning and execution systems in BiH. Once established,.this

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system would also further improve transparency and accountability in government policies and strategies. The mosturgent reforms in order to improve the budget planning are: (i) introducing strategic budget preparation; (ii)reintegrating recurrent and capital budgets; and (iii) strengthening institutional capacity. In addition, eachgovernment should establish a treasury department to ensure better budget execution, better control as well as betterevaluation of budget outcomes.

78. Reform of Budget Planning Processes. There are three major weaknesses in the existing processes forbudget preparation. First, the linkage between budgets and government policies and strategies is not strong.Second, the donor-financed investment program, a relatively large portion of the total public resource envelope inBiH, is separated from the remainder of the budget. Third, the medium-term perspective in the planning ofgovernment expenditure programs is weak. Consequently, the government has very little capacity to develop bothexpenditure policies and priorities consistent with resource constraints and, more generally, with a macroeconomicframework within which the budget operates. This shortcoming is demonstrated by existing budgeting practices,whereby line ministries submit budget estimates that are considerably in excess of available resources; thesubsequent cutbacks during the allocation process negate much of the initial budget preparation work. Moreimportantly, the lack of capacity to set the appropriate balance between capital spending and recurrent spendingundermines not only the government's ability to meet operations and maintenance costs but also its ability tomaintain fiscal stability once donor assistance is phased out. In the Federation, the highly decentralized localstructure poses additional problems in linking resource allocations to broader Entity level policies, in ensuring anequitable distribution of public sector resources, and in establishing a clear rationale for the distribution of aidfinancing.

79. Systemic weaknesses in budget planning are reinforced by institutional deficiencies in both Entities. Ineach Entity, the MoF currently has a very limited economic policy and forecasting role; responsibility for externalaid is located outside of the MoF. Policy and programming capacities within line ministries are poorly developed,and where they do exist, they tend to be located in donor-supported project implementation units (PIUs), orspecialized institutes. Finally, in the Federation, relationships between the respective Federation and cantonal lineministries remain unclear, and co-ordination between the two in budget planning is weak.

80. Addressing the weaknesses in budgetary planning in BiH will, therefore, require developing a two-prongedstrategy. The first part involves developing a comprehensive budget strategy, consistent with government'smacroeconomic and sectoral policies and integrating capital and recurrent budgets. To this end, a medium-termexpenditure framework (MTEF), supportive of such an integrated approach to budgetary planing, must bedeveloped. The second part involves strengthening the institutional capacity and establishing a cooperativeapproach for budget planing. This entails, consolidating and developing core expenditure planning functions withinthe MoFs; developing sector-wide policy and programming functions within the line ministries; and establishingworking groups involving representatives of relevant institutions. Under the proposed Credit, an agreement on theframework of budgetary reforms in these areas has been reached, and preliminary work has been initiated by bothEntities.

81. The new system for budget planing and preparation would work as follows. There will be three buildingblocks of the MTEF. The first one is the macroeconomic framework, which would provide the basis for projectingresource base and expenditure allocations as well as the context against which key budget issues could be analyzed.Initially, it would be based on the IMF/World Bank framework. In time, as the economic forecast and analysiscapacity within the MoFs is built up, it would increasingly reflect the MoFs' own analysis. The second buildingblock is the sector strategy framework, which would establish overall government policy objectives for the sect6r aswell as strategic program areas and financing requirements within the sector, consistent with overall govermnentresource constraints. This would, in turn, help determine the strategic shifts in inter-sectoral resource allocationsand provide the basis for monitoring and evaluating sector program outcomes. The third building block would besectoral expenditure plans, covering both recurrent and investmnent allocations and the related financing. Initially,this would require a major exercise to incorporate externally financed projects within the Entity budgets. In the

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Federation, the MTEF would also incorporate cantonal expenditure plans, with an emphasis on enhancing thelinkages between cantonal expenditure plans and the Federation-wide sector strategies and the macroeconomicframework.

82. The time horizon for the MTEF will be three years, within which the MTEF would be revised and "rolledforward" each year. The MTEF will be prepared during the first half of the year in the forn of a "BudgetFramework Paper" (BFP); it will be approved by the respective Entity Cabinets. The BFP will then provide thestrategic framework and resource ceilings for the subsequent preparation of the annual Budget. With the assistancefrom the World Bank, the Entities have already initiated the work towards preparation of the first BFP. To facilitatethis, each Entity has established both a BFP Working Group and Sector Working Groups (SWG). Initially, theSWGs was formed for a limited number of pilot sectors (including health, education and transport in the Federation,and transport, education, and agriculture in Republika Srpska) which will be the focus of the initial BFP. BothEntities plan to finalize their respective draft BFPs for submission to their Cabinets by June 1999. The Entities alsoinitiated work towards integrating externally financed public expenditures into the BFP and the budgets. Finally, asa first step towards strengthening economic policy and analysis capacity in their respective MoFs, both Entitiesintend to establish a macroeconomic forecasting unit within the MoF.

83. Reform of Budget Execution Systems. Establishing a treasury system at both State and the Entity levels isthe single most urgent reform for improving budget execution in BiH. Under the present system, the Entitypayment bureaus undertake a treasury-like function independently of the MoFs. Consequently, the MoFs have veryweak financial planning and control capacity. There is also very little cash management, and the execution of theState and the Entity budgets largely follows the annual plans with substantial revisions during the course of the year.The treasury, when established, will maintain the exclusive authority for transfer and spending, and hence, it willsubstantially improve budget control and cash management capacity at all levels of government.

84. In the face of the ongoing efforts to abolish, by the end of 2000, the payments bureau system in BiH, theBosnian authorities recognize the need for rapid progress towards establishing the treasury system. The Entitybudget system laws provide the legal basis for the establishment of the treasury system. The initial modeling worktowards the establishment of the State Treasury System began in 1998 with the assistance from the IMF and the USTreasury; the Entities are now considering initiating a similar process with the assistance from the World Bank, IMFand the US Treasury. To achieve this, all three governments are intending to complete, by early 2000, the transferof accounts to the Treasury Ledger for all budget institutions, prepare the centralized payments system and TreasurySingle Account, develop the system of commitment reporting, and complete staffing of the treasury department foroperation starting mid-2000.

Actions to be Supported Under PFSAC n

85. The proposed operation will support the design and implementation of MTEF and Treasury systems tosupport a better integrated, better managed, more transparent and more accountable system of public financialmanagement in BiH. During the period of PFSAC II implementation, the program will focus on the following: (i)improving the preparation process and strategic orientation of the Entity budgets by preparing an initial BFP as abasis for the year 2000 annual budget; (ii) imnproving the budget coverage by incorporating externally financedpublic sector expenditures into the BFP and the budget; (iii) establishing the institutional framework for thedevelopment of a medium term budget planning process; and (iv) initiating the design of an appropriate treasurysystem for the Entities. In this context, by Board presentation, both Entities will have established the BFP WorkingGroup to co-ordinate the preparation of the initial BFP and will have drafted the initial BFP. In addition, it isexpected that establishment of Sector Working Groups for undertaking sector reviews and preparing sector strategyframneworks be initiated in both Entities.

86. By the time of the second tranche release, both Entities will have (i) incorporated capital projects in theyear 2000 budget plans, including those which are externally funded; (ii) established macroeconomic fiscal analysisandforecasting units in their respective MoFs; and (iii) finalized the initial BFP and obtained approvalfrom their

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respective Cabinets. By the time of the third tranche release, (i) both Entities will have adopted a strategy andtimetable to integrate external aid management ffnctions; (ii) both Entities will have revised the BFP to guide theyear 2001 budget and submitted it to their respective Cabinets; and (iii) the State and the Entities will have begunoperating with Single Treasury Account and manage budget execution through Treasury Ledger Account.

87. Thereafter, implementation of budget reform should be continued in the following areas: (i) furtherstrengthening of policy and programming capacities in the MoF and the line ministries for systemic preparation of athree year BFP; (ii) extending sector policy and strategy reviews to all sectors and developing sector strategyframeworks; (iii) strengthening the State and the Entity treasury systems. The technical assistance provided throughprevious operation and during the preparation of this operation will continue through implementation. Continuedreforms to consolidate and broaden the proposed PFSAC II program would, in due course, be supported by futurestructural adjustment operations.

E. Establishing Auditing Procedures and Institutions

Current Situation

88. The existing public sector institutional framework in Bosnia and Herzegovina lacks an audit function. As aresult, there is no comprehensive system to promote transparency and accountability in public sector performanceand provide legislative bodies with the necessary infornation to exercise control over the executive. To address thisproblem, the first PFSAC program supported the establishment of external auditing institutions as one key reformelement in strengthening both public finances and the performance of the public sector in the country. Followingextensive discussions with govermment authorities at all levels, the initial work focused on the development ofappropriate government audit models. This phase was concluded at the end of 1998, resulting in a proposal on theorganizational and functional framework of the external audit system. It was also uniformly agreed thatInternational Association of Supreme Audit Institutions (INTOSAI) standards form the basis for the audit system inBosnia and Herzegovina. Building on the initial proposal, the Bosnian authorities are now considering completingthe design of the audit system and establishing the organization structure before the end of 1999. The authoritieshave asked the World Bank to continue providing assistance under the proposed PFSAC II.

89. In addition to the external audit functions, there is a need to strengthen the internal audit functions in bothEntities and at the State level. Currently, each of the two Entities MoFs has an Inspection Unit, which possesses thefunctions of internal control. In addition, the Entity payments bureaus undertake a quasi-audit in review of theirrespective transactions. A more systematic and harmonized approach is needed in order to establish effectiveinternal audit procedures. This will enable government agencies to exercise managerial control within theirorganizations and to prepare analysis and reports to management on their systems, practices and organization, aswell as compliance with budgetary and accounting requirements.

Issues and Plans for Instituting Auditing Procedures and Practices

90. Institutionalizing exdernal auditing. The most critical aspect in designing an external audit system in BiHwas to determine a feasible organizational structure that would enable several layers of largely autonomousgovernments to undertake sound audit functions within their jurisdictions while at the same time ensuringconsistency of standards, methodology and quality across all levels of govermment. The Bosnian authorities haverecently agreed on an organizational structure that would meet these requirements. This entails: (i) establishing aSupreme Audit Institution (SAI) in each Entity and at the State level for carrying out external audit functions ofrespective central and local government activities and organizations; (ii) establishing a National CoordinatingCommittee (NCC), comprising the State and Entity Auditor-Generals, for setting audit standards, for ensuringconsistency of standards, methodology and quality, for assigning audit responsibility for activities that extend acrossthe Entities and/or the State, and for determining representation on international bodies. The NCC will be chairedby the State Auditor-General and meet according to a fixed schedule on at least a quarterly basis; (iii) appointing theState and the Entity Auditor-Generals through a Parliamentary act for a fixed and non-renewable term. In March,

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the authorities initiated the process of establishing the SAIs by forming a Working Group comprising therepresentatives of the State and the Entities, including cantons in the Federation. The group, with the World Bankassistance, is responsible for the various steps leading to the creation of th,e SAIs, starting with the preparation of thelegal framework.

91. The objective of the external audit in both Entities and the State will be to carry out (i) compliance audit tGensure that all legal and regulatory requirements have been met, or report any failures; (ii) certification audit in theform of a report on the financial statements, and (iii) performance audit (value for money) to measure theperformance of individual public institutions with regard to efficiency, economy and effectiveness. The externalaudit by the SAIs will embrace all government activities and organizations that are partially or wholly owned,controlled or funded by public sources or that are provided by an external organization on loan or grant basis. As istrue elsewhere, maintaining independence and ensuring operational integrity are key to effective operation of SAIs.To prevent political or other unwanted interference, SAIs will be constitutional bodies reporting on their activities totheir respective Parliaments at the State, Entity and Canton levels. However, due to relatively longer process ofamending the constitution, they will commence operation under legislation for a transitional period. Their budgetswill be charged items on respective government budgets. In the case of the Federation, the cantons will alsocontribute to the cost of the Federation SAI, on the basis of a fee determined by the size of audit work to beperformed on their behalf. The authorities expect each SAI to prepare the first audit reports before the end of 1999.

92. Institutionalizing internal auditing In conjunction with the ongoing work to develop extemnal auditingsystem, there is a need to institutionalize internal auditing at all levels of government. The best approach would beto start this process within the Entity Ministries of Finances, including cantons in the Federation, and then togradually expand it into other public institutions and the State Ministry of Finance once it is established. This couldbe most efficiently done by re-organizing the existing Inspection Units with internal control functions, as InternalAudit Units with proper internal auditing capacity reporting to the Minister of Finance. The new Entity organicbudget laws provide the Ministers of Finance with such legal authority by giving them responsibility for theaccounting and supervision of revenues and expenditures. The same applies to the canton Ministers of Finance inthe Federation. In the initial stage, the Internal Audit Units must be responsible, at a minimum, for compliance auditto improve the control and management of budgetary expenditures. Gradually, internal auditing must be broadenedto include operational efficiency and effectiveness. In the process of developing the external and internal auditingfunction, special attention must be given to ensure that the two functions would reinforce, rather than duplicate,each other. The Entities intend to follow the above presented strategy to bring the work on the internal auditing upto comparable speed with that of the external auditing.

Actions to be supported by the PFSAC H

93. The proposed operation will support the development of a strong auditing capacity in BiH. As an initialstep in this direction, prior to Credit effectiveness, the State, the Federation and Republika Srpska will have (i)submitted draft legislative framework and budgets for their SAIs to their Parliaments; and (ii) appointed theirActing Auditor-Generals. The legislative framework and budgets will be adopted by the State and EntityParliaments by the time of the second tranche release and will be under implementation by the time of the thirdtranche release. In addition, by the time of the second tranche release, the State and the Entity Parliaments willhave appointed Auditor-Generals for their SAls. It is also expected that during this timetable, the authorities will (i)prepare and process necessary amendments for establishing SAIs as constitutional bodies during 2000; and (ii)introduce necessary measures to strengthen the regularity and institutional framework for internal auditing.

94. The Bank has been providing technical assistance to support the authorities in their efforts and will continuethis assistance under the PFSAC II. It is also expected that parallel, donor-financed assistance will be providedduring PFSAC II implementation, particularly to support the establishment and operationalization of the SAIs. Thetechnical assistance will (i) assist and advise the SAls in developing planning capabilities, designing audit systemsand strengthening operational effectiveness; (ii) support the SAIs in the development of software tools, procurement

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of office equipment, and formal and on the job training of staff; and (iii) assist the State and the Entity governmentsin strengthening the regulatory and institutional framework for internal auditing.

F. Strengthening Debt Management Capacity

Current Situation

95. During 1998, Bosnia and Herzegovina made significant progress towards building its public debtmanagement structure, which was supported by the World Bank through the first PFSAC. The Entity Laws onexternal debt, consistent with each other and with the State Law on External Debt, were adopted by both Entities.Debt management units (DMU) were established in the State Ministry for Foreign Trade and Economic Relations(MFTER), as well as in each of the two Entities' MOF's. The London Club and Paris Club Agreements on therescheduling of BiH's external debt to commercial banks and official creditors, respectively, were concluded,thereby wiping out a large part of the debt inherited from the SFRY. An automatic and transparent debt servicingsystem was established, substantially improving the regularity of debt service payments; a comprehensive foreigndebt tracking system was established in the State MFTER. A Protocol on information sharing between the State, theEntities and CBBH was signed by the four parties to regularize and streamline the exchange of debt-relatedinformation between various debt management agencies. An Agent Agreement was signed between the StateMFTER and the CBBH that acts as the debt servicing agent of the State. Furthermore, in the Federation, progresswas achieved in building the capacity of Entity MOFs and commercial banks to manage the credit riskarising fromdifferent forms of borrowing, with extensive assistance from international donors.

96. Both Entities made their first steps to regulate the sub-Entity borrowing, whereby local governments areallowed to borrow only externally for investment purposes within a certain limit. At present, however, few localgovernments and municipalities have the technical and fiscal capacity to carry the debt burden; neither the State northe Entities possess mechanisms to monitor and supervise borrowing at the lower levels of government. To date,few local governments have contracted any external borrowings. The present time is opportune for establishing acomprehensive debt tracking system in the BiH to foster fiscal discipline.

