Report No. 891 8EC Ecuador Public Sector Finances: Reforms for Growth in the Era of Declining Oil Output January 23, 991 Country Departnent IV Latin America and the Caribbean Region FOR OFFICIAL USE ONLY V.:~~~~~~~~~~~~~~~~~~~~~, /~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~. Docment of teWorld Bank This document has a restricted distribution and "may be used by reipients only in th~ performace of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit - Sucre (SI.) Average Exchange Rates (Sucres/US$): Year Official Free 1990 766.75 826.17 FISCAL YER January 1 to December 31 GLOSSARY OF ABBREVIATIONS BCE Banco Central del Ecuador (Central Bank of Ecuador) BEDE Banco Ecuatoriano De Desarrollo (Development Bank of Ecuador) CEPE Corporaci6n Estatal Petrolera (Ecuadoran State Petroleum Ecuatoriana Corporation) CONADE Consejo Nacional de Desarrollo (National Development Office) DINAC Direcci6n Nacional de Catastres (National Agency for Appraisals and Cadastres) ECUATORIANA Ecuatoriana de Aviaci6n (National Airline of Ecuador) ENAC Empresa Nacional de Almacenamiento (National Enterprise for y Comercializacion de Storage and Sale of Productos Agropecuarios Agricultural Products) ENFE Empresa Nacional de Ferrocariles (National Railway Corporation) ENPROVIT Empresa Nacional de Productos (National Enterprise of Vital Vitales Products) FERROCARRILES see ENFE FLOPEC Flota Petrolera Ecuatoriana (Ecuadoran Petroleum Fleet) FODEH Fondo de Desarrollo Municipal (Municipal Development Fund) FODESEC Fondo de Desarrollo Seccional (Local Government Development Fund) FONADE Fondo Nacional de Desarrolo (National Development Fund) FONAPAR Fondo Nacional de Participacion (National Participation Funu) GTZ Gesellschaft fur Technische (German Technical Zusatmenarbeit Assistance Organization) IESS Instituto Ecuatoriano de (Ecuadoran Social Security Seguridad Social Institute) IETEL Instituto Ecuatoriano de (Ecuadoran Telecomnunications Telecommnicaciones Institute) INECEL Instituto Nacional de (National Institute of Electrificaci6n del Ecuador Electrification) NFPS Nonfinancial Public Sector PETROECUADOR Empresa Estatal Petroleos del (Ecuadoran Petroleum State) Ecuador Enterprise TAME Transportes Aereos Militares (Ecuadoran Military Air Transport) TRANSNAVE Transportes Navales Ecuatorianos (Ecuadoran Shipping Line) FOR OFFICIAL USE ONLY ECUADOR: PUBUC SECTOR FINANCES Refoms for Growth In the Era of Declining on Output Tubb d Coatens Pop Qn EXECUTlVE SUMMARY .......................................................... hv L GROWT. ECONOMIC STABILITY, AND THE RISE OF STATE INERVENTION . .............. 1 A. The Crisis of the State-Led Growth Model ..................................... 1 B. The Quest for Stabilization: 1988 1990....................................... 3 C. Public Sector Reform and Growth: A Scenario for the 1990s ....................... 6 Oil Revenues and Public Sector Surpluses .................................. 8 Expenditures ....................................................... 9 Quasi-FFal Deficits ................................................. 11 D. Conclusions .......................................................... 1t I. NONFINANCIAL PUBLIC SECTOR EXPENDIITRES AND DEFICITS ....................... 13 A. Introduction .....................13..................... I .............. 13 B. The Nonfinancl Public Sector ............................................ 13 The Increased Role of Nonfinancial Public Sector Expenditures .................. 14 The Fiancing of Nonfinancia Public Sector Expenditures ...................... 18 Overall Nonfinancia Public Sector Balances ................................ 19 Noinancial Public Sector Deficits and Growth of External Debt ..... ............ 21 C. Main Components of Nondinancri Public Sector Defits ........................... 22 Central Government Expenditures ....................................... 22 The Social Security System (IESS) ...................................... 25 Other Government Agencies ........................................... 27 The Development Bank of Ecuador (BEDE) ................. .............. 27 Provincial and Municipal Councils ..................................... 28 Other Public Sector Enities ........................... 29 m. CENTRAL BANK NET INCOME AND CONSOUDATED PUBLIC SECTOR DEFICrS .... ....... 30 A. Quasi-Fiscal Defifts: a Definition ............... ........................... 30 B. Estimates of Ecuador's Quasi.Flscal Deficits .................................. 31 Composition of the Balance Sheet ....................................... 32 Nominal Quasi-Fscl Defict in 1989 and 1990 ........ ...................... 33 Quasi-fical Result: Decomposition of Subsidies ........................... . 35 C. Recommendations ..................................................... 37 This report summarizes and integrates a number of studies of different aspects of Ecuador's public sector. Most of these studies were prepared as part of a cooperative effort to obtain an understanding of key public sector issues and the required reforms. The studies include: Financial and Economic Evaluation of Social Insurance (IESS) In Ecuador (Carmelo Mesa-Lago); Local Government Finance in Ecuador (Humberto Petrei); The Financial Condition of the Public Sector In Ecuador (P. Lucio-Paredes); Ecuador: Transferenclas del Gobierno Central a los Goblernos Seccionles (Humberto Petrei); Los Impuestos con Destino Especifico (Humberto Petrel); Non-Oil Revenues and Tax Reform In Ecuador (Osvaldo Schenone); Ecuador: Planteamientos parm Melorar el Sistema de Presupuesto Gubiernamental (A.Premchand, E. P6rez-Cajlao, George Guess, IMF); Ecuador: Quasi-fiscal Deficits - Walking through the Maze of Subsidies (Luca Barbone and Maro Vicens). The report also drew upon World Bank documents relating to municipal finances (prepared by James Hicks, David Vetter, Herrando Garz6n) and on idividual public enterprises (E. Martinez). The report -as written by Luca Barbone and Derek A. White. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. - ii - IV. GOVERNMENT REVENUES: ISUES FOR FURTHE ........................PR E REFOR 39 A. OR Tax R e v e n u e s ...................................................... 40 B. The Non-OR Tax System ................................................ 43 Composition of Tax R e v e n u e s .......................................... 43 Tax Reform, igego ................................................ 44 Inome Tax Reform ..... 44 The VAT (Tax on Mercantile aatis)..47 The Specfic Consumption Tax (TSC) .............. .. .................... 49 Tax Adminittion .................................................. 50 C. Condcusions .......................................................... 51 V. PLANNINO AND CONTROL OF EXPENDITURES: THE BUDGETARY PROCESS ..... ........ 53 A. Intducion ............................................... 53 B. The Budgetary Process ............................................... 54 Ecuador's Current Budgetary System ...................................... 54 Proposa for Reform of the Budgetary Process ........ ..................... 58 C. Eamarking of Revenues and Expeditures ............ ....................... 59 OD Tax Revenues .................. ........................ 61 Shfts over Time in the DItribun of 00 Revenues ........ .................. 61 Scical Security Taxes ........................................... 63 Other Sources of Earmarking .......................................... 63 Earmarking of Expendoures .......................................... 65 Issues and Options for Reform . . ...................................... 65 V. THE SOCIAL SECURITY SYSTEM ....................9...................... 6 A. Background and Current Organiation ....................................... 69 B. IESS Fhiancing ........................................... 9 State Debt .......................................... 71 Private and Other Public Employer Debt ........... ....................... 72 C. IESS Expenditues ............... ............................ 72 POrtfoio Investment ........................................... 72 Population Coverage and Inequalites ..................................... 74 Benefit Expendiures ........................................... 75 Adminbistive Costs and Effhcny . ..................................... 78 D. Recommendations ................................................ 81 Vll. LOCAL GOVERNMENTS . ............................................... 83 A. Background ............................................... 83 B. Local Government Finances .............................................. 83 Provincial Govenment Revenues......................................... 83 Municipal Revenues ............................................... 84 Trarsfers from the Central Govemment ............ ....................... 85 Municipal Tax Revernes .............................................. 87 C. Local Govemment Expenditures . .......................................... 90 Provincal Counci Expendtures . ........................................ 9o Municipal Debt ................................................ 92 Budgeting and Plannig .............................................. 93 0. Reform of Local Fances ............................................... 94 Main Requiremes for Reform . ........................................ 94 Reorrns of the Municpal and Provin i Transfers Systems .....5................ 95 VOL PUBLIC ENTERPRISES ..................................................... 97 A. Oveiview ............................................................ 97 Relaive Importance ....................... .......................... 97 Financial Perfomance ......................8......................... g - iii - Debt Siuton ........................ . 99 Instilnad Contrds ......................... 100 B. Ind hdual PubicEn [alme ......................... ..u. . 101 PETROECUADOR ....................... . 101 INECEL ...................... 102 IETEL .................... 104 ECUATORIANA .................... 105 TRANSNAVE .................... 106 FLOPEC ............................ 107' TAME .................... 108 ENFE .................... 109 ENAC .................... 110 C. Conclusom ................... 111 ANNEX TAEUES .................... 113 STATISlCAL APPENX ...5.................. 156 EECUTIE SUM2ARY i. This report was prepared to support the ongoing World Bank-Government dialogue about public sector developments and issues and to facilitate cooperation between the World Bank and the Government in implementing key aspects of the Government's program. After analyzing macroeconomic developments over the past few years and their interrelation with the growth of public sector expenditures and deficits, quantitative projections are presented. These are macroeconomic performance scenarios under the assumption of successful implementation of the proposed structural reform measures. Next, critical developments in the evolution of nonfinancial public sector finances over the past two decades are identified, followed by a discussion of the main developments and issues in the Government sector. The contribution of the Central Bank to the overall public sector deficit (through quasi-fiscal operations) is addressed. Then an assessment of the tax system and an evaluation of tax reform is provided along with consideration of the tax earmarking system and its relation to the budgetary process. Finally, critical issues pertaining to the social security system, local governments, and the public enterprises are discussed, and possible solutions proposed. Economic Background ii. Following a decade of rapidly rising output (9.1 percent a year) between 1971 and 1980, Ecuador's growth slipped to only 2.1 percent in the ten years to 1990, considerably below the rate of population growth (2.8 percent). Between 1982 and 1988, per capita GDP dropped 17 percent. Basic structural changes are now required to restore adequate growth to the Ecuadoran economy and reverse the socially devastating impact of declining per capita real incomes. The public sector has played an important role in shaping Ecuador's growth path. Oil revenues, appropriated by the state, were used to finance growth through expansion of public expenditures; they also provided collateral for increased external indebtedness. However, the cessation of commercial bank lending in 1982 and the collapse of oil prices in 1986 precipitated a prolonged period of fiscal crisis, adjustment, and macroeconomic instability that peaked in 1988. Sizable external arrears were built up. iii. The past three years have been marked by a quest for stabilization, a necessary precondition for resumptior of sustainable growth. A new Government took office in August 1988 and proceeded to implement strong fiscal and monetary measures adjustment measures, which included politically difficult decisions such as a doubling of domestic petroleum prices and a sharp devaluation of the sucre. These measures made it possible to contain the fiscal deficit at 5.1 percent of GDP, to decelerate inflation, and to replenish the exhausted foreign exchange reserves. Substantial progress also was attained in 1989. The fiscal deficit was held to 2.2 percent of GDP, a better performance than targeted. Again, domestic petroleum prices were substantially increased in real terms, with the price of gasoline rising from US$0.25 to US$0.45 per gallon, or about 75 percent of international prices. iv. The improvement in economic conditions during 1990 was much less than hoped for, despite the favorable effects of the oil price increase in the latter part of the year. Estimated GDP growth is 1.5 percent, compared with the target of 3.5 percent. Inflation has remained more resilient than anticipated, ending the year at just under 50 percent, against a target of 25- - v - 30 percent. In the external account indicators (the current account of the balance of payments and the growth in international reserves) the targets have been bettered; however, this Is due almost entirely to the rise in oil prices and to low growth. v. Achieving economic stabilization must remain the major objective of macroeconomic policies in Ecuador in the short run. The currently high oil prices, if sustained, pose at the same time a challenge and provide an opportunity for completing the stabilization task. While Ecuador stands to gain in a substantial way from higher oil prices, it must however resist the temptation to use the increased revenues for a quick, transitory reactivation of the economy via increased government spending, lest the vicious cycle of the past, documented in the body of this report, is repeated again. The creation of an Oil Stabilization Fund (in operation since late 1990) has been a positive step in the right direction, as sizable resources have been sequestered away from the automatic spending mechanisms in existence. If this fiscal policy can be sustained, together with an appropriately supportive stance of monetary policy, further progress in economic stabilization can be expected in the near-future, which would form the basis for a reactivation of the economy as the economic reforms underway begin to bear fruits. The Government'sa Reform Program vi. The Government is well aware of Ecuador's needs. Its ear;l and determined policy efforts have contributed to a reduction of macroeconomic imbalances and brought the public sector accounts under better control. The conditions are now ripe for a resumption of sustained growth, if the task of stabilizing the economy can be completed and complemented by structural adjustment policies that can liberate Ecuador's productive potential. The Government has indicated that it is willing and prepared to stay on this route by undertaking trade and tariff policy reforms, continuing in its financial sector and interest rate policy reforms, and accelerating public sector reforms. In the public sector, the Government recently established an Oil Stabilization Fund, which has helped in restraining the spending pressures generated by the unexpected oil revenue bonanza. More fundamentally, the reform program begun in 1988 has endeavored tos (i) assure the efficient pricing of public services, continue the process of tax reform, and control spending; (ii) achieve more efficient manageuent and reduced operating costs in the public enterprise sector; (iii) downsize the tax earmarking system to achit e greater flexibility in allocating public resources in accordance with emerging needs; (iv) improve public investment selection, monitoring and control; (v) harmonize public financial entities' interest rates with liberalized interest rates in the private financial sector; (vi) reform the social security system; and (vii) carry out reforms to improve the transparency, predictability and equitableness of central Government transfers to local governments and foster increased local self-sufficiency. Reforming the Public Sector: an Agenda to Restore Sustainable Growth vii. The proposed reforms are central for success of the strategy to resume sustained growth. Since the beginning of the oil era, nonfinancial public sector current expenditures have risen substantially, causing total - vi - expenditures to be 6 percent of GDP higher in 1989 than in 1970. Ecuador is thus using near'ly all its oil revenues--about 10 percent of GDP--to sustain roughly a 6 percent of GDP increase in public consumption and a 2 percent of GDP reduction in taxes compared to the pre-oil era. In setting out its objectives for medium-term reform, the Government ought to regard its availability of oil revenues as qualitatively different from its ability to raise resources through taxation. More specifically, the Government should consider that, given the limited nature of oil reserves, it should aim at consuming out of oil revenues only that which can be sustained over time, i.e., investing a sufficiently large amount to compensate for the estimated future reductions of other revenue sources. viii. While the exact amount of sustainable consumption depends on several parameters (the relevant real rate of interest, the social discount rate, etc.) on which little information is available, calculations based on the known oil reserves and the projected extraction rate, as well as 'reasonable' values for the relevant discount rates, suggest that less than a third of the value of total production should be devoted to current consumption, with the balance invested. This contrasts with the current situation, where, as argued, all of oil revenues effectively finance increases in consumption. The medium-term financial objective for the consolidated public sector, comprising the nonfinancial public sector and the Central Bank, must thus be the cessation of the use of these capital resources for the financing of public and private consumption. This implies that the public sector should go from the current position of moderate overall deficits to that of a surplus, which would be returned to the private sector for investment purposes. It also underscores the need to adopt policies for a further development of private financial intermediation, for an efficient allocation of the available resources. The availability of finance, in fact, will be more easily translated into higher private sector investment directed towards investment opportunities with the highest social return if the reform of the public sector is part of a broader reform effort to eliminate artificial price distortions and disincentives to trade, to reform an excessively restrictive labor code, and to allow financial markets to redirect the flow of savings toward final users, in contrast with the past reliance on Central Bank credit lines and interest rate controls. ix. Reallocating a substantial part of public oil revenues to support economic growth will require strong measures to contain public spending and/or raise taxes if an unsustainable expansion of the public sector deficit is to be avoided. The reforms of the tax system, both accomplished and proposed, are likely to restore greater momentum to non-oil revenues growth, and prepare the country for the expected reduction in oil production of the late 1990s. Continued control of current and capital expenditures will also need to be exercised, however. The evidence of widespread overstaffing and inefficiency in the public sector auggests that increased delivery of better public services in education, health, security could be accomplished without further increases in the ratio of expenditures to the national product. Ways of accomplishing this--e.g., by streamlining procedures, raising efficiency, and eliminating redundant staff (preferably through attrition and the provision of economically justifiable incentives)--should receive urgent study. - vii - Issues in Government Finances x. The dependence of Government finances on oil revenues (ranging during the 1980s from a peak of 60 percent of total budgetary revenues in 1985 to 37 percent in 1987) has had the unfortunate consequence of both increasing the instability of public finances and their vulnerability to external shocks, and of inducing a deterioration of the formal tax system. Tax revenues as a percentage of GDP have decreased during the 1980s, and the tax administration has lagged in its modernization efforts. In addition, the expected reduction in oil production and exports will inevitably compel the Government to seek increased recourse to traditional taxation. Reform of the tax system is high on the current Administration agenda, and indeed a major change in tax legislation was approved by Congress in December 1989 after a protracted public debate. The reform, desigaed to be broadly neutral in the short run, brings about a major improvement in the efficiency of the tax system, first by simplification--through the abolition of over 100 small taxes--and second by the introduction of important changes in the income tax (unification and lowering of rates, abolition of special exemptions, introduction of inflation- adjustment clauses), the value-added tax (by increasing the base and abolishing exemptions), and selective consumption taxes (TSC). However, the tourism and forestry industries will be able to reduce their taxable income by the amount of their investment, subject to a maximum of 30 percent of the previous year's taxable income. Such concessions may in time undermine the tax system, and result in open-ended subsidies. If it is deemed necessary to subsidize particular activities, this should be done only in the context of the budget. xi. Future reforms of the tax system are expected to cover: (i) further extension of the VAT; (ii) further reduction or elimination of earmarking; (iii) municipal tax reform; and (iv) a reform of taxation of public enterprises. The latter should be reassessed, with a view to harmonizing it with private sector taxation. xii. The VAT reform represented a first step towards a full generalization of the tax. Future action should provide for a gradual abolition of all exemptions. Sixteen commodity groups--mainly basic necessities and agricultural inputs--a large majority of services and purchases by public entities currently are exempt from the VAT. Under the VAT debit/credit system, only the value-added of the exempt commodity group will escape the VAT, but only when sold to a final consumer rather than as an input to a further stage of production. The "exemptions" are thus only partly effective; however, to the extent that they are, they undermine the economic neutrality of the VAT and should be eliminated. In addition, the Government should seek flexibility in the setting of the VAT rate (currently at 10 percent)--which could provide an effective way of increasing tax revenues as the need arises. xiii. The Government also should be encouraged to reassess the level of the rates established within the TSC (excise) tax. Given the low welfare costs associated with taxation on "vice" goods, and the relative ease of collection of excise taxes, a substantial increase in revenue from these sources appears viable. - viii - xiv. Composition of Public Expenditures. Despite the lack of accurate statistics on the matter, it appears that, in response to the adjustment needs and to the progressively higher external debt burden, the composition of total public expenditures has progree3ively shifted towards interest payments on external and internal debt. which now represent a quarter of total expenditures (on an accrual basis). Serious retrenchment has occurred in the areas of education, agricultural development, and the provision of social security. An exception to these trends is represented by 'General Services,' which represent the overhead of the various ministries and agencies. as well as the part of military expenditures going through the budget. The share of these expenditures has increased slightly over the last ten years, and now represents over a third of the total. It thus appears that the burden of adjustment of public accounts has fallen disproportionately on those sectors where providing public services is paramount for economic development, whereas the Central Government bureaucracy and other powerful interest groups (such as the military) have buttressed their relative and even absolute position. Quasi-Fiscal Expenditures xv. Not all public expenditures are performed by the nonfinancial public sector. In Ecuador, as in other countries, important expenditures of a fiscal nature have been shifted to the Central Bank, and beyond the control of the budgetary process. This has entailed additional deficits that have the same macroeconomic consequences as those resulting from the activities of the central Government. There are two main sources of this quasi-fiscal deficit in Ecuador. First, as a result of the 1984 so-called 'sucretization,' the Central Bank assumed t!-s service of the external debt of the private sector, but without being given a sufficiently large domestic counterpart. Second, the Central Bank has long engaged in financial-intermediary activities, lending at subsidized interest rates by using free resources provided by the unremunerated reserves of the banking system and deposits of other public sector entities. With monetary policy relying increasingly on market interest-bearing bonds, the marginal cost of funding for the Central Bank is becoming higher, and could result in large losses in the future. In addition, the Central Bank has in the past engaged in the practice of granting nonrefundable grants to a number of recipients, generating at times considerable cash requirements. Estimates for 1989 and projections for 1990 show that the deficit of the Central Bank is equivalent, respectively, to 1.4 and 2.1 percent of GDP; these contrast with the consolidated nonfinancial public sector balance for the two years of -2.2 and 1.2 percent of GDP, respectively. xvi. Measures to contain the quasi-fiscal deficit should include: (i) an end to the Central Bank's intermediation role, with, in the interim, full market interest rates charged on outstanding credit lines; (ii) the transfer to the Treasury of external debt-servicing, either directly or through budgetary allocations to cover the losses on this account; and (iii) the continued prohibition of engaging in the practice of nonrefundable grants. - ix _ The Budgetary Process xvii. Part of the problems encountered in controlling the growth of public expenditures and in directing them towards the uses with greatest social return are due to the archaic nature of the budgeting system. The basic problems with the system relate tot (i) the naturu of budgetary submissions; (ii) the annual budget process; (iii) budget administration; and (iv) public service productivity. xviii. Budgetary submissions embody differing and inconsistent accounting concepts and definitions and some are based on poor accounting practices. The submissions provide an inadequate basis for the analysis of programs and do not draw upon modern programming and budgeting techniques. Annual budget preparation is highly fragmented. Numerous separate budgets are formulated and approved in different ways and at different times, some with considerable delays. Revenue earmarking greatly limits the scope of the central budget and results in inadequate scrutiny of many aspects of public spending. These characteristics make it impossible to develop a coherent overview of the Government's entire budget and its implications. The initial central budget is not fully comprehensive, since it excludes externally financed investment. There are few links between the budget, economic policy and the evolution of the public debt. Budget administration is characterized by overcentralization of controls over expenditure approvals and cash flows involving numerous bureaucratic rigidities, yet administration of the public debt remains weak. Ecuador lacks an integrated system of financial administration; the budget execution process varies among the different public entities. Poor public sector productivity is widespread, yet it is not a central concern in budgeting. Links between the budget and management productivity are inadequate. xix. The Government has embarked, starting with t}.e 1990 budgetary cycle, in a program of reform of the budgeting system that involves changes in procedures as well as legislation. Several steps will be necessary, to be executed over the next few years. To improve the quality of budgetary submissions, accounting concepts and definitions by the central Government and public enterprises should be standardized. Public entities should be given greater responsibility to define their own programs, establish units of measurement, measure results, and select areas for intensive evaluation. Each public entity should prepare a program document covering its activities, assessing the expected costs and benefits of each program. The capacity of public entities to plan current and capital expenditures and evaluate performance and productivity should be strengthened, through programs aiming at retraining personnel involved in budget preparation both in the Ministry of Finance and in the decentralized agencies. xX. The annual budget preparation process should be improved by working towards the preparation and consideratioh by Congress of a fully comprehensive and consolidated budget for the entire public sector. In the interim, the budget preparation process should begin earlier, so that approval of the central budget and (in global terms) the special budgets can be completed by December of the preceding year. Earmarking should be considerably scaled down, as the budgetary ability of government agencies improves. The budget should be made fully transparent and hidden subsidies and doubtful loans replaced by open donations and grants. Budget cuts, where required, should be on the basis of priority rankings rather than the application of fixed percentage cuts. xxi. Budget execution needs to be simplified. Detailed, bureaucratic controls over commitments and payments should be replaced by a quarterly advance quota system covering both commitments and payments. This should be backed by systematic ex post auditing by the Controller-General. Superfluous forms and procedures currently causing delays in the execution of the budget should be eliminated before computerization is extended, so as to avoid further entrenchment of existing bureaucratic processes. The submission of punctual financial reports and the use of EDP systems should be encouraged to ensure timely execution of the budget. A detailed schedule of the legal, administrative, and technical steps needed to establish a comprehensive and improved budgetary system and eliminate most earmarking should be worked out, to assure an orderly and efficient transition from the present system to the new one. Earmarking of Revenues and Expenditures xxii. The inefficiencies of the budgeting process are both cause and effect of the widespread recourse to earmarking of revenues and expenditures, a practice whereby different interest groups try to secure stable financing outside the budgetary process. Between 50 and 60 percent of general government revenues are earmarked; in addition, a constitutional provision mandates that 30 percent of public expenditures be destined to education. There are three main earmarked revenue streams: petroleum revenues; social security system revenues; and earmarking of other taxes. About 65 percent of earmarked revenues in 1989 were public oil revenues (all of which are earmarked) and another 18 percent social security contributions. Many other taxes--including some broad taxes, such as income tax and customs duties--are earmarked. xxiii. The regulations governing the distribution of fiscal oil revenues vary according to where they are generated, according to whether oil production is above or below certain limits, and according to prevailing prices and exchange rate. Thus, the oil revenue earmarking system is essentially a complex economic lottery that reallocates oil revenues primarily in response to movements in three volatile variables: int2rnational petroleum prices; domestic refined product prices; and the sucre/dollar exchange rate. Under present arrangements, the major beneficiaries are the military and PETROECUADOR. xxiv. The earmarking system, far from guaranteeing reasonable stability in the allocation of public revenues, has produced an unforeseen and irrational redistribution in the case of oil revenues, undesirable rigidities in other cases, and inadequate public scrutiny of certain areas of expenditure. The system should be replaced by one in which the largest possible proportion of resources is rationally allocated through the central budget, and earmarking is retained only where, by linking costs to benefits, it serves to improve resource allocation or secure greater taxpayer acceptance. The issues of - xi - eliminating earmarking and reforming the budgetary process are different aspects of the basic problem of improving public resource allocation and should be regarded as inseparable. Earmarking seems appropriate in the case of social security contributions, where there is a clear connection between contributions and benefit entitlements. The essential issue in social security is thus not earmarking. With other earmarked taxes, earmarking appears justified in some cases in the sense of reflecting a clear link between the taxpayer and the beneficiary; in other cases (e.g.. the allocation of 50 percent of customs duty revenues to government wage increases), the main motivation for earmarking appears to be the demands of powerful interest groups for secure revenue sources. The Social Security System xxv. The IESS system is excessively complex, arbitrary, and poorly coordinated. Insurance coverage of the population and employed labor force is poor by Latin American standards, while coverage of spouses and dependents is very restricted. Peasant Insurance covers only 10 percent of the rural population. Excessively generous benefits for the covered population nonetheless make the system very expensive. These benefits are fundci by the insured, but also by employer contributions, the state, and earnings from IESS's Investment portfolio. xxvi. The state is legally required to pay out of general revenues 40 percent of general pension costs for Armed Forces and police pensions, pension enhancements for other groups, and part of the cost of Peassnt Insurance. However, the state has incurred huge debts to the IESS for unpaid employer and third-party contributions and has heavily decapitalized the institution by negotiating consolidations of these debts at highly negative real interest rates. A similar situation, although on a much smaller scale but involving, in addition, considerable evasion of payments, has prevailed in the case of private employers. Despite the erosion of the original state debts by inflation to less than a quarter of their original value in real terms, total state debt outstanding to the IESS at the end of 1988 stood at around SI. 182 billion (US$603 million). xxvii. The IESS also was heavily decapitalized internally through the extension of personal and mortgage lWans to those insured at highly negative real interest rates. More realistic investment policies were introduced in 1989 but their effect has yet to be assessed. Pension benefits are extremely generous for some groups but wide inequalities exist. Health-maternity benefits are average but costs are high and contributions inadequate. The health system is inefficient and poorly coordinated with those of the other health agencies. The administrative efficiency of the overall social security system is low. xxviii. Although the social security system is not currently a source of deficit for the public sector, it is replete with problems that impinge on its efficiency, and may lead to a future financial crisis. A comprehensive program for reform is now needed. First, it would be advisable to separate the pension plan from other schemes. The planned passage of the administration of workers' reserve funds to the banking system is a welcome - xii - step in this direction (although its consequences on loss financing should be reflected in adjustment to contributory rates andlor reduction of benefits). More generally, encouragement should be given to the development of private retirement schemes, under which individuals (and their empl ers) would contribute to personal retirement accounts in a form similar to the Chilean system. Government pension benefits should move towards taking a safety net role. This would encompass some or all of the following measures: (i) elimination/reduction of generalized pension benefits such as three extra monthly pensions a year, payment of minimum wage under the special retirement pension program, rights of parents and brothers/sisters to survivor pensions, and 100 percent survivor pension: and (ii) termination of privileged programs, such as improved pensions available to a few insured groups. The provision of health services would need to be better integrated to the rest of the national health service; cross-subsidization between pension schemes and health services is not justified. As interim measures, consideration should be given to (i) the elimination ot some of the programs tnat IESS cannot afford, among which part of the cost of dental prothesis, contact lenses, and travel and medical treatment abroad; (ii) better supply of medicines to IESS facilities so as to minimize the costly buying of such medicines in private pharmacies; (iii) drastic cuts in administrative expenditures (including reductions in both personnel and excessive fringe benefits) as well as improvements in administrative efficiency; and (iv) a change in the predominantly curative orientation of health-care, with more emphasis placed on preventive and primary health-care, integration of all public health facilities, and the assignment of priority to repairs and the reequipping of existing facilities over the construction of new facilities. xxix. To raise revenues, the following steps should be taken: (i) increase premiums for health-maternity, so as to make this program (including its capital expenditures) self-sufficient; (ii) standardize the percentage contribution paid by all insured (based on the previous elimination of privileged benefits); (iii) settle the Government's overall contribution to lESS, based on the one hand more realistic evaluation of fiscal capacity and on the other the renegotiation of the past state debt on fairer terms; (iv) improve the control and collection of mora and set the interest/penalty for mora at a level above inflation; and (v) computerize registration, monthly payments, and individual accounts to reduce evasion and mora. xxx. Finally, the misuse of IESS assets should be halted. The attempts at actuarial solvency have been frustrated by compelling the IESS to invest to a great extent in Government paper, which does not increase the public sector's ability to service future pension obligation. The ability of the Institute to run credit programs (now sharply reduced because of the freeze in nominal maximum lending amounts) and to make investments in unrelated activities should be halted; real yields on existing investments should be increased by drastically reordering the portfolio (e.g., by eliminating, or sharply reducing and tightening the terms of, mortgage and personal loans and increasing fixed-term deposits with profitable yields). - xiii - Local Governments xxxi. Local government expenditures have fallen sharply during the 1980s, dropping from a peak of 16.6 percent of total public spending in 1981 to only 11.8 percent in 1987 and from 2.9 percent of GDP in 1983 to 1.7 percent in 1989. Provincial and municipal investment spending was hard hit; as a result, urgent local needs for infrastructure increasingly have gone unmet. These expenditure declines stemmed from severe cutbacks in revenues: in the case of provincial councils, from 0.8 percent of GDP to 0.4 percent; in the case of municipalities, from 2.1 to 1.4 percent. The origins, stability, and use of local government revenues have thus become increasingly important issues. xxxii. Provincial councils depend primarily, and Increasingly, on various transfers from the central Government, which rose from 64 percent of their revenues in 1981 to 84 percent in 1987. Locally collected revenues declined in importance. Municipalities vary greatly in their dependence on transfers; from only 34 percent in the case of Quito and Guayaquil over the 1982-87 period to 91 percent in the case of the smallest municipalities. Municipalities' locally collected revenues--particularly service charges--have been growing in real terms in recent years. Among transfers, earmarked petroleum revenues plummeted from 37 percent of total in 1981 to only 6 percent in 1988, but transfers from the budget, central agencies, and IETEL rose over the period. Municipalities also benefit from Ministry of Public Works municipal projects. xxxiii. Reform of the Transfer System. Significant reforms of the transfer mechanism were recently introduced, which would regulate central-local government relations from 1991. A newly created fund, FODESEC (Fondo de Desarrollo Seccional) replaces FONAPAR and will receive--besides the revenues previously assigned to FONAPAR--2 percent of the total non-earmarked resources of the National Budget, St. 3 billion per year from the oil export revenues (to be adjusted annually beginning in 1991 using the consumer price index); and future budget allocations from the National Budget. This amount will first be distributed among municipalities based on clear criteria. Part of the funds will be distributed on the basis of automatic criteria, and on the basis of indicators of development and need, and part on the basis of fiscal effort in relation to total capacity to pay. BEDE will be the main vehicle for the distribution of the funds and the evaluation of the projects to be financed. Thus, the reform will go a long way toward attaining three ancillary objectives: (i) capitalization of BEDE by onlending of the Fund's resources to municipalities; (ii) up-front subsidies for low-income families for whom 100 percent cost recovery through user charges is not feasible; and (iii) matching grants for current account surplus on a one-to-one basis to encourage such saving. xxxiv. In summary, this new system is a big step in the direction of a more predictable, transparent, and sustainable transfer system that should contribute significantly to the development of a more efficient and equitable system of fiscal federalism in Ecuador, with incentives for local governments to contribute to the macroeconomic goals of lowering the fiscal deficit. - xiv - xxxv. Scope exists for substantially increasing local revenues and improving the municipal tax system. Better returns from urban property taxes and the rural land tax could be realized from more up-to-date cadastres and property valuations and tighter controls over collections. Higher property taxes should be substituted for excessively high property transfer taxes, which penalize normal turnovers; perhaps more importantly, they should be applied to up-to-date property valuations. Rates for the business license tax, which currently barely covers its collection costs, should be increased. Rates for the urban property transactions profits tax are excessive; coupled with provisions permitting deductions for duration of possession, they discourage normal property transfers. The rates should be lowered and the present 5 percent annual deduction abolished. The working capital tax could be merged with the business license tax. Setvice charges are inadequate, and should be reformed to cover costs. Finally, the collection of local improvement charges needs to be improved. On the expenditure side, municipal spending on wages and salaries is inflated by union pressures and central Government wage policies. The Public Enterprises xxxvi. Ecuador experienced an explosion in the role and importance of the public enterprises during the decade following the beginning of the oil boom. Four of these companies--PETROECUADOR, IETEL, INECEL and ECUATORIANA-- accounted for 86 percent of total public enterprise expenditures in 1989. PETROECUADOR/CEPE, INECEL and IETEL have also typically accounted for the bulk of the public enterprise deficit, which averaged 0.5 percent of GDP over the 1983-89 period. xxxvii. The deficit had a number of origins: tight central Govesrnment controls over tariffs; declining transfers (to CEPE and INECEL) from earmarked public oil revenues; the rising sucre cost of imported goods and foreign debt service attributable to the decline in the external value of the sucre; rising labor costs and overstaffing; and continuing substantial public enterprise investment programs. xxxviii. The boards of directors of the public enterprises exert strong central political control over tariffs, budgets, and personnel policies and intervene in many operational decisions; however, they rarely provide strategic guidance, impart a clear commercial orientation to the enterprise, or set financial, commercial, and economic performance goals. Cumbersome procurement and financial administration laws and procedures and restrictive public sector policies governing employees' remuneration and conditions of employment severely limit management's ability to improve efficiency and raise productivity. Control over public enterprise budgets by the Ministry of Finance and Congress is fragmented and incomplete, while external checks on the size of enterprises' external borrowings and the quality of their investments are weak. xxxix. The new PETROECUADOR law providing the company with increased revenues and enhanced operational independence raises several important issues: (i) the rationale for increased state involvement in, and commitment of additional scarce public funds to, comercial oil-related activities; (ii) the future financial impact of PETROECUADOR's cost-plus basis of operation, potentially at the expense of public cil revenues for which private funding and expertise are readily available; (iii) the present lack of clear criteria for determining either the appropriate size and rate of return on PETROECUADOR's investments or the limits to its assumption of external debt; (iv) the absence of mechanisms to assure PETROECUADOR's economic efficiency as it gains increased monopoly powers; (v) what PETROECUADOR's performance goals are and how they are to be monitored and reviewed; and (vi) what Ecuador's long-term energy development and oil revenue use strategy is and the role PETROECUADOR is to play in it. xl. Close central political control over the public enterprises has meant that the pursuit of short-term political and social objectives has predominated over maintenance of the financial strength of the enterprises, enhancement of their economic efficiency, and support of private sector economic growth. Basic reforms are needed so that the public enterprises can play an active role in helping reverse the stagnation of recent years in the non-oil economy. xli. Improvements in performance could potentially be achieved through privatization. Suitable candidates might be: some of PETROECUADOR's activities (refining, marketing and distribution); parts, or all, of IETEL; some, or all, of INECEL's distribution companies; ECUATORIANA; TAME; TRANSNAVE; and FLOPEC. The economic rationale for the continued existence of ENAC and ENFE should be reviewed. Privatization would need to be accompanied by the establishment of clear performance criteria and suitable regulatory machinery to ensure that it produced real economic benefits and not simply the substitution of potentially rapacious and inefficient private monopolies for inefficient state monopolies. If privatization were not feasible, serious thought should be given to the possibility of changing the structure of enterprises to that of corporations. xlii. Greatly improved financial performance would be needed from those enterprises not privatized or closed down. Measures to realize this should include a phased but firm transition to cost-based tariffs, the pursuit of fully competitive returns on invested capital, better use of existing plant and equipment, the elimination of overstaffing, improved training, and the provision of financial and other inducements to higher productivity. Improved economic efficiency should be sought in lowered costs of operation and far more rapid adaptation to market shifts. The legal structures of the public enterprises should be modified to permit much greater operating autonomy. At the same time, the enterprises should be assigned strict, measurable performance goals. The negotiation of formal performance contracts could be useful. A prerequisite to the successful employment of this mechanism would be the establishment of standard accounting practices, regular external auditing, and clear lines of accountability for performance to external authority (e.g., the Minister of Finance and Congress). Managerial remuneration and career advancement should be explicitly linked to the attainment of their enterprises' performance goals. The procedures governing the presentation of public enterprise budgets to Congress should be unified as part of the proposed overall reform of the budgetary process. - xvi - General Conclusions xliii. The agenda for thoroughgoing public sector financial reform is a difficult one. Of overriding importance is the conservation of Ecuador's oil capital, most of which is currently being used to finance Government consumption, low levels of non-oil taxation, and implicit subsidies to consumers of jetroleum products, instead of being invested through the banking system to finance productive private investment. There is also an urgent need to reform the structure and the finances of the social security system, by scaling back average benefits to what the Government can realistically afford to pay. While this report does not provide a detailed blueprint for fiscal reform, it does establish the general need for public enterprise reforms, including substantial but selective privatization. xliv. While the means for Ecuador to reform the finances of the public sector and achieve more rapid growth are reasonably clear, formidable political obstacles stand in the way of implementing the necessary policies. Ecuador's regional, class, and ethnic differences are deeply rooted. The state has responded in the past by establishing what is now a heavily entrenched system of import and export controls and prohibitions, protective tariffs, price controls, administrative restrictions, tax concessions and exemptions, restrictive labor laws, public sector job creation, credit allocations, interest rate subsidies, and extensive public ownership of commercial enterprises. This system has led to widespread economic inefficiency, serious distortions in the allocation of the country's resources, and impairment of the economy's capacity to respond to change. The surge of oil-related prosperity in the 1970s for a time obscured the underlying structural and policy deficiencies, and contributed to the introduction of major additional distortions and rigidities. However, in the 1980s, despite support to the economy from continued increases in oil output, the distortions have become more apparent and represent the underlying cause of the country's poor adaptation to changing economic circumstances and its continued sluggish growth. The past few years have witnessed the beginning of a process of cautious but sustained structural change. If the momentum can be maintained in the future, and the political leadership can successfully continue to put Ecuador's interests ahead of those of special groups and privileged classes, the country can look forward to an economic and social turnaround that will propel it into the realm of modern and developed economies during the next decade. 