Report No. 10318-HO

HondurasProspects for Public Sector Reform(In Two Volumes) Volume l: Summary of Main Findings and Recommendations

September 30, 1992

Public Sector Management DivisionTechnical Department MICROFICHE COPYLatin America and the Caribbean Region Report No.:10318-HO Type: (SEC)

FOR OFFCIAL UE ONLYTitle: PROSPECTS FO)R PUBLIC SECTOR RE'FOR OFFICIAL USE ONLYAuhr DE MP,Author: DEL1 CAMPO,A.Ext.:37775 Roc.m:I-4 159 Dept.:LATPS2 VOLS

Document of the World Bank

This document has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

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GLOSSARY OF ACRONYMS

BANASUPRO Suplidora Nacional de Productos BgsicosBANMA Banco Municipal AutdnomoBANTRAL Banco Central de HondurasBCIE Banco Centroamericano de Integracidn EcondmicaCG Contadurfa GeneralCGR Contralorfa General de la RepdblicaCM Consejo de MinistrosCNA Consejo Nacional AgrarioCOHDEFOR Corporaci6n Hondurehla de Desarrollo ForestalCONAPLAN Consejo Nacional de PlanificacidnCONSUPLANE Consejo Superior de Planificacidn EconomicaCOPEN Comite Permanente de Emergencia NacionalCSC Consejo de Servicio CivilDGA Direccidn General de AduanasDGCP Direccidn General de Credito PiblicoDGP Direcci6n General de PresupuestoDGT Direcci6n General de Tributaci6nENEE Empresa Nacional de Energfa ElectricaENP Empresa Nacional PortuariaFNH Ferrocarril Nacional de HondurasGDS Gabinete de Desarrollo SocialHONDUTEL Empresa Hondurefha de TelecomunicacioneslAs Instituciones Aut6nomasIHCAFE Instituto Hondureflo del CafeIHMA Instituto Hondurehlo de Mercadeo AgrfcolaIHSS Instituto Hondurefho de Seguridad SocialINPREMA Instituto Nacional de Previsidn del MagisterioINA Instituto Nacional AgrarioINFOP Instituto Nacional de Formaci6n ProfesionalINJUPEMP Instituto Nacional de Jubilaciones y Pensiones de Empleados del Poder EjecutivoJNBS Junta Nacional de Bienestar SocialPANI Patronato Nacional de la InfanciaSANAA Servicio Aut6nomo Nacional de Acueductos y AlcantarilladosSCT Secretarfa de Cultura y TurismoSDNSP Secretarfa de Defensa Nacional y Seguridad PlSblicaSEC Secretarfa de Economfa y ComercioSECOPT Secretarfa de Comunicaciones, Obras Piblicas, y TransportesSECPLAN Secretarfa de Planificaci6n, Coordinacidn y PresupuestoSEP Secretarfa de Educacion PiblicaSGJ Secretarfa de Gobernaci6n y JusticiaSHCP Secretarfa de Hacienda y Credito PdblicoSP Secretarfa de la PresidenciaSRE Secretarfa de Relaciones ExterioresSRN Secretarfa de Recursos NaturalesSSP Secretarfa de Salud PtblicaSTPS Secretarfa de Trabajo y Prevision SocialTGR Tesorerfa General de la RepdblicaUNAH Universidad Nacional Autonoma de Honduras

FOR OMCIAL USE ONLY

HONDURAS: PROSPECTS FOR PUBhIC SECTOR REFORM

TABLE OF CONTENTS

L THE MACROECONOMIC CONTEXT AND THE NEED FORPUBlICSECTORREFORMi ..... * ...... ......... *... 2

IL AN ASSESSENTOFTHE PUBLICSECTOR . e............ . se. .. . 4

A. Major nstitonl andlepa Phbles . . . . . . . . . . . . . . . . . . . 4

B. Budgetar Trends in the Publlc Sector ........................... .S

C. PubecSector npynae d Wages ........ . . . . . . . . . . . . . 7

nL REDRM OFTHE HONDU RANPUBCCSECTOR ...... ............. 8

A. Rdmin tieReforn ofthe PublSector .................. 8

B. Reform of the of Key Publc SectorFunctions witin the Centrl Govaement .................. . 1

ofTaxRevenums ..........................

= nwmsofEqxpediurs ..........................1

i-vflnmentEiomg ....... . . . . ..

Ftnancal Management ............................. 14

TI repnot i basedon the findip of a PubNi Seeto Aswesm&et Sun n tbatAsied Bondurasin October 199L MIain ctibutoi sto the report iclude Antnmio Mart del Camp.(o ionbader), LAIPS; Angd Gouz0krMsfIexeoivarrf LATPS; Jaine Vwfi=r* -Caro, LATPS; PabloGerchnoff l ); Ann Mifhel Rons t);iard Moore (Consul ); and InderRupra h(Coula). Edga Manerdm (C)abo ---1- mlptea in the ndsdon. BaranThncer,Ld Economist, LA2C2, advised e ii The reponsible _ werse ShhddA. Chadhry, Chief, LATS; MarkoVolic, Che, LA2C=; asdlaeraB. Sbtckan, Direr, LA2.

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This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorliation.

in4m~Ofk nATi2othna I....................... esos 14

Of interadl and ExIenD Control .a. . . .. .. . ... . . . . 15

C. Reounof theDecnatraizeddAd.i nktIlon .............. ....a 16

Pbbic Enterpri .o ............ ....................... 17

Agdcukuraland FoodDlstdbu'on

SerdasEntedvs~~~~~~~~ . . . ... e.. 18PubUc U ditieand LiangnSeriteesEnt e d . ...........................18

D.~~ hqkeftarfmttg ........... .......... o..23.........lI(nliaIiIies .*.......*.*.... . . . .... *.* * .............. .21

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INTRODUCTION

1. This study contains an assessment of the public sector issues in Honduras, and aset of recommendations to increase the internal efficiency of the public sector and itscontribution to the Honduran economic development. The study lays down the foundation fora policy dialogue and subsequently for a possible IDA credit in support of a public sectorreform.

2. The report is structured as f-llows. The first section reviews the macroeconomiccontext and Fdentifies the need for p rblic sector reform in order to ensure the sustainability ofprogress made under the current economic program. An assessment of the Honduran publicsector is presented in the second section. The last section discusses three areas for public sectorreform proposed by this study: Administrative Reform, Reform of Public Sector Management,and Reform of the Decentralized Administration.

3. The three areas for public sector reform proposed by this study should be seenas complementary parts of a broad strategy, and ideally progress should be made in all frontssimultaneously. However, expedence in other countries, as well as the analysis of the Honduranpublic sector, indicate that public sector reform should involve a sequence of reforms thatcombines a sense of priority with feasibility. Administrative reform of the Honduran publicsector can be implemented in the short term; at the same time, progress can be made in thedesign and implementation of specific programs to reform and improve public sectormanagement. Finally, administrative reform should also provide the vehicle to prepare, at theinstitutional level, restructuring/privatization programs for the Autonomous Institutions, and tosupport actual implementation of the new role foreseen for the Municipalities.

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I. THE MACROECONOMIC CONTEXT AND THE NEED FORPUBLIC SECTOR REFORM

4. Throughout the eighties Honduras experienced moderate economic growth,worsening medium term imbalances, and growing macroeconomic instability. The primarycause of the medium term imbalances was a persistent fiscal deficit and growing intervention ofthe public sector in the economy. The fiscal deficit of the non-financial public sector (NFPS)ranged from 6 to 12 percent of GDP during 1980-90 and was 8.5 percent in 1990. Fiscaladjustments during this period were achieved only at the expense of public investment, whichfell by almost half as a proportion of GDP during 1980-89.

