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EXCURSION TO
FISCAL POLICY AND THE
BUDGETING PROCESS

Copyright © UNITAR, United Nations Institute for Training and Research, 2016,
on behalf of PAGE.

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Course authors:
Giuliano Montanari, Maya Valcheva, Amrei Horstbrink (UNITAR); Philip Gass (IISD)

Contributors:
Jason Dion (IISD); Sirini Withana (UN Environment); Sarwat Chowdhury, Massimiliano Riva
(UNDP).

Creative Concept:
Arturo Rago

Graphic Design:
Pilar Lagos (UNITAR)

Photo credits
Unless stated otherwise, the photos used in the journal are under a Creative Commons license.
 3

TABLE OF CONTENTS
Introduction 5

1 THE FUNDAMENTALS OF FISCAL POLICY 6

OVERVIEW 6
FUNCTIONS OF FISCAL POLICY 6
THE IMPORTANCE OF FISCAL SPACE 12
KEY DETERMINANTS OF FISCAL POLICY 13

2 CENTRAL FEATURES OF THE NATIONAL BUDGET PROCESS 19

OVERVIEW 19
WHAT IS THE BUDGET CYCLE? 19
RESPONSIBILITIES IN BUDGET FORMULATION 21
TYPES OF BUDGET SPENDING 21
BASIC STEPS IN BUDGET FORMULATION 22
SOUND BUDGET PRINCIPLES AND LEGAL FRAMEWORK 23

3 LINKING POLICY, PLANNING AND BUDGETING 25

OVERVIEW 25
DIFFICULTIES IN CREATING LINKAGE BETWEEN POLICY, PLANNING AND BUDGETING 25
WHAT DOES IT ALL MEAN FOR GREEN FISCAL REFORM? 27

4 KEY LEARNING POINTS 29

REFERENCES 30
ABBREVIATIONS 31
 5
Introduction
G
reen fiscal reform (GFR) is an
approach to rearranging government
spending and revenue with the
goal of advancing sustainable development
objectives of countries. GFR is concerned
with both fiscal policy and environmental
policy. In general terms, fiscal policy is
responsible for organizing public financial
flows in view of achieving specific national
objectives.
The national budget is a key mechanism for
implementing fiscal policies and influencing
the behaviour of market actors within the
national economy. The budget is an official
government document, which compiles all
proposed fiscal policies, i.e. revenues and
expenditures, for the financial year.
1 Please note that this lesson is not meant to develop a comprehensive understanding of fiscal policy
and budgeting processes, but rather to highlight their relevance in the context of designing and
implementing green fiscal policies.
Given the learners´ diverse backgrounds and
the complexity of fiscal policies and national
budget issues, this optional preparatory
Module aims to provide an introduction to the
fundamentals of fiscal policy and the national
budgeting process. Understanding these
subjects is essential for grasping the scope of
objectives and instruments that green fiscal
reform is concerned with. 1
Lesson 1 of this introductory module centres
on the rationale for fiscal policy, while
Lesson 2 examines central features of the
national budgeting processes. Lesson 3
looks at linkages between policy, planning
and budgeting processes. If learners already
dispose of sufficient knowledge on these
issues, they may proceed directly to Module 1.
 6

THE FUNDAMENTALS
OF FISCAL POLICY
Fiscal policy and the well-being of societies are closely intertwined. Societies
depend on the provision of a number of public goods, which are essential to
development. Governments use fiscal policy to ensure their provision.

OVERVIEW
In simple terms governments employ fiscal
policy to adjust public spending and taxation
in order to keep in check and influence the
nation’s economy. This first lesson outlines
the main functions of fiscal policy and how it
regulates the economy (Section 1.2). Section
2.2 explains what fiscal space is while Section
1.3 outlines key determinants of fiscal policy.

FUNCTIONS OF FISCAL POLICY

Fiscal policy is understood as the use of
government spending and taxation to
influence the economy (IMF 2012a). It
reflects a crucial function of the modern
state, i.e. the ability to collect revenue and
exercise spending in accordance with the
political goals chosen in national decision-
making processes.
social conditions and public good are in
place, such as health care, law enforcement
and education, etc.
As markets do not consistently provide
funding these goods by default, a rationale
for public action is created. This is where the
rationale of fiscal policy lies (WB 2012).

