ANALYTICAL TOOLS VERSUS BUDGET RULES

ANALYTICAL TOOLSVERSUS BUDGET RULES SHOULD NEW FORMS OF DATA AND ANALYSISINFORM BUDGET MAKERS OR CONSTRAINHOW THEY ALLOCATE MONEY? ALLEN SCHICK International Monetary Fund 19 September 2007

PRESENTATION International Monetary Fund 19 September 2007

TOOLS AND RULES • Many analytic concepts can be formulated into rules that guide or constrain budget and other policy actions of government • Alternatively, analytic tools can be deployed solely to inform decisions, but not to dictate how governments allocate resources • This seminar reviews tools that have been proposed as rules and explores criteria for determining the adoption of new rules • TOOLS THAT HAVE BEEN CAST INTO DECISION RULES • Baseline projections that estimate the future cost of current policies • Medium-Term Expenditure Frameworks that limit future spending • Fiscal Rules that limit key fiscal aggregates, such as the deficit • TOOLS THAT HAVE NOT BEEN TRANSFORMED INTO RULES • Herbert Stein’s proposal to allocate the budget as shares of GDP • The Tax Expenditure Budget and the Regulatory Budget • The Program Budget Concept to allocate money according to government objectives rather than spending units

CRITERIA FOR DETERMINING WHETHER TOOLS SHOULD BE FORULATED AS RULES • Lessons from past successes and features • Why governments should be parsimonious in devising new rules • Proposed Criteria • Applying the criteria to accrual budgeting and performance budgeting • CONTEMPORARY CANDIDATES FOR NEW RULES • Accrual Accounting and Accrual Budgeting • Performance-Based Budgeting for link resources and results

ANALYTIC TOOLS VERSUS BUDGET RULES • An analytic tool assists budget makers in deciding the purposes and amounts to be allocated • A decision rule is information that dictates either how decisions are made or the types of decisions • Medium-term projections that inform budget makers of the future fiscal outlook are analytic tools • Medium-term frameworks that limit future spending or other budget elements are decision rules • Economists often seek to convert analytic tools into decision rules because of concern that the information will not be used in deciding the budget • Over the years, both analytic tools and decision rules have proliferated in budgeting • Not every tool of analysis is appropriate for making budget decisions: tools expand budget choice, rules constrain choice

PARSIMONY IN BUDGETING RULES:EXPENDITURE CLASSIFICATION • The classification of expenditure is one of the most important decision rule in budgeting • Government can have only one decision structure in budgeting • It can have multiple supplementary classifications which serve as analytic tools • The traditional classification has been by organizational units and items of expenditure (inputs) • Efforts to replace spending units as the decision structure through program or performance budgeting have been unsuccessful • The organization structure has survived as the main decision structure because it is the basis for implementing the budget, carrying out authorized activities and maintaining accountability

TOOLS THAT HAVE BEEN CAST INTO RULES: BASELINE PROJECTIONS • Baseline projections of Medium-Term or longer budget trends under current policy have become the starting point for budget work in many developed countries, as well as the official benchmark for measuring the budget impact of proposed or adopted policy changes. • In Most countries, these projections began as internal estimates in the finance ministry or budget office. It used the projections to inform itself of the fiscal outlook for the years immediately following the budget year. Over time, projections were improved and published, and were converted into the standard metric for budget decisions.

BASELINE: WHY THIS TOOL WAS FORMULATED INTO A RULE • Baselines serve other recent innovations in budget rules, in particular medium-term frameworks and fiscal rules. These innovations would not be workable without authoritative baselines. • Baselines strengthen the finance ministry in negotiations with spending units, for it can show the downstream impacts of expenditure increases on the government’s fiscal position. • Baselines serve the interests of program beneficiaries and government agencies by building price or workload changes into projections, thereby shifting the focus of budgeting from cash to volume. • Baselines recognize the inherently incremental character of budgeting by focusing budget decisions on marginal changes. • Baselines comfort with the shift in budgeting from control of inputs into a process for deciding policy changes.

