35116 Public Disclosure Authorized

A Contemporary Approach to Public Expenditure Management

Allen Schick Public Disclosure Authorized Public Disclosure Authorized

Governance, Regulation, and Finance Division Public Disclosure Authorized

i The findings, interpretations, and conclusions expressed in this document are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organi- zations, or the members of its Board of Executive Directors or the countries they represent.

Copyright © 1998 by the International Bank for Reconstruction and Development

First Printing May 1998 Second Printing April 1999

The World Bank enjoys copyright protection under protocol 2 of the Universal Copyright Convention. This material may nonetheless be copied for research, educational, or scholarly pur- poses only in the member countries of the World Bank. Material in this series is subject to revision. The views and interpretations in this document are those of the author(s) and should not be attrib- Contents

Foreword ...... v

Chapter 1 An Overview ...... 1

Chapter 2 Managing Public Expenditure in Developing Countries ...... 29

Chapter 3 Aggregate Fiscal Discipline ...... 47

Chapter 4 Allocative Efficiency ...... 89

Chapter 5 Operational Efficiency ...... 111

Tables Table 1.1: Basic Elements of Public Expenditure Management ...... 2 Table 1.2: Institutional Arrangements for Enforcing Aggregate Fiscal Discipline ...... 13 Table 1.3: Institutional Arrangements for Improving Allocative Efficiency ...... 16 Table 1.4: Institutional Arrangements for Improving Operational Efficiency ...... 19 Table 2.1: Special Problems of Some Developing Countries ...... 31 Table 2.2: Aggregate Fiscal Discipine Problems of Some Developing Countries...... 36 Table 2.3: Allocative Efficiency Problems of Some Developing Countries ...... 39

iii iv

Table 2.4: Operational Efficiency Problems of Some Developing Countries ..41 Table 2.5: Public Expenditure Conditions Associated with Economic Development ...... 44 Table 3.1: Controlling the Costs of Entitlements...... 75 Table 3.2: Issues in Managing Financial Risks ...... 77 Table 3.3: Controlling Contingent Liabilities and Other Financial Risks...... 79 Table 5.1: Types of Expenditure Control ...... 115 Table 5.2: Instruments for Improving Managerial Accountability ...... 124 Table 5.3: Types of Output Targets ...... 126 Table 5.4: The Definition and Measurement of Cost...... 132 Table 5.5: Using Performance Information to Improve Operations ...... 134

Boxes Box 3.1: Australia’s Forward Estimates System ...... 57 Box 3.2: Strengthening Fiscal Discipline in Sweden...... 60 Box 5.1: New Zealand’s Contractual Model...... 121 Box 5.2: Performance Targets in the United Kingdom...... 129 v

Foreword

In the last ten to fifteen years, a wave reforms. With their budgets under of change in the management of pub- siege and their economies sagging, lic budgets has swept through devel- many developing countries have began oped countries and has begun to to seek innovative ways of using the engulf many developing countries as national budget more effectively to well. Much of this impetus was promote socio-economic development brought about by dismal macroeco- and to experiment with variants of the nomic performance as reflected in sus- successful reforms in developed coun- tained structural budget deficits and tries. Even the highly successful East balooning national debt. From New Asian economies have began to focus Zealand to the United States, devel- very ardently at reforming their budg- oped countries embarked on a massive etary systems as they now confront the effort of “government reengineering” most serious economic crisis in thirty to restore discipline in the budget years, a shock that has put a serious process and to better target dwindling dent on their public budgets. budgetary resources towards higher In order to encapsulate and dis- priority uses. The resounding success seminate the wealth of knowledge of New Zealand and the more modest embodied in these reforms, the achievements of other developed coun- Economic Development Institute of tries have stimulated a renewed interest the World Bank has developed a course among developing country govern- on Budgeting Processes and the ments in public management reforms Analysis and Management of Public and more specifically on budget Expenditures. Prof. Allen Schick has prepared this manuscript to serve as I have had the great pleasure and the main text for the course. A number privilege of working closely with Prof. of colleagues provided invaluable assis- Schick in molding the substance and tance in shaping the material. Sanjay charting the direction of the course and Pradhan and Malcolm Holmes were the manuscript. It is my hope that both particularly helpful in providing will provide public officials, scholars, (sometimes) stinging but useful com- and practitioners around the world use- ments and suggestions. ful guidance in their efforts to study, develop, and/or implement much needed reforms in the public sector.

Jose Edgardo Campos Senior Economist Economic Development Institute The World Bank Chapter 1 An Overview

ublic expenditure management PEM covers a broad range of institu- (PEM) is a new approach to an tional and management arrangements, Pold problem. The problem is not just those traditionally associated the allocation of public money with budgeting. PEM recognizes that through collective choice. For more budget outcomes are not likely to be than a century, these allocations have optimal if the public sector is poorly been made through the machinery of structured and managed, or if the budgeting—the routines and proce- incentives and information given poli- dures devised by governments to cy makers and program managers decide the amounts spent, the balance impel them to act in ways that produce between revenue and expenditure, and perverse results. the allocation of funds among public The first critical difference is that activities and entities. PEM operates conventional budgeting operates through budget decisions, but differs through accepted procedural norms, in two important ways from conven- while PEM emphasizes substantive tional budgeting. First, it supplements outcomes. These outcomes pertain to the conventional procedural rules with (a) total revenue and expenditure, (b) substantive policy norms. In PEM, it is the allocation of resources among sec- not enough that governments apply tors and programs, and (c) the efficien- the right procedures; it also is essential cy with which government institutions that they strive to efficiently achieve operate. These elements and their desired policy outcomes. Second, salient characteristics are summarized

1 2 A Contemporary Approach to Public Expenditure Management in Table 1.1. PEM recognizes that even ing and PEM. In the former, what when a government adheres to accept- matters is how the process of budget- ed budget principles, it may fail to ing is organized; PEM by contrast, obtain optimal fiscal outcomes. In fact, casts a broader net that takes into many developing countries have sound account how public institutions are budget and financial management sys- managed. PEM is premised on the tems but still lack fiscal discipline, are notion that budgeting is not a process unable to reallocate resources in accord unto itself but is part of a broader set with strategic priorities, and operate of institutional and governing arrange- inefficiently. ments. To achieve positive public To achieve its preferred outcomes, expenditure outcomes, it is necessary a government must manage public that information, incentives, and other expenditures to implement avowed institutional arrangements be properly policy objectives. It must create an aligned. institutional framework that enhances The reorientation from conven- the probability that actual outcomes tional budgeting to PEM has been will conform to professed targets. This driven by unsatisfactory public expen- consideration leads to the second dif- diture outcomes in many developing ference between conventional budget- and developed countries. Developing

Table 1.1: Basic Elements of Public Expenditure Management

Aggregate Fiscal Budget totals should be the result of explicit, enforced Discipline decisions; they should not merely accommodate spending demands. These totals should be set before individual spending decisions are made, and should be sustainable over the medium-term and beyond. Allocative Efficiency Expenditures should be based on government priorities and on effectiveness of public programs. The budget system should spur reallocation from lesser to higher priorities and from less to more effective programs. Operational Efficiency Agencies should produce goods and services at a cost that achieves ongoing efficiency gains and (to the extent appropriate) is competitive with market prices. An Overview 3 countries have long been afflicted by and controlling public expenditure. severe fiscal imbalances, the maldistri- This chapter introduces the core ele- bution of public resources, and chron- ments of public expenditure manage- ic inefficiency in the provision of pub- ment; and it discusses how the various lic services. Often these adverse condi- elements relate to one another. The tions have persisted even when the next chapter explores public expendi- government has implemented the stan- ture problems of developing countries. dard budgetary rules and practices pre- Each of the subsequent chapters elabo- scribed by international organizations. rates on a particular element of PEM. Similar deficiencies have cropped up in As an emerging field, PEM still is industrial democracies, though they undergoing conceptual development often have been masked by affluence and refinement as a management tool. and the amplitude of public resources. The ideas and approaches discussed in But even in rich countries, the less this publication are provisional; they robust economic growth of the past are likely to be modified and elaborat- two decades has revealed entrenched ed as PEM matures and experience on shortcomings in the management of its application accumulates. public expenditure. Many developed countries have experienced chronic Due Process in Budgeting deficits, a significant rise in public The practice of budgeting emerged expenditure as a proportion of the during the 19th century in Europe as a gross domestic product, difficulty in means of dealing with growth in pub- reallocating public money from declin- lic expenditure. Although the public ing to emerging priorities, and weak sector was much smaller in all coun- productivity gains in government tries than it has become in the present operations that have persistently century, it had grown sufficiently large lagged behind the gains achieved in the to require regular procedures for allo- market sector. cating and controlling government This publication outlines the con- expenditure. These procedures gener- cepts of public expenditure manage- ally came to be regularized as budget ment. It explains how PEM supple- practices. Since its genesis, budgeting ments formal budget process rules has been defined as a set of procedures with behavioral norms for allocating that recur, typically with little or no 4 A Contemporary Approach to Public Expenditure Management change, year after year, by means of and transparency (the government which governments ration resources should publish timely information on among their agencies and control the estimated and actual expenditures). amounts each spends. Budgeting is the The principles of budgeting are routinization of choice with respect to implemented and enforced through public finances; this characteristic dis- detailed procedural rules specifying the tinguishes budgeting from other gov- scope of the budget, the information ernmental actions affecting public to be included in it, the timetable for expenditure, such as national planning taking particular actions, the forms to and cabinet policy decisions. be used, the authorization required As routine, budgeting differs from before public funds are spent, and so one venue to another. Each govern- on. Every principle is backed by formal ment has its peculiar forms and proce- rules which are enforced by budget dures, its distinctive labels and lan- controllers at the center of government guage. Very early in the development and in the spending departments. The of budgeting, however, efforts were accumulated principles and procedures made to codify the basic routines into comprise due process in budgeting. a set of procedural rules that should be The term “due process” connotes followed by all governments, regardless the judgment that if the procedures are of the political-administrative frame- sound, the outcomes are the right work within which budget activities ones. That is, the outcomes should be are carried on. The basic principles assessed in terms of the procedures that have been elaborated and refined over generate them, not in terms of sub- the years, but they have had remark- stantive criteria. Whatever results able staying power. They include com- ensue from a well-run budget process prehensiveness (the budget should are appropriate. If, for example, the include all revenue and expenditure); budget is comprehensive and all bids accuracy (the budget should record for resources are submitted and actual transactions and flows); annual- reviewed according to a uniform ity (the budget should cover a fixed schedule, then the allocations made to period of time, typically a single fiscal departments or programs are to be year); authoritativeness (public funds accepted as legitimate and efficient. should be spent as authorized by law); Due process norms are indifferent to An Overview 5 the outcome itself; these norms may policies or outcomes. International result in balanced budgets or deficits, advisers may caution recipient govern- rising public expenditure or stable ments against excessive deficits or urge spending trends, frozen budget priori- that budget allocations be shifted from ties or significant reallocations. Due one sector to another. But their main process in budgeting is politically neu- role is to recommend improvements in tral; it can accommodate both left of the machinery of budgeting. A major center and right of center govern- exception to this limited role occurs ments. With due process norms in when international organizations such place, actual outcomes are likely to as the IMF impose conditions for pro- vary with changes in political and eco- viding financial assistance. These con- nomic conditions. As these conditions ditions usually pertain to fiscal out- differ from one country or time to turns, such as the size of the deficit. another, so too do expenditure out- Due process in budgeting encourages comes. Due process in budgeting is governments to centralize the manage- analogous to due process in litigation. ment and control of public expenditure. In the latter, if proper judicial proce- The strong hand of central authority is dure is followed, the ensuing verdict needed to ensure that the budget is must be accepted as legitimate. comprehensive, that all spending enti- Budgeting has the same mind set. ties conform to the rules, and that rou- Due process in budgeting provides tine procedures are completed on an active but limited role for interna- schedule. Centralization goes hand in tional institutions. They may push for hand with uniformity in budgetary improved budgeting practices, procedure. All spending units must use demanding, for example, that the the same forms, operate according to budget cover all public expenditures the same timetable, and follow the and that special funds and accounts same steps in implementing the budg- not be excluded. They may insist on et. Agency initiative and variation are accurate budget data and sturdy con- discouraged because they increase the trols to ensure that the budget is probability that due process will be implemented according to plan. This violated. is a politically limited role, for it stops Due process fosters the notion that short of dictating particular budget budgeting is a self-contained activity, 6 A Contemporary Approach to Public Expenditure Management with its own rituals and roles, cutoff ditures because it systematically leads from other management practices. In to unwanted or adverse outcomes. all but the smallest government, the Looking at the recent fiscal perform- budget process is operated by a central ance of both developed and developing office which makes the rules, monitors countries, one is compelled to conclude compliance, prepares the budget, and that good budget practices regularly pro- controls spending. Some budget duce outcomes at variance with those offices have additional management sought by the affected governments or responsibilities, but the budget is their regarded as inefficient by outside bread-and-butter role and it shapes observers. For decades, international insti- their posture on other managerial tutions have assisted developing countries work. Rather than regarding the budg- in installing sound budget practices, but in et as part of a family of management many cases the outcomes are as subopti- practices, central control agencies seek mal today as they were years ago when the to leverage their budget power to gain first budget reforms were introduced. influence over spending units. Arguably, being poor has a lot to do with unwanted outcomes, but even if this point Inherent Shortcomings in is conceded, one must question whether Due Process Budgeting due process reforms suffice to make things A due process approach to budgeting much better. The typical reform package has some important advantages. For consists of procedural innovations: return one, it establishes the basis for finan- excluded funds to the budget; tighten cial control within government; for spending controls so that the budget is another, it seeks to ensure that finan- implemented as planned; install a new cial information is reasonably accurate, accounting system that produces timely, uniform, and timely. These and other reliable information. As desirable as these elements of due process are essential reforms may be, they do not by themselves building blocks in public expenditure ensure improved budget outcomes in poor management. A government cannot countries. If lack of resources is the root effectively manage its expenditure if cause of adverse budget outcomes, pro- due process is materially breached. posed remedies must recognize this condi- Nevertheless, due process is an inade- tion to produce realistic, achievable out- quate basis for managing public expen- comes. An Overview 7

Fiscal outcomes generally appear tivity in public organizations by spend- to be more favorable in developed ing more on operations. When countries because they are not beset by resource constraints tighten, however, the severe resource constraints that the inadequacies in public expenditure afflict poor countries. Nevertheless, management become more visible and the record in some is not one to boast less tolerable. Deficits become alarm- about. Over the past two decades, ing because incremental resources are many rich countries have had deficits inadequate to pay for them, and citi- that grew when the economy was weak zens (faced with stagnant or declining and persisted when the economy disposable income) resist tax increases; recovered. Most have rigid budgets, old priorities get frozen into the budg- with little opportunity for the govern- et and new priorities are frozen out; ment to shift public funds from lower low productivity impels a shift in to higher priorities. Many have had national income from private to public meager public sector productivity consumption. What is different in bad gains that have lagged behind those times may not be the performance of achieved in the private sector. There government but the awareness or the have been a few notable success stories; perception of low performance. some of these are described in volume two (forthcoming). Why Good Procedures May Affluence and the availability of Produce Bad Results incremental resources made it appear A key question that warrants considera- that budget outcomes were more tion is why adverse outcomes result from favorable in the postwar decades when the exercise of due process in budgeting. economic growth was very high than If robust budgetary procedures are inte- in the more recent period when gral elements of PEM, why shouldn’t the growth was more modest. When results that ensue from them be favor- money is plentiful, governments can able? Addressing this question elicits an spend more without tripping alarms important distinction between PEM and about the budget deficit; they can conventional due process approaches to respond to fresh priorities without tak- budgeting. Procedural rules deal with the ing money away from old programs; formal features of budgeting: how and and they can pay for stagnant produc- when decisions are made, the structure 8 A Contemporary Approach to Public Expenditure Management and form of the estimates, the scope of their interest. This “tragedy of the the budget, and so on. These rules do not commons” problem is ubiquitous in take sufficient account of the interests budgeting. A common interest— and behavior of budgetary participants. whether it be in land, money, or any- In fact, seemingly good rules can generate thing else of shared value—often has perverse incentives and lead to unwanted three basic characteristics: it is a finite outcomes. For example, rules requiring resource, it has many users, and it is comprehensive budgets may be under- depleted by overuse. Although it is in mined by the establishment of extrabud- the collective interest of all users to getary funds or by other actions that ration use of the common resource, it weaken fiscal discipline. Because of this, it is in the individual interest of each user is essential that expenditure outcomes be to take as much as he can get. In budg- assessed independently of the process by eting, each agency may prefer that the which they are generated. PEM does so government maintain a sound fiscal by focusing on incentives, that is, on posture, but each acts in its self-inter- informal aspects of budgeting: how par- est by demanding as much as it can ticipants behave, and how their actions get. Because no single spending agency are affected by budget rules. is responsible for total expenditures, it In considering the behavioral does not see itself as damaging the gov- dimensions of expenditure manage- ernment’s fiscal capacity, even though ment, one is led to examine the incen- this may be the result of all individual tives given those who bid for resources spending actions. or control the pursestrings, the infor- Inasmuch as due process only regu- mation available to them, and the lates budgetary procedure, it does not organizational roles assigned to them. resolve the question of what total On all three of these counts, procedur- expenditure should be. Conventional al due process can produce unwanted budget rules structure the process so budget outcomes. that the aggregates are decided through competition among spending Incentives claimants. As long as the competition is Claimants for resources act on the comprehensive (no extrabudgetary basis of self-interest, but the collective spending), fair (no earmarked funds), results of their actions may not be in and authoritative (no improper expen- An Overview 9 diture), then the outcome is deemed the Operational efficiency also is right one. But suppose rather than com- degraded by rationally-behaving budg- petition there is collusion (claimants et makers. The formal rules generally logroll to get what they want) or frag- emphasize compliance and control, mentation (the various claims are decid- not managerial initiative and perform- ed sequentially, with little interaction or ance. These rules include: spend funds friction among different parts of the only as authorized by law; itemize budget), due process will not assure expenditures and conform to the favorable outcomes. Instead of prevail- detailed schedules in the estimates and ing through competition, spenders win other budget documents; make sure to by collectively taking more from the get advance approval before taking commons, that is, by increasing aggre- actions (such as hiring staff or purchas- gate spending. When this occurs, fiscal ing equipment) that entail the expen- discipline is weakened, and the budget’s diture of funds; all unspent funds lapse totals become hostage to individual at the end of the fiscal period. These spending decisions. and other rules penalize managers for The “commons” problem also underspending, not for underperform- impairs allocative efficiency, for it dis- ing. They spur managers to seek more courages claimants from reallocating resources, even when these do not resources from lower to higher priority result in more output. programs. Spenders get more by demanding incremental funds, not by Information volunteering to shift funds to more Budget outcomes are affected not only effective uses. Although they may want by incentives but also by the informa- budget allocations that reflect the gov- tion policy makers and managers have ernment’s strategic objectives, they in spending public money. would be rational in refusing to give Information, like the commons, is a up what they already have in exchange constrained resource, not only because for the opportunity to participate in a it costs money to produce and distrib- reallocative competition. They risk los- ute, but because the amount of infor- ing resources if they offer to reallocate mation that can be generated and con- without having advance assurance of sidered in the compressed budget what their future budget shares will be. schedule is severely limited. Ignorance 10 A Contemporary Approach to Public Expenditure Management and information asymmetry are wide- are explicitly shifted from less to more spread behavioral conditions in con- effective programs on the basis of eval- temporary budgeting, even in coun- uative findings. tries that have state-of-the-art expendi- Why don’t policy makers have ture management systems. These con- appropriate information to make effi- ditions are due to two related factors; cient budget choices? Part of the answer the cost of generating and disseminat- is that the structure of budgeting con- ing relevant information; and the tributes to this informational deficit by advantages that information producers making those at the top (in departmen- (agents) have over information users tal headquarters or at the center of gov- (principals). ernment) dependent on those in the Allocative and operational efficien- middle or bottom ranks. Spenders (pro- cy depend on an ample supply of rele- gram officials and line managers) know vant data on programs and operations. more about their programs and opera- Almost everywhere, however, much tions than do those who pass judgment less is known about the relative effec- on their budget requests. It is to the tiveness of programs than is needed to advantage of the spenders to “capture” make optimal budget allocations, and budget makers by supplying information much less is known about the volume, that enhances the probability that they quality, and cost of outputs than is will get what they want. Spenders may needed to operate efficiently. A great know more about what works and does- amount of information is processed in n’t, how funds actually are used, the the course of compiling budgets, but interests and strength of program benefi- in the typical country, most of it ciaries, and other relevant factors than do describes ongoing activities and item- those who have nominal authority over izes inputs. There are some notable budget allocations. Moreover, they have exceptions, but even when program little incentive to be forthright in advis- and output data accompany the budg- ing policy makers on program and oper- et, they rarely are the basis on which ational issues. Central budget makers budget decisions are grounded. Thus, often try to redress the informational it is truly rare that increments of budg- imbalance by commissioning special et resources are directly linked to incre- studies and analyses, by changing the ments of budget outputs, or that funds informational rules for annual budget An Overview 11 decisions, or by strengthening their own position that these rules are not substan- capacity to monitor and assess perform- tively neutral; they affect three impor- ance. These palliatives may help for a tant outcomes: the total amount spent, while, but over time, spenders are likely the composition of expenditure, and the to develop countermeasures that restore efficiency of government operations. their informational advantage. PEM seeks procedures that increase the probability of achieving preferred out- Formal Roles comes. The key aspects of budgeting In due process budgeting, central con- affecting expenditure outcomes are trollers have formal authority to institutional arrangements, the types of decide everything—from the budget’s information available for making and totals to discrete spending items. This enforcing expenditure decisions, the centralization reinforces the adversari- incentives* provided spenders and con- al relationship between controllers trollers to behave in ways that promote and spenders, and encourages the lat- desired outcomes, the issuance and ter to withhold or color information implementation of substantive, ex ante so as to gain some advantage vis-à-vis budget rules, and ex post accountability their adversaries. When this occurs, for budget outcomes. These elements of the formal powers held at the center of PEM are applied in the follow-up chap- government are weakened, as is the ters to the three basic objectives of mod- ability of central controllers to reallo- ern public expenditure management: to cate or to extract efficiency gains from strengthen aggregate fiscal discipline, to operating agencies. allocate public resources in accord with strategic priorities, and to promote the Modern Public Expenditure efficient provision of services. These Management PEM objectives are introduced in the Contemporary public expenditure man- remainder of this chapter. agement (PEM) is interested in the Fiscal discipline requires effective process of budgeting primarily because control of budget aggregates: total rev- procedural rules strongly influence enue and spending and the balance expenditure outcomes. PEM takes the between these totals. When aggregate

* Incentives are influenced/generated by institutional arrangements. Ex ante rules and ex post accountability for output are examples of institutional arrangements. 12 A Contemporary Approach to Public Expenditure Management control is effective, these outcomes are public expenditure management from disciplined rather than accommodat- due process in budgeting. ing; they result from explicit, enforced decisions on the aggregates by govern- Aggregate Fiscal Discipline ment. They are not merely the sum of Aggregate fiscal discipline requires that powerful demands on the budget. spending (and other budget) totals be PEM also seeks allocative efficiency, an set independently of and before deci- expenditure mix that is responsive to sions are made on the various parts of changing government priorities as well budget. If they are not, the spending as to evaluative findings on the com- totals will inexorably rise to accommo- parative effectiveness of alternative date demand. The totals must be rea- expenditure programs. Allocative effi- sonably firm—hard constraints rather ciency depends on the capacity to shift than soft targets—and must be resources from old programs to new enforced throughout the year while ones and from less to more productive spending is underway, not just during uses, in correspondence with changing the period when the budget is being public policy objectives. Finally, PEM prepared. Moreover, the aggregates seeks efficiency in administrative oper- must be sustainable over the medium- ations, the progressive reduction, term or longer through policies and through productivity gains, in the run- instruments that enable the government ning costs of government agencies and to maintain discipline year after year. in the unit cost of services. Table 1.2 sets forth basic arrangements Although some of these terms for maintaining aggregate discipline. may be unfamiliar to persons Aggregate fiscal discipline deals schooled in conventional budget with the interaction between two vari- processes, the three objectives repre- ables: revenues and expenditures. In a sent ubiquitous tasks of budgeting. limited sense, a government can be Every national budget system pro- said to maintain discipline even when duces spending totals, retards or pro- spending (in real terms or as a share in motes allocative efficiency, and gener- GDP) rises year after year, as long as ates higher or lower operational effi- this increase is matched by revenue ciency. How government pursues increases. In a broader sense, however, these objectives distinguishes modern maintaining aggregate fiscal discipline An Overview 13

Table 1.2: Institutional Arrangements for Enforcing Aggregate Fiscal Discipline

Rules Limits on total spending (in some cases sectoral spending as well) are established before individual spending bids are considered. Total spending must be consistent with these limits. The limits may be expressed in money terms, relative to GDP, as rates of change, or in terms of the balance between receipts and expenditures. The limits are set for the medium-term (3–5 years) and budget decisions are made within a medium-term expenditure framework. Roles A strong finance ministry is empowered to enforce the budget aggregates in bilateral negotiations with spending departments and Cabinet discussions. The finance ministry is the official scorekeeper of the budgetary impact of spending proposals and other budget actions. During implementation of the budget, it may intervene to block (or notify the Government) of actions that would cause the fiscal aggregates to be breached. Information The medium-term expenditure framework provides a baseline for measuring the budgetary impacts of policy changes. Throughout formulation of the budget, information is provided on changes to the baseline. During implementation of the budget, spending is monitored to ensure compliance with the fiscal aggregates.

entails enforcing spending limits that spending is not controlled, there is a do not require ongoing increases in strong possibility that the expenditure revenues. One way of accomplishing objective will be compromised and this would be to limit total spending as that the government will seek to a proportion of GDP; another would achieve the desired fiscal posture by be to set absolute limits (in money raising taxes or selling assets rather terms) on total spending; a third than by constraining expenditure. would be to specify the maximum Due process budgeting convention- amount by which expenditures will be ally operates in a bottom-up environ- permitted to increase over the previous ment. Spenders are invited to bid for year’s or the baseline level. If total resources through the recurring proce- 14 A Contemporary Approach to Public Expenditure Management dures of budgeting, while controllers In retrospect, it is apparent that review the bids, compare their relative soft fiscal targets and the changed value, trim some bids, and decide on composition of public expenditure the amounts to be spent. In some gov- contributed to the postwar uptrend in ernments, the process begins with ten- the ratio of public spending to GDP in tative targets, either for total expendi- almost all democratic regimes. ture or for the amounts that particular However, faced with chronic budget spending units may bid for. But these deficits and structural economic weak- constraints tend to be soft; they are pro- ness, many governments have retreated visional and often yield in the face of from Keynesian demand management pressure for additional funds. and have adopted fixed fiscal targets. Soft aggregate targets were in vogue The Maastricht norm of budget during the postwar Keynesian era, when deficits no higher than 3 percent of many governments abandoned fixed GDP is an important manifestation of budget rules (such as the balanced budg- this trend. PEM is consistent with this et principle) in favor of flexible targets movement, but it targets expenditure that respond to changes in economic totals, not just net budget balance. conditions. They also were a byproduct How hard are the new constraints of a fundamental change in the compo- on aggregates? Probably not as hard as sition of national expenditure: relatively advocates want, but not as soft as the less spent on public consumption and old targets were. They cannot be truly investment, and much more on entitle- rigid because contemporary govern- ments and transfers. The new mix ments cannot turn the clock back to the served Keynesian objectives because, time, decades ago, when public expen- unlike consumption and investment ditures were concentrated on consump- expenditures which typically are limited tion and investment rather than on in amount, entitlements usually are transfers. Nor can developed or devel- open-ended, with spending rising to sat- oping countries insulate themselves isfy all legally-sanctioned demands. This against the destabilizing impacts of feature makes entitlements effective sta- recessions and other economic shocks bilizers and safety nets that respond on their budgets. It is an open question, quickly and automatically to changes in therefore, whether national govern- economic circumstances. ments have the capacity to stay with An Overview 15 hard fiscal constraints for a period doesn’t, sectoral pressures will impel longer than the medium-term (3-8 the government to spend in excess of years) business cycle. Few have tried, budgeted totals. and fewer have succeeded. The true test Tension between the totals and the of aggregate fiscal discipline is whether parts is ubiquitous in budgeting. it can be maintained through bad times, Without hard constraints, the totals when revenues drop and economic are the sum of the parts; with con- adversity generates pressure for more straints, the totals can hold only if sec- public spending and higher deficits. toral pressures are disciplined. PEM But the good times also are a test tries to change the contest between the of fiscal discipline. When the economy parts and the whole from one in which is booming and tax revenue is rising, controllers are on one side and there tends to be strong pressure on the spenders on the other to one in which government to spend more. During spenders are entrusted with responsi- these times, hard constraints can bility for keeping within the con- strengthen the government’s resolve to straints. See Table 1.3 for the main fea- resist new spending demands and tures of allocative efficiency. thereby mitigate the budget impacts of Due process budgeting is predicat- cyclical weakness in the economy. ed on the notion that controlling the Firm but not rigid, resolute but not parts depends on a process in which all obdurate—this is the posture that PEM claims on the budget compete against takes with respect to budget aggregates. one another. When the budget is com- Effectively managed, even if fiscal disci- prehensive, as due process dictates, pline were weakened by political or eco- central controllers can weigh the vari- nomic force majeure, PEM would pro- ous claims, establish budget priorities, duce smaller deficits and less total and allocate resources. The logic of this spending than would ensue in the approach appears unassailable, but the absence of aggregate constraints. practice often fails to live up to the promise. If spenders and controllers Allocative Efficiency have antagonistic interests, the odds No government can effectively control are that in many budget seasons the the budget’s totals unless it also con- spenders will get much of what they trols the elements of expenditure. If it want. Either within the bounds of due 16 A Contemporary Approach to Public Expenditure Management