Issues and Plans for Strengthening Debt Management Capacity

97. The borrowing activity in BiH is currently low due to severely limited financing capacity; a largeproportion of the reconstruction needs continue to be financed by international aid flows. In the medium-term,however, as aid-flows and concessional financing diminishes, alternative sources of external finance, includingborrowing from capital markets, will be a more significant option in financing the reconstruction and developmentneeds. BiH's access to such external financing will be determined, to a large extent, by the effectiveness and theprudence of its borrowing arrangements. Developing a strong external debt management capacity, therefore,remains to be an important challenge for the Bosnian authorities. This requires continued improvements to theinstitutional setup and reforms to strengthen both borrowing policies and policy coordination between governments,including the development of a policy framework for sub-Entity borrowing.

98. As mentioned above, substantial progress was made during 1998 in creating the legal and institutional setupfor external debt management. Further steps must now be taken to develop policy-making, credit-analysis andmonitoring functions in the State and Entity DMUs that would promote fiscally prudent borrowing operations. Thisincludes broadening Entity DMU's mandate to manage their debt portfolio, not merely to execute debt servicetransactions. They must be able to track and control borrowing by lower levels of government and enterprises andevaluate sub-Entity debt for its sustainability. It also includes broadening information sharing and policy co-ordination arrangements between the State and the Entities to improve the quality and the coverage of theinformation used for sovereign decision-making. To develop a co-ordinated approach in addressing these issues,both the State and the Entities intend to develop "Guidelines" for public sector borrowing building on the presentlegislative framework. The Guidelines will establish (i) a comprehensive debt reporting system; (ii) strong andtransparent selection, budgeting and supervision procedures for loans and guarantees; and (iii) procedures for

23

borrowing policy coordination. The authorities have asked the World Bank to continue providing its assistance inthis undertaking under the proposed PFSAC II.

99. Reporting procedures are already well established for State and Entity borrowing. These must be extendedto cover debt liabilities of sub-Entity governments, public enterprises, and utilities as well as liabilities of publicagencies that have separate budgets such as social security funds. As the first step in this direction, debt databasesmust be created in each Entities' MoF's (in DMU's) and compulsory reporting procedures must be introduced forall public sector borrowing. The Entity MoF's must share such data with the State MFTER. For comprehensivedebt reporting, the CBBH must also establish a similar database and reporting procedures for private sector debts.Debt data reconciliation should be regularly conducted between the State MFTER and CBBH. Once the State andEntity Treasuries are created, such reporting flows could be streamlined thereby simplifying data reconciliation.

100. The Guidelines must enforce ceilings on the amount of annual borrowing allowed by a sub-Entitygovernment as specified in the Entity Budget System Laws. To this end, the guidelines must establish (i) reportingrequirements with sufficient detail on terms and purpose of loans to enable the authorities to prepare reliable debtservice projections and to control the fiscal risk; (ii) budgeting procedures that will allow for tracking the real valueof obligations outstanding; (iii) monitoring criteria that will help track the utilization of loan proceeds and theprogress of the project. They should also include transparent appraisal and approval procedures in order to preventinstances of connected borrowing (sub-Entity borrowing from the commercial banks that they either own or control)and market loans (short-term sub-Entity borrowing from local commercial banks, usually for liquidity managementpurposes, often with extensions of maturity). Finally, the guidelines must establish clear procedures for the issuanceof State and Entity guarantees concerning external borrowing of sub-Entity governments and enterprises (as allowedby the existing legislation) while prohibiting the issuance of guarantees by sub-Entity governments for certainduration.

101. Furthermore, policy-coordination needs to be strengthened between the State and the Entity DMU's inorder to harmonize borrowing plans with the country's ability to service its external debt. The separation ofborrowing, debt servicing responsibility, and fiscal authority in BiH creates potential for a free riderproblem. As aresult, irresponsible or mistaken borrowing decisions on the part of Entity or sub-Entity governments as well aspublic agencies, may jeopardize the borrowing ability not only of the Entity concerned, but the other Entity and theState. Coordination of borrowing strategies would limit the free rider problem and, hence, enhance thecreditworthiness of all borrowers, both public and private. The State Debt Law provides for the establishment of ahigh-level Debt Advisory Committee, with representation from all State and Entity agencies involved in managingexternal debt of BiH. For this purpose, the Interagency Working Group--originally constituted to ensure theconsistency and transparency of debt information--should gradually assume the functions of piloting the country'sdebt strategy.

Actions to be Supported by PFSAC II

102. The proposed operation will support the authorities' efforts in strengthening the countrywide debtmanagement capacity by (i) assisting the DMU's in further clarifying their mandates in debt monitoring and policyformulation; (ii) supporting the introduction of comprehensive reporting and consistent data reconciliationprocedures; and (iii) assisting and advising the Bosnian authorities in developing and implementing Guidelines forprudent borrowing operations and policy co-ordination. By the time of the third tranche release, the State and theEntities will have initiated the implementation of the Guidelines. The technical assistance, which has been providedboth through the previous operation and during the preparation of this operation, will continue throughimplementation.

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V. THE PROPOSED CREDIT

A. Rationale for Bank Involvement

103. The Bank Group's assistance strategy for FY98/99--as outlined in both the Country Assistance Strategydated July 31, 1997 and the progress report dated August 6, 1998--aims to assist BiH in moving from immediatepostwar reconstruction towards sustainable recovery and growth. The key objectives of this strategy are:(i) strengthening the institutions of macroeconomic management; (ii)initiating structural reform measures,particularly in privatization and banking reforms; and (iii) carrying forward physical reconstruction of the country.

104. Particular emphasis will be placed on support for developing economic institutions and policies. Keyamong these efforts are reforms in fiscal management, including, inter alia, rationalization in the assignment ofrevenue and expenditure responsibilities, sound budget and external debt management, improved transparency andaccountability in the use of public sector resources and the establishment of a sustainable social assistanceframework for the most vulnerable. As noted in the CAS, the FY98/99 program includes two public finance reformoperations. The proposed PFSAC II is the second of these two operations. The first operation, PFSAC, wassuccessfully implemented, and its second and final tranche disbursed in December 1998. The PFSAC II isdesigned to help BiH deepen and expand the reform measures in public financial management initiated under thePFSAC.

B. Credit Amount and Borrower

105. The proposed IDA credit, in an amount equivalent to US$72 million (SDR 53.2 million), will be bnt toBosnia and Herzegovina (the State) for a period of 35 years, including a 10-year grace period, on standard IDAterrns. The State will onlend, through subsidiary agreements, US$42million equivalent of the Credit proceeds tothe Federation and US$30 million equivalent of the Credit proceeds to Republika Srpska, on the same terms as theIDA Credit. The beneficiaries would be Bosnia and Herzegovina (the State), the Federation and Republika Srpska.Co-financing on grant terms is expected to be offered by the Government of Netherlands. Funding for technicalassistance required for the preparation of this operation is being provided through two PHRD grants.

C. Credit Design

106. The proposed Credit would provide quick-disbursing funds for fiscal and balance of payments assistance insupport of the government's efforts to reform public finance institutions and policies. The main elements of theprogram supported by this operation include: (i) broadening tax policy hannonization and strengtheningadministrative co-operation between the Entities to enhance revenue capacity and to encourage free flow of goodsacross BiH; (ii) improving revenue and expenditure assignments within the Entities to prevent large differentials inthe provision of public services; (iii) initiating reforms to develop an affordable, efficient, and equitable social safetynet; (iv) developing a comprehensive budgetary strategy aimed at improving fiscal efficiency and control; (v)establishing audit institutions and procedures to improve transparency and accountability in public sectoroperations; and (vi) strengthening country-wide policy coordination in external debt management, includingdeveloping a policy framework for sub-Entity borrowing. In view of the critical importance of establishing afunctioning fiscal system for the entire country, this operation puts its main emphasis on assisting the Bosnianauthorities to harmonize policies, and to strengthen policy co-ordination both within, and between the Entities aswell as between the State and the Entities. Conditionality (as specified in section F below) is mostly linked tointergovernmental financial relations, the tax system, budgetary management and institutional aspects required forthe functioning of the country as a unified State. Other substantive reforms discussed in the previous sections,particularly regarding the social safety net, are clearly important for the operation of an efficient public financesystem in the longer term. The Bank intends to support these reforms through future structural adjustmentoperations.

25

D. Administrative Arrangements

107. The State MFTER is responsible for overall administration of the Credit on behalf of Bosnia andHerzegovina, the borrower. Each Entity's Ministry of Finance is responsible for administering the pre-allocatedamount of funds of the Credit. Based on discussions with government authorities, it is understood that thecounterpart funds of the proposed Credit would be used to support fiscal expenditures of the State and Entitygovernments, in particular, contributions of the Entities to the 1999-00 State budget for debt service obligations,essential social expenditures such as pension payments, and minimum income support, as well as costs related toinstitution-building efforts in the areas of budget management, external audit, tax administration and health finance.

E. Disbursement

108. The Credit will be disbursed in three tranches to the deposit account of the State at the Central Bank ofBosnia and Herzegovina (CBBH). The entire amount of all three disbursements will be transferred from the State'sDeposit Account to the budgetary accounts of the Entities in the CBBH. The first tranche (US$28millionequivalent, with a Federation share of US$16 million and a Republika Srpska share of US$12million) would beavailable upon Credit effectiveness. The second tranche (US$24 million equivalent, with a Federation share ofUS$14 million, and a Republika Srpska share of US$10 million) and the third tranche (US$20 million equivalent,with a Federation share of US$12 million, and a Republika Srpska share of US$8 million, respectively) would beavailable upon satisfactory review by IDA of the implementation of the adjusttnent program as a whole and thefulfillment of the specific second and third tranche conditions as described in the following section.

F. Monitoring Arrangements and Tranche Release Conditions

109. Implementation of the policy program will be monitored by a Committee composed of the representativesof the State MI TER and the Entity Ministries of Finance. With input from participating ministries/institutions, theCommittee will have responsibility for monitoring and evaluating progres.- mider the various components of theprogram. IDA will monitor implementation with the help of the Committee's reports, and through supervisionmissions. Specific conditions for Board presentation of the Credit, Credit effectiveness and second and thirdtranche release of the Credit are presented below and in the policy matrix in Annex I.

(i) Reforming and Harmonizing Tax Policies and Coordinating Tax Collection

Board Presentationa) Entities to implement the State-set tariff surcharges.b) Entities to eliminate special trade agreements with Croatia and Yugoslavia.c) Entities to equalize the excise tax rates on domestic and imported goods.d) Entities to establish a Working Group to develop a plan for coordination between the two tax

administrations.Second Tranche Releasea) Entities to complete the harmonization of the sales tax systems by reducing differences in sales tax rates.b) Entities to submit to their Parliaments amendments to their sales and excise tax legislation on inter-Entity

allocation of the sales tax on excisable goods and excise taxes.c) Entities to adopt a plan to strengthen the coordination between their Tax Administrations, including an

information sharing system.Third Tranche Releasea) Entities to implement new legislation on inter-Entity allocation of sales and excise taxes.b) Entities to implement new arrangements for administrative co-ordination, including an information sharing

system.

26

(ii) Reforming the Intergovernmental Finances within the Entities

Board Presentationa) Entities to eliminate existing tax relief and exemptions with a specific expiration date, unless provided for

under their respective tax legislation or by international treaties and including those exemptions granted toduty-free shops, by allowing them to expire at the end of their current term.

Second Tranche Releasea) Entities to eliminate all tax and duty exemptions without a specified expiration date and that are not provided

for under their respective tax legislation or by international treaties, and to adopt measures to effectivelycontrol duty-free shops and ensure that transactions at such establishments are limited to authorized persons.

b) Federation to adopt amendments to its tax legislation to improve collection and allocation of sales tax onexcisable goods between the cantons.

c) Republika Srpska to develop and adopt guidelines to improve administrative efficiency in health servicedelivery and the collection of health contributions.

d) Federation to establish cantonal health insurance funds and adopt service responsibilities and financingsources for the Federation Health Insurance Fund.

Third Tranche Releasea) Federation to implement the new collection and allocation system for sales tax on excisable goods between

the cantons.b) Federation Government to adopt amendments to the Law on Health Care regarding service responsibilities

and financing sources for the Federation Health Insurance Fund.

(iii) Reform of Social Safety Net

Credit Effectivenessa) Entities to prepare a report on actuarial projection of their pension finances and their pension income

distribution.b) The Federation Pension Agency to submit to the Federation Government the draft legislation on the merger

of the two pension funds.Second Tranche Releasea) Republika Srpska to adopt amendments to pension legislation on benefit forrnula and eligibility criteria.b) Federation to adopt amendments to pension legislation on the financial and administrative unification of the

Federation Pension Fund and new benefit formula and eligibility criteria.c) Entities to submit to the Bank a comprehensive analysis of beneficiaries for their veteran's programs.Third Tranche Releasea) Federation to implement amendments to its pension legislation.b) Republika Srpska to implement amendments to its pension legislation

(iv) Reforming the Budgetary Management System

Board Presentationa) Entities to establish the BFP Working Group to co-ordinate the preparation of the BFP and to draft the initial

BFP.Second Tranche Releasea) Entities to incorporate capital projects in the year 2000 budget plans including those which are externally

funded.b) Entities to establish macroeconomic analysis and forecasting units in their respective MoFs.c) Entities to complete the initial BFP and to obtain approval from their Cabinets.Third Tranche Releasea) Entities to adopt a strategy and timetable to integrate their external aid management function.

27

b) Entities to revise the BFP, to guide the year 2001 budget, and to submit it to their Cabinets.c) Entities and State to operate with Single Treasury Account and manage budget execution through Treasury

Ledger Account.

(v) Establishing Auditing Procedures and Institutions

Credit Effectivenessa) State and Entities to submit draft legislative framework and budgets for their SAIs to their Parliaments.b) State and Entities to appoint their respective Acting Auditor-Generals.Second Tranche Releasea) State and Entities to adopt the legislative framework and budgets for their SAIs.b) State and the Entity Parliaments to appoint Auditor-Generals for their SAIs.Third Tranche Releasea) State and Entities to operationalize their SAIs.

(vi) Strengthening Debt Management Capacity

Third Tranche Releasea) State and Entities to implement Guidelines goveming public sector borrowing and policy co-ordination.

G. Environmental Assessment Requirements

110. In accordance with the Bank's Operational Directive on Environmental Assessment (OD4.01, Annex E),the proposed operation has been placed in Category "C" and does not require an environmental assessment.

H. Benefits and Risks

111. Benefits. The implementation of the proposed operation will help BiH consolidate the public financereforms began under the PFSAC, substantially strengthen prospects for continued fiscal stability, enhancesustainability of the structural reform process, and reintegrate the economy. The reform program will promote freeflow of goods between the Entities and improve tax revenue collection by completing harmonization of major taxstructures, strengthening administrative co-operation and revenue distribution. It will facilitate development of amore robust intergovernmental system, which is supportive of the Entities' stabilization and structural reforms andwhich will improve efficiency and coverage of public sector services. By pursuing essential policy and institutionalreforms in budget planning and execution, the operation will help the Entities correct the medium-term imbalancebetween revenues and expenditures and set appropriate priorities for public outlays. The proposed reform programwill also improve medium-term financial viability and targeting of the pension system, initiate design of anequitable and sustainable social safety net system, and ensure a certain level of equalization in the provision ofhealth services through development of an efficient health insurance system in both Entities. By instituting soundauditing procedures, it will significantly enhance transparency, efficiency and accountability of public serviceoperations.

112. Establishment of an effective and integrated public finance structure will help BiH conduct soundmacroeconomic management, reduce cost to economic transactions, and achieve external creditworthiness. Bysupporting the development of a public sector which is more suitable to a market economy, the operation will alsocontribute to private sector development, employment creation and poverty reduction.

113. Risks. The Credit faces two major risks. First, there will be risks associated with BiH's process ofreconciliation, as has been demonstrated so far since the signing of the Dayton Accords in December 1995. Severalmeasures supported by the proposed Credit are subject to intense political debate within the country-and, moreparticularly, between the different ethnic groups-thus creating a potential for non-implementation of the agreedmeasures and/or reversal of the adopted reforms. Particular among them are the harmonization of the Entity taxpolicies, pension reform in the Entities, especially unification of the Federation pension funds, and reform of

28

intergovernmental financial relations, particularly in the Federation. To mitigate these risks, the Bank requires theupfront fulfillment of conditionalities whenever possible and will work closely with the IMF, the US Treasury andothers to jointly promote the implementation of the reform agenda. The Bank also agreed with the BiHgovernments to set up working groups on key reform areas and maintain close co-ordination with the existing onesto promote consensus. The Bosnian authorities' strong commitment and success in implementation of equallydifficult set of policy measures under the first operation has shown that obstacles created by low political tolerancecan actually be mitigated.

