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Report No. 33549-TR Turkey Country Economic Memorandum Promoting Sustained Growth and Convergence with the European Union

February 23, 2006

Volume I: Main Report Poverty Reduction and Economic Management Unit Europe and Central Asia Region

Document of the World Bank

CURRENCY AND EQUIVALENTS UNITS

Currency Equivalents (Exchange Rate Effective February 22, 2006)

Currency Unit: New Turkish Lira US$1 = 1.3245

Government Fiscal Year January 1 - December 31 Weights and Measures

Metric System

ABBREVATIONS AND ACRONYMS AOD Abuse of Dominant Position BITT Banking and Insurance Transaction Tax

CAP Common Agricultural Policy CBRT Central Bank of the Republic of Turkey

CCT Conditional Cash Transfer CGG Consolidated General Government

CIT Corporate Income Tax CITE Centros de Innovacione Tecnologicas

DRG Diagnosis Related Group EU European Union

FDI Foreign Direct Investment FIAS Foreign Investment Advisory Services

GNI Gross National Income HICES Household Income and Consumption

Expenditure surveys

ICS Investment Climate Study ICT Information and Communication Technologies

IPA Investment Promotion Agency IPR Intellectual Property Rights

MoT Ministry of Transport MTEF Medium-Term Expenditure Framework

MOU Memorandum of Understanding NBFI Non-Bank Financial Institutions

NIS National Innovation System NPAA National Plan for the Adoption of the

Acquis

NQCS National Quality Certification System PIT Personal Income Tax

PMR Product Market Regulations RUSF Resource Utilization Support Fund

SGEI Services of General Economic Interest SOE State Owned Enterprises

SPO State Planning Organization TINA Transport Information Needs Assessment

TPE Turkish Patent Institute TSE Turkish Standard Institute

Vice President: Shigeo Katsu Country Director: Andrew N. Vorkink Sector Director Cheryl Gray Sector Manager C. Felipe Jaramillo Task Team Leader Aristomene Varoudakis

CONTENTS

VOLUME I MAIN REPORT EXECUTIVE SUMMARY ........................................................................................................... i PART A: POLICY AND INSTITUTIONAL FRAMEWORK FOR CONVERGENCEWITH THE EUROPEAN UNION ...............................................................1 CHAPTER 1. UNLOCKING TURKEY’S POTENTIAL FOR GROWTH AND PREPARING FOR EU ACCESSION .........................................................................................3

1.1. From crisis to stability .........................................................................................................3 1.2. Re-energizing the Engines of long-term growth..................................................................5

(a) Sources of long-term growth .......................................................................................5 (b) Ensuring growth with external sustainability ..............................................................8

1.3. Fast income convergence with the European Union is feasible but will not be spontaneous..........................................................................................................................9

1.4. Policy Coordination for enhanced growth and Management of EU Accession: The Acquis and beyond.........................................................................................................................13 (a) Policy prioritization during EU accession .................................................................13 (b) Policy coordination on the way to the EU .................................................................15

CHAPTER 2. PUBLIC FINANCE MANAGEMENT ON THE WAY TO THE EU........19

2.1. Quality of Fiscal Adjustment and the Size of Government ...............................................19 (a) The expenditure side ..................................................................................................21 (b) The Revenue side.......................................................................................................25

2.2. Public Debt Sustainability..................................................................................................26 PART B: STRUCTURAL POLICIES – IMPROVING THE FUNCTIONNING OF KEY MARKETS AND THE EFFICIENCY OF PRODUCTION FACTORS ...............................29 CHAPTER 3. PRODUCT-MARKET REGULATIONS AND THE INVESTMENT CLIMATE ............................................................................................................................31

3.1. Administrative Barriers......................................................................................................32 (a) Firms’ entry, operation and exit.................................................................................33 (b) Resolving commercial disputes .................................................................................35

3.2. State Aid ............................................................................................................................36 3.3. Barriers To Trade...............................................................................................................37 3.4. Competition Policy ............................................................................................................38 3.5. Complementary Measures To Improve Attractiveness To FDI.........................................39 3.6. Conclusions........................................................................................................................39

CHAPTER 4. EXPANDING EMPLOYMENT—THE LABOR MARKET REFORM AGENDA ............................................................................................................................41

4.1. Turkey’s Employment Performance in a European and International Context.................41

4.2. Employment creation and EU Accession ..........................................................................43 4.3. Labor market policies and institutions...............................................................................44 4.4. An agenda for reform.........................................................................................................46

CHAPTER 5. FINANCIAL SECTOR REFORM: MOBILIZING FINANCE FOR INVESTMENT ............................................................................................................................49

5.1. Status of financial sector reform agenda............................................................................50 5.2.Reform areas and challenges ahead .....................................................................................53

CHAPTER 6. FOSTERING TECHNOLOGY ADOPTION, INNOVATION, AND SKILLS ............................................................................................................................57

6.1. Promoting technology adoption and innovation at the firm level......................................57 6.2 Improving the national quality system and the use of quality standards ...........................62 6.3. Aligning the skills of the labor force with the needs of the private sector ........................63

CHAPTER 7. INFRASTRUCTURE SERVICES FOR IMPROVED COMPETITIVENESS.................................................................................................................65

7.1. Information and Communication Technologies ...............................................................66 7.2. Linking up with Trans-European networks .......................................................................67 7.3 Energy ................................................................................................................................70

(a) Power............................................................................................................................71 (b) Gas................................................................................................................................72

7.4. Common Reform Directions..............................................................................................73 PART C: PROMOTING INCLUSIVE GROWTH.................................................................75 CHAPTER 8. ALIGNMENT WITH EU AGRICULTURAL AND RURAL DEVELOPMENT POLICIES ....................................................................................................77

8.1. Alignment with the European Union Common Agricultural Policy (CAP) ......................78 (a) Comparative support to Agriculture in Turkey and the EU .........................................78 (b) Impact of Alignment with CAP – General Equilibrium Modeling..............................81

8.2. Promoting Rural Development and its European Union Alignment .................................82 (a) Regional Dimensions of Rural Development Investment Patterns ..............................82 (b) Using EU Pre-Accession Funds for Rural Development...........................................84

CHAPTER 9. ENHANCING POLICIES FOR SOCIAL COHESION ..............................87

9.1. Social Inclusion..................................................................................................................87 9.2. Managing the Health Care System ....................................................................................89

(a) Consolidating hospitals and improving efficiency ....................................................91 (b) Strengthening delivery of health services ..................................................................91 (c) Reforms in provider payment mechanisms................................................................92 (d) Containing outpatient care provided by hospitals......................................................92 (e) Managing pharmaceutical costs.................................................................................93

ANNEX 1 – STATISTICAL TABLES……………………………………………………....95 VOLUME II EXPANDED REPORT List of Figures Figure 1.1 Annual average per capita GDP growth and its decomposition 05 Figure 1.2 GDP per capita relative to EU 15 09 Figure 2.1 General government expenditure as a % of GDP 22 Figure 2.2 Functional allocation of general government expenditures 22 Figure 3.1 Turkey’s performance on key PMR indicators 32 Figure 3.3 Administrative barriers, selected indicators, 2003 33 Figure 4.1 Elasticity of employment to output growth 41 Figure 4.2 Turkey’s employment protection rating (OECD index) 45 Figure 5.1 Bank deposits/GDP, 2004 52 Figure 5.2 Bank Credit to Private Sector/GDP, 2004 52 Figure 6.1 Capital goods import/investment 58 Figure 6.2 royalty and license fee payments 58 Figure 6.3 Gross expenditure on R&D, total and compostion:2001-2003, most recent data

available 59 Figure 6.4 Distribution of students by PISA proficiency level in Turkey and EU , 2003 64 Figure 9.1 Health expenditure and GHI per capita Turkey and comparator countries 89 List of Tables Table 1.1 Sources of labor productivity growth in Turkey, 1973-2003 06 Table 1.2 Income gaps to EU average and speed of convergence 12 Table 1.3 Negotiation of the Acquis – experience from the new EU members 14 Table 3.1 Entry and exit, Turkey and comparator countries, 2004 34 Table 3.2 Contract enforcement 35 Table 4.1 Employment rates in 2004 relative to the Lisbon targets, Turkey, EU members,

and Bulgaria and Romania 42 Table 5.1 Structure of the financial sector 51 Table 8.1 Indicators of support to agriculture Turkey and EU (1986-2004) 78 Table 8.2 Change in value of production with EU CAP alignment (in %) 79 List of Boxes Box 5.1 Foreign Strategic Investments in the Turkish banking system 53

ACKNOWLEDGEMENTS

This report was prepared by a core team composed of: Mediha Agar, Michel Audige, Gordon Betcherman, Steen Byskov, Mukesh Chawla, Michael Edwards, Indira Konjhodzic, Mark Lundell, Marialisa Motta, Zafer Mustafaoglu, Kamer Karakurum-Ozdemir, and Aristomene Varoudakis (Task Team Leader). Significant contributions were provided by Gokhan Akinci; Nina Budina; Sirin Elci (consultant); John Innes; Bart Kaminski (consultant), Rughvir K Khemani, Robin Horn, Ranjit Lamech, Gareth Locksley; Koshy Mathai (IMF); Ebru Ocek (consultant); Marc Reichel (consultant), Selin Sayek (consultant); Sumter Lee Travers; Dominique Van Der Mensbrugghe, Charles Vuylsteke (consultant), and Sweder van Wijnbergen (consultant). Contributions were also received by: Cecilia Briceno-Garmendia; Ferhat Emil (consultant); Edgardo Favaro; Isabel Sanchez Garcia; Vinod K. Goel; Itzhak Goldberg, Ufuk Guven, Mizuho Kida; Brian Levy; Richard Messick, Georgine Ann-Marie Newman-Alawode, Panagiota Panopoulou, Taras Pushak, Anita Schwarz. Research assistance was provided by: Faruk Baykal, Mehmet Gorpe, Thomas Haven; Antoneta Stavreska, Victor Sulla; Olga Vybornaia, Omer Yalvac, and Izzet Yildiz. Peer reviewers were: Kyle Peters and Carlos Silva Jauregui. Guidance was provided by Cheryl Gray (Sector Director), Pradeep Mitra (Chief Economist, ECA Region), and Felipe Jaramillo (sector manager). External reviewers were:Daniel Gros, Director, Center for European Policy Studies, Brussels; and Jorge Braga de Macedo, Professor, Nova University of Lisbon, former Minister of Finance and Member of Portuguese Parliament, former President of the OECD Development Center. Comments were provided by: Ismail Arslan, Enis Baris, Rodrigo Chaves, Franz Kaps, Ali Mansoor, Fernando Montes-Negret, Samuel Otoo, Mathew Verghis, and Deborah Wetzel. Valuable comments were also received from Lorenzo Giorgianni (IMF); Peter Grasmann, Dirk Verbeken, Alain Deckers, Catherine Combette, Kerstin Rosenow, (EU Commission); Rauf Gonenc and Anne-Marie Brook (OECD). Administrative support by: Lalani Dammika Somasundaram and Aikaterina Stefanova. Valuable support from the counterpart team, organized by the Undersecretariat of the Treasury, is gratefully acknowledged, and especially from the services of the State Planning Organization, which provided information on many parts of the study. Comments from the counterpart team were received on a first draft of the summary report.

EXECUTIVE SUMMARY

1. The EU accession process will continue to be a driving force for Turkey’s reform efforts. Commitment to sound economic policies since 2001 has placed the Turkish economy in a good position to embark on a sustained path of faster growth. The process of European Union (EU) accession that was launched on October 3 2005 will provide an anchor for the continuation and deepening of reforms in the years ahead, thus fostering Turkey’s growth potential and accelerating convergence to EU living standards. 2. This study aims to contribute to the ongoing process of elaborating a strategic vision on Turkey’s policy priorities during EU accession. The thrust of the analysis in the CEM is on two simultaneous challenges:

• How could Turkey take advantage of policy and institutional convergence with the EU, while managing the broader development agenda that lies outside the scope of the EU Acquis, so as to prioritize reforms with the greatest benefits for growth with social inclusion?

• How could Turkey smoothly manage the EU accession process, by appropriately sequencing reforms and alignment with the EU Acquis, so as to best prepare for EU accession and minimize the costs of transition?

3. Because of the broad-ranging reform agenda to be addressed, the complexity of implementation, and the span of the accession time frame, this study is part of a programmatic series. This first study reviews the macroeconomic factors affecting Turkey’s capacity to sustain faster medium-term growth and job creation; addresses overarching challenges in public finance management and policy coordination; reviews policy priorities for improving the functioning of key markets and the efficiency of production factors—such as product market regulations; labor market reform; financial sector development; innovation and skills; infrastructure services, and agriculture. It also provides an overview of challenges for inclusive growth, addressing issues in rural development, social inclusion, and cost-effectiveness of health care services. The expanded report (Volume II) provides the full analytical background of the findings highlighted in the main report (Volume I). 4. Future work is intended to cover additional subjects. Because of the expected length of the negotiation period for Turkey’s EU accession, but also the uncertainty surrounding, until the December 2005 EU Council summit, the EU’s Financial Perspective for 2007-2013, calculations of the budgetary costs and benefits of EU accession for Turkey will be conducted in a future exercise. Moreover, environmental

protection will be addressed in a next study because, while alignment with the Acquis will be costly and will necessitate a major shift in investment priorities, the planning horizon is likely to be long to the extent Turkey is granted additional compliance time post-accession, as in the case of new EU members. Additional subjects to be covered in a follow-up study include public sector governance, education, and regional development.1 5. Turkey’s economic performance since the 2000/2001 crisis has been very strong— Following the 2001 crisis, the Turkish economy rebounded very strongly, with annual growth averaging 8 percent during 2002-2004 and a 5 percent growth rate for 2005 well within reach. Inflation has come down to single digits in 2004 (9.3 percent) for the first time in the last 35 years, greatly facilitating the reduction in interest rates. Two weak spots have emerged in the picture: (i) Despite strong growth for three consecutive years, high unemployment continues to persist, at an estimated 10.4 percent on average in the first half of 2005; (ii) The current account deficit reached 5.2 percent of the GNP in 2004 and continues to remain a cause of concern as it may exceed 6 percent of GDP in 2005, especially as the imported energy bill gets inflated with the spike in the price of oil. 6. —and has been powered by far-reaching policy reforms. Resolute fiscal consolidation has been the cornerstone of the economic program. The public sector primary balance moved to a surplus of 6.8 percent of GNP by 2004, from a deficit of 2.5 percent in 1999, enabling a reduction of gross public debt from 108 percent of GDP in 2001 to 77 percent in 2004. Monetary policy focused on implicit inflation targeting, facilitated by fiscal consolidation and the introduction of a floating exchange rate regime. Progress has been achieved in restructuring the financial sector, improving the business environment, and reforming the public sector. Key markets have been liberalized and regulatory capacity in the economy has been strengthened. Turkey has thus strengthened its position as a functioning market economy, although further reforms are needed to secure resilience and strengthen the capacity of the economy to cope with competition in the EU single market. 7. Contrary to comparator countries, Turkey missed the opportunity to achieve convergence over the past decades. Slow labor productivity growth and declining labor utilization prevented Turkey from realizing its full long-run growth potential, particularly in the 1990s. The decrease in labor productivity growth during the 1990s fully reflects slower Total Factor Productivity (TFP) growth. There is evidence that high output volatility adversely affected both TFP growth and the investment ratio. Moreover, labor productivity growth in services has turned almost stagnant, owing to low efficiency and extensive informality, reflected into negative TFP growth. Stronger TFP growth will be the key to achieving accelerated convergence in the years ahead. But fast productivity growth will also have to be combined with stronger job creation than in the past, with support by healthy private investment, to achieve the required acceleration of growth. Evidence points to increased trade openness and greater financial depth as pillars for strong TFP performance—underscoring the importance of continuing integration in the

1 Other studies conducted in parallel by the World Bank (education, labor markets, investment climate assessment, public expenditure review) provide a more comprehensive analysis of challenges in specific areas and complement the analysis in the CEM series.

EU single market and of pressing ahead with the financial sector reform agenda. With services now by far the largest sector in the economy, reforms that enhance efficiency and job creation in services would be a precondition for faster growth of the economy as a whole. 8. EU accession holds the promise of significant economic and social benefits for Turkey. EU accession will promote growth and social development in different ways: (i) by strengthening the overall policy framework, facilitated by the adoption of the EU Acquis—especially in the many areas related to deeper integration into the EU single market; (ii) by making Turkey a better place to invest, especially by attracting higher FDI; (iii) by fostering absorption of superior know-how and promoting productivity growth; (iv) by extending the Customs Union with the EU to agriculture—with expected significant net benefits down the road for Turkey’s farmers, but also for consumers, as a result of better access to EU markets; (v) through inflows of EU CAP and structural funds, which, with the right policy framework in place, will provide an impetus to regional and rural development. Above all, by strengthening the investment climate, EU accession will create more employment opportunities for Turkey’s rapidly growing labor force. The prospect of eventual free labor mobility will deliver further welfare gains, both for Turkey and the EU. 9. Turkey should take advantage of the EU accession process as an anchor for continuing reform, economic stability, and accelerated growth. EU accession will provide impetus for deepening the reform process in the years ahead, and contribute to improving convergence of Turkey’s living standards to the EU average. This process will be self-reinforcing, as accelerated income convergence would enhance prospects for Turkey’s eventual membership. But income convergence is not spontaneous. The experience of EU cohesion countries suggests that benefits of EU integration are not guaranteed—they are contingent on the quality of the policy framework, efficient and effective public management, and maintaining the reform momentum. The task will be even more demanding for Turkey, requiring more intense and focused efforts, because, contrary to new EU members, accession will be conditional on effective compliance with the EU Acquis, not only legal alignment and commitment to implement the Acquis. 10. The speed of convergence to EU average living standards will depend on the pace of structural reform. In a base-case scenario, where sound economic policies are maintained and structural reforms are kept on track, per capita income in Turkey would increase from 29.1 percent of EU25 in 2004 to 34.2 percent by 2015, giving rise to some but not substantial convergence. However, in a high-case scenario, where the scope of structural reforms is broadened in a number of priority areas reviewed below, per capita income could reach 40.4 percent of the EU25 by 2015—assuming constant real exchange rates. In the high-case scenario, income convergence could be further accelerated by productivity-driven real exchange rate appreciation—up to an estimated 50 percent of the EU25 by 2015. The estimated convergence speeds for Turkey under these scenarios are in line with the experience of EU countries. Downside risks should not be disregarded, however, as reform fatigue and vulnerability to external risks could lead to a low-case scenario with virtually no convergence to the EU.

11. As strong growth of domestic demand is likely to persist in a fast-growth scenario, preserving current account sustainability raises a simultaneous challenge for both macroeconomic and structural policies. On the macroeconomic front, it is important that fiscal discipline be continuously maintained through a high primary budget surplus, to ensure needed mobilization of domestic savings for the financing of investment. Moreover, a sufficiently tight fiscal stance would be needed to support monetary policy and avoid high short-term real interest rates in order to achieve inflation targets—which would risk further appreciating the currency and damaging the external balance, as well as increasing the cost of borrowing in domestic markets for the Treasury. Continuing liberalization of product and service markets and further strengthening of competition policy would enable competitive cost reductions, especially in non traded services—thus facilitating an easier stance of monetary policy. Structural reforms to strengthen the investment climate would not only be a condition for higher private investment and faster growth, but also for attracting foreign savings in the form of foreign direct investment and thus for ensuring sustainable financing of the external current account. Financial sector reforms that ensure a better mobilization of domestic private savings will also help contain the current account deficit in the years ahead. 12. The challenge of regional convergence should be addressed on the way to the EU. With per capita income in the richest provinces 6.9 times higher than in the poorest, Turkey stands out as a country with large regional disparities by international comparison. Internal migration has been extensive and would have been expected to somewhat contribute to bridging the gap in per capita income across regions. However, per capita incomes have not converged, with GDP growing much faster in rich than in poor regions. Faster growth of backward regions would thus contribute to reducing disparities, but also to accelerating growth of the economy as a whole. The challenge for Turkey will be to make best possible use of “pre accession funds” to promote regional development during accession. 13. Reforms should be conducted with the aim of sustaining faster and inclusive growth while preparing for EU accession—by maintaining a stable macroeconomic and fiscal framework, improving the functioning of key markets and the efficiency of production factors, and ensuring cost-effectiveness of safety nets.

• Structural fiscal reforms deserve particular attention because they underpin the broader reform agenda. Maintaining a sound fiscal framework is a precondition for economic stability and sustained faster growth, while more fiscal space should be created for growth-enhancing public expenditures and lower taxes that would support productivity and a sound investment climate.

• Prominent structural reform areas, reviewed in this study, are those conducive

to stepped up productivity growth and a strong investment climate. These reform areas encompass both: (i) the functioning of key markets (ensuring competitive and investment-friendly product market regulations; improving

responsiveness of labor markets to changing conditions; furthering the capacity of the financial sector to mobilize finance for productive investment; enhancing the capacity of agriculture to respond to structural change on the way to the EU Common Agricultural Policy); and, (ii) initiatives to improve the efficiency of production factors (fostering increased technology absorption and innovation; aligning worker skills with private sector needs; improving the quality and lowering the cost of infrastructure services).

• In particular, while a pro-growth investment climate and sound

macroeconomic environment are important prerequisites for growth, the labor market reform agenda deserves special attention as it holds the key for accelerating the pace of job creation and reducing informality.

• Reforms to improve the cost/effectiveness of social protection and health care raise a particular challenge for Turkey, in view of the existing important social and regional gaps, the need to shift protection “from jobs to workers”, and the potential for the EU accession process to create “winners”, but also some “losers”.

Policy options in the above key reform areas are summarized below and presented in synthesis policy tables. 14. Steering the process of EU accession and ensuring effective compliance with the Acquis will critically hinge on the quality of policy coordination across various parts of the public administration. Because implementation of the Acquis will be a prerequisite for EU accession, strengthening vertical and horizontal coordination, in particular within large ministries and agencies, would deserve special attention. In parallel, the operating efficiency of the government should be strengthened by clarifying policy and other competences, and reducing their fragmentation and overlapping; ensuring strong quality control of new regulations; improving the procedural efficiency of policy-making; and reducing procedural delays within line ministries and agencies. Structural Fiscal Reforms and Public Finance Management 15. Turkey’s focus for achieving fiscal consolidation has been more on revenue-increasing measures rather than expenditure rationalization. While primary revenues of the consolidated general government increased by 4.8 percent of GDP over 1999-2004, primary expenditures declined by only 0.6 percent of GDP—and, at 33 percent of GDP, remain higher than in other fast-growing emerging economies. The increase in tax revenue was mainly generated by higher indirect taxes. As a result, fiscal revenues in Turkey stand at 40 percent of GDP, a level that is now similar to EU countries, despite a smaller welfare state. Cuts in investment expenditures and capital transfers have merely offset a growing social security deficit, which reached 3.8 percent in 2004. Expenditures for personnel, goods and services and current transfers were largely unaffected by fiscal consolidation. However, although more steps are clearly needed, initiatives have been taken to prevent wasting in expenditures and set expenditure priorities, which have supported a better control of expenditure growth than in the past.

16. Improving the quality of fiscal consolidation will greatly help meet Turkey’s development challenges on the way to the EU. Structural fiscal reform, aimed at improving the quality of fiscal consolidation, is the only viable means of sustaining the adjustment in the future while making appropriate fiscal space for growth-enhancing expenditures and lower taxes. Room for increased expenditure will be needed in education, in infrastructure for less-developed regions, in areas where alignment with the EU Acquis entails a cost (e.g., environment), and when significant co-financing is needed for absorbing pre-accession funds (e.g., rural development). But expenditure is already high compared to other fast-growing countries and it should also be contained in order to make room for lower taxes in the future. Moreover, a high primary budget surplus will need to be maintained in order to accelerate the reduction of public debt in proportion to GDP and forestall pressures on the external current account. 17. Trade offs in expenditure allocations would need to be combined with expenditure reforms aimed at efficiency gains. Increased fiscal space should be sought possibly by reducing spending in functional areas where it appears to be oversized in international comparison (such as general public services, defense, public order and safety), and by implementing reforms that improve efficiency and help contain costs in areas where expenditure pressures are being felt—such as health care and pensions. Horizontal reforms, focused on the modernization of civil service pay and employment and the careful formulation of the investment program, would also help contain pressures on the wage bill and investment spending across functional areas. Ensuring appropriate allocations for operation and maintenance of public capital is important because accelerated decay of capital goods may unduly burden the investment program in the future. 18. Moving to a simpler and more transparent compensation system would contribute to containing pressures on the wage bill. Since 1999, and despite downsizing of public employment, total compensation for General Government employees has been relatively stable, at around 10 percent of GDP. The share of personnel expenditures on economic affairs is particularly high in international comparison. Linking wage increases to inflation has not proven enough to contain growth in the wage bill, probably because other forms of compensation have provided room for increases in personnel costs. About 32 percent of personnel compensation is composed of various allowances, compensations, and rewards—many of these exempt from the income tax. The system of allowances and overtime pay is complex and offers substantial opportunities for discretion. 19. Reforms to improve tax efficiency and broaden the tax base have been initiated and should be continued. Because there is little fiscal space for lowering the tax rates in the short term, reform efforts should focus on tax rationalization and base broadening. This will improve tax efficiency while laying the groundwork for lowering tax rates in the future. Important reforms of the Corporate and Personal Income Taxes have been initiated, with a reduction in the CIT rate and tax base broadening, and a simplification of the rate structure of the PIT, together with the harmonization of the taxation of wage and

non-wage income. Further reform options for the Personal Income Tax (PIT) could include: replacing the costly and potentially inequitable VAT-based consumption credit with a simpler tax credit; introducing reduction for dependents so as to reduce the high tax wedge on married workers;. Further reform options for the Corporate Income Tax (CIT) could include: avoiding regional and sectoral tax incentives; and incorporating dividends into a new regime for capital income taxation, with a view to progressively phasing out the double taxation of dividends. 20. Despite significant progress, debt reduction remains a challenge. The level of gross debt still remains high, especially when compared with new EU members and acceding countries. In a base-case scenario, sound macroeconomic fundamentals will lead to a further reduction in the gross debt ratio to about 60 percent in 2008. However, the level, short average maturity, and interest rate and currency composition of public debt underscore the need of credible policies that maintain a robust fiscal framework in order to further build confidence. Preserving a tight fiscal stance, as needed for accelerating the reduction of the debt ratio, and using projected large privatization proceeds to further reduce public debt, would be the best course to mitigate surrounding risks.

Structural policies—improving the functioning of key markets and the efficiency of production factors

Product Market Regulations to improve the Investment Climate 21. Progress has been made in reducing administrative barriers to business entry, operation and exit but further steps should be considered. Further measures are needed to reduce start up costs and streamline business registration across the country. Focus should be on measures that reduce the time and costs of licensing, both for general and for sector-specific licenses. Factors that complicate licensing include: an excessive number of licenses overlapping responsibilities of several agencies and municipalities in the licensing process and requests for excessive documentation. Further steps to streamline bankruptcy procedures should be assessed after an evaluation of the 2005 reforms of the bankruptcy law. 22. Contract enforcement has improved, but backlogs in the commercial courts and enforcement proceedings remain of concern. Since 2000, Turkish authorities and the judiciary have taken important steps to speed the resolution of commercial disputes. Further suggested reforms—with a specific focus on reducing backlogs in the commercial courts and enforcement proceedings—include: (a) adopting a case management system and an associated alternative dispute resolution mechanisms; (b) reforming the system for choosing experts; (c) applying to domestic arbitrations the same rules that govern international arbitrations; (d) providing competitive restraints on fees for legal professionals; and (e) evaluating the courts’ caseload to ensure the principle of proportionality is observed.

23. Progress in the area of state aid is urgently needed. Turkey has yet to comply with commitments to reform the state aid regime taken in 1996, as part of the Customs Union agreement with the EU. Several programs and instruments channel state aid, in amounts that still lack sufficient monitorable disclosure, although progress towards horizontal design of the system is noted. Some of these instruments have a potentially distorting effect on competition—such as electricity consumption subsidies granted to firms established in less developed areas, as they constitute operating rather than investment aid. Suggested reforms include: (a) adopting state aid control legislation; (b) setting up a state aid monitoring agency with adequate capacity; (c) increasing transparency by preparing and disclosing an inventory of “Existing State Aid Programs”; (d) based on the results of the assessment, devising and ensuring implementation of a strategy to eliminate aid with a potentially distorting effect on competition. 24. Progress towards stronger market contestability should be sustained. While the competition law and the Competition Authority are overall very effective, the following additional measures could be implemented: (a) clearly delineating the responsibilities of the competition authority and sector-specific regulatory bodies; (b) speeding up the adjudication of cases under appeal; and (c) establishing de minimis principles for exempting agreements involving only small companies. Antidumping laws could be replaced with competition laws to deal with potentially predatory dumping, while accelerating transposition of the EU competition Acquis, and enhancing the capacity to enforce the EU rules in competition policy and state aid. 25. On top of credible preparation for EU accession and a strong commitment to reform, increasing attractiveness to FDI will be facilitated by more targeted initiatives. In addition to improving product market regulations and the investment climate, attracting FDI will require full implementation of the existing FDI legislation. Elimination of FDI restrictions in some sectors (including civil aviation, maritime transport, mining, and energy), would also send strong signals to the business community. Attracting FDI through promotion and foreign investment policy advocacy is an important complementary measure, and the performance in this respect of General Directorate of Foreign Investment of the Undersecretariat of Treasury should be evaluated against international best practice and necessary follow up measures be taken. Expanding Employment—the Labor Market Reform Agenda 26. Labor market performance is a concern as Turkey prepares for EU Accession. Employment grew by less than 1 percent per year over the past decade, far less than what is needed to provide jobs to Turkey’s rapidly growing labor force. Output growth has not been fast enough to create needed jobs, but also Turkey has not translated output growth into job creation as well as most other countries. The employment elasticity of growth, especially in services, has been at the low end of comparators. The employment rate in 2004 was 46 percent, far from the “Lisbon agenda” target for 2010 of 70 percent. Creating enough job opportunities at home and reducing the large pool of unemployed workers would alleviate concerns about potentially large labor flows out of Turkey, seeking work in Europe, and would greatly support Turkey’s bid for EU membership.

