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Public Finance and Management

Public Finance and Management. Microeconomics of the Budget M. Baher El-Hifnawi East Asia and the Pacific World Bank May 1, 2006. Public Expenditure Analysis. Rationale for Government Intervention Instruments/Mechanisms for intervention

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Public Finance and Management

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  1. Public Finance and Management Microeconomics of the Budget M. Baher El-Hifnawi East Asia and the Pacific World Bank May 1, 2006

  2. Public Expenditure Analysis • Rationale for Government Intervention • Instruments/Mechanisms for intervention • A Framework for the Appraisal of Development Expenditures

  3. When should governments intervene? • Market failures (public goods, externalities) • Redistribution

  4. How should governments intervene? • Subsidy • Regulation • Public provision

  5. Mechanisms for intervention • Regulation • Grant/Subsidy • Direct provision

  6. Framework for Appraisal of Development Expenditures • Sector analysis • Cost benefit analysis • Cost effectiveness

  7. Framework for Appraisal of Development Expenditures • Cost Benefit Analysis • Economic analysis: is the project worthwhile? • Financial analysis: what are the fiscal impacts? Is the project financially sustainable? • Stakeholder analysis: Who gains? Who loses? Any contributions to poverty reduction? • Basic needs analysis: any additional benefits attributed to addressing a basic need? • Risk analysis: how robust are the results?

  8. Project Parameters Project Parameters (Tables 1a, 1b, and 1c) Price Levels and Exchange Rate (Table 2) Financial Analysis Unit Cost of Production (End of Table 5) Loan Schedule (Table 7) Investment and Depreciation Schedule (Table 9 and 10) Production and Sales (Table 3a, 3b, 4 and 5) Working Capital (Table 6) (Interest Expense) (Cost of Good Sold) (Depreciation Expense) Income Tax Statement (Table 11) (Taxes) Total Investment Cash Flow (Nominal) (Table 12) (Loan) Equity Holder’s Cash Flow (Nominal) (Table 14) Total Investment Cash Flow (Real) (Table 13) Equity Holder’s Cash Flow (Real) (Table 15)

  9. Economic Analysis Step One:National Economic Parameters: a. Economic Opportunity Cost of Capital b. Foreign Exchange Premium (Table 16 for FEP) + • Step Two: Economic Conversion Factors for: • a. Project Output(s) • b. Project Inputs, including • Investments • Operating Expenses • Labor • c. Working Capital • d. Taxes, Tariffs, Subsidies, and Loans • (Table 17a,17b, 17c, 17d and , 17e) • Step Two: Economic Conversion Factors for: • a. Project Output(s) • b. Project Inputs, including • Investments • Operating Expenses • Labor • c. Working Capital • d. Taxes, Tariffs, Subsidies, and Loans (Applied to Real Financial Cash Flow Statement) Statement of Economic Costs and Benefits (Table 18)

  10. Stakeholder Analysis A. Economic Real Net Resource Flow (Table 18 of MPR Case) - (Minus) B. Financial Real Net Resource Flow (Table 13 of MPR Case) (Yields) C. Net Resource Flow of Externalities (Table 19 of MPR Case) D. Present Value (Table 20 of MPR Case) E. Allocation of Externalities (Table 20 of MPR Case)

  11. Stakeholder Analysis (Continued) F. Summary of Stakeholders’ Net Benefits (Costs) (End of Table 21 of MPR Case) G. Reconciliation of Economic and Financial Analyses: (Top of Table 21 of MPR Case) Economic NPV = Financial NPV + PV Externalities H. Basic Needs Analysis

  12. Risk Analysis A. Sensitivity Analysis (Table 22 of MPR Case) B. Risk Variables (Table 23 and 24 of MPR Case) C. Results (Table 25 and 26 of MPR Case) (Figure 1, 2, and 3)

