Document of The World Bank FOR OFFICIAL USE ONLY OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION AND THE TO THE EXECUTIVE DIRECTORS

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION AND THE Report No. P7453 IN INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A CREDIT IN THE AMOUNT OF SDR 58.9 MILLION (US$75 MILLION EQUIVALENT) AND A LOAN IN THE AMOUNT OF US$75 MILLION TO INDIA FOR THE KARNATAKA ECONOMIC RESTRUCTURING May 25, 2001 Poverty Reduction and Economic Management South Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS Currency unit: Rupees (Rs) as of May 21, 2001 $1 = Rs GOVERNMENT'S FISCAL YEAR April 1 - March 31 ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Activity KERL Karnataka Economic Restructuring AusAID Australian Agency for International Loan/Credit Development KPTCL Karnataka Power Transmission C&AG Comptroller & Auditor General Corporation Limited CAS Country Assistance Strategy KSBPE Kamataka State Bureau of Public CDF Comprehensive Development Enterprises Franiework MoU Memorandum of Understanding CM Chief Minister MTFP Medium Term Fiscal Plan DANIDA Danish International Development NGO Non Government Organization Assistance O&M Operations and Maintenance ERC Expenditure Review Committee PE Public Enterprise FDI Foreign Direct Investment PEM Public Expenditure Management FRP Financial Restructuring Plan PHC Primnary Health Center GDP Gross Domestic Product PHDMS Poverty and Human Development Got Government of India Monitoring System GoK Government of Karnataka PRI Panchayati Raj Institution GSAP Governance and Strategy Action Plan PSAL Progranmnatic Structural Adjustment GSDP Gross State Domestic Product Loan/Lending HDR Human Development Report PSU Public Sector Unit HUDCO Housing and Urban Development Company PWD QRs Public Works Department Quantitative Restrictions IDFC Infrastructure Development Finance TA Technical Assistance Corporation VAT Value Added Tax IMF International Monetary Fund VRS Voluntary Retirement Scheme IT Information Technology KERC Karnataka Electricity Regulatory Commission The World Bank Vice President Ms. Mieko Nishimizu Country Director : Mr. Edwin R. Lim Sector Director : Mr. Roberto Zagha Task Managers : Mr. Stephen Howes Ms. Lili Liu

3 FOR OFFICIAL USE ONLY INDIA KARNATAKA ECONOMIC RESTRUCTURING LOAN/CREDIT TABLE OF CONTENTS I. SETTING: ECONOMIC SITUATION AND RECENT DEVELOPMENTS IN INDIA... I II. KARNATAKA AND ITS REFORM PROGRAM... 2 A. The State of Karnataka... 2 B. Kamataka's Reform Program... 4 III. WORLD BANK ASSISTANCE STRATEGY... 9 A. Country Assistance Strategy... 9 B. The Bank's Assistance Program in Kamataka IV. KARNATAKA'S FISCAL AND GOVERNANCE REFORMs..12 A. Overview.12 B. Fiscal Reforms and Public Expenditure Management.13 C. Administrative Reforms.22 D. Private Sector Development.25 E. Poverty and Human Development Monitoring.27 V. THE PROPOSED LOAN/CREDIT A. Kamataka's Financing Needs B. Actions Activating the First KERL C. The Second and Subsequent KERLs D. Implementation Arrangements, Performance Monitoring and Outcomes E. Loan/Credit Administration VI. BENEFITS AND RISKS.35 A. Benefits.35 B. Risks.36 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

4 ANNEXES A. Karnataka Letter of Development Policy B. Kamataka Economic Restructuring Program Matrix C. Kamataka Medium-Term Fiscal Plan D. Kamataka Govemance Strategy and Action Plan E. Karnataka Policy on State Public Sector Reforms and Privatization F. Kamataka Deregulation of Business Environment G. Poverty in Karnataka H. Kamataka Poverty and Human Development Monitoring System I. Fiscal Annex J. Statistical Annex Map Task Managers: Advisors: Fiscal/Public Expenditure Management: Task Team Lili Liu; Stephen Howes (Senior Economists) Edgardo Favaro (Lead Economist); Sanjay Pradhan (Regional Advisor, Public Sector Management and Governance) Trichur K. Balakrishnan (Financial Analyst); Vikram K. Chand (Public Sector Management Specialist); Kanishka Ghoshal (Research Analyst); Stephen Howes; Sanjay Pradhan; Vinod B. Sahgal (Lead Evaluation Officer) Robert Beschel (Senior Public Sector Specialist); Vikram K. Chand; Sanjay Pradhan Administrative Reforms: Private Sector Development: Sameer Akbar (Environmental Specialist); Paramita Dasgupta (Economist); Sunita Kikeri (Lead Private Sector Development Specialist); Lili Liu Poverty Monitoring: Monica Jain (Research Analyst); Valerie Kozel (Senior Economist) Salman Zaidi (Econorist) Sectoral Inputs: Lucio Monari (Senior Economist), Djamal Mostefai (Lead Energy Specialist), Judith K. Plummer (Senior Financial Analyst), Sumeer Shukla (Financial Analyst) (energy); Guang Zhe Chen (Senior Economist, roads); Sajitha Basthir (Senior Education Economist, education); Hnin Hnin Pyne (Public Health Specialist), Tawhid Nawhaz (Lead Human Resources Specialist) (health) Legal Counsel: Syed I. Ahmed (Senior Counsel) FMS/Disbursement Officer: Hyacinth D. Brown (Senior Financial Management Specialist) Team Assistants: Shunalini Sarkar; Rita Soni; Juliet Teodosio

5 INDIA KARNATAKA ECONOMIC RESTRUCTURING LOAN/CREDIT Loan and Credit Summary Borrower: Govemment of India. Implementing Agency: Government of Karnataka. Beneficiaries: Amount: Terms: Onlending Terms: Description: State of Karnataka. Credit: SDR 58.9 million (US$75 million equivalent) Loan: US$75 million IDA: Standard with 35 years maturity and 10 years grace period Loan: Payable in 20 years, including 5 years of grace and annuity principal repayment; at six-month LIBOR for USD plus variable spread for Variable-Rate Single Currency Loans. Standard terms of central resource transfers for state developmental budgets. Karnataka is a state of 53 million people in the south of India. Karnataka's poverty and social indicators are about average for India, but there are significant disparities within the state. Karnataka's growth record is good, but its prospects may be dimming due to: (i) a rapidly declining fiscal position; (ii) a bankrupt power sector and other infrastructural constraints; and (iii) policies and regulations which deter private investment. To meet these challenges, Karnataka has embarked on a major reform program, and has already emerged as a leader among Indian states with respect to fiscal and governance reforms. The Karnataka Economic Restructuring Loan/Credit (KERL) would support the government's reform program in four areas. First, the fiscal and public expenditure reforms of the KERL include a multi-year framework for fiscal adjustment and reforms to improve fiscal transparency, tax and expenditure policies, public expenditure management, financial accountability, and procurement transparency, with the objectives of restoring the state's financial health, creating additional fiscal space for high-priority expenditures, and promoting more efficient and transparent management of the government's financial resources. Second, the KERL's administrative reforms focus on civil service reforms, freedom of information, service agency reforms, anti-corruption initiatives, decentralization, and e-governance, with the objectives of improving the efficiency and transparency by which government conducts its business and delivers services. Third, the private sector development component focuses on improving the business environment through deregulation and privatization/closure of public enterprises. Finally, the KERL supports the establishment of a poverty and human development monitoring system to enable the state

6 Benefits: Risks: Disbursement: Project ID Number: to better track the impact of its services, policies and reforms on poverty and social indicators. The proposed loan/credit will be disbursed in one tranche, and is the first in a proposed sequence of about four operations. The actions triggering the presentation of this operation to the Board have all been completed. The operation would support and help finance the reform program of the Government of Karnataka. Expected benefits for Karnataka from its comprehensive reforms include: (a) restoration of the state's financial health; (b) improved governance and service delivery; (c) higher levels of investment; and (d) higher economic growth, reduced poverty and improved social indicators. The operation reinforces recent initiatives by the Government of India to stimulate reforms in the states, and it is expected that Kamataka's reforms will encourage similar reforms in other Indian states. The major risks are: (a) non-adherence to the agreed fiscal framework; (b) delays in implementation of key sectoral reforms, especially in the power sector; and (c) resistance to institutional and governance reforms. The loan/credit would be disbursed in one tranche in an amount equivalent to US$150 million upon effectiveness. IN-P

7 -1- I. SETTING: ECONOMIC SITUATION AND RECENT DEVELOPMENTS IN INDIA 1. India has seen a fundamental economic transformation over the last ten years which has put the economy on a higher growth path, and improved prospects for poverty reduction. Economic growth initially surged to an unprecedented 7% for several years, with a decline to around 6% since Inflation has fallen in recent years to around 5-6% on an annual average basis. The current account deficit of the balance of payments has remained in the range 1-1.5% of GDP, while India's extemal debt to GDP ratio (21% at present) and debt service ratio (20% of current account receipts) have declined continuously. 2. India's fiscal position improved in the first half of the nineties, but deteriorated in the second half, with increases in both the central and state government deficits. Some fiscal adjustment can be observed at the central level since , but the Government of India (Gol) has succeeded so far in preventing a further rise in the fiscal deficit, but not in bringing the deficit back down to the levels of the mid-nineties. Gol has proposed a Fiscal Responsibility Act to provide legislative backing to its fiscal reform efforts. A key fiscal challenge lies at the state level: combined state deficits now contribute almost half of India's general government deficit, up from less than one-third in the mid-nineties. While India's system of center-state transfers is basically sound and provides a largely transparent, predictable and rule-based framework, certain weaknesses do exist in the fiscal federal arrangements. In particular, weak linkages between resources and performance have resulted in inadequate incentives for fiscal reforms at the state level. Building on initiatives started in 1999, and the report of the Eleventh Finance Commission, a Fiscal Reform Facility has been established by Gol to provide grant funds (about US$2.5 billion over four years) to states which improve their fiscal performance. 3. The pace of reform at the central level has undoubtedly slowed from the early nineties where the impetus of a macroeconomic crisis led to quick action and a number of "stroke-of-the-pen" reforms. India's strong performance since has significantly reduced the possibility of a macroeconomic crisis, but the remaining reform agenda is much more difficult to implement, with significant institutional and legislative changes required. However, reforms have continued. Significant initiatives in the last few years include: trade liberalization, with a progressive lifting of quantitative restrictions (QRs) completed by April 1, 2001; further liberalization of normns governing FDI flows; deregulation of important sectors from restrictive small-scale industry reservations; the end of the public monopoly on insurance; and strengthening of prudential regulations and enforcement in the banking system alongside with legislation presented to Parliament to reduce to a minority holding the government stake in banks. Progress has been lacking or too slow, however, with respect to privatization of public manufacturing enterprises, reforms in labor legislation, and deregulation of agriculture, though the February 2001 budget speech proposed important measures in each of these areas. The recent report of the Prime Minister's Economic Advisory Council provides a road map for structural reforms to accelerate growth to 7-9% which would in turn help accelerate the pace of poverty reduction. 4. State reforms. There is a consensus that many of the reforms required to accelerate India's growth and poverty reduction need to be implemented by the states. These include not only fiscal reforms to address the resource constraints which are increasingly circumscribing the states' developmental role, but also power sector reforms to address a fundamental source of fiscal pressure and constraint to growth, and governance reforms to make state governments smaller, more accountable and effective in the delivery of services. The momentum for reforms is definitely growing at the state level as an increasing number of states embrace fiscal, governance and sectoral reforms.

8 -2-5. IMF perspective. In its May 2000 staff report, which was discussed by the IMF's Board in June, 2000, the staff noted that, notwithstanding India's recent strong growth performance, there remain important impediments to maintaining high growth and achieving the authorities' objectives for poverty reduction. In particular, failure to address the fiscal situation and implement needed structural reform could undermine the economy's growth potential and also leave it increasingly vulnerable to adverse shocks. On the fiscal front, the staff stressed the need for an ambitious and time-bound program of fiscal deficit reduction, and supported the authorities' stated objective of eliminating the revenue deficits of the central and state govemments in order to achieve fiscal sustainability. To support this objective, the staff recommended expenditure and tax reforns, buttressed by fiscal responsibility legislation and reforms in center-state relations. On the structural side, a broad range of reforms was considered needed in order to enable India to benefit from the increased globalization of trade and investment flows. These measures included liberalization and reform in the agricultural and power sectors, regulatory reforms to increase labor market flexibility, improvements in the legal mechanism for debt recovery, continued financial sector reforms and trade liberalization. The IMF Board consideration of the 2001 Article IV consultation is scheduled for late June. 6. Growth and poverty. Despite data inconsistencies and limitations, there is a growing consensus that poverty did fall over the nineties, though whether the decline has been as rapid as suggested by recent official statistics is a matter of debate. It seems that there is a rise in regional disparities, with the fastergrowing southern and western states leaving the slower-growing northem and eastem states behind. Some increase in regional disparities may be the inevitable result of greater policy responsibility passing to the states, and a more direct link between state government performance and state development. 7. Recent political developments. India saw three elections in three years during The election of September 1999 led to a relatively more stable coalition govemment, its members being elected on the basis of a common program. On balance, this has led to some acceleration on the reform front. However, expectations of rapid reform have given way to the realization that the pace will still be gradual because of the political cost of reforms, coalition politics, and the diversity of opinions within the country. A number of recently elected state govemments have begun to speak the language of reform and initiate important changes, with some outpacing the reforms of the central govemment. Several state governments have shown considerable determination in backing reforms in the face of opposition and strikes. A. The State of Karnataka II. KARNATAKA AND ITS REFORM PROGRAM 8. Kamataka is India's 8th largest state with a population of about 53 million. It is one of India's states which has most benefited from the liberalization of the nineties. As Table 1 shows, average growth in the 1980s at 4.8% was below the all-india average of 5.4%; but growth in the 1990s averaged 6.9%, above the all-india figure of 6.1%. Agricultural, industrial and services growth in the 1990s were all up on the 1980s and exceeded all-india averages for the 1990s. Table 1. Sector-Wide Growth of Real GSDP in Karnataka and All-India, (%) Agriculture & Allied Industry Services Real GSDP Services 1980s 1990s 1980s 1990s 1980s 1990s 1980s 1990s Growth Kamataka All India Share in GSDP Kamataka All India

9 -3-9. Despite this progress, Karnataka's per capita income (at US$410)is still slightly below the national average. The state is heavily dependent on agriculture, more so than India as a whole (Table 1). Literacy is at average levels for India. Infant mortality is lower than the India average, but above the more relevant comparator of South India (Table 2). There are various estimates of poverty in Karnataka: poverty levels in the state seem to be either at or above the all-india average. (Annex G, on poverty in Kamataka, provides more detail.) Intra-regional disparities are sharp in Karnataka with the northern regions of the state having the highest concentration of poverty. There are also social divides: women and the population comprising scheduled castes and scheduled tribes appear to be disadvantaged in accessing opportunities in the nonfarm sector and on average suffer lower welfare outcomes. Table 2. Selected Indicators of Economic and Social Development Unit Karnataka Southern All India States* Rural Poverty Headcount Index ('93) % Urban Poverty Headcount Index ('93) % Infant Mortality Rate('97) per ' Overall Literacy ('97)\a % Female Literacy ('97)\a % Per capita income ('97) ( prices) Rs lafor population of age 7years and above * Average ofkarnataka, Tamil Nadu, Andhra Pradesh, Kerala Sources: Infant Mortality Rate - Sample Registration System Bulletin, Oct '98; Overall Literacy and Female Literacy - National Sample Survey Press Brief 1997; Poverty Headcount Ratio - India: Achievements and Challenges in Reducing Poverty, World Bank Karnataka faces several developmental challenges: * The first is to sustain growth. Karnataka's high growth rates hide a number of serious problems. The fastest growth sector over the last five years has been information technology, with Bangalore known as one of the top ten high-tech cities in the world, and accounting for over 35% of India's software exports. However, many other industries are stagnating with an increasing number of sick firms. Karnataka's future growth will be within a more competitive environment, due to the phasing out of QRs on imports in April 2001 and the expected phasing out of the Multi Fiber Agreement (MFA) by 2005, and the expected further reduction in import tariffs which remain high. Improving the climate for investment in Kamataka - through, inter alia, improving infrastructure, deregulating, and reducing bureaucratic harassment - will be critical to improving growth prospects. * Accelerating growth and employment in rural areas is key to poverty reduction. Increasing the area under irrigation is vital, but at most 1/3 of Kamataka's arable land can be brought under irrigation, so improving dryland productivity is just as important. The rural non-farm sector in Kamataka is relatively underdeveloped, contributing only 20% of rural income, compared to an India average of 30% and 46% in neighboring Tamil Nadu. A massive expansion in rural infrastructure and connectivity will be needed to broad-base economic growth. * Human capital and social infrastructure are still sadly lacking. A large percentage of the rural population in Kamataka has virtually no education. Some 74% of poor rural household heads are illiterate. Another 13% are educated only up to some level below primary. The rural poor are also almost entirely unserved by modern sanitation infrastructure and reside in homes with earthen floors. Expanding social infrastructure and improving service delivery throughout the state is the third challenge facing the Government of Karnataka (GoK).

10 -4- B. Karnataka's Reform Program 11. A Congress Party government was elected to power in Karnataka in November 1999 with a comfortable majority (132 out of 224 seats). The new Government's reform agenda for the "eradication of poverty through economic growth tempered with equity" is set out by the Chief Minister in his March 2000 and 2001 budget speeches (Box 1). Box 1. Karnataka's 10-Point Reform Program: Chief Minister's Budget Speech, March The topmost priority, to eradicate poverty, empower women, and provide food and nutritional security for vulnerable sections. 2. To achieve a minimum 7-8% growth per annum for the next five years. 3. To strengthen the foundations of agriculture and give it a new momentum. 4. To expand irrigation and utilize irrigation potential created more effectively. 5. To expand the state's infrastructure, through more resources but, equally important, through better management, and innovative organizational mechanisms. 6. To mount an assault on social backwardness. 7. To provide a conducive climate for new investments. 8. To provide the people of Kamataka with a transparent, responsible, responsive and decentralized government. 9. To mainstream the backward regions, particularly in the north, into the development process. 10. To develop a fiscal system that serves the needs of the poor, a pattem of public expenditures that addresses pressing socio-economic concerns, and that keeps the state away from a debt trap. Fiscal and Governance Reforms 12. Karnataka has always been one of India's better managed states. Its fiscal indicators are among the best of any Indian state, and its bureaucracy among the more capable. Law and order is not a serious issue. Nevertheless, Karnataka faces serious problems. Its fiscal position is rapidly deteriorating, and its power sector is hurtling towards bankruptcy. The Government of Karnataka is by no means immune from the governance problems which afflict both state and central governments in India. "Non-transparency, limited accountability,... and inadequate performance appraisal weaken the civil service's administration, as do the standard problems of political interference in specific situations and government's widespread and intricate interventions that delay actions, create unwarranted power and provide opportunities for corruption."' 13. Karnataka has therefore embarked on a major program of fiscal and governance reform, and has quickly established itself as one of the states leading reforms in these areas (Box 2). On the fiscal front, after two years of successive rises, the budgetary fiscal deficit is estimated to have fallen in as a percentage of GSDP on the back of strong revenue growth and expenditure restraint. The Government is now building on this correction, to tackle off-budget sources of fiscal weakness, and to achieve its announced medium-term fiscal goals through a Medium Term Fiscal Plan (MTFP). Creation of an Administrative Reforms Commission has given rise to a new Governance Strategy and Action Plan, which sets out the govemment's goals for improved service delivery through civil service reform, greater transparency, less official discretion, and a campaign against corruption. The Government has also started to rid itself of the burden of state-owned commercial enterprises, and has launched a business deregulation drive to improve the investment climate. The proposed loan/credit is designed to help broaden and deepen the government's fiscal/governance reform program (Section IV provides more details). The following paragraphs briefly outline Karnataka's sectoral reforms. 1 "India: Policies to Reduce Poverty and Accelerate Sustainable Development," World Bank, January 2000, also referred to as the Social and Structural Policy Review (SSPR), 2000.

11 -5- Box 2. Karnataka: One of the leaders in fiscal and governance reform among India's states oi First state to enact a Transparency in Public Procurement Act Q Has enacted India's most progressive Right to Information Act E First state to introduce a legislative cap on government guarantees o Leader in fiscal transparency (first state to publish monthly financial accounts, to release to the public information on tax expenditures and tax arrears, and to introduce an "Action Taken Report" on previous year's budget commitments; one of the first to publish an accessible fiscal overview) /2001. Li The most advanced state in terms of institutionalizing a medium-term budgetary perspective (e.g., the first to establish an Expenditure Review Committee) /2001. o First state to commllit to introduction of Fiscal Responsibility Bill o o One of the leading states in respect of preparation for VAT introduction - ongoing. One of the first states to publicly monitor and take measures to reduce premature transfers of civil servants Power Sector Reforms 14. Power sector reforms are critical to Karnataka's growth and to the success of fiscal reform. Serious power shortages, unreliability, and losses and theft (officially estimated at 37%, but possibly much higher) have made the power sector the leading infrastructure constraint for the state. High-tension industrial consumers have already started to leave the utility's grid. 80% of industries have back-up power, substantially reducing their competitiveness, particularly that of small and medium firms, and seriously reducing the opportunities for off-farm employment and broad-based growth. Half of the rural population still does not use electricity at home. 15. In addition, Karnataka's power sector deficit is increasing rapidly and poses the most serious threat to fiscal sustainability in the state. From about 1% of GSDP for the first half of the nineties, the power sector deficit has more than doubled (reaching about 2.1% of GSDP in ). Losses in the power sector are mainly due to high theft and losses and a heavy subsidy to agriculture, estimated at Rs 18 billion, only part of which is met by cross-subsidies from industry. The causes for the recent financial deterioration in the power sector include: increased reliance on thermal generation, and purchases from new and relatively expensive private power producers; higher fuel (coal) costs; and the departure of high-paying industrial consumers from the grid. Tariffs were not increased from 1998 to January Reforming the power sector has thus become an important part of GoK's comprehensive reform efforts. The ultimate objective of the power sector reforms is for the Government to withdraw from the power sector as an operator and regulator of utilities. Consumers would be provided with reliable, highquality and cost-effective electricity supply by creditworthy and commnercially operated, largely privatelyowned utilities functioning in a competitive and appropriately regulated power market. The power sector would cease to be a drain on public finances, and a constraint on growth. 17. First Phase of Reforms Completed. Several key reforms have already been implemented: * The Karnataka Electricity Reforrn Act, which embodies the above vision, was enacted in 1999, and the Cabinet has recently approved various amendments to this Act to strengthen it. * The Cabinet approved in December 2000 a power sector reform policy based on the privatization of distribution. * An independent Karnataka Electricity Regulatory Commission (KERC) has been established and in December 2000 awarded Kamataka's first tariff increase since 1998.

12 -6- * The Cabinet has approved a new policy to rationalize its generation expansion consistent with financial viability. A decision not to provide any escrow cover for new independent power producers (IPPs) has been announced. * Various policies to crack down on power theft have been introduced (a collection drive, use of profit centers), and collections have improved in recent months. * GoK has commissioned environmental and social assessments of power sector reform, and has developed a reforms communications strategy. * The Cabinet has approved a Financial Restructuring Plan (FRP) for the power sector, to map out a path towards reduction, and eventual elimination, of the power sector deficit, and the Board of Kamataka's main power sector utility, KPTCL, approved a budget for the utility for consistent with this plan. 18. The FRP for the power sector has important implications for GoK's objective of restoring fiscal health in the state. The FRP sets out a gradually declining path for the power sector deficit - from 2.1% of GSDP in to 0.8% of GSDP in This would significantly contribute to reducing the fiscal deficit over the medium term - from 7.2% of GSDP in to 3% of GSDP in , as set out by the MTFP (see paras and Table 3). The declining power sector deficit as articulated by the FRP is predicated on several important reform measures. Eliminating the power sector deficit is a challenge that can only be met in the medium term. In the near term, the FRP focuses on improving the sector's operational performance based on expanding metering, improving billing and collection, tariff adjustments, and preparing for privatization. 19. Specifically, the measures underlying the FRP include: (i) a reduction in losses and theft from 37% currently to 28% over 5 years; (ii) an improvement in collection efficiency so that receivables fall from 95 days currently to 85 days over 5 years; (iii) universal metering within three years; and (iii) annual tariff orders from the KERC so that the average tariff approaches cost recovery. The FRP also limits power supply to agriculture below available levels, assumes limited new generation capacity, and contains capital investment in transmission and distribution to about Rs 52 billion over five years all in line with the sector's financing capability. The FRP for the power sector is a rolling document which is realized through the annual budget of KPTCL. The Govemment plans to monitor the power sector deficit on a monthly basis so that it can take prompt action to keep the deficit within the prescribed limits. 20. Next Phase of Reforms. The 2001 budget confirms the Government's commitment to the next phase of power sector reform, mainly via commitments to: * The govemrnment meeting in full its financial obligation to the power sector, as set out in the MTFP. * Universal metering within the next three years - this is a crucial step to capping the massive power subsidy to agriculture (most farmers are currently not metered) and reducing theft of power. * Introduction of new legislation in 2001 to curb the theft of power, including severe punishment and the establishment of special courts to deal with such crimes. * The privatization of distribution in Near Term Outcome. By the end of calendar year 2001, significant progress in these areas is expected: * Progress towards privatization as measured by the adoption of a privatization strategy and the unbundling of KPTCL into separate transmission and distribution companies.

13 -7- * Submission of a tariff application by KPTCL and the implementation of KERC's second tariff order. * Loss and theft reduction as measured by (i) substantial progress in implementation of the 3-year universal metering program, with a target of 150,000 meters installed, and (ii) an anti-theft legislation enacted and anti-theft program intensified, with the aim of reducing loss and theft from the current 37% to 34% by the end of the fiscal year. Other Sectoral Reforms, and Interlinkages 22. Reforms in the road sector. Inadequate road infrastructure and its deterioration have adversely affected the spread of growth beyond Greater Bangalore. The Government plans to expand spending on roads and bridges with increased reliance on the private sector for construction, maintenance and financing. Important institutional reforms are planned for the sector. An institutional strengthening action plan for the sector has recently been approved by GoK. The plan aims to transform the Public Works Department (PWD) from a traditional public-sector roads department to a performance-oriented and user-responsive modem road agency. Major changes outlined by the Plan include: * Separation of the roads and buildings function of PWD into two separate departments (Highways and Buildings). * Expanded private sector participation in the road sector through outsourcing and oversight of road sector management by a Road Users Board. * Improvements to financial management, audit and accountability, and a computerization program to support the modernization of road management. 23. Water Supply and Sanitation. A major thrust is being given to improving water supply and sanitation, now recognized as a maj or health determinant. Currently, only 72% and 24% of households have access to safe drinking water and toilets, respectively, with high costs in terms of both public health and the environment. Both urban and rural water supply and sanitation sectors in Karnataka suffer from chronic inefficiencies, unreliable service quality, limited coverage, and low cost-recovery. e In the rural sector, the Government is turning to greater community participation and cost-sharing as the solution. Its new Rural Water Supply and Sanitation Policy ( ) targets an increase in rural areas in drinking water availability from 40 litres of water per capita per day to 55 litres for all households by 2005, as well as improved quality (fluoridation is a major problem), and Total Village Sanitation through provision of better paving, drainage, solid waste management practices and smokeless cooking fuels, as well as the construction of household, group and community latrines, and information campaigns. The strategy relies on a participatory, demand-driven approach with a target of 100% paymnent of O&M and 15% of capital costs by users, organized into village Water Supply and Sanitation Committees. * In urban areas, the Government is implementing private sector solutions. GoK is in the process of preparing a policy paper on Urban Water and Sanitation, which will serve as a basis for urban water reforms, including the introduction of private sector management, recently approved in principle by the Cabinet. 24. Education sector. GoK's target is to ensure that by 2007 all children in the age group 6-14 years are in school and complete 8 years of elementary schooling. To achieve this goal, Government has taken up a number of actions, including: hiring of additional teachers (15,000 in ); a large school and toilet/drinking water construction program; and a new program to bring drop-outs back to school. In 2003, Karnataka will increase the elementary cycle from 7 to 8 years. Teacher quality is expected to improve

14 -8- with the introduction of a transparent exam-based recruitment system. Looking beyond elementary education, GoK has established an Education Task Force, and is the first among Indian states to undertake a sector study of education covering all levels of education. The report will provide recommendations for policy and institutional reforms to improve the effectiveness of public educational services as well as the management of government support to private educational institutions. 25. Health. GoK has set health and nutritional goals including reductions in infant and matemal mortality/s and malnutrition, and better control of communicable diseases, such as TB and HIV/AIDS. To achieve these goals, the recommendations of the Task Force on Health have already begun to be implemented, including the filling up of vacant posts of doctors and para-medics, and increased supply of essential equipment to and enhanced budgets for Primary Health Centers (PHCs). As in education, transparency has been introduced into the recruitment of medical personnel. Service delivery is being improved by greater reliance on performance monitoring and user feedback. The Govemment has already begun to invite NGOs and the private sector to manage PHCs. To improve the supply of doctors to rural areas, compulsory rural service for post-graduate medical students is being introduced. 26. Agricultural productivity. An Agricultural Commission has been established, led by extemal experts, to recommend measures to boost agricultural productivity. GoK has also established a Global Advisory Networking Group on Agriculture to draw on expertise from outside of India. 750 Farmer Contact Centers have been set up across the state to disseminate scientific and technical advice to farmers. New seeds are being developed and tried. A multi-disciplinary Watershed Development Department has been established to improve agricultural productivity in drylands. Programs for attracting private sector investment into cold storage, agribusiness, barren lands, and biotechnology, with adequate safeguards, have been introduced, including a plan for the development of 5 agro-processing parks. A reform program has been initiated in the irrigation sector, with a new ordinance to establish water-user groups, and increased funding being made available for O&M (matched by a more than doubling of water charges on the revenue side). 27. Public-private partnerships. Underlying all of these initiatives is a strong emphasis on consultations and public-private partnerships. To promote private sector participation in infrastructure, the Infrastructure Development Corporation of Karnataka has been established as a joint venture. Some 10 task forces have been established covering topics from health and education to infrastructure, IT and biotechnology to provide the government with outside thinking. The Bangalore Agenda Task Force has been particularly effective in providing private-sector solutions for the Bangalore municipal government. The Govemment's partnership with the Confederation of Indian Industries has resulted in, among other things, the Global Investors Meet, which attracted firms and publicity around the world, and resulted in US$6 billion of investment proposals. The Govemment has been consulting the business community in the formulation of a medium-term strategy for business deregulation. The Government has also sought partnerships with a number of financial institutions, chief among them the World Bank, but also, from within India, IDFC and Hudco for infrastructure financing. 28. Interlinkages. While the Government's reform program is most easily described under the various fiscal, govemance and sectoral heads, the linkages between the various elements of the reform program cannot be over-emphasized. The inter-relationships between fiscal and power sector reforms were articulated by the Kamataka Chief Minister in his 2001 budget speech: "We cannot attack poverty and we simply cannot invest more in social and physical infrastructure if we do not improve the state 'sfiscal position. And without a fundamental change in the way the power sector is organized, managed and financed today, fiscal improvement will be impossible. " Links between govemance reforms and improvements in service delivery are equally important. Core governance reforms to promote transparency in procurement and recruitment will result in practical benefits of better teachers and cheaper schools. Likewise, governance reforms piloted in individual sectors can be scaled up to benefit all sectors. This can be seen through the transparency in recruitment initiative which began in the education department.