Table 1.3: Institutional Arrangements for Improving Allocative Efficiency

Rules Spending limits are established for sectors or portfolios, and ministers are encouraged to reallocate within these limits. Bids to reallocate must be based either on evaluative findings of program effectiveness or on plans to evaluate policy initiatives. Roles Strong capacity at center of government to define national priorities and objectives, and make cross- sectoral allocations consistent with its medium-term expenditure framework. Strong sectoral ministers with broad authority to reallocate within their areas of responsibility, subject to review by Cabinet and/or Parliament. Information Ministers and managers generate or receive information on the actual or expected effectiveness of programs, as well as on the social outcomes ensuing from ongoing programs, budget actions, and policy initiatives. They also receive information on the expenditure impacts (relative to the medium-term framework) of authorized and proposed budget actions. process or by infringing some of the to prepare zero-based budgets. Wherever rules, spenders can outwit the budget’s they have been tried, these and similar guardians, evade the controls, pressure approaches have failed to strengthen the government to raise taxes rather strategic reallocation or to weaken incre- than cut spending, and force it to mentalism’s hold on the budget. accept incremental rather than real- Although each type of reform has its own locative outcomes. deficiencies, all failed because they over- During the past 30 years, democrat- loaded the information-processing ic governments have sought to counter capacity of central controllers and budgetary incrementalism in a variety of departmental spenders, they increased ways. One has been to link the budget to budgetary conflict between controllers formal priority-setting procedures such and spenders, and they spurred those as program budgeting or planning-pro- threatened with a loss of resources gramming-budgeting systems (PPBS); through reallocation to take counter another has been to direct spending units measures that protected their interests. An Overview 17

Allocative efficiency can be advanced lating the budget. Most adjustments to only if informational demands are man- programs, including cutbacks, are initi- ageable, budgetary conflict is muted, and ated by the responsible ministers or their spenders do not sabotage the priority set- managers, not by the government as a ting and implementation process. PEM whole or by those who operate the promotes these conditions by devolving machinery of budgeting. This devolved major reallocative responsibility to sec- structure (1) reduces information toral ministers and officials. Rather demands, (2) concentrates budgeting on than having all reallocations made by major policy questions, (3) reduces con- central controllers, PEM shifts a signifi- flict between spenders and controllers cant part of the burden to politicians over the details, and (4) gives affected and managers. Government still must ministers incentives to reallocate rather adjudicate competing intersectoral than to fight spending shifts. The result demands; that is, it must decide how may be more reallocation than occurs much should be allocated to each major when the central machinery of budget- sector or portfolio within the budget. ing is organized for reallocation. Carrying out this responsibility requires At first glance, this conclusion that it have sufficient strategic capacity seems anomalous. Why should alloca- to establish spending subtargets and tive efficiency be more robustly pur- program priorities for each sector or sued when the task is dispersed among portfolio. But once it has made broad spenders whose interests may be served inter-sectoral decisions, the government by keeping with the status quo? The leaves the task of making most of the answer is that for significant realloca- reallocations to those in charge of the tion to occur, spenders must be given various sectors. In this way, it enlists strong incentives to cooperate; it may spending ministers and managers in the not suffice that reallocations are forced cause of allocative efficiency. on them from the center. PEM In this devolved environment, the encourages spenders to look to their big decisions on strategic objectives and own portfolios for savings because it priorities continue to be made at the denies them incremental resources center, but these represent only a frac- though the annual budget bids and tion of the program decisions and real- entrusts them with making most real- locations made in the course of formu- locations. Depending on the scope of 18 A Contemporary Approach to Public Expenditure Management the reallocation and the policy itemize the amount that may be spent impacts, in some cases spenders can on each category of inputs purchased reallocate only after receiving govern- by spending managers. Where item- ment approval, in others, on their own ized input controls are exercised, initiative. spending units have to receive central For PEM to spur reallocation, approval before they employ staff, pur- ministers and managers must be given chase items, or take other actions that spending constraints within the gov- spend public funds. Over time, many ernment’s global budget. In addition, governments have consolidated the budget decisions must be taken within line items into broader categories and a framework that enforces the rules of established systems of internal control reallocation and discourages evasion. that give managers increased discretion The elements of this framework are in spending appropriated funds. But in described in chapter 4. They include a many countries, budgeting continues multi-year budget, baseline projects of to focus on the amounts spent on the future authorized expenditure, an eval- various inputs. uation capacity for assessing the rela- Input control retards operational tive value of programs, and computa- efficiency, because it does not give tional rules for measuring the budget- spenders incentives to economize and ary impacts of proposed reallocations. does not relate the amounts spent to Without these elements, devolving the outputs produced. Not surprising- spending responsibility risks signifi- ly, therefore, many governments that cant erosion in spending control. maintain seemingly strict expenditure controls have been afflicted by the “rel- Operational Efficiency ative price effect”, the tendency of One of the oldest purposes of budget- prices to rise faster in the public sector ing has been to economize on the than in the market economy. Stagnant operations of the government by con- productivity resulting, in part from an trolling items of expenditure, the vari- input focus, gives governments little ous things (personnel, supplies, equip- choice but to accommodate the ment, and so on) purchased by govern- demands of spenders for more ment agencies. The conventional resources: if they fail to do so, the means of exercising this control is to delivery of services would suffer. An Overview 19

Table 1.4: Institutional Arrangements for Improving Operational Efficiency

Rules Running (or operating) costs are cash limited, but managers are given broad discretion in using these resources, including (in some countries) discretion to carryover unused funds or to prespend a small portion of the next year's running costs. Running costs are progressively reduced by a percentage equal to all or a portion of expected efficiency gains. Roles Strong line managers authorized to determine the mix of operating resources within fixed limits. Operating discretion devolved to subordinate managers, including those infield or regional offices. Information Budgeted outputs are specified in advance, and actual outputs are compared to the targets. Costs are allocated (ideally, on an accrual-basis) to the activities responsible for them. Information on financial and organizational performance is published in annual reports and other documents.

In industrial democracies, erosion proportion of the labor force as have in operational efficiency has been other operating expenditures. masked for decades by the rise in enti- PEM bolsters operational efficien- tlement spending. The assumption has cy by shifting the focus of spending been that inasmuch as government control from inputs to outputs and by consumption has declined as a propor- decentralizing the management of tion of public spending, the problem operating resources. These critical fea- must lie elsewhere. Moreover, govern- tures of public management reform are ments have comforted themselves with underway in a number of democratic the notion that consumption expendi- countries. ture is controllable; they can (and Operational reform is centered on often do) cut the amounts spent on the notion that managers should be personnel and other items. But despite given discretion to run their operations periodic economy drives and nominal as they best see fit and should be held control over spending, in most coun- accountable for results, including the tries public employment has risen as a outputs produced. 20 A Contemporary Approach to Public Expenditure Management

The institutional arrangements resources from the public treasury that encourage better operational effi- while resisting reallocation and spend- ciency include hard constraints on ing budgeted funds with little regard running costs, use of efficiency divi- for efficiency. dends and across the board cuts to spur Getting politicians and managers managers to be efficient, managerial to change their behavior boils down to freedom to spend running costs, out- a matter of incentives. They have to put targets, and audit or review of per- have a strong inducement to abide by formance. In pursuing operational effi- spending limits, and they must be will- ciency, governments must guard ing to shift resources to higher priority against hidden reductions in service programs and to rearrange operations volume or quality. This is one of the so as to make them more effective. By reasons why they emphasize output changing rules, roles, and information, measures, service quality, and perform- PEM seeks to alter the incentives avail- ance reviews. Table 1.4 specifies insti- able to budget makers. The changes are tutional arrangements for operational summarized in Tables 1.2, 1.3, and efficiency. 1.4, and explained in the paragraphs that follow. Restructuring Budget Institutions to Manage Aggregate Fiscal Discipline Public Expenditure In many countries, aggregate fiscal dis- Improving the management of public cipline has been undermined by self- expenditure entails changes in budget- interested spenders who benefit by tak- ary institutions—the roles of spenders ing more from the commons because and controllers, the rules under which they bear only a portion of the cost. As they claim, allocate and use resources, indicated in Table 1.2, PEM seeks to and the information available to them. remedy the common resource problem Without institutional change, there by enforcing rules that limit the total would be no basis for expecting self- that all spenders can draw from the interested politicians and managers to pool. This solution is similar to that behave differently. If they have incen- devised in medieval England when the tives and opportunity to do so, they commons were enclosed and grazing would continue to draw more was restricted. In the case of public An Overview 21 expenditures, the limits have to be Budget rules are not self-enforc- firm, though not unbending. They ing, nor can they be enforced when have to be established in rules and spenders have the upper hand in rela- norms that cannot be easily changed tions with controllers. In fact, the his- by budgetary expediency or political tory of budgeting is strewn in many whim, and they have to be enforced countries with aggregate constraints through changes in the balance of that have not worked. Effective limits budgetary power between spenders on the fiscal aggregates require that and controllers. the role of central controllers (in the The limits can be in the form of ministry of finance or a similar organ) norms or targets, such as ceilings on the be bolstered, so that they have the ratio of spending to GDP or on the size authority to block spending actions of the deficit. Limits may also be estab- during formulation or implementa- lished for the public debt, the rate of tion of the budget that would cause growth in public expenditure, or the tax the limits to be exceeded. Central con- burden. To be useful, the limits must trollers must be sufficiently powerful constrain; they should not merely that they can enforce the aggregates, accommodate all claims on resources, even in the face of opposition from nor should they be adjusted whenever spenders. But as they strengthen their strong demands exceed the preset limits. grip on the totals, these controllers Nevertheless, absolutely rigid limits are may find it expedient to let go of some not likely to be enforceable when the controls, over personnel and procure- force majeure of changing political or ment, for example, that finance min- economic conditions compel politicians istries traditionally have exercised. to breach the totals. But aggregate con- Devolving responsibility for particular straints should be enforceable in normal spending decisions to line ministers times or under moderate fiscal-stress. In and program managers may facilitate these circumstances, yearly limits com- enforcement of the fiscal aggregates by pel spenders to compete for resources reducing the number of matters on within pre-determined budget totals which the finance ministry must and (in some cases) sectoral subtotals. negotiate with the spending depart- For some claimants to get more others ments, thereby reducing budgetary must get less. conflict and transaction costs. 22 A Contemporary Approach to Public Expenditure Management

Central controllers cannot be contest between them and spenders. If effective if they lack timely and accu- the rules work as intended, rather than rate information on the status of the taking as much as they want from the budget and on the potential impact of commons, politicians are constrained spending demands on future totals. to spend only up to the amount PEM recognizes that asymmetry in the allowed by the rules. But this is a big supply of information may undermine “if”, for rules that are made by politi- enforcement of the totals as well as of cians can be broken by them. In the their expenditure objectives. When concluding section of this chapter, we spenders know more than controllers argue that politician-made rules can about the political strength and budg- have teeth. Politicians can bind them- etary impacts of ongoing programs selves, though the rules cannot be and policy initiatives, they may with- enforced in all circumstances. hold information or provide faulty estimates. To counter these possibili- Allocative Efficiency ties, central controllers need their own Enforcing aggregate fiscal discipline is capacity to project the medium-term a mixed blessing for allocative efficien- cost of programs and the impacts on cy. On the one hand, it may impel old budget baselines. Using this informa- and new claimants to compete for tion, central controllers become the resources within or across sectors; on authoritative scorekeepers of the budg- the other hand, fiscal discipline may et process, determining whether par- make it more difficult to fund new pri- ticular spending bids can be accommo- orities. Whether the first or the second dated within the approved medium- outcome predominates depends on the term expenditure framework. institutional arrangements that With appropriate rules, roles and encourage or retard reallocation. The information in place, budgeting main rules, roles, and informational becomes more competitive and less requirements associated with allocative prone to spending drift. Inasmuch as efficiency are set forth in Table 1.3. the rules and limits are set in advance, Several conditions must be pres- before claims on the budget are con- ent to facilitate active reallocation. sidered, central controllers have some First, in terms of roles, government advantage in the inherently adversarial and its central organs should be An Overview 23 responsible for strategic guidance and Operational Efficiency for establishing the main priorities The conventional rules of budgeting and initiatives for the medium-terms give self-interested managers a strong and (where appropriate) beyond. But incentive to spend all available line ministers and spending depart- resources, even if the result is an ero- ments should be responsible for set- sion in the organization’s operational ting program priorities within the efficiency. The disincentive to be effi- strategic framework laid down by the cient is summed up in the “use it or government. Second, budget rules lose it” attitude which is said to influ- should encourage reallocation by ence agency managers. Managers rou- enabling politicians to shift within tinely assume that if they do not spend sectors without significant risk that all of this year’s budget, they will be doing so will cause them to lose given fewer resources the next year. resources. This condition is necessary Many managers operate in a controlled because spenders will subvert realloca- environment in which their spending tions if they are penalized for trying actions are overseen by outsiders whose to shift resources from old to new approval is needed before staffing, pur- uses. Reallocation also must be sup- chasing and other decisions are taken. ported by information on program Moreover, spending units typically costs and effectiveness. Reallocation cannot retain unused funds. Finally, must be undertaken in a framework and possibly most important, the per- that enables budget controllers to formance of managers typically is assess the impact of spending shifts on assessed in terms of compliance with aggregate and (where applicable) sec- procedural rules, not in terms of the toral limits, and encourages spending outputs they produce or the efficiency ministers to assess the comparative of operations. worth of programs. Finally, spenders Operational efficiency depends on should be accountable for program managers who are willing to take steps results; if they are not, the govern- that reduce running costs or that boost ment cannot be confident that reallo- the volume or quality of outputs. cations will be in accord with its External controllers can create condi- strategic objectives, or that they will tions that foster operational improve- promote allocative efficiency. ments; they cannot dictate these 24 A Contemporary Approach to Public Expenditure Management improvements. Rather, the incentive to ed outputs. This need has spurred improve efficiency must come from some governments to introduce accru- the managers themselves, but they can al accounting schemes and to improve be induced to behave efficiently only if cost accounting and allocation systems conditions enable them to do so. in departments. It also has led to the ex Foremost among these conditions ante specification of output and service are rules that give managers broad targets, and to the publication of discretion in running their opera- annual reports that compare targeted tions while holding them accountable and actual performance. for the cost, quantity and quality of Integrating the elements of public outputs. The key rules change gives expenditure management. In an uncon- managers broad flexibility in using strained world, governments would seek budgeted resources, including the concurrent improvements in all three ele- opportunity to retain a portion of ments of public expenditure management. efficiency gains and to carryover Doing so may be difficult, however, some unused funds to the next finan- because of the political and financial cial year. The rules should also costs of reforming public institutions. require that operating costs be cash Strong political interest and support limited, so that managers may not usually are needed to impose aggregate seek supplemental funds during the limits and to transfer resources to high- year. These rules changes have to be er priority uses. Political support also accompanied by adjustments in the may be needed to overcome bureaucrat- roles and relationships of line man- ic or legislative reluctance to give man- agers and external controllers. In the agers operating freedom. Compliance new arrangement, controllers (in cen- costs also are high because of the need to tral agencies or departmental head- develop and maintain new reporting quarters) specify performance targets and control systems. Because of the var- and monitor results, but operating ious costs, governments tend to empha- managers are given discretion to opti- size one or two PEM objectives, but not mize the use of budgeted resources. all three. For example, Australia has pur- Promoting operational efficiency sued a reform strategy focused on requires vast new amounts of informa- improving resource allocation in gov- tion on the cost of producing budget- ernment, while New Zealand has con- An Overview 25 centrated on operational issues. tiveness, it adopted some operational Nevertheless, important interac- improvements such as accrual budget- tions among PEM’s objectives may ing and tighter cost controls. On the impel some governments to move on all other hand, after its operational reforms three fronts. The task of maintaining fis- were bedded in, New Zealand intro- cal discipline is eased when the govern- duced new instruments such as strategic ment improves allocations (and thereby and key result objectives that upgrade reduces pressure for additional spending the government’s capacity to establish on new priorities) and squeezes waste and implement strategic priorities. out of agency operations, thereby As PEM matures and additional enabling it to reduce running costs. features are grafted onto older budget Moreover, strong constraints on fiscal practices, compliance and other trans- aggregates may persuade politicians to action costs are likely to escalate. At finance emerging priorities through some time in the future, therefore, a reallocation; they may spur managers to new cycle of public expenditure man- cover workload increases by improving agement reforms may be needed to productivity rather than by seeking purge redundant or inefficient rules and incremental funds. procedures. Without the periodic con- There are inherent linkages of allo- solidation of systems, the last genera- cation and operational issues. A govern- tion’s reforms become the next genera- ment that is lax in managing operations tion’s routines, and the focus on budget does not have an optimal allocation of outcomes, which is PEM’s most distinc- resources. The converse also holds: a tive feature, may be blurred by proce- government that drives to improve pro- dural rules that get in the way of results. grams may seek to cut overhead and other operating costs so as to make Do New Budget Institutions more money available for policy initia- Make a Difference? tives. Over time, therefore, a govern- PEM purports to influence budget out- ment that pursues one PEM objective comes by changing the behavior of may broaden its reform agenda to spenders and controllers. If the changes encompass other objectives as well. A have the intended effects, spenders dozen years after Australia initiated would conserve resources, allocators reforms that emphasize program effec- would reallocate, and managers would 26 A Modern Approach to Public Expenditure Management perform, not just comply. One of the arguments run in opposite directions: unsettled questions in institutional eco- some indicate a dismal prognosis for nomics is whether changes in the rules new rules of the game, others are more of the game suffice to produce the favorable. intended results. The argument runs as First the downbeat arguments. It follows. Rules are needed because with- may be that rules changes have salutary out them rational spenders would mis- effects in the short-run, when the new use public resources. They would spend rules are fresh, have a lot of political more than the government could support and attention, and politicians afford, favor old priorities over new are on good behavior. Over time, how- ones, and operate in a wasteful manner. ever, constraining rules break down, But if spenders—whether politicians or either because of a buildup of deferred managers—were driven to behave in spending pressures or because politi- these self-interested ways, why don’t cians and others learn how to outwit they break or repeal new rules that them. As the rules become routinized, stand in their way? Why don’t politi- interest in enforcing them wanes, new cians who are inclined to give voters tactics are devised to evade them, and what they want violate or revise aggre- the rules either are abandoned or are gate constraints that bar them from overtaken by events. For example, spending as much as they want? And if tough aggregate constraints may they are truly determined to protect become counterproductive if they spur existing programs against cutbacks, politicians to enact extrabudgetary why don’t they use their power to block means of financing coveted programs. reallocation? In other words, if rules are Or in the face of economic stress, necessary because spenders want to politicians may vote for more spending spend, how can they be effective when despite the impact on the deficit. they prevent spenders from doing what Allocative efficiency may degrade over they want? time as politicians and managers learn In the absence of long-term evi- how to “game” the evaluation and per- dence on budget outcomes through formance measurement processes. And one or more economic and political operational efficiency may weaken if cycles, one can only conjecture on how the new freedom given managers is not PEM-oriented rules will work. The reciprocated with more demanding An Overview 27 accountability for results. When these lating them can entail high political unintended behavioral changes occur, cost. Second, the rules have enforcers, efforts to redirect funds to strategic central controllers in some cases, the priorities and effective programs may courts in others, international institu- be defeated by spenders who give lip tions in still others. Their job is to service to reallocation, program evalu- enforce the rules and restrain violators. ation, outcome measures, and other In the long term, the answer to the results—enhancing processes, while question “do new budget institutions protecting their vested program inter- make a difference?” will depend on the ests. Moreover, line managers may balance of power between controllers merely comply with the new routines and spenders, guardians and claimants. rather than drive for further productiv- When new outcome-based rules are ity gains. adopted, the immediate effect is to But there is another side to the empower the controllers and argument. Changing rules and roles guardians. As long as they hold on to can have positive impacts because the this advantage, the rules will make a same politicians who are spenders also difference. But, if because of econom- prefer prudent fiscal management, ic, political or other developments, the effective programs, and efficient opera- balance tilts in favor of spenders and tions. This is why they accept spending claimants, the rules will lose effective- limits, new accountability require- ness. If this were to occur, further insti- ments, and other constraining rules. tutional changes can be expected in the Once the rules are in place, politicians future to reinforce PEM objectives and and managers pay a price for violating rebalance the relationship between them. The situation they face after new spenders and controllers. ❧ rules have been introduced is marked- ly different from the one they faced before there were outcome-based rules. Two additional factors may make them think twice before they stray too far. One is that because PEM rules are out- come-based, they can be more trans- parent than procedural rules, and vio- 28 Chapter 2 Managing Public Expenditure in Developing Countries

n all countries, managing public ment of poor developing countries is expenditure is an essential but diffi- fundamentally different from that of Icult task. Governments in both rich developed countries, and that pre- developed and developing countries scriptions and processes that are appro- are pressured to spend more than the priate for the latter may hold disap- economic or tax base can sustain, to pointing results in the former. continue financing old programs even Developing countries generally have when new priorities are judged to be greater difficulty maintaining fiscal dis- more urgent, and to pay the rising cipline and pursuing efficient budget expenses of inefficiently-operated outcomes. They have weaker control of departments. In addition, many devel- their budgetary fate, and outcomes that oping countries face special problems appear to be the result of lax expenditure in managing public finance because management often are byproducts of their resources are extremely con- under-development. If this argument is strained, the stockpile of needed skills right, it implies that while the basic and information is inadequate, pres- objectives of public expenditure man- sure to spend more than they can agement may be similar, the path taken afford on unmet needs is very intense, by developing countries may be some- and they have meager reserves to ride what different from the one usually out shocks or unexpected difficulties. taken by developed countries. This chapter is grounded on the In seeking the root causes of budg- argument that the budgetary predica- etary differences, one is drawn to a basic

29 30 A Contemporary Approach to Public Expenditure Management distinction between developed and economies generally differ from those developing countries. Developing coun- common in the developing world. tries are poorer, they have a lower, some- Many developing countries have a small times much lower, per capita GDP. public sector; government in transition- Being poorer, they are heavily depend- al countries tends to be very large rela- ent on capital inflows; they have a large tive to the overall economy. Transitional backlog of development needs; market countries have an immediate need to transactions generally are more informal establish modern public management than in developed countries; they oper- institutions; they do not have the option ate in an unstable fiscal environment; of allowing these institutions to evolve as and much of the public sector also oper- the public sector grows. Moreover, they ates on the basis of informal rules and have to undo many of the rules and sys- relationships. tems operated during decades of social- More than two thirds of the coun- ist management. They must replace sub- tries in the world are “developing”. This sidies with transfers, dismantle state category includes indigent countries enterprises, establish and administer that are on the edge of subsistence as new tax systems, and forge regulatory well as rapidly-growing countries whose institutions that facilitate open, robust standard of living has approached that of markets. The progress made by some developed countries. The problems and transitional countries during the 1990s tendencies discussed in this chapter are has been truly remarkable, but others most pronounced in poor countries; have lagged behind and have been slow they diminish as a country improves its to transition. But even the most economic condition. The reverse also advanced of the transitional economies applies: when an affluent country goes still have much unfinished business in through severe economic stress, it some- managing its finances. times behaves in ways that resemble Differences between developed developing countries. and developing countries both pro- Transitional countries are a mixed mote and impede reform. On the one lot. Some are at an advanced stage of hand, developing countries can adopt development, others are at a much earli- practices that have evolved over the er stage. In several aspects, the econom- years and have become widely accept- ic problems facing transitional ed in the developed world; on the Managing Public Expenditure in Developing Countries 31 other hand, the special problems fac- On Being a Poor Country ing poor countries may make them Table 2.1 identifies various problems inhospitable venues for certain prac- associated with being a poor country. tices. Moreover, what is exported to Not every poor country has all of the list- developing countries are not just the ed problems, but many do. Generalizing tried practices but novel or experimen- about poor countries sharpens the dis- tal ones as well. Politicians and officials tinction between them and rich coun- in developing countries sometimes are tries and enables one to comprehend as eager to buy avant-garde practices as why solutions that make sense in one sit- reformers are to sell them. When this uation do not work in another. occurs, the ambitious reforms typically Being poor means that a country fail to deliver the promised results. lacks sufficient resources to respond to

Table 2.1: Special Problems of Some Developing Countries

Ceondition Impact on public expenditur

Poverty Lack of resources to respond to rising demands/expectations for public services Economic Instability Inadequate slack to "ride out" cyclical shocks and other disturbances