27. The reform agenda to accelerate job creation is multifaceted. Some essential elements rest outside the labor market—for example, a sound macroeconomic environment and a pro-growth investment climate. However, a number of critical factors fall within the ambit of the labor market, including regulation, labor institutions, active and passive programs, labor costs, and workforce development. Recent initiatives, including the 2003 Labor Code, have brought Turkey’s labor market framework into closer alignment with EU requirements. While the labor market reform agenda goes well beyond the Acquis, more changes will still be needed for full Acquis alignment. These generally represent useful reforms for achieving a more efficient and equitable labor market but some of the reforms will require careful design and implementation in order not to work against the job creation objective. 28. The underlying policy principle for labor market reform should be to shift protection from jobs to workers. More flexible rules for severance pay requirements and flexible contracting would encourage employment creation, especially in the formal sector—with women and young people the main beneficiaries. As more flexible job security rules are put in place, better protection for workers would need to be provided through less restrictive eligibility requirements and higher benefit levels of the unemployment insurance (UI) system. Improved capacity to implement cost-effective active labor market programs would also be needed. Changes to the UI system would be facilitated by the strong financial position of the UI Fund, but should be designed with a view to preserving the Consolidated General Government’s strong fiscal position. 29. The “tax wedge” on labor income is high, hampering job creation in the formal sector. Turkey’s personal-and-payroll tax burden on workers with dependents is the highest compared to all EU countries. Low-wage workers face a relatively high tax wedge regardless of their family situation. Solid evidence does not exist to confidently assess how much these taxes are constraining employment in Turkey. The strategy should be to successfully implement social security reforms, to generate a surplus that could fund significant payroll tax cuts in the future. Regardless of the employment impact, reducing payroll taxes and strengthening tax collection and inspection would bring more workers into the formal labor market and social protection system. Financial Sector Development 30. Resolute reform steps have been taken since the 2000/2001 financial crisis but the contribution of the financial sector to efficiency and growth remains uneven. Between 1997 and 2002, 20 banks were taken over, the bank supervisory system strengthened, and public banks were restructured and recapitalized. Turkey’s financial sector provides a good payment system and has efficiently mobilized savings, but the mobilized funds have historically not been supporting private sector investments and have instead been largely invested in few large firms and in Government securities. 31. A multi-pronged financial sector reform agenda lies ahead. The three large state banks, which required fiscal outlay of US$ 22 billion (15 percent of 2001 GDP) in

the aftermath of the financial crisis, are yet to be sold to private investors. The supervisory frameworks are still in the process of building capacity while adapting to the EU directives and Basel II requirements. The credit markets, which to a great extent remained dormant during the time of economic volatility, need institutional support in the areas of auditing and accounting, credit information system, collateral regime, enforcement of contracts, as well as more sector specific reforms, for instance in the mortgage market. Financial intermediation is also distorted by transaction-based taxes, which should be abandoned. A sound regulatory system, good accounting and auditing, credit information infrastructure, collateral registry and regime, contract enforcement and an effective judiciary will be the foundations for a sound and efficient financial sector. Some reforms are directly required by the EU, others are indirectly necessary, and yet others should be pursued by the objective of facilitating sound financial sector development. By pursuing such reforms, Turkey has the prospects for a vibrant financial sector that will provide a key pillar for more broadly developing the private sector by allocating credit in a more sound and efficient manner. Fostering Technology Adoption, Innovation, and Skills 32. Harnessing the knowledge factors—technology absorption, innovation, quality standards and labor skills—is critical to promote TFP growth and improve the country’s capacity to cope with competition in the EU single market. Despite some recent improvements, such as the surge in FDI in 2005, Turkey lags behind comparator countries on many indicators in the knowledge areas, including Greenfield FDI and importing of capital goods, R&D, patents, access to finance for start up, university/firm collaboration, and use of quality standards by labs and firms. Skilled workers that can match the need of the private sector are also in short supply. 33. The reform agenda to improve technology adoption and innovation encompasses both cross-cutting regulatory reforms and strengthening of institutional capacity. Main initiatives include: (i) improving effectiveness of the National Innovation System (NIS), which in turn requires strengthening TUBITAK’s institutional capacity and further improving overall coordination; (ii) reviewing the industrial and intellectual property rights (IPR) legislation to ensure full alignment with EU and international requirements, while improving IPR enforcement by increasing the autonomy of the Turkish Patent Institute (TPE), improving its staff’s capacity, increasing the number of IPR courts and reducing piracy and counterfeiting; (iii) ensuring productive uses of public R&D as institutional capacity to deploy increased resources efficiently is low; (iv) promoting private R&D and access to finance for start ups by assessing effectiveness and fiscal impact of existing R&D tax incentives, matching grants and loan programs and by reducing constraints to development of the venture capital industry; and (v) creating a technology infrastructure that facilitates university/firm collaboration while revising the legal framework to support this collaboration beyond technoparks. 34. Turkey has gone a long way towards establishing a modern quality standards regime, but some further steps should be taken. Suggested reforms include aligning

some sector-specific legislation with Acquis requirements, further progress in adopting food safety and foodstuff legislation, reforming the Turkish Standard Institute (TSE), including assigning responsibilities for testing and certification to a private institution, and increasing Turkish labs’ requests for accreditation and firms’ requests for certification. 35. The skills of the labor force need to be better aligned with the needs of the private sector and the modernizing economy. This will require further reforms of the curriculum for all educational levels to ensure that students can develop the full range of academic, knowledge, and behavioral competencies required for success in the labor market, in further levels of schooling and training, and to serve as a foundation for lifelong learning; providing more flexibility for students to move horizontally between programs and courses at both the secondary and tertiary levels of schooling; promoting greater diversification of higher education institutions across the domains of teaching, research, and service; modernizing the admission system to postsecondary education; and reforming post-secondary vocational schools (MYOs) to ensure that their quality increases and that they provide training that is relevant to local labor market needs. Infrastructure Services for Improved Competitiveness 36. In key infrastructure service areas, Turkey has already made substantial progress in designing the changes to legal and regulatory structures needed to meet EU Acquis requirements. The combination of internal market liberalization and effective integration with international markets offers efficiency gains that will increase competitiveness and employment growth. Although Turkey is relatively well-endowed with infrastructure compared to other emerging economies, it falls short of OECD and EU standards. Businesses are burdened by costly, low-quality backbone infrastructure services. In particular, the cost of telecommunication services and energy remains among the highest in the OECD area. The dominant transport mode, road, suffers from deteriorating road quality. This combination suggests that much can be gained through more efficient, user financed, operations. 37. Promoting growth across all segments of Information and Communications Technologies (ICT) holds the promise of important productivity gains. To promote ICT, continued efforts to liberalize the ICT market should head the reform agenda. This will be particularly important further to the privatization of Turk Telekom, to ensure that market power over bottleneck facilities do not impede the development of competition. Reducing high and potentially distortionary excise taxes on mobile phone services would also help. The transposition and effective implementation of the Acquis for electronic communications, well before EU accession, would speed ICT diffusion. The government can also play a vital role through its procurement of ICT, both by fostering more intense competition in and encouraging the aggregation of demand for certain goods and services to bring about lower prices. 38. Challenges facing the transport sector go well beyond alignment with the Acquis. Turkey needs to develop a sustainable model for road sector financing,

especially to meet maintenance needs, while a shift is needed between the various modes of transport, especially for gradually transferring the transport of freight from the roads to the railways. On the regulatory front, steps have been initiated, and need to be carried forward, for alignment with road transport legislation; railways and air transport (particularly air safety and air traffic management); and maritime safety. The rail system has been a major drain on government fiscal resources and ongoing restructuring efforts of the Turkish State Railways should be pursued. Plans for port privatization should be designed carefully, by implementing an adequate regulatory framework for concessions and ensuring effective regulatory capacity. 39. Ongoing restructuring efforts of the energy sector will need to go in tandem with liberalization and adequate regulation to lead to more competitive, higher quality supply. Power prices are higher than those faced by average EU users and the tariff structure creates a cross-subsidy to households from businesses that cannot be sustained under the EU acquis. In the gas sector reform initiatives are in the right direction but should be fine-tuned. Moving to competitive gas wholesaling, which is established policy in the EU, and now explicitly called for in Turkish legislation, is important for promoting the efficiency of the sector.

Promoting inclusive growth Agriculture and Rural Development 40. The reform of agricultural subsidies through the non-distortionary Direct Income Support is a valuable start towards promoting efficiency, but indirect subsidies to producers, through trade protection, is still high. With reform of most budgetary subsidies for agricultural outputs and inputs and substitution by a Direct Income Support program, the overall level of support (comprising both direct subsidies and indirect support through trade protection) remains about 10-15 percent below that of the EU. However, continually high import tariffs on agricultural commodities and non-trade barriers have kept agricultural prices high, with 22 percent of consumers’ food expenditures an indirect subsidy to agricultural producers—roughly on par with the EU-25. 41. Eventually, full alignment with CAP would entail a decrease in tariff protection, but also free market access for exports, while direct subsidies will have to be aligned with a moving CAP landscape. As producer prices for many commodities are comparable to (often higher than) those in the EU, while EU external tariffs are on the decline, alignment of indirect subsidies through trade protection with CAP is expected to reduce prices and value of production for several products. However, because the structure of CAP keeps evolving, it is uncertain that upon accession CAP budgetary transfers could increase by enough to offset the expected decline in EU agricultural trade protection. Free EU market access for Turkish agricultural and food exports will act as a countervailing factor, with the potential of boosting agricultural output but also entailing structural change in production.

42. On current CAP structure and EU trade policies, Turkish agriculture is poised for growth as a result of EU accession. Simulations of the long-term impact of EU accession, based on a general equilibrium model, suggest that free market access into the EU could generate an increase in demand that would support significant long-term growth of the agricultural and food sectors in Turkey. Moreover, net exports of agricultural and food products are also projected to increase, despite the decrease in tariff protection. Net fiscal savings are also expected as a result of domestic support to agriculture being funded by the CAP—and despite the expected drop in tariff revenues from agricultural imports—of an estimated 0.9 percent of GDP. The extent to which farmers can switch across crops will underpin the potential gains from accession. 43. Because the CAP landscape is moving, alignment of tariff protection with the EU external tariffs should proceed throughout the accession period. It is uncertain that, upon Turkey’s EU accession, large enough budgetary transfers from CAP would become available to offset lower indirect subsidies from reduced tariffs on imports of agricultural commodities. Turkish agricultural policy during pre-accession should thus aim at gradually reducing tariffs so as to converge to EU levels prior to accession and avoid any sharp falls in prices and contractions in agricultural income. Consumers would benefit as food expenditures would decline. At the same time, government budget support for agriculture should remain more focused on non-market distorting instruments to ensure efficiency. 44. The dual challenge is to support adjustment to structural changes in agriculture and promote rural development off-farm more widely. Analysis of rural spending at the provincial level suggests that targeting may need to be strengthened to better reflect the regional priorities of the government—with the exception of GAP investments. In the years ahead, particular emphasis will have to be placed on coherence of instruments and policy objectives between the agricultural and rural development policies, and of their respective institutional and implementation arrangements, as determined by on-going changes in the CAP. Support to non-farming activities in the services and industry sectors should be given particular attention, with priority on financing of essential infrastructure rather than subsidies. To take maximum advantage of pre-accession funds for rural development, several complementary actions would be needed—elaborating a rural development strategy and an IPARD plan; establishing a Rural Development Agency; strengthening participatory management processes. Policies for Social Cohesion 45. Promoting social inclusion is a major element of meeting the Copenhagen criteria and thus keeping the entire accession negotiation process on track. Turkey has made notable progress in strengthening the social safety-net towards the disadvantaged and vulnerable. Main priorities in the years ahead include: (i) maintaining and strengthening the Conditional Cash Transfer program targeted towards the poorest children; (ii) developing an integrated social policy under one lead ministry, with the aim of improving the monitoring and evaluation of social services and then expanding cost-effective services to underserved population groups; (iii) taking initiatives aiming at

youth empowerment and inclusion; (iv) providing continuous support to female employment, reducing the pay gap and in general integrating women as full equal partners in society. 46. Health care expenditures and outcomes are unevenly distributed. In 2003 Turkey spent around 6.7 percent of its Gross National Income on health, of which public expenditures account for about 70 percent. Per capita expenditure is relatively higher than in countries with similar income levels, while the health system fails to reach the poor and vulnerable sections of society and the health status of the population is well below that of countries of comparable income. There is thus ample room for efficiency gains in public expenditure for health care. Public provision of health is characterized by poor incentives for managers and providers alike, leaving them open and vulnerable to alternative sources of income to augment their salaries. Like financing, the delivery of health care is fragmented, and there is little continuity in the different levels of care. Clinical effectiveness of existing medical interventions and treatment protocols is not always tested and attention to quality and effectiveness of care is uneven. 47. Reforms to contain expenditure should be a necessary complement of the move towards improved access to health care services. Key elements of ongoing reforms that aim at improving equity and access to health services are the introduction of Universal Health Insurance (UHI) and the creation of a health insurance fund that would integrate all flows of funds in the health sector. Unless it is accompanied by cost-reduction and efficiency enhancing measures, the introduction of UHI could lead to higher levels of public expenditure on health in the short run and jeopardize the fiscal sustainability of the system. Emphasis needs to be increasingly on ensuring that the desired access and efficiency outcomes are achieved without any increase in public expenditures on health. Consolidating hospitals, strengthening delivery of health services, separating provision and purchasing of services, reforming provider payment mechanisms, containing outpatient care provided by hospitals, and managing pharmaceutical costs are some of the measures that need to be urgently put in place with due attention paid to sequencing. 48. Policies for enhanced growth and social inclusion encompass large parts of the EU Acquis, but also a broader development agenda. The many areas where the alignment with the Acquis can strongly contribute to reinforcing the economic management framework would deserve particular attention early on in the accession process (e.g., market contestability; services liberalization; financial system supervision). Areas where the scope of the reform agenda goes beyond the EU Acquis, yet are important underpinnings of medium-term growth with better social inclusion, should also receive due attention in the reform agenda. In areas where the EU Acquis is less complementary with economic management, or compliance costs are significant (e.g., environmental protection), reforms could be paced so as to intensify when an advanced stage of the accession process is reached and faster, sustained growth has taken hold. The cost of reforms (fiscal and social) should be appropriately factored in the prioritization of the agenda, as efforts and social consensus to reform would need to be maintained over a long time. Structural reforms with low fiscal cost and public finance reforms that create

needed fiscal space for more costly initiatives in the future would thus merit to be prioritized.

PART A: POLICY AND INSTITUTIONAL FRAMEWORK FOR CONVERGENCEWITH THE EUROPEAN UNION

CHAPTER 1. UNLOCKING TURKEY’S POTENTIAL FOR GROWTH AND PREPARING

FOR EU ACCESSION

1.1 Commitment to sound economic policies since 2001 has placed the Turkish economy in a good position to embark on a sustained path of faster growth. Progress has been achieved in reducing inflation and real interest rates, improving public finances, restructuring the financial sector, improving the business environment, and reforming the public sector. Key markets have been liberalized and regulatory capacity in the economy has been strengthened. The process of European Union (EU) accession is expected to provide an anchor for the continuation of the reform process in the years ahead, and contribute to increasing Turkey’s growth potential and improving convergence prospects to the EU average. At the same time sustained high growth rates would enhance prospects for Turkey’s eventual membership by accelerating income convergence between Turkey and the EU. This chapter looks into Turkey’s prospects for achieving faster growth during a sustained period of time, so as to start closing the income gap with the EU-25 average.

1.1. FROM CRISIS TO STABILITY

1.2 A strong recovery has taken hold since 2002, while inflation has been reduced to single digits. Following the 2001 crisis, the Turkish economy rebounded very strongly and was one of the fastest growing economies in the world in 2004. Annual growth averaged 8 percent during 2002-2004 and a 5 percent growth rate for 2005 seems well within reach. Inflation has come down to single digits in 2004 (9.3 percent) for the first time in the last 35 years, greatly facilitating the reduction in interest rates. Inflation continued to decelerate in 2005 (7.7 percent) and realized below the year-end target of 8 percent despite soaring oil prices. Rapidly rising labor productivity, amounting to 23 percent for the whole period 2002-2004, has underpinned strong growth. Thanks to improved competitiveness exporters have penetrated into new markets, while the composition of exports has changed towards more high tech products, such as automobile, electrical and electronic equipment and machinery. However, despite strong growth for three consecutive years, high unemployment continues to persist, at an estimated 10.1 percent on average in the first three quarters of 2005, only marginally down from 10.4 a year before. 1.3 The current account deficit has also widened. The current account deficit reached 5.2 percent of the GNP in 2004 and continues to remain a cause of concern, especially as the imported energy bill gets inflated with the spike in the price of oil in

2005. The current account deficit is projected to reach 6 percent of GDP in 2005, boosted by the imported energy bill, which could increase by an estimated 1.5 percentage points of GDP for the year as a whole. Turkey had no difficulty in financing the large current account deficit and foreign reserves rose to the equivalent of 5.2 months of imports in 2005. However, short-term capital continues to be a significant part of these flows. Thanks to stepped up privatization efforts—but also increased appetite of foreign investors for acquisitions of Turkish companies and especially banks—FDI in 2005 has boomed and reached $9.6 billion on a cash-flow basis (2.6 percent of GDP). This is a notable improvement compared to past performance, when FDI inflows remained compressed to less than 1 percent of GDP, despite strong worldwide growth. 1. The macroeconomic policy framework has been considerably strengthened. The policy mix followed since 2002, based on tight fiscal and monetary policies and a flexible exchange rate regime, has proven to be expansionary as it increased confidence in the markets and enabled a lower risk premium on Government bond interest rates. The Central Bank of the Republic of Turkey (CBRT) gained independence in 2001 and price stability was set as its primary objective. Monetary policy followed a path of implicit inflation targeting since 2002, facilitated by a resolute effort at fiscal consolidation that eased fiscal dominance over the conduct of monetary policy. The floating exchange rate regime allowed the Central Bank to focus on price stability and freed it from the constraint of following many targets at the same time. Strong fiscal performance has been the cornerstone of the economic program. There has been a strong improvement in the public sector primary balance, which moved to a surplus of 7 percent of GNP by 2004 from a deficit of -1.6 percent in 1999. Resolute fiscal consolidation enabled a reduction of gross public debt to GDP ratio, from 108 percent in 2001 to 77 percent in 2004 (64 percent on a net basis). Nevertheless, as further explained in chapter 2, risks continue to exist, due to the still high level of debt and its maturity and currency composition. Improving the quality of fiscal adjustment is an important challenge in the years ahead, to ensure its sustainability and make room for growth-enhancing expenditures and lower taxes.

1.4 Fiscal consolidation has laid the groundwork for the upcoming introduction of explicit inflation targeting—which has the potential to deliver superior results if implemented with reasonable flexibility. The CBRT will be operating an explicit inflation targeting regime as of January 2006. Evidence from developing countries suggests that adoption of inflation targeting delivers better results in terms of lower and more stable inflation, as well as lower volatility of nominal exchange rate and real interest rates (IMF, 2005). The traditional problem faced by inflation targeting regimes is a fiscal stance that is too expansionary to be compatible with stable debt-output ratios and low inflation. Although vulnerabilities remain, if the primary surpluses of 2004/2005 can be maintained, policy inconsistency will not be an issue for switching from implicit to explicit inflation targeting in Turkey. However, flexibility seems to be the preferred option in the implementation of inflation targeting, until the fiscal program is more firmly established and external imbalances are reduced. The approach adopted by the CBRT allows for reasonable flexibility, by attaching a tolerance band of plus or minus 2 percentage points around the headline CPI program target. Additional options may

involve using an inflation target zone based on inflation forecasts over a longer time period (for example, 18 months to two years). Although targeting the “headline” CPI has merits in terms of simplicity and communication, setting an appropriate core inflation target, to avoid reacting to excess volatility in case of recurrent supply-side shocks, could also be an option.

1.2. RE-ENERGIZING THE ENGINES OF LONG-TERM GROWTH

(a) Sources of long-term growth

1.5 High and chronic inflation, large public deficits, frequent current account crises, and rising debt have been main impediments to growth in the past. Long-term growth has been relatively slow, with average annual per capita income growth in 1970-2003 at two percent—less than half of per capita growth in the emerging economies of East Asia, and closer to growth seen in Latin American countries. Transition economies in Eastern and Central Europe that joined the EU in 2004 grew much faster than Turkey in 1993-2003. Volatility in the Turkish economy has been high in international comparison. Estimations for Turkey show that higher output volatility adversely affects both TFP growth and the investment ratio. There is evidence that growth volatility also leads to real depreciation in the exchange rate, which might be triggered by heightened uncertainty and resulting capital outflows.

Figure: 1. 1 Annual Average Per Capita GDP Growth and its Decomposition

Contributions to Annual Average Per Capita GDP Growth1980-2003

GBR AU

USA FI

NLD IT

BEL IS

ALP EMP WORK GDP P CAP

1.6 Slow labor productivity growth and declining labor utilization accounted for lackluster long-run growth performance, particularly in the 1990s. Poor performance in employment generation has put Turkey behind many fast growing countries. While labor productivity and working age population in proportion to total population increased by 2.8 percent and 0.7 percent on an annual basis during 1980-2003 respectively, the employment ratio declined by 1.4 percent per year. Slow employment generation has held back long-run potential growth in Turkey (Figure 1.1). Labor productivity growth slowed to around 1.5 percent in the 1990s, mainly due to recurrent crises, contributing to a further slowdown of potential growth. In the years ahead Turkey faces the twin challenge of sustaining fast labor productivity growth, combined with accelerated employment generation. Policy options to promote productivity growth in the business sector and accelerate job creation are examined in part B of the study. 1.7 Drivers of labor productivity growth have varied over time depending on the policy regime. Analysis of contributions to labor productivity growth points to the following stylized facts (Table 1.1):

• In the high protection environment of the 1970s, productivity growth was driven by fast capital accumulation, despite low production efficiency, as evidenced by negative total factor productivity growth.

• Patterns reversed in the 1980s, further to economic liberalization, with much faster labor productivity growth, driven by a surge in TFP growth, which more than offset slower capital accumulation.

• The onset of macroeconomic instability in the 1990s has been associated again with slower labor productivity growth. The decrease in labor productivity growth during the 1990s is fully accounted for by slower TFP growth.

Table: 1. 1 Sources of labor productivity Growth in Turkey, 1973-2003

Growth in labor productivity

Contribution of capital deepening2

Contribution of Human capital

Contribution of TFP growth

1973-1980 1.89 2.15 0.36 -0.62 1981-1990 3.13 0.80 0.52 1.81 1991-2003 1.93 1.04 0.37 0.52

Source: World Bank staff estimates 1.8 Stronger TFP growth will be the key to sustained growth and accelerated convergence in the years ahead. There is certainly room for faster labor productivity growth to be fuelled by higher investment, in view of Turkey’s investment ratio gap compared to other fast growing economies. Moreover, improving educational attainment will contribute to productivity growth, as Turkey has one of the lowest levels of schooling in the working age population among a group of fast-growing comparator countries (see vol. II, Figure 1.10). However, there is a limit to the contribution of these two factors to growth. Stronger TFP growth will thus be the prerequisite for accelerated growth in the future, as also suggested by the experience of other new EU members that have embarked on steep convergence paths (especially Hungary, Poland, and Slovenia).3 Consolidating and further strengthening the sound macroeconomic foundations laid out over the past three years will be an overarching factor for faster TFP growth. Reforms in product markets (discussed in detailed in chapter 3), policies geared towards improving innovation capacity and labor skills (discussed in detail in chapter 6) as well as infrastructure (discussed in detail in chapter 7) are also very important for promoting faster growth of TFP across sectors. In addition, horizontal reforms that promote financial sector development and the efficient allocation of credit to most productive activities will greatly contribute to TFP growth. 1.9 Evidence points to increased trade openness and greater financial depth as pillars for strong TFP performance in Turkey. Turkey’s trade openness, as measured by the sum of exports and imports over GDP, sharply increased between 1993 and 2003, from 33 to 59 percent and has supported efficiency of the modern business sector in a difficult macroeconomic environment. Turkey ranks high in terms of trade in goods, in particular when country-specific characteristics are taken into account. However, there is 2 Capital stock data is taken from Cihan, Saygili and Yurtoglu (2005). 3 Doyle Peter, Kuijs Louis. And Guorong Jiang (2001), Real Convergence to the EU Income Levels: central Europe from 1990 to the long term, IMF Working Papers 2001/146.

still considerable unrealized potential for exports in (non travel) services. There is evidence that increasing the level of financial development will enhance productivity, besides ensuring smooth financing of productive investment. As further explained in chapter 5, Turkey has now put the banking system on a more sound footing, but still needs to increase financial depth, liquidity of markets, and diversify the sources of finance. Moreover, bank credit to the private sector as a ratio of GDP is quite low and far below the EU average. 1.10 Turkey’s trade integration into global markets for goods has significantly expanded and the level of processing in Turkey’s trade has improved. Exports of capital and transportation equipment and automobile parts have dramatically expanded while their imports have kept up with the overall growth of total imports. The expansion in exports of more processed goods took place in highly demanding and competitive Pan-European markets. The most visible change in Turkey’s EU-oriented exports has been a shift away from low tech, unskilled labor intensive operations towards medium and high technology products. The share of skilled labor and capital intensive products in Turkish total exports increased from 29 percent in 1996 to 43 percent in 2003. Skilled-labor and capital-intensive exports as a share of Turkey’s total exports is now comparable to that of new EU members before the start of their accession process in 1996. The shift towards exports embodying higher levels of technology and using skilled labor has been facilitated by the entry of Turkish-based firms into ‘producer-driven’ networks. With the right framework in place, increasing trade openness could further boost growth in the years ahead. However, sustainability of exports of capital and skilled labor intensive products hinges on availability of high-quality human capital to avoid bottlenecks from the supply side. It also depends on firms’ absorptive capacity of new technologies, which is affected by the overall regulatory framework in product markets (see chapter 3). 1.11 The contribution of services to economy-wide labor productivity growth has been losing momentum. Trade liberalization and companion reforms had a much stronger impact on industry, where efficiency gains and TFP growth became the single most important factor of labor productivity growth. However, labor productivity growth in services has turned almost stagnant, owing to low efficiency and negative total factor productivity growth.4 Slow liberalization in some key trade-related services during the 1990s (Transport, ICT) may have contributed to slow TFP growth. Moreover, the high level of informality in services is holding back overall efficiency and TFP growth. With services now accounting for 57 percent of GDP (in constant prices) and 48 percent of total employment, it would be very difficult for Turkey to accelerate growth for the economy as a whole without a concomitant acceleration of TFP growth in services. As further explained in the following chapters, some complementary initiatives would include:

• further regulatory reforms to open services market to competition; • more widespread use of ICT in services;

4 Note that despite increasing size of services in the economy, its contribution, when adjusted for its size, declines overtime and suggests a slowing trend of labor productivity growth in the services sector compared to industry.

• constant adaptation of education and training policies to changing requirements for new skills; • reform of labor market policies and regulations with a view to facilitating employment creation and adjustment while promoting more flexible forms of work and formalization.