15 Link to poverty reduction. Poverty reduction is GoK's central objective (para. 11). Overall, the Government's program appears to be well-designed to achieve this goal, based on the following policypoverty links: * The focus on improving agricultural productivity is well-justified given that 69% of Karnataka's poor live in rural areas, and that 80% of rural income in the state is derived from agriculture. * The Government's regional emphasis on investments in northern Karnataka derives strong support from the large inter-district disparities in the state's poverty profile. * The focus on expanding social and physical infrastructure is consistent with the poor's greatly reduced access to such infrastructure (Annex G). * The Government's fiscal and governance reforms hold various potential benefits for the poor, including a more pro-poor expenditure pattern, a better business environment for small business, greater opportunities for off-farm employment, and a lower burden of corruption on the poor (see para. 123). 30. Implementation of the Government's reform agenda has been impressive, but difficult at times. Unpopular and controversial steps have been taken, in particular the hiking of various user charges. In January 2001, GoK, while accepting the electricity regulator's tariff rulings for other customer categories, decided to provide another subsidy to agricultural customers rather than increase the agricultural tariff, thus "buying down" the tariff increase from 17% to 12%. Attempts to increase higher education fees and to reduce government support for private higher education institutions have also been partially rolled back after protests. While the financial impact of these decisions is individually relatively small, the decisions themselves are significant, though not unusual for a reforming Indian state. A. Country Assistance Strategy III. WORLD BANK ASSISTANCE STRATEGY 31. The Country Assistance Strategy (discussed by the Board on April 5, 2001) aligns Bank Group assistance with India's poverty reduction strategy, as defined by its Ninth Five Year Plan, the main themes of which are strengthening the enabling environment and supporting pro-poor interventions. This proposed Loan/Credit is aligned to the CAS theme of strengthening the enabling environment by improving government effectiveness and promoting private-sector led growth. The CAS highlights three strategic principles to guide the Bank Group's assistance program, namely, selectivity, reliance on partnerships, and adoption of a programmatic approach. Based on the selectivity principle, the strategy focuses on reforming states, something which started with the previous CAS, and which has been endorsed by the recent Country Assistance Evaluation for India. 32. Lessons learnt from state reforms. The Bank has been supporting comprehensive reforms at the state level for about three years, beginning with Andhra Pradesh, then Uttar Pradesh, and most recently Karnataka. The Bank's state-focus strategy is viewed as successful within India and by the donor community. There has been growing competition by states for Bank support, which in turn has helped create incentives for reforms. By focusing on reforming states, the Bank can use its resources more effectively by forging deeper, more focused, and longer-term partnerships for reforms and development. The use of programmatic adjustment lending in Uttar Pradesh for the first time (in April 2000) proved very useful for supporting reforms in that state. At the same time, state-level reforms have in general been more difficult to sustain than expected. From three years of Bank support to state reforms the following lessons have emerged:

16 -10- * A long-term perspective is needed both because the structural and institutional reforms facing the states are long-term in nature and because the adjustments needed are so large that economic and political economy considerations imply that they be introduced in a phased manner. * Correction of the distortions and fiscal excesses of several decades touches on many vested interests, and is often met with strong resistance, including strikes and riots. Government ownership of the reform program is essential. Flexibility on the part of the Bank is also important, including the ability to intensify support when reforms build momentum, or to disengage when reforms go off track. * Many of the reforms carry large short-term costs, and gains only in the longer run (e.g., utility tariff increases before improvements in service delivery). Much needed increases in development spending, on deferred maintenance and health and education, and improvements in governance, all of which can have immediate effects on delivery of services, help bring forward the benefits of reform and increase their acceptability. 33. While support for individual reforming states is central to the India CAS, it is only one part of that strategy. At the state level, in collaboration with the Planning Commission and other Indian institutions, the Bank is trying to spread the lessons of reform across all states and to broaden and deepen the momentum for reform. The Bank continues to engage with Gol on a range of national issues via a large AAA program. It also supports Gol initiatives to link central resources and performance (para. 2), which will strengthen incentives for reforms. Areas where joint action is needed by central and state governments are the reform of indirect taxes and modernization of financial management. The Bank can be effective in such areas by working at both the state and national levels, by bringing in lessons from other countries, especially other federations, and by encouraging learning across states, and between the center and states. 34. The India CAS also reflects an increased emphasis on fiscal and governance reforms, the former following from India's fiscal deterioration in the second half of the nineties (para. 2), and the latter from an emerging consensus in India that without better performance, governments will have neither the credibility to persuade their citizens to pay taxes, nor the capability to convert public resources into growth. As the Secretary of India's Planning Commission has recently remarked: "[S]tates will be neither able to end the fiscal crisis nor to restore growth unless they are able to address problems of governance." 35. The final aspect of the CAS relevant to this operation is an increased reliance on programmatic adjustment lending. Programmatic budgetary support combines the flexibility necessary in the Indian political environment with a medium-term approach required to implement India's deep and difficult structural reform agenda. It allows for a tighter focus on policies, a better link between Bank support and the budget, and provides important financial backing to state-level reform programs. Under the CAS base case scenario, US$ million per annum is envisaged for use in adjustment lending to support reforming states. B. The Bank's Assistance Program in Karnataka 36. Karnataka approached the Bank through the Government of India for support in late Since then a substantial program of assistance has been developed. In line with the CAS, it has a number of distinguishing characteristics: (i) it is aligned to the government's reform program; (ii) it is focused on poverty reduction, with a particular geographical focus on the poorer, arid regions of the state; and (iii) it is programmatic in nature, with a sequence of interventions designed to further government reforms and goals. 37. As mentioned (para. 32), working at the state level allows the Bank to take a CDF-approach, cutting across sectors and individual operations, in a way that is both comprehensive and integrated. The size and sequencing of the program depends on the extent and pace of overall reforms in the state. In particular, the

17 -11- experience of other states shows that power and fiscalgovemance reforms are critical to the Govemment's poverty reduction efforts (para. 29). Progress with respect to these twin pillars of reform will determine the size and scope of Bank assistance to Karnataka. Given the close link between the power sector deficit and the success or otherwise of fiscal adjustment (paras. 15, 18), progress in power sector reforms (paras ) will determine the state's capacity to efficiently absorb Bank financial support, and thus will be a key determinant of the size and scope of Bank assistance to Kamataka. 38. Instruments. The program of support being provided by the Bank to Kamataka consists of analytical work, technical assistance, adjustment lending, and investment lending: * Analytical work has informned the Bank's assistance and dialogue, and helped build consensus for reform. In 1998, the Bank conducted a comprehensive economic report/public expenditure review of Kamataka, Karnataka: Economic Reforms for Sustained Growth. More recently, the Bank has completed a number of policy notes, including: a fiscal assessment; a poverty note; a note on growth prospects and the business environment; a prelimninary financial accountability assessment; and a draft rural policy review. A procurement assessment will commence shortly, and a State Financial Accountability Assessment will be undertaken this year. Two background studies on the financing of education, and on labour market and training needs are underway. A report on rural decentralization in Kamataka has been completed. * Technical assistance is being provided through the India Technical Assistance for Economic Reform Credit to support VAT introduction and power sector reforms. In the future, technical assistance is expected to support civil service reform as well, and the govemment's poverty monitoring. Technical assistance from AusAID will be used to strengthen public expenditure management. - Programmatic adjustment lending (PSAL) is proposed to support Kamataka's core fiscal and govemance reforms (i.e., Kamataka Economic Restructuring Loans/Credits - KERLs). The KERLs are envisioned to be a series of one-tranche loans/credits based on up-front fiscal and govemance reforms. They would help provide financial backing to the state's reform program, and protect high-priority development expenditure. Because the pace of reforms determines the state's capacity to use resources efficiently, each KERL will follow the adoption of reforms and be based on the need for financing. This approach takes full advantage of the flexibility which the PSAL framework offers, with an expectation of annual or biannual loans/credits depending on the pace of reforms and financing needs. * Investment lending is also proposed to support Kamataka's reforms, including sectoral reforms in the power, infrastructure and social sectors and priority pro-poor rural interventions. The reforms supported by these investment projects complement and deepen in each sector the fiscal and govemance reforms to be supported by the adjustment lending. Three loans/credits are at a relatively advanced stage: Kamataka State Highways Improvement Project, negotiated in April 2001, the Kamataka Watershed Development Project and the Second Karnataka Rural Water Supply and Sanitation Project. 39. Sectoral priorities. The Bank's support in Kamataka is spread over a number of priority sectors: * In the power sector, the Bank is supporting reforms through the provision of technical assistance and dialogue. Discussions are currently underway conceming a possible investment loan to help the rural sector adjust to commercial electricity pricing, by enhancing rural power supply and possibly other infrastructure facilities, and accelerating metering (paras ).

18 -12- * In the urban sector, the Bank is supporting the government's policy shift towards private sector participation in urban water: an urban water project under preparation will support private sector management of urban water delivery in poorer northern towns (para. 23). * A state highways project is underway to improve highway capacity and maintenance and support important institutional reforms in the roads sector (para. 22). * A number of Bank-supported health projects are already underway in Karnataka, including for infectious diseases, such as HIV/AIDS, for reproductive health, and for strengthening of the state's health system. A follow-up health system project is under consideration to assist the government implement its new health reform agenda (para. 25). * In education, the Bank is helping Karnataka universalize education through the District Primary Education Program, targeted at districts where female literacy is low (para. 24). * Three community-based rural projects are under preparation to improve rural livelihoods especially in the poorer and arid north - rural water supply and sanitation, irrigation tank rehabilitation, and watershed development. The Bank also has a dialogue on rural policy and have completed a draft rural policy review. Karnataka participates in the Bank-supported Rural Women's Development and Empowerment Project. - Environment. Kamataka participates in the Bank's Industrial Pollution Prevention Project which is supporting institutional strengthening of the Karnataka Pollution Control Board. 40. Partnerships. The Bank is providing its assistance in partnership with other institutions. In the power sector, GoK has signed reform-based MoUs with both Government of India and the Infrastructure Development Finance Corporation. In the watershed project, the Bank is collaborating with other bilaterals who have supported similar projects, including the Swiss Development Corporation and Danida. AusAID (Australia) is arranging technical assistance for public expenditure management reforms and is supporting water sector reforms in Bangalore. The Institute for Social and Economic Change (ISEC) is carrying out a large amount of analytical work to support the Government's reforms. IV. KARNATAKA'S FISCAL AND GOVERNANCE REFORMS A. Overview 41. Main issues. As mentioned (para. 12), Karnataka is one of India's better managed states, with a stronger fiscal position and more robust and effective institutions than many states. However, a fiscal crunch together with weaknesses in governance have undermined government effectiveness. In Karnataka, as in many other Indian states, critical problems that have undermined the quality of public administration and service delivery include the politicization of the transfer process, the lack of openness in government, corruption in the tendering process, a weak performance evaluation system for government schemes and operations, over-regulation of private businesses, and the failure to adequately prioritize and program expenditures over time because of the absence of a medium-term fiscal framework. 42. Yet Kamataka also holds the promise of real improvement in public sector management. It is already one of the leaders among Indian states with respect to fiscal and governance reforms (Box 2). The challenge is to deepen and broaden those reforms already underway, and thus ensure their success and sustainability. 43. Reform objectives. Karnataka's fiscal and governance reform strategy is two-pronged. As articulated in the Governance Strategy and Action Plan, the strategy aims to: "(i) Rationalize the role of the state to focus on the most critical public goods and services which the private market cannot effectively supply, and (ii) Enhance the effectiveness, transparency and accountability by which the state performs this role."

19 Strategy formulation. The Govemment has invested heavily in analytical work to inform and shape its reform program. In addition to work undertaken by the Bank (para. 38), the Government has received extensive reports from the Tax Reforms Commission and the Administrative Reforms Commission both of which the Chief Minister established a year ago. The Govemment has also commissioned various background papers and convened workshops in areas such as: subsidy targeting and management; poverty monitoring; governance reforms; improving the accuracy of budgetary estimates and forecasts; public expenditure management and business deregulation. On the basis of this work, the Government has prepared a number of policy papers. The two most important ones for this operation are: * The Medium Term Fiscal Plan (MTFP), the first version of which was approved by the Cabinet in September 2000, and a revised 2001 version of which was approved by the Cabinet in March 2001 and will be laid in the Legislature as soon as it reconvenes (expected June 2001). The MTFP sets out the government's medium-term fiscal policy (Annex C). * The Governance Strategy and Action Plan (GSAP) has also been approved by the Cabinet and will also be laid in the Legislature when it reconvenes. The GSAP sets out the Government's policies for improving governance and administration (Annex D). 45. Reform components. As per the Government's Letter of Development Policy, the various components of Karnataka's fiscal and governance reform program can be conveniently summarized under four headings: * The Government'sflscal and public expenditure reforms include a multi-year framework for fiscal adjustment as well as reforns to improve fiscal transparency, tax and expenditure policies, public expenditure management, financial accountability, and procurement transparency. The common objective of these reforms is to restore the state's financial health, create additional fiscal space for high priority expenditures, and promote more efficient and transparent management of the government's financial resources. * The Government's administrative reforns focus on civil service reforms, freedom of information, service agency reforms, anti-corruption strategy, decentralization, and e- govemance, with the objectives of improving the efficiency and transparency by which government conducts its business and delivers services. * The private sector development reforms focus on improving the business environment through deregulation and privatization/closure of public enterprises. * Finally, the Government is establishing a poverty and human development monitoring system to enable the state to better track the impact of its services, policies and reforms on poverty and social indicators. The sub-sections which follow provide more detail, as does the Government's policy matrix (Annex B). B. Fiscal Reforms and Public Expenditure Management Fiscal Analysis 46. Understanding Karnataka's fiscal position requires looking well beyond conventional budgetary deficits. Karnataka is one of several Indian states which, in order to gain access to additional sources of finance, make extensive use of off-budget borrowing for which debt servicing reverts fully to the budget. In , the budgetary fiscal deficit was 4.5% of GSDP. Consolidating on- and off-budget borrowing brings the fiscal deficit to 5.6% of GSDP. In addition, Kamataka, again like many states, has a

20 -14- significant and rapidly growing liability in the power sector which is only partially funded by the budget (the remainder being financed by arrears and/or utility borrowings). In , Karnataka's power sector deficit was 1.5% of GSDP, and the consolidated fiscal and power deficit 6.2% of GSDP (Table 3). 47. Kamataka's fiscal position has traditionally been stronger than that of many states. Its fiscal indicators have been well above average. Karnataka has not, unlike many states, run out of cash and been forced to resort to overdrafts with RBI or liquidity support from Gol. However, the state's fiscal situation has deteriorated sharply in recent years. It is now reaching close to crisis proportions, with rapidly mounting debt, and accumulating unpaid liabilities. For example, comparing with revised estimates for , the interest/revenue ratio has almost doubled from 12% to 20%, a revenue balance has become a deficit of 2.6%, and the debt stock (including off budget borrowing) has increased from 20.0% to 26.8% of GSDP. This deterioration has come in the second half of the nineties: the state's public debt stock actually fell in the first half of the nineties. 48. The sources of fiscal decline in the second half of the nineties include a large and growing power deficit (see para. 15), other expenditure pressures, and a declining revenue-gsdp ratio: * Apart from the power sector, there have been a number of other expenditure pressures on the state. The overly generous national pay settlement of the late nineties undid the beneficial impact of Kamataka's hiring restraint through the nineties. It brought the salary bill back to the level of the early nineties as a percentage of GSDP, and also pushed up the pension bill. The combined salary and pension bill was 7.0% of GSDP in up from 6.5% in the mid-nineties. Interest payments grew through the nineties by a percentage point of GSDP (up to 2.7% of GSDP in ) due to the growing debt burden and higher interest rates. Finally, the increasing reliance by Kamataka on off-budget borrowing has prevented the compression of capital spending seen in many other states (para. 53). While arguably good for the state's development, this has also pushed the deficit up, as well as average interest rates, as the off-budget borrowing has been relatively expensive. * On the revenue side, Karnataka is one of India's two or three highest-taxed states. However, the tax/gsdp ratio fell from 9.0% during the first half of the nineties to as low as 8.2% in , on account of low buoyancy of Kamataka's two most important taxes, the sales tax and excise. The low sales tax buoyancy reflects in part the industrial recession of the late nineties, but also inter-state competition, which drove down rates, and the proliferation of tax incentives. Non-tax revenue has fallen by about half a percentage point over the nineties. The fall in non-tax revenue is partly due to less lending to public enterprises, and so lower interest receipts, and partly due to falling cost recovery. 49. Fiscal outcomes for Revised estimates for indicate a reversal in the trend of increasing deficits over the late nineties, with a fall in the budgetary fiscal deficit from 4.5% of GSDP in to 4.0% in 2000/01 (Table 3), corresponding to the deficit staying approximately flat in nominal terms at Rs 42 billion. 2 However, Kamataka did not tackle off-budget sources of fiscal weakness in Net off-budget borrowing rose sharply in (from 1.1% to 1.8% of GSDP), as did the power sector deficit (from 1.5% to 2.1% of GSDP). As a result the consolidated fiscal deficit including power rose in to 7.2% of GSDP from 6.2% in Bringing these off-budget items under control is 2 It is importanto note that the figures are revised estimates. Revised estimates are often unreliable, though scrutiny in this case gives some comfort. Actuals will be available by December 2001, and will be used to confirm progress. The financial management and reporting reforms are intended, among other things, to improve the reliability of budget and revised estimates.

21 -15- critical to the state's fiscal health, and central to the govemment's fiscal reform strategy (see paras. 53 and 54). 50. Fiscal reform and public expenditure management strategy. The strategy of the government aims to regain fiscal sustainability, improve the composition of expenditures, and strengthen the fiscal and financial architecture of the state. As a first step, a White Paper was issued in March 2000 to build a consensus for fiscal reforms. The Government's fiscal reform and public expenditure management strategy includes the following elements outlined below: (i) development of a medium-term fiscal framework; (ii) promotion of fiscal transparency; (iii) revenue reforms; (iv) expenditure restructuring; (v) improvements in public expenditure management; (vi) strengthening of financial accountability; and (vii) reforms in procurement. Medium Term Fiscal Plan (MTFP) 51. The Medium Term Fiscal Plan (MTFP) is a rolling 4-year fiscal forecast. The first MTFP was approved by the Cabinet in September 2000 and was used to prepare the budget. This has now been updated, approved by the Cabinet in March 2001, and will be presented to the Legislature when it reconvenes, expected in June Subsequent MTFPs will be presented with successive budgets, along with reports on performance against previous MTFP targets. GoK intends to provide the MTFP with legislative backing - the March 2001 budget speech announces the intention of the state government to table a Fiscal Responsibility Bill. This is a first for an Indian state government (GoI has tabled such a Bill, but it has not yet been enacted), and could set a precedent which would significantly enhance fiscal discipline not only in Karnataka, but in all of India's states. 52. Medium-term objectives. GoK's fiscal objectives, as articulated in its MTFP, are to reduce the fiscal deficit to 3%, the revenue deficit to zero, and to stabilize debt as a percentage of GSDP by In terms of composition of expenditures, the MTFP aims to reduce the share of wages, pension, and non-merit subsidies and protect and promote high-priority development expenditures, particularly social sector and infrastructure spending (para. 68). The MTFP assumes real growth of 7.5%, the average for the second half of the nineties, and inflation of 6%. 53. Off-budget borrowing. The MTFP consolidates off-budget borrowing (defined in para. 46) with budget borrowing, and sets targets for the consolidated figures. This is important given the sharp rise in offbudget capital outlays (para. 48), which now exceed on-budget capital outlays. The major use of such offbudget borrowing is for major irrigation investments on the Upper Krishna River, completion of which in a time-bound manner is forced on the state by an inter-state water award. But the Government has since extended the use of off-budget borrowings to include other irrigation investments on the Krishna River, and other investments such as for roads and housing. These borrowings are actual rather than contingent liabilities, as it is expected from the start that debt servicing will fall on to the budget. Off-budget borrowing is non-transparent, and distorts and damages the integrity of the budget process. GoK has decided to reduce reliance on off-budget borrowing over time, and to eliminate it completely by the end of The MTFP sets specific annual, declining nominal caps on off-budget borrowing. In addition, to restrict and discipline access to off-budget borrowing in the course of the year, the Government's March 2001 Budget Overview for the first time sets out "budget estimates" for off-budget borrowing during not only an aggregate cap, but itemized by borrowing agency. 54. MTFP and the power sector. The MTFP includes allocations for the power sector sufficient to fully meet subsidy obligations and to reduce past arrears. As mentioned earlier (paras ), a Financial Restructuring Plan (FRP) for the power sector has been approved by the Government. The MTFP and FRP are fully consistent in that the amounts allocated for the power sector in the MTFP are those assumed as government inflows in the FRP. Just as the MTFP sets a declining path for the fiscal deficit to follow, so the FRP defines a declining path for the power sector deficit.

22 Adjustment path. The fiscal adjustment path set out in the MTFP is summarized in Table 3, which shows the various relevant definitions of the fiscal deficit. The consolidated fiscal deficit (including the power sector deficit), the broadest measure of fiscal health, falls annually starting in The fiscal (budgetary) deficit also falls annually, except in on account of a deliberate change in strategy towards funding the power sector deficit on budget, rather than funding it off-budget as in earlier years. Bringing the power sector deficit on to the budget and financing it in full, as against allowing the build up of arrears and maintaining budgetary support at its current inadequate level, represents a major claim on the budget, one which is essential to enable the government to push through privatization and thus tum the sector around (paras , 66). To abstract from this distorting impact, it is also useful to track the nonpower fiscal deficit, which is the fiscal deficit less budgetary support to the power sector. This is estimated to have fallen from 3.7% in to 3.2% of GSDP in , and is projected to fall further to 2.4% in Table 3. Aggregate Fiscal Indicators for Karnataka, to (% GSDP) RE BE Proj. Proj. Proj. Fiscal Deficits Fiscal deficit including off-budget borrowing and power sector (KPTCL) deficit Fiscal deficit including off-budget borrowing Fiscal (budgetary) deficit Non-power fiscal deficit Debt Stock Debt stock (including off-budget borrowings) On-budgetdebtstock Memo Items Net off-budget borrowing Power sector (KPTCL) deficit Notes: Figures calculated/taken from GoK MTFP / power sector FRP. The non-power fiscal deficit excludes gross budgetary support to the power sector. The fiscal deficit including off-budget borrowing adds net off-budget borrowing to the fiscal deficit. The fiscal deficit including off-budget borrowing and the power sector deficit adds to this the off-budget (unfunded) portion of the power sector deficit, i.e., the power sector deficit net of budgetary support to KPTCL. The power sector deficit is the cash deficit of KPTCL, Karnataka s main power utility. For more detailed definitions see Annex L Fiscal Transparency 56. Karnataka is a leader among Indian states in terms of fiscal transparency. Steps taken to date include: publication of a White Paper on state finances; a Budget Overview, which, for the first time, makes available to the public summary fiscal indicators as well as data on public debt, guarantees, subsidies, offbudget borrowing and tax expenditures (i.e., the cost of tax incentives) and tax arrears; posting of monthly financial accounts on the Internet; and publication of an "Action Taken Report," which reports on actions against commitments made in the previous year's budget speech. Publication of the MTFP and annual reporting against it will also improve fiscal transparency. 3 In , only a small fall in the fiscal deficit is projected. This is for two reasons: (i) an assumed temporary drop in revenue associated with the introduction of VAT (para. 110); and (ii) an increased debt-servicing burden for off-budget borrowing which is counted above the line in the budget. The more relevant consolidated deficits show substantial decline in : from 5.9% to 5.1% excluding the power sector deficit, and from 6.4% to 5.2% including the power sector deficit.

23 -17- Revenue Reforms 57. Although Kamataka has one of the highest tax/gsdp ratios in India, this ratio has fallen since the early nineties (para. 48). The goals of tax reform in the state are twofold: additional revenue mobilization, and reduced compliance costs. The strategies, covering both policy reforms and tax administration, are: rationalization, base broadening, simplification, and computerization. GoK has established a Tax Reforms Commission, chaired by a former Chief Minister, with an internationally renowned membership. Based on wide consultations with, and a survey of, tax-payers, the Commission has issued its first report which calls for a revamping of the tax system. 58. Sales tax reforms. The sales tax is Karnataka's most important tax, accounting for 57% of the state's own tax revenue. In line with the all-india agreement, sales tax incentives for new investments in Karnataka were abolished and floor rates for all commodities introduced in January These two reforms attack the two main sources of low buoyancy in the sales tax. Kamataka is also one of the first states to computerize its sales tax department. The above reforms, however, mark only a start. India has probably the most complex indirect tax system in the world. Rationalizing and simplifying it will require effort at both the central government and state level. At the state level, there is widespread agreement that states should convert their sales taxes into Value Added Taxes (VATs). VAT introduction, and associated administrative reforms, will have several benefits for Karnataka's tax payers: * The Government proposes to base VAT on self-assessment, so that most businesses will be able to file returns without direct interaction with government officials. The Government has announced an ambitious self-assessment scheme to start this year, with provision for random audit. * The Government will also move to a functional VAT administration, which will reduce opportunities for official discretion. * The VAT eliminates distortions caused by input taxation. * The VAT will replace not just the sales tax, but also the smaller turnover and entry taxes, thereby reducing the burden of compliance and the likelihood of harassment. Simple forms of the VAT will be used for small businesses. 59. A target date of April 2002 has been agreed on by the states for VAT introduction. No Indian state has yet successfully introduced a VAT. 4 While the target date is ambitious, Karnataka is expected to be one of the first to introduce VAT. Although much more work remains to be done, including in coordination with other states and Gol on interstate and national issues, preparations in Karnataka are at a relatively advanced stage. The first phase of VAT introduction, now complete, included a number of administrative actions, namely the setting up of VAT working groups and a full-time VAT team, the selection of consultants to assist with VAT introduction, and the issuance of a VAT discussion paper. In addition, Karnataka has also made important policy progress towards VAT, in particular via the introduction of self-assessment. This now applies to 90% of tax payers, putting Karnataka ahead of other states, significantly reducing dealerofficial interaction, and freeing up staff time for audit and enforcement. Self-assessment has been introduced on a retrospective basis, with the aim of eliminating the three-year scrutiny backlog within a matter of months. 60. Other taxes. Karnataka's second most important tax is the excise on alcohol. This has been growing rapidly over the last three years after an earlier period of policy uncertainty (concerning possible moves towards prohibition) came to an end. The third and fourth most important taxes are the two weakest 4 Maharashtra introduced a VAT in 1997, but withdrew it in 1999.

