Report No. 52536-PL Poland Public Expenditure Review (In Two Volumes) Volume I: Analysis of Social Sectors and Public Wages March 8, 2010 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank TABLE OF CONTENTS INTRODUCTION ....................................................................................................................................................... 1 OVERVIEW ................................................................................................................................................................ 2 I ECONOMIC DEVELOPMENTS ..................................................................................................................... 5 I.1 STRONG ECONOMIC EXPANSION ....................................................................................................................... 5 I.2 SHARP SLOWDOWN BUT NO RECESSION ........................................................................................................... 6 I.3 FEEBLE RECOVERY?.......................................................................................................................................... 7 II FISCAL POLICY ............................................................................................................................................. 11 II.1 FISCAL FALLOUT OF THE CRISIS ................................................................................................................. 11 II.2 TAX WEDGE AND DEMOGRAPHIC CHANGE: CHEQUE IS IN THE MAIL ......................................................... 12 II.3 RISING PUBLIC DEBT .................................................................................................................................. 13 II.4 FISCAL CONSOLIDATION STRATEGY ........................................................................................................... 16 II.5 EXPENDITURE-BASED ADJUSTMENT ........................................................................................................... 17 III TOWARDS VISION 2030 ........................................................................................................................... 23 III.1 PENSIONS .................................................................................................................................................... 25 III.2 AGRICULTURAL PENSIONS .......................................................................................................................... 26 III.3 EDUCATION ................................................................................................................................................ 29 III.4 HEALTH ...................................................................................................................................................... 30 III.5 SOCIAL ASSISTANCE ................................................................................................................................... 33 III.6 LABOR MARKET PROGRAMS ....................................................................................................................... 34 III.7 PUBLIC SECTOR WAGE BILL ....................................................................................................................... 36 IV PUBLIC SPENDING REFORMS - SIMULATING THE FISCAL IMPACT ....................................... 37 IV.1 PENSIONS .................................................................................................................................................... 39 IV.2 EDUCATION, HEALTH AND SOCIAL ASSISTANCE ........................................................................................ 40 IV.3 PUBLIC SECTOR WAGE BILL ....................................................................................................................... 41 IV.4 OVERALL FISCAL IMPACT ........................................................................................................................... 43 V THE CONTRIBUTION OF INSTITUTIONAL REFORMS ....................................................................... 45 V.1 MEDIUM-TERM BUDGETING ....................................................................................................................... 45 V.2 PERFORMANCE BUDGETING ........................................................................................................................ 45 VI ANNEX 1. PUBLIC EXPENDITURE SIMULATION ............................................................................. 49 VII ANNEX 2. DETERMINANTS OF PUBLIC SECTOR WAGE INCREASES ....................................... 50 VIII ANNEX 3. CONTRIBUTIONS TO THIS REPORT ............................................................................... 51 TABLES Table 1: Medium-Term Economic Outlook .................................................................................................................. 7 Table 2: Medium-Term Fiscal Outlook ......................................................................................................................... 8 Table 3: KRUS Reform Options.................................................................................................................................. 28 Table 4: Macroeconomic Assumptions ....................................................................................................................... 38 Table 5: Performance Budgeting and Medium-Term Budgeting Action Plan, 2009-2012 ......................................... 47 Table 6: Employees of the State Budgetary Sphere and Components of 2009 Wage Bill Increase ............................ 50 FIGURES Figure 1: Monthly Economic Indicators from 2004 to 2009 (Percent Change, Year-on-Year)..................................... 8 Figure 2: General Government Balance Projections from Updates of the Convergence Program ................................ 9 Figure 3: Poland Recently Reduced its Tax Wedge to Boost the Employment Rate .................................................. 13 Figure 4: Poland Carries a Large Fiscal Burden due to Structural Reform ................................................................. 13 Figure 5: Poland has already Fixed the Fiscal Fallout from Demographic Change..................................................... 13 Figure 6: Support for Financial and Other Sectors and Upfront Financing Needs (% of GDP) and Projected Primary Balance Target to Reduce Public Debt-to-GDP Ratio to 40 Percent from 2014 to 2029 ............................................15 Figure 7: Credit Default Swaps Spreads for the EU10 Countries ................................................................................ 15 Figure 8: General Government Expenditures and Revenues in 2008 (% of GDP) ...................................................... 18 Figure 9: Composition and Lengths of Fiscal Adjustment in Recent Stand-By Arrangements (% of GDP)............... 18 Figure 10: Trends in Social Sector Spending .............................................................................................................. 20 Figure 11: Poland’s Social Expenditures are Large Relative to its Income Level ....................................................... 20 Figure 12: Poland spends Efficiently on Education and Health .................................................................................. 21 Figure 13: Poland Spends Equitably across Gminas ................................................................................................... 21 Figure 14: Poland Spends to Ensure Equitable Access in Education and Health ........................................................ 21 Figure 15: From Welfare State to Workfare Society ................................................................................................... 24 Figure 16: Challenges for 2030 ................................................................................................................................... 24 Figure 17: Pensioner Households are Fairly Well-Off ................................................................................................ 39 Figure 18: Gross Average Replacement Rates for Mixed and Full CPI Indexation of Pension Benefits .................... 40 Figure 19: Room for Public Expenditure Savings in Education .................................................................................. 40 Figure 20: Recent Trends in Health Spending ............................................................................................................. 41 Figure 21: Growth Rates of Wages and Budget Execution of Employment Limits and Wage Expenditures ............. 42 Figure 22: Public Expenditure Trends under Baseline and Reform Scenario.............................................................. 43 Figure 23: Composition of Public Expenditure Savings under Reform Scenario 2012 versus 2009........................... 44 Figure 24: General Government Wage Bill by level of Government in 2008, (% of GDP) ........................................ 44 Figure 25: Composition of Government Spending by Level of Government (% of GDP) .......................................... 44 BOXES Box 1: Poland’s Three Public Debt Ceilings ............................................................................................................... 15 Box 2: Instruments for Fiscal Consolidation ............................................................................................................... 18 Box 3: Simulated Expenditure Items ........................................................................................................................... 38 Box 4: Government Cost Estimates of Social Sector Reforms .................................................................................... 38 Box 5: Simulating Trends in Social Assistance Payments .......................................................................................... 38 Box 6: Employment Limits by Professional Group under the Reform Proposal ......................................................... 42 Box 7: Government’s Proposal on Employment Reductions in Public Administration .............................................. 42 4 ACKNOWLEGMNET This report was prepared by a team from the World Bank for the Government of Poland from April 2009 to December 2009. Findings of the report were discussed during two workshops at the Ministry of Finance on July 8, 2009 and November 13, 2009. The report team benefited greatly from collaborative work with the Government of Poland during three missions (April, June and November 2009). The team is very grateful for the comments, feedback, and guidance received from the Government during the preparation of the report. Government counterparts for this reports included officials from the Ministry of Finance, Chancellery of the Prime Minister, Ministry of Labor and Social Policy, Ministry of Health, Ministry of National Education, Ministry of Science and Higher Education, Ministry of Interior and Administration, Social Insurance Fund and National Health Fund. The World Bank team included Leszek Kasek, Ewa Korczyc, and Kaspar Richter (public financial management and synthesis report); Ufuk Guven, Anita Schwarz, and Sergiy Biletsky (pensions); Alberto Rodriguez and Mikolaj Herbst (education); Mukesh Chawla and Charles Griffin (health); Truman G. Packard, Anna Ruzik and Katarzyna Pietka (social assistance); Jan Rutkowski (labor market programs); and Marc Robinson (medium-term budgeting and performance budgeting). Monika Bazyl, Maciej Bukowski, Malgorzata Guzowska, Adam Kozierkiewicz, and Piotr Lewandowski provided important contributions. Luca Barbone (Sector Director), Bernard Funck (Sector Manager), Thomas Blatt Laursen (Country Manager) and Swati Ghosh (Lead Economist) provided excellent overall guidance. Fabienne Ilzkovitz, Theresa Jones, Maureen Lewis, Kathy Lindert, Ahmadou Moustapha Ndiaye, Pia Schneider, Jos Verbeek, Hermann Von Gersdorff, and Penny Williams provided very useful comments. Malgorzata Michnowska and Mismake D. Galatis provided excellent administrative support. 6 INTRODUCTION 1. Poland is facing stark economic challenges in politically sensitive times. Even though the financial crisis emanated from the other side of the Atlantic and affects Poland less than some of its neighbors, some of the hallmarks of Poland’s development, including the rapid integration with the EU, make it now vulnerable to the recession in the EU15 and the collapse in regional capital, trade, and labor flows. The impact of the imported crisis is enlarged by homegrown vulnerabilities, ranging from current account and fiscal deficits to product and labor market rigidities. Structural reforms could support market confidence and improve economic prospects before demographic changes turn unfavorable towards the middle of the decade. However, the political environment for reforms is challenging in view of the upcoming Presidential and Parliamentary elections in 2010 and 2011. 2. Boosting the health of the economy and ensuring continued convergence with the EU requires concerted policy actions to unwind economic imbalances and advance structural reforms. The two- way policy response would aim to: • Bring about fiscal consolidation and restructure public finances, strengthen financial stability, and mitigate the social impact of the crisis in the short-run. • Step up structural reform to address deep seated economic problems which both magnify the impact of the international crisis and hamper longer-term convergence prospects. 3. Fiscal consolidation is central to the immediate focus of preserving confidence of the financial markets. While the timely response of the Government and concerted action in EU member countries succeeded in stabilizing financial markets soon after the crisis broke in September 2008, the confidence of financial markets is still vulnerable to a worsening in public sector balance sheets. The fiscal response to the crisis, including the support and guarantees to the financial sector, has increased budget deficits, public debt ratios, and contingent liabilities of the government sector. As international investors take a closer look at the vulnerabilities of emerging economies, there is a large premium on strong domestic policies. While financial markets may have under-priced the risks relative to the fundamentals in Poland and other countries in the region prior to the crisis, this under-pricing has now disappeared. 4. As stagnation gives way to recovery, Poland can strengthen the foundations for an economy centered on inclusive growth with productive jobs. With the crisis still unfolding, much of the policy makers’ attention is understandably on addressing immediate needs. Yet, the crisis has been a reminder of the dangers of policies that produce bubble growth instead of sustainable growth. Advancing structural reforms to safeguard the achievements of transition and put the economy back on track for convergence remains vital. Restructuring public finances is crucial to protect priority spending that improves prospects for jobs and growth; to raise labor productivity; to help the reallocation of resources from the non-traded to the traded sectors; and to promote accountability and outcome-orientation. 5. The report highlights core components for a reform of public expenditures of social sectors and public wages. Ultimately, the success of public expenditure reform will depend less on the policy of public expenditure reform and more on the politics of public expenditures. Beyond adequate administrative resources and an implementation strategy, this will require a clear political recognition of the importance of the task and the willingness to persist with reform over the long haul. OVERVIEW 6. This report looks at public spending on pensions, education, health, social assistance, labor market programs, and public wages. Presenting the findings of a series of studies and notes compiled sice April 2009, it highlights how reforming such spending, which comprises about one quarter of GDP, is essential for mitigating the impact of the economic crisis and for transforming Poland from a welfare state to a workfare society in line with Government’s Vision 2030. 7. The report has two main messages. First, Poland can take measures to reduce public expenditures on social sectors and public wages by around 2.3 percentage points over the next three years. This would go a long way towards reducing the fiscal deficit from around 6 percent of GDP in 2009 to below 3 percent of GDP in 2012, consistent with the Maastricht threshold and as advised by the European Council from July 2009. The adjustment would allow the Government to maintain public debt below the constitutional ceiling of 60 percent of GDP and to aim for euro adoption by the middle of the decade. Such fiscal consolidation can be done while maintaining economic and social priority programs that mitigate the social costs of the crisis and enhance growth prospects. Delaying the adjustment to latter years would make the problem more difficult to address, raises the probability of new fiscal crisis in the years ahead, and runs the risks of constraining policy flexibility in future. 8. Second, beyond supporting the fiscal adjustment required in the context of the economic crisis, public expenditure reforms can also help bring about structural changes envisioned as part of the Government’s strategy for 2030. This vision entails a fundamental transformation to a workfare society in response to the challenges of globalization, energy deficiency, climate change, and population aging. The aim is to build a competitive, innovative and energy efficient economy supported by a well performing state for a socially and regionally cohesive society. 9. This report provides a comprehensive assessment of Poland’s social sector and public wage polices and lays out options for reform. The summary report has five parts. The first part lays out the macroeconomic context. It emphasizes that Poland has weathered the global economic crisis remarkably well but that the recovery is likely to be feeble and subject to uncertainty. The next part discusses the fiscal fallout of the crisis and argues that public expenditure reform should be a crucial pillar for fiscal consolidation. Sections III to V contain the main findings of the report. Section III presents a list of important reforms of public expenditures on social sectors and wages in support of Vision 2030. Section IV simulates the fiscal impact of public expenditure reforms, with a particular focus on state budget expenditures. The final section discusses how institutional reforms in the areas of medium-term and performance-based budget can support the reform agenda. Volume 2 presents the detailed analyses of social sectors and institutional reforms of public finance. 