TOOLS THAT HAVE BEEN CAST INTO RULES: FISCAL RULES • Fiscal Rules limit one or more fiscal aggregates, such as the balance between revenue and expenditure, the primary or structural deficit, or total expenditure as a share of GDP. The rules are set in advance of submission and review of budget bids, and typically pertain to the Medium-Term or longer. • Fiscal Rules were introduced near the end of the 20th century in the form of targets that guided but did not constrain budget decisions. Often, the targets were political statements that lacked enforcement, but were intended to indicate that the era of rapid expenditure growth that permitted large deficits had come to an end. Goaded by regional treaties (particularly the Stability and Growth Pact, IMF conditionalities, and fiscal responsibility laws, fiscal rules have become a prominent feature of budgeting.

FISCAL RULES: WHY THIS TOOL WAS FORMULATED INTO A RULE • Regional and international organizations have monitored compliance and have occasionally intervened to enforce the rules. • Voter and political resistance to tax increases and government expansion, and projections from long-term fiscal imbalances due to the ageing of the population have emboldened politicians to embrace fiscal constraints. • Finance ministries welcome the bargaining advantage given them by fiscal rules in cabinet debate and bilateral negotiations with spending ministries. • Research on fiscal institutions by Von Hagen and others influenced governments to accept fiscal rules. • Financial crises (East Asia, Sweden, Latin America) persuaded political leaders of the need for stronger fiscal discipline.

TOOLS THAT HAVE BEEN CAST INTO RULES: MEDIUM-TERM FRAMEWORKS (MTEF) • MTEF extends budget decisions from the year immediately ahead to the medium term, typically the next 3-5 years. Decisions for each of the out-years are firm, but may be revised as the MTEF is rolled forward each year. Although MTEF has been introduced in many countries, only a small number have fully integrated annual budgeting into the Medium-Term Framework. • MTEF began as a means of estimating the out-year impacts of current budget decisions. With the aim of sensitizing policymakers to the future implications of changes in revenues or expenditures. With development of baselines and imposition of fiscal rules, MTEF displaced annual budgeting as the authoritative basis for budget decisions.

MTEF: WHY THIS TOOL WAS FORMULATED INTO A RULE • MTEF is a critical accessory of new public management’s drive to transform budgeting from a process that controls inputs to one that focuses on policy changes. • MTEF enables policymakers to do something about the medium and long-term fiscal outlook. • MTEF institutionalizes incrementalism, changing budgeting from a process that purports to allocate all resources to one that emphasizes marginal changes in revenue and expenditure policy. • MTEF encourages spending units to make tradeoffs that enable them to spend more on policy initiatives by cutting back on existing programs.

TOOLS THAT HAVE NOT BECOME RULES: THE TAX EXPENDITURE BUDGET • The term “ Tax Expenditures” was devised in the 1960s to identify and measure deferrals, exemptions, deductions, credits, and other deviations from the normal tax structure. The term connotes that these exceptions convey financial benefits to recipients and impose costs on government. • Proponents of the tax expenditure concept urged that governments adopt a “Tax Expenditure Budget” that would limit and allocate benefits from these provisions in the same manner as the budget allocates and limits direct expenditures. Although many governments publish estimates of the revenue losses from these provisions, they do not compile a tax expenditure budget.

THE TAX EXPENDITURE BUDGET: WHY THIS TOOL HAS NOT BEEN FORMULATED INTO A RULE • Because of interactions among different tax expenditures, it is difficult to tally aggregate changes in revenues, which is the core component of the tax expenditure budget. • Inasmuch as the value of tax expenditures is a function of tax rates, changes in rates, change in value of tax expenditures, leading to the perverse result that raising the liability of taxpayers boosts the subsidies they receive. • Powerful interests do not favor a concept that would limit the benefits they receive through the tax code. • Trading off between tax and direct expenditures (reductions in tax would allow increases in direct expenditure) could open the door to significant enlargement of government.

TOOLS THAT HAVE NOT BECOME RULES: THE REGULATORY BUDGET • The regulatory budget is a measure of the full cost of compliance with government regulations. It includes the direct cost of operating government regulatory programs (principally expenditures of regulatory bodies) as well as the cost to households and firms for complying with the regulations. • During the drive to deregulate governments in the late 20th century, strong proposals were made to adopt a regulatory budget that would limit the total cost of regulation, including compliance costs. The proposal has not been adopted in any country, though analysts do estimate costs.

THE REGULATORY BUDGET: WHY THIS TOOL HAS NOT BEEN FORMULATED INTO A RULE • Estimates of compliance costs may be unreliable, and different analysts can produce widely different estimates. • This concept is a fundamental break with conventional budget practices, which measure the costs of expenditure to government, not social costs. • Opponents of the concepts feared it would be used as a frontal attack against social and environmental regulation.