24 -18- performing taxes in recent years, namely stamps and registration, and the motor vehicle tax. The Tax Reforms Commission has come out with detailed plans for reform of these two taxes, and the Government has decided to implement these starting in Reforms in stamps and registration concern the closing of various loopholes; those with motor vehicle taxation, rationalization and a shift to ad valorem rates. Implementation of these reforms is expected to yield substantial revenue, to improve transparency, and reduce compliance costs. Payment of the motor vehicle tax, and associated vehicle registration, is one of the pilot services GoK is re-engineering and releasing citizens' charters for (para. 87). 61. Tax administration. The above reforms include a number of important administrative reforms to improve compliance, and reduce compliance costs. The Government has launched an initiative to upgrade tax collecting departments via computerization, modernization of facilities, and additional manpower for enforcement and intelligence. Physical checkposts of the different tax departments will be integrated and computerized to combat evasion, and to cut down on the repetitive stoppage of goods vehicles. 62. Non-tax revenues and user charges. The main avenue open for increasing non-tax revenues is by increasing user charges for services such as higher education, tertiary health, irrigation, water supply, and buses, which are very low in Kamataka and have declined over the years. The MTFP envisions rate increases for these services and cost recovery according to a pre-determined schedule over the medium term. Initial steps have already been taken (e.g., increases in user charges for canal irrigation; automatic linking of bus tariffs to the cost of service provision). Higher education fees have also been increased, though the increase was reduced after protests. 63. Revenue performance in After four years of low tax growth (between 8-12%), analysis of the first eleven months of suggests tax growth for the year of about 18%. Consistent with this, the revised estimates show an increase in the tax/gsdp ratio in of 0.6 percentage points to 8.8%, the first increase in the tax/gsdp ratio in about four years. While partly attributable to the economic recovery, this rapid tax growth is also attributable to improved compliance in sales tax, and a more stable environment in excise, as well as rate increases in excise duty. 64. Medium-term revenue path. The MTFP assumes that the reversal of the decline in the tax/gsdp ratio seen in can be sustained. Own-tax revenue increases in the MTFP as a percentage of GSDP from 8.8% of GSDP in to 9.4% in (Table 4). This is caused by rapid growth in sales tax from improved compliance, though it is also assumed that in the first two years of VAT introduction there is a temporary dip in revenue owing to possible teething problems and to the end of tax exporting which will be associated with VAT introduction. Improved performance for motor vehicle tax and stamps is projected. In , an increase in total own-tax revenue of 0.4 percentage points of GSDP is targeted. This is based on the reforms in stamps and motor vehicle tax mentioned above (para. 60), as well as improved compliance and selective increases in sales tax rates. The MTFP also assumes an increase in resources from the central government, in line with the Gol budget, and the recommendations of the Eleventh Finance Commission. Table 4. Karnataka: Revenue Receipts in the Medium Term Fiscal Plan, to (/o GSDP) RE BE Proj. Proj. Proj. Revenue Receipts OwnRevenue Tax Non- Tax Central Resources Shared Taxes Grants /a Figuresfrom GoK MTFP (Annex C) except that the infrastructure cess has been included under non-tax revenues.

25 -19- Expenditure Reforms 65. Controllng the wage bill. GoK does not appear to be over-staffed in the aggregate owing to a longstanding policy of hiring restraint (see Table 7). 20,000 vacant posts were abolished in and GoK is now abolishing another 55,000 vacant posts - about 9% of the current size of the civil service. However, all vacant posts in priority departments (education, health, police and forestry) are being filled - the state plans in , for example, to hire 15,000 new elementary teachers. As people retire through attrition, vacancies for front-line staff in priority departments will continue to be filled, but only two-thirds of such vacancies in other departments will be filled. Restrictions on hiring are enforced by requiring that clearance from the Finance Department be obtained for all recruitment. The overall impact of these policies is a very gradual reduction in civil service size of about 0.5% per year. If Government is successful in its administrative rationalization (in terms of both functions and processes - see paras ), the rate of decline in the civil service size will be higher. 66. Power subsidy. Reduction of Karnataka's power sector deficit is crucial for the state's fiscal sustainability. The Financial Restructuring Plan for the power sector (para. 18) shows a turnaround in the sector starting in and a decline in the power sector deficit over time. Achieving this reduction in turn depends on the reforms described in the Cabinet-approved power sector reform policy (paras ). Even with these reforms, the decline in the power sector subsidy will be at best gradual - indeed the first challenge is to reverse the trend of rapid increases in the deficit. Even with an aggressive reform program, as assumed in the FRP, it is estimated that the Government will need to provide some Rs 90 billion of financial support for the power sector over a five year period. If power distribution is to be privatized in Karnataka, it will have to be privatized with a government subsidy, which means that government must be able to credibly commit to payment of the power sector subsidy. The MTFP budgets for full payment of the power sector subsidy and payment of arrears starting in A monthly payment schedule will be adhered to, and matched by monthly monitoring of KPTCL ' s adherence to its budget. Part of the remit of the power sector privatization consultants is to establish a subsidy mechanism for use after the distribution companies are privatized. 67. Other subsidies. Other explicit subsidies are smaller than that for the power sector by an order of magnitude. GoK has already taken measures to contain the food subsidy, its second largest, within a nominal cap of Rs 3 billion, via tightening household eligibility requirements. Government support for small industries which had led the accumulation of some Rs 3.4 billion in liabilities has been virtually withdrawn. The Government has announced a policy of reducing subsidies to private higher educational institutions, but has run into opposition on this, and has only been able to take mild action to reduce this subsidy. Housing subsidies for disadvantaged households are being expanded. GoK has commissioned a study to quantify all implicit and explicit subsidies and suggest reform measures, and the March 2001 budget speech announces the govemment's commitment to implementation of its recommendations. 68. Priority development expenditures. The MTFP protects and promotes certain priority developmental expenditures - elementary and secondary education, health, roads and rural water supply, and non-wage O&M for irrigation and public buildings. However, the full increase will have to be spread out over several years in accordance with government's deficit targets. The priority in the early years is to protect priority sectors from being cut. Spending in these priority areas is expected to rise gradually from 4.75% of GSDP in to 5.62% of GSDP in (Table 5).

26 -20- Table 5. High Priority Development Expenditures in the Medium Term Fiscal Plan to (% GSDP) RE BE Proj. Proj. Proj. High Priority Development Expenditure Elementary & Secondary Education Health Roads * Water Supply * Irrigation ** Public Buildings ** * non-wage O&M and capital spending only ** non-wage O&M only 69. Medium-term expenditure path. As a result of the above measures, expenditure (including that financed by off-budget borrowing) is forecast to fall from 18.6% of GSDP in to 17.7% in (Table 6). The greater part of the fall is due to salaries and pensions which decline by 1.6 percentage points. The budgetary support to the power sector is brought back under control and falls to less than 1% of GSDP, despite the shift in policy to fully fund the power sector deficit on budget. Non-wage O&M increases by 0.5 percentage points. Capital outlays return to their earlier level of less than 3% of GSDP, as the large irrigation projects now underway come to an end, and are only partially replaced by expenditures in other infrastructure sectors. Table 6. Karnataka: Expenditure in the Medium Term Fiscal Plan, to (% GSDP) RE BE Proj. Proj. Proj. Total Expenditure Revenue Expenditure Interest Payments Salaries & Pensions Subsidies & Transfers Gross Budget Support to the Power Sector Non-Wage O&M Other Revenue Expenditure Capital Expenditure & Net Lending Note: Figures are after consolidating off-budget borrowing, and are all taken from GoK MTFP (see Annex C). Subsidies and transfers include transfers to urban local bodies; non-wage O&M aggregates major and other non-wage O&M in the MTFP. For more detailed definitions see Annex I. Public Expenditure Management (PEM) Reforms 70. Strengthening the budgetary process. A main aim of Kamataka's public expenditure management reforms is to institutionalize the Medium Term Fiscal Plan (para. 51), and with it bring a medium-term perspective and fiscal discipline to the budgetary process. This has already started through use of the MTFP to prepare the budget both to set aggregate resource envelopes and fiscal targets and to set departmental spending limits. GoK has also established an Expenditure Review Committee (ERC), comprising Finance, Planning and a few key spending departments, to identify the medium-term costs of new and existing policies and make recommendations on departmental hard budget constraints.

27 Three departments have been selected as PEM pilots (PWD, Elementary and Secondary Education, and Health) and have prepared policy notes on their medium-term objectives and policies consistent with MTFP resources. This process will be deepened in the coming year, and expanded to other departments. 72. One weakness is proliferation and insufficient screening of schemes. New schemes are now screened by the ERC before inclusion in the budget. In the coming year, line departments will be given greater flexibility to prioritize spending within their budgetary ceilings with scope to retain a significant portion of any identified savings. To deepen performance orientation, impact and performance evaluation of ongoing programs and schemes will be more widely used. 73. The accuracy of budget estimates is poor in Karnataka - actual deficits often exceed budget estimates by a large amount. Tax forecasts are typically over-optimistic resulting in cash rationing during the year, and either under-spending or an accumulation of arrears. This both limits departmental flexibility and makes any forward planning of limited value. Revised estimates, prepared at the end of the year, are often also inaccurate, reflecting a lack of up-to-date financial information. The financial management reforms detailed in the paragraphs following will help improve the situation, and GoK has also contracted a study to develop forecasting tools to reduce the discrepancies between budget and revised estimates and actuals - this will be one of the important performance indicators for the proposed operation. 74. Reforms in liability management. In the past, Karnataka has, like most if not all Indian states, borrowed as much as it could rather than as much as it could afford, at the cost of delaying needed policy reforms. It now plans to reverse this strategy, and in particular to reduce reliance on high-cost formns of borrowing. GoK is also cutting its costs on bond issues, by auctioning its own bonds separately from the general RBI issue of state bonds, and obtaining lower interest rates. There is a legislative cap on guarantees, and guarantee fees have already been introduced. Guarantee management will be improved over time, with the introduction of better reporting and allocational rules. Public Financial Accountability and Management 75. A preliminary public financial accountability assessment has been carried out for Karnataka, including review of the state's latest external audit reports. This indicated that GoK has reasonable foundations for a satisfactory public financial accountability system. Major strengths of the system include: (i) the wellestablished role of the legislature as the principal watchdog over public finances; (ii) existence of detailed guidelines for budgeting and monitoring of the use of public funds, and legislative approval of annual budgets; (iii) regular preparation and compilation of accounting information, and presentation of annual state accounts which provide comprehensive information on expenditures and revenues - public debts, guarantees, loans and advances, investments, etc. are also presented with varying quality; (iv) good procedural controls over expenditures; and (v) the well established independence of the public auditor (C&AG) from the executive and its broad mandate. However, there is also need to significantly strengthen and modernize the system to improve transparency, enable better financial and operating performance measurement and reporting, more effective legislative oversight and follow-up on audit observations, and address identified weaknesses in internal control and public accountability. Actions to address these have been initiated. In , the Bank and GoK plan to jointly carry out a State Financial Accountability Assessment (SFAA, covering Government departments, rural and urban local bodies, public enterprises, and other government entities), whose findings and recommendations will be used to develop GoK's medium-term public financial accountability modernization strategy and program, and define medium-term benchmarks. 76. Accounting and audit. Karnataka's published accounts are compiled not by the Government of Karnataka but by the Accountant General of the C&AG. Karnataka plans to develop its own accounting capability to improve the timeliness and ownership of financial management and public reporting. To do this, it has identified two pilot departments to prepare parallel accounts and related financial statements.

28 -22- Work has also begun in a number of critical areas to strengthen the accounting function, such as clearing the backlog of accounts and responses to external audits of government agencies, and plugging key internal control weaknesses (e.g., reconciliations). Audit is the responsibility of the C&AG, which also publishes the audit reports on its web site. The audit was received from C&AG in March 2001, and will be made public as soon as the Legislature reconvenes (expected June 2001). In future years, GoK will continue to table in the Assembly and make available the annual audit reports as soon as possible after receipt from C&AG (usually within 12 months of the fiscal year end, as has been the case for the last four years). GoK plans to improve its responsiveness to audit observations, and in particular to cut down on time lags in this regard. 77. Financial reporting has traditionally been slow, at the cost of both financial management and fiscal transparency. However, GoK has now become the first state to publish annual and monthly financial statements on the Internet. The monthly statements are produced within two months of the end of each month, while GoK aims to make available its annual Finance Accounts and Appropriation Accounts within 9 months of the end of the fiscal year, rather than 12 as previously: while the compilation of accounts are, as mentioned, a C&AG responsibility, achieving this goal will require the active collaboration of GoK Treasuries and Departments. 78. Computerizing key accounting functions is key to improving the timeliness of financial reporting and to reducing opportunities for fraud, waste and abuse of public resources. Computerization of treasuries, through which most government payments are made, is the top priority. This is now under implementation and the pilot phase is expected to be completed by March Karnataka is completing the first phase of its public financial accountability and management improvement program with the following actions: establishment of a 'Controller's Office' and task force to lead the program; posting of monthly financial accounts on the Internet; and initiation of treasury computerization. Procurement reforms 80. GoK has passed an important Transparency in Public Procurement Act, requiring all government departments to follow more transparent procurement practices. For instance, details of all tender applications received and accepted are now required to be published in a Tender Bulletin maintained by departments at both the state and district levels. The Rules, notified in October 2000, also lay down clear procedures for Tender Inviting and Tender Accepting Authorities, and provides for an appeals process and penalties for officials who contravene the provisions of the Law. GoK is now starting to place its Tender Bulletins on the Internet, and to undertake sample audits of selected procurement processes and contracts. Further procurement reforms will be identified based on the state-level procurement assessment the Bank is initiating in Karnataka as part of its Country Procurement Assessment Review. C. Administrative Reforms 81. The medium-term objectives of GoK's administrative reforms are: (i) a smaller but more effective public administration; (ii) a higher level of transparency and accountability, accompanied by fewer opportunities for corruption; and (iii) more efficient and responsive delivery of essential public services. GoK is approaching this exercise in a phased manner in order to build consensus for the overall reform process. To this end, the near-term actions focus on curbing politicization in the transfer process, enhancing transparency through the adoption of a pioneering Right to Information Act, and introducing pilot service delivery reforms through the use of e-governance, citizen charters, and improved feedback mechanisms.

29 The Administrative Reform Commission's first report (para. 44) provides detailed analysis and recommendations for the government to improve govemment efficiency and transparency. Building on this report, the Govemment's own strategy, the Governance Strategy and Action Plan, is designed to provide a road-map for reforms in the coming year and beyond. Civil Service Reforms 83. The Kamataka civil service is not overstaffed in aggregate terms relative to other Indian states (Table 7). Kamataka's civil service appears to have avoided many of the problems that have beset other states. Staffing norms allocate fewer support staff to secretaries and section officers. Department of Finance clearance is required for all recruitment. This relatively good starting point notwithstanding, Karnataka's civil service is nevertheless performing well below potential. Table 7. Civil Service Size in Different Indian States Core Total Gov. Total Gov. & PE State Population Civil Service Ratio Employees* Ratio Employment Ratio Andhra Pradesh 73,000, , ,052, ,369, Karnataka 53,000, , , , Orissa 35,000, , , , Rajasthan 51,000, , , , Uttar Pradesh 162,000, , ,242, ,390, *Total Government employees combines the core civil service with local government employees and employees at governmentaided institutions. 84. Civil service transfers. The most important immediate priority is to drastically reduce the politicized and premature transfers of civil servants that disrupt the functioning of public administration, undermine the ability of civil servants to commit themselves to the job, and lead to significant opportunities for corruption. The Chief Minister publicly announced in his March 2001 budget speech that there will be no general transfers in , and this has since been put into effect through the new transfer policy for , approved by the Cabinet in April A new system is in place to monitor and publicly report on the number of transfers and average tenure by key positions by department and district. In addition, the Govemment has decided to opt for a system of civil service boards to control transfers, and to introduce a requirement that reasons for premature transfers be publicized in Transfer Orders. The Govemment also plans to enhance the transparency of recruitment via mainstreaming recent departmental initiatives to reduce the importance of interviews, and thus the element of discretion, in the recruitment process. 85. Over the medium term, reforms will focus on the rightsizing and rationalization of public administration, and the institutionalization of more effective performance monitoring and accountability measures. GoK also intends to begin the process of reducing overlapping and duplicating organizational structures, and streamlining business processes. A start has already been made in this regard with the announcement of a merger between the Departments of Finance and Institutional Finance, and with the announcement of the abolition of all Divisional level posts by July 2001 (divisions are an intermediate layer between districts and the state). The Administrative Reforms Commission has commissioned functional reviews of 15 major departments to be conducted by outside agencies. These will be ready by the end 2001 to provide guidelines for reducing staff size and rationalizing the functioning of key departments. 86. Speeding up internal transactions. The government plans to improve the efficiency of its operations by reducing the number of layers through which a file passes for approval by introducing new procedures such as the single-file system, which allows for field Heads of Departments to send a file directly for action

30 -24- by the relevant Secretary, as well as the desk officer system in the Secretariat, which eliminates section officers from the chain of file movement which will now stop at the higher Under-Secretary level. These reforms will be introduced on a pilot basis this year. Changes in human resources policies to bring out greater flexibility for redeployment, and creation of a human resource database are also part of the Government's medium-term civil service reform strategy. Service Delivery 87. Citizen charters initiatives. Improving the delivery of services to the public both delivers large welfare gains and builds support for the reform program. GoK has initiated the public dissemination of citizen charters for a number of agencies, and has ambitious plans to extend citizen charters to much of government. To ensure that citizen charters are credibly implemented, GoK is focusing first on pilots in Bangalore involving three services with a large public interface (such as vehicle registration and licensing). These services have engaged in a process of seeking user feedback through surveys and/or consultations, carrying out business process re-engineering and/or computerization to meet stipulated service standards, and specifying improved standards and a grievance redressal mechanism through the publication of citizen charters. Report cards or beneficiary surveys from users of public services - such as those pioneered by the Bangalore Public Affairs Center (an NGO) - will be subsequently undertaken by the participating departments to see if customer satisfaction with the pilot services has increased. Over the medium tern, GoK plans to roll out its initial pilot agency reforms to other parts of the state, and introduce these reforms in other services that have wide impact, such as primary health care and the public distribution system. 88. Parallel to this, efforts are underway to mainstream cross-cutting fiscal and governance issues into the design of sectoral projects to improve the delivery of essential public services. Examples include: institutional reforms in the Public Works Department (para. 22); enhanced service delivery through the application of better performance monitoring standards and feedback from user groups in the health sector (para. 25); and efforts to promote grass-roots participation and strengthen accountability mechanisms in participatory rural projects, such as for watershed development, rural water supply, and irrigation (para. 23). Freedom of Information 89. Improving the access of public to governmental information is increasingly recognized in India as a critical reform for reducing corruption and improving service delivery. The freedom of information movement began in Rajasthan as a result of NGO agitation. Rajasthan was the first state to pass freedom of information legislation and now several other states are following suit. The Government of Kamataka has recently enacted and notified India's most far-reaching Right to Information Act. The Act is striking in the very limited number of exemptions, and represents a major step towards a more transparent form of government in Kamataka. The key next step now required is the formulation of rules under this Act so that it can be made effective. GoK is also starting to catalogue and index its records, and plans to conduct public surveys to identify the specific forms of information that the public would most like to see. E-governance 90. GoK has launched a number of initiatives in the area of electronic governance for public transparency and for better functioning of departments. These include the computerization of agricultural titles and tenancy information, treasury computerization, and computerization of the sales tax department. A number of GoK departments now have web pages. The scope for e-governance is much greater, however, and GoK will prepare a status report and action plan on e-governance initiatives.

31 -25- Anti-corruption strategy 91. The enforcement dimension of Karnataka's anti-corruption effort is spearheaded by the Lok Ayukta Office which is one of the best resourced institutions of its kind in India in terms of staff size and budgetary allocations. The Government plans to computerize the Lok Ayukta Office for greater effectiveness, and to review the Lok Ayukta Act to see how it can be strengthened. GoK also plans to establish an Ombudsman to deal with complaints against local government. 92. The focus on enforcement is being complemented by a significant emphasis on corruption prevention and systemic reform. A number of measures being taken by GoK will address key underlying sources of corruption, including reductions in patronage-based transfers, strengthened financial management and accountability, more transparent public procurement, deregulation, and right to information. To monitor the implementation of these anti-corruption measures as well as to identify and implement other measures on an ongoing basis, GoK plans to set up an inter-departmental Corruption Prevention Committee (CPC). The CPC will consult with civil society, the private sector, the media and other branches of government and the Lok Ayukta. It will oversee surveys of households, enterprises and public officials on corruption, and will publicly report on the progress of the government's anti-corruption program. Decentralization 93. India has separate local governments for rural and urban areas. Rules for transfer of resources to both sets of governments are set every five years by the State Finance Commission, Karnataka's second of which will report by end Urban local governments are stronger than rural, but are nevertheless often ineffective and starved of revenue. Their most important source of revenue is the property tax, and the most important reform for urban local governments is strengthening of the property tax. Bangalore introduced self-assessment last year for property taxes. As a result, property tax revenues have risen by some 30%. GoK now plans to introduce legislation to make self-assessment possible in all of the state's urban areas. It has also announced a new funding scheme for Bangalore and other major cities, which will provide incentives to their municipalities to improve financial and operational efficiency. 95. GoK has a long tradition of rural decentralization stretching back to the 1870s. In 1987, GoK implemented an ambitious rural decentralization program. A large number of staff- including all teachers - and the largest share of public expenditures of any state have been transferred to rural local governments, known as Panchayati Raj Institutions (PRls). The Government has announced significant initiatives to enhance the autonomy of PRIs, with the recent annual budget announcing a 75% increase in the allocation of untied funds, and important reforms to enhance the tax base of PRIs (doubling of land revenue rates, and removal of property tax ceilings). The Government is also taking measures to enhance the effectiveness of PRIs, including through computerization and capacity building. Nonetheless significant issues remain to be clarified about the functioning of the panchayat system - including concerns that the state-level bureaucracy and political establishment exercise a disproportionate role in panchayat governance, that the PRIs still have a very limited amount of untied funds, and that the quality of local governance is very low. A state study of rural decentralization in Karnataka has been undertaken by the Bank, and a workshop on this subject is planned to better define issues and build consensus. D. Private Sector Development 96. The importance of state governments in determining and improving the investment climate is being increasingly recognized. Research carried out by the Bank and the Confederation of Indian Industry suggests that the cost differential between operating in "good" and "bad" investment climate states is as much as 30%. The same research suggests that Karnataka already has one of the better investment climates

32 -26- among India's states. However, India significantly lags other emerging economies with respect to its investment climate, and there is much Kamataka can do to improve the climate for private sector development in the state through business deregulation and public enterprise reform. Business deregulation 97. Business deregulation seeks to reduce excessive regulations that create impediments to private sector investment and growth and generate significant opportunities for corruption. Surveyed investors in Karnataka ranked the number one constraint to investment and growth as excessive bureaucratic interference in business operations. 5 The Government's strategy in this regard is contained in its policy paper "Deregulation of Business Environment," (Annex F) which has been approved by the Cabinet. Box 3 summarizes how the Government plans to simplify the business environment in Kamataka. Implementation of the policy paper will follow in the coming months. Progress will be tracked via use of regular business surveys, the first of which will be undertaken in Box 3. Simplifying the Business Environment in Karnataka Issue Current Situation Proposed Reform Measures a/ Starting a Investor needs to obtain many, often repetitive, One application form for starting a business permits/licenses/registration from various departments and business to be submitted to single Nodal agencies using multiple application forms. Agency/contact point with rules set out Prolonged process of approval. in one handbook. Streamlined and time-bound clearance process. Running a Multiple rolls, registers, and returns required under various Consolidate and combine (in some cases business acts and rules. abolish) rolls, registers and returns. Frequent, excessive, discretionary inspections from various One annual inspection combining departments based on comnputer- generated random sampling. All other inspections will be restricted to specific complaints. departments which interface with business, giving rise to corruption. a/from the GoK "Deregulation of Business Environment" Policy Paper. The measures deal only with those provisions of laws which are under the purview of the state. Public Enterprise Reform 98. Based on March 1999 data, Kamataka has 78 public enterprises (PSUs or Public Sector Units), with a total of 162,000 employees. Five are utilities (power and public transport) and are being dealt with through separate reform programs. Of the remainder, 32 are manufacturing (ten of which are non-operational), 23 are service and marketing, 16 are development enterprises, and two are financial institutions. In 1998/99, 25 PSUs had negative net worth. Excluding the public utilities, the sector made an aggregate net loss of Rs. 1.1 billion. Reducing the PSU burden will not only help the state's fiscal position (loss-making PSUs do not repay government loans, and many survive through salary payments from the budget) but will also help the govemment to focus on the challenge of improving the business environment: the Department of Commerce and Industry, whose main job this should be, has to supervise some 30 enterprises, very few of which have a legitimate claim of government attention. 99. The GoK Cabinet has recently approved a Policy Paper on Public Sector Reforms and Privatization (Annex E), the basic principle of which is that the state will withdraw from all commercial activities through sale or closure. Non-commercial PSUs will be restructured through mergers and reorganization, 5 Investors' Survey, Public Affairs Center, Bangalore 1999.

33 -27- including the involvement of strategic partners where feasible. Phase 1 of the program targets the sale or closure of 10 enterprises by March Phase 1 consists predominantly of manufacturing PSUs, with a mix of small (mostly closed), medium and large PSUs, including four with employment of over 1,300 and three with a tumover of more than Rs. 1 billion. With the completion of Phase I, it is expected that some of Karnataka's major loss-making public-sector manufacturing units will have been closed or sold. GoK plans to close or privatize the remaining commercial PSUs in yearly batches of about 10 PSUs by 2005 while rationalizing and restructuring the rest. It is expected that only those PSUs providing mainly promotional and social services will remain beyond A Public Sector Restructuring Commission has been established to give recommendations on individual firms. A High Powered Committee has been set up to monitor and coordinate the overall program. Detailed privatization procedures and proper safeguards on social safety net and environment have been established and are contained in the policy paper. An environmental screening process is being followed for each of the PSUs targeted for closure and/or sale. Those enterprises which are shown to have environmental risks are then subjected to a more detailed audit. The social impact of closures and downsizing will be mitigated by a safety net, including retraining opportunities The Govemment also manages a large number of co-operatives, originally intended to operate as selfmanaged, independent businesses. GoK has drafted, and plans to introduce shortly, a new cooperative law which will allow cooperatives to operate with greater autonomy. Subsequent work will focus on helping co-operatives to take advantage of this new framework. E. Poverty and Human Development Monitoring 102. Despite its impressive growth record, poverty in Kamataka may be higher than prevailing All-India level (see the poverty note attached as Annex G). GoK's reform program has as its over-riding objective "the eradication of poverty through economic growth tempered with equity" (para. 11) and the links between the overall reform program, as well as specific fiscal and govemance reforms with poverty reduction are explained elsewhere (paras. 29, 123). This sub-section details the efforts of the Govemment to improve its ability to monitor poverty, and to better evaluate the impact of its policies and reforms on poverty in the state GoK has taken important steps recently both to enhance its poverty and human development monitoring capacity as well as to demonstrate its willingness to leam from and act on the basis of the information collected. The state was one of the first in India to publish a Human Development Report (HDR) in The findings in that report conceming inter-district disparities within Kamataka are starting to influence govemment policies and allocations. GoK is now working towards institutionalizing that oneoff effort with the creation of a Poverty and Human Development Monitoring System (PHDMS - Annex H) to be managed by a Human Development Division within the Department of Planning, under the guidance of an Advisory Group with outside experts. The objectives of the system are to help the Govemment make more informed policy decisions, better determine the impact of its policies, reforms, and services on the poor, as well as to inform public debate from the perspective of poverty reduction. The PHDMS will do this by systematically monitoring progress, as well as any emerging problems, in key areas related to poverty reduction and human development, and by making this information available to the govemment and the public on a regular and timely basis. Following a public workshop in February 2001, the Govemment has finalized the key indicators and terms of reference for the PHDMS (Annex H) The PHDMS will focus on both consumption and non-consumption dimensions of poverty, including related issues such as agricultural prices and service delivery. It will be survey-based. Kamataka made excellent use of the national household survey in the 1999 HDR, and processing of data from the survey is now underway. The 2001 decennial census has just been completed. Other available household surveys include: the National Family Health Survey, the Reproductive and Child Health Survey,

34 -28- and the state's own recently-concluded literacy survey. As part of the PHDMS, Karnataka will strengthen its statistical system by: quicker processing and greater utilization of data from these surveys; strengthening of other existing data collection systems such as the Civil Registration System (CRS); improved coordination and better linkages with data collection units in other line-ministries; and commissioning new annual surveys, starting in , to fill remaining data gaps, as well as to cross-check the accuracy and reliability of existing data collection systems The PHDMS reporting system will include: (i) a new chapter on poverty and human development monitoring in GoK's Annual Economic Survey; (ii) a comprehensive Human Development Report to be prepared every 3-5 years - the next is targeted for 2002/03 based on the findings of the Census as well as other household surveys recently conducted in the state; (iii) monthly reports focusing on district-level changes in wages and agricultural prices, to track short-term indicators of deprivation and vulnerability; and (iv) special studies. The first such special study is a district-level HDR for one of the state's poorest districts, Gulbarga in the far north of the state. As part of this, a survey of users, facilities and public officials in relation to key government services - rural water supply and primary education in particular - will be carried out using the report-card approach pioneered by the Public Affairs Center in Bangalore (para. 87). This survey - the first of its type to be carried out in rural areas - will be completed by October 2001 and will provide a diagnostic and base-line for improvements in rural service delivery Work under the PHDMS will reinforce the focus of Karnataka's governance reforms in several areas. The production of district-level HDRs will help strengthen rural local governments (para. 95). The emphasis on performance monitoring complements the government's public expenditure management reforms (paras ), and the statistical strengthening will help make a performance orientation feasible. V. THE PROPOSED LoAN/CREDIT 107. The Bank proposes to support the initial phrase of Karnataka's fiscal and governance reforms through a PSAL (para. 38). The first Karnataka Economic Restructuring Loan/Credit (KERL) is proposed for the amount of US$150 million. Given the Government of Karnataka's projected financing gap for of about US$250 million (see Table 8), it is envisioned to submit a second KERL to the Board for approval in the fiscal year, subject to satisfactory reform progress. Subsequent KERLs would likely be on an annual basis, again subject to satisfactory reform progress This section presents: (i) Karnataka's financing needs, (ii) activating actions for the first two KERLs, and themes/benchmarks for subsequent KERLs; (iii) implementation arrangements; (iv) performance monitoring and outcomes; and (v) details of loan/credit administration. A. Karnataka's Financing Needs 109. Total Bank support to Karnataka is based on the state's ability to absorb resources, as measured by the strength of its reforms (para. 37). Bank assistance in the form of budgetary support depends on the states' financing needs and availability of other sources of finance. The state's financing needs over the next few years will be influenced by the financing needs of the power sector, the costs of reforms such as retrenchment or tax reform, and the need to bnrng developmental spending to a level consistent with the state's poverty reduction and growth objectives. The current forecast embedded in the Government's MTFP is that Kamataka will need about Rs.47 billion (about US$1 billion) of Bank budgetary support over the next four years to close its financial gap The power sector's claim on the budget over the four year period starting in is about Rs 81 billion. This is some Rs 44 billion above historical levels, reflecting the decision of the Government to fully fund the power sector deficit on budget (paras. 55, 66). Implementation of VAT may lead to an initial loss