10. The analysis offers three original contributions to the debate on public expenditure reform in Poland. First, based on empirical evidence from administrative and household survey data, the report provides in-depth treatments of the social sectors. It takes stock of the achievements of the last years, presents outstanding challenges and lays out policy options to support Vision 2030, drawing on experience in the central Europe and elsewhere. Second, based on the Government’s latest macroeconomic framework, the report present estimates of fiscal savings for specific public expenditure reforms. While these calculations rely on a number of simplifying assumptions, they relate public expenditure reforms to a fiscal framework and provide order-of-magnitudes for potential savings. Third, the report presents an action plan to meet the goal of program-based budget appropriations in financial year 2013, as well as the new Multi-Year State Financial Plan. 2 11. This reports deals only with some of the many aspects of Poland’s public expenditures. The focus reflects Government priorities for analytical work, the desire to avoid duplication with available literature, data constraints, and, last but not least, the need to keep the task manageable. Five limitations are worth highlighting explicitly: • The main topic is public expenditure policy. Public expenditure policy is intimately related to budget administration, as any implemented public expenditure policy has to pass the test of administrative feasibility. This report does not offer a discussion of Poland’s budget process, financial management, procurement and accountability. • The sectoral coverage is limited to social sectors and public wages, leaving out important sectors such as transport, energy and economic affairs. These other sectors have important contributions to make to fiscal consolidation in the short run and structural transformation of the economy in the long run. • There is no discussion of revenue policies and debt sustainability. Revenue measures in the area of dividends, fees, or tax compliance could facilitate fiscal consolidation. Similarly, revenues from privatization could help to limit the rise in public debt. Furthermore, structural changes in tax policy could increase the buoyancy of the tax system, broaden tax bases, reduce distortions and improve equity. • While the sectoral chapters discuss outcomes of social services provided at the local level, there is only a limited analysis of local government finances at the voivods, powiats and gmina levels, which account for government spending of around 14 percent of GDP. For example, the simulations of fiscal adjustments over the next three years focus on items that are under the direct control of the state budget. • Finally, politics is a key determinant of the level and structure of public expenditures in any country, but we do not provide an analysis of the politics of public expenditure reform. We offer no remedies for removing political constraints to good public expenditure structures other than to argue that more transparency and a better appreciation of the gains to be had from sound public expenditure policy might lead to better outcomes. 3 I ECONOMIC DEVELOPMENTS I.1 Strong Economic Expansion 12. Poland entered the crisis on the back of an impressive economic expansion. Following difficult structural transformations in the decade after the first partially democratic elections in Poland in June 1989, Poland established strong trade, financial and labor ties with European neighbors. In 2004, after over half a century of political divide, Poland, along with other seven countries in central Europe, became full EU member. Output grew by about 6 percent from 2006 to 2008, as EU accession, supported by credit growth, bolstered business confidence, spurred investments, and boosted wages and employment. 13. Macroeconomic imbalances remained relatively manageable. On the external side, even though rapid import growth boosted the current account deficit from around 2 percent of GDP in 2003 to 5.5 percent of GDP in 2008, it remained lower than in most neighboring countries. Over the same period, Poland’s global export market share rose from 1.4 percent to 2 percent, suggesting that there was no large misalignment of the real exchange rate. On the internal side, foreign-owned banks, representing about 80 percent of the banking sector assets, fuelled credit expansion in Poland, but the growth was less rapid than in other countries, and more focused on the household than the enterprise sector. Credit to the private sector was below 50 percent of GDP in 2008, less than in the Czech Republic, Hungary, Bulgaria and the Baltic countries. 14. Sound macroeconomic and structural policies helped to limit macroeconomic vulnerabilities, even though Poland’s growth started to slow down in mid-2008 in view of emerging capacity constraints. Poland expanded by 5.0 percent in 2008, down from 6.7 percent growth in 2007, as year-on- year growth moderated from 5 percent in the third quarter to 2.9 percent in the fourth quarter. • The government’s euro adoption target of 2012 provided a strong fiscal anchor. Poland reduced the fiscal deficit from 6.3 percent of GDP in 2003 to 2 percent of GDP in 2007, below the 3 percent of GDP Maastricht threshold, allowing the European Council in July 2008 to abrogate Poland’s excessive deficit procedure initiated in May 2004. Public debt fell from 47.1 percent of GDP in 2003 to 44.8 percent of GDP in 2007. The Public Finance Act reinforces prudent fiscal policy, as it prompts corrective action at the public debt trigger levels of 50 and 55 percent of GDP, in addition to the Constitutional ceiling for public debt of 60 percent of GDP. • Structural reforms to improve the performance of the labor market, while raising potential tax collection in the long run through an expansion in the tax base, contributed to an increase in the 2008 fiscal deficit for three reasons. First, in order to boost labor force participation, the tax wedge was lowered by cutting in half disability contributions, which in turned reduced revenues by about 1.5 percent in 2008. Second, the eligibility to early retirement was tightened from 2009 onwards, slashing the number of eligible workers from above one million to about 250,000. This increased the number of new pensioners in ZUS from 220,000 in 2006 to 430,000 in 2008, as people availed of early retirement options before they were faced out. Finally, the pension reforms of the 1990s led to a transition deficit equivalent to 3 percent of GDP in 2008. • The National Bank of Poland’s effective inflation targeting regime with a free-floating exchange rate helped to anchor inflation expectations over the decade. With record-low unemployment pushing wage increases in excess of productivity gains and high international commodity prices, inflation peaked in July and August 2008 to 4.8 percent above the upper end of the 1.5 to 3.5 percent tolerance range but quickly stabilized thereafter. Financial stability was strengthened by adopting banking supervision in line with the EU legal framework, unifying financial supervision under the Polish Financial Supervision Authority in January 2008, and creating a Financial Stability Committee. I.2 Sharp Slowdown but No Recession 15. The global economic crisis has ended Poland’s fast economic expansion over the recent years, but in contrast to its neighbors Poland has avoided a decline in economic activity. Since late 2008, Poland has been hit by two shocks: the recession in high-income countries, which has hurt external demand for exports; and the global financial crisis, which has reduced capital inflows and thereby lowered domestic demand. Nevertheless, year-on-year growth reached 0.8 percent in the first quarter of 2009, compared to a contraction of close to 5 percent for the European Union, and negative growth for all other EU10 countries. In the second quarter, the economy grew by 1.1 percent year-on-year. Poland’s crisis is muted for a number of reasons: the relatively solid initial macroeconomic situation, the large size of the domestic market, the flexible exchange rate, and broadly appropriate policy responses. 16. While the global crisis has affected Poland in view of its deep market integration through trade, capital and labor, most indicators have recovered from their lows. First, manufacturing has bottomed out and the current account is improving. The contraction in global spending on capital goods and durables has curtailed export-oriented manufacturing, although exports accounts for only around 40 percent of GDP in Poland, compared to around 80 percent of GDP in the Czech Republic, Hungary, and the Slovak Republic. Industrial production declined by 15 percent year-on-year in January 2009; and exports by over one quarter in the first quarter of 2009. However, the drop in industrial production was only 4 percent in June 2009, and the 12-month rolling current account deficit narrowed to 2.1 percent of GDP in June 2009 compared to 5.5 percent of GDP in 2008, as imports fell more quickly than exports. 17. Second, although capital inflows declined in response to the crisis, the financial sector remains relatively sound. Immediately after the collapse of Lehman Brothers in September 2008, the Polish interbank market froze, and in the subsequent six months, the stock markets declined by close to one half and the zloty depreciated by about one third. Net capital inflows declined from EUR33 billion in July 2007 to June 2008 to minus EUR1 billion in July 2008 to July 2009. Bank profits dropped by about half in the first quarter of 2009 year-on-year in view of the deteriorating quality of loan portfolios and lower interest margins. The banks’ reliance on cross-border funding raised concerns about the exposure to potential balance sheet pressures of parent banks. Fortunately, aided by a forceful global policy response, subsidiaries of foreign banks have largely maintained their exposure, and credit default swap spreads of parent banks have come down significantly. The appreciation of the zloty of over 10 percent since March 2009 has brought the exchange rate in line with its equilibrium value according to IMF estimates. This has also mitigated distress for foreign-currency indebted corporations and households and helped to stabilize banks’ profits in the second quarter of 2009. Most banks retained 2008 profits to strengthen their balance sheets, and the capital adequacy ratio improved from 11.2 percent in March to 12.5 percent in June, safely above the minimum level of 8 percent. The NBP has also reduced the policy rate from 6 percent in November 2008 to 3.5 percent in August 2009 in support of the recovery. Nevertheless, bank lending standards have tightened and the interbank market is active only for short-term maturities, as banks prefer to hold on to liquidity in view of economic uncertainties. 18. Third, the economic slowdown has not yet translated into major job losses, which has supported domestic demand. After a dramatic increase in employment in recent years, unemployment was expected to rise in 2009 on the back of the economic slowdown and higher return migration from EU15 labor markets. The LFS unemployment rate declined from over 20 percent in 2004 to 6.8 percent in September 2008, and increased only moderately to 8.2 percent in June 2009. Similarly, the registered 6 unemployment rate rose from a low of 8.8 percent in October 2008 to 11.2 percent in March 2009, and declined to 10.8 percent in June 2009. I.3 Feeble Recovery? 19. Poland has avoided an outright recession, but the growth outlook is uncertain. Most of the latest high frequency indicators, including industrial production, retail sales, unemployment rates and economic confidence, suggest a modest recovery of economic activity in recent months (Figure 1). Low inventory levels, some pent-up demand, and low interest rates could support a rebound of the economy. Nevertheless, future growth is likely to be lower than in recent years (Table 1). Robust growth is likely to return only once investment and exports rebound and consumer confidence is restored. In view of the deep market integration in the region, a recovery in Europe would be needed to support exports, spur credit growth, and strengthen job prospects in Poland. However, the sharp and synchronized contraction in European trading partners and joint economic and financial crisis in leading economies point to a sluggish recovery in neighboring economies. Polish exports are likely to remain sluggish as consumption in destination countries is set to remain weak as households increase their saving rates to rebuild their assets. In addition, investment is likely to be held back by weak capital inflows, as banks in Western Europe and North America continue to write-down loans and credits. In spite of the recent improvements in global financial markets, heightened financial strains could return, especially if policy support is withdrawn prematurely or policy coordination deteriorates. Finally, improvements in productivity depend on successful structural reforms in areas such labor markets, education, and business climate. Without such reforms, the remaining rigidities in the labor and product markets and the large public sector in Poland could become a drag for future growth. Table 1: Medium-Term Economic Outlook 2006 2007 2008 2009 2010 2011 EC Spring Forecasts -1.4* 0.8 -- IMF Article IV -0.6 1.5 4.3 Real GDP (% change) 6.2 6.8 4.9 Government 0.9 1.2 2.8 WB 0.5 1.3 3.0 EC Spring Forecasts 0.6 0.2 -- Private consumption (% change) IMF Article IV 5.0 4.9 5.4 1.5 1.0 3.5 Government 2.2 0.9 2.2 WB 2.2 1.0 3.4 EC Spring Forecasts -6.2 -0.8 -- IMF Article IV -4.8 2.5 10.0 Gross fixed capital formation (% change) 14.9 17.6 8.2 Government -2.5 0.3 4.6 WB -4.2 1.5 8.4 EC Spring Forecasts 2.6* 1.9 -- Consumer prices (% change) IMF Article IV 1.0 2.5 4.2 3.1 2.6 2.7 Government 3.6 1.0 1.8 WB 3.4 2.7 2.5 EC Spring Forecasts -4.7 -3.7 -- Current account deficit (% of GDP) IMF Article IV -2.7 -4.7 -5.4 -3.2 -3.4 -3.6 Government -0.7 -2.1 -2.7 WB -1.6 -2.5 -2.5 *According to the EC’s interim forecast of 14 September 2009, GDP is projected to increase by 1 percent and inflation to reach 3.8 percent in 2009. Source: EC Spring Forecasts May 2009, IMF Article IV August 2009, Government Macro Economic Assumptions July 2009, WB May 2009 Forecasts. 7 Table 2: Medium-Term Fiscal Outlook 2006 2007 2008 2009 2010 2011 EC Spring Forecasts -6.6 -7.3 -- Fiscal balance (% of IMF Article IV -3.9 -1.9 -3.9 -6.0 -6.2 -5.7 GDP) Government -4.6 -- -- EC Spring Forecasts 53.6 59.7 -- Public debt (% of GDP) IMF Article IV 47.7 44.9 47.1 52.6 56.1 57.7 Government 51.0 -- -- *Based on IMF definition. Source: EC Spring Forecasts April 2009, IMF Article IV July 2009, Government Fiscal Notification to the Eurostat April 2009. Figure 1: Monthly Economic Indicators from 2004 to 2009 (Percent Change, Year-on-Year) Industrial Production Retail Sales 30 30 25 25 20 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 -20 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Jan-04 May-04 Jan-05 May-05 Jan-06 May-06 Jan-07 May-07 Jan-08 May-08 Jan-09 May-09 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 May-04 May-05 May-06 May-07 May-08 May-09 Unemployment Rate Economic Sentiment Indicator 25 20 15 20 10 5 15 0 -5 10 -10 -15 5 -20 0 -25 -30 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 May-04 May-05 May-06 May-07 May-08 May-09 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Jan-04 May-04 Jan-05 May-05 Jan-06 May-06 Jan-07 May-07 Jan-08 May-08 Jan-09 May-09 Source: Central Statistical Office, Eurostat, European Commission 8 Figure 2: General Government Balance Projections from Updates of the Convergence Program General Government Balance (% of GDP) General Government Balance (% of GDP) 0.0 0.0 2005 2006 2007 2008 2009 2010 2011 -0.5 -0.5 -1.0 -1.0 2007 -1.5 -1.5 Mar-08 -2.0 -2.0 -2.5 Dec-08 -2.5 -3.0 -3.0 -3.5 -3.5 -4.0 -4.0 Mar-09 -4.5 -4.5 -5.0 -5.0 Source: Ministry of Finance, World Bank Staff Calculations 9 II FISCAL POLICY II.1 Fiscal Fallout of the Crisis 20. After years of improving fiscal balances on the back of a strong economy, Poland is now facing large and growing fiscal deficits. This reflects a number of reasons: • Pro-cyclical fiscal policy in the last few years, when high increases in public spending were masked by unsustainably high revenue growth, which in turn allowed benign developments in headline fiscal deficits in spite of an unfinished agenda of public expenditure reforms • Weak public expenditure controls leading to an unexpectedly high discrepancy between the cash-based and accrual-based fiscal deficit in 2008 • Crisis-related revenue losses due to falling imports and manufacturing production, declining assets prices, and perhaps worsening tax compliance • Crisis-related expenditure increases due to higher outlays for unemployment benefits and sickness days. For example, ZUS spending on sickness leave increased from PLN6.6 billion in 2006 to PLN9.2 billion in 2008. • As discussed below, the fiscal costs of important structural reforms. 21. The slowdown in economic activity in the last quarter of 2008 led to a sharp increase in the 2008 fiscal deficit. Revenue shortages and higher deficits of local governments could not be fully compensated by spending cuts of the central government. The fiscal deficit increased from 2.0 percent in 2007 to 3.9 percent of GDP in 2008, some 1.3 percentage points higher than projected in the December 2008 convergence program (Figure 2). Public debt rose from 44.8 percent in 2007 to 47 percent of GDP in 2008. On 7 July 2009, based on the 2008 fiscal outcome, the European Council opened an excessive deficit procedure for Poland, and recommended bringing down the fiscal deficit below the Maastricht threshold of 3 percent of GDP by 2012. 22. In early July, the Government adopted a supplementary budget for 2009, formalizing saving measures taken in early 2009. In January 2009, line ministries were asked to prepare plans for reducing state budget expenditures by 10 percent, while excluding certain expenditure categories, such as pension and disability payments, capitation grants to local governments for primary and secondary education, public sector wages, debt servicing, and co-financing for the absorption of EU funds. Nevertheless, state budget expenditures, excluding EU-related spending, increased by 20 percent in current prices during the first half of 2009 year-on-year, while state budget revenues, excluding EU transfers, contracted by 5 percent with the economic downturn. The July supplementary budget introduced the following changes to the 2009 budget: • increase of state budget deficit from 1.4 percent of GDP to 2.1 percent of GDP • reduction of state budget expenditure by 1.0 percent of GDP, and • shift of 0.8 percent of GDP transport expenditures from the state budget to the National Road Fund. 23. Overall, the budget revision is expected to limit the increase in the 2009 general government fiscal deficit to about 6 percent of GDP. This compares to a fiscal deficit target of 2.5 percent in the December 2008 convergence program, and a Government projection of 4.6 percent of GDP in April 2009 (Table 2). The increase in the fiscal deficit is essentially due to the impact of automatic stabilizers through lower revenues and higher expenditures on unemployment benefits and other social spending. The 3.5 percent of GDP increase in the fiscal deficit relative to the December 2008 target is roughly due to lower revenues of about 2 percent of GDP and higher expenditures of about 1.5 percent of GDP. II.2 Tax Wedge and Demographic Change: Cheque is in the Mail 24. The weak fiscal position is to a large extent related to crucial reforms. They include the reduction in the tax wedge and the shift to a funded public pension pillar supported by state budget transfers during a transitional period. While these reforms imply upfront fiscal costs, they improve fiscal balances over the long run by lowering budget expenditures or broadening the tax base through higher growth. 