(b) Ensuring growth with external sustainability

1.12 Sustaining faster growth will depend on how well the economy can escape out of the boom-and-bust cycle of the past. Maintaining a high investment rate is a necessary condition for long-term accelerated growth. However, in the absence of sufficient domestic savings—as it has often been the case in the past—greater investment would risk being reflected into a larger current account deficit. This would pose risks for financing and external debt sustainability, unless non debt-creating foreign savings are available in the form of foreign direct investment. Turkey had no difficulty in financing the increasing current account deficit since 2003. However, a significant part of these flows continue to be short-term capital.5 Large capital inflows have also contributed to substantial real effective exchange rate appreciation since the end of 2002. 1.13 The large external current account deficit is of concern for the sustainability of fast growth, and raises challenges for both macroeconomic and structural policies. Although a high energy bill has inflated the current account deficit in 2005, the continuing strong growth of domestic demand, and in particular of investment in the face of still weak domestic savings, underpins existing current account tensions. With strong fiscal consolidation achieved so far and a flexible exchange rate regime in place, Turkey is in a much better position to face current account imbalances than in the past. However, as further explained in chapter 2, a sudden depreciation of the exchange rate remains a source of vulnerability. Because of the still large foreign-exchange linked component of the public debt, and the increase in real interest rates that a significant depreciation of the exchange rate may entail, the currently declining path of the debt to GNP ratio could be interrupted, with a negative impact on medium-term growth. Thus, as strong growth of domestic demand is likely to persist in a fast-growth scenario, preserving current account sustainability raises a simultaneous challenge for both macroeconomic and structural policies. 1.14 On the macroeconomic front, it is important that fiscal discipline be continuously maintained through a high primary budget surplus to ensure needed mobilization of domestic savings for the financing of investment. Moreover, a sufficiently tight fiscal stance would be needed to support monetary policy in the context of the upcoming introduction of explicit inflation targeting. Without support from fiscal policy in forestalling domestic demand pressures, monetary policy would have to rely on high short-term real interest rates to keep disinflation on track, with the risk of further

5 About 53 percent of total net inflows (excluding IMF credits and official reserves) were in the form of short-term flows in 2004, but this ratio declined to 41 percent in 2005.

appreciating the currency and damaging the external balance as well as increasing the cost of borrowing in domestic markets for the Treasury. 1.15 With continuous fiscal discipline as a precondition, structural reforms to promote FDI, energize domestic savings, and liberalize key services markets, would greatly help ensure external current account sustainability in the medium term. Strengthening the investment climate, by complementary reforms further analyzed in chapters 3, 4, 5 and 7, is not only a condition for higher private investment and faster growth, but also for attracting foreign savings in the form of foreign direct investment and thus for ensuring the sustainability of growth. Better mobilization of domestic savings will be also needed—partly through sustaining the fiscal consolidation effort, and partly through greater mobilization of domestic private savings. Empirical analysis, based on a panel of 70 countries, including Turkey, suggests that fiscal policy, growth, financial sector development, and demographics are key factors that affect private savings. Continuing liberalization of product and service markets, through early alignment with the EU acquis and further strengthening of competition policy, would enable competitive cost reductions, especially in non traded services, which would accelerate disinflation. This would possibly allow a policy mix with an easier monetary policy stance, and would thus prevent currency appreciation induced by persistently high interest rates.

1.3. FAST INCOME CONVERGENCE WITH THE EUROPEAN UNION IS FEASIBLE BUT WILL NOT BE SPONTANEOUS

1.16 The speed of convergence will depend on the pace of structural reform. Convergence is not spontaneous and depends on many factors—especially on the quality of policies and institutions. The EU accession process can provide opportunities to Turkey for speeding up its convergence with the EU. However, faster growth for a sustained period of time is usually underpinned by a well-functioning legal, administrative and physical infrastructure, and a stable macroeconomic and political environment. Also the experience of EU cohesion countries suggests that benefits of EU integration are not guaranteed—they are contingent on the quality of the policy framework and the reform momentum.

Figure 1.2 GDP Per Capita Relative to EU15

Czech Republic

Estonia

Hungary

LatviaLithuania

Poland

Slovak Republic

Slovenia

Turkey

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

1.17 Contrary to comparator countries, Turkey missed the opportunity to achieve convergence over the past decades. Per capita income in Turkey relative to the EU15 hovered at around 25 percent since 1975. However, EU cohesion countries, some fast-growing Asian countries, and the Eastern European transition countries that joined the EU in 2004 achieved significant per capita income convergence vis-à-vis the EU15 countries (Figure 1.2). Turkey is now in a better position to break free from the past stop and go growth cycles and achieve convergence with the EU. However, there could be broad range of possible convergence outcomes.

How much and how quickly Turkey can actually benefit from EU integration will depend on how much efforts Turkey will put in continuing to implement reforms as well as extending the scope of structural reforms. 1.18 In a base-case scenario, Turkey can resume per capita income convergence with the EU by implementing sound economic policies backed by structural reforms. In a base-case scenario it is assumed that Turkey continues to implement current sound macroeconomic policies envisaged in the latest IMF Stand-By agreement and Pre-Accession Economic Program of the government, secure strong fiscal balances and consolidate the structural reforms initiated so far. Under this scenario, it is estimated that the per capita income in Turkey would increase from 29.1 percent of the EU25 in 2004 to 34.2 percent of the EU25 by 2015, giving rise to some but not substantial convergence (Table 1.2 provides a summary of growth scenarios). 1.19 However, Turkey can do better by implementing more ambitious and mutually reinforcing structural reforms. In a high-case scenario it is assumed that, while preserving macroeconomic stability, Turkey broadens the scope of structural reforms in a number of priority areas—further reviewed in the following chapters—including labor markets, public sector governance and public service delivery, corporate governance and commercial judiciary; reinforces the implementation of the reforms; supports productivity enhancing and technology creating activities such as research and development, FDI inflows and competition in the product and factor markets particularly in the services sector. Under this scenario, it is estimated that per capita income in Turkey would increase from 29.1 percent of the EU25 in 2004 to 40.4 percent of the EU25 by 2015. 1.20 Downside risks should not be disregarded. Turkey has been reforming its economy since the 1980s and international experience suggests that in the absence of tangible results, reform fatigue may become prevalent and the reform process might be suspended. Moreover, the accession negotiations are likely to continue for a long time, with possible turbulence expected during the process. Despite improvements and the resilience of the Turkish economy, the high level of public debt and its structure, as well as the widening current account deficit can magnify the incidence of “ups and downs”. Under such circumstances, characterizing a low case scenario, per capita income in Turkey would merely increase from 29.1 percent of EU25 in 2004 to 30.1 percent of the EU25 by 2015. 1.21 Income convergence can be accelerated by productivity-driven real exchange rate appreciation. Healthy productivity growth under the base- and high-case scenarios should lead to real appreciation in the Turkish lira.6 This would allow per capita income in Turkey to reach 38.1 percent of the EU25 under the base-case scenario with 1 percent

6 The Balassa-Samuelson effect states that an increase in the relative productivity of tradables versus non-tradables of one country compared to other countries induces an appreciation of the real exchange rate. Balassa, Bela, (1964), “The Purchasing Power Parity Doctrine: A reappraisal,” Journal of Political Economy, Vol. 72, No.6, pp.584-589. and Samuelson, Paul, (1964), “Theoretical Notes on Trade Problems,” Review of Economics and Statistics, Vol. 46, No. 2, pp. 145-154.

real appreciation per year, and 50.1 percent of the EU25 by 2015 under the high case scenario with 2 percent real appreciation per year (Table 1.2). However, real exchange rate appreciations can support convergence on a sustained basis only to the extent they are productivity-driven. Productivity gains would ensure that real exchange rate appreciation remains consistent with maintaining competitiveness of exports and of domestic production against imports. External current account sustainability could thus be preserved. Moreover, when the real exchange rate appreciates, upward price pressures may be felt in the non-tradable sector (in particular in services), as a result of increasing disposable income and consumer spending. Offsetting such pressures would require an appropriate framework for competition policy and regulatory reform with a view to liberalizing key services markets. 1.22 Maintaining continuing fiscal discipline is a precondition for sustained growth—especially if the real exchange rate were to appreciate on the way to the EU. With domestic savings projected to increase in step with investment in the base-case scenario, as mentioned earlier, pressures on the current account deficit would subside. With the EU accession process proceeding on track, increasing inflows of foreign savings, in the form of FDI, would provide needed, non debt creating, financing. However, the projected decline in the public sector deficit in the years ahead—as a result of continuing fiscal discipline and lower interest payments on public debt—is a key pre-condition in this scenario. If the decline in the public sector deficit failed to materialize, growth in domestic savings would fail to match the increase in domestic investment, and the current account deficit would increase to unsustainable levels—inconsistent with stable growth. It is thus important that fiscal discipline be preserved by maintaining a high primary budget surplus in the years ahead. Despite the projected decline in public debt as a proportion to GDP (see chapter 2), the fiscal room from lower interest payments on the public debt should not be used for increasing spending or lowering taxes until conditions for current account sustainability have been secured. 1.23 Experience from European Union countries suggests that fast income convergence for Turkey is feasible. The speed of convergence (the percentage of the income gap closed per year) has been significant in both the EU cohesion countries and the new member countries (Table 1.2). The estimated convergence speeds for Turkey are in line with the experience of the European countries. Although estimated speeds of convergence for Turkey are at the middle or lower bound of the observed speeds for other countries, it must be taken into account that Turkey has faster population growth relative to others—a factor that tends to slow down convergence of per capita GDP.

Table: 1. 2 Income gaps to EU average and speed of Convergence

1995 2003

New EU Members

Per capita income in % of EU15 average with constant 2000 PPP

rates β = Speed of Convergence Czech Republic 57.7 61.1 1.1 Estonia 32.8 50.5 3.8 Hungary 45.7 54.4 2.2 Latvia 25.3 38.3 2.4 Lithuania 30.9 43.7 2.5 Poland 35.6 42.5 1.4 Slovak Republic 43.2 50.4 1.7 Slovenia 61.3 71.5 3.8

Cohesion Countries (with constant 2000 PPP rates)

Per capita income in % of EU15 average with constant 2000 PPP rates Greece Ireland Portugal Spain

1975 57.8 1981 80.8 1986 59.6 73.0 1995 64.7 2003 74.5 141.0 67.7 83.6

β = Speed of Convergence -1.21, -4.22, 4.03 -na 1.3 2.9

Turkey

(Per capita income in % of EU25 average with constant 2003 PPP rates) 2004 2015 β = Speed of Convergence Base Case 29.1 34.2 0.8 High Case 29.1 40.4 1.5 Low Case 29.1 30.1 0.1

The number of years required for Turkey to close half of the income gap would be 86

years under the base-case and 46 years under the high-case scenarios Turkey ( with real exchange rate appreciation) 2004 2015 β = Speed of Convergence Base Case 29.1 38.1 1.0 High Case 29.1 50.1 2.6 Low Case 29.1 30.1 0.1

The number of years required for Turkey to close half of the income gap would be 69

years under the base-case and 27 years under the high-case scenarios

Source: World Bank Staff 1: 1981-2003 2: 1981-1995 3: 1995-2003 1.24 On the way to the EU Turkey needs to address the simultaneous challenge of faster growth and regional convergence. Large regional disparities in development bring about a range of risks, from uncontrolled migration and socio-economic pressures in urban centers, to environmental issues. Regional income disparities are broader in Turkey compared with the new EU members and acceding/candidate countries. With the ratio of per capita income in the richest provinces to that in the poorest at 6.9, Turkey

stands out as a country with large regional disparities by international comparison.7 Internal migration has been extensive during past decades and would have been expected to somewhat contribute to bridging the gap in per capita income across regions. However, past trends reveal absence of convergence in regional per capita income, because GDP has been growing much faster in rich than in poor regions. As a result, since the late 1980s, the share of income accruing to the 25 percent of the population living in the poorest provinces has failed to increase. Faster growth of backward regions would thus contribute not only to reducing disparities, but also to faster growth of the economy as a whole. Turkey will benefit from significant amounts of “pre accession funds” during EU accession, and the challenge will be to make best possible use of these financing instruments to promote regional development—as further analyzed in chapter 8 regarding use of funds for rural development.

1.4. POLICY COORDINATION FOR ENHANCED GROWTH AND MANAGEMENT OF EU ACCESSION: THE ACQUIS AND BEYOND

(a) Policy prioritization during EU accession

1.25 Turkey could take advantage of the EU accession process as an anchor for reform and macroeconomic stability Some of the challenges facing Turkey are long-term in nature, but because the reform agenda is complex, the efforts have to begin early on. Other challenges, especially related to the quality of the business environment, could be met over the medium term by strong efforts to align early on with the EU Acquis. It is in Turkey’s interest to place particular emphasis during the accession period on the many areas where the alignment to the Acquis can strongly contribute to reinforcing the economic management framework. In areas where the EU Acquis is less complementary with economic management, or compliance costs are significant (such as, for example, in harmonization of environmental regulations), reforms could be delayed until an advanced stage of the accession process is reached and faster, sustained growth has taken hold. 1.26 —but it is also important that the broader reform agenda—beyond alignment with the Acquis—be appropriately prioritized. Despite their different time dimensions due to the policies and institutions that need to be changed, many reform areas are highly complementary and mutually reinforcing.8 Reform areas where policy complementarities are strongest should be prioritized, to maximize the benefits from the reform process and avoid the pitfalls of a piecemeal approach. In addition, to take advantage of policy

7 In the new EU members and acceding countries this same ratio was much lower, ranging from 1.7 in Bulgaria to 2.2-2.3 in Poland and Hungary, and 2.8-2.9 in the Czech Republic and Romania (Eurostat data). 8 For example: reforms of product market regulations to strengthen the investment climate may not yield full benefits in terms of job creation unless complemented by reforms to improve labor market flexibility; reforms to ensure financial sustainability of the pension system usually underpin initiatives to reduce the non wage costs of labor, which in turn helps combat informality and further strengthen the viability of the social security system. For further analysis see J. Braga de Macedo and J. Oliveira Martins, (2005).

complementarities, reforms that go beyond the EU Acquis, yet are important underpinnings of Turkey’s medium-term growth prospects and broadening of social inclusion, should become prominent in the reform agenda. The cost of reforms (fiscal and social) should also be appropriately factored in the prioritization of the agenda as the social consensus to reform would need to be maintained over a long time. Structural reforms with low fiscal cost, and public finance reforms that create needed fiscal space for more costly initiatives in the future, would merit to be prioritized. A detailed set of reform options and sequencing is presented in the policy tables in the beginning of the study. 1.27 The experience of the new EU members could provide useful insights on the prioritization of reforms to successfully manage the accession process— The amount of time spent for negotiating each of the 29 Acquis chapters, and the selection of chapters to begin with, was not uniformly distributed among EU acceding countries. Moreover, the whole process took longer in some countries than in others.9 For the purposes of the analysis, negotiation of the EU Acquis chapters has been categorized into “up-front”, “medium term”, and “deferred”, based on the average length of time between the opening of EU accession negotiations and the closing of each chapter—as a percent of the length of the negotiation period for each new EU member (Table 1.3). Differences in the negotiation pattern of the various chapters could partly reflect the approach adopted by the parties, and partly difficulties inherent in the respective policy areas. In addition, some chapters require more financing efforts for alignment than others. It must be underscored that the observed pattern does not necessarily reflect any strategically optimal prioritization in terms of economic or other type of return to the adjustment. Table 1.3: Negotiation of the Acquis—experience from the new EU members

Up-front Medium term Deferred Small and medium-sized

enterprises Telecommunications Energy

Science and research Economic and monetary union Competition policy Education and training External relations Taxation Statistics Fisheries Transport policy Industrial policy Free movement of goods Justice and home affairs Consumers and health

protection Culture and audio-visual policy Regional policy and coordination of

structural instruments Common foreign and

security policy Company law Agriculture

Social policy and employment Financial and budgetary provisions Freedom to provide services Free movement of capital Financial control Customs union Freedom of movement for persons Environment Note: The chapters in the “up front” category are those negotiated, on average, within the first one-third of the total negotiation period of each new EU member; those in the “medium-term” group have been closed within the first two-thirds; and those categorized as “deferred” have been closed in more than two-thirds of the total negotiation period. 9 The analysis is based on the timetable for the negotiation of the Acquis chapters by the Czech Republic, Estonia, Hungary, Poland, Slovenia, Latvia, Lithuania, and Slovakia. The first five countries started negotiations in March 1998, while the last three in February 2000. Negotiations were completed for all countries by December 2002.

1.28 —although Turkey’s priorities for accession will be affected by different starting conditions, country-specific factors, and the need to ensure effective compliance with the EU Acquis. Turkey is in a different position than the new member countries when they started negotiations, because a Custom Union with the EU has been in place since 1996; a longer relation with the EU has been effective since the 1960s, while the economy is not facing the challenges of the transition to the market that new EU members were still facing in the mid-1990s. Turkey has already achieved significant alignment in some chapters, so that under normal circumstances negotiation of these chapters could be quickly completed. However, Turkey can still draw lessons from the recent accession experience of the new member countries. In addition, some chapters involve economic, political or technical difficulties and there fore are likely to stay at the negotiation table longer irrespective of the level of current alignment. In the case of Turkey, the negotiation pattern will also be influenced by the need to demonstrate effective compliance with the Acquis before each chapter could be declared closed.

(b) Policy coordination on the way to the EU

1.29 Strengthening policy coordination is a precondition for successfully managing a multi-faceted reform agenda during EU accession. Managing the process of EU accession and ensuring effective compliance with the Acquis will critically hinge on the quality of policy coordination across various parts of the public administration. Because implementation of the Acquis will be a prerequisite for EU accession, strengthening vertical and horizontal coordination, within and across line ministries and agencies and between sectors at local level, would deserve special attention. The challenge is even taller because Turkey needs to pursue the broader development agenda for growth and social inclusion in parallel with the EU accession agenda. 1.30 Management of the EU accession process necessitates the creation of inter-ministerial structures to coordinate cross cutting issues and to act as a counterbalance to the fragmentation of policy making. Moreover, the accession countries are expected to establish ‘a mechanism for collective ministerial strategic supervision, inter-ministerial working arrangements with the capacity and authority to co-ordinate EU integration work internally and externally, and to monitor progress, and administrative unit or units to support those coordinating arrangements, and adequate European integration capacity in ministries’.10 1.31 Turkey has made good progress in establishing such arrangements, but complementary steps would be needed. Initiatives taken so far include: setting up the coordinating body for EU affairs (European Union General Secretariat), EU Units in public institutions, and the Internal Coordination and Harmonization Committee (for 10 Sigma Baselines, OECD, October 1999. The baselines, prepared upon the request of the European Commission, provide a basis for conducting assessment of civil service, external audit, financial control, public expenditure management systems, policy-making and co-ordination machinery and public procurement management systems.

legal approximation with the EU acquis), as well as the framework for the EU financial assistance comprising various entities. However, the scope of work of the Internal Coordination and Harmonization Committee and of the Financial Coordination Committee do not seem to cover the management of cross-cutting policy issues, and the coordination between the policy making, legal approximation, and the planning and monitoring of enforcement. Directions for complementary action would involve:

• Harmonizing national plans and programs, as envisaged by the Article 357 of the 8ht Development Plan, • Strengthening the link between the planning of National Plan for the Adoption of the Acquis (NPAA) measures with the planning of budget, based on an all-encompassing strategy for entry into the EU and the dynamics of a cost-benefit and impact analysis of EU membership, and • Defining the appropriate coordination system.

1.32 Overlapping and fragmented competences would complicate the accession process. The capacity of the government to drive through the EU-related, but also other reforms, is influenced by the horizontal division of tasks and responsibilities. A situation of overlapping and fragmented competences is observed in some rather important policy areas such as economic policy, environmental policy, trade related issues, energy or transport. Moreover, the combination of fragmented competences and of weak horizontal coordination has resulted in a number of national plans and programs which are not harmonized. This is indirectly reflected in what appears to be a certain lack of clarity regarding the selection of investment projects to be proposed for EU funding and included in investment programs. 1.33 Defining the appropriate coordination system involves assigning roles and responsibilities, but also deciding whether to opt for more or less formalized system. The Turkish Government is in the process of refining internal organization arrangements for steering the EU accession process, learning from the experience of new EU members and acceding countries. The general trend across countries seems to have been to position the system close to the centre of the government, and to establish regular structures as compared to ad hoc arrangements. The experience of the new member states suggests the critical importance of horizontal coordination at inter-ministerial level for managing EU-related activities. This is particularly true for the negotiations, as any unresolved differences are almost certain to come to the surface when commitments to irrevocable national positions have to be made. The lesson learnt is also that establishing a top political committee for European Integration helps in expediting the decision making process, and reduces the risk of overloading the Cabinet with issues that may be competently dealt by such committee. 1.34 The start of the accession negotiations will call for strong efforts of line ministries in Turkey to organize internal coordination of the preparation of position papers, but also of all other EU related activities. Internal coordination and control of EU-related issues has proved to be a challenge in every accession country, largely because of barriers to exchange of information that followed from the vertical structures

of ministries. Based on experience from other EU accession countries, an option could be to assign the role of coordinating the preparations of the position papers to the Strategy Development Boards, which are planned to be established in line ministries, under the draft Law on Public Administration. Their work may be assisted by the EU units, which need to be fully integrated in the daily routine of ministries, including policy development processes. Additionally, it would seem of advantage to establish a core group of senior officials, responsible for coordinating and monitoring all other accession related activities, and reporting on those to the head of administration. 1.35 Ensuring sectoral coordination at local level is equally important. The OECD SIGMA report from 2002 points towards weak co-ordination between ministries and agencies at local level. Apparently, there is a significant degree of overlapping between inspection and enforcement services, such as in the area of environment and physical planning. This is an area calling for urgent attention, not least because the issue of enforcement will be at the heart of the negotiations but also because the Government plans to grant greater policy implementation competences to sub-national levels of government. It would be advisable to develop the strategy for reducing the overlapping between inspection and enforcement services at local level and promoting their coordination. 1.36 Efforts should be deployed towards improving the procedural efficiency of policy processes— The technical aspects of how policy proposals and draft laws move through the government influence the overall procedural efficiency of the policy processes. Yet, the procedural framework in Turkey does not provide formal guidance regarding time within which certain stages of the policy-making process are to be completed. Specifically, the Principles on Preparation of Laws, Decrees Having Force of Law, Regulation and Draft By-Laws do not formally specify timeframe for intra-agency consultation process, which creates opportunities for procedural delays and could be a significant bottleneck as the number of changes to be implemented increases. 1.37 —in particular at the level of line ministries and agencies. Large ministries and agencies are more complex and have stronger needs to ensure coordination and control, which may lead to procedural delays. It is advisable to explore options for reducing such delays in ministries and agencies. The first step would be to establish how the work gets done, focusing on processes for developing policy across ministry, and its implementation, monitoring and evaluation. That would help in sorting out components of ‘reasonable’ procedural delay versus ‘excessive’ or ‘unreasonable’ delays. The next step would be for the heads of central agencies and their respective teams to develop an action plan for eliminating or minimizing those ‘excessive’ or ‘unreasonable’ delays, with clearly specified tasks and responsibilities at the agency level and the timetable for completing necessary actions. Providing strong commitment of the government and the heads of administrations, it is possible to achieve improvements in a relatively short period of time. 1.38 Strong quality control of new regulations is of utmost importance for managing the accession process and for promoting sustained growth. Strong quality control of

new regulations is critically important for ensuring correct transposition of the acquis, which is one of the factors that will influence the pace of the negotiations. Further, poor quality of regulations does not help in improving business environment. Prospects for strong quality control are significantly enhanced if there is one single unit responsible for coordinating the quality control. In Turkey, however, such responsibility is fragmented, pointing towards the need to entrust it to one single unit. 1.39 Impact assessment mechanism is instrumental for improving the quality of policy-making, ultimately facilitating strategic policy coordination. As other accession countries, Turkey is also expected to start developing a mechanism for impact assessment (budgetary, economic, social and environmental impact, and efficiency and practicability in implementation).11 Such mechanism helps to improve the quality of policy-making by assessing the impact that a particular policy option may have on the budget or on other policy areas. For all these reasons, Turkey is strongly encouraged to introduce the impact assessment mechanisms, starting with the development of a standardized format or guideline for the preparation of budgetary impact assessment, and making that exercise a mandatory part of the quality control of new laws and regulations. In addition, there is an urgent need to organize and provide training in impact assessment to those that will be involved in preparing the position papers for the purposes of the accession negotiations. The preparation for negotiations includes assessing the implications of different policy options before determining national negotiating objectives, strategies and tactics. This requires people skilled in impact assessment, such as in impact assessments technique, such as social impact assessment, budgetary impact assessment, and environmental impact assessment.

11 The SIGMA baselines include the mechanism for impact assessment of policy options.

CHAPTER 2. PUBLIC FINANCE MANAGEMENT ON THE WAY TO THE EU

2.1 Improving the quality of fiscal adjustment remains a key challenge on the way to EU membership. Turkey’s newly achieved macroeconomic stability hinges crucially on the strong fiscal adjustment, however, sustainability of the adjustment can only be ensured by improving the quality of adjustment. Aiming for a higher quality of fiscal adjustment would call for action on many fronts and in particular: (i) structural fiscal reforms that yield efficiency gains in public expenditures, by determining the low value programs that should be retrenched, in order to make appropriate room in the budget for growth-enhancing public expenditures and lower taxes; (ii) tax reforms that broaden the tax bases while reducing distortions and inequities associated with the existing system. This chapter discusses the patterns of fiscal adjustment; benchmarks the public expenditure allocations and structure of fiscal revenues in international comparison; and points to broad directions for expenditure reforms in view of improving fiscal sustainability.12 It provides an assessment of debt dynamics and sustainability in the face of surrounding risks. The issue of fiscal dominance, in the context of the upcoming introduction of formal inflation targeting, is also addressed.

2.1. QUALITY OF FISCAL ADJUSTMENT AND THE SIZE OF GOVERNMENT

2.2 Turkey has gone through an impressive fiscal adjustment during 1999-2004. In the aftermath of the 1999 and 2001 crises, Turkey had to generate a sizeable primary surplus to reduce its public debt stock. Turkey’s fiscal position improved dramatically between 1999 and 2004, as it is reflected in the improvements in the primary balance of the Consolidated General Government (CGG), from a surplus of 0.5 percent of GDP in 1999 to a surplus of 5.9 percent in 2004.13 The CGG borrowing requirement decreased by 7.1 percentage points of GDP between 1999 and 2004, driven by the larger primary surplus and the gradual reduction in interest payments on public debt—from a peak of 25.4 percent of GDP in 2001 to 13.5 percent in 2004. 2.3 Turkey’s public sector—comprising the general government plus the state owned enterprises (SOEs)—achieved even a bigger fiscal consolidation. Over 1999-2004, fiscal adjustment at the level of the public sector amounted to close to 9 percent of

12 Turkey’s public expenditures and options for expenditure reforms will be discussed in the upcoming Public Expenditure Review of the World Bank. The status of expenditure management reforms will also be discussed in this study. 13 See Annex 2.1 of the main report for a detailed description of data sources and methodology.

GDP, from a primary deficit of 1.6 percent of GDP in 1999 to a primary surplus of 6.9 percent in 2004.14 The improvement in the financial situation of the SOEs was mainly generated by a close to 2 percentage points of GDP reduction in their investment expenditures, and 1 percentage point cut in their personnel compensation. With the privatization of profitable SOEs, like Turk Telekom and Tupras, the contribution of the SOEs to the primary surplus will decrease. However, revenue losses for the consolidated budget will be mitigated by corporate tax receipts from privatized SOEs. International experience suggests that additional tax receipts may offset foregone fiscal revenues from profitable SOEs as a result of growing business activity in liberalized sectors. In addition, with privatization revenues used to pay down public debt, there will be room for expenditure savings as a result of lower interest payments on the public debt stock. 2.4 Fiscal consolidation came primarily from the revenue side, with heavy reliance on indirect taxes: Despite the partial shift in the adjustment pattern since 2002, Turkey’s focus for achieving fiscal consolidation has been on revenue-increasing measures rather than expenditure rationalization. While primary revenues increased by 4.8 percent of GDP, primary expenditures declined by only 0.6 percent of GDP between 1999 and 2004. Thus, 90 percent of the 5.4 percentage points of GDP increase in the CGG surplus from 1999 to 2004 came from revenue-increasing measures. The increase in tax revenue was mainly generated by higher indirect taxes. Indirect tax revenues increased from 11.7 percent of GDP in 1999 to 15.7 percent of GDP in 2004. In addition, non-interest expenditures reflect no major changes during 2000-2004, with expenditures for personnel, goods and services and current transfers largely unaffected by fiscal consolidation. It should be noted, however, that initiatives have been taken to prevent wasting in expenditures, improve spending quality, and set expenditure priorities—for example by setting recruitment limits and eliminating low-priority investment projects from the investment program. These measures have supported a better control of expenditure growth than in the past. 2.5 Fiscal adjustment has been impeded by a growing social security deficit, which reached 3.8 percent in 2004:15 Turkey’s fiscal situation would have been much better if Turkey had managed not to expand the social security deficit after the 1999 reform. Although the 1999 reform resulted in a one-off benefit in 2000, the fiscal balance of the system started to deteriorate mainly due to ad-hoc policy reversals such as above-inflation benefit increases, amnesties for contribution arrears, and implementation delays due to legal bottlenecks. Given the favorable demographic profile of Turkey, the currently high deficits (compared to other emerging market countries) pose a bigger challenge in the long run considering that the number of elderly will start to increase as the demographic shift starts to kick in.

14 The IMF’s Stand-By Arrangement (SBA) program target of 6.5 percent GNP primary surplus for 2005-2007, includes primary surplus of the SOEs together with the general government. The general government data used are from the State Planing Organization (SPO). 15 The deficit of the social security institutions do not include payments made on behalf of the consolidated budget since those expenditures are treated as part of the consolidated budget expenditures.