35 -29- of sales tax revenue (para. 64). The MTFP assumes about 95% recovery of sales tax estimates for the first 2 years following VAT introduction (2002/ /4), resulting in a loss of revenue of Rs 8.5 billion. Voluntary retirement (VRS) payments to help closure/sale of public enterprises will also constitute a major reform cost. VRS payments to an estimated surplus employment of 35,500 over four years would cost about Rs 4.5 billion. In total, the above claims come to about Rs 57 billion (about US$ 1.2 billion) over the next four years, or about 1% of GSDP a year For the first year of the program, , the key financing challenges facing GoK are to shift the power sector deficit on budget and to reduce reliance on off-budget borrowing. Table 8 shows how this is proposed to be achieved. Off-budget borrowing in falls marginally from Rs 20 billion (25% of the gross borrowing requirement) in the previous year to Rs 19 billion (22% of the gross borrowing requirement), while financing by the power utility, previously mainly through accumulation of arrears, falls dramatically from 18% to 7% of the gross borrowing requirement. Reliance on conventional on-budget borrowing sources increases, but still leaves a financing gap of about Rs 12 billion (about US$250 million or 13% of the gross borrowing requirement). Table 8. Karnataka: Gross Borrowing Requirement and Sources of Financing, to (Rs billion) % of total % of total % of total actual RE BE Gross borrowing requirement /a Gross borrowing requirement as a % of GSDP Sources of Financing Off-budget borrowing On-budget borrowing Government of India Small savings State Plan loans etc. (excl. World Bank adjustment loan) Market borrowing Loans from fmancial institutions Provident fund (net) Change in reserves and deposits & cash balances Net financing by KPTCL (the power utility) Borrowing Change in working capital World Bank adjustment loan la Adjustedfrom fiscal deficit to include principal repayments, 30% grant component in pass-through of Bank adjustment lending from Gol, off-budget borrowing and power sector deficit financing. B. Actions Activating the First KERL 112. The Govemment of Karnataka has already taken a large number of important reforms, many of them controversial, such as increasing irrigation charges and other user fees. It has improved the state's fiscal position over the last year ( ), and has launched a wide-ranging program of govemance reforms, including specific measures such as business re-engineering and release of citizens' charters for pilot agencies to improve service delivery, the introduction of procurement sample audits, the publication of information about individual procurement processes, and the introduction of a general ban on premature transfers of civil servants. A listing of actions taken by the Govemment to date in its fiscal and govemance reform program is given in the policy matrix (Annex B) - see also Table 1 of the Govemment's Letter of Development Policy "Kamataka's Economic Restructuring Programme: a summary." Of the many reforms

36 -30- taken, those selected as upfront actions to activate the first Karnataka Economic Restructuring Loan/Credit are shown in Box 4 below. Box 4. Activating Triggers for the First KERL Measures For details see... Fiscal Policy and Public Expenditure Management 1. Reduction in the budgetary non-power fiscal deficit from 3.7% Table 3 and of GSDP in to 3.2% of GSDP in para. 55 (corresponding to stabilizing the non-power deficit in nominal terms below Rs 35 billion). 2. Approval by Cabinet of a Medium-Term Fiscal Plan (MTFP) to Para. 51 achieve the Government's fiscal goals. 3. Presentation of a budget consistent with the MTFP, Table 3 and including a targeted reduction in the non-power budgetary fiscal para. 55 deficit from an estimated 3.2% in to 2.4% of GSDP in Completion of key steps towards institutionalization of the Paras. 70- Medium-Term Fiscal Plan into the budgetary process Completion of the first phase of preparation for VAT Para. 59 introduction. 6. Completion of first phase of financial management Para. 79 modernization. 7. Passage of Karnataka Transparency in Public Procurement Act. Para. 80 Administrative Reforms 8. Cabinet approval of a Governance Strategy and Action Plan, Paras. 13, including measures to reduce transfers within the civil service. 82, Passage of Kamataka Right to Information Act. Para. 89 Private Sector Development 10. Cabinet approval of the Policy Paper on Deregulation of the Para. 97 Business Environment. 11. Cabinet approval of Policy Paper on Public Sector Reforms and Para. 99 Privatization. Poverty Monitoring 12. Establishment of Poverty and Human Development Monitoring Paras System. 106 C. The Second and Subsequent KERLs 113. The proposed series of KERLs will be timed according to the pace of reforms, and the need for financing, taking full advantage of the flexibility which the PSAL framework offers, with an expectation of annual or biannual loans/credits, as articulated in the assistance strategy for the state (paras ). As already stated, the first two KERLs have been structured to make it possible for GoK to access both within the same (government) fiscal year (para. 107) The second KERL focuses on implementation of reforms, and on reforms where more time is needed for the government to develop a track record. Indicative triggers for the second KERL are as follows:

37 -31- Fiscal Policy and Public Expenditure Management 1. Progress towards agreed fiscal targets, as indicated by: (i) actuals for ; (ii) monthly fiscal accounts data for ; and (iii) progress in implementation of revenue and expenditure reforms. 2. Further development of the MTFP, including greater use of sectoral/departmental ceilings, development of three departmental MTFPs, and greater integration of performance evaluations. (paras ). 3. Draft Fiscal Responsibility Legislation (para. 51). 4. Wider Internet posting of Tender bulletins and additional sample procurement audits (para. 80). Administrative Reforms 5. Drastic reduction in number of civil servant transfers (para. 84). 6. Implementation of pilot reforms to reduce elapsed time in government administrative transactions (para. 86). 7. Completion of functional reviews for major departments to rationalize the government administration (para. 85). 8. Establishment of the Corruption Prevention Committee to monitor and publicly report on the Government's anti-corruption program. (para. 92). 9. Roll out of pilot agency reforms to other parts of the state (para. 87). 10. Notification of rules for, and effectiveness of, Right to Information Act (para. 89). Private Sector Development 11. Implementation of reform measures in the Karnataka Policy Paper on Deregulation of the Business Environment (Annex F, Box 3). 12. Closure or sale of 3 Public Enterprises (para. 99) Subsequent KERLs after the first two would likely be on an annual basis. If Karnataka is able to proceed this far along the reform path, it will have a very impressive reform track record, and the Bank should be willing to disburse larger amounts at less frequent intervals. Depending on progress made, it is expected that the objectives of KERLs would be met by Reforms intended to be supported under these later KERLs are indicated in the Government's policy matrix (Annex B) and summarized in Box 5 below.

38 -32- Box 5. Benchmarks/Themes for Future KERLs (2002/ /05) Reform Area Benchmarks/themes for future KERLs (2002/ /05) Fiscal and Public Expenditure Management Reforms Fiscal Continued fiscal adjustment as indicated by budgetary outcomes and targets. Sustainability Annual publication of Medium Term Fiscal Plan, including reporting of results against targets. and Application of and adherence to new fiscal responsibility legislation. Transparency Reduced reliance on off-budget borrowing. Improved contingent-liability management. Improved methodologies for budget estimation and pension forecasting. Reform VAT introduction in Reforms of motor vehicle tax, stamps and registration. Revenue Computerization of tax administration. System Increases in user-charges. Expenditure Completion of subsidy study, and implementation of sector strategies to improve subsidy targeting. Composition Continued reduction in power sector deficit as indicated by utility budgetary outcomes and targets. Annual issuance of power sector Financial Restructuring Plan, with reporting of results vs. targets. Annual increases in priority sector spending (health, education, rural infrastructure). Public Institutionalization of the MTFP in the context of the and successive budgets. including at the Expenditure departmental level. Management Expanding use of performance evaluations for government schemes. Financial Formulation and implementation of Public Financial Accountability Improvement Program. Account- Departments to start maintaining/compiling parallel accounts, beginning with 2 pilots. ability Improved response to audit accounts. Complete treasury computerization, and extend computerization to other accounting functions. Public Implementation of Transparency in Public Procurement Act. Procurement Widespread publication of Tender Bulletins on the Internet and use of sample procurement audits. Completion of Procurement Assessment, with additional measures arising from this. Administrative Reforms Governance Annual updating of the Governance Strategy and Action Plan, including reporting of results against plans. Strategy Civil Service Implementation of strategies to reduce transfers of civil servants and improve transparency in recruitment. Reforms Rationalization/consolidation of government activities and staffing based on functional reviews. Measures to improve internal efficiency of government decision making. Installation of computerized humnan resources data base. Citizen Monitoring of performance of pilot surveys, including through user surveys. Charters Expansion of geographical and service coverage of agency reforms. Decent- Roll out of property-tax self-assessment. ralization Further measures to strengthen rural local government to be identified based on studies/workshops and second State Finance Commission Report. E-govemance Completion of e-govemance status and action plan. Expansion of e-governance. Freedom of Publicizing of Right to Information Act. Information Use of information technology and survey of information needs to improve flow of information to citizenry. Anti- Measures to strengthen anti-corruption enforcement (strengthening of Lok Ayukta, creation of Corruption Strategy Ombudsman for local governments). Inter-Departmental Corruption Prevention Committee to oversee and publicly report on progress against corruption. Private Sector Development PE Reform Progressive closure/sale of public enterprises. Business Implementation of the Policy Paper on Deregulation of Business Environment. Deregulation Institutionalization of public/private sector dialogue, including through regular surveys. Poverty and Human Development Monitoring. Annual Poverty and Human Development Monitoring chapters in Economic Survey. District-level Human Development Reports. Second Human Development Report incorporating 2001 Census Results. Surveys of rural service provision and other special topics.

39 -33- D. Implementation Arrangements, Performance Monitoring and Outcomes Implementation arrangements for the KERL are shown in detail in the GoK Letter of Development Policy (Annex A). The overall program will be coordinated by the Chief Secretary. The nodal agency for the fiscal and public expenditure management reforms is the Finance Department. Administrative reforms are the responsibility of the Departments of Personnel and Administrative Reform - a number of other departments are also important in this regard and overall coordination for this component will be provided by the Additional Chief Secretary. Under the private sector development component, business deregulation is the responsibility of the Department of Commerce and Industry, while the Karnataka State Bureau of Public Enterprises is the nodal agency for public enterprise reforms. Finally, the Planning Department is responsible for the newly-created Poverty and Human Development Monitoring System Performance monitoring. Strengthening of monitoring and public reporting is a theme of the Government's reform program. The Govemment's two basic reform policies, the Medium Term Fiscal Plan and the Govemance Strategy and Action Plan, will both be published annually, and subsequent versions will include the reporting of results against stated intentions. In addition, the following measures in the Government's reform program will strengthen performance monitoring and reporting: * The establishment of the Poverty and Human Development Monitoring System (Annex H) is an important effort to improve availability of data about poverty, and the impact of Government policies and reforms on the poor. * Financial/fiscal reporting: various measures, from the regular provision of a wider range of fiscal information to the public to the posting of monthly financial accounts on the Intemet and the development of the Government's accounting capability, will greatly improve the extent, accuracy and timeliness of the Govemment's public fiscal and financial reporting. * Performance evaluations are being taken up for various government schemes and projects as part of the public expenditure management reforms, as are a number of sample procurement audits. * Monitoring of premature transfers of civil servants on the Internet is being introduced to promote transparency, and as a tool to reduce the number of such transfers. * The Government's citizen charter initiatives rely on the use of systematic feedback from users to promote good performance. * Karnataka's new Right to Information Act is intended to enable the public to be better informed about and thus be better equipped to monitor the government's performance. * Various computerization/e-governance initiatives will greatly improve the flow of data (e.g., treasury computerization, human resource database). * Survey-based monitoring will be emphasized, with regular new surveys planned of businesses, officials, and households. * A separate social assessment is being undertaken for the power sector reforms, including surveys of consumers, to establish a base-line for monitoring the impact of this important reform on the poor In addition to these governmental initiatives, Kamataka benefits from significant NGO monitoring both of specific services and of overall performance. For example, the Public Affairs Center has recently completed a report card on the first year of Kamataka's new government, based on a citizens' surveys Performance indicators for the Government's reform program are included in the Government's Policy Matrix in Annex B. Box 6 below summarizes the key outcomes sought and performance monitoring mechanisms that will be used to assess progress under the four components of the Govemment's fiscal and govemance reforms, as well as under its overall economic reform program. As the various monitoring and

40 -34- strengthening initiatives take root, the database for judging performance will be greatly improved, and assessments of government performance will be increasingly able to be based on achievements of outcomes (such as education and health levels) rather than progress with respect to inputs (such as policy changes). Box 6. Outcomes and Performance Indicators for Karnataka's Fiscal and Governance Reforms Reform Area Outcomes Sought Performance Indicators/Monitoring Mechanism Overall 7-8% economic growth Administrative data. Government Universalization of elementary education (by 2004, all Census data. Reform children aged 6-10 years to be in school; by 2007, all National Accounts Statistics. Program (see children aged 6-14 years to be in school.) Household survey data. Section ILb) 55 litres per day drinking water availability for all Traffic surveys. rural households by 2005, up from 40 currently. Health targets (IMR, MMR, nutrition, infectious diseases (including <3% AIDS infections), immunization, client satisfaction). Improvements in state highway quantity and quality. Fiscal and Fiscal deficit less than 3%. Annual publication of Medium Term Fiscal Plan, and Public Off-budget borrowing and power sector deficit to be power sector Financial Restructuring Plan including Expenditure brought under control, reduced over time and reporting of results against targets. Management eliminated in the medium-term. Monthly and annual monitoring of fiscal performance Reforms Improved revenue performance. and of cash-flow position, including of the power sector More effective pattems of government expenditure. and off-budget borrowings. More transparent, public and timely financial/fiscal Tax/GSDP ratio. reporting. Feedback from taxpayers via regular surveys of More transparent and competitive procurement. business. Expenditure allocation figures, as well as regular surveys of households to gauge progress on the ground. Timeliness and frequency of financial reporting, and auditing cycle; reduction in defined financial irregularities. Number of published Tender Bulletins, and sample procurement audits. Administrative A smaller but more effective public administration. Annual publication of Govemance Strategy and Action Reforms A higher level of transparency and accountability, Plan, including reporting of results against intentions. accompanied by fewer opportunities for corruption Size of the civil service, number of departments and More efficient and responsive delivery of essential layers, average time taken for administrative public services. transactions. Regular surveys of public officials to gauge changes in perceptions of corruption, quality of administration, etc. Systematic feedback for individual services as part of the citizen's charter initiatives. Household surveys to provide regular feedback for both state and local-government provided services. Greater reliance on e-governance, especially in delivery of services. Private Sector Withdrawal of state from direct involvement in Number of public enterprises closed or privatized. Development commnercial activities. Quality of Kamataka's investment climate as judged by Reduction in administrative and fiscal burden of regular surveys of business. public enterprises. Improved business environment, with less bureaucratic interference. Poverty and A better information base for pro-poor policy making Functioning of the Poverty and Human Development Human and program design. Monitoring System. Development Use of its results by policy makers. Monitoring

41 -35- E. Loan/Credit Administration 120. Funds flow arrangements for the Loan/Credit are as follows. Upon effectiveness, GoK through Gol will submit to the Bank a withdrawal application. The US Dollar proceeds of the Loan/Credit will be transferred from the Bank to GoI's account held at the Reserve Bank of India, into which all Bank disbursements are deposited. The account is controlled by the Office of CAAA (Controller of Aid, Accounts and Audit) of the Department of Economic Affairs, GoI, and is part of GoP's general foreign exchange reserves. The Rupee equivalent funds will be promptly transferred by GoI to the Consolidated Fund of the GoK in one tranche on standard terms for central resource transfers for state developmental budgets (30% as grant and 70% as loan, with Gol bearing the foreign exchange risk). GoK will promptly confirm to the Bank the receipt of these funds, and its credit to the Consolidated Fund of the GoK Procurement. Disbursement of the loan/credit proceeds will not be linked to specific purchases. However, GoI will not use the loan/credit proceeds to pay for certain expenditures included in the Bank's standard negative list which includes expenditures on military hardware, luxury goods as defined in the Standard International Trade Classification, and environmentally hazardous goods Financial accountability environment. In preparing this project, the Bank supplemented the 1998 public expenditure review of Karnataka (para. 3 8) with a preliminary public financial accountability assessment for the state. The results are described in para. 75 and show that, although there are weaknesses, the foundations of Karnataka's public financial accountability system are reasonable. Key actions for improvement and strengthening are included in the policy matrix (Annex B). Procurement and financial accountability assessments of the state will be carried out later this year, leading to the adoption of a medium-term action program by the government. The funds flow arrangements for the Loan/Credit described in para. 120 above are satisfactory to ensure that the proceeds of the Loan/Credit are used for the intended purposes. A. Benefits VI. BENEFITS AND RISKS 123. Impact on poverty. Kamataka's reforms are expected to have a strongly positive impact on poverty reduction through various channels. Many of the links between the state's overall reform program and poverty reduction (para. 29) lie in the benefits Kamataka's fiscal and governance reforms will have for the poor. Specifically: * Karnataka's deregulation will improve the investment climate, especially for small and medium enterprises. This will help generate non-farm employment, of great benefit to the poor, but where performance has been lagging in Karnataka. * Karnataka's governance reforms seek to improve the delivery of public services at local levels (e.g., through citizen charters, user surveys, and performance monitoring. The governance reforms should also reduce corruption and harassment, which tend to hurt the poor disproportionately. * Karnataka's fiscal reforms will enable a greater share of resources to be focused on poverty-related expenditures. The MTFP seeks to reorient public spending towards high priority development spending (primary and secondary education, primary health care, drinking water, basic infrastructure) that will provide basic social services to the poor and help agricultural growth.

42 -36- * Increasing user charges is also a progressive, though controversial, policy. In the case of electricity, about 50% of Kamataka's rural households make no use to electricity at all. There is also a life-line tariff, which about 20% of Kamataka's consumers benefit from, and which is expected to remain in place. (Out of a total of about 8 million households with electricity connection, there are about 1.6 million electricity consumers with a single-bulb connection. These households pay a charge of equivalent to about 20% of the cost of supply.) Regarding the farming community, and the impact on marginal and small farmers, Bank research conducted in other states suggests that the negative impact of tariff increases would remain limited and is expected to be mitigated by an improvement in the quality of power supply. * The emphasis being given to improving poverty monitoring will help the govemment to better track poverty, and to adjust its policies and programs accordingly. This includes the Poverty and Human Development Monitoring System (Annex H), as well as sector-specific studies such as the social assessment being undertaken in the power sector (para. 17) Support for reforms. Bank backing for the Government's reform program helps provide support for implementation, and the lessons of international experience. Success with respect to the Govemment's fiscal and govemance reform program will improve the enabling environment for Bank-supported and other sectoral investments in Karnataka (paras ). The additional financing which the Bank can provide will help ensure that high-priority expenditures are protected and expanded rather than crowdedout at a time of fiscal stress. It also provides financial backing for the state's reform program (para. 109), and in particular helps fill the financing gap which arises from fully funding the power sector deficit on budget (paras. 55, 66) - an important component of the state's power reform strategy (para. 16) Impact beyond Karnataka. Kamataka is a state with a considerable potential demonstration effect. Given its traditionally strong fiscal and govemance position and its already-established position as one of the states leading reforms in these areas (Box 2), Karnataka has the potential to set precedents in many difficult areas, and thereby to generate competition and reform momentum across Indian states. B. Risks 126. Non-adherence to the agreed fiscal framework could worsen Kamataka's deteriorating fiscal position. Experience in some other states shows the difficulties in adhering to agreed medium-term frameworks. This risk is being mitigated by institutionalization of the MTFP (paras ) and the announced provision of legislative backing to the MTFP (para. 51). Nevertheless, both the fiscal and power sector deficits can easily be larger than planned due to developments outside the state's control, such as reduced resource transfers from the center, or, in the case of power, accidents and weather. These risks will be mitigated by close monitoring. There is a particular risk in the coming year that a growth slowdown in India will mean that GoK's ambitious revenue targets are not achieved. This will possibly require adjustments on the expenditure side to ensure that deficit targets are not breached The planned introduction of the VAT also carries with it substantial risks. Successful introduction will require co-operation from Government of India and other states, and good planning and communication within Karnataka. The consultancy GoK is engaging should reduce risks within the state, while the Bank will need to highlight state VAT issues which require a national solution The political commitment to reform could weaken due to resistance to institutional and governance reforms which tackle vested interests. This risk is mitigated by broad ownership of key institutional objectives among senior political leaders, bureaucrats and civil society. Careful consideration has been given in the design of the reform programs to broaden public support for the reforms. Some key government services with wide interface with the public have been chosen to improve service delivery in a

43 -37- visible manner to help generate public support for the reform process, particularly as these pilot initiatives are extended to other parts of the state (para. 87) Challenges remain regarding the government's capacity to fully implement deep reforms across a wide range of sensitive areas. Although Karnataka has a competent bureaucratic apparatus, the reforms proposed are complex and the government's capacity for managing reforms is limited. To address this, close attention is being paid to sequencing issues in the context of a flexible, medium-term programmatic framework, and trying to avoid an over-loaded agenda. Provision of technical assistance is also critical in this regard. GoK is using about $10 million of TA for its fiscal, governance, and related power sector reforms (para. 38), and this amount is expected to grow. The infusion of the lessons of intemational experience will strengthen the government's capacity for managing the medium-term reform programs Finally, the achievement of fiscal sustainability is conditional on sustained and successful sectoral reforms (paras ), but there are risks associated with these, especially with power sector reforms - for example, tariff increases are politically controversial, and foreign investors are increasingly cautious about investing in the India power sector. The measures the govemment is taking in each sector (e.g. in the power sector, the launch of a communications campaign and the use of highly experienced advisers), as well as the close links between GoK's sectoral and core fiscal and governance reform programs will help mitigate these risks, as will the integrated, comprehensive approach the Bank is taking in Kamataka (paras ) For all the mitigating measures built in to this operation, and mentioned in the above paragraphs, this is nevertheless a high-risk operation, primarily on account of the controversial nature of some of the reforms the government is pursuing. If some of the risks identified above become a reality then the development impact the operation seeks to achieve may fail to materialize. In this case, the program of Bank support will have to be re-assessed. However, at this juncture, Kamataka's record to date and promise for the future clearly warrant Bank support. James D. Wolfensohn President Washington, D.C. May 25, 2001 by Zhang Shengman

44 Letter of Development Policy (A signed Letter of Development Policy is forthcoming) Annex A

45 Reform Area Annex B Page I of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Government Strategy Actions Already Future Milestones (Indicative target dates) Performance l- I Taken December 2001T April 2002 April benchmarks I. FISCAL REFORMS & PUBLIC EXPENDITURE MANAGEMENT A. Establish Develop a Medium-Term Fiscal Plan to guide White Paper on State's Fiscal Revised MTFP to Medium-term fiscal plan to MTFP to be issued Fiscalperformance Framework for fiscal adjustment to avoid a debt-trap, and Position issued and medium-term provide basis for be issued with annually including reporting Annual deficit reduction Fiscal Sustainability issue it annually with the budget, including fiscal targets announced budget. budget, including reporting of outcomes against targets targets derived from & Transparency reporting of outcomes against targets. Medium Term Fiscal Plan (MTFP) Draft Fiscal of outcomes Off-budget borrowing to be Government's MTFP for Objective Provide legislative backing to the MTFP approved by Cabinet and made Responsibility against targets. eliminated after both budgetary deficits and through a Fiscal Responsibility Act. public. Legislation to be Fiscal Responsibility including off-budget Fiscal adjustment to Identify and consolidate all off-budget prepared. Legislation to be tabled in borrowing and the power avoid a debtrap. sources of borrowings into fiscal indicators; the House. sector deficit; monthly Fiscal transparency move away from reliance on off-budget reducedisparities to promote public borrowing, an develop a Financial between budget revised debate and Restructunng Plan to reduce the power sector and actual estimates. awareness. deficit. Cash /hiabicity management Number of days of overdraft Adhere to contingent liability cap and better Legislation capping contingent Guidelines for sectoral with RBI (target of zero); manage contingent liabilities. liability passed, Guarantee fees allocations of guarantees. reduced borrowings from made mandatory. public account; borrowing Make as much fiscal information as possible Overview of Budget expanded to Further expand the based on fiscal targets available to the public. include information on off-budget information released in the rather than availability. borrowing, tax expenditures and Budget Overview. Contingent liability tax arrears. Publication of monthly management accounts on the internet Compliance with Ceiling on commenced. Guarantees Act; low/zero Improvestimation and forecasting of key Completed study on Complete study on Improved methodologies for devolution of guarantees to variables (major taxes, pensions, other budget estimation and pension forecasting. budget estimation and GoK. expenditure items) forecasting (fiscal pension forecasting marksmanship) place. B. Reform Revenue Establish Tax Reform Commission to set out Tax Reform Commission first Tax Reforms Growth in tax revenue and System road map for tax reforms - both on policy and report submitted. Commission to submit tax/gsdp ratio. administrative arrangements. final report. Reduction in tax arrears. Objective: Policy and Replace sales tax, entry tax and tumover tax Sales tax concessions for new Draft VAT legislation. Approve VAT legislation. Introduce VAT ( ) Positive feedback from administrative by Value-Added Tax based on self- investments abolished and floor Complete VAT taxpayers. reforms to raise assessment and a functional organization. rates for sales tax introduced. preparation. additional revenue, VAT preparation: VAT working improvefficiency, groups functional; full-time VAT and reduce team in place; VAT consultants compliance costs. selected; VAT discussion paper issued; self-assessment and partial rebating of inputs.

46 Annex B Page 2 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Reform Area Government Strategy Actions Already Future Milestones (Indicative target dates) Performance Taken December 2001 April Apnil _ benchmarks B. Reform Revenue Overhaul stamps & registration, and motor Changes in stamps & registration Implement reforms and modernization System (Cont.) vehicle tax to close loopholes, boost and motor vehicle tax announced. buoyancy, as well as to improve service to customers/tax-payers. Improve cost-recovery for 'non-merit' Rates increased for canal Continue to increase user charges. government services, such as irrigation, irrigation, higher and technical transport, higher and technical education, education. Automatic indexation of hospital services, and water supply. bus fares introduced. C. Improve Control wage bill while staffing-up high- Recruitment strategy established, Find opportunities for tighter control of wage bill. Wage bill and civil service Composition of priority areas (education, health, police, including high-level control size. Public Spending forestry). procedure. Spending priority sectors Shift spending towards high-priority areas: Spending priority sectors Further increases Additional annual increases Power sector deficit health, elementary & secondary education, protected in the budget. priority sector spending in priority sectors. (monthly monitoring). rural water supply, roads; and maintenance budget. Spending on subsidies. irrigation and public facilities. Shift spending from salaries & subsidies to non-wage O&M. Protect capital spending during fiscal adjustment. Make power sector less dependent on Financial Restructuring Plan (FRP) Revised FRP issued, with Annual issuance of FRP for government, develop and implement a for the power sector approved by consistent utility budgets power sector. Financial Restructuring Plan to reduce the Cabinet. power sector deficit over time, KPTCL budget consistent with FRP approved, Reduce and better target subsidies via Study commissioned to develop Study on subsidy Implement recommendations of subsidy study individual reform strategies. individual subsidy reforms reforms completed Food subsidy redesigned to improve targeting, and funding capped in nominal terms.

47 Annex B Page 3 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Reform Area Government Strategy Actions Already Future Milestones (Indicative target dates) Performance Taken December 2001 April 2002 April benchmarks D. Strengthen Institutionalize the Medium Term Fiscal Plan FY02 expenditure ceilings Revised MTFP Further institutionalize Fully institutionalize rolling Shifts in expenditure Public Expenditure into the annual budgetary process. allocated to line departments available to guide MTFP in context of MTFP process in priorities over the medium Management Establish up Expenditure Review Committee consistent with MTFP. budget preparation for 03 budget government's policy term. (ERC) to debate priorities and rigorously Three pilot line departments making, planning and Closure or restructuring of Objectives: review any new schemes for consistency with (Health, Education, PWD) initiated budgeting process schemes following Institutionalize a MTFP before inclusion budget. expenditure programming Three pilot line independent evaluation medium-term consistent with MTFP, including departments (Health, Better delivery of perspective into the identification of objectives, Education, PWD) to expenditure programs as budgetary process priorities and monitoring. prepare measured by beneficiary Tighten the link Expenditure Review Committee comprehensive assessments in evaluations between expenditure set up, and made operational. departmental MTFPs and household surveys composition and New proposals scrutinized by ERC Expenditure savings policy priorities before presentation to Cabinet for identified by line Greater focus on inclusion the budget. departments performance of budget consistent with expenditure MTFP. programs. Subject an increasing number of schemes and Govemment Order issued to Initiation of Completion of evaluation Institutionalize performance projects to independent evaluation, and create institutionalize independent Independent pilot pilots. monitoring and evaluation mechanisms for acting on the findings of evaluations of Government evaluations of Evaluation findings system in all government these. projects and schemes. schemes across reflected in budgetary departments. major departments. submissions. Increase the flexibility of spending Committee for Elimination and Complete scheme/budget departments to provide them with incentives Rationalization of Redundant head merger/ to seek efficiency savings. Schemes created rationalization for at least budget eliminated, 10 Departments in the merged or rationalized many budget. schemes of several departments. Strengthen incentives for Departments to identify budgetary savings as part of the budgetary process.

