Question

Spending and Revenue are divided into ten categories, such as Investments, General Government, etc. Choose three spending categories and one revenue category to write about. What decisions to spend or cut did you make in each of the categories that you chose? Explain your choices. Be sure to read the pro/con arguments for each decision. Which arguments did you find most convincing?

Answer 1

An efficient budget preparation procedure should aim at making the government's priorities clear and at selecting, from the many budget requests by spending ministries, those which are really important to the government. In principle that requires two elements. First, a budget strategy needs to be determined at a political (typically cabinet) level, which determines (1) the affordable total, (2) new policies to be accommodated, and (3) any changes (often reductions) in existing policy provision. Second, each spending ministry and the budget department/planning ministry should meet to discuss each ministry's estimates. To accommodate new policies, the budget department/planning ministry must require each spending ministry to prioritize its requests.

But this ideal is rarely matched by the practices in many countries. Quite apart from weaknesses in the institutional arrangements, decisions on priorities at the budget preparation stage can be wholly artificial because (1) subsequent cash allocations or supplementaries will render them redundant; (2) amounts given by line item are deliberately loose or unclear, in anticipation of a real allocation during budget execution; and/or (3) in practice, the priorities are set outside the formal budget framework, for example, by the president's office.

Ultimately, the allocation of resources across spending programs is a political decision, although those preparing the budget will need to advise on what is realistically achievable. For this, economic analysis should play an important role. For example, ministries need to have as much information as possible on expenditure policies and programs, on costs, and, ideally, on their outputs and outcomes.

Whenever possible, however, the cost of all new policies that a line ministry wishes to pursue should be estimated separately from the estimates of the costs of ongoing policies. As supporting information, the spending ministry should provide data on expected results/performance from such new policies and incremental spending (ideally, outputs and outcomes) and preferably in a format that enables the requests across ministries to be compared. The ministry of finance should have a role in reviewing, and commenting on, such cost estimates. The data should be presented with enough detail to allow the budget department to judge the reasonableness of the budget request, the activities the request is intended to support, and the corresponding staffing levels.

Such systems are most advanced in a small number of industrial countries: even there, the practices (and results) are not wholly in line with the above principles. Real political agendas are sometimes nontransparent or inadequately articulated; the economic value of marginal expenditures across functions cannot be properly compared; and the measurement of policy outcomes, and their links to individual programs, has proved quite difficult in practice. Yet, considerable progress has been made, particularly on measuring output and on requiring better assessments of the results of new policies or programs proposed before they can be incorporated in the budget. Developments in this direction are to be encouraged, and there are some useful short cuts.

As noted earlier, to facilitate discussion on resource allocation, it is helpful for the budget department to set, within the macroeconomic total, guidelines/targets for each spending ministry on their total spending, when the budget circular is issued. In addition to targets by line ministry, an allowance should be made within the affordable total for suitable planning and contingency reserves (see below). This allows budget negotiations to coalesce around a realistic target for each ministry, consistent with the affordable macroeconomic total.

Such guidelines or targets can be normative (e.g., when they are derived from a medium-term expenditure planning framework; see below) or purely indicative (e.g., based on shares in the latest year's outturn figures).

Each line ministry/spending agency can be asked to put forward its estimates for its existing or baseline policies within that guideline. (This should automatically be the basis of the data when the figures are derived from a medium-term framework.) Separately, each ministry should be asked to identify what policies and programs would be enhanced/introduced or cut back, if their allocation were 5 or 10 percent above/below the guidelines. While such an approach can be abused (by line ministries offering only politically unacceptable items for reductions), with experience, and with a well-informed challenge capacity within the ministry of finance that identifies lower-priority items in advance, it can help to concentrate discussion on priorities at the margin, within an affordable total.

A planning reserve is a sum (usually one or two percent of total expenditure) not allocated in the guidelines, which the ministry of finance later plans to allocate to new programs, if necessary above the guidelines during budget negotiations. A contingency reserve is a reserve for in-year expenditures above appropriations for handling genuine contingencies; it should be modest in size (if too large, a bidding process from ministries may quickly set in) and thus it is unlikely it should exceed 2 or 3 percent of total expenditures. It should be under the control of the ministry of finance, and access should be granted by the ministry of finance only under stringent conditions.

Where priorities are not being clearly established during the budget preparation process, the budget department/planning ministry can establish benchmarks using these mechanisms and thus set the basis for a discussion by policymakers of the priorities among the requests.

