Policy Formulation and Budget Preparation Basic PFM Training Program The World Bank Group

“The core of good budget preparation is to confine politics to the start, when the key policy decisions are made, and to the end of the process, when coherent technical proposals have been prepared and submitted to the political leadership … in the middle, no political interference should occur, precisely to allow the administration to prepare a budget consistent with the policy choices.” Schiavo- Campo (2007), pages 235-6

Overview of the Presentation Introduction Macroeconomic policy environment and MTEFs Budget circulars and budget timetable Setting expenditure ceilings Preparing and negotiating budget requests Improving efficiency of public spending Bad practices in budget preparation Role of the legislature Role of independent fiscal councils

Introduction The budget formulation process is essentially political, requiring as it does choices between different priorities, but needs to be informed by strong technical analysis. Good institutional design of the budget process is critical to deal with the principal agent problem and the common pool problem. The principal-agent problem can be mitigated by ensuring that the budget is comprehensive and the budget process is transparent. The common pool problem can be mitigated by centralizing the budget process and by building in hard budget constraints and other fiscal rules.

Macrofiscal policy environment A starting point for budget preparation is a coherent framework of macroeconomic policies and objectives, e.g., for sustainable management of government borrowing and debt. It is essential that a country develops its capability to prepare robust forecasts of macroeconomic aggregates, and government spending and revenue. In recent years, interest in fiscal responsibility laws and fiscal rules that aim to reinforce discipline have grown substantially – e.g., EU convergence criteria - but these have had mixed success.

The budget/planning interface In many low- and middle-income countries, the annual budget/MTEF process coexists with a national development plan and public investment plan (PIP). These processes are hard to coordinate and reconcile since the budget is prepared by the MoF but the PIP by a separate planning ministry which may be more powerful than finance. A “dual budget” often exists. Attempts to merge the budget and planning functions, while theoretically desirable, are often obstructed by political constraints.

Stages in developing an MTEF A medium-term fiscal framework (MTFF) contains a statement of fiscal policy targets and projections. A medium-term budget framework (MTBF) in addition contains medium-term budget estimates for the main sectors and programs. A medium-term performance framework (MTPF) in addition contains information on the economy, efficiency and effectiveness of spending programs.

Key issues in preparing an MTEF Length of planning horizon, and price basis. Policy basis of expenditure. Estimating the costs of existing policies. Planning new policies and programs. Planning assumptions and contingency reserves. Linking annual budgets and multi-year estimates.

Linking the MTEF and budget preparation - South Africa Initial policy review – May to September. Submission of MTEF/budget proposals by line ministries to MoF – by August 2. Review of proposals by Medium-Term Expenditure Committee of officials – August-September. Approval by Cabinet, and submission to Parliament of the draft Medium-Term Budget Policy Statement – by end-October. Line ministries prepare their draft MTEF-budget – November-December. Finalization – complete MTEF-budget tabled in Parliament – February. Source: Schiavo-Campo, 2007, Box 8.1.

Stages in preparing multi-annual spending estimates Figure 1 below shows five main stages: Updating the costs prepared the previous year. Preparing the MTFF and expenditure projections. Establishing initial ceilings below projected aggregate spending, to accommodate a contingency reserve. Identifying savings on ongoing programs and policies. Establishing room for new programs and policy changes.

Figure 1: Preparing multi-annual expenditure estimates

Budget circulars Most finance ministries issue a budget circular to spending agencies early in the budget process. Such documents include: Statement of macroeconomic developments and outlook. Statement of budget priorities. Initial expenditure ceilings by sector and program. Guidance for line ministries in preparing their budget requests, including key economic assumptions.

Budget preparation cycle The optimal length of the budget preparation cycle is country-specific, and depends on economic and political circumstances. A calendar that is too short does not allow spending agencies sufficient time to prepare their requests, and to negotiate with the MoF. A procedure that is too elastic runs the risk of incorporating out-of-date economic/fiscal assumptions, and may lead to excessive negotiations. In general, a cycle that starts about six months before submitting the budget to the legislature is appropriate for many developing countries – see Table 1.

Table 1: Illustrative budget timetable

Setting expenditure ceilings Setting initial ceilings includes the following steps: Assessing compatibility of ceilings with macroeconomic projections and targets. Assessing room for maneuver to include policy changes and new policy initiatives. Distributing by sector/program, the total envelope for increased activities and/or new policies.