1. GROWTH, ECONOMIC STAB3ILITY, AND THE RISE OF STATE INTERVENTION A. The Crisis of the State-Led Growth Model 1. Economic growth in Ecuador over the last 20 years has been shaped by developments in the oil sector and by associated public policy choices. The discovery and exploitation of oil and gas, and the subsequent rise in oil prices, provided the country with large--albeit limited--resources. The value of petroleum and natural gas output, which was virtually zero in 1971, jumped to 9.5 percent of current GDP in 1973 and 23.0 percent in 1974, reflecting both the start-up of large-scale production and the fourfold increase in world oil prices. This newly found wealth could have been used as the basis for an expansion of its capital base and a sustainable improvement in its standard of living. However, the oil revenues, largely appropriated by the public sector, were used to finance an increase in the size of the state and to subsidize private consumption (through low prices of domestic petroleum products). This strategy was successful at first, but proved unsustainable when external circumstances changed. Actual and potential revenues allowed the Ecuadoran public sector to increase access to the international capital markets and to finance the growing public sector deficits. Growth of domestic production of manufactures was also stimulated by the adoption of policies of import substitution, which shielded a budding but inefficient, domestically-oriented manufacturing sector. Average real GDP grew at a 9.1 percent rate between 1971 and 1980, with the most explosive growth concentrated in the early years (Table 1.1). Table 1.1: oOP GROnnH AND INFLATION, 1971 - 1990 (Percent) Year GOP Growth Inf ltion Year GDP Growth Inflotion 1971 6.8 7.6 1961 8.9 14.4 1972 14.4 1.2 1962 1.2 17.0 1978 26.3 7.1 198a -2.8 38.7 1974 6.5 40.0 1954 4.2 89.2 1975 6.8 10.0 1986 4.8 80.9 1976 9.2 12.9 1986 3.1 20.9 1977 6.6 17.6 1987 -6.0 88.0 1979 6.6 7.9 1968 11.2 56.5 1979 6.8 16.1 1969 0.2 76.8 1960 4.9 19.5 1990 1.6 46.6 Average 9.1 14.0 2.1 80.0 Source: National Accounts, Central IBnk of Ecuador. 2. The sudden cessation of external credit from commercial sources in 1982 and the sharp decline in Ecuador's terms of trade (chiefly due to lower oil prices) radically altered the economic outlook. The Government had to change its method of financing expenditures, increasing its recourse to domestic sources, and thus increasing financial instability. Previously held notions of a sustainable external current account deficit had to be revised downwards, and measures to close the gap had to be adopted. As a result, real GDP growth averaged only 2 percent between 1981 and 1986, with over half coming from - 2 - still rising oil production. There has been little improvement sinces in the decade to 1990 growth has averaged only 2.1 percent, well below the rate of population growth. Slow economic growth, continued public sector deficits, and the massive devaluation of the sucre added enormously to the burden of the external debt, which rose from the equivalent of 37 percent of GDP in 1982 to 122 percent in 1988. Its orderly servicing was suspended in 1987. Per capita GDP declined from US$1,444 in 1982 to US$977 in 1988--a drop of 32 percent. 3. Low growth in the 1980s was accompanied by increasing instability, attributable in part to the inability to restrain public deficits after a successful adjustment period following the 1982 crisis. Public finances deteriorated markedly starting in 1986, triggered by the sharp decline in oil prices (from US$25 per barrel in 1985 to US$12.7 in 1986) and by lack of control over expenditures. During that election year, total revenues fell by 3.3 percent of GDP, despite a substantially stepped-up tax effort. The Government was unable to adopt the necessary adjustment measures, but rather increased its speuiding substantially. Total non-interest expenditures rose to 25.7 percent of GDP (with capital expenditures increasing from 6.2 to 8.3 percent of GDP). The progress made in the three previous years in restoring a sizable primary surplus was wiped out. By the end of 1986, a primary deficit of 1.1 percent of GDP, together with external and internal interest payments of the order of 4 percent, brought the overall balance of the NFPS to a negative 4.1 percent of GDP. 4. The deterioration continued in 1987. Earthquakes destroyed Ecuador's only pipeline and interrupted oil exports for three months; oil prices remained depressed; oil revenues fell by a further 2.3 percent of GDP, and total revenues by 2.9 percent. Non-interest expenditures again proved inflexible, actually rising by almost 1 percent of GDP. Together with sharply increased external interest payment, these developments contributed to an overall public sector deficit of almost 10 percent of GDP. Despite the accumulation of sizable external interest arrears, the Government had to resort to Central Bank financing, which, along with expanded credit to the private sector, led to a sizable increase in domestic credit and heavy foreign exchange losses. Inflation, which had decreased between 1983 and 1986 from 39 to 21 percent, rapidly climbed to reach the unprecedented figure of 86 percent (December to December) in 1988. The deficit in the current account of the balance of payments rose to over 12 percent of GDP (evaluated at the parallel exchange rate). Servicing of external debt of commercial banks was suspended in January 1987, and interest arrears climbed to almost US$1 billion by the end of the Febres-Cordero Administration in August 1988. 5. The deterioration of the economy peaked between late 1987 and the first semester of 1988. In the preelection period monetary and fiscal policies were geared towards short-term output gains, and serious misalignments in public prices and the exchange rate were allowed to occur. During the first half of 1988 the rate of growth of Central Bank domestic credit continued to accelerate; by August, the fiscal deficit was projected to top 10 percent of GDP, foreign reserves were depleted, external arrears of over US$1 billion had accumulated, and the gap between the free and official exchange rates reached almost 100 percent. Inflation exceeded 90 percent on an annual basis in August, and economic activity weakened substantially. B. The Quest for Stabilizations 1988-1990. 6. A new Government took office in August 1988 and proceeded to implement a strong adjustment program. It combined fiscal and monetary measures with control of exchange rate transactions and of some prices and wages. It also proceeded to announce exchange rate and inflation targets for 1989. Domestic petroleum prices were increased by an average of 93 percent, the sucre was devalued by 42 percent, some fiscal expenditures were reduced or postponed, and some tariffs and indirect tax rates were raised. On the fiscal front, the initial actions were accompanied by an administrative reform of the tax system (third quarter of 1988) aimed at reducing evasion. The reform, coupled with the rest of fiscal measures previously cited (cuts in fiscal expenditures and tariff increases), and the concomitant increase in oil revenues due to a rise in world oil prices in late 1988, made it possible to contain the fiscal deficit at 5.1 percent of GDP. The fiscal performance allowed the monetary authorities to bring monetary policy in line with the stabilization efforts, by sharply reducing the rate of expansion of monetary aggregates. 7. Substantial progress also was attained in 1989. The macroeconomic program hinged on further strengthening in the fiscal accounts; in the event, the overall nonfinancial fiscal deficit (including external interest obligations) was held at 2.2 percent of GDP, a tighter performance than targetted (3.4 percent of GDP). The improvement was attributable to a sharp increase in oil revenues, due in part to better prices for Ecuador's oil (US$16.2 per barrel against US$12.7 in 1988) and to the effects of the real increase in domestic petroleum prices. These were in fact substantially increased in real terms, with the price of gasoline rising from US$0.25 to US$a.45 per gallon, or about 75 percent of international prices, and the average of all petroleum prices rising by 15 percent in real terms. Non-oil revenues also rose somewhat, with tax revenues more than compensating for a reduction in social security contributions. Current expenditures were substantially cut for the second year in a row, with the sharpest reductions registered in wages and transfers. Finally, as a result of the oil price and public tariffs increases, savings of public enterprises rose by 1.8 percent of GDP. A surge in capital expenditures contributed to the eventual outcome. On a cash basis (subtracting external interest arrears equivalent to 2.4 percent of GDP) a surplus of about 0.6 percent of GDP was registered. 8. 1990 Economic Policies and the Oil Shock. Events in 1990 reflect the typical policy dilemma that Ecuador has faced in the past. The macroeconcmic program pursued continued stabilization: (i) a growth rate of GDP of 3.5 percent; (ii) reduction of inflation to 25-30 percent (December to December); (iii) a current account deficit of about 4.2 percent of GDP; and (iv) payment of approximately 30 percent of interest due to commercial bank creditors, together with a targeted increase in international reserves of US$100 million. The policies to attain these objectives included: (i) a further reduction of the nonfinancial public sector deficit, to 1.8 percent of GDP; (ii) continued restraint in domestic credit creation via direct lending from the Central Bank to the public; and (iii) an exchange rate policy consistent with the expected reduction in inflation and improvement in the external sector. - 4 - 9. However, the improvement in economic conditions during 1990 was much less than hoped for, despite the favorable effects of the oil price increase in the latter part of the year. Estimates of GDP growth now point to 1.5 percent, compared with the target of 3.5 percent. Inflation has remained more resilient than anticipated, ending the year at just less than 50 percent, against a target of 25-30 percent. In the external account indicators (the current account of the balance of payments and the growth in international reserves) the targets have been exceeded; however, this is due almost entirely to the effects of the oil shock. 10. This disappointing outcome reflects in part adverse external developments (chiefly on the non-oil commodity price side), but also a slippage in policy implementation. In particular, in the first part of the year, the increase in net deposits of the nonfinancial public sector (NFPS) with the Central Bank (a key indicator of fiscal policy performance) was substantially less than expected. Despite measures taken to sterilize the impact on base money creation (which included the freezing of credit to the private sector and higher reserve requirements on bank deposits), the worse- than-expected performance of the NFPS led to a considerably faster-than- programmed expansion of monetary aggregates. The shortfall in the NFPS's accumulation of net deposits was primarily a result of difficulties in implementing the broad tax reform approved at end-1989, of weakness in the oil markets in the second quarter of the year, and of higher-than-expected expenditures, notably the accelerated repayment of the floating domestic debt left from the previous year. 11. As the lack of improvement became evident, further measures were taken to control expenditures. Preliminary indications show that, as a result of these measures and of the revenue effects of the oil shock, the fiscal targets for the year were met; indeed, the overall balance of the NFPS could well have registered a surplus in 1990. Given the preliminary nature of the information available, fiscal policy trends must be interpreted with caution. Early estimates indicate that the NFPS result was the combination of: (a) A much lower-than-anticipated public investment performance. Indeed, rather than rising to 8.4 percent of GDP as envisaged, public investment fell in real terms, from 6.8 to 6.6 percent of GDP. This is reflected, as discussed below, in a much lower level of disbursements of external loans. (b) A mediocre performance of non-oil revenues. Tax revenues, in particular, fell as a share of GDP, as a result of the difficulties in implementing the 1989 tax reform, of transitory factors, and of a worsening of tax administration. (c) Lower-than-expected oil revenues, despite the higher average price, and the consequent accumulation of the Stabilization Fund for 1.2 percent of GDP. This is the result of slightly lower export volumes, and of the lower increase in real domestic prices of oil products, due to the higher inflation and the September suspension of gradual price increases. - 5- (d) An increase in non-interest current expenditures, spurred ir. part by an increase in the real wage bill. 12. As a result, the primary surplus fell from 8.0 to 5.5 percent of GDP. However, lower interest due contributed to the improvement in the overall deficit position. Despite the positive financial result, the situation remains rather precarious, as the effects of the imbalances in the first part of the year continue to be felt in an unsustainable rate of inflation, and pressures for increased spending build up. 13. Short-term Prospects: Managing the Effects of the Oil Price Increase. Achieving economic stabilization must remain the major objective of macroeconomic policies in Ecuador in the short run. The oil price increase, if sustained, poses at the same time a challenge and provides an opportunity for completing the stabilization task. 'While Ecuador stands to gain in a substantial way from higher oil prices, it must however resist the temptation to use the increased revenues for a quick reactivation of the economy via increased government spending, unless the vicious cycle of the past, documented in the body of this report, is repeated again. The main effects on Ecuador's economy and public finances can be summarized as follows: (a) For every dollar increase in the price of Ecuador's oil exports, the current account deficit of the balance of payments is reduced (ceteris paribus) by approximately 0.6 percent of GDP. Revenues of the non-financial public sector also are increased by approximately 0.5 percent of GDP. Since there is no automatic linkage to world oil prices, revenues from the domestic consumption of oil products do not necessarily increase. (b) Oil revenues are largely appropriated by the public sector; hence, the immediate effects on growth depend on the behavior of public expenditures. Automatic extra-budgetary allocations ensure that increased oil revenues translate into somewhat higher expenditures (through earmarked funds and through the investment budget of PETROECUADOR); however, this automatic effect is limited in the short run. An increase in expenditures matching the increared revenues thus depend on a deliberate policy decision of the Government, which often oc'urred in the past. 14. It is in the interest of the country that the latter course be rejected in favor of a strategy that: (i) perseveres in the removal of incentives against export-oriented activities, and in the process of fiscal adjustment; (ii) minimizes the appreciation of the real exchange rate; and that (iii) employs the resources provided by the windfall for an improvement in the country's future growth prospects. While several policy combinations might be used to attain these objectives, one option that stands out and that has been adopted in a Ministerial agreement in late September 1990 is the creation of an Oil Stabilization Fund. The Fund is activated if oil prices rise beyond a threshold level (US$17 per barrel), so that the automatic spending mechanisms now in existence do not take effect. Proceeds of the Fund - 6 - could be used to supplement revenues when prices are low, but, more importantly, could form the basis for a substantial decrease in net external liabilities through a debt reduction operation. Such use of the windfall revenues, given reasonable discounts, would represent an attractive option from a financial point of view, would improve the investment climate in Ecuador, and would contribute to restoring the country's creditworthiness in international markets, 15. As the Stabilization Fund has been in operation since late 1990, Ecuador already has sizable resources available, which have been sequestered away from the automatic spending mechanisms in existence. Congress is also debating the proposed budget for 1991, which would form the basis for the macroeconomic program for that year. The budget has been prepared on the basis of an oil price of US$16 per barrel; the stated intention of the Government is thus to sterilize all of the effects of the windfall, if this were to materialize also in 1991. If this fiscal policy can be sustained, together with an appropriately supportive stance of monetary policy, further progress in economic stabilization can be expected in the near-future, which would form the basis for a reactivation of the economy as the economic reforms underway begin to bear fruits. C. Public Sector Reform and Growth: A Scenario for the 1990s 16. Can Ecuador regain a sustainable growth momentum during the 1990s and beyond? The hurdles are formidable: a prospective decrease in oil output, starting from the mid-1990s; a considerable debt burden; a yet-incomplete stabilization task; deep-rooted social and regional imbalances. Yet the country has shown, in the past, the ability to meet demanding challenges. But for this to be true during the 1990s, two conditions must be met: (i) the stabilization effort must be completed; (ii) the ambitious program of broad structural reforms in a number of markets and policy areas should be accelerated and sustained. A new development strategy must be geared toward replacing the exhausted and unsustainable development model of the 19708, based on the growth of the public sector financed by oil revenues, protection of an inefficient domestic-oriented industrial structure, and inadequate exploitation of agricultural potential. Instead, the Government must pursue policies that will result in a more dynamic and diversified economic structure, capable of sustained growth that is based on improved productivity performance. This can be attained in the medium term if policies are successful in accomplishing fundamental changes in the economy: (a) a redefinition of the role of the State, first with the public sector becoming a provider of savings to the rest of the economy--rather than a user of capital resources for the financing of public and private consumption--and second by sharply reducing the scope of government regulation and intervention, while devoting greater attention to areas of clear public responsibility, such as social welfare and the environment; (b) continued progress in the reform and development of financial markets, with a progressive reduction of the role of Latermediation played by public institutions (the Central Bank in particular), the abolition of directed credit allocation and of credit subsidies; and (c) replacing the existing protectionist trade regime and the inefficient and co:ast.aining labor market policies, which encourage industrial development in areas where the country does not enjoy a comparative advantage, with a more neutral set of economic incentives, that are likely to stimulate economic diversification and promote a greater outward orientation. 17. Simulations of macroeconomic aggregates under plausible scenarios for major commodity prices, international interest rates, and financing of the current account deficit show that success of this strategy would result in fundamental changes in Ecuador's economy over the 1991-1998 period (Table 1.2). The sources of growth would be provided by: (i) expanding non- oil exports, as a result of appropriate exchange rate and trade liberalization policies; and (ii) greater productivity of investment, as a result of a shift from the public to the private sector and away from inefficient import- substitution manufacturing activities. A major component of the adjustment effort is the projected turnaround in public savings, as discussed below. These forces are expected to allow the economy to grow at rates above the 1980s average (4.8 percent against 2.6 percent) and resume per capita consumption growth. Table 1.2: ECUADOR - MACROECONOMIC OVERVIEW, 1981-1998 (Percent of GOP) 01-84 865-89 90-94 95-98 Savings/Investment Domestic Investment 20.8 20.6 21.6 22.0 Public 7.4 7.2 7.5 6.9 Private 10.4 13.4 14.2 10.1 Foreign Savings 6.0 7.8 4.1 5.7 National Savings 16.8 18.8 17.6 16.8 Public *- -0.2 4.8 4.6 Private .. 18.6 18.2 11.5 Memo Items GOP (Annual Growth) 2.7 8.0 8.9 6.0 Private per Capita Consumption -1.8 -0.8 1.1 8.8 Source: National Accounts; World Bank projections. 18. Investment rates under this scenario would return to historically high levels at over 22 percent of GDP. An increasing proportion of investment would be carried out by the private sector, as greater participation in the oil and mining sectors and the progressive opening of the economy would stimulate both domestic and foreign investment. On the financing side, - 8 - national savings would improve considerably, essentially, through the improvement in public sector savings performance; this would help reduce the dependence on foreign savings to levels considerably lower than those attained during the 1980s. Reform of the Public Sector 19. Central to this strategy is continued reform of the public sector. The establishment of an Oil Stabilization Fund with strict rules on the use of windfall revenues may go a long way towards solving one of the country's main problems, the instability of the sources of financing of public expenditures, and the tendency towards deficit. But, given the key role of the public sector in Ecuador's economy, and the quasi-monopolistic role that it has reserved for itself in the exploitation of the country's most important natural resource, oil, the reform effort must go beyond attaining stabilization. The nonfinancial public sector must become a net provider of savings to the rest of the economy. This implies that a sufficiently large surplus must be generated, so that (i) the expenditures of a quasi-fiscal nature performed by the Central Bank (the payment of interest on "sucretized" private foreign debt, and any interest subsidies) are financed by Government revenues and not by currency expansion, and (ii) the aggregate public sector return to the private sector resources that can then be used for investment purposes. 20. Success in the implementation of the policy reforms discussed in this report would lead the public sector to play a key role in raising national savings and reducing the current account deficit, reversing the fall in public savings from 5.3 percent of GDP in the 1980-84 period to a negative 5.7 percent of GDP in 1987 and 4.1 percent in 1988. Revenue and expenditure trends described below would also permit the nonfinancial public sector operational surplus to be sufficiently large so as to compensate for the losses of a quasi-fiscal nature that the Central Bank incurs into (Chapter III). The small surplus in the overall public sector would be channelled to the public sector through the finariclil system, which would act as intermediary in the allocation of available reseirces. 21. Oil Revenues and Public Sector SvRpluses. The need for a major turnaround in public savings generation goes beyond that dictated by stabilization policies. As argued in the previous chapters, the revenue windfall from oil captured by the Government during the 1973-82 period was largely spent on subsidies, particularly to domestic consumers of oil derivatives, with the balance being used to support an increase in the size of the public sector. The expansion in government current activities was detrimental to the long-term interest of the country: it was based on an excessive use of revenues from a nonrenewable resource (oil) and the savings of the social security system, decreasing the resources available for the financing of public and private investment. In setting out its objectives for medium-term reform, the Government ought to regard its availability of oil revenues as qualitatively different from its ability to raise resources through taxation. More specifically, the Goveernment should consider that, given the limited nature of oil reserves, it should aim at consuming out of oil revenues only that which can be sustained over time, i.e., investing a sufficiently large amount to compensate for the estimated future reductions of other revenue sources. 22. While the exact amount of sustainable consumption depends on several parameters (the relevant real rate of interest, the social discount rate, etc.) on which little information is available, calculations based on the known oil reserves and the projected extraction rate, as well as "reasonable" values for the relevant discount rates, suggest that less than a third of the value of total production should be devoted to current consumption, with the balance invested. This contrasts with the current situation, where, as argued, all of oil revenues effectively finance increases in consumption. The medium-term financial objective for the consolidated public sector, comprising the nonfinancial public sector and the Central Bank, must thus be the cessation of the use of these capital resources for the financing of public and private consumption. This implies that the public sector should go from the current position of moderate overall deficits to that of a small surplus, which would be returned to the private sector for investment purposes. It also underscores the need to adopt policies for a further development of private financial intermediation, for an efficient allocation of the available resources. 23. Medium-Term Revenue Trends. Revenues over 1990-1998 would be dominated by two contrasting trends (as discussed in Chapter IV): (i) the progressive reduction of volume exports of oil products and of production in general; (ii) a stronger buoyancy of the non-oil tax system, resulting from the implementation of the reforms already approved or under discussion. In the first case, a partial counterbalance is provided by two factors. On the one hand, price increases for international oil prices are projected to outpace the trend of Manufactured Unit values in dollar terms; given the underlying hypothesis of a stable real exchange rate, this results in a positive price effect for revenues. In addition, the projections assume that domestic oil pricing policies will result in the elimination of all remaining subsidies on domestic oil consumption by 1993, thereby increasing Treasury revenues. Nonetheless, as Table 1.3 shows, the reduction of oil revenues after 1995 is sizable: on average, oil revenues would be two percentage points of GDP lower in the latter part of the period, compared with the 1991- 94 period, and would be declining rapidly. 24. On the non-oil revenue side, the projections assume that the 1989 tax reform would be complemented by additional measures, including a progressive generalization of the VAT, the abolition of all remaining tax expenditures, the progressive increase in the role of personal income taxation, an increase in the membership in the social security system coupled with better compliance by employers, and increases in rates of excise taxation. These measures could contribute to a moderate increase in the elasticity of revenues based on real output, and an increase in the share of non-oil taxation to an average of 14 percent during the second half of the 1990s. 25. Expenditures. Little change is needed in the aggregate non-ittterest expenditures of the nonfinancial public sector from the 1989/90 levels if medium-term objectives are to be reached. Underlying the projections, however, is the assumption that the reform of budgeting, earmarking, and - 10 - public employment policies would contribute to a substantial modernization of the Ecuadoran state, and would permit a redeployment of expenditures toward service delivery. More specifically: (a) General administration expenditures (including central ministries and part of the expenditures for the military) would be reduced by approximately one-third; (b) The share of social sector spending would rise, thanks to (i) improvements in health care delivery, due to the reforms of the social security institute advocated in Chapter VI; (ii) increased focus on delivery of primary education, balanced by a shift away from excessive subsidies to higher education, and iiicreased cost recovery; and (iii) reduction in expenditures for the administration of price controls on a number of primary commodities. (c) These projections assume that no explicit debt relief would be forthcoming. While, due to the projected growth of economy and to lower expected international intereqt rates, the share of interest expenditures in total spending is expected to decline (the projections are on an accrual basis and exclude interest on interest arrears), it is expected that, in these circumstances, financing in the form of external payments arrears to commercial bank creditors would still be needed on balance-of-payments grounds. Table 1.8: ECUADOR - CONSOLIDATED PUBLIC SECTOR ACCOUNTS (percent of ODP) Actual Prel. Pro]. 1984-86 1987 1988 1989 1990 1991-94 1995-98 Non-FInancIal Public Sector Rvenu-n 26.4 21.7 20.8 22.8 26.3 26.6 23.8 OlI 10.8 6.9 7.8 8.4 10.0 11.8 9.4 Non-Oil 12.9 14.2 12.4 12.0 18.1 12.0 12.0 Operational Surplus of PEe 1.7 1.6 1.0 2.4 2.2 2.8 2.6 Current Expenditures 19.8 24.8 19.5 18.0 18.6 18.0 16.6 Interest Accrued 6.4 4.8 6.4 6.2 6.7 6.8 8.9 Other 14.4 19.6 14.1 12.7 11.8 12.7 12.7 Public Sector Savings 5.8 -2.6 1.3 4.8 6.8 7.6 7.2 Investment 6.9 7.0 6.0 6.8 6.6 6.9 6.6 Surplus/Def leIt -1.8 -9.6 -4.7 -2.0 0.2 0.7 0.7 Central Bank Net External Interest Payments 1.7 2.v -8.2 -1.6 -2.7 -2.3 -2.0 Do metic Operational Result 0.0 0.0 0.6 0.2 0.2 -0.8 -0.8 Overall Public Sector Savings 8.9 -6.2 6.1 6.4 9.7 9.6 9.0 Overall Public Sector Surplus -8.0 -12.2 -2.2 -0.7 2.7 2.8 2.6 Source: World Bank. - 11 - 26. As discussed above, overall public investment would experience a slight decline over the projection period, as the opening of several key sectors to private initiative would stimulate domestic and foreign investors, particularly in the oil and natural resources areas. Finally, the financial performance of public enterprises is also expected to show substantial improvements as a consequence of the pricing of publically-delivered services and goods being raised to economic levels; a modified regulatory framework would allow greater competition where warranted; closing or transferring to the market sector some enterprises that are structural loss-makers, or perform market-related activities. quasi-Fiscal Deficits 27. The projections also assume that the recommendations in Chapter III regarding the quasi-fiscal deficit of the Central Bank would be followedt (i) decreased role of the Central Bank in financial intermediation; (ii) market interest charges on outstanding loans and credits; and (iii) remuneration of outstanding balances of public sector entities. These measures should yield a broadly balanced domestic quasi-fiscal result, once operational costs are taken into account. The contribution to the overall surplus of the public sector would then consist of the requirements for the servicing of the external debt, for which the Central Government would provide sufficient financing through its operational surplus. D. Conclusions 28. The above projections are, by their own nature, merely indicative, since they are based on a set of exogenous assumptions that may or may not materialize, and on the hypothesis that successive governments would be able to maintain a complex and far-reaching policy agenda. They serve, however, to stress the central message of this report: that the public sector has been and remains key to the development of Ecuador, and that without major and fundamental reform of its institutions and functioning, there is little likelihood that resumption of sustainable per capita growth of private consumption will be forthcoming. 29. While the means for Ecuador to reform the finances of the public sector and achieve more rapid growth are reasonably clear, formidable political obstacles stand in the way of implementing the necessary policies. Ecuador's regional, class, and ethnic differences are deeply rooted. The state has responded in the past by establishing what is now a heavily entrenched system of import and export controls and prohibitions, protective tariffs, price controls, administrative restrictions, tax concessions and exemptions, restrictive labor laws, public sector job creation, credit allocations, interest rate subsidies, and extensive public ownership of commercial enterprises. This system has led to widespread economic inefficiency, serious distortions in the allocation of the country's resources, and impairment of the economy's capacity to respond to change. The surge of oil-related prosperity in the 1970s for a time obscured the underlying structural and policy deficiencies, and contributed to the - 12 - introduction of major additional distortions and rigidities. However, in the 1980s, despite support to the economy from continued increases in oil output, the distortions have become increasingly more apparent and represent the underlying cause of the country's poor adaptation to changing economic circumstances and its continued sluggish growth. The past few years have witnessed the beginning of a process of cautious but sustained structural change. If the momentum can be maintained in the future, and the political leadership can successfully continue to put Ecuador's interests ahead of those of special groups and privileged classes, the country can look forward to an economic and social turnaround that will propel it into the realm of modern and developed economies during the next decade. - 13 - II. NONPINANCIAL PUBLIC SECTOR EXPENDITURES AND DEFICITS A. Introduction 30. Ecuador's oil boom led to a substantially enlarged Government sector and a sizable expansion in the role of public enterprises. Most of the increase in Government spending took place in the current expenditures category, mainly to cover higher interest charges and a greatly enlarged bill for wages and salaries. During the 1980s, nonbudgetary government expenditures declined in importance vis-a-vis the Budget since revenue transfers to nonbudget entities have declined. Despite the large revenues from oil production, Ecuadoran Governments have incurred substantial nonfinancial public sector deficits for the entire past decade and a half (except for the brief period between 1983 and 1985). The long series of deficits almost invariably has been covered by external borrowing, contributing heavily to the costly ;xpansion of the public debt that took place between 1975 and 1988. Since the Government has had considerable difficulty in meeting its debt service obligations in recent years, continued external financing of excessive public sector deficits is unlikely to be feasible in the foreseeable future. 31. This chapter analyzes key nonfinancial public sector developments and reviews the financial operations of the Central Government including the National Participation Fund (FONAPAR), the Social Security System (IESS), the Ecuadoran Development Bank (BEDE), the provincial and municipal governments, and the military and universities. B. The Nonfinancial Public Sector The Composition of the Nonfinancial Public Sector 32. This section reviews the main developments in the aygregate nonfinancial public sector since the beginning of the 19709.- Discussions center on: (i) changes that have taken place over the past few years in the economy as a whole; (ii) the relative importance of the various elements in the public sector; (iii) the roles of non-oil revenues, oil revenues, and external and domestic borrowings in financing the sector; and (iv) the 11 In the rest of this document, unless otherwise indicated, the Consolidated Nonfinancial Public Sector is composed of: (i) The Central Government, in turn Composed of the Budget and the FONAPAR (FODESEC from 1991 on); (ii) the rest of General Government, in turn composed of The Social Security Institute (IESS), the Ecuadoran Development Bank (BEDE), the FONAPRE (national pre-investment fund), the Municipal and Provincial Councils, and Other Public Sector entities, which include the Universities, the Military, approximately two hundred small administrative entities, and some small enterprises for which insufficient data is available on a timely basis; (iii) the public enterprises, which are included, in the overall statistics, on a net basis (more precisely, their operational surplus is included in the overall revenues, and investment is included in expenditures). - 14 - evolution of the aggregate annual financial balances of the sector and their financing. The Increased Role of Nonfinancial Public Sector Expenditures 33. Rising oil revenues and the willingness of foreign creditors to lend to the Government of Ecuador on the strength of anticipated future oil revenues led to a strong expansion in the role of public sector spending during the 19709. According to National Accounts figures, the total expenditure of the consolidated nonfinancial public sector rose from 23.5 percent of GDP in 1973 to 31.7 percent in 1981. Over this period, current expenditures rose from 16.2 percent of GDP to 21.4 percent and capital expenditures from 7.3 percent to 10.3 percent (Table 2.1). Table 2.1s CONSOLIDATED NONFINANCIAL PUBLIC SECTOR EXPENDITURES, 1973-81 (Percentages of GDP) Year Current Capital Total 1973 16.2 7.3 23.5 1974 18.2 10.0 28.2 1975 20.3 9.1 29.4 1976 19.7 9.5 29.2 1977 20.6 10.9 31.5 1978 19.5 9.8 29.3 1979 19.0 9.2 28.2 1980 21.5 10.0 31.5 1981 21.4 10.3 31.7 Source: National Accounts, Central Bank of Ecuador. 34. In 1982 external commercial lending ceased, interest rates on the external debt rose, a world economic slowdown occurred and international oil prices dropped by 15 percent. As a result, the nonfinancial public sector deficit widened to 6.7 percent of GDP in 1982. Public spending was cut drastically to eliminate the deficit in 1983, falling from 29.6 percent of GDP in 1982 to 22.4 percent in 1983 (Table 2.2). Public spending rose steadily again between 1984 and 1987 (spending in the latter year reflecting outlays associated with earthquake relief). In 1988 spending was once more sharply reduced, when the new government introduced necessary corrective austerity measures. Overall spending in 1988 was reduced to nearly 3 1/2 percent of GDP below 1982 levels; however, several of the budget components were much higher - 15 - in 1988 than in the early eighties. For example, interest obligations (equivalent of 6.4 percent of GDP) remained 3.2 percentage points higher in 1988 than in 1983, and wages and salaries, at 9.1 percent, were 3.3 percentage points higher. Table 2.23 CONSOLIDATED NONFINANCIAL PUBLIC SECTOR EXPENDITURES, 1981-89 (Percentages of GDP) Year Current Capital Total 1981 19.6 8.9 28.5 1982 19.8 9.7 29.6 1983 15.7 6.7 22.4 1984 17.9 6.4 24.3 1985 19.8 6.1 25.9 1986 21.6 8.1 29.7 1987 24.3 7.0 31.1 1988 20.0 6.0 26.0 1989 19.0 7.0 26.0 Source: Annex Table la. 35. The National Accounts and IMF data differ in concept and coverage precluding a direct comparison of the levels of public expenditure. For example, National Accounts data for 1981 show total public expenditure 3.2 percent of GDP higher than IMF data. Even so, the 1973-82 increase in total spending appears to be significantly larger than the 1982-89 net decline. Overall, since the early stages of the oil era, total nonfinancial public current expenditures in Ecuador appear to have risen substantially. While large cutbacks in current expenditures took place in 1988 and capital expenditures have fallen since 1986, estimates of total expenditures over the entire 1970-89 period suggest that they were higher by about 6 percent or more of GDP in 1989 than in 1970. Despite the sharp 1988-89 expenditure cutbacks, the oil boom has left Ecuador with a disproportionately large public sector compared to the rest of the economy. Functional Composition of Expenditures 36. Available statistics on the functional composition of expenditures in the nonfinancial public sector are extremely sketchy, since the classification and level of aggregation are often arbitrary or questionable. Expenditures for 1980-1988, including those approved through the budget, the social security system, and of some entities whose revenues are based on earmarking, amount to roughly two-thirds of total current and capital expenditures of the consolidated nonfinancial public sector--with public enterprises included on a - 16 - net basis (Table 2.3). Absent from these statistics are data on public enterprises' investment (although capital transfers to public enterprises are included), investment activities financed through foreign loans (which, until now, are generally not included in the budget), and several funds funded by the earmarking system (mostly part of the military). Table 2.8: ECUDOR - PFUfC EXPUSIIUHE, 1980-OS (Percent of Tatei) 1980 1981 1982 1988 1984 1985 1988 1987 198 TOTAL a/ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 General Services 18.1 17T.9 7. 17.7 17.0 19.6 21.8 17.8 20.1 Culture A Education 26.0 23.8 20.6 21.4 19.8 19.7 20.6 18.7 17.6 Social Welfare 0.7 1.0 0.8 1.1 0.7 0.7 1.0 1.0 0.9 Health A Municipal Development 5.8 6.5 8.0 6.1 5.8 5.9 5.8 6.8 6.1 Agricultural Development 6.1 6.3 5.8 4.8 8.0 8.6 2.7 2.4 2.4 Natural Resources & Energy 0.7 0.9 0.8 0.6 0.6 2.2 1.2 0.9 0.6 Industry & Commerce 1.9 1.7 1.4 0.4 0.6 0.5 0.6 0.6 0.4 Transport & Communications 6.6 6.7 6.8 5.7 7.8 9.7 8.5 7.9 5.8 Social Security 28.8 16.5 21.9 28.6 22.4 19.6 19.8 17.0 16.4 Interest on Debt 6.7 10.1 14.4 18.8 17.2 17.2 18.7 18.5 24.2 External S/ 4.1 7.4 11.9 13.6 18.9 12.8 9.6 14.9 20.4 Internal 2.6 2.8 2.5 8.2 8.4 4.4 4.1 8.6 8.7 Other 6.1 9.0 5.6 2.8 6.6 1.5 4.8 9.6 6.8 Source: Ministry of Finance. a/ Excludes debt amortization. b/ Provisional estimates. S/ Foreign interest payments after 1986 are on a due rather than cash basis for consistency with other tables. 37. The table reveals interesting trends. First, the major item to gain in relative importance is interest, mostly due to external interest. As a result of the past reliance on external financing of the budget deficit and the real depreciation of the sucre, the share of interest payments in total expenditures has risen sharply over the past nine years, from one-fifteenth in 1980 to one-quarter in 1988. Moreover, this rise does not include part of the total interest payments due, since approximately one-half of the nonfinancial public sector payments is serviced by the Central Bank (see Chapter III). The Government's interest burden (which since 1987 has been relieved on a cash - 17 - basis partly by the accumulation of sizable arrears to foreign commercial bank creditors) clearly poses a serious constraint on the ability of the Government to deliver public services, particularly at a time of fiscal retrenchment. The table also shows that in the past few years education, agricultural development, and social security have suffered from retrenchment. Expenditures on education and culture (for which a constitutional provision mandates at least one-third of the budget) fell from 25 percent of the total in 1980 to 17.5 percent in 1988. Social security expenditures--which comprise a variety of services and even financial intermediation activities (as discussed below)--fell from almost 24 percent of the budget in 1980 to 15.4 percent in 1988. Agricultural development spending has been cut by more than half. 38. A notable exception to the above trends is represented by "General Services," which includes the overhead of the central ministries and other public bodies as well as the part of military expenditures that goes through the budget. The share of these expenditures in the total has, in fact, slightly increased over the 1980s, reflecting for the most part increases in the wage bill and in public employment, and now represents about one-fifth of total expenditures. 39. In general, although the nature of the data suggests the use of extreme caution in interpretation, the expenditure trends indicate that given the increasingly higher interest payments on debt, in itself the result of erroneous past policies, and faced with falling revenues, the burden of fiscal retrenchment fell most heavily on those sectors where providing public services is paramount for fostering economic development (i.e., education and agricultural development), whereas the Central Government bureaucracy and other powerful interest groups (i.e., the military) have retained their relative and even absolute positions. Shifts in the Institutional Composition of Public Spending 40. During the decade 1973-83, public enterprise expenditures grew very rapidly compared to those of the Government. For example, gross spending of public enterprises (excluding transfers) rose from the equivalent of about 30 percent of central Government expenditures (excluding transfers) in 1973 to 138 percent by 1983, Jumping from the equivalent of 4.4 percent to 24.2 percent of GDP, respectively. Approximately 50 percent of this increase can be attributed to the oil sector. The importance of the public enterprise sector relative to the public sector as a whole as well as GDP is overstated by using gross expenditures; however, the comparisons illustrate the enormous growth in public enterprise expenditures from the beginning of the oil era to the early 19809. Over this period, expenditure shifts within the Government sector were small (see Annex, Table 3), although central Government, local government and Social Security Institute spending all rose much faster than overall GDP (Annex, Table 3). An illustrative example is that despite the increase in the central and local government budgets, their share accounted for only 42 percent of total gross nonfinancial public sector spending in 1988. The relative importance of the rest of government declined substantially between 1983 and 1988. This appears related to the declining importance of intragovernmental transfers, which fell from 23.0 percent of - 18 - total public sector expenditures in 1983 to only 14 percent in 1988 (see Annex, Table 4) and to relative declinei in nonbudgetary earmarked oil revenues (see Chapter VII). The Financing of Nonfinancial Public Sector Expenditures 41. There is no generally acceptable data available to analyze the financing of the nonfinancial public sector for the period prior to 1981, although it is evident that public oil revenues became increasingly significant starting in 1972. However, the relative importance of the main categories of financing between 1981 and 1988 can be analyzed based on IMF data. During this ptriod, non-oil revenues provided 47 percent and oil revenues about a third of the resources needed to finance nonfinancial public sector spending (Table 2.5). The operating surpluses of public enterprises contributed a further 6 percent with the balance (13 percent) coming from foreign borrowings. The abrupt 1982 decline in the availability of external financing and non-oil revenues was partly offset by increased oil revenues and increased resort to domestic financing. Strong increases in the contribution of oil revenues in 1983, coupled with sharp expenditure cutbacks and major increases in non-oil revenues and public enterprise prices, precluded the need for internal financing in 1983, despite an extremely abrupt cut in external Table 2.4: THE FINANCING OF TOTAL NONFINANCIAL PUBLIC SECTOR EXPENDITURES (Percentages of Total) 1981 1982 1983 1984 1985o 9 l8 1987 1988 Avg. ------------------------------------------------------------------__---------__--------------- To...l Expenditure 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Current 68.7 67.1 69.9 78.7 76.4 72.6 77.6 77.6 72.9 Capital 31.4 82.9 30.1 28.8 23.6 27.4 22.4 22.6 27.1 Financing of Total Expenditure 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Revenues Oil 27.1 30.3 88.7 41.6 53.6 28.2 18.9 28.9 33.4 Non-Oil 47.6 41.8 53.6 48.6 48.8 48.7 46.4 47.8 47.2 Oporating Surplus of Public Enterprises 5.7 6.5 7.7 9.3 5.2 8.1 6.1 3.9 6.8 External Financing 20.9 15.2 3.0 5.9 5.3 18.6 18.9 14.6 (o/w arrears) (8.6) (8.1) Domestic Financing -1.3 7.4 -2.9 -3.6 -12.7 -1.4 5.8 14.6 Total Public Expenditure (percent of GDP) 28.5 29.6 22.4 24.3 25.9 29.7 81.3 28.3 27.3 Source: Annex, Table 1 financing. The revenues from oil production varied considerably during the period as a result of sharply rising production between 1983 and 1985, the decline in oil prices in 1986, and a 35 percent drop in oil output in 1987. These developments led to petroleum revenues reaching a peak of 53.5 percent - 19 - of total nonfinancial public sector expenditure financing in 1985 and then dropping to only 18.9 percent in 1987. The drop in oil revenues in 1986 and 1987 was offset by increased borrowing from abroad and a decline in the public sector's domestic credit balances. Overall Nonfinancial Public Sector Balances 42. From the mid-1970s to the present, the nonfinancial public sector generated continuing deficits (Table 2.4). The deficit reached 7.5 percent of GDP in 1982, reflecting mainly a sharp decline after 1979 in the operating surpluses of the nonfirancial public enterprises, coupled with still rising current and capital expenditures. Following cuts in current and capital public expenditures and a large rise in the operating surplus of the public enterprises, the deficit was sharply reduced in 1983. (IMF data show a zero balance for 1983, see Table 2.5.) By 1985, a significant surplus had emerged; however, the halving of oil prices in 1986 produced a sharp fall in petroleum revenues and the reemergence of a large deficit. Petroleum revenues were reduced still further in 1987, when the March earthquake cut the oil pipeline forcing a sizable cut in production and exports. The deficit reached a peak of 9.6 percent, since current expenditures continued to climb to a level almost 3 percent of GDP above that of 1985. In mid-1988, the deficit appeared to be headed even higher. However, the new government that assumed power in August moved decisively to cut expenditures and raise revenues. As a result, the deficit for the year was contained to 5.1 percent. Continued successful adjustment in 1989 led to a further reduction of the deficit to 2.2 percent of GDP (with external interest on an accrual basis). Notwithstanding their access to large oil revenues, successive Ecuadoran Governments incurred deficits averaging 4.3 percent of GDP between 1975 and 1982. Following a marked improvement between 1983 and 1985, the deficits averaged 5.5 percent of GDP between 1986 and 1989. Table 2.1: tWNFDNCIAL PUIJUC SECTOR SUIPUS, 197848 (percent"" of GOP) Year Surplus Year Surplus 1973 3.1 1979 -0. 