Low Revenue Base Vulnerability to adverse shifts in commodity prices, terms of trade, and low access to capital markets Informal Market Sector Much economic activity is extralegal, in disregard of formal rules and regulations; weak enforcement of property rights and contracts resulting in relatively high levels of corruption Informal Public Sector Formal rules concerning civil service, public expenditure and procurement tend to be ignored or violated Low Political Mobilization Inadequate development of interest groups to express public opinion and monitor government performance 32 A Contemporary Approach to Public Expenditure Management rising demands and expectations for maintain spending at budgeted levels public services. In most cases, it also and allow automatic stabilizers to means that the country lacks financial enlarge the deficit, which it can resources to pay for all ongoing pro- finance by borrowing internally. Poor grams. The pool of domestic savings is countries, however, lack this option; not likely to be adequate to finance the they are more likely to monatize the gap between current revenue and deficit, risking a capital outflow and expenditure. Unable to explicitly deterioration in their already-weak rebuff demands or to trim public financial condition. They may have to spending so that it fits within available discard the approved budget and (as resources, many poor countries over- will be discussed below) redo the budget; they authorize more in the budget one or more times before the budget than they actually intend to fiscal year is competed. With repeti- spend during the year. Hidden cut- tive budgeting, unplanned changes backs enable some countries to main- forced by economic force majeure tain aggregate fiscal discipline, but at during the fiscal year often are greater the expense of discrediting the budget than the spending changes planned and weakening democratic institu- between years. tions. When the budget does not cor- Poor countries have difficulty gen- respond to actual transactions, some erating sufficient tax revenue, either poor governments may devise other because much economic activity is means of falsifying the books, for it is informal or because enforcement of tax only a short step from having budgets laws is weak. In some poor countries, that do not disclose actual or intended revenues are highly sensitive to changes expenditure to having corrupt budgets in commodity prices, making it diffi- in which public money is used for pri- cult for the government to accurately vate gain. project the amount it will take in dur- Poverty takes a toll in economic ing the next year. management as well. Poor countries Financial markets tend to be typically lack sufficient reserves or under-developed and poorly regulated, slack to cushion cyclical shocks and making public and private borrowers other disturbances. An affluent coun- heavily dependent on inflows from try facing economic difficulty can international organizations and foreign Managing Public Expenditure in Developing Countries 33 investors, and vulnerable to sudden a mixed blessing: it cuts through red outflows, especially when economic tape, but it also perpetuates inefficien- problems arise. Debtor countries often cy and opens the door to corruption. have no choice but to borrow short- Finally, poor countries tend to term and to repay in hard currency. have under-developed democratic They therefore face significant interest political institutions, with low political and exchange rate risks in financing participation and few groups monitor- and rolling over their debt. ing government performance and Much economic activity in these demanding honest, fair and responsive countries is informal and extralegal, public services. and escapes both the tax collector and Are the various shortcomings and government regulation. Informal disabilities listed in Table 2.1 the cause transactions are a mixed blessing, for or effect of a country being poor? Are they both enable small enterprises to many less-developed countries poor operate and keep them small. Petty because they have systemic corruption, bribery is extensive, as informal enter- lax tax administration, informal mar- prises pay for the privilege of operating kets, and misguided regulation? Or is without interference from government the reverse the case: less-developed regulators who obtain payments for countries are susceptible to these defi- not enforcing the myriad rules and ciencies because they are poor. A fair procedures that blanket virtually all answer is that both tendencies may be business. Informal enterprises tend to at work: poverty generates dysfunc- be small, because their extralegal status tional institutions, and dysfunctional blocks access to capital. institutions keep countries poor. Informality spills over to the pub- Regardless of the cause, the impact on lic sector where detailed rules that pur- public expenditure cannot be ignored. port to govern the civil service, budg- Poor countries do not manage their eting, procurement, and other mana- finances as rich countries do, and gerial functions are routinely ignored almost half a century of prodding or bypassed. There are the rules, and them to do so hasn’t turned the tide. then there are the ways that wily politi- Government in poor countries cians and bureaucrats get things done. budget for the short-term. In some, As in the market sector, informality is looking ahead as far as a single fiscal 34 A Contemporary Approach to Public Expenditure Management year is difficult, for the conditions been counterproductive, it makes little under which they operate are highly sense to try to purge corruption and unstable and unpredictable. The stan- inefficiency by imposing additional dard prescription is to inject greater restrictions. Therefore, why not, try certainty into public expenditure man- some of the new managerial institu- agement by adopting a long-term tions pioneered in New Zealand, framework within which annual budg- Australia, Sweden, and the United ets should be prepared and implement- Kingdom? As appealing as this argu- ed. Other prescriptions include ment is, it neglects the fact that these strengthening adherence to rules by developed countries gave operating enforcing accounting and other finan- freedom to managers only after they cial management standards, emphasiz- had established reliable control sys- ing objectives and performance in allo- tems, not before. Reversing the cating public resources, and installing sequence risks giving managers license modern, integrated information sys- to do as they wish before a culture of tems. These prescriptions have not fall- compliance with the rules has been en on deaf ears; they have been tried in institutionalized. quite a few countries, but their impact Another popular innovation is to has been weakened by short-termism, install integrated financial manage- uncertainty, informality, an inadequate ment systems that link accounting, informational and skill base, and other budgeting, procurement, disburse- manifestations of national poverty. ment, and other financial operations. One of the popular recent reforms The reasoning here is that this type of has been to move away from central- system would train public managers in ized, ex ante input controls to systems modern information technology and that give line managers broad flexibili- make public transactions more trans- ty to operate within an accountability parent and less vulnerable to corrup- framework that measures the outputs tion. An integrated system would and outcomes that result from public make it difficult to hide transactions expenditure. The logic of this type of off the books or to have discrepancies reform (which is discussed in Chapter between the amounts entered at one 5) is that inasmuch as detailed restric- point in the system and recorded in tions on managerial discretion have another, for example, between the Managing Public Expenditure in Developing Countries 35 amount specified on a purchase order discussed in the sections that follow. and the amount disbursed to the ven- Aggregate fiscal discipline is predi- dor. Here, too, however, good inten- cated on a norm that often is taken for tions may run afoul of the limitations granted in developed countries: the of poor countries. The test of these budget should express the true inten- integrated systems is not in their tions of government with respect to design or in their initial application, future expenditure. It should not be a but in their utilization over a period of wish list, or a statement of what the years. It is not hard for corrupt persons government will spend if resources in the right places to bypass an inte- were available; rather, it should state grated system by maintaining covert or the actual spending that will ensue off-the-books accounts. And it is not during the fiscal period covered by the easy for poor governments to properly budget. But what should a government maintain these systems when donor do when it is poor and wants to assistance dries up, the systems archi- demonstrate that it is improving social tects and operators take their mar- conditions? One option would be for ketable skills to the private sector, and the government to be explicit about its a new generation of officials comes to fiscal impoverishment and to compile see integrated financial management as a budget that includes only what it just another set of rules that they have actually intends to spend. Such a to comply with. budget would be based on prudent, realistic revenue estimates that recog- Aggregate Fiscal Discipline nize the various things that can go A poor country tends to have patholo- wrong during the year. In effect, it gies in each of the three dimensions of would be a budget that announces public expenditure management. what will not be done: the schools that These pathologies arise out of its short- will not be built or that will be under- term behavior, informal governance resourced; the clinics that will lack and uncertain financial outlook. medical supplies, the muddy roads Table 2.2 sets forth the practices that will not be paved. Alternatively, that affect aggregate fiscal discipline; the government can prepare an unreal- some of these pertain to allocative and istic budget that trumpets the great operational efficiency as well, as will be strides that will be made in the year 36 A Contemporary Approach to Public Expenditure Management

Table 2.2: Aggregate Fiscal Discipline Problems of Some Developing Countries

Pmractice Proble

Unrealistic Budgeting The budget cannot be implemented as approved because it authorizes more spending than the government can pay for. Hidden Budgeting The "real" budget (actual revenues and spending) is known only to a small circle of insiders, or only in retrospect- after the fiscal year has ended. Escapist Budgeting Unrealistic budgets beget escapist budgeting: the government knowingly authorizes significant public spending that it knows will not occur so as to create the impression that it is responding to demands for social improvement. Repetitive Budgeting The budget is remade frequently during the year, in response to economic or political conditions. Cashbox Budgeting Government pays bills or undertakes spending as cash becomes available, not according to a preset budget. Deferred Budgeting The budget may report balance (or near balance), but only because some needs (such as maintenance) or liabilities (such as bills due) have not been paid. Deferred expenditures tend to escalate from one year to the next.

ahead. This unrealistic budget might crats who collude to maintain their authorize 120 percent or more of power while channeling funds to their expected spending, but the real budg- favored priorities. Even when this et—what actually will be spent—is behavior protects fiscal discipline, it controlled by a small circle of oppor- undermines democratic institutions tunistic politicians and senior bureau- and fosters corruption. Managing Public Expenditure in Developing Countries 37

When unrealistic, covert budget- defer disbursements or liabilities into a ing is practiced year after year, it may later fiscal year. Rich and poor countries lead to escapist budgeting whose pur- differ, however, in the pervasiveness of pose is to create impressions that are at these practices. In contrast to rich coun- variance with the reality. The budget tries which may have cash flow prob- becomes a means by which the govern- lems during part of the year (for exam- ment escapes from its fiscal confine- ple, because tax collections are lumpy ment by promising social improve- and not spread evenly throughout the ments that it cannot deliver. year) or in the final months of the year As noted earlier, maintaining fiscal during which they are striving to meet a discipline compels poor governments budget constraint, in poor countries, to engage in repetitive budgeting in cashbox behavior is year-round. In these response to changes in economic con- countries, the amount spent is not deter- ditions or in its cash position. When a mined by budget projections but by country is poor, it does not take much actual collections. The government to jar the government off course and to spends what it takes in; if it doesn’t rewrite the budget during the year. receive the money, it doesn’t make the Once repetitive budgeting becomes disbursement. institutionalized, the official budget Several of the budget pathologies loses its cachet as the authoritative identified in Table 2.2 enable poor statement of government financial pol- countries to maintain fiscal discipline icy and becomes merely the first round despite their economic straits. They in an ongoing process of adjusting to spend cash only when they have it; uncertainty, crisis, and changing fiscal they remake the budget during the circumstances. year if conditions turn out more The final items in Table 2.2 reflect adverse than they had hoped; they practices that while common in poor underspend the authorized budget. countries also are found from time to But these tactics are purchased at a time in developed countries. One is to high cost in budgetary integrity. implement the budget as if it were a cashbox, with expenses paid or spending Allocative Inefficiency authorized on the basis of the govern- Getting allocations right is a difficult ment’s cash position; the other is to task in all countries, and even more so 38 A Contemporary Approach to Public Expenditure Management in poor countries which have over- countries have to rebudget during the whelming unmet social needs and year, what is the probability that they meager fiscal increments. Yet the stakes will stay on course over 3–5 years? also are much higher. Improving budg- Paradoxically, medium-tern plan- et allocations in affluent countries ning is important in poor countries, in might raise per capita income by sever- some cases the plan is more prominent al percentage points; in poor countries, than the annual budget. But planning however, it might spell the difference sometimes is escapist, with the govern- between abject poverty and the capaci- ment promising in the plan what it ty to satisfy basic needs. Table 2.3 cannot afford in the budget. The tip- spells out some problems in obtaining off that a plan is escapist is its relation- allocative efficiency. ship to the budget. When the plan The short-termism of poor coun- ambitiously portrays a bountiful future tries hobbles their capacity to make with enhanced public services, but the efficient allocations. In all countries, budget fails to make a downpayment reprioritizing the budget requires a on that future—it does not allocate medium-term perspective that takes spending increases to social pro- account of the future financial and grams—then the government probably program implications of current budg- is using the plan to escape from its dire et decisions. A medium-term frame- predicament. work is necessary because relative pri- Budget allocations in poor coun- orities change slowly; indeed, major tries often differ markedly from those allocative decisions typically have a in wealthy ones. Poor countries typi- greater impact on future budgets than cally spend a smaller portion of GDP on the one for which they are initially and their budget on health services; made. But unlike rich countries which sometimes education spending lags can allocate money to high priority behind as well. They spend relatively programs in annual installments with more on operating government and, in reasonable assurance that all or most of some countries, on military forces. the promised funds will be forthcom- Why are allocations skewed this way? ing, poor countries have difficulty Why don’t national leaders recognize making or honoring commitments the social returns from having a health- that fall due in future budgets. If these ier, better educated population? There Managing Public Expenditure in Developing Countries 39

Table 2.3: Allocative Efficiency Problems of Some Developing Countries

Pmractice Proble

Short-term Budgeting Government budgets one year at a time, without considering medium-term implications, such as the recurring operating costs of new projects. Escapist Planning Planning is politically important but the government promises in the plan what it cannot pay for in the budget. Distorted Priorities Scarce resources are spent on showcase projects that produce meager social return while the budget underspends on human capital (health, education, etc.). “Enclave” Budgeting Efforts (often by international organizations) to protect certain priorities by establishing special funds, separate investment budgets, social (or physical) investment programs, and other devices that wall off the "enclaves" from the rest of the budget. are many answers to these questions, poor countries is to wall off social pro- for each poor country has its own grams with their own earmarked funds story. But one is that higher social from the overall budget. Often exter- spending is closely correlated with nal donors insist on special funds to political and economic development. ensure that assistance goes for intend- Citizens in rich countries have exten- ed purposes. One effect of establishing sive social programs because they these financial enclaves is to remove demand them and are willing to pay major allocative decisions from the taxes for them. The lack of robust budget process. Although this diminu- political institutions in many poor tion of the budget’s role as an allocative countries muffles citizen demands for instrument runs counter to widely- better services. accepted (but often violated) budget- An increasingly popular method ary principles, it recognizes that in for redressing the skewed priorities of poor countries, social programs would 40 A Contemporary Approach to Public Expenditure Management lose out in the competition for public Operating managers in poor funds if they lacked preferential countries have uncertain budgets. enclaves. Even after the budget has been approved and the fiscal year has com- Operational Inefficiency menced, they cannot be certain that Poor countries have systemic ineffi- the specified amounts will be avail- ciencies in both the market sector and able for the next month or quarter. government, that is due in substantial They are beset by several practices part to extensive reliance on informal mentioned earlier: unrealistic, repet- institutions. Private enterprises tend to itive, and cashbox budgeting, so that be small, under-capitalized, and labor they must vie with other spenders intensive, with low wages rather than throughout the year to obtain prom- high productivity giving them a com- ised resources. The lack of pre- petitive edge. This pattern is mirrored dictability reinforces short-termism in many poor governments which have and discourages managers from mak- a large, low-paid civil service. In devel- ing investments that will yield high- oping countries, there tends to be an er productivity in the future. It also inverse relationship between the size of encourages them to sharpen skills in the civil service and public sector nominally complying with the rules wages: the larger the workforce, the while outwitting the system. Getting more depressed wages are. Moreover, budgeted resources becomes more as the civil service grows, the decline in important than getting results. real wages accelerates. These and other conditions This condition is a recipe for low described in Table 2.4 are breeding productivity in the public sector, with grounds for petty corruption in the large numbers of ghost workers, public service. It is not hard for civil employees who are paid out of two or servants to justify their failure to put in more budgets, under-investment in a day’s work on the ground that they job training, and widespread cronyism are ill paid, or to channel contracts and in appointments and promotions. other favors to friends or relatives on These pathologies flourish despite the the ground that that’s the way the sys- installation of modern, merit and rule- tem really works. And the system does based civil service systems. work that way for those who are Managing Public Expenditure in Developing Countries 41

Table 2.4: Operational Efficiency Problems of Some Developing Countries

Pmractice Proble

Compensatory Spending To ameliorate unemployment, the size of the civil service balloons, but real public wages decline. Declining Productivity Numerous ghost workers, underinvestment in training and information technology, poor working conditions and other practices degrade operational efficiency. Disappearing Budgets The resources available for operations are highly uncertain, even after the budget has been approved and the fiscal year has commenced, managers operate hand-to-mouth without knowing what resources they will have for the next month or quarter. Detailed, Rigid Budgets On paper, spending control is highly centralized, with detailed rules concerning civil service (numerous classifications and grades), external control of procurement and other items of expenditure, but these formal controls often are violated in practice. Informal Management Informal arrangements coexist alongside the formal rules. Extralegal arrangements dictate how government operates: how civil servants get jobs or promotions, their pay scale, how procurement is contracted for, etc. Corruption When the formal rules are unworkable and government operates through extralegal means, corruption rises. There is ample opportunity for corruption, which (though widespread) often is undetected or unreported. trapped in it; only from afar can one ty, inattention to results, and failure to see the costs of a system that works this take measures that would improve way: inefficiency, loss of service quali- longer-term performance. 42 A Contemporary Approach to Public Expenditure Management

Can Public Expenditure Be stronger rule-based institutions in the Better Managed? public sector. When the state lets mar- In expenditure management, as in kets develop, it creates the very condi- many other government activities, it is tions that make it more effective. easier to diagnose shortcomings than It would take this chapter far afield to prescribe workable remedies. The to specify the many economic and fact that many countries remain political changes that might be made under-developed after decades of to promote development in poor external assistance and waves of reform countries. But it should be stressed attests to the difficulty of uprooting that at the end of the day, if the gov- embedded pathologies. Informality ernment still prepares unrealistic budg- thrives in the public and private are- ets, it will continue to be hobbled by nas, not because it promotes efficiency, the short-termism and other patholo- but because it enables politicians and gies discussed in this chapter. If the managers to muddle through. budget is unrealistic, it will not be Corruption persists, not only because implemented as planned, the govern- some benefit from it, but also because ment will continue to treat it as a cash- it cuts through red tape and in a high- box, covert budgets will substitute for ly uncertain world brings a modicum the official ones, informal behavior of predictability to public and private will preempt rule-based institutions, transactions. and the government will continue to Despite the relatively low probabili- allocate and operate inefficiently. ty of sustained success, it is imperative A budget is realistic when it is based that efforts to improve public manage- on assumptions that have a high proba- ment in poor countries be intensified. bility of occurring and when it is for- The 1997 World Development Report mulated with the intent to implement argues that an effective state is a neces- the revenue and spending policies spec- sary condition for robust markets and ified in it. Realism does not require sustainable development. Contributions budgets that can withstand all exoge- made by the state to open, formal mar- nous shocks, but budgets that are kets through deregulation, privatization, implemented as planned when assumed arms-length relationships between it and conditions materialize or when relative- financial institutions feedback to ly minor disturbances intrude. Managing Public Expenditure in Developing Countries 43

Realistic budgeting depends on merit-based civil service systems basic capacities to plan, control, and become more extensive and the skill account for public funds. These level of public employees rises. Central include having a strong budget plan- budget and planning systems—often ning and control agency at the center divorced from one another and entrust- of government that maintains fiscal ed to different agencies—mature. discipline, monitors revenue and Typically, the government operates a spending outturns, controls the use of line item budget and a uniform civil inputs, advises departments on means service system that emphasize the con- of improving efficiency, manages the trol of inputs and compliance with cen- governments cash and debt, and trally-enforced rules. ensures that actual spending conforms As the economy develops, the gov- to budgeted amounts. Once these and ernment has more money to spend, other basic practices have been institu- but this does not mean that the task of tionalized, it may be appropriate to managing public expenditure becomes introduce more flexible means of man- less important. In fact, Table 2.5 indi- aging public expenditure. cates, new problems come to the fore, as the process of development unleash- Managing Public es demands for better schools, more Expenditure During health facilities, and other improve- Economic Development ments in public services. Some of the Not every country that was poor 30 or spending increases are financed out of 50 years ago is poor today. Some have the dividends of a growing economy, joined the ranks of developed countries; but some may require tax increases or others are at the brink of doing so. As a deficit financing. country develops, the government’s Initially, the largest spending budget position improves. Large scale increases are likely to be in public con- enterprises emerge, the informal sector sumption and investment, the latter to recedes in size relative to the formal one, build infrastructure, the former the government has more success in col- because of voter and politician lecting taxes, and entrepreneurs more demands for more services. As devel- success in attracting outside capital. opment persists and incomes rise, pres- Public management also improves as sure escalates to provide (or enhance) 44 A Contemporary Approach to Public Expenditure Management

Table 2.5: Public Expenditure Conditions Associated with Economic Development

Ans the economy develops Explanatio

Public Spending Grows As A Rising expectations, strong demands for Percentage of GDP improved services, organization of interest groups, and easier availability of resources. Consumption Expenditure Rises Initial increases tend to be concentrated in services, such as health, education, environment, and sanitation. Transfer Payments Rise Later As development persists and matures, pressure rises to establish/enhance social security programs. Aggregate Fiscal Discipline May Depending on political conditions and Weaken institutional arrangements, budget deficits may rise as government overspends the dividends of economic growth and draws on its improved ability to borrow. Pressure to Improve Allocative Pressure to remove/reduce subsidies to Efficiency by Shift from Subsidies firms and to protect to Transfer disadvantaged/dependent persons through income redistribution schemes and expansion of “safety nets.” Operational Efficiency May Operational efficiency may improve as Decline a result of citizen pressure for better services, but counter pressures include failure of government to pay competitive salaries as private employment opportunities advance, tendency to spend newly available resources on operations, inability of pre-development bureaucracies to keep up with new demands/opportunities, and greater opportunity for rent-seeking and corruption. the social safety nets that are widely unemployed). In the euphoria of available in developed countries, such growth, there may be little attention to as income support for dependent per- the long-term commitment that the sons (the elderly, ill, disabled, and government undertakes when it enti- Managing Public Expenditure in Developing Countries 45 tles a substantial portion of the popu- politicians. Depending on how growth lation to future benefits. For the pres- is managed, public sector productivity ent, resources appear to be plentiful, may decline as public salaries and and it seems appropriate to share the career opportunities lag behind those fruits of affluence with those who are in the market sector. left behind. These possibilities suggest that As a country develops, it is cross- during high growth periods, it may be pressured with respect to aggregate appropriate to turn the spotlight on to spending policy. On the one hand, allocative and operational issues. growth schools political and economic During these times, the government elites in the advantages of fiscal pru- may have greater incentive to take a dence; on the other hand, it generates long-term perspective, it can more pressure to spend more, especially in clearly discern the connection between countries where the national legislature having effective programs and eco- enjoys budgetary independence and nomic development, and it has incre- can vote on spending items not includ- mental resources needed to improve ed in the government’s budget. public management. Ideally, the pri- Typically, the government still main- vate and public sectors should develop tains a short-term budgetary perspec- in tandem, with the government liber- tive, looking ahead only one year at a alizing the market at the same time as time, though it may have a separate it strengthens rule-based budgeting, planning apparatus (with its own personnel systems, and other manage- power base) that generates expecta- ment practices. In many cases, howev- tions of future spending increases. er, public improvement does not take During rapid growth, allocative place and only after the deficiencies in and operational inefficiencies become its operations become apparent does it more pronounced or apparent, either invest in medium-term expenditure because of higher expectations for pub- planning while instilling a culture of lic service, or because much of the performance and accountability in the additional spending goes to enlarge the public service. ❧ bureaucracy or to build grand projects favored by national leaders and infra- structure projects favored by local

Chapter 3 Aggregate Fiscal Discipline

ontrolling total expenditure is den. Typically, therefore, spending dis- an essential purpose of every cipline is accompanied by constraints Cbudget system. There would on other budget aggregates. If it isn’t, be no need for governments to budget the government may find it easier to if total spending were merely the sum meet deficit targets by allowing rev- of all claims on public resources. enues to rise than by reducing public Budgeting is ubiquitous because expenditure. claims always exceed what government Constraining the totals is not easy is able or willing to spend. Without because claimants have a strong incen- limits on the totals, unconstrained tive to demand all they can get from demands would likely result in chroni- government. For most claimants, the cally high deficits and a progressive rise benefits ensuing from higher govern- in the ratio of tax revenues and public ment spending outweigh any resulting expenditure to GDP. increase in their tax burden. Inasmuch Aggregate fiscal discipline pertains as program benefits tend to be concen- to all key measures of fiscal perform- trated while the tax burden is dispersed, ance: total revenue, the financial bal- particular beneficiaries have more net ance and the public debt, in addition gain from demanding additional spend- to total spending. It makes little sense ing than by advocating fiscal constraint. to establish spending constraints with- These unbalanced incentives lend self- out also deciding revenue totals, budg- interested claimants to demand more et surplus or deficit, and the debt bur- resources than they would want govern-

47 48 A Contemporary Approach to Public Expenditure Management ment to spend. This “common pool” or etary rules and roles differ among coun- “tragedy of the commons” problem is tries, governments vary in their capacity exacerbated when programs are debt to maintain aggregate fiscal discipline. financed and the government shifts costs This chapter discusses aggregate to future taxpayers. What constrains fiscal discipline in the light of contem- claims on the budget is not only the porary public expenditure manage- prospect of higher tax burdens (or other ment (PEM). The next section discuss- costs such as rising inflation or weaker es the evolution of aggregate spending economic growth) but the impossibility practices over the past century. It is fol- of all claimants getting what they want. lowed by a consideration of the condi- This impossibility is rooted in a funda- tions that reinforce aggregate disci- mental condition of government: pline: institutional arrangements, resources are more constrained than informational flows, and resulting demands. Giving everybody what they behavioral changes. want would exhaust current revenue and the government’s capacity to borrow. To The Three Stages of counteract the inclination of claimants Aggregate Budget Policy: to push for more, governments con- Lessons from Experience strain the spending totals. The question There are important differences is not whether spending totals should be between PEM and previous approach- constrained, but how hard a constraint es to aggregate fiscal discipline. PEM should be applied. Enforcing aggregate builds on and deviates from two earli- fiscal discipline is a contest between er doctrines—the balanced budget claimants and controllers; the latter can norm and dynamic fiscal policy. prevail only when decisions on spending Prior to World War II, virtually all totals are made somewhat independent- democratic regimes embraced the bal- ly of annual demands on the budget, anced budget norm. The operative rule and when these decisions are enforced was that spending during a fiscal year by budget rules that limit what should not exceed that year’s revenue. claimants can ask for and get, and when Governments differed in applying this controllers are armed with roles and rule: some applied it only to current authority than enable them to enforce revenue and expenditure, others to fiscal discipline. To the extent that budg- investment income and expense as Managing Public Expenditure in Developing Countries 49 well. Some included money carried tion were empowered to block spend- over from previous years in calculating ing that was not authorized in the available revenue, others included only budget, was deemed by them to be funds received during the fiscal year. unnecessary or wasteful, or that would, The balanced budget norm did not in their judgment, unbalance the distinguish between periods of eco- budget. Some governments went a step nomic growth and stagnation, nor did further and required that all spending its time horizon extend beyond a single actions be approved in advance by cen- fiscal period to a full economic cycle. tral controllers. The rationale was that Because it was rigid, the balanced total spending could be effectively budget norm was not always adhered constrained only if particular spending to. Few countries managed to keep items were controlled. With the bulk total spending within revenues during of public funds spent on the running wartime or recession; some even had costs of government, controlling the difficulty during good times. But items of expenditures usually was a although the norm often was dishon- manageable task. ored in practice, governments paid it The strict budgetary balance norm lip service as the right thing to do. was superseded after World War II by a Moreover, even when the budget was flexible rule that allowed the totals to imbalanced, governments used the accommodate cyclical changes in eco- norm to constrain spending demands. nomic conditions and secular changes in Inasmuch as prewar governments government policy. The new rule came were relatively small and tax rates were in several versions. One was that govern- relatively low, much of the burden for ment should maintain balance over the maintaining balance fell on the expen- course of an economic cycle; another diture side of the budget. Balance was was that total government spending enforced by ex ante controls on the should not exceed the revenues govern- items of expenditure. Spending control ment would take in if the economy were was centralized and reached individual at full (or high) employment. transactions, such as decisions on hir- Governments differed in the extent to ing personnel and purchasing supplies. which dynamic fiscal response should Moreover central controllers in the result from built-in stabilizers or from finance ministry or similar organiza- discretionary fiscal policy. Over time, 50 A Contemporary Approach to Public Expenditure Management dynamic fiscal policy came to mean that portion of public expenditure was government should act to reduce the determined by statutory formula gap between actual and potential out- rather than by annual budget deci- put. Even when the economy was sions. This portion of the budget has strong, deficit spending was common in to be spent regardless of other claims many democratic countries, along with on public resources and whether or not a steady updrift in the ratio of public government has sufficient revenue to expenditure to GDP. With aggregate cover the mandated entitlements. For constraints loosened, claimants had the example, governments typically are upper hand in demanding more from required by law to pay social security government. Claimants also were and other pension claims, regardless of advantaged by changes in budgetary the overall condition of the budget. In rules and roles, for in many countries, many countries, these payments are spending items were consolidated into funded by statutory or permanent law, broad categories, and the government not by annual appropriations. shifted emphasis from preaudits and Moreover, the year to year rise in statu- external control to postaudits and inter- tory payments often exceeds the incre- nal controls. These and related changes mental increase in tax revenues, forc- enabled spending agencies to use bud- ing governments to raise the tax bur- geted funds without obtaining central den and/or accept deficit spending. approval, thereby reducing the authority Most importantly, the rise in transfer of central controllers to intervene in payments has made public expenditure agency spending decisions. much more sensitive to changes in eco- Spending demands were strength- nomic conditions. ened in most industrial democracies by Aggregate fiscal discipline was a a fundamental change in the composi- casualty of these changes. Government tion of national expenditure, with outlays soared in virtually all demo- much more spent on transfers to cratic countries. In OECD countries, households and relatively less on con- they averaged 28 percent of GDP in sumption and investment. The chang- 1960 and about 40 percent two ing mix of expenditures weakened decades later, a growth rate in excess of aggregate fiscal discipline and promot- one half percentage point a year. In ed dynamic fiscal policy. An increasing many countries, higher expenditure Managing Public Expenditure in Developing Countries 51 and lax fiscal discipline were justified (and in some circumstances all) years in terms of the economic and social of the economic cycle, not only during gains achieved through government recession but also in its aftermath. expansion and flexible fiscal responses. When recession ends, its impact on the Whatever its virtues, an accommo- budget lingers for some time, because dating fiscal posture was called into revenues remain lower and interest question by the deterioration in eco- charges and certain transfer payments nomic performance of most industrial remain higher than what they would countries after the oil shocks in the have been in the absence of the down- mid-1970s and early 1980s. With eco- turn. Some countries have redefined nomic improvement no longer taken the balanced budget rule to focus on for granted, many countries encoun- the primary balance, which excludes tered increased political resistance to interest payments. During periods of tax increases. High deficits came to be sustained economic growth, when the seen as structural problems that persist deficit recedes and the budgetary even when the economy recovers, not effects of the previous recession dissi- as cyclical responses to short-term eco- pate, some governments renew their nomic difficulties. One after the other, commitment to strict budgetary bal- developed countries concluded that ance, but then they are jarred by the they had to exert more discipline over next recession into realizing that this the budget aggregates, including total rule cannot be enforced during eco- public expenditure. nomic downturns. In seeking to reassert fiscal disci- If the balanced budget norm is an pline, governments had to devise new unsustainable policy guide, so too is an approaches that differ from both the accommodating fiscal posture and lax balanced budget rule and accommo- financial discipline. Some countries dating fiscal policy. A strict balanced have come to the conclusion that budget requirement is unworkable active demand management is not a because the budget is sensitive to eco- viable option when structural budget nomic fluctuations and cannot be kept deficits are high; many now regard in balance when output falls and prolonged fiscal imbalances as a drag unemployment rises. A zero deficit on their future economic capacity. norm would be violated during most Almost all perceive that the once-com- 52 A Contemporary Approach to Public Expenditure Management mon distinction between cyclical and longer does what it is supposed to structural deficits is misguided because do—decide the totals. one year’s cyclical deficit often worsens Faced with the impracticability of future structural imbalances. There are a strict balanced budget rule and the both fiscal and political reasons for the undesirability of accommodating structural difficulty of fine tuning budgets, industrial democracies have cyclical budget policy. Cyclical deficits muddled through to a targeting strate- add to spending demands on future gy that permits controlled deficits that budgets by raising interest charges and are expressly set by the government other payments. Moreover, when a and are enforced through spending government loosens the purse strings limits and other budget rules. Like the by permitting cyclical deficits, it balanced budget rule, targets are fixed changes the behavior of politicians and rather than accommodating, but unlike others with an interest in higher this norm they usually are decided by the spending. Cyclical policy strengthens government, not by an a priori norm. the hand of those who justify higher Most early targets—those spending in terms of short-term announced in the 1980s—were politi- improvement in economic well-being; cal statements, not operational poli- and it spawns incentives to engage in cies, that were only loosely linked to creative bookkeeping practices that veil the budget and lacked strong enforce- increased public spending and deficits. ment mechanisms. Often, the When the government has an announced targets were unrealistic; accommodating posture, fiscal disci- even with genuine effort, they could pline is loose both when the budget is not be achieved. They typically formulated and during its implemen- focused on short-term outcomes rather tation. In the 1970s and the 1980s, it than on longer-term fiscal stabiliza- was not uncommon for within-year tion. Although they generally were changes to be greater than those made ineffective, the first-generation targets between budget years. When this signaled important changes in govern- occurs, the budget appears out of con- ment policy. They rallied public sup- trol, overtaken by exogenous circum- port for a tougher fiscal stance and put stances such as worse-than-expected claimants on notice that the era of lax economic performance. The budget no spending control was over. Managing Public Expenditure in Developing Countries 53