Fiscal policy is distinct from monetary policy,
through which an independent central bank
influences the country’s money supply
and controls the levels of interest rate and
inflation (IMF 2014).
In order to achieve national objectives,
governments need to ensure that certain
In light of these challenges, the traditional
threefold rationale formulated by Musgrave
(1959) is still valid:
Fiscal policy aims to organize the allocation of
resources, advance macro-economic stability
and address distributional disparities (Fig. 1).
 7

FISCAL POLICY
S TA B I L I Z A T I O N DISTRIBUTION ALLOCATION
Influencing economic Equality of Provision of basic
activity, sustainable opportunities, public goods for
public finances general fairness development

Fig. 1: Threefold rationale of fiscal policy

ALLOCATION FUNCTION
The allocation function refers to using fiscal
policies to ensure that basic public goods and
services, such as infrastructural development,
education, law enforcement, etc., are
provided for in society. This is necessary
since the market rarely creates these goods
and services by itself (see Box 1). 1
The amount of funds available for allocation
depends on the capacity of the government
to raise revenue, most commonly in the form
of taxes or loans from financial markets The
actual allocation of these revenues, e.g. via
public investments, subsidies, salaries to
public staff, is determined in the national
budget along the priorities laid out in
national development plans or administrative
policies.
Proper functioning of public services
enables the private sector to develop reliable
business plans and make investments. Where
these public goods are not guaranteed,
market actors would be hesitant to make
such long-terms investments that spur
innovation and create economic growth.

STABILIZATION FUNCTION
Fiscal policy is one of the economic
instruments available to government to assure
a smooth functioning of the economy.
Fiscal policy can help stabilize the economy
by minimizing excessive behavior, e.g.
excessive spending or saving, of market
actors as the economy evolves.
Such behavior may be characterized both by
overly optimistic or pessimistic expectations
about where the economy is going.
Stabilization implies short- and long-run fiscal
consideration (IMF 2012a).

1 There are two types of public goods: Non-excludable and non-rivalrous goods. Non-excludability means
that it is impossible (or very costly) to exclude other persons from enjoying a certain good. For example,
it is impossible to restrict individual access to a clean air. Non-rivalrous goods are enjoyed by many at
the same time at no (or very little) additional costs. A scientific discovery, for instance, does not deplete
regardless of how many persons enjoy it. By contrast, a barrel of petrol would be considered a private
good since it can be consumed only once (rivalrous) while its owner can easily exclude others from its
benefits (excludable) (UNEP 2011).

In the short run, fiscal policy is concerned
with restraining spending when the economy
shows signs of overheating, i.e. creating
excess demand, thus slowing it down to
more controllable levels.
By contrast, increasing public spending
can also spur demand when the economy
finds itself in a dangerous downward slide,
thus raising the expectations of market
participants that the economy will recover
soon.
The political response to the 2008 global
financial crisis is a practical example of
macroeconomic stabilization through fiscal
policy. Here, fiscal spending on a large scale,
also known as fiscal or economic stimulus,
was used to avert further deterioration
of national economies (see Figure 2 for
variation in regional responses).
Size and targeting of countries’ stimuli may
vary markedly due to national circumstances
BOX 1:
MARKET DEVELOPMENT AND THE PROVISION OF PUBLIC GOODS
In some cases governments may invest
in a particular infrastructure or industry
in early development stages when there
is little incentive for the private sector to
develop them.
For example, in Canada and many other
countries, railways and telecommunications
were originally public. This was due to the
fact that in vast, sparsely populated regions
services needed to be provided as a public
good at first as there was no market or case
to be made for private investment.
2 To a varying degree, stimuli also included dedicated funds to support greening of the economy (ILO 2011b). HSBC (2010)
estimates that around 16.3% of all fiscal measures was directed towards green stimulus by the end of 2009. In the Republic of
Korea, for example, nearly 80% of the total stimulus was categorized as ‘green’.
8
and affected sectors. In general, stimulus
measures after 2008 focused on liquidity
injections to the banking sector, extending
public infrastructure spending and temporary
tax cuts to boost private demand (ILO 2011a).2
In the long run, government budgets need
to adhere to sustainable ratios of revenue to
spending. This is because large annual deficits or
a rapid build-up of public debt can themselves
become a source of macroeconomic instability,
leading consumers, producers or creditors to
mistrust the capacity of government to act in
the future.
It should be noted that fiscal policy is just one
of the instruments to which governments can
resort in order to stabilize the economy. In
other instances, monitary policies that aim
to influence exchange rate, interest rates or
inflation, might be more appropriate.
As markets and technologies matured, e.g.
cell phone coverage, and populations grew,
many of the public-owned entities were
privatized since services could be provided
by market actors. Privatization, however,
needs to be carefully implemented in order
to ensure quality of and sufficient access to
basic goods and services.
SOURCE: Boardman/Vining, 2012.
 9

REFLECTION POINT
Can you think of specific fiscal measures that were used during the global financial
crisis in your country? What did they focus on?