2.6 Continued commitment to overhaul of the social security system is key for achieving long-term sustainability. The new social security reform package initiated by the government envisages separating pensions, health and social assistance functions and unification of the social security institutions for increased efficiency and transparency. While enactment of the draft legislation on the pensions and health components is still pending, the complementary institutional law and the social assistance law are still under preparation. On the pension front (for issues in health care reform see chapter 9), the reform introduces parametric changes including the retirement age, replacement rate, valorization rate and pension indexation. A significant improvement included in the draft law is that Emekli Sandigi contributions will be based on the total remuneration (as opposed to the existing base of only salaries). In addition, Bag-Kur income steps will be removed and contributors will be allowed to declare their own earnings level. With the help of the reform, pension system deficit currently at 3.5 percent of GDP is expected to decline by 1 percent below the baseline projection of “no reform” by 2020.16 However, the beneficial impact of these measures is expected to be rather limited over the medium run, thus creating little fiscal space for growth-enhancing expenditures. Moreover, long-run financial sustainability will be secured under a high level of payroll taxes by international standards, which is an impediment to job creation in the formal labor market (see chapter 4). More ambitious reforms would be needed to generate medium-term savings and also create room for a reduction in payroll taxes in the future.

(a) The expenditure side

2.7 Turkey’s primary expenditures are still at the low end of EU countries but much higher than in other emerging economies. At 32.7 percent of GDP, primary expenditures compare favorably with the average size of government in cohesion countries and new EU members, but are considerably higher than in other comparable emerging economies (Figure 2.1). 2.8 Expenditure pressures are being felt in some Government functions. International comparisons point to the following expenditure patterns (Figure 2.2):

• Turkey’s public expenditure for the provision of public goods (general public services, defense, public order and safety) is relatively high in international comparison. • Expenditure on health care is relatively high—also in per capita terms and including out-of-pocket private spending (see chapter 9). • Expenditure on social protection is high, especially in view of Turkey’s favorable demographics. • Expenditure on education is in line with comparators but may need to increase in the future.

16 The deficit of the pension system does not include the health-related deficits as well as the payments made on behalf of the consolidated budget.

• Expenditure on environmental protection is comparatively low and may need to increase on the way to the EU. • Expenditure on economic affairs (comprising mainly investment in infrastructure and various subsidies) is broadly in line with average levels in comparator countries.

Allocating expenditure to functions most critical for growth and social protection, while enhancing expenditure efficiency, is a key precondition for accelerated convergence and improved social inclusion.

Figure 2.2: Functional allocation of general government expenditures -- Turkey (2004) and comparators (2003); in % of GDP

Gen. Pub.Services

Defense andPublic orderand safety

Economicaffairs

Environmentprotection

Housing andcommunityamenities

Health Recreation,culture and

religion

Education Socialprotection

Turkey Comparators

Figure 2.1 : General Government Expenditure as % of GDP

Slovak

Poland

Portug

Greece

Bulgari

Turkey

Irelan

Turkey

iaBraz

Malays

iaKore

S. Afric

Argenti

naChil

Thaila

Mexico

Primary Expenditure Interest

2.9 Increased expenditure pressures in education should be expected in the near future— This will be due to three factors: (i) postponement of the expenditures, including education investments and maintenance of the existing capital stock, during the recent years of fiscal adjustment; (ii) fast growing school-age population; (iii) the increase in the proportion of youth entering and completing secondary education; and (iv) the need to improve the quality of education towards catching up with the human capital in EU. In order to expand access to primary and secondary education, promote equity in educational opportunity, and improve the quality of education (with the ultimate goal of increasing the employability of young graduates), Turkey needs to devote sufficient public resources to education while at the same time improving the distribution and efficiency of available resources. The recent Education Sector Study of the World Bank finds for example, that among the recommended policy options for education reform, expanding access to early childhood education and using information and communication technology to integrate new curriculum into classroom practice have high estimated cost impacts, particularly due to additional investment requirements. In addition, estimates suggest for example that solely the construction of new classrooms that will be required to reduce the number of students per class to 30 in primary education in 2006 is at 0.2 percent of GNP. 2.10 —but should go in tandem with improved efficiency of spending. Public expenditure on education in percent of GDP is similar to other EU countries and comparable to emerging economies, but educational attainment in Turkey is still lagging behind with respect to these comparators. This suggests some potential for efficiency improvements. Reforming the curricula at all levels; better targeting of public schooling

efforts to groups really in need; better management of teacher’s wage bill; could be examples of focus areas where efficiency gains could generate resources for new investments. 2.11 The Government wage bill has been bypassed by fiscal consolidation. Since 1999, total compensation for General Government employees has been relatively stable, at around 10 percent of GDP. Although civilian public sector employment is not exceptionally high by international standards, average compensation is. Linking wage increases to inflation has not proven enough to contain the growth in the wage bill, probably because other forms of compensation have provided room for increases in personnel costs. Slower growth in average compensation would have created considerable room for fiscal savings. For example, had the ratio of average compensation to per capita GDP remained constant at its average level in 1999-2000, the wage bill of consolidated budget agencies would have fallen by about 1 percentage point. 2.12 The wage bill in economic affairs and security is oversized by international comparison. A functional breakdown of the wage bill indicates that the wage bill in economic affairs and security is oversized with respect to a comparator group of new EU members, cohesion countries and emerging economies. In particular, the share of personnel expenditures on economic affairs is twice as high.17 2.13 Moving to a simpler compensation system would contribute to containing pressures in the wage bill. In 2004, about 32 percent of personnel compensation in consolidated budget agencies was composed of various allowances, compensations, and rewards on top of the basic salary of employees. Overtime pay represented 6.5 percent of total compensation. In addition, many allowances are exempt from income tax. Unlike wages, the system of allowances and overtime pay is quite complicated and seems to offer substantial opportunities for discretion. This may be distorting incentives, but further analysis is warranted. The Government is already addressing some of the deficiencies of the system in its civil service reform efforts. 2.14 The brunt of the fiscal adjustment on the expenditure side fell on the investment budget. The impressive fiscal adjustment in 2001-2004 was unbalanced in that the investment budget was cut sharply, particularly in 2003-2004.18 The total public investment level (inclusive of local administrations investment), stood at 4.7 percent of GNP in 2004, which is down from 6.8 percent of GNP in 2000, with infrastructure investment being hit the hardest. In 2001-2002, fiscal adjustment fell primarily on public investment by SOEs while investment by the consolidated budget increased. In 2003-2004 however, the cut was predominantly from the investment budgets of both the 17 There is an oversized wage bill especially in the rural agencies budget. Between 1999 and 2004, budget allocations for recurrent expenditures (excluding agricultural transfers) have been on average 70 percent of the consolidated budget. As much as 90 percent of recurrent spending of rural agencies is allocated for salaries alone. Therefore, there is limited funding for logistical and operational spending, which is extremely vital for effective service delivery. There is room for fiscal savings in rationalizing the personnel in rural agencies. 18 The rationalization of the existing public investment stock in 2001 has played an important role in the earlier part of the adjustment.

consolidated budget agencies and SOEs. Rationalization of the public investment program in 2001 has been quite effective in reducing average completion times of projects and reduced allocations from the budget in 2003-2004 put pressure on the PIP for further rationalization.19 2.15 Ensuring appropriate allocations for operation and maintenance of public capital is an important requirement for improving the quality of services and restricting the cost of the projects. As a result of fiscal adjustment, total maintenance expenditures declined in tandem with cuts in the investment budget—although available data do not allow reliable tracking of appropriations for maintenance in the budget. The transportation sector, as well as the social sectors—especially education and health—were subject to a reduction in their maintenance allowances during this period.20 Such reductions in O&M expenses should be avoided since they are not sustainable while they reduce the contribution of public capital to efficiency and growth. Moreover, inappropriate maintenance and accelerated decay of capital goods may unduly burden the investment program in the future. 2.16 Expenditure pressures in investment will only rise further as alignment with the EU accelerates. Although in its Preliminary National Development Plan the government recognizes pressing infrastructure needs, much needs to be done towards faster convergence with EU. When additional investment requirements are added, for example for alignment with the environmental acquis or the need for substantial education investment, effectiveness of investment spending and better project selection and monitoring is even more urgently needed. The reduction in completion times is welcome but alone does not certainly assure the rationalization of the PIP. Structural measures are bound to complement the rationalization of the investment stock, by enhancing the management of the public investments. 2.17 There are several potential measures towards reaching a more effective investment program. In the recent past, volatility of annual investment allocations has hampered implementation in line with strategic priorities, total costs and average completion times of projects. In order to close the quality gap in infrastructure, and improve the quality of its investments, Turkey needs to (i) utilize the newly introduced medium-term expenditure framework; (ii) as part of the ongoing introduction of performance-based budgeting, strengthen the consistency of investment and recurrent budgets to facilitate the achievement of sectoral policy objectives; (iii) improve the PIP management by strengthening the project selection process as well as monitoring and evaluation of ongoing projects and, (iv) promote private sector participation in infrastructure. 19 In 2005 investment spending by consolidated budget agencies went slightly up, reversing recent trends, from 1.8 percent of GDP in 2004 to an estimated 2.1 percent of GDP. 20 Evidence of lower than expected capacity utilization and shorter than planed economic life of some projects points to problematic maintenance, especially in the road network, where indicators of physical condition point to deteriorating quality—see chapter 7 (Figure 7.3; volume II). However, the relative roles of inadequate budget allocations and lack of appropriate incentives/culture for maintenance seems difficult to establish.

2.18 Trade offs in expenditure allocations would need to be combined with expenditure reforms to meet Turkey’s development challenges. As public expenditures are already high compared to other emerging economies and some new EU members there is little room for Turkey to further increase expenditure in order to meet pressing development challenges—such as in education and in infrastructure for less-developed regions, or in areas where alignment with the EU Acquis entails a cost (for example in environmental protection). Expenditure should also be contained in order to make room for lower taxes in the long run while preserving a sound fiscal framework. Policy would thus need to focus on trade offs in expenditure allocations, possibly by reducing spending in functional areas where it appears to be oversized in international comparison, and by implementing reforms that improve the efficiency of expenditure programs in areas where expenditure pressures are being felt—such as health care, education, social protection. Horizontal reforms, focused on the modernization of civil service pay and employment system and the careful formulation of the investment program, would also help contain pressures on the wage bill and investment spending and thus better control public expenditure in specific functional areas.

(b) The Revenue side

2.19 Fiscal revenues have increased to levels comparable to EU countries and much higher than in emerging market economies. In most EU cohesion countries and new EU members the tax burden has remained constant, or has even decreased in percentage of GDP, as a result of initiatives to contain the increase in the size of Government. But contrary to this trend, and as a result of the pattern of fiscal adjustment since 1999, fiscal revenues in Turkey stood at 40 percent of GDP in 2004, a level that is now similar to EU countries—despite the smaller size of Turkey’s welfare system. With a fiscal burden higher than in other emerging economies any further increase taxes would risk compromising prospects for growth. 2.20 The balance between direct and indirect taxes is considerably out of line with comparator countries but reducing the burden of indirect taxes would call for careful study and long-term design. The composition of revenues has shifted markedly toward indirect taxation over the last few years. However, options for reform in the short-to-medium term remain limited because revenue cuts in one area must—given the continued need to achieve large primary surpluses—be offset by gains in another. Substitution of direct for indirect taxes would not be advisable. When pervasive informality is present, as in Turkey, reliance on indirect taxes appears to be a reasonable way of ensuring some degree of compliance of those who would have otherwise escaped taxes altogether. This tends to alleviate the distributional consequences of indirect taxes. In addition, indirect taxes uniformly levied on consumption offer advantages on efficiency grounds: (i) they are relatively neutral towards saving and investment decisions; (ii) they do not distort incentives to work. Hence, all else equal, a tax mix relying more on indirect taxes may be more conducive to growth. Fiscal space for lower indirect taxation will have to be created over the long term from three main sources: (i) Continuous fiscal discipline to reduce the level of the debt ratio and create room for a lower primary surplus in percent of GDP; (ii)

better control of primary expenditures in low-value programs; (iii) tax base broadening and reduction in the size of the informal sector. 2.21 The tax landscape is changing fast. The authorities are currently in the process of reviewing and rewriting each of the major income tax laws. A new regime for capital income taxation will subject interest and capital gains, including on previously exempt government securities, to final withholding at 15 percent. Moreover, the 2006 budget and draft legislation to amend the existing CIT and PIT laws incorporate significant reforms of the Corporate Income Tax and the Personal Income Tax: (i) a reduction of the CIT rate from 30 to 20 percent, with a parallel elimination of the Investment Tax Allowance (ITA); and, (ii) a reduction of the top personal income tax rate from 40 to 35 percent, accompanied by a reduction in the number of tax brackets from 5 to 4 and a unification of the tax regimes for wage and non-wage income. The CIT tax reforms have the potential to promote investment on a sound basis and stimulate job creation, especially in the formal sector, while the PIT reform will improve the efficiency of the tax system and reduce costs of tax collection. Further reform priorities for the Personal Income Tax (PIT) include: (i) replacing the costly and potentially inequitable VAT-based consumption credit either with a standard deduction or a non-refundable credit, which are more pro-poor systems, and (ii) introducing explicit reduction for spouse and children. 2.22 Further reform initiatives for the Corporate Income Tax (CIT) could include: (i) avoiding regional and sectoral incentives; (ii) incorporating dividends into a new regime for capital income taxation, where a first step would be to include dividends in the base for the new harmonized capital income tax to be launched in 2006; and (iii) progressively phasing out the double taxation of dividends.

2.2. PUBLIC DEBT SUSTAINABILITY

2.23 Despite the significant improvements, debt reduction is still a challenge. The level of Turkey’s debt still remains high, especially when compared with EU member states and candidate states. In 2004, Turkey’s significantly reduced gross debt level, at 77.4 percent of GDP (63.5 percent in net terms; 80 percent in gross terms as a share of GDP, as defined in ESA 95),21 was much higher than all of the new member states (EU-8) which are below the 60 percent “Maastricht threshold” and EU-15 average.22 In addition, the Maastricht criteria may not be strong enough to ensure a sound fiscal framework in the face of Turkey’s vulnerabilities: First, the sustainability of a given debt-to-GDP ratio depends not only on its level, but also on the composition of the public debt portfolio, in particular with regard to maturity. Despite recent improvements, the average maturity of Turkey’s public debt remains much lower compared to EU-8, and especially 21 The Treasury definition of gross debt differs from the ESA95 definition . For a more detailed description of the latter, see Box 2.5 in Volume 2 of this study. 22 In 2004, gross public debt in proportion to GDP was, on average, 31.3 percent in EU-8 and 64.7 percent in EU-15—although significant disparities persist within the EU-15 group.

EU-15 countries, making refinancing more challenging, but also posing important liquidity risks that should be hedged by a lower debt ratio. Second, Turkey’s public debt ratio remains higher than in other comparable emerging economies, with a similar or slightly higher sovereign debt ranking. On average, the debt-to-GDP ratio of these comparators is below the Maastricht benchmark.23 2.24 In a base-case scenario, sound macroeconomic fundamentals will lead to a further reduction in the debt ratio over the medium term. In a baseline estimation, underpinned by the base-case growth scenario presented in chapter 1, the net debt-to-GNP level will continue to decline, falling below 60 percent in 2005 (74.5 percent in gross terms) and further below 50 percent in 2008 (60.2 percent in gross terms). 2.25 Debt dynamics have considerably improved but credible policies that maintain a robust fiscal framework will play a key role in building further confidence— To illustrate potential risks for debt sustainability, a downside scenario can be formulated where the political will to continue the fiscal program falters and the primary surplus does not exceed 3 percent of GNP in 2006-08. As a result, real interest rates could be in the 20 percent range, i.e., well above the projected program path, with growth falling to 3 percent per year. A reversal in the strong growth pattern and deterioration in the public debt dynamics could lead to capital account outflows and exchange rate instability which would exacerbate the impact on the debt burden. Under these hypothetical conditions, the public debt burden could begin to rise and the currently declining path of the debt to GNP ratio could be interrupted. 2.26 —especially as the way to the EU may be lengthy. The relatively appreciated real exchange rate and large current account deficit constitute a potential risk Turkey will need to cope with throughout the EU accession process. (A 20 percent depreciated nominal exchange rate compared to the program level at end-2005 would imply a 4 percent increase in the debt-to-GNP level). EU accession negotiations may boost capital inflows, providing relief from balance-of-payments pressures and contributing to some real exchange rate appreciation as also assumed in the base- and high-case scenarios discussed in the previous chapter. However, Turkey might also be exposed to capital flow reversals, in case the EU accession process were to occasionally stumble, with potentially destabilizing effects on the exchange rate, interest rates, debt dynamics, and the overall macroeconomic framework. 2.27 Maintaining a high primary surplus becomes increasingly more important for debt reduction. An analysis of the breakdown of the reduction in debt-to-GNP ratios shows that in the medium term the importance of maintaining a high primary surplus increases. At the same time, a high growth rate plays a significant role, while as the economy stabilizes more permanently the impact of reduced interest rate and inflation dies off. Therefore, preserving a tight fiscal stance as needed to accelerate the reduction of the debt ratio, and using projected large privatization proceeds to further reduce public

23 Comparators include (by increasing S&P’s sovereign debt rating): Brazil, Philippines, Ukraine, South Africa, Thailand, Tunisia, Mexico, Kazakhstan, Russian Federation, Egypt, India, Morocco, and Colombia. On average, the public debt-to-GDP ratio of these countries was 46.1 percent in 2003.

debt, would be the best course to mitigate surrounding risks while making needed fiscal room for growth-enhancing expenditures and lower taxes.

PART B: STRUCTURAL POLICIES – IMPROVING THE FUNCTIONNING OF KEY MARKETS AND THE

EFFICIENCY OF PRODUCTION FACTORS

CHAPTER 3. PRODUCT-MARKET REGULATIONS AND THE INVESTMENT

CLIMATE24

3.1 Improving product market regulations (PMRs) would strengthen the investment climate, in turn fostering productivity and sustainable economic growth. Product market regulations — including administrative barriers, barriers to trade, state control and competition — together with elements addressed in other chapters of this report (such as macroeconomic stability, access to infrastructure, finance and the labor markets) are critical determinants of productivity and investment, which can unleash private sector potential, help firms grow and reduce informality.25

3.2 Several facets of the Turkish economy indicate that PMRs are in need of improvement. First, FDI in Turkey is low (less than 1 percent of GDP) and has been stagnant for the past decade, especially for green-field investment. Evidence shows that openness to foreign trade and administrative barriers are key determinants of FDI.26 Second, sector productivity is uneven, hampered by lack of competition and presence of traditional (often small- and medium-size) players. Third, Turkish SMEs constitute 61 percent of total employment but contribute only 26.5 percent to the economy’s value added, about half the contribution of Polish SMEs and significantly less than SMEs in other comparator countries.27 SMEs’ low contribution to economic activity is related to limited market competition and barriers to entry, operation and exit, together with lack of integration with larger firms (except in a few specific sectors). Finally, the informal sector in Turkey produces 31 percent of GNI, more than in most comparator countries, and accounts for as much as 51 percent of the labor force. The high level of informality is also related to the disincentives firms face in the formal market, including taxes and administrative barriers.

3.3 Improving Turkey’s mixed performance on PMRs is critical for EU accession and facilitating rapid and sustained growth. Surveys by the OECD convey a sense of

24 The findings of this chapter will be further explored through — and complemented by — the results of an Investment Climate Study (ICS) based on a survey of 1,300 Turkish firms and 200 hotels, which the World Bank and EPRI are jointly preparing. The ICS will be completed in the spring of 2006. 25 World Development Report (World Bank, 2005). 26 See Sayek, “FDI in Turkey: The Investment Climate and EU Effects” (background paper prepared for the CEM, 2005). 27 Ayyagari, Beck & Demirguc-Kunt (2003)

Turkey’s mixed performance on PMRs — see Figure 3.4.28 While barriers to trade and competition policy have improved significantly in the past few years, administrative barriers and state control remain significant constraints on investment and productivity. The EU Progress Report also highlights the need for Turkey to improve several aspects of its PMRs, including: (a) registration procedures and costs of establishing a business (Acquis Chapter 3 on right of establishment and freedom to provide services); (b) state aid with a distortive effect on competition and competition policy (Chapter 8 on Competition Policy); (c) technical trade barriers (Chapter 1 on Free Movement of Goods), which are overdue to be addressed under the Customs Union agreement; and (d) restrictions on foreign ownership (Chapter 4 on Free Movement of Capital). The sections below analyze Turkey’s performance on key PMR factors and provide policy recommendations for improvement.

Figure 3.1: Turkey’s performance on key PMR indicators

Administrativeregulation

State control Barriers to tradeand investment

Barriers tocompetition

rier/c

Turkey Emerging market average High income average

Source: OECD database on PMR, 2005.

3.1. ADMINISTRATIVE BARRIERS

3.4 Reducing administrative barriers would strengthen Turkey’s business environment, increase investment levels and facilitate alignment with EU requirements on enterprise and industrial policy. As indicated by the evaluation of Turkey’s compliance with Acquis requirements in the 2005 EU Progress Report, while the Government has made some progress to reduce administrative and business judiciary hurdles, several procedures are still a significant impediment for business operation and 28 OECD PMR database (2005). The OECD developed a methodology to evaluate countries’ PMR performance based on surveys across member countries covering more than 800 data points. Current data reflect 1998 and 2003 and are available for 30 countries of which 6 (including Turkey) are considered emerging markets. The survey covers a wide range of topics that are important for the efficient functioning of product and service markets, such as state ownership and control over businesses (for instance, price controls), regulatory burdens and licensing, legal barriers constraining competition in certain sectors, the antitrust regime, and barriers to international trade and investment. The data points are weighted and combined into indicators at different levels of aggregation, allowing countries to evaluate their overall PMR regime as well as its components, all the way down to the 800+ specific data points.

should be reduced.29 In particular the areas of licensing and permit systems need improvement (see Figure 3.2).

Figure 3.2: Administrative barriers, selected indicators, 2003

its sy

Turkey Emerging market average High income average

Source: OECD database on PMR, 2005.

(a) Firms’ entry, operation and exit

3.5 Turkey has significantly reduced the time for business registration, but the cost is still high. Licensing procedures are also very cumbersome. Business registration in Turkey has been significantly simplified since 2003. As a result, starting a firm takes only 9 days in Istanbul, one of the shortest times among comparator countries (see Table 3.1) according to the 2006 Doing Business report30. However, the cost of business registration is still high at Turkish Lira 1,600 (US$1,000) equivalent to 28 percent of GNI per capita, versus 5 percent of GNI in Romania, for example. According to the most recent World Bank data, closing a business is also very difficult — the insolvency procedures take about 6 years, and the recovery rate is extremely low at 7 percent, although it is important to emphasize that these statistics do not yet reflect reforms of the bankruptcy law that were undertaken in 2003 and 2004. Licensing procedures are also cumbersome (see Figure 3.2). Firms often need licenses to become fully operational after registering, as well as to remain in business. Thus, licensing increases both start-up and operation times. Factors that complicate the licensing process in Turkey include: (a) an excessive number of licenses — estimated at about 200,31 (b) involvement of several agencies in the licensing process, and (c) municipalities often being responsible for examining other authorities’ approvals in several areas (e.g., urban planning, safety, health and environment).

29 See 2005 Turkey EU Progress Report, Chapter 20, page 97. 30 The Turkish Government indicates it may be as low as two days. 31 Turkish Treasury Licensing Report.

Table 3.1. Entry and Exit, Turkey and comparator countries, 2004. Starting a Business Closing a business in case of bankruptcy Time

(days) Cost

(% GNI per capita) Time

(years) Recovery rate

(cents on 1 US$) Turkey 9 28 5.9 7.2 International best practice 2 (Australia) 0 (Denmark) 0.4 (Ireland) 92.6 (Japan) EU best practice 5 (Denmark) 0 (Denmark) 0.4 (Ireland) 91.0 (Norway) Bulgaria 32 10 3.3 33.5 China 48 14 2.4 31.5 Croatia 49 13 3.1 28.4 Poland 31 22 1.4 64.0 Portugal 54 13 2.0 74.7 Romania 11 5 4.6 17.5 Slovak Rep. 25 5 4.8 38.6 Spain 47 17 1.0 77.8 Thailand 33 6 2.7 43.9 Source: World Bank, Doing Business Report, 2006. Note: data refers to the countries’ most populous cities.

3.6 A partial licensing reform is currently underway. The licensing system is currently being revised, with a bill in Parliament establishing a centralized system that will create “one-stop-facilities” for licensing at the municipality level.32 The reform should be evaluated, as international experience shows that mandatory one stop facilities often add another bureaucratic step to –rather than helping speeding up—the licensing process.

3.7 Administrative procedures should be further streamlined, with a specific focus on reducing cost of entry and simplifying licensing processes. Key measures that need to be undertaken to improve the registration process include: (a) reducing start up costs; (b) establishing an integrated registration system that includes a unified business number for both registration and taxation; (c) establishing an integrated registration and licensing system; (d) ensuring that the ongoing review of the Turkish commercial code covers compliance with EU disclosure requirements on company registration; and (e) introducing an online registration service to streamline business registration in all parts of the country. Further policy options to improve exit should be reviewed after evaluating the results of the ongoing bankruptcy reform, because interviews with several judges from commercial courts indicate that considerable streamlining of exit procedures is expected.33 Key measures to reduce the time and costs of licensing, both for general and for sector-specific licenses, include: (a) continuing the effort by the Minister of the Economy to create an inventory of existing licenses; (b) reconsidering the proposal to introduce a one-stop facility to acquire a license; (c) assigning each licensing task to a specialized authority (municipalities should concentrate on urban planning, construction requirements and specific safety issues only); and (d) developing less burdensome ways to regulate businesses, including keeping mandatory licenses to a minimum (i.e., for 32 Draft Law on Regional Agents. 33 Estimates indicate that ongoing reforms should lead to completion of a bankruptcy case in six months.

health, safety and environmental standards only); and (e) whenever possible, replacing licensing with a system of inspections or reporting requirements coupled with an effective enforcement system (fines and penalties).

(b) Resolving commercial disputes

3.8 Resolution mechanisms for commercial disputes have improved. Improving efficiency and transparency of the commercial judiciary increases predictability of the business environment in which firms operate, in turn increasing investments and reducing business costs. Since 2000, Turkish authorities and the judiciary have taken important steps to speed the resolution of commercial disputes, including approval (in 2001) of a new statute governing arbitration proceedings when one disputant is not Turkish,34 limitations of the courts’ ability to intervene in the proceeding or second guess the arbiter’s award, and measures aimed at improving the overall efficiency of the judiciary — such as cutting the judicial holiday from 45 to 36 days (in 2004), automating the central units of the Ministry of Justice, and linking field units to the center. Establishment of Intermediate Appeal Courts is also underway and the Civil Procedure Code is being revised to enable civil courts to operate more effectively and efficiently. The impact of these and other reforms are reflected in Turkey’s key indicators on contract enforcement. By and large Turkish courts compare well with those of EU8 and accession countries, with days and procedures needed to complete a simple debt case lower than the average across the EU8 and those in Bulgaria and Romania (Table 3.2).

Table 3.2. Contract Enforcement Country Days to

enforce a contract Number of procedures

Cost as percentage of overdue debt

Turkey 330 22 12.5% International and EU best practice

27 (Tunisia) 48 (Netherlands)

11 (Australia) 14 (Greece)

4.2% (Norway)

Bulgaria 440 34 14.0% Romania 335 43 12.4% EU8 450 27 10.8% OECD 225 19 10.6%

Source: World Bank, Doing Business Report, 2006.

3.9 However, the cost of litigation, backlogs in the commercial courts and enforcement proceedings without judgment remain problematic. The cost of litigation is still high at 12.5 percent of the amount owed.35 Two additional areas of concern include backlogs in the commercial courts (Asliye Ticaret) and enforcement proceedings without judgment (Ilamsiz Takip):

• Data from the Ministry of Justice Web site shows that during 2002 and 2003 Asliye Ticaret received roughly 95,000 cases per year, yet decided only half that number each year. The average time to decide a case is 417 days without

34 Reflecting best practice, the parties are now free to choose where the arbitration will be held and what procedures will control it. 35 By one estimate, a person paid the minimum wage must work 6.1 days to pay for one hour of oral advice and 10.7 days to have a lease reviewed.

counting the time if the case is appealed. Times to disposition across all chambers of the Court of Cassation are also on the rise.36

• At the beginning of 2003, Ilamsiz Takip had some 7.4 million actions pending, and 4.4 million were unresolved at the close of the year. The magnitude of these figure suggest that this procedure is being abused.

While more recent data are not yet available, the Turkish Ministry of Justice indicates that the situation has improved through various efforts, and that further initiatives are underway to address the efficiency of the judiciary.

3.10 Turkey needs to continue reforming its commercial and civil justice systems to trim the time and cost required to resolve disputes. Key measures to improve resolution mechanisms in Turkey include: (a) adopting a case management system and associated alternative dispute resolution mechanisms; (b) reforming the system for choosing experts, following, for example, the course set in the United Kingdom, France, and the United States; (c) applying to domestic arbitrations the same rules that govern international arbitrations; (d) providing competitive restraints on fees for legal professionals, in line with the European Commission’s recommendations on regulating the liberal professions; and (e) evaluating the courts’ caseload to ensure that the principle of proportionality is observed. In the United Kingdom, for example, the Woolf reforms introduced the principle that the resources devoted to a case must be proportionate to the value, importance, and complexity of the dispute.