Some countries have achieved tem- Implications for Types of porary success in disciplining the totals Fiscal Constraints when the economy was robust, but For fiscal limits to constrain revenue they have been compelled to ease and spending decisions, they must be aggregate fiscal controls when the imposed before the budget is formulat- economy has weakened or spending ed. In contrast to the balanced budget pressures have escalated. According to era, when unwritten constraints suf- a report by the U.S. General ficed because they were widely accept- Accounting Office, four countries ed, now the constraints are formal and (Australia, Germany, Japan, and explicit. Moreover, in contrast to the Mexico) that managed to restore fiscal Keynesian era when revenue limits balance during the 1980s experienced were set (and often changed) in the resurgent deficits during the early course of making and implementing 1990s, demonstrating that although the budget, the current emphasis is on “significant structural improvement in setting them in advance, and inde- fiscal policy is possible in modern pendently of annual budget decisions. democracies...such progress is difficult Aggregate constraints take many to sustain.” forms, ranging from constitutional The ineffectiveness of the early limits on the power of government to targets has let to more sophisticated tax, spend or borrow to indicative approaches that integrate target-set- statements that set forth the govern- ting with formulation and imple- ment’s fiscal posture but are not legally mentation of the budget, specify con- binding. The constraints may be self- straints on revenue, spending, the imposed or externally prescribed deficit, and (in some countries) the through conditions set by internation- public debt, establish subtargets for al organizations or other entities. Some major spending sectors, and take limits are established one year at a account of cyclical gyrations in fiscal time, others extend to the medium- outcomes. It will take years of experi- term (3-5 years) or beyond. The con- ence, through one or more economic straints may pertain only to the deficit cycles, before the impact of aggregate or cover other fiscal aggregates. They fiscal constraints on budget outcomes can be expressed in money terms, as can be assessed. rates of change, or as percentages of 54 A Contemporary Approach to Public Expenditure Management

GDP or of other indices. They can be category, as is the American Gramm- confined to the aggregates or cover Rudman-Hollings law enacted in major spending categories (such as sec- 1985. A somewhat more flexible tors, portfolios, or budget functions) as approach is to decide the limits each well. The constraints may deal only year and then to consider budget esti- with formulation of the budget, or mates within the agreed constraints. In they may include mechanisms for lim- Australia, the forward estimates are the iting parliamentary action and imple- authoritative starting point for consid- mentation of the budget. They may ering departmental bids for resources; have tough enforcement mechanisms in Sweden’s reformed budget system, that entail corrective action if the con- the totals are decided by the govern- straints are breached or they may not ment and parliament each year, before require any intervention. work commences on the annual budg- Because of their variety, the con- et. Another variant comes from New straints cannot be displayed in a single Zealand where the government pres- table. This section maps out some of ents a policy statement to parliament the alternatives available in designing several months before it submits the and implementing aggregate fiscal dis- annual budget. This statement indi- cipline. cates the government’s fiscal objectives for the medium-term and longer; it is Permanent Versus Annually Reset updated half-yearly, as well as during Constraints the runup to national elections. In seeking to discipline the aggregates, At first consideration, it may government may decide to operate appear that the more constrictive the under fixed rules that continue in constraint the more effective it is like- effect from year to year, or according ly to be in controlling the aggregates. to a process in which new decisions are Indicative statements would appear to taken on by the aggregates each year. be considerably less effective because The rules may be prescribed by consti- they do not formally bind the govern- tution, statute, international agree- ment and no specific action (other ment, or some other binding decision. than revision of the statement) is nec- The Maastricht criteria for the essary when fiscal conditions veer off European Monetary Union are in this course. Yet there may be circum- Managing Public Expenditure in Developing Countries 55 stances in which annual constraints The choice between constrictive have greater influence than perma- and indicative rules depends on insti- nent ones, and indicative policies are tutional conditions, which vary from more effective than constrictive rules. country to country. This conclusion is This argument rests on two premises: elaborated in the next section, but can first annual policies tend to be more be summarized here as follows: realistic and achievable than perma- Indicative constraints effectively disci- nent rules; second, annually estab- pline the aggregates when institutional lished constraints may have more arrangements promote fiscal prudence. political support than standing rules On the other hand, constrictive rules which have not been endorsed by cur- might be appropriate in countries rent politicians. No matter how hard when institutional arrangements pro- they are, constraints cannot be mote or tolerate fiscal laxity. If this is achieved if they are unrealistic or lack true, fiscal discipline must come to political support. When both condi- grips with an anomaly: when hard tions are lacking, politicians may con- constraints are most needed, they may spire to evade the constraints by be least workable; where conditions are delaying payments, resorting to extra- most hospitable for fiscal constraints, budgetary arrangements, underesti- they may be least needed. mating expenditures, and other book- keeping tricks. External Versus Internal Constraints Constraints tend to break down This anomaly suggests that self-disci- over time. When they are fresh and pline may be in short supply in coun- backed by political commitment, the tries that need it the most. Ideally, constraints may discipline budgetary democratic governments should estab- decisions. But as they age and lish and enforce their own fiscal rules, encounter new conditions, they often but when they are unable to do so, lose effectiveness. Moreover, over time external pressure may have a salutary spenders learn how to circumvent the effect. Quite a few European countries controls while paying lip service to have accepted fiscal austerity in order them. Periodically, therefore, fiscal to meet the criteria for entering EMU. constraints may have to be renewed to Over the years, many developing and restore their effectiveness. transitional countries have constrained 56 A Contemporary Approach to Public Expenditure Management their fiscal appetites in response to the fiscal constraints, the greater the conditions imposed by IMF and other incentive to avoid hard choices by international organizations. postponing the day of reckoning. These pressures may work These considerations suggest that a because they change the balance of medium-term expenditure framework political power within affected coun- is a useful, perhaps essential, instru- tries and enable politicians to shift ment of fiscal discipline. When it is the blame for taking unpleasant properly applied, a multi-year frame- measures to outsiders. Nevertheless, work compels the government to assess external pressure may be a weak sub- the impact of current spending actions stitute for self-discipline because on future budgets. Of course, if, as is external controllers must rely on the normally the case, the framework government to implement and extends only to the next 3-5 years, enforce the constraints. Some gov- spenders may have incentives to shift ernments are adept at holding out- expenditures (or other actions that side controllers hostage to their weaken fiscal discipline) to still later domestic interests, with the result years. Nevertheless, the incentive and that even with their best efforts, opportunity for politicians to break fis- international organizations often do cal discipline diminish when the not always get the promised out- framework covers future years. comes. Australia’s forward estimates sys- tem described in Box 3.1 establishes Annual Versus Multi-year the fiscal framework within which Constraints annual budget decisions are taken. Budgets usually are made for a single Although they can be altered by the year, and fiscal constraints usually are government, the approved forward expressed as annual targets. However, estimates are the fiscal boundaries one-year-at-a-time constraints may within which departmental spending induce spenders to defer expenditures bids are fitted. These bids are consid- to subsequent years, enabling the gov- ered in terms of spending impacts on ernment to claim that it has achieved the forthcoming budget and on the the current targets while making it dif- forward estimates for the following ficult to meet future ones. The tighter three years. Managing Public Expenditure in Developing Countries 57

Box 3.1: Australia’s Forward Estimates System Since the early 1980s, Australia has sions on proposed changes to the for- made annual budget decisions within the ward estimates. framework of estimates for the financial The forward estimates are rolled year immediately ahead and forward forward each year, and adjusted for estimates for each of the next three government decisions, changes in eco- years. The forward estimates have struc- nomic conditions, and revised estimates tured budget work during periods of of the costs of various programs. During program expansion as well as during formulation of the annual budget, periods of contraction, and they have Ministers are encouraged to finance survived several changes in Government spending initiatives out of savings in leadership. existing programs. The Department of Australia introduced the forward Finance oversees departmental bids to estimates because of serious deficiencies endure that adjustments to the forward in one-year-at-a-time budgeting. It estimates (both savings and proposed entered the 1980s with an annual budg- additional spending) are accurately cal- et process that focused Government and culated. A proposed initiative must esti- Parliamentary action on estimates and mate outlays for each of the next four appropriations for the next fiscal year. years. If the government accepts not to The outyear implications of budget deci- adjust the forward estimates, a Minister sions often were ignored. Moreover, who seeks program initiatives must offer budgetary work was concentrated on the savings elsewhere in the portfolio. details of expenditure, with lengthy The forward estimates are not debate in Cabinet and Parliament on the designed to cut back expenditures or to estimates, even when no significant poli- down-size government, though they can cy of financial issues were involved. be used toward these ends. Rather, they The forward estimates establish an enable the government to set program authoritative baseline or starting point and spending priorities within an aggre- for work on each year’s budget. When a gate fiscal framework that disciplines Minister proposes a program change, claims on future budgets. In a period of she or he adjusts to the forward esti- constrained budgets, the system has mates accordingly. Rather than review- eased the inevitable frictions of budget- ing the detailed estimates, the Cabinet ing and has permitted the government to evaluates program initiatives and sets finance new priorities while slowing the inter-sectoral priorities by taking deci- growth rate of public expenditure.

Some countries that budget within fits this model (see Box 3.2), but inas- an annual framework nevertheless con- much as it has been in place only since sider the outyear implications of fiscal the mid-1990s, there is insufficient decisions. Sweden’s new budget system evidence for assessing its effectiveness. 58 A Contemporary Approach to Public Expenditure Management

Expenditures and Other Fiscal and with other countries, and recog- Aggregates nizes that the affordability of a govern- In managing its finances, a govern- ment’s spending depends on (among ment produces at least four fiscal other measures) the volume of nation- results: total revenue, total spending, al output. Nevertheless, focusing on the deficit (or borrowing requirement), expenditures (or revenues) as a per- and the public debt. Governments that centage of GDP may bias public budget on a commitments basis also expenditure upward. If the govern- have data on the total commitments ment seeks to stabilize public spending issued or outstanding. Separate aggre- as a percentage of GDP, it may accept gates may be calculated for loans guar- real spending increases when the econ- anteed by the government and for omy expands but find it difficult to other contingent liabilities. Finally, reduce spending when the economy governments that publish consolidated stagnates. Over the course of an eco- financial statements produce data on nomic cycle, this pattern may result in assets, liabilities, and net worth. The a progressive rise in the ratio of public various aggregates may pertain only to spending to GDP. the central government, or to other Constraining a single fiscal aggre- portions of the public sector as well, gate also is likely to generate distor- such as social security, subnational tions in budgetary behavior. If only the governments, public enterprises, and deficit is targeted, the government may other entities that normally are exclud- contrive to meet the constraint by sell- ed from the national budget. ing assets, postponing expenditure, or The various fiscal aggregates can be resorting to nonrecurring revenue targeted in different ways: in money sources. Moreover, a fiscal constraint terms, as a percentage of the gross confined to the deficit may impel domestic product or of some other politicians to meet the target by raising index, in real (inflation adjusted) revenue rather than by cutting expen- terms, or as a rate (or amount) of diture. A broad set of constraints that change over a previous fiscal period. targets several fiscal aggregates may Expressing public expenditures and discourage this behavior, especially if other aggregates as a proportion of the targets include the government’s GDP facilitates comparisons over time net worth, a measure that is not affect- Managing Public Expenditure in Developing Countries 59 ed by asset sales or by the shift in assets held by it. In contrast to the bal- receipts or payments from one fiscal ance sheet which measures net worth period to another. It should be noted, (assets minus liabilities) the gross debt however, that few governments cur- measures only liabilities, and only rently produce the consolidated finan- those liabilities that are in the form of cial statements needed to calculate net debt. It is an incomplete measure of worth. the government’s financial condition Many developed countries pay that does not reflect net worth. The closer attention to the debt to GDP government can lower the gross debt ratio than they once did. This develop- to GDP ratio by selling physical or ment has been spurred by the steep rise financial assets and using the proceeds in debt burdens and by the Maastricht to repay a portion of the debt. This Treaty which conditions initial mem- transaction would change the compo- bership in EMU on holding gross pub- sition of assets and liabilities, but not lic debt below 60 percent of GDP. This the government’s net worth. ratio is an indicator of the sustainabil- The gross versus net basis also per- ity of chronic budget deficits. In con- tains to constraints on total expendi- trast to the deficit which measures ture. Just about every national govern- financial balances within a short fiscal ment obtains some income from user period, the debt to GDP ratio signals charges, state-owned enterprise, and changes in financial condition over an other commercial type activities. If it extended period. A rise in this ratio accounts for finances on a gross basis, means that the debt burden is increas- this income would be budgeted as rev- ing faster than economic output. This enue; if it uses the net basis, some or all trend cannot be sustained indefinitely, of this income would be budgeted as and can be reversed only by curtailing an offset to expenditure. Netting ver- annual deficits to a rate that is less than sus grossing does not affect the size of the rise in GDP. the deficit, but it does affect total The debt to GDP ratio usually is spending; hence, the issue is important calculated on a gross basis; it measures when a government imposes a fixed the total owed by the government. constraint on total spending. The net This ratio is not reduced by money basis is popular in some countries owed to the government or by other because it encourages spending depart- 60 A Contemporary Approach to Public Expenditure Management

Box 3.2: Strengthening Fiscal Discipline in Sweden

The Swedish Government (and the pub- subdivided into 27 expenditure areas. In lic sector) have had recurring budget the first years that it has been applied, deficits since the mid 1970s. The typical the ceiling included a margin (equal to response has been for the Government approximately 2 percent of central gov- to adopt austere budgets which, through ernment expenditure) to cover overruns a combination of spending cuts and rev- and unanticipated circumstances. The enue adjustments, reduce the deficit to spending ceiling is a gross amount. The manageable size or eliminate it alto- Government also submits an indicative gether. For example, in 1982, the spending ceiling for local governments. Government implemented a “crisis pro- The first stage of the process concludes gram” that progressively reduced the with adoption of the spending ceiling by deficit and briefly eliminated it by the Parliament. end of the decade. Stage two entails preparation of the However, a recession in the early annual budget bill by the Government 1990s, combined with upheavals in and voting of appropriations by financial markets, resulted in a budget Parliament. Both the budget and appro- deficit that reached approximately 13 priations must be within the pre- percent of GDP, far higher than the approved spending ceilings. As a result, imbalances experienced previously. At preparation of the Government’s budget about the same time, a comparative has become more of a top-down process study of budget practices (led by Jorgen (though bilateral negotiations between von Hagen) concluded that Sweden’s line ministries and the Finance Ministry budget process was very weak com- continue as before). In Parliament, work pared to that of other European on appropriations is assigned to various Community governments. It further committees, each with its own spending found that lax budget procedures are ceiling. In contrast with past practices, closely correlated with higher deficits budget amendments must have offsets, and a growing public debt. so that total spending is within the ceil- Sweden introduced a reformed ings. budget process in 1996 that has more The reformed process provides for than doubled its score on the von Hagen close monitoring and periodic reports on fiscal stringency scale from 25 to 58. budget outturns, as well as for handling Prior to the reforms, Sweden ranked expenditures in excess of the approved 12th among the 13 EC member states amounts. on this scale; post reform, it ranks 3rd. In the first years that the new system The centerpiece of the reforms is a has been applied, Sweden’s fiscal pos- new two-step budget procedure. In the ture improved considerably. But it is too Spring, the Government establisheds a early to determine the extent to which multi-annual expenditure ceiling for this is due to overall improvement in eco- each of the next three years. The ceiling nomic conditions or to more stringent is expressed in nominal terms, and is budget rules. Managing Public Expenditure in Developing Countries 61 ments to charge users for the benefits spending claims are considered. But if they receive while making it easier for allocations to sectors or other major the government to adhere to a con- categories also are set, these subtotals straint on total spending. Sweden, would constrain the amounts that however, recently rejected the net claimants may bid for. basis; it now budgets for gross govern- Contemporary budget reform in ment spending. In the Swedish system, developed countries suggests several amounts paid to the European approaches to constraining expendi- Community are budgeted as expendi- ture subcomponents. In Sweden’s new tures and amounts received from it are budget system explained in Box 3.2, budgeted as revenues. The two flows when the aggregates are decided, are not netted out. This approach was spending is broken into 27 sectors; selected by Sweden because it empha- each is given its own allocation. When sizes control of total spending. Parliament votes appropriations, it must adhere to the agreed sectoral lim- Controlling the Main Expenditure its. Australia’s forward estimates are Components structured into 17 portfolios, each of Maintaining aggregate fiscal discipline which is the responsibility of a obviously requires that the government Minister. While the Government may control the budget’s totals. Decisions increase spending in the course of on the elements of expenditure would developing the budget, the expectation came later, in the course of preparing is that ministers will first look for sav- estimates and reviewing expenditure ings in their portfolios before seeking bids. Arguably, however, effective con- additional funds. In the United States, trol of spending requires that decisions when Congress adopts a budget plan, on the totals be coupled with decisions it divides total spending into approxi- on major subaggregates, such as sec- mately 20 budget functions. These tors, portfolios, or budget functions. allocations, however, are indicative; This argument rests on the notion that they do not constrain subsequent if agreement has not been reached on appropriations. the main components, the government The question of whether it is desir- might be unable to withstand pressure able or necessary to couple sectoral and to raise the totals when individual aggregate limits may turn on the cohe- 62 A Contemporary Approach to Public Expenditure Management siveness of the government. When ments for preparing, approving, and budget making is highly centralized, implementing the budget, as well as the government may be able to keep to the types of information, the powers of the agreed totals even though it has not the Finance Ministry and other partic- made any sectoral decisions. But when ipants, the scope of changes that may the budget is decided by Cabinet in a be made by the legislature, and adjust- collegial manner, or when Parliament ments that may be made during the authorizes more spending than was fiscal year, in the course of implement- requested by the government, early ing the budget. Informal rules pertain controls on sectoral allocations may to the actual behavior of participants; strengthen aggregate fiscal discipline. these have a wider scope to the extent that formal rules are ignored or evad- Institutions: Rules, Roles, ed, or do not specify how particular and Information situations should be handled. The for- Maintaining aggregate fiscal discipline mal rules specify how the budget almost always entails changes in insti- process should operate; informal rules tutional arrangements; these influence specify how it actually does. For exam- the incentives and, therefore, the ple, formal rules may provide for the behavior as well, of claimants and con- government to intervene when spend- trollers. The key requirement is that ing exceeds targets, while de facto, the budgetary controllers be sufficiently government may simply accept the powerful to enforce fiscal discipline; if additional spending without taking they are not, claimants will behave as remedial action. self-interested takers from a common A growing body of empirical resource pool—taking as much as they research demonstrates a close correla- want until the pool is depleted. tion between budget rules and out- comes. Although the research methods Rules may appear to be somewhat defi- Budgetary institutions are the rules cient—they generally rely on question- according to which budgets are pre- naire responses, subjective assessments pared, approved, and carried out. by observers or participants, and crude These rules may be formal or informal: weighting schemes—the fact that vari- formal rules spell out legal require- ous studies concentrating on different Managing Public Expenditure in Developing Countries 63 regions (Asia, Latin America, and The same vein of research, howev- Europe) have come to approximately er, also indicates that the checks and the same conclusion adds to the balances of fragmented or divided gov- strength of the findings. ernment lead to less total spending Various studies have found a than in majoritarian regimes. strong correlation between the stabili- Apparently, when government is split, ty and cohesiveness of the government its capacity to expand programs is on the one hand and the deficit and diminished, either because a majority debt to GDP ratios on the other. A is lacking to support the initiative or key finding is that fragmented govern- because parties do not want to vote for ments (such as multi-party coalitions) additional spending that might occur have less capacity to assemble and while they are out of power. maintain a majority in support of the While these studies focus on broad tough measures needed to maintain political institutions, a more direct fiscal discipline. Cohesive govern- approach has been to examine the rela- ments, in which a single party consti- tionship between budget rules and tutes the government (in parliamen- outcomes. The relevant rules pertain to tary regimes) or controls both the the three critical stages of budgetary executive and legislative branches (in decision and action: formulation of the presidential systems) have greater abil- government’s budget, review of the ity to constrain the aggregates and budget and appropriation of funds by withstand pressure to spend or borrow the legislature, and transfer or supple- in excess of targeted levels. In general, mentation of expenditures during exe- the more parties that comprise the cution of the budget. coalition, the less able the government In studying budget preparation is to establish and enforce stringent rules, researchers have found that col- fiscal discipline. Aggregate discipline legial forms of decision-making lead to may be particularly difficult to main- more lax fiscal discipline than authori- tain when (as sometimes happens in tarian rules. Collegiality refers to rules coalition governments) one party con- that give all ministers approximately trols the finance ministry and another an equal say in budget decisions, the controls one or more of the major finance ministry decides spending lev- social portfolios. els in bilateral negotiations with line 64 A Contemporary Approach to Public Expenditure Management ministers, and the Cabinet collectively spending, and have an adverse effect approves the budget. Authoritarian on fiscal balance. rules give a strong advantage to the Finally, a distinction can be drawn Prime Minister (or the Finance between flexible systems that permit Minister) who can overrule the spending increases during execution demands of spending ministers in and rigid systems that either bar such negotiating the budget. In these types increases or require that they be consis- of regimes, fiscal targets are likely to tent with agreed fiscal aggregates. drive budget decisions, in contrast to Flexible systems tend to have liberal collegial systems in which spending rules that permit the transfer of funds demands drive the fiscal totals. between votes or accounts in contrast Authoritarian rules emphasize disci- to rigid systems that restrict such trans- pline and consistency, collegial rules fers. In some flexible systems, the gov- favor compromise and consensus. ernment does not need to obtain leg- Differences also emerge during islative approval for spending increases legislative action on the budget. Here until after the additional funds have the contrast is between restrictive pro- already been spent, sometimes years cedures that bar amendments that later; while in rigid systems, any such would increase spending (or reduce increases must be approved in advance. revenues) versus open procedures that There are nuanced differences in do not constrain budget amend- the terminology and findings of vari- ments. An intermediate arrangement ous empirical studies, but inasmuch as would permit amendments increasing they all point in the same direction, spending provided that overall bal- there are not significant; overall, the ance is maintained by requiring off- findings justify the conclusion that a setting cuts in other expenditures. In government bent on enforcing aggre- open systems, legislative amendments gate discipline must do more than are not matters of confidence; in merely establish fiscal limits. restrictive systems, they may be. Given the localized political base of Roles most national legislatures, it is highly Budget rules are not self-enforcing. likely that open rules would encour- The fact that a government restricts age amendments that increase total certain actions that would weaken dis- Managing Public Expenditure in Developing Countries 65 cipline does not mean that it follows override the targets when politicians or the rules when they become so con- sectoral interests regard them as too straining as to prevent a political constrictive. There is good reason to majority from getting its way. Except believe that enforcing fiscal discipline when they are inscribed in the consti- depends on the strength of the finance tution or in some superior law that ministry and its budget unit vis-à-vis cannot be changed by majority vote, other government entities. In general, restrictive rules can be brushed aside. the relative strength of the budget The same politicians who make the office is enhanced when it is located in rules can break them. a finance ministry that has broad gov- Why, then, don’t politicians ernmental powers. Germany and change or breach the rules when they Japan, for example, have powerful, prove to be too constrictive? Why do encompassing finance ministries; over rules make a difference at all? Part of the full post-war period, they have the answer is that once budgetary rules been among the most successful in are in place, politicians may pay a price maintaining aggregate fiscal discipline. for violating them. The rules change The German Finance Minister may be the incentives of politicians. Another overruled by the Cabinet only when part of the answer is that rules work the Chancellor sides against him; when they have enforcers, that is, Japan’s Finance Ministry has had politicians and officials at the center of extensive regulatory powers extending government who have the will and the to financial institutions, securities, and authority to maintain adherence to the other sectors, in addition to its power- rules. ful role in revenue and spending poli- In virtually all countries, budget cy. But even in these countries, fiscal enforcement is centered in the finance discipline has been undermined: in ministry or the central budget organi- Germany, by spending pressures fol- zation. This unit has the lead role in lowing unification; in Japan, by the maintaining aggregate discipline; it deepest recession since World War II. must be strong enough to withstand The targeting process and the pressures to evade spending targets by changed composition of public expen- removing some transactions from the ditures have affected the manner in budget or through other ploys, and to which the central budgeting organiza- 66 A Contemporary Approach to Public Expenditure Management tion maintains fiscal control. In classi- exchange for firm limits on the total cal budgeting, the budget office each may spend. This quid pro quo reviewed detailed bids for resources may promote allocative and opera- and recommended the amounts that tional efficiency, two key objectives of should be made available. It also public expenditure management, in policed implementation of the budget addition to enhancing aggregate to ensure that public funds were spent spending discipline. only on approved items and that the The United Kingdom and amounts spent did not exceed author- Australia are among the countries ized levels. In this model, controlling that have vigorously moved in this the totals was a byproduct of control- direction. Following a “fundamental ling the items. The budget office pre- expenditure review” of its operations sumed that total spending could not in 1994, the U.K. Treasury staff was be controlled unless the individual reduced by about one-quarter as it items were. Contemporary fiscal disci- withdrew from various itemized con- pline is moving in the opposite direc- trols that had been maintained for a tion. It emphasizes that the totals should century or longer, and sharpened its be controlled independently from the focus on macro-budgeting. In parts; disciplining the totals must be a Australia, the Department of Finance central responsibility; responsibility for introduced running cost arrange- spending items can be devolved to sec- ments that give departments control toral ministries or operational entities. over operating resources in exchange In some countries, the budget for tighter controls over total spend- organization has disengaged from the ing and portfolio allocations. In these items of expenditure and has taken the and other countries, the central position that it can more effectively budget office has devolved control constrain the totals by concentrating over administrative expenditure on subaggregates, such as departmen- while strengthening aggregate spend- tal running costs or total resources ing discipline. allocated to each portfolio. The central Spending controllers deal as much budget office may be willing to con- with assumptions as with hard data. cede discretion over the spending The typical budget baseline is com- items to various departments in posed by making assumptions con- Managing Public Expenditure in Developing Countries 67 cerning future prices, program work- these and other devices. Ironically, as loads, and other factors affecting fiscal norms become tougher and expenditure levels. Estimates of the more constrictive, budget claimants spending impacts of program initia- have greater incentive to evade them. tives and legislative actions rely on Over the medium-term or longer, similar assumptions. One of the criti- budget guardians will not be able to cal tasks of public expenditure man- uphold fiscal discipline unless they agement is ensuring that actual spend- have steadfast political support. ing does not deviate significantly from Politicians need incentives for buy- projected levels. This is a difficult task ing into fiscal discipline. They must which depends on government capaci- have actual or expected gains, such as ty to accurately measure the assump- success at the polls, acclaim in the tions that drive its budget projections. media, or the conviction that they are doing the right thing. But incentives Building Support for Fiscal are not a one-way street; for every Discipline gain that accrues to politicians from Budget controllers cannot maintain exercising constraint comes the cost fiscal discipline if they stand alone of cutting programs, raising taxes, or without strong allies in government. rebuffing claims on the budget. These They need both political allies who costs must be manageable and (in accept the political risks of constrain- some political calculus) less than the ing public expenditures, and manage- expected gains. Costs are made man- rial allies who accept the imperative of ageable by having realistic targets, operating within agreed constraints. spreading the constraints over a peri- It is unlikely that they will win every od of years, softening the aggregate battle against wily and politically targets, controlling net spending potent spenders whose weapons (total spending minus income from include proposals that hide the true user charges or other earmarked rev- cost of policy initiatives, resort to enues) rather than gross spending, extrabudgetary funds, and bookkeep- and allowing relatively minor over- ing arrangements that underestimate shoots of the target. The common ele- budgetary impacts. Under PEM, it is ment in these approaches is that necessary to guard the budget against aggregate fiscal discipline may be 68 A Contemporary Approach to Public Expenditure Management stronger when the constraints are a bit comes unless they are reinforced by more accommodating. external constraints. Anyone who has managed public Opportunistic Budgeting expenditure has encountered oppor- Having appropriate budgetary institu- tunistic behavior by politicians cater- tions may be a necessary condition for ing to voter preferences or by managers disciplining the aggregates, but it is who want bigger budgets to carry out not always sufficient. Aggregate fiscal their responsibilities. The catalog of outcomes can be driven off target by opportunistic budget tactics includes: exogenous factors that are weakly con- under-estimating or hiding the costs of trolled by the government, if at all, or programs; selling assets and booking by endogenous factors such as oppor- the income as current revenue; shifting tunistic behavior by politicians and payments back to the previous fiscal other budget makers. Exogenous con- year or forward to the next; miscoding ditions are considered in the next sec- accounts so that money provided for tion; this section deals with oppor- one purpose is spent on another; pay- tunism that is stimulated by the very ing liabilities with chits rather than rules that purport to restrain politi- with cash; accelerating tax collections; cians and others. disregarding the liabilities of state- Opportunism is rife in budget- owned enterprises in budget state- ing, as in other economic transac- ments; transferring balances in state- tions. Opportunism is self-interested owned enterprises to government behavior that undermines budgetary accounts; and labeling current expen- constraints. Politicians may want to ditures as capital investments. A 1997 run smaller deficits, but they also IMF working paper identifies 28 types want to spend more and tax less. of opportunistic revenue and expendi- When rules try to prevent them from ture actions that might be used by doing the latter, they opportunisti- European Community countries to cally seek ways to evade or disable show compliance with the Maastricht the rules. Without opportunism, deficit and debt rules. there would be no need for strong When budgetary opportunism is rules; with opportunism, the rules carried out on a small scale, perhaps might not yield the intended out- nothing needs to be done to stanch Managing Public Expenditure in Developing Countries 69 it, especially if the rules strengthen dampen opportunism by enabling aggregate discipline. Suppose, for one branch to block the actions of example, that in response to constric- the other, or to call public attention tive rules, the government reduces to the misbehavior. In presidential the deficit, mostly by cutting pension systems, an independent legislature benefits and in a small part by defer- can check executive actions; in parlia- ring some payments to pension mentary regimes, the legislature can funds. In this case, the rules have have an effective watchdog role, even constrained expenditure, even though it is not fully independent. In though full compliance is lacking. the United Kingdom, the nonparti- Arguably, the government should set- san Public Accounts Committee has tle for the real deficit reduction it has played this role in recent decades; it achieved without taking further steps has been joined by an array of stand- to tighten the rules. On the other ing committees which oversee and hand, a case can be made for tougher sometimes influence government enforcement on the grounds that this actions. An independent central bank small breach might well turn into a also can check budgetary oppor- much larger one as opportunists tunism, provided that it enjoys suffi- become emboldened to devise bigger cient public esteem so that its voice evasions. can be heard above the din of politi- Opportunists cannot be relied on cal debate. to curb their self-interest. More rules, It is doubtful, however, that inter- or clearer specification of their terms, nal constraints suffice when willful might help somewhat, but as contract opportunists seek to twist ambiguities law demonstrates, rules alone do not or gaps in budget rules to their advan- put an end to opportunism. What is tage. In president-centered countries required is that the rules be accompa- the two branches often collude rather nied by strong enforcement mecha- than check one another; in parliamen- nisms. In some countries, the tary systems, legislative committees Finance Ministry plays this role, in often behave as sleepy watchdogs. In others the supreme audit authority all countries, it is rare that the central does. The checks and balances built bank challenges the actions of oppor- into democratic political systems can tunistic politicians. 70 A Contemporary Approach to Public Expenditure Management

