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Pem Aus NZ Spore
Pem Aus NZ Spore
35116
A Contemporary Approach to
Public Disclosure Authorized
Allen Schick
Public Disclosure Authorized
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-
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The World Bank enjoys copyright protection under protocol 2 of the Universal Copyright
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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
Boxes
Box 3.1: Australias Forward Estimates System ................................................57
Box 3.2: Strengthening Fiscal Discipline in Sweden ........................................60
Box 5.1: New Zealands 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.
P
ublic expenditure management
(PEM) is a new approach to an tional and management arrangements,
old 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
budgetingthe 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
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
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 valueoften 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- ernments 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
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 dont 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 nt, 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 everythingfrom the budgets 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--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
hard fiscal constraints for a period doesnt, 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 governments 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
obduratethis 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 budgets 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
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
ernments 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
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 spenderswhether politicians or either because of a buildup of deferred
managerswere driven to behave in spending pressures or because politi-
these self-interested ways, why dont 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 dont 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 dont 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
resultsenhancing 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
I
n all countries, managing public
expenditure is an essential but diffi- fundamentally different from that of
cult 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
Practice Problem
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
etwhat actually will be spentis 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
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 35 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 futureit does not allocate
medium-term perspective that takes spending increases to social pro-
account of the future financial and gramsthen 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 dont 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
Practice Problem
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 budgets 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
Practice Problem
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
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
C
ontrolling total expenditure is
an essential purpose of every cipline is accompanied by constraints
budget system. There would on other budget aggregates. If it isnt,
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 governments 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 doctrinesthe 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 years 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
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. Australias 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
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. Swedens 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- ments 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 governments
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 governments 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 governments 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
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 Governments 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 Swedens 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, Swedens 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 Swedens 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. Australias 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 budgets 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
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- governments 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--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, dont 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, Japans 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
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 participants 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
In All Countries
1. Moral Hazard Persons/firms take undue risks when losses are
compensated by the Government.
Developing/Transitional Countries
Method Advantages/Disadvantages
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.
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 governments 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 governments 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
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 years 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
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 budgets 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.
TIONS
INTEND THEM TO BE
E
very budget system rations
resources by allocating money those objectives. To allocate efficiently,
for 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
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- ters 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
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 governments 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
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 ments 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
O
perational efficiency is the
ratio of the resources diture and transfer payments as well.
expended 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-
ments 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 governments 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 inputsboth 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 governments
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 timea century ago in many
to two distinct entities; control is exer- countries, only a few decades ago in
cised exclusively over inputs; and control othersgovernment 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
Preaudit of transactions
Postaudit of transactions
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 mentalityit is more important to
ment, it economizes on public expen- follow the rules than to operate effi-
ditures, it separates those who decide cientlyand 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 standardstrict rules and
the individual items receded in impor- loose complianceis 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 departments 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
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 earlierfirst 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
Instrument Advantages
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.
Separation of Purchasers/Providers Reduces capture of purchasers by
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
Volume/Workload The agency will process 562,400 claims during the fiscal
year.
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 writers 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
Term Definition
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.
Cost Allocation A method of charging costs to the
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.
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 listperformance sacked as work levels rise or fall.
budgetingindicates 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
Activity Purpose
Performance Measurement Provides basis for specifying expected
performance and assessing managers and
their organizations.