Reform of the Public Financial Management System in Korea

1. Reform of the Public Financial Management System in Korea May 2005 Youngsun Koh Korea Development Institute

2. Contents • Introduction • Background of the Reform • Limitations of the Previous System • Main Characteristics of the Reform • National Fiscal Management Plan • Top-down Budgeting • Main Contents of NFMP 2004-2008 • Improvements Required

3. - 1 - Introduction • The Korean government strengthened its efforts to overhaul the financial management system after the crisis of 1997 • The new government introduced a medium-term expenditure management framework (MTEF) together with a top-down budgeting system in 2003 • MTEF provides for a mechanism to reflect policy priorities in budgeting and facilitate a strategic decision-making. • The budget for FY 2005 was prepared under the new system. • The introduction of “program budgeting” and “performance management system” is in progress

4. - 2 - Background of the Reform • Changing environment • The size of the government spending increased from 57 billion won in 1960 to 118 trillion won in 2004. • The structure of budget is getting more complicated. • There is an increasing emphasis on “autonomy and devolution” and “accountability and performance” as the guiding principles of government. • Limitations of the previous system • Centered on a single budget year • Relied excessively on a bottom-up approach in budgeting • Focused on the general account

5. - 3 - Limitations of the Previous System • Centered on a single budget year • Little consideration is given by the central budget office and the parliament to the out-years beyond the budget year. • Medium- to long-term planning is also quite weak in line ministries. • As a result, it is difficult toidentify and cope with the trend increase in spending. • Without a medium-term strategy for fiscal management, public spending has been on a rising trend since the mid-90s.

6. - 4 - Limitations of the Previous System • The counter-cyclical role of fiscal policy is constrained. • The current principle of “balanced budget in each year” has the potential to produce a pro-cyclical fluctuation in spending. • The so-called “automatic stabilizer” can be strengthened when spending increases at a pre-determined, constant rate and the balanced budget is pursued over the medium term. Surplus Surplus Expenditure Revenue Revenue Expenditure Deficit

7. - 5 - Limitations of the Previous System • Excessive reliance on a bottom-up approach • At the initial stage of budget preparation, the central budget office makes rough estimates of the total size and the sectoral allocation of the next year’s budget. • But the estimates are not transmitted to line ministries and therefore cannot guide line ministries in preparing their budget requests. • In reviewing the budget requests by line ministries, the central budget office focuses on the microscopic spending control of individual programs. • The sectoral allocation and the total size of the budget are determined at the last stage of budget preparation by aggregating the expenditures on individual programs.

8. - 6- Limitations of the Previous System • As a result, the control of inputs assumes the major importance in budget discussions and little attention is paid to outputs or outcomes. • The central budget office has little scope to review and analyze policies themselves, and the linkages between budgeting and policy-making are very weak. • The accountability and autonomy of line ministries in preparing and managing their budget is severely limited. • Line ministries usually request unrealistically large amount of budget, and massive cuts are inevitable.

9. - 7 - Limitations of the Previous System • Centered on the General Account • The central budget office spends most of its time on reviewing and preparing the budget of the General Account. • Less attention is paid to Special Accounts and Funds.

10. - 8 - Main Characteristics of the Reform • A medium-term perspective • “National Fiscal Management Plan,” covering the current year, the budget year, and three out-years. • Top-down budgeting • Line ministries given greater discretion in the preparation of budget requests within the ceilings set by MPB. • Performance management • Introducing a system similar to the Program Assessment Rating Tool (PART) of the U.S. federal government. • Program budgeting • Adopting a program structure in budget accounts.

11. - 9 - National Fiscal Management Plan • Main features • Covers 5 years on a rolling basis. • Includes the General Account and various special accounts and funds. • Sets out major policy directions, fiscal aggregates, and the sectoral resource allocation. • Prepared through an intensive policy dialogue involving line ministries and other interested parties. • Closely linked to annual budgeting.

12. - 10 - National Fiscal Management Plan • Timetable • Setting out the framework (Jan. - early Apr.) • Line ministries submit medium-term spending projections to MPB by the end of January. • Sectoral taskforces (composed of staff from MPB and relevant line ministries and private-sector experts) are organized to discuss sectoral policy directions and spending priorities. • Taskforces present their results in a series of public hearings in March - April.