5. The government also increased its presence in the economy through the adoptionof ati array of rules and regulations. As these new regulations were designed to "contain" theeconomic disequilibria, they targeted certain specific problems without consideration of long-term consequences. These regulatory changes produced uncertainty and discourageddevelopment of private sector economic activity in the formal economy.

6. The manifestations of the economic disequilibria and negative impacts of thepersistent deficit were temporarily contained by the use of a series of ad hoc measures. Thesetemporary actions implied increased arrears on foreign debt and additional command controlmechanisms. By the end of the eighties the country's economic performance sharplydeteriorated, reflecting the fundamental structural weaknesses in the economy and the lack ofconsistency in economic policy. In 1990, the rate of GDP growth was 0.1 percent, inflation hadnsen to 23 percent (average for the year) and the current account deficit of the balance ofpayments was nearly 8 percent of GDP.

7. In 1990, a new government initiated a broad-based economic reform programconsistng of a four-pronged strategy. First, the Govemnment adopted a stabilization programincluding a commitment to reduce the fiscal deficit and shift to non-inflationary finance, alongwith efforts to obtain a competitive exchange rate. Second, the Government took steps torebuild ties with the international financial community by resuming debt service payments tomultinational institutions. Third, structural reforms were designed and partally implementedin the areas of foreign trade liberalization, financial sector reform, reform of tax policy andadminisbaion, and a reduction in the negative incentive structure in agriculture. Finally, theGovernmext initiated a targeted poverty program to alleviate the hardsips faced by the extremepoor exacerbated by the reform measures.

8. The new strategy and reforms, if continued and deepened, should reverse thedecline in the economy. Progress to date in the economic reform program of the Governmenthas been noteworthy and is beginning to translate into positive economic growth.Macroeconomic stability, however, remains fragile. A critcal factor that endangers success

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remains the continued high fiscal deficit' and excessive government involvement in theeconomy. The public sector is not only oversized; but also inefficient, and unable to adequatelyperform its core functions.

9. The fiscal adjustment achieved thus far also remains unconsolidated. The recentreduction in the fiscal deficit partialy reflects temporary measures to raise revenues that cannotbe sustained in the long term. A temporary export tax was implemented to capture the gainsfrom the exchange rate devaluation of March 1990.2 In addition, Public Enterprise priceincreases adopted in late 1990 and mid-1991 allowed for adequate recovery of production costs.However, while tariffs for international services are to be kept constant in dollar terms in thecases of HONDUTEL (telecommunications) and ENP (ports) and there is Governmentcommitment to maintaining ENEE (electric power) tariffs in real terms, for the rest of the publicservices there is no adequate pricing policy criteria, and in the case of SANAA (water andsewage) there is even lack of an effective revenue collection mechanism. Several other factorswill put increased pressure on government resources in the near future and could make the fiscaladjustment unsustainable, if additional measures are not implemented. These include: (a) risingdebt service payments; (b) the need to raise real wages of civil servants to avoid losing the mostqualified personnel; (c) the pressures derved from the political expeinditures cycle; and (d) theneed to expand investment in basic economic and social infrastructure.

10. The degree of the fiscal adjustment required suggests that it will only be possibleand sustainable if accompanied by a comprehensive public sector reform. Reform is not onlynecessary to achieve fiscal adjustment, but also to enable the public sector to perform itsessential functions more efficiently and reliably. Public sector reform should aim to: (a) reducethe fiscal deficit to a level compatible with price stability and a stable or falling debt to outputratio, (b) improve the overall organization and management of government functions, (c)stimulate private sector development through the elimination of inefficient and unnecessaryregulatiGn, and (d) withdraw state participation from economic activities that can be performedmore efficiendy by the pnvate sector.

I Although the fiscal deficit declined to less than 4 percent of GDP in 1991, the burden of itsfinancing is on external sources on concessional terms which are unstable and likely to decline over time.

2 This temporary export tax implied an increase in revenues of 1.4 percent of GDP in 1990 and 0.65percent in 1991, but was phased out by January, 1992.

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H. AN ASSESSMENT OF THE PUBLIC SECTOR

11. While adjustment is It 'rtive for Honduras, equally imperative is theestablishment of a public sector wiP' capacity to carry out economic reforms. Theimplementation of successfil policy rewr - requires the creation of a responsive institudonalreform environment. From the pFrsective of public sector reform, the question is whatproactive role should the public sector take to make markets work, and what is required of thepublic sector to carry out this role?

A. Major Institutional and Legal Problems

12. Since the 1950s, the public sector increasingly became entrepreneurial,interventionist, and paternalistic, assuming responsibilities for basic infrastructure, basic socialservices, and committed to undertake activities in the productive sectors traditionally consideredthe domain of the private sector. This incremental expansionist role in response to theexigencies of economic crisis is evident in the growth of the Central Government in theintergovernmental system and, most spectacularly, in the growth of the Decentralized orAutonomous Institutions. However, this expanded role has not been based on a clear vision ofthe State's appropriate role in stimulating economic development and intemal efficiency. As aresult, the institutional apparatus of the State now is unmanageable, and the organizational andfunctional distribution of government responsibilities has grown in an often inchoate fashion,responding to legal prescriptions and incremental tendencies that severely restrict itseffectiveness.

13. One of the major difficulties resulting from the expansion of State responsibilitieshas been the inadequate capacity of the legal system to respond. The incrementalist form inwhich the legal instruments have been added has not provided a conceptual logic for thefunctional organiztion of the public sector. In particular, the Law of Public Administrationestablishes the principal norms for institutional behavior in the executive branch of governmentbut lacks a precise definition of responsibilities among the fundamental public sector entities.There is a need to clarify and to define with greater specificity the functional and organizationalstructure of the public sector. In addition, within the law, there are a number of institutionalrelationships that either remain unclear or contradict other legal statutes. For example, the Lawestablishes that entities of the Stae can be created or terminated in response to administrativeand economnc citeria or need (art. 3). Yet, it is not clear who assumes this responsibility. TheConstitution specifies legisladve preeminence, and the LPA should delimit (eliminate)discionary powers of the Executive to create secretarats. Whlde Dls (Als) are subject toCongressional jzrsdiction in terms of both their creation and dissolution (art. 261), theiractivities are subject to executive control. Also, Artice 260 (section 7) empowers the PublicAdministration Law to exercise juridical control over DIs. In addition, direction, coordination,and control over DIs is the purview of the corewponding Secretariat (art. 36, section 11); yet,

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the implication of budgetary "control" terms remain unclear. The LPA should clarify therelationship of Als to the Central Administration according to modern management principlesthat delineate lines of authority, autonomy, and accountability.

14. The expansion of the public sector over the past decades has resulted in a numberof fundamental institutional problems in the public sector. These include: (a) overextension ofgovernment; (b) overlapping and unclear demarcation of responsibilities within the CentralGovernment, resulting in poor coordination among lines of authority; (c) multiple and sometimescontradictory lines of authonty and responsibility over the Decentralized Administration, bothwith regard to the Autonomous Institutions and the Municipalities; (d) weak public sectormanagement; (e) expansion of executive control over all levels of gows mment; and (f) weakadministrative capacity of the legislature to perform its oversight functions. In addition, and asit is discussed in the next two sections, the public sector is characterized by: (g) perverse trendsi the categorical and functional composition of its expenditures; and (h) excessive level andimproper composition of public employment, inadequate level of remunerations, very highcompression of the salary scale, and absence of personnel policy. A consequence of theseinstitutional weaknesses has been the omnipresence of a public sector characterized by poorperformance, rigidity, and lack of transparncy in governmental functions and, therefore,inappropriate for the promotion of economic growth.

