Flagship Course on Governance and Anticorruption April 22, 2003 Allen Schick MANAGING PUBLIC EXPENDITURE: Objectives and Approaches

Conventional budgeting emphasizes procedures; PEM focuses on outcomes Conventional budgeting assumes that policymakers are rational; PEM argues that they act on the basis of incentives Conventional budgeting often results in big deficits; PEM demands fiscal discipline Conventional budgeting often results in frozen priorities; PEM enlarges governments capacity to allocate resources on the basis of new priorities Conventional budgeting often results in inefficient operations; PEM encourages efficient provision of services How Public Expenditure Management Differs from Conventional Budgeting

Basic Elements of Effective Government Budgeting Fiscal Discipline - Budget totals should be the result of explicit, enforced decisions. They should not merely accommodate spending demands. These totals should be set before spending decisions are made, should be enforced during implementation of budget, and should be sustainable over the medium term and beyond. Allocative Efficiency: Expenditure decisions should be based on government priorities and on evidence concerning the effectiveness of public programs. The budget system should facilitate reallocation from lesser to higher priorities and from less to more effective programs. Operational Efficiency: Agencies should provide goods and services at a cost that achieves ongoing efficiency gains. These services should be accessible to citizens and responsive to their needs and should be provided in a fair and courteous manner.

RULES Limits on total spending (and, in some cases on sectoral spending) are established before individual spending bids are considered. Total spending must be consistent with these limits. The limits may be expressed in a variety of ways: in money terms, relative of GDP, as rates of change, or in terms of the balance between revenues and expenditures. The limits are set for the medium-term (3-5 years) and budget decisions are made within this medium-term framework. Institutional Arrangements for Enforcing Aggregate Fiscal Discipline

Advantages/Disadvantages Balanced budget: In any fiscal year, spending shall not exceed revenue. This rule constrains Government and the Legislature and provides a reasonably simple basis for monitoring compliance. But it is rigid and does not accommodate changes in economic conditions. It cannot be achieved when they economy is depressed. Dynamic fiscal policy: Fiscal totals should be set each year for (and adjusted as necessary) to stabilize the economy at a level that results in low inflation and high employment. This rule recognized the Government’s responsibility managing the economy and improve the well-being of citizens. But the rule is politically difficult to maintain because it is easier to raise demand than to contract it. Over time, this rule leads to growth in the size of the public sector and higher tax burdens. Enforced fiscal targets: Targets are set by Government and the legislature before revenue and spending decisions are made. These targets may require a balanced budget or permit a deficit. Targets are explicitly fixed in advance. They do not merely accommodate political demands or automatically fluctuate with changes in economic conditions. The main problem is that few governments have been successful in enforcing targets over the long term through changes in economic conditions. Alternative roles for Fiscal discipline

Institutional Arrangements for Enforcing Aggregate Fiscal Discipline ROLES A strong finance ministry enforces the budget aggregates in cabinet decisions and bilateral negotiations with spending departments. The finance ministry measures the budgetary impact of spending proposals and of other actions affecting the totals, and advises the government on the status of the budget. During implementation of the budget, the Finance Ministry may intervene to block (or notify the government) of actions that would cause the fiscal aggregates to be breached.

Factors that Undermine fiscal discipline INFORMATION The medium-term expenditure framework establishes a baseline for measuring the budgetary impact of proposed or adopted policy changes. Throughout formulation of the budget, information is provided on deviations from the baseline due to new policies, changes in economic conditions, or re-estimates of existing programs. During implementation, spending is monitored to ensure compliance with the fiscal aggregates.

Factors That Undermine Fiscal Discipline FACTORDISCUSSION Unrealistic Constraints When totals are selected for political reasons, without regard to their achievability, they may weaken fiscal discipline. Unrealistic BudgetsSome governments (especially in poor countries) adopt budgets that that purport to show fiscal discipline but have little to no possibility of being implemented. EntitlementsWhen citizens have a legal right to payments from the government regardless of budget conditions, it may be difficult to stay within fiscal targets. Contingent Liabilities The cost of contingent liabilities often is underestimated when the government accepts the risk (such as guaranteeing loans or the performance of enterprises). When the cost comes due (because of default or other contingency) it is not controllable through ordinary budget means.