  13. Economic Analysis:Three Basic Postulates forApplied Welfare Economics A. The competitive demand price for a given unit of an item measures the value of that unit to the demander • Willingness to pay B. The competitive supply price for a given unit of a good or service measures the value of that unit to the supplier • Opportunity cost C. Costs and benefits accruing to different groups should be added up to determine overall economic benefits; i.e. A dollar is a dollar no matter to whom it accrues

  14. Illustration of Basic Postulates Postulate A: Willingness to Pay Postulate B: Opportunity Cost Price Price Market Supply Curve Market Demand Curve d 0 P s 0 P Quantity per year Quantity per year Qo Qo

  15. Non-Tradable Commodities • A good or service is considered non-tradable when its domestic price is determined by local demand and supply. • An increase in demand (or supply) by a project could affect the amounts demanded by domestic consumers (or produced by other suppliers).

  16. Non - Tradable Good Price S Domestic Supply Distorted World Supply Price Em* PCIF* (1+Tm) + Fm Pm Distorted World Demand Price Em* PFOB* (1-tx) - Fx D Domestic Demand Quantity per year

  17. Steps to Estimate the Economic Value of a Non-Tradable Good or Service 1) Adjust for distortions in the market for the item (whether input to, or output of, the project). 2) Correct for the foreign exchange premium if there is an impact on the quantity supplied by other suppliers in the market (ws). 3) Correct for distortions in the markets for the inputs used to produce the item. Correction is applied to the proportion of the item produced by other suppliers in the market (ws).

  18. Non-Tradable Goods Economic Benefits of Project Output (No Distortions) Price S0 A S0 + Project C P0 E G F P1 B D D0 s1 Q Q0 QT d1 Quantity Q Value of Resources Saved Value of Increased Consumption

  19. Calculating the Economic Value of Non-Tradable Goods Economic Value = W s P s + W d P d =weighted average of supply (Ps) and demand (Pd) price Supply Elasticity  = Where: W s = Supply Elasticity - Demand Elasticity  -  Demand Elasticity - W d = = Supply Elasticity - Demand Elasticity  -  P s = Supply Price  = (defined positively)own price elasticity of supply P d = Demand Price  = (defined negatively) own price elasticity of demand

  20. Drinking Water Washing Water S 37.8 pesos 18.9 pesos S S +Project S +Project 5.69 pesos 5.135 pesos 5.135 pesos D w/ Project D w/ Project Q Q Q Q Q Q Q Q d1 T1 s1 d1 T1 o o s1 Cubic Meters Per Day Cubic Meters Per Day - Q Q = Incremental Project Water consumed by Paying Users d1 s1 Potable Water Supply Expansion:The Manila South Water Distribution ProjectThe Economic Benefits of Water to Paying Customers

  21. Price S0 A d0 m0 S0 + Project P P = (1+ts) N F d1 m1 P = P (1+ts) G s0 m0 E P = P J s1 m1 P = P H B D0 D s1 d/s0 d1 D0 Net of Tax Q Q Q Quantity Value of Resources Saved Value of Increased Consumption Step One: Adjusting for Distortions in the Market for Good or Service Non-Tradable Goods Economic Benefits of Project Output (Tax on Output) Economic Benefits W s P m0 + W d P m0 (1+ t s ) Example W s =1/3, W d=2/3 Pm=120, t s =0.15 Pe=1/3(120)+2/3(120)(1+0.15)=132 Pe=40+80(1.15)=132

  22. Non-Tradable Goods Economic Benefits of Project Output (Subsidized Output) Price S0 S After subsidy 0 s0 m0 P = P / (1-k) H A S After Subsidy 0+Project s1 m1 P = P / (1-k) F d0 m0 E I P = P J d1 = m1 P P G B C D D0 Quantity Q s1 Q d/s0 Q d1 Economic Benefits P m0 W s + W d P m0 (1-k) Value of Resources Saved Value of Increased Consumption Example W s =1/3, W d=2/3 Pm=90, k=0.40 Pe=1/3*(90/(1-0.4))+2/3*(90) Pe=1/3(150)+2/3(90)=110