Multiyear planning

Focusing on the current or next fiscal year's expenditures alone can be misleading. Expenditure planning should be extended beyond one year, not least to gain a full appreciation of the future spending implications of present policy decisions. Nowhere is this more important than on the recurrent costs of capital spending. For countries with multiyear PIPs, such plans need to be reintegrated with recurrent expenditures and into a multiyear expenditure plan that provides the basis for establishing a realistic global budget. Although the introduction of a regular procedure of medium-term planning frameworks by function, by ministry, and (ideally) by program takes time to develop, those analyzing and preparing the budget should begin this process by preparing medium-term fiscal scenarios.

There are several variants of such a planning framework. The simplest has only aggregate projections for public spending for the two or three succeeding years beyond the budget year. A second has "illustrative" figures by line ministries--sometimes on a mechanistic basis (e.g., shares of a global total are assumed to be held constant to the proportions in the budget year). A third is normative in that it projects costs of existing and any new policies agreed for introduction over the medium term, but these medium-term figures play no role in subsequent-year budget negotiations. The best approach uses these figures for the past budget year as the starting guideline for the next year's budget negotiations.

A legitimate need for extrabudgetary funds

Extrabudgetary funds (as defined in the GFS manual) generally refer to accounts of government transactions that are not included in budget totals or documents and typically do not operate through normal budgetary execution procedures. Such transactions may, for example, be financed through foreign aid or earmarked revenues not included in the budget.

Unfortunately, extrabudgetary funds are often set up for inappropriate reasons, not consistent with principles of good governance. For instance, they may be designed to allow the president or some parts of the executive branch to bypass the normal budget procedures (for example, the comptes spéciaux in the francophone system). In this case, the fiscal economist should aim to identify all such funds and then ensure that they are consolidated on a gross basis in fiscal tables. This may be difficult where expenditures from these accounts cover security or presidential spending, which can be considered highly sensitive issues. When consolidated, however, and when the political authorities can be persuaded to consider them as a legitimate component of the published budget, at some point those preparing the budget may be able to close these accounts or at least to reduce their number. The affected expenditures should then follow regular budgetary procedures and appear in the relevant heading in the consolidated budget.

Another reason to create this kind of account may be to earmark revenue for a particular purpose. In this case, a specific kind of revenue is transferred to this account when collected, and whatever funds are available must be spent on a given item. While there are advantages and disadvantages in operating such funds in many countries, in many cases the disadvantages far outweigh the advantages(see below box on the pros and cons of extrabudgetary funds). In the worst instances, new extrabudgetary funds may be established specifically to divert expenditures out of the budget, sometimes with the aim of publishing a lower fiscal deficit. The practice of opening such accounts is often an indication that the budget process is not functioning properly, and that resources for priority tasks must be allocated through other mechanisms. Unfortunately, this practice gives rise to rigidities in the short and long term. In the short term, financial management will be impaired because resources transferred to a special account are typically not available to the treasury for cash management purposes--for example, to relieve short-term cash shortages. In the medium term, a shift in government priorities may be impeded by the fact that a part of the available resources is set aside for a special task.

Pros and Cons of Extrabudgetary Funds Pros Can increase efficiency by simulating private market conditions where levels and standards of service are linked directly to fees or charges. Can provide more consistent source of funds for expenditures that yield high benefits yet do not get much recognition (road maintenance expenditures are a primary example). Cons Can result in a loss of aggregate expenditure control; such expenditure may be outside the control of ministry of finance. Can distort allocation of resources by circumventing the budget process and review of priorities. Earmarked revenues can become entrenched so funding is no longer based on priority needs. Less transparency may lead to inefficiency and/or misuse of funds. Can facilitate rent-seeking and abuse of monopoly power. Leads to less flexibility at the margin to reallocate when budget is under stress. Is incompatible with good cash management practices.

While having too many extrabudgetary funds should be discouraged, there can be a case for a selective use of such funds, quite apart from separate social security funds that are a feature of many countries--for example, for earmarking resources for infrastructure maintenance. If it is apparent that a lack of maintenance is leading to higher capital expenditures in the long term, for example, earmarking may prevent the diversion of resources needed for road maintenance (often seen as not politically attractive) to other purposes. But the use of earmarked revenues should be accompanied by either administrative mechanisms or market-like incentives that promote accountability and efficiency (sometimes referred to as the "agency model")--something that is rarely achievable in developing countries. Without such extrabudgetary controls, funds can end up serving corrupt interests and weaken good governance. Below provides a list of diagnostic questions for assessing the legitimacy of using extrabudgetary funds.