48 Annex B Page 4 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Reform Area Government Strategy Actions Already Future Milestones (Indicative targetdates) Performance Taken December 2001 April 2002 April benchmarks E. Strengthen Develop accounting capability Controller's Officestablished to Complete State Approve 2 pilot departments More timely GoK financial Public Financial lead the public financial Financial Public Financial maintaining/compiling statements Management and Improve timeliness and disclosure of financial accountability improvement Accountability Accountability parallel accounts (April Reduction in backlog of Accountability reporting program. Assessment (SFAA) Improvement Program, 2003). accounts and audits of local Study Clear baklo of aconsdemonstrate capacity to bodies and PS Us. Objective: Published summarized budget Study Car backlog tof acou handle own accounting and Modies and PSUs. Improve information (based on monthly controls in priority of PRIs (ZPs, TPs, GPs), payroll functions More timely and complete transparency, enable accounts) on Internet. areas: rioritiof PsU KGI s, P) (mainstreaming of responses to audit bekter financial areas: reconciliations, PSUs, KGID. departmental accounting). observations prepared and performance Clearing of backlog of accounts for Personal Deposit Further clear and eliminate disclosed. measurement and local governments and PSEs Accounts, repoureming anddres initiatgoved mentsandp loans/advances, and backlog of accounts and Reduction in audit weaknesses in guarantee/debt audits. qualifications. intemal control and recording/ reporting. GoK to prepare financial Better internal controls public accountablity statements according to demonstrated through and enable better accepted public sector reduction in un-reconciled legislative oversight. accounting standards; and items, reduction in disclose timely financial magnitude of Personal statements. Deposit account. Robust internal control system operational. Transparency and accountability of local Improve audit responsiveness Computerize key accounting functions Provide official response to the CAG's letter on the Audit Report. Computerization of treasuries initiated. F. Reform Public Legislate to enforce transparency in Transparency in Tenders and Procurement procurement Procurement Law passed. Objective More transparent and competitive procurement processes that improvefficiency, lower costs and reduce corruption. bodies improved. Implement measures to GoK and all government ensure timely responses entities to take timely to audit findings. follow-up on audit findings, Prepare GoK's response including disclosure to audit report, Complete pilot Computerization of payroll computerization of and DDOs. Treasuries. Complete computerization Award contracts for ZP of Treasuries, ZPs and and TP computerization. TPs. Review efficacy of Increased number of Procurement Act and take Tender Bulletins on corrective action Intemet. Increased number of procurement audits. Perception of reduced corruption in procurement, as measured by survey of offcials and public.

49 Reform Area F. Reform Public Procurement (Cont.) AnnexB Page 5 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Government Strategy Actions Already Future Milestones (Indicative target dates) Performance Taken December 2001 F April 2002 April benchmarks Make procurement decisions public by use of First Bulletins on Net by KBJNL Expand number of departments/agencies All departments/agencies Tender Bulletins, also to be placed on and KNNL. Intemet. Undertake sample procurement audits by First sample audits in pilot Expand sample audits Extend sample audits throughout Government independent agencies in a widening range of departments and PSUs (KBJNL to other PSUs and government agencies. and Minor Irrigation). Departments, including KPTCL. Further measures to strengthen procurement Introduce further procurement reform measures based on the Karnataka Procurement Assessment. 11. ADMINISTRATIVE REFORMS A. Define Articulate Government strategy to define the Administrative Reforms Final ARC report to be Second GSAP approved Continue updates of GSAP, Monitoring of action taken Govemance role of Govemment and for improving Commission established. received. by Cabinet, with action monitor and publicly report against proposals in Strategy efficiency and transparency of govemment First ARC report received, taken report on the first on progress. successive GSAPs. operations. Governance Strategy and Action GSAP. Plan (GSAP) approved and made public. B. Reform the Civil Reduce and rationalize transfers of civil Governments publicommitment Approval of new rules Public reporting on Monitor progress in Drastic reduction in number Service and Public servants through (i) a monitoring system; and to reduce transfers drastically. under the Civil progress in implementing reducing transfers and take of transfers, starting Administration (ii) putting place new institutional Monitoring system introduced and Service Act to reduce transfer policy, including corrective actions mechanisms. placed on the intemet. transfers. number of transfers, Stability and increase Objective: General Transfers for 2001 average tenure by tenure for key positions in Improve banned department, district and monitoring system transparency, reduce bne.positions, against targets Reduced corruption in corruption, rationalize New government policy on recruitment and transfers, departments and transfers included GSAP. and improved employee functions, improve Increase transparency in recruitment. Weight given to and motivation, as internal efficiency, interviews to be measured by survey strengthen human reduced vis-a-vis Elimination and resource competitive/ qualifying consolidation of management. examinations. departments Rationalize the civil service, and reduce it in Functional reviews for 15 Completion of Announce and begin Revise CSR terms and Reduction in size of civil size, by restructuring and reducing the size of departments initiated. functional reviews for elimination and conditions to promote service, particularly in areas major departments. Mines & Geology Department major departments. consolidation of restructuring and where functions are consolidated with Major Irrigation overlapping functions and redeployment eliminated and consolidated Department. Announcement made departments based on Complete rationalization Greater meritocracy in to merge Institutional Finance findings of functional based on functional recruitment, promotion and Department with Finance reviews. reviews. personnel evaluation. Department.

50 Annex B Page 6 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Reform Area Government Strategy Actions Already Future Milestones (Indicative target dates) Performance Taken December 2001 April 2002 April benchmarks B. Civil Service and Speed up Government administrative Introduction of desk Introduction of single file Public transactions/decision-making time. officer system for system on a pilot basis. Administration selectedepartments (Cont.) in Secretariat. Monitoring of reduction of time taken for administrative transactions. Human resource reforms: Initiate computerized Initiate participatory Installation of computerized * Improve personnel review (ACR) HR database project. personnel review process HR database. * processes - supervisors meet with employees and review Survey public officials to benchmark and their ACR. monitor CSR. monitor CSR. ~~~~~~~~~~~~~~~~~~~~~~~Public officials' surveys to * Install computerized human resource benchmark and monitor database progress C. Citizen Charters Improve services in a widening number of Agency reforms, up to issuance of Roll out pilot reforms Monitor and provide report Carry out independent Improved service delivery, & Agency Reforms agencies through agency reforms citizens' charters for three pilot to cover broader on the performance of the evaluation of pilot agency as measured by user to Improve Service consisting of: (i) user surveys or services with large public interface geographical areas. three pilot services, reforms. surveys and reduction in Delivery consultations to identify problems and in maternity wards of Bangalore, including user surveys. time to deliver services benchmark progress; (ii) improvement in police, and motor vehicle Expand coverage of Objective business process/ computerization; (iii) registration, driving license and tax agency reforms(e.g., PDS, Improved service establishment of grievance redressal payment stamps and registration). delivery in services mechanisms; (v) publication of citizen with large public charters. interface Use demonstration effect for scaling-up. D. Enhance For urban local govemments, increase their Self-assessment in property tax Roll-out self-assessment Extend self-assessment to Increase revenue base at Effectiveness of revenue base introduced Bangalore to 5 major cities. all municipalities. localevels. Decentralization Strengthen other tax bases Objective for Municipalities. Mor efficient delivery of local services, as measured Mor effective local by household surveys. govemments by strengthening For ruralocal govemments, strengthen Untied element of PRI funding Give Gram Panchayats responsibility for larger number accountability administration and financial capability. increased. of development programmes. mechanisms at the Land revenue and property tax Further measures to decentralize local government localevels while Devolve larger funds and greater powers to rates in rural areas increased. based on studies/workshops enhancing autonomy. the Gram Panchayats. Undertake training programs for panchayat functionaries in planning and budgeting.

51 Annex B Page 7 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Reform Area Government Strategy Actions Already Future Milestones (Indicative target dates) Performance I Taken December 2001 April 2002 April benchmarks E. Enhance Provide legislative basis to righto Righto Information (RTI) Act Notify rules and make Evaluate functioning and Increased public access to Freedom of information. passed. RTI Act and Rules impact of RTI law. information, measured by Information effective. surveys of Objective Greater Make government records accessible. Cataloging, indexing, and computerizing of government records households/officials. flow of information to Apply information technology to improve flow of information to citizens. Make public to increase indices of govemment documents available on the intemet. Train information participation, officers. transparency and accountability, and to Focus on areas of public demand for Survey on public Put resources into making reduce corruption. information. information needs information available where there is high public demand. F. Use Electronk- Expand the use of e-governance throughout E-governance initiatives underway Prepare e-governance Mainstream e-governance Greater use of e- Govemance to govemment. in sales tax, revenue, and status and action plan initiatives more broadly governance in departments. improve efficiency treasuries. Implement more far- within and across and transparency reaching initiatives to use departments Objective Use IT to reduce delays & corruption, and enhance transparency. G. Implement and Monitor a Comprehensive Anticorruption Strengthen anti-corruption enforcement Measures included the Govemance Strategy and Action Plan (GSAP). electronic governance Implementation of measures to strengthen Lok Ayukta. Perception of reduced Establish office of 'Ombudsman' to look into complaints corruption, as measured by against functionaries of local bodies. surveys Program Strengthen corruption prevention measures. Govemment's corruption Establish inter- Monitor implementation of corruption prevention Objective prevention strategy included the departmental initiatives, assess progress, and take deeper measures Enhanced public GSAP Corruption Prevention as necessary. monitoring, reduced Committee, to consult Undertake surveys to identify principal areas of corruption and with the medi and corruption and the scope for system-wide reforms aimed enhanced credibility legislators monitor at prevention. of the state and publicly report on progress in anticorruption and deepen system reforms.

52 Reform Area Annex B Pag 8of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Government Strategy Actions Already I Future Milestones (Indicative target dates) Performance Taken December 2001 A 2002 _il Api benchmarks III. PRIVATE SECTOR DEVELOPMENT A. Restructure and Set up policy framework and durable Public Sector Restructuring Privatize Public institutional mechanism to support PSU Commission established and Enterprises closure/privatization. functional. Objective Govemment approval of policy Number of PSUs sold/closed/restructured. Withdraw state from paper on PSU Reform and commercial activities Privatization and related to reduce procedures, with 15 PSUs administrative and identified for first phase of fiscal burden of PSU. program. High-Powered Committee established for implementation of new PSU policy. Close/privatize PSUs Operations closed, environmental Close/privatize an Close/privatize an Close/privatize 10 screening complete, and VRS additional 4 PSUs. additional 5PSUs additional PSUs by March, payment offered in 1 PSU Close or privatize remaining PSUs covered by policy paper by March, Restructure the remaining PSUs. B. Deeglaio Policy reforms to improve the business Cabinet approval of Approach Introduction of rules Complete implementation of proposed reform measures Feedback from industry via B. Deregulas on and environment: Paper on Business Deregulation and operating of the Approach Paper. surveys (e.g. on number of Busiessprocedures as per the inspections, time to set up a Environment * Reduce excessive regulations related to Approach Paper. business). starting or running a business. Objective Ratiof investments Improved business * Reduce and rationalize inspections. grounded to investment environment; less Get regular feedback from the private sector. Conference business Undertake and publish Institutionalize the proposals. bureaucratic environment with stakeholders and first survey of industry public/private dialogue interference; more the private sector. interface with government private investment department. and higher growth.

53 Reform Area Annex B Page 9 of 9 KARNATAKA ECONOMIC RESTRUCTURING PROGRAMME: May 2001 Government Strategy Actions Already Future Milestones (indicative target dates) Performance Taken December 2001 April 2002 I April benchmarks IV. POVERTY AND HUMAN DEVELOPMENT MONITORING Objective Develop Poverty and Human Development Human Development Division StafFing with Functioning of the PHDMS. A better information and Poverty Monitoring System (PHDMS) constituted, and Advisory Group consultants and Use of its results by policy base for policy- appointed. experts. Users. making and program Institutionalize the 1999 Human Development After consultations, finalize terms District-level poverty Human Development Publication of second e design Report with regular tracking of and reporting of reference of the proposed estimates to be Monitoring Report to be Human Development Human development More information on poverty and social indicators monitoring system and list of prepared based on included as a chapter in Report following the targets to judge success of the public domain. indicators be tracked (including the analysis of the the annual Economic processing of data from the overall program (including baselinestimates where pooled central & state Survey published by GOK Census Data. health and education A more pro-poor available). samples of the 55m targets) development strategy round NSS Consumer and better-informed Expenditure Survey. policy making made possible by high- Institute monthly quality data being reporting system for available on a timely tracking district-level basis changes in agricultural wages and prices. Undertake special studies to focus policy attention critical poverty-related issues Gulbarga (District) Human Development Report initiated. Initiate additional data collection/ strengthening exercises. Surveys of rural drinking water and primary education in I Gulbarga. Publish Gulbarga District HDR. Carry out other special-purpose studies as needed

54 Annex C Page I of 24 I. Introduction: MEDIUM TERM FISCAL PLAN FOR KARNATAKA, to Economic reforms, under way since 1991, have posed important challenges as well as opportunities to the state governments. Accelerating economic growth and reducing poverty call for releasing resources for strengthening infrastructure facilities in the states and making substantial allocation of resources to rural development, health and education. State governments have a predominant role in the task of strengthening physical infrastructure and, more particularly, in human development. Besides, the greater role assigned to the private sector has confronted the states with the challenge of creating an accommodating environment in the wake of fierce inter-state competition. Karnataka has to participate in this competitive environment. This calls for the creation of a climate for realising the growth potential by attracting private investment. However, to be a favourable destination for private investment the State government should not only follow investment-friendly policies but also create high quality infrastructure and finance it through an efficient tax system. The challenge is particularly severe because the fiscal condition of the State has been deteriorating sharply. Although the fiscal situation in Karnataka, unlike in many other states, has not yet reached the crisis point, it will not be long before it becomes unsustainable if the present trend continues. 2. The State government is seized of the problem and is keen to undertake immediate corrective measures to put its finances back on the rails. To promote wider discussion on the fiscal health, the State government placed a White Paper on Karnataka State finances in the last budget session of the Assembly (March 2000). The White Paper has identified the sources and causes of stagnancy in 1

55 Annex C Page 2 of 24 revenues and the reasons for the proliferation of public expenditures, and has indicated directions and guidelines for undertaking corrective measures. White Paper has also stated that it is necessary to calibrate the reforms carefully to achieve the required fiscal correction. 3. The fiscal deterioration in the State is not the result of fiscal operations in one or two years but is a culmination of problems accumulated over several years. Given the magnitude of the problem, fiscal correction cannot be achieved within one or two years. Besides, fiscal decisions of one year are not confined to that year, but have multi-year consequences. Thus, a road map for corrective measures will have to be drawn up carefully in the medium term. The The medium term framework allows designing implementable reforms, and applying remedies depending on changing situations and imperatives. Therefore, the White Paper has emphasised the need to have an explicit medium-term fiscal framework for the State Government. 4. The preparation of Medium Term Fiscal Plan (MTFP) is part of the State Government's commitment to greater fiscal transparency. Other important steps already taken in this direction include publication of an "Overview of the Budget" which provides basic fiscal data and information on guarantees. To further improve transparency, the Govt has included in this publication information on off-budget borrowings, tax arrears and tax expenditure (cost of tax incentives) from the current year. The Govt has also started publishing monthly financial accounts on the Internet ( 5. The medium-term framework should set fiscal targets and detail the policy package necessary to achieve them. These targets and policies will have to be dovetailed to the annual budgetary exercises to operationalise the restructuring plan. The budgetary exercise also provides an opportunity for the State government to update the medium-term fiscal framework every year. This 2

56 Annex C Page 3 of 24 framework sets the targets for all the years up to and details the important policy measures to achieve these targets. 6. It must be mentioned at the outset that bringing about fiscal rectitude entails hard decisions. This has to be a rational community choice to achieve the common good on a sustainable basis. Difficult but unavoidable measures will have to be taken to raise revenues, to weed out unproductive expenditures, rationalise and target subsidies, enhance efficiency and accountability in public spending, and to stabilise debt. Postponing these measures will only compound the problems, necessitating much harsher remedial measures in the future. After carefully considering the available options, the State government has decided to embark on the medium-term plan to achieve fiscal balance by reforming policies, processes and institutions. Il. The Problem: 7. The White Paper on the State's finances has brought out significant deterioration in the fiscal position in Kamataka over the last decade particularly since The fiscal position was transformed from a revenue surplus of Rs.159 crores in (accounts) to a revenue deficit of Rs.2325 crores in (accounts). Similarly, during the period from to , the fiscal deficit increased from Rs. 513 crores to Rs.4276 crores. This has created an unstable fiscal situation characterised by a vicious cycle of increasing interest payments feeding into deficits and debt stock. The continuation of the prevailing trend will surely land Karnataka in a crisis within the next few years. 8. An important cause of deteriorating fiscal situation in the State is declining share of revenues to Gross State Domestic Product (GSDP). The ratio of tax revenue to GSDP has fallen from 9.3% in to 8.2% in The ratio of non-tax revenue to GSDP has shown a decline from 2.2% in to 1.17% in , mainly due to low and declining cost recoveries from non- 3

57 merit public services and poor performance of the public enterprises. Annex C Page 4 of 24 Implicit subsidies due to uneconomic pricing of irrigation and drinking water supply, higher and technical education and urban health services amount to about 1.2 per cent of GSDP. Cost recovery in irrigation in the State is only a fraction of the corresponding figures prevailing in the neighbouring states. 9. An equally worrisome issue of the State finances in Kamataka is the dismal financial performance of public utilities and enterprises. In , the State Government paid Rs.914 crores to Karnataka Electricity Board by way of explicit subsidy alone. The losses from Karnataka State Road Transport Corporation in amounted to Rs.54.6 crores (after payment of a State Govt subsidy of Rs.41.2 crores). Besides these, there are a number of public enterprises, many of which are of commercial nature, which have been making significant losses. Out of 78 Govt companies, 33 made losses in amounting to Rs.197 crores. In case of 22 companies, the accumulated loss exceeds the share capital, reserves and surpluses put together. 10. Another important reason for the fiscal problem is the fast expansion of public expenditures within the revenue account during the last few years. The significant increase in salary and pensions, interest payments, subsidies and transfers has pre-empted a high and increasing proportion of borrowed funds for meeting current expenditures. Interest payments as a proportion to GSDP increased from 1 per cent in to about 2.12% per cent in During this period, the subsidies and transfers as a ratio of GSDP also increased by about one percentage point. 11. The problem is accentuated by the declining productivity of public expenditure, which in turn has come about due to a sharp increase in administrative expenditures, poor maintenance of public assets, declining proportion of capital expenditures and long gestation periods in completing 4

58 Annex C Page 5 of 24 infrastructure projects. Moreover, increase in indebtedness has resulted in higher and higher amount being set apart for debt servicing, leaving a relatively less amount for productive expenditure. III. Objectives and Targets: 12. The medium-term fiscal restructuring plan will have to reverse the historical trend of the deteriorating fiscal situation in order to phase out public dissavings in the medium term so that borrowed funds are invested to create productive assets and shore up the fiscal situation. The strategy in the medium term should also enhance productivity in public spending to ensure efficient and equitable delivery of public services. Finally, increasing requirements of public expenditure should be financed through an efficient and equitable tax system and proper cost recovery. Thus, the medium-term fiscal plan, while ensuring satisfactory levels of infrastructure should also pave the way for increased private sector investments, which will result in accelerating economic growth and reducing poverty in the State. 13. The State government places emphasis on substantially achieving the above objective in the medium term. medium-term fiscal plan for is as follows: With this in view, its main target under the (i) Phasing out revenue deficits by from 1.49 per cent of GSDP in (BE), so that borrowing is not used to finance current expenditures. (ii) Reducing fiscal deficit from the present level of 3.66 per cent of GSDP ( BE) to 3 per cent of GSDP during the same period to stabilise debt stock, and prevent an ever-increasing burden of interest payments. (iii) Safeguarding adequate allocation to social sectors like basic health care and primary and secondary education and for physical infrastructure requirements, both for investment and for maintenance. 5

59 Annex C Page 6 of These objectives will have to be achieved by initiating a concerted programme of tax reform, reform in the structure and management of expenditures, levying appropriate user charges, public enterprise reform and reform in administration and governance. objectives will require: Specifically, achieving the above * improving the revenue productivity of the taxes by bringing about systemic changes in the base, rate structure and administration and enforcement mechanisms. The simplification of the sales tax system leading to the introduction of value added tax (VAT) would be one of the major reform initiatives. This would not only rationalise the consumption tax system, but would also improve revenue productivity; * enhancing productivity of non-tax revenues. In case of user charges, this is to be brought about by greater community participation in maintenance of assets and by ensuring quality and reliability of services. Public enterprise reforms would help to achieve productivity gains for generating better receipts; - reducing budgetary support to public enterprises. This has to be achieved by disinvesting and restructuring public enterprises. While in some cases it may be necessary to introduce voluntary retirement schemes (VRS) to reduce over-employment, government may have to close down or privatise some of the enterprises; * drastic reduction of implicit and explicit subsidies to electricity and transport sectors through economic pricing, improving productivity in generation, transmission and distribution and metering the consumption of electricity by the agricultural sector and privatisation of distribution; * achieving significant improvement in cost recoveries and reducing implicit subsidies in respect of services, such as drinking water supply, irrigation, higher and technical education, and secondary and tertiary health care, particularly those not directed to the poor; * reducing the quantum of food subsidies by eventually targeting it strictly to persons below the poverty line; * improving the efficiency of government expenditures by increasing allocation to the creation and maintenance of infrastructure facilities and augmenting outlay on human development; 6

60 Annex C Page 7 of 24 * compressing unproductive government expenditures by reducing government employment and re-deployment to social sectors such as primary and secondary education and health; * assessing expenditures in irrigation, and public works departments by closely scrutinising the schedule of unit rates. Sequencing expenditures on major projects to minimise time and cost overruns and improving public expenditure management and control systems by increasing the level of public participation and investment (e.g. through creating water user associations); * ensuring a careful debt management plan to reduce the composition of high cost borrowing and to limit contingent liabilities. In particular, a close scrutiny of contingent liabilities, moving away from borrowing at high cost from small savings loans and from specialised financial institutions like HUDCO, LIC and NCDC; borrowing on the basis of repayment capacity rather than availability as in the past; * improving governance, putting in place a sound public expenditure management programme to improve the efficiency of expenditure and targeting. 15. The State government has already initiated a number of reform measures in many of the above areas. These include establishment of the Tax Reforms Commission, Administrative Reforms Commission and Public Sector Restructuring Commission, initiating measures to restructure and privatise the power sector, adoption of a new policy for restructuring of public sector undertakings, increases in user charges for various services, hiring restraint and abolition of positions, and initiating action towards introduction of Value Added Tax. Revised estimates for already show a substantial improvement in fiscal performance, for example a reduction in the fiscal deficit from 4.5% of GSDP in to 4.03% and a reduction in the revenue deficit from 2.45% of GSDP in to 2.11%. 16. Since it is the responsibility of the State Government to repay the loans contracted by two specialised irrigation finance corporations, i.e., KBJNL and KNNL, a set of "consolidated" fiscal indicators have been worked out by adding 7

61 Annex C Page 8 of 24 the off-budget borrowings and repayments to the traditional budgetary figures. The "consolidated" figures also capture the borrowings by State undertakings, e.g., from HUDCO or through raising bonds, where the liability for repayment is on the State Government. These are actual repayment liabilities of the Government and not in the nature of contingent liabilities. MTFP assumes that such exceptional borrowings by KBJNL and KNNL to complete the Krishna river projects will cease by It is also the intention of the State Government to reduce offbudget borrowings and to move all such borrowings back on to the budget by end No additional recourse to off-budget borrowing will be made beyond the current beneficiaries. At present, these "consolidated" figures have greater relevance in the assessment of the true fiscal situation of the State. An important objective of the MTFP is to stabilise consolidated debt as a ratio of GSDP, besides reducing consolidated fiscal deficit to 3% of GSDP. 17. One important method of limiting debt service payments is to adopt a borrowing strategy to move away from short-term/high-cost loans to longterm/low-cost borrowings. Admittedly, small savings loans are one of the highcost sources of borrowing and the State Government, in order to ease its hard budget constraint, has been encouraging borrowing from this source. This has been one of the factors in the fast escalation of debt service payments. As a part of debt management strategy, the government will substitute these high-cost loans with low-cost/long-term borrowings from agencies such as the World Bank, ADB and bilateral donor countries. Setting these targets and deciding on an appropriate mix of borrowings would also help in stabilising public debt. 18. The fiscal restructuring plan should cover all contingent liabilities including guarantees issues by the government. The State government has already passed the Ceiling on Government Guarantees Act, has introduced guarantee fee, will make budgetary provisions to meet the eventuality of possible discharge of 8

62 Annex C Page 9 of 24 contingent liabilities, and is presently working on the rules for sectoral allocation of guarantees every year. 19. The next stage in working out the medium-term fiscal plan is to project the fiscal scenario during the period on the basis of a reasonable growth of revenues and expenditures. The target growth rates chosen for projections should take into account the degree of fiscal correction required. These targets should be realistic and achievable. For Karnataka, all the targets are expressed as percentages of GSDP in the State. In order to obtain the target in absolute values, GSDP is projected by assuming 7.5 per cent growth per year in real terms. This is in keeping with the recent growth performance in the State, which has averaged 7.4 per cent during the 5 years ending The inflation rate is assumed to be 6 per cent. 20. As already mentioned, the basic reason for the fiscal imbalance in the State is that the growth rate of revenue receipts was significantly lower than that of revenue expenditures. During the last decade, the average annual growth rate of revenue receipts in Kamataka was 14.9 per cent whereas revenue expenditures grew at 15.9 per cent per annum. The actual plan of phasing out fiscal imbalance in the State will have to combine the strategies of increasing the growth of revenues and compressing expenditures, keeping in view the efficiency in raising revenues and productivity of public expenditures. 21. In the medium-term fiscal plan worked out for Kamataka, a combination of the strategies to accelerate the growth of revenues and decelerating expenditures has been adopted. Taking the baseline fiscal situation as in , expenditure and revenue projections are simulated to arrive at an implementable plan of achieving the targets. The policy package necessary to achieve the targets for accelerating the growth of revenues as well as decelerating the growth of expenditures has been worked out. The detailed assumptions used for making the 9

63 Annex C Page 10 of 24 final set of projections of individual items of revenues and expenditures are listed in the Annex. The policy imperatives for restoring fiscal balance in Karnataka are discussed in the following sections. IV. Revenue Projections and Reforms: 22. Improvement in the fiscal situation in the State cannot be achieved unless concerted action is taken to reform the tax system. A comprehensive package of tax reforms will be undertaken after receiving the final recommendations of the Tax Reforms Commission, which are due in June, The Commission's report is expected to provide a blueprint for reforms not only to minimise distortions, but also to enhance the revenue productivity of the tax system. The first report of the Commission submitted to the Government in February, 2001 has highlighted the fall in growth rate of the tax revenue from 1980's to 1990's and also the fall in the ratio of tax revenue to GSDP. At the same time, the Commission is of the opinion that tax rates are generally high. The crucial issues that need to be addressed are to expand the tax base, i.e., improve coverage and reduce exemptions, rationalise tax structure, improve tax compliance and strengthen tax administration and enforcement. The Commission has recommended simplification of the sales tax system with a view to introducing a Value Added Tax and has provided a road map for the same. It has also given concrete recommendations to improve revenue productivity in case of State Excise Duties, Motor Vehicles Tax, stamp duties and registration fees and the profession tax. Some of the recommendations have already been incorporated into the budget of The State Government will prepare an implementation programme based on the Commission's recommendations to improve the tax buoyancy. 23. In the mean time a number of steps have already been taken to improve the buoyancy of commercial taxes. The recent imposition of floor rates in all the States and Union Territories is likely to reduce revenue loss due to trade diversion. 10

64 Annex C Page 11 of 24 The abolition of tax incentives for industries too will improve the revenues and reduce distortions. A decision has been taken to bring about a phased introduction of Value Added Tax (VAT) in The introduction of VAT, though predicated to be revenue neutral, may result in a small decline in the revenue in the short run. The government will have to improve the administration and enforcement of the taxes to make sure that this decline is confined to only the initial period of 2 years. 24. The reform measures already initiated and those that will be taken up are expected to improve revenue productivity of the tax system. The historical buoyancies and those that are assumed in our projection are given in the Annex. Implementation of tax reforms in the coming years and better administration and enforcement of the taxes are expected to improve revenue productivity at least to the extent assumed in this exercise, and will also result in an improved tax-gsdp ratio (from 8.15% in to 9.42% in ). Tax-GSDP ratio has already improved from 8.15% in to 8.95% in (RE). 25. In regard to non-tax revenues, the Government's objective is to improve cost recovery in general and to ensure full recovery of operating costs for nonmeritorious economic services. However, it will take time to achieve this goal, and will be attempted in a progressive manner. In order to inculcate a sense of ownership of assets and services, beneficiaries should contribute towards the capital costs, either at the initial stage of the project, or later during the operation of the services. Appropriate policy measures will have to be taken to increase user charges from higher and technical education, health, irrigation and drinking water supply. This will be easier to achieve if simultaneous steps are taken to enhance the quality of service provided to the users. Higher cost recoveries in respect of these services are necessary not merely to improve the fiscal situation but also to reflect their economic values with appropriate adjustment made for social obligations. Thus, in the case of the health sector, proper pricing of secondary and tertiary health care services and various clinical and other medical tests conducted 11