15. The needed transformation of the public sector will require the alteration of thenature of public sector responsibility to adjust and to respond to changes in the environmentwithin which the State must act. This transformation of the Honduran public sector requires thata new vision of the State in society be created. In turn, this suggests the need to restructure thegovernmental organization, to refine the functional distribution of responsibilities, to redefinethe procedures by which governmental action is taken, and to provide a more efficient,professional, and committed human element for the conduct of governmental affairs. Theproblem of the public sector has two sides: inefficiencies in the administrative apparatus whichrequires careful review of the relationship between functions and organs of government, andinefficiencies in the use of human resources in government, which requires review andstrengthening of public personnel in relation to proper functions.

B. Budgetary Tltnds in the Public Sector

16. The Honduran Government has maintained weak cohtrol over expenditures at aUlevels of the public sector. Central Government expenditures rose from 22.7 to 25 percent ofGDP between 1980 and 1990, twith the largest increases being in interest payments, the wagebill, and transfers to the Decentralized Administration. Interest payments increased from about5 percent of total expenditures in 1980 to about 13 percent in 1989. Wage expenditure wasabout 35 percent in 1980 and had risen to about 38 percent by 1989. As a share of GDP, wageexpenditure rose from 8 percent of GDP in 1980 to a peak of 9.4 percent in 1987 and havefallen only sightly since then. Growth in expenditures (in lempiras) dunng 1989/90 was 31percent, composed of a weighted growth of 27 percent in transfers and net lending, 6 percentin the wage bill, and 3 percent in interest payments.

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17. There is also a disturbing trend in the composition of Central Governmentexpenditures by function; the importance of secretariats involved in core activities has declined.The combined share of expenditures of the education (SEP), health (SSP), and communications,public works and transport (SECOPI) secretaiats declined from 45 percent of total expendituresin 1984 to 35 percent in 1989. Expenditures of secretariats involved in control and regultions,as well as military expenditure (particularly those of the National Defense and Public Securitysecretariat (SDNSP), however, increased. This changing expenditure pattern within the CentralGovernment suggests that the public sector is increasingly departing from its central role ofproviding basic services.

18. Government debt grew in importance steadily throughout the 1980s, increasingfrom 16 percent of GDP in 1980 to about 30 percent in 1989. Given the government'scommitment to providing prompt debt service, the rising debt service represents a significantportion of govemment expenditures that cannot be cut.

19. Total Central Government revenues rose by 2.4 percent of GDP between 1980and 1990. Recent growth in revenues (in lempira) during 1989/90 came from a 17 percentincrease in foreign trade taxes and a 15 percent rise in domestic indirect taxes.

20. The overall deficit of the Central Government reached a peak of 11 percent ofGDP in 1984 and has remained consistently high at about 8 percent of GDP since then. If nettransfers to the Decentralized Administration, however, are excluded from the CentralAdministration's budget, its fiscal deficit has been consistently lower. This disturbing trend isa clear argument for reform of the parastatal sector.

21. The Decentralized Administration which includes the Public Enterprises, thePublic Institutes, and the Municipalities has, in general, represented a burden on the non-financial public sector budget. Public Enterprise fiscal performance deteriorated during the1980s. The Public Enterprise overall fiscal budget has in general been in deficit, except for theyears 1987/88 and 1990. Net of transfers from the CG the PE deficit has been even worse.Within the PE sector, however, there are considerable differences in the relative importance ofindividual enterprises, as well as in their financial and budgetary performance. In 1990, ENEE(electricity generation and distnbution) and SANAA (water and sewage) received a hugemajority (about 95 percent) of net transfers from the Central Government, while HONDUTEL(telecommunications) was in surplus.

22. While the Public Institute's current revenues have been sufficient to cover currentexpenditures, they have consistently required transfers from the Central Government of about1 percent of GDP to finance capital expenditures. Furthermore, increases in Public Institutecurrent expenditures are mainly due to an unwaranted rise in wage expenditures.

23. The central feature concerning local governments or Municipalities is that theyhave had a fiscal deficit throughout the 1980s (except for 1982-1983). The current account hasbeen consistently in deficit since 1986. Within current revenues about half are tax revenues with

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the rest composed mainly of operational revenues but including transfers from CentalGovernment. Lack of clear rules of the game for government tran3fers has resulted indiscretionary expenditures. One aggravating effect of Central Government transfers Is that theyhave tended to discourage tax revenue collection by the municipalities.

C. Public Sector Employment and Wages

24. Major sources of weakness in the Honduran civil service t ;- .dstration are itspartial coverage of public employees and lack of management information systems. The civilservice administration is only responsible for Ceritral Administration "permanent staff"- itscoverage neither includes the military, teachers, doctors and nurses--and has little or no facilityfor analyzing wage/employment data. The civil service system has further deteriorated as aresult of the tradition of granting employment and promotion to favorable political activists,further aggravating the problem of excessive public employment.

25. Public sector employment grew consistently throughout the 1980s, with the largestincreases occurring in the Decenthalized Administration. Recent efforts at employmentrationalization have not achieved meaningful reductions. Significant reductions in the wage billwere achieved, but only through a strong deterioration in real wages, which were already low.

26. Another major problem with public employment is the excessive number of staffwith administrative and support responsibilities. As of 1990,administrative and serviceemployees represented over 64 percent of total employment and 48 percent of wages in theCentral Govenment, while professional and technical staff only represented 20 percent ofemployment and 38 percent of wages. In addition, there is significant variation among differentsecretariats.

27. The struchtral and institutional inadequacies of the public sector, described above,combined with the destabilizing and unsustainable trends in the fiscal deficit and publicemployment, suggest that administrative refonn of the public sector is long overdue and urgentlyneeded.

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mIL REWORM OF TlI HONDURANPUBLIC SECTOR

28. Reform of the Honduran Public Sector requires measures to be undertaken at threelevels. First, a broad mi:nhlat frXM M gmm is needed to redefine the public sector'sprimary functions, establish an efficient organizational structure with a clear demarcation ofresponsibilities, and reforn the civil service system. Second, reform of mangmt of keypublic sector functions in the Central Government is needed to raise internal efficiency andimprove the allocation of resources and provision of services by the govemment. Third, rexormof the D=tralized Administrain (DA) would aim to eliminate nonessential public enterprisesand public institutes and improve their managerial functions, as well as improve financial andmanagerial coordination between the Municipalities and the Central Administration. As thesethree levels of reform are highly interdependent, each can be fully successful only if necessarychanges are accomplished in each of the other areas.

A. Ad sratie Reform of the Publc Sector

29. The implementation of administrative reform of the public sector in Honduras isfacilitated by the facts that: (a) there is commitment of the Government to the modernization ofthe State, as evidenced by the recent approval by Congress of the Law of the Modenization ofthe State and the establishment of a Presidential Commission created by the Law; (b) legislationon the public administration and the civil sewrice enables the executive branch to implement theationalization measures required by the reform; and (c) the financial viability of a rationalization

process even in the short term.