External Constraints financial markets contribute to aggre- It may be appropriate, therefore, to gate discipline by penalizing countries supplement the internal controls for fiscal mismanagement. Open mar- with external constraints on budget- kets allow investors to swiftly with- ary opportunism. Constraints can be draw capital whenever they fear that a imposed by outside entities which large deficit might generate inflation monitor a government’s performance, and devaluation. Moreover, investors by financial markets which punish demand higher interest rates as a pre- imprudent budget policies, or by the mium for taking the risk of placing accounting profession which promul- funds in the country. In general, gates standards and polices compli- Campos and Pradhan conclude, the ance. These and other external con- more open its financial markets, the straints are effective only when they smaller a country’s fiscal deficit will be. are underpinned by transparent It may be the case that budgetary budgets which provide reasonably opportunists will devise means of hid- accurate and complete information ing their tricks from vigilant finan- on public finances. ciers, but if they do so, the reactions In the wake of the EMU’s enforce- that ensue when the legerdemain is ment of the Maastricht norms, one can revealed will punish the offending expect the role of international organi- country even more. zations in overseeing budgetary poli- Financial markets work well when cies and outcomes to increase. This budget documents and financial state- role has long been played by the World ments are transparent. But without Bank and IMF in enforcing condition- robust accounting standards and atten- alities on loans and other forms of tive auditors and other monitors, assistance. In many instances, however, transparency can be more of slogan international enforcers have been than a reality. As financial markets locked in a cat-and-mouse relationship have become more closely interlinked, with the recipient country, in which and outside institutions have become tough conditions have generated eva- more involved, significant steps have sive responses. been taken to elaborate and harmonize There is some evidence (presented accounting standards across countries. by Campos and Pradhan) that open These steps have been spurred by Managing Public Expenditure in Developing Countries 71 efforts to discourage various types of There are degrees of hardness in fiscal opportunism. fiscal constraints, as there are in all In the future, pressure will increase political decisions. To say that con- to impose these standards on budget- straints cannot be maintained in all ary documents, not only on financial circumstances does not mean that they statements. Moreover, rules will be can be enforced in none. One of aggre- elaborated for the assumptions that gate fiscal discipline’s valuable contri- underlie budget projections and for butions to public finance may be to estimating the impact of policy encourage the adoption of policies that changes on future budgets. The budg- reduce the budget’s exposure to exter- et will be a battleground between nal disturbances and thereby enable opportunistic politicians and vigilant governments to attain more rather guardians. than less of their fiscal objectives. Doing so depends on the capacity of How Hard Are the governments to design policies and Constraints? Entitlements, programs in ways that limit risk before Risks, Cycles and Shocks external circumstances force their Aggregate fiscal discipline is predi- hand. Remedial action almost always is cated on the notion that govern- too late when it is taken at the point of ments are the masters of their budg- crisis or when the only acceptable etary fate. It assumes that they can options are those that would breach chart a fiscal course and can enforce fiscal discipline. hard constraints regardless of the Government budgets face four conditions under which their budg- types of “bad news” that vitiate fiscal ets are formulated and implemented. constraint: (1) the unbudgeted, In reality, however, governments unwanted, or unaffordable costs of often have weak control over the eco- open-ended entitlements; (2) contin- nomic and political circumstances in gent liabilities incurred in one fiscal which they operate. If the fiscal period that become payable in a later impact is big enough, exogenous (sometimes much later) period; (3) changes can dislodge even the most cyclical weakness in the economy that obdurate government from its imbalances the budget; and (4) big intended fiscal course. shocks that jar government from its 72 A Contemporary Approach to Public Expenditure Management intended course and destabilize the appropriations; the amount provided budget. The four sets of conditions are each year determines what is available sequenced from those over which gov- for expenditure. Entitlements, howev- ernment has most fiscal control to er, typically are open-ended; there is no those over which it has the least. A gov- fixed limit on the amount to be spent. ernment can opt not to establish cer- Moreover, the volume of expenditure tain entitlements and can hedge against is determined by permanent law rather contingent obligations, but it may be than by annual appropriations. For unable to avoid the adverse budgetary many entitlements, the budget typical- impact of an economic downturn or ly accounts for the amounts to be the shocks resulting from major spent; for consumption and invest- upheavals, such as the onset of war. ment programs, the budget decides the The four categories are closely amount to be spent. linked. A government that spends Spending on annual entitlements much of its budget on entitlements is often is driven by exogenous factors, likely to be more affected by cyclical particularly economic and social condi- downturns than one that does not; a tions, not by explicit budget actions. government that indemnifies firms or The effective decisions were taken years households for fiscal risks will be more or decades earlier when the entitlement exposed to political or financial shocks was established (or expanded) and than one which adopts risk-averse poli- when eligibility criteria and payment cies. Despite these and other intercon- formulas were enacted. Because of nections, discussing each category on these characteristics, entitlements its own sheds light on the problems undermine both short-term fiscal disci- contemporary governments face in pline and the long-term capacity of maintaining fiscal discipline. government to stabilize its financial condition. In the short run, it may be Entitlements difficult for the government to accu- It generally is more difficult to enforce rately estimate the amounts to be spent constraints on entitlements than on or to buffer the budget from unantici- consumption or investment expendi- pated (or unwanted) swings in eco- ture. The latter usually are definite in nomic conditions. In the long run, the amount and are controlled by annual budgets of many countries will be Managing Public Expenditure in Developing Countries 73 exposed to the fiscal consequences of on the beneficiaries’ rights by borrow- an aging population, especially in their ing or “printing” the needed funds. pension and health sectors. Even when The best time to control entitle- short-term fiscal policies are affordable, ments is before they have been estab- they may become unsustainable as the lished. Beyond this point, the gov- dependent population rises and entitle- ernment can exercise fiscal control ments take a larger share of the budget. only by taking away previously con- Entitlements suffer from a costly ferred benefits. This is in sharp con- variant of the “common resource pool” trast to the politically expedient problem that drives total public spend- function of the budget—to distrib- ing upward, in many cases to unsus- ute benefits. Inasmuch as “taking tainable levels. In the standard com- from” is much more difficult than mon pool situation, each “taker” acts “giving to”, when a government enti- alone or logrolls with others to draw tles others, it inevitably weakens fis- resources from the pool. The takings cal self-discipline. are individualized; what one gets, oth- Developing (and some transition- ers do not. In entitlements, however, al) countries generally have small enti- the takings are mutual; one gets tlement budgets. But as they progress because others also get. All get even if and economic conditions improve, they do not logroll or actively stake a these governments tend to follow the claim to the pooled resources because path taken by the developed world: entitlements confer broad rights to they introduce or enhance pension beneficiaries. These rights are not schemes, improve citizen access to diminished by the government’s inabil- health care, provide financial assistance ity or unwillingness to pay, or by other to the disabled and unemployed, and claims on the budget. In the com- so on. Transitional countries may face mons, when the pool is depleted, pressure for broadened entitlements nobody takes because there is nothing early in their embrace of market-ori- left. In entitlement programs, however, ented democracy, as they seek to cush- beneficiaries continue to get, even ion households against the economic when the government’s revenues have hardships caused by the end of sub- been depleted. When it runs out of sides, rising prices, and the privatiza- money, the government makes good tion or closing of state enterprises. 74 A Contemporary Approach to Public Expenditure Management

Ideally, developing and transitional was inscribed in law. Although devel- leaders should be cautious in taking on oped countries have had few success new fiscal burdens, because the entitle- stories in disciplining their entitlement ments established to ease the transition budgets, some have tried and an or in response to real improvement in increasing number can be expected to economic well-being will draw scarce make the effort in the years ahead. funds from the public treasury for Efforts along these lines are likely, for if many years to come. entitlements are not effectively con- During the past two decades, most trolled by the time that the financial industrial democracies have been implications of an aging population reluctant to create or expand entitle- impacts national budgets, supposedly ments. They have been wary of adding hard constraints on aggregate spending entitlements because their national will turn out to be very soft. budgets have been strained by chronic Table 3.1 lists some of the deficits. A few have adopted formal approaches that may be taken by gov- rules that bar new entitlements that ernments bent on strengthening fiscal would add to the deficit. Since 1990, discipline. They range from options for example, the United States which disentitle current or future ben- Government has enforced a pay-as- eficiaries to those which retain the basic you-go rule that has made it difficult structure of entitlements but save to expand entitlements. Under the money by making marginal adjust- rule, legislation that increases entitle- ments in payments or eligibility rules. ment spending must be offset by cut- Disentitling is the boldest approach, backs in other entitlements or by rev- but politically the most difficult. It can enue increases. The rule is enforced be accomplished by terminating legal through a multi-year expenditure base- rights and making payments depend- line that provides Congress and the ent on discretionary appropriations. President timely information on the Alternatively, the government can con- projected costs of new entitlements. vert certain entitlements into private Most formal and informal efforts schemes, thereby reducing its fiscal lia- to constrain entitlements have come bility. For example, some countries only recently, after the costly frame- have been influenced by Chile’s social work of existing entitlements already security reform to create a two-tier sys- Managing Public Expenditure in Developing Countries 75

Table 3.1: Controlling the Costs of Entitlements

Msethod Asdvantage Disadvantage

Disentitlement. Spending would be Would reduce Terminate legal rights to subject to budget government's role in payment and decide decisions, and would stabilizing and amount (if any) to be paid depend on government's redistributing income, and through annual ability to pay. impair its ability to protect appropriations. citizens against recession, aging, illness, and other adversities. Voluntary Opt-out. Market incentives would Risk of adverse selection, Citizens may withdraw favor most efficient plans, with most vulnerate from certain entitlements while reducing financial persons remaining in by enrolling in private risk to government. government programs. insurance schemes. Government would have moral (or legal) obligation if private plans failed. Capped Entitlements. Entitlements would have Dependent populations Total entitlement spending to compete against other would be adversely (or spending on a claims on the budget. affected. Moreover, particular program) Spending in excess of enforcing the caps might would be limited. budgeted amount would be impractical for political Spending above the limit not be automatic or open- or technical reasons. would require an express ended. decision by the Government or legislature. Disindexation. Payment increases would Real value of payments Payments would be fixed, not be automatic and would be eroded by adjustments for inflation could be made in the light inflation, with greatest would require of the Government's impact likely on low- Government or budget condition. income recipients. parliamentary action. Targeted Scarce resources would Public support for certain entitlements. go to most need entitlements would be Payments would be recipients, thereby undermined, as would the means-tested; they would reducing cost to concept of universal no longer be universal. government. benefits. Tax benefits. Effect would be similar to Marginal tax rates would Payments would be targeting, but might be be very high for some universal, but would be politically easier to recipients, discouraging subject to income implement. them from income- taxation. earning activity. 76 A Contemporary Approach to Public Expenditure Management tem in which only a portion of pen- and it means-tests the value of entitle- sions are financed through the public ments through the tax system. budget. One tier is a defined benefit In striving for aggregate fiscal disci- plan in which the government guaran- pline, some governments might limit the tees a minimum payment to all partic- amount paid out each year. Entitlement ipants; the other tier is a defined con- programs would be cash-limited, just as tribution plan in which the amount running costs and other payments are in paid out depends on the performance some countries. In enforcing the limits, of each participant’s pension account. the government might prescribe pro rata The shift from defined benefits to reductions in transfer payments or (in defined contributions also can occur programs such as health care) in fees to within a wholly-public pension system. providers. Alternatively, if the limit were While drastic restructuring of breached, the government would be entitlements may be feasible in some required to take an explicit decision to countries, others are likely to settle for raise the limits or to make some other marginal reforms. One option is to adjustments that would hold spending trim entitlement spending by target- to the preset ceiling. ing payments to lower-income indi- In imposing fiscal discipline on viduals or by reducing the real value entitlement budgets, governments of the benefits. Australia has taken the must be mindful of the risks entailed first path, limiting some transfer pay- in weakening or disabling built-in sta- ments to low-income households; the bilizers and in adverse impacts on Netherlands has taken the second dependent persons. As important as it path, reducing the percentage of is, fiscal discipline is not the only wages replaced by unemployment financial objective of governments. benefits and other schemes. Still Many also seek to protect citizens another approach is to trim entitle- made dependent by age, unemploy- ments indirectly, by taxing benefits as ment, or other economic circum- if they were ordinary income. This stances, and they seek to counter the tactic has two advantages: it enables adverse effects of recessions and infla- the government to retain universal tion. Doing these things entails benefits, which are (in some coun- income support and stabilization tries) a hallmark of the welfare state; through entitlement programs. Managing Public Expenditure in Developing Countries 77

Table 3.2: Issues in Managing Financial Risks

In All Countries

1. Moral Hazard Persons/firms take undue risks when losses are compensated by the Government.

2. Lack of Transparency In cash budgeting, the cost to Government is not accounted for until payment is made.

3. Lack of Information Government usually does not know the extent of its contingent liabilities and other risks, the probability of the contingency occurring or the prospective cost. 4. Lack of Budgetary Control Funds are allocated after the contingency has occurred, too late for the government to effectively control the amount it spends.

Developing/Transitional Countries

5. Underdeveloped Insurance Government often assumes risk because the Market private insurance system is under-developed.

6. Efforts to Privatize To encourage investors (or to obtain a higher Enterprises price) the Government may provide explicit or implicit guarantees to purchasers of state-owned enterprises. 7. Inadequate Regulation During transition or development, there may be a tendency to under-regulate financial institutions (and other risk takers) either because of cozy relationships between politicians (or bureaucrats) and the institutions, or because of failure to appreciate the need for robust, arms-length regulation. 8r. Risky Behavior There may be a tendency for risky behavio during early stages of market development, encouraged by inadequate regulation and lack of instruments to assess and manage risk. 9. Concentrated Risk Because markets are under-developed, risk may be concentrated in a small number of enterprises or risk takers, making it difficult for the government to assess or control the risks. 78 A Contemporary Approach to Public Expenditure Management

Although entitlements will contin- suffice for operating expenditures as ue to be the most prominent part of well as for most transfer payments and national budgets, it is highly probable public investments; it is not adequate that no later than the second decade of for transactions in which the govern- the next century, most developed ment is obligated to make a future countries will take significant measure payment if certain contingencies to curtail transfer payments. Many of occur. Cash-based budgeting fails to these efforts will be controversial; some record the government’s contingent will cause the downfall of govern- risk at the time it is incurred. It does ments; all will require strong political account for any subsequent payments, leadership. but at this point it is too late for the Developing and transitional coun- government to effectively control the tries would do well to study the expe- expenditures it must make in fulfill- riences of more economically advanced ment of its contingent liability. In fact, countries before they assume the enor- when the government charges an orig- mous financial risks inherent in an ination fee for providing guarantees, entitlements culture. To a far greater the cash budget records this income as extent than happened in the developed revenue, but it does not show the gov- world, they have the opportunity to ernment’s potential exposure to future explore market-type instruments for payments. Of course, if default (or protecting citizens against the risks of some other contingency) were to economic distress. occur the cash budget would account for any payments, but these amounts Contingent Fiscal Risks would be “uncontrollable” obliga- The conventional tools of government tions. The government would not budgeting have been designed to man- strengthen control of expenditure it is age cash flows; they generally have not obligated to make in fulfillment of its been applied to contingent liabilities contingent liability just by recording and similar fiscal risks. With few the amount paid in the budget. The exceptions, governments account for appropriate time for constraining fis- revenue when money is received and cal risks is when they are incurred; at for outlays when money is paid. This that point, however, the government form of budgetary accounting may typically is unaware of the full cost of Managing Public Expenditure in Developing Countries 79

Table 3.3: Controlling Contingent Liabilities and Other Fiscal Risks

Msethod Advantages/Disadvantage Market Solutions 1. Government marketizes risk by selling Formal exposure to risk is reduced, but state-owned enterprises, withdrawing government may still have moral guarantees from financial institutions and obligation to indemnify private risk-takers, other entities, and refusing to indemnify especially in developing and transitional losers in market transactions. countries where markets are fragile. 2. Government purchases re-insurance Reinsurance limits fiscal risk, and informs that covers all or a portion of its fiscal risk. the government of the cost of the risk it is In developing and transitional countries, taking. But the cost of reinsurance is likely reinsurance would likely be purchased to be quite high, and the government may from multinational insurers, not from be unwilling or unable to finance it in the domestic firms. budget. 3. Government charges risk-based These premiums would discourage some premiums which transfer the costs from risk-takers from seeking government taxpayers to risk-takers or beneficiaries. protection, but they may also reduce These charges may include origination productive risk-taking needed to develop fees or annual service charges. the economy. 4. Government insures last rather than Risk is shared by government and risk- first loss by having high deductibles that takers. But government may be pressed to are risk-based or adjusted for different cover first loss, especially when failure to types of risk-takers (e.g. households, firms, do so injures households or the economy. types of firms, sectors, etc.). Public Solutions 5. Government budget includes estimated Cost of risk is transparent, but it may be costs as an expenditure, in effect setting difficult to make reliable estimates, aside a reserve for future payments. especially in developing and transitional countries where experience with similar risks is limited. 6. Government records estimated risk on Government's financial condition reflects financial statements, such as the balance contingent liabilities and other risks. But sheet or statement of contingent liabilities. few countries (even developed ones) publish comprehensive financial statements. the liabilities to which it is exposed. appear that the government is profit- Matters are made worse by the prac- ing from taking the risks, when, in tice of booking up-front origination fact, it often incurs heavy losses. fees as current revenue. This makes it Contingent liabilities come in 80 A Contemporary Approach to Public Expenditure Management many forms and just about every exchange rate fluctuations; depositors national government has them. Hana against bank failures; entrepreneurs Polackova of the World Bank has against losses; investors against default; mapped out different types of risks and and so on. Because of the inadequacies the measures governments might take of cash accounting, the extent and to control them. For the present dis- magnitude of contingent commit- cussion, the most relevant risks are ments rarely are fully documented. In contingent liabilities that require the United States, the General future payment if a certain event, such Accounting Office has estimated that as default or natural disaster, occurs. by 1995, the federal government had Many contingent liabilities are explic- accumulated $5 trillion in insurance itly recognized in law, contract or other commitments, an amount equal to formal commitment; others arise out three years budget outlays. With of the “moral obligation” of the gov- implicit guarantees and other types of ernment to assist those who have suf- contingent liabilities added in, the fered financial loss, or form the expec- total might be considerably higher. tation that it will provide such assis- When government indemnifies tance. Obviously, the government losers, it spurs risk takers to behave in knows less about these informal risks a morally hazardous manner by taking than about explicit contingencies, yet risks they would avoid if they had to the potential cost may be greater. In bear the full cost of their actions. fact, the expectation that the govern- Moral hazard is widespread in govern- ment will act may escalate as the losses ment-insured programs: depositors increase. For example, if a small bank seeking the higher yields offered by fails, the government may opt to do weak financial institutions; homeown- nothing, but when a large bank fails, ers building in flood-prone areas; the government may be impelled to act bankers lending to high-risk borrow- in order to stabilize financial markets ers; exporters not hedging against cur- and restore public confidence. rency rate fluctuations; and much The list of contingent liabilities is more. The common element in moral lengthy. It includes: indemnifying hazard is that risk takers need be con- farmers against crop losses; homeown- cerned only about the adequacy of the ers against floods; exporters against government’s commitment, not about Managing Public Expenditure in Developing Countries 81 the riskiness of their actions. As a con- rule and do not yet appreciate how sequence, risks escalate, along with the sound regulation contributes to eco- cost to government. nomic development; in less developed Developing and transitional countries because weak or poor gov- economies are especially prone to shift- ernments lack the will or resources to ing risk to government. Table 3.2 item- regulate powerful interests, or because izes some of the reasons why govern- cozy relationships with these interests ment in these countries expose them- deter them from doing so. selves to costly contingencies. One of Contingent liabilities can best be the main reasons is that private insur- managed when there are many risk ance usually is unavailable or inade- takers, each of whom takes a small risk. quate during the early stages of transi- The classic case is of homeowners who tion or development, leaving investors, obtain mortgages insured by the gov- entrepreneurs, lenders, and other with ernment. Because there are many bor- little recourse but to seek risk protec- rowers, the risk is pooled, government tion from government. can charge each homeowner a risk- In many instances, the government based premium, so that when some is the insurer of last resort. If it fails to borrowers default, premium revenue accept the risk, economic development covers all or part of the cost. In transi- would be retarded. Moreover, in priva- tional and developing countries, how- tizing state enterprises, the govern- ever, risk tends to be concentrated: a ment may be impelled to guarantee small number of big risk-takers (finan- minimum financial results, either to cial institutions, conglomerates, etc.) obtain a higher sales price or to enable take a very large part of the risk. When the enterprise to continue as a going this occurs, it is hard to estimate the concern. The government’s exposure risk faced by government and harder to risk may also increase because of the yet to charge risk-based premiums. tendency during the early stages of Matters are further complicated when development to under-regulate finan- cozy relations and deficient accounting cial institutions; in transitional coun- practices spur financial institutions to tries because the new democratic extend credit to failing enterprises. regimes have dismantled the regulato- To maintain fiscal discipline, gov- ry systems imposed during communist ernments must control their contin- 82 A Contemporary Approach to Public Expenditure Management gent liabilities. Table 3.3 divides con- wait until contingencies occur before trol mechanisms into those that rely on paying the cost. Reinsurance would be market decisions and those dependent priced by the market, and would be on government action. Market-based expensed at the time it was purchased. solutions withdraw government from Up front costing would likely dampen indemnifying losers or require risk-tak- the willingness of government to ers to pay the cost of government-pro- assume the risk, and might induce it to vided insurance. Market solutions gen- require risk-takers to share a portion of erally are favored in developed coun- the cost. Another approach to sharing tries, for despite the extensive govern- risk is to impose high deductibles on ment exposure most economic risk is government-insured transactions. insured by private institutions. Government-based remedies Although this approach might not yet would have the government undertake be appropriate for developing or tran- contingent liabilities, but these would sitional countries that have inadequate be itemized in the budget or in finan- private insurance systems, it would be cial statements. Future costs would be sensible for governments in these estimated, using accounting principles countries to avoid policies that would devised for this purpose. This retard the development of private approach has been adopted by New insurance. As long as government is Zealand which lists all quantifiable and the insurer of first resort, the market non-quantifiable contingent liabilities for private insurance will remain in its consolidated financial state- underdeveloped, and risk-takers will ments. Notes to the statements esti- behave in morally-hazardous ways that mate future pension liabilities, risk in overburden government finance. managing debt and foreign currency, Another market-based solution and certain other liabilities. The would be for government to purchase United States has taken a different reinsurance when it enters into a con- approach. It expenses the net discount- tingent commitment. A big advantage ed cost of all estimated future cash of this approach is that the total cost flows (inflows and outflows) of each would be transparent, the government guaranteed loan program in the budg- would not have to rely on estimates of et. Although the same methodology future liability, nor would it have to can be applied to other contingent lia- Managing Public Expenditure in Developing Countries 83 bilities, thus far the U.S. Government (tax cuts or spending increases) that has used it only for loan guarantees. enlarged the budget deficit. It was fashionable at the time to distinguish Economic Cycles between cyclical and structural deficits, A government is most likely to be and to assume that cyclical imbalances exposed to the costs of contingent lia- would fade away once growth resumed bilities when the economy is weak, and government revenues rose. Various financial institutions are in trouble, fiscal measures were devised to distin- and its currency is losing value. During guish between the two types of deficits these periods, the government may and to calculate the appropriate size of have to prop up or take over insolvent the deficit. banks, make good on exchange rate Few developed countries actively guarantees, assist failing enterprises, manage the economy this way any- and take other actions that add signifi- more. Most have found that the added cantly to public expenditure. This is costs (such as higher interest payments not the most propitious time for con- due to increased spending on public tingent liabilities to come due, because works or income support) approved it also is a period during which rev- when the economy is weak continue to enues are declining (or not growing as burden the budget when the economy robustly as hoped for) and the budget recovers. This concern has been deficit is rising. heightened by lower growth rates dur- Can a government maintain fiscal ing the past two decades than were discipline under these adverse condi- experienced during the postwar boom tions? Judging from experience in years. Further, fiscal policy also has developed countries over the past two been influenced by changes in eco- decades, the answer is yes and no. Yes, nomic theory, such as the rational in terms of discretionary fiscal stimu- expectations argument that because lus; no, in terms of the impact of built- government intervention during peri- in stabilizers on key budget aggregates. ods of weakness is expected, it fails to Prior to the oil shocks and lower produce the intended effects. growth in the 1970s and early 1980s, But if discretionary action is out of many developed countries intervened style, built-in stabilizers still do their to stimulate recovery by taking actions work. An automatic drop in revenue or 84 A Contemporary Approach to Public Expenditure Management rise in transfer payments can produce economies, these countries may have large, unplanned deficits. A govern- to constrain public spending in the ment can try to stay on its fiscal course hope that fiscal discipline will be by raising taxes or curtailing benefits, rewarded by long-term improvement but it generally is inopportune to do so in economic conditions. when the economy is stagnant. Countries that tighten fiscal discipline Shocks in these circumstances may unwitting- These disturbances are far more desta- ly prolong and deepen the recession bilizing than those caused by a cyclical without achieving their budget targets. downturn; they jar a government off Japan may be a contemporary case in its fiscal course and force structural point. During a protracted slump, it changes in public policy. The primary ended temporary income tax relief, cause might be the onset of war or the boosted consumption taxes, and cur- collapse of political order, but the tailed supplemental public works pro- budget is deeply affected. The unifica- grams. It acted in this manner because tion of Germany began as a bold polit- policy elites were more concerned ical decision, but has left a legacy of about the long-run unsustainability of unplanned deficits and rising public fiscal imbalances in the face of a rapid- debt. In developing countries, a severe ly aging population than about short- drop in commodity prices or a sudden term economic distress. capital outflow can make it impossible Developing and transitional coun- for the government to abide by agreed tries also face unstable budgets during fiscal policy. In transitional countries, economic difficulty. But they also risk the collapse or inefficient enterprises capital flight, a run on their currency, and difficulty in implementing a new illiquid financial institutions, and tax system can have enormous impacts political instability. These countries on the budget. may be compelled to adopt stringent In dealing with shocks, as with budget policies as a condition of cyclical downturns, it is important to receiving international assistance or to distinguish between fiscal balance and restore investor confidence. To the fiscal discipline. Losing the former extent they are dependent on capital may be unavoidable; but the latter can inflows to stabilize or develop their be maintained even under stressful Managing Public Expenditure in Developing Countries 85 conditions. Obviously, a government effort has left it in sturdier condition will be compelled to alter its fiscal tar- than if it had not tried. gets when shocks register on its budget accounts. But this does not mean that Summing Up: the Basic fiscal discipline also is abandoned. It is Elements of Aggregate when things seem to be falling apart Fiscal Discipline that a disciplined approach to public Maintaining aggregate fiscal discipline spending may be most urgent. requires changes in budgetary institu- Constraining expenditures will not tions to establish and enforce spending produce fiscal balance, nor will it constraints. The following are promi- enable the government to achieve pre- nent elements of systems used in vari- shock targets. But it will moderate and ous countries. shorten the after effects of shocks on political or economic order. •TARGETS SHOULD REFLECT Germany’s response to unifica- POLITICAL COMMITMENTS MADE tion illustrates how fiscal discipline BY POLITICAL LEADERS can be maintained in the face of Selecting the appropriate fiscal con- severe budgetary shocks. To rebuild straints is a key political responsibility of the Eastern sector, the government government. Developing appropriate far exceeded expenditure plans, but targets must engage major political it did raise taxes to finance a signifi- actors—the head of government, cant portion of the added cost and it Cabinet, in some cases party leaders, did constrain other portions of the and, (in coalition governments) an budget. Despite these moves, the agreement among the governing parties. government failed to achieve revised If politicians are not involved in agree- fiscal targets because it underestimat- ing the targets, they cannot be expected ed the cost of unification and faced a to take steps necessary to implement shortfall in economic performance. them. Even when the targets are exter- When shocks occur, it may be nally imposed, as in the case of the impossible to foresee the full cost at European Monetary Union and IMF the outset or to make all appropriate conditionalities, achieving them adjustments in government policy. depends on political commitment and But the fact that Germany made the action in the affected country. 86 A Contemporary Approach to Public Expenditure Management