  23. Non-Tradable Goods Economic Costs of Project Input (Subsidized Input) Price S0 H s1 m1 P = P / (1-k) C After Subsidy 0 G S s0 m0 P = P / (1-k) B D I E d1 m1 P = P F J d0 = m0 P P A D0+Project D0 Quantity d1 d/s0 s 1 Q Q Q Economic Costs P m0 W s + W d P m0 (1-k) Value of Postponed Consumption Value of Additional Resources Example W s =1/3, W d=2/3 Pm=90, k=0.40 Pe=1/3(90/(1-0.4))+2/3(90) ; Pe=1/3(150)+2/3(90)=110

  24. Pesos/KWh S0 s1 P = .169 L s0 P = .167 H S After Subsidy d1 A P = .122 B d0 P = .120 m1 P = .102 E G m0 P = .100 D0 F D Net of Tax + Project Wd Ws D Net of Tax Q d1 Qo Q s1 Quantity (Million kWh/Yr) 5.8 6.0 6.1 Example 1: Project Uses Electricity(Sales Tax, Subsidy on Cost of Electricity Production, No Other Distortions) m0 Financial Market Price (P )Net of Tax = .100 pesos/kWh m0 Financial Demand Price (P = P + Tax) = .120 pesos/kWh d0 s0 m0 Financial Supply Price, (P = P + Subsidy) = .167pesos/kWh Economic Price (Pe) = Wd * Pd + Ws*Ps. If Wd = 2/3, and Ws = 1/3, then Pe = 2/3(.120) + 1/3(.167) = .136 pesos/kWh

  25. Tradable CommoditiesClassification of a Project’s Inputs and Outputs A good or service is considered tradable when an increase in demand (or supply) by a project does not affect the amount demanded by domestic consumers • An increase in demand for an IMPORTABLE commodity results in an increase in demand for imports • An increase in demand for an EXPORTABLE commodity results in a reduction in exports • When a project produces a tradable commodity, there will be either a reduction in imports or an increase in exports. An Importable commodity includes imported goods and domestically produced goods that are close substitutes for imported goods An Exportable commodity includes exported goods and close substitutes for exported goods

  26. Importable Good Price S Domestic Supply Distorted World Supply Price Pm Em* PCIF* (1+Tm) + Fm D Domestic Demand Quantity per year so do Q Q so do Imports = Q - Q Em= Market Exchange Rate FM = Domestic Freight to Market Tm = Rate of Import Tariff PCIF=Price of imports at entry point to country, including international freight and insurance changes expressed in units of foreign currency

  27. Project Supplies More of an Importable Good Price S domestic S w/ project Em * PCIF* (1+Tm) + Fm S world D domestic Q1 Q2 Q3 Quantity Project reduces quantity imported. No change in domestic consumption.

  28. Project Demands More of an Importable Good Price S domestic Em * PCIF * (1+Tm) + Fm S world D w/ project D domestic Q1 Q2 Q3 Quantity Project requirements will be met by additional imports (world supply). Domestic consumption is not affected.

  29. Exportable Good Price S Domestic Supply Em* PFOB* (1-tx) - Fx Distorted World Demand Price Pm Domestic Demand D Quantity per year do so Q Q so do Exports = Q - Q Em= Market Exchange Rate tx = Export Tax Fx = Freight and Trading Costs to Port PFOB=Price of exports at point of export from country in units of foreign currency

  30. Project Supplies More of an Exportable Good Price S domestic S w/ Project Em * PFOB * (1-tx) - Fx D world D domestic Q1 Q2 Q3 Quantity Project increases exports. Domestic consumption remains unchanged.

  31. Project Demands More of an Exportable Good Price S domestic Em * PFOB * (1-tx) - Fx D world D w/ Project D domestic Q1 Q2 Q3 Quantity Project requirements will reduce quantity exported. Consumption of previous consumers remains unchanged.