114. A second risk is that the Government's administrative and institutional capacity will be insufficient tohandle the complexity of the budgetary and auditing reform actions envisaged in the PFSAC II. TheGovernment is cognizant of this risk, and its program is designed to minimize its administrative burden, byappropriate phasing of the measures and application of the technical assistance where needed. Certain essentialtechnical assistance activities have already been financed by PHRD grants. The bulk of the technical assistancerequirements would have to be carried through grant financed TA programs and/or parallel donor financed TA toaugment the limited local capacities.

VI. RECOMMENDATION

115. I am satisfied that the proposed Credit complies with the Articles of Agreement of the Association, and Irecommend that the Executive Directors approve it.

James D. WolfensohnPresident

by Sven Sandstrom

Attachments

Washington, D.C.June 1, 1999

29

SCHEDULE A

BOSNIA AND HERZEGOVINA

PROPOSED SECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT

TIMETABLE OF KEY PROJECT PROCESSING EVENTS

1. Time taken to prepare: three months

2. Project prepared by: Government with IDA assistance

3. Identification Mission: November 1998

4. Preparation Mission January/February 1999

5. Appraisal Mission: April 1999

6. Negotiations: May 1999

7. Planned Board Presentation: June 1999

8. Planned Effectiveness: July 1999

9. Expected Project Completion: Not applicable

10. Relevant SAR: Not applicable

30

SCHEDULE BPage 1 of 2

STATUS OF BANK GROUP OPERATIONS IN BOSNIA AND HERZEGOVINA

A. STATEMENT OF BANK LOANS a'(As of May 24,1999)

US$ MillionLoan Fiscal (Less Cancellations)No. Year Borrower Project Loan Undisbursed

Loans/Credits/Grants

IBRD O4038-BOS 1996 Bosnia and Herzegovina Consolidation Loan A 28.6 0.04039-BOS 1996 Bosnia and Herzegovina Consolidation Loan B 284.9 0.04040-BOS 1996 Bosnia and Herzegovina Consolidation Loan C 307.1 0.0

Total 620.6 0.0

Of Which: Repaid 24.9Total Now Held by the Bank: 595.7

TFBH' (Under Disbursement)TF-024030 1996 Bosnia and Herzegovina Emergency Recovery Credit 45.0 0.0TF-024031 1996 Bosnia and Herzegovina Emergency Farm Reconstrucbon 20.0 0.0TF-024032 1996 Bosnia and Herzegovina Emergency Water Supply 20.0 0.0TF-024033 1996 Bosnia and Herzegovina Emergency Transport 35.0 1.8TF-024034 1996 Bosnia and Herzegovina Emergency District Heating 20.0 0.0TF-024035 1996 Bosnia and Herzegovina Emergency War Victims Rehabilitation 5.0 0.0TF-024040 1996 Bosnia and Herzegovina Emergency Education Reconstruction 5.0 0.0

Total 150.0 1.8

IDA2897-BOS 1996 Bosnia and Herzegovina Emergency Educabon Reconstruction 5.0 0.02896-BOS 1996 Bosnia and Herzegovina Emergency War Vicbms Rehabilitation 5.0 2.62902-BOS 1997 Bosnia and Herzegovina Emergency Housing Repair 15.0 0.02903-BOS 1997 Bosnia and Herzegovina Emergency Power Reconstruction 35.6 0.22904-BOS 1997 Bosnia and Herzegovina Emergency Public Works and Employment 10.0 0.82905-BOS 1997 Bosnia and Herzegovina Emergency Landmines Clearance 7.5 0.02906-BOS 1997 Bosnia and Herzegovina Emergency Demobilization and Reintegrabon 7.5 0.52914-BOS 1997 Bosnia and Herzegovina Transition Assistance Credit 90.0 0.0N001-BOS 1997 Bosnia and Herzegovina Emergency Industry Re-Start Guarantee 10.0 0.0N002-BOS 1997 Bosnia and Herzegovina Emergency Microenterprise/Local Inibtatives 7.0 0.4N003-BOS 1997 Bosnia and Herzegovina Essenbal Hospital Services 15.0 3.7N032-BOS 1998 Bosnia and Herzegovina Transport Reconstructon II 39.0 6.7N035-BOS 1998 Bosnia and Herzegovina Education Reconstruction II 11.0 2.73028-BOS 1998 Bosnia and Herzegovina Reconstruction Assistance Project 17.0 4.83029-BOS 1998 Bosnia and Herzegovina Emergency Natural Gas 10.0 0.43070-BOS 1998 Bosnia and Herzegovina Emergency Pilot Credit (RS) 5.0 2.73071-BOS 1998 Bosnia and Herzegovina Power iI 25.0 25.0N040-BOS 1998 Bosnia and Herzegovina Forestry 7.0 6.23090-BOS 1998 Bosnia and Herzegovina Public Finance I (Structural Adjustment) 63.0 0.03191-BOS 1999 Bosnia and Herzegovina Local Development 15.0 15.03020-BOS 1999 Bosnia and Herzegovina Basic Health 10.0 10.0

Total 409.6 81.7

The status of these projects is described in a separate report on all Bank/IDA financed projects in execution, which is updated twice yearly and circulated to theExecutive Directors on April 30 and October 31.

Consolidation Loans A, B, and C were approved on June 13, 1996 and becamne effective on June 14, 1996.

Trust Fund for Bosnia and Herzegovina.

Page 2 of 2

B. STATEMENT OF IFC INVESTMENTS(As of March 31, 1999)

Gross Commitments------ US$ Million------

FiscalYear Obligor Type of Business Loan Equity Total

1977 Tvomica Kartona I Ambalaze Cazin Timber, Pulp and Paper 3.65 0.00 3.651985 Sour Energoinvest Industrial Equipment and Machinery 8.53 0.00 8.531997 Horizonte BiH Enterprise Fund SME Investment 0.00 1.93 1.931997 Microenterprise Bank Microcredit 0.00 0.57 0.571997 Sarajevska Pivara Beverage Manufacturing 3.89 0.00 3.891998 SEF Akova Abbatoir, Meat Packing and Processing 2.08 0.00 2.081998 Wood Agency Credit Line Furniture and Other Wood Products 13.69 0.00 13.691998 SEF Lignosper Fumiture Manufacturing 2.27 0.00 2.271999 SEF Kupex Industrial and Consumer Services 2.46 0.00 2.46

Total Gross Investments 36.57 2.50 36.57Participations, Cancellations, Terminations, Exchange Adjustments,Repayments, and Arrears (Principal Only) 13.01 0.00 13.01

Total Commitments Now Held by IFC 36.57 2.50 36.57

Total Undisbursed 14.20 1.54 14.20

Total Outstanding 22.37 0.96 22.37

SCHEDULE CPage 1 of 2

Bosnia and Herzegovina at a glance /19

B"osia furope& ______

POVERTYancuSOCIAL and Central LOW-Heozegovina Asia Incom Development diamond*

1 998Population, mid-year (mlins) .. 4.2 476 2,048. Life expectancyGNP per capit (Atla method, US$), 92 2,320 350GNP (A4la method US$ bIio) 3.9 1,108 722

Avera se annual growth, 1091-97

Population (%/) 0.1 .2 2.1 GNLabor force (%) 0.3 0.5 2:3 GPGross

per primaryMost recent estimate (1atet year 'available, 199147) r capita enrollmentPovry( fppltion below national povetly Mie)*

Urban poulatior (% offtal poplatIon)42 67 28Life expectancy at birt la~ 60 59Infant mrtality (per 1,000 live bIts)~ 1's 25 78Child malnutrition (% of children under 5) I* * Access to safe waterAccess to safe watert (%of popu1ation) 71IllliteracyN( of popultion age 15)47Gross primary enrollment (% of coo-g popultn)9 91 - Bsi n ezgvn

Male . ~~~~~~~~~~~~~~~~~100' Low-income group

KEY ECONOMIC RATJIOS and LONG-TERM TRENDS.

1978o 1988 197 1998Economic ratios*

Gross domestic investment/GDP . ... 42.0 380TrdExports of~ goods and servicealGOP .. . 29.3 33~5TrdGross domestic ssavngslGQP . , . 49 1 .Gross national savingelGOP i.. . 1. 0,4

Current account batanclGOp .. ,. 41.0 .-27.8 DomesticInterest paymentslGDp. . 6.7 2.7 InvestmentTotal debt/GDP . . 128.3 705 SavingsTotal debt servcleprts . .38

Present valUe of debtlGDP .. . 9.8Present value of debtlexpprts . . . . 178 8

Indebtedness10764 1987-97 109 1997 19

(average annual grWth)GDP. ., . 69.1 29.5 1, -Bosnia and He,zegovinaGNP per capita . . 74.0 301 1 .4 Low-income groupExports of goods and services . . 99.3 57,7 34.7 __________________

STRUCTURE of the ECONOMY1976 1986 1997 1998 Growth rates of output and investment I%)

(% of GDP) 200Agriculture .. .....

IndustryIManufacturing .o

Services 50

Private consumption . ... .92 93 94 99 99 97 98

General government consumption .. . GDI 0--GDPImports of gGods and services . .. 76.1 70.2

(average anual growth)1976486 1987-97 1997 1998 Growth rates of exports and imports 1%)

Agriculture . .. 200

Industry . ... * ISOManufacturing

Services 050

Private consumption .

General government consumption .. . . .

Gross domestic investment . .. 61.2 10.2 92 93 94 95 99 97 99Imports of goods and services . .. 31.7 3.7 -Exports -0-ImportsGross national product.. ._____________________

Note: 1997 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average, If data are missing, the diamond willbe incomplete.

Page 2 of 2

Bosnia and Herzegovina

PRICES and GOVERNMENT FINANCE1976 1986 1997 1998 Inflation (%)

Domesfic prices(% change) 115

Consumer prces .. .. 110ImplicitGDPdeflator .. .. 11.2 3.1 100

Government funance ss(% of GDP, includes current grants) goCurrent revenue . ... .. 92 93 94 ss srd 97 go

Current budget balance - GDP deflator -O--CPIOverall surplus/deficit .. .. _.._..

TRADE1976 1986 1997 1998 Expot and Import bvels (US$ millions)

(US$ millions)

Total exports (fob) .. .. 575 817 3,000Commodity I .. .. 2,500Commodity 2 2,000Manufactures ..

Total imports (cif) .. .. 2,333 2,573 1,500-Food 1.000Fuel and energy .. .. .. .o0Capital goods .. F. .. . 91 92 93 94 ss srd 97 rza

Export price index (1995=100) ..Import price index (1995=100) -I . Exports 11 ImportsTerms of trade (1995=100) .. .. .. ..

BALANCE of PAYMENTS

(US$ millions) 1976 1986 1997 1998 Current account balance to GDP ratio (%)

Exports of goods and services .. .. 1,002 1,367 0 I .Imports of goods and services .. .. 2,606 2,864 s o 92 93 94 95 9s 97 9aResource balance .. .. -1,604 -1,498

Net income .. .. -228 -109 -15Net current transfers .. .. 772 480 -20 l

Current account balance .. .. -1,060 -1,127 -2I

Financing items (net) .. .. 971 1,158 -30 -

Changes in net reserves .. .. 89 -31 -ss

Memo:Reserves including gold (US$ millions) ..

Conversion rate (DEC, locabUS$) ..

EXTERNAL DEBT and RESOURCE FLOWS1976 1986 1997 1998

(US$ millions) Composition of total debt, 1998 (US$ millions)Total debt outstanding and disbursed .. .. 4,392 2,879

IBRD . .. 596 581IDA .. .. 291 433 A:581

Total debt service .. .. 385 123 E: 822IIRD .. .. 35 35IDA .. .. 2 3

Composition of net resource flowsOfficial grants .. .. 574 727 Er: 433Official creditors .. .. 431 363Prvate creditors .. .. -107 -75Foreign direct investment .. .. 0 100 I77Portfolio equity .. .. 0 0 D.988

World Bank programCommitments .. .. 77 100 A - IBRD E - BilateralDisbursements .. .. 111 142 B - IDA D - Other multiateral F - PnvatePrincipal repayments .. .. 0 0 C - IMF G - Short-termnNet flows .. .. 111 142Interest payments . .. 37 38Net transfers .. .. 74 104

Development Economics 5/11/99

ANNEX IPage I of 9

BOSNIA AND HERZEGOVINASECOND PUBLIC FINANCE STRUCTURAL ADJUSTMENT CREDIT - POLICY MATRIX

(Items in italic and bold are conditions for tranche releases)

1. Maintaining a StableMacroeconomic Framework

Monetary Policy

* Maintaining policies conducive * Has restored and maintained * Maintain currency board * Continued satisfactory * Continued satisfactoryto monetary stability. monetary stability since 1995; principles and abstain from implementation of the implementation of the

* Established countrywide extending credits to the public monetary policies. monetary policies.operational structure for the sector or the banking system.central bank; introduced thenew national currency.

* Modernizing the payments * Developed a comprehensive * Initiate the implementation of * Continued satisfactory * Continued satisfactorysystem and liquidating payment two-year reform strategy to be the reform program. implementation of the reform implementation of the reformbureaus across BiH. implemented through end- program program

2000.Fiscal Policy

* Maintaining a fiscal policy * Has maintained budgets * Balance budgets on a cash * Continued satisfactory * Continued satisfactoryconsistent with the monetary balanced on a cash basis and basis; abstain from borrowing implementation of the fiscal implementation of the fiscalpolicy and overall structural abstained from borrowing from from the nonbank and banking policies. policies.reform strategy. the domestic banking sector. sector; and prevent

accumulation of arrears.* Established clear arrangements * Continued satisfactory * Continued satisfactory * Continued satisfactory

for the financing of the State implementation of the State implementation of the State implementation of the Statebudget, including an automatic finance mechanism. finance mechanism. finance mechanism.transfer mechanism betweenthe Entity and the StateGovernments.

11. Reforming and HarmonizingTax Policies and CoordinatingTax Collection

* Broadening and accelerating * Entities began implementing * Entities to inplement the State- * Entities to conplete the * Implement;the process of harmonization of the State-set common custom set tariff surcharges; harmonization of sales taxthe Entity tax systems; and and trade policy; * Entities to elininate special system by reducing differencesestablishing strong * Entities began harmonizing trade agreements with Croatia in sales tax rates;administrative co-ordination their sales and excise tax and Yugoslavia;between the Entity tax systems by adopting similar tax * Entities to equalize the exciseadministrations. bases and by harmonizing the tax rates on domestic and

collection point in the inported goods;distribution process;

ANNEX IPage 2 of 9

POIJCY AREAS AND ocerves AofHlVEMdlwr/MPAws M-v9 sudS PRORTG!*BQAR MER& OR I SEcOND: MEA.IS PRIMI TOfiE >TSDALiwDYt'r c PSENATtOM . n . DBUR T

__ _ _ _ _ __ _ _ _ _ _ (JU E I~99 ) (0 CE BE : .......5_P) (J O NE 2000O)* Entities both strengthened their * Entities to establish a Working * Entities to adopt a plan to * Entities to Implement new

own tax administration and Group to develop a plan for strengthen the coordination arrangementsforinitiated a dialogue, under the coordination between the two between their Tax administrative co-ordination,EU's supervision, for tax adninistrations. Adninistrations, including an including an informationimproving administrative co- information sharing system. sharing system,operation with each other.

* Improving revenue attribution * Entities to submit to their * Entities to implement newrules between the Entities. Parliaments amendments to legislation on inter-Entity

their sales and excise tax allocation of sales and exciselegislation on Inter-Entity taxes.allocation of the sales tax onexcisable goods and excisetaxes.

* Tax Working Group to initiate * Entities to complete proposalsthe work on value added tax for introduction of VAT system(VAT) system.

III. Reforming theIntergovernmental Financeswithin the Entities

Federation

* Improving revenue attribution * Improved the revenue * Begin preparing a plan to * Adopt changes to the tax * Implement the new collectionrules within the Federation. allocation between cantons by improve allocation of (i) sales legislation to improve and allocation systemfor sales

attributing sales tax on taxes on excisable goods by collection and allocation of taxes on excisable goodsexcisable commodities to the ensuring greater revenues to be sales taxes on excisable goods between cantons.first buyer's location. allocated to the place of between cantons.

destination; and (ii) profittaxes by re-defining theassignment and/or distributionrules between the cantons andthe Federation

* Strengthened the co-ordination * Eliminate/agree to elininate * Eliminate all tax and duty* Enhancing and protecting between the Tax (FTA) and existing tax relief and exemptions without a specified

revenue capacity across Customs Administration (FCA) exemptions with a specific expiration date and that areFederation. and enhanced the information expiration date, including not providedfor under tax

sharing arrangements between those granted to duty-free legislation or by internationalthe FTA, FCA and the shops, unless providedfor treaties; and adopt measuresFinancial Police. under tax legislation or by to effectively control duty-free

international treaties, by shops and ensure thatallowing them to expire at the transactions at suchend of their current term. establishments are limited to

authorized persons.

