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March 10, 2008

Extrabudgetary Funds -- Removing the 'Extra' and Minimizing the Risks

Posted by Bill Dorotinsky

Extra-budgetary funds (EBFs) are a large and persistent issue in developed and developing countries. An October 26, 2007, blog post highlighted the magnitude of such funds, offered a taxonomy of EBFs, and suggested some questions for evaluating them. This post offers a similar perspective, drawing on a draft World Bank policy note prepared for the Polish authorities in 2001.

Public finance professionals generally oppose creation or continuation of 'extra-budgetary funds' because they undermine comprehensive budgeting, fragment financial reporting and cash management, and frequently there are transparency, oversight, and accountability concerns for the EBF's directly. But there are principles that, if followed, can minimize the risks from EBF’s, effectively removing their ‘extra-budgetary’ character.

Defining funds

Definition is all important. EBF's are defined as extra-budgetary. To the extent EBFs operate under separate budget formulation and execution procedures, with their own chart of accounts, they may undermine accuracy and transparency of the financial accounts. The term EBF is misleading, and is a remnant of an earlier era when many special funds were entirely off-budget. Today, a wider array of funds exist, some of which may be reported in the annual budget even if not approved in the budget.

The first best solution is get rid of existing EBF's and avoid creation of new ones. This may not mean entirely abolishing the separate accounting or special arrangements for special funds, but rather removing the adverse consequences of such arrangements.

Risks from Special Funds

Caiden and Wildavsky pointed out the deleterious effects of EBFs in their classic work "Planning and Budgeting in Poor Countries" (1974), noting that EBF's were a rational approach to solving the uncertainty of budgeting and cash flow in developing countries. They point out that, despite the appearance of rationality, this is a common pool problem -- use of EBF's actually makes the uncertainty of cash and budgets for other programs and the government as a whole worse, creating a vicious circle where individual actors have even more incentive to create EBF's. They point out the need to break the cycle.

Rationale for some special arrangements

For middle-income and developed countries, and selectively for developing countries, EBF's created for some specific purposes have a strong rational for being separate. For example, health insurance funds, with separate social or tax contributions, large volumes of transactions, and a need to balance revenues and expenditures and assets and liabilities, perhaps should be treated separately. For the health sector, it is important to establish the link between individual payments and benefits, and frequently to engage civil society in discussions over the sector and its financing and structure far more than the budget would normally allow.

The previous blog post offered some guidance on evaluating EBF’s and special funds generally. Guidance on minimizing the risk of EBF’s and special funds fall into two categories: PFM-wide issues, and special fund specific considerations.

General guidance when reviewing special arrangements

If created, EBF’s should be:

  • Included in annual budget documents on the same information base as the general budget (with additional charts arraying spending by other categories as appropriate, but these supplement rather than replace the basic, common display). For example, health funds would report by standard economic classification their administrative costs --- salaries, rent, utilities, etc. The bulk of spending under such accounts, however, is likely to fall under ‘contracts for services’ --- payments to health providers for services. This limits the usefulness of the information. As a consequence, health fund budget tables should be supplemented with additional information on the contract line item, showing the purposes or programs funded, such as primary care, tertiary care, etc. Generally, the budget would not try to array the contract service payments themselves by economic classification --- that is, wage costs for doctors and other health professionals, hospital maintenance, etc. Where there is a publicly owned health system, the latter makes sense, but this may be reported separately from the health fund itself. The exact form will be dictated by the structure of the health system in each country. This supplemental information is the minimum requirement for information and transparency purposes, and does not resolve whether the EBF’s budget is formally approved by the Government or Parliament, or subject to standard budget execution rules.
  • Subject to at least the same degree of scrutiny as on-budget spending, including issues of outcomes, efficiency and effectiveness. (Some EBF’s may be governed by laws that dictate how the money is spent, leaving little discretion to fund managers. Budget review would include reviewing the appropriateness of these laws relative to program outcomes and limitations on spending. This is in some sense a sub-field of budget analysis that differs in analytical technique and policy recommendations from budgeting for discretionary programs)
  • Meet common requirements for accounting, internal control, internal audit, and reporting. In some cases, clarification and modification are necessary to suit the nature of the activity. For example, health funds. The volume of transactions and number of health providers necessitate different approaches to internal audit and control. Frequently these take the form of data analysis to detect outliers in reimbursements, which become targets for auditors. Random sampling of claims for reimbursement may also be undertaken to uncover fraud or abuse.
  • Record and report accounts on the same time frame and frequency as general budget and financial reports (e.g. the government’s fiscal year, monthly cash flow statements)
  • Follow general principles of transparency in reporting and operation (e.g. frequency of reporting, procurement and contracting rules).

