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October 26, 2007

Extrabudgetary Funds - Threat or Opportunity?

In a recent article in the OECD's Journal of Budgeting (Richard Allen and Dimitar Radev, "Managing and Controlling Extrabudgetary Funds", OECD Journal of Budgeting, Vol. 6, No. 4, 2006), FAD staff analyze the current status of, and policy regarding, extrabudgetary funds (EBFs). EBFs account for about half of central government expenditures in developed countries, and some 40 percent in developing countries. About two-thirds of these totals represent the activities of social security funds, which are the most important single category of EBF. Other EBFs represent, in many countries, a heterogeneous group of government entities and accounts that include natural resource stabilization and savings funds, sovereign wealth funds, and road maintenance funds.

The article sets out a taxonomy of EBFs. It argues that EBFs mainly exist or are established because of the combination of "market" or budget system failures, and political economy factors. Common examples of budget failures include the "capture" element in the budget process and interference of special interest groups; weak governance arrangements for transparency and accountability; and ineffective mechanisms for addressing donors' fiduciary concerns, thus driving donors to plan and disburse their aid programs outside the national budget.

Political economy factors include protecting politically sensitive programs from cuts; giving the appearance (but not the reality) of a smaller budget deficit; generating political support for introducing new taxes, and for activities that are characteristically underfunded in the budget (e.g., maintenance of infrastructure); and protecting funds from public scrutiny.

EBFs have often been regarded as problematic since they can undermine fiscal discipline, flexibility and transparency. The article argues, however, that such problems are not necessarily endemic to EBFs, and may normally be attributed to poorly designed financial management and governance procedures. The "agency model" of public sector management - actively used in countries such as Australia, New Zealand, Sweden, and the U.K. - frequently establishes public agencies as EBFs in order to give them greater managerial autonomy and flexibility. In such cases, EBFs can lead to microeconomic efficiency gains by simulating private market conditions where levels and standards of service are linked directly to fees and charges. 

The article recommends that data on EBFs be consolidated within a unified system of fiscal reporting, and proposes an analytical framework that governments might use to evaluate and enhance the effectiveness and efficiency of their EBFs. In some, but not all, cases - especially countries with weak governance arrangements, including many low-income and middle-income countries - the appropriate policy response will be to incorporate EBFs in the national budget. Key criteria for evaluating the role and impact of EBFs include the following:

  • Is there a satisfactory economic, governance and political economy case for establishing the EBF?
  • Is the EBF properly classified according to the IMF's Government Finance Statistics guidelines?
  • If the EBF is financed by earmarked taxes, are there suitable arrangements for collecting these revenues?
  • Does the legal basis for the EBF establish adequate arrangements in terms of financial management and reporting?
  • Does the EBF have sound governance arrangements that promote transparency and accountability?
  • Is the EBF subject to audit by the country's national audit body?

Posted by Richard Allen

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