10 9.1

5.9
6
4.3

4 3.4
2.6

Asia and the Pacific Africa and the Central and Eastern Advanced Latin America
(not including Japan Middle East European and Economies and the Carribbean
and the Republic of Former Soviet
Korea) Republics

Fig. 2: Economic stimulus in response to the global financial crisis as percent of 2008 gross domestic product (GDP)
(ILO 2011a)
 10

DISTRIBUTION FUNCTION
The distribution function refers to the need
to improve the distribution of income,
opportunities, assets and risks within the
society. If not regulated, market activity tends
to create social disparities that may conflict
with widely shared ethical values. Fiscal
distribution policy is thus a central expression
of the concept of fairness and merit prevalent
in an economic community.
For example, countries in Northern Europe
traditionally favor a more equal distribution
of income, reflected in higher tax transfers
through the social welfare system, as opposed
to countries such as the United States,
where lower taxation and more open markets
have indicated a trend to higher Gini figures
(Figure 3). 3
Policymakers have two main instruments at
their disposal to reduce income inequality.
On the one hand, direct taxes may target
personal income and wealth, while indirect
taxes levy consumption. On the other
hand, cash transfers, i.e, direct government
payments to poor or vulnerable groups, may
raise incomes of lower-income segments
(IMF 2015a). 4

0 5 10 15 20 25 30 35 40 45 50 55

Member of Occupy
Sweden Wall Street, a
movement that
Bulgaria started in 2011 to
protest against
Germany social and economic
inequality.
UK

Yemen

Bhutan

Togo

USA

Gabon

China

Argentina

Malaysia

Brazil

Fig. 3: Gini coefficient 2013 (WB 2013)

3 The Gini coefficient measures the distribution of income within a society. When the value is 0,
income distribution is perfectly equal. At value 1, one individual enjoys all income.
4
For an in-depth discussion about how fiscal policy can address inequality, consider IMF (2015b).
 11

The distributional impact of income
taxes depends on its progressivity. In a
progressive tax system the income tax rate
rises with the increase in personal income.
By contrast, if a tax system is regressive,
the tax burden decreases in proportion to
rising income levels (Figure 4). By most
accounts, regressive taxation benefits the
rich and is considered unfair. Countries
may decide to set a minimum tax rate.
In Figure 4, the minimum tax level is set
at 10% for the progressive tax system,
meaning that everyone in society would
have to pay at least 10% tax regardless
of their income level. In other countries,
income tax rates may even become
negative if personal income falls below
a specified level. This would result into
money transfers to the individual if his/
her income is below an established level
(Figure 5).
A fiscal system that is designed along the
thee functions covered in this section
allows its policymakers to make gradual
and controlled changes to the economic
system, and is therefore a prerequisite for
achieving nationally determined objectives.

50
Regressive tax
40 system
Progressive tax
Tax rate (%)

system
30

20

10

Income

Fig. 4: Progressive and regressive taxation (with 10% minimum tax rate)
Retrieved from https://11cresma.wordpress.com/definitions-diagrams/

30

20
Tax rate (%)

10

0 Income

-10

-20

Fig. 5: Model of a hybrid tax system combining positive and negative tax rates.
 12

REFLECTION POINT
How did the Gini coefficient develop in your country in recent years?
Does the tax system support poorer groups by taxing the affluent population?

THE IMPORTANCE OF FISCAL SPACE

The availability of fiscal space refers to
whether or not the state has the necessary
resources to perform the allocative, stabilizing
and distributive functions, as described above.
The following two factors are key when
evaluating the fiscal space of a country (IMF
2005):
- The level of public indebtedness
(typically measured as percent of GDP);
- Balance of the current national budget.
Fiscal space is a product of both past and
present management of public finance. 5
Generally speaking, countries with low levels
of public debt and balanced (or surplus)
national budgets have more fiscal space, i.e.
can deploy more funds comparative to those
running high public debts and budget deficits.
As a guideline, policymakers should avoid a
fiscal situation that is marked by high public
debt and budget deficits, which generally
lead to loss of confidence on the part of both
national and international institutions in the
ability of the state to effectively run its public
finance (see Box 2).

BOX 2:
GOVERNING WITHOUT FISCAL SPACE
The experiences of several countries facing
major crises of public finance in Europe
illustrate the difficulties related to lack of
fiscal space.
In the wake of the global financial
meltdown of 2007-2008, Ireland,
Italy, Portugal and Greece have been
running considerable budget deficits in
combination with high levels of public
debt. In turn, loss of confidence in the
sustainability of public finances resulted in
significantly higher costs for loans obtained
on financial markets for these countries.
Notably, mismanagement of public
finances prior to the meltdown amplified
the crisis impact by gradually diminishing
fiscal space. The worsening of market
conditions for financing can quickly put
governments at the brink of bankruptcy
SOURCE: EC 2009.