6 1974 0.8 1980 -4.5 1976 -2.2 1981 -6.8 1976 -3.3 1982 -7.6 1977 -6.6 1983 -2.2 1978 -5.0 Source: National Accounts, Banco Central del Ecuador. 19G3 0.0 1987 -9.6 1984 -0.8 1988 -6.1 1986 1.9 1989 -2.2 1986 -6.1 Source: Annex Table la. - 19a - Figure 2.1 Non-financial Public Seotor Surplus (p*ouen* of GOP? 40 - 30 - 20 10 ol,llul~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ I I I #( t981 1982 1983 1984 1985 1986 1987 1988 1989 1MRevenues IL ExpendItures LII SurplusI - 20 - Financing the Deficit of the Nonfinancial Public Sector 43. Until 1986 external financing has been more than adequate to finance the nonfinancial public sector deficits incurred by the Government, the only exception being 1982 (see Table 2.6). In 1982, the Central Bank was called on to finance an amount equal to 2.9 of GDP, producing a 60 percent increase in the M2 money supply. As a result, the CPI rose 48 percent in 1983, compared to 16 percent in the previous year. Recourse to domestic credit also was very pronounced in 1987 and 1988, reflecting the crisis in the fiscal accounts, and once again contributing to a strong acceleration in growth of monetary aggregates and to heavy reserve losses. In addition, involuntary external financing was provided in the form of interest arrears on external debt, to an average of 3 percent of GDP per annum since 1987. The adjustment in the fiscal accounts achieved in 1989 is shown by the fact that on a cash basis (i.e., on the basis of external interest actually paid) the year closed almost on balance; net (voluntary) external financing was then reflected in the accumulation of positive balances in the Central Bank and in other public financial institutions. Tabl, 2.6: FDlUNCDIO OF THE NON-F4IUACIAL PFULIC SECTOR OEFICIT (Pretof GOP) 1977 1978 1979 1980 1981 1982 1988 1984 1985 1086 1987 1988 1989 Deficit 8.8 6.2 2.0 4.6 5.6 6.7 0.0 0.6 -1.9 6.1 9.6 5.1 2.2 Financing: External 9.7 6.4 8.4 5.4 6.0 4.6 2.2 1.4 1.4 6.5 7.8 8.0 6.1 Borrowings 18.1 12.8 14.8 11.0 11.4 9.8 1.4 2.4 2.1 7.7 7.6 4.9 6.7 Amortization -8.4 -6.4 -11.4 -5.6 -6.4 -4.8 0.6 -1.0 -0.7 -2.2 -4.3 -8.2 -8.7 Arrears 4.6 1.8 3.1 Domestic -1.4 -0.1 -1.4 -0.7 -0.4 2.1 -0.6 -0.9 -3.3 -0.4 1.8 2.1 -2.9 Central Bank (net) -1.7 -0.7 -1.2 -0.6 -0.8 2.9 -0.4 -1.1 -3.9 -0.6 2.4 1.4 -2.7 Other Banks -0.2 -0.8 0.1 -0.2 -0.2 0.1 0.4 -0.4 0.0 0.1 Other 0.8 0.6 -0.2 0.1 0.2 -0.9 0.0 0.4 0.5 -0.8 -0.2 0.7 -0.8 Source: Annex Table is. 44. Externally financed deficits may be appropriate where they are incurred to finance a vigorous program of high-yielding public investment that supports strong private sector growth and produces a rapidly rising tax base to sustain the increase in debt-service payments. Obviously, such has not been the case in Ecuador. The deficits were not used primarily for high-yield investment, private sector growth has been poor, and the expansion of the tax base feeble, while the Government has experienced great difficulty in collecting the revenue required to service its external debt obligations. Continued external borrowing to finance deficits--that result from excess government consumption and inadequate generation of revenues--is an unsustainable approach to public finance. - 21 - Nonfinancial Public Sector Deficits and Growth of External Debt 45. Heavy reliance on external sources to finance the succession of deficits since 1975 contributed in a major way to the growth of the external debt (Table 2.7). External debt more than doubled between 1970 and 1975, then increased nine-fold from 1975 to 1980. Its growth subsequently slowed. The 1985 level was 74 percent above that of 1980, while from 1985 to 1988 the debt grew only 25 percent. The bulk of the external debt is public: at end-1988, for example, only 1.1 percent of the total debt was private since the Government assumed most of the private debt in the early eighties. Table 2.7: OUTSTANDING EXTERNAL DEBT 1970-88 (Year-End Balances, Millions of U.S. Dollars) Final Final Interest Year Balance Year Balance Arrears Total 1970 241.5 1980 4651.7 - - 1971 260.8 1981 5868.1 - - 1972 343.9 1982 6632.9 - - 1973 380.4 1983 7380.7 - - 1974 410.0 1984 7596.0 - - 1975 512.7 1985 8110.7 - - 1976 693.1 1986 9075.9 - - 1977 1263.7 1987 9827.9 437.C 10264.9 1978 2974.6 1988 10169.3 835.1 11004.4 1979 3554.1 1989 10085.6 1514.2 11599.8 Source: Statistical Appendix, Table 34. 46. Public debt is mostly on the books of the Central Government and of the Central Bank. If the amount refinanced by the Central Bank in the 1983 rescheduling is added to other General Government debt, the share of the latter would be over 60 percent of public external debt at end-1988 (Table 2.7). Financial public sector debt (primarily Central Bank) represented about a third of the total and public enterprise debt about 6 percent. It should also be noted that about a third of the financial public sector debt represents private debt refinanced under the Government's 1983 sucretization program. 47. The growth of the debt in dollar terms indicated by Table 2.7, precipitous though it was, understates the rise in the burden of the debt in domestic terms. The real exchange rate for the sucre rose 89 percent from 1975 to 1987, implying a corresponding increase in the real sucre burden of any debt outstanding in 1975 that remained outstanding in 1987. The burden of debt accumulated since 1975 was increased by smaller fractions depending on when it was incurred. The current, extremely heavy burden of public debt (122 percent of GDP in 1988) thus is attributable to: (i) the rapid growth after 1975 in both nonfinancial and financial public sector borrowing; - 22 - (ii) slow growth in GDP since 1981; and (iii) tb- major depreciation since 1975 in the real value of the sucre. C. Main Components of Nonfinancial Public Sector Deficits 48. The nonfinancial public sector incurred deficits after 1975 in every year except 1985, when a surplus of 1.9 percent of GDP was realized. The state budget, the rest of general government (notably the military and the universities), and the public enterprises all contributed significantly to this poor overall financial performance (see Table 2.8). The Budget, despite its relatively modest size, has been the major instrument in government attempts to reduce the overall nonfinancial public sector deficit. The very large financial adjustment (6.5 percentage points of GDP between 1982 and 1985, for example) was largely accomplished through the budget. Similarly, the 1988 overall deficit reduction came almost entirely from cuts in the central Government budget deficit. This section briefly reviews developments in the main public sector components. A more detailed discussion of individual issues is provided in the next few chapters. Table 2.8: COMPOSMON OF NONFINACIAL PUBUC SECTOR FINAKIAL DEFICITS (P.reentg of GOP) 1977 1978 1979 1980 1981 1982 1983 1994 1985 1988 1987 1988 Avge. Cent. Govt. -3.1 -1.2 -0.8 -1.9 -5.1 -4.9 -3.0 -0.6 1.9 -2.2 -6.1 -1.8 -2.3 Rest of General Govt. -6.0 -8.8 -1.1 -1.9 0.7 -1.1 2.7 -0.6 -0.4 -2.0 -1.7 -1.5 -1.3 Pub. Ent. -0.2 -1.2 -0.2 -0.8 -1.2 -0.7 0.3 0.6 0.3 -0.9 -1.7 -1.8 -0.6 Consolidated NFPS -8.3 -6.2 -2.0 -4.6 -5.6 -6.7 -0.0 -0.6 1.9 -6.1 -9.6 -6.1 -4.8 Source: Annex Table 6. Central Government Expenditures 49. The National Budget. Budgetary expenditures recently averaged about 40 percent of total public sector expenditures (including the gross expenditures of the public enterprises). Averaging 15.3 percent of GDP over 1983-89, have risen by 2.7 percent of GDP since 1983, with notable reductions in 1988 and 1989. Wages and salaries and interest payments were entirely responsible for this increase, since purchases of goods and services and current transfers declined in importance. (The rise in wages and salaries is biased upward by the inclusion through 1984 of a portion of wages and salaries in current transfers and expenditures for goods and services.) Only in 1987 were government current savings negative. Fluctuations in oil revenues strongly influenced the size of the budget balance. - 23 - Table 2.9: SUUMARY OF BUDGETARY DEVELOPMENTS,,198989 (Perc.ntages of CDP) 1988 1964 1985 1988 1997 1968 1989 Total Revenue 10.7 12.8 17.1 18.6 18.1 18.8 15.8 Petroloum Revenue 5.0 5.7 10.2 6.8 4.8 6.8 7.1 Non-Petroleum Revenue 5.8 6.6 6.9 8.2 8.8 8.1 8.1 Total Expenditure 18.8 18.0 16.1 15.6 19.1 15.8 15.6 Current 10.7 10.8 12.1 12.4 16.8 1383 14.0 Wages & Salaries 2.9 2.4 4.8 6.8 7.6 5.8 5.9 Purchases of Goods A Services 0.6 0.4 0.4 0.4 2.8 0.8 0.8 Interest 2.6 2.8 3.2 2.6 8.9 4.8 4.4 Current Transfers 8.5 4.0 2.9 1.6 1.7 2.8 2.8 Capital 2.6 2.2 8.0 8.2 2.8 2.0 1.7 Fixed Capital Formation 1.8 1.5 2.0 1.5 1.1 0.6 0.2 Capital Transfers 1.8 0.8 0.9 1.8 1.8 1.8 1.S Other 0.0 0.0 0.2 0.5 0.4 0.0 0.0 Balance -2.5 -0.7 2.0 -2.1 -B.0 -1.9 -0.5 Source: Appendix Tables (1, 7, A 8]. Table 2.10: SOURCES OF BUDGETARY NON-PETROLEUM REVENUE, 1988-88 (Percentages of total) 1988 1984 1985 1986 1987 1988 1989 Tax Revenue 96.0 90.9 92.4 98.8 98.5 98.7 96.6 Taxes on Income A Profits 21.1 17.8 19.0 17.8 17.7 16.4 20.7 Taxes on Property 1.2 0.4 0.2 0.8 0.1 0.1 1.1 Taxes on Goods & Service 89.9 87.8 87.6 44.6 46.7 46.6 44.8 General Sales Tax 22.9 21.2 28.8 88.2 81.9 88.9 29.9 Selective Excise Taxes 17.0 16.1 14.2 11.8 14.8 14.7 18.8 Taxes on International Trade 85.6 85.4 87.7 84.9 29.6 26.9 28.7 Import Duties 82.8 82.8 88.9 81.8 27.8 24.8 26.6 Export Duties 0.8 0.2 0.0 -0.1 0.0 0.0 0.0 Exchange Profit Taxes 2.5 8.0 8.6 8.2 1.7 1.6 2.1 Other -2.2 0.4 -1.0 -8.7 -0.5 2.8 3.4 Non-Tax Revenue 4.8 5.2 5.8 6.2 5.5 6.1 8.4 Transfers 0.0 8.9 2.2 1.0 1.0 0.2 0.0 --- --- - -- - - -- - - - -- _- -- ---- - --- Total Revenues 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total Revenue as 5.6 6.6 6.9 8.2 6.4 6.1 8.1 Percentage of GDP Source: Statistical Appendix, Table 6. 50. Total revenues, which averaged 13.6 percent of GDP, have grown by 3.5 percent of GDP over the period, with petroleum and (budgetary) non-petroleum revenues contributing equally to the increase (see Table 2.9). Petroleum revenues have, of course, been far more volatile than nonpetroleum revenues, reaching a peak of 60 percent of total budgetary revenues in 1985, dropping to a low of 37 percent in 1987, and recovering to 47 percent in 1987. Non-oil - 24 - revenues exceeded oil revenues even in 1989. Budgetary revenues in 1989 were dominated by taxes on goods and services (45 percent), taxes on international trade (largely import duties) (29 percent), and to a lesser extent, taxes on income and profits (21 percent) (Table 2.10). The general sales tax has risen rapidly in importance since 1983, while income and profits taxes, selective excise taxes, and import duties have all declined (See Chapter IV). 51. The National Participation Fund (FOMAPAR). The National Participation Fund (recently replaced by the FODESEC, see Chapter VII) was a mechanism created to channel funds from various central Government revenue sources to the provincial councils and municipalities and, to a much smaller extent, to certain other public bodies. Its "expenditures," which are in fact intragovernmental transfers, fell from 1.7 percent of GDP in 1983 to 0.8 percent in 1988 and from 11.4 percent of central Government expenditures to 4.9 percent (see Table 2.11). Table 2 11: FONAPAR TRANSFERS, 1983-88 (Percentages of Total) 1983 1984 198S 1986 1987 1988 Transfers to: Provincial Councils 20.8 26.6 25.8 26.9 26.1 25.0 Municipalities 48.4 64.6 70.0 71.5 72.9 73.4 Other Public Entities 25.2 9.8 4.2 1.5 1.0 1.6 Total Expenditure 100.0 100.0 100.0 100.0 100.0 100.0 Memo Items Total Expenditure as X of GDP 1.7 1.0 1.1 0.9 1.1 0.6 Total Expenditure as % of Central 11.4 7.2 6.7 6.7 6.4 4.9 Government Expenditures -----------------------------------------------------__----------------------__------------ Source: Statistical Appendix, Table 9. 52. As shown in Table 2.12, transfers to public entities other than local governments, which in 1983 represented a quarter of FONAPAR expenditures, dwindled to insignificance between 1983 and 1988. Municipal transfers now represent a much larger fraction of FONAPAR'S total expenditures than in 1983 but have nonetheless fallen from 0.8 percent to 0.6 percent of GDP. Transfers to provincial councils have maintained a relatively constant fraction of total FONAPAR expenditures but have fallen from 0.4 percent to 0.2 percent of GDP. 53. FONAPAR's revenues fell somewhat less abruptly than its expenditures, from 1.2 percent of GDP to 0.9 percent, so that its deficit declined from 0.5 percent of GDP in 1983 to zero in 1988. Petroleum revenues represented over a third of FONAPAR's revenues in 1983 but fell steeply to under 4 percent in 1988 (see Table 2.12', reflecting one of the numerous anomalies of the oil revenue earmarking system discussed in detail in Chapter V. Transfers from the budget and other accounts have assumed increasing importance as oil revenues have declined. About two-thirds of FONAPAR's revenues in 1988 were still from earmarked sources but only about 5 percent of these were from oil. - 25 - Table 2.12: FONAPAR REVENUES, 198a-88 (P ercentages of TotaI) 1988 1984 1986 1986 1987 1988 --------------------------------------------------------------------__-------__---------- Taxes on Income 47.0 44.8 22.8 28.3 23.2 19.6 On Petroleum Income 36.8 88.0 22.8 10.2 6.8 3.7 On Nonpetroleum Income 10.3 11.4 0.0 18.1 16.4 15.7 Excise Tax on Domestic Cigarettes 8.8 10.2 8.8 9.4 10.2 18.5 Taxes on International Trade 22.1 20.6 32.5 28.8 81.6 24.8 Import Outies 22.1 20.6 82.6 28.8 31.8 24.8 Basic Imports 6.9 8.0 21.9 7.9 1.1 0.4 Luxury Imports 0.0 0.0 0.0 0.0 0.0 0.0 Fixed Sup from General Tariff 18.2 12.5 10.5 20.5 30.5 24.0 Export Duties 0.0 0.0 0.0 0.0 0.0 0.0 Stamp Tax 14.7 17.0 17.5 17.8 13.6 16.4 Other Tax Revenues 0.0 0.1 16.7 0.8 0.0 0.0 CATS (-) 0.0 0.0 0.0 -1.6 -0.6 -1.1 Transfers 7.4 6.8 1.8 17.8 22.0 28.6 Total Revenue 100.0 100.0 100.0 100.0 100.0 100.0 memo Ite Total Revenues as X of GOP 1.2 1.1 1.0 0.9 1.0 0.9 Deficit (-) as X of GDP -0.5 0.1 -0.1 -0.0 -0.1 0.0 Source: Statistical Appendix, Table 9. 54. In summary, FONAPAR's role in transferring resources to the local governments has declined substantially over the past few years, largely as a result of a collapse in its oil revenues. By 1988 the agency was no longer a contributor to the overall nonfinancial public sector deficit. Despite its relative decline, FONAPAR remains the major revenue source for local governments. 55. The Social Security System (IESS). The development and the finances of the IESS are discussed in greater detail in Chapter VI. Its aggregate contribution to the overall deficit can be summarized as follows: Since 1979, social security system revenues have been declining as a percentage of GDP. Over the period 1983 to 1988, they fell from 4.1 percent of GDP to 3.1 percent, while social security contributions declined from 3 to 2.4 percent (Table 2.13). Other current revenues (including interest and property income, as well as penalties) declined more sharply than contributions over the period; it is not clear, however, if this development is part of a continuing trend. - 26 - Table 2.13: SOCIAL SECURITY INSTITUTE REVENUES, 1983-88 (Percentages of Total) 1983 1984 1985 1986 1987 1988 …------------------------------------------------------------------__-------- Social Security Contributions 73.3 77.6 70.7 73.5 78.9 77.2 Current Revenue 26.7 22.4 29.3 26.5 21.1 18.8 Transfers from Budget 0.0 0.0 0.0 0.0 0.0 4.0 Total 100.0 100.0 100.0 100.0 100.0 100.0 Total as Z of GDP 4.1 3.5 3.9 3.7 3.2 3.1 ---------------------------------------------------------------------__----- Source: Statistical Appendix, Table 12. 56. The overall 1983-88 decline in revenues has been matched by a decline in expenditures, so that the IESS did not register a deficit in 1988, although there were deficits in four of the previous five years (see Table 2.15). Both current (including pension payments) and capital expenditures have declined as percentages of GDP. The drop was particularly sharp in IESS's net lending activity, which fell from 0.8 percent of GDP to 0.4 percent but transfers to the private sector also fell over the period, from 2 to 1.4 percent of GDP. Purchases of goods and services, and, to a lesser extent, wages, have claimed a rapidly rising share of total expenditures over the period. These two categories jumped from the equivalent of 52 percent of transfers to the private sector in 1983 to 76 percent in 1988. This development lends statistical support to the widely held view in Ecuador that the IESS has become heavily overstaffed and inefficient. Table 2.16: SOCIAL SECURITY INSTITUTE EXPENDITURES, AND OVERALL BALANCES, 1983-88 (Percentages of Total Expenditure) 1983 1984 1985 1986 1987 1988 Wages A Salaries 18.7 17.0 13.7 16.9 16.9 21.4 Purchases of Goods * Services a5 5.68 6.0 8.0 10.5 14.2 Interest Payments 0.9 1.8 1.4 1.7 1.4 1.2 Current Transfers 60.4 40.2 47.0 82.4 4656 46.7 To Public Sector 1.7 1.6 1.6 0.2 0.0 0.0 To Private Sector 48.7 88.6 45.4 J2.2 46.6 46.7 Total Current Expenditure 76.5 64.a 68.1 58.0 78.3 88W5 Fixed Capital Formation 8.0 3.9 4.9 5.9 4.7 4.5 Net Lending 20.4 81.8 27.1 86.1 22.0 12.0 Total Capital Expenditure 23.6 85.7 81.9 42.0 28.7 16. 6 -----------------------------------------------------------------------__----__----------------- Total Expenditure 100.0 100.0 100.0 100.0 100.0 100.0 Total Expenditure (percent of GOP) 4.0 8.9 3.8 8.9 3.6 3.0 Overall Balance (percent of GDP) -0.0 -0.4 0.1 -0.2 -0.3 0.1 Source: Statistical Appendix, Table 12. - 27 - Other Government Agencies 57. The Development Bank of Ecuador (BEDE). The Development Bank of Ecuador (BEDE) was established in 1979 to channel funds into public sector capital projects. Its operations are financed by shareholder capital, resources from the national development funds (notably the National Development Fund (FONADE) and the Municipal Development Fund (FODEM)), earmarked oil revenues, income from its own operations, and borrowing. BEDE has enjoyed an exceptionally high (99 percent) rate of loan recovery, since its loans to local governments have either been collateralized by FONAPAR transfers or covered by central Government bailouts. During the early eighties, lending for central Government projects represented only 42 percent of total BEDE lending but by 1988 the central Government's share had risen to 84 percent. However, a substantial proportion of the central Government projects financed by BEDE represented municipal and provincial projects undertaken by central ministries. Lending directly to local governments fell from 16 percent of total BEDE lending in the early eighties to 6 percent in 1988, while lending to public entities other than the central or local governments fell from 42 percent of the total to 10 percent over the same period. In the later 1980s, BEDE lending has focused increasingly on social infrastructure and away from economic and municipal development projects. This shift has taken place largely in response to political pressures, since little effort has been made to establish clear priorities for BEDE-financed projects. 58. BEDE's role has rapidly declined in importance in recent years as its share of oil revenues under the mechanistic earmarking system collapsed as a consequence of declining oil prices and a rising exchange rate. At the same time, the institution was progressively decapitalized by being obliged to lend at nominal interest rates (around 18-25 percent) that were substantially negative in real terms. An additional negative effect of lending at subsidized interest rates was the encouragement of misallocation of capital. BEDE's revenues fell from 1.9 percent of GDP in 1983 to only 0.4 percent in 1984 (see Table 2.15), but the institution did not trim its lending operations accordingly. As a result, it slipped from its earlier surplus position to a deficit position between 1986 and 1988 and was obliged to draw down earlier reserves and obtain financing from the Central Bank, thereby adding to the rising proportion of its expenditures devoted to interest payments. 59. BEDE's originally intended role as a vehicle to channel oil revenues into growth-enhancing investment has not been realized. Further, the institution has been undermined by the collapse in its share of oil revenues, by decapitalization, and by the increasing use of its funds to finance central Government projects. An alternative role for the institute would be to use part of its analytical and project management resources to strengthen the central Government's project evaluation and monitoring capabilities and part to integrate the various forms of transfer to local governments and to strengthen those governments' own capacities to plan and finance projects, as is envisaged by the reform of intra-governmental transfers discussed in Chapter VII. - 28 - Table 2.15: BIDE OPERATIONS, 1983-85 (Percentages of GDP) Prel. 1983 1984 1985 1986 1987 1983 Petroleum Revenue 1.3 0.9 0.6 0.2 0.2 0.1 Non-Petroleum Revenue 0.7 0.4 0.4 0.4 0.5 0.3 Total Revenues 1.9 1.3 1.0 0.6 0.6 0.4 Wages & Salaries 0.0 0.0 0.0 0.0 0.0 0.0 Other Expenditures n.a. 0.3 0.1 0.1 0.2 0.1 Net Lending n.a. 0.4 0.8 0.7 1.1 0.7 Total Expenditures n.a. 0.6 0.9 0.8 1.3 0.8 Surplus or Deficit (-) n.a. 0.7 0.0 -0.2 -0.7 -0.4 Source: Statistical Appendix, Table 11 and Annex Table 12. Provincial and Municipal Councils 60. Municipal council revenues and expenditures decreased between 1983 and 1989 as a percentage of GDP. Revenues declined from 2.1 to 1.7, while expenditures fell from 2.1 to 1.4. The main cause of the decline was a drop in municipal oil revenues, which fell from 0.4 percent of GDP to under 0.1 percent, or from 20 percent to 3 percent of total municipal revenues (see Annex, Table 13). Transfers rose in importance: while direct transfers from the budget fell, other public sector transfers more than compensated for the decline. Municipalities' own revenues also rose as a share of their total revenues over the period. 61. On the expenditure side, total municipal capital expenditures bore most of the brunt of the decline, dropping from 53 to 34 percent of total municipal expenditures and from 1.1 percent to 0.5 percent of GDP (see Annex, Table 14). Interest payments, IESS contributions, and spending for goods and services rose as a fraction of total spending. Although the municipalities incurred deficits of 0.2 percent of GDP between 1986 and 1988, they recorded a small surplus of 0.1 percent of GDP in 1989. Municipal government finances are discussed in greater detail in Chapter VII. 62. Provincial council revenues and expenditures fell even more steeply than those of the municipal councils over the 1983-89 period. Revenues declined from 0.8 percent to 0.3 percent of GDP and expenditures from 0.8 percent to 0.4. Part of the cause was a drop in petroleum revenues from 0.2 percent to 0.02 percent of GDP, or from 26 percent of total provincial revenues to 6 percent; however, transfers also fell sharply as a share of GDP (see Annex, - 29 - Table 15) although retaining roughly the same share of total provincial revenues. A strong decline in direct budgetary transfers was offset by an equally strong increase in nonbudgetary public sector transfers. 63. On the expenditure side, provincial council capital expenditures declined over the 1983-89 period proportionately more than current expenditures, from 62 percent of total provincial spending to 43 percent (see Annex, Table 17). Interest payments, transfers, and payments for goods and services rose strongly as shares of total provincial spending. Provincial councils have incurred deficits averaging a little under 0.1 percent of GDP between 1983 and 1989. Other Public Sector Entities 64. remaining public sector entities comprise the military, the universities, the minor public enterprises, and other small accounts. Rever es have fluctuated between 1.5 and 2.5 percent of GDP over 1983-89 witW at any clear trend, but expenditures rose from 1.7 to 5.3 percent of GDP (see Annex, Table 18). As a result, these accounts moved from a surplus of 0.8 percent of GDP in 1983 to a deficit of 3.0 percent in 1989, mainly reflecting large capital expenditures in 1989. The residual accounts are thus the main contributor to the overall nonfinancial public sector deficit. However, the lack of detailed information prevents close analysis of the underlying causes. 65. On the revenue side (see Annex, Table 17) petroleum revenues, which were the sole positive revenue source in 1983, dropped to only 18 percent of total revenues by 1989, when transfers from the budget represented almost half of the total and current revenues were close to a third. On the expenditure side (see Annex, Table 18) both purchases of goods and services and capital expenditures have been highly variable but the causes have yet to be determined. 66. The impact of a rise in residual accounts spending on the overall financial position of the nonfinancial public sector is a matter of concern. The rise in residual accounts spending was equivalent to 3.6 percent of GDP between 1983-89, partly driven by rapidly increasing transfers from the budget. It appears that large-scale military and other acquisitions were made with budgetary transfers and borrowed funds. The lack of control over the spending from the residual accounts shows that it will be important for the Authorities to acknowledge that all forms of public consumption spending in Ecuador will need to be greatly reduced before the country can generate the public sector surplus needed to spur faster growth and a larger GDP. The currently large claims on scarce resources will mean the sacrifice of an otherwise potentially large pool of national revenues that will undoubtedly be needed for the future development of the economy. - 30 - III. CENTRAL BANK NET INCOME AND CONSOLIDATED PUBLIC SECTOR DEFICITS A. Quasi-Fiscal Deficitss a Definition. 67. While the main focus of this report is on the finances of the nonfinancial public sector, the analysis would be incomplete without an investigation of the contribution of the Central Bank to the overall public sector deficit. Increasing attention has been paid in recent years to the economic effects of Central Bank deficits, as a result, in part, of the experiences of Argentina and Brazil in this respect. This attention goes beyond the traditional focus of macroeconomic analysis, generally centered on the nonfinancial public sector deficits, and that implied that the only way the Central Bank can give rise to a macroeconomic disequilibrium is when domestic credit policy is not in line with the behavior of the demand for Central Bank liabilities. The Central Bank, however, is not conceptually different from other public enterprises, with the important exception that it can finance its own deficit, and that it is the first recipient of the proceeds of the inflation tax and of seignorage. A crucial difference with the nonfinancial public sector in a variety of countries, in addition, lies in the fact that the transparency of its accounts is very poor, and that, over the years, a number of expenditure functions have been shifted--perhaps because of the very lack of budgetary control--from the nonfinancial public sector to the Central Bank. In mary countries, this has led to increasing financing requirements, met by money emission or by other Central Bank liability increases. It is thus clear that, particularly in cases such as these, the relevant concept to measure the financial needs of public sector deficit is the consolidation of both the nonfinancial deficit and the Central Bank net income, the latter being usually referred to as the quasi-fiscal deficit. 68. The Central Bank deficit has two important implication for macroeconomic stability. The difference Lftween revenues and expenditures on a cash basis is part of the financial needs of the Central Bank. Monetary programs thus must incorporate the ex-ante financial effects of quasi-fiscal deficits derived from the stocks of assets and liabilities together with the cash flow derived from the expected change of credits, invtstments and liabilities during a given period. The economic concept of the deficit, i.e., the difference between revenues and expenditures accrued during the period, is a measure of the total demand on national savings posed by the Central Bank operations, and is thus the concept most relevant for economic analysis. It is, incidentally, a concept that is consistent with the accounting of non- financial public sector finances. 69. The quasi-fiscal deficit is often symptomatic of problems that go beyond the issues of macroeconomic stability, but also impinge on the allocative efficiency of the financial sector. The Central Bank, in Ecuador as in many other countries, finds itself at the center of a complex maze of subsidies. For instance, in general only its asset holdings of private sector liabilities yield interest, since the Central Bank transfers part of the seigniorage and the inflation tax it collects to the nonfinancial public sector, by not charging interest on its net credits to the NFPS--loans minus deposits. But at the same time, the income flows between the Central Bank and - 31 - the rest of the economy can result in transfers from the public sector to the private sector. This happens, for example, when the interest rate charged on Central Bank loans or other credits is below market rates. Subsidies to the private sector may also take other forms. Several governments have engineered transfers of the private external financial debt to the public sector; in some countries, this has been accomplished via the assumption of the private sector external debt by the Central Bank. In many cases, the domestic counterpart of the private sector to the Central Bank is insufficient to preserve the latter's net wealth. All of these different cross-subsidies tend to obfuscate the signals that the financial markets are supposed to give regarding the allocation of resources across different sectors, and also tend to hide the true cost of particular operations, resulting in efficiency losses that can be very costly for the country. B. Estimates of Ecuador's Quasi-Fiscal Deficit 70. The quasi-fiscal deficit of the Central Bank of Ecuador is dominated by three basic features of its balance sheet, which are partly the result of past policies and of the recent instability of the Ecuadoran economy. First, the Central Bank has long acted as a financial intermediary, by far the most important one. However, interest rates on its loans to the private sector have been systematically below market levels and, in addition, until recently were not adjusted in line with increases in the rate of inflation and the real rate of interest. 71. The second feature reflects the assumption by the Central Bank of the foreign liabilities of the public and private sectors without a full counterpart on the asset side. This has been the case since 1984, when the domestic private sector was offered the opportunity of converting its external liabilities into domestic ones, with the Central Bank providing the credit for the operation. The terms of the credit, however, were extremely generous: (i) the interest rate was sharply negative in real terms; (ii) the amortization of principal was rescheduled several times; and (iii) the Central Bank assumed virtually all of the exchange risk, as the exchange commission provision resulted in a strong underadjustment of principal in sucres. 72. Thirdly, the demand for money has been declining in the past few years. This has implied that, ceteris paribus, the Central Bank has been compelled to issue interest bearing internal debt to sterilize the excess supply of monetary base, in the process increasing its marginal cost of funds. 73. As an offset to these problems, the Central Bank balance sheet is favorably affected by the fact that a large part of its liabilities are unremunerated. This includes compulsory reserves of the banking system, and, in particulIr, deposits of public entities, which are very large, and receive no interest-. This feature reinforces the characterization of the Central Bank as an agency for the execution of transactions of a fiscal nature, but without the checks and balances provided by the budgetary process. 21 This despite the existence of legal provisions mandating remuneration of deposits, for instance, of the Social Security Institute. - 32 - Composition of the Balance Sheet 74. Table 3.1 shows the composition of the balance sheet of the Banco Central del Ecuador for selected years. Foreign currency obligations and assets are evaluated at the intervention exchange rate, rather than at the official exchange rate. The table reveals interesting trends. First, "net unclassified assets" (a balancing item) account for over 90 percent of total assets. This line item reflects any past losses as well as the revaluation of large external debt carried in the books of the Central Bank. It is also an indication of possible future losses: net unclassified assets (negative net worth) do not generate income. 75. The main counterpart of the net unclassified assets is of course the large external debt carried in the books of the Central Bank, amounting to about 40 percent of GDP. By contrast, net international reserves amounted, at end-1989 to little over Z percent of GDP. The large external indebtedness is composed of: (i) rescheduled public debt (about half of total); (ii) the "sucretized" private debt (amounting to about one billion dollars, or 20 percent of total); (iii) and other obligations, taken over by the Cen ral Bank either in its role of financial intermediary, or for other reasons.- As will be discussed below, the Central Bank has very limited resources available for the servicing of this debt--short of accumulation of external arrears-- which has thus become a major source of involuntary financing for the external deficit. 76. Table 3.1 also shows a dramatic decline in outstanding credit to the financial and private sectors, which has decreased from over 14 percent of GDP at end-1986, to less than 3 at mid-1990. This important shift is the reflection of a decreased financial intermediation role performed by the Central Bank in the past few years, and of the strict and determined stance of monetary policy since 1988, in the pursuit of economic stabilization. Net credit to the nonfinancial public sector has also slightly decreased in the course of the last two years, as a consequence of the improved fiscal performance. 77. The monetary base (defined as currency in circulation plus uaremunerated monetary reserves of financial institutions) has considerably fallen in the course of the past two years, from a peak of 7.5 percent of GDP at end-1987 to 5.1 percent of GDP in mid-1990. The fall reflects the changes in the composition of financial assets of the public, brought about by higher inflation (which increases the opportunity cost of holding unremunerated demand deposits) and the beginning of a process of financial deepening, with the emergence of a number of new attractive financial instruments (polizas de acumulaci6n, etc.). 3/ It should be noted that large discrepancies exist between balance sheet data in national currency for external debt and external debt statistics in foreign currency. In addition, neither set of statistics deal adequately with the issue of the interest arrears that have been incurred since 1987. - 33 - Tabl- 3.1: SANCO CENTRAL DEL ECUADOR - BALANCE SHEET 1/ (Percent of GDP) Dec 1988 Dec 1987 Dec 1988 Jun 1989 Dec 1989 Jun 1990 A. Net Intornational Reserves -0.80 -1.90 -2.80 -1.38 2.83 2.11 B. Domestic Credit 15.61 18.88 9.28 7.56 5.91 4.94 Credit to the Public Sector 1.68 3.42 3.82 2.78 2.09 1.67 Credit to the Finencial System 12.01 9.34 4.84 8.78 8.04 2.81 Credit to the Private Sector 2.07 1.12 0.62 1.00 0.79 0.66 C. Other Not Uncfassified Assets 41.16 60.38 6e.18 48.77 40.27 44.80 D. Medium and l.t. External Debt 86.72 41.87 44.44 89.28 89.87 37.78 E. Non-monetary Liabilities 12.36 13.09 11.71 9.88 9.05 8.49 Deposits of Public Sector 8.64 7.74 6.92 8.79 8.81 8.88 Deposits of Financial Sector 0.98 1.21 0.90 1.00 0.70 0.81 Bonos do Estabilizacl6n 0.a8 0.23 0.46 0.93 0.89 0.78 Liabilities to Priv. Sector 2.38 8.92 8.44 1.16 0.86 0.62 F. Monetary Base 6.88 7.49 6.99 6.85 5.79 5.10 Currency In Circulation 4.31 4.47 4.27 8.88 8.48 8.15 Reserves 2.65 8.02 2.72 2.52 2.80 1.95 Total Assets = Liabilities 56.96 62.46 88.14 55.00 54.81 61.85 Source; Banco Central del Ecuador; World Bank 1/ Evaluated at the intervention exchange rate of the corresponding date. Nominal Quasi-Fiscal Deficit in 1989 and 1990 78. The structure of the balance sheet is reflected on the income of the Central Bank. Table 3.2 shows estimates of the net income accounts for 1989 and a projection for 1990, based on the monetary program of the Central Bank for the year, as well as on other assumptions on macroeconomic variables (inflation, exchange and interest rates) as contained in the Government's economic program. The quasi-fiscal deficit of the Central Bank amounted in 1989 to S/.71.6 billion, or 1.4 percent of GDP. By comparison, the deficit of the consolidated nonfinancial public sector during the same period was 2.2 percent of GDP. For 1990, it is estimated that (based on the official assumptions of the Government's economic program) the deficit would amount to SI.163.7 billion, or 2.2 percent of GDP. Again, the targeted deficit for the consolidated nonfinancial public sector for the same period is 1.8 percent of GDP. 79. The large quasi-fiscal deficits for both years are accounted for by large losses on external operations and by high operating costs that are not even matched by net income on domestic operations. Large losses (at least on paper) are instead registered on account of external operations of the BCE. Interest on external reserves provided 0.2 percent of GDP in 1989, and is expected to provide 0.4 percent of GDP in 1990. Supplementing these revenues are the receipts from the exchange transaction tax, which was particularly - 34 - high in 1989, and from the exchange risk commission on the sucretized debt. These two sources provided 1 percent of GDP in 1989 and are expected to provide 0.8 percent of GDP in 1990. Against these revenues, however, stands the large interest bill due on the medium- and long-term debt in the books of the Central Bank, which is estimated at 2.8 and 3.1 percent, respectively. Thus external operations provided an extremely negative influence on the income of the Central Bank. Toblo 8.2: BANCO CENTRAL DEL ECUADOR - qUASI-FISCAL RESULT 1989 1990 Interest Interest Average Average Million Percent of Average Average Million Percent of Amount Int. rate Sucreo GDP Amount Int. rote Sucres GDP (A) Domestic Result Interest-bearing Avseta 819,741 14.9 47,657 0.91 868,271 17.8 65,489 0.88 Cret to Privete Sector 201,644 15.8 80,795 0.59 247,206 21.8 52,607 0.71 (olw Sucretization) 43,996 21.5 9,459 0.19 28,257 a2.0 7,442 0.10 Credit to Public Sector 116,198 14.8 16,761 0.82 121,064 10.6 12,682 0.17 Intereet-bearing Liobilities 61,276 29.0 17,760 Stabilization Bonds 44,028 35.7 16,729 0.80 74,001 40.0 29,6e0 0.40 Other Obligations 17,248 11.6 2,031 Net Interest Income 29,797 0.67 86,888 0.48 (8) External Result -80,982 -1.64 -186,286 -1.86 Interest on Intern. Reserves 11,448 0.22 29,647 0.40 Interest Due on External Debt of ECE 144,481 2.76 227,788 8.05 Net External Interest -182,9"8 -2.54 -197,985 -2.86 Other Income 62,061 0.99 69,700 0.80 Transaction Tax 88,879 0.64 85,000 0.47 Exchange Risk Sucretization 16,672 0.86 24,700 0.88 (C) Operating Costs and Other -20,434 -0.89 -25,420 -0.84 Operating Costs 80,666 0.68 48,420 0.68 Other Income 10,280 0.20 18,000 0.P4 (D) Quasi-fiecal Result (A+BC) -71,570 -1.87 -168,656 -2.19 Source: 8cnco Central Dal Ecuador, World Bank. 80. Interest received on domestic credit amounts to about 0.9 percent of GDP both in 1989 and 1990. In ex-post terms, this implies an average interest rate of 14.7 percent in 1989 and 17.8 percent in 1990. Credit to the private sector (direct and through the financial system) bore a somewhat higher interest rate (16 and 21.3 percent, respectively), which was nonetheless substantially negative in real terms in both years. On the liability side, the BCE paid out approximately S/17.7 billion in 1989 and is projected to pay - 35 - 29.6 billion in 1990, chiefly on account of the service of stabilization bonds. Net interest income is thus positive in both years, for 0.6 and 0.5 percent of GDP, respectively. 81. Operating costs net of other income (from sale of books, commissions, fees, etc.) are estimated at almost 0.4 percent of GDP in both years, adding sharply to the financing requirements of the BCE. The sum of these elements results in the figures discussed above. These figures differ from the accounts of the BCE (which are seldom published), as those reflect only external interest payments actually made, rather than due, thps incorporeting a financing item (arrears) above, rather than below the line.- Quasi-fiscal Result: Decomposition of Subsidies 82. Table 3.3 provides, for 1989, a decomposition of the quasi-fiscal result into the subsidy and nonsubsidy components. The domestic result from Table 3.2 is decomposed into a "potential net income" and the net subsidy from the nonfinancial public sector and the private/financial sector. Potential income is defined as the income that would result from charging market interest rated on all domestic assets, and remunerating all domestic non- monetary liabilities at the same rates. The subsidy from each broad economic agent (NFPS and private/financial sector) is then calculated as the sum of the interest differential on outstanding assets and liabilities. 83. The table reveals interesting facts. The potential income from domestic operations would be negative in absence of subsidies: as nonmonetary liabilities towards the nonfinancial public sector are substantially greater than assets, the losses that would accrue on this account from remunerating NFPS deposits at market rates would, together with the service burden provided by stabilization bonds, far outweigh the positive gains from credit to the private/financial sector. In 1989, these factors would have resglted in a deficit of 0.3 percent of GDP on account of domestic operations.- The fact that public sector deposits are not remunerated, however, and that there are ample nonremunerated liabilities of the private/financial sector (in addition to required reserves on bank deposits), resulted in the Central Bank receiving a subsidy of 0.8 percent of GDP (0.6 percent from the nonfinancial public sector, and 0.2 percent from the privatelfinancial sectors). As a consequence, the domestic result was positive (0.5 percent of GDP) in 1989. The latter fact is particularly surprising, given the common wisdom that sees the Central Bank as a provider of subsidies to the private sector. It must be remembered, however, that 1989 represented an exceptional year in that it saw the net credit to the private sector decline to its lowest level (Table 3.1). Similar calculations for earlier years would have probably shown a rather different picture, as credit was large, and interest rates extremely subsidized. 41 No Oregalias* were handed out in either 1989 or 1990, in contrast to previous years, when nonreimbursable grants had been used at times liberally. 51 In Table 3.3 the interest received on account of sucretization bonds is included in part B, external result, rather than part A, as in Table 3.2. - 36 - Table 8.8: DECOMPOSITION OF THE BCE QUASI-FISCAL DEFICIT BY SUBSIDY, 1989 Sucres Percent of Million GDP A. Domestic Component Potential Income from Net Credit to Public Sector -19346 -0.87 Net Credit to Financial and Private Sectors 17797 0.34 Stabilization Bonds -16729 -0.80 Total -17277 -0.88 Net Subsidy to 1/ Nonfinancial Public Sector -2808 -0.65 Financial and Private Sectors -10879 -0.21 Equals: Domestic Result 22406 0.48 B. External Result Subsidy to Public Sector 1/: 82178 1.67 Net Interest on External Reserves 11448 0.22 Interest on Public Debt 98625 1.79 Subsidy to Private Sector 1/: -10708 -0.20 Interest Due on Sucretized Debt 50607 0.97 Payments from Private Sector 61510 1.17 Interest on Sucretized Bonds 9469 0.18 Exchange Risk Commission 18872 0.a8 Transaction Surtax 88879 0.84 Total External Result -71478 -1.86 C. Operating Costs and Other Operating Costs -80865 -0.58 Other Revenues 10281 0.20 QUASI-FISCAL RESULT -69508 -1.88 Source: World Bank. 1/ Negativ, sign means tax on recipient. 84. Part B of the table also shows that a large subsidy is provided to the nonfinancial public sector on account of external interest obligations. While the Central Bank earned 0.2 percent on its external reserves, it had (accrued) payments on public debt amounting to 1.8 percent of GDP, for which the Treasury provided no resources. In addition, the revenues accruing to the Central Bank from the service of the sucretization bonds (the interest on the bonds and the exchange risk commission) fell short of the (due) interest, implying a subsidy to the private sector of about 0.5 percent of GDP. Offsetting this, however, was a special foreign exchange transaction tax, - 37 - which resulted in the private sector contributing a net subsidy of 0.2 percent to the Central Bank on account of external operations.- 85. This decomposition thus shows that the quasi-fiscal deficit of the Central Bank of 1.4 percent of GDP for 1989 was the result of numerous and contradictory cross-subsidies: the nonfinancial public sector was discharged of the obligation of servicing an important portion of the external debt, but at the same time was compelled to maintain large and unremunerated deposits with the Central Bank. The private sector received subsidies on account of the sucretization of the debt, and of less-than-market rate credit lines, but was also compelled to maintain unremunerated deposits and pay a special transaction tax. The end result is a large loss for the Central Bank, whose monetary consequences could only be avoided through the accumulation of arrears on external interest payment. 86. In addition, it should be noted that the coexistence of positive and negative subsidies implies that the relationships between the Central Bank and the private/financial sector becomes erratic and arbitrary, as the agents that receive positive subsidies are not necessarily the same who are compelled to maintain unremunerated deposits. This naturUlly increases the perception of the system as unfair and lacking in transparency. C. Recommeendations 87. The preceding discussion shows that the quasi-fiscal deficits represent a sizable additional burden on the nation's savings. The Central Bank of Ecuador, beyond its monetary policy functions, has had, and continues to have, an important fiscal role, and is at the center of a complex maze of subsidies to and from the nonfinancial public sector and the private/financial sector. Estimates for 1989 and projections for 1990 show that the deficits were substantial, of almost the same magnitude as the deficits of the consolidated public sector. Their macroeconomic consequences have been lessened by the fact that part of the payments on external debt have not been made; nonetheless, these figures reveal the existence of a serious problem. 88. In principle, the Central Bank of Ecuador need not run any deficit, if its only function were that of regulating monetary aggregates. Reducing the deficits will thus require that the function that it is currently performing that are extraneous to its role be discontinued. There is no reason why the Central Bank should continue to play a predominant, or even marked, role in financial intermediation. Economic efficiency is enhanced if financial resources can flow towards the investments with better returns, rather than being administratively directed towards arbitrarily determined priority subsectors. In the context of the progressive liberalization of interest rates and the development of more modern financial institutions in Ecuador in the recent years, it appears appropriate that the Central Bank 6/ In practice, virtually no interest wa- paid out by the Central Bank on the sucretized debt, so that, in cash terms, the subsidy from the private/financial sector was considerably larger. - 38 - proceed to eliminate its direct intermediation role. This would imply that directed credit lines to the private sector should be discontinued, and that the financial surplus generated by other public institutions would find its uses through the intermediation of the financial markets. Alternatively deposits of public institutions would be remunerated, if it were necessary to use them as a means of monetary policy. 89. The implementation of these recommendations might lead to greater Central Bank deficits; but these should be recognized as part of the overall public sector deficit. The Central Government should provide for a sufficiently large operational surplus in the accounts of the nonfinancial public sector, so as to compensate for these losses. In addition, the public external debt should also be transferred to the Central Government, or sufficient resources should be provided for its servicing to the Central Bank. - 39 - IV. GOVER T REVENUESs ISSUES FOR FURTHER REFORI Introduction 90. As discussed in Chapter II, a large portion of Government revenues has been provided by the rents and profits from the exploitation of oil (Figure 4.1). During the period 1983-89, for instance, oil revenues ranged from a maximum of 51 percent of total revenues (in 1985) to a minimum of 31 percent (in 1987). Dependence on oil revenues, now reduced somewhat, raises a number of issues, both oui maCLoeconomic and efficiency grounds. During the oil boom of the late seventies and early eighties, Government spending tended to rise in parallel with availability of oil revenues. As discussed in Chapter II, this resulted in the use of a capital revenue for financing consumption, reducing the country's long-run productive potential and its sustainable level of consumption. In addition, heavy dependence on oil revenues poses particular problems for macroeconomic management. Fluctuation in oil prices (and in output levels) are the main causes of the erratic variations in the oil revenue share and thus total revenues. An unfavorable external shock, such as the fall in oil prices of 1986, is immediately translated into an ex-ante fiscal disequilibrium, and gives rise to an internal transfer problem. To bring absorption in line with income, the Government must take restrictive actions that are politically difficult to implement. 