ANNEX IPage 3 of 9

* Initiate preparation of a * Adopt and implement; * Implement;proposal to clarify localautonomy to implement localtaxes;

* Design an approach to * Adopt and implement.gradually expand the existing,excise tax-based, property taxsystem toward a traditionalproperty tax;

* Agree, based on reform * Develop a plan to strengthen * Adopt and implement;proposals developed with the the co-ordination between theEU-CAFAO's assistance, on a local branches of the FTA andstrategy to merge Financial the cantonal MoFs.Police with the FTA and FCAand initiate implementation.

Improving public service . Basic governance structure has * Initiate preparation of a * Adopt the proposal; * Implement;delivery and preventing large been established across proposal to shift responsibilitydifferentials in the supply of Federation including adoption for higher education topublic services between of the Law on the revenue and Federation, determiningcantons. expenditure assignment. locality, governance structure

Certain areas (e.g. health, financing sources anddefense, social welfare), modalities.however, left with less clearassignment.Adopted laws on health * Establish cantonal healthinsurance and health protection. insurance funds;

* Deternine and adopt services * Federation Government toresponsibilities andfinancing adopt amendnents to the Lawsoarces for the Federation on Health Care regardingHealth Insurance Fund. service responsibilities and

financing sonrces for theFederation Health InsuranceFund

* Refrain from providing * Refrain from providing * Refrain from providingcontribution relief or contribution relief or contribution relief orexemptions from heath exemptions from health exemptions from healthcontributions; contributions; contributions;

ANNEX IPage 4 of 9

PoLicy ARiAS AN ORJECrIVYS Ac m rIMESu MEASURES PRIOR T BOARD ME t SRESPRIOR TOT'H SECOND. MLASuRES PRiOR h O fWR THIRDAL...AV :.R.Oi.EP PRESENTATION T"W..I&. sM3NT TAKCHEDISBUlSftMENr

:._ _ __ _ _ __ _ _ _ . . M . . . . . . . . . . ( M. .... ,, JuN 1 9 ) ( .E cg~ a 19 9 ) (JuN E2 000)

Republika Srspka

Enhancing and protecting * Improved tax inspection * Eliminate/agree to eliminate * Eliminate all tax and dutyrevenue capacity. capacity for better enforcement. existing tax relief and exemptions without a specified

exemptions with a specific expiration date and that areexpiration date, including not provided for under taxthose granted to duty-free legislation or by internationalshops, unless providedfor treaties; adopt measures tounder tax legislation or by effectively control duty-freeinternational treaties, by shops and ensure thatallowing them to expire at the transactions at suchend of their initial ternm establishments are limited to

authorized persons.* Agree, based on reform

proposals developed with theEU-CAFAO's assistance, on astrategy to merge FinancialPolice with the FTA and FCAand initiate implementation

* Design an approach to * Adopt and initiategradually expand the existing, implementation;excise tax-based, property taxsystem toward a traditionalproperty tax.

* Strengthening health care * Develop and adopt guidelines * Adopt and implement.finance by increasing to improve administrativetransparency in resource efficiency in health serviceallocation and enhancing the delivery and collection ofhealth expenditure accounting. health contributions.

* Refrain from providing * Refrain from providing * Refrain from providingcontribution relief or contribution relief or contribution relief orexemptions from heath exemptions from heath exemptions from heathcontributions; contributions; contributions;

* Designing an effective * Prepared draft legislation on * Review and revise the draft * Submit the proposed legislation a Adopt and implement.decentralization strategy. local management that legislation with a view to to the Rcpublika Srspka

proposes to decentralize the enhance administrative Government.government structure. Proposed efficiency by clearly definingoperational relationship the role of the proposedbetween the governments, intermediate governmentshowever, remained unclear. accordingly.

ANNEX IPag 5 of 9

nh. Establishing Efficient andEquitable Social Safety Net

(i) Pension Reform

* Achieving longer-term fiscal * Federation Government passed * Entities to prepare a report on * Entities to adopt amendments * Entities to implementsustainability and improving a new legislation to (i) prevent actuarial projection of their to pension legislation on anendments to their pensiontargeting of the most destitute accumulation of pension pensionfinances and their benefitformula and eligibility legislation.pensioners by (i) redefining arrears; (ii) gradually increase pension inconme distribution. criteria;benefit rules to align promised the retirement age; and increasebenefits with the projected the minimum service period * Entities to adopt a temporary * Implement;resources; and (ii) increasing required for retirement; and scheme to increase lowestlowest pensions more (iii) tighten eligibility criteria; pensions more generously untilgenerously until reaching a * The Management Board of reaching a reasonablereasonable subsistence level. Bosniac Pension Fund subsistence level.

improved targeting byflattening the benefit payments;Republika Srspka restrictedeligibility and preventedsystemic accumulation ofpension arrears.

* Entities to begin developing, * Entities to adopt explicit * Implement;based on actuarial projections, financing and budgeting rulesa financing scheme to improve for special military benefits andthe sustainability of the special contributions and to eliminatemilitary benefits; unviable schemes;

* Entities to refrain from * Entities to refrain from * Entities to refrain fromproviding contribution relief or providing contribution relief or providing contribution relief orexemptions from pension exemptions from pension exemptions from pensioncontributions; contributions; contributions;

* Reintegration of the Federation * The new Federation pension * Federation to begin designing a * Federation to adopt andpension system. legislation created a Federation mechanism to retire all implement this mechanism

wide framework for pension outstanding claims (including prior to the establishment ofpolicy and established a both unpaid contributions and the new unified Federationtimetable for design and pensions); Pension Fund;adoption of the neworganizational structure;

* Federation established a * The Federation Pension * Federation Government to * Implement;Federation Pension Agency to Agency to submit to the adopt legislative changes fordesign and implement a re- Federation Government the financial and administrativeintegration strategy. drafi legislation on the merger merger of the two pension

of the two pension funds. funds alongside with thechanges to the benefit formulaand eligibility criteria.

ANNEX IPage 6 of 9

PoutcYv M&ARS o OwEcvfs ACHl*WEMENT1MEASURES MEASURESWKIUORT BOADo MiFsuR sPaTotsusICoNa MEASVREPRIOI rouin* ThaRzDALRvAnVJ1NThOOUC90 PMUSENTAION TTYci8E 1ANCilEV M WU IW

g~~~~~~~~~~~~~~~JN _9~ (DKIWE t9..) : ^.aM=(JU)NKt- * Comprehensive medium-term * Entities to begin developing

pension reform. proposals for medium-termreforms, including privatelymanaged pensions.

(ii) Other Social ProtectionPrograms

* Achieving longer-termn fiscal * Entities drafted a new * Entities to initiate a survey of * Entities to subndt to the Bank * Implement;sustainability, improving legislative framework for the beneficiaries under veteran a conprehensive analysis ofgovemance as well as targeting veteran's benefits scheme. programs; beneficiariesfor theirof the veteran's benefits and Benefit formula and eligibility veteran 's programs;other social protection criteria, however, are still notprograms by (i) redefining compatible with realities of * Entities to begin preparing a * Entities to adopt (i) new benefit * Implementbenefit rules to align promised future resources and objective report on actuarial projection of rules to align veteran's benefitsbenefits with the projected of protecting the most destitute. their veteran's finances; with projected resources; andresources; (ii) re-defining the (ii) new indexation rules to linkeligibility criteria and benefit adjustments to theimproving distribution rules to availability of resources.channel adequate resources to * Entities to re-define benefit * Implement.most needy; and (iii) re- categories, including throughorganizing the administrative reducing their number,structure, designing one-time

compensation programs, andimproving targeting;

* Entities to re-define the * Entities to finalize the processbeneficiary identification cards. of linking databases on

* Entities to initiate a beneficiary profiles in theircomprehensive review of respective CSWs; and,existing social welfare subsequently, complete theprograms, including review of social welfarecomposition of beneficiaries programs.and financing sources. * Entities to review the CSWs

budgets and provide eachCSWs with adequate financingfor basic administrativeexpenditures and for mostcritical assistance programs.

* Reintegration of the Federation * Federation to begin developing * Federation to adopt the * Adopt and implement.veteran's benefits system. a re-integration proposal for proposal and begin drafting

veteran's programs along the necessary legislativelines of the pension system. amendments.

ANNEX IPage 7 of 9

F rgW..,,,,/,, gC fV.. .

Developing a comprehensive * Both Entities are in the process * Entities to determine a * Entities to initiate the survey; * Entities to complete the survey;medium-term social protection of developing legislative timetable and begin preparing a * Entities to begin developing a * Entities to finalize the draftstrategy. frameworks for their respective comprehensive poverty new social protection strategy, proposal for submission to the

social assistance system. analysis built on a household focusing on target level of Government.expenditure and income survey. assistance, eligibility criteria,

administrative structure and thefinancing modalities.

V. Reforming the BudgetaryManagement System

* Improving budget planing * Established legal basis for the * Entities to establish the BFP * Entities to complete the initial * Entities to revise the BFP toprocesses by developing: budget process and Working Group to co-ordinate BFP and to obtain approval expand its time-horizon to(i) a comprehensive multi-year strengthened the basic budget the preparation of the BFP from their Cabinets. threeyears and guide theyearbudget strategy (MTEF) procedures and organizational and to start the preparation of 2001 budget and submit it toconsistent with government's structures. the initial BFP; their Cabinets.macroeconomic and sectoral * Improved budget classificationpolicies and integrating capital and adopted a uniform budget * Entities to establish Sector * Entities to extend sector * Entities to extend Sectorand recurrent budgets; classification in the Federation; Working Groups in selected Working Groups and policy Working Groups to cover main(ii) strengthening the * Improved coverage of revenues sectors and to prepare sector work to cover at least two more sectors and initiate sectorinstitutional capacity and and expenditures and initiated policy and strategy sectors compared to the initial policy and strategy reviews toestablishing a cooperative commitments reporting; frameworks; composition; develop sector strategyapproach for budget planning. * Began including external frameworks;

budget support and relatedexpenditures in the budget. * Entities to establish formal * Entities to incorporate capital * Entities to adopt a strategy and

procedures for co-ordination projects in the year 2000 timetable for integrating theirbetween the MOF and Aid Co- budget plans including those external aid managementordination Units; which are externally funded functionL

* Entities to begin modifyingexisting databases by recordingaid disbursements moresystematically

* Entities to initiate work to * Entities to establish * Entities to operationaliseestablish macroeconomic macroeconomic analysis and macroeconomic analysis andanalysis and forecasting units forecasting units In their forecasting units;in each Entity MoF. respective MoFs;

* Entities to determine the pilot * Entities to initiate work tosector ministries for establish policy andestablishing policy and programming units in pilotprogram units and their sector ministries.functional organizations.

ANNEX IPage 8 of 9

POLICY ARiAS ANDOBWE6rEivS ACHvIKVME*/MNSURES MWVREfPOR'TO B0M MwRJI=PORmo TO ThSEOND MzaIsPRI TOi UE7WALuREADY bmOCED ORRSNTATION TR c II'Zm 7RANCHE DisBBWtSMmNr

.__ _ __ _ _ __ _ ___ . ... !.. . .... _ . . :. JU E c ........ :, , , ) ........ .. ,,, ... I ) * Strengthening budget control * Entities adopted the legal basis * Entities and State to adopt * Entities and State to adopt the * Entities and State to operate

and cash management capacity for the establishment of the regulations on the Treasury new systems and begin with Single Treasury Accountby establishing a treasury treasury system; Department identifying preparing required reports. and to manage budgetsystem at the State and the * State initiated the process of functional responsibilities. execution through TreasuryEntity levels. developing a model for * Entities and State to begin LedgerAccounts.

establishing a treasury system; developing systems for cash* Agreement reached on the management budget execution,

gradual transfer of government accounting and reporting.accounts in the PaymentsBureaus to Entity TreasuryLedger Accounts.

VI. Establishing AuditingProcedures and Institutions

* Promoting transparency and * Agreed on the organizational * State and Entities to submit * State and Entities to adopt the * State and Entities toaccountability in public sector structure, mandate and a work draft legislativeframework legislativeframework and operationalize their SAls.performance and providing plan for establishment of the and budgetsfor their SAIs to budgetsfor their SAIs.legislative bodies with the Supreme Audit Institutions their Parlianents; * State and the Entitynecessary information to (SAls) and established a * State and Entities to appoint Parliaments to appointexercise control over the Working Group to initiate the their respective Acting Auditor-Generalsfor theirexecutive. technical work towards this Auditor-Generals. SAIs.

end. X State and Entities to adapt audit * Sate and Entities (includingstandards, promulgate cantons in the Federation) toregulations and prepare training begin preparing and publishingmanuals; audit reports.

* Entities to initiate preparationof Constitutional amendmentsfor establishment of their SAls

* Strengthening internal audit * Began developing a strategy to * Entities to develop a plan to re- * Entities to adopt and implement * Entities to adopt a timetable forprocedures within public strengthen internal audit organize the Inspection Units the plan for establishing gradually expanding internalinstitutions by developing a procedures. within their MoFs as Internal Internal Audit Units in their auditing to include operationalmore systematic and Audit Units with proper MoFs, responsible, at efficiency and effectivenessharmonized approach to internal auditing capacity minimum, for a compliance and initiate implementation;internal audit function. reporting to the Minister of audit;

Finance. * Entities to expand the process * Entities to adopt and initiateto develop a similar approach implementation.for strengthening the internalaudit function in other publicinstitutions.

ANNEX I

Vil. Strengthening DebtManagement Capacity

Strengthening debt * Created legal and institutional * Develop a plan to strengthen * Adopt and implement. * Implement;management capacity to framework for external debt policy-making, credit analysisenhance the efficacy and management; and monitoring functions in theeffectiveness of the external * Established a comprehensive State and the Entity DMUs;borrowing and to facilitate the foreign debt tracking system inreintegration of BiH into the the State MFTER; * Initiate preparation of * State and Entities to adopt the * State and Entities tointernational capital markets. * Adopted a Protocol on Guidelines to govern the public Guidelines; inplement the Guidelines;

information sharing between sector borrowing, including atthe State, the Entities and the the Sub-Entity level, * Create debt databases in each * Create a Debt AdvisoryCBBH; establishing: (i) a Entity DMU and introduce Committee at the State level,

* Entities adopted a general comprehensive debt reporting compulsory reporting with representation from theframework to govern Sub- system; (ii) transparent procedures for all public sector Entity DMUs, to co-ordinateEntity borrowing. selection, budgeting, and borrowing (including, Sub- borrowing strategies between

supervision procedures for Entity governments, public different levels ofloans and guarantees; and (iii) enterprises and utilities, extra- governments.procedures for borrowing budgetary fund etc.)policy co-ordination.

ANNEX II

Second Public Finance Structural Adjustment Credit to Bosnia and Herzegovina

May24, 1999

Mr. J. WolfensohnPresidentWorld Bank1818 H Street NWWashington, D.C. 20433 U.S.A.

LETTER OF DEVELOPMENT POLICY

Dear Mr. Wolfensohn:

As you know, Bosnia and Herzegovina (BiH) has been experiencing continuing economic andsocial recovery since the signing of the Dayton/Paris Peace Agreement in December 1995. While livingstandards are still low for many families and economic activity is still at about 40 percent of the prewarlevels, the reconstruction effort has already yielded significant results, as reflected by increasedproduction and trade, reduced unemployment, restored services, and improved infrastructure.

Our progress toward building Dayton-mandated common institutions and the governancestructure in the Entities, as well as implementing structural policy reforms, has also gained momentum,particularly since 1998. Many critical institutions and policies are now in place. These include: thecentral bank and national currency; a legislative and regulatory framework for both the banking sectorand for enterprise privatization; a uniform customs tariff and trade regime; financing means andmechanisms for the common institutions; a legislative framework for budget management; and aninstitutional and legislative framework for debt management. These achievements not only made itpossible for State institutions to begin functioning last year but also provided the basis for initial co-ordination between the Entities in key areas of economic management. We have also achieved significantprogress in removing barriers to the movement of goods and people within the country, including initialsteps towards harmonization of tax systems across the Entities.