Guidance for special arrangements

J0385427 Despite being isolated in a separate account, the activity of the EBF is still a government responsibility. It is not uncommon for some to come to think of the EBF as separate from the Government responsibility, especially when the EBF runs arrears or is out of balance. But this is fiction. The Government is ultimately responsible for the laws establishing the EBF, the operation of the EBF, any liabilities incurred, and the results achieved. In this context, it behooves the Government to incorporate sound financial management practices when constructing EBF's.

  • Structural balance. Attention should be paid to assuring congruence between the expected revenues and expenses of funds. For some, such as Road Funds, this is more easily achieved: expenses may not exceed annual revenues (realized revenues, not estimated). Roads are constructed or maintained up to available resources, and no more.For other types of Funds, such as pension and health, care must be taken with regard to the laws establishing the level and types of benefits to be paid from the Funds. If the actuarial cost of benefits exceeds annual revenues, serious adverse financial and operational consequences may result. This is perhaps the most common problem for this type of EBF: misalignment of statutory responsibility with available revenues. New mandates on types and level of benefits to be paid are enacted with insufficient attention to available resources, and the Fund managers are not given authority to modify benefits or payments to bring expenditures in alignment with revenues.
    In these cases, several measures may be appropriate:
    1. general requirement that expenses not exceed revenues
    2. Require new laws effecting revenues or payments to have zero net effect. This may involve costing of proposals prior to enactment by parliament and special parliamentary procedures preventing passage of such proposals without costing or with positive net costs.
    3. Some authority granted to Fund management to modify benefits to bring spending into alignment with revenues in-year (applicable to health rather than pension funds).
  • Limits on debt issuance/fiscal discipline. Related to structural balance is the authority of an EBF to issue debt. EBF debt issuance should be subject to the review and approval of the Government or Ministry of Finance. Where structural imbalances exist, independent EBF authority to issue debt may allow a Government to ignore the EBF financing problems until large arrears or debt are built-up.
  • Clear oversight authority. Even if an EBF is established with an independent Board of Directors, clear oversight responsibility should be given to a line Ministry (sectoral policy issues) and to the Ministry of Finance (financial accountability).
  • External audit. EBF’s should be clearly subject to audit by the country’s Supreme Audit Institution. External verification of the accuracy of accounts and financial reports, adequacy of internal controls, and other financial management practices, still applies to EBF’s as for other Government agencies. Where an SAI does not have sufficient expertise, it may be appropriate to require annual audits by a private audit firm selected by the Ministry of Finance.
  • Internal audit. For some EBF’s with high volume payments or complex benefit rules, it may be appropriate to require the supervisory line Ministry or the Fund itself to establish an internal audit unit to more closely monitor operations for fraud, waste or abuse, provide internal management consultancy services, assure the integrity of financial management, and assure compliance with management policies. Sound internal audit operations can lessen the burden of work on external auditors, though not replace their independent external review and assurance that financial statements accurately reflect financial condition.
  • Gross Accounting. Transactions should be recorded and displayed on a gross basis for transparency and accountability. Recording transaction on a net basis is misleading, and can open opportunities for corruption where artificial pricing is used to conceal transfers.

If followed, these measures would remove the 'extra-budgetary' nature of special arrangements, and do much to remove the negative implications of any special arrangemnts that might be deemed necessary.

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Comments

i am on the lookout for a concrete definition of what may still be characterised as extrabudgetary funds and what may not - and having read your interesting blog, I am wondering if you can help me. For example, what makes Chinese local EBFs extrabudgetary? And, referring to another country case, to what extent can local funds be characterised as extrabudgetary if revenues and expenditures are reported on-budget in the aggregate and they are incorporated in the TSA system but apart from that the details of revenue and expenditure are managed fairly independently and intransparently by the locality( often outside their legal mandate), being subject only to highly limited budget control?

Domenica should read the recent article that I wrote with Dimitar Radev on EBFs: "Managing and Controlling Extrabudgetary Funds". This was orginally published as an IMF Working Paper, subsequently in the OECD Journal on Budgeting, Vol. 6, No. 4, 2006. The definition given in this paper is "Government transactions, often with separate banking and institutional arangements, that are not included in the annual state (or federal) budget law and the budgets of subnational levels of government." However, the article points out that the concept of an EBF is quite complex, and there is no consensus on a definition. Box 1 gives a range of alternative definitions and approaches that have been suggested in the literature.

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