•TARGETS MUST BE REALISTIC AND spending or the deficit typically ACHIEVABLE requires implementing action over sev- If they are not, the targets will either be eral years. A multi-year framework can ignored or induce politicians to dis- establish milestones along the way semble and conceal the true condition toward full implementation. Second, it of the budget. In the mid-1980s, both is easy to evade fiscal discipline when the United States and Australia estab- the targets pertain only to the current lished aggregate fiscal targets, the for- or the next financial year. Spending or mer through a statutory limit on the revenue actions can be accelerated or size of the deficit, the latter through a delayed, depending on the year for trilogy policy that prescribed reduc- which the budget outcome has to be tions in taxes, spending, and the made to seem more favorable than it deficit. The American targets were actually is. Assets can be sold, new breached in every year (1986-90) that spending can be scheduled to take they were in effect; Australia, by con- effect in the future, nonrecurring rev- trast, had significant (though not last- enue sources can be exploited. Evasion ing) success in constraining the aggre- also is possible in a medium-term gates. Australia’s targets were achiev- framework, but the incentive and able, the American targets were not. opportunity to manipulate the num- However, achievable, does not mean bers is lessened. without constraint. Fiscal norms must be The typical framework includes constrictive, for if they merely accommo- projections of future budget aggregates date demands on the budget, there would and the main subaggregates, a baseline be no gain in having them. Targets must that reflects authorized spending and discipline the fiscal aggregates, that is, revenue for the medium-term, proce- they must result in lower deficits and less dures for estimating the fiscal impact spending than would otherwise occur. of policy changes, accounting rules for enforcing fiscal discipline, and a •A MEDIUM-TERM FRAMEWORK FOR process for establishing budget con- SETTING AND ENFORCING THE straints. Developing and operating this BUDGET AGGREGATES medium-term framework becomes the The medium-term is appropriate for major responsibility of the central several reasons. First, constraining total budget office. As aggregate fiscal disci- Managing Public Expenditure in Developing Countries 87 pline matures, annual budgets are for- various spending items, advance deter- mulated in the context of multi-year mination of the fiscal aggregates would constraints. The annual budget be unduly influenced by particularistic becomes one year’s installment in the claims on the budget. multi-year fiscal strategy. Even with a multi-year framework, •THE CONSTRAINTS SHOULD COVER governments periodically find it neces- MOST KEY AGGREGATES, NOT JUST sary to retarget fiscal policy. Doing so TOTAL SPENDING OR THE DEFICIT in a medium-term context enables If only the deficit were targeted, aggre- them to assess the impacts of cyclical gate discipline might be weakened by swings or policy shocks on the fiscal paying for spending increases with tax aggregates. increases. If, however, only spending were constrained, politicians might cut •AGGREGATE NORMS SHOULD BE taxes and allow the deficit to rise. The SUPPORTED BY SUBTARGETS constraints do not have to cover all fis- Fiscal norms are not likely to hold in cal aggregates, but there may be con- the face of spending pressures if only siderable value in extending them to the totals are targeted. Ideally, spend- the public debt. A few countries have ing constraints should extend to major begun to constrain contingent liabili- subcomponents. These may include ties, but most lack sufficient informa- limits on running costs, discretionary tion to set effective limits on these fis- spending limits, or limits on particular cal risks. budget sectors, functions, or portfo- lios. When these sublimits are agreed, •AGGREGATE CONSTRAINTS the aggregate constraints are sturdier SHOULD COVER MANDATORY because they reflect prior agreement on SPENDING how total resources are to be parceled Constraints that permit an open check- out. The totals are not merely pie-in- book for entitlements or other mandated the-sky numbers, but commitments costs weaken aggregate fiscal discipline. on future spending plans. Although it is unlikely that democratic Yet it also is important that early governments will disentitle major benefit agreement be confined to major subto- programs or disable the budget’s built-in tals. If decisions also were made on the cyclical stabilizers, it is highly probable 88 A Contemporary Approach to Public Expenditure Management that they will act to trim entitlement needed for controlling spending totals spending at the margins, slow the spend- and the deficit. Hardness is a matter of ing growth in this area of the budget, and degree, however. Absolute prohibition impose barriers to the establishment of against breaching the totals may be too new entitlements. As the fiscal burdens rigid to withstand political pressure or of demographic change draw nearer, economic necessity. As aggregate fiscal more governments will be impelled to discipline gains prominence as an make hard choices about mandatory objective of expenditure management, programs and to take politically unpop- democratic governments may find ular actions. If they do not, aggregate fis- supple arrangements which allow a cal discipline will resemble a poorly safety valve for political and economic designed dam that cannot hold back the pressures more lasting and effective pent-up pressure building up against it. than unyielding targets. ❧

•AGGREGATE TARGETS SHOULD INCLUDE ENFORCEMENT MECHA- NISM, INCLUDING IN-YEAR MONI- TORING AND OUT-YEAR PROJEC- TIONS Targets are not self-implementing; enforcement never is automatic. Effective constraints must include ongoing review during the year to assess whether the fiscal trends is in line with forecasts, as well as actions to be taken when the aggregates veer off target.

•HARD CONSTRAINTS RARELY ARE AS HARD AS FISCAL POLICYMAKERS INTEND THEM TO BE The literature on aggregate fiscal disci- pline suggests that hard constraints are Chapter 4 Allocative Efficiency

very budget system rations contribution of public expenditures to resources by allocating money those objectives. To allocate efficiently, Efor some uses and withholding it government must be strategic and eval- from others. The effectiveness of gov- uative; it must both look ahead and ernment programs depends on these define what it wants to accomplish and allocations, but governments face look back to examine the results. numerous impediments to making The linkage of strategic planning truly efficient allocations. One of the and program evaluation to ongoing key tasks of modern public expendi- budget procedures has been a perenni- ture management is to create the con- al issue in public expenditure manage- ditions that foster allocative efficiency. ment. Forging a tight link has been a Allocative efficiency refers to the recurring theme in budget reform dur- capacity of government to distribute ing the past half century. Many gov- resources on the basis of the effective- ernments have tried, few have succeed- ness of public programs in meeting its ed. The failure rate has been high strategic objectives. It entails the because striving for allocative efficien- capacity to shift resources from old pri- cy increases informational burdens, orities to new ones, and from less to transaction costs, and political conflict. more effective programs. Allocative Informational needs are higher because efficiency requires that the government of the demand for additional data on establish and prioritize objectives and program impacts; political conflict that it assess the actual or expected escalates because of efforts to redistrib-

89 90 A Contemporary Approach to Public Expenditure Management ute budgetary resources. The task of however, financial conditions can contemporary public expenditure make a big difference in whether and management is to improve allocative how governments seek allocative effi- efficiency without overstraining the ciency through the budget. capacity of government to process In developed countries, during the information and cope with conflict. long postwar expansion, budgeting Unless information demands and was oriented to allocating incremental budgetary conflict are manageable, resources. Budget bids were made and governments may prefer suboptimal reviewed as claims for additional allocations that enable them to muddle resources, and relatively little attention through the annual budget exercises. was paid to the base of previously This chapter considers the condi- authorized expenditure. Incremental tions (institutional arrangements, budgeting enabled the government to including informational flows and respond to fresh demands without tak- behavioral implications) that promote ing resources away from existing budg- allocative efficiency in the context of et holders. Budgeting was a distribu- efforts to strengthen aggregate fiscal tive, not a redistributive process. Intra- discipline. governmental conflict was low because explicit tradeoffs generally were avoid- The Pursuit of Allocative ed; winners gained by claiming incre- Efficiency mental resources, not by taking from Ideally, governments should seek those who already had shares in the allocative efficiency under all fiscal budget. Relative priorities were conditions, when the budget is grow- rearranged by awarding different ing and when it is shrinking, when growth rates to the various parts of the incremental resources are available to budget. The central budget office finance additional spending and when accrued power by serving as the hub of they are not, in poor countries and in this incremental process; by allocating affluent ones, during boom times and the increments, it influenced the when the economy is in distress. In all future direction of government. cases, government should spend its Budgeting paid lip service to alloca- limited resources on programs that tive efficiency by insisting that there be a yield the greatest social return. In fact, nominal review of all expenditure claims Allocative Efficiency 91 each year. Spending departments sub- Classical budgeting seeks allocative mitted detailed justifications of all items efficiency by requiring that the budg- of expenditure, not just of the incre- et be comprehensive and that all ments. Formally the process was highly claims compete against one another adversarial; the budget office had in a global competition for public authority to review and challenge any funds. It assumes that if all claims are items and to seek the cutback or elimi- standardized as to form and are sub- nation of those it considered unproduc- mitted according to a prescribed tive or of lesser value. In fact, however, schedule, the allocations deriving the process was relatively calm and from the budget competition will be accommodating. Conflict was mitigated correct. But as budgeting hardened by the tendency to continue most ongo- into incremental patterns, structural ing programs. Although all of the budg- impediments to the optimal alloca- et was nominally reviewed, almost all tion of government money became escaped serious review. Few changes apparent. One is the “stickiness” of were made, except those financed by public expenditure; another is the additional resources. short time frame of annual budget- Incremental budgeting suited the ing; and a third is a lack of adequate times, but it is a flawed means of allo- information on program effective- cating public money. It encourages ness. Stickiness refers to the difficulty allocative inefficiency and the creeping of taking funds from existing pro- enlargement in the relative size of the grams and agencies. Budgets are public sector. It weakens aggregate fiscal sticky because recipients mobilize discipline by presuming that spending and logroll to protect their shares and will be higher next year making the totals because there is no market mecha- accommodate the parts. Spending nism to drive out inefficient perform- departments generally have few con- ers. Moreover, within the framework straints on proposing program initia- of annual budgeting, it often is diffi- tives, but these typically are bids for cult to make reallocations that unfold more money, not trade-offs within over several years or whose program fixed budgets. impacts lie in the future. Finally, by Incremental behavior calls into allocating inputs conventional budg- question due process assumptions. eting does not sufficiently consider 92 A Contemporary Approach to Public Expenditure Management whether funded programs are achiev- were exported by bands of consultants ing governmental objectives. (often encouraged or financed by Recognition that due process in international institutions) to many budgeting often produces inefficient developing countries. The reforms outcomes led to a series of abortive were even less fruitful in poor coun- efforts to reform government budget- tries than they had been in rich ones, ing. One popular vein of reform ideas for they overtaxed the capacity of gov- was centered around PPBS (planning- ernments to generate policy analysis programming-budgeting systems) and and budget alternatives. similar arrangements in many devel- This is not the place for reviewing oped countries; another was zero-based the many reasons why efforts to reform budgeting (ZBB) and its variations. budget allocation systems have failed, PPBS sought to give budgeting a but it is important to distinguish con- longer time horizon and to upgrade its temporary PEM from PPBS and ZBB- analytic capacity; zero-based budgeting type innovations. The earlier reforms sought to redistribute resources within were confined to budgeting; they tin- the base of existing programs and kered with the informational content expenditures. Although they differed and procedures of the annual budget procedurally, both PPBS and ZBB process. PEM, by contrast, views budget- sought to intensify competition for ing as a critical part of the larger institu- budget resources, the former by pro- tional environment in which it is embed- viding information on the cost effec- ded. PEM connotes a Copernican shift tiveness of alternative means of achiev- in the relationship of budgeting and ing government objectives, the latter institutions: rather than budgeting being by having each spending unit prepare the driver of political and managerial alternative budgets (each with incre- actions, it is the behavior of politicians mental resources and outputs). With and managers that drives budgeting. To the prospect of greater competition, change budget allocations requires, however, came increased informational therefore, changes in the incentives pro- burdens and conflict, along with often vided those who decide the budget, successful political-bureaucratic tactics including the institutional arrangements to disable the new budgetary mecha- in which they work and the information nisms. Variations of both approaches supplied to or by them. Allocative Efficiency 93

The test of the allocative strength by eliminating program initiatives rather of any budget systems lies not in its than by stringently reviewing the effec- procedures but in the allocations tiveness of existing expenditures. The themselves. Due process in budgeting more austere the spending norm and the does not suffice. It is possible to have a longer it is maintained, the greater the well-run budget process that allocates risk that budget priorities will rigidify. inefficiently because of the stickiness The risk is greatest when economic of expenditures and the refusal of growth is weak and fiscal increments are politicians and managers to reallocate. inadequate to finance normal year-to- Budget stakeholders need incentives to year increases in spending. In this cir- cooperate and the rules that matter the cumstance, a strong case can be made for most are that they operate under con- reallocative initiatives that transfer straints that impel them to reallocate resources from current budget holders to and that they have a large say in the new spenders. Paradoxically, however, reallocations that are made. Anything while striving for allocative improvement less will blunt allocative efficiency. is most needed when the budget is tight, this may be the condition under which it Allocating Under Fiscal Constraints is most difficult to achieve. To keep the In terms of allocative efficiency, enforc- budget fresh and supple when there is lit- ing fiscal discipline can be a mixed bless- tle or no money to expand programs ing. Although it stabilizes the budget requires that the government have the totals and makes them congruent with strategic capacity to reallocate resources government economic objectives, a fiscal in accord with its priorities. norm that constraints total spending Both rich and poor countries suffer risks freezing old programs into the from allocative inefficiency, but the cost budget and new ones out. This outcome may be significantly higher and more is highly likely because it is politically apparent in the latter. When they fund safer to continue old programs than to ineffective programs, developed coun- terminate them in order to make room tries obtain suboptimal returns on public in the budget for spending initiatives. expenditure. Per capita income is some- Consequently, a government whose fiscal what lower, citizens are deprived of social norms compel decremental budgeting benefits they might otherwise receive, might seek to meet aggregate constraints and government is not sufficiently 94 A Contemporary Approach to Public Expenditure Management responsive to emerging problems. other failed budget reforms. Both Depending on the pattern of inefficien- PPBS and the public expenditure cy, there may be distortions in private model seek to enhance allocative effi- investment and consumption as well as ciency by establishing a multi-year in the distribution of income. Poor budget framework, generating data countries face all of these costs, but rela- on program performance, and allocat- tive to the country’s wealth, the price ing resources to more productive uses. paid may be far higher. When a poor One difference is in their fiscal con- country tolerates serious inefficiencies in text: PPBS-type reforms were intro- the allocation of public resources, it may duced during a period of rising expec- underspend on critical needs (such as tations about economic well-being public health and education) and over- and the affordability of program spend on other areas (such as military expansions. The logic of PPBS-type forces); facilities and other capital invest- systems was that through multi-year ments acquired through international planning and program analysis, gov- assistance may fall into disrepair because ernments would be more efficient in they are inadequately maintained; allocating the dividends of a growing money may be wasted on showcase proj- economy. Although governments gave ects that offer meager social returns. lip service to reallocation, the prevail- When poor countries misallocate ing mood was that planning and resources, development is retarded and analysis would lead to improved allo- poverty persists. It is especially urgent, cations of new money. therefore, that countries striving to lift Contemporary public expenditure themselves out of impoverishment is being managed in a different envi- improve allocative efficiency in public ronment. Austerity is the order of the expenditure. day, promoted by efforts to curtail the legacy of past deficits, weaker econom- The Institutional Framework ic growth than was enjoyed in the past, for Reallocation: Rules, and taxpayer unwillingness to pay Roles, Information more to finance government programs. The procedural elements of a public In this environment, most program expenditure reallocation system are initiatives have to be financed by real- similar to the elements of PPBS and location, not by new money. The dif- Allocative Efficiency 95 ference in fiscal condition and govern- drawn from the pool is rationed, self- ment ambitions has affected the insti- interested spenders cannot opportunis- tutional context, informational tically take more than is permitted. resources, and behavioral patterns in Enforcing this rule requires a vigilant, public expenditure management. powerful central office that reviews spending demands and assesses adher- Rationing Public Expenditure ence to budget constraints. But no The key change in rules is that budget enforcement mechanism is perfect, allocations are made pursuant to and wily ministers and managers can explicit constraints on the amounts maneuver to spend more resources that can be spent. These constraints than are in their envelope. As long as need to be set before departments bid the excess is marginal, it will not do for resources, and they must be cen- much damage to the fiscal constraints; trally set for each sector and portfolio but if spenders succeed in breaking the in accord with government objectives. constraints, preset limits will have little In contrast to conventional bottom-up impact on budget outcomes. budgeting which permits open ended bids for resources, PEM requires that Organizational Roles: The Center department requests be within the Versus Ministers and Managers resource envelope provided them. Reallocation is difficult because it stirs Moreover, in contrast to PPBS and up political conflict, spurs those other “rational allocation” systems threatened with a loss of resources to which base budget decisions on net take counter-measures to protect their benefit considerations, PEM requires budgets, and requires an enriched flow beneficial programs to compete for of information on program objectives constrained resources: just because a and results. Nevertheless, governments program yields net benefits does not can facilitate reallocation by building necessarily mean it will be funded. their capacity to specify strategic objec- Rationing public expenditures tives and reprioritize programs within mitigates the common resource pool medium-term expenditure constraints. problem of public finance, but can Seen in this light, reallocation is a worsen the principal-agent problem. function of strategic capacity, that is, Inasmuch as the amount that can be the ability of a government to antici- 96 A Contemporary Approach to Public Expenditure Management pate and plan for future changes in its and managers are responsible for sub- environment, to recast its objectives allocations in their respective fields of and programs on the basis of planned responsibility. change, to define future desired out- comes and to reallocate resources to Top-down Versus Bottom-up achieve them, to measure progress in Budgeting achieving the planned outcomes, and In classical budgeting, the production to assess the effectiveness of programs. of information proceeds in a bottom- Having all these capabilities promotes up sequence, while decisions flow in a use of the budget as an instrument of top-down sequence. Spending agencies change, but doing all these places sig- are permitted to ask for as much as nificant demands on the analytic and they want, with little or no guidance conflict-resolving capacities of govern- from the center. In bidding for ment. Few governments make serious resources, agencies submit vast efforts along these lines; those that do amounts of information on their activ- generate more reallocation than those ities and expenditures. This informa- that do not. tion and the associated bids are The strategic capacities set forth reviewed by central authorities who above must be concentrated at the cen- decide the amounts provided to each ter of government where responsibility agency or activity in the government for national priorities and inter-sec- budget. Invariably, the total demanded toral allocations is lodged. Moreover, by agencies exceeds available resources. strategic decision-making should be The fact that not all demands can be linked to allocative decisions; if they satisfied gives the central budget office are not, the plans made by government the lead role in allocating budget will not be effectively implemented. resources. The greater the excess of Allocating resources is the stock in bids over resources, the greater the cen- trade of the central budget organiza- ter’s influence in dictating where the tion; reallocating resources may money goes. require a more sensitive division of This arrangement puts spending labor in which central budget makers agencies and central budget makers on are responsible for strategic decisions a collision course. Much of the and major priorities, while ministers increase sought by agencies is denied Allocative Efficiency 97 by budget guardians. But friction typi- obtain a bigger budget, reallocation cally is eased by weak aggregate fiscal depends on government decisions that discipline (the total can be raised as certain objectives should be accorded spending pressures intensify), the incli- priority in the competition for public nation of central officials to give agen- funds. Reprioritizing can be an explic- cies at least as much as they were allo- it decision that A is more important cated for the previous year, the avail- than B, or an implicit choice that is ability of spending increments, and revealed only by the outcome—A gets avoidance of explicit reallocation. more money and B gets less. Either When austerity removes these favor- way, reallocation requires capacity at able conditions, central controllers no the center of government to change. In longer regard bottom-up, open-ended contrast to allocation which often pro- requests as useful. Such requests enable ceeds in a fragmented manner, reallo- spenders to avoid hard priority choices cation requires a high degree of central and explicit reallocation. When central coordination. Not much reprogram- controllers want significant realloca- ming of public funds occurs when tion, they cannot rely on spending spending departments logroll to divide departments to voluntarily surrender the budget among themselves. resources in the normal course of com- There is no standard process for piling their budgets. Central con- reconsidering and changing govern- trollers have to intervene early and ment objectives and priorities. Some effectively by providing substantive governments are guided by party plat- guidance on the government’s prefer- forms, others by the views of strong ences and strategic interests. leaders. In some multi-party govern- ments, coalition agreements map out Changing Government Priorities the policy initiatives that will be taken, What does the center do when it is including changes in the use of public bent on reallocating resources? The funds. In some countries, the Cabinet short answer is that it changes govern- meets months before the annual budg- ment priorities. Reallocation entails et is prepared to specify medium-term changing what government does with priorities and to decide the fiscal enve- public money. In contrast to allocation lope for each sector or department. In which is driven by the opportunity to recent years, a few countries have 98 A Contemporary Approach to Public Expenditure Management announced the strategic areas that are Medium-term Expenditure to be favored in budget allocations. In Constraints these countries, ministers and man- Because strategic changes typically agers must demonstrate that the unfold over an extended period and resources they are bidding for would have greater impact on future budgets contribute to the government’s strate- than on the one immediately ahead, a gic objectives. second element of reallocative capacity All of these processes can be used to is for the government to set medium- reallocate, but they are more likely to be term fiscal targets, including the margin used for allocative purposes, that is, to (if any) available for spending initiatives claim larger budgets. Strategic planning or the net savings required to meet the potentially is oriented to reallocation, preset targets. The margins and savings though it is not always applied to this usually are calculated on a net basis: end. In business, strategic planning is new spending minus savings from pro- used to decide which markets to enter gram cutbacks. Net budgeting encour- or exit; in government, it typically is ages reallocation by protecting spenders used to decide which programs to against a loss of resources when they expand. When used to its full capacity, shift funds in response to changes in the strategic planning questions the role government’s strategic priorities. and objectives of government entities The medium-term constraints and considers how they might be trans- should be consistent with the govern- formed by terminating some activities ment’s fiscal objectives, and they and starting others. should not be so accommodating as to The common element in the vari- enable the government to avoid reallo- ous approaches is that they provide an cation. It is also the case, however, that opportunity for the government to (as discussed in the previous chapter) rethink its strategic goals and to shift the constraints have to be attainable. If resources to new or underfunded pri- they aren’t, the government might be orities. Governments operating in a impelled to resort to accounting constrained environment are likely to maneuvers that understate the true find that they can respond to new pri- amount of public expenditure. orities only when they cut funding on Medium-term spending con- some existing activities. straints are not self-enforcing. In fact, Allocative Efficiency 99 the drive to reallocate can open the above the baseline and that others door to efforts by spending depart- should have decreases. In parliamentary ments to substitute more expensive regimes, these decisions usually are programs for the ones they are replac- made by the Cabinet, often pursuant to ing. A familiar ploy is to overstate the recommendations from the Prime savings from program cutbacks and to Minister or the Finance Minister. In a understate the spending on new pro- presidential system, the chief executive grams. To forestall these tactics, it is usually sets the constraints. important that the government main- Reallocation can be made at any tain a baseline that projects the spend- stage of budgeting, but there is a clear ing impacts of authorized programs advantage to doing it early, before over the next 3-5 years, and enables it spenders stake their claims for to estimate the future budgetary resources. If the government were to impact of proposed policy changes. As defer these decisions to the give-and- will be discussed below, scorekeeping is take of budget formulation, the out- one of the important functions of the come might be very little reallocation central budget office. and pressure to accommodate spend- ing demands by raising the totals. Inter-sectoral Decisions Moreover, when sectoral decisions are Reallocations across sectors are not like- a byproduct of unguided departmental ly to emerge from bottom-up bids by bids for resources followed by bilateral departments for resources. Decisions to negotiations between them and the take money from one sector and assign Finance Ministry, there is a good them to another must be made at the chance that the budget will not be top, or they will not be made at all. aligned with the government’s objec- Accordingly, reallocation requires that tives and priorities. the government specify a resource enve- lope for each sector or major spending Intra-sectoral Spending Decisions unit before ministers and departments The contemporary drive for fiscal dis- compile their budget estimates. In the cipline may tempt the government to course of setting these envelopes, the maintain a tight grip by making government may decide that some sec- detailed budget allocations within sec- tors should be permitted increases tors or departments. Central control of 100 A Contemporary Approach to Public Expenditure Management spending details might seem to be a teracted by the center, this behavior logical response to the current budget would undermine both aggregate fiscal situation in many countries. If discipline and the government’s capac- spenders are reluctant to trade off ity to establish program priorities. In within their areas of responsibility, it sum, if spending agencies will not (or may make sense for central authorities cannot be trusted to) make the trade- to do the job for them. There are a offs, central budget authorities should number of strong reasons for centraliz- do the job for them. But despite these ing intra-sectoral allocations in the arguments for centralized intra-sec- Cabinet or Ministry of Finance: (1) toral reallocation, the current condi- The center can reallocate more broad- tion of government finance in many ly than can a line minister or depart- countries—fiscal constraints, inade- ment; (2) The central organs have a quate increments, and pressure to more comprehensive and strategic make room in the budget for program view of the government’s interests and initiatives—may justify a decentralized priorities than a single department approach for budgeting within sectors which is beholden to sectoral pressures and departments. Arguably, more real- and perspectives; (3) Central authori- location will occur if spending minis- ties can promote reallocation based on ters and managers have an active role evidence of program effectiveness, in generating policy changes. Trying to evaluative findings, and objective do the job centrally may result in analysis; (4) Central involvement is much conflict and little reallocation. essential for establishing rules and pro- The threat of losing resources and cov- cedures that enforce fiscal discipline eted programs may impel departments and ensure that the cost of program to resist the tradeoffs and savings proposals is accurately reflected in the demanded of them. Although they are budget; (5) Without strong pressure not at the center of power, depart- from the center, departments may pro- ments have formidable weapons at tect existing programs rather than real- their disposal. They can withhold locate resources; (6) Departments have information needed to make cost- incentives to launch programs at low effective tradeoffs; they can enter into cost and to underestimate the full logrolling coalitions with other impact on future budgets. If not coun- spenders to protect their budgets Allocative Efficiency 101 against cutbacks and reallocations; the information needed to make effec- they can mobilize support among tive reallocations. Central authorities affected interests and within govern- can seek to develop independent ment. Judging from the past, it is by sources of information by installing a no means assured that central authori- performance measurement system or ties will win the battle for reallocation; by developing a comprehensive evalua- instead, they may end up with status tion capability. But even if they take quo budgets. these steps, central allocators inevitably Central organs operate at a disad- depend on spending departments for vantage vis-à-vis spending departments much of the raw data that goes into when they aggressively seek to reallo- evaluation and measurement. cate resources. They may lack suffi- To gain the cooperation of spend- cient information on program and ing departments, it may be sensible to political impacts of proposed policy give them a prominent voice in the changes, and (despite their central reallocation process. A devolved perch) sufficient political support to arrangement would free up the accomplish the task. Departments Cabinet (or other central decision- know a lot more about their pro- making organs) to focus on major pol- grams—what works and what does icy changes rather than on the details not—than do the ministry of Finance, of expenditure. When the government Cabinet and other central authorities. dictates the myriad spending items, its They may also have a better apprecia- attention to the details often drives out tion of the political risks of changing consideration of strategic issues. policies and programs. This asymme- When intra-sectoral matters are try is due to the high cost of obtaining entrusted to ministers and their depart- program and political information, as ments, the government allocates a well as to the understandable reluc- spending margin or savings target to tance of departments to provide infor- each sector minister in accord with its mation that may cast their programs in budget priorities. In Australia, for exam- an unfavorable light or lead to loss of ple, the forward estimates (described in resources. In other words, central Box 3.1) give each minister an approved organs are beholden to (or captured spending baseline for his/her portfolio. by) spending departments for much of The forward estimates may be set at a 102 A Contemporary Approach to Public Expenditure Management level that accommodates spending reorientation in the role of central increases, in which case the minister budgeting organs and their relation- would be able to propose program ship with spending departments. In expansions consistent with the govern- seeking allocative efficiency, they ment’s priorities; or they may be set at a would act more as referees of the real- level that requires cutbacks, in which location system than as close reviewers case the minister would have to propose of department budgets. They are likely savings. These targets serve both as con- to have a lead role (shared with the straints on spending requests and as the Cabinet or some other policy coordi- starting point for compiling and review- nating organ) in managing the trade- ing the budget. Within the assigned tar- off system and in ensuring that pro- get, a minister may propose increased gram changes and budget reallocations spending on some activities to be are consistent with the government’s financed by savings derived from other fiscal norms and policy objectives. In activities in the same sector or portfolio. this arrangement, the budget office In this devolved institutional arrange- would be responsible for guidelines ment, ministers would have authority to and procedures for proposing and approve relatively minor spending implementing program changes. It changes below a preset threshold on would maintain baselines and data their own; proposed reallocations above bases for assessing the budgetary the threshold would be reviewed by the impact of program initiatives and real- government to ascertain whether the locations; it advises ministers and the policy change would contribute to its Cabinet on the financial and program priorities and to estimate the impact on impacts of proposals; and it conducts future budgets. Australia has a AUS$5 or promotes the ongoing evaluation of million threshold below which depart- programs and reporting on perform- ments can act unilaterally. This thresh- ance. As it emphasizes these allocative old clears the government’s agenda for tasks, the budget office would likely major policy issues. withdraw from (or curtail its involve- Shifting much of the initiative and ment in) some traditional controls. It responsibility for intra-sectoral alloca- would no longer decide or monitor tions downward to the affected spend- detailed items of expenditure; if it con- ing entities entails a fundamental tinued to do so, spending departments Allocative Efficiency 103 would have little incentive to cooper- diture system bent on significant ate in reallocation schemes. Instead, reallocation, however, ministers must departments would be permitted to get involved earlier to set the “fiscal manage their operating budgets within envelope” within which sectoral deci- guidelines and financial limits set by sions are made and to establish base- the government. This devolution lines and/or reallocation targets for would free the central budget process the various ministers or portfolios. If to concentrate on strategic objectives politicians do not play these roles, and policy decisions (and contribute to the central budget office will lack suf- operational efficiency—to be discussed ficient leverage to compel depart- in the next chapter). ments to reallocate. A devolved reallocation scheme The institutional rearrangements dis- may require more political support cussed here aim to make spending depart- and earlier involvement of politicians ments allies in reallocating public than one in which central authorities resources. But even when a cooperative try to shift resources. In convention- relationship is established, the interests of al budgeting, reallocation decisions spending departments may not perfectly are made late in the process, if at all. align with those of central authorities. The process generally revolves Reallocation engenders tension and con- around bilateral negotiations flict between those who want to hold on between the finance ministry and the to or increase their resources and those affected spending departments. who want to shift money to other uses. These “bilaterals” begin with middle Decentralizing some decisions and giv- managers who strive to resolve issues ing departments a greater say in budget in their competence, then move to outcomes can diminish friction, but it senior managerial levels. Ministerial cannot ensure that the allocations will discussions take place at the end of be optimal and free of conflict. the process and consider only those To promote more effective reallo- matters not resolved at official level. cation, it would be appropriate for the After bilaterals between the finance government to insist that ministers minister and the affected spending first look to their own portfolios for minister, remaining issues may be savings before approaching it for addi- taken to Cabinet. In a public expen- tional resources. 104 A Contemporary Approach to Public Expenditure Management

