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January 02, 2008

A Principal-Agent Theory Approach to Public Expenditure Management Systems in Developing Countries - IMF Working Paper

Posted by Luc Leruth

A well-functioning public expenditure management (PEM) system is considered a critical pillar of government efficiency by most practitioners, who place it at par with a low-distortion tax system and an efficient tax administration. It is therefore unfortunate that economic research has shown so little interest in the design of PEM systems, especially on the theoretical side. A recent IMF Working Paper entitled "A Principal-Agent Theory Approach to Public Expenditure Management Systems in Developing Countries" by Elisabeth Paul and myself discusses Public Expenditure Management (PEM) systems in developing countries using an analytical framework based on principal-agent theory.

On the empirical side, papers have generally focused on the efficiency of public expenditure in key sectors (health and education) and only a few attempts have been made to quantify the welfare losses associated with a weak PEM system. They all point to rather high economic costs. The importance of a good PEM system has also come to the forefront of the debate in the context of the debt initiative for Heavily Indebted Poor Countries (HIPCs), which provides substantial debt relief from the international community while requiring eligible countries to pursue good economic policies and to make their budget more “pro-poor,” using the HIPC relief received for spending on priority areas of a country’s poverty reduction strategy (PRS). The difficulty in tracking public expenditure in order to monitor the implementation of the initiative has clearly appeared during the systematic assessment of the capacity of some 26 HIPCs by the IMF and World Bank (see December 10, 2007, blog post).

The paper takes the example of the relationship between a Ministry of Finance (MoF), acting as the principal, who delegates the production of public output to a representative line ministry (LM), acting as the agent. We show that the model could also apply to other relationships within a PEM framework. We interpret the pair “expenditure program – budget appropriation” as the two components of a contract between the MoF and the LM. We also interpret corruption and misspending as resulting from the existence of an informational rent captured by the LM at the expense of the principal.

This simple model can be applied to various PEM systems, and allows for comparisons between institutional settings. To illustrate this, we analyze the benefits derived from the use by the MoF of two control instruments, ex post audits and ex ante controls, and assess their value in terms of their ability to deter cheating. We derive a set of possible “control regimes” which can be used by the MoF. The choice of regime is determined by the agency costs incurred by the MoF, and this depends on a number of country-specific parameters. We also discuss cases where constraints limit the ability of the MoF to implement the optimal contracts as derived from the theoretical framework. In particular, if the ability to impose penalties on the LM is limited (say for social reasons), as is often the case in poorer countries, the MoF will not be able to deter cheating through ex post audits. However, although we moslty illustrate the use of the model using developing countries, we also argue that it is relevant to developed economies.

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