3.2. STATE AID 37

3.11 State Aid lacks sufficient monitorable disclosure. Turkey committed to implementing reforms of the state aid regime at the beginning of 1996, when the final phase of the Customs Union became effective.38 These reforms include making Turkish State Aid legislation compatible with the EU Acquis, as well as notifying the EC of all aid schemes in force and of any individual aid to be granted that would be notifiable were Turkey a Member State. Turkey has yet to fulfill these commitments. Consequently, and in the absence of a detailed inventory, the EC has not been able to carry out any comprehensive assessment of state aid in Turkey.39 An initial assessment prepared for this report shows that, although Turkey has made progress towards horizontal objectives,40 it still uses a wide range of state aid instruments without formal procedures 36 In the 11th chamber, which hears commercial cases, processing time rose from 152 days in 2002 to 202 days in 2003, the latest year for which data is available. 37 This report does not specifically address the issue of privatization, which will be covered in the Investment Climate Study and in subsequent CEMs. 38 Under the EU Acquis, an advantage conferred by the State is regarded as State Aid if it is granted by a Member State or through State resources, it distorts or threatens to distort competition, it favors certain undertakings or the production of certain goods, and it affects trade between Member States. 39 EU “2005 Progress Report.” It should be noted, however, that the Turkish authorities are working towards systematic disclosure of state aid in the context of the screening process of national regulations in relation to the EU Competition policy Acquis. 40 Horizontal State Aid, which is aid aimed at broad development objectives may benefit from an exception regime following EU criteria. In contrast, vertical State Aid, targeting more specific sectors or individual firms, is not compatible with the EU Acquis.

for monitoring and control as to their potentially distortive effect.41 Examples include grants, state guarantees, exemptions from customs duties, exemptions from VAT, reduced electricity tariffs, credit allocations from the budget, and land allocation. Electricity consumption subsidies granted to firms established in less developed areas are likely to be distorting as they constitute operating aid. These subsidies are considered by the Government as a means to promote employment generation in less-developed areas as they are linked to the level of firm employment. Under EU state aid rules, aid to the ongoing production would be compatible with competition rules only in exceptional circumstances and under tight restrictions. The total fiscal cost of these programs is not available due to the general lack of systematic disclosure on the issue.

3.12 State aid should be monitored, to comply with EU requirements, and ensure a level and competitive playing field. Suggested reforms include: (a) adopting a state aid control legislation aligned with EU directives; (b) setting up a state aid monitoring agency with adequate capacity; (c) increasing transparency by preparing and disclosing to the EU an inventory of existing aid; (d) based on the results of the assessment, devising and ensuring implementation of a strategy to eliminate potentially distorting aid –Turkey will be under pressure to demonstrate a strong start to enforcement well ahead of accession, because alignment with EU directives is considered a complement of the Customs Union; (e) ensuring correct treatment of public services receiving State Aid (they should be placed under the regime of “Services of General Economic Interest” or SGEI) and (f) stopping aid outside of the SGEI regime.

3.3. BARRIERS TO TRADE

3.13 The Customs Union Agreement with the EU, and a decrease in the incidence and pervasiveness of non-tariff barriers have contributed to significantly improve the contestability of domestic markets for industrial goods. In the past few years, tariff and non-tariff barriers for industrial goods have dramatically decreased, while the quality of services facilitating trade, including customs, has improved. Bilateral liberalization under the EU preferential trade arrangements, combined with Turkey’s multilateral liberalization, triggered by its adoption of the EU’s much more liberal MFN tariffs on industrial products, have also heightened competitive pressures on Turkish producers of industrial products. Technical barriers to trade have also significantly declined with Turkey’s gradual transition to the EU technical standards regime (see Chapter 6). In a similar vein, competitive conditions in Turkish markets have improved as a result of progress in establishing a competition infrastructure, with most components already in place (see below). Last but not least, Turkey’s performance in some essential areas of trade facilitation, such as customs environment, is no different from that of new EU members.

3.14 Replacing antidumping laws with competition laws will further improve Turkey’s trade policies. Despite significant progress resulting in barriers reduction,

41 Vertical aid, targeting specific beneficiaries, sectors or products, includes support to state banks and other state companies, public service institutions and specific provisions for certain sectors, including agriculture, fisheries and (most aspects of) transport.

Turkey’s continued heavy reliance on the use of antidumping (AD) as a tool of contingent protection is still a cause of concern. The number of AD measures instituted by Turkey over 1995-2004 exceeded the total for new EU members and EU candidate countries, and the number of AD initiations in 2002-04 roughly equaled that in the EU25. The Government considers this situation as reflecting the increased unfair trade practices by certain countries and existing differences and vulnerabilities in the structure of the Turkish economy compared to the EU. Implementation and effective enforcement of the competition, state aid control, and other relevant parts of the Acquis related to the internal market will allow suspension of application of trade defense measures in the Customs Union between Turkey and the EU, and a progressive alignment towards a common anti-dumping policy with the EU before accession.

3.4. COMPETITION POLICY 42

3.15 Reform of Competition Policy is on the right track. An effective competition policy encompasses instruments that address government economic and regulatory policies, as well as restrictive private sector business practices that significantly distort the competitive process, thereby undermining the efficient functioning of markets and consumer welfare. Turkey’s antitrust regime is in line with international best practice, but several sectors (particularly electricity, gas, water and telecom) remain highly concentrated due to a combination of: still large portfolio of state owned enterprises despite the recent acceleration in the privatization process, legal barriers to entry; exclusive rights historically given to individual firms; still low levels of credit to the private sector; and other investment climate barriers to effective competition.. In 1997, Turkey established an independent Competition Authority and Competition Board to implement a new competition law. The law addresses issues such as agreements on price fixing and bid-rigging, abuse of dominant position (AOD), and mergers and acquisitions (M&A) and joint ventures (JVs), which could potentially distort competition. The law is considered to be closely aligned with EU requirements, as well as with the broader objective of ensuring effective product market competition. The Competition Authority is widely viewed as a well managed government body that is implementing the law efficiently and well and is successfully exercising its competition advocacy role.

3.16 Some additional measures could be implemented to further promote competition by improving the antitrust regime and bolstering the Competition Agency’s advocacy role. These include: (a) eliminating legal uncertainty and speeding up the adjudication of cases under appeal; (b) reducing reliance on adjudication by expanding the Competition Authority’s use of consent orders and business advisory opinions and improving its communication on fines and remedies for anti-competitive behavior to the business community; (c) reducing compliance burdens for small firms by establishing de minimis principles for exempting agreements involving only small companies; (d) clearly delineating the roles, responsibilities and powers of the Competition Authority and sector-specific regulatory bodies on competition matters (as well as on monitoring of

42 For more information on Competition Policy and the Competition Agency in Turkey, including activities, cases reviewed and decisions made, see R. Kehmani, Foreign Investment Advisory Services (FIAS), World Bank, 2005. “Competitiveness, Investment Climate and Role of Competition Policy in Turkey”.

state aid), especially in the telecommunication, electricity and transportation sectors; and (e) Maintain safeguards that ensure competition concerns are considered in privatization of state enterprises.

3.5. COMPLEMENTARY MEASURES TO IMPROVE ATTRACTIVENESS TO FDI

3.17 An improved legal framework to encourage FDI, coupled with macroeconomic and political stability, and positive signals for EU accession, are expected to increase FDI inflows to Turkey. Turkey’s extremely low FDI levels (before the boom observed in 2005) are likely to improve in the next few years, thanks to (a) a new Foreign Direct Investment Law (2003) which has established a liberal FDI regime, in line with international best practice, by eliminating additional permits and procedures that were originally required for foreign investors and by streamlining the foreign investment process, (b) improved macroeconomic stability, (c) EU accession discussion and (d) expected microeconomic investment climate reforms.

3.18 However, specific additional measures are required to improve FDI attraction through FDI promotion and foreign investment policy advocacy. These include reducing FDI restrictions in some sectors (i.e., civil aviation, maritime transport, radio and TV broadcasting43) and ensuring effective investment promotion. The main Turkish authority responsible for FDI promotion is currently the General Directorate of Foreign Investment within the Undersecretariat of Treasury. The performance of the Directorate in attracting FDI should be evaluated against international best practice and follow up measures taken to ensure that the Agency operates effectively. As part of a public body, the current IPA has no funds of its own, has little experience with the core functions of investment promotion, and is not exclusively dedicated to promoting FDI. International experience indicates that several criteria are necessary for an IPA to operate effectively, including (a) a clear strategy and sufficient independence from the Government, (b) policy advocacy on foreign investment as a key mandate, (c) staff with advanced skills and staffing policies, (d) private sector involvement in key decisions, and (e) sufficient budget and adequate financing to ensure long-term sustainability.

3.6. CONCLUSIONS

3.19 This chapter has made the case that improving product market regulations in Turkey would strengthen the investment climate and thereby increase productivity and help Turkey achieve sustainable, long-term economic growth. Although Turkey has made progress on improving product market regulations in recent years, there is still much to be done, particularly in reducing start up costs and licensing procedures, streamlining the resolution of commercial disputes, monitoring and eliminating state aid with a distortive effect on competition, refraining from the use of antidumping measures, enhancing the antitrust regime and advocacy for competition, and attracting more FDI through promotion of foreign investment. As in other areas, continued progress requires

43 2005 Turkey EU Progress Report, Op. Cit.

firm commitments from and cooperation between the Turkish government and the private sector. Table A1 summarizes short- and medium-term recommendations for product market regulations and the investment climate.

CHAPTER 4. EXPANDING EMPLOYMENT—THE LABOR MARKET REFORM AGENDA

4.1. TURKEY’S EMPLOYMENT PERFORMANCE IN A EUROPEAN AND INTERNATIONAL CONTEXT

Figure: 4.1 Elasticity of Employment to Output Growth

Industry Services

Elasticity of employment to output growth (1980-2003; based on averages of annual growth rates)

4.1 Employment generation has been weak. As analyzed in chapter 1, despite a boost during the 1980s, output growth has not been fast enough to create enough jobs for Turkey’s rapidly growing population. Moreover, Turkey has not translated output growth into job creation as well as most other countries. The employment elasticity of growth was a mere 0.27 during 1972-2000, at the low end of comparator countries. This partly reflects the structural change out of agriculture. However, in industry also the employment intensity of growth in Turkey has been low relative to other middle-income countries that have similar production and cost structures, such as Brazil and Mexico, though it compares favorably with Southern European countries (Figure 4.1). Most importantly, growth in services (which account for 48 percent of employment in Turkey) has been almost half less intensive in jobs than in both Southern European countries and other middle-income countries.

4.2 Low employment generation, combined with a rapidly rising population between 1980 and 2004, has led to significant declines in the employment ratio. Owing to weak job creation, the employment rate in 2004, at 46 percent, was far from the Lisbon target for 2010 of 70 percent. The two special Lisbon targets for women and older workers represent the most dominant reasons why Turkey lags so far behind the 70 percent overall standard (Table 4.1). Without major improvements in the participation and employment rates of these groups, this target will remain far above Turkey’s actual

performance. The unemployment rate was 10.6 percent in 2004 and this does not capture the substantial underemployment in the large informal sector.44

Table 4.1: Employment rates in 2004 relative to the Lisbon targets, Turkey, EU members, and Bulgaria and Romania

Overall employment (15-64 years)

Female employment (15-64 years)

Older workers (55-64 years)

Employment rate 2004

2010 70% 2005 67%

2010 67% 2005 57%

2010 55%

Turkey 46.1 24.3 33.1 EU-15 64.8 57.0 41.9 EU-10 60.5 53.3 32.3 Bulgaria 54.2 50.6 32.5 Romania 57.7 52.1 36.9 Source: SIS HLFS, Eurostat. 4.3 Labor force participation in Turkey has been declining over time and it is extremely low by international standards, especially for women. While the low participation rates may reduce immediate pressures on job creation (and, thus, unemployment), they are an important factor in explaining Turkey’s poor employment record and they represent a major loss in terms of achieving the country’s full productive potential.

4.4 Roughly half of total employment is informal and this share is not declining significantly. The informal economy must be acknowledged as an important generator of jobs and as a type of safety net. However, it is characterized by low productivity, poor wages, and workers in the sector have no access to formal sources of social protection.

4.5 Turkey’s demographic trends create both opportunities and challenges. Turkey already has a larger working-age population than any current member of the EU and demographic trends will ensure that this segment continues to grow rapidly throughout the accession period. This situation offers Turkey the possibility of benefiting from a population structure that is weighted towards potentially productive age groups. However, this productive potential will only be realized if the economy can generate adequate employment opportunities. Even at the currently low labor force participation rate of about 40 percent for the 15-24 year age group (where the new entrants will largely come from), about 335,000 new jobs would need to be created annually just to address this new labor supply.

44 This is the OECD-standardized unemployment rate, which covers the working age population (15-64 years of age). SIS typically reports employment data for those 15 years and older which results in slightly different numbers. For example, the SIS unemployment rate for 2004 was 10.3%. In this report, we use the 15-64 year definition where possible in order to provide international comparability.

4.6 Turkey is very competitive in terms of its labor costs, which, with the right policies and institutions in place, should underpin faster employment creation. Unit labor costs both for industry and for the total economy are similar now to what they were in 1990 and are well below those in the EU-15, the EU-10, and Bulgaria and Romania.

4.2. EMPLOYMENT CREATION AND EU ACCESSION

4.7 Labor market performance is a concern as Turkey prepares for EU Accession. Demographic trends, the ongoing shift out of agriculture, and the expectations of an increasingly well-educated youth cohort will ensure that job creation will persist as a major domestic pressure through the accession period. As analyzed in chapter 1, stronger employment creation is a key precondition for faster growth and accelerated convergence to the EU average per capita income. Moreover, while in an optimistic scenario of strong job creation, Turkey’s rapidly growing working-age population could provide a useful (and selective) source of labor for an aging Europe, the context would be quite different if job creation is slow and unable to accommodate the supply of new entrants into the Turkish labor market. In a context of free labor mobility, existing member countries will be more at ease with Turkey’s application if it is creating jobs for its citizens and does not have a large pool of unemployed workers. Existing EU members would undoubtedly be very concerned about large labor flows out of Turkey seeking work in Europe because of scarce opportunities at home.

4.8 Turkey’s economic convergence to EU living standards will depend on job creation that is based on increases in productivity through better allocation of resources, technological change, and a more skilled workforce. The challenge for decision-makers will be to further establish and implement a policy framework that supports this development path in the context of economic liberalization. Certainly, because fast job creation has to be underpinned by faster growth and stepped up investment, some essential elements in such a framework rest outside the labor market—for example, the macroeconomic environment and a pro-growth investment climate. However, a number of critical factors fall within the labor market, including regulation, labor institutions, active and passive programs, labor costs, and workforce development.

4.9 The European Employment Strategy is intended to support member countries to create the conditions for full employment, higher quality and productivity at work, and social cohesion and inclusion. Accession candidates are expected to work with the EU to develop and implement a national action plan that will reach these objectives. As well, candidates are required to comply with the directives that are part of the Acquis. In its 2005 report on Turkey’s progress towards accession, the European Commission has identified areas where further reforms are required to implement the European Employment Strategy guidelines. These include worker representation and collective bargaining, social dialogue, elimination of child labor, and equal treatment (especially gender). The Commission has also emphasized that Turkey faces a major challenge to fully implement and enforce its labor laws on the ground.

4.10 With the 2003 Labor Code, Turkey has more closely aligned its laws to EU employment directives. However, further reforms will be needed to fully conform to directives regarding organization of working time, some aspects of fixed-term work, employees’ rights in the event of transfers, information for employees, and consultation and employee representation (Taymaz and Ozler 2005).

4.3. LABOR MARKET POLICIES AND INSTITUTIONS

4.11 The “tax wedge” on labor income is high. Relatively high payroll taxes are levied on employees (20.5 percent) and employers (20.5-26 percent) to finance social security. An international comparison of payroll tax rates concluded that Turkey’s combined rates were significantly higher than the average rate (25 percent) for middle-income countries. When Turkey’s taxes on labor – income and payroll45 -- are compared with European and other OECD countries, the relative burden depends on the family status and earning level of the worker. This is because, unlike most of these countries, Turkey does not levy lower income tax rates on families with children and on low earners. As a result, Turkey’s personal-and-payroll tax burden on workers with children is the highest of all EU countries. Low-wage workers, in general, face a relatively high tax wedge regardless of their family situation.46 Married women and youth -- groups with low employment rates – are overrepresented in these categories of labor with particularly high tax burdens. Even when these calculations take into account Turkey’s consumption credits that somewhat ease the tax burden on workers, the tax wedge remains high.47

4.12 Unfortunately, solid evidence does not exist to determine how much these taxes are constraining employment. This impact will depend on (i) the incidence of the tax – i.e., who actually pays the taxes – and, thus, its effect on total labor costs; and (ii) labor elasticities – i.e., what happens to employment as labor costs change. Based on limited evidence that does exist on these effects in middle-income countries, a 10 percent decrease in payroll taxes (i.e., 3-4 percentage points) would result in a one-time employment increase somewhere between 1-4 percent (roughly 200,000 to 800,000 jobs).

45 Payroll taxes dominate in Turkey, accounting for about 70% of the total. 46 The OECD and Eurostat have calculated the tax wedge for single workers earning 67% of the average production worker at 41.8% in Turkey, compared to 36.4% among EU members. The “tax wedge” is defined as income taxes and combined (employer-employee) social security contributions as a percentage of total labor compensation. 47 The effect of including the consumption tax credits differs depending on the earnings level and the family situation of the worker. Calculations made by the IMF and the World Bank indicate that including these credits into the calculations reduces the tax wedge by roughly 3-6 percentage points for different types of workers. Even with this adjustment, Turkey’s tax wedge remains above EU averages for many categories of labor and among the highest for the types highlighted in the text.

However, this range is suggestive only and empirical analysis is needed to estimate Turkey’s actual labor tax incidence and labor elasticities.48

4.13 Major reductions in payroll taxes should only follow ambitious social security reform, to address the precarious fiscal position of the social security funds. Taxes for unemployment insurance could be decreased without threatening the integrity of the UI Fund (as discussed below) but, since this represents a minor part of overall social security contributions, any employment gains would be relatively small. The strategy should be to successfully implement social security reforms to put the system on a better financial footing which would allow for deeper tax cuts in the future. In the meantime, institutional reforms to improve tax collection and reduce non-compliance would be useful. Whatever the aggregate employment impacts, reducing payroll taxes and strengthening tax collection and inspection would bring more workers into the formal social protection system.

Figure 4.2 : Turkey's employment protection rating (OECD index)

Turkey

Southe

rn Eur.

Contin

Nordic

New EU

OECD Asia

Anglo-

4.14 Turkey also has restrictive labor market regulations, specifically regarding hiring and firing, with potentially significant labor market impacts. Even with the changes under the 2003 Labor Code, Turkey’s employment protection rules are very restrictive by OECD and European standards (Figure 4.2). In fact, they rank with Portugal’s as the strictest in the OECD.49 Turkey’s high score is primarily due to its rules concerning flexible work contracting (temporary and fixed-term employment) which are the most restrictive in the OECD. It also reflects the severance pay requirements that are much more generous than is typically the case in other middle-income countries, or in Europe and the rest of the OECD. Turkey has short employment periods for severance eligibility and the payment levels are very high, especially for long-service employees.

4.15 Strict employment protection rules can provide important job security for workers but they can also have unintended consequences. Strict employment protection raises the cost of labor and, thus, discourages job creation – specifically formal sector jobs. Women and youth are disproportionately affected because they are underrepresented among the “insiders” who benefit from the job security rules.

48 It should be noted that the World Bank has requested data from the Government to undertake an analysis of the effects of payroll taxes on employment and informality. 49 This is based on the OECD’s index which is calculated according to dismissal regulations for permanent or regular workers; regulations regarding flexible work forms; and regulations governing collective dismissals. For details on the methodology and the results, see OECD (2004).

4.16 Compliance with labor market regulations, as with social security contributions, is weak in Turkey, especially in the SME sector. But this does not mean that reforms should not be implemented. The current policy framework still influences behavior -- with unfavorable economic and employment impacts. Employers appear to use different strategies to avoid the formal obligations associated with regular employees and to compensate for the restrictions on flexible contracts. One strategy is simply to operate informally. Another is to employ the existing workforce for long hours, rather than hiring new workers. In fact, workers in Turkey report actual hours that are among the highest in the world – far beyond European countries and even longer than in East Asian countries that are known to have long work weeks. An analysis of a sample of large firms during and after the most recent crisis found that formal sector employers maintain very stable employment levels even in the face of very unstable business conditions – including a reluctance to hire during the recovery.

4.17 The labor market policy framework is in the process of being modernized but it still creates disincentives for job creation, especially in the formal sector, and provides little protection to large segments of the workforce. Turkey entered the new century with many labor market policies and institutions that were no longer appropriate for a dynamic economic and social context. In the last few years, policy-makers have introduced some important modernizing reforms. But further progress is still needed to support job creation, enhance productivity growth, better protect workers, and broaden inclusion in the labor market.50 These reforms, coupled with continued economic growth, should result in an increasingly favorable climate for job creation and real wage growth as Turkey moves through the accession candidacy period.

4.4. AN AGENDA FOR REFORM

4.18 Recent initiatives, including the 2003 Labor Code, have brought Turkey’s labor market framework into closer alignment with EU requirements. While the labor market reform agenda goes well beyond the Acquis, more changes will still be needed to fully comply with the Acquis. These generally represent useful reforms for achieving a more efficient and equitable labor market but some of the reforms will require careful design and implementation in order not to work against the job creation objective. Moreover, Turkey’s negotiations with the EU should recognize that some of these could require a long transition period, either because they will be costly or because it will be difficult to get agreement from the social partners.

4.19 There is also a broader labor market reform agenda to create the conditions for full employment, higher quality and productivity, and social cohesion and inclusion. These objectives, which drive the European Employment Strategy, represent critical 50 Detailed analysis on many of the reform proposals included in this chapter was carried out by the World Bank in its recent study of the labor market in Turkey. See World Bank (2005).

challenges for Turkey’s continued development and for the process of convergence to EU living standards. Pursuing these objectives will necessarily require a wide range of reforms involving social security, labor legislation, employment programs, industrial relations, and education and training.

4.20 The underlying policy principle for achieving the objectives articulated in the European Employment Strategy should be to shift protection from jobs to workers. This will involve making labor market regulation more flexible while strengthening the support workers can receive through unemployment insurance, active labor market programs, and skills development. This reorientation is necessary if Turkey’s labor market is going to have the flexibility to benefit from the opportunities of ongoing economic liberalization, to provide full access to a diverse population, and to offer workers the tools to enhance their employability and to manage the inevitable adjustments in a dynamic economy. The summary policy table at the beginning of the study prioritizes the reform agenda needed to comply with the Acquis and to pursue the targets set by the European Employment Strategy.

4.21 More flexible job security rules would encourage employment creation, especially in the formal sector. The proposed reforms would bring Turkey more in line with comparator countries in Europe in terms of severance pay requirements and flexible contracting. Increasing flexibility in this way does not need to jeopardize the protection of the basic rights of workers. International experience suggests that women and young people would especially benefit in terms of increased access to formal employment.

4.22 As more basic job security rules are put in place, better protection for workers needs to be provided through a stronger safety net with wider labor force coverage. The key elements in this safety net would be an improved unemployment insurance system and capacity to implement cost-effective active labor market programs. Finally, a strong skills development system is essential for workers to be productive in a higher value-added and more competitive economy.

4.23 The unemployment insurance system needs to be reformed to increase its coverage. Currently, less than 5 percent of unemployed workers collect UI benefits. While this partly reflects the fact that the UI Fund is relatively new, this does not fully account for the slow build-up of beneficiaries. Less restrictive eligibility requirements and higher benefit levels would expand the coverage of the system and improve the support UI can offer to unemployed workers. The Bank supports the Government’s intention to modify both eligibility and benefit rules. However, our recommendations differ in detail from those currently under discussion in the Government.

4.24 The Government is in a position to consider liberalizing changes to the UI system given the strong financial position of the UI Fund. Because of low liabilities

and very high rates of return, the Fund now has a surplus of over 15 billion YTL (over $11 billion). Projections undertaken by the Bank show that the parametric reforms proposed, as well as a cut in contributions from 4 percent to 2 percent, could be financed without jeopardizing the sustainability of the UI Fund in any way. This finding does not change even when a macroeconomic shock and low interest rates are entered into the simulations. However, changes to the UI system should be designed in a broader medium-term fiscal framework, with a view to preserving the Consolidated General Government’s strong fiscal position.

4.25 Over the longer term, policy-makers may want to consider a more far-reaching reform strategy that fundamentally changes the architecture of income support for unemployed workers. This would involve integrating the existing severance and UI systems into fully-funded individual accounts to provide income support to workers who have lost their jobs. While many design issues would have to be worked out, such accounts have the potential to efficiently protect workers while solving some of the employment and compliance-related concerns that are currently difficult issues in Turkey.

4.26 In either case, income protection needs to be complemented by cost-effective active labor market programs for unemployed and otherwise vulnerable workers. Currently, Turkey has very little capacity to support these workers through better labor market information, job training, or job creation measures. However, the international experience suggests that capacity should be built up cautiously, with realistic expectations, and should be based on hard cost-benefit analysis. The evidence from other countries shows that these programs are not a panacea for unemployment but well-designed and implemented interventions can improve the functioning of the labor market and assist workers to find jobs.

4.27 Ultimately, in an environment where knowledge is becoming increasingly important, job creation and convergence to EU living standards will require education and training reforms that lead to a more skilled workforce. Currently, Turkey lags behind EU members on virtually all human capital indicators. Improvements need to be made to address deficiencies in basic skills, to enhance the quality and relevance of secondary and postsecondary education, and to increase training activity in industry. This will require challenging and far-reaching reforms but, given Turkey’s youthful demographic profile, preparation of the future labor force must be a priority.

CHAPTER 5. FINANCIAL SECTOR REFORM: MOBILIZING FINANCE FOR INVESTMENT

5.1 Turkey’s financial sector is repositioning itself to better facilitate growth of the private sector. The financial sector’s development was impeded by past macroeconomic instability and fiscal deficits, crowding out credit generation to the private sector. As a result, the sector today is smaller than its potential size and performing below its potential in terms of prudently allocating credit in the economy. Increasing credit to the private sector will not only facilitate capital accumulation, leading to growth and better labor productivity, but it will also improve the allocation of capital leading to TFP growth. This chapter provides an assessment of strengths and weaknesses in Turkey’s financial sector and lays out the main reform challenges during EU accession in order to facilitate sound financial sector development and maximize its impact on growth.

5.2 EU accession is a force for change directly through the acquis harmonization and indirectly through the positive impact on Turkey’s financial markets. EU directives will guide reforms of for instance bank and insurance supervision as well as auditing and accounting. Importantly, EU accession establishes a medium term policy anchor, which creates trust among international investors that Turkey is on a convergence path with EU. Together with the economic program supported by the IMF, this has contributed to a significant extension of maturities on Government securities in local currency and reduction in interest rates. In February of 2005, the Government successfully marketed a 5-year bond51 with a yield lower than the 1 year T bill, and international issuers have followed with maturities of as much as 10 years52. These are positive forces for the development of access to credit and in particular medium- and long-term credit products in local currency. As the market conditions for medium term credit are improving, increased attention should be paid to the divestment of state-owned financial assets and the institutional underpinnings of credit markets such as credit information, collateral regimes, and auditing and accounting standards.

5.3 The flip side of EU accession’s positive effect on financial markets is that a real or perceived loss of political commitment to the EU accession process would have an adverse effect on the financial sector. While the financial sector is significantly more robust than in the run up to the 2000/2001 crisis, vulnerabilities remain. A loss of confidence could lead to increasing interest rates, a depreciation of the currency, and a slow down in the real economy thereby not only leading to losses in the sector, but also contributing to a contraction of credit to the private sector.

5.4 In sum, financial sector reform remains an unfinished agenda. As Turkey continues on its path of economic and financial stability, the key challenges are to (a) 51 The bond carried a fixed coupon. 52 A 10-year fixed coupon bond was issued by EIB.

complete the majority privatization of the state banks; (b) strengthen the prudential framework for banks and non-banks alike; and, to (c) create a more robust credit facilitating infrastructure that will enable sound and efficient expansion of credit to the private sector, which in turn will foster competitiveness, growth and employment.

5.1.STATUS OF FINANCIAL SECTOR REFORM AGENDA

5.5 Resolute reform steps have been taken since the financial crisis of 2000/2001, and the banking sector is now healthier. Between 1997 and 2003, 20 banks were taken over by the SDIF, and all but one have been liquidated, merged or sold53, while one bank, Imarbank, was liquidated due to bankruptcy in 2003. Moreover, Kibris Kredi Bank was voluntarily liquidated without any burden to the public. The gross cost of the interventions amount to US$ 27 billion. As of June, 2005, US$ 3 billion had been recovered by the SDIF, and recently a large cell phone company was sold by the SDIF for US$ 4.55 billion included in the estimated additional US$ 11 billion to be recovered by the agency54. Capital adequacy of the banking system is now 23.6 percent, while gross NPL/total loans ratio has declined to 5.1 percent with a high provisioning level of 89.5 percent55. The bank supervisory system has been strengthened, and the deposit insurance fund has been separated from the regulator and has made substantial progress on resolving assets of the failed banks. The fiscal cost of restructuring the banking sector has been estimated at US$ 22 billion for the public banks and US$ 17 billion for the private banks transferred to SDIF for a total of US$ 39 billion or 27 percent of GDP. The total cost at US$ 39 billion is net of US$ 15 billion worth of recoveries on the SDIF banks that were taken over with US$ 32 billion worth of liabilities, and the SDIF expects to collect more than US$ 5 billion in addition over the next two years. The World Bank has supported the recovery and development of the banking sector through a series of adjustment loans, PFPSAL I-III.