5 Especially for developing countries, it also shaped by agreements with international finance institutions, such as the
World Bank, which may provide public funds under specific conditions.

KEY DETERMINANTS OF FISCAL POLICY
Governance influence over the economy
can have an effect on the prices of goods
and services in the economy, e.g. by taxing
or subsidizing various products. States are
thus able to influence the levels of supply and
MACROECONOMIC CIRCUMSTANCES
Economies are never static, which means
that fiscal policy needs to adjust accordingly
to a constantly changing macroeconomic
environment.
Free market economies tend to develop along
recurring business cycles (WB 2006). Within
the course of these business cycles, economic
upturns, i.e. rising GDP, eventually slide into
economic downturns, and vice versa.
Upturns and downturns depend on a range
of factors, such as changing income or trade
patterns, price levels of commodity, housing,
manufacturing, etc.
Output (GDP)
Time
Fig. 6: Typical course of the economy6
6 The figure is simplified. For further discussion, please check the World Bank website.
13
demand. The design of fiscal policy depends to
a large extent on two factors:
- Macroeconomic circumstances;
- The role of the state in the economy.
Figure 6 below illustrates this cyclical nature
of economies over the course of time.
In a positive business cycle, increased levels
of investment and production lead to more
employment, which increases the disposable
income of citizens, hence fueling consumption
(Figure 7).
In a negative business cycle, a decrease
in consumption reduces the means for
further investments or the need to increase
production. This leads to less jobs being
created and lower income for the population
(Figure 8).
Actual growth
Growth trend
Downturn
Upturn
 14

Fig. 7:
POSITIVE BUSINESS CYCLE
LEADING TO RISING GDP EMPLOYMENT

PRODUCTION INCOME GROWTH

INVESTMENTS CONSUMPTION/SPENDING

PROFITS DEMAND INCREASE

Fig. 8:
NEGATIVE BUSINESS CYCLE
LEADING TO SHRINKING GDP
LESS EMPLOYMENT
DEMAND

DECREASED
PRODUCTION DECLINING INCOME

INVESTMENTS LESS CONSUMPTION/

ON HOLD MORE SAVING

SHRINKING
PROFITS DEMAND DECREASE
 15

If unchecked, both upturns and downturns shared expectations that citizens and
can quickly turn into feedback loops that businesses develop about the future course of
destabilize the economy by virtue of widely the economy (see Box 3).

BOX 3:
BOOM AND BUST IN THE ECONOMY

Sudden economic crises, or busts, have
frequently hit developed and developing
countries in recent decades. Such crises
were often preceded by phases of rapid
economic expansion, or boom. Although
economic observers are typically aware
that phases of expansion and recession do
not last forever, but rather follow a cyclical
course, predicting the turning point
remains very difficult.
The great economic disruptions of the
1930s and late 2000s (and their preceding
expansions) are the two largest in a series of
crises that have hit modern economies in the
past.
SOURCE: IMF 2012a

The general unpredictability of economic

trends is one reason why consumers,
producers and policymakers tend to form
expectations based on recent experience.
If these expectations are prevalent
throughout the economy, they begin to
reinforce (mutually strengthen) each other
until supply and demand diverge markedly.

Fiscal policy can be an effective tool to
smooth the magnitude of business cycles, i.e.
keep the upper and lower peak of economic
activity in a healthy and manageable corridor.
When economic indicators point to excessive
private spending and production levels, e.g.
via rapidly increasing inflation and investment
patterns, fiscal policy can reduce or slow
down demand through, inter alia, higher
taxation, thus reducing the income prospects
of households and business.
In turn, these market participants are
expected to restrain their spending as well,
thus reducing the likelihood of speculative
manias in the market (IMF 2012b).
The same mechanism works in the opposite
direction, too. In the case of the economy
showing signs of downward pressure, e.g.
through decreasing consumption and
investment levels, fiscal policy can intervene
by raising government spending or cutting
taxes.
When the fiscal policy aims to run against
the business cycle, as described above, it is
called countercyclical (IMF 2008)
(Figure 9).
 16

Actual growth

Countercyclical
fiscal policy

Government
Output (GDP)

spending increases
Government
spending decreases

Growth trend

Time

Fig. 9: Countercyclical fiscal policy (amended based on FIG. 6)