25. Poland undertook major steps from 2007 to 2009 to reduce the tax wedge. The ratio of total labor taxes to total labor costs declined significantly by lowering disability contributions from 13 percent to 6 percent in two steps; and consolidating the personal income tax from a three-bracket system of 19, 30 and 40 percent to a two-bracket system of 18 and 32 percent (Figure 3, left panel). In addition, family tax allowances were introduced in 2007. Lowering the cost of labor contributed to an increase in the employment rate for 15 to 64 year-olds and 55 to 64 year-olds, although the gap to the EU15 average in the employment rate remains about 16 percentage points for the 55 to 64 year-olds percent (Figure 3, right panel). These reforms imply an estimated revenue loss to the budget of around 2 percent of GDP in 2009. 26. The pension reform imposes also sizable temporary funding pressures. The traditional pay-as- you-go system inherited from the socialist times was replaced in 1999 with a multi-pillar pension system that included a notional defined contribution (NDC) scheme and a mandatory fully funded defined contribution scheme. The Government transfer to the second pillar amounted to 2.9 percent of GDP in 2008, and to 3.2 percent of GDP in 2009 (Figure 4). 27. The pension reform is the main reason why there are no direct adverse fiscal consequences from aging at least from the pension side. According to EC projections, Poland’s working age population will decline from 27 million in 2007 to only 16 million in 2060. As a result, the effective economic old-age dependency ratio is projected to increase from 30 percent to over 100 percent during this period. In other words, while in 2007, there are more than three employed working-age persons per one inactive person aged 65 and above, there will be more inactive old persons than employed working- aged persons by 2060. Poland scores worst on this indicator out of all 27 EU member countries. 28. In spite of this dramatic change in the demographic structure, the fiscal balance will not be upset. In fact, according to EU calculations, Poland is the only country in the EU where age-related general government spending will decline between 2007 and 2060 (Figure 5). This is a remarkable achievement, as for many advanced economies, the fiscal consequences of population aging are worse than the impact of the current economic crisis. Poland is so well placed mainly due to the pension reform, as future pensions will increasingly be paid from the private pillar. And in spite of the global financial crisis, the assets of the second pillar still achieved a real annual return of 5.5 percent from 1999 to 2008. Another factor is the decline in the share of the school-age population, which will reduce the need for public spending on education. However, these projections are sensitive to a number of assumptions. They include fairly conservative estimates of the impact of aging on public health care expenditures and low replacement ratios of pensions relative to wages that might turn out to be politically and socially untenable. 12 Figure 3: Poland Recently Reduced its Tax Wedge to Boost the Employment Rate Tax wedge on Labor Cost (Relative Tax Burden for Employment Rate an Employed Person with Low Earnings) g ( p y g ) Employment Rate (Persons in employment divided by the total population of the same age group) 50 70 70 EU15 Aged 15 to 64 45 65 65 EU27 Average 40 60 60 35 PL Aged 15 to 64 55 55 30 50 50 25 45 EU15 Aged 55 to 64 45 20 40 40 15 35 35 10 PL Aged 55 to 64 5 30 30 0 25 25 1997 2003 2008 FI SI T BG Z O LU R 09 L 15 27 07 6 FR U Y IE K ES SK EE K LV SE E BE PT LT IT AT N L0 C M C U D D G H R PL EU EU PL PL Source: Eurostat, Central statistical Office, World Bank Staff Calculations Figure 4: Poland Carries a Large Fiscal Burden due to Structural Reform Fiscal Cost of Structural Reform (% of GDP) Fiscal Costs of Structural Reform (% of GDP) 4.0 4.0 3.5 Pension reform 3.5 3.0 3.0 2.5 2.5 Tax wedge reduction 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 2007 2008 2009 2010 2011 Source: Eurostat, Central statistical Office, World Bank Staff Calculations Figure 5: Poland has already Fixed the Fiscal Fallout from Demographic Change Age Related General Government Spending in 2007 and Age-Related Government Spending by Sector in 2007 and 2060 (% of GDP) 2060 (% of GDP) Age-Related General Government Spending in 2007 and 2060 (% of GDP) Age-Related Government Spending by Sector in 2007 and 2060 (% of GDP) 40 28 26 35 24 22 30 EU27 2060 Average 20 25 18 Education 16 Unempl. Ben. 20 14 Long Term Care 12 15 Health Care 10 8 10 6 4 5 2 Pensions 0 0 LV EE PL BG SK LT EU10 RO CZ UK HU IE CY DK IT EU27 PT ES DE MT AT SE NL FI FR BE SI GR LU PL'07 PL'60 EU10'07 EU10'60 EU27'07 EU27'60 Source: Eurostat, Central statistical Office, World Bank Staff Calculations II.3 Rising Public Debt 13 29. While Poland’s fiscal deficits have increased in part for the right reasons, such as to support structural reforms or to prevent a contraction in economic activity, they will bring about large increases in government debt. This could raise concerns about the sustainability of fiscal balances and trigger increases in interest rates on government paper, which in turn would undermine the economic recovery. The increasingly stringent public debt limits of 50 percent, 55 percent and 60 percent, as embedded in the public finance act and the constitution, make it especially important for the Government to avoid snowballing debt dynamics and restrict the rise in public debt (Box 1). According to the latest IMF estimates, the public debt-to-GDP ratio is projected to increase from 45 percent of GDP in 2007 to 52 percent in 2009, and to 58 percent in 2012. The spring estimates of the EC puts the public debt-to-GDP ratio close to 60 percent already in 2010, in part due to lower growth forecasts. 30. The Government has committed large resources to guarantee, recapitalize and resolve financial institutions, although the numbers pale in comparison to some of the amounts spent by advanced European economies. The Government has issued explicit guarantees over 3.2 percent of GDP, although upfront government financing is negligible and the eventual costs are likely to be smaller than the amount of guarantees (Figure 6, left panel). For example, the IMF estimates that for the countries of the Euro area, outlays from contingent liabilities over 25 percent of GDP could amount to around 2 to 5 percent of GDP from 2009 to 2013 (IMF 2009). 31. The scale of the adjustment required to stabilize or lower the public debt-to-GDP ratio is sizable. In order to reverse the increase in the public debt-to-GDP ratio, Poland will have to achieve sizable improvements in the primary balance. Poland would need to bring down its primary deficit from an estimated 3.1 percent of GDP in 2009 to 0.6 percent of GDP from 2015 onwards in order to stabilize its debt-to-GDP ratio at 57.6 percent of GDP (IMF Article IV July 2009). Or alternatively, Poland would require a primary balance surplus of over 1.1 percent of GDP to reduce the public debt-to-GDP ratio to 40 percent by 2029 (Figure 6, right panel, IMF July 2009 WEO projections). Inflation would lower debt-to- GDP ratios, but not without undermining economic health. Real appreciation of the zloty would also reduce public debt, but pose risks to the competitiveness of the economy. Rapid growth can play a crucial role in reducing large debt-to-GDP ratios, both directly, as it increases the denominator, and indirectly, as it facilitates rapid revenue growth. Nevertheless, in view of the uncertain growth prospects, fiscal consolidation is likely to remain the most important channel of bringing debt-to-GDP ratios down. 32. One positive development is that the sovereign default risk premia for Poland and other EU countries, which increased sharply on the back of the crisis, have come down again recently. The rise in risk premia is linked to country-specific factors, including the stark rise in public deficits and concerns about the solvency of national banking systems and their budgetary impact. For example, while sovereign credit default swaps spreads in Poland, as in other EU10 countries, have declined from their peaks in September 2008, they remain some 70 basis points above the pre-crisis level (Figure 7). The international market responded well to the Government’s handling of the crisis. In January, the Government placed a EUR1 billion issue at a spread of around 300 basis points above German Bunds. In early May, on the back of the IMF board approval of a USD 20.5 billion one-year facility under the new Flexible Credit Line for countries with sound macroeconomic policies, Poland placed a EUR750 million issue at a spread of about 40 basis points below the January level. In early July, following the World Bank board approval of the USD1.25 billion development policy loan, Poland placed a USD 3.5 billion of 10Y bonds on the US market at a spread of 290 basis points above the relevant US T-bonds. 14 Figure 6: Support for Financial and Other Sectors and Upfront Financing Needs (% of GDP) and Projected Primary Balance Target to Reduce Public Debt-to-GDP Ratio to 40 Percent from 2014 to 2029 Guarantees and Upfront Government Financing in the Required Primary Balance in Selected Emerging Economies (% G20 and Emerging Economies (% of GDP) of GDP) 9 3.0 8 2.5 7 2.0 6 5 1.5 4 Upfront Government Financing Guarantees 1.0 3 2 0.5 1 0.0 0 Mexico Philippines Argentina Malaysia Poland Turkey Brazil Hungary India Brazil China Poland Indonesia India Argentina Turkey Russia Hungary G20 Source: IMF 2009. For 2014, the WEO projects Poland’s public debt-to-GDP ratio to reach 50.2 percent, while the July 2009 IMF Article IV projects the ratio to reach 57.6 percent. Figure 7: Credit Default Swaps Spreads for the EU10 Countries 1400 Czech Republic 1200 Estonia 1000 Hungary 800 Latvia 600 Lithuania 400 Poland Slovakia 200 Romania 0 Bulgaria Jan-08 May-08 Sep-08 Nov-08 Jan-09 May-09 Mar-08 Jul-08 Mar-09 Jul-09 Slovenia Source: Reuters, Bloomberg, World Bank Staff. Box 1: Poland’s Three Public Debt Ceilings According to the budget law, a breach of the 50 percent limit of the public debt-to-GDP ratio implies that next year’s budget deficit target of central and local governments must not be larger, as a ratio to revenue, than the projected outturn of the current year. A breach of the 55 percent limit implies that next year’s budget deficit target must lead to a decrease in the central public debt-to-GDP ratio. A similar provision applies to local governments. A breach of the constitutional 60 percent limit implies a freeze on any new government guarantees, a zero budget deficit target for the next year, and an enactment of a rehabilitation program that brings down the public debt-to- GDP ratio below 60 percent. Source: Public Finance Act, Constitution of the Republic of Poland, World Bank Staff 15 II.4 Fiscal Consolidation Strategy 33. The global financial crisis has worsened Poland’s fiscal outlook, even though it is faring better than other countries in the region. With limited resources in a fast evolving economic environment, the Government faces the difficult challenge of reconciling three objectives: to ensure fiscal consolidation over the medium term; to protect priority programs for economic and social development so that growth prospects are enhanced; and to mitigate the social cost of the economic crisis. 34. Fiscal policy has to manage a difficult balancing act between cyclical and sustainability considerations. During the boom years, Poland could accelerate spending and reduce the fiscal deficit thanks to rapidly rising revenues. Now, revenues are falling sharply which leads to a large rise in the fiscal deficit in the absence of substantial expenditure consolidation. A sharp fiscal adjustment would exacerbate the economic recession. For example, while public infrastructure investment is often viewed to be an ineffective during a normal business downturn due to delays in project implementation, it can be an effective stimulus in the current environment due to the depth and duration of the crisis and support the recovery. Yet, allowing high fiscal deficits could erode market confidence, raise the cost of public borrowing, bring public debt levels close to the constitutional ceiling of 60 percent of GDP, and leave larger adjustment for coming years. The remarkably robust performance of the economy and the resilience of the labor market suggest that the Government has managed to strike the right balance between providing a fiscal stimulus and containing the increase in fiscal deficits. It has allowed the automatic stabilizers to operate for both revenues and expenditures, propped up the financial sector without major up-front fiscal cost, and restrained from large discretionary expansionary fiscal measures. 35. A sustainable reduction in the fiscal deficit is nonetheless required going forward in view of Poland’s commitments as part of the EU Stability and Growth Pact. Under its preventive arm, countries are required to steer fiscal policy in line with medium-term objectives to safeguard against the risk of breaching the 3 percent of GDP budget deficit threshold. In the December 2008 convergence program, the Government endorsed a 1 percent of GDP structural deficit as medium term objective, compared to a structural deficit of about 3.4 percent of GDP in 2008. During 2009, the structural deficit has increased further. In its decision to open an excessive deficit procedure in July 2009, the European Council advised Poland to prepare by end-2009 a fiscal strategy to reduce the fiscal deficit below 3 percent of GDP by 2012 through a structural annual fiscal effort of over 1 percentage points of GDP starting in 2010. 36. Fiscal consolidation is crucial for the Government’s goal of early Euro adoption. In mid-2009, the Government had to delay plans for an entry to European Exchange Rate Mechanism in 2010 with a view of Euro adoption in 2012 due to the fiscal deterioration, exchange rate volatility, and lack of political consensus on constitutional issues. The credibility of such a timetable would depend on progress towards meeting the economic conditions for the introduction of the common currency and advancing structural transformation of the economy. This is all the more important because the pace and scale of the improvement in the external environment remains uncertain. 37. Reconciling these objectives will require embedding fiscal policies in a medium term fiscal consolidation strategy. A credible medium-term framework can reinforce Government’s commitment to fiscal consolidation in line with improving economic conditions, consistent with the Euro adoption timetable, and supportive of structural reforms and appropriate social spending. The amended Public Finance Law could strengthen the institutional basis for medium-term fiscal frameworks and performance orientation (see Section V). 16 II.5 Expenditure-based Adjustment 38. The Government should aim to bring down the fiscal deficit from around 6 percent of GDP in 2009 to below 3 percent of GDP in 2012. This would be in line with the recommendation of the European Council from July 2009. It would also be in line with the latest assessment of the IMF, which argued for permanent fiscal consolidation measures of about one percent of GDP annually from 2010 to 2012. This target would allow the Government to aim for euro adoption by the middle of the decade, an ambitious but feasible euro adoption timetable that could support market confidence. 39. Poland’s fiscal adjustment should best be expenditure-based. There are two ways in which Government can bring down the fiscal deficit: increasing revenues or reducing expenditures (Box 2). The scope for revenue increases from taxation or public sector dividends is limited. Poland’s government is large, and high tax rates, especially on labor, finance large programs of social benefits and transfers. This reduces international competitiveness and adds to labor market rigidities. The revenues of Poland’s public sector accounted for close to 40 percent of GDP in 2008 (Figure 8). While this was 5 percent of GDP below the EU27 average, the revenue share is high relative to Poland’s income level – per capita income adjusted for purchasing power differences is less than half the EU27 level. Indeed, the Government is not planning to adopt tax measures as part of the 2010 budget. As spelled out in Poland’s convergence program and Vision 2030, the Government envisages a reduction in the size of the public sector, and hence of public expenditures, relative to the size of the economy. 40. The economic literature on fiscal adjustments highlights factors that favor successful fiscal consolidations (Gray et al, 2007, IMF 2007 and OECD 2007). Such consolidations tend to be: • Crisis-related, perhaps because this facilitates broader consensus about the need for reform. • Expenditure-based, perhaps because they reflect deeper structural reforms and a stronger political commitment to adjustment • Incremental, spanning periods from two years to a decade, perhaps because they allow for savings from structural reform to materialize. • Poland’s fiscal consolidation is crisis-related; likely to be more expenditure-based; and spanning a period of about three years. The recent stand-by arrangements in Hungary and Romania also proposed expenditure-based fiscal adjustments (Figure 9). 41. Reducing public spending will require difficult political choices. There are large rigidities in public expenditures imposed by laws and regulations, and national co-financing of EU-funded projects need to be protected. For example, in 2004, the Ministry of Finance estimated that about two-fifths of general government expenditures are ‘fixed’. Yet, if done well, it can contribute both to fiscal stabilization and structural reforms. For example, moving beyond across-the-board-cuts towards selective expenditure reductions consistent with government policies can improve the quality of the fiscal adjustment by raising the allocative and operational efficiency of public spending. 