Top-down Budgeting

1. Top-down Budgeting A Tool for Central Resource Management December 15, 2006 2006 OECD Asian SBO Korea Institute of Public Finance John M Kim, PhD jhrv@kipf.re.kr

2. Outline • What is it? • Why do it? • How to do it? • Caveats

3. What is Top-down Budgeting? • It is not: Bottom-up Budgeting • Traditional way of budgeting • Sum of ministry budgets  Total budget • Difficult to control aggregates (total budget, deficit) • Difficult to control allocation among major sectors • Defense vs. pollution control vs. infrastructure, etc. • Additional Problems • Focus on annual numbers (myopic) • Inefficient process • Iterative negotiations (game-playing & adjusting for totals) • Inability to utilize ministries’ expertise

4. What is Top-down Budgeting? (2) • It is:Budgeting in 2 Steps • Ceilings (aggregate numbers) • Decide total spending & deficit levels (agg. ceiling) • Decide allocation among major policy areas (sectoral ceilings: about 30) • Defense vs. pollution control vs. infrastructure, etc. • Intra-sectoral allocations (details) • Ministry/agency budgets

5. What is Top-down Budgeting? (3) • It is:ADivision of Roles/Responsibilities • Ceilings (aggregate numbers) • Final decision by PM & Finance Minister • Focus on • Aggregate fiscal management • Medium-term perspective (multi-year ceilings) • Policy priorities • Intra-sectoral allocations (details) • Ministries formulate their own budgets • But must follow rules

6. What is Top-down Budgeting? (4) • It is: • Effective for fiscal consolidation • A key tool for enforcing MTEF (NFMP) decisions (ceilings are often multi-year limits) • Ensures spending is aligned with priorities • Efficient in time and effort • Utilizes ministries’ expertise

7. Outline • What is it? • Why do it? • How to do it? • Caveats

8. Urgency of Reform? • Huge deficits ca.1990 in many OECD countries forced them to adopt major fiscal reforms

9. Different Motivation for Korea • Top-down adopted as key part of 4 fiscal reforms • Need for longer-term perspective Anticipate need for controlling future spending growth in social welfare, etc. • Efficiency • Need to focus on broader policy priorities • Eliminate unproductive games in budget negotiations • Utilize ministries’ expertise • Need to focus on performance management, rather than controlling inputs

10. (What are Korea’s 4 Reforms?) • National Fiscal Management Plan • Medium-term (5-year) fiscal plan for 14 sectors • Top-Down budgeting • Tier 1: Fixed spending envelope for each sector/ministry • Tier 2: Autonomy for line ministries in own budgets • Performance Management • Assess performance of spending programs • Enhance link between performance and budget • Digital Budget and Accounting System • Program Budgeting • Accrual Accounting • Computerization of accounting system

11. (Why the 4 Reforms?) • Anticipate fiscal difficulties driven by aging & other socioeconomic changes • Population aging and low fertility rate • Old population (65 and above): 7.2 (2000)  14.4(2019) • Total fertility rate: 6.0(1961)  2.1(1982)  1.19(2003) • Less workers must support welfare of more elderly people Public pensions and health care financing will suffer most • Society demands better quality of life (social welfare, education, culture, environment) • Economic growth slowing down  so will tax revenues • Emphasis on participation and transparency • Spending growth may outrun revenue increase, so try to get fiscal system in good shape before it’s too late

12. (Some Background: Current Fiscal Status) • Up to the financial crisis, Korea’s public finances were solid, thanks to two decades of balanced budgeting • Some deterioration resulted from coping against crisis (national debt more than doubled), but fiscal situation remains better than most other OECD countries What does this mean for the 4 Reforms? • Korea’s reforms are not driven by an immediate crisis, but this may end up somewhat undermining the momentum of the reforms

13. Top-down vs. Bottom-up Comparison of Bottom-up & Top-down Approaches

14. Top-down vs. Bottom-up (2) • Top-down and bottom-up methods are complementary • Information for evaluating new initiatives • Program reviews for monitoring programs/activities Approaches to Determining Expenditure Ceilings ○: actively used, △ : used as reference, - : not used