Key Questions Concerning Extrabudgetary Funds What is the purpose of the extrabudgetary fund? What is the rationale for keeping such a fund off-budget? Financing Issues What is the source of funding? Does the source of funding make sense; does it help to relate marginal benefits to marginal costs--for example, user fees? How are user fees determined; are there limits to prevent abuse of monopoly power (especially if demand is inelastic)? Are there general benefits (positive or negative externalities, public goods arguments) in addition to user benefits that justify support from general budget revenues? If there is a split, how is the share of financing determined? Is the source of financing an important government revenue, and can the government afford to lose the associated degree of flexibility in prioritizing expenditures? Do earmarked revenues detract from the government's capacity to collect traditional revenues? Expenditure Decisions How are expenditure decisions made by the extrabudgetary fund? What use is made of cost effectiveness or cost-benefit analysis? Does the management of the extrabudgetary fund promote efficiency, for example through quasi-market mechanisms or through mission statements, objectives, performance measures? How are consumer interests represented and taken into account in expenditure decisions? If governed by a board, is membership of the board biased toward certain needs--for example, regional needs? Management Issues Does the management of the extrabudgetary fund meet good governance requirements? Is it free of political interference or unduly influenced by suppliers or trade unions? Is it possible for funds to be diverted to other uses? Can these accounts be "raided" for other uses? Is the extrabudgetary fund independently audited? How are the cash resources of the extrabudgetary fund handled? Does the government have access to these funds for overnight borrowing to minimize government borrowing needs? Does the treasury or ministry of finance have the legal right to reduce funds available for expenditure in extrabudgetary funds if the budget is under severe pressure?

Are quasi-fiscal activities and contingent liabilities to be taken into account

Some operations of a fiscal nature are not conducted through the budget. Examples of such quasi-fiscal expenditures include interest subsidies paid by the central bank on loans to public enterprises, and special support operations for banks and public or private sector enterprises administered through the banking system. Quasi-fiscal expenditures also include spending by nonfinancial public enterprises that represents the provision (or subsidization) of public goods (e.g., schools or hospitals). By definition, such expenditures do not pass through the budget and cannot be easily consolidated with the statement of general government operations.

In general, it is difficult to extract information on, let alone estimate the cost of, quasi-fiscal activities so as to consolidate such data in the general government tables. But, to gain an overall assessment of the fiscal stance, it may be necessary to assess the size of such operations and to notionally add the figures to the information on general government operations. In addition, those preparing the budget should take every opportunity to persuade policymakers to transform such nontransparent activities into explicit subsidies, transfers, etc., to the extent they should continue at all, within the budget.

Governments also have, at any point in time, certain contingent liabilities. The most common is the existence of explicit government guarantees, usually on bank lending to industry or lower tiers of government, which can fall due. But there are other forms of implicit contingent liabilities: for example, there may be a challenge in the courts to the government interpretation of a law that, if the judicial decision goes against the government, will have expenditure implications.

In general, countries should be urged to ensure that a careful record of all such explicit contingent liabilities is maintained (while recognizing that there will always be some uncertainty on aspects like judicial decisions as well as moral suasion pressures on "implicit" government guarantees) and to make prudent allowance for such guarantees being "called" (i.e., payments being due) or for adverse judicial decisions, by ensuring that there are sufficient resources in the contingency reserve to meet such expenditures. Of course this will always be a difficult judgment; in some years the reserve may be more than adequate--in which case the unused balance can be used to improve the fiscal position relative to the budget. In other years, some excess, even after the contingency reserve, may arise and should be met transparently through supplementary estimates. Those preparing the budget should ensure that some estimate of expenditures from both explicit and implicit contingent liabilities is allowed for in budget preparation.

Appropriations-in-aid be handled

Many countries have spending agencies that are able to finance a large part of their activities from their own sources of revenue--normally fees and charges. An example might be a dedicated passport office that charges for the issue of passports but receives budgetary resources for its capital expenditures. These budgetary resources are often termed appropriations-in-aid, or sometimes net appropriations--that is, the amount sufficient to meet the gross service costs, after an assumed contribution from the fees and charges they raise.

There are three issues in this regard. First, irrespective of how far the costs of the service--for example, the issue of passports--are financed from earmarked charges rather than from general budgetary resources, the activity is essentially within the government sector. Thus, in terms of measuring the size of government, the appropriations-in-aid data are insufficient. The gross expenditures or gross costs of the service need to be identified, as well as how much is financed from own fees and charges, and how much from general budgetary resources. Second, though it is essentially a budget execution issue, there are often cases where the fees are paid into a separate bank account held by the relevant spending agency in a commercial bank. As explained in the next Section, this is generally poor budgetary practice, which can lead to abuse with the monies being diverted into other areas of expenditure. Third, in budget preparation, it is often necessary to be aware of deliberate underestimation of the likely revenues from fees and charges, so as to maximize the contribution from general budgetary resources. In particular the ministry of finance needs to insist on the annual updating of fees and charges to allow for inflation--quite apart from any separate expenditure policy issues about how much of the service cost should be met by users and how much by the general taxpayer.