  32. Estimating The Economic Prices of Tradable Goods 1. Adjust for commodity - specific trade distortions • Financial prices for the commodities demanded (or supplied) by a project must be adjusted for commodity-specific distortions and costs that drive a wedge between their international prices and their domestic market prices • Taxes and Subsidies are transfers between consumers, producers, and the government. Therefore, they are not part of the real resources consumed or produced by a project. 2. Value the foreign exchange at the economic (shadow) exchange rate (Ee) • Multiply the CIF and FOB prices at the border by the economic price of foreign exchange (Ee) • Alternatively, add a foreign exchange premium [(Ee/Em) - 1], or [(Ee/OER) - 1], per unit of foreign exchange demanded (or supplied) by a project. 3. Adjust for handling and transportation costs • The economic costs of handling and transportation that are necessary to move trade commodities to or from the point of entry must be included • In the case of imported commodities, these costs should be added to the CIF price. • In the case of exported commodities, these costs should be subtracted from the FOB price.

  33. Visayas Communal Irrigation Project Basic Facts • The National Irrigation Administration (Philippine National Agency) proposes to rehabilitate 55 damaged communal irrigation systems and to build 25 new systems in Visayas. • The project’s additional components include water protection and erosion control, the strengthening of irrigation association, and the development of agricultural extension services. • The goal of the project is to alleviate poverty, while improving environmental sustainability of the region. • The life of project is 20 years. • The economic benefits arise from the increased production of rice and corn, which must otherwise be imported. • The foreign exchange premium is 24.6%. • The project is expected to cost approximately 480.910 million pesos (US$19.78 million). • The project will be financed with US$15.1 million loan from the International Fund for Agricultural Development, and remaining funding would be provided by the Philippine government.

  34. Summary for Tradable Goods Economic Cost of Imported Input: CIF (adj. For Economic Exchange Rate) + Economic Cost of Freight to Project Economic Value of Import Substitute Production: CIF (adj. For Economic Exchange Rate) + Economic Cost of Local Freight from Port to Market - Economic Cost of Local Freight from Project to Market Economic Cost of Exportable Input: FOB (adj. For Economic Exchange Rate) + Economic Cost of Local Freight from Export Producer to Project - Economic Cost of Local Freight from Export Producer to Port Economic Value of Export Production: FOB (adj. For Economic Exchange Rate) - Economic Cost of Local Freight from Project to Port

  35. Stakeholder Analysis

  36. DISTRIBUTIONAL/STAKEHOLDER IMPACTS FOR ALL INPUT AND OUTPUT VARIABLES: NPV economic = NPV financial + S Stakeholder Impacts • Stakeholder Impacts are often called externalities of project Example of a non-traded good with a sales tax: Economic Value = Financial Value + Change in Government Tax Revenues + Increase in Consumer Benefits - Loss in Profits to other producers

  37. Financial, Economic and Distributive Effects of Project to Supply Non-Traded Goods with no Distortions P S S + Project A P0 B P1 C D Q QS Q0 Qd Financial Value of Output = QsCBQd or P1 (Qd -Qs) Economic Value of Output = QsCABQd Difference (Economic - Financial) = CAB CAB = P1P0AB -P1P0AC = Gain in Consumer Surplus - Loss in Producer Surplus Economic Value = Financial Value + Gain in Consumer Surplus - Loss in Producer Surplus = Financial Value + Distributive Impacts

  38. d0 (P0+T) = P d1 s0 P s1 P s1 s0 s1 s0 s1 s1 s0 d1 d0 d1 d0 s0 Financial, Economic and Distributive Effects of Project to Supply Non-Traded Goods with Unit Tax P S E P S + Project F A C B D Dn Q QS Q0 Qd Financial Value of Output = QsCBQd Economic Value of Output = QsCAQ0+ Q0ABQd +AEFB AEFB = Increase in Government Revenue CAB = PPAB - PPAC Since PPAB = PPEF Therefore, CAB = PPEF - PPAC = Gain in Consumer Surplus - Loss in Producer Surplus Economic Value of Output = Financial Value of Output + Change in Government Tax Revenues + Increases in Consumer Surplus - Loss in Producer Surplus