TOOLS THAT HAVE NOT BECOME RULES: BUDGETING SHARES OF GDP • Analysis routinely measure aggregate and sectoral spending as shares of GDP to facilitate comparisons among countries and to analyze changes in the composition of government expenditure. In 1989, Herbert Stein, an influential American economist published a book that strongly urged the United States to allocate resources as shares of GDP. Doing so, he argued, would enable government to see the full cost of policies. Stein’s proposal has not been adopted, though the analytical tool is still widely used.

BUDGETING SHARES OF GDP: WHY THIS TOOL HAS NOT BEEN FORMULATED INTO A RULE • It is difficult to estimate or control the full social cost of a policy. Moreover, actual costs are likely to vary significantly from budgeted costs. • In contrast to conventional budgeting, this concept includes costs to firms and households, not only those borne by government. • Critics of Stein’s proposal feared that it would open the door to central planning.

CRITERIA FOR DECISION RULES • Every decision rule biases budget decisions • Will the rule impair government’s ability to complete its budget work? • Is the information required for implementing the rule readily available? • Do budget makers regard the rule as sensible and relevant to their work? • Does government have adequate means to enforce the rule? • What happened to past efforts to introduce similar rules? • How does a proposed rule relate to other ongoing budget rules?

SHOULD PERFORMANCE BUDGETING BE A TOOL OR A RULE? • Shifts budgeting from decisions on inputs to decisions on outputs or outcomes • No standard definition of performance budgeting • Some governments define performance budgets as budgets that contain information on actual or estimated results • Others define performance budgeting as budgets in which increments in resources are linked to increments in results • In the broad definition, performance budgeting is only an analytic tool

SHOULD PERFORMANCE BUDGETING BE A TOOL OR A RULE? continued • In the strict definition, performance budgeting serves as a decision rule • Others define performance budgeting as budgets in which increments in resources are linked to increments in results • In the broad definition, performance budgeting is only an analytic tool • In the strict definition, performance budgeting serves as a decision rule

PERFORMANCE BUDGETING • No standard definition or application of performance budgeting • Strict version increments of resources and results hard to implement: few countries have succeeded • Allocating on the basis of results ignores other salient considerations; pressure to finance ongoing activities, political promises and interest group demands • Systems that require agreement on objectives and results increase conflict and jeopardize timely completion of budget work

PERFORMANCE BUDGETING, continued • Performance budgeting is dependent on performance management and commitment of public employees to produce good results • Hard to use performance as a decisional rule for outcomes • Basing allocations on the volume of outputs requires cost accounting systems that distinguish between fixed and variable costs • Measuring performance has received most attention in performance budgeting, but not enough consideration of how and whether the measurements are used

SHOULD ACCRUAL BUDGETING BE A TOOL OR A RULE? • Shifts budgeting from cash flows (money received and payments made) to revenues earned and liabilities incurred • The accrual basis would align budgeting and financial reporting: both would be on the same accounting basis • It is feasible to report in terms of accruals and to budget on a cash basis • If budgeting were continued on the cash basis, financial reports would be analytic tools • If budgeting were shifted to the accruals, accounting principles would become decision rules in budgeting

ACCRUAL BUDGETING • Many governments report finances (ex post) on the accrual basis: few governments budget (ex ante) on the accrual basis • It is not inconsistent to report and budget differently and to reconcile the two types of financial statements • Financial reports are subject to audit; budgets are not • Although cash-based budgeting is subject to manipulation of the timing and recognition of transactions, accrual budgeting is vulnerable to manipulation of key assumptions • Shifting the budget to the accrual basis weakens the capacity of political leaders to comprehend and take responsibility for accrued expenditures • There may be an “accruals anomaly” in government similar to the anomaly in public firms

ACCRUAL BUDGETING, continued • The accrual basis provides a more reliable statement of fiscal condition, but in well-run countries, differences between cash and accruals tend to be small • Accruals do not provide an adequate assessment of long-term fiscal sustainability because they exclude liabilities for general benefits such as social security and health care • Accruals enable managers to better manage cost only when they have broad operating discretion • There are many unresolved issues in accrual budgeting pertaining to the recognition and valuation of assets and liabilities

ANALYTICAL TOOLS VERSUS BUDGET RULES