30. Significant fiscal savings would result from an administrative reform. Each 10percent reduction in public employment would result In a reduction of the wage bill equivalentto one percent of GDP. In addition, decompression of the salary scale, incorporating wageincreases, particulirly for senior level management and "key positions" may substantially befinanced with other related savings resulting from administtative reform (e.g., reductions inmaintenance and facilities expenses).

31. Following from the redefinition of the role of the state in the economy,administrative reform on the basis of a functional review would redefine public sector functionsand responsibilities, and establish a more efficient organzational structure. A primary goal ofadministrative reform would be the rationalization of resource utilizaion, with particularemphasis on civil service reform. The role of SECPLAN in particular needs to be reevaluated.SECPLAN should concentrate on investment programming and monitoring, external aidcoordination, and possibly also on longer term development policy analysis; SECPLAN's areasof overlap with the Secretaiat of Finance should be eliminated.

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32. The lessons from public sector reform programs in other Latin American countriesprovide the following general principles for aiding in the design of an administrative reformprogram in Honduras. First, uniform criteria and design of organizational structure should beapplied to all Secretariats, in terms of responsibilities and administrative correspondence acrossdifferent levels, and the maximum number of agencies that should depend on each organizationallevel. Second, a unique primary responsibility should be assigned to each entity at each levelof the organizational structure. Third, a minimum organizational level should be established atwhich an entity can be identified as an executing administrative unit (generally the Direcci6nGeneral). Fourth, there should be functional specalization at the level of executing unit. Theapplication of these principles would aim to eliminate duplication, give clarity to the definitionof responsibilities, facilitate delegation, and generate,effective coordination within the CentralAdministration.

33. Rationalization of public employment in Honduras is both essential and financiallyviable in the short term. The Civil Service Law (applicable for all of the Central Administrationand a few of the Public Institutes) establishes that public employees can be asked to leave serviceif there is a need for budget rationaization or if it is required in order to increase the efficiencyof the administrative organization. The law also specifies that employees should receiveseverance payments equal to two months of salary after receiving notice of resignation plus onemonth of salary for each year of service up to a maximum of eight months of salary. In otherLatin American counties the availability of funds to fiance severance payments has been a keyconstraint on the reduction of public employment. In the Honduran Central Administration thefinancing of redeployment should not constitute a major constraint sitiX each redeployed person,even assuming the maximum indemnification, will generate fiscal savings within one year.3

34. Civil sevice reform should include measures to rationalize public employment,decompress the salary scale, and establish adequate personnel policies. To achieve these goals,reforms should distinguish between short term measures and longer term sustainable solutions.In the short term, the number of government employees should be reduced based on anevaluation system of organizational need and individual performance. A primary source forthese reductions would be from the cancelation of positions following the elimination of somepublic entities. Targets for employment reduction in the Autonomous Institutions will have tobe the result of a concerted agreement with the corresponding unions in which the commonobjectivr of improving the quality of persomnnel and their remuneation should act as a leadingforce. Wage levels, particularly for senior level maagement, should also be raised in order toavoid loss of qualified personnel. At the same time, the compression ratio (max./min.),currently estimated at about 5:1, should be increased to at least 10:1 during the first stages ofimplementation of the progrm.

35. Over the long term the civil service reform should include the following actions.First, the ratio of technical/operational to support personnel should be radically incsed from

3 In Argentina the average cost of redeployment from tie public sector is twenty months of salary.

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less than 1:1 currently to 2.5-3.0:1. Second, a comprehensive personnel management system,including procedures for recruiting and retaining qualified personnel through testing,performance evaluation, and remuneration policies should be established. Third, both anincentive system and improved training programs should be created to improve individualefficiency.

36. Specific mechanisms for reducing public employment should include: (a) freezingor cancellation of vacancies, (b) voluntary resignation with full payment of indemnification, (c)selective transfer of personnel to the municipalities, (d) efforts to transfer personnel to theprivate sector, and (e) cancellation and imposition of severe constraints on the contracting oftemporary personnel. A meaningful rationalization of public sector employment also requiresmaking use of direct redeployment measures.

37. In addition to the strong commitment of the Government, a program like the onejust delineated will require a solid institutional basis for design and implementation of thereforms. The Law for the Modernization of the State provides the legal basis for a global effortof State reform. The Presidential Commission, as a representative body, is expected to developthe social and political consensus on the need for reform, and should constitute the fundamentalmechanism for successful concerted action. The Presidential Commission would be supportedby a Technical Secretariat that would help formulate, implement and follow up on the actionsundertaken in executing the Global Program for the Modernization of the State.

38. The modernization of the State is conceived in the Law as a broad process oftransformation at several levels that witl involve the administrative, legislative and judicialactivities of Government (National and Municipalities), as well as the electoral process.Accordingly, the Presidential Commission and its Technical Secretanat would have toconcentrate on complex political processes and decisions that may make difficult for them to dealwith the specific technical analysis and proposals for implementation of the administativereform. Since the administrative reform program is only one of the components of the broaderstrategy for the reform of the State, it seems appropriate to recommend that the Executiveconsider the establishment of a focal point for coordination and technical support to the designand implementation of the administrative reform. This focal point, or Special (ad-hoc) TechnicalGroup, could produce the basic policy orientation and guidelines, and later could advise on theirapplication in each entity of the Central and Decentralized Administration.

39. In the context of the overall strategy for modernization of the State, anadministrative reform program of the executive branch could begin implementation with aPresidential Instruction to all the Secretaries and Heads of the Autonomous Institutions definingthe basic policy orientations, targets, and timetable for the reform process, as well as prescribingthe mechanisms that will ensure a concerted effort across all levels of the public sector,particularly the institutional arrangements made for coordination and control of the reform.

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B. Reform of the Management of Key Public Sector Functionswithin the Central Government

40. One of the primary needs of public sector reform in Honduras is reform ofmanagement of key functions in the Central Administration. Weaknesses in public sectormanagement generate not only low internal efficiency, but also inefficient allocation ofresources, poor quality of public services, and macroeconomic instability. There is a need toreform and strengthen the following key management functions: (a) macroeconomic policyformulation and implementation; (b) management of public sector revenue generation, collection,and monitoring; (c) management of expendiures and budgetary and investment programmingand control systems; (d) procedural and operational efficiency and consistency of the internaladministration of the Central Government; and (e) institutional structure for internal and externalcontrol.

Macroeconomic Management

41. Several factors contribute to weak macroeconomic policy management inHonduras. First, there is lack of cordination between the preparation and execution of thebudget and the macroeconomic program. Second, the capacity to plan, monitor, and controlpublic expenditures is weak. These weaknesses are further exacerbated by insufficient, untimely,and inaccurate information flows, especially on public finance and monetary statistics. Thepublic sector must have the capacity to adapt policies to changing economic conditions; hence,failure to correct these problems will put the sustainability of the macroeconomic program atrisk.

42. The key to successful macroeconomic policy management is the availability of areliable, highly qualified management team. This team must be capable of analyzing economicpolicy options, making decisions in a coordinated way among agencies, and maintaining effectivecommunications with individuals at all political levels to ensure consistency between politicaldecisions and macroeconomic policy.