 17
ROLE OF THE STATE IN THE ECONOMY
Government engagement in the economy
also plays a major role in the regulation of
supply and demand. While any government
takes into account macroeconomic
circumstances in its fiscal decision-making,
states also select policies depending on
whether they generally play an active or
passive role in the economy (WB 2012).
For instance, governments may choose
to leave the provision of goods, such as
healthcare or education, to a large extent
to the market, thus minimizing the need for
revenues and, subsequently, taxation.
BOX 4:
HEALTH CARE SYSTEMS IN THE NETHERLANDS AND THE USA
The Netherlands substantively reformed
its health care system in 2006, which
features mandatory universal coverage
for basic treatments.
The state makes sure that everyone
has access to common health care and
uses up to 10 percent of its GDP for it
(2013). Private medical spending is thus
moderate and accounts for 1 percent of
GDP.
The role of public finance would be limited
in such a scenario. On the other hand,
governments may be convinced that the
market does not effectively provide public
goods, thus creating a responsibility for
the state to step in via public spending and
taxation. In this scenario, the state would need
more revenue.
The comparison in Box 4 between the
approaches to health care in the Netherlands
and the USA illustrates the different
understandings regarding the role of the state
and its implications for the fiscal system.
The United States, by contrast, deploys a
more mixed approach to medical care with
the primary source of insurance coverage
being employer-sponsored insurance
(bought with pre-tax dollars). Private
medical spending is significantly higher –
around 9 percent of GDP– to make up for
the lack of universal coverage. As a result,
the country spends less public money on
health care, i.e. 8 percent.
SOURCE: OECD 2015.
 18

60
56.7
55

50
49
50

46.9

42
45

40.8 41.5
39.8
40
35

30.9
27.1 27.5
30

23.3 24.3
25
20
15
10
5
0

Chile

Thailand

Grenada

India

Vietnam

Algeria

Barbados

United States

Croatia

Ireland

Sweden

Netheralnds

Denmark
Fig. 10: Government total expenditure as percent of GDP 2011 (IMF 2012)

The total government expenditure (as percent Given the basic characteristics of fiscal
of GDP) reflects the share of public spending policy outlined above, policymakers
activities in the entire economy. The sectoral would need to take into account both
priorities of this spending, however, can differ macroeconomic dynamics and the role of
greatly from country to country. Figure 10 the state in providing public goods, when
gives a comparison between the levels of designing a green fiscal reform.
public spending in selected countries.

REFLECTION POINT
What is the role of public spending in your country? Which sectors does
the government spend most of its revenue on?
 19

CENTRAL FEATURES OF THE

NATIONAL BUDGET PROCESS
Fiscal reform involves a reorganization of public financial flows.
Budgeting is a central tool of public financial management, thus fiscal
policy reform is reflected in the process of drafting the annual national
budget.

Overview
Now that we have become familiar
with some of the fundamentals of fiscal
policy, let us look at national budgeting
as a key instrument for public financial
management.
Understanding of national budget processes
will allow you to better assess the soundness
of budgets and identify the rules that
demarcate what the budget can or cannot
do. Awareness of basic procedural steps
and responsibilities enables policymakers
to identify which agents to address when
considering fiscal reform.
This lesson features a brief description of the
budget cycle (2.2), before examining the
responsibilities in budget formulation (2.2),
the types of budget spending (2.3), basic
steps towards obtaining budget approval (2.4),
and the principles and rules for assessing the
effectiveness of budgets (2.5).

WHAT IS THE BUDGET CYCLE?

Public financial management is typically
structured around a three-phased budget
cycle including budget formulation,
execution, and evaluation (Figure 11). 8
The first phase –budget formulation–
entails all analytical and coordination
processes between the Ministry of Finance
and line ministries that lead to the approval
of an annual national budget by the
legislature.
The second phase –budget execution– is
concerned with the allocation and oversight
of budgetary funds to line ministries,
specialized agencies and their activities
to achieve pre-determined government
objectives.
 20

Fig. 11: The three phases of the budget cycle7

1. BUDGET
FORMULATION

3.
EVALUATION

2.
BUDGET EXECUTION

The third phase –evaluation– serves to

gather evidence on the reliability of budget
video
execution, as well as the observed impacts in AN ANIMATED EXPLANATION
light of intended outcomes. OF THE BUDGET CYCLE AND
ITS FUNCTIONS.
This phase informs the systematic review
of policies and subsequently develops
recommendations to government bodies
that are concerned with planning and policy
formulation.

This lesson focuses on the first phase, as it is

key for introducing or changing policies, e.g.
through GFR, which need to be reflected in WATCH THE VIDEO
the national budget.