15. Results? • No more excessive budget requests • Increase rate of budget requests in the general account dropped significantly: 30.8%(’04)  11.7%(’05)  7.0%(’06) • Self-initiated restructuring of spending by line ministries • Restructuring of multi-year programs and introduction of new programs have nearly doubled

16. Outline • What is it? • Why do it? • How to do it? • Caveats

17. Example of Linking Multi-year Plans to the Annual Budget (Sweden)

18. Y+5 Y+1 Y+1 Budget Formulation in Bottom-up vs. Top-down Systems • Strategic resource allocation emphasized Line Ministries MoF Budget Requests ( by line items) Budget Formulation (line item-oriented) Before Cabinet Meeting MPB Line Ministries MoF Consultation and Review Budget Formulation Within Ceilings  Total Ceiling  Sectoral Ceilings NFMP Now

19. Determining Expenditure Ceilings • Overall Ceiling • Prudent Economic Assumptions (Growth, etc.) • Sensitivity analysis • Independent panel or private sector forecasting • Built-in bias for lower growth rate • Fiscal Rules for Good Discipline • Sweden: structural surplus of 2% GDP • Chile: Structural surplus of 1% GDP • UK: Balance current budget over econ. cycle • Surplus automatically goes to repaying debt

20. Determining Expenditure Ceilings (2) • Sectoral Ceilings • Must not affect overall ceiling • Usually overlaps with ministerial boundaries (good program budget design) • New initiatives may be required to be funded from savings from existing programs

21. Determining Expenditure Ceilings (3) • Operating/Capital Ceilings • Ministries tend to favor operating expenses • Denmark: separate ceilings for current & capital expenses • Sub-ceiling for salaries/wages in operating ceiling • UK • Current expenses: Golden Rule • Capital expenses: Sustainable Investment Rule

22. Determining Expenditure Ceilings (4) • Number of Ceilings • Korea (200+) vs. Sweden (27) • Optimal number is around 30 • More ceilings make budgeting decisions politically difficult • Need to give ministries room to exercise autonomy to ensure their proactive participation • This means Budget Office needs better tools: • Performance management • Information system to monitor execution • Enhanced analytical capacity for policy assessment

23. Determining Expenditure Ceilings (5) • Buffers against Contingencies • Built-in buffers in prudent forecasts  Windfalls (repay debt, tax cut, etc.) • Budget Margin • Overall Ceiling = Sect. Ceilings + Budget Margin • Covers unexpected changes (forecasts errors, etc.) and institutional reforms after ceilings were fixed • Usually does not cover new policy initiatives

24. Determining Expenditure Ceilings (6) • Expenses in or excluded from ceilings? • Discretionary expenses usually included • Mandatory expenses (social security entitlements, etc., mandated by law) • Sweden, Korea, Chile, Netherlands: included • Canada, Denmark: excluded • Interest on debt • Sweden, Denmark: excluded • Chile, Netherlands, Korea: included

25. Determining Expenditure Ceilings (7) • Funding for new policy initiatives • Sweden: must come from existing ceilings • Most countries have review process to judge new initiatives  adjust ceilings • Australia, Canada: Cabinet committees • Netherlands, Denmark: simply verify fit with coalition agreement • Chile: pooled “Bidding Fund” from savings on obsolete or poorly performing programs

26. Outline • What is it? • Why do it? • How to do it? • Caveats

27. Conditions for Top-down Budgeting • Good monitoring system to compensate for delegation of authority to ministries • Performance & program reviews • Information system to monitor execution • Enhanced policy capacity + Behavioral change • Budget Office: better forecasts & projections, must be able to defend fiscal rules, but work better “together” with line ministries • Ministries: need to learn internal allocation decisions • Strong PM & Finance Minister • Commitment to rule-based budgeting (Fiscal Rules) • Remove arbitrariness in budgeting decisions, but leave room for flexibility and judicious discretion/autonomy • Support from the legislature

28. Remaining Tasks (Korea) • Areas for improvement • Consensus and understanding on the top-down system • Ex-ante consultations with line ministries when setting spending ceilings • Further expansion of autonomy at line ministries • Insufficient preparation and guidelines by MPB • Future plans • Surveys and consultations with line ministries • Sectoral and ministerial spending ceilings set after sufficient discussions • Active use of performance assessments to restructure spending programs • Detailed budget formulation guidelines

29. This ends the presentation Thank You!