42. In line of the focus of this report, we discuss the contributions that the social sectors and the wage bill could make to this process. Public spending on these two items might not harbor starker inefficiencies than on other items. But they together account for about two thirds of government spending, so they are naturally part and parcel of any expenditure-based fiscal consolidation. 17 Figure 8: General Government Expenditures and Revenues in 2008 (% of GDP) EU General Government Expenditures (% of GDP, 2008) EU General Government Revenues (% of GDP, 2008) p ( ) EU General Government Revenues in 2008 (% of GDP) 55 55 50 50 EU27 Average EU27 Average 45 45 40 40 35 35 30 30 25 25 20 20 15 15 10 10 5 5 0 0 SK LV BG RO LT ES LU EE IE CZ PL SI DE CY GR MT NL PT EU27 UK FI AT IT HU BE DK FR SE SK RO IE LT LV ES EE BG PL GR MT CZ UK SI PT LU DE EU27 CY IT NL HU AT BE FR FI DK SE Source: Eurostat, World Bank Staff Calculations Figure 9: Composition and Lengths of Fiscal Adjustment in Recent Stand-By p Arrangements p j (% of GDP) y g ( ) 7.5 30 7.0 Months of Program (#) 6.5 25 6.0 5.5 5.0 Revenues 20 4.5 4.0 3.5 15 3.0 2.5 10 2.0 Expenditures 1.5 1.0 5 0.5 0.0 Hungary Latvia Romania -0.5 0 Source: IMF, World Bank Staff Box 2: Instruments for Fiscal Consolidation There are other avenues for fiscal consolidation aside from the adjustment of public expenditures and public wages. The development of an overall fiscal consolidation strategy would have to take a comprehensive look at all the available options both on the expenditure and revenue side. They include: • a realistic revenue effort, including measures to improve tax compliance which tends to deteriorate during economic crisis • reducing expenditure needs by allowing and facilitating the private sector to undertake investment and activities which to date have remained in the public sector domain • generating savings through shifting of public funds from low priority to high priority sectors, functions and uses and by assigning functions to the level of government that is best suited for their implementation • savings mobilized through more efficient implementation of Government’s on-going activities, and • stepping up privatization to help reduce the size of public debt. 18 43. Public expenditure reform in these areas is complicated for another reason. A range of indicators suggest that Poland spends public money fairly well on social services. It spends rather modest amounts in absolute terms, and the amounts are used efficiently and equitably to produce education and health services. Hence, while the fiscal crisis requires expenditure adjustments, such adjustment should aim to preserve the quality of social spending. 44. Poland spends moderate amounts on social sectors compared to some of its peers. When social sector spending, including education, health, and social protection, is measured in purchasing power standards in order to remove distortions related to price differences across countries, Poland spent in 2007 less than half the EU average, and less than any of the central European countries (Figure 10). In addition, Poland has made progress in reducing the size of social spending. The latter fell from 29 percent of GDP in 2003 to 26 percent of GDP in 2007, the largest reduction of among the EU countries, primarily due to lower social protection spending. However, Poland’s public expenditures on social sectors still remained fairly high relative to its income level (Figure 11). 45. Poland also scores well on efficiency analyses of public spending in social sectors. For example, a comparison of expenditure levels and associated outcomes in G7 countries and other OECD countries based on the Data Envelopment Analysis finds consistently that Poland’s education and health spending is close to or on the best-practice frontier (Verhoeven et al. 2007). Poland manages to produce a given level of social services with few public resources, or, alternatively, to produce with a given level of resources a large amount of social services. Figure 12 shows the results for two outcome measures – the 2006 PISA test score for mathematics of secondary students, and healthy life expectancy in 2006. One caveat is, however, that these data sets provide few comparator countries at Poland’s income level. 46. Last but not least, Poland provides remarkably equitable access to social services, whether we look at poor versus rich Gminas, or poor versus rich households. Figure 13 groups Poland’s 2487 Gminas (municipalities) into quartiles by own revenues sources per capita in 2006. Unsurprisingly, there are important differences in own-source revenues between the bottom and the top quartile: Gminas in the top quartile have 3.75 times the amount per inhabitant than Gminas in the bottom quartile. However, once we add other revenues of municipalities, including the education subvention, the equalization subvention, targeted grants and other small subventions, the revenue gradiant has become far flatter. Gminas in the top quartile have only 25 percent more revenues per capita than Gminas in the bottom quartile. Clearly, Poland’s fiscal transfer system performs impressively in terms of equalizing resource endowments across localities. This in turn ensures that access to adequate social services, largely provided by municipalities, is ensured across the country. Turning from Gminas quartiles to household quintiles, household survey data from 2007 suggests that Poland’s public education system is very effective in providing access for households irrespective of their income level. Similarly, access to the general practitioner for health consultations and treatments is easy for seven out of eight respondents, and very difficult for hardly anyone, whether their income level puts them into the bottom or top quintile (Figure 14). While such access statistics do not tell us about the quality of service, it does suggest that public social services perform rather well at least certain basic functions. 19 Figure 10: Trends in Social Sector Spending Social Sector Expenditures in PPS per capita for 2007, EU General Government Expenditures on Social Sectors (EU27=100) (% of GDP) p p p ( ) p ( ) 240 40 220 200 35 180 2003 2007 160 EU27 2007 Average 30 140 120 EU27 2007 Average 25 100 80 20 60 40 20 15 BG RO LV LT EE PL SK HU CY MT CZ PT SI ES GR EU27 IT IE UK DE BE NL FI FR AT SE DK LU RO LV BG CY EE LT SK IE ES CZ LU MT PL GR NL SI HU UK EU27 IT BE PT DE FI AT FR SE DK Change in EU GG Expenditures on Social Sectors from Change in EU GG Expenditures on Social Sectors from 2003 to 2007 (percentage points of GDP) 2003 to 2007 (percentage points of GDP) Change in EU GG EXP on Social Sectors from 2003 to 2007 (%age points of GDP) 2.5 4.0 3.5 2.0 3.0 2.5 1.5 2.0 Health SP+E+H 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -1.0 EU27 Average -0.5 -1.5 EU27 2007 Average -2.0 -1.0 -2.5 -3.0 -1.5 -3.5 Social Protection -4.0 -2.0 -4.5 -5.0 -2.5 -5.5 Education -3.0 -6.0 -6.5 -3.5 -7.0 SE PL BG DE SI LU SK DK AT FI LV MT CZ BE EU27 CY HU FR EE NL IT LT ES GR PT IE UK RO SE PL BG DE SI LU DK SK AT FI LV MT CZ BE EU27 HU CY FR EE NL IT LT ES GR PT IE UK RO Source: Central Statistical Office, Eurostat, European Commission Figure 11: Poland’s Social Expenditures are Large Relative to its Income Level Social Sector Expenditures as % of GDP Relative to PPS per Capita (EU27=100) for 2007 40 35 30 Percent of GDP 25 POLAND EU10 20 15 20 40 60 80 100 120 140 160 PPS Per Capita Source: Eurostat, World Bank Staff Calculations 20 Figure 12: Poland spends Efficiently on Education and Health Source: Verhoeven et al. 2007. Note: HALE stands for healthy life expectancy which is defined as the average number of years that a person can expect to live in “full health” by taking into account years lived in less than full health due to disease and/or injury. Figure 13: Poland Spends Equitably across Gminas Fiscal Equalization in Gminas by Own Revenue Per Capita Quartiles in 2006 (PLN Per Capita) 2600 2600 2400 2400 Total Revenues 2200 2200 2000 2000 1800 1800 1600 1600 1400 1400 1200 1200 1000 1000 Own Revenues 800 800 600 600 400 400 200 200 0 0 Bottom 2 3 Top Source: World Bank Staff Calculations Figure 14: Poland Spends to Ensure Equitable Access in Education and Health Access to Schooling by Household Per Capita Consumption Quintile in 2007 Access to General Practitioner by Household Income Per Capita Quintile in 2007 None 100 100 No School Very dif ficult Private 90 School 90 Sometimes diff icult 80 80 70 70 60 60 50 50 40 40 Public School 30 30 Easy 20 20 10 10 0 0 Bottom 2 3 4 Top Bottom 2 3 4 Top Source: OECD 21 III TOWARDS VISION 2030 47. Reform of social sector spending is not just required to support the fiscal adjustment during the economic crisis, but also to bring about structural changes envisioned as part of the Government’s strategy for 2030. This vision entails a fundamental transformation from a welfare society to a workfare state and welfare society, or, in short, a workfare society (Figure 15). The need for this transformation arises from the challenges of globalization, energy deficiency, climate change, and population aging (Figure 16). The aim is to build a competitive, innovative and energy efficient economy supported by a performing state for a socially and regionally cohesive society. Taking the current economic crisis as a stepping stone for Poland’s modernization, Vision 2030 provides a framework for long term development to inform the process of designing, developing and implementing public interventions. 48. Bringing about this change means reaching specific targets. They include: • increasing the long-term growth rate from 4 percent to 5 percent • increasing and equalizing the retirement age at 67 years • increasing the employment rate from 60 percent to 75 percent • ensuring universal early education of children • closing the life expectancy gap to the most developed countries in Europe • increasing the share of social transfers going to the poorest 10 percent households from 10 percent to 30 percent. 49. Volume 2 of this report discusses the main challenges and policy options for supporting this transformation into a workfare society for pensions, education, health, social assistance, labor markets and public finance institutions. The following sections present the main findings and recommendations. As an illustration, the next paragraph discusses the notion of a workfare society for labor markets. 50. The key labor market issue in Poland is the low labor force participation rate among persons of working age. Thus, to move towards a workfare society Poland needs to substantially increase labor force participation. One key reason for the presently low labor force participation is a relatively generous system of social welfare benefits leading to welfare dependence. They include early retirement provisions (although these were substantially tightened in 2009), disability pensions and social assistance benefits. Accordingly, moving towards workfare society and away from the welfare society requires reforming the system of social benefits. The main principle here is activation: linking benefit receipt to active job search and labor market attachment. In other words the idea is to link rights (to benefits) with obligations (to actively look for employment). Activation policies are thus meant to reintegrate able bodied benefit recipients into the labor market by providing job search assistance, vocational counseling and training, as well as work experience by means of enrollment in public works and workfare schemes. Poland has recently started to implement activation policies, for example by developing workfare schemes (known as “socially useful works”). However, more needs to be done. The goal is that all able bodied beneficiary of social assistance benefits are subject to activation policies, and are engaged in job search or participate in workfare programs. The ultimate test for Poland moving towards the workfare society will be thus a significant increase in the labor force participation rate. Figure 15: From Welfare State to Workfare Society Source: Poland Vision 2030 Figure 16: Challenges for 2030 Source: Poland Vision 2030 24 III.1 Pensions 51. The 1999 pension reform will help Poland to avoid major fiscal stress of the pension system related to the rapidly aging society. The traditional pay-as-you-go system inherited from the socialist times was replaced with a multi-pillar pension system that included a notional defined contribution (NDC) scheme (the first pillar) and a mandatory fully funded defined contribution scheme (the second pillar). 52. In recent years, the Government has been completing outstanding issues from the 1999 reform. This reform did not fully address early retirement, disability pensions, and specification of payout mechanisms for the second pillar. • Early Retirement. In 2008, the Government revisited the occupational categories eligible for early retirement and tightened early retirement provisions to ease the fiscal burden of early retirement on the pension system. It is expected that these reforms reduce the number of people eligible for early retirement pensions from about 1.2 million to around 300,000. • Disability Pensions. While the Government was successful in reducing the disability rate and tightening criteria for disability pensions, integrating and aligning the system with old-age benefits remains a challenge. The Government recognizes the importance of making the disability and survivor benefits consistent with the reformed first pillar old-age benefit. In some cases, individuals eligible for disability benefits could receive higher benefits than under the old age system. To avoid providing new incentives for disability certification which undo the progress made to date, the Government sought to realign the disability benefit structure with the old age benefit structure. The parliament adopted a Government draft law in 2008 which linked consistently disability pensions to old-age pensions but the President vetoed the law. • Reforms to the funded system. Legislation identifying the principles on how the funded system would pay out benefits for those retiring between 2009 and 2013 was issued in 2008. The legislation specifies a temporary pension and a lifetime pension (annuity) as two types of pensions. 53. Important medium and long-term challenges are as follows: • Low retirement age, especially for women. The women’s retirement age of 60 is low, 5 years below men’s retirement age. This leads to low retirement benefits for women retiring at the set retirement age. Benefits for men are double the benefits for women, even though men’s wages are only about one fifth higher than women’s wages, as women retire so much earlier than men in spite of a higher life expectancy. • Unreformed disability benefits threaten to swamp the system. Currently, more than two-thirds of pension benefits go to old age beneficiaries while only one in seven go to disability beneficiaries. With the sharp reduction in old age benefits, an unreformed disability system with its much higher benefits than old age benefits could result in a roughly equal share of spending allocated between old age benefits and disability benefits. • Fiscal surplus over the next 15 to 20 years due to a large reduction in pension benefits relative to wages. This surplus is brought about by the decline in future pension benefits relative to wages. According to the World Bank’s PROST model, benefits could fall from currently close to one half of gross average wages to less than one quarter of gross average wages over the next fifty years. In view of the aging of the population, there is no need for the pension system to accumulate a long run surplus. 25 54. The main policy recommendations are as follows: • Raise the retirement age, particularly for women. Many advanced economies have equalized retirement ages of men and women, and some are increasing the retirement age gradually beyond 65. This will help to raise replacement ratios of pension benefits to wages. • Reform the disability system and reallocate some of first pillar contributions to the funded system. Reforming the disability program would bring benefit levels in line with old age pensions and reduce expenditures on disability. This would make it possible to reallocate some of the contributions currently financing disability to the old age system. In addition, as the NDC system begins to generate surpluses, some of the existing NDC contribution could also be reallocated to the funded system to increase the benefit levels further. • Improve the efficiency of the second pillar. Given the increased importance of the second pillar in financing future pensions, the funded pillar of the pension system will need to become more efficient. As the crisis has shown, payout options need to be designed so that they are flexible enough to withstand market fluctuations while protecting workers. Countries like Slovakia, Hungary and Estonia have introduced funded individual retirement savings pillars with multiple portfolio options for workers’ mandatory savings. Together with a mandatory shift toward a fixed income portfolio in the years prior to retirement, this can be one way of protecting workers against sudden drops in the valuation of financial assets close to retirement. • Adopt legislation to further reduce management fees. While Poland’s pension funds operate with relatively low administrative costs and fees, accelerating the pace of fee reductions from 7 percent for all new contracts to 3.5 percent in the year 2014 can help to increase workers’ savings balances at retirement and safeguard the funded pillar from political pressures. The Government is drafting such legislation. • Integration of special schemes within the pension system. Poland still maintains a number of separate occupational schemes, such as those for farmers (see next section), the military, and police. While integrating these occupations into a national scheme is difficult in most countries because of occupational limitations, labor market flexibility is sacrificed by maintaining many separate schemes. III.2 Agricultural Pensions 55. At the outset of the 1999 pension reforms, all citizens were supposed to be covered by the new arrangements, but the plan was eventually scaled down and KRUS, the Agricultural Social Insurance Fund, remained outside the reformed system. The early concept envisaged the unification of KRUS and ZUS, the Social Insurance Institution. This component of the reform agenda was dropped in part for political reasons – reforming ZUS was difficult enough without having to deal with the powerful agricultural lobby – and in part because the necessary time and resources were lacking to prepare the required changes in the areas of social assistance, income taxation, and social security administration. 