91. As the country enters the 1990s, it must face the prospect of declining production levels by the middle of the decade, even if strong investment efforts in the oil sector are pursued. While the recent events in the Persian Gulf demonstrate that oil prices are extremely difficult (if not impossible) to forecast, under not too conservative assumptions it can be estimated that in the second part of the decade oil revenues would decline steadily to about 7 percent of GDP and continue to decline thereafter. This prospective raises further questions on both the ability to maintain stable macroeconomic conditions and to move the public sector toward the position of revenue surplus needed to resume sustained growth. In particular, a considerable burden is placed on the non-oil tax system, which will need to increase its revenues to about a level of around 14-15 percent of GDP, in order to finance expenditures 92. An Oil Stabilization Fund. The current circumstances in the Persian Gulf is resulting in an unexpected oil windfall for Ecuador. This situation is extremely challenging, although it offers an opportunity for long-lasting reform. Ecuador should now reject the temptation of inward-oriented model of the mid-seventies-early eighties to use the windfall oil revenues to expand public consumption, thereby stimulating growth trasitorily at best. As discussed in Chapter I, it is in the interest of the country that this course be rejected in favor of a strategy that: (i) perseveres in the removal of incentives against export-oriented activities, and in the process of fiscal adjustment; (ii) minimizes the appreciation of the real exchange rate; (iii) maximizes the use of the windfall to improve the country's future growth prospects. While several policy combinations might be used to attain these objectives, a better one is the creation of an Oil Stabilization Fund. - 39a - Figure 4.1 - Composition of Revenues (percent of GOP) 30 25 20 1 I=: 15 0 1983 1984 1985 1986 1987 1988 1989 Tax Revenue E Non-tax Revenue El] Oil Revenue - 40 - 93. Economic logic dictates that a temporary increase in disposable income should be largely translated into savings rather than consumption. Under present circumstance, the most prudent use of the windfall would thus appear to be the completion of the stabilization task, and for a lasting solution to the debt overhang problem. The establishment of the Stabilization Fund in late 1990 has prevented a translation of higher revenues into expenditures. It is important that the Fund be retained if prices remain high, and that its proceeds be used for a lasting improvement in the country's external creditworthiness. A. Oil Tax Revenues 94, Besides the issues related to the need for an Oil Stabilization Fund, several problems, again of a fiscal and efficiency nature, relate to oil revenues. These concern (i) the arrangements governing the distribution of oil export revenues (discussed in greater detail in Chapter VII); and (ii) the rules governing pricing of domestic oil products. 95. Ecuador in 1989 produced about 283,000 barrels of crude oil R day. Of total 1989 production, 61.6 percent was exported as crude oil. 33.7 percent went for domestic consumption, and the rest was exported in the form of fuel. Table 4.1: 1989 OIL PRODUCTION BY MAIN PRODUCING CENTERS Producing Centers Partial Total Percentage Percentage …_________________________________________________________________ PETROECUADOR-Texaco Consortium 73.33 CEPE 45.83 Texaco 27.50 Northeastern PETROECUADOR 24.33 Up to the limit 15.93 Above the limit 8.40 PETROECUADOR-City Association 2.00 CEPE 0.55 City 1.45 PETROECUADOR Santa Elena Peninsula 0.33 Total 100.00 …______________________________________________________. Source: Hydrocarbon Agency. - 41 - 96. The PETROSCUADOR-Texaco consortium was until recently the largest revenue producer,- followed by the PETROECUADOR fields in the Northeast. The PETROECUADOR-City association and the PETROECUADOR fields in the Santa Elena peninsula account for minor shares of the total (see Table 4.1). 97. There are two sources of revenue from oil production: exports and domestic sales. Petroleum revenues, in sucre terms, depend on the volume of oil production, the levels of exports and domestic consumption, international oil prices, domestic consumption prices, and the sucre/dollar exchange rate. From oil exports the Ecuadoran public sector receives all the sales proceeds, minus the share accruing to the oil companies. As the sharing arrangements are governed by different rules, the distribution of revenues varies according to whether the revenues are considered part of royalties or of taxes on companies, whether they are generated by PETROECUADOR or Texaco within the consortium and PETROECUADOR or City within the association. In addition, there are different regulations governing the distribution of revenues from the PETROECUADOR fields in the Northeast depending on whether production is below or above a specified level. Table 4.2: DOMESTIC AND BORDER PRICES OF OIL PRODUCTS Dec 87 Jun 88 Dec 88 Jun 89 Dec 89 Jun 90 Sep 90 Gasoline, Regular 65.4 62.2 75.6 41.9 61.9 48.7 87.9 assoline, Premium 74.4 68.4 87.0 50.9 76.8 59.9 48.4 Fuel Oil 40.2 34.8 43.8 30.0 e3.6 97.4 61.6 Diesel 48.2 48.0 66.0 47.2 59.5 83.0 87.4 Kerosene 22.0 21.5 12.1 9.2 8.2 10.2 4.2 Turbo Fuel 18.2 18.0 69.7 44.9 61.2 75.7 82.2 LPG 14.0 11.6 10.5 6.5 11.2 10.5 7.8 Average 47.5 41.1 68.0 6.56 58.4 68.0 84.6 Legend: Ratios of Ecuadoran domestic oil prices (converted at the intervention rate) to comparable border prices (US West coast, adjusted for distribution and transportation costs). Source: Platte Oilgram; Ecuadoran Government; World Bank Steff calculations 98. The main determinants of the revenues from its sale of refined oil products to domestic consumers is the domestic price in sucres. As in several other oil exporting countries, in the past this price has been heavily subsidized, distorting the allocation of resources and reducing Government revenues. It is calculated that the subsidy reached the peak of 7 percent of GDP in 1980. More recently, and with great vigor under the present Administration, domestic prices moved towards opportunity cost levels (Table 4.2), so that the implicit subsidy has been considerably reduced and fiscal revenues have correspondingly risen. However, the recent increase in international prices have once again resulted in the opening of a wide gap between domestic and international prices, and in the loss of considerable fiscal revenues. It is calculated that, if domestic prices were to be raised 7I PETROECUADOR took over all operations of the consortium in July 1990. - 42 - to about three-quarters of current international levels, the reduction in subsidies to oil consumption would be such as to close the fiscal gaps and further greater macroeconomic stability. 99. On the whole--after classifying oil revenues into payments to productive factors, fiscal revenues and implicit subsidies to Ecuadoran consumers--in 1989, 29 percent of the total went to the productive factors as costs, f.rms' profits, and labor remuneration; 61 percent went to the Government as fiscal revenues; and the rest, around 10 percent, went to consumers in the form of implicit subsidies on refined oil products for domestic consumption (Table 4.3). Table 4.3: DISRI0UTION OF 1989 OIL REVEIMS PRIOR TO THE NEW PEIROEWAOt LAW Millions Percentage Percentage of Sucrer of Total of GDP Production Valued at 646,464.00 100.0 17.0 International Prices 1. CEPE, Firms, & Factors 167,617.21 29.0 4.9 2. Fiscal Revenues 395,612.22 61.2 10.4 Royalty Revenues 104,927.42 18.2 2.8 Income Taxes 171,591.80 26.6 4.5 Other Fiscal Revenues 119,093.00 16.4 8.1 Total of Fiscal Revenues 588,229.43 90.2 16.4 & Firms 8. ImplicIt Consumer Subs IdIes 68,284.57 9.6 1.7 Source: World Bank estimates. Assumptions: Price of cruds oil: 18 U.S. dollars; exchange rate: 478.60 sucres per U.S. dollar; production: 105 million barrels. 100. Future oil revenues will depend on the production level and international and domestic prices. Current scenarios point to a decrease in production starting from 1994195, at a rate of about 5 percent per year. This decrease would be enough to generate rapidly decreasing revenues in the second half of the decade even with international oil prices increasing in real terms. The decrease in revenues will become more serious if domestic petroleum product prices were again allowed to lag in real terms, encouraging domestic consumption, preventing exports, and reducing fiscal revenues. It is thus of paramount importance that further progress be made on ensuring that domestic oil prices are kept close tointernational oil prices. - 43 - D. The Non-Oil Tax System Background 101. The Ecuadoran non-oil tax system suffered a progressive deterioration during the late 19709 and 1980s. This phenomenon is commonly observed in countries heavily dependent on one or few commodity exports with trade monopolized by the Government. Capital revenues from the exploitation of natural resources are diverted to the financing of public and private consumption; the pressure then arises to lower tax rates or not enforce the rules of the formal tax system. Ecuador is no exception. As seen, while Government oil revenues rose as a share of GDP from the early 19708 into the mid-1980s, Government non-oil revenues declined from about 11 percent of GDP during the 1971-73 period to 9.4 percent over the 1985-87 period and 9 percent in 1988. Although some of the decline in the share of non-oil taxes in GDP is attributable to the effects of rising oil production on the growth of GDP, non-oil tax revenues also fell as a percentage of non-oil GDP (from 11.4 percent in the 1971-73 period to 10.5 percent in 1987). Given the increasing fiscal disequilibria, and as part of the Government's structural adjustment efforts, tax reform was put on the agenda in the past two years. Its main features and the areas open for further action are discussed in the next few sections. Composition of Tax Revenues 102. Prior to the latest reform, the tax system showed several features common to Latin American countries. A proliferation of tax exemptions granted for a variety of purposes had led to the simultaneous loss of generality of the 'modern' taxes, and to the need to impose very high marginal tax rates, particularly in the income tax. The practice of earmarking has had its counterpart in a myriad of small, low-yield taxes, levied at arbitrary rates on a number of economic activities unrelated to the beneficiary. 103. Over the period 1970-89, the composition of tax revenues has shown sharp changes (Figure 4.2). First and foremost, taxation of external trade, which accounted for half of non-oil revenues in the early 1970s, dropped to less than a third in the late 1980s. This is partly the result of progressively less restrictive tariff policies, but is also due to the proliferation of tariff exemptions under various development laws, and to increasingly lax administration. These two factors may also help explain the undistinguished performance of the income tax during the mid-1980s. The administrative measures taken in late 1988 (Phase 1 of the tax reform) helped increase the yield from this tax by almost 50 percent in 1989. Of increasing importance have been the VAT (formerly tax on mercantile transactions and selective excises on tobacco, alcohol, etc.), which together accounted for almost 44 percent of total non-oil revenues in 1989. Evidence of the simplification of the system is provided by the low and declining weight of "other" taxes, that by 1989 contributed a mere 3 percent of total non-oil revenues. - 43a - Figure 4.2-Composition of Non-Oil Taxes (percent of GODP) 10 -t _ Intn'l trade C::J Income tax 12~~~~~~~~~ I jiiii I!A 4 2- 1970-741975-791980-84 1985 1988 1987 1988 1989 IntnIl trade [2incomie tax L]A'T MExcises F-MII other taxes - 44 - Tax Reform, 1988-90 104. Reform of the tax system has been high on the agenda of the current Administration. Immediately after taking office, it approved a series of administrative measures aimed at an overhaul of the tax administration, emphasizing third-party collection and abolition of loopholes. More importantly, after a broad process of consultation, a comprehensive reform package was approved by Congress in December 1989, bringing changes to the income tax statutes, to the VAT and to excise taxation, and simplifying the system both by abolishing a large number of low-yield, inefficient taxes, and reducing the scope of earmarking in the non-oil tax system. The overall aim of the reform was to establish a domestic taxation system roughly equally based on the income tax and the VAT, with the former mostly collected from corporations and large companies. As the reform was designed to be broadly revenue neutral, a further phase is envisaged, during which the VAT base would be broadened, the earmarking of revenues would be substantially scaled down, taxation powers of local governments enhanced, and the taxation of public enterprises better defined. Income Tax Reform 105. Income tax collections almost tripled in real terms from 1970 to 1981 but have since declined somewhat, dropping back to 1970 levels as a share of GDP by 1988. The poor performance reflected (as noted) the effects of exemptions, the complexity of the system, which left large loopholes for tax avoidance and evasion, and poor administration. In addition, the tax was characterized by multiple rate structures, punitive marginal rates, and an irrational treatment of different types of income. The objectives of the 1989 reform were to reduce its complexity to the taxpayer; make it more equitable; reduce average and marginal tax rates; promote a less leveraged and sounder financial structure for firms; reduce the costs of tax collection to both taxpayers and the Government; facilitate administrative control; and reduce evasion. These aims were pursued through changes in the law that led to the unification of previously different tax rates on different sources of income; the elimination of personal tax deductions and corporate tax exemptions; adjustments for inflation; and the establishment of special regimes and presumptive income. 106. Unification. This aspect of the reform involved: (i) replacing with a single tax a number of separate taxes on personal income that differed according to the source of the income; and (ii) eliminating earmarked income tax surcharges. Under the old regime, four different taxes were levied on personal income8; their combined effect was to produce minimum marginal tax 8/ These were the progressive tax, applied to all income except earnings from certain financial instruments at rates varying from 8 percent to 40 percent; the "Unicon (sole) tax, at a rate of 8 percent to the yields on the exempted financial instruments; the proportional tax on earnings from labor and capital, with rates from 6 to 18 percent; and surcharges of 11 percent and 8 percent, applied to the sum of the progressive and proportional taxes, and (continued...) - 45 - rates varying between 8 percent and 30.94 percent and maximum rates varying between 8 percent and 69.02 percent, with the variations entirely dependent on the source of the income (see Table 4.3). The tax reform, instead, provides for only one personal income tax with rates from 10 percent to 25 percent. Those earning less than SI. 2 million a year (about US$2,800) will not be subject to tax. Table 4.4: MARGINAL TAX RATES UNDER THE OLD AND THE NEW SYSTEMS Old System NW- System Marginal Tax Rate Marginal Tax Rate Minimum Maximum Minimum Maximum Interest 8X 8X 10% 25% lfw J& Salories lOX 26X 8 tl-ll +O%) 9.62% (40.6X%) (1+11%4816) 64.74% Earnings of Labor 10% 26X cum Capital (81.+6%) (1.11X6%) 1.66% (40%6.8) (1.1116%) 64.74% Corporat 2SX 25X Undistributed ProfIts 20 (1'16 +OX) 24.6% 24.6% CorDorate Distributed 26X 26X Profits (100l) (8%+18X) (1.1X181) 30.94% (40%118%) (1.11%-8%) e9.02% Non-Corporate Profits 26% 26S Wh18X) (1+11%-8 ao 0.94% (40X 18%) (1-11X-8%) 69.02% Non-Residents 36e 38x 401(1+151.8%) 49.2 49.2 Source: Non-Oil Tax Rovenues and Tax Reform In Ecuador, 0. Schenone, January 1990. 107. In addition, no integration existed between the corporate and personal income taxes, a well known source of distortions in the financing of investment. Business income was subject to different treatments depending on 8/(... continued) earmarked for universities, certain schools, and for the Transit Commission of Guayas and the Rehabilitation Center of Manabi. - 46 - several factors.9 The tax reform provides instead for a form of integration of the corporate and personal income taxes. All domestic company corporate and noncorporate profits, whether distributed or undistributed, will be taxed at the flat rate of 25 percent, and shafgholders will not pay any additional tax on distributed profits (Table 4.4).- Foreign companies will also be taxed at 25 percent; this tax can be claimed as a credit by foreign residents receiving dividends, who are subject to a tax rate of 36 percent. 108. The elimination of the wide dispersion in tax rates on different forms of income will reduce opportunities and incentives for tax evasion and avoidance and eliminate the incentive to allocate resources in such a way as to reduce taxes rather than to the most economically productive or efficient uses. The reduction in the range of rates from 8 to 69 percent to a range of between 10 and 25 percent will, by itself, reduce revenues. However, reduced evasion and avoidance might to some extent counteract this. 109. Adiustment for Inflation. In addition, the reform of corporate taxation introduces an important element of economic rationality in the computation of corporate income by allowing for the effects of inflation on historic-cost accounting profits. This would be accomplished (as is the practice in several other countries) by having corporations adjust for the full rate of inflation the book values of non-financial assets and liabilities, and treat these adjustments to assets and liabilities as profits and losses, respectively. Net profits will be registered only to the extent that asset values are increased by inflation more than the value of liabilities. These adjustments will eliminate paper losses or profits resulting from the one-sided correction of liability or asset values for inflation, giving rise, in turn, to inadequate or excessive taxation. 110. This reform will remove an incentive to overleverage investment expenditures, particularly when inflation is high. This is because, as a result of the adjustment for inflation, only the real part of interest payments on debt will be deductible as an expense, rather than the full nominal amount under the old system. Its revenue effects will depend on the 9/ Non-incorporated business income. The individual partners in an unincorporated business were taxed under the personal income tax schedule, as described above. For corporate income, retained profits were subject to a tax of 20 percent, plus surcharges of 15 percent and 8 percent earmarked in the same way as the personal income tax surcharges. Income derived frot financial instruments issued by recognized institutions was taxed at 8 percent, as under the personal income tax. Profits distributed to shareholders were taxed at 18 percent. For foreign companies, total profits were taxed at 40 percent, plus the 8 percent and 15 percent surcharges. 10/ The differential treatment of interest income and payments, and the lack of application of the inflation adjustment at the individual level (a measure extremely difficult to administer), imply that the integration between corporate and personal income taxes will remain imperfect. - 47 - degree of leverage of the corporations. Given the past structure of corporate liabilities, influenced by the direct, low-cost credit from public institutions, the increase in taxable business income resulting from the removal of the exemptions is estimated by the Ministry of Finance at about SI. 11 billion for 1989. Taxes would be increased by 25 percent of this, or by SI. 2.75 billion. 111. Elimination of personal income tax deductions and business tax exemptions. Deductions from personal income for number of dependents and rent and mortgage payments were eliminated under the reform. More importantly, several business income tax exemptions were abolished that had been granted over the years to a vast array of economic sectors that at one point or another had been considered "strategic" (although exempttons already granted will be gradually phased out over the next four years).- However, firms in the Tourism and Forestry industries will be able to reduce their taxable income by the amount of their investments up to a maximum of 30 percent of the previous year's taxable income, and the Government is contemplating granting further tax subsidies to the mining sector and export-oriented activities. The elimination of exemptions removes a source of economic misallocation of investible funds induced by artificial tax incentives. The rationale for continued favored treatment for forestry, tourism, and the prospective ones for mining and exports, is unclear. The VAT (Tax on Mercantile Transactions) 112. The tax on mercantile transactions (TMT) has functioned over the years as a value-added tax. Its revenues fluctuated between 1.2 percent and 1.6 percent of GDP during the 1971-85 period. In 1986, the rate of the tax was raised from 6 percent to 10 percent, raising revenues by a little over 1 percent of GDP. The TMT superseded the income tax as the prime revenue source from 1985 on. Nonetheless, it yields little more than half of its theoretical revenue, based on the rate of the tax and the estimated taxable value of sales, pointing to the presence of substantial evasion, as in other countries that have adopted the VAT. 113. The reform of the tax, besides changing its name to Value-Added Tax, consists of a mild broadening of the base to include several currently exempted services, such as: laundry; telecommunications; car repair; packing and storage; hotels, restaurants, discotheques and casinos; airline tickets; photo development; insurance; and the private international shipping of letters and documents. The reform also provided for an abolition of the exemptions under the development laws (which took effect immediately, rather i1/ As elsewhere, the proliferation of tax incentives for economic development led to a progressive narrowing of the tax base, as can be deduced from the number of laws exempting firms from taxation: Industrial Development Law; Automobile Development Law; Artcraft Development Law; Ocean Shipping Development Law; Tourism Development Law; Mining Development Law; Fishing Development Law, Forestry Development Law; and Agriculture Development Law. - 48 - than being spread over time, as in the case of the income tax reform). The reformed VAT in Ecuador will be of the consumption type, i.e., capital outlays by firms can be deducted from the tax base as they are made, without the need to depreciate them over time. 114. VAT Exemptions. The exemption of a commodity group from the VAT, without the submission of a VAT declaration implies not only that no VAT is included in the price of the commodity involved but that no credit can be claimed for the VAT embodied in the prices of the inputs required to produce the commodity. Thus, when the exempted commodity is sold to a final consumer, only the value-added (not the total value) is tax free; nonetheless, this entails a loss of tax revenue to the Government. However, when the exempted commodity is sold as an input into the production of a non-exempt commodity or sector, the buyer cannot claim a fiscal credit because no VAT was included in the price of the input. Thus, the value of the output of the non-exempt sector, including both its own value-added and the value of the input, will be subject to the VAT. Ir. this second case, the apparent VAT "exemptions" are not, in fact, true exemptions. The VAT is paid by the producer at the next stage and there is no loss of VAT revenue to the Government. 115. Under the tax reform, the following commodity groups remain exempted: meats, milk, bread, sugar, salt, butter, canned fish and seafood, medicines, seeds, animal feed, fertilizers, herbicides and insecticides, books, artcraft, and certain imports. In addition, the majority of services will also continue to remain exempt. To the extent that these are used as inputs into non-exempt forms of production--which may be the case to some extent with seeds, animal feed, fertilizers, herbicides and insecticides-- they are not truly exempt. In the remaining cases, however, it is likely that, for the most part, not only will potential VAT revenue be lost but the relative prices of these goods will be artificially reduced, resulting in excess demand and the allocation of an excessive volume of resources into their production. The virtues of the VAT, notably its economic neutrality and administrative simplicity, are compromised by exemptions. Since some of the exemptions are not true exemptions and those that are true exemptions both distort the allocation of resources and entail foregone revenues, it is recommended that all exemptions be eliminated. 116. A distinction should be made between exempting a commodity or sector from the VAT and zero-rating it. The latter involves incorporating the commodity into the VAT system but applying a zero-rate VAT to it. Since the commodity is within the VAT system, its inputs carry a VAT credit, i.e., they are supplied tax-free. Thus the entire value of the product, including that of the inputs, is tax-free. The oniy zero-rated activity in Ecuador will be exports, which will appropriately be entirely VAT-free. This is the standard treatment of exports, which provides them with an effectively free trade environment for inputs. 117. The VAT Rate. Ecuador's 10 percent VAT rate is relatively low compared to rates in most other countries (see Annex, Table 43); an increase would ake it to an excessive level. In addition, two factors suggest the need .ncreased flexibility in setting the rate: the foreseen reduction of - 49 - oil revenues in the second half of the 1990s, and the extreme variability of these measures as a result of price variability. 118. The 1986 increase in the VAT rate from 6 to 10 percent (i.e., by 67 percent) as matched by a proportional increase in revenues from the tax. However, raising the rate increases the incentive to evade the tax, so a somewhat lower proportional response of collections to the change in the rate is likely. A conservative estimate of the effects of an increase in the VAT rate from 10 to 16 percent (i.e., by 60 percent) would be a 30 to 40 percent increase in revenues, equal to about 0.7 percent of GDP. The Specific Consumption Tax (TSC) 119. The tax on specific consumption goods replaces four separate excise taxes. Revenue, which had been less than 0.5 percent of GDP, jumped in 1978, when taxes were imposed on domestically produced cigarettes, and reached 1.1 percent of GDP in 1989. 120. This tax applies to the traditional "vice goods' (cigarettes, beer, alcohol and alcoholic beverages), with the unusual addition of soft drinks and mineral water. The tax replaces previously earmarked taxes on the same goods at the same rates. In addition, over 100 minor Haxes, many of them earmarked, which yielded negligible revenues were abolished -. The following rates apply to both local and imported goods: cigarettes - from 10 percent to 260 percent, depending on the quality of the tobacco, the filter and the packaging; beer - 85 percent; soft drinks and mineral waters - 20 percent; and alcohol and alcoholic beverages - 100 percent. 121. Beer and cigarettes have yielded about 80 percent of TSC revenues. Soft drinks and alcoholic beverages have yielded very little revenue (less than 0.15 percent of GDP each and below 0.09 percent during the 1980s). This 12/ Among the taxes abolished by the reform are some that stopped yielding any revenue long ago while most others yield revenues of less than 0.01 percent of GDP. The taxes include: selective consumption; profits on the sale of rural land; stamp; cement production; airline tickets; ocean freight; casinos and gambling houses; oil exploration; ocean freight of crude oil and oil derivatives; sale of imported liquor; trees, cutting and wood sale; rice processing; coffee processing; cotton and synthetic fibers; purchase of raw cotton; profits of private electricity companies; commercial and industrial users of electricity; all users of electricity; electricity meters; electricity users in Quito; air freight; airlines that rent planes from other companies; airlines for passenger services; advertising in airplanes; services given to airlines by service companies; public shows (such as cinema, theater, etc.); public sport shows (such as soccer, baseball, etc.); slaughterhouses; fire insurance premiums; Insurance premium if the insurance company is in Guayaquil; railroad freight and passenger tickets; International air freight; excess luggage; toilet articles locally produced; telephone users; diesel consumption; airplane fuels and lubricants used by international commercial airlines; and bequests. - 50 - is partly due to the rather low rates, by international standards, particularly on cigarettes and alcoholic beverages. Given the low welfare losses associated with excise taxation of vice goods, and the relative ease of collection of the taxes, the Government might consider a substantial increase in their use. Tax Administration 122. In the last few years, the administration of taxes and of customs was also allowed to deteriorate. Indeed, insufficient understanding of the strategic needs of tax administration seems to be a perennial element in the Ecuadoran tax system. The legal tax system made the work of the administration more complex through the combination of small, ad hoc taxes and of the generous granting of exemptions brought about by the various development laws and by the lack of generality of the main taxes. The complexity and arbitrariness of the tax code stimulated taxpayer noncompliance. In addition, erratic management practices affected the morale of the tax inspectors, and contributed to the growing perception of a complacent administration. Lastly, the needed modernization of techniques and material support was not carried out with a coherent strategy. This latter aspect is evidenced by several changes that the computerization strategy: between 1985 and 1990 four different approaches were tried, and currently overlap the operatiens of the recci6n General de Rentas, with associated waste in the use of equipment.- 123. In contrast to the previous attitudes, the requirements of a sound tax administration policy in Ecuador was an important consideration in the process of designing the tax reform started by the new Government. However, some implementation problems that have resulted from organizational conflict and lack of clarity in the line of authority have hampered the efforts done at the design level. Full management of collections and returns by the banking network and the innovation introduced with the reform demanded an administrative adjustment in the DGR. Insufficient administrative foresight resulted in a reduced pace in setting up the computer applications needed to receive the tapes from the banks, a setback whose administrative costs may be high. In the short run, the flow of this year's tax funds stopped abruptly, contributing to the shortfall in public sector accounts in the first quarter of 1990, discussed above. 124. A well-managed computerization of tax and related administrative processes is the main task for the next couple of years. The main short-term priority should be the immediate computerized support of tax collections through the banking system. In addition, the consolidation of the tax reform process will depend on the defence of the principles of generality and equity by the Government. To achieve this objective the Government should establish 13/ Currently DGR has a combination of overused/unused microcomputers, mid-size computers and mainframes. The mainframe computer of the Ministry of Finance is used no more than 8 hours a day. The support of the DGR operation has a much smaller network currently available. - 51 - precise guidelines of tax policy for ministries and public enterprises, and most importantly, provide tax administration with the physical and data processing resources required for a reasonable performance. Given the stated desire to continue granting preferential treatment to selected economic sectors. it is important that better control and monitoring systems be set up to avoid abuses and unrestrained extension of the exemptions. The Government should consider replacing open-ended exemptions with certificates payable against the obligations, subject to an annual limit approved by Congress within the budget. A special unit within the Ministry would oversee the scheme and would coordinate the monitoring with the Direcci6n General de Rentas. C. Conclusions 125. Stabilizing overall revenues and setting up mechanisms that prevent excessive use of oil revenues for consumption purposes are two fundamental tasks in the process of reform of the public sector. The Government has made important progress in this respect, although much remains to be done. Regarding oil revenues, the Government has instituted an Oil Stabilization Fund, which has the potential to sterilize the current windfall and to contribute to macroeconomic stability, help solve the external debt problem, and prevent the rapid increase in the size of the State observed in previous occasions. Regarding domestic oil prices, the cost of continued subsidies to the domestic consumption of oil is reflected in economic instability, lower export revenues, and insufficient generation of resources for investment in the oil and other sectors. A more appropriate policy would instead aim at a rapid closing of the gap with opportunity cost, which would raise revenues that would be more than sufficient to compensate those deserving of public support. 126. Regarding the non-oil tax system, the medium-term task remains that of increasing its revenue-raising ability to balance the projected loss of oil revenues in the second half of the 1990s, while reducing the distortions it generates. 127. The Government has completed the first two phases of its tax reform. The first phase comprised administrative improvements and the implementation of procedures for retention at the source. The second comprised the tax changes described above. The Government now believes that the basic structure of the system is in place, with most of the revenues coming from income and VAT taxation. Besides increased attention to tax administration and the completion of ongoing restructuring programs, further reform measures will need to be undertaken to meet these challenges. These should involve: (i) further extension of the VAT; (ii) a further reduction or total elimination of earmarking; (iii) the possible extension of taxation to the public enterprises; and (iv) reforms to the municipal tax regime. In these areas, an appropriate package would be: (i) elimination of the remaining exemptions to the VAT, together with an increase in the VAT rate accompanied by a substantial decline in public expenditures; (ii) total elimination of earmarking; and (iii) reforms to the municipal tax regime, as discussed in Chapter VII. Taxation of public enterprises should be considered in the context of an examination of the potential for an overall reform of the - 52 - sector, including the setting ox more realistic tariff levels (as discussed in Chapter VIII). Its guiding principles should be to provide an environment as close as possible to that existing for private sector activities. - 53 - V. PLANNING AND CONTROL Of EXPENDITURESs THE BUDGETARY PROCESS AND REVENUE EARMARKING A. Introduction 128. Inadequate budgeting and control procedures have hampered the ability of the Government to make rational expenditure decisions and to implement fiscal policy in general. The present budgetary system, in particular, suffers from a number of serious deficiencies. These include the lack of a comprehensive budgeting framework, and, consequently, a poorly coordinated budget preparation process: the lack of technical expertise, particularly outside the Ministry of Finance, in the formulation, execution, and evaluation of budgets; the lack of a multiyear budgeting system; the lack of cash budgeting, and an antiquated and cumbersome payments system. As a consequence, the budget process is an ineffective vehicle for the formulation of a coherent fiscal policy, which often has to rely on across-the-board and inefficient cuts to meet program targets. Budget allocations tend to be based on inertial and incremental criteria, rather than on well-conceived lists of priorities; in the execution of programs, formalistic controls take precedence over substantive ones. Investment priorities, while formally under the domain of CONADE, more often reflect non-economic criteria. * 129. A complicating factor is the preponderance of earmarking of revenues, which is both a cause and an effect of the problems of the budgetary process. While considerations of public economics suggest that at times earmarking of specific revenues for some related activities may be appropriate, this practice has been excessive in Ecuador, spurred by and in effect becoming a substitute for the poor planning and budgeting abilities of the country, and used as a way to resolve interregional differences. Earmarking in the past has had preassigned proportions as high as three- quarters of overall revenues. Even after the 1989 tax reform, about one-half of total revenues remain earmarked. Of these, 20 percent go to the Social Security Institute; 18 percent to the Armed Forces (which also receives substantial budgetary allocations); 45 percent to current expenditures, such as payment of wages and of external interest; and the remaining 18 percent to a multitude of funds, universities, and local governments. In addition, a constitutional provision mandates that 30 percent of total expenditures be devoted to education. The pervasiveness of the system has been compounded by the fact that its allocation rules, particularly those pertaining to oil revenues, with the passing of time have become arbitrary, and can be likened to the functioning of a lottery. With the possible exception of the military, few if any of the funds that are enriched in whole or part by the earmarking system can meet their originally intended purposes. This chapter provides an analysis of the budgeting (Section B) and earmarking (Section C) issues and outlines possible avenues for reform. - 54 - B. The Budgetary Process Ecuador's Current Budgetary System 130. The national budgetary process, defined broadly to cover the budgetary processes of all public bodies--including the central and local governments, other public agencies and entities, and the public enterprises-- fulfills two basic roles. First, it serves as the formal, legal means by which taxes are raised, public expenditures authorized and executed, and the incurring of public debts approved. Second, it seLves as one of the main instruments with which the public authotities deliberately or unintentionally influence a country's macroeconomic performance. 131. However, for the budget to serve as an effective instrument of national economic policy requires, first, that the Government have the capacity to formulate and pursue clear economic policies and secure support for them, and, second, that the overall budgetary process be sufficiently comprehensive and coherent for it to effectively fulfill the desired role. In Ecuador this is not presently the case. As a consequence, the budget is inadequate to fulfill its primary function of serving as a means to efficiently formulate, approve, and execute the public expenditure program. 132. The principal problems affecting the present system are several. First, the structure and discussion process of the budget is fragmented and untimely. Central government budgetary expenditures in 1988 of SV. 437.2 billion sucres represented only 54 percent of consolidated public sector expenditures of S/. 806.5 billion (see Statistical Appendix, Tables 2 and 6). And since over 50 percent of budgetary revenues are earmarked, the scope for discretionary budgetary spending is further limited. Moreover, little explicit linkage is made between the economic and developmental objectives of the Government and the budget requirements of the public entities. Indeed, the current budget law does not require that the different budgets be discussed together, in a document that can evidence the interactions among various agencies, and that can be used as a means of planning fiscal policy. The formulation varies according to the level of government (national, provincial, municipal); the nature of the institutions (central government or decentralized agencies, funds, and enterprises); and type of activity. The law requires that the central Government budget be approved before the beginning of the fiscal year, but this is not true for the rest of the nonfinancial public sector, which comprises about half of total expenditures. Delays in the formulation and approval of budgets for these entities in the past have amounted to several months. Even for the central government budget, the legal requirements are formalistic and often redundant. 133. The problems are particularly serious with the public enterprise sector. Public enterprise budgets are approved according to three different processes that entail different control procedures on the part of the Ministry of Finance. Some enterprises must submit their budget for approval to the Ministry. Others are only required to obtain an opinion. For the largest, the respective executive boards send the budgets for approval directly to Congress. For this latter group, which includes the strategically important oil company, PETROECUADOR, the possibility of influencing the direction of - 55 - spending and the contribution of the companies to the overall public sector deficit is limited to the Ministry's representatives on the executive board. This latter possibility has not proven successful in recent times. In addition, public enterprises and attached entities prepare and submit their budgets very late, generally well within the year of execution. This obviously limits, or voids, the usefulness of these budgets as tools for fiscal planning. 134. Second, the formulation of individual budgets suffers from inadequate planning ability at the sectoral and central levels. Although in theory budgeting should be done by program, in practice it tends to be done automatically by increments on existing spending chapters. The lack of expertise at either end of the formulation process leads to a perverse game through which individual entities submit unrealistic and undocumented requests, in the expectation, dutifully fulfilled, that the Ministry of Finance will substantially reduce it. As a result of these problems, the planning and execution of the delivery of services is particularly poor. The problem is further aggravated by persistent deficiencies in accounting practices among many of the decentralized organizations, and by haphazard omissions in the national budget--for instance the inclusion of only external interest paid rather than due, and the exclusion of the external count, nart of externally financed investment projects (and sometimes of the internal counterpart funds as well). In the case of the largest public enterprises, the separate nature of the formulation and approval process results in little cohesion with the rest of the spending priorities that may be set at a national level. The CONADE, which theoretically should ensure consistency among investment priorities and objectives, is particularly ineffective in this respect. 135. Finally, the execution of the budget is also marred by a series of problems. The lack of a cash budget, of adequate management information systems, and of coordination among the various public entities results in unpredictable shifts in spending patterns during the execution period. The central level exercises a formalistic control over payment orders, which can result in lengthy and unjustified delays in the authorization to execute previously approved works or expenditures. The ability of the Government to control public finances during the execution of the budget and to monitor on a continuous basis fiscal policy is severely diminished by the lack of comprehensiveness of the budget, the limited analytical ability of the Ministry of Finance, and the lack of a properly established management information system. Only Treasury operations are known with sufficient reliability and limited delays; as discussed, this encompasses a relatively limited part of nonfinancial public sector operations. This has led on several occasions to severe short-term problems with respect to quarterly targets under IMF stand-bys, and has often resulted in the need to take drastic expenditure-cutting actions. 136. All of the above problems are aggravated by the excessive and pervasive earmarking of revenues and expenditures, as discussed in Section C. Indeed the very deficiencies of the budgetary process constitute the most powerful incentive for an extension of earmarking, which, by itself, short- circuits the budgetary process. When earmarking becomes widespread, the - 56 - quality of the budgetary process suffers, since it loses relevance, comprehensiveness, and adaptability to changing circumstances. Proposals for Reform of the Budgetary Process 137. Improving the budgetary environment and establishing a more rational and useful (if not perfect) budgetary system is a complex and medium-term task, which will require a sustained commitment in addition to a series of reforms of a legal and administrative nature. For example, the budget framework law is inadequate, and the budgeting framework for public enterprises too dispersed. Strong efforts will need to be made to increase the programming and executing ability of ministries and agencies, particularly in the social sector. The-Government has been paying increasing attention to these problems, particularly after lack of control over the execution of the budget has threatened to thwart its macroeconomic objectives. With the technical assistance of the IMF, the Government has begun to change its procedures for the preparation of the 1991 budget and several of the recommendations listed below will be implemented either in the 1991 or 1992 budget preparation process. The Government is also contemplating a change in the budget law so as to ensure greater comprehensiveness and reduce bureaucratic requirements. In recent months, it has also issued decrees that will enable the Ministry of Finance to include a greater proportion of the public sector in its budget and to improve the monitoring and control of expenditures. Finally, a program for retraining of budget officials in the Ministry of Finance and in the other public sector agencies has begun to show its beneficial effects. 138. Generally speaking, the measures to be considered or undertaken can be divided into those for the short, medium, and long-term. Among the key recommendations for a modification of the budgetary process in the short-run are the following: (a) The budgetary preparation process should be started earlier, in April, the budget should go to Congress in August, and it should be approved by October. The scope of the budget should be increased to encompass all decentralized agencies, and the budget should be approved as a unified document. This latter recommendation might entail changes in the budgetary laws, which should be pursued accordingly, and in the laws affecting individual public enterprises, particularly PETROECUADOR, INECEL and IETEL. The budget should also move towards adopting generally recognized practices. In particular it should include all expenditures on an accrued basis, all revenues on a cash basis, and properly account for external and domestic counterpart funds of investment projects. (b) The budgetary instructions, forms, and manuals should be thoroughly revised to eliminate duplications, conflicting requirements, and to emphasize substance over formal requirement. The Controller-General should ensure the use of standardized accounting concepts and definitions to replace the divergent definitions currently employed by the central - 57 - Government and the public enterprises, as well as in the preparation of the financial accounts. The itinerary of the budget preparation process should be modified to eliminate useless repetition of steps, particularly in the case of decentralized agencies. (c) A high priority should be given to a thorough retraining of the personnel charged with budget preparation in all ministries; needed organizational changes should be accomplished in parallel. This would involve, in the particular case of the Ministry of Finance, the strengthening of the Undersecretariat of the Budget, both in its evaluation ability (as a counterpart to the budget submission of other public entities) and in its economic/analytical functions, now severely limited. In the first respect, it would be desirable that, in parallel with the awarding of greater authority to the Ministry vis-&-vis the formulation of public enterprises budgets, a specialized unit dealing with public enterprises problems be created. In addition, the strengthening of the economic/analytical function is a sine qua non for effective management of fiscal policy in the course of the execution of the budget. Training of officers in decentralized public entities also should be an important priority, since the reform process must necessarily be a two-legged one. (d) The current plans for an increased use of computerized equipment and programs should be pursued, paying close attention to the contemporaneous reduction in existing superfluous forms and procedures causing delays in the budget process. Otherwise, existing bureaucratic practices and the problems relating to them will simply become further entrenched. 139. The above measures could be gradually applied over a period of, say, two budget exercises. As the strengthening of the capacity of public bodies to plan current and capital expenditures progresses--emphasizing, in particular, their capacity to evaluate performance and productivity--further consideration should be given to ways to improve the quality of the budget. An ideal system would consist of determining the collection and allocation of all public resources (including public financial sector resources) within the framework of the general government budget. An analysis of the structure of expenditures would be a key feature of the budget. Studies of the costs and benefits of most of the programs would be undertaken every two or three years. An overall rolling three-to-five-year plan, together with a multiyear budget, would be developed and updated. Finally, the system would provide for periodic comparisons of proposed and realized objectives. 140. This ideal system is the one to which all budget makers should aspire; hence, measures in Ecuador should aim to incorporate as many of its features as possible. This could be accomplished by moving reform efforts in a strategic direction emphasizing, among other things: - 58 - (a) The development of a modern budgetary system, drawing on experience gained through the applicat'on of Programming and Budgeting techniques, giving greater responsibility to public entities to define their own programs, establish units of measurement, measure results, and select areas for intensive evaluation; (b) The adoption of the technique of budget by results, as a complement to budget by programs. Each public entity should be encouraged to prepare a program document covering its activities. The costs and benefits of each program should be assessed in an effort to ensure that it is cost effective in attaining the Government's objectives. The overall set of documents would provide a basis for the use of the budget as an instrument of macroeconomic management. (c) The inclusion in the budget of subsidies and other expenditures performed by other public institutions. This is particularly important in the case of the Central Bank, as discussed in Chapter III. The losses derived from financial intermediation activities and from the servicing of part of the external debt should be made explicit and budgeted as such. Similarly, as discussed in Chapter IV, the budget should include any tax subsidies that the Government may want to award to selected sectors or activities. These measures would contribute to unifying public accounting and the budget, to making the budget transparent, and to strengthening controls over the budget and the public sector as a whole. 