Sustaining and broadening the positive developments of the past year is the key challenge BiH facesfor continued rapid reconstruction and growth in the medium term. This challenge has been increasedsubstantially by the crisis in Kosovo. Nevertheless, we intend to accelerate structural policy reforms with anemphasis on preparing BiH to increasingly rely on its own resources and institutions in designing andimplementing the policies required for long-term development. Public finance reform is a key element ofthis strategy and the cornerstone for achieving further progress in institution-building, in strengthening fiscalcapacity, and in achieving robust supply response in the economy.

Specifically, over the next twelve to sixteen months we intend to:

* broaden tax policy harmonization, encourage inter-Entity trade, and strengthen administrative co-operation between the Entities by eliminating Entity-specific protective and implicit tariffs and specialtrade agreements with Yugoslavia and Croatia, by improving tax revenue attribution rules between theEntities, and by establishing information sharing arrangements between the Entity Tax Administrations;

* improve revenue and expenditure assignments within the Entities by adopting measures to strengthencollection and distribution of local revenues and to improve provision of public services with geographicspillovers and Entity-wide impact, particularly health care services;

* create a fiscally viable and equitable social safety net by aligning pension and veteran benefits with therealities of available resources, by improving distribution of benefits to better protect the most needy, byinitiating the design of a sound social protection system and, in the case of the Federation, by integratingthe Bosniac and Croat social safety net systems;

* develop a comprehensive budgetary strategy by introducing strategic public resource allocation,reintegrating current and capital budgets, strengthening institutional capacity and coordination in budgetplaning and execution, and introducing treasury function;

* establish audit institutions and procedures to improve transparency and accountability in public sectoroperations;

* strengthen country-wide policy coordination in extemal debt management, including developing apolicy framework for sub-Entity borrowing.

Reforming and Harmonizing Tax Policies and Coordinating Tax Collection

We have taken significant steps to date in reforning tax policies and strengthening taxadministration within the Entities. The Federation Government has simplified its sales tax structure, furtherreduced the combined wage tax and contribution rates and hence the burden on labor. It has broadened thewage tax base to include some non-wage benefits, such as per diems and allowances; reduced the profits taxrate, and developed a global income tax. With assistance from the EU-CAFAO, the Federation Govemmenthas also developed a reform program to improve tax collection by strengthening the coordination betweenthe Federation Tax and Customs Administrations.

In Republika Srpska, the wage tax was also reduced through a reduction in the pension and healthcontribution rates and the wage withholding tax. Similarly, sales and profit tax rates were significantlyreduced. In conjunction with these measures, the Ministry of Finance took several initiatives to maintainrevenues, including significant improvement in the inspection capacity for better enforcement and wideningof the tax net. These efforts successfully resulted in increased revenue collection despite the implementationof significant rate cuts.

We have also initiated policy harmonization and administrative cooperation between the Entities formutual benefits. Both Entities began implementing the State-set common customs and trade policy for mostimports. In an effort to broaden harmonization of the tax systems, the Entities have also begun harmonizingtheir sales and excise tax systems by adopting similar tax bases and by collecting revenues at the same pointin the distribution process.

Further progress in coordination of tax policies and tax administration between the Entities iscritical to avoiding harmful tax competition and tax evasion, as well as for encouraging the free flow ofgoods between the Entities. To this end, our near-term priorities are: (i) incorporating all Entity specifictariffs into the State customs law and eliminating both implicit tariffs imposed by the Entities and specialtrade agreements with Croatia and Yugoslavia; (ii) completing the harmonization of the sales and excise taxstructures between the Entities; (iii) developing a revenue distribution system between the Entities; and (iv)developing adequate cooperative arrangements between the tax administrations in the Entities. Efforts areunderway to implement these priorities.

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Harmonization of Entity tax systems. Over the last several months, the Tax Working Group(composed of representatives from both Entities) and the State and Entity Ministries of Trade have starteddeveloping a joint approach for eliminating the Entity-set protective and implicit tariffs. Regarding theprotective tariffs, with the assistance from the OHR, we identified the list of items on which additionalcustoms tariffs will be applied during 1999 and selected a set of uniforn rates. The State Council ofMinisters adopted the list and the rates in March 1999. Both Entities are in the process of adjusting theirsystem for implementation of the new rates and expect to initiate the implementation by no later than mid-May 1999. Regarding the elimination of the implicit tariffs, with the assistance from the US Treasury andthe ORR, the Tax Working Group is continuing to work on setting identical rates for excise taxes ondomestic and imported commodities in the Entities. This approach will ensure that all differential taxes areaccounted for in the additional tariffs enacted by the Council of Ministers. It will, at the same time,harmonize the excise tax rates on domestically produced goods between the Entities. Both Entities expect toadopt the new and harmonized excise tax rates by no later than June 1999. Additionally, in an effort tofurther limit tax avoidance and to encourage the free flow of goods across BiH, we intend to complete theharmonization of the sales tax system between the Entities by aligning the sales tax rates by the end of 1999.

We recognize that for full harmonization of the customs system, Federation and Republika Srpskamust also eliminate their special trade arrangements with Croatia and Yugoslavia, respectively. Thesearrangements effectively exempt most imports from customs tariffs and subject them to domestic, ratherthan foreign, excise tax rates. A decision towards elimination was taken by both the Federation andRepublika Srpska in mid-May 1999. Both Entities are currently adjusting their customs system forimplementation of State-set common customs rates for trade with Croatia and Yugoslavia by no later thanJune 1999.

Improving revenue attribution rules between the Entities. As trade between the Entities grows,there is also the immediate need to address the taxation of inter-Entity sales. The existing inter-Entity taxrevenue attribution rules result in sales tax revenues on excisable goods and excise tax revenues remainingwhere they are collected. Consequently, they create incentives for harmful tax competition, result ininequitable inter-Entity revenue distribution and discourage free trade between the Entities. To improve thesystem, we will develop a mechanism that would ensure maximum revenue collection while providing thesales tax revenues on excisable goods and excise tax revenues to the Entity where the commodities are to beconsumed. Accordingly, revenues shall be collected at the point of import or manufacture and passed fromthe collecting Entity (where manufacture or import occurs) to the consuming Entity (the Entity ofdestination) through a mechanism which would ensure that revenues are paid to the proper Entity, such asintroducing tax stamps. The Tax Working Group has begun developing the rules and the operatingprinciples of the new attribution system and will subsequently determine the necessary amendments to theEntity Sales and Excise Tax legislation. By December 1999, both Entities will have submitted to theirParliaments the amendments to their legislation on inter-Entity allocation of the sales and excise taxes. BothEntities will have implemented these amendments by no later than March 2000.

We intend to deepen, in the next two years, reform of the sales tax system by introducing a valueadded tax system (VAT). The VAT system would not only generate more revenues, reduce theadministrative complications of the existing sales tax system and close opportunities for evasion, but itwould also further the alignment of our tax system with European norms. Both Entities are consideringanalyzing how VAT system could be structured within and across the Entities over the next six to eightmonths, and both Entities are developing a proposal for submission to their Governments by no later thanJune 2000.

Strengthening administrative co-ordination between the Entities. At present, due to very limited co-ordination, the Entity tax administrations are unable to fully audit transactions and tax returns that involveboth Entities; they are unaware of many transactions between firms across the Entities. We recognize thateffective elimination of the potential for tax evasion, introduction of new attribution rules for revenue

3

allocation between the Entities, and eventually a VAT system all require strong administrative cooperationbetween the Entities revenue collection agencies. As a first step in this direction, the Entities haveestablished a Working Group to study ways for improving administrative cooperation. The Group willdevelop a plan to strengthen information sharing arrangements and coordination between the Entity TaxAdministrations so as to ensure effective implementation of the new inter-Entity allocation rules for the salesand excise taxes. By December 1999, both Entities will have completed and adopted this plan and both willhave begun implementing it by no later than March 2000.

Reforming the Intergovernmental Finances within the Entities

Under the Dayton Accords, major government budgetary responsibilities are divided among thefour levels of government: the State, the Entities, the cantons and the municipalities. The design of theintergovernmental fiscal system assigns limited economic and fiscal management responsibility at theState level but significant autonomy at the Entity level. The Entities have different fiscal structures. Inthe Federation, canton level administration is being developed to allow for greater local control for settingservice levels. A more centralized approach is operating in Republika Srpska. Due to the Federation'smore complicated structure, issues in intergovernmental finances are relatively more significant in theFederation than in Republika Srpska.

Since mid-1997, we intensified our efforts to establish Dayton-mandated budgetary financingarrangements between the State and the Entities. In 1998, we established both clear financing arrangementsand a transfer mechanism between the Entity and the State governments. Based on this system, we havebegun formulating and implementing mutually consistent budgets across all three Governments. Thesearrangements have substantially improved stability and the transparency of financial relations between thethree governments, and provided the State with the resource base to undertake its administrative functionsand to meet external obligations. We will continue to fully implement these arrangements during both thecurrent fiscal year and in the future.

Progress in establishing the cantonal governance structure has continued in the Federation,including considerable, though uneven, progress in integrating the administrative structure in the twoethnically mixed cantons. At present, all cantons have basic fiscal management and legislative structures inplace. Since 1997, the revenue and expenditure assignments have generally followed the structure laid outin the new Federation Constitution. The Federation Government has achieved some improvement in thesales tax revenue allocation between cantons by re-defining, in late 1997, the collection point for the salestax revenues.

Likewise, the Republika Srpska Government has, since 1997, improved the revenue allocation toprovide certain municipalities with a higher share of tax revenues, depending on their characteristics. Theallocation of revenues is higher for those municipalities that are on the border, have high social problems,have significant damage from the war, or have large numbers of refugees. These adjustments constitute astep towards eliminating financial imbalances at the local level.

Over the next sixteen months, we will deepen our reform efforts to support the development of asound intergovernmental financial system in both Entities. Specific issues we intend to address in theFederation involve enhancing both revenue collection and distribution, and provision of minimum servicelevels, particularly in health. In the Republika Srpska, we are working on a decentralization strategy aimedat creating a more efficient intergovernmental system and health finance reform.

Improving revenue attribution rules within Federation. Existing arrangements in the allocation ofrevenues between the cantons result in a relatively wide range of revenues on a per capita basis (about 5:1 in1998). Our initial attempt to address this issue by attributing sales taxes on excisable commodities to thefirst buyer's location in October 1997, while improving overall revenue allocation between cantons, resulted

4

in disproportionately greater per capita revenues in those cantons with high economic activity and cantonswhere importing is concentrated. Similar deficiencies exist in the current allocation of profit tax revenues tothe headquarters canton in cases where companies operate in more than one canton.

To further improve the revenue allocation rules between cantons, we have agreed on developing amechanism that will ensure allocation of greater revenues to the place of destination while maximizingrevenue collection. This mechanism will be operated by collecting sales taxes on excisable commodities atthe import or manufacturing stage and by allocating them according to a formula that constitutes a soundproxy for the distribution on a destination basis and that yields additional revenues for all cantons. Asdemonstrated by the forms of sales tax evasion to date, collecting sales taxes at import or manufacture willsignificantly minimize tax evasion, which, in turn, will allow all cantons to receive higher revenues. TheFederation MoF, in co-ordination with the cantonal MoFs, plans to finalize the design of the mechanism bySeptember 1999 and, subsequently, to draft the associated amendments to the sales and excise taxlegislation. By December 1999, the Federation Parliament will have adopted these amendments forimplementation starting January 2000. Likewise, we will consider improving allocation of the profit taxes inthe near future by re-defining the allocation rules between the Federation and cantons, along with thoseexpenditures that have a Federation-wide impact, but are presently assigned to cantons without clearfinancing arrangements, such as higher education.

Enhancing and protecting revenue capacity in the Entities. Both the tax bases and the tax rates formost of the important taxes in the Federation--including sales, wages, and profits--are determined at theFederation level due to associated administrative and compliance efficiencies. We recognize, however, thatthe cantonal revenues must be protected from the Federation's exempting taxpayers or narrowing the basefor taxes assigned to cantons and re-assigning revenues/expenditures unilaterally. To this end, we intend totake the following steps over the next eight months: as a first step, we will allow existing tax relief andexemptions, including those exemptions granted to duty-free shop, with a specific expiration date to expire,unless the exemptions are specifically provided for by either international treaties or the existing tax laws; asa second step, we will, eliminate, by December 1999, those tax and duty exemptions that are without aspecified expiration date and that are not provided for by either international treaties or the existing tax laws,and will adopt measures to effectively control duty-free shops and ensure that transactions at suchestablishments are limited to authorized persons; as a third step, we will require Parliamentary acts for anychanges to cantonal tax bases and rates. In Republika Srpska, practice of tax exemptions/relief to date hasbeen comparatively limited and the above stated principals will be guiding the tax policy in the future.

On the administrative side, to improve the tax collection both in the Federation and RepublikaSrpska, we plan to reform and transform the revenue collecting institutions in each Entity and improvecoordination between local tax administration offices and the cantonal Ministry of Finances in theFederation. Our aim is to ensure that taxpayers are confronted with coordinated audits. The new, re-organized administrative system will have begun operating in the near future.

In addition, we plan to adjust the Federation tax system, both to establish appropriate opportunitiesfor cantons and municipalities to increase revenue collection, and to allow them a reasonable capacity tomeet the differential preferences of their citizens. To this end, we will adopt, by December 1999, legislationthat will establish the cantonal capacity to set minimum tax rates so as to limit the degree of tax competitionbetween the cantons and municipalities. We further plan to gradually expand our currently limited propertytax system toward a traditional property tax system in order to augment local government finance,particularly in municipalities in both the Federation and Republika Srpska. This work will also involveestablishing cooperation between finance, cadastral and tax administration offices of the Entities' localgovernments.

Strengthening intergovernmental finance in Republika Srpska. Over the past months, we havebegun developing a new local management strategy which aims to decentralize the governance structure

5

by creating an intermediate set of governments in the form of districts. We are envisaging the creation ofeight such districts that would be responsible for roads, communications, secondary education, andregional health care. The districts will be financed mainly by a percentage of tax revenues raised in theirjurisdictions. We are currently in the process of developing the legislative framework for this newsystem which will be finalized by the end of 1999. We recognize that operational relationship betweenthe governments needs to be clearly laid out in the legislation with a focus on enhancing theadministrative efficiency. To achieve this, we will restrict the role of districts to be de-concentrated armsof the central government and will legislate their responsibilities accordingly.

Improving public service delivery in the Entities. We recognize the need for developing efficientmechanisms for delivering and financing education and health services in both Entities, particularly in theFederation due to its decentralized governance structure. Our priority in the case of education services is toaddress the present weaknesses in higher education services in the Federation, which are currently beingdelivered and largely financed by selected cantons, although the benefits are received by residents frommany cantons. To this end, we plan to develop, by the end of 1999, a clear service delivery frameworkinvolving a re-definition of respective responsibilities of the Federation and cantons in higher education.

In the case of health services, we have already begun designing a strategy to establish an effectivegovernance framework and to improve both collection and usage of health care resources in both Entities.An important integral element of our strategy is to ensure that all eligible residents will have access to basichealth care services, with a particular emphasis on designing the most cost-effective basic health package ineach Entity. Building on these principals, each Entities' Ministry of Health has prepared, with the assistancefrom donors (including the World Bank, World Health Organization, EU-PHARE and the Government ofUnited Kingdom), policy papers laying out their health care reform strategy in the medium-term. BothEntities have also initiated technical studies to facilitate the design of specific policy measures andmechanisms to achieve the objectives of their reform strategy. These studies include: (i) preparation of acomprehensive "Health Account" in each Entity covering both public sector revenues and expenditures inhealth, and private, out-of-pocket health spending; (ii) determination of the most cost-effective basicpackage of health services in each Entity along with management tools and incentives to promote theireffective provision and usage; and (iii) completion of a survey on public evaluation of and expectations fromthe health care system in the Entities to increase the responsiveness of the system to the needs of thepopulation. In addition, with the support from the Bank's Basic Health Project, we plan to develop newincentive mechanisms for improving efficiency in remuneration of health service providers in the nearfuture.