56. KRUS is a special pension scheme, defined for farmers owning at least one hectare of land. KRUS has much lower contribution rates than ZUS but provides the same minimum pension. Contributions cover less than 15 percent of expenditures of this scheme. While in 2008, the state budget subsidy per ZUS beneficiary was PLN2,000, it was PLN10,210 per KRUS beneficiary. And the gap widened since 2004, where the respective numbers were PLN2,100 for ZUS and PLN8,850 for KRUS. Clearly, the system provides valuable social assistance for rural households through old age protection of the rural poor. However, many KRUS beneficiaries are not poor, and rural income is rising as EU agricultural payments are phased-in. This makes higher contribution rates more affordable for some farmers and raises farmers’ demands for higher pensions than those currently being provided. 26 57. There has been broad agreement among successive Polish governments that KRUS needs to be reformed in order to improve its financial sustainability, but this issue is on the medium-term rather than short-term reform agenda. There are competing views as to whether the reform should leave KRUS as a separate entity functioning along different – be it improved – rules or whether perhaps KRUS rules should be harmonized with those of ZUS and thus a universal pension system be created. A related but separate issue is whether there should be a single entity administering public pensions or whether KRUS and ZUS should remain separate agencies. 58. The main policy recommendation is to reduce eligibility and increase contribution revenues in order to reduce the fiscal burden of KRUS by selecting one of two reform options: reform of a stand- alone KRUS or unification of KRUS with ZUS (Table 3). Since most KRUS retirees already receive a pension equal to the minimum benefit, a significant reduction of the average replacement rate is not desirable. The second option of unification could be achieved by reducing KRUS membership to zero and raising farmers’ social security contributions to the same level as those paid by ZUS members. The main difference between the two reform options is not their objective – increasing farmers’ contribution burden per unit of pension benefit – but the degree of changes adopted and the institutional arrangements for reform. It is crucial that contribution revenues from farmers are gradually but significantly increased, although a unified social security agency would certainly continue requiring budget subsidies for some time. The ongoing phase-in of agricultural subsidies from the EU should help smooth over the transition. 27 Table 3: KRUS Reform Options Option Expected benefit Possible drawbacks Expected fiscal impact Costs and conditions of implementation - Increasing contribution - Higher taxes potentially forcing - Impact depends on the pace - Slowly and marginally (1) Full but revenues from agriculture farmers into non-compliance of phasing-in higher growing pension entitlements gradual - Slowly contracting budget - Increased reliance on social contributions and the effect of have little impact on benefit unification with subsidies assistance by rural pensioners in the the increase in contributions expenditures low earners and - Potentially increasing pension medium-term or higher rural poverty on non-compliance - Small increase in social unemployed benefit for contributing farmers and unemployment rates, depending - Improved fiscal assistance outlays for active age exempt from - Incentives to move to more on individuals’ efforts to comply sustainability of the population contributions productive jobs - Potentially jeopardizing the (combined) pension - Major increase in social - Sector-neutral contribution commercial viability of least scheme(s): contributions assistance to the rural elderly policy, leading to equal productive small and medium-sized increase more than pension after the grandfathering rules treatment of contributors farms, entitlements and social expire irrespective of sector of - Politically costly assistance to the elderly - Addressing ZUS’ current data employment - Fiscal gains primarily driven processing problems and - Lower total administrative by revenue impact enabling the unified agency to costs after unification accommodate the new affiliates will incur both investment costs and increased recurring expenses - Implementation is conditional on broad political consensus - Maintaining KRUS reduces - Differential tax treatment of labor - Depends on the number of - Implementation is simple and (2) Farmers political difficulties associated income in different sectors and the farmers choosing ZUS and the requires no investments, benefits reduced with the reform improvement of fiscal sustainability switching rules between ZUS - Social assistance expenses to to reflect lower - Improved improving financial depends entirely on farmers’ and KRUS active farmers are not expected contributions, sustainability of contributory assessment of the costs and benefits - On the short-term, depends to increase while social with an option to pension schemes, (marginal of joining ZUS entirely on the revenue side assistance to the rural elderly shift to ZUS fiscal impact if other transfers - Optional KRUS/ZUS affiliation and is assumed to be small as would only start to rise to the elderly are also either determines insurance status for only few farmers are expected gradually, after the considered) life or introduces regulatory to shift to ZUS grandfathering rules (if any) - Marginally increasing complication and uncertainties into - On the medium and long run, expire, contribution revenues paid by the financing of both schemes the fiscal effect is also - ZUS should only be opened up farmers joining ZUS - Reduced KRUS pensions will build determined by the average to farmers once its - Gradually reduced benefits for pressure for increasing benefits or old-age income financed from administrative problems are those remaining in KRUS social assistance payments wage and other taxes (KRUS resolved, pensions and social assistance) III.3 Education 59. Poland’s education system has undergone profound changes during the last two decades both in terms of financing and management with a view to aligning the education system to the needs of a successful market economy. Education decentralization started in 1990 and over time the tasks of maintaining and managing preschools, primary schools and finally secondary schools were gradually transferred to local self-governments in gminas and poviats. To fund these services, local governments were given a lump-sum grant, the educational subvention, and a higher share of income tax from the state budget, to ensure financing of education tasks. 60. In 1999, the Government of Poland stepped up reforms of secondary education. They improved the integration of general secondary and vocational education and delayed the vocational training track in order to expand students’ exposure to general secondary curricula. These reforms helped to provide young people with flexible skills and improved their ability to absorb and generate new knowledge and technology. 61. Recently, the Government expanded access to preschool and primary education. Pre-primary enrolment in Poland is very low by international standards. International experience indicates that early childhood education has high payoffs in improving the ability of children to learn and in generating equitable educational outcomes. The Government reform makes preschool obligatory for 5 year-old and the first class of primary school for 6 year-old. 62. Overall, Poland’s education system is remarkably efficient and equitable. Expenditures in education are broadly in line with Poland’s peer countries, and the outcomes are impressive in terms of both coverage, with the noticeable exception of preschool education, and quality, where Poland’s performance has improved during this decade and matches, and sometimes exceeds, the average of typically richer OECD countries. 63. While the achievements are impressive, there remain important challenges: • Adjusting the pupil/teacher ratio to demographic trends. While Poland’s student population in primary and secondary education continues to fall, the number of teachers has not declined in proportion to the demographic shift of the student population. Inflexibilities in the management and deployment of teachers make this adjustment difficult. Local governments have inadequate incentives to adjust the teaching force to demographic changes by consolidating schools and classrooms. As a result, there is scope to use resources more effectively within education. • Financing of tertiary education. While the growing role of private institutions and financing in Poland’s tertiary education has been an important factor in expanding coverage, public financing of higher education can be made more equitable and fiscally sound. Currently, subsidies for tertiary education are based on merit alone, which tends to cause a regressive distribution of public subsidies (favouring better-off families). A shift to some level of means- tested subsidies would improve access to higher education by students from poorer families. 64. To address those challenges, the government could envisage the following options: Increase coverage of preschool education: • Diversify service delivery for 3–4 year-olds. The efforts to diversify service delivery and create a flexible and effective framework for monitoring service delivery could be deepened. This can be done by expanding the involvement of non-public institutions that have lower per- capita costs and creative staffing and management arrangements. • Enhance gradually participation of 5 year-old. The Government could strengthen the schooling of 5 year olds by linking their classrooms to primary schools and by developing age- appropriate curricula. This is crucial in rural areas, where participation is low and primary schools small. Improve management of the number of teachers and teacher salaries: • Set centralized indicative standards on class size to be applied mainly by urban local governments, and determine the per-student allocation of the subvention based on standard average class sizes. • Establish a central fund to subsidize severance payments to teaching staff by local authorities. • Remove the established floor for the subvention envelope; determine total funding based on the development of indicative standards for service delivery, such as class size, teacher ratios, teaching time, wages, non-recurrent educational inputs, and facilities. • Further expand the weekly hours of work of teachers to rationalize the teaching workforce. • Increase entry salaries for teachers but reduce the tenure-related salary increases throughout a teacher’s career over time to attract an energetic and well-prepared teaching force that may leave the profession earlier and be replaced by a new cohort. Better alignment of secondary education to the labor market needs: • Further delaying tracking into specialized training to 10th grade. • Continue reform of the upper secondary education curriculum to better integrate vocational training with general education. This implies a further consolidation of tracking options within secondary schools to focus more on broad skill development instead of specific occupation training. • Establish stronger and more stable national examinations by revamping the matura test and including mandatory mathematics testing at the final year of secondary education. More equitable and fiscally sustainable financing of higher education: • Expand student loan opportunities. International experience suggests that making the loan scheme more flexible and affordable will expand its reach with little risk to repayment given that the students’ human capital and associated future income are a good insurance for repayment. • Revise the tuition policies of public universities to ensure that those able to pay provide tuition independently of the type of program (day, evening, or weekend) attended. Improvements in the quality-assurance mechanisms of higher-education programs: • Establish a quality-assurance framework by linking the existing accreditation system to international accreditation agencies and scale up the importance of good evaluations. • Centralize a national one-point access to the regional web-based labor market observatories. III.4 Health 65. A major accomplishment of the Polish system has been maintenance of almost universal coverage of the population by health insurance. There has been a steady and substantial reduction since 2000 in the percentage of respondents citing financial problems as a reason for not seeking needed services. Poland is successfully providing protection from catastrophic medical costs for inpatient care, 30 use of which is almost even across consumption quintiles with very low out-of-pocket expenses. It has also succeeded in delivering a fairly high level of satisfaction with general practitioner services and has been whittling away at out-of-pocket costs as public funding has increased. In the process, over years of incremental improvements since 2000, the health system has been transformed. It is far from perfect, but many of the problems that previously existed have been addressed. Challenges remain, of course, and the remainder of this discussion is about them. 66. The health policy agenda of the current government was passed by Parliament in late 2008. The agenda includes definition of a basic care package to be financed by NHF (finally signed into law in June 2009), introduction of private insurance to finance services not covered by that package, the transformation of hospitals organized as independent public institutions (SPZOZ) into joint stock commercial code companies (NZOZ), creation of a single Patient’s Ombudsman, a new legal framework for accreditation, and a new legal framework for health professionals. Implementation of this agenda has been slowed by Presidential vetoes of most of it. Other aspects of the government program include a shift to hospital reimbursement via DRGs (Diagnosis Related Groups) and increases in public expenditure through the NHF via an increase in the tax rate to 9 percent and a recent increase in the base for the tax. 67. The spectre of cost escalation. From 1989 to 2005, Poland struggled to pay the bills, caused by a combination of low fiscal effort for health and an expensive and unaffordable endowment of inappropriate infrastructure and excess personnel. 2005 seems to have been an inflection point when, through a combination of higher incomes and a higher NHF tax rate, resources flowed into the system in volumes sufficient for hospitals to incur less debt for operations and for NHF to start experiencing surpluses. Yet health care expenditures around the world are highly income elastic, rising faster than incomes. Inevitably this will happen in Poland, and the challenge will be how to manage pressures for costs and expenditures to escalate. Two important policies have been put in place that will help manage these pressures in the future; in our budget scenarios, we assume they lead to a reduction in cost pressures over the next three years: • Corporatization of hospitals. This reform, to shift public hospitals to commercial code companies, promises to make hospital management accountable for business-like operational decisions with a binding bottom line, while giving them freedom from political interference to manage their affairs. Success is not guaranteed by any means. The voluntary nature of the program, the need for a similar program to handle the 47 highly indebted university hospitals, the unproven willingness of local governments to support commercial operation, and the true test of letting uneconomic entities fail are but a few of the predictable issues. If successful, though, this program could create a dynamic hospital sector that restructures itself without additional public intervention. Restructuring is necessary to reduce costs and to adapt these institutions to the appropriate role of hospitals in a modern health system, with less emphasis on inpatient services. • Adoption of DRGs. Prospective payment of hospitals by diagnosis, presumably within a global budget cap and revised regularly to reflect average costs, can contribute to cost control and better decision making in the hospital sector. Poland proposes to couple inpatient DRGs with outpatient DRGs and DRG-like reform for the current fee-for-service specialist compensation system. Combined with an effective corporatization program, this payment system could encourage the restructuring that should continue in the hospital sector as well as a better integration of these three types of care. Two elements of the package have not yet been implemented, the outpatient and specialist DRGs, so current distortions continue (for example, 28 percent of hospitalizations are for 1 or 2 days). The inpatient DRGs have been implemented to guarantee hospitals no reduction in revenue, which is a reasonable strategy at this point but should not continue for long. 31 68. In short, these are complex and risky policy changes. If implemented successfully, however, they will provide the means to manage specialist, outpatient, and inpatient costs; to encourage management of these services as a package (possibly in a network); and to provide incentives for better economic and medical performance by hospitals. 69. Quality. The government’s package of reforms includes changes to the accreditation regime for the medical sector, which up to this point has been voluntary. Despite initial expectations, the proposed law does not offer any immediate benefits for accredited units. Yet, if combined with competitive contracting by NHF, accreditation would create a financial benefit for medical institutions to become accredited and improve basic standards of care. A quality improvement function within NHF could use comparative data and the power of its purse to encourage constant improvement of quality. 70. Patient Expenditures, Equity, and Attitudes toward the Health System. • Patient Expenditures. Although Poland has long been criticized for high out-of-pocket spending on health, we found that the proportions of private spending stabilized at around 30 percent of the total in the past several years. Between 2005 and 2007, analysis of HBS data shows that out-of-pocket expenditures on health goods and services fell, even while overall consumption increased rapidly. This fall is coincident with a large increase in NHF funding. While this is an important accomplishment, an opportunity may have been missed to target reductions in expenditures (particularly on pharmaceuticals) to the poor or the elderly, which would have required introduction of sliding scales or differential cost sharing arrangements on services, equipment, and specific drugs that affect them more. The issue going forward is probably less the overall level of out-of-pocket spending and more these narrower questions about how to improve vertical equity and reducing barriers to needed services by specific vulnerable groups. • Equity. 