1. Budgeting of investments Eivind Tandberg Brasilia April 25, 2005

2. Overview Why is it difficult to budget government investments? Common problems Objectives and priorities Budget process and timetable Roles of different institutions Key budget process issues Summary of recommendations

3. April 25, 2005 Why is it difficult to budget government investments? Time consistency problems Budgets have short-term focus Valuation of benefits No market prices Demand side uncertain High preparation costs Trade-off quality and cost Complex process and organization

4. April 25, 2005 Common problems I Budget management focuses on crises and short term decisions. Imbalances between current and capital costs in the budget. Timing of investment planning is poorly matched with the budget process Separate budgets for current and capital spending Sometimes managed by different ministries Investment proposals inadequately developed Difficult to ensure that most productive projects are realized No clear decision process Decision process does not reward good project design.

5. April 25, 2005 Common problems II Decisions mainly based on first-year budget impacts Incentives to adjust implementation plans Cost estimates change as project progresses Incentives to under-estimate initial costs Incentives to over-estimate initial costs Operating costs are under-budgeted Maintenance costs for existing capital are under- budgeted Investment projects disproportionately targeted for budget cuts Yield significant cuts through single decisions

6. April 25, 2005 Budget management objectives ObjectiveShort term focusMedium-term focus Cost-effective service delivery Cost minimizationModernization Efficient allocationStatic efficiencyDynamic efficiency Fiscal controlEx-ante controls Transaction controls Ex-post accountability Aggregate controls

7. April 25, 2005 Budget time perspective General agreement (?): Medium-term perspective most appropriate Budget system should not only promote fiscal control, but also efficient resource allocation and cost-effective service delivery This agreement is often not reflected in practices! Continued overwhelming focus on annual budgets Medium-term budgets often ritualistic Often result of difficult economic circumstances Countries in fiscal crisis must handle immediate problems Attempts to introduce advanced reforms can be counter- productive More stable countries are in better position to introduce medium-term budgets and emphasize performance

8. April 25, 2005 Medium-term budget frameworks Key elements Clear fiscal policy statement Medium-term macroeconomic forecast Realistic revenue estimates for the plan period Estimates of expenditures beyond the budget year All multi-year projects reflected Formal status to “forward” estimates Basis for preparation of following year’s budget Figures for individual ministries become hard budget constraints in cash terms

9. April 25, 2005 Budget management processInvestment planning process Budget year – 2 Develop new projects Budget year – 1 JanuaryRoll over MTBF for existing policies, projects Update capital estimates FebruaryMacroeconomic frameworkScreening of new proposals MarchUpdate MTBF AprilCabinet budget meeting I: Decisions on MTBF, room for new initiatives and projects, ministry spending envelopes Decide on which projects to put forward to Cabinet MayExternal quality assurance Budget timetable I

10. April 25, 2005 Budget management processInvestment planning process JuneCabinet budget meeting II: Decisions on new initiatives and investment projects JulyUpdate estimates: - Capital and operating costs for new investments - Capital and operating costs for ongoing investments - Maintenance costs AugustDetailed budget proposals SeptemberCabinet budget meeting III: Decisions on detailed budgets Decisions on guarantees OctoberBudget to Parliament DecemberBudget approvedDetailed implementation plans Budget timetable II

11. April 25, 2005 Budget management processInvestment planning process Budget year January -Execute budgetImplement investment projects JulyMid-year budget reviewUpdate estimates: - Capital and operating costs for new investments - Capital and operating costs for ongoing investments - Maintenance costs for other capital DecemberYear-end technical adjustmentsDetermine carry-over to next budget year Budget timetable III

12. April 25, 2005 Institutional responsibilities MOF and planning ministries Separate current and capital budgets? Fragmentation, coordination problems Largely abandoned in OECD countries The role of the Cabinet Separate technical and political considerations MOF manages the technical process Cabinet takes political decisions Increases the legitimacy and credibility of the budget

13. April 25, 2005 Analysis of proposals Investment proposals are inadequately analyzed Missing or inadequate standards Standards not properly enforced. Political pressure, “urgency” First-best: refuse to consider non-compliant projects Enforceable? May be legitimate need for exceptional procedures Clear exceptional procedures Limit as much as possible Same decision-making mechanism as other projects Covered by same budget allocation

14. April 25, 2005 Partly user-financed projects Full user financing, no state guarantee or other fiscal risk – outside budget Partially funded off-budget - subject to same requirements for development, costing and analysis as other projects (Most PPPs) Decisions should follow same procedures and timetable as other projects Budget decisions based on budget impacts over project life-time Budget documents should also disclose total costs, financing modalities and fiscal risks Explicit or implicit guarantees related to project subject to same decision-making and disclosure requirements as other state guarantees.

15. April 25, 2005 Decision criteria for investments As part of the MTBF, cabinet decides on aggregate allocations for new policy initiatives and investments Covers whole MTBF period Line ministries put forward proposals to be financed within this allocation Pre-screening to ensure quality and realistic volume Disclose budget impacts beyond MTBF period Following cabinet decision on which projects to finance, line ministries incorporate the detailed cost estimates in their draft budgets Multi-year appropriation for major projects Competition improves quality of decisions

16. April 25, 2005 Cost estimates Cost increases absorbed in annual budget updates Incentives to under-estimate initial costs Make line ministries responsible for cost overruns Real reduction in other costs not extension of investment period. Cost reductions reallocated to other activities Incentives for efficient project implementation Also incentives to over-estimate initial costs Allow ministries to retain part of cost reductions Changes in rational implementation pace Allow limited carry-over/”borrowing” between years

17. April 25, 2005 Operating and maintenance costs Operating costs for new projects under-budgeted Required detailed disclosure of expected operating costs Indicate how accommodated or financed Condition for consideration of project Under-budgeting of maintenance costs for existing capital also persistent Limited incentives to maintain “political” projects Ensure that all projects have clear net value Require plan for financing long-term maintenance costs at the time of approval Sufficient maintenance financing for existing capital could be condition for new investment proposals

18. April 25, 2005 Budget amendments Investment projects highly susceptible to budget cuts Large, discrete budget components Significant budget reductions through single decisions Can seem reasonable in the short-term Over time: under-funding of investment and maintenance Given very real needs for budget adjustments, no simple solutions MTBF provides basis for realistic assessment of implications Cut in maintenance costs or delay in investments provides temporary respite Other budget cuts may yield permanent improvement

19. April 25, 2005 Conclusions I Medium- to long-term time perspective Medium-term budget framework (MTBF) Credible annual budget process requires time Budget timetable with clear phasing MOF full responsibility for managing budget preparation Cabinet responsible for political decisions Clear standards for investment planning Exceptional procedures close to general standards MTBF should include allocations for new policy initiatives and investments

20. April 25, 2005 Conclusions II Mechanisms for pre-screening and prioritization of proposals to balance proposals and available funds Partially funded projects subject to same requirements as other projects. Decisions based on net impacts over life-time Full disclosure of total costs and risks Costs and benefits of approved projects disclosed in budget material Incentives to prepare realistic cost estimates and implement projects efficiently Cost overruns covered by real reductions in existing budgets Cost reductions can be (partly) reallocated to other activities.

21. April 25, 2005 Conclusions III Multi-year appropriations for major investments Full costs reflected in MTBF and the budget Hold ministries accountable for implementation Mechanisms for carry-over and “borrowing” Can improve the quality of investment budget management Investment project proposals should include a detailed disclosure of expected operating costs and indicate how these will be financed. MTBF specification of maintenance of existing capital Condition for making new investment proposals. MTBF basis for assessment of budget cuts