43. In Honduras the strengthening of policy analysis capabilities is particularlyimportant in key institutions such as the Central Bank of Honduras (BANTRAL), and theSecretariat of Finance and Public Credit (SHCP), and perhaps the Secretariat of Economy andCommerce (SEC). This could be achieved by establishing a team of possibly as few as 30qualified professionals distributed among the three institutions. The two existing groups ofeconomic policy analysts-the Technical Advisory body within the SHCP and the EconomicStudies Department at BANTRAL-constitute a basis on which a strong management team couldbe developed. This is a case where improvements in civil service pay, benefits, and employmentpolicies for high-level personnel would be essential to attract and retain qualified personnel.Furthermore, efforts to strengthen the capacity for policy formulation and implementation outsidethe aforementioned institutions, and even outside the government, would produce additionalpositive externalities. It may be advisable, for example, for the Honduran Government to

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support the UNAH and other politicaUy independent institutions. In the immediate future, thelimited use of international consultants to assist current policy analysis capabilities is advisable.

44. The core of the institutional setting for macroeconomic management (i.e., theEconomic Cabinet) also has to be strengthened, and the responsibilities of its members clearlydelineated. Coherence in macroeconomic policy also requires that the fiscal objectives of themacroecrnomic policy actually be implemented through the budget process. An effective linkbetween the management of the macroeconomic program and the fiscal budget, and efficient andtimely flows of accurate fiscal and monetary information should therefore be established.

Management of Tax Revenues

45. Tax revenue remained constant at about 13 percent of GDP until 1989 andincreased to about 16 percent in 1990, a tendency that basically continued in 1991. Thisimproved tax revenue performance results from the ongoing tax reform and managementmeasures aimed at upgrading and simplifying the tax system that the current administrationbegan after taking office.

46. Key problems, however, still remain. First, intensive use of tax incentives hascaused the deterioration of the effectiveness of the system. Second, income tax rates remainhigh by intemational standards and unnecessarily progressive for business incomes. Third, somerelatively minor taxes still demand disproportionate administrative attention by DGT relative totheir revenue yield. Fourth, the distribution of operational responsibilities between the TaxDirectorate (Direcci6n General de Tributaci6n - DGT) and the Customs Directorate (Direcci6nGeneral de Aduanas - DGA) still does not follow the logical distinction between taxes on basesgenerated domestically and taxes on bases generated from foreign trade activities. DGA is incharge of import and export taxes but also for various other taxes under the responsibility of theequivalent of DGT in other countries. Fifth, both DGA and DGT lack fully integrated computersystems to efficiently compile and process tax information. Sixth, erroneous classification andunder-valuation of merchandise are characteristic of customs operations. Approximately one-third of all imports are not taxed in part due to the application of special regimes, but alsobecause of fraudulent operations.

47. The authorities have to define and put to work a sustainable tax system able tocope with the level of debt service and the required amounts of public expenditure under thereformed state. Improvements in revenue administration require the following actions. First,the base definition of main taxes should be further simplified by eliminating exemptions and thepreferential treatment associated with promotion regimes. Second, surcharges and the two-ratesystem should be eliminated and replaced with a uniform income tax rate at levels comparablewith international standards. Third, there is further need for simplification in the tax code,especially with regard to minor taxes that are administratively cost-inefficient and encouragenon-compliance. Fourth, the division of responsibilities between revenue collection agencies needto be redefined and the institutional structure strengthened. Fifth, although efforts tocomputerize the revenue collection system are currently underway, a more comprehensive

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approach is needed to provide computerization of revenue administration to all components ofthe revenue collection system. Sixth, significant additional efforts are needed to reduceerroneous classification and undervaluation of merchandise in border operations. Finally,strengthening of staff quality, improvements in employee incentives, and streamlining thenumber of employees will be necessary to attain increased institutional capacity of the revenuecollection agencies.

Management of Expenditures

48. There is an urgent need to reduce overall government spending in Honduras andto improve the management and programming of both public investment and currentexpenditures. It will not suffice to institute short-term expenditure reduction targets in thecurrent account in the absence of long-term managerial reforms. A primary goal of managementreform in the Central Administration should be the establishment of effective and integratedsystems for both investment programming and financial management.

Investment Programming

49. Investment decisions in Honduras generally occur at the level of the executingagency without effective standards and norms, evaluation, prioritization, and centralizedcontrols. There is neither sufficient linkage of annual investment planning to the medium termnor capacity for regional or local investment planning and coordination. Although the 1986Planning Law gave technical responsibility to SECPLAN for short term operational activities andmedium-term investment planning, this agency has neither the administrative nor technicalcapabilities to carry out this role. Ambiguity and lack of coordination also exists betweenprogramming responsibilities of SECPLAN and the project executing units and the financial orbudgetary responsibilities of SHCP -- DGP (Budget Office) and DGCP (Public DebtManagement Office) -- and BANTRAL.

50. To improve the investment programming process, first, there is a need tostrengthen the coordination of the public investment process. A more efficient and effectivepublic investment programming process calls for the restructuring of SECPLAN to focus on thismajor responsibility. Second, the institutional capacity of SECPLAN should be strengthened soas to enable it to effectively integrate, analyze, and monitor public investments. Third,standardized criteria should be developed for project selection, includig the evaluation of aproject's relationship with national development priorities. Fourth, the application of suchcriteria requires that individual planning units within key entities such as SECOPT, SRN, SEP,SSP, ENEE, HONDUTEL, and SANAA. be strengthened. Fifth, effective procedures forgathering, recording, and transmitting basic information on project goals, projected benefits, andthe impact on basic indicators (e.g., employment) should be developed. Finally, the attainmentof these reforms will likely imply the need for modification in the Law of Public Administrationand abrogation of the Planning LAw.

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Financial Management

51. A primary source of inefficiency in the financial management system in Hondurasis the unclear definition of responsibilities among agencies as well as the considerable duplicationof activities at various stages of the budgetary process. Both SHCP and SECPLAN, forexample, have direct responsibility for budget formulation and various aspects of budgetexecution and control. There ig also an inadequate distribution of responsibilides among keyfinancial management agencies within SHCP. While the DGP (Budget Office), CG (GeneralAccounting Office, GAO), TGR (Treasury), and DGCP (Debt Management Office), each playa key role in the financial management system, the operational reality of the system concentratestreasury and accounting functions within D5P. Yet despite DGP's responsibility for day-to-dayoperations, there is no overall expenditure planning system. The absence of an efficient systemof budget programming means there are few links between the operational aspects of financialmanagement and policy formulation.

52. In addition to poor budgetary programming, a weak system of budgetary executionand control results from ineffective accounting norms, unreliable and untimely financialinformation, and tremendous duplication of effort. These problems stem largely from flaws inmanagement of the financial information system, particularly in the flow of information betweenagencies. Contradictory information is provided by different agencies, and information is ofteninterpreted in different ways by distinct users.

53. The following recommendations are given for strengthening the financialmanagement system. First, the legal responsibilities among institutions at all levels of budgetaryprogramming, execution, and control should be clearly defined. This calls for the removal ofSECPLAN from the financial management system. Second, institutional control within DGPshould be strengthened. This requires that DGP's institutional authority over currentexpenditures be firmly established and that extra-budgetary expenditures outside of DGP purviewbe eliminated or controlled. Third, a consistent and efficient system should be developed forrecording financial data and transmitting it to the appropriate institutions. Finally, effectiveintegrated financial management requires that, in the context of a clear arrangement for sectoralcoordination and discipline, counterpart institutional structures within the secretariats and theDecentralized or Autonomous Institutions be created and/or strengthened to ensure compatibilityand co-responsibility in the budget execution and control functions. In effect, this strengtheningat the decentralized level will assure that SHCP does not assume authority and responsibility ina very centralized controlling fashion.