100 percent coverage of the population and protection from catastrophic expenses are the basic building blocks of an equitable health financing system, and Poland has achieved these goals. Self reported financial barriers to use have dropped consistently since 2000, and the share of consumption expenditures devoted to heath care in 2007 was lower for the poor (3.2 percent) than for the rich (5.5 percent). Yet use of any medical service other than inpatient hospital care is fairly sensitive to total consumption, according to HBS data for 2006, and the poor report significant barriers to affordability of drugs. The big problems have been solved; the narrower problems of targeting some subsidies and making sure the poor are in regular contact with the health system and able to follow their treatment regimes are challenges that remain. • Patient Attitudes. Despite widely held perceptions, 90 percent of the respondents of the 2006 HBS health survey said their overall satisfaction with medical services was good or very good. Points of satisfaction include access to general practitioners and hospitals, treatment of patients, and the system for purchasing medicines. Problem areas include waiting for dentists and specialists, and lack of adequate access to specialists. Half or more of the nationally representative sample called these “bad or very bad.” This impression is reinforced by the frequent use of non-NHF dentists and specialists because of perceived higher quality and better service. Important parts of the system are working reasonably well, according to this survey. In terms of payments, over 80 percent thought that costs of hospital stays were small or very small; but for pharmaceuticals 80 percent thought the cost was high or very high. Dentists, doctors, and diagnostics fell between these two extremes. Again, it appears that once-pervasive problems have been addressed successfully at least to a degree. Pharmaceuticals, specialists, and dentists are sources of serious patient dissatisfaction; hospitals and general practitioners are not. The question is what specific, cost effective changes could be made in the areas of 32 dissatisfaction that would make a perceptible change that people would recognize as a useful improvement. 71. Health Outcomes. Many argue that health systems do not have much effect on general indicators of health (such as life expectancy). All agree that Poland has done very well over the past 20 years to improve life expectancy, and this improvement is probably due to a combination of income growth, education, and even improved health care. However, for specific diseases, there is no question that public awareness, changes in behavior, better health services, and targeted interventions can make a difference. Poland lags the pre-2004 EU by five years of life expectancy. The difference is primarily due to excess mortality among adults, and 84 percent of that excess mortality is estimated to come from cardiovascular disease. Many countries have experienced declines in mortality due to cardiovascular disease of 30 percent over a ten-year period, with about two-thirds due to a reduction in risk factors (obesity, smoking, etc.) and one-third due to better treatment. As with the previous points, health policy in this area could be targeted and progress could be made. III.5 Social Assistance 72. Relative to other branches of the social protection system, Poland’s spending on social assistance is low, even by regional standards. Of the 15.7 percent of GDP Poland spent on social protection in 2007, only 1.4 percentage points was spent on family and child allowances and minimum income assistance, compared to 9 percentage points spent on old age pensions. In a region where long- term unemployment and dependence on social assistance has long been a problem, and where means testing social assistance benefits in order to improve efficiency is still a relatively new and rare policy approach, low levels of spending are not on their own a cause of concern. However, even among the countries of Central and Eastern Europe that target family and child benefits to poorer households, spending in Poland on these benefit categories is still relatively low. In aggregate the share that Poland spends on targeted social protection programs (as a share of all social protection spending) has risen since 2004 with the consolidation of family and child allowances. Other than Poland, the countries in the region that target family and child benefits to poorer households are the Czech Republic and Slovenia, where governments spent 2.5 and 2.3 percent of GDP on family and child benefits and minimum income assistance, respectively, in 2007, compared to Poland’s 1.4 percent of GDP. 73. Furthermore, about 31 percent of the population who met the eligibility criteria for some form of targeted social assistance in 2007 was not receiving benefits. The social insurance branches of the social protection system help make up this short fall: when all social protection benefits are taken into account, the share of the population eligible for social assistance benefits but not receiving any form of social protection falls to 14.8 percent. For an EU member country, this coverage gap is still surprisingly large. Although there have been measurable improvements since 2003 in targeting when performance statistics are disaggregated to capture differences across voyvods, the impact of the steps taken to decentralize social assistance has been mixed. The evidence does not point to any clear improvement in performance from giving local governments a greater role in administering social assistance. In several cases the targeting of family allowances and minimum income assistance has actually worsened. 74. Aside from low coverage, benefit leakage to non-poor persons is a challenge. Analysis of the 2007 household budget survey indicates that 47 percent of the population receiving social assistance benefits would be ineligible when eligibility is assessed by consumption. 75. There are three main policy issues arising from this analysis. In order to come to a more definitive conclusion about what is contributing to large gaps in coverage, leakage to non-poor and otherwise ineligible households, and the impact of decentralization, a more thorough examination of 33 benefit administration at the Gmina level is required using data that can capture improvements at the local level. Nevertheless, the results of this report are sufficiently robust to support these policy changes: • International experience suggests that large gaps in coverage typically reflect a lack of outreach to find households that are likely to be eligible but uninformed about their rights. This points to the need for more proactive outreach to vulnerable groups from local social welfare offices. • Given that there is no robust evidence for a better performance of the social assistance system in response to decentralization, a careful consideration of the appropriate role for local governments in the delivery of targeted social assistance is required. In particular, the Ministry of Labor could step up its monitoring and supervision of Gmina social welfare offices to ensure consistent application of standards and procedures. The disparities in performance across voyvods could reflect serious differences in administration capacity across gmina social welfare offices. • Substantial leakage of benefits to non-poor groups could indicate a need for better, or more frequent cross checking between administrative databases of different social protection programs, and with income and asset administrative data held by other government agencies. III.6 Labor Market Programs 76. The Labor Fund is well place to alleviate the impact of the economic crisis on the labor market. The rise in unemployment creates strong pressure on the growth in labor market expenditures. Workers who lose their jobs claim unemployment benefit and expect government’s assistance in finding a new job. There is also a pressure to protect the existing jobs, for example by means of government wage subsidies. These expenditures act as an automatic stabilizer and dampen the fall in income and demand. However, all this creates fiscal strain. Fortunately, the Labor Fund has sufficient resources to cope with the rise in such expenditures thanks to the substantial surplus accumulated during the period of falling unemployment. Simulation results suggest that there will be enough resources to finance unemployment benefits and active programs under the falling employment and high unemployment scenario until at least 2011. This is important given that the unemployment benefit goes mainly to poorer households and is thus an effective poverty mitigation instrument. At the same time the unemployment benefit system is not overly generous and thus does not create significant labor supply disincentives. 77. The level of labor market expenditures in Poland is broadly adequate. The level is moderate by OECD standards. Expenditures on active labor market programs per unemployed (relative to labor productivity) are in line with other EU10 countries but lower than EU15 countries. The key issue is thus the efficiency of labor market spending in Poland, rather than the level of spending. 78. Certain challenges limit the efficiency and effectiveness of labor market programs. Some of these issues are structural and cannot be resolved without an overhaul of the whole system. • Governance structure. The highly decentralized structure for employment programs delivery limits MOL’s scope to influence program design and to reallocate resources across regions and programs. • Increasing program costs. The unit cost of most programs increased well above inflation in recent years without increasing job placement rates. • Regional allocation of funds. Labor Fund resources are allocated to regions according to the formula that depends on the absolute number of the unemployed in the region. This limits the incentives to reduce registered unemployment, as lower unemployment implies lower transfers; 34 • Substantial variation in cost-effectiveness across programs. Some programs are costly while their benefits in terms of improved chances of sustainable employment are either low or uncertain. • Lack of impact of some programs. Programs also differ substantially with respect to their net impact. A recent impact evaluation study found that job search assistance and counseling have little impact on the unemployed chances to find a job, even though in general job search assistance is found to be the most cost-effective program. This suggests that the quality of services provided is low. • Regional variation in programs’ cost-effectiveness. In some regions program unit cost and cost per job placement are much higher than in others irrespective of differences in regional labor markets. This implies that some local Labor Offices are more efficient than others. • Mixed evidence on program targeting. Public works and wage subsidies appear well targeted to low-skilled unemployed and to rural areas and small towns but hardly improve future employment chances. Training and apprenticeships, the two largest programs, are only partially targeted to the less-skilled workers whose employment prospects are significantly worse than those of better skilled workers. Business support, the most expensive program, benefits mostly relatively well educated. 79. In the circumstances, the Government could consider the following: • Lower the contribution rate to the Labor Fund once the labor market impact of the economic crisis has faded. The contribution rate should be set so as to secure resources sufficient to finance labor market programs under the steady-state unemployment rate. That is, it should be set so that revenues equal expenditures over the business cycle. Put differently, Labor Fund should generate surplus during the period of economic upturn, which then can be used to finance the increased expenditures during the period of downturn. • Revise the formula for allocating Labor Fund’s resources across regions so as to strengthen incentives for the reduction in registered unemployment. One possibility is that the relevant formula would include the job placement rate (adjusted for the regional unemployment rate), so that better performing regions are awarded additional funds. • Develop the methodology and encourage regional (voivodship) Labor Offices to use performance based budgeting to improve the effectiveness of local (poviat) Labor Offices. • Introduce a system for monitoring and evaluation of active labor market programs. Whereas monitoring should be carried out on a regular basis, program evaluation should be done periodically. The objective of the system is to determine cost-effectiveness, targeting efficiency and net impact of different programs for different groups of the unemployed. Use the results to reallocated funds to programs that are most efficient, and to target programs to those unemployed who benefit most from a given intervention. • Develop a more efficient system of job search assistance and activation policies by (a) strengthening the capacity of public employment services, and (b) contracting out specialized employment services to non-public service providers. This should be coupled with introducing performance based budgeting, which links funding to effects and awards efficiency in the delivery of services. 35 III.7 Public Sector Wage Bill 80. Over one-fifth of public expenditures, or about 10 percent of GDP, go towards paying wages of public employees in Poland. The tightening of the labor markets in the run-up to the crisis fuelled public sector wage growth. Now, the outlook of the labor market has changed, and the need for fiscal consolidation make the public sector wage bill a natural source of fiscal savings in coming years, as indeed many countries of the region have discovered. In Poland, there are three concerns about the public sector wage bill (Annex 2). 81. First, the 475,000 employees in the state budgetary sphere, which are under the direct control of the central government, have recently benefited from large wage increases. Expenditure on the wage bill of the state budgetary entities increased in nominal terms by 5 percent in 2006, 8 percent in 2007, and 19 percent in 2008. It rose at a still sizable 9 percent in 2009 (Figure 21, left panel). Since the employment level was stable, the increase in the wage bill translated into an increase in average wages. In addition, employees benefited recently from the reduction in the tax wedge: the employee’s contribution was lowered from 6.5 percent to 1.5 percent, and the personal income tax reduced and simplified. 82. Second, wage increases are financed by keeping employment below the levels foreseen in the budget. As highlighted by the Polish Supreme Chamber of Control, actual employment was around 9 percent lower than stipulated in the budget acts from 2003 to 2008, while overall spending on wages was only by 4 percent lower (Figure 21, right panel). 83. Third, public wages in state budgetary units financed directly from the state budget are not presented transparently in the budget documentation. Budget acts and annual budget reports focus on employment and remuneration in the state budgetary entities, regulated in the Act on Remuneration in the State Budgetary Sphere. This excludes about 60,000 employees of the main public offices (Parliament, President, courts, tribunals, and other chief central offices), classified in budgetary expenditure parts 1 to 15 and part 52. 84. The report’s proposal for improving the control over the wage bill during 2010 to 2012 has two elements. • First, employment limits in the budget could be adjusted to their real utilization in order to restrict the scope for funding wage growth from unfilled posts. This adjustment could be done separately for each group of professionals financed based on historic trends (Box 6). • Second, the adjusted wage bill could grow in line with CPI inflation, with the exemption of funds spent on wages in projects co-financed by the EU or other donors. In contrast to the Government proposal (Box 7), this reform would not necessarily require across-the-board redundancies, as the adjustment could be achieved through moderation of wage levels. Finally, the measures could be extended to voivod budgets, as the latter have one of the largest discrepancies between the projected and actual number of employees. 36 IV PUBLIC SPENDING REFORMS - SIMULATING THE FISCAL IMPACT 85. Drawing on simplified simulations, we argue that social sectors and public wages can go a long way towards reducing the fiscal deficit from 6 percent of GDP to 3 percent of GDP by 2012. But an important caveat has to be kept in mind: our calculations are based on simple assumptions that do not adequately reflect the complex array of factors that determine supply and demand for government programs. Clearly, it would be important to generate more sophisticated estimates based on better information about public expenditure determinants. Nevertheless, the results should be sufficiently robust to pinpoint some of the main areas for potential savings in public spending. 86. The simulation of public expenditure savings in the social sectors and public wages is based on a number of assumptions. First, we focus on the reform initiatives outlined above in the areas on pensions, education, health, social assistance and labor market programs. For pensions, education, health and social assistance, we look at spending items under the direct control of the state budget (Box 3) and include government cost estimates of endorsed or proposed reforms (Box 4). We also account for the projected increase in demand for social assistance due to the economic slowdown. We also look at public sector wages, separating employees of the state budgetary sphere and other public sector employees. As discussed above, the Labor Fund’s surplus is projected to be sufficient to fund unemployment benefits in line with the estimated increases in unemployment. Hence, we do not include any state budget subsidies for this item. Overall, we look at expenditure items amounting to PLN230 billion in 2009, or 17.1 percent of GDP, or about two-fifths of general government spending. 