Budgeting of investments

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. 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. 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. 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. Budget management objectives

7. 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. Medium-term budget frameworksKey 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. Budget timetable I

10. Budget timetable II

11. Budget timetable III

12. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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