141. An additional constraint to the orderly execution of budgeted expenditures is the combination of cumbersome procurement procedures and the formalistic and bureaucratic controls. To tackle this issue the following steps should be considered: (a) The rules and regulations on procurement of materials and services should be overhauled and made more flexible. (b) The existing, detailed bureaucratic controls on commitments and payments should be replaced by a quarterly advance quota system covering both commitments and payments. Ex post auditing of expenditures and results should be undertaken by the Controller-General. (c) The system of fund allotments and cash controls should allow reprogramming during the year and should go beyond day-to-day financial controls to actual evaluation of physical/financial results at the end of the year. ro accomplish this, the steps and forms currently required to authorize fund allotments by spending objective will need to be revised. The ability of each public entity to evaluate its own performance should be improved by the application of formal programming and budgeting techniques to program management. - 59 - 142. Finally, as the budgeting and executing ability of the Administration is enhanced, currently earmarked revenues and expenditures could be gradually eliminated and incorporated into the budget. This would permit operational audits by the Controller-General and evaluation by the Ministry of Finance except for those cases where earmarking is indeed justifiable, as discussed below. C. Earmarking of Revenues and Expenditures Background 143. Earmarking consists of sequestering from general revenues of the state a portion for a specific destination, usually outside of budget scrutiny. Alternatively, it may entail mandating by law certair expenditures within the budget. Both of these effects are greatly in evidence in the Ecuadoran public accounts. As a matter of fact, the earmarking of public revenue sources for particular purposes is a traditional Ecuadoran form of financing that goes back to the nineteenth century. A high proportion has been earmarked ever since. During 1986/89, between 52 and 67 percent of total general government revenues were earmarked (Table 5.1). (Earmarked taxes represented about 38 percent of total budgetary revenues in 1986 and 43 percent in 1987.) In 1989, earmarked revenues represented about 54 percent of total general government revenues. Thus, very substantial proportions of Ecuadoran budgetary and general government revenues are earmarked and the practice is deeply embedded. With all oil revenues earmarked, fluctuations in the price of oil can cause significant variations in the earmarked portion of total government revenues Table 5.1: ROLE OF EARMARKED TAXES, 1986189 (Billions of Sucres) Your Budget Autonomous Agencies and Special Accounts General Earmarked Total Social Others Local Total Share of Taxes Security Governent General Earmarked Contributions Taxes Government Revenues (1) (2) (8) (4) (5) (a) (7)=(3)+(4) (8)m((2)+ 4.(S).*(6) (4)- (6))/ (7) 1986 180.8 79.2 210.0 38.4 38.7 9.6 291.6 61.9 1987 146.0 110.0 256.0 41.8 62.2 8.6 868.1 56.8 1988 251.8 188.7 4165. 67.9 102.0 5.6 591.0 66.4 1989 860.2 461.6 811.7 110.2 182.9 7.5 1112.8 8e.9 Source: Central Bank and Ministry of Finance. - 59a - Figure 6.1 Earmarking of Revenues, 1990 Total _ Social Security - Military - 'Redundant' PETROECUADOR Other Funds 0 10 20 30 40 50 60 70 (percent of total revenues) Before Tax Reform After Tax Reform - 60 - 144. There are three main sources of earmarked revenues in Ecuador14: oil revenues, social security revenues, and other earmarked nonoil taxes. The share of each in total earmarked public revenues in 1989190 is estimated roughly as follows: 1989 1990 Oil revenues 64.8 70.5 Social security contributions 17.7 19.6 & other current revenues Other earmarked nonoil taxes 17.5 9.9 Total earmarked revenues 100.0 100.0 145. Nearly all earmarked revenues go to various parts of the general government (including the budget).. For example, about 98.4 percent of 1989 fiscal oil revenues were distributed to entities in the general government sector. (However, this has been changed somewhat by the new (late-1989) PETROECUADOR law, discussed below, which allocates increased revenues to PETROECUADOR (formerly CEPE).) The Social Security Institute (lESS) and FONAPAR, both major beneficiaries of earmarked non-oil revenues, form part of the general government. In the case of other earmarked non-oil taxes, although some small amounts are earmarked to public enterprises, e.g., IETEL and ENFE, the bulk are again allocated to various general government entities. As a basic proposition, it should be stressed that the earmarking system has evolved in Ecuador in the past 15 years as a result of successive, and virtually incompatible, spending decisions. Consequently, little relationship exists between the original intent of the legislation and the spending mechanisms currently in place. 146. The main theoretical arguments that can be advanced in favor of earmarking are: (a) The need to have *stable" financing for key economic development programs and mechanisms; 14/ Ecuador is not alone among Latin American countries in making extensive use of earmarking. Earmarked taxes represented, for example, 45 percent of tax revenues in Colombia in 1979. In Argentina, about 25 percent of taxes (excluding social security taxes) currently collected by the central Government are earmarked. In addition, payroll taxes for the social security system and housing represent 20 percent of total public sector tax revenues. Nearly all Latin Americar. countries have earmarked taxes to finance the social security system. However, the extent of earmarking in Ecuador is exceptional. - 61 - (b) The need to establish a close link between those paying a given tax and those receiving benefits from the resulting expenditures; and (c) The need to encourage willing payment of a tax by establishing clearly on what it will be spent. Few (if any) of these theoretical advantages are realized by Ecuador's present system of revenue earmarking. First, the financing of the key development agencies (mainly, but not exclusively, through oil revenues) has been anything but stable. Second, in a majority of cases, there is no discernible link between the taxpayers and the beneficiaries. Third, the system, especially in the case of oil revenues, instead of establishing clearly on what taxes are to be spent, has become little more than a complex economic lottery. Earmarking of Oil Tax Revenues 147. The most important source of earmarked revenue is Government oil revenues, which have long attracted the attention of several powerful lobbies. As discussed in Chapter IV, oil revenues have amounted to roughly one half of total Government revenues; nearly all of them are earmarked, either for funds and entities outside the budget or for specific expenditures within the budget. For all categories of oil revenue earmarking, the "distribution rules" are based on complex formulas reflecting prices and exchange rates at the moment of approval of the measures that instituted the earmarking (Box 5.1). This results in unpredictable shifts as any of those variables change. In 1989, of total oil revenues, 81.6 percent were allocated to the budget, 14.5 percent to the Aimed Forces, 1 percent to INECEL, and 1 percent to the local governments. State universities and BEDE received shares of 0.79 and 0.50 percent, respectively. Only 30 percent of the total allocated to the budget was for general use. A very significant portion (67.6 percent) was allocated to finance the wage bill and the rest to other programs, among the most important of which were the rural roads programs. Under the new PETROECUADOR law, the amounts going to PETROECUADOR will increase, while the amounts going to all other recipients, except the Armed Forces, are reduced. Shifts over Time in the Distribution of Oil Revenues 148. The distritution of oil revenues is directly influenced by the levUls of international and domestic petroleum prices and the sucre/dollar exchange rate. The structure of the complex oil revenue earmarking system is such that there are strong winners and losers from movements in these three variables (Table 5.2). - 62 - Box 5.1 - DISTRIBUTION RULES FOR OIL REVENUES Different distribution rules apply to oil revenues, depending on whether they are classified as royalty payments, income taxes, or other taxes. The rules are briefly summarized as follows: 1 RnIlties. Royalties represented 27 percent of fiscal revenues In 1989. They ore comp.bedas a fixed percentage of the total value of production. Thus, 18.5 percent is levied on the PETROECUADOR-Texaco consortium and on the production of PETROECUADOR in the Northeastern fields, and 12.5 percent on the PETROECUADOR-City association. Different distribution rules apply to each of the production centers. About 74 percent of total royalties is allocated to the general budget, but more than 80 percent of this allocation Is In turn allotted to the wage bill. Thus, only 12.9 percent of the total goes into the budget without constraints. The armed forces are another important recipient of royalties, with 21.7 percent of the total. INECEL is next in importance. There are other recipients, but with smaller shares. 2. Income Tax and PETROECUADOR Revenue-Sharing. Private oil firms are subject to a tax of 87.31 percent on profits. Special revenue-sharing regulations apply to PETROECUADOR. Under the new PETROECUW0OR law, all direct revenues of PETROECUADOR, together with indirect revenues from contractual arrangments, are identified. Royalties and certain othvr legally required allocations, allotments to the military under Supreme Decrees 218 and 387, and the costs and expenses of PETROECUADOR and Its affiliates, are deducted from these revenues. Of the remainder, 10 percent Is then allocated to a new Petroleum Investment Budget managed by PETROECUADOR, while the reminder is distributed by the Central Bank in accordance with existing laws. At least 40 percent of the Petroleum Investment Budget is to be allocated to oil exploration and production and the remainder to other investments. The financial effects of the new law are thus to cover all of PETROECUADOR's costs and provide it with a flow of investment funds, to protect the share of the military, and to reduce revenues to the Government. 3. In 1989, three-quarters of Government income tax and revenue-sharing receipts were assigned to the budget, but 91.7 percent of this total was earmarked, under a number of separate laws, again for the wage bill A total of 20 percent was channeled to the Armed Forces. The universities, BEDE, FONAPAR, and other agencies received smaller portions. A minor share was assigned to private universities and labor. 4. Other Taxes. Other taxes on petroleum products include taxes on foreign currency transactions and maritime freight charges, an export tax of 6 sucres per barrel, and taxes on Increases In the prices of refined oil products for domestic consumption, which amount to 70 percent of the total. The general budget receives 98 percent of the total, but only a little over two-thirds of this amount may be freely allocated; 27 percent is assigned to wage increases and the rest to other agencies, such as the provincial councils, which receive a fixed share of 8 billion sucres. The tax on price increases on fuels for domestic consumption, most of which goes to the budget, mainly accounts for the large share of the general budget. - 63 - Table 6.2: DISTRIBUTION OF OIL REVENUES: SELECTED YEARS (Percentages of Total) Recipients 1972 1974 1976 1980 1989 --------------------------------------------------------------------__-------__----------- Budget 56.a 35.7 30.4 34.8 81.6 General (60.2) (28.6) (27.0) (83.3) (24.6) Earmarked (6.1) (7.2) (8.4) (1.5) (57.0) INECEL 14.9 10.6 8.7 11.2 1.1 BEDE (FONADE) 6.0 32.6 33.3 8.2 0.6 Local Governments -.- -.- -.- 6.0 1.0 Others 24.8 20.3 19.3 26.4 14.6 PETROECUADOR -.- 10.0 8.3 14.4 0.2 TOTAL 100.0 100.0 100.0 100.0 100.0 Source: Oil Statistics, The Ministry of Finance, 1981; and World Bank estimates. 149. Although some of the shifts in the distribution of oil revenues were the result of conscious policy decisions either to raise or not to raise domestic petroleum product prices, the predominant influence was the huge depreciation of the sucre. The earmarking mechanism converted this depreciation into a massive transfer of resources away from public investment (by INECEL, BEDE, PETROECUADOR, and local governments) into funds for the financing of wage increases. This outcome was neither foreseen nor desired-- clearly the antithesis of rational allocation of scarce public resources to priority purposes. 150. The oil revenue earmarking system evolved out of difficult political compromises and was expected to stand the test of time. However, it has clearly been rendered obsolete by subsequent events. Social Security Taxes 151. In 1987, contributions to the social security system represented 12.2 percent of total public sector tax revenues. Social security taxes are collected from employers and employees' contributions in percentages that vary according to the risks covered. The most important are those for retirement benefits (see Chapter VI). Despite relatively high evasion rates, these taxes are resisted less than others, since there is a recognized relationship between the taxpayer and the beneficiary. Other Sources of Earmarking 152. National Revenue-Sharing Fund (FONAPAR). FONAPAR was created at the end of the 1960s to simplify the complicated tax system then in effect. All the extrabudgetary tax revenues allocated to several agencies were to be channeled through FONAPAR. In addition, FONAPAR was intended to reorganize the system of transfers to local governments. At the same time, a simplification of the system was achieved by eliminating a large number of taxes that were interfering with domestic trade. - 64 - 153. The original goal--to channel all funds to local governments and agencies through FONAPAR--was not realized. Shortly after it began operating, other channels evolved. Thus, currently, the fund channels only a portion of these transfers. The distribution of FONAPAR funds is not regulated by established rules but results from political negotiations in which the Ministry of Finance plays a central role. 154. FONAPAR has changed over time. Currently, a very high percentage of its expenditures represent transfers to local governments. From its creation in 1971 until 1985, FONAPAR has been losing importance. Its share in total public revenues fell from 9 percent to an average of 3.7 percent for the last three years, reflecting, inter alia, the strong impact of the depreciation of the sucre on its share of oil revenues. The reform of the fund (discussed in Chapter VII), through the creation of FODESEC, will contribute to restoring greater stability to total revenues distributed, in addition to improving incentives for fiscal responsibility of local governments. 155. Other Earmarked Revenues. After the 1989 tax reform, the most important source of earmarked non-oil taxes is represented by the allocation of about 25 percent of the income tax to a number of local governments, a holdover from the previous income tax surcharges. The maintenance of these earmarked revenues seems to conflict with the spirit of the reform of FONAPAR just discussed. A significant number of minor taxes and portions of the general taxes are also earmarked. Some taxes are earmarked, in practice, if not in theory, because their revenues tend to be combined with other revenues assigned to a given activity through the budget. Fifty percent of the revenues from the customs duties for wage increments and a 1 percent tax on credit transactions are allocated to teachers' wages. Where general revenues partly finance the same activity, earmarking has no effect, since it can be offset in the budgetary process by providing a larger or smaller allocation to the activity. 156. Some taxes are levied on services provided by certain enterprises, yet the same enterprises are the recipients of the revenues. Examples include a tax of 2 sucres per telephone allocated to IETEL and a tax of 20 sucres per quintal transported by ENFE allocated to the state railways. These taxes do not seem justified, since the same result could be obtained by raising the prices of those services by the amount of the tax. 157. In other cases, taxes are levied on the users of certain services and the revenues collected in turn allocated to activities with different beneficiaries. These taxes evolved as a result of weakness in the administration of the more general taxes, which constituted a serious barrier to increasirg tax collections. If the administration of these taxes were strengthened, such financing could be provided by them. 158. The resources of local governments are also collected to a great extent from earmarked taxes. An example is the additional levy on the rural land tax collected by several provinces, which is used to finance the construction and maintenance of schools in the cantons where the tax is collected. - 65 - Earmarking of Expenditures 159. In addition to the destination of specific revenues for payment of wages ot for payment of external interest, there exists another important earmarkir.g mechanism, the constitutional requirement in Ecuador to allocate 30 percent of government revenues to education. While laudable in its intent, this requirement imposes potential rigidity on the use of public funds, and may indeed be impossible to fulfill. Indeed, the provision has generally been circumvented by interpreting the 30 percent rule to apply only to the untied resources of the general budget, which exclude earmarked tax revenues. 160. The use of rigid earmarking regulations can result ir. problems when funds are allocated in this way among various levels of government. The growth of demand for public services may vary according to whether provincial, municipal, or central Government services are involved. Any attempt to provide stabler shares by these means must allow for needs that grow at different rates. Regulations that provide for a review of the system after 5 to 10 years of operation should be implemented. Issues and Options for Reform 161. The earmarking system is based on a series of historical political accords and reflects the desires of the interested parties to those accords to guarantee stability in their revenue shares. The problems that have arisen partly reflect the fact that the allocation system for oil revenues turned out to be extremely unstable, due principally to the impact of the massive devaluation of the sucre and the excessive claims laid on revenues by too many parties. The persistence of the overall system into the present is anomalous and the distribution of revenues indefensible on rational grounds. Its continuance places the allocation of public resources in a straitjacket and undermines the role of the budget. At the same time, many areas of public expenditure are, by virtue of the earmarking that assures their funding, subjected to only cursory public scrutiny and negligible control. 162. The economic and practical irrationality of the system calls for its replacement with a more comprehensive and effective budgetary process. Some taxes, e.g., contributions and revenues under a revised social security system, local improvement taxes and other local government levies would appropriately remain earmarked. The central issue is whether oil revenues, other broad taxes or parts of them, and certain categories of expenditure (e.g., budgetary expenditures) should be earmarked or whether allocation should be the end result of a rational and orderly priority-setting process. This obviously requires that the changes to the budgetary mechanisms discussed in the previous section be successfully implemented. 163. A first line of reforms could involve earmarked expenditures that are 'redundant,a in the sense of mandating expenditures that are below the actual budgeted levels. First and foremost are the provisions for the financing of the wage bill, described above. The main reason for the abolition of these - 66 - provisions-5 is to restore order to the budgetary process; the practical implications would be few. In essence, a reform like this would make it possible to weigh the use of these funds as programmed against other uses. 164. The Armed Forces. The basis for determining the share of the Armed Forces was established in 1970 by confidential decrees that were originally approved for 15 years and later extended for an additional 10 years. Under these provisions, 8 percent of oil export revenues are automatically transferred to the Armed Forces. In addition, resources are provided to service the foreign debt resulting from purchases of military equipment. Originally, the Armed Forces were to receive 50 percent of the royalties from PETROECUADOR-Texaco but this share was reduced in 1989 to less than 50 percent. Notwithstanding this, in 1989, the Armed Forces received 14.5 percent of total oil revenues. 165. Currently, more than half of the revenues allocated to the Armed Forces are for servicing their foreign debt. The treatment of the foreign debt should be unified, since there is little justification for different treatment of the various areas of the public sector. The amount received by the Armed Forces for this item should be allocated from general revenues. The budget for 1989 includes an amount representing 8.7 percent of total petroleum fiscal revenues for servicing the foreign debt of the Armed Forces. 166. Since defense is the exclusive function of the Central Government, there is also no reason for maintaining an earmarked tax for this purpose. The 8 percent share of oil revenues could be maintained during a transition period by setting a limit on the exchange rate, as in the case of some other recipients, and transferring the remainder to the general budget. 167. PETROECUADOR. As discussed in Chapter VIII, the new arrangements embodied in the 1989 PETROECUADOR law represent a modification to the earmarking system so as to permit the financing of PETROECUADOR's investment program out of a reduction in the shares (mainly wages) of the remaining beneficiaries of the earmarking system (excluding the Armed Forces). Concerns are that: (i) the principle of earmarking is still retained; (ii) PETROECUADOR may be able to operate essentially on a "cost-plus" basis, with little check on its efficiency; (iii) the amounts earmarked for investment are quite arbitrary; (iv) PETROECUADOR's proposed investments should not be given special preference but should be evaluated competitively on the basis of their expected rates of return compared to those on other proposed public investments; and (v) that PETROECUADOR may be given scarce fiscal resources to carry out investments better undertaken--especially if they are risky--by private companies. Under the new arrangements, whether Government financial and performance monitoring will be adequate becomes an important issue. 15/ The abolition of import surcharges under the Government's trade liberalization program will eliminate, as of 1991, a further part of earmarked revenues (in this case, revenues for the payment of external debt). - 67 - 168. The new tax earmarking arrangements for PETROECUADOR should be reviewed in the context of any overall reform of earmarking. The objective should be to treat PETROECUADOR more like a private company and require it to compete with other private companies so as to ensure its efficiency. 169. The Social Security System. Earmarking is not the key issue relating to the social security sy3tem. The main issues are the system's basic soundness, its looming cash deficit, its continuing state-imposed decapitalization, high contribution rates, the inequity and inadequacy of the system's coverage, IESS's involvement in too many activities, and its low operational efficiency. The IESS's problems are discussed in detail in Chapter VI. 170. FONAPAR. Revenue earmarking has not provided a stable share of public resources for FONAPAR. The reform measures discussed in Chapter IX, establishing FODESEC, would go a lcng way toward establishing a better transfer system with no need for earmarked revenues. 171. INECEL. INECEL's share of oil revenues has, as noted earlier, fallen from 15 percent of oil revenues in 1972 to 1 percent in 1989. The ready availability of investment funds, while facilitating INECEL's expansion, undermined its efficiency and the realism of its tariffs. It should generate more resources by raising tariffs and running a current account surplus on its operations. Its investments should yield competitive returns and be financed to a significant extent out of its current account surplus. It should not depend on earmarked public revenues. 172. BEDE. As noted earlier, BEDE's share of total oil revenues has declined precipitously since the early 1970s and it has not fulfilled its intended role as a development bank. A redefinition of BEDE's role is required. In the interim, BEDE's access to earmarked revenues should be eliminated and replaced (if required) by transfers from the budget, as envisaged in the reform of FODESEC. 173. Rural Roads. The share of oil revenues earmarked to rural roads has also declined because of the depreciation of the sucre. Rather than receiving a share of oil revenues, provincial governments might be given responsibility for levying and collecting the rural land tax. This would establish a close link between taxes paid and benefits received, since provincial investment is primarily in rural roads. 174. Other Budgetary Accounts and the Universities. The Ministries of Foreign Relations, Labor, and Public Health receive minor contributions to their budgets from petroleum revenues. These and the earmarked contributions to universities should be eliminated as part of any budgetary reform/elimination of earmarking package. Other earmarked taxes should be reviewed. Their existence is not justified, despite the fact that they account for a very small amount of revenue. A comprehensive review should result in improvements in the distribution of resources and the allocation of expenditures. The tax of 5 sucres per barrel on exported crude and taxes on the purchase and sale of oil-generated foreign currencies are deductible from other taxes. Their net revenue effects are virtually nil and only alter the - 68 - distribution among recipients, in many cases only marginally. They could easily be eliminated. Where taxes share the same base and recipient--e.g., taxes on the production and consumption of refined oil products and on price increases in refined products--they could be combined into a single tax. - 69 - VI. THE SOCIAL SECURITY SYSTEM A. Background and Current Organization 175. Social security in Ecuador, administered mainly through the Institute of Social Security (IESS), has evolved in a gradual and fragmented manner into a system stratified along occupational lines (see Annex, Table 20). The most powerful groups were the first to be covered while the least influential were the last, or remain unprotected. Some of the problems of the IESS result from the diversity of activities that fall under its preview. The IESS manages several insurance programs: old age, disability and survivors' pensions; health-maternity; occupational accidents and diseases; funeral aid; and severance pay. It also runs personal, pawn, and mortgage loan programs and a housing program for the insured. 176. A 1960s merger of the public and private systems (known as Sections "A" and "B") was poorly planned and executed. The two systems remain largely separately administered, with divergent contribution rates and conditions of entitlement. The military, the police, and teachers continue to enjoy privileged treatment. 177. The IESS has created eight regional divisions since the mid-1980s. However, this process was again poorly conceived and executed, resulting in disorganization and failure to meet objectives. The IESS has its own network of health facilities, the second largest in Ecuador after that of the Ministry of Health. The Ministry of Defense, charities, municipalities and the private sector also operate health facilities. However, there is no coordination, even within the public sector. Duplication (especially of IESS and MOH facilities) and significant gaps are readily apparent. Despite some attempts during the 1980s to address these problems, nothing lasting has been achieved. B. IESS Financing 178. Wage and Other Contributions. The IESS is financed by: (i) wage contributions from the insured and their employers; (ii) subsidies from the state budget (in addition to the state's contribution as employer); and (iii) investment income. Wage contributions are determined as percentages of the wages or salaries of the insured and are paid by the insured and the employer in the case of salaried workers. For salaried workers, total percentage wage contributions (including the employer's share) range from 15.85 percent to 30.2 percent--the most common being 20.2 percent--with no ceiling on the amount. in 1987/88, Ecuador had the eleventh highest total percentage contribution rate in Latin America. 179. Differences in Contribution Rates. Wage contributions vary widely among the various groups covered (see Table 6.1 and Annex, Table 24), despite steps taken in May, 1989 to achieve greater uniformity. Some, but not all, of these differences are related to the greater benefits received, or the shorter time worked, by the group in question. The self-employed insured person pays substantially more than the average salaried insured person. In addition, he or she must have a minimum income and be a member of a cooperative, union, or association. The head of a peasant family contributes only 1 percent of the - 70 - minimum salary in agriculture. The peasant program is subsidized by a 1 percent wage contribution shared among the insured and employers (0.35 percent each) and the state (0.30 percent). Table 6.1: INSURED AND EMPLOYER LEGAL CONTRIBUTIONS TO IESS: 1989 (as a Percentage of Wage or Income) Insured Group. Insured Employor Totai 1. General Obligatory System (All Salaried) Private Sector (White & Blue Collar) 9.85 10.85 20.2 Public Sector (Civil Servants) 11.85 8.86 20.2 2. Special Replimes Obli;atory a. Salaried Public Teachers 16.85 18.86 80.2 Agricultural Sugar 18.85 16.35 29.7 a Construction 9.86 10.85 28.56 Printing (Public) 18.85 14.96 28.2 Printing (Private) 11.86 16.N8 28.2 Autonomous Institutions A Banks 11.85 10.86 22.2 Professional Driver. 9.36 10.86 20.2 Artisans A Domestic Servant. 8.86 7.36 16.2 Salaried Agricultural Workers 8.50 7.85 16.85 b. Se I fEm loyed Liberal Professions, Artisans, 16.5 15.6 Artists, Workshop MasterS, & Associated Self-Employed 3. Voluntary Other Self-Employed, Continuation of 16.5 1656 Coverage, any Other Adult -----------------------------------------------------------------__----------__--------- Source: Legislation of May 2, 1989. a/ Includes 8.88 percent from the Reserve Fund (not clear who pays this) b Associated In unions, cooperatives, etc., which take responsibility for payment. 180. State rhird-Party Contributions. The state became legally required to cover 40 percent of the cost of pensions in both sections of the general system following the emergence of an actuarial deficit in 1941 in the public pension fund. The burden on the state has been so heavy that it has consistently tried to reduce or eliminate it. The state in 1959-64 also became bound to pay military and polica pensions, as well as special additional pensions for other groups. 181. In summary, the financing of Ecuador's social insurance system is in need of drastic reform: the overall percentage contribution is high, differences in the insured's and employers' contributions are still significant although seldom justified, and the state's subsidy to pension payment is high. Several studies, including an IESS evaluation in 1988, have recommended uniformity for all IESS percentage contributions. Pragmatic assessments of the state's subsidy have concluded that it should be reduced to - 71 - more realistic levels. However, government inertia and vested interests have maintained the status quo. The heavy burden placed on the state and employers, coupled with poor IESS control and inspection and high rates of inflation, have provided powerful incentives to evade or delay payments. State Debt 182. The state has often failed to meet its obligations as employer and third-party contributor (40 percent of the costs of general system pensions, military and police pensions, 0.30 percent for peasant insurance, and improved pensions for special groups). 183. Beginning in 1964, the state has signed eleven consolidation agreements with the IESS formally recognizing its debts and providing for amortized repayment. Accurate data relating to the basis for calculating the state debt are unavailable. The limited information available is summarized in Table 6.2, which makes clear that the debt was consolidated fcr long Table 6.2: STATE DEBT PAYMENT AGREEMENTS WITH IESS: 1964-1988 Year Reason Interost Term Amount Constant (Percent) (Years) (Millions (Millions of Sucres) of Sucres) ------------------------------------------------------------------__---------__------------ 1. 1964 Capital Amortization Not Paid (1956-63) 7 25 168.0 4.1 2. 1966 Employer Contributions, etc. (1962-4) 7 20 196.4 5.2 3. 1966 40X Pensions (1968-64) 7 20 110.6 2.9 4. 1969 Employer Contributions + 40X (1965-67) 7 20 862.1 26.8 S. 1970 Employer Contributions (1988-69) 7 20 662.6 10.9 6. 1972 Additional Insurnce Railroads (1970-72) 7 20 106.7 4.0 7. 1973 Mlltary and Police Pensions (1970-71) 7 19 1,004.7 42.6 8. 1976 Employer Contributions (1972-74) 7 20 2,026.6 132.8 9. 1979 Employer Contributions (1975-76) 7 20 8,656.8 888.8 10. 1984 Employer Contributions (1977-88) 15 15 22,702.5 6,167.8 11. 19865 Employer Contributions (1983-84) 18 15 6,829.4 2,867.0 TOTAL 88,814.7 9,086.6 Estimated Total State Debt to IESS at the End of 1988 (MIIIion Sucres) With Without Million US$ Agreements Agreements Totel (1988 Exch. Rate) _________________________________________________________________________________ Capital 32,873 52,902 85,196 282.4 Interest 86,661 59,900 96,561 820.2 TOTAL 69,034 112,802 181,757 602.6 -- -- -- -- -- -- -- -- -- -- - - - - - - - - - - - - - - - - - - ---- - - - - - - - - - - - - -- -- -- -- -- - - - Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Logo, Nov. 1989. periods at low rates of interest. Subsequent inflation heavily eroded the initial amounts so that the cumulative debt had in real terms shrunk to - 72 - 24 percent of its original nominal value by 1988. The total amount owed by the state to the IESS nonetheless totalled 182 billion sucres (US$600 million) at end-1988. The state paid nothing to the IESS in 1988 and by July 1989 had paid only 16 percent of an estimated SI. 16.6 billions owing in respect of its liabilities as third-party contributor to pensions and Peasant Insurance alone. In addition to not meeting its obligations as third party contributor, the state systematically delays payment of its contribution as employer. The IESS has thus been forced to use its own funds to pay benefits due to the armed forces. The cumulative deficit of the armed forces fund in 1988 was over one billion sucres. Despite legal efforts to force the state to meet its obligations, it continues not to, decapitalizing the IESS in the process. Private and Other Public Employer Debt 184. In addition to the state debt, mora (arrears) are owed to the IESS by private employers, national public employers other than the central Government, and provincial and municipal employers. At end-1988, these had reached 10.5 billion sucres (US$35 million) (see Annex, Table 25). Despite the availability of numerous administrative and legal means to control mora, the IESS has not availed itself of them and high inflation has taken its toll, since the rate of interest charged delinquents by the IESS has again been substantially below the rate of inflation. In 1983, for example, the maximum interest rate plus a 4 percent penalty still yielded a real interest rate of minus 17 percent. In 1988 the mora interest rate was 28 percent, but, with inflation at 80 percent, the real interest rate was minus 29 percent. Thus, the successive mora debts since 1982 have declined ranging between 32 and 86 percent in real terms. The problem of controlling mora is exacerbated by ineffectual monitoring of employer payments, delayed action to recover arrears, and poor coordination among the responsible departments in IESS. However, a national plan for the control of mora introduced in 1987 has resulted in increased identification and higher collections. The management of the IESS reported in early 1990 that the IESS recouped 10 billion sucres of mora debt in 1989, that detection of evasion is increasing, and that interest rates on arrears have been raised to 48 percent. 185. Debt owed to the IESS at end-1988 exceeded its budget and equalled its total reserves. Although the payment of government debt is beyond the IESS's control and progress has been made in controlling and collecting mora, the IESS has shown serious negligence and inefficiency in dealing with these problems in the past. C. IESS INVESTMENTS AND EXPENDITURES Portfolio Investment 186. As the IESS has generally enjoyed a financial surplus position (a consequence of the continued expansion of its membership), it has found itself in a position to administer a large pool of assets. In general terms, these have been used: (i) to finance the overall deficit of the state budget; (ii) to provide personal and mortgage loans to the membership at highly subsidized rates; and (iii) to engage in extraneous activities such as real estate, manufacturing, etc. The yield of the IESS portfolio has been greatly - 73 - negative in real terms. Even if it had been positive In real terms, however, the fact that a large part of the investments have been in government paper, whose future service depends on the ability to raise taxes on future generations, would belie the notion of an autonomous, actuarially sound institution. In fact, the average yield on IESS investments has been so low that invested assets as a percentage of GDP fell from 2.8 in 1986 to 1.4 in 1989, as a result of the high inflation of recent years. 187. The composition of IESS's investment in 1989 was as follows: 38 percent public/mortgage bonds; 19 percent personal loans; 11 percent mortgages; 7 percent miscellaneous investments; 10 percent shares and 13 percent real estate (see Annex, Table 26). IESS investment is classified into two major categories: directly beneficial to the insured (privativas) (e.g., personal and mortgage loans and hospital construction) and not directly beneficial (non-privativas) (e.g., bonds, bank deposits, shares and real estate). In the 1970s, the majority of IESS investments were in non- privativas instruments, but by 1988, 79 percent of investments were in privativas yielding about one-fourth of the return obtainable on non- privativas (see Annex, Table 27). -In 1988/89, the IESS itself criticized the predominance of investment in privativas as a distortion of the nature and objectives of social insurance, noting that such investments had decapitalized the system. The IESS pointed out that this had happened because political considerations had predominated over technical criteria and pressure from users over social insurance interests. The management of the IESS reported in early 1990 that the proportion of privativas investments dropped to 68 percent in 1989 and that decisions had been made to increase interest rates for both types of privativas investments, as well as to decrease terms. 188. Yields. Except for the two years 1979 and 1980, real yields on IESS investments were negative for the decade 1978 to 1988, averaging minus 19.6 percent during the high inflation years over the 1983-88 period. Fixed interest rates for personal/mortgage loans and low starting rates for mortgage loans were primarily responsible for these negative yields. Real yields on mortgage loans, estimated at minus 3 percent in 1980, worsened to minus 34 percent in 1983 and minus 36 percent in 1988. This resulted from declines in nominal interest rates from 9.9 percent in 1980181 to 6.6 percent in 1982/83 and 4.8 percent in the 1984-86 period, when inflation was rapidly increasing. The reason for this interest rate decline was that, from 1982, the mortgage interest rate became variable, fixed every five years, but beginning at a very low rate. The lESS reports that, as of 1990 (the result of the decapitalization of its mortgage funds) five loans must be repaid to provide enough funds for each new mortgage. Factors further exacerbating IESS losses were totally inadequate mortgage loan insurance premiums and inadequate amortization of capital. Despite some changes, the worst features of the policy remain in force, with a (declining) privileged minority reaping the benefits. 189. The nominal yield on personal loans fell from 9.6 percent between 1980 and 1982 to 7.5 percent between 1983 and 1986 while real yields fell from minus 3 percent in 1972 to minus 26 per ent in 1983 and minus 42 percent in 1988. These loans had an enormously negative impact on the overall yield on IESS investments but were lucrative for borrowers, who could deposit the - 74 - proceeds of an IESS loan in a commercial bank paying ten times the interest. Losses to the IESS were increased by the IESS's failure to charge for the administrative costs of both mortgage and personal loans. 190. Other loans represent mainly loans to institutions and pawn loans. Loans to public institutions, now prohibited, were governed by the same regulations for 43 years and yielded 6 percent interest for most of that time, generating large (and continuing) real losses for the IESS. "Hidden loans' to the IESS health-maternity program, in reality representing transfers or gifts (since they bear no interest and are not repaid) have been made since 1984. Pawn loans in 1988 yielded 18 percent to 23 percent (discounted from the loan) but did not include adiiinistrative charges of 11 percent. The real yield was estimated by IESS at minus 34 percent. Nominal yields on public bonds rose from 16 percent to 23 perce:It between 1980 and 1986, while real yields fell from 2.6 percent to zero (far superior to yields on personal and mortgage loans). The 1989 investment plan established the yield on these bonds at 40 percent, compared with January-August inflation of 36 percent. Fixed-term deposits yielded positive real rates of return during most of the 1974-81 period but such deposits were largely eliminated in 1982183. In 1990, the IESS had S/. 60 billion on deposit at the Central Bank paying zero interest. 191. Investments in private company and public enterprise shares and IESS- owned businesses have also registered poor real yields, averaging minus 14 percent between 1984 and 1987 (see Annex, Table 28). Real estate investments have earned poor returns because of failure to adjust rents to inflation and the loss of property to squatter invasions. "Other" investments include IESS shops, which do not even cover operat!ag expenses. 192. Recognition of the poor performance of IESS investments 'ed at end- 1986 to increases in interest rates on mortgages up to 22 percent and on loans up to 28 percent, but these rates still did not imply positive real yields. Further attempts to improve yields were made in March 1989, wher the projected allocation to non-privativas was increased to 55 percent, mortgage/personal loans were drastically reduced--to 30 percent, the legal maximum--and programmed yields were sharply increased to a global nominal figure of 29.5 percent. State debt agreements were to be renegotiated to adjust interest to inflation and capital and interest on mortgage, personal and other loans were to be adjusted to inflation. Numerous other reforms to improve IESS's financial performance were proposed, although two--to construct buildings for IESS offices and to reintroduce the housing program--are questionable, based on past performance. Most of the proposed reforms are desirable. The key question is whether the IESS will be able to implement them. ln the meanwhile, as maximum lending limits for mortgages have been kept fixed in nominal terms, the demand for these loans has considerably decreased. This provides an opportunity for a formal elimination of tz'S program. Population Coverage and Inequalities 193. The financial position of IESS will be influenced, among other things, by the rate at which coverage (and therefore contributions) increases. A marked increase in membership, however, is only a temporary solution, - 75 - particularly if benefit growth is not contained: the financial crisis is simply postponed. Nonetheless, it remains true that social insurance coverage in Ecuador is very limited and there are marked inequalities in benefits. Most salaried people working for an employer and some groups of self-employed workers are compulsorily covered by social insurance. Most self-employed can opt for IESS coverage. However, unpaid family, home, and most temporary workers and the unemployed are excluded. Coverage of insured's dependents is one of the two most limited in the entire Latin American region. Spouses are not entitled to health-maternity care, while children are covered for medical care (but not medicines) only up to one year of age. 194. The percentage of the total population covered by social insurance is estimated to have risen from 5 percent in 1965 to 13.8 percent in 1987, with a rise in the coverage of peasants during the 1980s accounting for about half the increrse (see Annex, Table 21). (However, in 1980, Ecuador ranked sixteenth in terms of population coverage among 20 Latin American countries.) Coverage of the economically active population (EAP) rose from 12.6 to 26.2 percent over the same period. Nonetheless, in the 1985-88 period, Ecuador ranked only ahead of the Dominican Republic, El Salvador and Honduras among Latin American countries in coverage of the economically active population. 195. Ecuador's low social insur'.nce coverage can be largely explained by the fact that it covers mainly wage-earners coupled with the fact that the proportion of wage earners in the EAP (47.6 percent) in 1982 was one of the lowest in Latin America. Voluntary extension of coverage during the 1980s under the Peasant Insurance Program has considerably expanded the scope of social insurance, yet only 10 percent of the peasant population were covered in 1987. Voluntary affiliation by the self-employed became available in the 1980s but few appear to have availed themselves of this option. Benefit Expenditures 196. Between 1975 and 1987, IESS expenditures rose substantially in importance in relation to GDP and total government expenditures (see Table 6.3) although the conflicting and inadequate data series that are available present somewhat different indications of the extent. About 85 percent of IESS expenditures go to benefits. These expenditures became increasingly dominated by pensions over the 1972-83 period (see Table 6.4) while the shares going to health-maternity and severance benefits declined substantially. This trend reflects both the maturation of the pension plan and the liberalization of benefits and entitlement conditions. It has exercised a negative impact on the accumulation of reserves, on the viability of the health-maternity program (which depends on transfers from the pension reserves), and on the pension program itself. - 76 - Table 6.3; SIZZ OF IESSi 1975-1988 (in Billions of Sucres at Current Prices) Ceneral Gov't IES Curr. EX. Percent IESS ExR ndituros of Current IESS* ILO GOP Gov't Yeor CDP Expenditures (1) (2) (8) (4) 8/1 4/1 8/2 4/2 1976 107.7 29.6 2.9 2.7 1950 298.3 80.4 10.9 10.1 8.7 8.4 12.6 1981 846.7 96.0 18.2 12.7 8.8 8.8 18.7 18.2 1982 415.7 116.6 16.4 14.6 8.9 8.5 14.2 12.6 1983 S6o.8 149.6 20.0 28.8 8.5 4.2 18.8 16.0 1984 812.6 219.6 28.9 2.9 10.9 195 1,109.9 861.2 36.6 8.2 10.2 1986 1,836.2 a88.0 51.6 8.7 13.4 1987 1,807.5 461.7 57.4 8.2 12.7 Source: Financial and Economic Evaluation of Socvil Insurance In Ecuador, C. Mesa-Lgo, Nov. 1989. Table 6.4: SOCIAL-INSURANCZ BENEFIT EXPENDITURE BY FROGIhMs 1972-1983 (Percentage Distributions) Program 1972 1974 1960 1981 1982 198 Ponsions 59.2 60.8 76.7 75.2 74.2 75.8 Health-Maternity 29.8 29.1 14.7 16.0 16.6 16.9 Severance 10.5 9.5 6.4 6.6 7.1 6.7 Occupational Risks 0.7 0.8 2.2 2.2 2.2 1.6 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa- Lago, Nov. 1989. 197. The limited group of IESS beneficiaries receive more benefits and easier entitlement than in most other countries in the region. Benefits include: old age, disability and survivors' pensions plus seniority pensions, three extra monthly pension payments each year, and a supplemental program for privileged groups; medical and hospital care, dental care, medicine and paid leaves in the event of common sickness, maternity and occupational accidents and diseases (plus pensions for the latter); severance payments and unemployment pensions; and funeral aid. The insured is also eligible, as noted, for a variety of (implicitly subsidized) loans. The overall age of retirement is 55 with 30 years of contributions, one of the three lowest in the region. This reflects to a certain extent the low life expectancy prevailing some decades ago. However, life expectancy has increased 16 years since 1955 alone, and the 55-year threshold is no longer justifiable. Ecuadoran pensioners enjoy an average 20 to 21 years of retirement, the third longest period in the region. Other benefits include the option to retire after 35 years' work at any age; retirement on dismissal at 45 with a reduced - 77 - pension; severance pay on retirement; funeral aid to survivors; survivors' benefits to parents, brothers, and sisters (not spouses or children); and augmented pensions on retirement for those taking second jobs. The health- maternity program offers additional benefits such as dental prosthesis, contact lenses, and travel and treatment abroad (at the IESS's discretion), but, as noted previously, only very limited benefits to dependents and children. 198. The real value of pensions (excluding those of the military, which were preferentially adjusted) increased almost 74 percent from 1970 to 1980 but fell back to 25 percent over 1970 levels by 1986 (see Annex, Table 29). The IESS states that real pensions rose again by 20 percent between August 1988 and August 1989. IESS benefits evolved in response to political pressures, with the most powerful and organized groups securing the greatest advantages. The military and police come first, followed by teachers, miners and communications workers. Domestic servants, artisans, irtists, temporary sugar workers, agricultural wage earners, the self-employed, and the voluntarily insured have the lowest incomes, the least political influence and the poorest benefits. Table 6.5 shows that, since 1981, the police and the military have greatly improved their relative position, largely because, since 1984, retired military personnel have been compensated at the same rates as active. Table 6.5: IESS ANNUAL AVERAGE PENSIONS, BY INSURED GROUPS: 1981 AND 1986 1981 1986 Average Average Insured Groups Pension Indexa/ Pension Indexb/ (sucres) (sucre3) -----------------------------------------------------------__--------- White and Blue Collars (Private Sector) 32,860 100\ > 100 131,055 100 Civil Service and Banking 35,880 109/ Police 37,056 113\ > 128 244,937 187 Military 51,277 156/ -----------------------------------------------------------------__--- Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa- Lago, Nov. 1989. a/ All pensions related to the lowest (private sector). b/ Armed forces and police pensions related to civilian pensions. 