87. Second, we link the fiscal adjustment to trends in core macroeconomic parameters. The numbers reflect the latest Government forecasts for the 2010 budget for 2010 to 2012 (Table 4). The only exception is the unemployment rates, which are taken from IBS to be consistent with the labor fund simulations presented in the labor chapter of Volume II. We use a single set of macroeconomic trends for our scenarios. This is clearly unrealistic – after all, the size of budget deficits has a bearing on economic growth and inflation. We do not allow for any feedback from fiscal policy to macroeconomic parameters in order to keep the calculations simple and transparent and focus the discussion on the issue of public expenditure consolidation. 88. Third, we distinguish two scenarios: baseline and reform. The baseline scenario assumes no new policy change, but does include the costs of reforms that have already been adopted. The reform scenario takes into account additional reform options for the Government (Annex 1). Spending trends for the baseline are extrapolated based on GDP elasticities with regard to the respective expenditure line items from 2004 to 2008 or 2009, where 2009 numbers are taken from the 2009 budget act. There are two exceptions. The state budget subsidy to NHF is extrapolated in line with the average annual health expenditure growth rather than NHF transfers due to the sharp increase in NHF transfers in 2009 related to the financing of medical rescue. The increase in family benefit recipients from 2009 to 2012 was based on the World Bank Povstat model, drawing on the macroeconomic framework and the 2008 Poland Household Budget Survey (Box 5). Box 3: Simulated Expenditure Items Direct state budget expenditures: • state budget subsidies to cover the deficits of the pension funds FUS (workers, self-employed) and KRUS (farmers) • state budget spending on special pensions • state budget subsidies to cover the deficit of the health fund NFZ • the education subvention from the state budget to lower levels of government, and • state budget transfers for social benefits to lower levels of government. Government cost estimates of reforms in social sectors: • Making pre-school compulsory for 5-year old • Bringing disability pensions in line with the reform old-age pensions • Advancing corporatization of hospitals; and • Providing adequate funding for increasing family benefits for families with three or more children. Box 4: Government Cost Estimates of Social Sector Reforms • The enacted reform on pre-primary program for 5 year-old children and primary education program for 6 year-old children is estimated to be around PLN1.7 billion from 2009 to 2011. • The implementation of the hospital corporatization plan, which offers financial and technical assistance to public hospitals to restructure their debts and convert hospitals to corporate entities under the Code of Commercial Companies, is estimated to be around PLN1.2 billion from 2009 to 2011. • The revision of family benefits, adopted in August 2009 by the Council of Ministers, is estimated to cost the budget around PLN1.1 billion in 2010. Table 4: Macroeconomic Assumptions 2008 2009 2010 2011 2012 Nominal GDP (PLN mln) 1,271,700 1,341,100 1,368,600 1,434,600 1,511,100 Nominal GDP growth (yoy) 108.1 105.5 102.1 104.8 105.3 Real GDP growth (yoy) 104.9 100.9 101.2 102.8 103.0 GDP deflator 103.0 104.5 100.8 102.0 102.3 CPI (yoy) 104.2 103.6 101.0 101.8 102.3 Real wage growth (yoy) 105.7 104.5 101.0 101.9 102.5 Unemployment rate (%) 9.5 12.1 12.5 12.7 12.6 Box 5: Simulating Trends in Social Assistance Payments Using the 2008 Poland Household Budget Survey, we separate households into three groups depending on the labor force status of the household head: unemployed; employed or self-employed and others. We then assume that the share of households with unemployed household heads increases in line with the unemployment rate in Table 4, and that household incomes increase in line with the wage growth and pension and benefit indexation rules. Using Povstat, we project a rise in the share of the population living in households with per capita income less than PLN 504, the income threshold for family benefit, from 27.7 percent in 2008 to 29.7 in 2009 and 2010, 28.7 in 2011 and and 27.6 in 2012. Finally, we apply the growth rates of the share of population below the minimum income threshold to derive the growth rates in social assistance payments. 38 IV.1 Pensions 89. For pensions, we discuss the fiscal impact of the change in the indexation formula and the reform of the disability benefits. Other important pension reforms, including the increase and equalization of the retirement age and of KRUS and special pensions, while crucial over the longer run, would have a fairly modest impact on fiscal balances by 2012. • Change in indexation formula. We simulate the switch from the current system of adjusting pension indexation based on the sum of 100 percent growth in the CPI and 20 percent growth of real wage to a CPI indexation only for FUS, KRUS, and special pensions. This would bring savings of around PLN2.5 billion in 2012. This reform would align Poland’s pension indexation with best practice (World Bank 2009) with non-negligible fiscal benefits. If maintained over the longer term, the break-even point of the FUS pension system would be advanced compared to the current indexation rule by about five years. While it would lower pension levels, households headed by pensioners have the highest expenditure levels and the lowest share below the income threshold for family benefits (Figure 17), even though these comparisons are subject to assumptions on equivalence scale for household size and household composition. Hence, from an equity point of view, today’s pensioners would seem well place to contribute to the national fiscal consolidation effort. However, two concerns would have to be addressed as part of such a reform. The fiscal consolidation of FUS is the result of a stark reduction in pensions relative to wages. Pension benefits fall from the current level of approximately less than half of the average gross wage by more than half, which is quite low by international standards. Without compensating factors, the shift to a full CPI indexation could further increase old age poverty, although the actual impact would depend on the difference between wage and price increases (Figure 18). Since pension benefits upon retirement are strictly tied to life expectancy, there is a need to work longer and accumulate a larger notional capital at retirement. This notional capital would then be converted into pension annuity using a lower life expectancy at retirement hence a higher replacement rate. In addition, entering a discussion about the indexation formula entails some political risks, as it might reopen the debate on other aspects of the pension system. • Disability reform. Disability pensions have not yet been brought in line with the reformed old age pension system. While the Parliament adopted a new design of the disability pension formula, it was vetoed by the President on 20 October Figure 17: Pensioner Households are Fairly Well-Off 2008. According to the 60 Shares and Expenditure Levels of Households by Household Heald (2008 HBS) 1000 Government’s calculations, Per Capita Expenditure the reform would bring (PLN) 900 50 savings of around PLN 0.2 800 billion in 2012, which would 700 increase to around PLN 2 40 600 billion annually after 2015. Share below Income Population Threshold PLN504 30 500 90. Even without any further Share 400 reforms, the recent tightening of 20 early retirement provisions is 300 projected to reduce the number of 200 10 people on early retirement from over 100 one million in 2009 to around 300,000 in 2012. This reform is set to reduce 0 Retired Self-employed Employee Inactive & Student Unemployed 0 sharply the number of men retiring in the next years. Without the early Source: Based on HBS data, World Bank Staff Calculations 39 retirement provision, men born in 1949 are to retire only in 2014 at age 65 rather than previously in 2009 at age 60. This in turn will lower state budget subsidies to FUS by reducing the number of pension recipients and increasing the number of contributors, in addition to boosting workers’ savings. The corresponding change for women took place in 2003, so women have started retiring in full cohorts in 2009 at the age of 60, the current retirement age for women. Figure 18: Gross Average Replacement Rates for Mixed and Full CPI Indexation of Pension Benefits 100% CPI Mixed 60% 50% 40% 30% 20% 10% 0% 2009 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 2051 2053 2055 2057 2059 2061 2063 2065 2067 2069 2071 2073 2075 Source: World Bank Staff Calculations based on Prost model IV.2 Education, Health and Social Assistance 91. In education, the main reform being simulated is to allow school funding fully to reflect demographic changes. As explained in the background paper on education, the central government provides an education subvention to local governments to fund primary and secondary education. Yet, while the number of primary and secondary pupils decreased from Figure 19: Room for Public Expenditure Savings in close to 7 million in 2000/01 to 5.5 Education Education Subvention and Primary and Secondary Students (2000/01 to 2007/08 million in 2007/08, the education 7.0 24 subvention increased in constant Pupils (mn) 23.5 prices from PLN 18.1 billion to 23 PLN 23.4 billion over the same 6.5 22.5 period (Figure 19). In other words, 22 the per-student education subvention grew by 6 percent 6.0 21.5 annually in real terms over the last 21 seven years. The proposed reform Education Subvention (PLN bn, constant 20.5 5.5 would establish the education prices) 20 subvention on a standard of service 19.5 delivery, thus resulting in a per- 5.0 19 capita allocation that would then be 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 applied to the subvention formula. Source: World Bank Staff Calculations This would imply that the total education subvention might decline from one year to the next in line with demographic changes. As a 40 conservative assumption, we keep the education subvention constant at the nominal level of 2009. This would bring savings relative to the baseline scenario of around PLN3 billion in 2012. 92. In health, the proposed objective would be to stabilize public spending in nominal terms. While health spending remained stable at around 6.5 percent of GDP from 2005 to 2007, it increased to 7.4 percent of GDP in 2008 (Figure 20). In addition to strong wage growth, the lowering of the disability rate increased contributions to NHF, as health insurance payments, just as income tax, is applied on taxable income, defined as income net of employer’s and employee’s social security contributions, which include disability contributions. The reduction in the tax wedge lowered taxable income by less than one-to-one, and hence resulted in an increase in NHF contributions. In addition, as discussed in the health chapter in Volume 2, the introduction of diagnosis-related groups as a cost accounting and payment mechanism in all hospitals from 2009 and hospital corporatization are expected to lead to efficiency gains. The development of integrated care networks, the development of private insurance, and the introduction of fee-based services beyond basic packages are additional tools for fiscal savings. We model such expenditure adjusting by keeping the state subsidy to NHF constant in nominal terms at the 2009 level of 1.8 PLN billion. This would bring savings compared to the baseline scenario of around PLN 0.4 billion in 2012. The state budget pays subsidies to NHF in order to compensate for the provision of important health services for the socially excluded, those affected by contagious diseases, emergence services and others. These expenses are well justified. Hence, the freezing of the state budget subsidy in nominal terms should not lead to a reduction in such services, but NHF should offset any loss of state budget subsidies from savings elsewhere. 93. Social assistance could be better targeted. As discussed above, the 2007 HBS suggests that close to one in two beneficiaries of social assistance have consumption in excess of the income threshold. Improvements in the targeting of social assistance are assumed to lead to efficiency gains of around 5 percent annually, which would translate into savings of PLN 0.7 billion in 2012 relative to the baseline. IV.3 Public Sector Wage Bill This report proposes to Figure 20: Recent Trends in Health Spending enhance the control over Public and Private Health Spending (% of GDP) the wage bill by (i) 7.5 limiting the capacity of 7.0 spending agencies to use 6.5 vacant positions to 6.0 finance salary increases 5.5 Private and (ii) curtail the 5.0 growth of the adjusted 4.5 wage bill to CPI 4.0 inflation. This reform is 3.5 estimated to yield saving 3.0 of about PLN3.9 billion 2.5 in 2012. To ensure a 2.0 similar public wage bill Public 1.5 control at lower level of government, we assume a 1.0 parallel adjustment for 0.5 public sector employees 0.0 2005 2006 2007 2008 in other general Source: World Bank Staff Calculations government entities. In 41 this calculation, we exclude teachers, as their salaries are funded primarily through the education subvention. The projected savings relative to the baseline would be PLN15.7 billion in 2012 Figure 21: Growth Rates of Wages and Budget Execution of Employment Limits and Wage Expenditures Nominal Growth Rates of Wages and Wage Bill (2004 to 2009) Budget Execution of Employment Limits and Wage Expenditures (2003 to 2008) 20 20 100.00 100 State Budget Wage 18 Bill 18 99.00 99 16 16 98.00 Wage Expenditure (% 98 of Plan) 14 14 97.00 97 Public 12 Sector 12 Wages 96.00 96 10 10 95.00 95 Economy- 8 Wide 8 94.00 94 Wages 6 6 93.00 93 Filled Posts (% of Plan) 4 4 92.00 92 2 2 91.00 91 0 0 2004 2005 2006 2007 2008 2009F 90.00 90 2003 2004 2005 2006 2007 2008 Source: World Bank Staff Calculations Box 6: Employment Limits by Professional Group under the Reform Proposal For Civil Service Corps, customs officers, judges employed in the Ministry of Justice and public prosecutors we propose adjusting the 2009 wage bill by coefficients equal to average utilization of post limit during 2003 to 2008 (89.8 percent for the Civil Service Corps; 97.5 percent for customs officers; and 96.4 percent for judges and prosecutors). For professional soldiers and officers we propose a higher coefficient (95 percent) than the historical average (92 percent) due to the plans for the professionalization of the army and higher staffing requirements in other uniform services. For those employees not covered by the multiplier system, we propose to maintain the 2009 wage bill level as base wage. In order to estimate spending on additional wage (13th salary), we assume a constant ratio of the wage to the basic wage in the previous year. We also allow for an earmarked reserve for unexpected pay rises of no more than one percent of the total wage bill. Box 7: Government’s Proposal on Employment Reductions in Public Administration The Chancellery of the Prime Minister presented in August 2009 draft legislation to rationalize employment in public administration. The draft law covers both selected state budgetary entities and selected establishments of the general government sector (general and agricultural social security institutions – ZUS and KRUS, National Health Fund (NFZ), and state target funds and governmental agencies). This amounts to about 359,000 employees as of mid-2009. It does not apply to subnational governments and those workers of state budgetary units who are not employed under contracts regulated by the Labor Code, such as professional soldiers and officers, judges, and public prosecutors. According to rough estimates, the wage bill of the employees covered by the draft law constitutes around PLN18 billion (1.4 percent of GDP). This is less than a half of the state budget’s wage bill, about 15 percent of the total wage bill in the general government sector, and around 3 percent of total general government spending. The target is to reduce employment in the covered entities by at least 10 percent between 30 June 2009 and 30 June 2010. In addition, the 2011 wage bill should not be higher than 92 percent of the 2009 wage bill. According to our estimates, the reform could bring savings of around PLN 11.7 billion by 2012 relative to the baseline. 42 IV.4 Overall Fiscal Impact 94. The simulations indicate that reforms of public spending on the social sectors and wages could make an important contribution to fiscal consolidation over the next few years. Such expenditure rationalization would not have to sacrifice spending on vital reforms, such as universal pre-school for 5 year-old or hospital corporatization, or undermine the provision of social assistance to poor and vulnerable people. (Figure 22). In the baseline scenario, public spending on those items decreases from 17.1 percent of GDP in 2009 to 16.6 percent of GDP in 2012, as the tightening of the early retirement provision leads to a reduction in the state budget subsidy to FUS. In the reform scenario, spending drops from 17.1 percent of GDP in 2009 to 14.9 percent of GDP in 2012. Hence, relative to the baseline, reforms are projected to economize 1.7 percent of GDP in public spending in 2012. Relative to 2009, the savings in 2012 would be even 2.3 percent of GDP. These calculations suggest that such reforms would go a long way towards providing the fiscal savings of around 3 percent of GDP that Poland needs to meet the fiscal Maastricht criteria and allow the European Council to abrogate the excessive deficit procedure. 95. There are three big ticket items for fiscal consolidation. Comparing 2012 with 2009, the 2.3 percent of GDP savings are composed as follows. Pensions contribute 44 percent to the savings (1.1 percent of GDP), public wages 37 percent (0.9 percent of GDP), and education 14 percent (0.3 percent of GDP). Social assistance and health (2 percent of the savings, or 0.05 percent of GDP each) make up the balance. About two-thirds of the pension gain (0.6 percent of GDP) accrues as dividend of the already implemented tightening of early retirement provisions, if indeed this is as effective as assumed in boosting employment rates. About one-fifth of the public sector wage gain (0.2 percent of GDP) relies on wage bill moderation in the state budgetary sphere. The remaining component (0.7 percent of GDP) is outside the direct influence of the central government. Local governments spend more on public sector wages than the central government, as they cover the bulk of public social sector employees. Ensuring commitments from local governments to contribute to the fiscal adjustment of the public sector wage bill and other spending is clearly important (Figure 24 and Figure 25). 