Management of Internal Administration

54. Improvements must be made in the management of the internal administration.Current practice is characterized by a lack of clarity and overlap in responsibilities and authorityacross secretariats and agencies and by weak lines of authority within agencies. The absenceof consistent organizational structures for administrative support functions has resulted in a highdegree of centralization of responsibilities with little appropriate delegation of authority and

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responsibility to the sub-Secretariat and other executing unit levels. Further, the absence ofuniform and transparent personnel policies, along with weaknesses in the overall civil servicesystem, have created uncertainty in the organizational environment and lowered staff motivationand morale. Finally, the absence of clear and consistent procurement procedures and facilitiesmanagement creates the potential for fraud and abuse.

55. The establishment of a modern, integrated system for public sector internalresource administration requires reform in the following areas. First, a consistent design inorganizational structure should be developed for aU secretariats so that there is directcorrespondence in administrative functions across the Central Administration. Second, withinindividual secretariats, clear and more decentralized lines of authority and accountability shouldbe developed for administrative decisions. Third, transparent and consistent personnel, financial,and facilites management policies and procedures should be developed across aU agencies in theCentral Administration. Procurement policy in particular needs to be modemized, as currentpractices contribute to paralysis of government operations and increase the cost of doing businesswith the govemment.

Management of Internal and External Control

56. 1h theory, the General Accounting Office (GAO-Contadurfa General) in Hondurashas the responsibility for recording and consolidating all financial transactions of theGovernment, as well as for establishing accounting norms and practices. The GAO, however,is not preared institutionally or in terms of personnel to carry out these functions. The annualreport prepared by GAO offers little guidance for the annual budget process and providesvitually no control over finances. Delays in the preparation of the annual report are often morethan one year. Excessive quantities of unanalyzed data are presented without any criticalcomments on the figures. Furthermore, this raw data represent substantial duplication ofinformation produced by SHCP.

57. The following recommendations would aid in improving the general accountingfunction. First, the Government should increase the number and quality of personnel in theGAO, including the transfer of personnel located within the individual secretariats involved inthe accounting function to the GAO. Second, uniform and transparent standards and proceduresfor basic financial accounting and management should be developed. Third, there is a need forstandardization and centraized control of the financial information system, including theimprovement of computer facilities and taining of personnel in the use of these facilities.Finally, GAO should develop a consolidated financial statement for the entire public sector.

58. Like GAO, the Comptroller General (Controlaria General de la Repdblica-CGR)has insufficient capacity to perform its duty of extenal audit control. Although CGR is requiredto submit an audit report to Congress within 40 days of the end of the fiscal year, as well as anintegated Balance Sheet to the SHCP by April 30 of each year, actual submission of each isgenerally several years behind schedule. The institutional capacity and in particular the quality

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of staff of COR is very weak largely because litde funding is available for the agency. Inaddition, there is an absence of an institutional structure for internal control in the CentralGovernment part of the-Executive branch.

59. To improve the functioning of COR, the Government should first assess pay andemployment pol;cies and hire more qualified personnel at significantly higher wages. The totalnumber of stiff, currently at 125, should be increased to a level that can handle a workload ofan agency responsible for superAsing some 1,300 endties., Second, there is a need forimprovement in -the information capabilities through expansion of computer facilities and stafftaining programs. Finally, as a first stage in the development of a more adequate institutionalstructure for internal control of the Executive branch, in the short term, an Internal AuditAgency (IAA) should be established within the national government, reporting directly to theOffice of the Presidency.' In the longer term, this assumes the existence of an efficient unit ofinternal audit dully staffed in each secretariat and public sector entity. These units, while

ministvely depending from the secretary or head of the entity, would be technicallycoordinated and monitored by the IAA.

C. Reform of the Decentraled Adminisation

60. In recent years, the Autonomous Institutions have been a primary source ofinases in government expenditure in Honduras. This was pardy due to the fact that thesevices provided by the State were extended to more affluent sectors of society. Several otherfactors have distorted the allocation of resources and reduced internal efficiency in theAutonomous Ibstitutions, thus also contributing to rising expenditures and falling revenues.First, the role of institutions in the economy has not always been clearly defined. Second,public enterprises, particularly the public utilities and those in charge of transport services, haveMot had sufficient managerial autonomy from the Central Government. The incentive regime,the insdtutional and legal framework, as well as public policies have forced enterprises to deviatefrm their commercial goals and have thus discouraged efficiency. Tird, some public agencies-providing social servic bave strayed from their original mandates, maldng them unable tosaftsfy the needs of targeted groups.

'Similar Auditoras del Ejecutivo Nacional operate efficienty in M6xico (SECOGEF) and are beingdeveloped in Argentina (SIGENAC).

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Public Enterprises

61. Public Sector reform will have to include divestiture of a part -or all of sombpublic enterpriss, and stricter control of their budgets during the stabilization process. Oncethe urgency of fiscal adjustment has been reduced, there is need for a broad-based reform of therelation between public enterprises and the Central Government to obtain greater managerial andfinancial autonomy of the public enterpises, combined with greater accountability ihroughperformance evaluation. Finally there is need for improvement In their competitive environmentthrough a reduction in barriers to entry, forcing enterprises to respond to market pressures.Additional specific reform strategies will need to be designed according to the principaleconomic role of the enterprises.

Agriculual and Food Digbution Se,ces Entes

62. The primary problem within public enterprises associated with agricultural andfood distrbution seic is ove=regulation and excessive intervention in activities that could bemore efficiendy performed by the private sector. This applies to the enterprises involved ingrain marketing (HMA), food distribution (BANASUPRO), forestry (COHDEFOR), and coffee(IHCAFE), as well as to the National Agarian Institute (INA).

63. COHDEFOR, for eample, has extended its role into all aspects of forestrydevelopment and exploitation, including production, pricing, control of private agents, marketngof processed wood products, as well as maintning a legal monopoly on timber exports. It hassupported inefficient regulatory mechanisms, including (i) a stumpage fee system thatdiscourages thorough harvesting and results in wovergrading"; (ii) short term exaction permits(less than one year) that inhibit investment; and (iii) limits on foreign participation in enterprisesrelated to forest exploitation. These distortions have contributed to an alarming rate ofdeforestation: Honduras' forested area declined from 6.8 milLion hectares in 1960 to an estimated5 million in 1990. Deforestation has also resulted from the movement of landless families intothe practice of slash and burn agriculture and extensive livestock ranching, flowing fromperverse incentives associated with the agrarian reform.

64. In the coffee sector, IHCAFE has expanded its duties to include: support of smallcoffee producers by building roads and providing other infrastructural services; establishmentof coffee production quotas for domestic and forign markets; setting of domestic prices toneutralize the market power of the coffee toasters; quality control and the granting of exportcertificates; and, in the past, the administration of a fund to support producers. These serviceshave been financed with revenues from a charge for export certficates of 7 lempiras per saclk.This charge, combined with the 7 percent export tax on coffee, has created strong exportdisincentives.

65. INA (a "public institute") created in 1961 to carry out the agrarian reform has alsonot met its initial goals. The agrian reform affected only 15 percent of total farm area, andthe land tides granted by INA are only provisional, with about 70,000 of the beneficiaries

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receiving land almost exclusively as "collective propety" managed by cooperatives or producersassociations.