13. - 11 - National Fiscal Management Plan • Timetable • Preparing the draft (Apr. - early May) • MPB prepares a draft NFMP, which includes among others the tentative ceilings on sectoral spending. • At the end of April, a two-day cabinet meeting is held to discuss and finalize the ceilings. • In May - June, line ministries prepare their budget requests for the next year based on the ceilings. • Finalizing the NFMP (May - early Oct.) • In July - September, MPB negotiates with line ministries on their budget requests, prepares the draft budget, and revises the NFMP. • After approved by the cabinet, the NFMP is tabled at the National Assembly together with the draft budget in early October.

14. - 12 - Top-down Budgeting • Main features • Line ministries prepare their budget requests within the ceilings set out in NFMP. • Ceilings are set for 14 spending areas such as social infrastructure, agriculture, education, and environment and then disaggregated into 56 programs. • For example, social infrastructure has 7 programs, including roads, railways, subways, ports, airports, housing, and water resources. • Separate ceilings are also set within each program for the general account and various special accounts and funds.

15. - 13 - Top-down Budgeting • Progress to date • Pilots on four agency-level organizations for FY 2004 • Government-wide implementation for FY 2005 • A smaller increase in budget requests by line ministries above the previous year’s budget: 11.7% for FY 2005 vs. 30.8% for FY 2004 • Larger reallocation of budget across programs: cutting back 2.7 trillion won on existing ones and introducing new ones worth 3.0 trillion won for FY 2005 • The same numbers for FY 2004 were 1.6 and 1.5 trillion won, respectively.

16. - 14 - Main Contents of NFMP 2004-2008 • Fiscal aggregates • In 2004-2008, the economy is expected to grow 5% p.a. in real terms and 8% p.a. in nominal terms. • The total revenue grows by 7.4% p.a. and the total spending by 6.3% p.a. • The target balance will record a small deficit (within 1% of GDP) in 2004-2007 but the deficit will be eliminated by 2008. • The target balance refers to the consolidated budget balance excluding the social security funds and the transformation of financial-sector restructuring bonds into treasury bonds. • The debt-to-GDP ratio will increase slightly in 2004-2006 but stay at the 2006 level afterwards.

17. - 15 - Main Contents of NFMP 2004-2008 • Resource allocation • Priority areas • Improving the growth potential: R&D and education • Strengthening the social integration: Welfare • Meeting the challenges for national security: Defense • Areas that needs readjustment • Social infrastructure: Greater use of public-private partnership • Agriculture: Promote structural changes following the market opening • Industry and SMEs: Focus on R&D and human resource development

18. - 16 - Improvements Required • Clarifying the medium-term targets • Presently, it is not clear which variable the government is targeting in the medium term; the budget balance, the total spending, or the debt-to-GDP ratio. • An ideal target would be “a balanced budget over the business cycle,” given the low level of debt-to-GDP ratio in Korea. • In this scenario, a lower-than-expected growth will produce deficits and a higher-than-expected growth surpluses, with deficits and surpluses averaging out over the cycle. • And the debt-to-GDP ratio will decline slowly over the years.

19. - 17 - Improvements Required • Setting out the annual operational targets • There are two types of operational targets commonly employed -- budget balance and total spending. • Total spending is a superior choice because • it is less influenced by the cyclical position of the economy and therefore easier to target; and • it assists in a counter-cyclical management of fiscal policy by leaving the balance to fluctuate over the cycle. • Presently, the Korean government intends to keep the annual spending totals unchanged in successive NFMPs, and thus appears to have the total spending as annual targets.

20. - 18 - Improvements Required • Analyzing the risk factors • Risk analysis is being called for that studies the impacts of • the projected medium-term growth rates and other macroeconomic variables on the government financial position; • the various contingent liabilities of the government; and • the changing demography on the long-term fiscal sustainability and on the public pension system.

21. - 19 - Improvements Required • Introducing “program budgeting” • The Korean government is currently redesigning the structure of its budget accounts around functions, administrations, and programs. • The resulting program structure will make it easier to allocate resources according to the national priorities and set ceilings on sectoral spending. • “Programs” will also act as the basic units of performance management in the future.