5.6 Development of the financial sector is uneven. The banking sector is still the largest and most important part of the Turkish financial system (see Table 5.1). Although the public equity market has grown since the late eighties to a substantial size, the non-bank financial institutions (NBFI) sector56 remain small, and the NBFIs are generally owned by or otherwise affiliated with the major banks. The Government debt market, including a repo market, is large and liquid with significant participation from domestic banks, foreign investors, domestic mutual funds, pension funds and insurance firms. In contrast, the corporate bond market is virtually non-existent. It was recently announced that starting January 2006, a 15 percent withholding tax will be applied to all financial

53 This section draws on BRSA (2003), “Banking Sector Restructuring Program –(VII)”. 54 Please note that numbers in this paragraph have not been discounted to account for the time value of money, but rather are based on the cashflows converted into US$ at the time of the cashflow. 55 Ratios are based on BRSA monthly bulletin and reflect October 2005. 56 The sector includes mutual funds, pension funds, insurance, leasing, factoring, asset management and consumer finance firms.

instruments including Government debt securities, which were previously exempt, and that will contribute to increased appetite for corporate debt securities.

5.7 The contribution of the financial sector to efficiency and growth has been uneven too. A good financial sector contributes to economic wealth by providing an efficient payment system, by facilitating savings mobilization and investment, by transferring and sharing risks, and by allocating capital to where it is most productively applied. Turkey’s financial sector provides a good payment system and has efficiently mobilized savings, but the mobilized funds have historically not been supporting private sector investments and have instead been largely invested in few large firms and in Government securities. Therefore, it has neither allocated capital to the private sector efficiently, and nor has it diversified risks for investors.

Table 5.1: Structure of the Financial Sector57

2004 Mill. YTL Mill. US$Share of sector

Share of GNP

Number of entities

Banks 306,452 228,781 63.9 71.4 50State banks 114,917 85,791 24.0 26.8 6Private banks 191,535 142,990 39.9 44.7 44

Insurance and pension /1 8,124 5,817 1.7 1.9 61Non-life insurance 3,677 2,633 0.8 0.9 35Life insurance and pension firms 3,893 2,787 0.8 0.9 24Reinsurance 554 397 0.1 0.1 2

Leasing companies /2 4,227 3,027 0.9 1.0 82Factoring companies /3 2,019 1,446 0.4 0.5 110Brokerage firms 1,131 810 0.2 0.3 117Investment trusts (net asset value) 1,183 847 0.2 0.3 32

Of which real estate investment trusts 1,179 844 0.2 0.3 9Mutual funds 19,622 14,050 4.1 4.6 244Portfolio management firms na na na na 21Special finance houses 3,878 2,895 0.8 0.9 5Stock market capitalization 131,672 98,299 27.5 31 na

Total 479,486 356,815 100 112 731Sources: Treasury, ISE, and Banks Association.

/2 Data reflect March 2004

/1 Consolidated for insurance, re-insurance and pension fund companies. Pension includes only the private pension funds. Emeklilik Sandigis are reportedly significant.

/3 Data reflect 2002. Asset data are not available for 2004, but according to Factor Chain International, volume in US$ terms doubled between 2002 and 2004 suggesting that factoring assets are closer to 1 percent of GNP.

57 As of October 2005, total assets of the banking sector were US$ 268 billion of which state banks accounted for US$ 86 billion.

5.8 The banking sector is responding to the changing market conditions by shifting assets towards credit to the private sector. The banking sector is transforming its business model from earning a healthy spread between bank deposits and T-bill interest rates into a business model based on the assessment of credit risk opportunities and providing value added services for clients. By international comparison, the banking system performs comparably well against other non-Asian emerging markets in terms of mobilizing deposits, but credit generation to the private sector remains very poor (Figures 5.1 and 5.2)58. The near term challenge for the banking sector is to expand its credit and value added services to customers in a prudent manner, while staying profitable in the face of pressures created by declining margins between T-bills and deposits and the increased competition in the sector.

5.9 The recent rapid growth in credit to the private sector has been highly skewed towards consumer lending, highlighting the need for improving the SME credit environment. In the period 2002 to June 200, credit to the private sector increased from 14.8 percent of GDP to 20.5 percent of GDP59. However, about half of the growth was accounted for by retail lending, which increased from 14 to 31 percent of total credit to the private sector. In contrast, credit to firms in real terms has yet to reach pre-crisis levels. Moreover, firm credits remain concentrated with large firms, although that pattern is now changing along with the increasing credit. The skewed pattern highlights the need for improving the institutional underpinnings for an SME credit market.

Figure 5.1: Bank Deposits/GDP, 2004

68.061.3

41.8 41.435.7

24.1 23.6 23.1

Source: IFS and Staff Calculations

Figure 5.2: Bank Credit to Private Sector/GDP, 2004

32.2 27.7 27.619.8

14.4 10.3

Source: IFS and Staff Calculations Note: Reflects claims on private sector of deposit money banks.

5.10 The transformation challenge is particularly great for the state owned banks. State owned banks still retain 33 percent of banking system assets and are much more invested in Government securities than the private banks. In addition, the services 58 In most banks and in most countries, loan to deposit ratios are below one, but occasionally such as in the case of Malaysia, credits exceeds deposits and are funded with borrowings, issued securities, equity and other non-deposit liabilities. 59 Based on data from the CBT.

provided by the state banks tend to be less advanced than those provided by the private banks. In the aftermath of the 2001 financial crisis, each of the three large state banks was recapitalized and operationally restructured, and all three are now profitable. After privatizing these three large banks, beginning in 2006, Turkey will have a banking sector with less vulnerability and fewer potential distortions.

5.11 The forces for change in the banking system are strengthened by the increasing interest among foreign investors. Since December 2004, when Turkey got a date for starting accession talks with the EU, foreign investor interest in the Turkish banking sector has strengthened. Since January 2005, six foreign financial entities have bought or agreed to buy equity stakes in six domestic banks (see Box 5.1). The mentioned banks account for 24 percent of total Turkish banking sector assets or 38 percent of assets of the private banks. Foreign investors’ share in total assets and in assets of private banks is 12 and 26 percent, respectively. Foreign investors bring in new capital, lower cost financing, new governance requirements and risk management technologies, thus improving the access to finance for Turkish firms and enhancing the competitiveness of the sector.

Box 5.1: Foreign Strategic Investments in the Turkish Banking System • TEB, BNP Paribas bought 50 percent of the holding company for the bank • Koc Bank, Unicredito bought 50 percent of the holding company for the bank • Sekerbank, Rabobank acquired a 51 percent stake • Yapi ve Kredi Bank, the Koc/Unicredito partnership bought a 57.4 percent stake in the bank. • Disbank, is acquired by Fortis, which took an 89.3 percent stake in the company • Garanti Bank, strategic owner, Dogus Group, sold about half of its shares, 25.5 percent of the

total stock, to GE Consumer Finance.

5.2.REFORM AREAS AND CHALLENGES AHEAD

5.12 While substantial post-crisis progress is recognized, a multi-pronged reform agenda lies ahead. The three large state banks are yet to be sold to private investors. The supervisory frameworks are still in the process of building capacity while adapting to EU and Basel II requirements. The credit markets, which to a great extent remained dormant during the time of economic volatility, need institutional support in the areas of auditing and accounting, credit information system, collateral regime, enforcement of contracts, as well as more sector specific reforms, for instance in the development of a mortgage market. By pursuing such reforms, Turkey has the prospects for a vibrant financial sector that will provide a key pillar for more broadly developing the private sector by allocating credit in a more sound and efficient manner. The table in the beginning of the study summarizes the key recommendations by topic and identifies priorities under existing EU initiatives.

5.13 Almost all the major private banks are affiliated with large financial and/or industrial conglomerates through their shareholders. Related lending remains prevalent, as reported direct and indirect loans to shareholders amount to as much as 15

percent of capital in the Turkish banking system. In addition, almost all major banks have subsidiary or otherwise affiliated financial institutions such as life and non-life insurance firms, leasing firms, factoring firms, investment banks, and asset management companies. This presents governance and supervisory problems, because financial reporting is often incomplete without a consolidated group reporting requirement in place. While the reporting requirements for banks in Turkey do require the preparation of financial statements for the consolidated group, importantly, the consolidation does not include non-financial firms. In addition, the ultimate parent of groups that include banks is not required to present consolidated financial statements. Thus, consolidated supervision of the financial groups is incomplete and vulnerabilities are opaque, as affiliated firms have a comparative advantage over non-affiliated firms in accessing credit from affiliated banks. However, these issues are being addressed by the new Banking Law enacted in 2005 and its secondary legislation under preparation. The new banking sector legal framework is closely in line with the EU standards. Provisions under the new law include; lending to entities affiliated with the bank is limited to 20 percent of equity and the bank’s board may extend that limit to 25 percent under certain condition, which are in line with EU directives.

5.14 The financial sector is still taxed with transaction taxes that are distorting financial intermediation. The Banking and Insurance Transaction Tax (BITT) and the Resource Utilization Support Fund (RUSF) transaction tax are currently applied to credits and insurance premiums and have contributed more than 0.5 percent of GDP to annual fiscal revenues. For the banks, the tax base is interest paid by private borrowers leading to an increased loan-to-deposit interest rate spread and creating an impediment to developing access to credit for the private sector. The Government should consider abandoning the transaction-based taxes. At the same time, it would be advisable to reassess the tax system for the financial sector to make sure that tax neutrality prevails and distortions are minimized.

5.15 Auditing and accounting represents a critical area in need of reform in Turkey. While a good accounting may have limited merit in a high inflation environment, it is becoming a critical tool for improved transparency and governance, and it will be critical component for further developing credit markets as well as the corporate bond and public equity markets.

5.16 With the right framework in place the mortgage market is poised for strong growth. The mortgage market represents a high potential credit market in Turkey, and efforts led by the Turkish Capital Markets Board are underway to modernize and promote the primary market and establish a secondary market in order to provide alternative funding mechanisms to the primary lenders in the form of mortgage backed securities and/or mortgage bonds. In the near term, the priority will be to finalize the mortgage law, and in the medium term the greater challenge will be to effectively implement the law and establish effective regulation and supervision of the market.

5.17 Credit information and the collateral regime should be improved. These are important pillars for the credit environment for bank credit as well as for leasing, factoring and other credit institutions. The current state of credit information on SMEs is poor, but efforts by a private sector credit bureau are underway to improve credit information on firms, and these efforts should be supported by the necessary legislation and regulation.

5.18 The insurance sector remains poorly developed, but is poised for strong growth as the demand for products such as mortgage insurance grow. The supervisory regime has been highlighted by the EU as particularly poor, and a draft law designed to improve the regime has been lingering for some years. Efforts should be accelerated to modernize the supervisory framework in line with the EU Acquis.

CHAPTER 6. FOSTERING TECHNOLOGY ADOPTION, INNOVATION, AND SKILLS

6.1 Harnessing the knowledge factors—technology, innovation, quality and skills—is essential for increasing Turkey’s productivity and ensuring alignment with EU policies and strategies. Productivity improvements are driven by absorption of existing technologies, innovation, collaboration between firms and research centers, use of quality standards and the availability of a skilled labor force that can stimulate technology adoption and innovation.60 Admitting that the knowledge factors are drivers for productivity and growth, the European Commission placed them at the core of its economic policy objectives by issuing a Green Paper on Innovation in 1995 and by setting as one of its key objectives at the 2000 Lisbon Council Summit “making the European Union the most competitive and dynamic knowledge-based economy by 2010.” The 2003 Innovation Communication identified specific challenges that candidate countries must address in the knowledge areas in order to improve the performance of the enlarged EU. These are addressed in several sections of the Acquis, including Chapter 25 on Science and Research; Chapter 7 on Intellectual Property Law; Chapters 1 and 4 on Free Movements of Goods and Capital; and Chapter 26 on Education.61. This CEM chapter highlights key challenges related to technology adoption, innovation, quality standards and skills in Turkey, both to meet Acquis requirements and, more broadly, to improve the country’s productivity, which is essential to accelerate long term economic growth and generate employment.

6.1. PROMOTING TECHNOLOGY ADOPTION AND INNOVATION AT THE FIRM LEVEL

6.2 The three main avenues for acquiring existing technology in an open economy — foreign direct investment (FDI), licensing, and importing capital goods — are underutilized in Turkey. As explained in chapter 1, FDI has boomed in 2005, to an estimated 2.6 percent of GDP, after having remained compressed at less than 1 percent of GDP in the 1990s, despite a worldwide increase by a factor of 12. For FDI to meet its potential as a means of absorbing technologies the increased observed in 2005 will have to be sustained in the future. Import of capital goods, a major absorption channel, is only 26 percent of total investment, about one third of the proportion in Bulgaria and one fourth of that in Thailand (Figure 6.1). Licensing is similarly weak at about US$2 per

60 For a detailed discussion of the impact of technology, innovation and skills on productivity, see Closing the Gap in Technology and Education (World Bank, 2003). 61 European Commission, Turkey 2005 Progress Report. November 9, 2005.

capita, one-tenth of the amount in Poland and comparable to the amount in Korea during the 1960s (Figure 6.2). Turkey has had, however, some success in specific industries. Multinational corporations have played a major role in developing the automotive sector, with high positive spill-over effects on the local economy. Licensing agreements, particularly in the automotive, automotive spare parts, and white goods sectors, have also led to an accumulation of know-how and the development of local technological capacities.62

Figure 6.1: Capital goods import/investment

ital g

Turkey Bulgaria Chile Poland Romania Thailand Source: World Bank.

Figure 6.2: Royalty and license fee payments

)Turkey Bulgaria Chile Poland Romania Thailand

Source: World Bank

6.3 Turkey’s progress on innovation, in terms of investments in R&D and patents filed by Turkish inventors, remains uneven. Both overall investment in R&D (GERD at 0.66 percent of GDP at the end of 2002) and the share of R&D financed by the private sector (41 percent of the total in 2002) have increased (Figure 6.3) and are in line with Turkey’s level of development. The latest budget confirms that the government is moving in the right direction — funds allocated from the 2005 budget are higher than in all previous years. However, and notwithstanding recent initiatives to increase institutional capacity –including the creation of the Turkish Research Area (TARAL), which has as one of its key objectives that of increasing institutional capacity for innovation and supporting public-private cooperation in this area —more effort is needed to ensure that Turkey has coherent programs and capacity to utilize these resources effectively. Priorities for the future are improving firms’ investment in R&D, a key determinant of a country’s ability to ascend the technological ladder, and ensuring productive use of public R&D resources. The number of patents filed by Turkish innovators in the US, in the EU and at home is lower than for most comparator countries.63 Protection of Intellectual Property Rights (IPR) has recently been improved through (among other initiatives) changes to the law on trademark protection to ensure compliance with other 62 S. Elci, Innovation and Technology (background paper, 2005). 63 Turkish inventors filed 0.4 and 0.9 patents in the US and the EU Patent Office respectively, versus 1.1 and 2.0 filed by Bulgarian inventors, and 3.9 and 8.2 filed by Czech inventors. Turkey also underperforms comparator countries in filing patent applications at home: 8 patents filed per million people, versus 39 in Bulgaria and 60 in the Czech Republic. US patent figures are from USPTO (2003), European figures are from the European Patent Office Annual Report (2004), and national patent figures are from WDI (2002).

Turkish laws and EU requirements, decrees related to protection of pharmaceutical and medical processes and products and biotechnological inventions, and administrative changes to the Turkish Patent Institute (TPE). In addition to these recent changes, further effort is needed to enhance both IPR legislation and IPR enforcement, in turn ensuring full compliance with Acquis requirements and fostering productive innovation.

6.4 Investments in innovation are promoted through tax incentives, matching grants and reimbursable loan schemes, while venture capital is almost nonexistent. There are four main fiscal provisions to support R&D in Turkey. Turkish firms do not find tax postponement or support for R&D investment beneficial, and do not use these schemes. On the other hand, the incentives provided by the Technology Development Zone and R&D Tax Exemption Laws are very generous64 and should be reviewed to assess their effectiveness, fiscal impact and consistency with the Acquis. Fiscal incentives often do not benefit SMEs, which have insufficient profits to use the tax benefits and do not record R&D expenses separately on financial statements, making them ineligible. TUBITAK-TIDEM, TTGV and KOSGEB offer matching grants and reimbursable loans for innovative initiatives. Before scaling up, it is important that the outcomes of existing and new programs be evaluated on the basis of international best practices. Finally, although Turkish legislation was modified in 2004 to promote venture capital investment, both supply- and demand-side factors still constrain the VC industry in Turkey.

Figure 6.3: Gross expenditure on R&D, total and composition: 2001-2003, most recent data available

0.23 0.190.35 0.30 0.34

0.52 0.55 0.44 0.53 0.39

0.12 0.18

0.17 0.260.27

0.27 0.29 0.530.65 0.79

0.39 0.4

0.56 0.580.66

0.94 0.95

1.26 1.31

Mexico

Poland

Slovak

Portug

Industry-financed GERDGovernment-financed GERDGERD financed from abroad and by other national sourcesTotal

Note: Data from 2003 except Mexico (2001) and Turkey and Portugal (2002). Source: OECD, Main Science and Technology Indicators database, 2005.

6.5 Industry/research collaboration — a key condition for focusing research on productive purposes and stimulating technology adoption and innovation at the firm level — is limited. The main reasons are insufficient intermediaries, a lack of incentives to collaborate, perceptions that the quality of Turkish scientific institutions is low, and cultural differences between academia and business. The 2001 “Law on Technology 64 For all firms: deduction of 40 percent of R&D expenditures from taxable corporate income, in addition to the ordinary Investment Tax Allowance (deduction of 40% of investment expenditures); for firms located in technology development zones: exemption from CIT for software development and R&D activities, as well as PIT-exemption for salaries of R&D personnel until the end of 2013.

Development Zones” provides incentives for firm-university collaboration by allowing private companies in technoparks to hire university researchers and researchers to start companies in the parks. However, these incentives are unavailable outside technoparks. In fact, researchers who provide services to firms not located in technoparks must transfer 70 percent of their income to their universities and cannot start their own businesses. This isolates scientists and researchers from the industrial world. Other initiatives to facilitate firm-research collaboration include TUBITAK-TIDEB’s University-Industry Joint Research Centres (USAMPs), KOSGEB’s Technology Development Centers targeting SMEs (TEKMERs) and TTGV’s technology development financing program, which helps create linkages between firms and the R&D community. In 2005, TUBITAK also initiated a National Public Research Program to encourage public agencies to establish partnerships with industry and academia, and an Industry Liaison Office in cooperation with the Chamber of Commerce (TOBB), aimed at training TOBB staff to intermediate between industry and TUBITAK. Despite the recent increase in technoparks, USAMPs and TEKMERs and more recent initiatives, the Turkish innovation infrastructure is not sufficient to jumpstart university-firm collaboration throughout the country.

6.6 Policy and legal changes are needed to improve incentives for firm-level innovation and collaboration between researchers and firms, including extending to all universities incentives currently granted only to technoparks. University researchers, excluding students, can benefit from their own research in Turkey — an innovative academician owns the related IPR and has the right to commercial revenues from patents the research generates. While this policy is satisfactory, additional measures are needed to: (a) extend the benefits currently provided to researchers working in technoparks to all universities by eliminating the rule requiring academicians working outside technoparks to transfer to universities 70 percent of their extramural income; (b) provide students with the same rights as researchers, because they may contribute to increasing productive innovation and patent levels in Turkey; and (c) create patent cost sharing schemes between inventors, universities and governments, and introduce clear rules about IPR ownership between researchers, research institutions and private firms.

6.7 The industrial and intellectual property rights (IPR) legislation should be reviewed and IPR enforcement strengthened. As mentioned above and indicated in the EU 2005 Report on Turkey’s Progress towards Accession, Turkey has already significantly improved its IPR regime. However, further progress is needed to ensure full alignment with the Acquis on both IPR legislation and enforcement.65 The final legislation should be reviewed in collaboration with international experts and relevant stakeholders to ensure that it meets international requirements. Improving the IPR regime also requires strengthening of IPR enforcement. The most important measures are: increasing the autonomy of the Turkish Patent Institute (TPE) and further improving its staff’s capacity, knowledge and experience with registration and protection of IPR; further increasing the number of IPR courts and training programs for judges and prosecutors to ensure they can address the many IPR infringement cases; and limiting

65 European Commission, Turkey 2005 Progress Report, Chapter Seven on Intellectual Property Law, pages 66-68. November 9, 2005.

piracy and counterfeiting by applying sanctions and improving border controls following the EC Directive on IPR enforcement.

6.8 Increase the number of intermediaries that can improve communication and collaboration among firms, universities and research centers in Turkey. Innovation intermediaries (technoparks, USAMPs, TEKMERs, and the recent Industry Liaison Officers) should be evaluated so only successful approaches will be replicated more broadly.66 TUBITAK has recently started promoting public-private collaboration by requiring public agencies to establish consortia with universities and private firms in order to be eligible for funding, and by providing technical assistance and seed funds to young entrepreneurs. Successful international programs stimulating public-private collaboration which could be taken as a useful benchmark include the MAGNET program in Israel, TEKES in Finland and ATP in the US. The Spanish private-public Technology Innovation Centers (Centros de Innovacione Tecnologicas, or CITEs) may prove a beneficial model for promoting technology adoption among Turkish SMEs.

6.9 The design of the incentive system to increase finance for private R&D (i.e., fiscal incentives, matching grants and reimbursable loans) should be reviewed. The results of existing fiscal incentive schemes should be evaluated to assess their effectiveness, fiscal impact and consistency with the Acquis. Alternatives to fiscal incentives should be preferred for stimulating private R&D and innovation, particularly for SMEs. International best practice shows that well-designed matching grant schemes may be more beneficial in enhancing R&D investment and innovation. All matching grant and loan programs should periodically be assessed against international best practice, including the SPREAD program in India and, for matching grants, the experiences of Israel, Finland, Malaysia, Hong Kong, Chile and Mexico. Both TUBITAK and KOSGEB have started evaluating the results of their programs. External reviews could add value to the internal assessments by providing inputs based on lessons learned from international best practices. Finally, an overall support framework should be designed to: (a) replicate schemes with the highest impact on innovation, (b) assess and reduce overlap among providers, (c) increase collaboration between institutions and the funding ministries, and (d) reduce administrative hurdles in financing programs, which beneficiary firms say are a major drawback. The results of the agencies’ recent efforts to streamline processes (e.g., TUBITAK’s improvement in its TIDEB program including introduction of an advanced payment option in its R&D financing schemes) should be evaluated and complemented by similar initiatives aimed at streamlining administrative hurdles throughout the financial process.

6.10 Improving the effectiveness of the Turkish National Innovation System is important for conforming to EU policies and promoting innovation and technology absorption. An effective NIS is a prerequisite for successful technology adoption and innovation. Key measures to improve the Turkish NIS include: (a) reviewing the institutional capacity of TUBITAK to ensure alignment with international best practices; 66 The Ministry of Industry and Trade is developing a monitoring and evaluation (M&E) system to assess the results of existing technoparks. The M&E system should be designed on the basis of international best practices.

(b) complement ongoing internal assessments of TUBITAK’s programs and affiliate institutions (e.g., TUBITAK-TIDEM, MAM and UME), with external evaluations; (c) establishing regional policies, systems and infrastructure to support innovation and technology development at the local level;67 and (d) ensure that the national innovation strategy places productive innovation at the heart of all science and technology policies by strengthening the role of the business sector in the innovation process and broadening the definition of innovation to include non-technological improvements (e.g., organizational and process changes).68

6.2 IMPROVING THE NATIONAL QUALITY SYSTEM AND THE USE OF QUALITY STANDARDS

6.11 Turkey has gone a long way towards establishing a modern quality standards regime, but further improvements are needed.69 Standards adoption enhances firms’ capacity to export, absorb technologies and integrate with supply chains, in turn increasing productivity. Adoption of quality certification requires a well functioning National Quality Certification System (NQCS), comprehensive legislation and regulations, and sufficient accreditation and certification institutions. Turkey has replaced almost all national standards with EU and international standards and has a well functioning NQCS, comprising the Turkish Standard Institute (TSE), an accreditation agency (TÜRKAK) and a National Metrology Institute (UME). TÜRKAK, a full member of the European Cooperation for Accreditation, will soon be eligible for membership in the European Cooperation for Accreditation (EA-MLA), ensuring that its accreditations of Turkish notified bodies, its EC-type examination certificates and its conduct conformity assessments will be recognized in the EU. The transposition of harmonized European legislation into Turkish national legislation, as the first necessary step on the way towards full implementation of the legislation, is now nearing its completion. Public authorities are now at the stage of implementation of the transposed legislation. This requires, among other things, the establishment of a sound functioning market surveillance system with improved administrative and technical infrastructure.

6.12 Legal and institutional changes are needed to further improve Turkey’s National Quality System, coupled with provision of incentives to labs and firms to increase the use of quality standards. First, it is in Turkey’s interest to recognize tests

67 On Turkey’s overall need to improve decentralization, see EU 2005 Progress Report on Acquis Chapter 22 on Regional Policy and Coordination of Structural Instruments. 68 While Turkey has developed several strategic plans to support innovation, they have focused on R&D and science policies. The main science and technology objectives adopted by BTYK in September 2004 –confirmed by BTYK’s Science and Technology Strategies Implementation Plan for the period 2005-2010—are: increasing the share of GERD/GDP to 2 percent by 2010 (from 0.66 percent in 2002) and the number of full-time equivalent R&D personnel to 40,000 (from 28,964 in 2002), while increasing the number of vocational and technical staff proportionally. These are important objectives, but the strategy needs a clearer focus on productive innovation and technology adoption at the firm level and a stronger emphasis on output (rather than input) measures. 69 B. Kaminski, Technical Standards Regime and Trade (background note, 2005)

and standards for products originating in countries with which the EU has signed mutual recognition agreements (MRAs),70 It is also in Turkey’s interest to obtain similar recognition for its products from the same countries. This would reduce the cost of imports by increasing competitive pressures on preferential (i.e., free trade agreement) exporters to Turkey and Turkey’s quality standards. Second, some sector specific legislation should be aligned with the Acquis requirements (including for pharmaceuticals, cosmetics and chemicals), while food safety and foodstuff legislation should be adopted. Third, it is important to complete the process leading to TURTAK’s international recognition. Fourth, TSE’s responsibilities and functions should be compared with those of similar institutions operating in other countries. Fourth, there is a need to update the quality management system regarding standardization and development of a business plan on standardization work.71 Fifth, the government should encourage creation of private secondary metrology facilities to ensure national coverage. Finally, it is essential to increase Turkish labs’ and firms’ requests for accreditation and certification. Matching grants have proven successful at encouraging adoption of quality standards in several countries.

6.3. ALIGNING THE SKILLS OF THE LABOR FORCE WITH THE NEEDS OF THE PRIVATE SECTOR

6.13 Weak educational attainment is a bottleneck for widespread adoption of advanced technology and innovation. Turkish pupils do not acquire key skills for the knowledge-driven economy (e.g., problem solving, stating relationships between events, making complex inferences, creativity and continuous learning), leaving them out of sync with the needs of the private sector. Fifty-five percent of Turkey’s 15-year-olds perform at the lowest level on the PISA assessment of mathematics-quantitative proficiency, whereas the average in OECD countries is less than 21 percent (Figure 6.4). Similar results are found in reading literacy. Universities’ traditional academic curricula do not reflect the needs of the private sector. Partially as a result of this, unemployment among recent university graduates is high. Turkey’s vocational schools, both secondary and post-secondary, also provide insufficient quality education and training. This is particularly worrisome because employers in Turkey face a shortage of mid-tier, technician level workers.72

70 These countries include Australia, Canada, Israel, Japan, New Zealand, Switzerland and the United States. 71 EU 2005 Turkey Progress Report, page 56. 72 For a full analysis of education in Turkey, see the Turkey Education Sector Study (World Bank, 2005).

Figure 6.4: Distribution of students by PISA proficiency level in Turkey and EU, 2003

Source: Education Sector Study, The World Bank, 2005

<1 1 2 3 4 5 6 Proficiency

6.14 Improving the skills of the labor force and ensuring that they match the needs of the private sector requires rethinking the education system at all levels.73 It is essential that Turkey continues to reform and modernize primary and secondary school curriculum and teaching, as well as the structure of secondary education, to ensure that all Turkish students can acquire the skills that are needed by the labor market today and can serve as a foundation for lifelong learning in the future, including skills in problem solving, creative thinking. and communication.74 Reforms are also needed to encourage tertiary education institutions to differentiate their missions and strategies, with a different balance of effort across the functions of teaching, research and service provision, so as to provide more viable and desirable options for graduates of high school interested in pursuing postsecondary studies. The admissions system for tertiary education should also be modernized to provide incentives for all young people (both in vocational and general secondary schools) to study and learn the core competencies needed to have successful careers in a globally competitive labor market. There is a need to consolidate and refocus post-secondary vocational schools (MYOs) into fewer, more efficient, and higher quality institutions with their own budgets and missions, while maintaining the academic link to universities. Turkey should also consider using its funding of postsecondary education to upgrade MYOs into technical colleges or polytechnic institutions granting two- to four-year degrees in a broad variety of areas so as to more flexibly provide high end technical skills to its graduates, in line with labor market demands. Finally, more emphasis should be given to cultivating lifelong learning systems for continuously upgrading human capital and to promoting continuing vocational training.75 This can be accomplished by providing incentives to firms to both hire technical personnel and provide relevant training.