65 Annex C Page 12 of 24 in the hospitals and dispensaries should help in achieving higher cost recovery. Similarly, cost recovery in secondary education is estimated to increase from 0.95% ( RE) to 2.13%, in higher education from 0.3% to 2.2%, in technical education from 3.2% to 22.5%, in major and medium irrigation from 33% to 82%, in minor irrigation from 5.26% to 20%, and in rural drinking water supply from 0.61% to 2%. Other non-tax revenues are assumed to grow at their historical rates. The detailed cost recovery rates in each of the five years from for these sectors are presented in the Annex. The State Government has already revised the irrigation water rates during to about 2.5 times of the earlier rate. In case of rural water supply and health, the improved recovery will be used at the field level to meet part of the O&M expenditure and will not come back to the Government. This envisages progressively greater participation of the community in maintaining the assets. 26. Another area where concerted effort is needed is to enhance recoveries from the beneficiaries of housing provided by the government. While the expenditure on housing has increased substantially over the years, cost recovery from beneficiaries is negligible. Only when loans are recovered from beneficiaries will it be possible for the Government to repay the loan to the Housing Finance Agencies and obtain more loans for new beneficiaries. It is therefore proposed that on housing loans, the recovery will be stepped up from 18% in to 31% in Karnataka state has been a pioneer in democratic decentralisation. Rural and Urban Local Bodies receive funds from the State Government as per the recommendations of the State Finance Commission. However, these bodies are short of funds and are unable to provide satisfactory standards of services. Government will explore possibilities of augmentation of revenue of these local bodies. A system of self-assessment of property tax has shown considerable promise in Bangalore city. This will be gradually extended to other cities. 12

66 Annex C Page 13 of Revenue from central transfers accruing to the State depends on the recommendations of the Finance Commission, policies of the Planning Commission and programmes of the central ministries implemented through the States. The Eleventh Finance Commission has already made its recommendations regarding tax devolution, non-plan grants, and calamity relief. The State's entitlement for the five years has been worked out on the basis of these estimates. The second report of the Finance Commission deals with an incentive-linked additional transfer based on the fiscal reforms undertaken by the States. Since the present MTFP is fully consistent with such fiscal reforms, the allocation made for Karnataka on this account has been assumed in the MTFP. 29. The State Government recognises the importance of an accurate model for arriving at revenue projections for each year during the budgetary exercise. To improve revenue and expenditure forecasting, a study on fiscal marksmanship has been commissioned. Its results will be used from the budgetary cycle of V. Expenditure Reforms 30. Restoring fiscal health in Karnataka critically depends upon compressing unproductive expenditures and improve public expenditure prioritisation to enhance efficiency and effectiveness. It is also necessary to provide adequately for maintenance of existing assets. Continuously increasing the plan expenditures on the assumption that they are necessarily productive will only result in negligence of maintenance, which reduces technical efficiency in spending, as has been the case in the past. The expenditure policy, thus, will have to be calibrated to conform closely to the fiscal targets, commitments and priorities. 13

67 Annex C Page 14 of One of the most important components of expenditure expansion in recent years has been wages and salaries. The government has already announced its intention of abolishing 80 per cent of the vacant posts as per the Finance Minister's budget speech of This implies that almost 10 per cent of the posts of the State government would have to be reduced. However, while drawing up the medium term fiscal plan, liberal exemptions have been allowed in case of primary and secondary education, health, police, forest and wildlife protection as indicated in the Annex. 32. Another measure in the downsizing agenda is to leave posts vacant when the incumbents retire. The State government intends to abolish one-third of the retiring posts (other than primary and secondary education, health, police, forest and wildlife protection) in each of the ensuing four years. This would require detailed department-wise personnel planning, which will be undertaken as soon as possible. The two measures taken together will reduce the number of government posts by more than 12 per cent by Similarly, measures have already been initiated to reduce grants-in-aid to private higher educational institutions. 33. Unfortunately, there is not much flexibility in regard to expenditure on pensions and interest payments. Nevertheless, in the case of the latter, attempts will be made to reduce the composition of loans bearing high interest rates. Since a regime of falling interest rate prevails now, efforts are on to retire high cost debts of KBJNL by using fresh low-cost borrowings. Government will improve its pension forecasting capability through, inter alia, establishment of a human resources database. 34. As already mentioned, it is necessary to improve the productivity of public spending even while reducing expenditures. A major target of the medium term plan is to ensure adequate investments in the creation and maintenance of physical infrastructure. This is necessary to ensure a competitive edge to the economy. 14

68 Annex C Page 15 of 24 Therefore, the medium-term fiscal plan makes adequate allocation to maintenance of roads, buildings and irrigation works. In order to ensure this, the framework has provided for gradually enhancing the allocation so as to match the Eleventh Finance Commission norms. This involves significant stepping up of expenditures in these sectors. From the viewpoint of expenditure efficiency, stepping up expenditures in these sectors is highly desirable. 35. Another important area of fiscal correction is in compressing subsidies. This is an area where significant effort is necessary. As outlined in the White Paper, the State government has already commissioned a detailed study to quantify the volume and composition of implicit and explicit subsidies and to formulate appropriate strategies to reduce them in a phased manner, inter alia, through better targeting. 36. The power sector represents a huge drain on the Government's resources and poses the biggest fiscal risk in the near future. It will be impossible to eliminate revenue deficit without comprehensive structural reforms in this sector. Recognising this, the State Government has set up a regulatory commission, which has already issued its first tariff order. The electricity board has been corporatised and generation has been separated from transmission and distribution. Key to eliminating power sector subsidy is loss reduction, which will be done through universal metering and privatisation of distribution, and regular tariff increases to achieve full cost recovery. The MTFP assumes progressive decline in T&D losses from 37% in to 28% in The power sector reforms will bring back fiscal sustainability to the sector and make power supply more reliable for the consumers thus spurring economic growth. In the interim period, Government is fully_committed to meeting its financial obligations to the sector. Consistent with the MTFP, the Government has drawn up a Financial Restructuring Plan for the power sector, which gives a road map for elimination of subsidy over the next 10 years. 15

69 Amex C Page 160of Among explicit subsidies that need to be properly targeted is the food subsidy being given to ration cardholders. At present there are about 65 lakh green cards meant for families below poverty line. These cards entitle the families to buy food grains at a subsidised rate. The total subsidy stands at Rs.300 crores in The actual number of families below poverty line (BPL) in the State is much lower than this number and is estimated at about 30 lakh. Thus there were 35 lakh EBPL (extra BPL) cards, which could avail of food grain at BPL rate, but for which the State Government had to pay to FCI at a much higher APL (above poverty line) rate. Government has issued orders in July 2000 to remove 8 lakh ineligible cards from this category. This will significantly reduce the subsidy burden. Constant efforts will be made to target the subsidy to deserving beneficiaries in future. With this in mind, a new category of yellow cards for only BPL families is being introduced to target the really needy beneficiaries. For others left over under green card scheme, average prices of commodities will be higher requiring less subsidy per family. It is assumed that in each of the years from onwards, additional cards would be removed from EBPL category, The Government intends to cap the food subsidy in nominal terms to the level prevailing in and would work out a detailed strategy to make this happen. 38. In the case of the transport sector too, significant reduction in subsidies is envisaged by rationalising the pricing policy and improving productivity. The cost recovery from concessional pass holders is targeted to improve from 6% to 15% while permitting cross subsidisation from 74% at present to 82% in thereby reducing the subsidy obligation. The State Government has already permitted Road Transport Corporations to modify tariff automatically based on change in costs of inputs like diesel and salary. 39. Government used to give subsidies to encourage establishment of small scale industries. It was not possible to discharge the liabilities from year to year on this account. The liability has been discharged as a one-time measure through 16

70 raising of bonds by KSFC, where the repayment obligation Annex C Page 17 of 24 is on State Government. This has been captured in the Medium Term Fiscal Plan. From April 2000, this subsidy is limited to only tiny industries thereby bringing down the annual liability to a large extent. 40. Social welfare expenditure is meant to benefit the scheduled castes, scheduled tribes, backward classes, minorities and other weaker sections of the society. The State Government will try to ensure that assistance to these disadvantaged sections will be continued and in some cases expanded to enable them to access the benefits of growth. Thus, strength in social welfare hostels is assumed to increase at the rate of 2 per cent per year. Anganwadi expenditures are projected on the assumption of the number of children increasing at 2 per cent, the unit rate increasing by 20 per cent in and the remaining at that level till Social pensions too are projected to increase by 2 per cent per year and all other items of social welfare expenditure are assumed to grow at the rate of inflation. 41. Given that the State government has predominant responsibility in development of human capital, while compressing expenditure growth, it is necessary to protect allocations to the social sectors like primary and secondary education and health. As already mentioned earlier, 50 per cent of the vacant posts to be filled are assumed to be transferred to education and health sectors. In estimating the salary expenditures of these sectors, this additional employment has been taken account of. This additional provision of posts in these sectors is expected to ensure better spread and improvement in the quality of social services. The non-salary component of expenditure in education and health is assumed to increase significantly. With these projections, there would be adequate allocation for elementary education to achieve 100% enrolment by Specifically, the State Government's target is to ensure that by 2007, all children in the school going age group of 6-14 years are not only enrolled, but are enabled to complete 8 17

71 Annex C Page 18 of 24 years of schooling. Similarly, the enhanced allocation in health sector would be an important step in ensuring universal access to primary health care, and achieving the State's health targets. 42. A major target of the medium term fiscal plan is to ensure adequate investment in physical infrastructure, which has a catalytic effect on economic growth. In the Medium Term Fiscal Plan, reduction of revenue expenditure would result in more funds being freed for capital outlay. In turn, better physical infrastructure would attract larger private investment into the State to complement the efforts of the State Government. Another important feature would be completion of most of the irrigation works in Krishna Basin by , which would free resources for capital expenditure in other critical sectors. Thus the onbudget capital expenditure (actual expenditure on capital formation) will go up to a healthy 2.41% of GSDP, while off-budget capital expenditure will decline. It will also ensure that the size of the annual plan grows at a healthy rate and a greater portion of the plan is used for capital formation rather than on revenue account. More specifically, capital expenditure on drinking water supply, roads and bridges, education and health would receive a very significant boost. 43. The MTFP projections will result in significant increase in high priority development expenditures in a progressive manner throughout the five-year period. These expenditures can basically be classified into two types: (i) expenditure on social sectors and human capital formation, and (ii) expenditure on creation and maintenance of physical infrastructure. The projections on this count are given in the Annex. 44. An important component of expenditure reform is establishment of a system of accountability and incentives in expenditure implementation. This calls for a thorough overhaul of the public expenditure management system. Fixation of responsibilities to individual agents and ensuring the establishment of a system lx

72 Annex C Page 19 of 24 to ensure effective implementation are necessary to impart efficiency in public spending. The system should ensure that the expenditures are indeed incurred for the intended purpose in a productive manner to ensure creation of value for money spent. The system should create enough disincentives for rent seeking behaviour. As a first step, the Government has already constituted an Expenditure Review Committee with a mandate to scrutinise all new expenditure proposals and underlying policies, particularly with reference to their medium term implications. The policy paper on governance will consider the issue of public expenditure management in greater detail. 45. The policy changes envisaged when translated in terms of projection of revenues and expenditures show phasing out of the revenue deficit in Karnataka as a part of the set target. In fact, the projections based on the assumptions detailed in the Annex are estimated to improve the revenue deficit from 1.49% ( BE) to a revenue surplus of 0.42% in , and the consolidated revenue deficit of 2.01% of GSDP ( BE) to 0.17% in Similarly, as per the target, the on-budget capital expenditures are estimated to increase from the present level of 1.66% of GSDP ( BE) to 2.41% in Consolidated fiscal deficit during the same period would decrease from 5.44% of GSDP to 2.76%. The consolidated debt stock, after showing an initial increase from the current level of 30.61% ( BE) to 32.65% in , will decline to 31.03% in and will continue to fall thereafter. The main fiscal indicators in terms of rupees and as percentage of GSDP are given in Tables 1 & 2 respectively. 19

73 Annex C Page 20 of 24 TABLE - 1 KARNATAKA MEDIUM TERM FISCAL PLAN (Rs. Crores at current prices) Item Accts. BE RE BE Proj. Proj. Proj. 1. Revenue Receipts (a) State' Own Tax Revenues (b)NonTaxRevenues (c) Resources from the Centre Revenue Expenditure (a) Interest (b) Salaries (c)Pensions 2 (d)(i) Subsidies (Food, Housing, Transport, & Industry) (d)(ii) Power Subsidy 2 (e) Major O&M (Roads, Buildings & Irrigation) (f) Other O&M (Edn, Health, RD, WS, Agriculture & Forest) (g) Devolution to ULBs (h) Administrative Expenditure (i) Other Revenue Expenditure Revenue Deficit {(2)- (1)} Capital Receipt (Non-debt) Capital Expenditure /a Fiscal Deficit Total Debt Stock Debt Service Salary+Pension-Hrnterest Consolidated Revenue Deficit Consolidated Fiscal Deficit Consolidated Capital Expenditure Consolidated Interest Consolidated Debt Stock Off-budget Borrowings Interest/Revenue 16.21% 15.86% 16.75% 16.44% 16.43% 17.09% 17.15% 17 Consolidated Interest/Revenue 19.40% 19.40% 19.17% 20.57% 21.43% 21.85% 21.11% 18 Debt Service/Revenue 20.17% 19.25% 20.33% 20.52% 20.63% 21.89% 22.05% 19 Salary+Pension+lnterest)/Revenue 65.49% 59.49% 60.65% 57.42% 55.90% 53.77% 50.27% /a Capital expenditure is actual expenditure on capital formation, and excludes debt-servicing of off-budget borrowing, which is included in capital expenditure under budgetary definitions. Thus, in this table, the fiscal deficit does not equal the revenue deficit plus capital expenditure (net receipts). 20

74 Annex C Page 21 of 24 TABLE - 2 KARNATAKA MEDIUM TERM FISCAL PLAN (as percentage of GSDP) Item Accts. BE RE BE Proj. Proj. Proj. GSDPatCurrentPrices(Rs.crores) Inflation 7.50% 6.50% 6.50% 6.50% 6.00% 6.00% 6.00% GSDP Annual Real Growth 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 1. Revenue Receipts 13.06% 14.65% 14.01% 14.70% 14.65% 14.70% 14.96% 1 (a) State' Own Tax Revenues 8.15% 9.13% 8.95% 9.20% 8.98% 9.05% 9.42% 1 (b) Non Tax Revenues 1.17% 1.20% 0.83% 1.11% 1.06% 1.01% 0.99% 1 (c) Resources from the Centre 3.74% 4.32% 4.24% 4.39% 4.61% 4.64% 4.56% 2. Revenue Expenditure 15.51% 16.14% 16.12% 16.92% 16.40% 15.49% 14.54% 2 (a) Interest 2.12% 2.32% 2.35% 2.42% 2.41% 2.51% 2.57% 2 (b) Salaries 4.82% 4.86% 4.63% 4.49% 4.31% 4.01% 3.72% 2 (c) Pensions 2 (d)(i) Subsidies 1.62% 1.53% 1.52% 1.54% 1.47% 1.38% 1.38% (Food,Transport, 0.63% 0.61% 0.64% 0.64% 0.62% 0.54% 0.48% Housing & Industry) 2 (d)(ii) Power Subsidy 0.81% 0.85% 0.85% 1.95% 1.74% 1.35% 0.81% 2 (e) Major O&M (Roads,Buildings & Irrigation) 0.36% 0.39% 0.45% 0.38% 0.41% 0.41% 0.42% 2 (f) Devolution to ULBs 0.44% 0.52% 0.50% 0.57% 0.56% 0.56% 0.58% 2 (g) Other O&M (Edn, Health, RD, WS, Agri, Forest) 1.58% 1.77% 1.70% 1.56% 1.76% 1.85% 1.95% 2 (h) Administrative Expenditure 0.49% 0.43% 0.43% 0.39% 0.36% 0.34% 0.31% 2 (i) Other Revenue Expenditure 2.64% 2.86% 3.05% 2.99% 2.75% 2.53% 2.31% 3. Revenue Deficit 2.45% 1.49% 2.11% 2.23% 1.75% 0.79% -0.42% 4. Capital Receipt 0.15% 0.16% 0.16% 0.17% 0.15% 0.13% 0.11% 5. Capital Expenditure /a 1.79% 1.66% 1.56% 1.65% 1.69% 1.85% 2.41% 6. Fiscal Deficit 4.50% 3.66% 4.03% 4.35% 4.22% 3.70% 3.00% 7. Total Debt Stock 27.66% 25.77% 25.77% 26.86% 26.39% 26.86% 26.57% 8. Debt Service 20.17% 19.25% 20.33% 20.52% 20.63% 21.89% 22.05% 9. Salary+Pension+lnterest 65.49% 59.49% 60.65% 57.42% 55.90% 53.77% 51.27% 10. Consolidated Revenue Deficit 2.86% 2.01% 2.63% 2.80% 2.49% 1.49% 0.17% 11. Consolidated Fiscal Deficit 5.57% 5.44% 5.81% 5.87% 5.10% 3.82% 2.76% 12. Consolidated Capital Expend. 2.86% 3.59% 3.49% 3.25% 2.77% 2.46% 2.71% 13. Consolidated Interest 2.53% 2.84% 2.87% 3.02% 3.14% 3.21% 3.16% 14. Consolidated Debt Stock 29.90% 30.61% 30.61% 32.65% 32.35% 32.21% 31.03% 15 Off-budget Borrowings 1.06% 1.93% 1.93% 1.60% 1.08% 0.61% 0.29% /a Capital expenditure is actual expenditure on capital formation, and excludes debt-servicing of off-budget borrowing, which is included in capital expenditure under budgetary definitions. Thus, in this table, the fiscal deficit does not equal the revenue deficit plus capital expenditure (net receipts). 21

75 Annex C Page 22 of In the MTFP, the fiscal deficit and the revenue deficit fall every year till the Government's targets are reached in The only exception is the year , when the revenue and fiscal deficits rise. This happens because the Government is providing full funding for the power sector subsidy, which was not the case in the previous years. Over time, the power sector restructuring will greatly reduce the power subsidy, but in the interim period, full funding of this subsidy is essential to improve the quality of supply and to enable the restructuring to succeed. If the power sector requirement had been fully met in (RE), the fiscal deficit would have been Rs.5335 crores. This shows that in , the underlying fiscal position does in fact improve, as the fiscal deficit with full funding of the power subsidy requirement is lower at Rs crores. VI. Conclusion: 47. As stated in the White Paper, the State government is determined to restore fiscal balance, improve the standards of physical and social infrastructure and ensure a competitive advantage to Karnataka. The medium-term fiscal plan detailed above provides a blueprint for the state government to undertake necessary reforms to move in the desired direction. 48. The assumptions made in this exercise are realistic and the correctives considered are feasible. It is imperative to undertake these reforms in all seriousness if the objective of ensuring a sustainable fiscal situation in the State has to be achieved. In fact, if the reforms detailed above are implemented effectively, it will also enhance the competitive edge of the State. 22

76 Annex C Page 23 of While effective implementation of reforms on the lines explained in this document should enable the State government to meet the objectives of achieving fiscal rectitude, stabilising debt and creating quality infrastructure, it must be noted that many of the reform measures can involve some cost to the exchequer in the short and long terms. The power sector reforms will have to be calibrated carefully, and substantial initial government support will be needed to unbundle and restructure the sector. The beneficial results of the reform measures will only accrue in the medium term. Introduction of a workable voluntary retirement scheme for public sector enterprises would require initial financial support from Government to a large extent, though a part of the cost will be recovered from the disinvestment and sale proceeds of assets of the enterprises and the rest from the savings of implicit subsidies being doled out to PSUs. Design of VAT will assume revenue neutrality but in the initial couple of years there could be a loss of revenue, which has been explicitly provided for. To achieve fiscal sustainability in the medium term, these costs of reforms are inevitable and have been taken into account while preparing the fiscal plan. It is expected that these costs will be more than made good in the long run through attainment of fiscal sustainability and by imparting greater competitiveness to the economy. The cost can also be minimised through additional efforts in the direction of broad-basing of tax and non-tax revenue streams and putting in place an effective enforcement mechanism and through constant vigil on the expenditure side, particularly on compression of nonproductive expenditure and on improvement of composition and effectiveness of expenditure. 50. The Medium Term Fiscal Plan is an attempt by the State Government to achieve fiscal sustainability over the next 5 years. The implementation of the plan will create an appropriate enabling environment for higher investment in critical infrastructure and social sectors, which in turn will spur economic growth. This 23

77 Annex C Page 24 of 24 will result in a virtuous circle of higher revenue receipt and increased capacity of the Government to spend more on desirable activities. This in turn will enable the State to put up a relentless struggle on poverty and backwardness. Keeping in view the objectives and targets of the Medium Term Plan, the Government will design a matrix of reforms measures for implementation so as to achieve the desired end. Government is also committed to tabling a Fiscal Responsibility Bill in the Legislature, so that the MTFP can receive adequate legal backing. It is extremely important to ensure that the contours of the plan are kept in sight while preparing annual budgets. The Medium Term Fiscal Plan is essentially a dynamic document, which will have to be updated every year based on the performance of the previous years to monitor the progress of reforms. In the interest of fiscal transparency, MTFPs from next year onwards would also include a report of performance against targets in the previous year in addition to a summary of economic prospects as well as a statement of fiscal policies and forward projections. This will enable the Government to take additional measures to set the reforms programme in course. These fiscal reforms accompanied by governance and sectoral reforms are expected to project the State to a path of high trajectory growth and are expected to result in substantial reduction of poverty. 24

78 Annex D Page 1 of 12 Governance Strategy and Action Plan in Karnataka. While Karnataka has made considerable progress on various fronts since it gained statehood, and while it is cited as one of the betteradministered states in India, it is being increasingly felt that in order to meet the legitimate aspirations of the citizens, to cope effectively with the complex activities which the Government needs to undertake, to meet the challenges posed by the revolutionary changes taking place in the world and to enable Karnataka to remain in the forefront in a highly competitive environment, it is essential for the State to evolve a strategy for governance and to implement it in a time-bound manner. 2. Indeed, today, all nations of the world and states in India are taking a fresh look, inter-alia, at their goals and objectives, at the activities in which they are involved and at the existing machinery and systems for delivering services, in order to devise ways and means to make the administration more transparent, efficient and responsive. 3. From the financial point of view, there is an urgent need to see how, by cutting down on non-productive expenditure, resources can be found for sectors like infrastructure, agriculture, education, health, poverty alleviation. An embarrassingly large percentage of the revenue realized is being utilized for payment of salaries and wages at a time when more funds are required for improving the quality of life of the common man. This situation calls for a reorientation of the fiscal system of the state so that the pattern of public expenditure supports the achievement of the pressing socio-economic concerns. 4. It is in this background that the Government had requested the Indian Institute of Management to conduct a study on an overall framework for the governance strategy. The Government had also constituted the Administrative Reforms Commission, which has submitted its interim report. 5. Now the Government is taking the initiative of pronouncing its governance strategy. The strategy highlights the areas, which will receive special focus and where reforms will be introduced. While an action plan for implementing the strategy is also envisaged, for some of the areas the actual implementation schedule will be drawn up after the required studies have been completed and after the final report of the Administrative Reforms Commission is received. 6. Government of Karnataka's governance reforms strategy is two pronged (i) Rationalize the role of the state to focus on the most critical public goods and services which the private market cannot effectively supply, and (ii) Enhance the effectiveness, transparency and accountability by which the state performs this role.

79 Annex D Page 2 of The rationalization of the role of the state will be achieved by: - (a) Development and implementation of a Medium Term Fiscal Plan (MTFP): - The basic objective of the MTFP, which has been initially drawn up for a period of five years, is to introduce fiscal discipline. It will chart out how the fiscal recovery will take place. Revenue deficit will be brought down to zero by and the fiscal deficit to 3% of GSDP by the same year. To reinforce progress in this area, the Government intends to bring forward a Fiscal Responsibility Bill. Success in making the power sector commercially viable will play a crucial role in the fiscal recovery. Therefore a financial restructuring plan for the power sector consistent with the MTFP has also been drawn up. The MTFP and the financial restructuring plan for the power sector will be placed before the Legislature. (b) (c) (d) A review has been made of out-dated State Acts and amendments and action taken to repeal them. Progress has been made in this direction and twelve Acts and more than a thousand amendment Acts have been repealed. This process will continue. A high level committee has already scrutinized the existing schemes of various Departments. Based on the recommendations of the Committee, more than 21 schemes have been eliminated during the budget for Over all, as a result of merger, consolidation and outright elimination there has been a reduction of 78 schemes during the current year. Public enterprise privatization and restructuring: - The Government has already issued a Policy Document and action plan for reforms to be brought about in the State Public Sector. The main ingredients of the poiicy are- (i) Privatizing or closing those PSEs whose activities are commercial in nature or which produce consumer goods and in which there is a strong private sector presence;

80 Annex D Page 3 of 12 (ii) (iii) (iv) (v) PSEs not involved in commercial activities would be restructured by induction of strategic partners or through merger and reorganization; While bringing about efficiency in the PSEs providing utilities through such regulatory authorities as may be necessary, private sector participation in ownership and management of utility services would also be encouraged and facilitated; Voluntary retirement schemes and redeployment will be provided for and a suitable mechanism of social safety net would be developed to ensure that the interests of the labour are adequately protected. Suitable measures would be taken to mitigate environmental aspects. By March 2002, action will have been taken to privatize, disinvest in or close at least ten enterprises. (e) Restructuring and Reorganization of Govemment Departments: - Functional reviews of Government Departments is being undertaken to identify possibilities of reduction or consolidation. The Mines and Geology Department has already been consolidated under the Water Resources Department. A decision has been taken to merge the Institutional Finance Department with the Finance Department. The possibility of outsourcing certain services will be examined. All departments will be required to identify activities from which the State can withdraw. 8. The second major plank of the governance strategy would be to bring in effectiveness, transparency and accountability in the functioning of various agencies. This would include (i) administrative and civil service reform aimed at reducing excessive patronage and enhancing the productivity of the civil service (ii) sound public expenditure, financial management and accountability systems to enable the Government to achieve fiscal discipline, allocate resources in line with its strategic priorities and ensure efficient and effective use of public resources. (iii) Greater public transparency and oversight on government functioning through

81 Annex D Page 4 of 12 right to information, citizen charters, service delivery surveys, public monitoring of Government's anti-corruption programme and (iv) simplification and decentralization by strengthening accountability mechanisms at the local levels while enhancing autonomy. 9. Reforms in the administrative and civil service would include: - (a) (b) (c) (d) Drastic reduction in the politicized and premature transfers that disrupt the functioning of the public administration, undermine the ability of civil servants to commit themselves to the job, and lead to significant opportunities for corruption. Government shall amend the rules under the Karnataka State Civil Services Act, 1978 in order to bring in objectivity and transparency while effecting transfers. Transfers will be effected by Committees, the constitution of which will be specified; the maximum and minimum tenures for various categories of officers will be prescribed and a system will be put in place to monitor and publicly report on the number of transfers department-wise and district-wise. Reasons for effecting pre-mature transfers will be clearly specified in the Transfer Order. At a subsequent date, a legislation on the subject will also be taken up. Merit based recruitment will be further strengthened and transparency in recruitment increased. In the Medical and Health Department, the Education Department and for some posts like Stenographers, First Division Assistants etc., recruitment is already made on the basis of marks obtained in the qualifying examination or the special written competitive examination. This system will be extended to other recruitments to reduce\eliminate weightage to interviews. The relevant provisions of the Karnataka Civil Service Rules will be amended to enable compulsory retirement of inefficient government employees even before they complete 25 years of service. After necessary studies, the manpower in various departments will be right-sized and systems introduced to "de-layer" and ensure disposal of files within prescribed time limits. The Secretariat Manual of Office Procedure will be revised and amended to reflect the new systems, which will be put in place. 10. Reforms in the area of public expenditure, financial management and accountability systems would cover: -

82 Annex D Page 5 of 12 (a) To identify the medium-term costs of new and existing policies and make recommendations on departmental hard budget constraints, an Expenditure Review Committee (ERC) has been set up comprising of representatives from Finance, Planning and a few key spending departments. No new major scheme will be introduced without scrutiny of the ERC. It is proposed to allow line departments to prioritize spending within hard budgets with a scope to retain a significant portion of any identified savings but with a requirement to report on key outputs and outcomes. Ultimately, adequate incentives will be provided for adhering to the MTFP fiscal targets. Three pilot Departments (Health and Family Welfare, Primary and Secondary Education and PWD) have prepared sectoral policy notes consistent with the MTFP. (b) Focus on performance will be reinforced through an impact and performance evaluation study of ongoing programmes and schemes and through introduction of Performance Monitoring and Improvement Initiatives. A Government Order has already been issued earmarking funds for evaluation of major schemes. (c) A Controller's Office is being established in the Finance Departmento spearhead public financial accountability. A Task Force has been established to guide the modernization programme. Financial reporting is being made more timely, and monthly and annual accounts are now published on the internet. Key accounting functions such as Treasury, DDOs, payroll, and Zilla Panchayats/Taluk Panchayats accounting are being progressively computerized. Backlog of accounts and audit in public sector enterprises, local bodies, Departmental Undertakings and other institutions is being cleared. Measures will be taken to provide and disclose responses to audit observations and ensure follow-up action, in a timely manner. Measures will also be taken to improve internal controls in areas such as reconciliation, Personal Deposit accounts, loans/advances, and guarantee/debt recording and reporting. (d) The process of public procurement will be made more transparent. The "Karnataka Transparency in Public Procurement Act" has been put in place. The Act lays down clear procedures for Tender Inviting and Tender Accepting authorities. Details of all tender applications received and accepted are now required to be published in a Tender Bulletin maintained by departments at both the State and district levels. Some of the agencies have put

83 the tender bulletins on the Internet for easy accessibility. Other Departments will adopt this practice. Annex D Page 6 of The effectiveness of the state institutions will be considerably enhanced by facilitating much greater public transparency, participation and oversight. Measures include: (a) G.O.K. has passed a far-reaching Right to Information Act. The Act has very limited number of exemptions, and represents a major step towards a more transparent form of government in Karnataka. To strengthen this initiative, G.O.K. will initiate the process of cataloging and indexing its records and seek inputs from the public - through periodic surveys - to identify the specific forms of information that the public would most like to see. Rules under the Karnataka Right to Information Act will be framed by November 30th, (b) (c) G.O.K. has initiated the public dissemination of citizens' charters (specifying standards of service delivery and grievance redressal mechanisms) for a number of agencies, including the Bangalore Metropolitan Transport Corporation and the Karnataka Power Transmission Corporation Limited. G.O.K. has ambitious plans to extend citizens' charters to much of Government. To ensure that citizens' charters are credibly implemented, G.O.K. will focus first on four public services with large public interface (e.g., stamps and registration, maternity patients in Bangalore Mahanagar Palike, regional transport and police), specify improved standards through citizens' charters, provide managerial flexibility to these service providers in exchange for accountability to achieve intended results; initiate business process re-engineering to meet stipulated service standards; and conduct initial user surveys to establish baseline data. Beneficiary surveys from users of public services will also begin to be initiated by Government departments themselves with public interface to assess user satisfaction, identify problems and take corrective actions. This will begin with a survey for the four focus services with citizen charters indicated above. G.O.K. has launched a number of initiatives in the area of electronic governance for public transparency and for better functioning of departments. These

84 Annex D Page 7 of 12 include initiation of agricultural titles and tenancy information computerization, treasury computerization, computerization of the sales tax departments, and a number of G.O.K. departments now have web sites. The scope for e-governance is much greater, and G.O.K. will prepare a status report and action plan on e- governance initiatives. (d) (e) Government of Karnataka has constituted the Human Development Division in the Planning Department which will (i) Monitor progress in key areas related to poverty and human development, (ii) Identify emerging problems that may have an adverse impact on the poor (iii) Help the Government, through its monitoring, to take more informed decisions. The list of poverty and human development indicators has been finalized. Special surveys and studies will be initiated. Strategic guidance and advice to this division will be provided by an advisory group chaired by the Chief Secretary. (i) The Lok Ayukta plays an important role in the enforcement of Karnataka's anti-corruption efforts. Measures to increase the effectiveness of the Lok Ayukta will be identified. The records of the Office of the Lok Ayukta will be computerized and a review undertaken of the procedures under the Lok Ayukta Act. (ii) The focus on enforcement is being complemented by a significant emphasis on prevention and systemic reform. A number of measures being taken by the Government will address key underlying sources of corruption, including reduction in patronage-based transfers, financial management and accountability, public procurement, deregulation, right to information and public transparency. To monitor the implementation of these anti-corruption measures as well as to identify and implement other measures on an ongoing basis, Govt. of Karnataka will set up an inter-departmental Corruption Prevention Committee. The CPC will also consult with civil society; the private sector, other branches of government and the Lok Ayukta; undertake baseline and repeat surveys of households, enterprises and public officials on corruption; and publicly report on results and progress of the anti-corruption programme. iii) The number of local bodies is increasing. Allegations of corruption are being received against such bodies.