  39. Measuring Distributive Impact from Financial and Economic Values of Inputs with Tariffs P S B C F PW(1+t) Pw A E H G D + Project D Q Q s0 Q s1 Q d1 Q d0 Q d2 d1 d2 Financial Cost of Importable Goods = QCFQ Economic Cost of Importable Goods = QGHQ(Ee / Em) Where (Ee / Em - 1) = Foreign Exchange Premium (FEP) Difference (Financial Cost - Economic Cost) = GCFH - Q GHQ (Ee / Em - 1) = Gain in Tariff Revenues to Government - Loss in Government Revenues from Additional Use of Foreign Exchange in Importing This Input d1 d2 d1 d2

  40. Port Rehabilitation and Expansion: The Makar Project Basic Facts: • Makar Port, located in General Santos City at the northern side of Sarangani Bay, a well-protected bay in Mindanao, lies along the main north-south trading axis which skirts Mindanao on its western shore. • The objectives of the project are to increase the capacity and improve the efficiency of cargo handling facilities at the port to accommodate future flows • The project will cost approximately 635 million pesos1 • Seventy-five percent of the total project cost will be provided as a grant by the US Agency for International Development (USAID) and the other 25% will be provided from counterpart contribution by the Philippine government

  41. Port Rehabilitation and Expansion: The Makar Project • Project Outcome • Deterministic case appeared good with partial financial analysis NPV Financial (with Project)=10,760,000 million pesos • Full analysis shows project provide a negative economic performance • Project was implemented

  42. NPV (Total Investment Point of View) NPV (Economic Point of View) With Project (000s of Pesos) 10,760 (105,576) Without Project (000s of Pesos) 19,453 25,683 Incremental (000s of Pesos) (8,693) (131,259) Note: Peso is the Philippine currency and in Year 1 is equal to 0.037 US dollar (1994) Port Rehabilitation and Expansion: The Makar ProjectIncremental Financial-Economic Analysis

  43. FINANCIAL ANALYSIS Incremental Financial Cash Flow Statement (Real) (in thousands Peso) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 10 Year 15 Year 16 RECEIPTS - - - - 1,359 2,276 6,895 8,120 - Port Revenues - local - - - - 216 243 425 452 - Port Revenues - foreign - - - - 1,576 2,519 7,319 8,572 - Total port revenues - 3,000 3,000 3,000 3,000 3,000 3,000 3,000 - Rental income from Container Yard I - - - - 1,000 2,000 6,000 9,000 - Rental income from Container Yard II 69 69 69 69 69 69 69 69 - Other Income 22,148 155,088 219,215 79,719 - - - - - USAID Grant and Government Contribution - - - - - - - - 340,810 Liquidation Values: 22,217 158,157 222,284 82,788 5,645 7,588 16,388 20,641 340,810 Total Cash Receipts EXPENDITURES 22,631 103,995 153,285 49,006 - - - - - Investment cost-non tradable 2,758 93,124 139,002 57,285 - - - - - Investment cost-tradable - - - - 9,017 9,017 9,017 9,017 - Operating Cost: 1,100 1,100 1,100 1,100 1,100 1,100 1,100 1,100 - Loss of rental income from term. shed - - - - 79 54 64 19 (390) Change in Cash balance - - - - 158 109 128 38 (779) Change in Accounts Receivable - - - - (1,353) (123) (123) (123) 1,230 Change in Accounts Payable 26,489 198,219 293,386 107,392 9,001 10,157 10,186 10,051 61 Total Expenditures (4,272) (40,063) (71,103) (24,604) (3,356) (2,569) 6,202 10,589 340,750 NET CASH FLOW (8,693) NET PRESENT VALUE (at 9%) .

  44. Economic Benefits Makar Port Project • Additional port revenue from expansion in traffic including foreign exchange premium. • Additional rental income from containers yards. • Reduction in waiting time of ships. • Reduction in animal weight loss from waiting on ship.

  45. ECONOMIC ANALYSIS Incremental Economic Net Benefit Flow Statement (in thousands Peso)

  46. STAKEHOLDER ANALYSIS (in thousands Peso)

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