199. In summary, although the IESS has one of the lowest population coverages in Latin America, its expenditures as a percentage of GDP are among the highest in the region and rising. The main causes are liberal benefits, - 78 - entitlement conditions and adjustments for inflation. The age of retirement is the third lowest in the region and pensions take the largest, and an increasing, share of total benefit expenditure. Health-maternity benefits are above the regional average but entitlement conditions are average and benefits for dependents among the worst in the region. The IESS program of severance/unemployment is among the few in Latin America. Administrative Costs and Efficiency 200. Personnel Costs. IESS personnel costs are relatively high, consuming about 8 percent of contributions (despite the omission of the rental and amortization costs of buildings used by the IESS) and about 13 percent of all current expenditures ir. 1988 (see Annex, Table 32). The IESS is characterized by excessive staff, overly generous compensation, administrative deficiencies, and the high costs and inefficiency of the health program. The rising costs of imported medicine, surgical equipment, and other inputs have aggravated the problem. The system of remuneration, described by the IESS itself as 'chaotic," comprises 66 grades for 1,500 positions. Basic salaries account for only 58 percent of total compensation, with the remaining 42 percent covering 42 fringe benefits. 201. Administrative Deficiencies. These are apparent in excessively complex, unsystematic, and contradictory legislation, the separation of Sections A and B, unnecessarily diverse contributions and benefits, the duplication of functions, inadequately planned regionalization, excessive central control, triple auditing, cumbersome and legalistic bidding procedures, lack of computerized registration, underutilization of existing computer equipment for lack of know-how, and excessive use of manual operations. 202. The Health Program. Th& cost of the health program is high and its efficiency low. Its focus is mainly on curative medicine for urban groups in the 20-55 age group with the lowest health risks. Little is spent on preventive medicine. Several indicators suggest excess capacity and overutilization and inefficient use of health facilities. IESS hospitals had the highest occupancy rates in Ecuador but average days of stay were above the national average and high by international standards (see Annex, Table 33). Other indications of low efficiency are the high average number of out-patient consultations, unexplained differences among regions and facilities, obsolete equipment and poor maintenance, poor ambulant facilities, shortages of medicine and supplies, and poor inventory control. Costs per capita of IESS health insurance in 1986 were five times those of MOH and Peasant Insurance. The IESS currently claims to be improving health administration and increasing productivity. 203. The Peasant Insurance Division, which enjoys administrative independence, provides medical--including maternity--and dental care, using auxiliaries supported by a travelling physician and relatively inexpensive infrastructure. Patients requiring more elaborate treatment are in principle referred to IESS or MOH facilities. However, coverage of the program is limited and the immunization and sanitation programs are inadequate. - 79 - 204. Little coordination exists among the various health authorities, although integration or coordination could significantly reduce costs. The National Health Council has not acted decisively to achieve this. New IESS hospital construction, which consumes the bulk of IESS investment, is oriented toward cities and provinces that already have the highest IESS coverage and the best hospital facilities in the country (see Annex, Table 34). 205. Financial and Actuarial Imbalances. IESS accounting balances are available only with a four to five year delay. When released, they are incomplete and fail to provide an adequate overview of the IESS's financial affairs. Detail regarding the state's contributions is lacking, as are single, comprehensive and consistent series on investment, state debt ard mora. Transfers to the health-maternity program from surplus programs (mainly pensions) are unclear. The lack of adequate demographic data relating to the active insured and pensioners impedes the preparation of legally mandated actuarial reviews. The most recent available data indicate that all programs generated surpluses in 1980-87 except for health-maternity (which has experienced rapidly rising deficits), the military and police, and pensions (see Table 6.6). (In contradiction, IESS management claimed Table 6.6: FINANCIAL BALANCESal OF IESS PROGRAM:S 1980-1988 (Millions of Sucres) 1980 1981 1982 19983 1984 1996 1986 1987 1988 General (Pensions) 1,198 1,201 1,583 (27) 10,764 4,264 (2,597) (4,280) Health-Matern;tyb/ (272) (208) (580) (1,204) (348) (2,657) (2,921) (3,916) (0,sl2)s/ Severance 1,946 2,870 8,037 3,403 5,964 6,836 7,788 10,819 7,109 Additional Insurance 1,393 1,368 1,678 1,986 8,560 6,898 4,276 8,086 Military & Police (488) (701) (786) (841) 4,003 844 (1,162) (487) (1,886) Contracted Insurance 417 657 675 956 4,326 8,151 1,768 2,851 Funeral Aid 449 692 769 927 1,608 1,782 2,180 2,932 Other Insurance 819 1e8 996 1,238 1,860 8,292 8,341 8,101 Other Funds 80 gD25 11 0 0 479 200 0 TOTALd/ 6,188 6,096 7,771 7,698 82,464 26,972 16,769 21,200 Percentag of CDP 1.8 1.7 1.9 1.4 4.0 2.3 1.1 1.2 Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Lago, Nov. 1989. i Incoma minus expenditures. hI These deficits are covered by other programs (mostly pensions); hence, the health maternity lino is not included in the tot l. J/ The 1989 budget projected a deficit of 10.9 billion sucres. d/ The sum of the columns (excluding health maternity) usually is different than the total shown Tn the IESS source. in early 1990 than only the health program was experiencing a cash deficit.) The zeverance and additional insurance programs have registered the major surpluses. - 80 - 206. Financial Crisis. During the 1980s, total IESS expenditures have grown at a much faster rate than total revenues, producing deficits in the general program and aggravating the deficits in the health-maternity and military/police programs. As discussed, revenues have fallen short because of2 (i) non-payment of the state's obligation and subsequent delayed payment at highly negative real interest rates; (ii) rising private and public mora and subsequent payments at negative real interest rates; (iii) highly negative real interest rates on investments (especially mortgage and personal loans); (iv) inadequate contributions to the health-maternity program, necessitating transfers from other programs to cover the resulting deficits; (v) increasing unemployment and informal employment and declines in real wages, leading to reduction in the numbers of contributors and in the real sums paid; and (vi) expanding population coverage, mainly through Peasant Insurance, with low rates of contribution. 207. Expenditures have exceeded expectations because of: (i) liberalization of benefits and adjustments above inflation; (ii) the maturing of the pension program; (iii) excessive administrative costs; and (iv) the rising costs of imports, due to the devaluation of the sucre. A 1989 IESS report concluded that: (i) transfers to the health-maternity program had practically depleted pension program reserves; (ii) programs with surpluses would not be able to subsidize programs with deficits in the future; (iii) total lESS expenditures would exceed total income by 1993 if the state maintained both debt-service payments and current obligations; (iv) if the state did not do so, an overall deficit could be realized as early as 1989 or 1990; and (v) the continued use of reserves to cover the deficit would decapitalize the system, requiring it to shift to a pay-as-you-go basis of operation. The management of the IESS argues that, with coverage increasing at 5 percent a year, the social security system could operate without a cash deficit for another 20 years. However, pursuit of this course would be tantamount either to transferring the burden of today's public sector financial irrespo ibility to tomorrow's taxpayer or accepting the inevitability of a major future collapse of the system entailing a de facto repudiation of the state obligations to contributors. 208. Contributions to the health-maternity program total 5.4 percent of wages but, according to the IESS, should have been 8.4 percent in 1988, i.e., 55 percent higher. Currently, the IESS would like to increase health- maternity contributions to 9 or 10 percent. In view of the fact that 87 percent of the 1 percent contribution for paid leave is a surplus used for health care, the figure should be higher still. Also, it is not clear if the 1 percent contribution from occupational risk insurance is adequate to cover the cost of treating injured workers. Moreover, health-maternity expenditures are underestimated, because they exclude expenditures on plant and equipment financed by "loans' or transfers from other programs and rents for the use of IESS facilities. The 1980-88 cumulative deficit of the health-maternity program was SI. 18.8 billion and is projected to increase, further eroding IESS reserves. To eliminate the health-maternity deficit, it is first necessary to increase contributions; however, to calculate the required increment, it will be necessary to include capital costs in expenditures and to evaluate the contributions from paid leave and occupational risk. Costs should be reduced by increasing the efficiency of health-care services. - 81 - 209. The severance program has generated a surplus accounting for almost one-third of IESS reserves. However, planned and possible additional increases in benefits could eliminate future surpluses, accelerating the onset of an lESS financial crisis. The two other programs generating surpluses-- additional insurance and contracted insurance--do not appear to be sound in the medium term and it is not clear that the funeral aid program will be able to generate a surplus in the future. The remaining programs lack any actuarial base and either are incurring deficits or levying inadequate premiums. D. Recommendations 210. The analysis in this chapter makes it clear that, although the social security system is not currently a source of deficit for the public sector, it is replete with problems that impinge on its efficiency, and may lead to a future financial crisis. A comprehensive program for reform is now needed. First, it would be advisable to separate the pension plan from other schemes. The planned passage of the administration of workers' reserve funds to the banking system is a welcome step in this direction (although its consequences on loss financing should be reflected in adjustment to contributory rates andlor reduction of benefits). More generally, encouragement should be given to the development of private retirement schemes, under which individuals (and their employers) contribute to personal retirement accounts, in a form similar to the Chilean system. State pension benefits should instead move towards taking a safety-net role. This would encompass some or all of the following measures: (i) elimination/reduction of generalized pension benefits such as seniority pensions, three extra monthly pensions a year, payment of minimum wage under the special retirement pension program, rights of parents and brothers/sisters to survivor pensions, and 100 percent survivor pension; and (ii) termination of privileged programs, such as improved pensions, withdrawal of contributions, etc. available to a few insured groups. The provision of health services would need to be better integrated with the rest of the national health service; cross-subsidization between pension schemes and health services is not justified. As interim measures, consideration should be given to (i) the elimination of some of the programs that IESS cannot afford, among which benefits such as part of the cost of dental prosthesis, contact lenses, and travel and medical treatment abroad; (ii) better supply of medicines to IESS facilities to minimize the costly buying of such medicines in private pharmacies; (iii) drastic cuts in administrative expenditures (including reductions in both personnel and excessive fringe benefits) as well as improvements in administrative efficiency; and (iv) a change in the predominantly curative orientation of health-care, with more emphasis placed on preventive and primary health-care, integration (or at least close coordination) of all public health facilities, and the assignment of priority to repairs and the reequipment of existing facilities over the construction of new facilities. 211. To raise revenues, the following steps should be taken: (i) increase premiums for health-maternity, so as to make this program (including its capital expenditures) self-sufficient; (ii) standardize the percentage contribution paid by all insured (based on the rrevious elimination of privileged benefits); (iii) settle the state's overall contribution to lESS, - 82 - based on the one hand on a more realistic evaluation of fiscal capacity and on the other on the renegotiation of the past state debt on fairer terms; (iv) improve the control and collection of mora and set the interest/penalty xor mora at a level above inflation: and (v) computerize registration, monthly payments, and individual accounts to reduce evasion and mora. 212. Finally, the misuse of IESS assets should be halted. The attempts at actuarial solvency have been frustrated by compelling the IESS to invest to a great extent in government paper, which does not increase the public sector's ability to service future pension obligation. Inasmuch as this is tantamount to reverting the IESS to a pay-as-you go system, this should be recognizedt the ability of the Institute to run credit programs, and to make investments in unrelated activities should be halted; the yield of the existing investment should be drastically increased by reordering the portfolio (e.g., by eliminating, or sharply reducing and tightening, the terms of mortgagelpersonal loans and increasing fixed-term deposits with profitable yields). 213. For two decades, numerous studies (including one by the World Bank) have evaluated the IESS, pinpointed its flaws and proposed reforms, yet, despite modest progress, most IESS problems remain unsolved. The new IESS administration has--for the first time in the history of the institution-- openly and bluntly acknowledged these problems and proclaimed its intention to correct them. This is commendable but also unavoidable because, if such intentions are not carried out, an important opportunity to salvage the IESS will be lost. The task of global reform will be possible only if Ecuadorans as a whole embrace it. - 83 - VII. LOCAL GOVERNMENTS A. Background 214. There are 20 provinces in Ecuador and 162 cantones or municipalities, of which two--Quito and Guayaquil--account for 26 percent of the country's total population and 52 percent of the urban population. 215. Local government expenditures averaged 13.9 percent of total public expenditures over the 1973-87 period. (The share of current expenditures averaged 11.9 percent compared with 18.7 percent in the case of capital expenditures--see Annex, Table 35.) However, they fell from a peak of 16.6 percent of total public sector expenditures in 1981 to 11.8 percent in 1987. Provincial expenditures dropped from 3.1 percent to 2.6 percent, while municipal expenditures dropped from 13.5 percent to 9.2 percent. Municipal capital expenditures experienced a particularly sharp decline (see Table 7.1). As a percentage of GDP, local government spending dropped from a peak of 5.4 in 1981 to 3.1 in 1987 (see Annex, Tables 36 and 37). These expenditure declines resulted from a drop-off in revenues, particularly from earmarked oil revenues. Municipal expenditures in Ecuador--12 percent of total public expenditures in 1984--were relatively high compared with those in most neighboring countries for that year--Brazil, 9.5; Chile, 7.7; Colombia, 9.1; Costa Rica, 3.3; Mexico, 2.9 (see Annex, Table 38). Table 7.1: LOCAL GOVERNMENT SHARE OF TOTAL PUBLIC EXPENDITURES Provincial Municipal lties Councils Total Current Capital Total Current Capital Year Expenditures Expenditures Expenditures Expenditures Expenditures Expenditures 1981 13.5 7.7 6.8 8.1 1.0 2.1 1982 12.6 7.5 5.1 2.7 0.9 1.8 1983 12.6 7.8 4.7 2.4 0.8 1.6 1984 12.0 8.4 J.7 2.6 0.9 1.7 1986 10.9 7.1 3.8 2.6 0.9 1.6 1986 10.4 e.6 3.9 2.6 0.9 1.6 1987 9.2 6.9 3.a 2.8 0.9 1.8 Source: Local Government Finances in Ecuador, H. Petrei, April 1989. B. Local Government Finances Provincial Government Revenues 216. Provincial council revenues dropped from 0.8 percent of GDP in 1983 to 0.3 percent in 1989, while expenditures fell from 0.8 percent to 0.4 percent. Provincial councils are heavily dependent on transfers (which have fallen sharply in the 19809 as a share of GDP) for their revenues (see - 84 - Table 7.2) and have become increasingly so in recent years. Locally collected revenues fell from 18 percent of total revenues in 1981 to only 7 percent in 1987. Only four provinces had locally collected revenues near or above 10 percent of their total revenues. Guayas was exceptional with 37 percent (see Annex, Table 39). Transfers through FONAPAR have become increasingly important in total provincial council transfer revenues in recent years, as petroleum revenues, fixed at 900 million sucres under the earmarking system, declined rapidly in relative importance with rising inflation (see Table 7.3). Table 7.2: PROVINCIAL COUNCIL REVENUES, 1981-1987 (Percentages of Total Provincial Revenues) Year Taxes Nontaxes Capital Transfers 1981 7.7 10.5 17.6 64.2 1982 3.9 11.2 15.5 69.4 1983 3.6 9.6 14.7 72.2 1984 3.1 11.6 24.6 60.8 1985 2.8 6.7 20.5 70.0 1986 5.0 8.0 14.2 72.8 1987 2.2 4.7 9.5 83.6 Source: Local Government Public Finance in Ecuador, H. Petrei, April 1989. Table 7.3: SOURCES OF TRANSFERS TO PROVINCIAL COUNCILS Year Total Transfers FONAPAR PETROLEUM OTHER 1981 100 45.7 32.9 21.4 1982 100 49.0 29.7 21.3 1983 100 49.6 25.6 24.9 1984 100 52.1 23.9 24.0 1985 100 48.1 13.4 38.5 1986 100 45.3 11.9 42.8 1987 100 41.7 7.6 50.7 1988 100 75.7 10.2 14.1 Source: Ecuador: Transferencias del Gobierno Central a los Gobiernos Seccionales, H. Petrei, November 1989. Municipal Revenues 217. Municipal revenues fell from 2.1 percent of GDP in 1983 to 1.7 percent in 1989, mainly reflecting a decline in petroleum revenue transfers relative to GDP, while expenditures fell from 2.1 percent of GDP to 1.4 percent. While between 1982 and 1987 overall municipal revenues declined in real terms at an annual rate of 3.6 percent, taxes collected rose - 85 - 2.5 percent a year in real terms and service charges 7.7 percent a year, indicating that municipalities' own revenue collection efforts picked up as transfers declined. Transfers from the central Government represented 56.3 percent of municipa'l revenues over the 1982-87 period, taxes 21.7 percent, credit 11.7 percent, public utility rates 2.9 percent, local improvement taxes 1.5 percent, and rents, asset sales, etc., the remaining 5.9 percent. Transfers represented just over a third of the total revenues of the two largest municipalities (Quito and Guayaquil) but about 91 percent of the revenues of municipalities with under 15,000 inhabitants (Table 7.4). Conversely, local taxes and service charges represented 40 percent of the revenues of Quito and Guayaquil but only 3 percent of the revenues of the smallest municipalities. Table 7.4: Sorue of lknielppt Revemue, 1962 Population Municipallttie Percent of Total IService Capito I Strata Sample Total Taxes Chargs Other Transfe Crodits 1 >1,000,000 2 2 88.4 3.7 6.6 34.1 19.2 2 200,000-1,000,000 a 4 15.1 4.0 6.8 54.9 19.2 a 100,000-200,000 7 11 14.9 2.7 8.0 69.7 14.7 4 60,000-100,000 13 22 9.1 1.8 4.6 74.9 9.9 6 30,000-s0,000 15 33 12.6 1.8 0.6 17.8 6.2 6 16,000-30,000 1S 47 4.6 1.8 4.4 84.0 5.2 7 (16,000 18 39 2.2 0.8 2.4 91.0 3.6 TOTAL 71 158 Source: Local Government Public Finance In Ecuador, H. Petrei, April 1989 Transfers from the Central Government 218. Municipalities receive funds from the central Government through a number of different cha:anels: the National Revenue-Sharing Fund (FONAPAR), which is the most important; earmarked oil revenues; the budget; other sources; and IETEL (Table 7.5). Municipalities also borrow from numerous internal and external sources. FONAPAR's share of transfers rose from 45 percent of the total in 1981 to 57 percent in 1988. Notwithstanding this, FONAPAR transfers fell from 0.8 percent of GDP to 0.6 percent between 1983 and 1988--despite a strong increase in the proportion of its total transfers going to municipalities (see Table 2.13)--as a result of the sharp decline in its own netroleum income (see Ta:le 2.14). This occurred despite a strong increase in the proportion of FONAPAR's transfers going to municipalities (see Table 2.13). The municipalities receive a fixed amount of 2.1 billion sucres - 86 - from oil revenuesi6 but inflation had by 1987 reduced the real value of this allocaion to only 30 percent of the 1982 level. (Oil revenues nonetheless remain extremely important for smaller municipalities, which receive per capita allocations in some cases in excess of 50 times t%tose received by the largest municipalities.) Transfe-3 from the central Government budget have risen erratically from 5 percent of the total to 13 percent over the 1981-1988 period. Table 7.5: TRANSFERS TO MUNICIPALITIES, 1981-88 (Percentages of Total Transfers) Year FONAPAR Petroleum Budget Othersal IETELb/ Total 1981 45.4 37.1 5.3 12.2 - 100.0 1982 49.1 33.7 5.5 11.7 - 100.0 1983 50.2 30.6 8.1 11.1 - 100.0 1984 56.3 23.8 7.5 12.6 - 100.0 1985 56.5 14.4 10.9 18.5 - 100.0 1986 53.7 11.2 6.9 24.5 3.7 .?0.0 1987 62.9 9.6 4.7 19.0 3.9 100.0 1988 56.7 6.3 13.2 19.3 4.6 100.0 Source: Ecuador: Transferencias del Gobierno Central a los Gobiernos Seccionales, H. Petrei, November 1989. a/ Fondo Nacional de Emergencias (FONEM), agreements, capital contributions, etc. b/ Two-thirds of the 15 percent tax on telephone calls. 219. FONAPAR. FONIAPAR's transfers to municipalities flow through two channels: automatic retentions and designated investment funds. In 1988, two-thirds of the funds transferred by FONAPAR represented automatic retentions, but there were extremely wide variations in this share among municipalities. Smaller municipalities received bigger per capita grants than the larger municipalities through both channels. Automatic retentions are related to the amounts that were being collected by municipalities at the time FONAPAR was established in 1971 and that were replaced by FONAPAR transfers. Automatic retentions have subsequently been adjusted for inflation to pay for salary increases, often granted at the national level--and on a case-by-case 16/ Some 30 percent of oil revenue transfers from the tax on refined petroleum product price increases is distributed equally among the twenty- eight municipalities in Oriente and Galapagos provinces and 70 percent equally among the rest of the municipalities in the courntry. Municipalities ir. the province of Esmeraldas share about 100 million sucres in oil royalties. - 87 - basis. They are transferred to municipalities by the Central Bank. Investment transfers are determined by the Ministry of Finance, based, in part, on population, territory, and needs. 220. Not all municipalities avail themselves fully of the investment funds available through PONAPAR. In 1982, investment transfers were 80 percent higher than automatic retentions; however, in 1987, automatic retentions were 20 percent higber than investments, implying, in view of the overall declines in FONAPAR transfers relative to GDP, very sharp relative declines in investment transfers. Because of central Government delays in informing local governments about their allocations, the latter have difficulties in preparing their budgets. Laborious procedures for obtaining payments for investments, which are similar to those applicable to contractors to the central Government, cause delays in executing local government budgets. The separation of investment transfers from autematic retentions was intended to encourage municipalities to strengthen their own investment efforts, but there is scant evidence that it has been successful. 221. Other Transfers. Although FONAPAR was originally established to be the unique conduit for central Government transfers to municipalities, other channels accounted for over 40 percent of such transfers in 1988 (see Table 7.5). Petroleum revenues, 'ixed in nominal sucre terms, were eroded by inflation from 37 to 6 percent of total revenues from 1981 to 1988. However, budgetary and other transfers have grown in importance. Two percent of current budgetary expenditures are earmarked for the provincial capitals: 25 percent each to Quito and Guayaquil and the remaining 50 percent equally among the remaining provincial capitals. General budgetary transfers follow no set rules: the executive branch determines their distribution. Other transfers made by centralized agencies in the form of conditional subsidies represented 15 percent of total transfers between 1982 and 1987. While assisting the municipalities, they have hampered the decentralization of municipal expenditure decisions. In addition to explicit budgetary transfers, municipalities benefit from Ministry of Public Works projects benefitting individual municipalities. 222. Conclusions. The overall process for determining the amount and distribution of central Government transfers to the municipalities had become fragmented, arbitrary, duplicative, nontransparent, and unpredictable. Furthermore, it did not adequately address the alleviation of poverty. Transfers should be made on the basis of well-defined criteria that impart greater stability and predictability to the transfer process and encourage municipalities to make greater efforts to raise revenues themselves, as is the case under the new law establishing the FODESEC. Municipal Tax Revenues 223. Municipal taxes comprise mainly taxes uniformly applied in all municipalities, as prescribed by the law covering local government. Some 55 percent of such revenues represent taxes on real estate, transfers of ownership, and profits from sales. The rest are taxes on business activities, vehicles and other sources. - 88 - 224. Urban Property Taxes. Urban property taxes represented 34 percent of municipal tax revenues during the 1982-87 period. They are particularly important for the larger municipalities, for which they represent 40 percent of tax revenues, compared to only 5 percent in the case of the smallest municipalities. The base for the tax is 60 percent of the market value of urban property, including land and improvements. The efficient administration of the tax depends on comprehensive coverage of properties and adequate updatir,g of the municipal cadastres, but this is rarely achieved. Inflation is a particular problem. Coverage is 60 to 90 percent of the theoretical number of properties, although where the National Preinvestment Fund (FONAPRE) has been involved in preparing the cadastre, coverage has been good. Poor coordination and reporting delays between the municipalities and the National Agency for Appraisals and Cadastres (DINAC), which prepares the tax bills, sometimes leads either to properties being subjected to neither the rural land tax nor the urban property tax, or else, being subjected to both. Lack of expert appraisal, hindered by technical, legal and political problems, is the main barrier to the efficient functioning of this tax. The chief problem is political: there is strong local resistance to property tax increases. 225. Under the Fiscal Reform Act of December 1988, it became legal to revalue properties on the basis of indexes of inflation, making it theoretically possible to fix the inflaion problem. Distributive criteria-- lower tax rates for smaller property values--have been used by some authorities (e.g., Quito) when updating valuations. The tax itself is progressive and in principle based on the combined value of all the properties belonging to one owner in a municipality. In practice, most municipalities compute the tax on each property separately. Bracket creep attributable to inflation (tax brackets are fixed in nominal terms) could be a problem if inflation adjustments to property valuations become widely adopted. About 60 percent of taxpayers settle their bills during the year the bill applies. Delinquents face punitive interest charges. Although the municipalities can take coercive action against delinquents, strong, prompt action is rare and internal controls on overdue accounts are inadequate. 226. Reform of the urban property tax should emphasize the updating of municipal cadastres and valuations and proper follow-up of tax collection. The municipalities that are most effective in collecting taxes should be rewarded. Since the costs (about SI. 5000 per unit) of the usual methods of updating cadastres--surveys and photographic restitution--are excessive for small municipalities in relation to potential increases in revenues, simplified revaluation methods could be employed in such cases (e.g., based on the locality of the property, with land-based corrections for the most obvious deviations). Omissions in municipal cadastres could be dealt with by applying simple valuations based on the dimensions of the property and the type and year of construction, pending the completion of a more comprehensive and detailed cadastre. Mechanisms to improve tax collection could include the listing of all properties owned by the same taxpayer, independent cross- checks, and payment follow-up procedures. Legislative improvements could include provisions for adjusting tax brackets by a general index of inflation (the minimum wage used for some adjustments is insufficiently representative) and adjusting discounts and surcharges for early or late payments to market interest rates (from the current implicit 21 percent). - 89 - 227. Rural Land Tax. Rural land tax receipts fell from 9.2 percent of total municipal fiscal revenues in 1982 to only 4.3 percent in 1987. This mainly reflects poor maintenance of the cadastres and property valuations and, to a lesser extent, recession and the lack of adequate tax collection efforts. DINAC establishes the valuations for the land tax and submits the tax bills to each municipality for collection. DINAC receives 10 percent of the tax due. It maintains countrywide cadastral records but usually relies on municipalities to update valuations. In only a few municipalities has there been a complete survey of the rural areas. In these cases, DINAC covers about 80 percent of the properties; in the rest, coverage is about 60 percent. 228. The rural land tax rate is more progressive than urban property tax rates and is applied to all of the properties belonging to the same owner in a given canton. Tax creep has also resulted from inflation in this case and the average rate of tax on fiscal valuations--fiscal valuations are 20-30 percent of market values--has risen from 0.79 percent in 1982 to 1.05 percent in 1987. Only about 50 percent of taxpayers comply. The ratio of taxes received to amount of bills issued rose from 37 percent in 1982 to 53 percent in 1985 but dropped back again to 42 percent in 1987. 229. DINAC has established uniform tax bases for rural lands and has helped compensate for the administrative deficiencies of the municipalities. Nevertheless, problems remain. Tax bills should be issued well in advance. Cadastres should be updated across Ecuador, although, purely for tax administration purposes, tax rolls could be updated by simpler methods than the carrying out of detailed surveys. Better coordination between DINAC and the municipalities is needed. DINAC needs to speed up its registration of changes reported by the municipalities and the latter need to improve reporting to DINAC regarding changes in land use. Brackets in the progressive rate schedule should be defined in tax units adjusted for inflation rather than in nominal terms. Collection of this tax might be turned over to the municipalities. 230. Property Transfer Taxes. This progressive tax is levied on transfers of ownership of ships and real estate. Receipts accounted for between 13 and 15.4 percent of municipal tax revenues during the period 1982-87. Again, inflation coupled with fixed nominal tax brackets produces bracket creep. The fiscal valuation is used as the minimum basis for the tax, but generally the tax is based on prices as reported by the interested parties, usually substantially below market prices. The rate for this tax is very high, starting at 4 percent on amounts of SI. 500,000 and reaching 8 percent on amounts above SI. 10,000,000. This discourages transfers, and stimulates underreporting, and it would be better to substitute higher annual property taxes for high transfer taxes. Reforms should include indexing the tax brackets, reducing the rates, and updating property valuations. 231. Business License Tax. This is a progressive annual tax levied against the capital used by business. The brackets are fixed in nominal terms. The maximum tax, S/. 800, levied on capital over SI. 2,000,000, is barely enough to cover administrative expenses. In this case, the rate of tax should be increased and the brackets indexed. Municipalities should exchange - 90 - information and work with the National Revenue Service (DGR) to limit evasion of both income and business license taxes. 232. Urban Property Transactions Profits Tax. This tax, which represents, on average, only about 3.6 percent of total taxes and which has been falling sharply in real terms, is imposed on income from urban property sales, with rates rising from 10 percent on a base of S/. 10,000 to 42 percent on a base of SI. 1,000,000--an extremely high rate. The tax allows deductions for property improvements, plus 5 percent for each year between the purchase and sale dates, and incorporates an adjustment for inflation. The rate schedule should be lowered. 233. Working Capital Tax. This tax is now levied on total assets and has grown in importance. It could be merged with the business license tax, since the same taxpayers are involved. 234. Service Charges. Service charges represented about 8 percent of municipally generated revenues between 1982 and 1986 but rose to 12 percent in 1987. Charges typically cover a relatively small part of the cost of water, sewers, garbage collection and slaughterhouses, but there is wide dispersion among municipalities. On average, municipalities charge 30 percent of the cost of supplying water and typically charge equally for sewerage, implying a higher proportion of cost recovery in the latter case. The law does not allow for the costs of capital used to supply water to be covered--only (as a maximum) maintenance and service costs. The Ecuadoran Institute of Sanitary Works (IEOS) advises on rates but its conclusions are rarely adopted. Public lighting is nearly always estimated by the electricity companies as a fraction of residential consumption. A complete overhaul of service charges is needed that will raise municipal revenues and cover all costs, including capital costs. Subsidized rates should be granted only to very-low-income families and for basic needs. 235. Betterment Levies. Betterment taxes, which declined in importance from 1982 to 1987, are levied for urban repaving, fences, sidewalks, sewers, irrigation and public lighting. Legislation governs the types of public works to be assessed and the basis for calculating the levy. Collection is uneven, with some municipalities collecting at least a portion and others not. In some cases, there is no effective follow-up of bills. Tax installments are not adjusted for inflation. Early payment discount rates are below market interest rates. Collection of this tax needs to be enforced, with installments adjusted for inflation and early payment discount rates equal to market interest rates. The transfer of tax billing to the contractors themselves could ensuLe an improved collection rate. C. Local Government Expenditures Provincial Council Expenditures 236. Provincial councils allocate close to 60 percent of their resources to investment, mainly road construction and maintenance, although in recent years they have been expanding the range of services they provide. Between 1982 and 1987, the distribution of provincial spending was as follows: - 91 - Percent of total expenditures Wages & salaries 20.8 Social security contributions 4.4 Other current expenditures 5.9 Debt service 10.7 Public works 51.4 Other capital outlays 6.7 TOTAL 100.0 Municipal Expenditures 237. Local public services are deficient in all urban areas of Ecuador, particularly the coast. The availability of water is only 50 percent in Guayaquil, the worst-served city, and water is rationed in most urban areas. Sewerage services are even poorer, averaging only about 40 percent in coastal cities and 80 percent in the Sierra. Roads and garbage collection, particularly in poor neighborhoods, are inadequate. Though improvements were realized during the 1970s, backsliding has been the rule since the 1982-84 period. 238. These problems stem from inadequate finances and poor management. Inadequate revenues reflect the declines in petroleum revenues and insufficient local tax collection efforts. Municipalities are highly politicized and lack professional, stable management. Water tariffs do not even cover operations and maintenance costs and water companies exert inadequate control over water delivery, billing, and collection. Municipalities' budgetary resources are inadequate and, as noted, they raise little financing from their own sources (apart from Quito and Guayaquil, only about 22 percent in 1987). Wage and salary expenditures are inflated by union pressures and central Government wage policies. Improving this situation will require increased revenue-generating efforts by the municipalities and better allocation of expenditures. 239. An overall reduction of about 10 percent in real municipal spending took place from 1981 to 1987. Quito and Guayaquil increased their expenditures by about 12 percent, but the rest experienced declines averaging, for the various size categories, from 22 percent to 53 percent. The 1982-87 period distribution of municipal expenditures was as follows: Wages & salaries 24.8 Social security transfers 6.8 Other current expenditures 3.4 Debt service 14.6 Public works 36.5 Other capital outlays 13.9 TOTAL 100.0 - 92 - The wages and salaries share of municipal expenditures has been rising for most municipalities since 1982. Central Government minimum salary policy covers municipal white- and blue-collar workers and is reflected in automatically increased central Government transfers each time minimum salaries are increased. It is primarily the larger municipalities that have debt-service obligations. iMunicipal Debt 240. At end-1988, municipal debt stood at about 86 billion sucres, with annual debt service for 1989 projected at 9.6 billion sucres. A little over two-thirds of the debt was external (see Table 7.6), with over two-thirds owed to international organizations. The central Government has assumed responsibility for the bulk of external debt. Over 80 percent of the domestic debt was owed for electrification programs and to BEDE. Borrowing from IESS relates to IESS purchases of municipal bonds plus consolidated and unconsolidated debts relating to unmet social security obligations. Table 7.6: MUNICIPAL DEBT AND DEBT SERVICE (MilIlons of Sucrer) ------------------------------------------------------------------__---------__----------------- Debt Outstnding Percentage Annusl Debt December 19e8 Distribution Service 1989 Internal Debt BEDE ..9,025 .10.6 .992 FONAPRE ..876. 1.0 .846 IESS 1,452 .1.7 .6 IESS (Other) 620 .0.6 .146 Government (Bonds) 114. 0.1 .56 IEOS 219 .0. . . . . 8 . . . 24 Electric Companies and Rural . 18,434 .15.7 . . 2,070 Electrification Electric Companies . .2,117. . 2.5 Purchases of Energy Total Internal Debt 27,757 82.4 8,987 External Debt Banks 2,405 .14.5 . e International Organizations 39,061 .46.6 .4,106 Suppliers 1,623 .1.9 .8 Covernments 4,944 . 5..2 ---------------------------------------------------__------------------------------------------ Total External Debt .8,0 .6. 07 6,24 Total Debt 85,790 .100.0 .9,611 Source: Local Government Public Finance in Ecuador, H. Petrel, April 1989. Municipalities also owed significant amounts for unpaid electricity bills for services to public offices and public lighting. Legally, municipalities are required to charge prices or rates adequate to service the debts associated with a project but in practice this requirement is ignored and there is no mechanism to enforce compliance. Total financial debt service is not legally permitted to exceed 20 percent of the budget but several municipalities violate this provision. Debt service exceeds more than 60 percent of locally - 93 - generated revenues for about a half of the municipalities. Financing public works through borrowing has some advantagess it increases local government responsibility for administering their funds, yet at the same time loan conditions can assure compliance with existing regulations and proper execution of a project. Budgeting and Planning 241. Budgets at the local level serve primarily recording and reporting, rather than planning, functions. Furthermore, weak municipal administration and uncertainty about central Government transfers delay their timely preparation. Each budget is submitted for approval to CONADE, which ensures, in particular, that forecast revenues are within the capabilities of the municipality; if not, the budget is rejected and a new one requested. Budget execution depends heavily on the receipt of revenues from the central Government, which are, as noted, subject to delays and, in the case of investments, the completion of detailed procedures. An auditor or the financial director supervises the execution of the budget, sometimes with the participation of council members. The Controller-General reviews periodic reports from the municipalities and carries out selective audits. 242. Needed improvements include: the establishment of priorities, beginning at the budget preparation stage; the development of simplified cost accounting by program, based on the manuals that have been prepared by Oe Controller-General; the tightening up and standardization of reporting;- and the strengthening of administrative procedures so as to permit clearer definition of priorities and closer awareness of the financial position of the municipality. 243. Achieving these improvements will entail: providing technical cooperation to train local government officials; computerizing operations using instructions and standard programs prepared by central agencies; installing effective cost accounting; establishing effective auditing and supervision; linking improved, standardized reporting to eligibility for transfers and loans; publishing comparative quantitative data covering all municipalities; adopting human resource policies, linked to increased revenues, that encompass increasing the numbers and raising the salaries of profe'sional personnel; and the secondment of central Government employees for tours of duty at the municipal level. 244. An urban planning capacity exists in every large and medium-sized municipality. However, in general, external assistance contracted by FONAPRE and the municipality has proved necessary to establish an adequate planning framework, although close cooperation with the municipality has usually been 17/ For example, income tax and social security payments from salaries should be reported as expenditures only when they are paid to the Central Government, not when they are deducted from the salaries of employees, as is often the case. These payroll deductions in arrears serve as an important source of "financing" for these governments, and are disguised in the accounts. - 94 - needed to ensure that the result was fully adapted to its needs. FONAPRE cooperation with municipalities should continue, but with greater participation by local officials and local organizations. Municipal urban planning offices should be strengthened. A technical cooperation program should be implemented for the smaller municipalities. D. Reform of Local Finances Main Requirements for Reform 245. Improving the Provision of Local Public Services. Increasing the availability of local public services and improving the efficiency of local public resource allocation calls for a strengthening of local government. This would at the same time entrench democratic traditions and enhance social stability. The main elements in a package to improve the provision of local public services would be: (i) simplifying, unifying and making more transparent and predictable the flow of central government transfers to the provincial councils and municipalities; (ii) providing more generous per capita transfers to the poorer municipalities; (iii) providing strong inducements for municipalities to provide a higher proportion of their own revenues and particularly to strengthen cost recovery procedures for the services they provide; (iv) strengthening the municipalities capacities to budget and administer taxes and service charges and to prepare and execute productive investment projects; and (v) clearly defining provincial councils' and municipalities' roles and responsibilities. 246. Provincial councils should have the central role in providing services to rural areas and the coordination of projects or services covering more than one municipality. Municipalities would be responsible for providing urban services. Central agencies should gradually shift responsibility for local services to the local governments, refocussing their own efforts towards contributing to the development of the decision-making capabilities of the local governments. The inevitable costs of this process could be minimized by making it gradual (although on a firm schedule) and providing suitable forms of assistance, such as: (i) establishing a technical cooperation program administered, e.g., by the Association of Municipalities; and (ii) seconding central government employees to municipalities under the provisions of the civil service law. Also, experiments with the partial or complete transfer of slaughterhouses, markets, and garbage collection to the private sector, thereby freeing-up municipal resources for more urgent needs, could be tried. 247. The revenue-generating capacities of the provincial councils and municipalities should be enhanced. The proceeds of the rural land tax could be transferred to the provinces if they are to play a more important role in the provision of public services to rural areas. For municipalities, efforts to increase returns from the urban property tax are vital. Service charges, especially for water and sewerage, and betterment levies should be increased to cover all costs, including the capital costs, of the services provided. - 95 - Reforms of the Municipal and Provincial Transfers Systems 248. Reform of the Transfer System. In accord with the policy intents defined in the Policy Letter for the Municipal Development and Urban Infrastructure Project (cofinanced by the World Bank, the Interamerican Development Bank and the German GTZ), Congress recently passed legislation ivpforming the whole national/local goverygent transfer system to make the system more predictable and transparent.18 Under this law, FODESEC (Fondo de Desarrollo Seccional) replaces FONAPAR and will receive the following resources: (i) 2 percent of the total non-earmarked resources of the National Budget to be distributed directly to the provincial capitals; (ii) all of the revenues previously assigned to FONAPAR; (iii) three billion sucres per year from the oil export revenues (to be adjusted annually beginning in 1991 using the consumer price index); and (iv) future budget allocations from the National Budget. All of these resources will be deposited directly into FODESEC's account in the Central Bank for future distribution to the local governments. In all, the total amount to be distributed annually via FODESEC should exceed US$87 million. 249. The 2 percent of the non-earmarked National Budget going to the provincial capitals will be distributed as follows: (i) Quito and Guayaquil will receive 25 percent each, and (;. the remaining 50 percent will be divided equally among the rest of the provincial capitals. The remaining amount of FODESEC will be distributed, first, between provinces and municipalities and, then, among the entities of each of these three groups. Panel A of Chart 7.1 shows the criteria used in the first stage of the distribution: (a) 20 percent to the Provincial Councils and the Instituto Nacional Galapagos (hereafter, the provinces); (b) 75 percent to the municipalities; and (c) 5 percent for the Emergency Reserve Account. 250. The 75 percent going to the municipalities will be divided into two portions: 60 percent for automatic distribution and 40 percent for the Investment Fund. As Panel B of Chart 7.1 demonstrates, the following three criteria will be used in automatic distribution: (i) 60 percent by population; (ii) 30 percent by povert 1 and (iii) 10 percent by fiscal effort in relation to total capacity to pay.- Following IMF guidelines, these 18/ Ecuador, Congresso Nacional, "Ley de desarrollo seccional y de reformas a las leyes de regimen municipal, regimen tributario interno, arancelaria, organica de administracion financiera y de control tributario y financiero", May 8, 1990. 19/ The 20 percent going to the provinces will be distributed as follows: 60 percent by population; 20 percent by geographical area; and 20 percent by poverty. _ 95a - Chart 7.1 ECUADOR A. Prlmary Distribution of FODESEC a/ See text for cdtstributional criteria B. Distribution to Municipalities A,IOfiOtf , i ISt,, ... 60% 40%C OC~O by POOulet'n b Dv P"grty by F.ScOI Effot, Son OfIefng S dfir bGQtf O'Se a/ Up-front subSidles to poor families C. Distribution to Provinces 20% Provinces (AutomatiC) 60% 220%0% by Population by Area by Poverty - 96 - resources should be considered to be municiml revenues, because they are automatically set aside for municipalities.- The Investment Fund will be the primary source of counterpart funds of municipal governments for the proposed IBRD/IDB project. 251. In summary, this new system is a big step in the direction of a more predictable, transparent, and sustainable transfer system that should contribute significantly to the development of a more efficient and equitable system of fiscal federalism in Ecuador with incentives for lucal governments to contribute to the macroeconomic goals of lowering the fiscal deficit. Chart 7.1 summarizes all of the distribution criteria and shows the total projected amount to be distributed under each criteria in 1991. Nevertheless, there is still room for progress, such as by: reducing the budget allocations for discretionary grants not consolidated in FODESEC; and also of consolidating the many special laws transferring revenues to individual provinces or groups of them. Using the consumer price index to adjust the amount of the allocation from oil exports may well cause fiscal problems in the future, as this breaks the link between the actual amount of these profits and the budget allocation. It would have been much wiser to adjust this amount with reference to the profits on oil exports. 