Information produce these data, especially when, as Allocative efficiency depends not only is often the case, the program’s out- on institutional arrangements that comes are outside the direct control of facilitate reallocation, but also on the affected department. In a realloca- information concerning the effective- tive budget process, departments have ness of programs. The drive to reallo- to make special efforts to build evalua- cate can add significantly to informa- tions into their work. They must tion demands on spending depart- design appropriate methodologies, ments. In addition to detailed operat- gather and interpret the data, and ing data, they have to supply informa- apply the findings in allocating tion on multi-year impacts and pro- resources. gram results. In seeking broader reallo- The cost of evaluation is not only in cation, budgeting risks information the money expended in searching for overload, as occurred when PPBS and and analyzing data, but also in the other reforms were introduced. threat to departments that coveted pro- Overload is common because depart- grams will be found wanting. ments have limited capacity to pro- Departments undertake programs duce the demanded data and central because they “know” the activity is authorities have limited time to review worthwhile, and because they know the material within the confines of this, they want to continue ongoing annual budget routines. activities. Turning an evaluation spot- Decentralizing the reallocation light onto a program calls it into ques- process and entrusting spending tion. It is the rare program that passes departments with most operational every major evaluation test and is there- decisions can ease the informational fore judged worthy of being continued burden by reducing the volume of without change. Not surprisingly, there- operational detail produced by depart- fore, departments often protect their ments for central review, and by dele- program interests by giving little more gating much of the analysis and evalu- than nominal support to the idea of ation to spending units. But these evaluation. Where evaluation is con- informational savings are offset by the ducted, it is typically on a hit or miss vast increase in program evaluation basis, as is the application of evaluative and performance data. It is costly to findings to resource decisions. Allocative Efficiency 105

Developing a systematic approach ments of programs, it is necessary for to evaluation requires a substantial government to prod departments to commitment of money and political take the process seriously. support. To influence the allocation of The government also has to strike public finds, this commitment must be a balance between organizing program strong and continuing, and it must be evaluation as a free-standing process manifested in the use of evaluative without any formal tie-in to the budg- findings in allocating resources and et cycle, or feeding it directly into making other program decisions. resource decisions. A tight linkage Without follow through to allocation, might discourage departments from evaluation withers. cooperating, for fear that the data they In establishing an evaluation produce will be used against them at process, the government must strike a budget time; but without a formal balance between leaving the task to linkup, there is a strong possibility that line departments and entrusting it to a data on performance will not be used central agency. If the finance ministry in allocating resources. There is no per- or some other central unit conducts fect or permanent solution to this the evaluations, spending departments problem, but a sensible middle ground may be unwilling to act on the results. might be to establish evaluation as an When departments lack a vested inter- independent process, while prodding est in the evaluation, they can refuse to departments to apply the findings in cooperate with evaluators, withhold reallocating resources. data, or refrain from using the findings Australia’s ambitious evaluation in making budget and program deci- strategy has been designed to influence sions. But turning responsibility over budget allocations. Each portfolio to the departments, without strong must publish evaluation plans that central guidance and commitment, describe the studies to be conducted will likely mean that little genuine over the next three years. In addition evaluation is done. Yet, as important as to the periodic review of ongoing pro- it is for departments to have a say in grams, Cabinet rules require that each the process, most have a quite limited program proposal submitted to it indi- capacity for self-evaluation. To under- cate how the initiative will be evaluat- take thorough and objective assess- ed if it is approved. The Department 106 A Contemporary Approach to Public Expenditure Management of Finance monitors the evaluation linked to increments in performance at process, participates on many of the the time budget decisions are made. working groups that oversee the stud- Despite these seeming advantages, ies, advises on appropriate methodolo- no government has yet devised a per- gies and best practices, reviews portfo- formance-oriented budget system that lio evaluation plans, and maintains a directly links program outcomes and roster of completed evaluations. It also budget allocations, though several reports on the extent to which evalua- (Australia, New Zealand, Sweden, and tions are used in allocating resources. others) have made significant progress. Despite this substantial investment, One reason for this difficulty is that many budget allocations are made outcome measures are costly to develop without regard to the evaluations. In and difficult to apply. In contrast to Australia, as in other countries, there evaluation which probes deeply into often is a big gap between doing and program operations and results, out- using evaluation. come measures express key aspects of a Australia and a few over govern- program’s contribution to public objec- ments have sought to link evaluation tives in relatively few (usually quantita- and allocation through performance tive) indicators. It is rarely easy to distill measurement systems that report on a complex program with multiple and program results and social outcomes. sometimes conflicting objectives into a In their most advanced forms, these few measures, or to devise measures that systems seek to feed data derived from fairly account for the various factors ex post evaluations and other research (some of which may be beyond the gov- into annual budget decisions. ernment’s control) that contribute to Systematic reporting on performance the observed outcomes. can influence budget allocations in In countries that emphasize out- several ways: (1) performance trends come measures, departments that start can be tracked over an extended period down this path often end up with out- and related to program and spending put measures instead. The tighter the trends; (2) performance results can be formal linkage of performance measures compared to ex ante targets and vari- and budget allocations, the greater the ances can be analyzed; and (3) incre- likelihood that the data will pertain to ments in resources can be explicitly outputs, and the greater the incentive Allocative Efficiency 107 for spending units to select easy rather affected by its programs. It would be than challenging performance targets. logical to regard outcome measures as When budgeting and performance directional signals, as stimulants to reporting are tightly linked, so that policy review and change. When used measurable results become the basis for properly, they should spur policy allocating marginal resources affected makers to review existing programs departments may have little choice but and explore opportunities to do bet- to report on outputs because only these ter. They indicate whether conditions can be directly correlated with the level are getting better or worse, whether of expenditure. Inasmuch as outcome the government is closer to achieving data are much more relevant to alloca- stated objectives or further away, tive efficiency, it may be sensible for the whether existing programs should be government to loosen the connection continued or retargeted. Even when between performance measures and particular programs do not by them- budget decisions. selves cause the measured social con- Even when circumstances are ditions, ministers and officials should favorable, measuring and reporting be mindful of whether established on outcomes is difficult and costly. It policies are working. takes special effort to gather appro- These considerations dictate a priate outcome data. Major outcomes loose coupling of outcome measures typically result from a confluence of and budget choices. Government factors, including government policy, should use outcome data in estab- private behavior, and social condi- lishing strategic priorities and in tions. Attributing outcomes to specif- evaluating results. But strategic plan- ic budget allocations does not ning and program evaluation need enhance allocative efficiency when not be conducted solely within the the cause-effect nexus is problematic. prescribed routines of the annual Nevertheless, policy makers must be budget process. To promote alloca- mindful of outcomes when they tive efficiency, budgeting should be make budget and program decisions. viewed as only one of the govern- After all, the objective of government ment’s policy tools. If it is the only actions and expenditures is to one, there may be less reallocation, improve the condition of those not more. 108 A Contemporary Approach to Public Expenditure Management

Summing Up: The Path to This reasoning justifies a division Allocative Efficiency of labor in reallocation, in which cen- The incentive to reallocate is inherently tral authorities establish national weak in public organizations. In con- objectives and strategic priorities and trast to markets which are non-stop manage the budget process but the reallocation mechanisms, in which affected departments or portfolios resources are continuously rearranged have considerable latitude in propos- in response to changing consumer pref- ing and implementing program erences and other signals, the public changes within their respective sectors. sector faces strong pressure to maintain There is a risk that entrusting so much the status quo. Program evaluation and power to those who would be most performance information can prod affected by change will lead to little or departments to adjust their program no reallocation. Yet central authorities mix, but there is no self-enforcing need not be helpless when faced with mechanism to ensure that resources are departmental intransigence. Their job shifted to more effective use. is to push for reallocations by giving In reallocation, the behavioral strategic direction to government, objective is to turn potential adversaries demanding that departments adhere to into active allies. This is not easy to the strategy, insisting on robust evalua- do because the interests of those at tions and performance reports, and the center of government are not the adjusting the baseline to encourage same as those of ministers and man- cooperation. agers in departments. At the least, The logic of this division of labor in however, it is essential that politicians reallocation is that the center cannot do and officials not be penalized for real- the job by itself, but neither can it leave locating resources; they should not be the task solely to the affected depart- any worse off than they would be if ments. The center must manipulate they had refused to cooperate. As incentives to promote cooperation, even much as ministers and managers may though it will not always get the cooper- want to do public good, they will not ation it seeks. If it doesn’t, stronger aggressively seek to reallocate if in direction from the center may be neces- proposing to shift resources their sary, but the first choice should be to budgets are cut. induce cooperation, not to compel it. Allocative Efficiency 109

Basic elements of a public expendi- ministries in accord with the ture system oriented to reallocation government’s strategic priori- include the following: ties. Within a target, a minister • The government establishes may increase the resources strategic objectives and priori- available for program enhance- ties before departments bid for ments by taking resources from budget resources. These can be other programs within his/her global objectives (for society or portfolio. The extent to which the public sector) or sectoral ministers can reallocate on their (for particular areas of govern- own without obtaining ment activity). approval from government will • The government establishes depend on the size of the reallo- medium-term (3–5 years) fiscal cation and the structure of gov- objectives, including the mar- ernment. The scope for reallo- gin (if any) for spending initia- cation is greater when there are tives or the net savings required relatively few portfolios. to meet the fiscal target. The • The government maintains a margin and savings usually are baseline for projecting future calculated on a net basis: new budget conditions, establishing spending minus savings from targets, and measuring the fiscal program cutbacks. The net impact of policy changes. The margin is the amount of unallo- baseline covers three or more cated money (incremental years and is rolled forward with resources plus savings from each annual budget. existing programs) available for • The government encourages new spending in a sector or reallocations that promote pro- portfolio; net savings are the gram effectiveness by requiring amount by which spending in a departments to systematically sector or portfolio must be evaluate their activities and reduced to meet the govern- expenditures and to report on ment’s expenditure target. outcomes and performance. • Spending margins or savings • Cabinet review of the budget targets are allocated among concentrates on policy changes, 110 A Contemporary Approach to Public Expenditure Management

not on discrete items of expen- Finance, and the relevant portfolio diture. Authorized policy minister; and preparation of the budg- changes (both expansions and et. Moreover, resource allocations are cutbacks) are incorporated into supported by an ambitious evaluation the baseline which becomes the strategy that requires ministers to sys- starting point for the next tematically review ongoing programs round of budget allocations. and approved policy initiatives. ❧ As Box 3.1 indicates, most of the elements of a strategic reallocation process have been implemented by Australia since the mid-1980s. Annual budget decisions are made in reference to medium-term forward estimates which project spending (and other fis- cal aggregates) for the budget year and the three following years. The forward estimates specify the amounts that will be provided in future budgets unless policy changes are made or underlying economic or program conditions (such as prices or program participation rates) are reestimated. By definition, a policy change is a revision to the for- ward estimates. Proposed policy changes are considered in a prescribed sequence that includes identification of options; consideration of policy proposals by the Cabinet’s Expenditure Review Committee; Cabinet decision on allocations to portfolios; the costing of policy changes proposed by portfo- lio ministers; trilateral negotiations between the Treasurer, Minister for Chapter 5 Operational Efficiency

perational efficiency is the ciency which covers investment expen- ratio of the resources diture and transfer payments as well. Oexpended by government For example, operational efficiency is agencies to the outputs produced or concerned with the cost of processing purchased by them. The resources can pension claims, but not with the be measured in money terms or in amount paid out in benefits. The dis- terms of other inputs, such as work tinction is not always clear-cut, howev- hours or years. Output is convention- er, because operational efficiency often ally measured in volume terms, but affects program allocations. In unem- qualitative dimensions can also be ployment compensation for instance, measured. These include the accuracy the volume of benefits paid varies with of payments (or of other transactions), the efficiency (accuracy, timeliness, the timeliness of services, the courtesy etc.) with which claims are serviced. with which they are provided, and the Nevertheless, it is useful to distinguish satisfaction of recipients. In measuring the cost of producing outputs from the operational efficiency, these qualitative cost of providing a particular level of indicators can be correlated with the benefits. The distinction parallels the volume of resources or other inputs. one commonly drawn between out- Operational efficiency generally puts and outcomes. refers to government consumption Operational efficiency spans much expenditure in the national income more than the running costs of gov- accounts, in contrast to allocative effi- ernment agencies, though this is the

111 112 A Contemporary Approach to Public Expenditure Management part of the budget that has been most of government, the allocation of impacted by recent efforts to enhance resources between the public and pri- efficiency. In some developed coun- vate sectors, and the reliability of infor- tries, running costs add up to only mation on public finances and pro- about 10 percent of the central govern- grams. Operational efficiency is partic- ment’s budget, but this low percentage ularly important in poor countries. typically excludes significant operating When government is inefficient, pub- expenses, such as the cost of repairing lic sector wages tend to be low, much and maintaining roads, feeding prison public expenditure is absorbed by inmates and hospital patients, and deadweight administrative costs, and teaching schoolchildren. Even with an the government is robbed of resources expanded definition, operating costs needed for critical social development. have declined as a share of national During the past two decades, sig- expenditures in developed countries, nificant advances in management the- though they still are a significant part ory and practice have generated new of the budget. In these countries, the interest in improving operational effi- bulk of the central government’s budg- ciency. With concepts and applications et is spent in transfers to households liberally adapted from institutional and to subnational governments. In economics and business organizations, developing countries, transfer pay- the new public management (or man- ments tend to be less prominent and agerialism, as it is sometimes called) operating costs dominate the national has led in some countries to expanded budget. In some of these countries, operating discretion for public man- operating costs are very high because agers, new forms of contracting within public employment rolls are bloated government and between public enti- and productivity is low. Regardless of ties and private providers, greater the composition of the budget, opera- attention to results and accountability tional efficiency is important because for performance, and the moderniza- it affects the availability of resources tion of information systems. Some for social development, citizen atti- countries have sought to improve tudes toward government, the relative operational efficiency through the ex prices of government and market-pro- ante specification of output targets and vided goods and services, the integrity the ex post review of results. Efficiency Operational Efficiency 113 gains have been very high in countries stages: external control of spending (such as the United Kingdom and items by central agencies; internal con- New Zealand) that have separated trol on inputs by spending depart- service delivery from policy advice and ments; and managerial discretion and the purchase of services from the pro- accountability for producing outputs. vision of services, leading other coun- In the formative years of their budget tries to consider a similar restructuring systems, all governments seek to estab- of their own operations. lish external control. Some have per- Following the structure of previ- sisted with external control even when ous chapters, this chapter discusses their budget system was highly devel- the evolution of operational efficien- oped; others have moved to internal cy, its key elements, and institutional, control systems. Thus far only a few informational and incentive prereq- have shifted to managerial accounta- uisites of reform. bility for outputs. This sequence indi- cates that a government must establish Evolving Concepts of the rudiments of external control before Operational Efficiency it can safely switch to internal control, Operational efficiency deals with the and it must have robust internal controls relationship of budget inputs and pro- before it can entrust managers with gram outputs. Over the years, many broad flexibility and accountability for governments have sought to enhance resources and outputs. Some developing operational efficiency by controlling and transitional countries seeking the inputs; recently, a few have shifted rapid improvement in public adminis- to control of outputs. tration have tried to leap from inade- Modern budgeting began in 19th quate internal control systems to man- Century Europe as a process for con- agerial accountability, but (as discussed trolling the volume of inputs—both below) there may be substantial risk in total expenditure and the individual ceding broad discretion to managers items. But while spending control before internal controls are highly always has been an essential feature of developed. budgeting, the manner in which it is The form of budget control affects exercised has changed over the years. operational efficiency in several ways. Budget control has gone through three First, the various approaches differ in 114 A Contemporary Approach to Public Expenditure Management their informational requirements and usually is the finance ministry, the civil procedures, and, therefore, in the oper- service agency, or an agency responsi- ating costs they impose on government ble for overseeing the government’s departments. Second, the controls dif- purchase of supplies and equipment. fer in the incentives they give managers In some governments approval has to to be efficient in spending public be obtained for each discrete transac- money. To anticipate the argument tion; in others, blanket authorization is made later, devolving control to man- provided for a group of expenditures. agers reduces information and compli- For generations, external control was ance costs while giving managers practiced through Treasury control in incentives to improve efficiency. But the United Kingdom and other these gains come with the risk that if Westminster countries; by inspectors internal control is not effective and or controllers of finance in France, accountability is not strictly enforced, Germany, and many other countries; spending control might break down, and through line item budget and and there would be a loss in efficiency. accounting systems. Table 5.1 compares the three types of Looking back at the evolution of control system. public expenditure management in developed countries, one can under- External Control stand why strict external controls This form of control has three basic once were regarded as a signal characteristics: spending actions and advance in public administration. At control of operating funds are entrusted one time—a century ago in many to two distinct entities; control is exer- countries, only a few decades ago in cised exclusively over inputs; and control others—government was small, its is imposed before any action entailing program objectives modest, and the expenditure of funds is taken. needed administrative skills were in External control means that line short supply and concentrated in managers must obtain authorization central agencies. Civil service systems from central controllers before they and rules were in their infancy, pro- spend public money, even if funds curement was not well regulated, and were budgeted and appropriated for public accounting practices were not the purpose. The outside authority standardized. Operational Efficiency 115

Table 5.1: Types of Expenditure Control

Tyype of control Edxerised b Wyhat is controlle Mode of acountabilit Elxternal Control Centra Inputs: specific Compliance with Itemized Agencies items of expenditure Budget and Government- wide rules

Preaudit of transactions

Ignternal Control Spendin Inputs: classes of Department Systems Departments expenditure comply with Government- wide standards

Postaudit of transactions

Managerial Spending Outputs and total Accountability for outputs Accountability Managers running costs Ex ante specification of outputs

Ex post audit of results

External control was an appropri- To the extent these conditions still ate response to this unsatisfactory state persist, as they certainly do in many of affairs, for it inculcated the habits developing countries, it would be and ethic of compliance with rules in appropriate for management reforms government organizations. Because to concentrate on strengthening exter- control was centralized, operating nal controls, so as to reduce corrup- managers had to hone the skills of tion, build up managerial capacity in preparing and implementing detailed central agencies and spending depart- budgets, employing and supervising ments, and prepare the way for shifting staff under civil service rules, and pur- to internal controls. chasing supplies in accord with gov- External control is exercised on the ernment regulations. They also had to input side of the budget; outputs are provide central authorities with peri- not explicitly considered and data on odic reports on their activities. them are not systematically compiled. 116 A Contemporary Approach to Public Expenditure Management

Despite its limited scope, input control because they are enforced by burden- can be effective because it is activated some procedures, and require extensive before spending occurs, it can be monitoring. They breed both a compli- applied uniformly throughout govern- ance mentality—it is more important to ment, it economizes on public expen- follow the rules than to operate effi- ditures, it separates those who decide ciently—and evasion of the rules. In on the legality and propriety of expen- countries which enforce external con- diture from those who actually spend trols, managers learn how to “game” the the money, and it can be pinpointed to civil service pay and classification sys- specific transactions. But adverse tem, how to spend on coveted items effects on operational efficiency are even when budgeted funds are not avail- ignored because these controls pertain able, how to rig contracts so that pur- only to inputs. chases are made from favored vendors. Although external controls may An informal administrative culture have worked reasonably well in devel- emerges: there are the rules, and then oped countries when government was there are the ways things really get done. small, as public expenditure increased, This double standard—strict rules and the individual items receded in impor- loose compliance—is a breeding ground tance. Moreover, operating agencies for inefficiency and corruption. now had their own administrative com- petence, and central agencies such as Internal Control the ministry of finance became more External control still is practiced in interested in program and economic some developed countries, but since the issues than in operating detailed input postwar period there has been a marked controls. Within departments, corps of trend towards internal control. In its line managers were trained to operate most basic sense, internal control means modern personnel, budgeting, and pro- that those who spend public funds have curement systems. It became prudent, first-instance responsibility for ensuring therefore, to entrust them with some the legality and propriety of their actions. measure of managerial discretion. Under internal control, operating agen- As a government grows, the cost of cies must establish personnel, purchas- managing on the basis of external con- ing and other management systems that trol escalates. These controls are costly comply with government-wide stan- Operational Efficiency 117 dards. Control still focuses on inputs, still operate with a compliance mental- but managers no longer have to obtain ity, and despite the liberalization of outside approval before they act. In lieu operating rules, managers still are of preaudit (before the expenditure is strictly regulated in using the funds made), the government shifts to postau- appropriated to them. dit (after the financial period has There are three main reasons why ended), and instead of reviewing all internal control does not put managers transactions, it samples a small number in charge. First, the pursuit of unifor- to ascertain whether the system in oper- mity deprives managers of operating ation (and not only in design) complies discretion. “One size fits all” still con- with the rules. strains public managers. Second, man- Although internal control vests agers still must receive central approval managers with greater operating dis- for key operating decisions. For exam- cretion, uniformity still is demanded. ple, a central agency typically assigns In managing resources, they must accommodation to government agen- abide by government-wide pay and cies, charging their budgets for actual classification schemes, they must make or imputed rents, even though man- purchases following prescribed proce- agers have little or no say about the dures, and they must comply with premises they occupy. Finally, when externally-imposed rules. The key dif- central agencies relax their control, the ference is that they rather than out- controls often migrate to departmental siders make the determination as to headquarters. From the perspective of whether a particular transaction would operating managers, it makes little dif- be in compliance with the rules. ference whether they are restricted by Internal control improves opera- the central civil service board or by tional efficiency by reducing compli- their own department’s personnel ance costs and by giving mangers some office. In both situations, managers leeway in organizing work and carry- cannot exercise judgment on how best ing out assigned responsibilities. to operate. Nevertheless, internal control, as it has Although they do not enable man- been practiced in various countries, is agers to optimize operational efficien- only a modest step forward. Managers cy, internal control systems facilitate still feel bound by external rules, they the transition from external control to 118 A Contemporary Approach to Public Expenditure Management arrangements which give managers vir- occupied, whether services should be tually complete control of operating provided in-house or outsourced, and funds. Without the experience, infor- so on. The government may retain mation, and managerial skills devel- some residual controls, such as equal oped under internal control, managers opportunity rules for staffing, maxi- would not be prepared to take full mum pay levels for senior civil ser- responsibility for operations. vants, or a ceiling on the value of con- tracts that can be tendered without Managerial Accountability competitive bids. This arrangement shifts the focus of Some governments have been control from inputs to outputs, from spurred to enlarge managerial discretion what managers are buying to what they by adverse budget conditions. Faced are producing. It does so by giving with chronic deficits and escalating them broad discretion to spend appro- transfer payments and interest charges, priated resources, in exchange for some have sought to cut operating costs, which it holds them accountable for by means of spending freezes, across- performance. The two sides of the the-board cuts, cash limits, and other exchange are inextricably linked: with- methods. Britain has had cash limits on out discretion, managers cannot be operating expenditures since the mid- held accountable for results; and with- 1970s; Japan has enforced a sinking lid out being held accountable for results, on these expenditures for approximately managers would (or should) not be two decades; Australia cuts operating given operating discretion. Only a few budgets by a percentage equal to a countries have moved in this direction, required efficiency dividend; Sweden most notably, New Zealand, the has constrained operating costs for United Kingdom, Australia, and almost two decades; the United States Sweden. has had a statutory limit on appropria- In countries embracing managerial tions since 1990. The longer these con- accountability, managers are given straints are in place, the more onerous wide discretion in spending operating they become, and the greater the risk funds. They can decide how much to that affected departments will adjust to spend on personnel, whom to hire, the loss of resources by cutting the vol- how to pay them, the premises to be ume or the quality of services. Operational Efficiency 119