Practices that Strengthen Fiscal Discipline Targets should reflect political commitments made by government leaders. Targets must be realistic and achievable. Targets should be set and enforced within a medium- term fiscal framework. Limits on aggregates should be supported by sub- targets on sector/portfolios. Fiscal constraints should cover mandatory spending. Government should publish audited financial statements on fiscal condition.

Institutional Arrangements for Improving Operational Efficiency RulesSpending limits are established for sectors or portfolios, and ministers are encouraged to reallocate within these limits. Bids to reallocate must be based on evaluation of program effectiveness or on outcome measures. RolesStrong capacity at center of government to define national priorities and objectives, and make sectoral allocations consistent with the medium-term expenditure framework. Sectoral ministers have broad authority to reallocate within their areas of responsibility, subject to review by Cabinet and/or Parliament. InformationMinisters and managers generate or receive information on the actual or expected effectiveness of programs, as well as on social outcomes. They also receive information on the expenditure impacts (relative to the medium-term baseline) of authorized and proposed budget actions.

The Institutional Framework for Reallocation Fiscal Constraints Constraints must be sufficiently effective so that government cannot avoid reallocation by spending, taxing, or borrowing more.. Medium-Term Framework Constraints budget allocation for 3-5 years ahead and establishes Framework within which allocations and reallocations are considered.. Strategic Capacity Government establishes realistic priorities/objectives along with policies/programs to implement its strategy.. Reallocations Between Sectors Strong leadership at top of government including prime minister, finance minister, or cabinet. Central organs concentrate on strategic matters, and devolve expenditure details to sectoral ministers and program managers.. Reallocations Within Sectors Made by sectoral ministers subject to review by government.

Tools for Improving Allocative Efficiency STRATEGIC PLANNING Sets government objectives and priorities MEDIUM-TERM FISCAL FRAMEWORK Sets budget constraints for allocating resources PROGRAM BUDGETING Allocates resources in accord with priorities PROGRAM EVALUATION Assesses impact of programs on public objectives OUTCOME MEASURES Measures the effectiveness of programs and activities

Institutional Arrangements for Improving Operational Efficiency RULESRunning (operating) costs are cash limited, but managers are given broad discretion in using these resources. These costs are progressively reduced by a percentage equal to all or a portion of expected efficiency gains. ROLESLine managers determine the use of operating resources within fixed limits. Operating discretion is devolved to subordinate managers, in field or regional offices. INFORMATIONOutputs are specified in advance, and actual outputs are compared to the targets. Costs are allocated to the activities responsible for them. Information on financial and organizational performance is published in annual reports and other documents.

Innovations for Improving Operational Efficiency INNOVATIONEXPECTED IMPROVEMENT Running Cost BudgetManagers are given a single allocation for all operating expenses, thereby reducing compliance costs and enabling them to operate efficiently Devolved BudgetsLine and field managers have their own operating budgets and are able to adjust to local needs and conditions Efficiency DividendPercentage reduction in running cost budgets equal to expected productivity gains impel managers to seek efficiency improvements Output TargetsManagers have advance notice of expected performance, thereby enabling government to hold them accountable for cost and outputs Out-SourcingEnables government to select more efficient producers by privatizing or out-sourcing the production or delivery of services Performance Agreements Formal contracts between purchasers and producers specify resources to be provided and outputs to be produced Annual Reports and Audits Compare actual and contracted (or targeted) financial and operating results, with independent review to access accuracy of reported results

Perverse incentives Spenders have incentive to use all the resources provided them; if they don’t, they risk cuts in the next budget Information asymmetry Service providers know more about outputs and costs than do those who allocate resources: To get more money, providers manipulate or withhold information from superiors Rigidity Managers have no opportunity to use their skills and information to improve efficiency Compliance costs Detailed, ex ante controls are costly and drive out initiative and variation Budget maximizing behavior Inasmuch as government must pay whatever it costs to operate its programs, inefficient producers are rewarded with bigger budgets Capture Government is captured by service providers: it lacks independent information on performance and must purchase services from them Factors that Degrade Operational Efficiency