252. Reform of Municipal Government. The above reforms of the transfer system will provide the institutional foundation for the Municipal Development and Urban Infrastructure Project which will assist these governments in increasing their revenues (through better tax administration, changes in local and national legislation, increased use of user charges, etc.) and also through improved efficiency in public expenditures. This would be accomplished through institutional development and training, seeking to strengthen the overall capacity of municipalities to mobilize resources (e.g., update cadavtres, improve billing procedures, and revise legislation) and allocate them efficiently (e.g., improvements in budgeting, planning, procurement and personnel policy). Under the previously mentioned law, local governments wer 1given the power to recover the full cost of urban infrastructure.- 20/ 'It may be useful to attribute tax revenues to noncollecting beneficiary governments ... when under provisions of the tax law they automatically receive a given percentage of the tax collected." IMF, A Manual on Government Finance Statistics, Washington, D.C. 1986, p. 53. 21! Op. cit. Before this law, local governments could recover operating and maintenance costs, but not capital costs. - 97 - VIII. PUBLIC ENTERPRISES A. Overview Relative Importance 253. There are 57 non-financial public enterprises in Ecuador; however, statistics are readily available only for the ten most important, which are discussed here. Data for the remainder are grouped under the residual accounts. As noted earlier, public enterprises grew very rapidly between 1973 and 1983; the impact of the public enterprises on the overall efficiency of the Ecuadoran economy and on the overall financial position of the non- financial public sector became correspondingly more important. Since 1983, the public enterprise share of total public expenditure has stabilized. 254. The total expenditures of the ten major public enterprises, defined as the sum of operating and non-operating expenditures plus capital expenditures, amounted to SI. 551.1 billion sucres in 1989, or about 10 percent of GDP. The contributions of individual enterprises to this total are shown in Table 8.1. PETROECUADOR alone accounted for 46 percent of total public enterprise expenditures, while the top four public enterprises-- PETROECUADOR, IETEL, INECEL and ECUATORIANA--accounted for 86 percent. Table 8.1: EXPENDITURES OF PUBLIC ENTERPRISES, 1989 -----------------------------------------------------------__--------------- Billion Percent of Percent Sucres GDP of Total --------------------------------------------------------------------__------ CEPE (PETROECUADOR) 250.6 4.6 45.5 IETEL 86.6 1.6 15.7 INECEL 74.3 1.4 13.5 ECUATORIANA 61.2 1.1 11.1 TRANSNAVE 32.1 0.6 5.8 FLOPEC 15.6 0.3 2.8 TAME 9.5 0.2 1.7 FERROCARRILES 7.4 0.1 1.3 ENAC 7.4 0.1 1.3 ENPROVIT 6.3 0.1 1.2 551.1 10.3 100.0 Source: IMF and World Bank Estimates. - 98 - Financial Performance 255. Over the years 1983-89, the overall public enterprise sector deficit averaged about 0.5 percent of GDP and accounted for about a sixth of the overall nonfinancial public sector deficit (Table 2.9). The deficit was sharply reduced from 1988 to 1989, reflecting, for the most part, a turnaround in CEPE's balance from a deficit of 0.5 percent of GDP in 1988 to a surplus of 0.4 percent in 1989 (Table 8.2). The overall balance for the nonfinancial public enterprise sector is dominated by the balances for CEPE, INECEL and IETEL. No simple conclusions can ho firawn ahout the performance of the three enterprises from the magnitude of these deficits, since--like Ecuador's other public enterprises--they do not enjoy operational or financial autonomy. CEPE's net income position, for example, has been affected by declining earmarked public petroleum revenue transfers and by what it has legally been permitted to regard as costs under the Hydrocarbons Law. INECEL's financial position has also been influenced by declining earmarked oil revenues, only partly offset by Government transfers. IETEL's financial position has been dominated by massive cross-subsidies to its domestic operations from its international operations. Finally, all public enterprise prices and tariffs are subject to close political control. Table 8.2z PUBLIC ENTERPRISE BALANCES, 1983-89 (Percentages of GDP) 1983 1984 1985 1986 1987 1988 1939 CEPE/PETROECUADOR -0.1 0.4 -0.2 -0.6 -0.9 -0.5 0.4 INECEL 0.2 0.2 -0.1 -0.5 -0.7 -0.7 -0.6 IETEL -0.1 -0.1 0.3 0.0 0.0 -0.5 -0.3 ECUATORIANA 0.0 0.0 0.1 0.1 0.0 0.0 -0.1 ENAC 0.1 0.0 0.1 0.0 -0.1 0.0 -0.1 ENPROVIT 0.0 0.0 0.0 0.0 0.0 0.0 0.0 TAME 0.9 0.0 0.0 0.0 0.0 0.0 0.0 FLOPEC 0.1 0.1 0.1 0.1 0.0 0.0 0.0 TRANSNAVE 0.0 0.1 0.1 0.1 0.0 0.0 0.4 FERROCARRILES 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Overall Balance 0.3 0.6 0.3 -0.9 -1.7 -1.8 -0.2 Source: IMF, Ministry of Finance. 256. At the beginning of 1990 PETROECUADOR and IETEL were projecting significant current account surpluses for the year. These surpluses were expected to finance the bulk of their investment programs, with the balance covered mainly by foreign financing. INECEL's current account surplus has recently been small or negative, despite the company's receipt of substantial central Government transfers to meet its external debt payment obligations and despite its relatively low debt burden. (INECEL's low debt burden reflects the fact that much of its earlier investment program was financed out of - 99 - earmarked oil revenues.) Most of INECEL's 1989 investment program was externally financed. In financial terms, INECEL is the weakest (at current tariff/price levels) of the three largest public enterprises. 257. The existence of significant public enterprise deficits need not, by itself, be a cause of concern. If the enterprises in questicn are facing strong effective demand, charging realistic prices, generating adequate revenues, controlling costs, and undertaking sound investments, then borrowing to finance a substantial part of their investment programs may be fully justified. However, these conditions do not obtain for INECEL and IETEL--or for most of the other public enterprises--and there is no present assurance that they will obtain in the case of PETROECUADOR. Debt Situation 258. External Debts. Only the three major enterprises are shown in published Central Bank data as having external debts. At end-1990, their total outstanding debt (including arrears) amounted to US$623.2 million, distributed as follows: Percent of Percent of Total US$ Million Total PE Debt Public External Debt INECEL 373.1 59.9 3.4 PETROECUADOR 103.9 16.7 0.9 IETEL 146.2 23.5 1.4 623.2 100.0 5.7 This situation is likely to change rapidly if PETROECUADOR, as allowed under its legal charter, finances an expanded investment program through external borrowings. INECEL and IETEL, on the other hand, will probably face serious constraints. INECEL, in particular, appears unlikely to be able to expand its borrowings significantly, since it is both subject to constraints on its tariffs and unable to service its existing debt from its own resources. 259. Internal Debts. PETROECUADOR had cumulative debts to the central budget amounting to S/. 23.6 billion in 1988 (see Annex, Table 6). These debts resulted from PETROECUADOR'S inability to transfer out of its receipts from domestic petroleum product sales all of the amounts legally owing to the central budget under the earmarking regulations. This situation arose, in turn, because its income was no longer adequate to cover both its costs and its investment program financing requirements following the massive decline in its share of oil revenues (from 14.4 percent of the total to 0.2 percent) between 1980 and 1989. The cumulative amount shown in Annex, Table 6 does not include accrued interest charges. IETEL does not have any debts to the central Government; on the contrary, relatively small amounts are owed to it by the Government. At end 1989, INECEL was owed a total of Si. 5.6 billion by various Government entities (see Annex, Table 40). INECEL has no debts to the central Government and the Government (as noted) is covering its external debt servicing obligations. - 100 - Institutional Controls 260. Formal Controls. The state exercises formal control over the public enterprises through the composition of their boards of directors. For example, even under PETROECUADOR's new law, the structure of the Board of Directors is such as to assure continued strong central political control over the enterprise. The Minister of Energy and Mines presides and a representative of the President serves as alternate president. Other representatives include the Minister of Finance, the Minister of Industry, Commerce, Integration and Fisheries, the Chief of the Joint Command of the Armed Forces, the Manager of the Central Bank, the Secretary General for Planning of CONP)E, and an elected representative of PETROECUADOR and its affiliates' worke.s. Formally, the Board establishes policies for PETROECUADOR and its affiliates, approves organizational arrangements, salary policies, plans, and budgets, and evaluates their execution together with that of other management functions established by PETROECUADOR's governing regulations. However, public enterprise boards typically go beyond their legally defined roles and intervene directly in day-to-day operational decisions. 261. Budgetary Controls. As discussed in Chapter V, centralized budgetary control by the Ministry of Finance is limited by the fragmented character of the process for submitting enterprise budgets. There are three separate processes. Some enterprises, (e.g., ENAC, ENPROVIT, ENDES) are required to submit their budgets to the Ministry of Finance in June/July one year in advance. The Ministry of Finance has two months to review them and negotiate modifications, if required, before sending them on to Congress with a covering report for approval in December. Another group (e.g., FLOPEC, TRANSNAVE, ECUATORIANA, TAME) send their budgets directly to Congress, without review by the Ministry of Finance. These budgets are approved during the first quarter of the year to which the budget applies. PETROECUADOR, INECEL, and IETEL represent a third group. Their budgets are also approved during the first quarter. IETEL's budget goes through the Ministry of Finance, PETROECUADOR's goes to Congress directly, while INECEL's either goes through the Ministry of Finance or directly to Congress, depending on whether or not the enterprise is seeking budgetary assistance. This fragmentation of the budgetary process reflects the importance and partial independence of various political forces, including the military. Attempts to consolidate the overall public enterprise budgetary process under the Ministry of Finance are thus likely to encounter opposition. 262. Normally, the Ministry of Finance will not finance a public enterprise deficit. An exception is made in the case of INECEL, where the Ministry of Finance has a written agreement to cover the servicing of the company's debt. The Government, on the other hand, has a debt to INECEL (see Annex, Table 34) relating to unpaid bills by Government entities, but it is relatively minor. Government transfers to INECEL were SI. 24.2 billion in 1989, whereas the cumulative amount owed to INECEL was S/. 5.6 billion. The budget also occasionally covers the deficits of, or provides subsidies to, enterprises that do not submit their budgets to the Ministry of Finance. This is done on an ad hoc basis, at the request of the enterprise concerned. - 101 - 263. Ministry of Finance officials contend that they do not control the finances of the public enterprises, even though their Ministry is represented on their boards of directors. They do not even receive adequate data, although they are now beginning to collect data (for PETROECUADOR, INECEL, and IETEL) as the first stage in a movement towards establishing control. Data relating to public enterprise investments are first made available to the Ministry of Finance first through the investment budget. However, again, the Minister of Finance does not control them. Nominal control by the Ministry of Finance over the public enterprises' assumption of external debt is afforded by the Ministry's representation on the respective boards of directors. In practice, this control is not exercised either. B. Individual Public Enterprise Issues PETROECUADOR 264. PETROECUADOR (formerly CEPE, the State Petroleum Company) is the most important company in Ecuador, with sales of about US$1.4 billion in 1988 and a workforce of 4,228. The company produces, refines, stores, transports, and delivers oil and oil products. As CEPE, the company was, in addition, the majority stockholder in the CEPE-Texaco Consortium (with 62.5 percent & the shares), the largest stockholder in the CEPE-City Association, and a minority shareholder in the ANGLO and REPETROL refineries (with 12.5 percent of the shares). As PETROECUADOR, the company was scheduled to take over the CEPE- TEXACO Consortium, the Transecuadorian pipeline, and the ANGLO and REPETROL refineries. 265. Despite its enormous economic importance, CEPE was not set up, and thus was unable to operate, as an economically efficient, commercially oriented enterprise. Rather, it operated in many respects like a Government department in a complex political, legal, and regulatory environment in which several poorly coordinated institutions, some with overlapping responsibilities, duplicated many of CEPE's functions and influenced its actions. This situation prevented the company from responding flexibly to the dynamics of the oil industry. Its financial position was determined by ti? interpretation of the National Hydrocarbons Law, which allowed CEPE to rec.-ver its historical costs of operation and earn a 'reasonable" profit. Howev;e:, calculated costs, which excluded those for exploration, were below actual costs and the profit margin allowed was low. This arrangement left CEPE with inadequate funds and thus entirely dependent on earmarked public petroleum revenues--which, being fixed at SI. 44 to the dollar, have declined sharply in real terms--to finance the bulk of its investment program. CEPE was also subject to administrative and operational impediments and overstaffed with inadequately qualified people. 266. The 1989 law establishing PETROECUADOR was designed to strengthen the financial position of CEPE (renamed PETROECUADOR) and give it greater administrative, operating, financial, and economic autonomy. The law established separate subsidiaries for exploration and production, industrial activities, and marketing and transporting. The law also gives PETROECUADOR independence in personnel policies and procurement. Most important, It assigns to a Petroleum Investment Budget, managed by PETROECUADOR, 10 percent - '02 - of the company's consolidated gross income after deducting royalty payments, funds earmarked to the military, and the costs and expenses of PETROECUADOR and its subsidiaries. 40 percent of the Petroleum Investment Budget is to be devoted to exploration and production investments. PETROECUADOR can also incur external and internal debts to finance its investments. Further, it receives maximum priority in the allocation of foreign exchange, can maintain foreign accounts, and is exempt from taxes, charges, and customs duties. 267. There are several important issues relating to the impact of the new law. First, given Ecuador's need for increased investment and higher growth, the rationale for the expansion of the state's role in the petroleum sector and the allocation of additional scarce state funds and public borrowings to support it are unclear. Funds and expertise to develop oil are available from the private sector; the Government can assure that Ecuador receives as appropriate share of the sales of oil through setting and administering appropriate taxes. Second, the new law apparently permits the company to operate essentially on a cost-plus basis. It can, in fact, retain more net income by inflating its costs than by increasing its gross revenues. Allowable costs and the extent of tax exemptions (including PETROECUADOR's eligibility to deduct VAT payments as costs) need to be more precisely defined. (A new Directorate of Petroleum Auditing has been established in the Ministry of Finance to monitor PETROECUADOR's costs but its power to control them is uncertain). ihird, whether PETROECUADOP. is subject to any effective constraints on the size of its investment program and the degree of its external indebtedness is not sufficiently clear. Fourth, there is no assurance that returns on PETROECUADOR's investments will be competitive with those on other potential uses of the capital involved. Fifth, with PETROECUADOR's acquisition of increased monopoly powers under the nev law, the question of how to assure the company's economic efficiency has become even more important than before. Sixth, PETROECUADOR's performance goals are not explicit and it is unclear both whether it will be sufficiently accountable for its performance and how its performance will be monitored. PETROECUADOR's accounting has been deficient in the past and audits for the last three years are not yet available. Finally, Ecuador's long-term energy development strategy and PETROECUADOR's role in implementing it remain essentially undefined. INECEL 268. INECEL (Ecuadoran Electricity Institute), created in 1961, has overall responsibility for the supply of electricity in Ecuador. While it has a monopoly on electricity generation, transmission and distribution, it can authorize private operations. There are 17 distribution companies, of which 16 are set up as private corporations, with INECEL as the largest shareholder and the balance of the shares owned mainly by the municipalities. The seventeenth, the former Electrical Company of G,uayaquil, was recently taken over by the Government. 269. Large infusions of oil capital during the 1970s permitted INECEL to embark on major generation and transmission programs. However, recession and teduced revenues from oil during the 1980s--INECEL's share of total public earmarked oil revenues declined from 14.9 percent in 1972 to 1.1 percent in - 103 - 1989 (see Table 8.8)--reduced both the growth of demand and the resources available for expansion. 270. INECEL does not operate with the autonomy, efficiency, flexibility, responsiveness to customers, and concern for profitability of a business enterprise; rather, it is hamstrung by legal and regulatory red tape. Decision-making, concentrates in the Board of Directors, and is cumbersome, slow, and mainly political. Procurement under the national procurement law entails excessive delays. Accounting practices, although improving, need further strengthening. Tariffs are calculated on the basis of past investments and present costs when they are not set by congressional decree. Low-voltage tariffs fell from US 5.1 centsfkWh in 1980 to US 3.8 cents/kWh in 1987 and bulk sales tariffs from US 2.5 cents/kWh to US 1.8 cents/kWh. Tariffs in 1987 covered only about a third of long-run marginal costs. Residential users receive preferential rates and tariffs generally ignore differences in voltage levels, time of day, and user's position on the load curve. Reform of the tariff structure is under study. Other problems include system power losses averaging 18 percent of available power. This problem is now receiving attention from INECEL; however, the distribution companies, which can pass on their financial losses, have no incentive to cut system losses. 271. INECEL's investment program under the 1987 Master Electrification Plan appears unrealistic. Demand is inflated compared to what it might be if more realistic energy pricing and a rational rate structure were in effect, and capital requirements for a given level of demand higher than they would be if a rational tariff structure were in effect and system losses were reduced. However, INECEL's poor revenue generation and inability to service its existing debt obligations from its own resources limits its ability to finance an overly ambitious investment program. 272. INECEL's poor financial performance, despite its relatively low debt, springs from: (i) central political decisions not to adjust tariffs to economically realistic levels (until recently increases were limited to 3 percent a month--below recent rates of inflation--and at the end of 1990 rates for small users were frozen by congressional decree); (ii) declines in recent years in INECEL's share of earmarked petroleum revenues; (iii) a continuing high level of investment; (iv) an increase in the costs of local and imported inputs due to inflation and the decline in the external value of the sucre; (v) higher salaries, an increasing number of employees, and higher payments for contract services; (vi) non-payment of bills by public sector entities; and (vii) the elimination of INECEL's exemption from import duties after 1982. More than 50 percent of INECEL's budget now represents requirements for foreign exchange. 273. Dealing with INECEL's problems requires action on a number of fronts. First, a political decision is required on a program to raise average INECEL tariffs gradually, but on a prescribed schedule, to eaual long-run marginal costs. Second, the rate structure should be revised to reflect the different costs of supplying power under various conditions. Cross-subsidies should be eliminated. Preferential rates should be offered to nonpeak users to reflect the lower cost of supplying them with power and to encourage fuller use of - 104 - capital. Third, the reduction of system losses should receive high priority in the allocation of funds to and by INECEL. 274. At a more fundamental level, the possibility of privatizing INECEL-- e.g., some or all of the distribution companies--should be evaluated. Consideration of privatization options would need to be coupled with parallel consideration of a regulatorylincentive framework designed to encourage improved efficiency and competitive pricing among the privatized elements. To the extent that public ownersaip is retained, consideration should be given to changing the relationship between the central Government and INECEL. A refo&m package might include: (i) strengthening INECEL's general and cost accounting framework; (ii) loosening direct political control over INECEL's operational decision-making; (iii) giving INECEL greater autonomy in pricing, personnel policies, procurement and contracting; (iv) establishing clear, monitorable (including quantitative) performance goals for INECEL's performance, to which the remuneration and career prospects of INECEL's management would be linked; (v) establishing suitable reporting, monitoring, oversight and regulatory machinery to assure adequate general supervision of INECEL's performance; (vi) eliminating general budgetary and oil revenue transfers to INECEL; and (vii) compensating INECEL by means of explicit budgetary subsidies for all services provided for political or social reasons at below cost. IETEL 275. IETEL (Ecuadoran Telecommunications Institute) was established in 1972. It provides local, long-distance, and international telephone services and telex services and also oversees private companies authorized to provide telecommunications services. Despite a 5 percent per year growth in the provision of telephone services during the 19809, Ecuador has made little progress compared to other countries and has one of the lowest telephone-per- capita ratios (4 per 100) in Latin America--77 percent of the main lines are in Quito and Guayaquil, with about 28 percent of Ecuador's population. Inadequate telecommunications facilities impose a major constraint on the efficiency of the Ecuadoran economy. Fulfillment of the demand for telephones has risen only from 65 to 71 percent between 1980 and 1988. Furthermore, inadequate rehabilitation and maintenance of the present system results in poor quality service, frequent outages, and long delays in restoring service. There is widespread dissatisfaction in Ecuador's private sector with IETEL's service. 276. These problems spring fundamentally from inadequate tariffs, the poor adaptability of IETEL's instituticnal structure, technical management orientation, bureaucratic operating regime for the provision of commercial services, and inappropriate personnel policies. Domestic tariffs, which are determined centrally, were, until recently (when increases were agreed) calculated on the basis of US 0.38 cents per three-minute local call, which it is estimated to cost IETEL US 10 cents to provide. Connection charges of US$75 are far below IETEL costs of US$800. Tariffs on international calls, tied to the US dollar, rose from 43 percent of total operating revenues in 1983 to 70 percent in 1988. While the development greatly strengthened IETEL's overall financial position, it implicitly resulted in heavy cross- - 105 - subsidization of domestic consumption and heavy taxation of those engaged in international commercial activities. 277. Efficient telecommunications are vital to Ecuador's economic efficiency and growth, and assuring them should be the main criterion for reorganizing Ecuador's telecommunications system. Establishing domestic telephone tariffs that reflect the cost of service is fundamental. It would provide the means for expanding service with internal and external funds and, at the same time, allocate the expansion of demand to the highest priority uses. Meeting economic demand for telephone and telex service, rather than focussing mainly on technical issues, should be the basic orientation of the telephone company or companies. Privatization options merit very serious consideration--either privatization of IETEL as a whole or of certain activities, e.g., cellular technology or local telephone networks. To the extent that the telecommunications network stays in public hands, the company will needs (i) realistic domestic tariffs; (ii) less political/technical and more commercially oriented management; (iii) greater autonomy in procurement, contracting, and personnel management; (iv) the elimination of cross- subsidization of tariffs; (v) clearly defined responsibilities, performance goals, and criteria for evaluating management's performance, together with the means to hold management accountable; and (vi) the power to apply effective sanctions for nonpayment of bills, including nonpayment by state entities. ECUATORIANA 278. ECUATORIANA (Ecuadoran International Airline) was established in 1974 through the nationalization of the Compafiia Ecuatoriana de Aviacion. It serves 10 cities in South America and 4 in North America. Nominally under the jurisdiction of the Ministry of Defense, it is essentially an autonomous entity operating international routes, with five aircraft (4 Boeing 707s and a leased DC-10). The ages of the aircraft range from 19 to 26 years. 279. Total passenger traffic to and from Ecuador dropped from 572,000 in 1980 to 391,000 in 1983 but then climbed fairly steadily to 589,000 in 1989. Ecuatoriana accounted for between 36 and 39 percent of the total traffic, with an average occupancy coefficient of 56 percent over the 1980-88 period. Latin American traffic has been declining, so the increase has been to North America. Air cargo traffic rose from 19,000 tons in 1982 to 33,000 tons in 1988, while air cargo revenues climbed from 16 to 27 percent of total revenues. Despite this, ECUATORIANA's efforts to develop air cargo traffic have been limited. ECUATORIANA has incurred rising deficits in recent years as a result of the rising costs of landing rights and flight protection services, rising maintenance costs and high fuel costs linked to the age of its fleet, and rising administrative expenses (see Appendix, Table 21). On the other hand, the Government intervenes to keep fares at competitive levels and service on a par with that of other international airlines. 280. ECUATORIANA's political Board of Directors (representing the Presidency, the Ministry of Defense, the Ministry of Finance, the Ministry of Industry and Commerce, and the Commander of the Air Force) is not very effective in defining ECUATORIANA's key development goals or in optimizing its efficiency. ECUATORIANA has had eight executive presidents in 15 years. - 106 - Procurement processes cause delays, planning is unsystematic, investments have been uncoordinated, and the airline's response to changing international patterns slow. However, the creation of regional offices with substantial autonomy will facilitate the attainment of economic and operational efficiencies. A management consultant is to develop a comprehensive management information system and make recommendations to improve ECUATORIANA' s efficiency. 281. ECUATORIANA faces basic problems relating to growing competitive pressures from emerging tmega-carriers,' an old fleet of aircraft, and an inadequate management structure. An assessment of basic options, including reprivatization, seems called for. In the interim, ECUATORIANA's performance could probably be improved by: (i) giving more administrative authority to the executive president; (ii) establishing criteria to assess management's performance with regard to profit maximization or cost minimization, including the degree of attainment of operational targets; (iii) easing procurement procedures and other bureaucratic restrictions; (iv) emphasizing ECUATORIANA's increased participation in, and share ot, rising North American traffic, based on a reevaluation of the market and a suitable market plan; (v) making cooperative arrangements with a North American carrier to feed traffic to Ecuador and permit ECUATORIANA to participate in a frequent-flier program; and (vi) developing the air cargo market. TRANSNAVE 282. TRANSNAVE (Ecuadoran Shipping Line) was created in 1971, as part of the Armed Forces of Ecuador, to facilitate foreign trade and provide international maritime services to the country. TRANSNAVE became the beneficiary in 1973 of the Law of Cargo Reserve reserving to national flag vessels the right to transport 50 percent of all cargo to and from Ecuador. It subsequently joined a number of shipping conferences involved in marine transport to and from Latin Americas the Europe-South Pacific-Magellans Conference (ESPM, which later became the EUROSAL group); the Japan-West Coast South America Conference (JWCSA); the South America-Far East Conference (SAFECON); and the Mediterranean Group (MEDISPAC). The EUROSAL group, which is the most important for TRANSNAVE, pools the revenues and expenditures of participating companies. Profits and losses are divided in accordance with each company's share in the conference (Ecuador's share is 10.28 percent). TRANSNAVE's fleet comprises 26 vessels: 9 owned by the enterprise and 17 leased for the northern route. 283. TRANSNAVE's five-man Board of Directors is chaired by the Naval Commander, who nominates the other four members, who are high-ranking naval officers. The General Manager is appointed by the Naval Commander for a four- year period. The Board focuses largely on hiring and removing personnel. Management is limited by the cumbersome and bureaucratic procurement regime. It emphasizes technical matters and 'going-by-the-book,' rather than improving TRANSNAVE's operational efficiency or giving it an aggressively commercial orientation. Junior and middle managers need to be developed but there are legal constraints to removing people and hiring new, qualified professionals. Not surprisingly, TRANSNAVE's volume of business is closely geared to Ecuador's overall economic performance. - 107 - 284. The original fleet of eight ships is now obsolete, with limited storage and refrigerated capacity. Major investments are required, either for replacements or renovations/repairs. One modern vessel was recently bought at a cost of US$41 million and four, used multipurpose container ships are being purchased for US$41 million. 285. TRANSNAVE's financial position is satisfactory, with overall cash surpluses in recent years (see Statistical Appendix, Table 27), reflecting, among other things, better utilization of its capacity and the provision of additional services to profitable routes. TRANSNAVE's tariffs are set by the conferences to which it belongs on a cost-plus basis. 286. TRANSNAVE's partial monopoly on shipments to and from Ecuador and its participation in cooperative shipping arrangements appear to insulate it to a considerable extent from competition, although at some cost to the Ecuadoran economy. Profitable operation is to be expected under these circumstances. TRANSNAVE nonetheless appears to suffer from problems similar to those troubling other public enterprises: lack of adequately commercially oriented direction; deficient personnel policies; and subjection to inefficient procurement procedures. nLOPEC 287. FLOPEC (Ecuadoran Petroleum Fleet) was established in 1973 as a mixed publiclprivate enterprise but in 1978 became an autonomous state enterprise forming part of the Armed Forces of Ecuador. It has responsibility for transporting Ecuador's crude oil and derivatives to international markets; it also transports oil to and from third countries and has a shipping services agency at the Port of Esmeraldas. FLOPEC has five vessels, is considering the acquisition of a sixth, and, in addition, leases ships from several oil companies. The company has a monopoly on transporting oil to and from Ecuador. FLOPEC leases on a time-charter or voyage basis, with the client paying operating expenses. It often enters into back-to-back contracts in which it leases a ship and then subleases it to the client. In most cases, the ships that lift the petroleum are from the same oil companies that produce it; in that case, FLOPEC charges a commission for the use of its monopoly rights. Its main customer is PETROECUADOR and four of its ships are under lease to it. FLOPEC, like most of the public enterprises, suffers from delays resulting from cumbersome procurement process. 288. FLOPEC's board and management structure are essentially the same as TRANSNAVE's. Its organization seems adequate and the enterprise is effective in carrying out its responsibilities. It has enjoyed considerable continuity in management and its departments are well coordinated, facilitating planning and investment programming. FLOPEC has traditionally covered its current and capital expenditures out of revenues, although it experienced cash deficits in 1987 and 1988 (see Appendix, Table 24). FLOPEC currently charges world market tariffs, which fell sharply after 1985. 289. FLOPEC's existence is difficult to justify on economic grounds. Conserving foreign exchange is not in itself adequate economic justification for establishing a domestic monopoly. Ecuador's economic efficiency and - 108 - growth would be better served by earning foreign exchange from competitive exports than by saving it through the establishment of noncompetitive import substitution in the area of oil transport. FLOPEC's commissions are essentially fees for waiving its monopoly rights, requiring no economic contribution from FLOPEC. FLOPEC's recent adoption of world market tariffs implies the acceptance of some degree of external market discipline. Nonetheless, FLOPEC's raison d'etre should be reexamined, and much greater use made of private oil transport services, without the necessity to go through FLOPEC. If its monopoly power is retained, a decidedly less efficient option, the question whether its acceptance of world market tariffs is an adequate guarantee of efficiency should be considered. TAME 290. TAME (Ecuadoran Military Air Transport), created in 1962 as a unit of the Ecuadoran Air Force, became an autonomous agency in 1964 charged with promoting the economic integration of Ecuador's regions. Government policy is to control pricing and the provision of service in those parts of the domestic market considered essential to a national transport system. TAME's traffic is concentrated on the short-haul Quito-to-Guayaquil corridor. It has eight planes: a Boeing 727-200, three Boeing 727-lOOs, an Electra L-188, a Fokker F-28, and two leased 38-passenger Avros. 291. TAHE covers 16 cities, with a daily average of 3,000 passengers. It shares the domestic market with SAETA, a private company with three owned planes, which has 30 percent of the market. In a short time, TAME has managed to link the main production zones of the country to the most important industrial areas (Guayaquil, Quito, and Esmeraldas). It plans to increase routes and service to the country's Amazorn region, to which effective access is only possible by air. Tariffs will initially be very low and six additional aircraft will be required. TAME wishes to cross-subsidize air travel to the Amazon with earnings from other routes. 292. TAME does not have a board of directors. It is headed by a General Director appointed by the Air Force Commander. There is no management information 3ystem; however, some statistics are available and TAME is implementing a development program and becoming more business-oriented. The Government sets domestic tariffs, which are adjusted to maintain a minimum revenue/operating cost ratio. However, the tariff structure is inappropriate and the level of tariffs insufficient to cover the full costs of providing and developing service. The system is operationally oriented rather than geared to user needs. The Ministry of Defense is responsible for Ecuador's public airport infrastructure. 293. Total traffic has increased more than 120 percent from 547,000 in 1980 to 1,215,000 in 1988, mainly on routes to and from Quito, Galapagos, Guayaquil, Cuenca, Ambato, and Esmeraldas. Cargo traffic has increased 90 percent, from 6,341 tons to 12,412. However, there is little systematic evaluation of markets and no attempt to maximize profits. The company lacks an automated reservation system, leading to over- and underbooking. TAME's financial position has been satisfactory, despite its low fares and the high costs of maintaining an old fleet of aircraft, but it has undertaken no major - 109 - capital expenditures in recent years (see Appendix, Table 26). The allocation of funds for current and capital expenditures is part of the defense budget. 294. TAME needs a more commercial attitude, with a focus on making a profit while maintaining competitive fares. A detailed study of the domestic market is desirable to determine its air transport needs and the role it should play. To the extent that the Government believes that in the national interest certain routes should be served that are not commercially viable, it should compensate TAME for its losses by budgetary transfers rather than requiring or encouraging the company to impose implicit taxes on other routes. ENFE 295. ENFE (the National State Railway Company), created in 1970, has a monopoly on railway transport. It has three main lines and seven branch lines, organized into three networks, and currently operates 705 km of track--out of a network total of 1300 km--of which only 45 percent is in good condition. Its 20 locomotives and other rolling stock are obsolete. The tracks are in poor condition and derailments are frequent, necessitating low speeds on many sections. Line and network closedowns or restrictions have been the rule for many years. ENFE's overall network, which handles domestic goods and passenger traffic (there is no international traffic) links most of the important cities: Quito, Cuenca, Ambato, Riobamba, Latacunga, Milagros, Azogues, etc., with about half of the country's population. 296. ENFE's Board of Directors (representing the Presidency, Public Works, Finance, Defense and CONADE, together with representatives of the company's engineers and workers) controls tariffs, establishes regulations, supervises service, hires, promotes and disciplines staff, and formulates the budget. Because ENFE depends financially on budgetary transfers, the Ministry of Finance closely controls it, while its budget is subject to fiscal exigencies. 297. ENFE's organization is somewhat archaic, administrative procedures are complicated, and management lacks operational, statistical, and financial information for timely decision-making. There are few indicators of productivity. The company's primary problems appear to be poor planning-- including financial planning--and marketing, insufficient and inadequate maintenauce, and the low productivity and high costs of its workforce. Technical, financial, and management training are inadequate and require the support of external assistance. National operating and safety standards need to be developed. The Government has failed to set clear goals for ENFE, so management's horizons have been largely limited to budget preparation and execution; however, management did develop a Five-Year Plan for the 1988-92 period. 298. The volume of rail traffic has declined precipitously since 1980, reflecting ENFE's deficiencies, the closing of the Quito-Guayaquil line after the 1987 earthquake, and rising competition from more efficient road transport. Passenger traffic declined 75 percent between 1980 and 1988 and cargo traffic 82 percent. ENFE's labor force, however, only declined 3 percent and is heavily underemployed. While there is demand for bulk hauling - 110 - of cement and potential for hauling vegetables, fruit, and seafood, prospects in other areas are uncertain. 299. ENFE's financial performance is dismal (see Appendix, Table 25). Projected 1989 operating expenditures--of which salaries represent 72 percent --were 20 or more times operating revenues. ENFE depends almost entirely on Government transfers for its income. ENFE's passenger and freight tariffs, which are adjusted irregularly, relate only to distance travelled and are uniform for all routes and lines, with no differentiation relating to costs, degree of competition, time of the week or year, special terms for major clients, etc. Rolling stock replacemiexu and equipment and track repairs are needed to keep the system running. The Government has planned major expenditures on 157 km of new lines, locomotives, other rolling stock, repairs, and renovations over 1989-92, at a cost of US$123 million. 300. Before making any further commitments, the Government should undertake a serious evaluation of the economic viability of continued operation of ENFE's short, general-purpose railway lines. The study should estimate future traffic potential, the physical requirements of such traffic, necessary railway tariff levels to cover costs, the costs of competing modes, and the capacity of these modes to absorb existing railway traffic. It should identify expected Government-imposed requirements for service in pursuit of social objectives, methods for compensating ENFE for the costs involved, and the staffing and investment needs of an efficient system. EMAC 301. ENAC (the National Storage and Marketing Company) was created in 1974 to distribute food at low prices to the poor. It is authorized to purchase locally, import, store, and distribute basic items such as rice, sugar, corn, wheat, and cotton. It can also export surpluses, supervise wholesale markets and commodity exchanges, and collect and provide market information. Through controls and procurement, the Government has attempted to influence agricultural producer and wholesale prices. The Government fixes minimum producer prices for twelve agricultural products (mainly grains) and maximum consumer prices for eight agriculture-based consumer goods. ENAC has been more successful in supporting producer prices than in enforcing maximum consumer prices--largely due to its direct intervention in the market when prices threatened to fall below preestablished minimum levels. 302. ENAC's Board is chaired by the Deputy Minister of Agriculture and Livestock, the Director of Marketing and Enterprises, the Director of External Trade of the Ministry of Industry, Commerce and Integration, the Deputy General Manager of the National Development Bank, and a representative of the Agricultural Chambers Federation. The Board establishes policies and approves annual investment plans, contracts, and other major operational decisions. Its decisions tend to be slow and political. ENAC's organization is inadequate, management is weak, and the enterprise is poorly coordinated and not very effective in carrying out its responsibilities. Planning and investment programming are inefficient. ENAC has been subject to excessive political intervention, instability in management, and shifts in policy with each change in Minister of Agriculture. While ENAC's marketing interventions - 111 - have supported the Government's crop protection and subsidy policies, they have by the same token contributed to the misallocation of resources resulting from those policies and have discouraged private warehousing of grains. (ENAC increased its storage capacity by 32 percent over 1980-88 and now controls 27 percent of Ecuador's agricultural storage capacity.) ENAC's policy dialogue with the Ministry of Agriculture has been unsatisfactory and investment decisions involving the Ministry, ENAC, and the Ministry of Finance have been insufficiently coordinated. Conflicts have arisen between the financial objectives of the Ministry of Finance and the social objectives of the Ministry of Agriculture. ENAC has relied for its financing on Government contributions and bank lines of credit, but the latter have led to rising interest payments (see Appendix, Table 22). 303. While the elimination of excessive short-term instability in agricultural prices is a desirable objective, achieving this objective--and demonstrating that it has been achieved--through Government intervention is extremely difficult. Poorly timed or overly supportive interventions can result in excessive stock buildups and consequent financial losses, as well as distortions in domestic production patterns leading to losses in the overall efficiency of agricultural production. On the other hand, market intervention for purposes other than short-term price stabilization is difficult to justify on economic grounds. With its organizational weaknesses, changeable policies, apparently one-sided interventions, and poor coordination with other agencies, it is highly doubtful that, over time, ENAC will play any useful economic role, particularly when considering the majir distortions already introduced into agriculture by price controls and impott and export prohibitions and quotas. It thus represents an unnecessary drain on the Government's finances. A reexamination of ENAC's role is required--preferably in the context of a basic review of agricultural policies. C. Conclusions 304. Some efforts have been made in the past few years to improve management and performance of the public enterprise sector. These attempts have been supported by World Bank technical assistance and financial commitment. In general, however, important hurdles remain. The enterprises, most of which are either monopolies or enjoy monopoly power in many of their activities, still operate under excessive political, and to a considerable extent, operational control. This is manifest in the composition of public enterprise boards of directors and the powers that they exert over tariffs, budgets, hiring, firing, personnel, wage policies, many operational decisions, and in time-consuming and bureaucratic controls over procurement. Most enterprises have operated more like government departments than commercial enterprises providing vital economic services. At the same time, they have been given little effective longer-term policy guidance and have generally lacked explicit commercial, economic, and financial performance goals. Furthermore, central control over their assumption of external debt and the quality of their investment programs has at best been loose. Central control has mainly meant that the pursuit of short-term political and social objectives has subsumed the pursuit of economic efficiency, the financial strength of the enterprise, and active support of private sector growth. Continuation and strengthening of basic reform efforts are called for, notably - 112 - in the direction of giving the companies more operational independence and a mainly commercial role, and subjecting them to explicit performance requirements. 305. The review of public enterprise performance provided above suggests that considerable scope exists for privatization leading to potentially more efficient provision of essential services. Candidates for privatization could include: some of PETROECUADOR's numerous activities (e.g., refining, marketing, and transporting); some or all of the electricity distributing companies; parts, or all, of IETEL's functions; ECUATORIANA; TAME; and TRANSNAVE. The economic rationale for the continued existence in any form of FLOPEC, ENFE and ENAC should be carefully reviewed. The economy would probably benefit if they were simply closed down and their assets sold off. Three important advantages of a significant privatization program would be: (i) to establish comparative standards of efficiency and financial independence; (ii} to begin to open up the rigid formal Ecuadoran economy to dynamic influences and enhanced competition; and (iii) to support greater labor market flexibility. However, any privatization strategy would need to ensure that inefficient and predatory private monopolies did not replace inefficient state monopolies. Were privatization impossible to implement for political reasons, the Government should at least move in the direction of creating a corporate operating structure for the enterprises, so as to contribute to a better definition of their economic objectives and to increase managerial powers and accountability. 306. Improved financial performance for the enterprises that are not privatized or closed down should be sought in a phased but deliberate transition to cost-based tariffs, the realization of competitive returns on invested capital, better use of existing plant and equipment, the elimination of overstaffing, improved training, and the provision of financial and other inducements to higher productivity. Improved economic efficiency should be sought in lowered costs of service and far more rapid adaptation to market shifts. The legal structures of the public enterprises should be modified to permit them much greater operating autonomy. At the same time, they should be assigned strict, measurable performance standards. The negotiation of formal performance contracts could be useful. A prerequisite for the successful employment of this mechanism would be the establishment of standard accounting practices, regular external auditing, and clear lines of accountability for performance to external authority (e.g., the Minister of Finance). Managerial remuneration and career advancement should be explicitly linked to the attainment of performance goals. Finally, the procedures governing the presentation of public enterprise budgets to Congress should be unified as part of the proposed reform of the budgetary process proposed in Chapter V. - 113 - ANNEX TABLES Ecuador - Key Economic Indicators 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 P Annual Real Growth Rates GDP (market prices) 6.8 2.0 -2.1 4.0 4.2 8.0 -0.0 11.2 0.2 1.5 GNP 8.6 -1.1 -2.1 1.9 4.7 8.4 -6.4 12.2 -0.6 1.5 GNP per capita 0.? -4.0 -5.8 -0.4 2.9 1.0 -8.0 9.1 -3.8 -1.8 Private Consumption per capita 1.4 -1.8 -6.9 -l.a -0.8 -2.2 -0.2 -0.1 -1.3 -1.9 Debt Indicators Total DOD 1/ (in USI) ?822.7 781.9 ?S44.0 82S1.0 697.0 9228.0 10446.4 10588.3 11840.7 11512.0 DOD/Current GDP 58.1 83.2 71.2 80.7 70.9 82.0 112.6 96.6 103.2 102.0 Debt Service/JGP 10.0 16.8 7.2 10.4 9.2 8.3 11.8 22.8 20.7 20.8 Interest/GOP 4.2 7.4 4.8 8.3 6.7 8.1 8.2 8.2 9.0 9.4 Coverage ratio 2/ -41.9 -25.7 160.3 101.0 120.9 S5.1 -28.4 79.4 88.8 107.4 National Accounts (9 of constant 1968 CDP) Total Investment 81.1 82.8 28.9 22.1 22.7 22.8 24.7 22.0 22.1 21.4 Public 8.0 8.9 5.7 5.8 6.9 8.5 6.7 4.9 4.8 4.6 Private 28.1 25.4 18.2 16.8 16.8 16.8 18.0 17.1 17.8 16.9 National Savings 27.2 19.8 22.2 22.2 28.8 14.8 11.4 14.8 18.9 17.3 Public 8.7 6.8 8.1 8.1 -2.6 0.8 4.8 6.8 Private .. .. 