Governments can seek to avert cumstances, to prespend a small por- hidden cuts by specifying the outputs tion of the next year’s operating funds. that are to be produced with budgeted New Zealand probably has gone resources. Most of the countries men- further than any other country in reor- tioned above have greatly increased the ganizing its public expenditure system volume of output data published in to increase managerial discretion and the budget and related documents. A accountability. Since the early 1990s, few (New Zealand and the United appropriations have been made by out- Kingdom) routinely compare actual put classes; the budget, the supporting and targeted outputs; others (Australia estimates, and appropriations do not and the United States) use a variety of itemize inputs. The budget, appropria- performance measures. In these and tions, and financial statements are on other countries, the government has an accrual basis, showing the full cost taken steps to make managers account- of producing outputs. Departments able for outputs through annual are charged for the capital invested in reports, performance measurements them by the government, and they are systems, and the auditing of perform- charged for depreciation of fixed assets. ance data. Departments manage their cash bal- But targeting outputs is not likely ances, earning interest if the rate of to induce managers to be more effi- spending is lower than expected and cient if they lack discretion in using paying interest if it is higher. If depart- appropriated funds. Being accountable ments divest assets (for example, by for outputs requires that managers remitting excess cash balances to the have the freedom to decide on the mix government), they reduce the capital of inputs. Accordingly, a few countries charge, and the savings can be applied have greatly increased the operational to any other operating expenses. discretion of managers. Australia and Accountability for outputs is main- the United Kingdom have running tained through a series of contract-like cost arrangements that give managers a documents. When the government lump sum operating budget. Australia submits the budget to Parliament, each and Sweden allow managers to carry department tables a “forecast report” over unused operating funds from one itemizing the major outputs to be pro- fiscal year to another and, in some cir- duced pursuant to the amounts bud- 120 A Contemporary Approach to Public Expenditure Management geted for it. More detailed specifica- ple, managers have incentive to econo- tion of outputs is contained in pur- mize on the cost of accommodation chase agreements negotiated each year because savings can be applied to any between the chief executive of each other operating expenses. department and the minister purchas- ing outputs on behalf of the govern- Application to Developing and ment. In design, but not always in Transitional Countries practice, the minister has the option of There is understandable interest in purchasing outputs from the depart- developing and transitional countries ment or from any alternative supplier. to accelerate the pace of reform by These and other features of the New adopting the most advanced and Zealand model are reported to have promising innovations devised by produced substantial gains in opera- developed countries. This interest has tional efficiency. Additional informa- been whetted by the attention and tion on New Zealand is provided in acclaim given the New Zealand model, Box 5.1. and by the hope that enormous gains Managerial accountability con- can be quickly achieved in operational tributes to operational efficiency in efficiency. Yet there are important pre- two ways. First, by targeting (and, in a conditions for the successful imple- few countries, contracting for) out- mentation of managerial accountabili- puts, it makes managers responsible ty, and these should not be ignored by for the volume, timeliness, and quality countries striving to improve public of the services produced. Unlike con- sector management. trol systems which define efficiency in The typical developing or transi- terms of economizing on inputs, man- tional country has a formal external agerial efficiency expands the opportu- control system, extensive evasion of nity for efficiency by optimizing on the controls, and low operational effi- outputs. Second, by giving managers ciency. Advising these countries to go full (or near-full) operating discretion, through the sequence of managerial this arrangement enables them to reforms outlined earlier—first estab- apply their professional skills, judg- lish reliable external controls, then ment, and information to select the shift to internal control systems, and most efficient mix of inputs. For exam- only after these systems are well Operational Efficiency 121

Box 5.1: New Zealand’s Contractual Model

In every formal contractual relationship, (3) Provider freedom. To enter into five conditions must be present in order contract, providers must have discretion for the parties to enter into the agree- to manage their operations as they deem ment and to perform according to the appropriate. In New Zealand, each terms of the contract. (1) The two sides department is headed by a chief execu- must have an arms length relationship; tive who serves under an employment (2) the purchaser must have freedom to contract for a fixed term. The chief exec- purchase goods or services from alterna- utive has full discretion to use the tive suppliers; (3) the supplier must have resources available to the department, freedom to produce the contracted without constraints on the amounts that goods and services; (4) the contract must can be spent on personnel, supplies, and specify the cost of the goods or services; other inputs. and (5) the contract must specify the per- (4) Specification of cost. In contract- formance required of the supplier. ing, the purchaser and supplier must Beginning with the enactment of the agree on the amount of money that the State Sector Act 1988 and the Public former will provide to the latter. This Finance Act 1989 and continuing into the amount must reflect the full cost of pro- 1990s, New Zealand has transformed ducing the services. Accordingly, New public management to satisfy each of the Zealand accounts and budgets on an five conditions for contracting. accrual basis, which shows the full cost (1) Arms length relationship. In most (including depreciation charges and a departments, the government has decou- charge on the use of capital) of produc- pled policy advice from service delivery, ing the services. either by hiving off the latter into new (5) Specification of outputs. Finally, organizational units or by reorganizing contracts must specify the outputs to be the department into a number of discrete supplied. This requires that outputs be business units. For example, the Ministry of specified in advance and that depart- Defense was restructured so that it is ments compare actual outputs to targeted responsible only for providing policy outputs. In New Zealand, the budget is advice to the minister; military operations prepared and appropriations are made are entrusted to a new organization, New by output class, not by inputs. Moreover, Zealand Defense Forces which contracts each department submits a “departmen- with the Minister for various services. tal forecast report” specifying the outputs (2) Purchaser freedom. In New for the next fiscal year, and negotiates a Zealand, appropriations are made to the purchase agreement with the Minister Minister who has the option of purchas- specifying the outputs to be provided. er services from government depart- After the year is over, each department ments, other public entities, or outside published an annual report detailing suppliers. In fact, most services are pur- both its financial performance and its chased from governmental suppliers, but outputs for the year. many are not. 122 A Contemporary Approach to Public Expenditure Management embedded move to managerial internal control, and that internal con- accountability—may seem to be a pre- trol is a precondition of managerial scription for failure. After all, why rely accountability. External control nur- on centralized controls (civil service tures the habits and practices of man- classification and pay schemes aging according to the rules. True, it enforced by a central agency, budget takes a bite out of operational efficien- estimates that itemize and separately cy, but the cost is justified when the control each category of inputs, and so rule of law is implanted in the public on) when these controls breed corrup- administration. tion, evasion, and inefficiency? Why Once this occurs, government stretch out the process of managerial can safely adopt systems of internal reform over decades when the oppor- control which entrust operating tunity is at hand to leapfrog to state of managers with greater control of the art systems? their inputs. In a formal sense, inter- Notwithstanding these arguments, nal control means, as was explained governments take enormous risks if earlier, that the spending agency is they adopt a regime of managerial dis- responsible for systems that ensure cretion and accountability before legality and efficiency in expendi- strong, reliable controls are in place. ture; in a behavioral sense, it means There are two elements to effective con- that the controls are internalized, trols systems: workable rules and proce- that managers accept the rules—not dures; and patterns of behavior that because their actions are monitored accept the rules and procedures as legiti- by others or because they would be mate. To say of a country that actual penalized for violating the rules— expenditures do not conform to the but because they regard the rules as amounts shown in the budget, or that legitimate and workable. Without the hiring and remuneration of staff is this behavioral dimension, internal not based on civil service rules and control would open the door to procedures, is to say that the time is abuse, no matter what safeguards are not ripe for managerial freedom. built into the formal control systems. Rules work when they are accepted as This culture of compliance paves fair and rational. It is for this reason the way for managerial accountabili- that external control typically precedes ty in which managers have formal Operational Efficiency 123 carte blanche in purchasing inputs Basic Elements of but are responsible for producing Managerial Accountability budgeted outputs. Managerial Inasmuch as managerial accountability accountability does not mean that systems are in their infancy, their basic anything goes in spending inputs; it elements have not yet been standard- means rather that managers, having ized. Nevertheless, the following ele- internalized the rules, can be trusted ments seem essential in systems that to spend properly and efficiently. purport to give managers operating Without this internalized behavior, discretion in exchange for enforcing managerial discretion would be risky strict accountability. Some of those are and costly. discussed in Table 5.2. Although developing and transi- • Managers are given global oper- tional countries may not be ripe for ating budgets avant-garde managerial systems, the Within this total, spending process of development need not items are fungible; managers stretch over decades or longer. The have incentives to be efficient process can be accelerated by (a) because they have more to rationalizing external controls, remov- spend on some items by spend- ing duplicative and deadweight con- ing less on others. trols (for example, by consolidating budget items and civil service classifi- • Managerial control is devolved to cations); (b) tendering internal control operating levels authority to well-managed depart- Those who provide the services ments that can handle enlarged (field offices, for example) are responsibility; (c) instilling a manage- given their own operating rial ethic in the public service through budgets and managerial flexibil- skills-based and behavioral training; ity. Without devolution, mana- and (d) developing first-generation gerial power would be concen- performance measuring systems. These trated in headquarters and steps would enhance operational effi- operating managers would lack ciency and prepare the way for bolder incentive to be efficient, or reforms in the future. opportunity to be accountable. 124 A Contemporary Approach to Public Expenditure Management

Table 5.2: Instruments for Improving Managerial Accountability

Isnstrument Advantage Running Costs Budget Managers are given a single allocation for all operating expenses to spend on inputs as they deem appropriate, thereby reducing compliance costs and giving manager incentive to operate efficiently. Devolved Budgets Line managers in field offices and other units control their own operating budgets, thereby enabling them to respond to local needs and conditions and to operate efficiently. Efficiency Dividend Percentage reduction in operating budgets equal to expected annual productivity gains compels managers to seek efficiency improvements. Output Specification Expected outputs are specified in the budget or related documents, thereby giving managers advance notice of expected performance, and enabling the government to compare targeted and actual results. Syeparation of Purchasers/Providers Reduces capture of purchasers b providers and enables purchasers to choose among alternative providers, thereby creating internal markers within government. Market Testing By comparing the cost of purchasing services from its own agencies versus outside suppliers, the government can select the most efficient means of obtaining services. Performance Agreements Contracts between the government and chief executives or their agencies specify the resources to be made available and the output to be provided, thereby establishing a basis for assessing individual or organizational performance. Annual Reports and Audits Agency reports on financial results and outputs are independently audited to assess reliability and relevance of performance information. Operational Efficiency 125

• Costs are allocated to outputs or providing outputs to know what activities they are buying or selling. A few If managers are to be efficient, countries (most notably the they must be charged the full United Kingdom) specify a cost of producing outputs and small number of key perform- of carrying out required activi- ance targets; others (such as ties. Some countries use cost Australia) encourage managers allocation models for appor- to specify the full array of out- tioning overhead and other puts to be produced. indirect costs; a few have cost accounting systems in which • Purchaser and provider roles resources are accounted for on are split an accrual basis. Along with In conventional public allocating and accounting for administration, policy deci- costs, it is necessary that man- sions on what the govern- agers have discretion with ment should do are combined respect to the costs charged in the same organization their budgets. For example, if along with operating deci- they are charged for accommo- sions on how services should dation, they should have free- be provided. This functional dom to decide where their integration was long regarded operations will be located. as a virtue because it facili- tates the free flow of ideas • Expected outputs are specified in and feedback between policy advance makers and operating man- Expected outputs are specified agers. But in modern public in advance, either in the course expenditure management, it of compiling the budget or in often is regarded as a disin- contracts between managers and centive to efficiency because their superiors. Ex ante specifi- (a) policy makers are cap- cation requires that outputs be tured by providers, (b) policy measured or stated in a form makers lack needed inde- that enables those purchasing or pendence and information to 126 A Contemporary Approach to Public Expenditure Management

Table 5.3: Types of Output Targets

Teype of measure Exampl

Volume/Workload The agency will process 562,400 claims during the fiscal year.

Timeliness 97 percent of claims will be processed within 3 days of receipt; 99 percent within 5 days.

Quality The error rate on determination of eligibility shall not exceed 2 percent. The error rate on amount paid per claim shall not exceed 3 percent. Service Quality At least 60 percent of recipients are very satisfied with the service; at least 80 percent are satisfied or very satisfied with the service. U2nit Cost The average cost per claim processed will be $4.6

enforce accountability, and ly applied and some countries (c) policy makers do not have (such as Australia) have the option of buying services rejected it. from the most efficient sup- plier. Some countries (the • The government maintains a United Kingdom through its comprehensive performance Next Steps initiative, New reporting and auditing system Zealand by restructuring To maintain accountability it is departments) have separated important that results be sys- policy advice from service tematically compared to tar- delivery. Separation aims to gets, and that data on results be create an arms-length rela- subject to audit. In the coun- tionship in which purchasers tries moving in this direction, it have freedom to obtain serv- has proven much easier to audit ices from in-house or alterna- financial performance than tive suppliers. It should be program outputs. Nevertheless, noted, however, that this some countries now require decoupled model is not wide- that each department publish Operational Efficiency 127

auditable performance data in gerial accountability is still in the early its annual report. stages of development, practices have not been standardized yet, and signifi- • Managers are personally responsi- cant differences have emerged in the ble for cost and outputs approaches taken by the countries that Once they have operating dis- have moved in this direction. cretion, managers can be held responsible for expected results Rules by linking their pay and job Two sets of closely linked rules are pre- tenure to performance. requisites for establishing managerial Implementing this feature of accountability. One pertains to the use managerial accountability of operating resources, the other to would compel the government accountability for outputs and other to abandon conventional civil dimensions of performance. The first service rules concerning pay without the second would give man- classifications, appointment, agers license to spend as they wished; the and termination. Under an second without the first would make accountability regime, man- managers accountable for results over agers would be employed under which they have little or no control. fixed-term contracts that speci- The first set of rules regulates the fy pay and other working con- volume and use of running or operat- ditions as well as performance ing resources. In managerial accounta- expectations. bility, running costs are cash limited; that is, managers are required to oper- Institutions, Information, ate within a fixed budget with no sup- Incentives plementation during the year for cost Adopting a managerial accountability overruns, except possibly for those due system portends significant shifts in to demand-generated increases (over rules governing operational expendi- which line managers have no control) ture, the roles of budget controllers in the volume of outputs. Moreover, and spending managers, and the infor- the cash limits are set progressively mation produced and used in running lower each year to capture expected government activities. Because mana- efficiency gains. Typically, this 128 A Contemporary Approach to Public Expenditure Management enforced cutback is applied across-the- Table 5.3 provides examples of types of board to all operating budgets, but output measures that may be specified agencies still can bid for additional in the budget or related documents. As resources during budget formulation. illustrated in this table, performance For example, if the “efficiency divi- measures are not limited to the volume dend” were set at 2 percent of operat- of outputs; quality, cost, and customer ing expenses, each agency’s baseline for attitudes also can be measured. running costs would be reduced by Once outputs have been specified, this percentage. However, agencies it should be possible to hold managers could, in the course of compiling the accountable for results. The results can next year’s budget, seek additional be presented in annual reports or other operating resources above the baseline. documents and formatted in ways that Once the operating budget is decided, facilitate comparison of projected and managers have broad discretion in actual outputs. Ideally, to maintain using resources, including authority accountability, performance measures (in some countries) to carryover some should be reviewed by independent unused funds to the next fiscal year, or auditors empowered to note deficien- to prespend a small portion of the next cies in the data and to recommend year’s running costs. Line managers— remedial actions. not controllers in central agencies or departmental headquarters—decide Roles on the amounts spent on personnel, External control concentrates decisions supplies, equipment, and other puts. on expenditures at the center of gov- This managerial discretion might be ernment and operating responsibility hedged by limits on pay and certain at the bottom; internal control keeps other expenditure items. operational responsibility at the bot- The second set of rules pertains to tom but shifts spending control to the accountability for performance. center of departments; managerial Ideally, expected performance would accountability devolves both control of be specified in advance so that the resources and responsibility for results budget would be an explicit or implied to operating units within departments. contract on the services to be produced These units can be field offices which in exchange for the resources provided. directly deliver services, regional Operational Efficiency 129

Box 5.2: Performance Targets in the United Kingdom Published performance targets are a responsibilities. The Government pub- central feature of management reform lishes an annual report that compares in the United Kingdom. These targets actual performance against targets for have been developed pursuant to two the previous year and specifies targets initiatives which have transformed cen- for the next year. tral government: the Next Step program The citizen’s Charter aims to launched in 1988 and the Citizen’s improve the quality of services by pub- Charter started in 1991. Although they lishing standards which users can were launched by Conservative expect for each service they receive Governments, both initiatives have been from Government, and entitling users to so successful that they have been con- an explanation (and in some cases com- tinued by the Labor Government elected pensation) if the standards are not met. in 1997. In addition to certain Government-wide Next Step refers to a process by standards (for example, that officials or which responsibility for service delivery employees will meet with citizens no has been transferred from central later than 10 minutes beyond the time departments to agencies which have for which an appointment was made), been granted operational independ- each department and agency has its ence. As of 1996, there were 129 such own service standards. agencies, comprising approximately The following performance targets three quarters of the civil service. Each and results pertaining to social security agency operates within a discrete area (published in the 1996 Next Step of responsibility. It is thought more effi- Reports) illustrate the types of perform- cient to have a large number of agen- ance information used to improve serv- cies, each with specific targets than a ice operations. small number of agencies with multiple

’593-’94 ’694’-9 ’795-’9 ’96-’9 Income Support Claims Cleared in 5 days T%arget 7%1 7%1 6%3 63 O%utturn 7%4 6%9 67 Accuracy of Payments T%arget 9%2 9%2 8%7 87 O%utturn 9%1 8%7 78 Customer Satisfaction T%arget 8%5 8%5 85 O%utturn 8%4 83 Overpayment Recovery (millions of pounds) T4arget 5570121 9

O0utturn 87121 12 130 A Contemporary Approach to Public Expenditure Management offices which oversee operations with- advising units, introduced output- in a defined area, headquarters units based budgeting, and various contract which provide overhead services, or like documents in which resources and any other organizational area with outputs are specified. (4) In contrast to specified resources and responsibilities. other countries, Australia has retained In the countries that have consolidated departments, but has embraced managerial accountability, pushed for devolution of resources and several models have been developed. operating discretion to field units. (1) Sweden has a long-standing separa- This organizational variety may be tion going back to the 19th century, partly due to the different political— between small ministries which have administrative cultures of the countries political and policy-making functions that have emphasized managerial and a large number of independent accountability. But behind the various agencies which carry out government approaches lie two distinct strategies programs. Managerial accountability for encouraging managerial accounta- has spurred the government to clarify bility. One is managerial, the other is the relationship between the two types contractual. Managerialism refers to of entities and to strengthen accounta- systems in which managers are given bility mechanisms. (2) Since the late broad scope to run the organization 1980s, the United Kingdom has estab- according to their judgment; contrac- lished more than 130 executive agen- tualism refers to relationships in which cies (popularly referred to as “Next agents who provide services write Steps” agencies), each headed by an explicit agreements with principals appointed chief executive, and each who control resources on the services operating under a framework docu- to be provided. Contractualism spurs ment that delineates what the agency government to decouple operations can do on its own accord and the mat- from policy; managerialism pushes ters for which it is accountable. See government to combine the various Box 5.2 for a description of the Next responsibilities in the same organiza- Steps initiative and sample perform- tion. Managerial flexibility is precondi- ance targets used in it. (3) During the tion for internal contracts, for if man- 1990s, New Zealand separated most agers lack discretion, they cannot be service-delivery functions from policy- responsible parties to an agreement. Operational Efficiency 131

Table 5.2 describes some of the instru- tion is costly, especially during the early ments devised in recent years to years of reform when new measurement strengthen managerial accountability. and reporting systems must be devel- oped. The more determined the govern- Information ment is in enforcing accountability, the Every form of control has distinctive greater these costs will be. To this informational demands. Maintaining writer’s knowledge, no country has sys- external control requires a bottom-up tematically measured the transaction informational flow, in which managers costs of establishing performance tar- provide superiors with detailed informa- gets, collecting data, monitoring per- tion or their operations. Internal control formance, and assessing results. It is rel- allows for the consolidation of informa- atively simple for governments to esti- tion sent by departments to central mate the costs foregone when input authorities, but still requires an extensive controls are terminated or relaxed; it is flow from operational levels to head- much harder for them to estimate the quarters. Managerial accountability new costs assumed when managers are greatly reduces the volume of input held accountable. information exchanged between organi- zational units, but also greatly increases Managerial Behavior the volume of cost and output informa- Getting the incentives right is critical tion. Managers have to generate, com- to the successful implementation of pile, transmit, and analyze cost and out- any managerial accountability system. put information; they need to specify This new approach is predicated on these in advance, and to assess results the expectation that managers will against targets; they must develop new behave efficiently if given the informa- cost measurement, accounting and allo- tion and opportunity to do so. But will cation systems, based on accrual princi- they? Some managers may prefer to ples; and they should have the capacity have more control if, as a consequence, to price outputs independently of input they also are not held to account for costs. Table 5.4 presents various con- failing to perform. Some managers cepts used in measuring costs. may feel threatened by the mass of cost Compiling and processing the new and performance information which types of cost and performance informa- they must prepare for use by others. 132 A Contemporary Approach to Public Expenditure Management

Table 5.4: The Definition and Measurement of Cost

Tnerm Definitio Expenditures Amounts paid by government entities in the course of operating programs. Expenditures are recorded on a cash basis in the fiscal period during which the payment is made. Cost (or Accrued Cost) The resources used in producing goods and services, regardless of the entity incurring the expenditure or the fiscal period in which payment is made. Ceost Allocation A method of charging costs to th activity/output which incurs them. Allocated costs include indirect and overhead costs, and costs paid by other entities or accounts, such as the cost of accommodation in government-owned buildings. Activity Based Costing A method of assigning costs to the activities (or "drivers") generating them.

Unit Cost The cost of producing a unit of output. Unit costs are used to compare the relative efficiency of different service providers, to calculate changes in productivity over time, to allocate budget resources, and to charge users for services. Marginal Cost The cost of producing an additional increment of output, in contrast to the average cost of producing total output.

Variable Cost Costs that vary with the volume of output, in contrast with fixed costs that are incurred regardless of the volume.

In real organizations, managerial ating freedom but find that their accountability rarely is implemented in budgets are hedged with all sorts of textbook fashion. Managers get mixed well intended restrictions (to guard messages when they are given against corruption or mismanage- resources. They may be promised oper- ment), but the result is that they are Operational Efficiency 133 not really free to manage. They may be operations. A true performance budget promised a certain volume of operat- is a variable budget. Introducing vari- ing resources for each of the next sev- able budgets in the public sector is a eral years, only to find that funds are challenging task because (a) appropria- cutback whenever the government is tions are legally fixed limits on expen- pressured to reduce the budget deficit; diture, (b) few governments have reli- they may be given arbitrary budgets able accounting systems for apportion- that are set without regard for the actu- ing costs and for distinguishing al cost of producing the specified out- between fixed and variable costs, and puts; they usually are given fixed budg- (c) managers rarely have sufficient ets that do not vary, even when the operating authority to control costs as volume of outputs produced is driven the volume of outputs varies. In gov- up by exogenous demands. ernment, the near-universal practice is Managerial incentives may also be to authorize fixed budgets that do not weakened by the failure of government vary with changes in the volume of to use available performance informa- outputs. The major exception occurs tion. It is not uncommon for managers when organizations are voted net to take special care in developing per- appropriations which permit them to formance data only to find that the spend certain self-generated money, material is not used in allocating such as revenue from user charges. resources or in making other operating Efficient firms, by contrast, have vari- decisions. Managers who are turned on able budgets, which distinguish when a new performance-based system between fixed and variable costs. is introduced turn off when the infor- Giving managers operating free- mation goes unused. There are many dom would require, among other different ways of using performance things, abandoning government-wide information. Table 5.5 arrays the prin- civil service systems and much greater cipal uses in a sequence from the least use of temporary, seasonal, and part- impact on decisions to the most. The time workers who can be hired or last entry on the list—performance sacked as work levels rise or fall. budgeting—indicates how far govern- Incentives for operational efficiency ments must go in transforming public also depend on advances on the expenditure management to optimize accountability side of the equation. 134 A Contemporary Approach to Public Expenditure Management

Table 5.5: Using Performance Information to Improve Operations

Aectivity Purpos Performance Measurement Provides basis for specifying expected performance and assessing managers and their organizations.

Performance Targets Notifies managers of the specific results they are expected to achieve and establishes basis for assessing their performance. Pderformance Reporting Compares actual and targete performance, with explanation of significant variances. Makes performance transparent and provides citizens/customers basis for judging the volume, quality, and cost of services. Performance Auditing Independent assessment of the reliability and relevance of performance reports.

Pgerformance Benchmarks (a) Provides basis for comparin performance with results achieved by other public or private producers; (b) Sets performance targets in reference to results achieved by most efficient producers. Peerformance Contracting Formal agreement between th government and internal or external providers setting forth amounts to be paid and outputs to be supplied. Performance-Based Pay Links all or a portion of a manager's pay to performance.

Performance Budgeting Allocates resources on the basis of expected performance, with each increment in resources linked to a specified increment in output. Variable Cost Costs that vary with the volume of output, in contrast with fixed costs that are incurred regardless of the volume. Operational Efficiency 135

Governments must establish challenging and repeatedly miscode information? performance targets, monitor compli- Answers to these and other questions ance, and intervene to reward successful provide vital clues in gauging a govern- performance or to penalize inefficient ment’s readiness to switch from exter- managers. Although some progress has nal to internal control. The efficacy of been made on this front, governments every internal control system depends generally have found it much easier to on ingrained habits of abiding by rules, divest input controls than to vigorously perhaps not in every case, but in enforce accountability. almost all. Without these habits, inter- nal control systems would not be reli- Summing Up: Pathways to able, and governments could not have Operational Efficiency confidence in the information sup- There are many routes to improving plied by their spending departments. operational efficiency, but few short- Internal control is the bridge cuts. Governments seeking rapid between external control and manage- progress in this area of expenditure rial accountability. Moving to internal management would do well by begin- control is no small feat, for it reduces ning with an assessment of their cur- compliance costs, and bolsters the rent control systems. If, as often is the capacity of departments to manage case in developing countries, depart- their own affairs, without having each ments are operating under the burden of their actions reviewed, and possibly of externally imposed and enforced vetoed, by central controllers. Once controls, the government should assess internal controls are in place, the role not only the compliance costs, which of central controllers is transformed are likely to be substantial, but from preauditing transactions to audit- whether departments actually comply ing systems. Each department main- with the rules. Have departments tains its own systems (for civil service, accepted the rules as fair and workable, expenditure, procurement, informa- or do they regularly ignore or evade the tion management, etc.) subject to gov- rules? In managing human resources, ernment-wide standards. In auditing as well as in managing public money, systems to ascertain compliance with do departments accurately record these standards, central agencies typi- transactions, or do they deliberately cally sample a small number of trans- 136 A Contemporary Approach to Public Expenditure Management actions to determine whether the sys- is restructured to give it greater oppor- tems work according to blueprint. For tunity to purchase services through the most part, however, departments market-type competition between in- manage their own operations. house and external suppliers. Yet from the perspective of line Managerial accountability systems managers, the shift from external inter- are still in their infancy; the oldest nal control often is hardly noticed. The were established in the late 1980s or controls seem to be as onerous as early 1990s. There is reason to believe before, and compliance as rigidly that these systems have improved oper- enforced. The reason for this is that in ational efficiency by reducing compli- shifting to internal control, the con- ance costs and giving managers strong trols previously exercised by central incentives to be more efficient. agencies often migrate to department Countries that have gone down this headquarters. For managers hobbled path give no evidence of backsliding. by command and control public In fact, the Labour Government elect- administration, it makes little differ- ed in 1997 after 18 years of ence whether the detailed rules are Conservative rule, has retained, and in enforced at the center of government some cases deepened, most of the or at the center of their own depart- managerial reforms it inherited. ment. In either case, compliance is the Should developing countries start order of the day, and considerations of down this path as a means of improving performance fall into neglect. public services and making operations Managerial accountability liberates more efficient? The answer depends not managers from the straitjacket of one on the attractiveness of managerial size fits all rules and procedures. In accountability systems but on the gaining new operating freedom, how- robustness of current control systems. A ever, managers are made to abide by government that has reliable internal tougher, more transparent perform- control systems in most departments ance requirements. Expected perform- may be a suitable candidate for giving ance is targeted in advance, and actual managers broad discretion. But a gov- results are compared to the targets. In ernment that has not yet reached this some venues, detailed performance stage of development would be advised contracts are written and government to build sturdy control systems before Operational Efficiency 137 venturing to the difficult and risky task of managing on the basis of outputs rather than inputs. ❧