73 See the Turkey Education Sector Study (World Bank, 2005). 74 The Government hopes to address these quality constraints by means of a comprehensive program of curriculum modernization that it launched in 2004 to improve teaching and learning across all of the core subject areas. 75 On the importance of lifelong learning, see also the EU 2005 Turkey Progress Report, page 118.

CHAPTER 7. INFRASTRUCTURE SERVICES FOR IMPROVED COMPETITIVENESS

7.1 In key infrastructure service areas, Turkey has already made substantial progress in designing the changes to legal and regulatory structures needed to meet EU acquis requirements. While much implementation work remains, Turkey recognizes that the combination of internal market liberalization and effective integration with international markets offers efficiency gains that will increase competitiveness and employment growth.76 This chapter of the CEM focuses on the nexus between EU accession and growth in three infrastructure sectors – Information and Communications Technology (ICT), transport, and energy. Within these sectors, the Government has choices to make in regard to phasing and timing of the changes needed to meet acquis obligations. This chapter offers guidance from Bank and international experience.

7.2 Infrastructure services are an important driver of growth. Transport and communications contribute approximately 15 percent of Turkey’s GDP. The importance of these services reflects both internal demand and Turkey’s geopolitical position – as a link between Europe and Asia. Energy services contribute an additional 3.5 percent of GDP. Each of these services offers the potential for substantial efficiency gains through structural changes – typically already underway – and regulatory strengthening.

7.3 Although Turkey is relatively well endowed with infrastructure compared to other emerging economies, it falls short of OECD and EU standards. Businesses are burdened by costly, low quality backbone infrastructure services. In particular, the cost of telecommunication services and energy remains among the highest in the OECD area,77 while quality is among the worst in that area.78 The dominant transport mode – road -- suffers from localized congestion and deteriorating road quality. While daunting, this combination suggests that much can be gained through more efficient, user financed, operations. The largest transformational challenge is moving from monopolistic state entities providing services toward the mix of private and state that characterizes efficient higher income economies. Of course, the infrastructure implications of meeting all 76 Embodied in the Turkish National Programme for the Adoption of the Acquis 77 OECD, Economic Survey of Turkey, Paris, 2004. 78 The Turkish Industrialist’s And Businessmen’s Association makes this point in their Working paper “Investment Environment And Foreign Direct Investments In Turkey” prepared for Investors Advisory Council Meeting, 15 March 2004, İstanbul TS/SEK/04-06

acquis requirements go well beyond those discussed in this chapter. In particular, the environmental dimension, with its very large financial costs, will be dealt with in a later CEM.

7.1. INFORMATION AND COMMUNICATION TECHNOLOGIES

7.4 Turkey has recently enjoyed very rapid growth in telecommunications, driven by expansion of cellular service. Yet internet use remains relatively low compared to other new EU member states, broadband coverage is similarly low, quality problems in mainlines remain pervasive, and prices high. The importance of further ICT development can be seen in the EU context, where ICT is credited with 50 percent of productivity growth between 1995 and 2000. Although productivity impact estimates have not been made for Turkey, if Turkey’s recent gains in telecommunications coverage can be extended to other elements of ICT, similar gains can be expected.

7.5 Turkey brings strengths in facing the challenge of ICT development. The telecommunications regulatory authority (TK) and competition authority (RK), have proven effective despite working in a difficult legal environment. That legal environment will improve as Turkey enacts and implements the relevant acquis provisions. Turkey has moved forward by ending the monopoly rights of Turk Telekom in 2003 and with a successful initial tendering for Turk Telekom in 2004 and the completion of the transaction (a block sale of 55 percent) in 2005, an important step toward market liberalization and improved efficiency. But Turkey’s progress in telecommunications needs to be complemented by a strategy leading toward convergence to the EU’s evolving ICT benchmarks.79 Responding to an environment in which Turkey’s household internet access is at 8.7 percent while the EU25 is at 42 percent, the government has intensified efforts to increase internet use, giving priority to schools from 2006.

7.6 Complementary actions, beyond the Acquis, are needed to facilitate ICT diffusion. The importance of ICT as the enabler of the Information Society was enshrined in the Lisbon Strategy which represents Europe’s response to the challenge of accelerating growth and job creation in the ‘knowledge based economy’. The implementation of the Acquis for electronic communications will provide the regulatory and business climate for increased investment in ICT and thereby improve the competitiveness of Turkish businesses. Acquis requirements must be, however, complemented by supporting legal instruments related to data protection, privacy, and e-security, as well as a panoply of initiatives related to the application of ICT in such activities as e-government, health, learning, work, business, mobility, transport, content and inclusion. Possibly discriminatory taxes also burden the development of the mobile

79 See http://europa.eu.int/information_society/topics/ecomm/index_en.htm

segment—a key underpinning of the ICT sector. In response, the Ministry of Finance is now reviewing sector tax policy.

7.7 Continuing market liberalization will play a key role. To promote ICT, the European Commission has emphasized the importance of continued implementation of Turkey’s efforts to liberalize the ICT market, with a view to increasing competition and lowering prices.80 The recent increase in market entrants signals the potential for meeting this goal, but legislative and regulatory behavior must work to curtail monopolistic behavior on the part of established providers. This effort, which has little fiscal cost to government, should head the ICT agenda. In particular, post-privatization of Turk Telecom, both TK and RK will need to be more vigilant regarding the progress of liberalization in order to ensure that the full benefits of competition in the sector materialize. A private Turk Telekom retains considerable market power over bottleneck facilities essential to the development of competition.

7.8 Turkey should consider a mutually reinforcing set of actions that further speed the development of the ICT sector. In addition to assigning cabinet-level responsibility for leading that work, Government should take the following set of priority actions:

• The transposition and effective implementation of the acquis for electronic communications well before EU accession.

• A re-examination by government of the definition and implementation of its ICT policy. Government needs to confirm their objectives regarding the e-agenda, including the aspect of social inclusion (especially regarding farming and rural areas) and broadband, and the role it will play in these developments, thereby sending clear signals to the market. The government can play a vital role through its procurement of ICT, both by fostering more intense competition in and by encouraging the aggregation of demand for certain goods and services to bring about lower prices.

• Reduction of taxes if review shows them to be discriminating against the mobile sector.

• Establishment of monitoring and evaluation schemes to measure progress and the fulfillment of objectives and reporting regularly.

7.2. LINKING UP WITH TRANS-EUROPEAN NETWORKS

7.9 The critical role of efficient transport in growth and the effective integration of the internal market lead to high EU attention to the sector. The most recent (October, 2004) EU Progress Report for Turkey concludes: “Some progress could be recorded in all transport modes, excepted air transport, but overall alignment remains limited and all modes present problematic issues.” With the EU now Turkey’s most important foreign

80 The EC makes this point in their “2004 Regular Report on Turkey’s progress towards accession” {COM(2004) 656 final}

trade partner, progress in this area must focus not only on sector-specific reforms, but also on comprehensive trade and transport facilitation in major corridors implementing the EU Integrated Border Management Initiative and EU policies to address modal imbalance.

7.10 Major efforts remain to be made in implementing the National Program for the Adoption of the Acquis Communautaire. In the transport sphere, the following actions have been initiated as part of the Revised Accession Partnership short-medium term action plan: (i) alignment on road transport legislation (market access, road safety as well as social, fiscal and technical rules), railways and air transport (particularly air safety and air traffic management); (ii) ensure effective implementation and enforcement of transport legislation, particularly as regards maritime safety, road transport as well as air transport; (iii) complete alignment with EU maritime legislation in safety and non-safety areas; improve maritime safety, in particular improve the performance of maritime safety administrative institutions, first as a flag State, and then as a port State, and guarantee their independence; (iv) implement a program of adaptation of the Turkish transport fleet, particularly maritime and road transport, to Community technical norms; and (v) adopt a program with a view to identifying main transport infrastructure needs in Turkey and related transport-network projects, in coherence with the European Community TEN-transport guidelines. In terms of regulating the road transport market, two pieces of new national legislation (Road Transport Law and Road Transport Regulation) entered into force, elaborated in accordance with EU legislation concerning access to the market and the profession.

7.11 Government is reviewing a draft National Transport Strategy for approval. In addition, a Transport Infrastructure Needs Assessment (TINA) study is currently being carried out by the State Planning Organization (SPO) and Ministry of Transport (MoT), with a view to identifying main transport infrastructure needs in Turkey and related transport-network projects, in coherence with the European Community TEN-transport guidelines. One clear message from analytical work to date is that a shift is needed between the various modes of transport, especially for the transport of freight which should be gradually – but steadily – transferred from the road to the railways. Due to the steady increase of containerized cargo, intermodal transport systems should also be promoted to improve the connections between the various modes of transport, e.g., improved railway linkage to ports.

7.12 The challenges facing the transport sector go well beyond meeting the needs of the acquis. Road transport, the mainstay of the system, with 92 percent of freight traffic, has faced substantial underinvestment in maintenance and rehabilitation over the past decade. The percentage of roads in the state road network rated in good condition has slipped from 80 percent in 1993 to only 45 percent in 2003. The development of a sustainable model for road sector financing presents a major challenge.

7.13 National Road Administration (KGM) is a fairly effective organization dedicated to gradually increasing its efficiency in road management. However, it must do so in the face of: (i) insufficient funding for the maintenance and rehabilitation of the road network, especially with regard to rural roads and motorways; (ii) high injury and fatality rates from road crashes. Investments in traffic safety have led to recent progress, however, Turkey is still lagging behind European countries; and (iii) the need to further develop outsourcing road works to the private sector, especially through performance based contracts.

7.14 The rail system has been a major drain on government fiscal resources, while handling only some 5.7 percent of freight and 2.2 percent of passenger traffic.81 In 2004, TCDD, the Turkish State Railways, lost US$780 million (US$ 470 milliom including subsidies) and total government transfers, including the capital investment program, amounted to US$1,023 million, or 0.4 percent of GDP. Although a very large sum, it must be noted that as a share of GDP this level of budget support together with uncovered losses is broadly comparable with other railways in middle-income countries in Europe82. Apart from the fiscal implications, within the transport sector, TCDD faces the greatest challenge in meeting the acquis requirement that social services be separated from commercial services.

7.15 In response to these challenges, the Government has taken a clear commitment for in-depth reform of TCDD, as will be defined in two new Laws: (i) a Railway Law providing a new legal framework for railway activity consistent with EU directives; and (ii) a TCDD Law supporting the reorganization of the national railway company. The restructuring includes the separation and eventually the privatization of the affiliated companies and of the ports operations, the reshaping of the labor force and the reduction in redundant staff. A social plan is to be implemented gradually in order to minimize the negative impact resulting from the staff adjustment process.

7.16 Port and rail sector reform are interrelated, as TCDD now manages the seven most important ports that are currently being privatized. The ports have been profitable, if inefficient, and at the end of 2004, the High Privatization Council annnounced that the Bandirma, Izmir, Samsun, Derince, Mersin, Iskenderun ports would be included in the privatization program.83 Port assets will remain public property, with TCDD involved in post-privatization monitoring of investor’s performance. The privatization plan calls for a transfer of operational rights for a 36 year duration.

81 The EC makes this point in their “2004 Regular Report on Turkey’s progress towards accession” {COM(2004) 656 final} 82 Croatian Railways (1.3% of GDP), Romanian Railways (0.7%), Bulgarian Railways (0.6%), Poland (0.4%). 83 Privatization High Commission decision 2004/128, December 30, 2004

7.17 Port privatization requires careful design. The Bank has discussed the port privatization process with the Privatization Administration and raised a number of concerns, including: (i) the ability to effectively regulate the private monopoly that will now control each major port; (ii) tariff policy after the initial three year freeze; and (iii) whether the technical documents adequately address pre-qualification and other concerns. One of the key lessons from the Latin American port privatization experience of the past decade was the importance of an adequate regulatory framework for concessions. The Undersecretary for Maritime Affairs now acts as the National Port Authority with the power to: (i) regulate port tariffs; (ii) ensure security and safety within the Turkish ports; and (iii) manage the Harbor Masters’ functions and responsibilities. The Undersecretary is involved in the design of the privatization process and will therefore play a key role in ensuring that recent international experience is incorporated in the regulatory approach finally adopted.

7.18 In maritime transport progress has been made, except for national cabotage services. The sector in Turkey is fully liberalized with significant progress recently observed in the quality of the vessels under Turkish flag complying with Paris Memorandum of Understanding (MOU) requirements. Regarding national cabotage services, the government has included its intention to liberalize national cabotage in the EU accession National Program, after EU membership.

7.19 Liberalization of domestic air transport. The recent opening of domestic air transportation to competition was followed by the emergence of several private carriers. These carriers provide cheaper transport options in certain high-volume routes with ticket prices reportedly around two thirds cheaper than THY. In 2004, the special process tax (ozel islem vergisi) and education support fund share (egitime katki payi) were eliminated from the airplane ticket prices.

7.3 ENERGY

7.20 Government has focused for several years now on the restructuring of the energy sector, working for liberalization and regulation that will lead to more competitive, higher quality supply. In EU terms, Turkey is signatory to the Athens Memorandum, 2003 – the Memorandum of Understanding on the Regional Energy Market in South East Europe and its Integration into the European Union Internal Energy Market. While the other regional members signed the Energy Community Treaty in October 2005, Turkey is currently in discussion with the European Community on some aspects of the Treaty, before it considers signing the Treaty. Turkey however, remains committed to implementing the Acquis as demonstrated by the progress – albeit uneven –on its ambitious and complex reform program in energy.

7.21 While Turkey has implemented a number of the requirements of the EU and has actually achieved more than is required under the directives, its overall alignment with the EU directives remains uneven across different areas of energy policy. The Government has, not allowed retail tariff increases over the past three years. They have partially compensated by increasing the use of hydro generation, the production cost of which is low. Government agencies and offices, notably municipalities, do not pay on time or adequately for their electricity consumption, leading to a further cash flow problem in the electricity sector – the Government is endeavoring to introduce new legislation to curb this problem. It is also hoped that with privatization of distribution, this problem of non-payment will reduce – privatization itself is delayed however, and it will take time to privatize the entire distribution network. There are delays in implementing the balancing market as well. There is a large degree of market opening at present, and Turkey aims to achieve the ambitious target of complete market opening by 2011.

(a) Power

7.22 Turkey has opened up the retail electricity market and is in the process of implementing a competitive market for electricity. Currently consumers with up to 7.7 GWh of demand are considered “eligible”, i.e., they can choose their electricity supplier. Current market opening is estimated at almost 30% of the total Turkish electricity market. A transitional balancing market is also being tested at this stage, and will consist of a bilateral contracts market complemented by a balancing and settlement system. At a later date, a day-ahead market with “spot” prices will be instituted. The market, once it is functional, is expected to provide the necessary price signals for potential new generation.

7.23 With the exception of Turkey, by late 2004, all South East Europe power systems were synchronously interconnected. The two existing 400 kV transmission lines between Turkey and Bulgaria would allow full integration of Turkey by the end of 2006. In addition to these lines, a new 400 kV line between Turkey and Greece is now under construction, with expected commissioning time is 2007. Turkey is not a member of the Union for the Coordination of Transmission of Electricity in Europe (UCTE), but would like to join. Turkey’s interconnection with UCTE is expected to contribute to the security of supply both in the South East Europe region and in Turkey through electricity trade. Turkey is undertaking key investments84 required for joining UCTE, and detailed technical studies in this regard have been initiated in coordination with UCTE. Turkey is the dominant power producer and consumer in South East Europe – current generation capacity however, is projected as adequate only to meet demand through the next four years, and thus, security of electricity supply beyond 2009/2010 is a key government 84 The World Bank is financing some of these investments through ongoing loans, NTGP, and ECSEE APL2.

concern. However, given that the electricity market is in transition towards a competitive one, and given that the Government does not want to take on further liabilities with regard to new generation facilities, few alternatives remain. The Bank and Government are beginning work on exploring options for obtaining additional generating capacity in the current situation – a competitive market in transition and delays in privatization of distribution..

7.24 Power prices are relatively high in Turkey. In 2004, prices were approximately US$0.085/kwh before VAT for households and US$0.095/kwh for industrial consumers. These prices are higher than those faced by medium consumers in all but three of the EU15 countries.85 Turkey currently has implicit cross-subsidies between regions and also for certain sub-categories of consumers. The Government is contemplating putting in place a transition period – through the use of a tariff equalization methodology which is envisaged for implementation starting in January 2006 – for reducing cross-subsidies and graduating to cost-reflective tariffs over the medium term.

(b) Gas

7.25 Reform initiatives are in the right direction but should be fine-tuned. The government has addressed the gas sector challenge through a 2001 Natural Gas Market Law86 and subsequent secondary legislation. Current legislation is compliant with the EU Natural Gas Directive and is designed to open the gas market to competition and, eventually, foster a role for Turkey as a transit country. The Bank’s recent policy note on the sector analyzes progress in implementing the law and highlights measures needed to achieve the objectives of the Government in the sector over the medium term.87 Gas has grown rapidly as a percentage of total primary energy supply in the past decade, now reaching 23 percent. Moving to competitive gas wholesaling within Turkey, which is established policy in the EU, is important for promoting the efficiency of the sector. The policy note highlights the importance of moving to competitive gas wholesaling within Turkey. The note also states that it may not be feasible to transfer BOTAS gas contracts, advocating instead the use of volume release programs, an accepted approach in EU countries. The Law has been amended in June 2005 to allow volume releases as well. The Government has launched a contract/ volume release program for about 64% of existing demand, though the process has been delayed due to the amendment to the Law. Contract release tenders have been realized on November 30, 2005. Bids are currently being evaluated. BOTAS is also in the final stages of separating its transmission, storage

85 Using medium sized industrial consumers as the guide price. EU15 prices faced by small consumers equal or far exceed US$0.085 in all but Sweden among the EU15. 86 Natural Gas Market Law - Law No. 4646 87 World Bank: Turkey: Gas Sector Strategy Note, Report No. 30030-TR, September 2004

and natural gas sales businesses into separate accounting entities, in preparation for eventual unbundling.

7.26 EMRA has also awarded licenses to private investors for building and operating greenfield gas distribution systems in 31 cities over the past two years. While it is still early to comment on the outcome of these privatizations, 20 of these cities are reported to have commenced the use of natural gas.

7.4. COMMON REFORM DIRECTIONS

7.27 The long run gains offered by liberalization of infrastructure services offset the costs, but do require thoughtful timing and legislative action to realize. The sectors discussed above share the qualities of high cost relative to comparator countries, and relatively low efficiency. The combination, while daunting, does mean that unlike many countries, Turkey has the potential to lower the cost of services while increasing quality and coverage. The means to achieve this – market liberalization to capture the benefits of competition – are embodied in the relevant acquis chapters, so Turkey’s on-going efforts to achieve that goal are consistent both with growth strategy and accession requirements. Furthermore, the needed actions typically have a low economic cost and offer fiscal relief. However, institutional reform comes with other costs that have slowed implementation. These include shifts in relative power among actors in the sector, with government agencies or state economic enterprises yielding power to more independent private entities (or state entities operating on commercial terms). The use of tariff policy as a social instrument will need to be altered in favor of explicit budgetary provision for social support. Finally, although the EU Acquis and practices allow for financial transactions and other practices through the “services of general economic interest” under well-defined conditions, the government’s flexibility in the use of Treasury shares, duty losses, and other ad hoc financial transactions with state economic enterprises should continue to be curtailed.

PART C: PROMOTING INCLUSIVE GROWTH

CHAPTER 8. ALIGNMENT WITH EU AGRICULTURAL AND RURAL

DEVELOPMENT POLICIES

8.1 Agriculture is poised for structural change. As Turkey still heavily protects its agriculture and foods sectors, a reduction in protection on the way to the EU would tend to hurt agriculture. However, simulations of the long-term impact of EU accession suggest that the increase in market access into the EU could generate a significant increase in demand that would support significant growth of the agricultural and food sectors in Turkey. Despite this favorable impact, the high share of employment in agriculture is likely to decrease in the future, as in other countries that have liberalized agriculture. The structural changes in production required to boost competitiveness and take advantage of the new environment will also put pressure on rural labor markets. Consequently, one of the key rural development concerns would be whether economic activities in rural areas will be able to absorb labor force leaving the agricultural sector. A main challenge will be to support adjustment to structural changes in agriculture, and promote rural development.

8.2 The dual challenges will be to support adjustment to structural changes in agriculture and promote rural development off-farm more widely. Strengthening policy coherence will be particularly prominent in the process of EU accession. Particular emphasis will be placed on coherence of instruments and policy objectives between the agricultural and rural development policies, and of their respective institutional and implementation arrangements in line with the CAP.88 The accession process also implies the EU alignment of Turkey’s national rural development policy and objectives. This chapter reviews options that may complement initiatives considered by the Government, including strengthening the coherence and coordination between commodity policies, rural investment policies, and irrigation and drainage policies.

88 The reformed CAP consists of two pillars, with the rural development representing the 2nd pillar. The 1st pillar concentrates on providing a basic income support to farmers, while the 2nd pillar supports agriculture as a provider of public goods in its environmental and rural functions and rural areas in their development. See: http://www.europa.eu.int/scadplus/leg/en/s04002.htm.

8.1. ALIGNMENT WITH THE EUROPEAN UNION COMMON AGRICULTURAL POLICY (CAP)

(a) Comparative support to Agriculture in Turkey and the EU

8.3 Turkey increased the level of producer support but mainly through tariff protection and trade barriers that are reflected in high consumer prices. Turkey increased the level of producer support (measured by percent PSE and NAC) since the second half of 1980s (Table 8.1). Continually high import tariffs on agricultural commodities and non-trade barriers have kept agricultural prices high, with 22 percent of consumers’ food expenditures an indirect subsidy to agricultural producers—roughly on par with the EU-25.89

Table 8.1. Indicators of Support to Agriculture Turkey and EU (1986-2004) 1986-88 2002-04 Turkey Total Support Estimate (TSE)/GDP (%) 3.94 4.40 Percent Producer Support Estimate (PSE) (%) 16 25 Percent Consumer Support Estimate (CSE) (%) -16 -22 General Services Support Estimate (GSSE) /TSE (%) 9.7 10.8 Nominal Protection Coefficient (NPC) 1.17 1.28 Nominal Assistance Coefficient (NAC) 1.20 1.34 EU Total Support Estimate (TSE)/GDP 2.82 1.24 Percent Producer Support Estimate (PSE) 41 34 Percent Consumer Support Estimate (CSE) -38 -21 General Services Support Estimate (GSSE) /TSE 9.1 8.2 Nominal Protection Coefficient (NPC) 1.80 1.32 Nominal Assistance Coefficient (NAC) 1.71 1.52 Source: OECD (2005) 8.4 Support, through direct payments and other programs, remains lower than in the EU. With reform of most budgetary subsidies for agricultural outputs and inputs and substitution by the recent Direct Income Support program Turkey’s overall level of support has been and continues to be about 10-15 percent below that of the EU.90 The

89 Non tariff barriers have been particularly distorting in the case of beef imports. Official beef imports have largely ceased owing to an import ban imposed by the government in 1996 on the account of mad cow disease. However, domestic beef production is not enough to meet demand for beef. On the other hand, a considerable cattle import has been made illegally (an estimated 1 million cattle in 2001), which is also of concern for public health. Owing to these illegal imports, beef prices do not increase as much as would be expected. Instead of banning legal beef imports, more targeted measures could be considered—such as establishing a system of cattle registration and traceability. In addition, the high cost of feed due to high import tariffs on maize and interventions of TMO could be adjusted to allow livestock farmers to access to lower cost as well as better livestock suitable feed crops such as soybeans. 90 Reflected by Nominal Assistance Coefficient (including both market support through tariff protection as well as additional payments made to producers).

difference reflects higher support extended by the EU through non-market subsidy instruments (i.e., budgetary transfers). Support in Turkey for general services, such as research and development, extension and marketing, has been quite volatile with considerable decline in 2004. Since success of alignment efforts with EU will largely depend on upgraded support to farmers on advice on cropping patterns, access to new technologies and better marketing, increased support for general services in agriculture will be quite important for Turkey.

8.5 Alignment of market support, through reduced trade protection, with CAP would have an uneven impact by major commodities but would enhance consumers’ welfare. Producer farm gate and world reference price differentials measured by the NPC are higher for many commodities in Turkey than those of EU (Table 8.2). A simple (static) simulation based on NPC ratios of 2004 show what would be the affect on production values in Turkey of alignment with the current levels of agricultural prices in the EU-25. The biggest reductions in price and in value of production would be seen for potatoes, grapes, sunflower, maize and barley. Beef, milk and wheat would have price reductions as well; whereas prices for sugar beet, poultry and sheep would have to be increased. It is important to note that these price reductions would positively affect consumers’ welfare as food expenditures would decline.91

Table 8.2 Change in Value of Production with EU CAP Alignment (in %) Production

Value Share

Difference in NPC, 2004 (Turkey vs. EU25)3

Difference in NAC, 2004 (Turkey vs. EU25)3

Change in Value of Production with Market Protection Alignment 1

Change in Supported Value of Production with Full CAP Alignment 2

Wheat 23.3 0.12 -0.18 -10 12 Barley 8.3 0.27 -0.25 -20 15 Maize 3.6 0.37 0.12 -21 -6 Sunflower 2.1 0.29 -0.1 -23 7 Sugar beet 5.4 -0.42 -0.48 16 17 Potatoes 5.9 1.55 -58 Grapes 11.4 0.51 -33 Milk 14.2 0.13 0.09 -9 -6 Beef 13.3 0.15 -0.97 -7 45 Poultry 7.1 -0.14 -0.26 8 15 Sheep 5.6 -0.29 -1.05 28 101 Weighted Average of above

0.19 -0.27

-12 17

Notes: 1 Assumes full NPC alignment with EU-25; 2 Assumes full NAC alignment with EU-25; 3 in percentage points Source: OECD (2005) and World Bank staff calculations 91 These static results do not take into account supply responses and production shifts across agricultural commodities, growth of domestic aggregate demand, nor any kind of general equilibrium effects (see the analysis below). As other studies have shown earlier, for example Nash, et al. (2002), and the modeling exercise conducted for the CEM has confirmed, CAP alignment may have a positive impact on both consumers and farmers in the medium to long term as farmers adjust to the new policies and as real household incomes increase.

8.6 On current EU policies, full alignment with CAP would entail an increase in overall support for Turkish agriculture, but subsidies will have to be aligned with a moving CAP landscape. Although the market support portion of the agricultural producers’ total support would decrease, Turkey’s total producer support would increase further for many commodities if it were to become fully aligned with the levels currently maintained in the EU-25. Comparing NAC ratios92 for major commodities, Turkey’s producer support for most of the commodities are currently lower than in the EU, and would have to increase, with the exception of maize and milk (Table 8.2). However, because the structure of CAP keeps evolving, it is uncertain that upon accession overall support for Turkish agriculture could in reality increase. In the years ahead, the share of CAP budgetary transfers in total support is unlikely to be growing by enough to fully offset the expected decline in EU agricultural trade protection. In addition, the CAP budgetary support to be received by producers in new EU members is likely to be phased in over long periods, with flexibility for the domestic budgets of Member States to “top-up” CAP transfers.

8.7 Full alignment is expected to take a long period, to be phased in after accession, and with a very different CAP landscape. First, the levels of NACs in the EU will likely continue its slow decline over the next ten to fifteen years, with NPCs falling further as a result of reduced trade protection, and the share of non-market transfers in total support growing but not by enough to fully offset the fall in NPCs. Secondly, the CAP non-market support levels received by agricultural producers in the recent 10 accession countries are lower than those in the EU-15. The level of support to agricultural producers in the EU-10 are being phased in from 2005-2012. Thus, if the current experience of recent EU accession countries is a good guide, Turkish agricultural producers would likely face a phase-in period as well. In addition, it is very unlikely that, in view of other spending priorities in the budget upon EU accession, Turkey will have much leeway to increase budgetary transfers to agriculture to “top up” CAP payments.

8.8 The implications for Turkish agricultural policy during the pre-accession period are fairly clear: market support for a number of commodities has to decrease in general through tariff reduction. This will facilitate convergence of such support to EU levels prior to accession and avoid any sharp falls in prices and initial contractions in agricultural income (as have been recently the case in Hungary). At the same time, government budget support for agriculture should be more focused on non-market distorting instruments. This should take the form of maintaining the DIS Program and expanding support for general services and the other non-distorting programs which Turkey is introducing through its draft Framework Agricultural Law. This is discussed in greater detail below.

92 Ratio between the value of total gross farm receipts including support, and production valued at world market prices without support.