Preparation of budget requests Budget requests submitted to the finance ministry by line ministries should include: A brief statement of sector policies, priorities and (ideally) performance indicators. Detailed expenditure estimates for the new budget. Identification of savings made on existing programs. Assessment of staff positions required. Estimates of the cost of investment projects and entitlement programs. Estimates of the acquisition and disposal of state property assets.

Budget negotiations The finance ministry should review the conformity of spending agencies requests with legal requirements, spending limits and changes in economic/fiscal environment. Major differences of opinion will normally be referred upward to the ministers concerned, and ultimately to the prime minister or council of ministers, who are responsible for final approval of the budget, before it is submitted to the legislature.

Budgeting for capital expenditures In most advanced countries, budgets for capital and recurrent expenditures are fully integrated, and included within an MTEF. As noted, however, in many LICs and MICs, there is a “dual budget” and/or a “development budget”, financed out of ODA which creates inefficiency in resource allocation. All ODA should be recorded in the budget, and managed efficiently, ideally by the finance ministry. New capital investment projects should be subject to rigorous cost-benefit analysis and financial appraisal.

Improving efficiency in public spending Like slimming remedies, techniques to improve efficiency in spending require continual renewal and reinvention in order to maintain their effectiveness. Despite advances in PFM, waste in public spending is prolific, even in advanced countries (Vani, 2011). Comprehensive “expenditure reviews” are popular in Australia, Canada, the Netherlands, New Zealand, the U.K., and other advanced countries, but have more limited applicability in less developed countries. They require strong centers of government, a disciplined approach, and advanced analytical techniques.

Bad practices in budget preparation Incremental budgeting - mechanically applied changes to last year’s line-item budget. Open-ended processes – requests made by line ministries without a hard constraint. Excessive use of bargaining – absence of a timetable and clear rules of procedure in the budget law and budget circular. Dual budgeting – separate processes for preparing the budget for recurrent spending and capital investment.

In-year budget amendments and supplementary budgets Amendments to the budget during budget execution should generally receive legislative approval in same way as the budget is originally approved. Supplementary budgets should generally be restricted to two or three per year. Rules should be developed that clarify the authority of spending agencies to make in-year budget reallocations, changes that need to be referred to MoF for approval, and those that require approval of the legislature.

Role of the legislature The legislature’s role should must be formally described in the constitution and legal framework. It must be given sufficient time to discharge its responsibilities for budget approval and oversight; be allocated a budget that is independently determined; and have well-developed internal rules of procedure. Good practice is that the budget be presented to the legislature 2-4 months prior to the start of the fiscal year. Powers of the legislature to amend the budget are critically important and must be enforced: there are huge variations in these powers across countries.

Role of independent budget agencies In many countries, especially in Europe, independent fiscal councils or agencies have been established. Objective is to add further discipline to the budget process, and make governments accountable for their decisions. These agencies, some of which are modeled on the CBO in the U.S., have varying powers, e.g., to make macroeconomic forecasts or advise on the fiscal performance of the executive branch. They can play a useful role in advanced countries, but their role in less developed countries, with weak governance systems and limited capacity, is more questionable.

Further references Richard Allen and Daniel Tommasi (eds.), 2001, Managing Public Expenditure: A Reference Book for Transition Countries, Paris: OECD, Chapters 5 and 6.   James Brumby, et. al., 2011, Review of Experience with Medium-Term Expenditure Frameworks, Washington DC: World Bank, forthcoming. Andrew Lawson, 2000, “Medium Term Expenditure Frameworks – Panacea or Dangerous Distraction?” Oxford Policy Management Review, May 2000. Salvatore Schiavo-Campo, 2007, “Budget Preparation and Approval”, Chapter 8 in Anwar Shah (ed.), 2007, Budgeting and Budgetary Institutions, Washington DC: World Bank, pages 235-278. Sanjay Vani, “Waste and Government Expenditures”, April 18, 2011, Public Financial Management Blog, http://blog-pfm.imf.org Jurgen von Hagen, 2007, “Budgeting Institutions for Better Fiscal Performance”, Chapter 1 in Anwar Shah (ed.), 2007, Budgeting and Budgetary Institutions, Washington DC: World Bank, pages 27-49.