66. The Government's program of price and commercial deregulation in theagricultural and food distribution sector should be continued and strengthened. IHMA shouldaggressively implement its agreed restructuring plan; in particular it should sell its silos, giveup access to preferential exchange rates and credit, and reduce its role to maintaining a strategicgrain reserve. BANASUPRO should clearly be privadzed; at the minimum it should limit itselfto market-cost sales of basic goods in low-income areas.

67. Reform of COHDBFOR and IHCAPE should focus on changes in the regulatoryand incentive regimes, as well as measures to raise intemal efficiency. It is recommended thatboth enterpnses focus exclusively on regulatory functions and agncultural extension, avoidingdirect production and commercial activities. The Government has already stated its intent tocorrect incentives in forestry through a gradual reduction in export duties on sawed timber, withtheir total elimination by 1993, and adjustments in stumpage fees to appropriate levels. In thecoffee sector, the Govemment should institute a gradual deregulation of production, processing,and marketing of coffee. Reform of IHCAFE should include intemal restructuring, measuresto reduce expenditures, along with gradual deregulation and elimination of inefficient subsidiesto producers. As a smaUer enterprise; IHCAFE would have greater management capacity tocarry out its primary tasks of agricultral extension, quality control, and eventually priceregulation in an oligopolistic domestic market.

68. The agricultural sector reforms should be accompanied by a clearer definition ofland titles, so as to discourage inefficient exploitation and predatory praces. INA coulddemand return of all unlawfully occupied public lands, however, it should adjudicate definitivetitles to those able to prove they have been rationally exploiting the land for no less than 10years, in accordance with the Govemment's initiative.

Pub lcUtlities and TranwOr Sexc: ]nteZrise

69. A primary problem assocated with the public utilities (SANAA, ENEE, arnHONDUTEL) and transport services enterprises (BNP-ports and FNH-railways) is lack ofautonomy from the Cental Government. The Government, for example, has maintainedexcessive intervention and has frequently given contradictory signals regarding PE employment.On the one hand, the Government has used PEs as a means to reduce unemployment so as tomoderate social conflict. On the other hand, during fiscal adjustment periods the Governmenthas established general and indiscriminate restrictions on the hiring of workers and preventedwage increases, which in some cases led to the deparre of qualifed personnel. The CentralGovernment has also interfered in PE investment decisions, causing the allocation of resourcesto be determined based on political rather than profitability criteria. Finally, the CentralGovernment's power to monitor the purchases and contracts of PEs has had the effect ofcurtailing the flexibility of purchasing and contacting policies and has often inhibited thefulfillment of commercial objectives.

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70. Another area in need of reform is pricing policy. The price and incentive regimesfor these PEs have tended to discourage productivity, thereby worsening the financial positionsof enterprises. Tariffs were frozen for a number of years as an anti-inflationary measure. InSeptember 1990 and again in May 1991, tariffs of some major companies were adjusted, leadingto significant improvements in the financial positions of the public utilities and ENP. In aneffort to address this problem, the Government recently established the 'Comisi6n NacionalSupervisora de los Servicios Pdblicos' which will have the task of approving tariffs on the basisof the economic costs for providing services to each category of consumers. This commissioi.contains members representing the Congress, different secretariats of the Executive branch, andrepresentatives of workers unions, and the private sector, and will face the challenge ofbalancing political interests and technical criteria.

71. A broad-based reform of the PE institutional framework has to be implementedto obtain greater managerial and financial autonomy, combined with greater accountabilitythrough effective performance evaluation. Political authorities should reduce intervention on alllevels of enterprise management. In addition to increased managerial autonomy, effectiveimprovement of PE employment and wages administration requires elimination of excessivepolitical and union interference. Economic criteria should predominate in making PE investmentdecisions, and mechanisms need to be developed for coordinating sectorl investment decisionsand its financing among the agencies of the public sector involved in this process. Procurementprocedures and the role of the Internal Auditors and the Office of Administrative Compliance(Direc,6n General de Probidad Administrativa) have to be simplified and improved followingmodern practices.

72. The appropriate functioning of the price setting mechanism (the -Comisi6nSupervisora de los Servicios Pdblicos") has to be ensured, as well as the application of soundpolicy criteria for all services produced by these PEs. Gradual adjustments in real rates shouldbe made in cases where prices are still below long-run marginal costs, particularly in SANAAand ENEE. Further rationalization of the tariff stmctures and improvement in revenue collectionmechanisms is required. In SANAA subcontracting of meter reading and revenue collection ishighly recommended.

73. The Government should investigate areas where deregulation would be feasibleand efficient. The high value added services, such as telecommunications, could be gradualyderegulated so as to aBow for private sector participation.

PzQvatization of Public Elntewses

74. The Honduran Government should also evaluate the desirability of a privatizationprogram for these PEs, including the assessment of options to decentralize some activities, asstated under the new Law of Municipalities. Privatization offers the following advantages.First, if concessions are granted through a competitive auction, the state will receive thecorreWonding fees, in addition to the elimination of the budgetary burden of transfers from theCentral Government. Second, if enterprise assets are sold, the Government will receive short-

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term financing that can be used for debt-service payments. Third, privatization may fosterincreases in productive efficiency as a result of a clarification in property titles and eliminationof distortionary intervention by the Govemment.

75. Given the experience with the privatizations that have already occurred inHonduras (primarily industrial, agro-industrial, and catde enterprises), it is apparent that theagency reonsible for privatization should be given greater political power, and improvementsshould be made in its institutional capacity. The reform of the legal framework of PublicEnterprises is also required to support divestiture. The debt status of enterprises offered for salealso needs to be clarified, and eventually their debts should be assumed by the government.Finally, use of competitive auctions should be encouraged in all privatization cases, allowinginterational firms to participate, so as to maximize the return.

Public Institutes

76. The Public Institutes are intended to provide administrative functions and services.The majority are concentrated in the areas of health services, social security, and education. Aproblem common to many of the Pls is lack of autonomy to carry out the specific goals of theinstitute. Many PIs hav representatives on their boards of directors, both from the Governmentand from private corporations that supply them with services. The board of directors of theIHSS, for example, contains a representative from the Honduras Medical Association. Thistends to reduce the Public Institute's autonomy and in some cases has caused employment andexpenditures decisions to be based on political or other criteria without due attention toefficiency objectives.

77. Within the Public Institutes, the Honduran Soial Security Institute (InstitutoHondureflo de Seguridad Social - IHSS) is in particular need of reform. Current revenues ofIHSS, which come primarily from wage-earner contributions, have been insufficient to cover

current expenditures. Two practices have limited these contributions. First, the ceiling onmandatory contributions; second, many private firms (and even the public sector) evade totallyor partally the payment of contributions. Low revenues have resulted in a dramatic andrecurrent shortfall in the Medical Fund account which is covered by direct transfers from thePension Fund. While this transfer resolves the short term deficit problem, in the longer termthese reserves are intended for future beneficiaries. If this trend of gradual decapitalization isnot corrected, the IHSS will eventually require direct transfers from the Central Govemment.Wbile the recent measure that increased the ceiling on mandatory contnbutions from 600lempiras to 1500 wiil substantially strengthen IHSS finances (though constrained by the fact thatcollections are still very, weak), medical services will continue to be pardally fmanced withtransfers from the Pension Fund. Furthermore, budgetary constraints of the Medical Fund havealso caused the qualihty of medical services to deteriorate. Medical personnel per 100 personsinsured fell from 2.1 to 0.8 and the number of paramedics from 5.6 to 2.8 between 1986 and1990.