96. The Government can scale up, or Figure 22: Public Expenditure Trends under trade in, the fiscal measures presented here Baseline and Reform Scenario in a number of ways. Better public Public Expenditure Simulation for 2009 to 2012 (% of GDP) 17.5 expenditure management can make a crucial contribution to deliver outputs and outcomes 17.0 BASELINE with fewer resources. Reviews of public 16.5 expenditure programs could help identify high-priority social and economic programs 16.0 that should be shielded from expenditure cuts, and identify areas where the private sector can 15.5 REFORM play a greater role in the provision of 15.0 infrastructure and services. There is also room for improvements in the operational 14.5 2009 2010 2011 2012 efficiency of public expenditures through a more efficient implementation of public Source: World Bank Staff Calculations activities. 43 Figure 23: Composition of Public Expenditure Savings under Reform Scenario 2012 versus 2009 Composition of Public Expenditure Savings 2009 to 2012 (% of GDP) Composition of Public Expenditure Savings 2009 to 2012 (%) 2.5 100% HEALTH SOCIAL ASSISTANCE HEALTH 90% SOCIAL ASSISTANCE EDUCATION EDUCATION 2.0 80% STATE BUDGET WAGES STATE BUDGET WAGES 70% 1.5 60% NON-STATE BUDGET NON-STATE BUDGET WAGES WAGES 50% 1.0 40% 30% PENSIONS PENSIONS 0.5 20% 10% 0.0 0% Source: World Bank Staff Calculations Figure 24: General Government Wage Bill by level of Government in 2008, (% of GDP) 14 12 10 8 6 4 2 0 CZ PL SK LT HU BG LV RO EE SI C en tr al go ve rn me nt Lo cal gove rn me n t So cia l s ecu rit y fun d s Source: World Bank Staff Calculations Figure 25: Composition of Government Spending by Level of Government (% of GDP) General Government Budget (% of GDP) 16.0 16.0 15.5 15.5 Central government 15.0 15.0 14.5 14.5 Social security funds 14.0 14.0 13.5 13.5 Local government 13.0 13.0 2005 2006 2007 2008 Source: World Bank Staff Calculations 44 V THE CONTRIBUTION OF INSTITUTIONAL REFORMS V.1 Medium-Term Budgeting 97. Institutional reforms can help to unwind the fiscal overruns through medium-term fiscal adjustment plans backed by structural reforms. For example, Hungary has strengthened fiscal sustainability by the adoption of a fiscal responsibility law establishing numerical debt and deficit limits; procedural rules to restrain expenditure growth, and a fiscal council to provide independent scrutiny of budget preparation and execution. 98. Poland has also taken steps to strengthen medium term budgeting. The need to strengthen the medium-term perspective in Polish budget preparation has been the subject of public discussion, and of comment from the European Commission, for some time. In response to this, the Government proposed in 2008 revisions to the Public Finance Act which would make mandatory a new Multiyear State Financial Plan (MYSFP), to be voted on by parliament. The MYSFP would include a statement of the government’s medium-term fiscal policy, medium-term projections of expenditure and revenue (on a function/task/sub- task basis) and aggregate fiscal projections together with macroeconomic assumptions. 99. The possibility that Poland might adopt the approach of countries like the Netherlands and Sweden in setting binding medium-term ceilings for aggregate expenditure was the subject of some discussion prior to the crisis. In formulating its proposed amendments to the Public Finance Act, the government considered and rejected this possibility. In the light of current crisis conditions, this is understandable. Whatever the merits of such ceilings may have been in the pre-crisis period, the present uncertain fiscal environment makes it difficult to establish and enforce binding forward commitments with respect to aggregate, sectoral or ministerial expenditure ceilings. However, Poland should consider this option when the foundations of medium-term budgeting are well established and macroeconomic and fiscal conditions have stabilized. Such ceilings would help to strengthen appropriate rules for the planning and execution of spending. 100. For the MTEF, the most fundamental challenge in Poland will be to ensure that the MYSFP matters, and that it does not become simply a document which looks impressive but has little impact on decision making either in executive government or in the parliament. Two issues which are particularly important in determining the outcome are the quality of the forward estimates, and the development of a good budget processes for reconciling expenditure policy with fiscal policy over the MT time horizon. 101. The detailed action plan identifies key steps required to meet the goal of program-based budget appropriations in financial year 2013, as well as the new Multi-Year State Financial Plan (Table 5). V.2 Performance Budgeting 102. Poland has made substantial progress in the last three years in performance budgeting, and is now moving to introduce a stronger multi-annual focus to budget preparation. Poland has been working since 2006 on the implementation of a performance budgeting system, with the encouragement and substantial financial support of the European Union. The first major step in the performance budgeting reforms has been the development of an indicative program budget—that is, a presentation of the budget in programmatic terms which is provided to parliament for information alongside a traditional budget law which appropriates money on the basis of a combination of economic classification, organizational unit and projects. The indicative program budget presents function, task and sub-task expenditure for the coming budget year and the subsequent three years, as well as stating task and sub-task objectives and identifying key performance indicators. The first indicative program budget, covering selected pilot agencies, was presented to parliament with the 2008 budget. The version presented with the 2009 budget extended coverage considerably to cover all ministries. Although considerable work will be required to refine program structure, objectives and indicators, the development of these indicative program budgets covering the whole of government is a considerable achievement. The 2013 budget is for the Government the tentative point for the crucial transition from a purely indicative program budget to program-based budget appropriations. 103. Making the Performance Based Budgeting framework fully operational and effective requires some additional adjustments: • Program structure: the program classification can be improved; the number of tasks and sub- tasks reduced which are based on support activities rather than outcomes and outputs; and to align tasks with ministry/agency boundaries to ensure that the budget appropriation system provides a clear statement of the total budget funding being provided to each ministry. • Program objectives: some task and sub-task objectives, and their associated key performance indicators, could be made more results-oriented—and, more particularly, defined as far as possible in terms of outcomes. • Performance information: the quality of performance indicators could be improved; the number of indicators could be increased, and more indicators could be focused on outcomes, output quality and quantity. In addition, good performance information also requires the development of program evaluation. • Cost information: Major changes in the financial management information system (FMIS) will also be required. One of the greatest challenges will be the development of a capacity to handle overhead costs, where the costs of support services such as IT will eventually need to be appropriately allocated between the results-oriented tasks to which they support. • Appropriation framework: The current appropriation structure has limited relationship to the program structure. The current tentative view of the MoF is that, when program-based appropriations are introduced, it will probably be in “parallel” with the present appropriations. A dual appropriation system would, however, be unduly complex, and could limit the effectiveness of the program budgeting. • Budget process change: systematic central spending review processes could be introduced to facilitate the use of performance information; they could cover two distinct areas: (1) review of all new spending initiatives; (1) continuous review of ongoing “base” expenditure. Poland has been weak in both of these areas. • Implementation arrangements: enhanced cooperation within the Ministry of Finance between departments dealing with the PBB reform and the Budget Department. It is essential that the Budget Department interest itself closely in the design of the reforms, because the success of performance budgeting will depend in substantial measure on the Budget Department using the program framework and associated performance information to prepare the budget. • Support for spending ministries: MoF coordination and leadership is critical to support the implementation of the performance budgeting framework at the spending ministry level. The MoF is well aware of this, and has commissioned a large-scale training program to build capacity within ministries. Guidelines (regulations) and supporting manuals to assist ministries in implementing key steps could be developed. 46 Table 5: Performance Budgeting and Medium-Term Budgeting Action Plan, 2009-2012 2009 2010 2011 2012 Action Comment Training/Capacity Building Needs Develop new budget Budget classification require for program-based classification appropriations, incorporating appropriate elements of (not yet commenced) economic and organizational classification. Formulate new chart The development of a new chart of accounts consistent with of accounts program budgeting and the new budget classification. (not yet commenced) Define required Reflecting decisions about budget classification and the chart functionality for of accounts. financial information This timing is consistent with the MoF’s current systems implementation schedule. (not yet commenced) Guidelines and These should emphasize results (especially outcomes) rather support manuals on than support activities and processes. program objectives and key performance indicators (not yet commenced) Further refine To ensure at tasks and sub-tasks are allocated to the Current training efforts in this program appropriate function, and sub-tasks to the appropriate task. areas need to be continued classification Also, to reduce the number of tasks and sub-tasks based on (already underway) support activities rather than outputs and outcomes. Improve specification Current training efforts in this of objectives areas need to be continued (already underway) Extend sectoral To cover whole general government sector. coverage of indicative program budget (already underway) Performance This process will be a long-term one which will continue Current training efforts in this indicator well beyond 2012. areas need to be continued and improvement made more “hands on” (already underway) Develop program This process will be a long-term one which will continue Major training effort will be evaluation well beyond 2012. required once procedures and Current MoF implementation schedule sets 2013 for this policies developed step. MoF to further Major training effort will be develop policy and required. performance analysis capacity (already underway) Implement changes FMIS project team to be established. Should take into Large-scale training required to financial account not only the needs of performance budgeting across government as a whole management system, but broader functionality required. information systems This proposes bringing this work forward substantially (not yet commenced) relative to the MoF implementation schedule, which postpones this to 2013. Preparation of first Consistent with the indicative target date in the MoF’s program-based current implementation schedule. budget law for 2013 financial year Create systematic Should be designed so as to use performance information in expenditure review a MT perspective. routines in the budget process (not yet commenced) Further develop Integrate these in the performance budgeting framework processes for review of new spending proposals (not yet commenced) Improvements to Work needed in both the MoF and spending ministries. Major training required across forward estimates government as a whole methodology (not yet commenced) Base budget Use first “out” year of expenditure forward estimates as preparation on the starting point for preparing each year’s budget. forward estimates 48 VI ANNEX 1. PUBLIC EXPENDITURE SIMULATION Baseline Spending (PLN mln, current prices) 2009 2010 2011 2012 Education - Education subvention for gminas, poviats and voivodships 33,269 33,782 35,008 36,413 - 5 year-old 574 519 543 0 Pension - FUS fiscal balance 34,189 34,701 29,986 27,169 - State subsidy to KRUS 15,964 16,734 16,932 17,306 - Special pensions 16,074 16,798 17,001 17,370 - Savings from disability reform 0 0 0 0 Health -State subsidy to the NHF 1,796 1,853 1,992 2,157 - Hospital corporatization 383 383 383 0 Social assistance - Increase in family benefits for poor households 0 1,100 1,125 1,132 - Social assistance 13,994 15,003 14,887 14,620 Public sector wages - Expenditure on budgetary sphere wages 24,752 25,437 27,094 29,045 - Expenditures on GG wages * 113,546 116,929 125,123 134,818 Reform Spending (PLN mln, current prices) 2009 2010 2011 2012 Education - Education subvention for gminas, poviats and voivodships 33,269 33,269 33,269 33,269 - 5 year-old 574 519 543 0 Pension - FUS fiscal balance 34,189 33,526 28,522 25,024 - State subsidy to KRUS 15,964 16,578 16,737 17,040 - Special pensions 16,074 16,653 16,966 17,307 - Savings from disability reform 0 -16 -70 -200 Health -State subsidy to the NHF 1,796 1,796 1,796 1,796 - Hospital corporatization 383 383 383 0 Social assistance - Increase in family benefits for poor households 0 1,100 1,069 1,076 - Social assistance 13,994 14,253 14,143 13,889 Public sector wages - Expenditure on budgetary sphere wages 24,752 23,986 24,504 25,117 - Expenditures on GG wages * 113,546 110,034 112,411 115,223 *General Government wage bill excl. salaries of primary and secondary education teachers VII ANNEX 2. DETERMINANTS OF PUBLIC SECTOR WAGE INCREASES There are two broad groups of employees of the state budgetary entities – those covered by the multiplier system, and those not covered by the multiplier system. Workers under the multiplier system include civil servant corps and other public professionals, such as soldiers, policemen, firemen, border guards, judges and prosecutors, and others. In a given budget year, their remuneration is based on the employment limit, the increase in the base amount by an annual pay indexation rate, and multipliers of the base amount, determined in separate regulations. The remuneration of workers not under the multiplier system is based on last year’s remuneration valorized by an annual pay indexation rate stated in the budget act. Budget managers may use various methods to increase wages. For worker covered by the multiplier system, raising the base amount is only one of many factors affecting the wage bill. In recent years, the rise of an average pay of workers resulted mainly in changes in the values of the multipliers of the base amount. For workers not covered by the multiplier system, wage increases resulted mainly from the change in regulations leading to a significant rise of wages and salaries attributed to individual posts. Another source for wage increases are include target reserves for budgetary entities for organizational changes and new tasks, dismissal wages, long-service bonuses, retirement gratuities etc. Finally, different rules can apply for wage increases in specific groups of professionals, such as members of the civil service corps, professional soldiers, etc. For example, nominal wage bill expenditure in state budgetary entities expanded in 2008 by 19.4 percent. This was part of an effort to modernize the remuneration system in public administration, which resulted in wage increases through higher multipliers or special pay supplements. However, the indexation of the base amount was only 2.3 percent was a minor factor. The increases differed by group, with the civil service corps (21.8 percent), workers not covered by the multiplier system (21.7 percent), and soldiers and officers (18.3 percent) receiving the highest increases. Among the employees covered by the multiplier system, the increases in the wage bill were driven by various factors (Table 6). According to the 2009 budget act, the wage bill in the state budgetary sphere is to increase by PLN3 billion, or 13.8 percent. The increase in the base amount accounts for only 13 percent of the rise in the wage bill. Table 6: Employees of the State Budgetary Sphere and Components of 2009 Wage Bill Increase 2004 2005 2006 2007 2 008 Specification Amount Employme nt coveredby a multiplier sy ste m 344,436 347,111 350,312 348,606 361,968 Civil Service Corps 105,950 107,465 107,359 107,506 111,966 Increase of the base amount 409,018 Soldiers and Officers 217,555 218,654 221,818 218,575 227,140 Indexation of wages for persons not covered by the multiplier 71,708 Customs Officers 13,868 13,738 13,793 13,595 13 ,660 Increase in multipier 686,941 Judg es emp loyed in the Ministry of Justice and public prosecutors 5,966 6,130 6,161 6,229 6,464 Additional increase in annual salary 420,462 Other 1,097 1,124 1,181 2,701 2,738 New posts 187,947 Target reserve 250,990 Employment not coveredby a multiplier system 118,396 112,417 113,734 111,442 112,503 Others 973,535 Total 462,832 459,528 464,046 460,048 474,471 Total 3,000,601 Source: Staff Calculations 50 VIII ANNEX 3. CONTRIBUTIONS TO THIS REPORT Title Authors Chapters Pensions Prepared by Ufuk Guven, Anita Schwarz, Sergiy Biletsky. Agricultural Pensions Prepared by Leszek Kasek, updating 2006 report Poland: Reform Options for the Agricultural Social Insurance Fund by Jan Pakulski, Csaba Feher and Joseph Goldberg. Education Prepared by Alberto Rodriguez and Mikolaj Herbst. Health Prepared by Mukesh Chawla and Charles Griffin. The chapter benefited from contributions provided by Adam Kozierkiewicz (corporatization program, DRG s, and other aspects of health policy) and Monika Bazyl (analysis of household budget survey and opinion poll data used in the household expenditure/equity section). Social Assistance Cash Transfers Prepared by Truman G. Packard, Anna Ruzik and Katarzyna Pietka. Labor Market Programs Prepared by Jan Rutkowski. The chapter benefited from information provided by the staff of the Ministry of Labor and Social Policy, in particular Malgorzata Sarzalska, Iga Magda, Justyna Garbarczyk oraz Ireneusz Pię takiewicz. Useful information on the functioning of local Labor Offices was provided by Jerzy Bartnicki, Director of Kwidzyn Labor Office. Medium-Term Budgeting and Performance Prepared by Marc Robinson. Budgeting Background Notes Social Insurance Fund simulations Prepared by Maciej Bukowski (The Institute for Structural Research). Labor Fund simulations Prepared by Piotr Lewandowski (The Institute for Structural Research). Public Sector Wages Prepared by Malgorzata Guzowska. 51