85 The institution of "Ombudsman" will be created to enquire into these allegations. The Ombudsman would be encouraged to visit the districts for the conduct of the enquiries. 12. Simplification and decentralization shall be brought about through the following measures: - Annex D Page 8 of 12 (a) Govt. of Karnataka has a long tradition of decentralization. In 1987, Govt. of Karnataka implemented an ambitious decentralization program - followed more recently by the 1993 reforms introduced after the passage of the 73rd and 74th amendments by the Central Govt. A large number of functions - and perhaps amongst the largest share of state public expenditure - have been transferred to Panchayat Raj Institutions (PRIs) at the district, taluk and village levels. Guided by the cardinal principle that what is appropriate at a given level of the three tier Panchayati Raj system should be done at that level and not at a higher level, the Government is determined to devolve larger funds and greater powers to the Gram Panchayats. The new initiatives will include - i. The annual untied grant to Gram Panchayats will be enhanced from Rs. 2 lakh per annum to Rs.3.5 lakh per annum. ii. The land revenue rates will be doubled and 50% of the total collection will be transferred to the Gram Panchayats. iii. The Karnataka Panchayati Raj Act will be amended to provide for levy and collection of property tax at a higher rate and for levy of development charges on use of land for certain purposes. iv. Gram Panchayats will be given the responsibility of implementing a number of development programmes like management of primary schools, anganwadi centres, village irrigation tanks etc. v. Gram Panchayats will be empowered to form Village extensions and, if necessary, borrow funds for this purpose from financial institutions.

86 b. Government is concerned about the plethora of clearances and approvals required for setting up business. This multiplicity of approvals, inspections and complicated rules and procedures have impeded private sector investment in the State. There is a clear need to simplify procedures and reduce the paper work. The Department of Industries and Commerce is preparing a proposal, which will provide for submission of a single form, self-certification, minimal statutory returns and reduced inspections. A bill, incorporating the revised system will be brought before the Legislature. Amnex D Page 9 of 12 c. The Government recognizes that Urban Local Bodies (ULBs) have an important role to play in the decentralized set up. However, they need to generate additional resources. In Bangalore, one of the ways identified to do this was to introduce the Self-Assessment Scheme for property tax. It has been well received. To give the scheme a legal backing and in order to introduce it in other ULBs, the necessary amendment bills have been introduced in the Legislature. Further, in order to bring about a more equitable and performance based system for transfer of resources from the State Government to the ULBs, the Government will explore the possibility of entering into a Memorandum of Understanding with the major ULBs. d. With the objective of achieving more efficient service delivery and of making things easier for the citizen, all Departments will identify areas where decentralization can be introduced and systems put in place for transparent, time-bound handling of grievances, applications etc. at the lowest level possible. 13. The Statement at Appendix-1 summarizes the action to be taken during the year to implement various parts of the governance strategy. 14. The process of reforms is a continuing one. As mentioned earlier, based on the various studies being undertaken, an examination of the recommendations made by the Administrative Reforms Commission in its final report and of other commissions and Task Forces set up by the

87 Annex D Page 10 of 12 Government, action plans will be drawn up for implementation during subsequent years. APPENDIX-1 GOVERNANCE STRATEGY ACTION PLAN FOR (April 2001 to March 2002) 1) TRANSFERS: DPAR to keep track of and monitor all transfers. Rules to be framed under the Karnataka State Civil Services Act. Thereafter, action to be taken to introduce a legislation on transfers. 2) RECRUITMENT: * Weightage given to interviews to be reduced / eliminated 3) ORGANISATIONAL RESTRUCTURING: Functional review of 15 departments of the Government. Manpower requirement estimation. Rationalization of staff and redeployment. Outsourcing of services (house keeping, horticulture, transportation etc). 4) CITIZENS' CHARTERS TO BE PUBLISHED FOR - * Stamps and Registration: Twelve Sub-registrars' offices where computerization is being introduced. * Transport: All RTO offices Police: Registration of Crimes Bangalore Mahanagara Palike - (1) Maternity Homes (2) Registration of Births and Deaths Three other sectors/departments which have a large interface with the public will be identified for issuing Citizens Charters.

88 Annex D Page 11 of 12 5) PUBLIC EXPENDITURE MANAGEMENT * The functioning of the Expenditure Review Committee will be streamlined. * Medium term frame work for three pilot departments, Health, PWD, Education Rationalization of schemes * Independent evaluation of ongoing programmes. 6) FINANCIAL MANAGEMENT AND ACCOUNTABILITY: Computerization of Treasury Department Reconciliation of accounts, through a working group Task force on modernization of financial management. Computerization of Zilla Panchayats and Taluk Panchayat accounts. Fund based accounting system in Bangalore Mahanagar Palike. 7) PUBLIC PROCUREMENT REFORMS: * Tender bulletins to be placed on the Internet * Sample audits for selected contracts to be conducted by the KBJNL, KNNL, PWD and Irrigation Department. 8) FREEDOM OF INFORMATION: * Frame rules under the Karnataka Freedom of Information Act. Conduct a survey of public information needs. Begin the process of indexing, cataloging, and computerizing data on a selective basis 9) DECENTRALIZATION AND DEREGULATION Increase share of untied funds to Panchayat Raj Institutions. Empower Panchayat Raj Institutions to augment resources, Enable Panchayati Raj Institutions to take up village level development works Legislation on Deregulation in industry. Annual survey of perception of Government by Industries. All Departments to identify areas where by deregulation and decentralization, relief can be given to citizens. 10) E-GOVERNANCE: Information Technology plan for each department Human Resource Database

89 Annex D Page 12 of 12 * Computerization of R.T.Cs. in all Taluks. 11) ANTI CORRUPTION PROGRAMME: * Inter-departmental Corruption Prevention Committee to be constituted. * Computerization of Lokayukta records and review of procedures under the Lokayukta Act. * Ombudsman to enquire into corruption allegations against local bodies. 12) RESTRUCTURING AND PRIVATISING PUBLIC SECTOR UNDERTAKINGS: * Closure of ten units, by March, 2002

90 Annex E Page I of 9 POLICY ON STATE PUBLIC SECTOR REFORMS AND PRIVATIZATION 1. EVOLUTION OF PUBLIC SECTOR ENTERPIRSES IN KARNATKA AND NEED FOR A POLICY ON PUBLIC ENTERPRISES REFORM AND PRIVATIZATION. 1.1 The erstwhile Mysore State launched industrial ventures as Government Undertakings to primarily exploit the available resources of raw material and power in certain localities, thus creating pockets of industrialization which gave rise to cumulative employment opportunities and a variety of other economic spin-offs. 1.2 The rapid expansion in the number of variety of Public Sector Enterprises in the State, sometimes without sufficient socio-economic justification or adequate financial, technical and managerial resources to back them up, has led to a situation where many became sick within a short span of time. The Karnataka State Bureau of Public Enterprises was therefore set up in 1980 as a nodal agency for monitoring the functioning of all Public Sector Enterprises in Kamataka and providing them with consultancy and other support services of general nature. 1.3 Much time has elapsed since then and the economic scenario has undergone momentous changes. In many cases, the circumstances and considerations which provided the initial justification for setting up these ventures have either changed beyond recognition or do not exist at all. Their raison d'etre, after decades of economic change and development, is no longer confined to the needs of the local economy, while the pricing and marketing of their products are factors dictated almost entirely by national and international market compulsions

91 Annex E Page 2 of 9 - I The policies of the Government of India in terms of Industrial Policy Resolutions from time to time as also those of the State Government moire or less remained unchanged until With the advent of liberalization / globalization the relative roles of the public and private sectors have changed dramatically. The recent policies of economic liberalization have necessitated a total reconsideration of the justification of investment in the public sector and raised issues of the relative priorities of investment in social sectors. In particular, the fact that the returns from the public sector have not been commensurate with investment has induced a process of appraisal of the Public Sector Enterprises from a different perspective in terms of privatization, rationalization/restructuring, merger, disinvestment or winding-up/ closure. It is now considered that investment in Public Sector Enterprises should be restricted to strategic sectors or sectors of social concern and that Government need not continue to involve itself in production of consumer products and marketing enterprises, particularly if they are not generating profits. 1.5 The State Public Sector Enterprises coming under the control of 18 Administrative Departments can broadly be grouped into seven categories as follows:- (i) Public Utilities. (ii) Financial Institutions. (iii) Development Enterprises (Non-Commercial) (iv) Development Enterprises (Commercial) (v) Service Enterprises (vi) Manufacturing Enterprises (vii) Marketing and Advertising Enterprises. 1.6 The State Government has taken several steps to bring about improvement in the performance of Public Sector Enterprises to equip them to face the challenges of the changed economic environment and globalization and to gradually shed those products and activities that have proved to be unproductive and unviable. In this context, the Government constituted a... 13

92 Annex E Page 3 of Committee in August 1988 under the chairmanship of the then Chief Secretary to undertake a thorough review of the State Public Enterprises. The Committee gave its report in October The salient recommendations were as under:- (i) Total privatization of 5 Companies. (ii) Winding up of 15 Companies. (iii) Merger of 4 Companies with other major Companies having similar activities. (iv) Rationalization and improvement of management of the remaining Companies. 1.7 In September 1990 the State Government constituted a Cabinet Sub- Committee to review the recommendations of the Committee on Public Enterprises. The Cabinet Sub-Committee felt that those Public Enterprise which were not serving any useful purpose and were suffering losses should be wound up and that multiplicity of Corporations in the welfare field should be avoided. The Cabinet generally agreed with the recommendations of the Cabinet Sub Committee but authorized the Chief Minister to take a final decision on each enterprise. However, the follow up action by the Administrative Departments is yet to yield tangible results except in the case of Vikrant Tyers. 1.8 At present there are 81 Public Sector Enterprises in the State. The total investment in the 78 PSEs existing as on was of the order of Rs. 18, 331 Crores. The share of the Government of Karnataka was Rs. 6, 393 Crores. The turnover of the enterprises during was Rs. 8,890 Crores, contributing an amount of Rs. 506 Crores to the exchequer. Out of the 78 PSEs only 35 Companies have shown profits amounting to Rs. 265 Crores and 33 Companies have suffered losses to an extent of Rs. 204 Crores. The remaining Companies have no profit or no loss or are defunct. In as many as 25 Companies the accumulated losses have exceeded share capital and reserves. 1.9 With the new policy of liberalization which envisages an increasingly larger role for the private sector and a limited role for the State only in essential or developmental sectors, there is need to evaluate the PSEs in terms of productivity and other parameters. It is also necessary to evaluate the performance of the PSEs to determine their utility or need for retention as

93 Annex E Page 4 of Public Sector Enterprises. The State has had to commit itself to large investments in many of these PSEs, with little benefit to the economy of tlhe State. It is recognized that the commitment of such large funds to PSEs, has eroded the ability of the State to provide adequate funds for essential development activities in the Social sectors, including meeting of minimulm basic needs It is in this context that the State Government considers it necessary to evolve a policy with regard to the Public Enterprises in the State. It is considered essential that these PSEs need to be restructured and that Government should restrict its direct investment in PSEs from the funds of the State to strategic sectors or sectors that involve social responsibility of the State. It has become imperative to the State Government to have a second look at the role and performance of the Public Sector Enterprises particularly in the context of near nil return on huge investments, with sorme of the PSEs having become a recurring burden on the public exchequer. 2. NEW INITIATIVE. 2.1 These issues have been under consideration of Government for some time. It is the firm view of Government that it has become imperative to give urgent attention to the restructuring of the State PSEs through rationalization, disinvestment, merger, privatization or closure. With thlis objective the Government has constituted a Public Sector Restructuring Commission in G.O. No. DPAR, (BPE) 23 ARU 2000 dated 15 th March 2000 and corrigendum dated 30 th March The broad Terms of Reference of the Commission are as follows. (i) To evaluate the State PSEs and suggest measures which would promote greater productivity and profitability in them within the next five years. (ii) Suggest measures which would a) reduce or eliminate budgetary support by the State, b) promote autonomy and enhance profitability of the stronger undertakings so as to increase their returns to the State. (iii) Evolve a long term reform programme which would enable

94 Annex E Page 5 of Government to identifya) Those PSEs which would require financial support from the Government to enhance long term profitability and the extent to which such support may be appropriate; b) PSEs which would benefit by the induction of strategic partners and the modalities of doing so; c) PSEs for which restructuring measures would be desirable extending to alternative systems of management including privatisation, disinvestment, merger and the modalities of doing so. (iv) Evolve appropriate principles of rationalisation of employment in the PSEs, ensuring that the interests of labour are adequately safeguarded. Such principles may include schemes relating to voluntary retirement, creation of rationalisation fund for the purpose etc., (v) Suggest measures for management of a rationalisation fund, including the composition and procedures of a High Power Committee for the purpose; (vi) In making its recommendations, take into consideration the interests of stakeholders, employees, consumers and others as may be appropriate in the case of each PSE. 3. POLICY INGREDIENTS. 3.1 As a firm commitment towards Public Enterprises Reform through restructuring, the Government has evolved a specific policy on public Enterprises Reform and Privatization with the following main elements:- (i) The PSEs whose activities are commercial in nature or which produce consumer goods and in which there is a strong private sector presence would be restructured through privatization or closure. No further infusion of funds from State budgetary resources would be made in such PSEs for the purposes of modernization, expansion or taking up new activities. (ii) The PSEs not involved in commercial activities would be restructured... I.6

95 Annex E Page 6 of by the induction of strategic partners or other appropriate systems of management, including mergers and reorganization, so as to eliminate the dependence on the budgetary support of the Government. Where joint partners are inducted the management role of the State would be minimal and restricted to specified crucial areas to safeguard the interest of the State and to prevent speculative activities; (iii) Duplication of activities, if any, between PSEs, Government Agencies and Co-operatives would be minimized by suitable rationalisation. (iv) The improvement of the efficiency of the PSEs providing utilities would be achieved through such regulatory authorities as may be necessary, with the objective of providing quality services to customers at econornic and reasonable prices. Private sector participation in ownership end management of utility services would also be encouraged and facilitated. (v) No new PSEs would be established with rare exceptions of appropriate institutional mechanisms for the expeditious execution of specific major projects that relate to development of infrastructure where also increased private sector participation in infrastructure activities will be encouraged and facilitated. Even when a strong institutional mechanism is needed for expeditious execution of infrastructure development project, first preference will be for achieving it through private sector, failing which it will be through joint sector of an existing PSE along with private sector participation. Only in rare circumstances when neither of them is feasible can a new PSE be though of. (vi) Rationalisation of employment in the PSEs would be ensured through implementation of schemes relating to voluntary retirement and possible redeployment among PSEs. In this process the interests of labour would be adequately protected and a suitable mechanism of social safety net would be developed. (vii) Suitable measures would be taken to mitigate environmental aspects, particularly in the case of PSEs identified for privatization or closure so that these processes are environmentally sound. Guidelines would

96 Annex E Page 7 of be developed for Environmental Liability Assessment and Remediation. (viii) The net proceeds realised from privatization or closure would be used on infrastructure development, rural development and welfare activities. 4. IMPLEMENTATION OF THE POLICY 4.1 The Government is committed to successful implementation of the policy within a time frame of end of March It is proposed to privatize or close at least ten PSEs in the first phase of its implementation by end of March Action would be taken to see that two of them are privatized or closed by end of March 2001 itself. At least ten more PSEs would be privatized or closed during Thereafter the PSEs remaining for privatization or closure would be covered by end of March The restructuring of the other PSEs which are required to be continued would also be completed well before the end of March The first phase would cover privatization or closure of PSEs which are either no longer serving any purpose or which are causing a big drain on the State exchequer. A list of PSEs identified by the Public Sector Restructuring Commission out of which at least ten would get privatized or closed in the first phase is enclosed as Annexure II which also contains the names of four of them, of which two will be closed by To achieve successful implementation of this policy, the Government would ensure that the Public Sector Restructuring Commission with its mandate and wide-ranging responsibilities arrives at conclusions and makes recommendations with regard to the State PSEs in an independent manner. While doing so, it would take into consideration the views of all stakeholders, including Government, but it would formulate its own views independently, keeping in mind the best interests of all concerned. The Commission would draw upon expertise both within itself and external to it for appraisal and evaluation of the PSEs and for evolving recommendations that would be conducive to industrial and financial strength while ensuring equity to the employees. It would ensure that due regard is paid to social and environmental concerns and issues of concern to the employees of the PSEs. It would also make recommendations with regard to the constitution... 8

97 Annex E Page 8 of 9 I.8 - and management of the fund that may be established for rehabilitation of personnel and for meeting commitments under the voluntary retirement schemes that may be evolved. 4.3 The recommendations of the Commission would be considered by Government at the highest level. A system with suitable procedure for due consideration of such recommendations would be evolved. For this purpose, a High Power Committee would be established to examine t]he recommendations of the Commission. This would expedite thne consideration of the Commission's recommendations and assist in the evolving of comprehensive proposals to Government for consideration at the highest level. The High Power Committee would submit its recommendations to the Cabinet for its consideration, through t]he respective Administrative Department. On receipt of the Cabinet decision on the recommendations, the Administrative Department would immediately initiate action to implement the process of restructuring, privatization or closure in close collaboration with the Karnataka State Bureau of Public Enterprises and the management of the PSE concerned. A Core Committee in the Administrative Department headed by its Secretary/Principal Secretary would be responsible for implementation of the Cabinet decision. 4.4 The restructuring, privatization or closure will be executed in accordance with detailed procedures to be prepared by the Commission on the basis of the guidelines enclosed in Annexure-III. Similarly the Voluntary Retirement Scheme will be executed in accordance with detailed procedures to be prepared by the Commission following the guidelines enclosed as Annexure-IV. 4.5 The High Power Committee would periodically review the progress of the restructuring process and would be empowered to take such action as mlay be necessary to ensure expeditious and successful implementation of the Cabinet decision. KSBPE will be the nodal agency in the Government with regard to the policy on Public Enterprises Reform. It will function as the secretariat of the High Power Committee

98 Annex E Page 9 of All-out efforts would be made to complete the process much earlier than the time limits included in the implementation schedule. (ABHAY PRAKASH) Director General, Kamataka State Bureau of Public Enterprises and ex-officio Principal Secretary to Government, Department of Personnel and Administrative Reform.

99 Annex F Page 1 of Preamble De-regulation of Business Environment - Reforming Measures Part A The State Government is committed to provide an efficient, responsive and transparent regulatory framework to promote growth of a market-driven, efficient and competitive industrial/commercial sectors in the State. In the context of economic liberalisation, industries and other establishments are facing several challenges. Despite certain strategic advantages Karnataka provides to industries/ other establishments, a plethora of rules and procedures and the multiplicity of regulatory departments/authorities constitute barriers to growth and new investment. 1.1 Entrepreneurs encounter difficulties at three stages: (a) Entry level (b) Implementation level (c) Operation level 1.2 With the objective of simplifying the regulatory framework, removing procedural impediments, reducing maintenance of records, submission of unnecessary/repetitive documents and of helping projects to be implemented with ease the following measures are proposed. 1. To make required changes in the respective rules framed under dilferent acts providing for the proposed reform measures. 2. Karnataka Udyog Mitra(KUM) to be made the Nodal Agency at the State level, to guide and to provide assistance to the entrepreneurs as well as to obtain the required clearances / allotments / consents / approvals / permissions / registrations / enrolments / licences and the like clearance etc. from various departments / authorities at the entry and implementation stages of a project. Similarly, the DICs to be made the Nodal Agency at the District level for this purpose. 3. To reduce the multiplicity of application forms, a Combined Application Form(CAF) for obtaining clearance / allotments / consents / approvals / permissions / registrations, enrolments, licences and the like, to be introduced. 4. Industries which are in restricted list and are dangerous, hazardous and highly polluting, will continue to be subjected to the present normal

100 Annex F Page 2 of 12 approval procedure and all other industries and establishments not included in the restricted list to be eligible for fast track clearances under the simplified procedures. 5. Under 'Fast Track Clearance', entrepreneurs will be required to complete the CAF and submit it to the Nodal Agency - KUM / DIC for obtaining necessary clearances etc., from various departments / authorities concerned. 6. The multiplicity of Registers/Records to be maintained under different provisions of applicable Acts/Rules, to be simplified and rationalised by introducing Combined Registers/Records, as set out in this note. 7. The multiplicity of periodical Returns to be filed under different provisions of applicable Acts/ Rules, to be simplified and rationalised by introducing Combined Monthly/Yearly Returns, as set out in this Note. 8. Inspections, by various departments/authorities under different provisions of law to be minimised and rationalised and to be conducted annually based on random sampling,with due notice. However, surprise inspections will continue to be conducted on the basis of specific complaints. 9. Providing for a provision of self-certification by the entrepreneur conforming compliance of the extant laws and rules. Failure to comply with the undertaking made in such self-certification will be subjected to penalty, prosecutions and punishment as provided under different Sections of respective Acts. Part-B 2.0 The following measures are proposed to simplify procedures for obtaining clearances etc. at the entry and implementation level. 1. At present, industries/other establishments are regulated by a large number of Acts, Regulations, Rules and Procedures administered by different departments/authorities. In order to consolidate the regulations and minimise the procedures, the need for certain changes in the respective rules has been felt. The proposed changes will provide for consolidation of various rules, regulations, procedures, and other reform measures which the Government proposes. The changes will deal with only those provisions of laws which are within the Legislative Powers of the State Government to make/ change rules.

101 Annex F Page 3 of In order to guide and render necessary assistance to entrepreneurs at entry stage and to facilitate in obtaining required clearances etc.at the implementation stage, Karnataka Udyog Mitra (KUM) may be designated as the Nodal Agency at the State level and DICs at the District level. KUM /DICs will be single contact point for all new entrepreneurs/investors. The KUM/DICs will also be the single point contact for all departments/authorities in liaisoning, processing, issuing the required clearances etc. 3. At present entrepreneurs are required to submit separate applications; under each applicable Act for obtaining the required clearances, allotments, consents, approvals, permissions, registrations, enrolments, licences and the like. With the objective of reducing the task of entrepreneurs, a Combined Application Form(CAF) is devised. This CAF will be in lieu of the existing different application forms, as indicated in the specimen. Specimen CAF is given in Annexure I. 4. Industries which are included in Restricted list, are considered to be dangerous, hazardous and highly polluting in nature. Such industries will continue to be subjected to the present normal approval procedures and all other industries and establishments which are not included in the Restricted list, to be eligible for Fast Track Clearance under the simplified procedures. The Restricted list of industries is given in Annexure II 5. Entrepreneurs will be provided with a Booklet by KUM/DICs, highlighting industrial policies, incentives and concessions; infrastructure facilities and advantages available in Karnataka; list of government departments/authorities and others concerned with the factories, business and other establishments; list of applicable Acts/Rules along with their salient features; check-list of requirement of each department/authority; location, extent of availability and approximate cost of lancl/sheds developed by the government agencies like KIADB, KSSIDC and KEONICS; availability and cost of power; educated and trained manpower; technical and other professional institutions etc. 6. An application form shall be provided to the entrepreneurs enabling them to apply to Single Window Agency(SWA) (both at State and District Level) High -Level Committee [HLC] for clearance of the project.