While the above stated overall objectives of the health care reform are similar across Entities, thecontent of reform differs between the Entities, reflecting differences in their governance and legislativestructure. In the Federation, as presented in the 1997 Health Insurance Law, we envisage a canton-basedextra-budgetary health insurance system (cantonal funds), financed by payroll tax contributions for health.Recognizing that such a system will lead to undesirable small risk pools, we also envisage the creation of aFederation level health insurance fund (Federation fund), responsible for certain joint health care functions.We have begun building this new institutional structure both at the cantonal and the Federation level, but theprogress to date has been limited. Only three cantons have established their funds so far. As a result,several cantons continue to deposit their health contributions in the general canton budget and to use aportion of these funds for financing other services. Our important priority during 1999 is completing, beforethe end of the year, the establishment of the cantonal funds, and ensuring that the health care contributionswill flow into these funds in all cantons starting in January 2000.

As for the Federation level structure, we established the Federation Health Insurance Fund andappointed its Director in December 1998. Another important priority for 1999, is to prepare theconditions for smooth operation of the Federation fund in the near future. To this end, we have alreadybegun formulating, in coordination with the cantons, the functional responsibilities of the Federation

6

fund and its financing modalities. We recognize that the design of the Federation fund is criticallyimportant in reducing the existing wide variations across cantons in access to health services, and inenhancing the overall health service delivery across the Federation. Therefore, we have agreed that theFederation fund will undertake the following major responsibilities: (i) ensuring that all eligible residentsof the Federation have access to basic health care services; (ii) financing services with Federation-widebenefits, such as eligible tertiary care services and highly specialized services that can only be deliveredeffectively in a limited number of locations for a larger risk pool; and (iii) providing technical andmanagerial assistance in operation of the cantonal health insurance funds, including centralizedprocurement of medical supplies. Regarding financing of the Federation fund, we have agreed that itsresource base will be derived from total payroll tax contributions for health; specifically, we areenvisaging assigning up to one-fifth of the total health contributions to the Federation fund. Building onthe above stated principles, by December 1999, we will have specified the functional responsibilities andthe share of the Federation fund in total health contributions. Based on this final framework, we shallhave drafted, by February 2000, the required amendments to the Federation Health Insurance Law on theresponsibilities and financing sources of the Federation fund. By no later than April 2000, the FederationGovernment shall have adopted these amendments to the Federation Health Insurance Law for operationof the Federation Health Insurance Fund starting from mid-2000 onwards.

In Republika Srpska, the health care system operates within a more centralized structure,including the Republika Srpska Public Health Insurance Fund and its four regional branches. The systemis being financed mainly by payroll tax contributions for health. The government finances healthcontributions of certain unemployed populations, such as refugees and demobilized soldiers, from thegeneral budget. During 1999, we are aiming to adopt a new Health Insurance Law in Republika Srpskawith a focus on (i) improving the financial viability of the system through promotion of cost-effectivenessand efficiency in public health service delivery; and (ii) developing a solidarity system, as in the case ofthe Federation, ensuring equal access to the basic package of health care services across RepublikaSrpska as well as financing eligible tertiary health care services. In addition, we plan to develop, byDecember 1999, guidelines to promote efficient operation of the Republika Srpska Public HealthInsurance Fund and its four regional branches. The guidelines will establish: (i) procedures forimproving transparency in budgeting and usage of health contributions; (ii) incentives/sanctions toimprove collection; (iii) procedures for strengthening coordination between the central fund and itsbranch offices; and (iv) prototypes of contracts to guide the purchasing of health services.

Reform of Social Safety Net

Reforming Pension System. Rising wages and employment over the last three years, and hencethe rising pension tax base, brought about a significant increase in pension revenues of the three pensionfunds presently operating in BiH -- two separate schemes in the Federation, covering Bosniac-majority areas(the Sarajevo Fund) and Croat-majority areas (the Mostar Fund), and a Republika Srpska scheme. Despitethe resulting parallel increase in benefits, however, benefit levels remain less than one third of their pre-warlevels in the Federation and less than one fifth in the Republika Srpska. The cause of the financial strain isthe high ratio of pensioners to contributors, which is presently at about 0.8:1 across the three funds.

At present, all three pension funds operate on a pay-as-you-go basis -- i.e. current contributions arepaid out as benefits in the same period. Each fund, however, pays pensions according to a differentfortnula: in the Sarajevo Fund, until the passage of the Federation Pension Law in 1998, the pre-war formulawas used to calculate pensions but roughly half of this amount was actually paid out, and the differencebetween the actual and statutory benefits was considered to be a debt owed to pensioners. The newlegislation declared all future benefit payments final, thereby precluding the possibility for further systemicarrears. In the Mostar Fund, earmarked revenues are divided by the number of pensioners resulting in a flatbenefit, zero balance as well as highest minimum pensions in BiH. The Mostor Fund is currently in theprocess of adopting a new formnula similar to that of the Sarajevo Fund in accordance with the

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harmonization principals of the new Federation Pension Legislation. The Republika Srpska Fund payspensions according to a formula which gives higher pensions to those with more education-as a proxy forpre-war higher earnings. It, however, operates with significant transfers from the budget since earmarkedcontribution revenues are not sufficient to cover outlays.

The existing pension schemes face several challenges in the short term. First, owing to financialdifficulty, both the Republika Srpska pension fund and the Sarajevo pension fund in the Federation havebeen late for several months in making payments to pensioners. Second, despite the rapid increase in theaverage pension level for some parts of the country, a significant number of the pensioners in both theFederation and Republika Srpska still receive pensions that are below the minimum required for subsistenceliving. Third, the pension finances are largely being managed according to principles we developed duringthe war-period in order to cope with the severe financial difficulties; a more comprehensive pension strategyneeds to be developed and gradually introduced. We recognize that, in the case of the Federation, dealingwith the third challenge requires rapid progress in reintegration of the Federation pension system, withoutwhich in-depth pension reforn is impossible.

The immediate challenge that we face is to address the financial constraints in a more systematicway. To achieve this, we plan to redefine benefit rules with the aim of aligning the benefit levels with therealities of future revenues and demographics. This approach shall be phased in gradually, with theobjective of attaining a financial balance over a reasonable time period. In the meantime, pension fundsshall give special attention to validating adjustments to the benefits by realistic projections about resourceavailability. In the case of the Federation, while the new Federation pension legislation prevents thesystemic accumulation of arrears, the benefit formula still needs to be adjusted to reflect the realities offuture resources. As a first step in redefining the benefit formula, by June 10, 1999, we will have prepared areport on actuarial projection of each Entities' pension finances. Based on this analysis, we will develop,during the second half of 1999, a new benefit formula and an eligibility criteria conducive to a long runbalance in Entity pension finances. By the end of 1999, we will have adopted the necessary amendments toEntity pension legislation in order to introduce this new system in 2000.

Another immediate challenge we face is to improve the targeting of the most destitute pensioners inthe short-term. In both the Republika Srpska and the Sarajevo Pension Funds, the present distribution ofbenefits results in relatively wide range of pensions (5:1). Given the low average perisions (about 75 DM inthe Republika Srpska and 150 DM in the Federation), the situation is especially difficult for those withbelow average pensions. We plan to improve the distribution of benefits through a temporary policywhereby the lowest pensions shall be increased relatively more generously when revenues are increased,until reaching a reasonable subsistence level. To this end, we aim to prepare a report on distribution ofpension income by June 1999. Based on this analysis, we intend to adjust, by the end of 1999, the benefitformula for provision of a reasonable minimum benefit starting in 2000.

We recognize that further pressures to pension finances would come from special military benefitsin both Entities. In the Federation, special lower contribution rates, along with a more generous benefitformula for the military has already created financial strains. While the new Federation Pension Lawenvisages the development of financing modalities for special military benefits through separate legislation,preparation of the legislation has been delayed. Similarly, several special benefit schemes for the militaryexist in Republika Srpska, where budgetary transfers provide supplementary financing. The resolution offinancing issues for the military by the end of 1999, is priority in both Entities in order to preventcumulating financial imbalances in their new pension systems. To this end, by no later than the end of1999, we shall calculate the additional liability caused by the special benefits and develop a transparentfinancing strategy, involving either earmarking revenues and/or reducing the special benefits. We furtherplan to support the viability of the new system by eliminating tax relief or exemptions from payroll tax forpensions.

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As indicated above, the decentralized state of public pension provision presents another importantchallenge in case of the Federation. An initial step to address this problem was taken last year through theadoption of the new Federation Pension Law. The Law created both a Federation-wide framework forsocial policy by requiring the two Federation funds to operate under one Federation-wide law, and aFederation Pension Agency with a mandate to begin the process of re-integration of the pension system. Asa further step towards re-integration, a new Federation Pension Agency, consisting of representatives fromboth pension funds, was established in January 1999 and assigned with the task of drafting this legislation byApril 1999. By early June, the ongoing work to prepare this draft will have been finalized; the draft willhave been submitted to the Federation Government by no later than June 10, 1999. The Federation intendsto take further steps toward the actual merger of financial and administrative aspects of the two funds duringthe second half of 1999; it intends to adopt, by the end of 1999, the necessary legislative changes forcreating the new, Federation-wide pension system alongside measures aimed at achieving fiscalsustainability and an adequate safety net described in above paragraphs. The Federation further plans todesign a mechanism to retire all outstanding claims (e.g., unpaid contributions from enterprises and themilitary, as well as unpaid pensions) prior to the establishment of the new, Federation-wide pension fund.

Building on the above mentioned actions, we plan to extend our reform efforts, in 2000, bydeveloping a medium-term strategy for introducing comprehensive pension reforms over the next couple ofyears. It should be noted that the new Federation Pension Law, has already introduced several positivefeatures which would lead to some reduction in medium term pension spending pressures. For examples itreduces future pensions, it restricts eligibility in the medium term via provisions on the assessment base andretirement age, and it brings post retirement indexation more into line with material resources of the funds.Most importantly, it equates actual with legal pension payments in the Sarajevo Fund. Nevertheless, werecognize that additional medium-term reforms must be studied both in the Federation and RepublikaSrpska, including the introduction of privately managed pensions.

Reforming Veteran's Benefits and Other Social Protection Programs. During the war, oursocial protection system financially collapsed and fragmented across the country; it largely remains so today.In addition to the pension system, only veterans' benefits and a few other social programs, mainly providingpoverty relief, can be funded at present. Budgetary transfers for veterans' programs, and donor assistancefor the other programs, provide the main funding source. Social assistance programs are generally theresponsibility of cantons in the Federation, except for veterans' programs, for which the Federation sharesfinancial responsibility. In Republika Srpska, we have a more centralized structure at the Entity level. Inboth Entities, municipal Centers for Social Work (CSW) administer the implementation of programs thatprovide poverty relief, mainly by managing foreign-financed programs, as domestically-financed programsare very limited.

As with the other social sectors, the system of social assistance today faces the dual challenge ofovercoming low levels of financing capacity and establishing a new and effective governance framework.In addition, the Federation faces the challenge of integrating its fragmented social assistance system with anemphasis on establishing an efficient and equitable system.

Veteran's Benefits Programs. The immediate challenges in this area are achieving fiscalsustainability, improving targeting of the most handicapped and their families, and re-integrating thepolicies and administration across the Federation. Over the last year, both Entities have made initialefforts to address these issues and have drafted legislation on their respective veterans' benefits schemes.We recognize that these pieces of legislation needs to be strengthened to: (i) more adequately address theincongruity between available resources and promised benefits; (ii) improve the indexation rules, whichcurrently tie benefits to average wage growth; and (iii) simplify the present schedule of benefits with anemphasis on increasing the funds available for the seriously handicapped and their families and reducingthe administrative costs of the system.

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The analysis necessary to design such policies requires data and information on the number andcomposition of beneficiaries in each Entity which at present is limited. Additionally, in the case of theFederation, beneficiary information is contained in separate databases for Croat- and Bosniac-majorityareas; the Federation Veteran's Directorate's access to such information has thus far remained limited. As afirst step towards addressing these critical issues, both Entities are currently intensifying their efforts togather data and information. Both will have completed aggregation and analysis by no later than July 1999.Subsequently, Entities plan to redefine benefit rules to align promises with projected resources and to tiebenefit adjustments to the availability of resources. They also plan to address the weakness in the definitionof the benefits system by a combination of policy measures. These measures include reducing the numberof benefit categories; separating discrete, one-time compensation programs and permanent entitlementprograms, e.g. paying one-time benefits to those with minor disabilities; and improving targeting ofresources to the neediest cases.

In addition, the Federation, building on the ongoing work towards unification of its pension system,plans, by the end of 1999, to develop an integration strategy for veterans' programs, both on the policy andthe administrative level. It is expected that this will help minimize the administrative costs associated withmultiple schemes and will harmonize benefit levels across the Federation.

Reforming other social protection programs. In the face of gradually diminishing foreignhumanitarian support, our main resource base for social assistance, the development and institutionalizationof a new social protection system in BiH is another near-term challenge that we are facing. Our immediateconcern is to sustain poverty relief before in-depth reform of the system is possible. To this end, we plan toimprove targeting methods to direct available resources to the most needy and to strengthen the existinginstitutional base for more effective provision of poverty relief. We have already begun identifying existingprograms and beneficiary coverage by consolidating the available information which is currently scattereddue to local implementation of programs. This process involves re-defining the beneficiary identificationcard for accessing CSW assistance, and establishing and subsequently linking the databases between theCSW within each Entity.

We further plan to improve the CSWs resource base to enable them both to run the most criticalassistance programs and to finance their basic administrative expenditures. As mentioned above, at present,financing for CSWs is primarily the responsibility of cantons in the Federation and the municipalities inRepublika Srpska. We recognize that this creates a potential for translating differences in local fiscalresources into differentials in the provision of social assistance. Given our extremely tight domesticfinances, in the near term, such pressures could be contained only by (i) continued strong donor assistance;and (ii) joint efforts with donors to direct available resources to places with the lowest social assistancecapacity.

Our medium-term strategy is to develop a permanent approach for addressing present weaknesses infinancing and governance capacity before the humanitarian assistance is phased out. In order to provide asound basis for this exercise, we first intend, with the assistance from donors including the World Bank, toundertake a comprehensive poverty analysis, built on household income and expenditure surveys. Buildingon this analysis, we subsequently intend to determine key aspects of our social assistance strategy, includingthe target level of social assistance, criteria for eligibility etc. and other policies with fiscal implications, aswell as the administrative structure and the financing modalities of the new system. In light of these studies,ongoing work in both Entities to develop the legislative framework for the social assistance strategy will befurther reviewed and revised.

Reforming the Budgetary Management System

During 1998, we made significant progress in establishing the legal basis for the budget processand in strengthening the budgetary organizational structures. The new Entity laws on the "Principles of the

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Budget," encompassing a set of key reforms, have been adopted. The coverage and comprehensiveness ofthe budgets have been extended by including external cash grants, general budgetary borrowing and relatedexpenditures into the budget. Necessary provisions have been included in the new budget laws therebyextending this system to incorporate capital budgets, including externally financed projects. Initial generalframeworks have been adopted to govern domestic and external local govermment borrowing. Otherachievements to date include: (i) significant progress towards introducing new and improved budgetclassification systems to create uniform standards across central and local governments and initiatecomprehensive expenditure reporting; (ii) improvements to the accounting systems, including adoption ofregulatory framework for commitments reporting; and (iii) adoption of a rew procurement regulations toestablish a system that promotes open competition and transparency.

As a further aspect of reform efforts aimed at improving fiscal efficiency and controt we anticipatedeveloping a comprehensive budgetary strategy that will contribute to more efficient budget planning andexecution systems in BiH. We expect that once established, this system would substantially enhancestrategic public resource allocation, ensure efficient resource use and further improve transparency andaccountability in government policies.

Reform of Budget Planning Processes. We have identified several areas in budget planning, whichcall for initiating actions. Chief among these are: (i) strengthening the linkage between budgets andgovermment policies and strategies; (ii) integration of the donor-financed investment program -- a relativelylarge portion of the total public resource envelope in BiH -- into the budget; (iii) introduction of a medium-term perspective in the planning of government expenditure programs; and (iv) strengthening the economicpolicy and forecasting function in the Entity MoFs and policy and programming capacities within lineministries as well as co-ordination between the MoFs and the line ministries in budget planing. To addressthese issues, we have agreed on a comprehensive reform program, covering budgetary planning processesand institutions, and initiated implementation in March 1999.