8.9 Adjustment of Turkish agriculture to reductions in tariff protection could be facilitated by further improving market access for Turkish exports to the EU during the accession period. EU imports of all agriculture products originating from Turkey are tariff free if the value of consignment is below a pre-set entry price. For four different kinds of fruit and nine vegetables, however, this suspension of the MFN tariff is limited to certain calendar periods ranging from 3-8 months depending on the type of the product. Removing such seasonal restrictions would facilitate adjustment towards more dynamic products where Turkey has a comparative advantage.93

(b) Impact of Alignment with CAP – General Equilibrium Modeling

8.10 The economic impact of Turkey’s accession to the EU has been analyzed using the World Bank’s global general equilibrium model. 94 The model focuses mainly on the agricultural and food sectors, where distortions are highest—except perhaps in services. The model is run in its comparative static version, i.e. with no dynamic aspects and results should be viewed as long-term changes to the steady-state assuming no change in the stock of factors (labor, capital and land) and productivity. Under the model simulation, Turkey eliminates tariffs on imports from the EU and aligns its tariffs with those of the EU, while the EU grants free market access to Turkish agricultural exports. As a result of alignment, the average agricultural tariff in Turkey declines to 6 percent, from 44.2 percent, and to 6.2 percent from 29.4 percent for processed foods. Domestic support—including export subsidies—would more than double under full EU membership, from base levels of $2.2 billion to $4.7 billion.

8.11 Accession would lead to some restructuring of output towards agriculture and an increase in net exports. The two agricultural and food processing sectors combined would see a slight rise in their share of total value added to 15 percent from an initial value of 14.3 percent, with an average output increase of around 15 percent. Within agriculture, the biggest simulated shift is in cotton, with output increasing by 63 percent and its share in agricultural value added increasing from 7.4 percent to 11.4 percent. Net exports of agricultural and food products are also projected to increase. The total increase in exports of these goods is $4.5 billion, with net exports increasing by $1.8 billion. Although imports would rise substantially because of the large decrease in tariffs, better access to EU agricultural markets would boost exports even more.

93 Also some tariff rate quotas, at zero or reduced rates, exist for EU imports originating from Turkey with the full MFN tariff or the specific tariff component only applied for above-quota imports. Turkey in general has managed to fill the quotas over the last years, but in many cases the quotas cannot be completely used owing to inability to meet food safety requirements. 94 The model was calibrated to the GTAP dataset (release 6.0) with supplemental information on Turkey’s domestic protection.. See van der Mensbrugghe (2005) for more details on this model. Prior to Turkey’s accession simulation, a “pre-simulation” is run that incorporates known policy commitments—final implementation of the Uruguay Round including the elimination of textile and clothing quotas, EU’s expansion to EU25 and China’s WTO accession commitments.

8.12 Net fiscal savings are also expected as a result of alignment with the CAP. Upon EU accession, and barring any transitional clauses or possible limitations mentioned earlier, domestic support to agriculture will be funded from CAP. Tariff revenues, on the other hand, would drop—from an initial level of $1.3 billion to $0.5 billion. Overall, EU accession would translate into an increase in net saving of $1.3 billion, or 0.9 percent of GDP.

8.13 Some caveats apply on the simulation results. First, the sectoral shifts within agriculture are based on a high degree of factor mobility across sectors. The actual extent to which Turkish farmers can switch across crops—for example from other crops towards cotton—may limit the gains from accession. Second, the gains are being measured against a relatively static policy environment. The model has used 'static' protection rates and does not attempt to predict the evolution of protection over time. For example, should the EU open further its market to non-EU countries (e.g., in its everything-but-arms initiative, where sugar is expected to enter duty- and quota-free by the end of the decade), the impacts of Turkey’s accession could be altered. Lastly, the usual caveats regarding the model’s assumptions apply here—closure rules, perfect competition and returns to scale, no productivity impacts, etc.

8.2. PROMOTING RURAL DEVELOPMENT AND ITS EUROPEAN UNION ALIGNMENT

(a) Regional Dimensions of Rural Development Investment Patterns

8.14 Creating opportunities for off-farm employment and strengthening agricultural productivity are key challenges. Turkey still has a considerable share of rural population (35 percent). This sizeable rural population generates pressure on urban areas as a means to rapid migration from rural to urban parts of the country leading to all sorts of problems in urban cities over the last decades. As the share of agricultural GDP and therefore employment declines, Turkey needs to develop of farm income and employment opportunities in rural areas not only to increase economic growth in these areas but also to moderate the pace of rural-urban migration to a more manageable level. Therefore, the industrial and service sectors particularly need to expand further in rural areas, as they have in a number of recent Central and Eastern European (CEE) EU accession countries over the 1990s. At the same time, agricultural productivity has to increase further by adapting to the recent global advances in agricultural technical efficiency.

8.15 Appropriately targeted public investment and participatory approaches should receive priority. In this regard, government expenditures on agricultural research and extension, as well as infrastructural investments including roads and irrigation need to

expand further. Moreover, greater emphasis should be given in the future on participatory approaches, determining service priorities, promoting private sector involvement in and financing of service provision, and expansion of the role of cooperatives, producers union, and other types of farmers organizations. This leads generally to greater co-financing by beneficiaries to infrastructure and other rural investment programs, which may be a sizeable future source of increased investment in the rural sector.

8.16 Rural spending at the provincial level tends to reveal that allocations may not very much reflect the regional priorities of the government with the exception of GAP investments.95 Although spending figures by seven regions seem to demonstrate that rural spending is higher in general in less developed regions, calculations made at the provincial level tend to indicate the opposite96. Correlations between per capita agricultural GDP and per capita rural spending by 81 provinces show positive correlations (average 0.60) meaning more spending is made in provinces where per capita agricultural GDP is higher. Correlations between rural illiteracy levels and per capita rural spending also show that for all of the agencies with the exception of DSI, there is a negative correlation between the two: agencies’ rural per capita spending is lower in provinces where rural illiteracy levels are high.

8.17 Project prioritization would deserve greater attention. Regional spending for each agency is diverse due to many reasons, particularly the location of natural resources (forests in the case of MOEF and water resources in the case of DSI). For example DSI allocates its agricultural spending based on ongoing irrigation projects in 26 different areas. However, funding amounts are insufficient to complete the current projects and there is no clear plan for prioritization of project implementation. Therefore, many areas that are in urgent need wait for a long time to receive enough funding to be completed. Another essential improvement for rural expenditures is to adequately prioritize the regional as well as “by project” investment needs. Dormant projects have to be eliminated from the investment program and projects that are close to completion must be given priority. For poverty alleviation purposes, less developed provinces mainly in the regions of East Anatolia, South East Anatolia and the Black Sea should receive greater shares of government investment expenditures.

95 Priority development provinces are determined but by the decisions of the Council of Ministers on the Implementation, Coordination and Monitoring of the Annual Programs issued each year. The latest program (2005) selected 49 provinces out of 81 provinces as priority provinces that are located mostly in the East, South East and Black Sea regions and which have in general the lowest per capita income. GAP is the biggest regional integrated project that has a significant share of investments. Approximately 15 percent of rural budget expenditures are allocated to GAP projects (excluding energy) in 2002. As of the end of 2001, 10.8 quadrillion TL have been spent for GAP, reaching a cash realization ratio of 48.1percent. 96 The sources for data gathered and methodologies used for this analysis are elaborated on in the recent World Bank Report ‘Turkey: Policy and Investment Priorities for Agricultural and Rural Development”, 2005. The types of rural expenditures considered included: agriculture - including farmer support services such as extension and research, animal health, plant protection; forestry, erosion control, and other agri-environment programs; and, irrigation and other rural infrastructure - rural roads, water supply and sanitation, electricity.

(b) Using EU Pre-Accession Funds for Rural Development

8.18 The scope for using EU funds during accession could be significant. The rural development instrument of regional development policy (IPARD) serves as the framework for supporting sustainable agricultural and rural development in EU applicant countries during the pre-accession period. It aims to solve problems affecting the long-term adjustment of the agricultural sector and rural areas, to help implement the Community acquis in matters of the CAP and related policies. Subject to ex-post checks carried out by the Commission, the national authorities of the beneficiary countries are entirely responsible for managing funds. This system has a positive impact on the absorption capacity of the rural development funds after accession as this acquired experience is intended to prepare the future Member States for eventual management of structural fund and cohesion fund programs. All the recent accession countries, without exception, have been able to take up this challenge successfully. Policy priorities in order to create absorptive capacity for structural fund programs and for adjustment of agricultural sector regulations and policies to EU CAP requirements are reviewed below and summarized in the policy table at the beginning of the study.

8.19 In order to be able to be eligible for IPARD funds, Turkey needs to complete three main activities:

• Rural development strategy: A framework for rural development projects has to be developed by identifying priorities and measures for rural areas and ensuring harmonization with the EU’s rural development policies. Efforts are under way to draw up the strategy, and the strategy is being finalized.

• An IPARD plan: This is to be a multi-year programming document which is based on the rural development strategy. The IPARD plan lays out the mix of prioritized activities drawn from the list of measures eligible for support.

• Rural Development Agency (Paying and Implementation): As payments under IPARD are to take place in a fully decentralized system (ex-ante controls), the new agency with all its branches has to be set up and proceed through a lengthy accreditation process. The agency can delegate some of its responsibilities to Special Provincial Administrations (SPAs, of which there are 81). In this process, Turkey should initially target a limited number of areas for developing a functioning administrative structure, and then accelerate the process to improve the system subsequently in more challenging rural areas.

8.20 The capacity of SPAs to identify, plan, and execute agricultural and food sector investment programs needs to be strengthened. Turkey also has to rapidly develop key acquis related food safety and regulatory functions such as phyto-sanitary inspection and control, livestock and dairy inventorization and traceability, agro-chemical control and organic certification, so that investments that need to comply with food safety measures, can be made eligible for the pre-accession funds.

8.21 Rural development policies that largely consist of support for non-farming activities in the services and industry sectors should be given particular attention. This has been demonstrated by the recent experience of Poland and Hungary. Maximum attention should be given to cooperation between agencies since rural development is multi-dimensional and covers various sectors. Examples of convergence in countries that heavily used structural funds have also shown that investment strategies need to be determined by careful analysis of regional specificities, bottlenecks and potential competitive advantages.

8.22 Country examples suggest that regional policies should be primarily focused on promoting efficiency, with growth oriented measures ensuring diffusion of convergence across regions. Also a number of studies have found that regional funding of essential infrastructure (transport, communication, power, water, education) is more effective than subsidies allocated to small businesses. As for the institutional arrangements, structural funds should be integrated into the government’s overall strategy and public resource management process.

8.23 Taking advantage of structural funds also poses a co-financing challenge. The availability of sufficient beneficiary contributions (at least 25-50 percent) for rural development programs linked to structural funds can be a very important obstacle for investments in rural areas. Increasing access to finance in rural areas will key for increased use of such funds.

CHAPTER 9. ENHANCING POLICIES FOR SOCIAL COHESION

9.1 Ensuring sustained and inclusive growth is an important challenge for Turkey in view of the existing important social and regional gaps and the potential for the EU accession process to create “winners”, but also some “losers”. Although reform is underway to define a more systematic approach to start closing the existing gaps, an integrated strategy will need to be formulated with a strong dimension on policies for social cohesion. The capacity of the social security system to contribute/strengthen social cohesion is impaired by several factors: it does not cover the entire population; it lacks financial stability, with the largest share of funds going to pensions; the presence of a large informal sector; and administrative and management problems which have adverse effects on the effectiveness in the delivery of services. This chapter provides analytical underpinnings in the key areas of social inclusion and health care, with emphasis on policies to improve efficiency and ensure financial sustainability.

9.1. SOCIAL INCLUSION

9.2 A wide range of policies and programs can have an important positive impact upon social inclusion and cohesion. Notable amongst these are basic and secondary education policies (discussed in the recent World Bank report on education) which extend high quality education at an affordable price to the entire citizenry. Tertiary education is more complex because of its higher unit costs, and more limited coverage. UHI, as discussed already, if implemented correctly, will be a powerful tool of social cohesion. However, a number of other measures are necessary. The key ones are highlighted below.

9.3 Poverty monitoring: Maintain the excellent work on poverty monitoring under the State Institute of Statistics (DIE) based upon annual household income and consumption expenditure surveys (HICES). Strengthen the poverty mapping function.

9.4 Conditional cash transfer (CCT): Maintain and strengthen the CCT which is targeted towards the poorest 6 percent of children (with the benefit paid to the mothers) which helps families to maintain the poorest children in school and obtain adequate preventive health services. This program is already reaching 2.0 million children and is administered by the General Directorate of Social Assistance and Solidarity (SYDGM)

through its 931 associated foundations throughout the country. The proxy means test for this program was updated in 2005 according to the 2003 HICES. The proxy means test for CCT will be systematically updated based upon the latest HICES, and in this manner strengthened so that it can be used for the determination of eligibility for other government programs (such as UHI premia paid for by the state) by adjusting the cut-off point accordingly.

9.5 Social Services: A wide range of agencies including municipalities, the Social Services & Child Protection Organization (SHCEK) and the SYDGM are providing social services. Unfortunately there is no integrating framework, and both problems of duplication and inadequate service provision apply, although the related agencies are doing their best to coordinate. There is a need to develop an integrated social policy under one lead ministry, improve the monitoring and evaluation of social services, and then expand cost-effective services to underserved population groups, although it would be very appropriate for the SYDGM to remain as an executive agency making payments and providing services but not under the direct control of the policy-making ministry..

9.6 Youth policy: With. youth aged under 25 accounting for 50 percent of the total population, youth are a particularly important population group to target as they represent nothing less than the future social and human capital of the country. It is urgent to give more attention to the issues of youth empowerment and inclusion, together with specific programs .to overcome barriers to youth employment (youth unemployment is 2.5 times the national average). Inter alia, this process would be enhanced through the development of a national youth policy and providing significantly more resources to youth programs.

9.7 Gender: Whilst Turkey has made good progress in addressing some gender inequities, and both primary and secondary school enrollment rates are converging for the two genders, there is still more to be done in terms of promoting and supporting female employment, reducing the pay gap and in general integrating women as full equal partners in society.

9.2. MANAGING THE HEALTH CARE SYSTEM

Fig. 9.1 Health Expenditure and GNI Per Capita Turkey and

Comparator Countries

0 5000 10000 15000 20000 25000

GNI Per Capita

Public Expenditures Total ExpendituresLinear (Public Expenditures) Linear (Total Expenditures)

TUR-Public TUR-Total

9.8 Health care expenditures and outcomes are unevenly distributed. Turkey spends around 6.7 percent of its Gross National Income (GNI) on health, of which public expenditures account for about 70 percent.97 Per capita expenditure is relatively higher than in countries with similar income levels (Figure 9.1), while the health system fails to reach the poor and vulnerable sections of society. Expenditures favor Turkey’s Central and Mediterranean regions over other parts of the country and East and Southeast Turkey receiving less than the proportionate share of spending given their population. The distribution of health benefits to different income quintiles shows a significant bias towards the top two quintiles, who consume about 52 percent more health care per capita relative to the bottom two quintiles.

9.9 There is ample room for improving health care outcomes and for efficiency gains in public expenditure. Despite spending levels on the high end of comparators, Turkey faces an unacceptably high burden of ill health and ranks far behind most middle-income countries in terms of the health status of its people. The reasons for such low outcomes are many and varied. There are gaps in nutrition, housing, access to clean water and satisfactory sanitation, and education, especially of girls and women – all of which are widely recognized to be powerful determinants of good health – that adversely affect health status. On the financing side, besides the fact that there are multiple problems with mobilization of resources, the available resources are not allocated efficiently and equitably. A significant proportion of the population has little or no financial protection, and despite support from special funds and programs like the Social Assistance Fund and

97 Public expenditures on health consist of expenditures incurred by the Ministry of Health, General Directorate of Coastal Health Services, Universities, Social Solidarity Fund, other Ministries and agencies, local governments, state enterprises, civil servants, and social security institutions: Sosyal Sigortalar Kurumu (SSK), Emekli Sandigi and Bagkur. Private expenditures on health consist of out-of-pocket treatment and pharmaceutical expenditures incurred by individuals and households, and by companies and individuals contributing to private insurance schemes. Social health insurance – offered by SSK, BagKur and Emekli Sandigi – accounts for almost 66 percent of all public expenditures on health, equivalent to about 12,875 trillion liras in 2004, with the balance (6,582 trillion liras in 2004) coming from the central government budget. A little over 53 percent of all public expenditures on health take place on care provided by hospitals, followed by 30 percent on the provision of pharmaceuticals and medical goods and 8.5 percent on outpatient care. Source: World Bank calculations, based on MOF/MOH/MOLSS data, reorganized and presented in the NHA2000 format

the Green Card, in practice the disadvantaged groups are not targeted effectively. In addition, there are multiple payers for same or similar services, and the institution of revolving funds – which allow health providers to accept user charges and account for them outside the budgetary flow of funds – introduces a variety of perverse incentives for providers and further constrains access to health services for consumers. Public provision of health is characterized by poor incentives for managers and providers alike, leaving them open and vulnerable to alternative sources of income to augment their meager salaries. Like financing, the delivery of health care is also fragmented, and there is little continuity in the different levels of care. Clinical effectiveness of existing medical interventions and treatment protocols is not always tested and attention to quality and effectiveness of care is uneven. The private sector is growing, but its full potential is not fully realized and their role and responsibilities not adequately defined.

9.10 Systemic and comprehensive reforms in the health sector are being undertaken. Key elements of the proposed reforms that aim at improving equity and access to health services are the introduction of universal health insurance and the creation of a health insurance fund that would integrate all functions and premium collections related to health in the existing insurance agencies such as SSK (Sosyal Sigortalar Kurumu), BagKur and Emekli Sandigi. The health insurance fund would combine all financial flows of fund in the health sector, including budgetary support to MOH (except for public health care activities), financial outlays for the existing Green Card program, and health expenditures of civil servants. Based on the principles of solidarity and risk pooling, all citizens of the country are proposed to be covered under universal health insurance, with the state making premium contributions on behalf of the indigent and others unable to do so on their own behalf.

9.11 Providing adequate financial protection for health care to the entire population is a key challenge. The present system of insurance leaves many without any coverage and with inadequate coverage for many who are nominally covered. Additionally, there are many who enjoy multiple sources of coverage, either by design or by circumstances. There is also little doubt that the different health insurances being offered through SSK, Bagkur and Emekli Sandigi, and the coverage provided to civil servants and welfare programs like the Green Card should – in the interest of efficiency, risk-pooling and consolidation of financing – be combined into one compulsory universal health insurance system.

9.12 Unless it is accompanied by cost-reduction and efficiency enhancing measures, the introduction of UHI could lead to higher levels of public expenditure on health in the short run and jeopardize the fiscal sustainability of the system. Public expenditure may increase not only because the state will have to bear the health insurance expenditures of those hitherto uninsured, but also due to the induction impact on account of changes in utilization of health services by the already insured as they adjust to new boundaries of coverage, and the utilization patterns of the newly insured. In order for the system to be fiscally sustainable, therefore, the introduction of universal health insurance

needs to be accompanied by system-wide efficiency changes that will contain health costs and compensate for the additional expenditures associated with extending financial protection to all segments of the population. The proposed introduction of universal health insurance has already triggered a number of reform measures in the health sector in Turkey, and the emphasis at this point needs to be not only on sustaining this momentum and extending it to other areas not included so far, but increasingly on ensuring that the desired access and efficiency outcomes are achieved without any increase in public expenditures on health. The more important of these focus areas are elaborated below.

(a) Consolidating hospitals and improving efficiency

9.13 While some gains in efficiency can be brought about simply by consolidating and reducing the number of hospital beds in many provinces, further gains will come about only by improving efficiency in the use of hospital resources and overall management and accountability. A large number of hospitals continue to be underutilized, and huge variations still exist in hospital occupancy rates among provinces. Many MOH hospitals are too small in size to allow for efficient operation and provision of care, and have significantly lower utilization rates compared to SSK and University hospitals. In addition, hospital managers enjoy very limited administrative and financial autonomy, and have very few incentives to adopt efficiency-enhancing measures. The proposed introduction of universal health insurance provides a good opportunity to further strengthen the gains from the merger of MOH and SSK hospitals under MOH ownership and management. However, the separation of provision and financing provides an opportunity to introduce innovative methods in management of health facilities, which can be achieved by granting financial and administrative autonomy to public hospitals. The introduction of hospital autonomy will require appropriate legislation that will allow for public assets to be managed outside the direct purview of the government, and related laws and regulation would need to be amended in order to facilitate the transformation of MOH and SSK facilities to autonomous bodies.

(b) Strengthening delivery of health services

9.14 The introduction of universal health insurance also provides an opportunity to initiate measures to improve delivery of health services. This process has also started with the piloting of the family medicine system, which is aimed at shifting the emphasis from treatment of the sick to health promotion and prevention of illness. The family medicine system will bring the physician and family members into closer and more personal contact, enabling the physician to play an important role in the family’s health and prevention of illness. Under the family medicine system, simple and routine diagnostic services and consultations could be provided under a single-window and

common illnesses could be treated across a broad spectrum of medicine domains, including internal medicine, gynecology and pediatrics. Family medicine places special emphasis on continuity of care and on quality of health services, and integrates preventive health services with basic health services and provides the full package under one window. The family medicine system has the potential for the strengthening of the patient referral system as well.

(c) Reforms in provider payment mechanisms

9.15 Changes in provider payment systems and incentives for physicians to provide quality care at lowest costs are required. Some of these changes are already being planned, and a system of paying family physicians on the basis of capitation is being worked out.98 Physicians participating in this scheme bear most risks of treating a patient, and therefore are likely to be conservative in the amount of health care they provide. Such a system would need to be extended to cover all outpatient care as family medicine is scaled up from the Duzce pilot.

9.16 Prospective payment mechanisms introduced at the hospital level would provide incentives to hospitals to contain costs. Prospective payment mechanisms rely on the fact that services associated with a particular treatment are reasonably predictable and can be bundled into a group to which a monetary value can be attached. The hospital then gets reimbursed according to a pre-fixed rate per bundle. Such payment mechanisms do not encourage excessive use, since the hospital can conceivably make a profit (or a surplus) by being careful about inputs and hospital lengths of stay. One of the most widely-known prospective payment systems is the Diagnosis Related Group (DRG), developed to classify treatments according to the resource costs of its treatment. To be certain, a DRG-based system by itself will not necessarily promote efficient use of resources. Hospital care providers and managers need the flexibility and tools to actively manage their resources and redirect their use, which will ensure that cost-savings in treatment of one case are passed through the entire system.

(d) Containing outpatient care provided by hospitals

9.17 A rules-based approach would be needed to contain costs. A large number of outpatient services in Turkey are provided in hospitals, accounting for almost 43 percent of total costs of outpatient services. Outpatient services provided in hospitals cost significantly more than outpatient services provided in outpatient clinics, and it is imperative that the introduction of universal health insurance and family medicine be

98 Physicians paid on the basis of a capitation fee per enrollee receive a fixed amount per enrollee regardless of the type and extent of treatment sought.

accompanied by a significant reduction in number of outpatient visits in hospitals that are paid out of the health insurance fund. This can be managed by establishing clear and transparent rules restricting reimbursement by the health fund of outpatient treatment carried out in hospitals.

(e) Managing pharmaceutical costs

9.18 Containing expenditures on drugs is a key challenge. Drugs are perhaps the single largest cost driver in almost all healthcare systems, and have been the most dynamically growing element in overall costs of healthcare services in recent years. According to new data released by OECD, spending on pharmaceuticals across OECD countries has increased by an average of 32 percent in real terms since 1998, reaching more than US $450 billion in 2003. Growth in drug spending has outpaced total health expenditure in most OECD countries, and Turkey is no exception. Expenditure on pharmaceutical products constitutes a significant proportion of total expenditures on health in Turkey, accounting for almost half of all SSK, Emekli Sandigi and Bagkur spending on health. While pharmaceutical prices have increased broadly in line with inflation, there has been a much larger change in consumption levels, including subtle changes in consumption in favor of newer and more expensive drugs.99

9.19 One of the reasons why Turkey spends a huge amount on drugs and pharmaceutical products is that most of the insured population is insensitive to pharmaceutical prices. Out-of-pocket payments for medicines constituting between 10 and 20 percent of total medicine bill of the insured.100 In addition to price controls, managing consumption of pharmaceuticals is critical in order to contain expenditures on drugs. Many countries have successfully adopted demand-side measures of controlling consumption, and cost-sharing has proved to be the most effective such measure.101 The consumption of pharmaceutical products among the insured is actually not low by international standards, and there is a strong scope for cost containment if indiscriminate consumption can be curbed.

99 Between the years 2000 and 2001, for example, the proportion of drugs consumed priced at half million TL or less decreased slightly from 34 percent to 30 percent, while the proportion of drugs consumed priced at 2 million TL or more increased from 34 percent to 47 percent. 100 Indeed, the high percentage of pharmaceutical expenditures in terms of overall health expenditures is as much a reflection of low overall expenditures on health as it is of high expenditures on drugs. 101 In the Netherlands, for example, the introduction of co-payments on prescribed pharmaceuticals (a fixed amount per prescription) led to substantial decrease in the total number of prescriptions. In Germany, drug cost-containment measures take the form of cost-sharing, prescription limitations, reference prices and the pharmaceutical spending cap that makes physicians’ associations liable for any overspending with no upper limit. These measures led to substantive decreases in pharmaceutical expenditures for social health insurance, mainly attributable to price reductions, changes in physicians’ prescribing behavior resulting in a reduced number of prescriptions by 11.2 percent and increased prescriptions for generics. The French government imposes a fine on pharmaceutical companies if pharmaceutical expenditures surpass budget ceilings either due to price or quantity increases.

9.20 Reforms should be phased in with appropriate sequencing. While all of the above measures are critical to ensure improvements in access, equity and efficiency, it is critical that utmost attention is paid to the sequencing of the above reforms so that the process is seamless and does not lose effectiveness and credibility in the process of its implementation.

Annex 1 – Statistical Tables

Turkey: Table A1: Selected Macroeconomic Indicators

1999 2000 2001 2002 2003 2004GNP Growth -6.1 6.3 -9.5 7.9 5.9 9.9

Consumption -1.7 6.3 -9.1 2.5 5.6 9.0Public 6.5 7.1 -8.5 5.4 -2.4 0.5Private -2.6 6.2 -9.2 2.1 6.6 10.1

Investment -15.7 16.9 -31.5 -1.1 10.0 32.4Stock 2/ 2.0 1.1 -4.0 7.1 3.0 1.1External Balance2/ -0.9 -3.0 12.4 -0.9 -3.1 -4.9

Exports -7.0 19.2 7.4 11.1 16.0 12.5Imports -3.7 25.4 -24.8 15.8 27.1 24.7

Unemployment Rate 7.7 6.5 8.4 10.3 10.5 10.3

CPI Inflation (Dec-Dec) 68.8 39.0 68.5 29.7 18.4 9.3

Nominal Interest Rate 106.2 38.0 99.1 63.5 44.1 24.9Real ex-ante Interest Rate 3/ 32.0 -9.5 35.5 30.3 30.2 14.2

Current account balance (% of GNP) -0.7 -4.9 2.3 -0.8 -3.4 -5.2Current account balance (billion $) -1.3 -9.8 3.4 -1.5 -8.0 -15.7

Exports (fob) 28.8 30.7 34.4 40.1 51.2 67.0Imports(fob) -39.0 -52.7 -38.1 -47.4 -65.2 -90.9

Capital Account (billion $) 4.8 9.6 -14.6 1.2 7.1 17.2FDI 0.1 0.1 2.8 0.9 1.3 2.0

Overall balance (billion $) 4/ 5.2 -3.0 -12.9 -0.2 4.1 4.3

Source: Government, IMF and WB1/ IMF and WB estimates.2/ Contribution to GDP growth3/Average of monthly nominal interest rate divided by 12-month ahead inflation4/Errors and omissions included

Actual

Turkey: Table A2: Public Sector Balances 1999 - 2004

1999 2000 2001 2002 2003 2004

Consolidated General Government (% of GDP) 1/Total Revenues 34.4 37.9 40.0 37.8 39.6 39.9

Taxes 2/ 21.8 24.4 25.6 22.2 23.6 23.6Other Revenues 12.7 13.6 14.3 15.6 16.0 16.4

Total Expenditures 48.6 50.0 59.4 51.7 49.8 46.1Primary Expenditures 34.1 33.0 34.0 33.5 33.0 32.6Interest Expenditures 14.6 17.0 25.4 18.1 16.8 13.5

Primary Balance -0.4 4.2 4.9 2.9 5.3 5.7Overall Balance 14.2 12.1 19.4 13.8 10.2 6.1

Total Public Sector (% of GNP)Primary Balance -2.4 2.6 5.1 4.0 6.0 6.8PSBR 19.6 17.1 13.5 9.1 4.8 3.5

MemoGross Public Debt ( % of GNP) 68.2 107.5 93.6 83.4 77.4

Domestic 43.1 71.1 56.3 56.4 54.5External 25.1 36.4 37.3 26.9 22.9

Source: SPO,IMF, Treasury and World Bank1/ Excluding Regulatory and Supervisory Institutions2/ Tax rebates excluding

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