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78. A similar situation exists for the pension fund for public employees of theexecutive branch (LNJUPBMP) and for the teachers' pension fund (INPREMA). In recent yearstheir authorities have made low profit investments, thus jeopardizing their future financialsituation and ability to satisfy future obligations.

79. As part of the public sector reform program, the Government should carry out athorough evaluation of the Public Institutes to determine whether their original goals andmandates still hold and to find mechanisms for improving managerial efficiency. To improvebudgetary performance and reduce dependence on the Centml Government, the Public Institutesrequire a simultaneous increase in service charges, a reduction in personnel, combined with agradual process of divestiture from some activities. Areas of divestiture might range from thesubcontracting of in-house cleaning and maintenance to the replacement of some existinginstitutions with private ones.

80. Public Institutes that provide health services and manage pension funds (WHSS,INJUPEMP, and INPREMA) must be required to separate financially these two functions. Thebasic parameters of the social security system should be redefined to reestablish the long-termsustainability of the system. The following specific recommendations are made for reform ofthe IHSS. First, improvements should be made in IHSS's collection system to reduce delays inpayment. Second, to eliminate the budgetary shortfall in the Medical Fund, IHSS should raiseuser charges for medical services. Third, rates and ceilings on pension fund contributionsshould be further reviewed on the basis of sound achtarial analysis. Foitth, cross-subsidizationof the Medical Fund through revenues from the Pension Fund should be curtailed and moreeffective investment of technical reserves in the Pension Fund should be established. Finally,the Government should explore mechanisms for encouraging private sector involvement in thepension fund market.

81. Public Institutes that provide educational services (UNAH and INFOP) shouldncrease their own sources of revenue - mainly through the adoption of realistic pricing policies- and should also eliminate non-core functions.

Municipalities

82. There are 289 municipalities in Honduras of various sizes and populationdensities. This high degree of municipal atomiation, however, does not imply a high degreeof political decentralization. The electoral system that rstricts voters to cast votes for the sameparty in local and national elections implies that municipal leaders are highly dependent on thecentral power. From an economic viewpoint, this centralized system has led to a ratherdiscretionary financial relationship between the Central Government and the municipalities. Asa result, the municipalities have accumulated a debt of over 428 million lempiras (4.3 percentof GDP) through transfers from the Central Government and loans from BANMA (Banco

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Municipal Aut6nomo) - Such high debts have resulted in high debt sevice payments andgrowing afrears for the Municipalities which have contributed to BANMA's bankruptcy.

83. The Honduran Government has taken action to reduce the discretionaryrelationship between the municipalities and the Central Govemment through the adoption of thenew Law of Municipalities. This law gives the municipalities full responsibility for thedevelopment, approval, and administration of budgets. The municipalities are 31so no longerrequired to contract with the national public enterprises for public utilities. Municipalities cantherefore now contract independently for services that can be provided more efficiently locally,such as water distribution, sewage service, and the expansion and maintenance of public roads.FinaUy, an automatic mechanism for revenue sharing should replace the previously discretionary(and often politicized) system. The new law establishes that the Government wil earmark 5percent of tax revenues for municipalities, of which 20 percent will be alocated equaUy Rcrossmunicipalities and 80 percent proportional to the number of inhabitants.

84. Even though the new law represents significant progress, problems still remain.In the new tax revenue-sharing system, there are no weights attached to fiscal efforts or toregional inequities in income distribution. Furthermore, coexisting with the 5 percent allotmentof tax revenues, there are two preexisting mechanisms for municipalities to obtain national publicrevenues. First, there is the mandatory distribution of 4 percent of revenues collected by theNational Port Enterprise (Empresa Nacional Portuia - ENP) to municipalities where ENP portsare located. Second, the municipalities in which coffee is produced receive a share of coffeerevenues. The greatest problem with the new law is that while it provides for mandatorydecentralization of tax revenues, there is no provision for decentralization of expenditures.Municipalities are therefore able to increase their revenues without taking on the responsibilityfor providing additional services actually paid for by the Central Government-thereby increasingthe total expenditure level and the overall deficit of the consolidated public sector.

85. The main recommendation for improving the relationship between themunicipalities and the Central Government is to eliminate the existing asymmetry in thedecentralization of public expenditure and public revenues. The municipalities should assumepart of the expenditure responsibilities of both the Central Government and the PublicEnterprises to prevent further deterioration in the fiscal deficit. Actual transfer ofresponsibilities can only take place once the required minimum institutional capacity has beendeveloped in the municipal corporations; accordingly, a focused technical assistance program iswarranted.

5The Central District and the San Pedro Sula MunicipalitY account for 85 percent of the total debt.

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D. Implementing a Reform Strategy

86. This study proposes three major areas for implementation of Honduran publicsector reform: Administrative Reform; Public Sector Management Reform; and Reform of theDecentralized Administration including Public Enterprises, Public Institutes and Municipalities.While these three areas are seen as complementary parts of a broad strategy for public sectorreform, actual implementation of reform measures will necessitate a clear definition of prioritiesand also will depend on the existence of feasibility conditions to ensure success of the reformprocess. An adequate sequence of reforms should result in greater capacity to implement areform strategy.

87. The administrative reform of the public sector is the keystone for starting anambitious process of state modernization. There are two reasons for this: (a) in Hondurasadministrative reform of the public sector is not only urgently required, but also feasible in theshort term; and (b) since administrative reform would comprise the entire public sector, it thusprovides an adequate context to prepare, at the institutional level, more specific restructuring andprivafization programs, particularly for Decentralized or Autonomous Institutions.

88. Specifically, it is suggested that the first phase (12 to 18 months) of the proposedpublic sector reform program be comprised of the following:

(a) the core of the administrative reform; this should include functional review,organizational change and resources rationalization with emphasis in publicemployment. The reform of civil service during this phase will target the numberand composition of employees and the decompression of the salary scale;

0b) continued efforts to strengthen public sector management systems in areas wherethere are ongoing efforts (tax administration, macroeconomic management, andpublic finance information systems) and new reforms and improvements in othersystems which are crucial for the sustainability of the economic reform program(customs administration, investment programming, integrated fnancialmanagement, internal administration and internal and extemal control);

(c) reform of the institutional framework of the Decentralized Administration (toincrease autonomy and improve accountability through performance evaluation)and of the policy environment (including generalization of cost based pricing,increased labor flexibility, elimination of litigious procurement practices and theestablishment of sound rules for investment programming and financing),especially where Public Enterprises are involved; at the same time and with aview towards a deep reform of Decentalized Institutions (PEs and PIs), specificprograms for restructuring/privadzation will have to be prepafed on a case-by-case basis for implementation during subsequent phases;

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(d) on the basis of an action plan assistance should be provided to facilitate theimplementation of the new, expanded role foreseen for the Municipalities.

89. In the second phase (involving two to three years or more) the programs for indepth restructunng/prvatization of Public Enterprises and Public Insdtutes will be actuallyimplemented. Also during this phase the new comprehensive civil service system will beconsolidated including the establishment of adequate personnel policies (e.g. career development,incentives, training), salary scale and administrative procedures. Public sector managementreforms and institutional strengthening programs in this phase will continue to be implementedand give emphasis to those functions for which, previously to the implementation ofstrengthening programs, major legal changes and/or other institutional and policy reforms willhave to be undertaken.

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