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Report No. 23349-MK FYR of Macedonia Public Expenditure and Institutional Review Public Disclosure Authorized April 2, 2002 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Public Disclosure Authorized u Public Disclosure Authorized Public Disclosure Authorized Document of the World Bank CURRENCY AND EQUI'VALENTS Currency Unit USUS$ 1 = Denar 67 FISCAL YEAR January 1-December 31 ACRONYMS AND ABBREVIATIONS BOO Build-operate-own BRA Bank Rehabilitation Agency CBA Collective Bargaining Agreements CEEC Central and Eastern European countries CPI Consumer Price Index FDI Foreign direct investment FIAS Foreign Investment Advisory Service FRY Federal Republic of Yugoslavia (Serbia and Montenegro) FTA Free Trade Agreement FWA Framework Agreement GoM Government of the FYR Macedonia GNFS Goods and non-factor services HIs Health Institutions HIF Health Insurance Fund IAS International Accounting Standards MIPA Macedonia Investment Promotion Agreement MUCE Ministry of Urban Planning, Construction and the Environment NBRM National Bank of the Republic of Macedonia PEIR Public Expenditure & Institutional Review PA Privatization agency PTA Preferential trade agreement ROW Rest of the world PRO Public Revenue Office RER Real exchange rate SB Stopanska Bank DIF Deposit Insurance Fund SEC Securities and Exchange Commission SRP Special Restructuring Program SSO State and socially owned enterprises VAT Value added tax ZPP Zaved za Platen Promet (payment bureau) Vice President: Johannes F. Linn Country Director: Christiaan J. Poortman Sector Director: Pradeep K. Mitra Sector Leader: Helga W. Muller Task Manager: Pascale N. Kervyn de Lettenhove ACKNOWLEDGEMENTS This Public Expenditure and Institutional Review (PEIR) has been prepared for the Government of FYR Macedonia. A World Bank team, working with Government officials and other donors, including the European Union (EU) and the United Kingdom's Department for International Development (DFID), completed the first draft for discussion with the Government in 2000. This version, finalized at the beginning of 2002, updates the analysis and reflects the Government's comments. It could not have been prepared without the Government's ongoing support and the excellent cooperation provided by numerous public officials. The donor community has been highly supportive of the reform agenda presented in the report and has provided the Govermment with substantial technical assistance to implement the recommendations.' The main recommendations of this report have also formed the basis for a Bank-supported adjustment operation (PSMAC) scheduled to go to the Board in 2002. The task manager and main author of this report is Pascale Kervyn de Lettenhove. The peer reviewers were Malcolm Holmes, Stefan Koeberle, Nick Manning and Hermann Von Gersdorff. Main contributions to the report were provided by Erika Jorgensen, Juan Carlos Ginarte, Xiaoqing Yu, Loraine Hawkins (Chapters 1-3); Gord Evans (Chapter 2); Michael Reddington, Bill Radburn, William Dorotinsky and Serif Sayin (Chapter 3); Gary Reid and Jana Orac (Chapter 4). Contributions were also provided by Slobodanka Matakova, Marius Vismantas, Evgenij Najdov, and Rajna Cemerska. Kathryn Rivera and Mismake Galatis provided excellent assistance in the final document preparation. 'The donors include: the Dutch Govemment, DFID, USAID, CIDA, SIDA and the Japanese Government. iii FYR of Macedonia Public Expenditure and Institutional Review CONTENTS EXECUTIVE SUMMARY .................................................... i Institutional Challenges .................................................... iv A Sequenced Agenda for Institutional Refonn .................................................... vi Phase 1: Improve allocation of resources within fiscal constraints..................................... vii Phase2: Institutionalizethe reforms through stronger accountability and capacity building. ............................................................................................................................................... ix Conclusions ..................................................................... x Report Organization .................................................................... xi 1. FISCAL STABILITY WITHOUT REFORM ................................................................... 1 Introduction ....................................................................... 1 Fiscal Adjustment Since 1994: Regaining Fiscal Stability ......................................................... 1 Budget hnbalance and Growing Fiscal Pressures ....................................................................... 3 Revenues ...................................................................... 3 Expenditures ...................................................................... 4 Public Sector Employment and Pay Structures ....................................................................... 7 Public Sector Employment Structure....................................................................... 7 Pay Structure ...................................................................... 9 Fiscal Reforms in Key Sectors: Health and Social Protection ................................................. 10 Health Sector: InstitutionalIssues ...................................................................... 10 Health Sector: InstitutionalReforms ...................................... ................................ 12 Social Protection:Issues ...................................................................... 14 Social Protection: Reforms ...................................................................... 15 Conclusion: Fiscal Stability with Institutional and Structural Reforms .............. ..................... 18 2. POLICY FORMULATION ...................................................................... 21 Introduction ...................................................................... 21 Political Institutional Constraints ...................................................................... 22 Incentives for Collective Decision-Making...................................................................... 22 Policy Management Structures ....................... ............................................... 24 Lack of Capacity in Central Agencies .................................. .................................... 25 Policy Management Role of CentralAgencies ..................................................................... 25 CoordinationAcross CentralAgencies ............................. 28 Process Gaps in Budget Formulation ............................. 29 Realistic FiscalFramework ............................. 29 Articulating StrategicPriorities ............................. 32 Multi-Year Budgeting............................. 38 Budget Unpredictability............................. 38 Reforming the Budget Process................................................................ 39 Budget Fragmentation ................................................................ 42 Special Revenue ................................................................ 43 Guarantees................................................................ 45 Implicit Liabilities in the Banking and Public Enterprise Sector ......................................... 46 Donor Funding................................................................ 47 3. BUDGET IMPLEMENTATION, MONITORING, AND ACCOUNTABILITY ........ 49 Introduction ................................................................ 49 Accounting, Financial Management and Control: Central Government ................................. 49 Accounting, Financial Management and Control: Health System ........................................... 57 Monitoring and Reporting ................................................................ 60 Executive Accountability ................................................................ 61 InternalAccountability ................................................................ 62 External Accountability ................................................................ 63 4. HUMAN RESOURCE MANAGEMENT .67 Introduction .67 Pay and Employment Issues .67 Establishing a Legal, Institutional, and Management Framework for the Civil Service . 71 Legal Framework and OrganizationalObjectives .71 InstitutionalBarriers to Meeting OrganizationalObjectives .73 Politicization.77 Implementing a Human Resources Management Framework .78 Tables Table 1.1: Economic composition of revenue and expenditure, 1993-2001 (1) .ii Table 1.1: Key Macroeconomic Indicators, 1991-2000 .2 Table 1.2: Economic Composition of Revenue and Expenditure, 1993-2000 .3 Table 1.3: Central Government Revenues and Expenditures in Central Europe, 1999 (as % of GDP) .4 Table 1.4: Projection of the Pension System Balance, Percent of GDP (Using Narrow Definitions) .16 Table 1.5: Fiscal Projections with Reform (in % of GDP) .18 Table 2.1: Policy Reliability: Survey of the Business Community (in %) . .22 Table 2.2: The Role and Perceptions of the Government .. 23 Table 2.3: Stages of Development for Four Key Central Agency Functions . .29 Table 2.4: GDP % Growth Estimates vs. Actual .. 30 Table 2.5: Forecasting Approach in FYR Macedonia .. 31 Table 2.6: A Process for Coordinating Macro and Fiscal Forecasting . .32 Table 2.7: Strategic Priority-setting in FYR Macedonia in 1999 . .34 Table 2.8: Strategic Policies and Fiscal Process .. 34 Table 2.9: The Budget Preparation Process in FYR Macedonia --