16.5 16.4 16.2 11.7 14.0 14.0 9.1 10.S Foreign Savings 8.9 12.6 1.7 -0.1 -0.6 8.0 18.4 7.2 8.1 4.1 Domestic Savings 88.0 28.2 30.4 82.2 81.4 23.0 17.1 20.2 19.9 28.2 Pub./Pri. Investment 85.1 28.9 32.5 88.0 87.7 41.8 87.8 29.8 28.9 26.8 Exports WIPS (real growth rate) 4.6 -5.0 2.4 12.5 12.0 9.6 -17.1 82.2 -1.4 5.1 Morchandise Oil 14.1 -6.0 88.4 8.8 14.9 10.1 -16.8 19.8 -0.2 -1.0 Non-oil -7.6 0.6 -36.8 31.0 16.7 19.6 0.0 1.9 0.8 9.7 Exports/Current CDP 20.9 21.6 26.0 28.8 27.2 28.0 26.4 25.7 27.6 29.9 Imports Oft (real growth rate) -9.2 8.7 -24.6 -2.4 7.3 -0.8 11.4 -10.4 4.7 -0.4 Imports/Current GDP 22.7 28.4 17.2 20.0 19.0 19.0 28.7 19.2 20.1 19.8 Resource Balance -1.8 -1.9 7.8 8.4 8.2 8.4 -2.8 6.6 7.6 10.1 Current Account (Million US8) a/ -99.o -1201.0 -184.0 -284.0 114.0 -658.0 -1181.0 -578.7 -568.7 -305.0 Current Account/GoP -7.1 -9.8 -1.8 -2.8 0.9 -4.9 -12.2 -S.8 -S.3 -2.8 Terms of Trade Index (1981 a 100) 100.0 79.4 61.3 56.8 41.2 26.2 26.2 26.3 26.2 26.8 GOP (Million US$) 18946.6 12446.8 10591.1 10221.8 12130.6 11256.1 10608.6 10292.6 10882.1 10860.6 Inflaston (Yoariy Averego, CPI) 18.8 18.8 48.4 81.2 28.0 28.0 29.5 58.2 76.8 48.6 Real Domestic Oil Prices (S Change) .. 0.0 -8.8 -16.9 42.7 -18.7 14.8 -0.9 2.7 21.2 PPP Exchange Rate Index 100.0 109.6 111.9 126.2 113.8 185.8 184.6 214.6 224.4 234.2 1/ Debt outstanding and disbursed; Includes IMF and Short Term Debt. 2/ The resource balance as percentage of total external interest payments. 8/ Including interest on arrears since 1988. P/ ProvislonIal Table 1: CONSOLIDATED PUBLIC SECTOR REVENUES, EXPENDITURES, BALANCES AND FINANCING, 1977-88 (Billions ot Suer"s) 1977 1978 19?9 1980 1981 1982 1988 1984 1985 1988 1987 1988 TOTAL REVENUE n.a. n.a. n.a. n.4. 79.8 9S.1 125.8 192.8 809.2 840.8 393.0 850.8 Petroleum Revenue n.a. n.a. n.a. n.m. 28.9 87.8 48.6 82.2 164.1 115.6 107.0 233.2 Non-Petroloum Roevnue n.r. n.a. n.a. n.m. 47.8 61.1 87.2 92.0 140.0 191.4 267.2 386.9 Operating Surplus of Non-Fin. P.E.'s n.a. n.m. n.a. n.a. 5.7 8.8 9.8 18.4 15.0 88.4 28.9 31.? TOTAL EXPENDITURE n.a. n.a. n.a. n.a. 998. 122.9 125.4 197.4 288.0 410.2 8668.1 090.5 Current Expenditure n.a. n.m. n.a. n.a. 68.2 82.5 87.7 145.5 220.0 297.9 439.3 826.1 Capital Expenditure n.a. n.. n.a. n.a. 81.2 40.4 87.7 51.9 87.9 112.4 128.7 181.4 OVERALL SURPLUS OR OEFICIT t-) -13.8 -11.9 -4.8 -13.6 -19.6 -27.8 -0.1 -4.S 21.1 -89.9 -173.1 -156.7 FINANCING 13.8 11.9 4.8 18.5 19.5 27.8 0.1 4.8 -21.2 70.1 173.0 115.6 External Financing 18.1 12.2 7.9 16.8 20.8 18.7 8.7 11.7 15.4 76.0 Drawings 21.8 24.4 34.6 32.2 89.8 88.S 8.0 19.8 28.1 106.0 Amortization -5.7 -12.2 -26.7 -18.4 -18.8 -19.8 4.8 -7.9 -7.7 -80.0 Domestic Financing -2.8 -0.3 -8.4 -2.3 -1.3 9.1 -3.6 -6.9 -36.6 -5.9 Central Bank (net) -2.8 -1.4 -2.9 -1.9 -0.9 12.1 -2.4 -8.8 -48.4 -7.8 Other Banks (a) (a) (a) -0.6 -1.1 0.6 -1.2 -1.3 1.1 5.7 Other 0.6 1.1 -0.6 0.2 0.7 -3.6 0.0 3.r 6.7 -4.0 (a) Included under Central Bank Source: IMF Table 2: CONSOLIDATED PUBLIC SECTOR REVENUES, EXPENDITURES, BALANCES AND FINANCING, 1977-88 (Percentages of GDP) 1977 1978 1979 1980 1981 1982 1983 1984 1985 1988 1987 1988 TOTAL REVENUE n.a. n.a. n.a. n.a. 22.9 22.9 22.4 23.7 27.9 24.8 21.7 21.2 Petroleum Revenue n.a. n.a. n.a. n.a. 7.7 9.0 8.7 10.1 13.9 8.4 6.9 7.8 Non-petroleum Revenue n.a. n.a. n.a. n.a. 13.8 12.3 12.0 11.3 12.6 13.8 14.2 12.6 Operating Surplus ot Non-Fin. P.E.'s n.a. n.a. n.a. n.e. 1.8 1.6 1.7 2.8 1.4 2.4 1.6 1.0 TOTAL EXPENDITURE n.e. n.e. n.a. n.n. 28.6 29.8 22.4 24.3 26.9 29.7 31.8 28.8 Current Expenditure n.s. n.s. n.a. n.s. 19.8 19.8 15.7 17.9 19.8 21.6 24.3 20.4 Capital Expenditure n.a. n.a. n.e. n.e. 8.9 9.7 8.7 8.4 8.1 8.1 7.0 6.9 OVERALL SURPLUS OR DEFICIT (-) -8.3 -6.2 -2.0 -4.6 -5.6 -8.7 .0 -0.6 1.9 -S.1 -9.8 -6.1 FINANCING 8.3 6.2 2.0 4.6 5.8 8.7 .0 0.6 -1.9 5.1 9.6 6.1 External Financing 9.7 8.4 3.4 6.4 8.0 4.5 0.7 1.4 1.4 6.6 0.0 0.0 Drawings 13.1 12.8 14.8 11.0 11.4 9.8 1.4 2.4 2.1 7.7 0.0 0.0 Amortization -3.4 -8.4 -11.4 -6.8 -6.4 -4.8 0.8 -1.0 -0.7 -2.2 0.0 0.0 Domestic Financing -1.4 -0.2 -1.6 -0.8 -0.4 2.2 -0.6 -0.8 -8.3 -0.4 0.0 0.0 Central Bank (net) -1.7 -0.7 -1.2 -0.8 -0.8 2.9 -0.4 -1.1 -3.9 -0.6 0.0 0.0 Other Banks (a) (a) (a) -0.2 -0.8 0.1 -0.2 -0.2 0.1 0.4 0.0 0.0 Other 0.8 0.6 -0.2 0.1 0.2 -0.9 0.0 0.4 0.S -0.3 0.0 0.0 (a) Included under Central Bank Source: Table 1 Table 3: SOURCES OF TOTAL REVENUES OF THE CONSOLIDATED PULIuC SECTOR, 1981-88 (Billions of Sucres) 1081 1982 1983 1984 1985 1908 1987 1988 DCET 89.2 44.9 80.1 100.2 189.4 186.8 28$.7 437.6 Transfers from Public Sect.r n.a. n.&. 0.0 -2.1 -1.7 -1.1 -1.6 -0.4 FONAPAR 8.4 4.0 8.8 8.8 11.4 12.7 17.7 26.7 Transfers from Public Sector n.a. n.a. -0.8 -0.6 -0.2 -2.2 -8.9 -7.0 REST OF GOVERNMENT 28.0 84.9 84.2 69.4 97.9 125.9 166.8 216.0 Transfers from Budget n.a. n.n. -8.6 -9.6 -11.2 -6.7 -21.1 -81.8 Transfers from Other Public Sector n.a. n.e. 0.0 0.0 0.0 -14.2 -23.2 -27.5 tn OPERATING SURPLWS OF PUBLIC ENTERPRISES 6.7 8.8 9.6 18.4 16.0 33.4 28.9 81.7 OIL REVENUES OF PUBLIC ENTERPRISES n.a. n.a. 7.7 8.1 8.6 5.7 3.8 8.0 ADJUSTMENT (1) - - -14.0 - - - - - TOTAL REVENUES 79.8 96.1 125.3 192.7 809.1 840.3 893.0 650.8 (1) Adjustment relating to interest payments by Central Bank on behalf of the public sector. Source: IMF Table . : SOURCES OF TOTAL REVENUES OF THE CONSOLIDATED PUBLIC SECTOR, 1981-88 (Perentage. of Total) 1981 1982 1988 1984 1986 1968 1987 1988 BlMGET 49.1 47.2 48.0 52.0 61.8 64.9 60.2 67.2 Transfers from Public Sector n.n. n.n. 0.0 -1.1 -0.5 -0.3 -0.4 -0.1 FONAPAR 4.8 4.2 6.4 4.6 8.7 8.7 4.6 4.1 Transfers from Public Sector n.e. n.s. -0.4 -0.8 -0.1 -0.8 -1.0 -1.2 REST OF GOVER3MENT 85.1 86.7 61.2 36.0 31.7 37.0 89.6 38.2 Transfer, from Budget n.n. n.&. -6.9 -4.9 -8.6 -2.0 -6.4 -4.9 Transfers from Other Public Sector n.&. n.e. 0.0 0.0 0.0 -4.2 -6.9 -4.2 OPERATING SURPLUS OF PUBLIC ENTEMPRISES 7.1 7.2 7.7 9.5 4.9 9.6 7.4 4.9 OIL REVENUES OF PULLIC ENTERPRISES n.n. n.n. 6.1 4.2 2.7 1.7 0.9 0.9 ADJUSTMENT (1) - - -11.2 - - - - - TOTAL REVENUES 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 (1) Adjustoent relating to interest payment by Central Bank on bhalf of the public sector. Source: Tabl- 2 Table 4: CROSS EXPENDITURES A TRANSFERS, BY MAJOR COUPONENTS OF THE PUBLIC SECTOR, 1983-88 (Billions of Sucres) 1983 1984 198S 1988 1987 1988 Gross Expenditures Budget 74.2 106.8 187.6 218.6 348.0 494.0 FONAPAR 9.6 8.2 12.0 13.0 19.9 25.6 Rest of General Government 82.4 53.1 78.4 111.2 141.6 188.9 Non-Financial Public Enterprises 47.6 73.4 91.4 141.8 187.6 345.2 Operating 30.3 49.6 81.8 86.8 114.3 241.2 Non-operating 3.6 4.7 8.9 11.8 18.0 31.2 Capital 13.6 19.1 20.7 43.2 66.3 72.8 TOTAL 183.6 240.6 349.8 482.3 896.0 1063.7 Transfers to Public Sector Budget 26.6 38.7 42.0 39.4 64.1 113.0 Current 19.4 32.4 32.3 21.7 29.9 93.0 Capital 7.2 6.3 9.7 17.7 24.2 20.0 FONAPAR 9.5 8.2 12.0 13.0 19.9 25.8 Rest of General Government 1.0 2.7 3.4 2.5 6.8 6.4 Public Enterprises 0.5 0.5 0.8 1.1 0.9 0.9 TOTAL 37.8 60.1 59.2 58.0 81.7 144.9 Gross Expenditures less Transfers Budget 47.6 87.1 126.6 177.1 291.9 381.0 Rest of General Gofornment 31.4 50.4 75.0 100.7 134.7 183.5 Non-Financial Public Enterprises 47.0 72.9 90.8 140.5 188.7 844.3 TOTAL 128.0 190.4 291.1 428.8 613.3 908.8 Total Transfers as % of Total Gross Expenditure 23.0 20.8 18.7 11.6 11.8 13.8 Source: IMF Tablo 4a: GROSS EXPENDITURES h TRANSFERS, BY MAJOR COMPONENTS OF THE PUBLIC SECTOR, 1983-88 (Percentage of GOP) 1988 1984 1986 1986 1987 1988 Gross Expenditures Budget 18.2 18.0 16.1 15.7 19.1 18.1 FONAPAR 1.7 1.0 1.1 0.9 1.1 0.8 Rest f Oeneral Governoment 6.8 6.5 7.1 8.0 7.8 8.1 Mon-Financial Public Enterpries 8.5 9.0 8.2 10.2 10.4 11.2 Operating 6.4 6.1 5.6 6.8 68. 7.9 Non-operating 0.6 0.6 0.8 0.8 1.0 1.0 Capital 2.4 2.4 1.9 8.1 8.1 2.4 TOTAL 29.2 29.6 e 1.6 84.9 88.4 84.8 Transfors to Public Sector 4.7 4.8 8.8 2.9 3.0 3.7 Budget 8.6 4.0 2.9 1.6 1.7 8.0 ao Current 1.8 0.8 0.9 1.8 1.8 0.7 Capital 1.7 1.0 1.1 0.9 1.1 0.8 FONAPAR 0.2 0.8 0.8 0.2 0.4 0.2 Rest ot General Government 0.1 0.1 0.1 0.1 .0 .0 Public Enterprises TOTAL 8.7 8.2 5.2 4.1 4.S 4.7 Gross Expenditures less Transfers Budget 8.6 8.3 11.8 12.8 16.1 12.4 Rest of General Government 6.8 8.2 6.8 7.9 7.4 6.0 Non-Financial Public Enterprises 8.4 9.0 8.2 10.2 10.3 11.2 TOTAL 22.6 28.4 28.2 80.8 38.9 29.6 Source: Tablo 4 Table 6: comPosrTrON OF CONSLATED NON-FINANCIAL PUBLIC SECTOR FINANCZAL BALANCES (Perconteg.. of CDP) 1977 1978 1979 1980 1981 1982 1983 1984 1986 1986 1987 1088 BUDGET -8.2 -1.2 -0.0 -1.4 -4.8 -4.6 -2.5 -0.7 2.0 -2.1 -0.0 -1.8 FONAPAR 0.1 -0.0 0.0 -0.6 -0.8 -0.4 -0.5 0.1 -0.1 -0.0 -0.1 0.0 REST GENERAL GOVERNMENT -5.0 -8.8 -1.1 -1.9 0.7 -1.1 2.7 -0.8 -0.4 -2.0 -1.7 -1.6 BEDE -0.4 -1.5 1.1 1.2 0.6 1.0 1.9 1.0 0.8 0.6 0.4 0.8 NESS 0.8 0.6 0.7 0.4 n.a. n.a. 0.0 -0.4 -0.0 -0.3 -0.8 0.2 FONAPRE n.a. n.a. n.a. n.a. n.a. n.e. -0.0 -0.0 0.0 0.0 0.0 -0.0 Municipallties n.a. n.a. n.a. n.s. n.a. n.s. 0.0 -0.0 0.1 -0.2 -0.2 -0.2 Provinces n.a. n.a. n.s. n.a. n.a. n.o. -0.1 -0.1 -0.0 -0.1 0.0 -0.1 Defence Board and Universities n.a. n.s. n.a. n.a. n.a. n.a. 0.8 -1.1 -1.3 -2.0 -1.5 -1.6 PUBLIC ENTERPRISES -0.2 -1.2 -0.2 -0.8 -1.2 -0.7 0.8 0.8 0.3 -0.9 -1.7 -1.8 CEPE 0.2 -1.0 0.4 0.0 -0.8 0.1 -0.1 0.4 -0.2 -0.8 -0.9 -0.6 INECEL -0.4 -0.2 -0.7 -0.9 -0.9 -0.7 0.2 0.2 -0.1 -0.6 -0.7 -0.7 IETEL n.a. n.a. n.a. n.a. n.a. n.m. -0.1 -0.1 0.8 -0.0 -0.0 -0.6 ECUATORIANA n.a. n.a. n.a. n.a. n.a. n.a -0.0 0.0 0.1 0.1 -0.0 -0.0 ENAC n.a. n.a. n.a. n.a. n.a. n.a. 0.1 -0.0 0.1 -0.0 -0.1 0.0 ENPROVIT n.s. n.s. n.a. n.e. n.a. n.a. -0.0 -0.0 0.0 0.0 -0.0 0.0 TAVE n.a. n.a. n.a. n.a. n.a. n.a. 0.9 -0.0 -0.0 0.0 0.0 0.0 FLOPEC n.s. n.a. n.a. n.a. n.a. n.a. 0.1 0.1 0.1 0.1 -0.0 -0.0 TRANNVE n.a. n.a. n.a. n.a. n.a. n.a. -0.0 0.1 0.1 0.1 0.0 0.0 ENFE n.n. n.a. n.a. n.s. n.. n.o. 0.0 -0.0 -0.0 0.0 -0.0 -0.0 CONSOLIDATED PUBLIC SECTOR -8.3 -8.2 -2.0 -4.8 -5.8 -8.7 -0.0 -0.6 1.9 -6.1 -9.6 -6.1 Source: IMP - 120 - Table: 6 CEPE'S DEBT WITH CENTRAL BUDGET GENERATED BY THE NON TRANSFER OF INTERNAL OIL RESOURCES Period: 1980-1988 Years Indetbed Values (Million Sucres) 1980 930.9 1981 488.5 1982 3,398.6 1983 649.4 1984 119.2 1985 3,281.5 1986 12,868.3 1987 11,794.9 1988 121.9 Total 23,648.3 Sourcet The Financial Situation of the Public Sector in Ecuador, 1970- 1988, P.L. Paredes - 121 - Tablet 7 ANNUAL GENERATION OF CENTRAL'S GOVERNMENT DEBT WITH IESS (Hillions sucres) Year Average 1970 652.6 1971 106.7 i972 473.2 1973 531.4 1974 606.8 1975 674.3 1976 745.4 1977 1081.6 1978 1225.4 1979 1349.3 1980 2855.0 1981 3235.0 1982 3765.1 1983 5562.7 1984 7252.9 1985 6829.1 1986 7500.0 1987 7887.0 1988 10300.0 1989 14000.0 Total 76633.7 Source: The Financial Situation of the Public Sector in Ecuador, 1970- 1988, P.L. Paredes - 122 - Table: 8 CENTRAL GOVERNMENT DEBT NEGOTIATION WITH I.E.S.S. Consolidated Bulletin Date Consolidated Interest Term Amount Rate Years (Million sucres) S First 601.709 09128164 168.0 7.00 25 Second 145.652 29/11166 195.4 7.00 20 Third 145.653 29/11/66 110.5 7.00 19 Fourth 168.595 28/10/69 862.12 7.00 18 Fifth 132.644 30/12170 652.6 7.00 19 Sixth 192.333 11/05/72 106.7 7.00 20 Seventh 155.690 31/12/72 1,004.7 7.00 19 Eighth 189.037 31/12/76 2,026.5 7.00 20 Ninth 149.239 13/12179 3,656.3 7.00 20 Tenth 147.202 31/12/84 22,703.5 15.00 15 Eleventh 143.105 31/12/85 6,829.4 15.00 15 Twelfth In Negotiation Source: The Financial Situation of the Public Sector in Ecuador, 1970/ 1988, P.L. Paredes - 123 - Table: 9 CENTRAL GOVERNMENT DEBT AMORTIZATION WITH IESS (Million Sucres) Debt Outstanding Consolidation Initial Value Annual Payments Capital Interest First 168.0 7.1 20.0 142.1 Second 195.4 9.1 - - Third 110.5 53.1 0 Fourth 862.5 42.5 _ _ Fifth 652.6 313.5 59.5 314.5 Sixth 106.7 49.5 26.6 33.5 Seventh 1,004.6 Variable 185.0 209.5 Eighth 2,026.5 Variable 759.9 2,127.7 Ninth 3,656.5 171.5 2,433.3 9,909.5 Tenth 22,703.5 2,009.5 20,932.4 21,270.9 Eleventh 6,829.4 687.8 6,494.7 8,637.5 Total 38,315.7 30,902.6 31,145.9 Twelfth 32,200.0 In Negotiation Sourcet The Financial Situation of the Public Sector in Ecuador, 1970-1988, P.L. Paredes - 124 - Tablet 10 BEDE'S CREDIT RESOURCES FOR CENTRAL GOVERNMENT PROGRAMS Million of Sucres 1980 52.0 1981 84.0 1982 118.0 1983 195.6 1984 210.9 1985 658.2 1986 866.6 1987 145.7 1988 196.0 Source: The Financial Situation of the Public Sector in Ecuador, 1970-1988, P.L. Paredes - 125 - Table: 11 BEDE'S DISBURSEMENTS STRUCTURE Period Period Period 79-08-10 84-08-17 1988 84-08-16 87-12-31 By Debtor Central Administration 41.6 48.9 25.8 Provincial Councils 2.6 3.1 4.0 Municipalities 13.5 8.9 2.0 Others 42.4 21.0 10.0 _ Sectors Economic Substructure 45.6 48.9 25.8 Agricul/Forestry/Fishing 5.4 14.8 3.1 Manufacture 2.3 0.4 0.7 Electric Energy 12.3 5.2 5.7 Vialidad Y Terminales 22.1 15.3 8.1 Communication - 0.5 8.1 Mining - 5.4 5.7 Transport 0.3 6.0 8.1 StoragelTrade 2.9 1.1 0.7 Tourism 0.3 0.2 - Social Substructure 34.8 51.1 74.2 Education, Science & Culture 7.8 5.4 6.1 Health 2.0 10.3 20.5 Housing 4.8 1.8 1.2 Drinkable Water/Sewage 10.6 15.7 15.6 Urban Development 7.6 14.4 25.2 Sportive Substructure 1.8 3.5 5.6 Multlple Development 19.6 - 1.2 Source: The Financial Situation of the Public Sector in Ecuador, 1970- 1988, P.L. Paredes - 126 - Tablet 12 OPERATIONS OF THE DEVELOPMENT BANK OF ECUADOR (BEDE) (In billions of Sucres) Prel. 1984 1985 1986 1987 1988 -------------------------------------------------------------------__------ Total Revenue 10.6 10.7 8.8 11.4 11.5 Petroleum Revenue 7.3 6.5 3.2 2.9 2.6 Nonpetroleum Revenue 3.3 4.2 5.6 8.5 8.9 Total Expenditure 5.2 10.3 11.5 24.0 24.2 Wages and Salaries 0.1 0.1 0.3 0.6 0.5 Other Expenditures 2.1 1.5 1.2 3.6 1.8 Net lending 3.0 8.7 10.0 19.8 22.1 Overall Surplus or deficit (-) 5.4 0.4 -2.7 -12.6 -12.7 Sources: Development Bank of Ecuador; Central Bank of Ecuador; and Fund staff estimates - 127 - Table: 13 MUNICIPAL COUNCIL REVENUES, L983-89 (Percentages of Total) 1983 1984 1985 1986 1987 1988 1989 Petroleum Revenue 19.8 18.0 13.0 7.5 5.6 4.4 3.3 Non-pertroleum Revenue 80.2 82.0 87.0 92.5 94.4 95.6 96.7 Current Revenue 29.3 31.2 41.2 36.0 35.6 38.5 33.1 Capital Revenue 0.0 0.0 0.0 1.1 1.1 0.8 0.0 Transfers 50.9 50.8 45.8 55.4 57.7 56.3 63.6 From Budget 50.9 50.8 45.8 17.6 13.0 14.0 15.8 From rest of Public Sector 0.0 0.0 0.0 37.8 44.7 42.3 47.8 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total as 2 of GDP 2.1 1.6 1.6 1.9 2.1 1.6 1.7 Sources Statistical Appendix Table 14 - 128 - Tablei 14 MUNICIPAL COUNCIL EXPENDITURES,1983-89 (Percentages of Total) 1983 1984 1985 1986 1987 1988 1989 Current Expenditure 46.6 7.3 60.1 51.1 55.3 60.3 65.9 Wages and Salaries 33.6 34.4 39.9 34.1 35.4 35.9 36.5 Purchases of Goods & Services 7.8 8.4 9.8 8.9 9.5 9.3 12.8 Interest Payments 0.0 0.0 3.1 2.0 4.2 8.2 9.1 Current Transfers 5.2 4.6 7.4 6.5 6.2 6.9 7.4 To IESS 0.0 0.0 3.1 2.7 2.9 3.3 4.0 To Other Public sector 5.2 4.6 2.5 2.0 1.4 1.5 1.5 To Private Sector 0.0 0.0 1.8 1.7 1.9 2.2 2.0 Other Current Expenditures 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Capital Expenditure 53.4 52.7 39.9 48.5 44.7 39.7 34.1 Fixed Capital Formation 48.2 48.1 35.6 46.4 43.2 39.6 34 1 Net Lending 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 5.2 4.6 4.3 2.0 1.4 0.2 0.0 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total as Z of GDP 2.1 1.6 1.5 2.1 2.3 1.8 1.4 Deficit or surplus as Z of GDP 0.0 0.0 0.1 -0.2 -0.2 -0.2 0.1 Source: Statistical Appendix Table 14 - 129 - Tablet 15 PROVINCIAL COUNCIL REVENUES, 1983-89 (Percentages of Total) 1983 1984 1985 1986 1987 1988 1989 Petroleum Revenue 25.6 28.3 17.2 12.6 7.7 7.9 5.5 Non-petroleum Revenue 74.4 71.7 82.8 87.4 92.3 92.1 94.5 Current Revenue 11.6 10.9 31.0 19.5 22.2 23.2 32.7 Capital Revenue 0.0 0.0 0.0 1.1 0.9 0.7 1.2 Transfers 62.8 60.9 51.7 66.7 69.2 68.2 60.6 From Budget 62.8 60.9 51.7 19.5 15.4 25.8 16.4 From rest of public sector 0.0 0.0 0.0 47.1 53.8 42.4 44.2 Total 100.0 100.0 100.0 100.0 100.0 10U.1 100.0 Total as X of GDP 0.8 0.6 0.5 0.6 0.6 0.5 0.3 Source: Statistical Appendix Table 15 - 130 - Tablet 16 PROVINCIAL COUNCIL EXPENDITURES, 1983-89 (Percentages of Total) 1983 1984 1985 1986 1987 1988 1989 Current Expenditure 38.3 42.3 49.2 51.0 49.1 55.7 57.2 Wages and Salaries 27.7 28.8 31.1 24.5 29.3 28.7 31.3 Purchases of Goods & Services 10.6 11.5 8.2 9.2 12.1 11.5 13.0 Interest Payments 0.0 0.0 3.3 13.3 2.6 10.3 8.2 Current Transfers 0.0 1.9 6.6 4.1 5.2 5.2 5.3 To IESS 0.0 0.0 6.6 2.0 2.6 2.9 2.9 To Other Public sector 0.0 1.9 0.0 1.0 0.9 0.6 1.4 To Private Sector 0.0 0.0 0.0 1.0 1.7 1.7 1.0 Other Current Expenditures 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Capital Expenditure 61.7 57.7 50.8 49.0 50.9 44.3 42.8 Fixed Capital Formation 61.7 53.8 47.5 48.0 50.0 43.1 42.3 Net Lending 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other 0.0 3.8 3.3 1.0 0.9 1.1 0.5 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total as 2 of GDP 0.8 0.6 0.5 0.7 0.6 0.6 0.4 Deficit or surplus as 2 of GDP -0.1 -0.1 -0.0 -0.1 +0.0 -0.1 -0.1 Source: Statistical Appendix Table 15 - 131 - Table: 17 PUBLIC SECTOR RESIDUAL ACCOUNTS REVENUES, 1983-89 (Percentages of Total) 1983 1984 1985 1986 1987 1988 1989 Petroleum Revenue 100.4 106.9 99.5 95.1 26.4 28.4 18.2 Non-pertroleum Revenue -1.4 -1.6 0.5 4.9 73.6 71.6 81.7 Current Revenue 0.0 0.0 0.0 4.9 33.9 32.8 32.1 Capital Revenue 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Transfers 0.0 0.0 0.0 0.0 39.7 38.9 49.6 From Budget 0.0 0.0 0.0 0.0 39.4 37.1 49.4 From rest of Public Sector 0.0 0.0 0.0 0.0 0.3 1.7 0.2 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total as % of GDP 2.5 1.6 1.9 2.2 2.0 1.5 2.4 Source: Statistical Appendix Table 16 - 132 - Tablet 18 PUBLIC SECTOR RESIDUAL ACCOUNTS EXPENDITURES, 1983-89 (Percentages of Total) 1983 1984 1985 1986 1987 1988 1989 Current Expenditure 78.1 105.0 100.0 100.0 96.1 71.7 32.5 Wages and Salaries 0.0 0.0 0.0 0.0 21.7 18.8 7.4 Purchases of Goods & Services 100.0 105.5 100.0 73.1 38.3 13.5 1.5 Interest Payments 0.0 0.0 0.0 26.9 21.7 25.9 12.1 Current Transfers -21.9 0.0 0.0 0.0 3.1 2.4 0.9 To IESS 0.0 0.0 0.0 0.0 2.4 2.1 0.8 To Other Public sector 0.0 0.0 0.0 0.0 0.5 0.1 0.0 To Private Sector -21.9 0.0 0.0 0.0 0.3 0.2 0.1 Other Current Expenditures 0.0 0.0 0.0 0.0 11.3 11.1 10.6 Capital Expenditure 21.9 -5.5 0.0 0.0 3.9 28.3 667.5 Fixed Capital Formation 0.0 0.0 0.0 0.0 3.9 28.3 67.5 Net Lending 18.8 0.0 0.0 0.0 0.0 0.0 0.0 Other 3.1 0.0 0.0 0.0 0.0 0.0 0.0 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total as Z of GDP 1.7 2.7 3.1 4.2 3.5 3.1 5.3 Deficit or surplus as Z of GDP 0.8 -1.1 -1.3 -2.0 -1.5 -1.6 -3.0 Source: Statistical Appendix Table 16 - 133 - Table: 19 STATE DEBT PAYMENT A¢REDEMTS VITH IESS IN ECUADOR, 1964-1988 Interest TeM Amount Constant Year Reason (2) (Years) 1964 Capital amortization not paid (1956-63) T 25 168.0 4.1 1966 Employers contributions, etc. (1962-64) T 20 195.4 5.2 1966 402 pensions (1958-64) t 20 110.5 2.9 1969 Employers contributions + 40Z(1965-67) T 20 862.1 26.3 1970 Employers contributions (1968-69) T 20 652.6 20.9 1972 Additional insurance railroad (1970-) T 20 106.7 4.0 1973 For military & police pensions (1970-71) T 19 1,004.7 42.6 1976 Employers contributions (1972-74) T 20 2,026.5 132.8 1979 Employers contributions (1975-76) T 20 3,656.3 333.3 1984 Employers contributions (1977-83) 15 15 22,702.5 6,157.7 1985 Employers contributions (1983-84) 18 15 6,829.4 2,357.0 TOTAL 38,314.7 9,086.6 ESTIMATED TOTAL STATE DEBT TO IESS AT THE END OF 1988 (8) (million sucres) Vith Vithout Million U.S. Agreements Agreements Total at 1988 Exchange Rate Capital 32,373 52,902 85,196 282.4 Interest 36,661 59,900 a/ 96,561 320.2 Total 69,034 112,802 181,757 602.6 a/ Author's estimate Sources Flnancial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Lago, Nov. 1989 - 134 - Table: 20 EVOLUTION OF MAIN SOCIAL INSURANCE LEGISLATION BY RISKS AND GROUPS COVERED IN ECUADOR, 1900-1989 Year Risks Protected Covered Groups Early 1900s DS Military officer 1921 OR All workers (wage earns) 1923 ODS Teachers 1928 ODS, FA Public Fund for civil servants (state, municipalities), banking and insurance employees and armed forces 1935-37 All system Creation of INP; also addition of HM to public fund 1937 ODS, HM, FA Private fund for white- and blue collar workers 1940 Improved benefits Railroad workers 1942 ODS, HM, OR, FA New system for all wage earns 1948-60 at SP Military, teachers, civil servants banking and municipal employees, white-and blue-collars policemen 1963 All system Merge of public, military and private funds . 1964 OR Expansion and incorporation in INP 1964-65 at ODS, HM, PA Artisans, domestic servants, self-employed professional 1966-67 ODS, HM Artists, clergy, sportsmen 1967 ODS, HM,OR Voluntary insura"'e (not enforced immediately) 1968,1973,1981 OD, HN, FA Peasants and their dependents in selected geographical areas (Peasant Insurance) 1970 All system INP becomes IESS 1971 ODS, HM, FA Construction workers 1979 ODS, HM, FA Salaried artisans and apprentices 1980 ODS, HM, FA Self-employed artisans and apprentices, salaried agricultural sugar workers 1982 ODS,HM,FA Self-employed artists and associated taxicabs 1984 ODS, HM Other self-employed (voluntary) 1986 OD, NM, OR, FA Salaried agricultural wutkets, artisan fishermen. voluntary insurance for adults: informal marginal workers (not in operation) 1989 OR, FA Self-employed, domestic servants, artisans at Separate legislation for each group ODS = old age, disability and survivor pensions; OR= occupational risk insurance; HM- health -maternity insurance; FA- funeral aid; SP- severance pay. Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Lago. Nov. 1989 - 135 - Tables 21 lESS COEAOE OF THE POPULATION IN ECUADOR, 1965-1987 (to thousanda and percent egs) Popelotlo Inoured X of Coveume Ratio Activ./Pe eive g Total Excluding Year Total EAP Aetive / P 1Y-ve Pes*nt. I/ Total Pop. . EAP */ Over ll Peasants 19065 5,071 1,755 hJ 221 82 0 254 5.0 12.6 6.9 .09 1970 6,051 2,084 We9 46 4 868 5.9 14.8 G. 9e9 1975 7,084 2,166 428 01 66 $26 7.5 18.1 7.0 6.9 19Q0 6,118 2,70? 576 62 106 745 9.2 21.5 7.0 6.7 1065 9,876 8,147 701 16 190 1,211 12.9 26.1 7.5 .7 196 9,647 5,28 685 11o 484 1,204 18.4 25.6 7.6 e.8 187 9,922 8,524 h/ 672 114 h/ 472 1,872 h/ 18.6 S/ 26.2 7.6 6.9 / Includes ctiv Insured In bet" tESS nd Peoasnt Insurance; *xclud_ Armd Fores -/ Pens loner In IESS and Peasant lnsuroae: saxcl uda Armd force. ci Includes active Insured sad dependen*t (active p ueant Insured are *Iso counted undar the active column) d Sun of active, paslve and p 4eant Insurance, correcting the double counting of poseant active Insured. of total Insured/Total Population fi Active Ineured/EAP i Number of active dividend by number of pnasive; the first column Includes pe nt aetive insure while the second column exeludes this group Estiaate/proJectione Source: Financiel and Economle Evaluetion of Social Insurwnce In Ecuador, C. Veaa-Lago, Nov. 19M - 136 - Table: 22 DEGREE OF IESS COVERAGE BY ECONOMIC ACTIVITY IN ECUADOR, 1981 Active Economic EAP Insured Percent of Activities (thousands) (thousands) coverage Agriculture, live- stock, fishing 760.0 33.0 b/ 4.3 Mining, petroleum 6.8 3.4 49.8 el Manufacturing 275.2 117.3 42.6 Public utilities govt. administration 340.2 219.0 64.4 Construction 153.2 45.3 29.6 Commerce, finance, insurance 294.8 85.1 28.9 Transport. communications 100.3 a/ 14.8 14.8 Personal and social services. domestic 267.4 62.4 c/ 23.4 Not specified 51.1 21.6 42.0 Total 2,307.0 602.0 dl 25.4 a/ A large number of those in this category are self-employed. b/ Includes heads of family in Peasant Insurance. c/ About 62? of the insured in this category are domestic servants. d/ The original included 4,207 voluntary insured who could not be assigned to the distribution. e/ Combines a sector with high degree of coverage (petroleum) and others with low coverage. Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Lago, Nov. 1989 - 137 - Tablet 23 IESS POPULATION COVERAGE BY PROVINCE: 1982 AND 1986 (Percentages) Coverage Coverage: 1986 Rural 1 of Total Without Peasant Total 1982 Total Peasants Insurance Population Sierra (highlands) 12.5 16.9 11.3 5.6 51.6 Carchi 10.3 16.2 6.3 10.0 59.8 Imbabura 11.8 15.6 7.4 8.2 59.4 Pichincha 19.8 20.8 19.0 1.8 27.7 Cotopaxi 7.1 13.5 4.2 9.3 83.5 Tunzurahua 7.5 10.0 6.8 3.2 60.8 Bolivar 4.3 12.1 3.9 8.2 82.0 Chimborazo 9.8 17.8 5.7 12.1 69.5 Canar 5.3 15.1 4.2 10.9 75.1 Azuay 10.9 18.9 11.1 7.8 58.4 Loja 5.8 10.3 5.0 5.3 62.7 Coast (West) 8.5 10.1 7.1 3.0 4.3 Esmeraldas 6.6 12.3 4.7 7.6 48.9 Manabi 7.8 11.0 4.5 6.5 58.9 Los Rios 3.0 5.3 3.5 1.8 63.3 Guayas 10.9 10.9 9.7 1.2 27.8 El Oro 4.4 7.1 4.4 2.7 32.5 Oriente (East) 5.6 15.8 3.8 12.0 76.0 Napo 7.6 11.0 2.6 8.3 79.9 Postaza 7.9 21.3 8.8 12.5 64.1 Morona Stgo. 2.6 19.0 3.4 15.6 74.4 Zamora Ch. 3.6 19.8 4.2 15.6 75.9 Galapagos (Islands) 22.9 50.8 18.7 32.1 20.8 Totals 10.2 13.4 8.9 4.5 47.2 Source: Financial and Economic Evaluation ot Social Insurance in Ecuador, C. Mesa-Lago, Nov. 1989 - 138 - Table: 24 LEGAL CONTRIBUTIONS TO IESS BY PROGRAM AND SOURCE IN ECUADOR, 1989 (as a percentage of wages or income) Insured Self-employed Programs Salaried and Voluntary Employer State Total al Pensions: General (include HM care) bl 5-9.26 12 5-11.32 h/ 12-20.58 Two extra months yearly c/ 1-1.87 1 1-1.87 Improved pensions df 2-5 5-6 8-10 Health-Maternity (paid leave) SI 1-1.87 1-1.87 Occupational Risks f/ 1.5 1,5-2.81 1,5-1.87 Severance Pay 2 1 3 Funeral Aid 1 1 1 Peasant Insurance 0.35 0.35 0.30 1 Total 8,5-16.35 15.5 7,35-16.85 0.30 15,85-30.21 a/ Does not include contributions of self-employed and state. bI All insured pay 52 or 72 except temporary sugar cane workers who pay 9.262. cl All pay 12 except temporary sugar workers who pay 1.82 dl Additional contribution for improved pernsions and severance only for t5ree groups: printers (21 and 62), teachers (52 and 52) and contruction w.rkers (8.33x). ei All pay 1.52 except termporary sugar workers who pay 1.872. fl All pay 1.5Z except temporary sugar workers who pay 2.812. Domestic servants and agricultural wage earners pay this contribution (instead of their employers). &I Insured peasants pay 12 of the mitimum salary. hl the state pays 402 of the total cost of pensions as well as improved pensions of several groups. il The majority pays 20.22; for divergent totals see Table 6. Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Lago, Nov. 1989 - 139 - Table: 25 ESTIMATED VALUE OF EMPLOYERS' al DEBT FOR MORA TO THE IESS IN ECUADOR, 1982-1988 (at the end of the year; in million sucres) Detected Mora Cummulat.ive Debet in New Mora Collected Mora Constant by IESS Debt b/ Sucres Year (1) (2) (3) (1982) cl 1982 n.a n.a 3,766 3,766 1983 376 711 3,431 2,311 1984 480 1,042 2,869 1,474 1985 1,065 1,095 2,839 1,139 1986 1,351 894 3,296 1,074 1987 1,966 1,526 3,736 931 1988 6,061 3,085 10,539 1,465 8,102 n.a 1989 3,522 2,132 11,929 n.a a/ Public institutions (excludes State), provincial and municipal governments plus private employers. bl Column 3 (year 1) - column 1 (year 2) - column 2 (year 2) = column 3 (year 2). c/ Author's estimates based on average annual inflation (3J. di Partial: it includes 4,335 million in mora (with/without agreements) from provincial and municipal governments. el Total: it adds to the 1988 cumulative debt: 3,244 million for capital owed plus 583 million for interest due from national payment agreements f/ Planned (may be partial figures). Under cumulative debt, the first figure (8,102) is based on the partial comulative debt of 1988 and the second figure (11,929) on the total cumulative debt of 1988 [13J. Source Financial and Economic Evaluation of Social Insurance in Ecuador, C. Hesa-Lago, Nov. 1989 - 140 - t bsku.. 28MT c130571 *aSIIn RF Ai. YIELD OF tEuSt VNESM8 ASSETS IN ECUADCR 19754196 a/ (Si It to e wos)) tsrs lerB 11180 setts se92 low set4 sels ss ses 1w lo 190 Tot t lXt A"Ot Il 2S 202 S0.71 a ts a" 3t *72 37 432 42.25S sto Sol n5 40§ 91 4se (P.M t oe acre) Inreeted Assets S/ 5 62 3 977 12 86O 14 245 1s 266 M.614 2S.510 2s.256 8e 061 46 345 St 665 73 472 (wIll;en vcsr- ) Innee.tent Rttumr / ss5 6?4 1. 4" 1.723 1.745 1.615 1.2t6 2.1t8 8.076 (stt on aecree) lnetl yield (1) I/ 11t5 12.5 15. 1 18.3 12.5 1t10 1O.5 8.7 9.e 12.8 12.5 19 1 Rot. of Inftltion (t) 11.6 10.8 18.0 16.5 16.8 46.4 81.2 2S.0 30.2 1.9 85.53 Real Yield (6) -O 1 2.0 1.8 -2.1 -8 8 -25 2 -1S.8 -t5S.1 -10.6 -1S.7 -87,3 Ce=psition ts ditrt-1 ibli;c/m,tgoves 9end. 40 3 26.0 s8.6 85 2 19.0 17.2 9.6 10.2 38 0 ersonal 32.5 27.6 2e.2 SS.0 39.s 85.9 42.5 ss.2 30.7 29.1 19.1 .rtwoe 9 5 13.2 18.9 25.5 84.6 8s' 87.8 s9.5 87.5 84 3 10 e Others / 0 2 0O 6.3 4 8 4.7 5.0 7.2 5.8 a 6 P; .ad Ters sset_ t .1 Il la 2. L2 2.1 2.Q g9.Q 2o shares 5.2 0.4 0.2 0.4 0.2 0.0 0.1 S.5 9.8 It/ Rest Eate 3.e 4.7 5.0 8.0 1.2 2.5 2.5 8.2 126 other_ h Li la eI la I Li Li 2.2 LA et.l 100.0 100.0 100.0 100. 100.0 100.0 100.0 100.0 100.0 100.0 too 0 5J At the end of tho year tJ 976 1990 fr* o LO; ee- estimated by the sethor based 0o TM8 se- ro9e foresebh pProgrea. Year 1967 9;" by tS1S tt17. SI 6te0dee flwed nd not crrrent e*nst. RIO dots for 1976-1960 ein. 3.S tim the figures in tle tebl. d/ The I8 oi." budgeted date 0' *r,estweSt turns o t hiCher th n Uhe- th, ether 155 sie en .n U %l T*bte; the W,r tl. also hoe a series (1976-1983) which is frew 1009 to 2001 higlh. thVn the loble's; the IUI srlee (1976-1963) is f-r_ 261 to 1706 h;ihr ths. the Tebl-'t 9I Esti_sted by the uethr. based on th. for- ls (Ir . 2CY -- (11 12 .11 ,h. *T-. .n-eet_ni r n -sed e*seet (I. it the stag. of the year; at the sod of the yes. The 1eSS ros,n5l yielde *sue wyewsticell . well. be- t tVe. di.id. the in-etwomt return b, the -oset.d see.s both in U uas. year. No;inel yields fro 1287-69 " froe- It35S hence the **l ;yld ohuh sld be moseet hbitu*, There are two projected yeld*e for 989 fJ Smed Go the formula: I e , 100 shere y re oinst yield .Off,ciont end lunftetion orsffis,ent W Loe- to 1tes Progress (Sienness--etrnity includi. *frstre ure p 4esn qr '- an4 P.bltit asetor / Pe-n teens. non-seef;ed stoebl TM whose eto it Progr'sesd ji/ Imndet 7-AgestS i Saurceu ineru_cust and Seonoi;e En st;eten dof Soels IJnvrenee Int Ecusdor. C. "ove-Lg. "D... 1969 - 141 - Table: 27 PERCENTAGE DISTRIBUTION AND YIELDS OF INVESTED ASSETS IN PRIVATIVAS AND NON PRIVATIVAS INSTRUMENTS IN ECUADOR. 19S2-19S9 1989 1982 1983 1904 1985 1986 1987 1986 111] l1i] Percent Distribution Privativss 61.2 79.0 81.7 87.6 84.9 88.9 79.0 76.2 48.6 Non-privatives 88.6 21.0 16.8 12.4 15.1 16.1 21.0 21.8 656.0 Total 100.0 100.0 100.0 100.0 100.0 100.0 99.5 100.0 989. Nominal Yield Privativas 8.06 8.14 6.03 9.99 / 10.86 4/10.46 8.09 0.14 20.2 Non-privativas 16.76 17.99 16.64 17.94 20.65 21.94 30.48 24.68 87.0 Total d/ 11.43 10.21 6.87 10.98 cf 11.94 /12.81 12.76 10.18 29.5 Ratio of N-P Yield To P Yleld 2.1 2.2 8.1 1. c/ 2.0 e/ 2.1 8.7 4.0 1.9 aj Programmed. The IESS Economic Financial Division gave the first projection [17]nt the end of 1988 and the second [18] In March 1989. b/ There is 1.4X in not classified investment. _ Another IESS source gives 6.16 In 1966 and 5.89 In 1986 for privativas and 7.63 and 7.67 for total yield [16]. d/ Do not coincide with the serie* in Table 9 (except for 1987-89) because methods of calculation are different (see footnote e. Table 9). ci With the alternative figures. ratios would bh 8.4 1n 19S6 and 8.6 in I6. Source: Financial and Economic Evaluation of Social Insurance in Ecuador. C. Mesa-Lago. Nov. 1989 - 142 - Table: 26 NOMIL YIELDS OF IESS INVESTUEN IN ENTERPRISES (SIURES) IN ECUADOR. 1994-1988 Enterpriso 19U4 1963 1t66 1967 (n) (b) Distril- butlon ef A. Public EnterprIses 9.20 0.00 9.10 0.00 0.00 0.00 12.0 Banco VIvi end (houcIno) 24.16 0.00 24.15 0.00 0.00 0.00 5.2 Ouspan (cement) d/ 0.00 0.00 0.00 0.00 0.00 0.00 8.8 8 Private Enterprise 25.12 25.01 26.41 87.64 68.18 69.68 29.4 1. Banking A Finance 21.66 6l.l76 1.61 86.o0 82.e6 81.60 6.0 P Pacific* 40.00 12.00 64.70 86.74 52.59 46.19 0.2 S. Pichincha 24.26 60.41 82.00 52.19 22.60 20.86 0.4 t. PreestO.. 84.41 89.48 11.29 19.65 64.24 61.65 0.0 S. Popular 8a.45 6.80 16.79 87.01 40.66 40.s6 4.1 COFIEC d/ 6.00 26.46 7.50 89.54 22.09 21.24 8.8 2. Industrial 28.94 21.46 26.66 26.46 56.21 45.25 16.6 Art. Praectieo 8 72 0 00 0.00 0.00 0.00 0.00 8.6 Chiaborazo (Cement) 16.54 0.00 416.25 10.15 0.00 0.00 0.6 Andins (beer) 87.55 47.63 78.82 66.92 148.47 60.25 2.2 ECASA 0.00 0.00 0.00 0.00 0.00 0.00 0.4 lANCER (ougar) I/ 0.00 0.00 0.00 0.00 50.00 50.00 4.6 Internaelonal 25.00 55.07 181.41 60.50 117.8U 114.68 8.7 LUt. (pharmcuetics) 0.00 95.10 0.00 71.96 0.00 0.00 1.1 Socioeda Agricola (sugrr) 0.00 121.06 9.19 110.68 45.00 45.05 0.2 8. Cosercial A Serv Ies 87.70 50.84 50.61 66.04 260.60 281.79 4.0 Executive Club 8.00 8.00 8.00 80 150.00 0.00 0.00 0.o Dilinco (beer) 148.75 148.97 64.65 228.69 169.68 189.68 0.1 Hotel Colon 50.00 100.00 75.00 175.00 200.00 149.54 1.0 La Favorita (superearket) 80.00 88.00 48.00 65.00 261.51 264.09 8.5 C. Projecto in Progress 0.00 7.59 0.00 0.00 0.00 0.00 56.6 Totals I1 1 .62 11 87 7.02 9.40 24.46 n 100.0 TOTAL EXCLUDI3i C */ 17.49 18.11 20.8 26.00 69.06 62.02 nIESS estimated nominal yleld: dividendo in cash and sharos divided by nominol vslue of investment. I/ IESS estimated real yield (dividends In cahl and shores divided by real value of investment). e/ Percentage distribution I value of IESS nominal investment in enterprises (1666. d 189 ore estimtes since results are not *velloble. !/ Exludes 1.808.5 illon surer In ownership of Hotel Quito and Tellic Product Faetory. Source; Flenalol and Economle iEvluation of Social Insurance in Ecuedor. C. MW-'.Ago. Nov. 1969 - 143 - Tablet 29 REAL VALUE OF IESS AVERAGE ANNUAL PENSIONS IN ECUADOR. 1970-1986 Pensions a/ Average Indices: 1970 - 100 (million Pensioners pension per Nominal Real Year sucres) (thousands) cap. (sucres) Pension Inflation b/ Pension 1970 393 45 8,733 10.0 100.0 100.0 1971 509 48 10,604 121.4 109.7 110.7 1972 578 51 11,333 129.8 117.8 110.2 1973 633 54 11,722 134.2 132. 101.6 1974 848 58 14,621 167.4 144.6 115.8 1975 999 61 16,377 187.5 165.2 113.5 1976 1,120 65 17,231 197.3 182.1 108.3 1977 1,518 67 22,657 259.4 205.6 126.2 1978 1,647 72 22,875 261.9 232.5 112.6 1979 2,093 80 26.162 299.6 256.0 117.0 1980 3,595 82 43,841 502.3 288.8 173.8 1981 3,890 84 46,095 525.8 335.8 157.2 1982 4,420 88 50,410 572.2 390.5 147.8 1983 6,604 98 67,407 771.9 579.6 133.2 1984 7,851 103 76,310 873.8 760.4 114.9 1985 10,528 106 98,898 1,123.5 973.3 116.4 1986 14,393 110 131,108 1,501.3 1,197.1 a/ Old age, disability and survivor pensions, exclude pensions of the armed forces. h/ Average of the cost of living in the three largest cities. Source: Financial and Economic Evaluation of Social Insurance in Ecuador. C. Mesa-Lago. Nov. 1989 - 144 - Table: 30 GENERAL HEALTH FACILITIES AND STANDARDS IN ECUADOR, 1955-1986 Hospital Beds Physicians Mortality Rates Life Expectancy per 1.000 inh. per 10,000 inh. General Infant at at birth b/ 1955 - - 15.4 112.8 48.4 1960 1.6 3.7 14.1 101.1 51.4 1965 2.3 3.2 11.6 92.8 54.7 1970 2.1 3.4 10.5 83.0 56.8 1975 1.9 4.6 7.8 65.8 58.9 1980 1.8 7.8 7.0 63.8 61.4 1985 1.7 11.5 5.4 c/ 50.5 cl 64.3 1986 1.7 14.2 n.a n.a n.a a/ Since 1975 only relates to registrations in the same year of birth. bl In five-year periods, e.g., 1950-1955 = 48.4. c/ ECLAC gives 8.1 for general mortality and 69.6 for infant mortality. Source: Financial and Economic Evaluation of Social Insurance in Ecuador, C. Mesa-Lago, Nov. 1989 - 145 - Tabl-: 31 AVAILA9ILITY Of HOSPITAL FACILITIES AND FUIDS By TYPE OF HEALTH INSTITUTION IN ECUADOR, 1981-1985 Hoapital Expenditures p. Estimated Populotion bad Physlcians capito 161_ 19168 1.000 I100 Inotitution (000) I (000) (%) 1951 1988 (198) Sucree Rati0 o linistry of Heslth (1I") 0,642 76.0 1.2 2,201 100 8.700 02.0 1.5 Seneficlelca. and othore 066 t.0 0.9 8,132 144 Sociol Insurance (IESS) 761 9.6 974 11.0 2.1 1.9 16.6 8 0 274 Military and Police 210 2.6 221 2.5 6.1 5.6 11,742 533 Privets Sector 460 t.6 667 6.5 0.1 4.7 Total 6.171 100.0 86.57 100.0 1.9 1.6 11.8 1/ In relation to lowest per capita I MN a 100 / I_nefleencla de Ouayaqull Source: Financlol and Econoic Evaluation of Social Insurance in Ecuador, C. iee-ago, Nov. 109 - 146 - Table: 82 IESS ADMINISTRATINE COSTS AND EMPLOYENT IN ECUADOR, 1974-1988 Budgeted Expwnditure Number of ESployec (million of sucreg) Number of Inuured per, 1000 Year Adminiat- Total Percent Employeee (thousands) Insured rat we Current 1974 198 2,167 9.1 4,880 469 10.4 1975 800 2,672 11.2 6,696 626 11.2 1976 869 8,216 11.6 6,844 564 11.2 1977 S01 4,168 12.1 7,219 609 11.9 1976 ee6 4,760 18.9 7,600 648 11.0 1979 797 5,908 11.5 8,240 646 12.0 1960 1,264 5/ 9,868 */ 18.6 of 9,942 745 18.8 1981 1,745 */ 11,291 *J 15.5 6 10,680 781 18.9 19R2 2,162 */ 18,828 */ 16.2 */ 10,860 625 10.2 19V8 2,566 of 19,906 */ 12. 8* 11,872 951 12.6 1964 2,948 28,872 12.8 1,090 1985 8,865 43,768 8.9 1,211 1906 6,795 62,265 10.9 1,294 1987 7,976 72,076 11.1 18,171 b/ 1,872 9.6 S/ 1968 11,792 90,627 18.0 3/ ILO data on social Insurance expenditure (including eivil servants and the armed forces ore from 60% to 100X higher on administrative expenditure but only 6X to 17X higher on current expenditures, hence, percentage oare such higher: 28.7X In 1980, 26X In 1961, 26 In 1902 and 22.60 In 1968. 6/ Refor- to regulor or permanent employees, *xcludes tporay labor hired by contract. Source: Finanncil and Economic Evoluation of Social Insurance In Ecuador, C. Mesa-Lago, Nov. 1909 - 147 - Tablz U HOSPITAL EVFIXCY IN PROVINCES OF ECUtDOR, 19r9-190S Percent o Occufancy Averoag Doy of Stax All Hspitals E Hospitals All Hoopitels *ESS Hospitalt Provinc 1979 1079 19t1 1905 1979 1979 1901 1965 Corchl 60.1 * a a 3.6 O * a I abur. 62.2 68.1 67.7 62.6 7.2 8.8 9.6 .6. Pkchinch. 61.6 96.8 02.6 96.8 10.6 11. 10.2 10.0 Cotopaxi 46.2 76.8 62.9 57.6 7J 8.2 7.4 7.6 Tungurahue 44.8 54.9 59.1 72.2 6.0 0.8 5.7 6.0 solivar 86.8 a a a 7.5 a a a Chlborozo 47.9 70.7 74.8 79.9 7.6 0.1 6.t 8.S Caner 62.4 a * * 7.8 a * a Atuay 65.7 61.7 s6.5 66.8 8.0 8.0 8.0 8.2 Lois 46.0 60.8 70.8 67.2 6.9 7.8 6.6 7.6 Emeraldas 59.0 58.6 59.1 64.5 5.6 5.1 5.0 6.6 Manabi 6.6 77.1 76.7 71.0 . 8.8 6.6 6.9 6.6 Los Rios 41.8 80.2 51.s 40.4 3.6 4.0 5.5 5.1 Guayas 66.8 86.4 88.8 80-1 k/ 9.8 10.6 10.9 7-9.8 b El Or* 85.4 45.1 60.0 64.5 4.5 S.6 8.7 5.2 Nap* 81.8 a a a 6.7 a a a Postage s0.6 a 17.8 86.9 6.8 a 4.0 5.2 morona Stgo. 87.1 * * . 4.1 * a Zaors Ch. 46.5 a * a 6.5 a a * Galapagos 16.2 a * a *.6 a a a Total 56.0 84.0 s2.7 68.8 8.2 0.9 9.8 6.T _j There Is no IESS hospital. h/ Lowest Duren, highest Ouayaqull Source: Financlol and Economic Evaluation of Social Insurance In Ecuador, C. ese-Laogo, Nov. 1989 - 148 - Table: 84 IESS HOSPITALS tNDER CONSTRUCTION IN ECUADOR, 10980-196 Provincial DOts Occupancy Aver"g ""p. Leds Investment (1985) b/ Rote (%) Ooy* Stay x 1.000 in.o Hospital1 Province (million % dil- All IESS All IESS IESS Sucre$ trlbutlon 19079 198 1970 195 1965 Quito South S/ Pichlinch 2,291 85.1 61.4 98.8 10.5 10.0 1.7 Quito North c/ Pichincha 1,441 Cuenca Atuay 1,444 18.6 65.7 o.8 6.6 e.2 1.8 Abato _/ Tungurahuu 1,441 18.6 44.8 72.2 6.0 6.0 1.2 Ibarro ;/ Iubaburo 920 o.0 02.2 62.4 7.2 6.8 0.9 Latecung e/ Cotepxl 776 7.8 46.2 57.6 7.4 7.5 1.8 E_mruldas Esmeurldas 56O 7.1 69.0 64.6 5.6 5.6 1.1 Riobbe _/ Chimborazo 705 6.6 47.9 79.9 7.6 e.8 0.9 Monte e/ Manabl 648 5.1 62.6 71.0 5.8 0.9 0.4 Lois Loja 821 8.0 45.0 67.2 6.9 7.0 0.3 Total_/ 10,08 100.0 58.0 38.8 9.2 3.7 1.8 */ Excludes Ouyoaquil - Quayas and Peasant Insurance. bi Includes contruction of phy 1e l plent end *quipmnt. c/ Not completed by 1986; there iu no Information on Cuenca, E..eroldas, and Lojs a nen hospital is being built In Portovlejo but I could not get date on it. d/ Lost six columns are notional averages. Source: Financial end Economic Evaluation of Socisl Insurunc- in Ecuador, C. Mes*-Lago, Nov. 1989 - 149 - Table 35: SHARE OF LOCAL GOVERNMENT EXPENDITURES IN RELATION TO THE EXPENDITURES OF THE CONSOLIDATED PUBLIC SECTOR, 1973-87 Year Total Current Capital Expenditures Expenditures Expenditures 1973 16.37 15.77 17.71 1974 12.64 12.55 12.81 1975 13.33 11.96 16.41 1976 12.83 11.97 14.65 1977 11.83 10.77 13.87 1978 13.91 11.86 18.06 1979 12.71 11.58 15.09 1980 15.31 12.56 21.27 1981 16.60 12.83 24.56 1982 15.30 12.06 22.73 1983 14.99 12.26 21.66 1984 14.60 12.12 22.30 1985 13.40 10.97 19.91 1986 12.91 10.02 21.12 1987 11.81 9.34 18.26 Source: Local Government Public Finance in Ecuador, H. Petrei, April 1989. - 150 - Table e6: SHARE OF LOCAL GOVERNMENT EXPENDITURES IN GOP Municipalities I Provincial I Councils Total Current Capital I Total Current Capital Year Expenditures Expenditures Expendituresi Expenditures Expenditures Expenditures 1981 4 34 2.48 1.88 I 1.01 0.88 0.68 1982 4.20 2.50 1.70 i 0.91 0.81 0.60 1983 3.72 2.82 1.40 I 0.72 0.25 0.47 1983 3.72 2.32 1.40 I 0.72 0.2S 0.47 1984 8.17 2.21 0.96 i 0.68 0.22 0.46 198S 2.94 1.91 1.03 1 0.87 0.24 0.43 1986 2.81 1.76 1.05 0.69 0.26 0.43 1987 2.39 1.53 0.86 I 0.69 0.23 0.46 Source: Local Government Public Finance in Ecuador, H. Petrei, April 1989; National Accounts. - 151 - Table 37: SHARE OF LOCAL GOVERNMENT EXPENDITURES IN GDP, 1973-87 Total Current Total Year Expenditures Expenditures Expenditures 1973 3.81 2.53 1.29 1974 3.53 2.26 1.27 1975 3.91 2.42 1.49 1976 3.77 2.39 1.39 1977 3.78 2.27 1.51 1978 4.12 2.35 1.77 1979 3.62 2.24 1.38 1980 4.84 2.71 2.12 1981 5.35 2.81 2.54 1982 5.11 2.81 2.30 1983 4.44 2.57 1.87 1984 3.85 2.43 1.41 1985 3.61 2.15 1.46 1986 3.50 2.02 1.48 1987 3.08 1.76 1.32 Source: Local Government Public Finance in Ecuador, H. Petrei, April 1989 Notes Excludes expenditures of Municipal Enterprises. - 152 - Table 38: RATIO OF MUNICIPAL EXPENDITURES TO TOTAL EXPENDITURES OF THE CONSOLIDATED PUBLIC SECTOR INTERNATIONAL COMPARISONS, 1975 AND 1984 Industrialized Countries 1975 1984 Australia 6.92 6.87 Austria 19.75 16.90 Canada 22.53 18.29 Denmark 60.25 52.99 Federal Rep. of Germany 19.30 17.51 Finland 42.93 45.97 France 17.96 15.99 Holland 33.89 33.02 Ireland 33.09 30.32 Luxembourg 16.59 16.82 Norway 44.35 36.90 Spain 10.80 12.53 Sweden 50.97 43.83 Switzerland 27.29 24.02 United Kingdom 34.95 29.16 United States of America 26.72 22.10 Average 29.27 26.45 Standard Deviation 14.34 12.76 Developing Countries 1975 1984 Bolivia n.a. 16.56 Brazil 9.13 9.48 Chile 3.35 7.27 Colombia 7.7 9.10 Costa Rica 4.39 3.28 Ecuador n.a. 12.04 Kenya 9.30 6.06 Mauritius 4.45 4.81 Mexico 2.53 2.88 Paraguay 4.20 4.87 Domintican Republic 3.32 5.79 Iran 1.36 3.86 Sri Lanka 3.60 3.82 Uruguay 8.53 8.36 Average 5.16 7.03 Standard Deviation 2.64 3.69 Average* 5.16 5.84 Standard Deviation* 2.64 2.22 Source: Local Government Public Finance in Ecuador, H. Petrei, April 1989. * Not including Ecuador and Bolivia since there was only one observation. - 153 - Table: 39 PROVINCIAL COUNCILS. STRUCTURE OF REVENUES, 1987 (as percentages of the total) Provincial Council Taxes Nontaxes Capital Transfers Azuay 2.11 13.77 7.06 77.05 Bolivar 0.53 0.50 12.37 86.59 Canar 1.68 1.71 3.43 93.18 Carchi 0.00 0.21 5.59 94.20 Chimborazo 1.89 0.16 18.82 79.13 Cotopaxi 1.24 0.92 9.28 88.56 El Oro 0.37 9.11 -3.97 94.48 Esmeraldas 0.00 0.29 0.03 99.77 Guayas 14.18 22.61 8.32 54.26 Imbabura 1.55 1.49 18.26 78.70 Loja 0.76 1.71 18.81 78.73 Los Rios 2.49 7.23 0.62 89.66 Manabi 1.13 1.01 0.58 97.28 Morona Santiago 0.16 0.29 2.31 97.25 Napo 0.13 1.08 2.14 96.65 Pastaza 0.14 1.26 1.75 96.85 Pichincha 1.18 2.92 12.25 83.64 Tungurahua 1.61 4.04 4.69 93.41 Zamora Chinchipe 0.62 1.29 4.69 93.41 Source: Local Government Public Finance in Ecuador, H. Petrei, April, 1989. i g i I I- ; 7 ;e 3 - Ii r S f |l~~~~~~~~~~~~~~~~~~~. . I e~ I 8- l r iZE 3E < s. ^g ! Oe A S a.7 ; @SF W | ~~~~- * . 3 ;0;e|5rgD a g 'i3 i 2 5Xo * 0 z 8 g , g~~~~ CZ IC | U, t*- r^2v0 _ !~~~~~~~~~A _ *..2 SSJ;3_o - 155 - STATISTICAL APPEHDIX - 156 - Table 1: Ecuador - Conolidated Non-FInancial Pubtic SOctor (Billions of Sucrea) 1983 1984 1985 1986 1987 1988 1989 (a) Generat Oovernaent Operations Current revenue 68.9 92.2 140.2 191.4 257.1 386.0 654.4 Taw Revenue 65.7 89.4 135.8 le! 5 248.9 372.0 838.2 Non-tox Revenue 3.2 2.e 4.4 3.9 8 2 14.0 16.2 PaLroleu. Rovonue 1/ 53.3 74.5 14t.9 109.8 103 4 227.2 457.9 Current llpenditures 100.1 143.8 221.4 289.2 430.7 6(4.6 981.7 Wages 27.3 31.7 101.9 115.5 180.9 254.1 390.1 Cood- and Serv..e. 15.3 30.i 48.5 SS.7 86.7 43.3 65.1 Interest Payments 12.7 19.2 38.2 54.7 86.8 168.3 286.2 T,anafers 37.1 49.4 37.8 49.0 61.7 120.8 190.3 Othetr current e.pend;turoa 6.7 13.3 1.0 14.3 14.6 18.1 60.0 Savings of General Covernment 22.1 22.9 65.8 12.0 -70.2 8.6 130.6 (b) Public enterprisea Current Revenues 40.6 79.2 98.4 128.9 156.1 289.6 538.2 Current Expenditures 34.1 55.1 73.7 98.4 132.4 272.5 413.1 15.5 24.1 24.7 30.5 23.7 17.1 125.1 Sa inge of Public Enterprises 15.5 24.1 24.7 20.5 23.7 17.1 125.1 (c) Conaolidated NFPS Savings of NFPt 37.6 47.0 90.5 42.5 -46.5 25.7 255.7 Capital E.penditures 36.6 51.7 69.4 112.4 126.7 185.4 369.4 Finan,ing ne.do -1.0 4.7 -21.1 69.9 173.2 159.7 113.8 Primary surplus 17.9 18.8 65.9 -5.1 -70.1 37.3 212.9 Sources: Ministry of Firance: Central eank of Ecuador; and Fund staff estimates. 1/ E cludoe revenue distributed to public ent6rprises - 157 - Table 1: Ecuador Cenaovidatad Non-Financial Public Sector (percent of 8DP) ________________________________________________________________________--__________ 1903 1984 1088 188 198I 1988 19089 (a) Genera l Overnment Op*r*t' .o Current revenue 12.8 11.3 12.6 1S.6 14.2 12.4 12.3 Tax Revenue 11.7 11.0 12.2 13.4 13.8 11.9 12.0 Non-tox Revenu* 0.6 0.3 0.4 0.4 o.5 0.4 0.3 Petroleum Revenue 1/ 9.5 9.2 13.2 7.9 5.7 7.3 8.6 Curr.nt Espenditures 17.9 17.7 19.9 20.9 28.8 19.4 18.4 We#** 4.9 8.9 9.2 8.4 10.0 8.2 7.3 Goods and Servces, 2.7 8.7 3.9 4.0 4.8 1.4 1.2 Interest. Payments 2.4 2.4 3.4 4.0 4.6 S.4 5.4 Trana+frr 6.6 6.1 3.4 8.S 8.4 8.9 3.6 Obler current empenditure, 1.2 1.6 0.1 1.0 0.8 0.6 0.9 Savings of General Covernaent 3.9 2.8 5.9 0.9 -3.9 0.3 2.8 (b) Public onterprl. Savings of Public Enterpria.. 2.8 a 0 2.2 2.2 1.3 0.5 2.4 (c) Connolidated Wtt Savings of NFPS 6.7 s.0 8.1 8.1 -2.8 0.8 4.8 Copital Expenditures 6.8 6.4 6.8 8.1 7.0 6.0 6.9 Financing needs -0.2 0.6 -1.9 S.1 9.6 5.1 2.1 M4emo Items: Total Oil Revenue 10.9 10.2 14.2 8.3 5.9 7.8 8.7 Savinga of Soc. Sec, 0.9 0.8 1.0 1.2 0.5 0.5 0.8 NFPS aurplua + investment 6.7 5.8 8.1 8.1 -2.6 0.8 4.8 Consuaption financing by capital revenues end saving 8.0 5.2 7.1 6.4 9.0 7.2 4.4 Priary surplus 8.2 2.8 S.9 -0.4 -8.9 1.2 4.0 Total Expenditur* of On. Cov. 22.2 21.7 24.3 25.9 27.0 28.0 22.9 Non-nt. current amp. Cn CDv 15.4 18.8 18.6 17.0 19.0 14.0 13.1 Total NWM expenditure 80.8 80.8 32.8 36.1 a8.2 84.1 88.2 Total revenu. Can Oov 21.8 20.6 25.9 21.8 19.9 19.7 20.9 Sources, Rinistry of FInance; Central Sank of Ecuador; *ad Fund staff estimates. 1/ Excludes revenue distributed to public enterpriame - 158 - T ble 2: EOMDOR - Central Government Operatlons (8lltion- of Sucree) 1963 1984 1985 1986 1987 198 1969 Total revenue 67.0 108.0 200.9 199.3 254.4 464.4 865.8 Petroleum revenue 28.6 49.7 116.6 74.3 87.9 20.3 379 .2 Nonputroleu- revenuo 37.9 58.3 84.1 123.0 162.6 248.5 457.9 ____________________ Ton revenue 34.7 .3.4 79.4 116.0 152.9 234.1 440.6 Tests on income end profits 7.5 10-. 13.8 22.6 29.4 41.9 92.2 Tex*. an prop.rty 0.4 0.2 0.2 0.8 0.2 0.8 2.7 Taxes on goods and services 13.5 20.2 29.7 51.9 71.9 115.5 202.0 Oner-rl sales tex 7.4 11.4 17.9 37.8 47.9 78.0 1318.0 Selective cxexee taxes 6.1 8.8 11.8 14.1 24.0 37.5 64.0 Taxes on intan. trade 13,0 20.9 32.6 43.8 49.0 66.2 129.6 Import duties 12,1 19.2 29.7 39.8 47.3 62.5 120.6 Export duties 0.1 O.1 0.0 -0.1 0.0 0.0 0.0 Echoenge profits tex 0.8 1.6 2.9 5.6 2.5 3.7 9.2 Other texes 1.0 1.9 4.2 3.3 6.3 10.6 13.8 CATS and IEACS (-) -0,7 -0.1 -1.1 -5S4 -4.7 -0.4 0.0 Nontea revenue 8.2 2.8 4.4 S.9 8.2 14.0 16.2 Transfers 0.0 2.1 0.3 1.1 1.5 0.4 1.2 Total *xpenditur* 83.S 114.2 179.3 227.2 862.0 616.0 861.2 Current eup*ndlture Current Ewpendltures 69.1 96.0 141.9 182.3 310.7 455.2 766.3 vage end selar;ee 21 17.7 20.3 67.4 94.1 137.9 191.4 315.0 Purchei. of goods end servic;n 2.8 3.6 4.2 5.2 49.7 10.0 15.0 Interest payment, 13.5 18.8 85.9 86.2 69.6 135.2 286.6 Current tranefore 28.4 40.0 13.4 32.5 45.9 111.0 169.9 C.th.r current *xpenditure 6.7 13.9 1.0 14.3 7.4 7.6 82.0 Capitol expenditure 14.4 18.2 87.4 44.9 51.3 60.6 92.7 Fixed ceapital foretlon ?.2 11.9 23.9 20.7 20.3 40.8 12.4 Capital tranofere 7.2 6.8 12.6 1?.? 24.2 20.0 60.8 Other 0.0 0.0 0.9 6.6 6.8 0.0 0.0 Overall surplus -16.3 -s.0 21.6 -27.7 -107.6 -81.6 4.6 Sources: Minstry of Flnance; Central Sank of Ecuador; and Fund staff estimates 1/ The Central ovaern_ent ineludes the Sudget end FPAAR 2/ The figures for wages A ealarlee shown for 1985 onemrda are not coaeereble to prev. yeers becaue of a recleeification problem. Through 1984 a portien of xeg. A saler'ee a Included in current transfere and other expenditures. - 159 - Table 2x- Ecuador - Central Government Operetieof (Porcent of M0P) 1983 1984 1985 1986 1987 1968 1989 ------------------------------_---------------_----___--__----------__-------__---______ Total revenue I.96 18.36 18.10 14.42 14.07 14.92 16.27 _____________ Petroleum revenue 8.10 6.t2 10.51 5.37 4.86 6.69 7.13 Nonpotrolous revenue 6.76 7.17 7.58 8.89 9.00 7.98 8.61 ____________________ Tax revenue 6.19 6.57 7.15 8.39 6.4e 7.52 8.28 Taxes on income and profits 1.34 1.27 1.24 1.83 1.63 1.35 1.73 Taese on property 0.07 0.02 0.02 0.02 0.01 0.01 0.08 Taxes on goods and sorvice 2.41 2.49 2.68 3.75 3.98 8.71 3.80 General xsl-a tax 1.82 1.40 1.61 2.78 2.65 2.51 2.89 Selective *xetee taxes 1.09 1.08 1.06 1.02 1.33 1.20 1.20 Taxes on Intnl. trde 2.32 2.57 2.94 3.13 2.76 2.13 2.44 Import duties 2.16 2.36 2.68 2.68 2.62 2.01 2.27 Export duties 0.02 0.01 0.00 -0.01 0.00 0.00 0.00 Exchange profits tex 0.14 0.20 0.26 0.26 0.14 0.12 0.17 other taxes 0.16 0.28 0.38 0.24 0.85 0.34 0.26 CATS and IACS (- -0.12 -0.01 -0.10 -0.39 -0.26 -0.01 0.00 ; ntox revenue 0.57 0.34 0.40 0.43 0.48 0.45 0.30 Transfers 0.00 0.26 0.03 0.08 0.08 0.01 0.02 lotal *xpenditure 14.90 14.05 16.15 16.43 20.03 16.56 16.18 Curront expenditure 12.33 11.81 12.78 13.18 17.19 14.62 14.44 Wages end ealarles 2/ 3.16 2.50 7.67 6.60 7.63 6.15 5.92 Purchases of goods and services O.S0 0 44 0.38 0.88 2.75 0.32 0.28 Interost payments 2.41 2.31 3.23 2.62 3.86 4.34 4.45 Current transfers 6.07 4.42 1.21 2.35 2.84 3.57 3.19 Other current expenditure 1.20 1.64 0.09 1.03 0.41 0.24 0.60 Caaital expndwiture 2.57 2.24 8.87 3.25 2.84 1.95 1.74 Fliod capital formation 1.29 1.48 2.15 1.50 1.12 1.81 0.28 Capitol transfers 1.29 0.78 1.14 1.28 1.34 0.64 1.51 Other 0.00 0.00 0.08 0.47 0.38 0.00 0.00 Finanting requIremnts 2.94 0.69 -1.95 2.00 5.98 1.66 -0.09 Primary Surplue -0.54 1.62 5.16 0.61 -2.09 2.69 4.83 Sourceo: Minltry of Finance; Central Sank of Ecuador; and Fund staff estimates 1/ The Central Government Includes the Budget and FONAPAR 2/ The figures for wage & sal*erle shown for M985 onwards are not comeprable to prey. years because of a reclaesification problem. Through 1984 a port;on of wages A salries as ircluded In current transfers and other expenditures. - 160 - Table 3: Ecuador - Budgetary Op,r.tl