The program has two main elements. The first element involves developing an integrated approachto budgetary planning and preparation in the form of a medium-term expenditure framework (MTEF). TheMTEF will have three building blocks:

* The first one is the macroeconomic framework, which will provide the basis for projectingresource base and expenditure allocations as well as the context against which key budget issuescould be analyzed. Initially, we will base it on the IMFl/World Bank framework. In time, as theeconomic forecast and analysis capacity within the MoFs is built up, it will increasingly reflectthe MoFs' own analysis. Both Entities have already initiated development of macroeconomicframeworks to guide their budget preparation for the next year;

* The second building block is the sector strategy framework, which will establish our overallpolicy objectives for the sector as well as strategic program areas and financing requirementswithin the sector, consistent with overall resource constraints. This will, in turn, help usdetermine the strategic shifts in inter-sectoral resource allocations and provide the basis formonitoring and evaluating sector program outcomes. As an initial step in this direction, bothEntities have identified a limited number of pilot sectors and have established Sector WorkingGroups to develop the initial strategy framework in these pilot sectors (including health,education and transport in the Federation; and transport, education, and agriculture in RepublikaSrpska). We are planning to gradually expand the sector strategy frameworks to cover all themain sectors by mid-2000;

* The third building block will be sectoral expenditure plans, covering both recurrent andinvestment allocations and the related financing. We recognize that, initially, this would requirea major exercise to incorporate externally financed projects within the Entity budgets.Nevertheless, we perceive this exercise as a major instrument to enhance, not only our capacityto set the appropriate balance between capital spending and recurrent spending, but also our

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ability to maintain fiscal stability once donor assistance is phased out. As a first step in thisdirection, we have already started modifying existing databases by recording aid disbursementsmore systematically. By the end of 1999, we will have incorporated capital projects in the year2000 budget plans, including those which are externally funded.

The time horizon for the MTEF will be three years, within which the MTEF would be revised and"rolled forward" each year. The MTEF will be prepared during the first half of the year in the form of a"Budget Framework Paper" (BFP); it will be approved by the respective Entity Cabinets. The BFP will thenprovide the strategic framework and resource ceilings for the subsequent preparation of the annual Entitybudgets. In the Federation, the MTEF would also incorporate cantonal expenditure plans, with an emphasison enhancing the linkages between cantonal expenditure plans and the Federation-wide sector strategies andthe macroeconomic framework. We have already initiated the work towards preparation of the first BFP ineach Entity. To facilitate this, each Entity has established both a BFP Working Group and Sector WorkingGroups (SWG). Initially, the SWGs were formed for the above indicated pilot sectors which will be thefocus of the initial BFP. Both Entities intend to finalize draft BFPs for submission to their Cabinets by June1999, with an emphasis on guiding the subsequent preparation of the 2000 budget. Likewise, by June 2000,we will have revised this initial BFP to expand its time horizon to three years and submitted it to the EntityCabinets in preparation for the 2001 budget cycle.

The second element of our reform program involves strengthening the institutional capacity andestablishing a cooperative approach for budget planing. This entails: consolidating and developing coreexpenditure planning functions within the MoFs; developing sector-wide policy and programming functionswithin the line ministries; and establishing planing working groups involving representatives of relevantinstitutions. As indicated in the above paragraphs, we have already begun implementing these institutionalaspects of the reform program. Cooperation between Entity MoFs and aid coordination units is beingstrengthened, and a strategy and timetable for integration of aid management function will have beenadopted by no later than June 2000. In addition, by December 1999, Entities will have established aMacroeconomic Forecasting Unit within their MOFs. By June 2000, we plan to extend the Sector WorkingGroups to all main sectors and establish policy and programming units in the pilot sector ministries involvedin the 1999 BFP exercise.

Reform of Budget Execution Systems. In order to improve public sector cash management, toincrease control over public sector resources and to enhance fiscal transparency, we intend to moverapidly towards establishment of a treasury system. This will move parallel to our efforts to modernizethe payments system and reorganize the payments bureau functions. At the State level, a program fordevelopment of treasury functions has already been prepared. Accordingly, we intend to begin operationof centralized payments, a Single State Treasury Account and State Treasury Ledger Accounts by the endof 1999. At the level of the Entities, the new budget system laws provide the legal basis for establishingthe treasury system. However, the two Entities begin this task from different budgetary systems andinitial institutional arrangements for public sector payments. Therefore, the speed and content of reformwill differ from case to case.

In the Federation, a significant proportion of treasury functions are currently undertaken by thefinancial section of the Department of Mutual Services, which will be transferred to the Ministry ofFinance before the end of 1999. In the meantime, to initiate the establishment of a treasury department,the Federation shall adopt, by June 1999, regulations on the responsibilities of the treasury department,begin recruitment of staff and begin to develop procedures to transfer accounts from the PaymentsBureau to the Treasury ledger. By December 1999, the Federation shall have completed the transfer ofaccounts to the Treasury Ledger for all Budget Institutions, prepared the centralized payments system andTreasury Single Account, developed the system of commitment reporting and completed staffing of thetreasury department for operation starting from January 2000.

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In Republika Srpska, establishing the treasury function will begin with segregation of the publicsector transactions from the operations of the Srpska Development Bank. As an initial step towards thisend, Republika Srpska will appoint, in May 1999, a Working Group to develop an action plan forTreasury development. The Group shall finalize the action plan by the end of June 1999. Building onthis plan, Republika Srpska shall adopt, by September 1999, regulations on the establishment andresponsibilities of the treasury department, begin recruitment of staff, and begin to develop procedures totransfer accounts from the Srpska Development Bank to the Treasury Ledger. By June 2000, RepublikaSrpska shall have completed the transfer of accounts to the Treasury Ledger for all Budget Institutions,prepared the centralized payments system and the Treasury Single Account, developed the system ofcommitment reporting and completed staffing of the treasury department for operation thereafter.

Establishing Auditing Procedures and Institutions

We recognize that establishing a comprehensive audit system is a prerequisite to promotingtransparency and accountability in public sector performance and providing legislative bodies with thenecessary information to exercise control over the executive. Therefore, we plan to create external auditingprocedures and institutions in BiH and to strengthen the regulatory and institutional framework for internalaudit function at both the State and the Entity levels.

As a first step in this direction, we started, in 1998, designing the organizational and functionalframework of the external audit system. The most critical aspect of this work was to determine a feasiblestructure that would enable several layers of largely autonomous governments in BiH to undertake soundaudit functions within their jurisdictions, while at the same time ensuring consistency of standards,methodology and quality across all levels of government. We completed this work in early 1999 and agreedon the following specific arrangements that would meet these requirements:

* State and Entities shall establish a Supreme Audit Institution (SAI) for carrying out external auditfinctions of respective central and local government activities and organizations. InternationalAssociation of Supreme Audit Institutions (INTOSAI) standards shall form the basis for the auditsystem in Bosnia and Herzegovina;

* State and Entities shall establish a National Coordinating Committee (NCC), comprising theirAuditor-Generals, for setting audit standards, for ensuring consistency of standards, methodologyand quality, for assigning audit responsibility for those activities that extend across the Entitiesand/or the State, and for determining representation on international bodies. The NCC will bechaired by the State Auditor-General and meet according to a fixed schedule on at least a quarterlybasis;

* The State and the Entity Auditor-Generals shall be appointed through a Parliamentary act for a fixedand non-renewable term;

* The objective of the external audit in both the State and the Entities shall be to carry out:(i) compliance audit to ensure that all legal and regulatory requirements have been met, or

report any failures;(ii) certification audit in the form of a report on the financial statements;(iii) performance audit (value for money) to measure the performance of individual public

institutions with regard to efficiency, economy and effectiveness.• The external audit by the SAIs shall embrace all government activities and organizations that are

partially or wholly owned, controlled or funded by public sources or that are provided by anexternal organization on loan or grant basis.

We consider the independence and operational integrity of SAIs as central to their effectiveoperation. To prevent political or other unwanted interference, we shall establish SAIs as constitutionalbodies reporting on their activities to their respective Parliaments at the State, Entity and Canton levels.However, due to relatively longer process of amending the constitution, they will commence operation

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under legislation for a transitional period. Their budgets will be charged items on respective governmentbudgets. In the case of the Federation, the cantons shall also contribute to the cost of the Federation SAI, onthe basis of a fee determined by the size of audit work to be performed on their behalf.

In March 1999, we initiated the process of establishing the above described framework by forminga Working Group comprising the representatives of the State and the Entities, including cantons in theFederation. The Group is responsible for the various technical steps leading to the creation of the SAIs. Ouraim is to adopt the legislative and regulatory framework, establish all three SAIs and appoint the key staff bythe end of 1999. To achieve this, we envisage submitting draft legislative framework and budgets for eachSAIs to the respective State and the Entity Parliaments and appointing the State and the Entity ActingAuditor-Generals by June 10, 1999. The State and the Entity Parliaments will have adopted these legislativeframework and budgets, and appointed Auditor-Generals for their SAIs by August 1999. We will havebegun implementing the legislative and the institutional framework starting in January 2000 which willenable the SAIs to start preparing and publishing the audit reports thereafter. During this timetable, we alsointend to process necessary amendments for establishing SAIs as constitutional bodies during 2000.

In conjunction with the ongoing work to develop an external auditing system, we intend tostrengthen the internal audit procedures with a special focus to ensure that the two functions wouldreinforce, rather than duplicate, each other. Our objective is to develop a framework enabling governmentagencies to exercise managerial control within their organizations and to prepare analysis and reports tomanagement on their systems and practices as well as compliance with budgetary and accountingrequirements. We are considering initiating this process first within the Entity Ministries of Finances,including cantons in the Federation, and then gradually expanding it into other public institutions and theState Ministry of Finance once it is established. To this end, by December 1999, both Entities shall have re-organized the existing Inspection Units with internal control functions, as Internal Audit Units with properinternal auditing capacity reporting to the Minister of Finance. In the initial stage, these Internal Audit Unitsshall be responsible, at a minimum, for compliance audit to improve the control and management ofbudgetary expenditures. In the meantime, we will develop a timetable for gradually expanding internalauditing to include operational efficiency and effectiveness and initiate its implementation during the firsthalf of 2000.

Strengthening Debt Management Capacity

Since 1998, we have made significant progress towards building the public debt managementstructure. The Entity Laws on external debt, consistent with each other and with the State Law on ExternalDebt, were adopted by both Entities. Debt management units (DMU) were established in the State Ministryfor Foreign Trade and Economic Relations (MFTER), as well as in each of the two Entities' MOFs. TheLondon Club and Paris Club Agreements on the rescheduling of BiH's external debt to commercial banksand official creditors, respectively, were concluded, thereby wiping out a large part of the debt inheritedfrom the SFRY. An automatic and transparent debt servicing system was established, substantiallyimproving the regularity of debt service payments; a comprehensive foreign debt tracking system wasestablished in the State MFTER. Other achievements to date include the signing of: (i) a Protocol oninformation sharing between the State, the Entities and CBBH to regularize and streamline the exchange ofdebt-related information between various debt management agencies; and (ii) an Agent Agreement betweenthe State MFTER and the CBBH that acts as the debt servicing agent of the State. The Federation andRepublika Srpska also made their first steps to regulate sub-Entity borrowing, whereby local governmentsare allowed to borrow only externally for investment purposes within a certain limit.

The borrowing activity in BiH is currently low due to severely limited financing capacity; a largeproportion of our reconstruction needs continue to be financed by international aid flows. In the medium-term, however, as aid-flows and concessional financing diminish, alternative sources of external finance,including borrowing from capital markets, will be a more significant option in financing our reconstruction

14

needs. BiH's access to such external financing will be determined, to a large extent, by the effectiveness andthe prudence of its borrowing arrangements. Developing a strong external debt management capacity,therefore, remains an important priority for us during the near term.

To achieve this, we are planning to improve the institutional setup and to strengthen borrowingpolicies and policy coordination between governments, including the development of a policy framework forsub-Entity borrowing. As indicated in the above paragraphs, we have already made substantial progress increating the legal and institutional setup for external debt management at the State and the Entity levels. Weintend to further these achievements during 1999 by developing policy-making, credit-analysis andmonitoring functions in the State and Entity DMUs that would promote fiscally prudent borrowingoperations. This includes broadening Entity DMU's mandate to manage their debt portfolio, not merely toexecute debt service transactions.

We recognize that to be able to effectively undertake a policy analysis function, the State and theEntity DMUs must be able to track and control borrowing by lower levels of government and enterprisesand evaluate sub-Entity debt for its sustainability. To develop such coordinated approach in public sectorborrowing, we plan to develop Guidelines building on the present legislative framework. The Guidelineswill establish (i) a comprehensive debt reporting system extending existing reporting procedures to coverdebt liabilities of sub-Entity governments, public enterprises, and utilities as well as liabilities of publicagencies that have separate budgets such as social security funds; (ii) strong and transparent selection,budgeting and supervision procedures for loans and guarantees; and (iii) procedures for borrowing policycoordination. The Governments of the Federation and Republika Srpska will begin implementing theGuidelines starting in the 2000 budgetary year.

Through the implementation of the Guidelines, we particularly aim to enforce ceilings on theamount of annual borrowing allowed for sub-Entity governments as specified in the Entity Budget SystemLaws. To this end, the guidelines shall establish (i) reporting requirements with sufficient detail on tennsand purpose of loans to enable the DMUs to prepare reliable debt service projections and to control the fiscalrisk; (ii) budgeting procedures that will allow for tracking the real value of obligations outstanding; (iii)monitoring criteria that will help track the utilization of loan proceeds and the progress of the project.Likewise, the guidelines shall establish clear procedures for the issuance of State and Entity guaranteesconcerning external borrowing of sub-Entity governments and enterprises (as allowed by the existinglegislation) while prohibiting the issuance of guarantees by sub-Entity governments for certain duration. Tofacilitate the effective implementation of the guidelines, we shall have created, by the end of 1999, debtdatabases in each Entities' MoFs (in DMUs) and introduced compulsory reporting procedures for all publicsector borrowing. The Entity MoFs will share such data with the State MFTER.

In addition, we plan to strengthen policy-coordination between the State and the Entity DMU's inorder to harmonize borrowing plans with the country's ability to service its external debt. The separation ofborrowing, debt servicing responsibility, and fiscal authority in BiH creates potential for a free riderproblem which could be limited by coordination of borrowing strategies. This, in turn, would substantiallyenhance the creditworthiness of all borrowers, both public and private. The State External Debt Lawprovides for the establishment of a high-level Debt Advisory Committee, with representation from all Stateand Entity agencies involved in managing sovereign external debt. In 1996, we created a prototype of thisCommittee which analyzed the consistency of external debt information and prepared for the external debtrenegotiations that took place during the past three years. As the relations with external creditors areregularized, we are planning to proceed with the creation of the Debt Advisory Committee in early-2000.The Committee will gradually assume the functions of piloting the country's debt strategy.

We hope that the above elaboration of the program for the reform of our public finance systemshas clearly expressed our commitment to modernizing our economy and putting it on a sound and

15

sustainable path to growth and prosperity. The continued contribution of the World Bank together withother agencies is an essential part of this difficult endeavor.

Mr. Mirsad KurtovicMinister

Foreign Trade and Economic Relationssnia and Herzegovina

Mr. F •Bicakcic Mr. Mi:orad Dodikri 5e Minister 7' Prin . M;Q der

Fe 0 Rep14ka Sesra

Mr. ra Cavic Mr. Novak KondicDpep y ister and/ Minister

l\ Miryastor R ELeRubeIka SrpskaFede Mstyofnc XXFinance

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ANNEX III

HEALTH FINANCE REFORM PROGRAM

Introduction

1. This Annex presents a summary of key issues and objectives for the reform of health sectorfinance in Bosnia and Herzegovina (BiH). The pre-war system is reviewed in para 2 which is followedby a review of the post-war situation, including legislative framework and support provided by IDA andother donors to Government's reform efforts. The annex concludes with priority tasks to ensure asuccessful reform of health sector finance.

The pre-war situation

2. Estimates of pre-war total health expenditure vary. According to the Federation Ministry of Health(MOH), in 1991 it was about US$245 per capita, or 8.2 percent of GNP'. This was on the high side of therange encountered in the region of Central and Eastern Europe. Until the early 1990's, the health systemin BiH was financed through governmental institutions called "self-management communities of interest"(SIZ). These provided health insurance, social security and disability benefits to employees and theirfamilies. Insurance revenues were obtained from compulsory contributions from employers andemployees (gross salaries), pensions and other personal incomes at an average rate of about 9-12 percent,as well as through contributions paid by farmers. The health sector was already facing a trend ofexpenditures in excess of revenues before the war.