7 Alternative depictions of the budget cycle may feature four distinct phases depending on regional
tradition, e.g. (1) planning, (2) budgeting, (3) expenditure and (4) performance assessment (see the
video link below). The terminology varies to some extent, i.e. formulation = preparation, execution
= expenditure, evaluation = policy review or reporting.
 21

RESPONSIBILITIES IN BUDGET FORMULATION

The process of budget formulation is fairly
complex. In most cases, the Ministry of
Finance will take the lead in preparing a
budget, with input from the line ministries and
smaller spending agencies. A central budget
department within the Ministry of Finance
often exercises this function.
The nature of central budget departments
may vary significantly across countries. From
a political economy viewpoint, it is important
to understand the implications for the budget
process. The following set of questions (Box 5)
may help to identify the relevant agents and
their relative powers.
Being aware of relevant agents and their roles
in the budget process is important at a later
stage of this e-course, as we look into ways of
building coalitions for green fiscal reform.

BOX 5:
IDENTIFYING RELEVANT AGENTS IN BUDGETING
- Who initiates spending proposals?
- Who has the power of amendment?
- Does the legislative have a budgeting committee? If yes, what are its powers?
- How are budgeting powers distributed within the executive?
- How many agencies are involved, and who does what?
- Who has veto powers at what stage of the budgeting process?

SOURCE: IMF 2015: Section 3.

Types of budget spending

Budgets plan for two different sets of spending, Most capital expenditure can be seen as a
i.e. recurrent and capital expenditure type of public investment that will generate
(IMF 2009): returns to the government in the future.

- Recurrent expenditure entails regular
or periodic expenses (usually annually),
such as salaries and general utilities. These
are used to fund ongoing administrative
operations and include, for example, salaries
for civil servants and politicians.
Returns may take the form of concrete
revenues, e.g. taxes for new services or
infrastructure, or more broadly social
welfare gains, e.g. school buildings to expand
education.

- Capital expenditure, by contrast, is

reserved for non-recurring special
events or projects, such as infrastructure
developments or constructions. Such
expenditures can be fairly large, which is
why it is important to regularly reflect their
full project period in the annual budget
process.
 22

BASIC STEPS IN BUDGET FORMULATION

The drafting and approving of a budget government bodies. In principle, the standard
is a lengthy process that can last up to sequence includes a number of steps, as
eight months or more, involving multiple presented in Figure 12.

Fig. 12: Basic steps in budget formulation

SOURCE : IMF 2015c
6
CABINET
5 ENDORSEMENT

4 NEGOTIATIONS
SUBMISSION
3 OF BIDS
BUDGET
2 CIRCULAR
ALLOCATION OF
1 TOTAL FUNDS
MACROECONOMIC
FRAMEWORK

1. A formal discussion on the prospective 4. Line ministries then proceed to the

budget should start with the determination
of a macroeconomic framework for the
budget year. The projections made in the
framework serve as a basis to calculate the
overall level of revenue and sustainable
expenditure. The ministry of finance
typically prepares this step.
submission of bids to the ministry of finance,
usually explaining why the draft allocation is
inadequate.
5. Once the bids are submitted, official
negotiations seek to draft a final budget
agreement.

2. A first allocation of total funds among line

ministries is issued. 6. In the end, a consolidated cabinet
endorsement is issued and sent to the
legislative for final approval.
3. The dissemination of a budget circular
marks the third step. Based on the
macroeconomic framework, the circular
includes information on the rationale for
the indicative allocation to line ministries.
 23
As the budget becomes law, revenue and
expenditure flows from and to the population
can take effect for the respective fiscal year.
Notably, practices in budget preparation
can be very diverse across countries. For
instance, many countries do not prepare a
macroeconomic framework or draft allocation
before sending the budget circular. This makes
deficiencies in the budget preparation, such
as unrealistically high bids by line ministries,
more likely. As result, overall spending tends
to be driven up.
For developing countries in particular,
external funding, e.g. via official development
aid, may account for a significant share of the
national budget. Depending on the purpose
of these funds –addition to the total budget
or support for specified sectors– further
mainstreaming of policies might take place
(UNDESA 2015; OECD 2011).
SOUND BUDGET PRINCIPLES AND LEGAL FRAMEWORK
Building on decades of experience with
budget reform, the following set of principles
has proven to be useful to guide policy- and
budget-makers along the way.
Against these core principles, the soundness
of national budget processes can be assessed
(IMF 2015d) (see Table 1).
These principles are codified in the legal and
administrative framework regulating the
budget process. The exact legal framework
for national budgeting varies from country
to country, but it is typically laid out at three
levels (IMF 2015d).
The constitution embodies the highest rules
in the legal hierarchy. Notably, the rules
expressed in it are rather broad in nature. It
8 The Public Financial Management Blog, run by the IMF, features latest global and national
developments on PFM reform efforts.
Common understanding of policies
between ministries is key in budgeting.
By definition, the Ministry of Finance –
as the lead institution– possesses much
influence over the budget process. Its
fiscal experts, however, do not always have
profound knowledge of other policy areas
like transportation or environmental policy.
Experts from the sectoral ministries, by
contrast, may be less trained to use fiscal
instruments to reach their policy outcomes.
As a result, they might risk missing mutual
benefits, i.e. increasing revenue while
advancing environmental protection, from
green fiscal reform.
In order to raise interministerial awareness of
the cross-cutting opportunities, policymakers
could strengthen experience-sharing and
policy-integration between strategically
important ministries, for example through
regular consultation and coordination. 8
is important to consider that it structures the
relative powers of the executive and legislative
branches with regard to public finance
management. Furthermore, the constitution
defines financial relations between national
and subnational levels of government.
The organic law organizes the budget process
in more depth. It may contain concise
provisions on approval, execution, control and
auditing. It is called organic as it is less static
then the constitution and can be changed
more easily via legislation.
Financial regulations specify authorities of
government bodies or responsible ministers to
issue further instructions. These can be fairly
detailed.
 24