102 Annex F Page 4 of Once the project is cleared by the SWA/HLC, entrepreneurs will be provided with the CAF. Entrepreneurs are required to submit two sets of duly filled in CAF along with the required enclosures, payment of fees / deposits as prescribed, to KUM/DICs for obtaining necessary clearances/allotments, consents, approvals, permissions, registrations, enrolments, licences and the like. KUM/DICs will arrange for the required clearances/licences etc. from different departments/authorities and hand over the same to the entrepreneur within 35 days of submission of CAF completed in all respects. However, separate time-limits to be prescribed for each department to facilitate early stage-wise implementation of projects. To this end the applicable Rules will be amended suitably. 8. Since the SWA (for projects below Rs.50 crores) and HLC (for projects above Rs.50 crores) have representation from all departments/authorities concerned and the clearances etc. granted by these bodies, to be considered as final and the required notifications/orders by individual department/authority to be issued immediately thereafter without loss of time. 9. In case of failure of any department/ authority to issue the required clearance, allotments, consents, approvals, permissions, registrations, enrolments, licences and the like, within the period specified, such clearance shall be deemed to have been issued allowing the entrepreneur to proceed with the implementation of the project. The deemed clearances will be subject to 'Self Certification' and commitments made therein. The proposal of 'deemed clearance' and 'Self Certification' is to enable the entrepreneur to implement the project without delays on account of non-receipt of the required clearances etc. by the respective departments/authorities. Self Certification Format is in Annexure III. 10. Permission for building and installation of machineries by the Grama Panchayats/ Local Authorities. The entrepreneurs are required to obtain approval for the site, building plan and layout of plant and machineries from the Inspectorate of Factories & Boilers [IFB] under the Karnataka Factories Rules Once such approvals are obtained from the IFB, seeking permission to construct factory building and installation of machinerie separately from the Grama 'Panchayats or other Local Authorities is duplication of work. Therefore the entrepreneurs who obtain the required approvals from the IFB for site, factory building plan and layout of plant and machineries, in conformity with the prescribed provisions of the Karnataka Factories Rules, 1969, may be exempted from seeking such approvals again from

103 Annex F Paze 5 of 12 the Grama Panchayats and Town Panchayats. However in the interest of maintaining the financial stability of Grama Panchayats and Town Panchayats to provide and maintain basic infrastructure facilities, the taxes and fee prescribed from time to time under the Karnataka Panchayat Raj (Grama Panchayat Taxes & Fees) Rules will be collected by the IFB from the entrepreneurs and remitted to the respective GPs/TPs within 15 days of receipt of such fee. However, IFB will ensure compliance of building byelaws and related regulations before issue of such approvals. The Jurisdictional Inspector of Factories shall be delegated with powers to approve the plans of Factory building of nonhazardous Factories employing upto 100 persons. 11. Approval of Factory Building Plan by KIADB At present, in respect of KIADB land, the entrepreneur is required to obtain approval of factory building plans from the KIADB. Since the IFB is responsible for approval of factory building plan, the requirement of obtaining approval from the KIADB can be discontinued. Part - C 3.0 At the operational stage, employers are required to maintain a large number of Registers/Records prescribed under different Rules. In addition to this, ernployers are also required to maintain and submit a number of Returns periodically. In most of the cases these registers/records /returns are repetitive in nature. Factories are also subjected to frequent inspections by different authorities under various Acts to verify such registers/records/returns etc. 3.1 With the objective of eliminating unnecessary and repetitive maintenance of registers/records, the following simplification measures are proposed: 1. At present, separate Muster Roll/ Attendance and Payment Registers are required to be maintained under: Form No. Rule No. Rules i) Form 22 (Muster Roll) Rule 137 of Karnataka Factories Rules, 1969 ii) Form V (Wages) " 29(1) of Kamataka Minimum Wages Rules, 1958 iii) Form VII (Muster Roll) " 29(5) -doiv) Form -(Wages) " 5 of Kamataka Payment of Wages Rules, 1963 v) Form XVI (Muster Roll) "78(1) (a) (i) of Contract Labour (Regulation & Abolition)Kamataka Rules, 1974 vi) Form XVII (Wages) " " -do-

104 Annex F Page 6 of 12 Maintenance of different registers of attendance and wages to serve the requirement of each Rule, is a time consuming unnecessary and wasteful exercise. It is therefore proposed to maintain a Combined Muster Roll cum Register of Wages/Salary(CMR cum RWS) in lieu of above said registers. Specimen of Muster Roll cum Register of Wages/Salary is in Annexure IV 2. Though KST, KTEG and KTPTC & E are handled by the Commercial Tax Department, separate applications under KST, KTEG and KTPTC & E are required to be filed along with almost same set of documents/enclosures to obtain separate registration numbers. In the interest of simplification, it is felt that three different applications may be combined into one single Combined Application Form and one single authority may grant registration numbers and annual assessments under KST,KTEG and KTPTC&E. The annual assessment is presently done at the office of the Jurisdictional assessing authority and the entrepreneurs is required to produce all the required documents at his office for verification. Production of such large number of registers, records, applications etc., is burdensome. In order to facilitate faster annual assessment, it is proposed to carryout the annual assessment at the premises of the establishment/trade/dealer. The Combined application form is included in the CAF. 3. An employer is required to submit Monthly Returns to the Commercial Taxes Department under the Karnataka Sales Tax, Karnataka Tax on Entry of Goods and Professional Tax Acts separately. In addition to monthly returns, an employer is required to submit annual returns, based on which the final assessment of Tax is made. It is proposed to eliminate individual monthly returns under KST, KTEG and KTPTC & E Acts and adopt a combined Monthly Return Form to be submitted to Commercial Tax Department Specimen Combined Monthly Return Form is in Annexure V 4. More than 10 registers relating to overtime work payment, fines, deductions for damages, loss and advances etc. are required to be maintained under different Rules, as detailed below:

105 Annex F Page70fl2 Form No. Rule No. Rule i) Form 9 under Rule 107 of Karnataka Factories Rules, 1969 ii) Form XIII under Rule 78(1) (a) (iii) of Contract Labour(Regin. 3 Abolition) Karnataka Rules, 1974 iii) Form IV under Rule 28(2) of Karnataka Mini. Wages Rules, 1958 iv) Form I under Rule 3(1) (Fine), of Karnataka Payment of Wages 4 (Deduction) and Rules, (4) (Advances) v) Form II -do- -dovi) Form III -do- -dovii) Form XXI under Rule 78(1) (ii) of Contract Labour (Regulation & Abolition) Karnataka Rules, 1974 viii) Form XX -do- -doix) Form XXII -do- -dox) Form B under Rule 29 of Karnataka Labour Welfare Fund Rules, 1968 Payment of Wages Rules, 1963 The information sought by the above said registers can be made available in two combined registers which will serve the requirements of the Rules. It is therefore proposed that the two Combined Registers may be accepted in lieu of the existing registers. Specimen of Combined Registers are given in Annexure VI-A& B

106 Annex F Page 8 of Separate Annual Returns are required to be sent under the provisions of following Rules: Form No. Rule No. Rule i) Form 20 Rule 134 Karnataka Factories Rules, 1969 ii) Form XXV Rule 82 (2) Contract Labour (Regulation And Abolition) Karnataka Rule, 1974 iii) Form III Rule 22(4) Karnataka Minimum Wages Rules, 1958 iv) Form 'D' Rule 5 Payment of Bonus Rules, 1975 v) Form IV Rule 20 Karnataka Payment of Wages Rules, 1963 It is proposed to combine these returns into one to serve the requirement of the above said rules. The Combined Annual Return may be replaced as Form No. 20 under Rule 134 of Karnataka Factories Rules, 1969 and be accepted in lieu of annual returns as prescribed under other relevant rules. Specimen of Combined Annual Return is given in Annexure - VII 6. The returns, registers, documents, clearance, approvals and inspections if any under following miscellaneous Acts/ Rules may not be insisted upon: i) Karnataka Industrial Establishments (National & Festival Holidays) Act, ii) Karnataka Labour Welfare Fund Act, 1965 iii) Weekly Holiday Act, 1942 iv) Personal Injuries (Compensation Insurance) Act, 1963 v) Employees liability Act, 1933 vi) Children (Pledging of Labour) Act, 1933 vii) Weights and Measurement. The entrepreneur will be required to file a self-certification confirming compliance of the applicable provisions of the above said laws. Part- D 4.0 Industry Associations, in Karnataka have from time to time represented to the government to simplify/modify/liberalise certain restrictive/regulatory provisions of different acts. Such simplification/modification is essential to maintain the required discipline and run their enterprises in the competitive market driven environment.

107 Annex F Paj,e9of After examining the requests/suggestions of the associations, the following simplifications/modifications are proposed, which are within the powers vested in the State government under the relevant Acts/Rules. 1. Conciliation Under Section 4[1] of Chapter II of Industrial Disputes Act, 1947 the State Government, may, by notification in the official gazette appoint persons as it thinks fit to be conciliation officers to mediate and to promote settlement of industrial disputes. At present only officials working in the Labour department are appointed as conciliation officers. Due to lack of industrial experience and exposure such officers are often unable to act effectively resulting in non-settlement of disputes. The role of conciliation officers will be better served by persons who have served at Senior positions in the HRD/HRM field. The HRM/HRD persons have practical experience of handling industrial disputes understanding the problems of both management and ermployees. Therefore a panel of officers drawn from the field of HRD/HRM, Trade Unions and Legal Practitioners in Labour laws be created with the same duties and powers of departmental conciliation officers. Such experts will be able to play an effective role in helping the parties to solve their disputes without loss of time. Section 4(2) of Chapter II of Industrial Disputes Act, 1947 provides scope for appointment of such experts. 2. Public Utility Services The Karnataka Government has added a few industries to the list of Public Utility Services included in First Schedule under Section 2(n)(vi) of ][ndustrial Disputes Act, Under Section 22(1)(a) and (2)(a) a notice of six weeks has been made compulsory before going on a strike or declaring a lock-out in Public Utility Service Industries. For industries other than public utility services no notice is required to go on strike. As a result, many wild-cat strikes take place in such industries. Therefore, it is proposed that the industries coming under the following sectors: i) Information Technology and IT Enabled Services. ii) Bio Technology iii) Food Processing Industries (Only those set up in Agro Food Processing parks) iv) Electronics & Communication

108 Annex F Page 10 of 12 v) Export Oriented units vi) Garment vii) Auto ancillary units (only those set up in Auto Industrial Parks) be declared as 'Public Utility Services' by the State Government. 3. Industrial Employment Standing Orders Under Section 3(1) of Industrial Employment (Standing Orders)Act, 1946, an employer employing 50 or more persons is required to submit Draft Standing Orders(DSO) within six months of employing 50 persons, for certification and adoption. The Certification takes a long period. The draft standing orders can be framed only on matters provided in the Schedule to the Act. The subject matters in the schedule are limited and have not been changed to the requirements of the present day. The employer is required to follow the Model Standing orders(mso) in the interim period of certification. It is proposed that provision of certification of DSO may be repealed and MSO may be updated within three months and strictly be followed by the labour department. 4. Creche At present under Section 48(1) of the Factories Act, 1948, providing a creche is compulsory where more than 30 women workers are employed. Employer may be permitted to engage the services of NGOs / private organisations to manage the creche, at the cost of employer(s). Such arrangement may be permitted by the State Government under Section 48(3). 5. Rationalisation of Inspections: It is proposed that the number and periodicity of inspections done by various departments/agencies be rationalized. Under the provisions of various Acts, different authorities are created and it is common to find almost all such authorities keep visiting industries in the name of inspections which has become counter productive. In order to allow the entrepreneurs to concentrate more on their chosen business it is suggested, henceforth, industries may be subjected to one combined and joint annual inspection by the departments such as Inspectorate of Factories and Boilers, Karnataka State Pollution Control Board and Labour department in respect of registered Factories under the Factories Act. The Inspectorate of Factories and Boilers shall be the Nodal Agency. The selection of Industries for Inspection shall be on a random basis. A random number

109 Annex F Page 11 of 12 sampling generated through a computer - data base shall constitute the annual programme of inspections and shall be notified to the industries concerned, in advance. All other departmental inspections will be restricted to only specific complaints and self-certification of compliance filed by the entrepreneur may be accepted. To further simplify Inspection by multiple agencies, it is proposed to entrust the Inspectorate of Factories with the enforcement of some of the labour legislations presently being enforced by the Labour Department on the lines of State of Tamilnadu in respect of registered factories. The legislations are The Contract Labour Act, The Minimum Wages Act, National and Festival Act, Workmen Compensation Act, Interstate Migrant workmen Act, Equal remuneration Act, Labour welfare fund Act. However Labour Department will continue to enforce the said legislations in the areas other than the registered factories. 6. Upon approval of the above said proposals by the Cabinet, the C & I Department will draft the required changes in the respective Rules and forward to respective departments through the Law department for necessary amendment /notification. The implementation of deregulation measures will be reviewed and a status report will be submitted to the Cabinet periodically by the Principal Secretary C & I. 7. Other issues: The deregulation of business environment has attempted to simplify rules and regulations, which are within Legislative powers of the State Government. There are still a few issues, which need to be addressed for simplification and streamlining. These pertain to: i) Establishment of Industrial Township Authorities. ii) Inspection by the Electrical Inspectorate. iii) Permission for change of land use and land conversion. iv) Empowering DCs to permit purchase of agricultural lands by industrial units as per provisions of Section-109 of the Land Reforms Act. v) State level environment clearances. A Separate proposal on the above issues will be brought before the Cabinet for consideration with in eight weeks. Part-E 5.0 Keeping the overall objective set in the preamble to this Cabinet Note, the above referred reform measures have been proposed. These proposals have been

110 Annex F Page 12 of 12 discussed with the related departments and authorities and their views have been incorporated. Further, representatives of major industry associations have also been consulted and taken into confidence. 5.1 The Administrative Staff College of India, Hyderabad has prepared a detailed study report on 'simplification of procedures governing industries' at the instance of the Department of Industrial Policy and Promotion, Ministry of Industry, Government of India. Suggestions and findings given in the above said report have also been taken into consideration. 5.2 Even after these reform measures, the powers of granting mandatory clearances/approvals required for setting up industries shall continue to be vested with the administrative departments concerned. 5.3 The reform proposals suggested are expected to provide an enabling environment and a level playing field to the entrepreneurs/investors to set up their projects in Karnataka and to run them successfully.

111 Annex G Page 1 of 5 Poverty in Karnataka 1. Kamataka deservedly receives wide attention for its remarkable achievements in the rapidly growing information technology sector. Yet attacking poverty, particularly in certain chronically poor pockets of the state, remains an important developmental imperative. The publication in 1999 of the Human Development Report for Karnataka marked an important step forward in the establishment of a baseline understanding of the achievements in, and remaining challenges for, human development and poverty reduction in the Karnataka. The report brought together a wealth of detail on the diverse dimensions of human development during the 1990s, providing policy makers and other interested parties with a comprehensive information base upon which to draw. This note summarizes some of the main findings of the HDR, as well as of the poverty note prepared by the World Bank based on analysis of the National Sample Survey (NSS) data as well as the 1993/1994 National Council for Applied Economic Research (NCAER) rural household survey.' 2. Kamataka is India's 9th largest state (population: 53 million) with considerable physical, cultural, and linguistic diversity. It has 4 natural regions, (i) the coastal region, (ii) the ghats or malnad region, (iii) the southern maidan, and (iv) the northern maidan, all extending over 700 km. from north to south, and 400 km. from east to west. The state was formed in 1956, when Kannadaspeaking territories of Bombay, Madras, Hyderabad, Coorg and Mysore were merged together into one state. Partly on account of their dispersion in different political units, as well as partly due to different natural resource endowments and climactic factors, considerable disparity in living conditions prevail across different regions in the state. The Kamataka HDR included a disaggregated poverty "map" across 20 districts in the state, distinguishing between urban and rural areas in each, which revealed a remarkable degree of variation in poverty across districts - an important finding for policy makers considering where to focus their poverty alleviation efforts. For instance, in the northem more arid districts of Bidar, Gulbarga, and Raichur that border Andhra Pradesh, poverty levels continue to be considerably higher than in the rest of the state. Sources: Table 1: Mean consumption and Poverty in Karnataka and India, Karnataka India Urban Rural Overall Urban Rural Overall Mean per-capita monthly consuniption (Rs.) Head-count Estimates (a) UsingExpertGroupPoverty Line (b) 1997 World Bank estimates (c) Deaton & Tarozzi (1999) (a) Official figures (Planning Commission). (b) India. Achievements and Challenges. Reducing Poverty, World Bank, (c) Deaton, A. and Tarozzi, A. (1999) Prices & Poverty in India, mimeo. 3. A profile of consumption-poverty in the state reveals that the poor in Kamataka do not look much different from the poor in other, less advanced, states of India. The poor are virtually without education, have limited access to land, and are highly concentrated in low paying, physically demanding, and socially unattractive occupations such as agricultural wage labor (or in urban areas, in casual wage labor). In both urban and rural areas, the poor have very little access to modem sanitation services, and also commonly reside in houses of inferior quality. Scheduled castes constitute a sub-group of the population with a particularly high level of poverty. I Poverty in Karnataka: Profiles and Emerging Issues mimeo, World Bank, Washington D.C

112 Annex G Page 2 of 5 4. There are several estimates of poverty in Karnataka. Even though these estimates use the same household data, their use of different price indices leads to considerable variation in the extent of poverty in the state, both in absolute terms, and relative to the all-india average. The official poverty estimates for from the GOI Planning Commission show poverty in Karnataka to be lower than the All-India average (Table 1). Although mean urban consumption levels in the state are considerably higher than in rural areas, measured poverty was found to be higher in urban areas than in rural areas (40% vs. 30.0% ). However, there may be strong grounds to suggest that these statistical results are not robust. The finding of higher urban poverty results from the urban poverty line being 63% higher than the rural line in Kamataka, much higher than the difference between the two poverty lines in most other states. For these two poverty lines to represent the same standard of living, it must be argued that the cost of living in urban areas is higher by a similar proportion as the difference in the two poverty lines. Against a backdrop of free movement of goods and people, such an argument is rather implausible. Alternative methodologies show rural poverty to be much higher and rural poverty lower: two such estimates are also included in Table 1. Many other indicators of wellbeing (human development and other), suggest that rural areas are at a considerable disadvantage relative to urban areas, and the general perception in Karnataka that poverty is a largely rural phenomenon is very likely a robust conclusion. If poverty in rural areas is higher than that indicated by official statistics, given that roughly 7 out of 10 residents of Kamataka live in rural areas, this would raise considerably the estimated number of poor in the state. While the official figures show lower levels of rural poverty in Kamataka than the all-india average, the other two estimates show higher levels of rural poverty. (On progress in reducing poverty, see para. 11.) Table 2: Poverty Incidence by Level of Education of the Household Head Highest educational Incidence of Poverty Percentage of: Attainment of Head Urban Rural Overall Population Poor Not literate Less than Primary Completed Primary Completed Middle Completed Secondary Completed Higher level Overall Source: NSS Consumer Expenditure Survey 5. Education is a key dimension of welfare as well as an important determinant of rural incomes and economic livelihoods in Karnataka (Table 2). In urban Karnataka, the poverty rate of those who live in households whose head is illiterate is 67% compared to an urban average poverty rate of 40%. The incidence of poverty declines as household heads are progressively more educated, such that less than 10% of the poor live in households where the head of the household has an education beyond secondary schooling. In rural areas, the incidence of poverty for those in households with an illiterate household head is 38.3% relative to an average poverty rate of 30.1%. This suggests that in rural areas illiteracy is less clearly a defining characteristic of poverty as in urban areas. On the other hand, with an incidence of poverty of barely 1% among those where the household head has an education beyond secondary schooling, it is clear that those in rural areas who live in households with a highly educated household head run a very low risk of being counted among the poor.

113 Annex G Page 3 of 5 Table 3: Water source - by Sector and Poverty Urban Rural All Poor Urban Poor Rural Poor Tap Tube well/hand pump Well Tank/Pond/Reserve/Others Source: NSS Consumer Expenditure Survey 6. Access to safe water and sanitation for the poor in Kamataka is considerably poorer than the rest of the population. While a large majority (83%) of the urban population has access to tapped water, for the urban poor, the corresponding figure is 74%. For the rural poor, nearly 50% are reliant either on tube-well/hand-pumps (43%) or tank/ponds (5%). while in the urban population as a whole slightly over a quarter of the population (28%) of the population does not have access to any type of sanitation, the corresponding figure for the urban poor only is nearly 60%. Similarly, while about 40% of the urban population has access to a flush toilet, the percentage among the urban poor is below 20%. Such limited access to adequate sanitation services in urban areas may pose serious public health risks in urban areas. In rural areas, access to modem sanitation services remains very limited. The majority of the rural population (overwhelmingly in the case of the rural poor) have no access to modem services. 7. Poverty and access to land: In rural Kamataka, the connection between poverty and access to land is central to both understanding the causes of poverty as well as to designing policies to address poverty. The poor in Kamataka typically own less land than the non-poor and are highly represented among the landless. Moreover, variation in land quality is of particular importance in the context of the state, where access to irrigation is far from universal. Consequently, while the incidence of poverty is clearly highest among the landless and marginal landowners, there remains a considerable percentage of the rural population at risk of poverty even in the largest landowning category. Table 4: Rural Poverty Incidence by Land Ownership Poverty Percentage of: Amit. Of Land owned Incidence Population* Poor* Non-Poor* Nolandowned hectares hectares hectares hectares hectares Overall Source: NSS Consumer Expenditure Survey * Column shows poor population in land ownership category 8. Poverty and Occupational status: A very strong correlate of poverty in rural areas is involvement in agricultural labor (Table 5). The incidence of poverty is considerably higher (46.7%) for the rural population in which the household head is engaged in agricultural wage labor. Village studies indicate that agricultural wage labor is often viewed as a "last-resort" option by villagers due to the combination of hard physical labor which is involved plus a degree of loss of social status associated with working as a paid laborer for an outside employer. While agricultural labor is the occupation of about 35% of all household heads in rural Karnataka, 54% of poor household heads are agricultural laborers. In urban areas, the incidence of poverty is particularly high when household heads are employed as casual laborers. While only 16% of household heads in urban areas are engaged in casual labor, they make up nearly 30% of poor household heads in urban areas. There is

114 Annex G Page 4 of 5 also a slightly higher odds of poverty amongst those household heads engaged in self-employment activities. Table 5: Poverty Incidence by Occupation of Household Head Rural Areas Percentage of Urban Areas Percentage of Main Occupation Main Occupadon % Poor Popl'n Poor % Poor Popl'n Poor S.E. Non-agri SelfEmployed Agri. Labor Regular Salaried Other labor Casual Labor S.E. Agriculture Other Other Overall Overall Source: NSS Consumer Expenditure Survey S.E.: Self-employed 9. The non-farm sector in Kamataka offers a potentially important route out of poverty in rural areas. However, evidence on income shares suggests that in Karnataka, perhaps somewhat surprisingly given the State's high-tech profile, the rural economy remains relatively undiversified. Nonetheless, even in Kamataka as much as 20% of rural income accrues from non-farm sources. However, not all non-farm economic activity is equally productive, and at least some non-farm activities, particularly casual wage employment in non-agricultural activities, may as readily be a symptom of poverty as a route out of poverty. Because of low education levels, the poor are not well placed to gain employment in the non-farm sector, particularly regular employment in well paid jobs. Accelerating growth and employment in rural areas will be key to poverty reduction. Increasing the area under irrigation is vital, but since at most 1/3 of Karnataka's arable land can be brought under irrigation, improving dry land productivity is likely to play an equally important role in lifting the poor out of poverty. 10. Poverty and Social Identity: Women and the population comprising scheduled castes and scheduled tribes appear to be disadvantaged in the competition for opportunities in the non-farm sector. Analysis of the NSS data reveals a significant structural component to the difference between average per capita incomes of scheduled castes versus majority households. This indicates that alongside clearly visible differences in human capital levels and ownership of productive assets such as land, the returns on those assets and human capital received by scheduled castes differ from the returns received by majority households. There appears to be disturbing evidence that returns to education for scheduled castes are generally lower than for majority households; addressing this important dimension of social inequality thus poses additional, difficult, challenges to policy makers. Table 6: Recent Trends in Monthly Per-Capita Consumption NSS 43 rd Round NSS 50"' Round NSS S5"' Round A to A to Urban Rural Urban Rural Urban Rural U R U R Mean per-capita monthly consumption (Rs.): Karnataka % 78% 115% 86% Andhra Pradesh % 82% 89% 57% TamilNadu % 88% 122% 75% Kerala % 87% 89% 96% All-lndia % 78% 87% 73% Source: NSS data, various years Progress in reducing poverty: There has been much debate and controversy in India recently around the latest poverty estirnates released by the Government of India. While it is difficult to ascertain the extent to which poverty in the country has declined in recent years, evidence from

115 Annex G Page 5 of 5 various sources suggests that progress at reducing poverty in Karnataka has been somewhat better than in the rest of the country. NSSO survey data suggest that growth in mean per capita consumption in Karnataka, especially in urban areas, has been faster than in other states (Table 6). Similarly, results from the National Family Health Survey (NFHS) suggest that improvements in infant and child mortality, nutritional status, and other indicators of well-being have been more rapid than in the rest of India (Table 7). Table 7: Anthropometric Indicators and Mortality Rates All-lndia Karnataka All-India Karnabtka Infant mortality Child mortality Weight-for-age (% below 2 s.d.) Height-for-age (% below 2 s.d.) Weight-for-height (% below 2 s.d.) Source: IIPS (1995,) and IIPS and ORC Macro (2000)

116 Annex H Page 1 of 4 Karnataka Poverty and Human Development Monitoring System (Government Order No. PD-1-HDD Dated ) 1. Human Development Division in the Planning Department will coordinate all the activities relating to poverty and human development monitoring system in Karnataka with the active involvement of concerned departments in the Government. 2. Human Development Division will closely liason with poverty cell of the World Bank besides liasoning with All India Agencies like Census Department, National Sample Survey Organization etc. 3. List of indicators covering areas such as poverty, access to services, income, agricultural prices, employment and unemployment, demography and health etc. are given in the Annexure along with other details such as source of information, frequency, and present level of disaggregation, present status and name of the department to initiate action etc. Wherever name of the department is mentioned against a particular indicator, such department shall provide required information to the Human Development Division on a regular basis. The modality of furnishing of data will be finalised by the respective department in consultation with Human Development Division. 4. If any new indicator is required to be included or scope of the existing indicator is to be modified or enlarged, the Human Development Division will take necessary steps to include the same in the list of indicators with the involvement of the concerned department. 5. The Department of Economics and Statistics will take all necessary measures to strengthen the Civil Registration System in consultation with the Human Development Division. 6. Wherever special surveys/studies are suggested in the list of indicators given in the Annexure, the Human Development Division will take necessary steps to initiate action observing necessary formalities. 7. Action will be initiated to bring out State Level Human Development Report every 3 to 5 years utilising the census data, NSSO survey and other household survey results etc. 8. Human Development Division will initiate action for the preparation of District Level Human Development Report initially on a pilot basis with involvement of concerned Zilla Panchayat and District Administration, concerned Zilla Panchayat and District Administration will extend all necessary support as and when required by the Human Development Division for finalisation of the district level human development report. 9. Action will be take to include a chapter on poverty and human development in the annual economic survey of the State Government.

117 Annex H Page 2 of 4 Annexure Poverty and Human Development Indicators for Monitoring S. Level of Reporting Department No. Indicator disaggregation Data Source Periodicity Present Status / Comments to take action 1. Poverty: Percentage of population a) State, Annual NSS Consumer Expenditure Survey Annual Most recent estimates in Department of below the poverty line: Urban/Rural - Pooled central and State sample. Karnataka Human Development Economics b) By district Quinquennial NSS Consumer Expenditure Every 5 Report (data for ). and Statistics Survey (thick sample) Pooled central and years Data from the pooled 5 5 th round (DES) state sample. ( ) will be used to compute new district-wise poverty estimates later this year once unit-record data become available. 2. Access to services: Percent households with: a) By taluk Population Census 10 years Baseline to be set as results from Rural the 2001 Population Census are Development available, and Panchayat Raj (i) Access to safe b) By district (i) Rural Development & Panchayati Raj 3-5 years Data Collection system to be (RDPR) drinking water Department (RDPR) further strengthened. Additional data to be collected (ii) Kutcha homes (ii) Sample surveys of households through new household surveys, Special or through a special-purpose Survey (iii) Toilet facilities module canvassed in conjunction with the combined central-state (iv) Electricity Quniquennial NSS Survey.

118 Annex H Page 3 of 4 3. Income, Wages & Prices: (i) Wages (agricultural By district Department of Economics and Statistics Monthly A data series on real -grain DES & non-agricultural) (ii) Retail prices of essen- By district Department of Economics and Statistics Monthly equivalent of wages computed at the district level will provide an inexpensive yet powerful tool for monitoring variation in living standards on a timely basis. DES -tial commodities (iii) District income & its By district Department of Economics and Statistics Annual DES sectoral composition (iv) Wholesale prices of State Department of Economics and Statistics Monthly DES agricultural commodities 4. Employment: (i) Employment status a) State, Annual NSS Employment and Annual Employment status classified as DES Urban/Rural Unemployment Survey -- Pooled central (i) employed (ii) under-employed and state sample. (iii) unemployed & (iv) out of labor force. (ii) Composition of b) By district (i) Quinquennial NSS Employment/ 5 years Composition of employment DES employment Unemployment Survcy. Pooled Central and classified as (i) self-employed (ii) (iii) % of working children state sample salaried & (iii) casual. (iv) Labor Productivity (ii) Population Census of India 10 ycars (Working children: age group 5. Demography & Health: monitored: years). Infant Mortality Rates State Samplc Registration System (SRS) Annual NFHS data to be used to Department of Urban/Rural set baselines for monitoring. Health and Male/Female Anthropometric measures used to track severe and moderate child Family Welfare (i) Malnutrition State, region & Sample surveys: e.g. the National Family 3-5 years malnutrition (i.e. measures such (DHFW) gender Hcalth Surveys (NFHS), Rural Child Health as weight-for-age, height-for-age, Urban/Rural Surveys, etc. and weight-for-height to be used). Couple protection rate State (i) Department of Health data Annual Methodologies to compute DHFW Urban/Rural maternal mortality rates and life- Institutional delivery (ii) Sample surveys 3-5 years expectancy to be examined more DHFW carefully to determine data Matmalmorali tate e Not known at present requirements and explore DHFW Urban/Rural feasibility. Life Expectancy at Birth

119 Annex H Pae 4 of 4 6. Education: Literacy (a) By taluk Population Census 10 years Additional data to be collected Special through new household surveys, Survey Gross enrolment ratio (b) By district (i) Quinquennial NSSO Survey or other 5 years or through a special-purpose special-purpose survey module canvassed in conjunction Special Proportion of children 6-14 (ii) Literacy Survey recently conducted by with the combined central-state Survey years out of school the Department of Education Quinquennial NSS Survey. Education Drop out rates (iii) Department of Education data Annual Department 7. Other Indicators, comments, etc. Wherever feasible, the above indicators will be collected through integrated household-survey instruments so as to permit disaggregation by important groups of interest, such as by gender, poor / non-poor, backward regions, socially disadvantaged groups, etc. Other important performance monitoring indicators such as more effective tracking of outcome indicators such as school learning achievement and behavioral outcomes, process indicators such as whether text-books and other material reach schools in time, teacher attendance and regularity, etc., supplementing quantitative data with qualitative assessments, etc to also be eventually incorporated into the monitoring system once present capacity within GoK to carry out such analyses has been developed. In addition, wherever feasible, technical expertise will be developed to carry out more formal monitoring and evaluation of specific policy interventions.