The post-war situation2

3. The total health expenditure was DEM420 million (US$280 million), of which 86 percent was inthe Federation. Expenditures exceeded income in both Entities. The actual overspending was larger inthe Federation, but was greater in proportion to income in RS. Consolidated overspending was US$11million. Consolidated expenditures were 7 percent of GDP. Actual expenditures may be higher, theHealth Resource Account under-estimated the value of out-of-pocket payments made for private healthservices and some co-payments in the public sector. Health expenditure per capita has declined fromDEM364 (US$245) in 1990 to DEM1 13.5 (US$75) in 1997.

4. Policies, legislation and regulations. For clarity in examining the main issues regarding health carefinancing and payment mechanisms, it is important to distinguish among the following three:

* Revenue generation, structure and efficiency of the proposed finance regime: Health servicesmay be financed largely through general revenues, payroll taxes, user fees, or some combinationof all three. The Government of the Federation has already passed a Health Care Law in 1997(i.e. health insurance legislation), which becomes the practical starting point for discussions andpossible amendments. A Health Insurance Law is under preparation in RS.

* A politically acceptable and effective system for establishing solidarity based health financesystem between cantons in the Federation and regions in the Republika Srspka. This is required

Source: Federation Ministry of Health: Strategic Health System Plan (Draft). 1998.2 Source: Unless otherwise specified, materials contained in this section were obtained from the Health Resource Accounts inBosnia and Herzegovina - Report of the methodology and results from the pilot year, 1999. It was produced with technicalassistance from the U.K. Department for International Development. The data were for 1997.

if the poorer cantons or regions are to be able to afford essential health services. It is also asource of political tension.

Management of health services within each canton or region. There is a need to examine thestatutes, regulations and tools to ensure an effective balance between Entity-level responsibilitiesfor setting policies, standards and guidelines, and cantonal- or regional- level responsibilities formanagement of services.

5. Health sectorfinance in the Federation. The Federation MOH in 1998 prepared a "Strategic HealthSystem Plan", in consultation with Cantonal MOHs and with support from the World Health Organization.This document identifies in broad terms key health sector goals of universal access, equity and efficiency'.Furthermore, the Federation MOH has issued in December 1998 a more detailed "Policy and Strategy ofHealth Financing Reform in the Federation of Bosnia and Herzegovina"4 . It was prepared with supportfrom EU-PHARE, the World Bank and the Government of the United Kingdom. In this comprehensivedocument, the Federal MOH specified its commitment and implementation plan for a successful healthfinance reform, with the following objectives: (i) to establish a uniform health care system in the Federationwhich will be based on the cantonal organization as opposed to the ethnic one; (ii) to develop a sustainablehealth finance system by means of health insurance and also by mobilizing all available resources in thecommunity for health care; (iii) to control the expenditures at the macro level; (iv) to develop instrumentsfor the implementation of the health policy objectives through the contracting process; (v) to improveinstitutional efficiency; (vi) to promote the principles of solidarity; and (vii) to promote pluralism inownership patterns. In particular, the document has considered the issues of federal solidarity, prioritysetting in health care, equity, advantages of decentralization and economies of scale.

6. The Federation Law On Health Care of 1997 envisages a canton-based extra-budgetary healthinsurance system, financed by earmarked payroll tax contributions. Recognizing that such a system willlead to undesirable small risk pools, it also provides for the creation of a Federation level health insurancefund, responsible for certain joint health care functions. To date, progress in establishing this system hasbeen modest. Cantonal extra-budgetary health insurance funds were to be created by February 1998, butonly a few cantons have established such funds. Several cantons continue to deposit health carecontributions in the general cantonal budget, with a lack of clarity in resource flow and allocation. In somemixed cantons, certain municipalities are covered by cantonal funds other than the one in which they areresident. This is contrary to the 1997 Law On Health Care and the Dayton Accords. As for the Federationlevel structure, the Federation Health Insurance Fund was established, and its Director was appointed inDecember 1998. Nonetheless, both the services to be provided by the fund and financing sources have yetto be specified.

7. The effectiveness of this system in reducing the existing wide variations across cantons in access tohealth services, and in enhancing the overall health service delivery in Federation, critically depends on thedesign of the Federation level Insurance Fund. The Fund is expected to undertake a major responsibility in:(i) ensuring that all eligible residents of the Federation have access to basic health care services; (ii)financing services with Federation-wide benefits, such as eligible tertiary care services and highlyspecialized services that can only be delivered effectively in a limited number of locations for a larger riskpool; and (iii) providing technical and managerial assistance in operation of the cantonal health insurancefunds, including centralized procurement of medical supplies.

3 Source: Federation Ministry of Health: Strategic Health System Plan 19984 Source: Federation Ministry of Health. Policy and Strategy for Health Financing Reform in the Federation of Bosnia andHerzegovina. Sarajevo. December 1998.

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8. To effectively undertake these functions, the Fund must have an effective lead role for technicalsupport in the health system, as well as sufficient financing resources. The resource base of the Fund iscurrently envisaged to constitute no less than one-fifth of the total health contributions. The Federationgovernment also needs to determine an affordable package of basic health care services that will beprovided across the Federation, with options for additional services to be financed at the cantonal level. Thetechnical work towards this was initiated with assistance from the World Bank under the Health FinanceReform Component of the Essential Hospital Services Project and is being supported by the Health FinanceProject of EU-PHARE, and by the Government of the United Kingdom. The Federation is consideringtaking the actions necessary to complete the establishment of cantonal funds and to specify the parametersof the Federation fund before the end of this year so that health contributions can start flowing into thecantonal funds and the Federation fund can start operating in the new fiscal year.

9. Health care finance in Republika Srpska. The health care system in the Republika Srpska is beingfinanced mainly by payroll taxes, as is the case in the Federation. There are also transfers from thebudget to bridge any critical financing gaps for the provision of basic health services. The RepublikaSrpska government is considering introducing new Health Insurance Law in 1999. The draft statutesinclude provisions for a "solidarity fund" to promote risk pooling. Coverage of the insured would includea "basic minimum package of services", which is currently being defined, as well as eligible tertiaryhealth services and vertical programs of public health importance. A major challenge is to implementincentives and sanctions to improve collection.

10. The subject of a "basic package" of services needs to be treated with caution in both Entities.Although it was advocated by the World Bank in the 1993 World Development Report, itsimplementation is fraught with serous risks of failure. From a social and political perspective, the publicis highly unlikely to give up what it has theoretically been entitled tofiree of charge. Therefore, theimplementation of a system emphasizing health gains through cost-effective services would not beenabled by a mechanistic definition of positive and negative lists of services. It would be enabled by theuse of management tools and incentives to influence the behaviors of service providers and consumers.Such tools and incentives would encourage the delivery and use of more cost-effective services throughthe use of epidemiological information, cost-effectiveness, health technology assessment and businessplanning, the refinement and use of essential drug lists, rational use of drugs, targeted interventions, aswell as a careful introduction of formal co-payments where appropriate.

Health Finance Reform

11. The Government of each Entity is working with the World Bank, EU-PHARE and DFID toachieve the objectives of defining sector policy and strategic plans. The near-term objectives include thecompletion of the following in each Entity: (i) a detailed revenue and expenditure study of the healthsector, with the preparation of a National Health Account; (ii) studies on developing approaches topriority setting in health; and (iii) policy documents, strategic plans and indicative timelines for a phasedapproach to the rationalization of infrastructure and reform of management systems throughout the healthsector.

12. The main themes of the ongoing work are as agreed with the Entity Governments under theEssential Hospital Services project [IDA(ITF) Credit Number N003-0 BOS, Document Number T-699 1-BiH, Appendix 12, paragraph 4.3.1.]. Recent major activities include a six-day workshop and study tourto the Netherlands, and a three-day study tour and workshop in Slovenia for technical experts and policymakers from both Entities. The workshops were organized jointly by the EU-PHARE Health FinanceProgram and the World Bank. Drafts of the policy papers were completed in the Slovenia workshop inthe middle of December 1998. At this workshop, Ministers of Health and other representatives of bothEntities also agreed to establish a Committee for Inter-Entity Coordination, to address health sector issues

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where joint work is necessary or desirable. The Basic Health Project, approved by the World Bank onMay 4, 1999, will support implementation of incentives and changes in provider payment methods toincrease productivity and to control costs in primary care.

13. More specifically, the following are the near-team tasks in support of health finance reform:

In order to strengthen the basis for strategic decisions in the health sector, the following will becompleted in both Entities by December 1999:

(i) A comprehensive Health Account: Each Entity has already completed a Health Account,covering public sector revenues and expenditures. During the second half of CY99, a study ofprivate, out-of-pocket expenditures will be done, to provide a complete Health Account for eachEntity.

(ii) Studies on feasible approaches to priority setting in health services: This will includeconsiderations of the most effective approach to implementing a basic package of healthservices in each Entity. It will consider technical and social factors to ensure a successfulimplementation. Management tools and incentives will be developed to encourage the use ofmore cost-effective health services and to discourage the use of less cost-effective healthservices.

(iii) A study of public expectations, understanding and perceptions of the health system. Thisinformation will enable the health system to be more responsive to the needs of the population.

* Preparations are underway for these tasks, with support from the World Bank, the Governmentof the United Kingdom and the Health Finance Project of EU-PHARE.

• By December 1999, in the Federation, establishment of the Cantonal Health Insurance Funds asprovided for in the 1997 Law On Health Care. In this regard, the Federation Government andthe Cantonal Governments will develop, by September 1999, essential guidelines to facilitateoperations of the Cantonal Health Insurance Funds, with reference to: (a) revenue collectionfrom extra-budgetary taxes earmarked for health and (b) transparency in the flow of funds.

* By December 1999, in the Federation, development of guidelines to facilitate operations of theFederation Health Insurance Fund, with reference to the following:

(i) Solidarity: The objectives are to: (i) ensure that all eligible residents of the Federation haveaccess to basic health services; (ii) cover the costs of eligible tertiary services; and (iii) cover thecosts of vertical programs of public health significance, for example, tuberculosis control.

(ii) Source of revenues for the Federation Health Insurance Fund: Revenues for the FederationHealth Insurance will be derived from payroll taxes. In principle, this could be up to 20 percentof cantonal insurance revenues, as defined in the 1998 "Policy and Strategy for Health FinancingReform in the Federation of Bosnia and Herzegovina", and as agreed during a meeting ofrepresentatives of the Federation Ministry of Health, Federation Health Insurance Fund, CantonalMinistries of Health and Cantonal Health Insurance Funds on April 21, 1999.

(iii) Technical and managerial support to be provided by Federation Health Insurance Fund (asthe lead agency on health finance) to the Cantonal Health Insurance Funds. This will includecentralized procurement of specified medical supplies, to explore economies of scale.

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Adoption, by the Government of the Federation, of amendments to the 1997 Law On HealthCare, to provide a legal mandate for the funding, operations and functions of the FederationHealth Insurance Fund. We will ensure that this is achieved by June, 2000.

By December 1999, in Republika Srpska, the Government will develop guidelines to enableeffective operations of the Republika Srpska Public Health Insurance Fund and the fourRegional Branches. Guidelines will establish: (i) procedures for improving transparency inbudgeting and usage of health contributions; (ii) incentives/sanctions to improve collection; (iii)procedures for strengthening coordination between the central fund and its branch offices; and(iv) prototypes of contracts to guide the purchasing of health services.

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ANNEX IVPage 1 of 3

Table 1: Bosnia and Herzegovina - Key Economic Indicators

Estimate ProjectedIndicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

National accounts(as % GDP at currentmarket prices)

Grossdomesticproduct 100 100 100 100 100 100 100 100 100 100 100AgricultureIndustryServices

Exports (GNFS)' 20 24 29 33 34 34 35 35 36 36 36Imports (GNFS) 71 83 76 70 59 54 50 46 43 41 40

Memorandum itemsGrossdomesticproduct 1867 2741 3423 4082 4533 5333 6262 7090 7731 8386 9080(US$ million at currentprices)

Real annual growth rates%, calculated from 1995prices)Gross domestic product at 69 30 18 8 14 14 10 6 5 5market prices

Real annual per capitagrowth rates (%, calculatedfrom 1995 prices

Gross domestic product at 28 17 7 13 13 9 5 4 4market prices

Balance of Payments(US$m)

Exports (GNFS)a 381 658 1002 1367 1541 1816 2162 2498 2796 3044 3293Merchandise FOB 152 336 575 817 955 1131 1387 1628 1843 2008 2169

Imports (GNFS)a 1334 2278 2606 2864 2659 2863 3124 3234 3358 3460 3596Merchandise FOB 1082 1882 2333 2573 2397 2586 2826 2935 3051 3152 3278

Resource balance -953 -1620 -1604 -1498 -1118 -1047 -962 -736 -562 -416 -303Netcurrenttransfers 1002 1094 772 510 311 281 245 210 170 104 37(including official currenttransfers)Current account balance -193 -748 -1060 -1127 -896 -879 -831 -640 -504 -424 -350(after official capital grants)

Net private foreign direct 0 0 0 100 60 162 185 200 200 200 200investmentLong-term loans (net) -271 439 12 43 24 117 190 146 144 96 39Other capital (net, including 578 542 959 1015 944 648 528 390 242 182 161errors and omissions)

Change in reservesb -114 -232 89 -31 -132 -48 -72 -96 -82 -54 -50(continued)

ANNEX IVPage 2 of 3

Table 1: Bosnia and Herzegovina - Key Economic Indicators

(Continued)

ProjectedIndicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Memorandum itemsResource balance (% of -51 -59 -47 -37 -25 -20 -15 -10 -7 -5 -3GDP at current marketprices)Real annual growth rates(1995 prices)Merchandise exports 155 78 40 14 15 19 14 10 6 5(FOB)Merchandise imports S0 40 1I -10 5 6 1 1 0 1(CIF)

Public Sector Balances(as % of GDP at currentmarket prices)Expenditures 36 78 56 52 48 48 47 44 43 42 40Revenues 29 51 31 32 31 35 36 37 38 38 38Deficit (-) -7 -27 -25 -20 -17 -13 -11 -7 -5 -4 -2External Financing 7 27 23 20 17 13 11 7 5 4 2Others, incl. Arrears 0 0 -2 0 0 0 0 0 0 0 0

Monetary indicatorsM2/GDP (at current market 21 28 34 .. .. .. .. ..

prices)Growth of M2 (%) 9 96 52 .. .. .. .. ..

Price indices(1995=100)Implicit GDP deflators(% change)Federation -40.4 9.1 13.7 2.0 .. .. .. .. ..

Republika Sirpska 53.1 -35.7 -0.4 9.8 .. .. .. .. ..

a. "GNFS" denotes "goods and nonfactor services."b. Includes use of IMF resources.

Source: Official data and staff estimates.

ANNEX IVPage 3 of 3

Table 2: Bosnia and Herzegovina - Key Exposure Indicators

ProjectedIndicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Total debt outstanding anddisbursed (TDO) (US$m)a 3360 3884 4343 2879 3264 3632 3983 4289 4535 4758 4950

Netdisbursements(US$m)' 231 135 211 128 198 198 114 104 88 77

Total debt service (TDS)

(US$m)' 513 573 385 122 117 152 151 162 170 177 168

Debt and debt service indicators (%)TDO/XGS' 882 590 433 211 212 200 184 172 162 156 150TDO/GDP 156 117 127 71 72 68 64 60 59 57 55TDS/XGS 135 87 38 9 8 8 7 6 6 6 5Concessional/TDO .. .. .. .. .. .. .. ..

IBRD exposure indicators (%)IBRD DS/public DS 14 2 9 29 37 29 30 43 41 39 40

Preferred creditor DS/public DS (%)e 22 3 10 33 62 41 47 78 68 48 45IBRD DS/XGS 19 2 3 3 3 2 2 3 2 2 2IBRD TDO (US$m)d 623 596 596 596 596 596 604 594 589 584 560Share of IBRD portfolio (%) 0.5 0.5 0.5 .. .. .. .. ..

IDA exposure indicators (%)IDA DS/public DS .. 0.0 0.5 2.5 3.5 3.2 3.7 3.8 3.9 3.8 4.2IDA DS/XGS .. 0.0 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.2 0.2IDATDO (US$m)d .. 191 291 433 533 633 723 803 863 913 913

IFC (US$m)Loans 15 15 8 .. .. .. .. ..

Equity and quasi-equity' 0 0 0 .. .. .. .. ..

MIGAMIGA guarantees (US$m) 0 0 0 .. .. .. .. ..

a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short-term capital. After debt rescheduling.b. "XGS" denotes exports of goods and services, including workers' remittances.c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements.d. Includes present value of guarantees.

Source: Official data and staff estimates.

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