TABLE 1: Sound budget principles

COMPREHENSIVENESS TRANSPARENCY REALISM

- Is the coverage of - Is it easy to connect - Is the budget

government operations
complete?
- Are all expenses
covered in the budget
or do extrabudgetary
funds or other
mechanisms (dual-
budgeting) exist?
SOURCE: IMF 2015: Section 3.
policies and
expenditures through a
programme structure?
- Are spending priorities
clear and consistent?
based on a realistic
macroeconomic
framework?
- Are estimates based
on reasonable revenue
projections?
- Is there a realistic
costing of policies and
hence expenditures
(e.g. assumptions about
inflation, exchange
rates, etc.)?

In short, the constitution, organic law and
financial regulations form the very legal
framework within which the annual national
budget – embodied by law – is prepared and
approved. Knowledge of the legal framework
helps fiscal reformers identify potential
restrictions on how revenue and expenditure
can be used. 9
The constitution of Chile, for instance,
prohibits fiscal earmarking, i.e. reserving
revenue for a pre-defined purpose or agency.

9 The World Bank and IMF offer a joint Country Budget Law Database that enables quick access to a range of
national budget-related laws.
 25

LINKING POLICY,
PLANNING AND BUDGETING
Although the linkage between policy, planning and budgeting seems
rather obvious, integrating it adequately in decision-making is challenging.
Mismatches between budgets and policies may arise as a result.

Overview
This lesson briefly introduces difficulties implications for designing and implementing
in linking policy, planning and budgeting green fiscal reform (3.2).
processes (3.1), as well as resulting

Difficulties in creating linkage

between policy, planning and budgeting
The objective of any budget is to provide the
financial means (to ministries and agencies)
for the realization of chosen policies.
However, the size of a budget is defined
by the fiscal policies that a government
pursues. Thus, a coherent set of policies is
thus a prerequisite of a coherent revenue
and expenditure practice. Even the best
management of budgets cannot compensate
for misguided policies (WB 1998).
Furthermore, the role of planning is to enable
change for the better, while budgeting favors
continuity with a view on reducing costs
(OECD 2013). Securing funding within
a single annual budget is not an easy task;
however, the challenge is even greater in light
of the necessity to ensure policy funding for
multiple years. Unpredictability of funding
is a common problem in many national
administrations.

Planning and budgeting units work according Stronger institutional coordination is required
to different logics. Planning operates with to bridge the inherent differences between
long, multi-year time frames whereas various planning and budgeting processes.
budgeting focuses primarily on annual terms. Failure to create an institutional link, e.g.
 26

through a policy coordination body 10,
easily can result in governance units working
in isolation from each other, with each
ministry seeking to maximize its bid. As a
consequence, one can often observe a stark
mismatch between needs and available funds
to deliver on them (WB 1998).
Against this background, the following set
of general guidelines can help align planning
and budgeting (Box 6) and mitigate the
difficulties listed above (OECD 2013):
- Base planning and long-term policies on
reliable cost projections;
- Give government agencies explicit authority
to implement plans;
- Set performance targets and milestones to
monitor progress;
- Establish procedures for updating planning
when conditions change substantially
- Be clear about national priorities to guide
difficult budget decisions.

