Comments on Introducing MTEF in Korea Youngsun Koh March 15, 2004 Korea Development Institute

n Why do we need MTEF? n What should we decide on before proceeding?

n Why do we need MTEF? (1) To moderate the trend growth in government spending (2) To strengthen the planning capacity of line ministries (3) To facilitate the working of the automatic stabilizer

(1) To moderate the trend growth in spending n Government spending has been growing quite rapidly. Consolidated Central Government Spending Note : The figures for 2004 are based on budget estimates.

n The small size of total spending is mainly due to the immaturity of the pension system. General Government Expenditure (1) To moderate the trend growth in spending Note : The data for Korea and Japan refer to Others refer to Source : OECD.

n We can observe a slippage in fiscal discipline as indicated by frequent introduction of supplementary budgets. Number of Supplementary Budgets (1) To moderate the trend growth in spending Source : MPB.

n MTEF will enable us to moderate the trend growth in spending by imposing a global ceiling on medium-term expenditures. n It will also contribute to strengthened fiscal discipline by making clear to the public any deviation from the target levels of spending, deficit, and debt that is due to supplementary budgets. (1) To moderate the trend growth in spending

n Planning capacities are generally weak in line ministries. n Annual budget requests are unrealistically large. n Part of the reason can be found in the uncertainty surrounding the resource availability in the future Initial budget requests Final budget amounts Initial Budget Requests and Final Budget Amounts (% increase on previous years’ actual budget amounts) Note : Refers to the General Account budget. Source : MPB. (2) To strengthen line ministries’ planning capacity

n Such weak planning capacity can seriously damage the efficient utilization of scarce resources. n MTEF will reduce uncertainty, enhance predictability, and help line ministries to build their planning capacity. (2) To strengthen line ministries’ planning capacity

n An important principle in fiscal management has been “expenditure within revenue” for each year. n This practice has the potential to induce a pro-cyclical behavior in spending. (3) To facilitate the working of the automatic stabilizer Revenue Expenditure Surplus

n In MTEF, “balance” is pursued not for each year but over the business cycle, letting the automatic stabilizer work in full to dampen the cyclical fluctuation in the economy. (3) To facilitate the working of the automatic stabilizer

n What should we decide on before proceeding? (1) Medium-term targets for deficit and debt (2) Coverage of the global ceiling on spending (3) Escape clause for ceilings

n In the U.K., two fiscal rules guide the medium-term expenditure management of the public sector:  The golden rule: On average over the business cycle, the current budget is in balance or surplus.  The sustainable investment rule: Net debt as a proportion to GDP will held stable over the business cycle at a prudent level. The current target is to keep the net debt at below 40 percent of GDP. n In Sweden, the government aims to maintain the structural surplus of the general government at 2 percent of GDP. (1) Medium-term targets for deficit and debt

n In Korea, an appropriate medium-term target would be maintaining the consolidated central government in balance over the business cycle. n In computing the balance, we would exclude;  surpluses in the National Pension Fund (and possibly in other social insurance funds as well); and  the temporary expenditure to transform the KDIC bonds into treasury bonds as scheduled in 2003 through n In this case, the debt-to-GDP ratio is expected to stabilize at around 25 percent. (1) Medium-term targets for deficit and debt

n Once the medium-term targets for deficit and debt are determined, they are operationalized through the global ceiling on spending. n In other countries, ceilings are usually imposed on those parts of the spending that can be actually controlled in the annual budget process.  In the U.S., under the Budget Enforcement Act, caps were placed on “discretionary” spending, which excludes, among others, social security and interest payments.  In Sweden, all spending except interest payments is subject to the global ceiling. (2) Coverage of the global ceiling on spending

n An extended coverage of the ceiling would impose strong fiscal discipline on line ministries, especially in relation to welfare expenditures.  But it can disrupt annual budget process when, for example, an unexpected large increase in pension benefits necessitates a cut-back in other welfare expenditures. n A limited coverage will add to the tranquility in budget process.  But it is prone to unforeseen upsurges in total spending when the forecasts of “mandatory” spending are biased downward. (2) Coverage of the global ceiling on spending

n In Korea, I would define “mandatory spending” as comprising the expenditures on financial-sector restructuring, social insurance programs, local shared taxes, local transfer funds, and interest expenses.  Other spending would be designated as “discretionary.” n The global ceiling would be imposed on the discretionary spending.  At the same time, efforts would be made to build a reliable model to forecast mandatory spending (in particular, the pension-related spending). (2) Coverage of the global ceiling on spending

n In Sweden, no breaching is allowed of global ceiling. But too much rigidity can topple the whole framework unless backed up by a strong support from the general public and the political circle. n A clear and transparent escape clause would be a better choice than an outright ban of the breaching of global ceiling.  We need to hammer out the details of the escape clause in the ensuing discussions on MTEF. (3) Escape clause for ceilings