BOX 6:
AUSTRALIA’S RESPONSE TO BUDGET PRESSURES

In the early 1980s the Australian
government introduced public sector
reforms to improve policy coordination and
expose unsustainable budgeting practices.
The government’s challenges were similar
to those facing many developing countries
today. Decision-makers had to manage
both an immediate fiscal crisis and rising
fiscal commitments of previous policies.
These measures helped legitimize and
build consensus on reformulating policies,
leading to a more sustainable composition
of public expenditures. As a result, the
country budget deficit of four percent of
GDP turned into a surplus by the end of
the decade (WB 1998).

To discipline spending and reset national

priorities, the new government published
estimates of future spending under existing
policies, underscoring the need to scale
back expenditure and revise planning. In
addition, it provided cost comparisons of
existing and newly proposed policies and
how they matched with national priorities.

Robert Hawke, Australia PM from 1983 to 1991

10 One possible institutional body is a national planning commission (WB 2009).


What does it all mean for Green fiscal reform?
Changing economic incentives via fiscal
policy, induced by GFR, will necessarily affect
budgeting. In view of our discussion about
fiscal policy and budgeting, we need to be
aware of both legal provisions and political
dynamics within specific countries. The
following factors are important –although not
exhaustive– to consider as they substantively
influence the scope of GFR design and
potential success of its implementation
(Figure 13).
In legal terms, provisions on earmarking or
spending restrictions limit the freedom of
policymakers to determine how and where
fiscal instruments are to be used. Capital
expenditure restrictions, for example, may
require a specified spending maximum or
composition, in turn rendering some fiscal
measures less viable, e.g. subsidizing the build-
up of low-carbon infrastructure.
The distribution of budgeting powers,
moreover, can significantly shape policy
choice depending on how strong line
ministries are in relation to the Ministry of
Finance.
In the political arena, focus on short-term
results can be harmful to the legitimacy of
GFR. Fiscal reforms require gradual and
predictable changes to the economy in order
to avoid political discontent or even social
unrest (OECD 2005; WB 2005). This
relates also the realistic costing of policies.
27
LEGAL PROVISIONS
For example:
- Prohibition of earmarking
- Spending or capital expenditure
restrictions (e.g. debt ceilings)
- Distribution of budgeting powers
(e.g. right to veto or issue proposals)
P O L I T I C A L DY N A M I C S
For example:
- Short-term thinking
- (Lack of) interest in realistic
costing of policies
- Veto potential in budget
negotiations
Fig. 13: Legal and political factors in budgeting for GFR
If governments and their budgets are not
sufficiently credible to ensure the longevity
of green fiscal initiatives, newly instituted
incentives may have very little effect on
market participants, and are subject to later
repeal or weakening. In such a scenario,
necessary investments in infrastructure and
product innovation are likely to be held back.
There is also a need for regular review, to
assess costs and benefits of measures in light
of their intended outcomes. If a subsidy for
biogas electricity, for instance, turns out
to be more expensive than other options
(e.g. in light of new technological advances),
then planning needs to account for it. GFR
thus requires a balance between funding
predictability and political flexibility to adapt
to new realities.
 28
The existence of prevalent interests in
government shapes budget negotiations
and may further exclude (i.e. veto) the use
of particular fiscal instruments. If taxation
is unpopular or affects powerful interest
groups, higher taxes on coal-fired plants, for
example, might not be approved. 11
In such an environment, there is a danger of
isolated measures that do not form part of a
coherent economy-wide reform effort, are
too costly, or have unintended side effects.
For instance, policymakers could argue
for green subsidies in sectors like energy
or infrastructure, in turn raising the need
11 The role of interest groups and their positioning toward GFR is elaborated in more detail in Module 3.
for revenue. Without appropriate flanking
incentives, however, such as taxes on fossil
fuels, the additional energy supply may not
substitute environmentally harmful energy
sources, and thus miss an important goal of
sustainable development.
In summary, while GFR aims at altering
some of the traditional approaches of
fiscal policy and national budgeting, it is
still embedded in their main functions and
limitations. Notably, what GFR is able to
achieve, will depend to a large extent on
what can be achieved by fiscal policy and
budget processes in general.
 29

key
learning points
1
Fiscal policies are instruments through which governments ensure that public goods and
services are provided to the citizens.

4
Coherence between budgeting processes and policy objectives is key for successful
implementation policy reforms.
 30

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—. 2012. Fiscal Policy for Growth and Development, Economic Premise No. 91. Washington, DC.
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 31

Abbreviations

EC European Commission
GDP Gross Domestic Product
GFR Green Fiscal Reform
HSBC Hongkong and Shanghai Banking Corporation
IDB Inter-American Development Bank
ILO International Labour Organization
IMF International Monetary Fund
OECD Organisation for Economic Co-operation and Development
PFM Public Financial Management
UNDESA United Nations Department of Economic and Social Affairs
UNEP United Nations Environment
WB World Bank