Medium-Term Expenditure Ceilings: are they an Essential Part of Medium-Term Budgeting?

Posted by Marc Robinson

We often hear it said that medium-term expenditure ceilings for ministries or sectors are an essential part of good medium-term budgeting. Spending ministries, it is said, know what budget funding they will receive not only this year, but next year and the year after. The funding certainty this will give them will improve their planning and management, thereby boosting service delivery. Such increased funding certainty, the line runs, is the #1 objective of medium-term budgeting.

This is, with respect, wrong. Multi-year funding certainty for spending ministries is something which only the most advanced countries can aspire to. And while reduced funding uncertainty is a goal of medium-term budgeting, it is not the most fundamental goal.

Very few countries successfully set medium-term spending ministry budgets. This is because the preconditions for setting medium-term ceilings are very demanding, and include:

• Excellent forward projections (estimates) of revenue and expenditure,
• Reasonable macroeconomic stability,
• A strong expenditure review and prioritization mechanism,
• Sustainable aggregate fiscal policy settings.

Take the first point. Without a capacity to make excellent medium-term revenue forecasts, there is the danger that unrealistically high multi-year expenditure ceilings will be set. Down the track, when revenue turns out to be below-forecast, the government will be faced with the difficult choice between withdrawing its budget commitments to spending ministries or finding additional revenue.

It’s also worth looking closer at the third point. The UK is perhaps the most striking example of a country which has successfully implemented multi-year budgets for spending ministries. But in the UK’s case, these expenditure ceilings are set only after very thorough spending reviews. The detailed review and resetting of expenditure priorities which the Spending Review involves is possible only because the Treasury (finance ministry) has developed very strong policy and performance analysis skills, and is supported in its work by a system of performance information (indicators and evaluations) which is very well developed by international standards. This information and analytical basis took some decades to develop. Indeed, the move towards multi-year budgets in 1997 came after a long period of medium-term budgeting without multi-year expenditure ceilings.

Many—perhaps most—countries lack good mechanisms to scrutinize and reprioritize expenditure. The great danger is that without such processes, making medium-term budget commitments to spending ministries will simply increase expenditure inflexibility, and make it harder to reallocate spending over time to the areas where it is likely to deliver greatest benefits. With only limited capacity to review expenditure, the Ministry of Finance would find itself forced to recommend to the government multi-year ceilings largely based on the status quo rather than on critical analysis of the status quo. Under such circumstances, ministries which should have the budgets reduced could easily find themselves protected from scrutiny for a number of years at a time.

The preconditions for the adoption of multi-year ministry or sectoral budgets take considerable time to develop. As they develop, it is better to continue to determine ministry/sector budget allocations on an annual basis. This provides an opportunity to incrementally improve the prioritization of expenditure each year, using the gradually improving analytical capacity and information set which will be developed.

Some might object that to dispense with multi-year expenditure ceilings would be to rip the heart out of medium-term budgeting. But this is surely not true. The real essence of medium-term budgeting is something quite different. It is about improving the consistency of expenditure and revenue policies with fiscal policy. The key tool for this purpose is good forward estimates: that is, projections which indicate with a considerable degree of accuracy what the costs of current expenditure policies (and new initiatives) will be over the next three or four years, as well as the revenue which can be expected from the maintenance of current revenue policies. Such estimates indicate the aggregate fiscal outcomes—aggregate expenditure, total revenue, and the resultant deficit—which can be expected to result from current tax and spending policies. If these are inconsistent with fiscal targets, there will be a need to adjust current spending and/or tax policies or, possibly, the fiscal targets themselves. If, for example, the maintenance of current tax/spending policies will produce a deficit higher than targeted, then it will be necessary to do one or a combination of three things: cut spending, raise taxes or adjust the deficit target itself in the event that the forward estimates were to make it clear that the spending/tax policy changes required to meet it were not feasible. Such a process can certainly help to reduce the uncertainty which spending ministries face about future budget funding levels. But it is not one which gives them commitments about medium-term funding. Government retains the right to change next year’s projected funding if it needs to do so.

The #1 objective of medium-term budgeting, from this point of view, is not funding certainty. It is, rather, improved capacity to stick to sustainable fiscal policy.

Comments

[Bill Dorotinsky]

The essence of the blog is to air different views, and Marc's post is a welcome challenge to conventional wisdom on medium-term expenditure frameworks. But, with all due respect, it is a rather flawed set of arguments, and misses some fundamentals of budgeting and medium-term frameworks. Budgeting is at least as much ‘art’ as ‘science,’ and proceeding from the assumption that multi-year ceilings must be perfect and immutable to be useful seems an unrealistically high standard.

Indeed, the arguments posed for not setting ceilings are actually arguments against budgeting. Why have a ministry annual budget target at all if there is macroeconomic uncertainty? (In cases of severe hyperinflation, there are countries that have abandoned budgeting as pointless.) No analysis or spending reviews?

MTEF's are more than just macroeconomic stability. An MTEF actually tries to support all three objectives of public financial management systems: (1) macrofiscal stability; (2) strategic allocation of resources; and (3) operational efficiency.

Strategic allocation of resources across ministries or sectors need not be a hyper-rational exercise. Yes, ideally, good analysis and spending reviews, and performance information, would help inform the choices. But at a minimum, annual increments of spending can be disproportionally allocated to higher priority sectors, to achieve Millenium Development Goals, for example. So ceilings serve a signaling and reallocation role, even absent a hyper-rational budgeting system in place.

Moreover, MTEF’s are about changing incentives within PFM systems. Many budget systems do operate without ceilings, and find line ministries (a) making multi-year strategic plans absent any resource constraint, or even indication of what available resources might be (indicative or hard ceilings), and (b) annual requests from ministries are nearly always additional --- keep the current base, and ask for new money for all new initiatives.

Ceilings --- indicative, not necessarily hard ceilings --- can serve as a guide to more realistic – and useful – planning. So many strategic plans are wasted efforts because they are un-costed, or if costed, far exceed any possible resource envelope.

In terms of incentives, ceilings can start pushing line ministries to re-examine their own spending, to look for lower priority or less effective spending that can be reallocated to higher-priority or higher impact programs, or new initiatives. Yes, some of this incentive can be introduced without ceilings. For example, a budget office might require ministries to show how they have reallocated internally before granting new funding requests. Prime Ministers and cabinets might ask the same thing. But, ceilings can also help. Indicative ceilings can give some notion of realistic funding expectations for the ministry, and the funds they broadly have to work within. They do not need to be perfect estimates to serve their purpose. And hard ceilings (firmer numbers approved by cabinet at the beginning of a budget cycle, for example) can have even more impact --- individual ministers have already signed-on to the ceilings, and understand the over-all economic constraints faced by the country which led to the ceilings. Some pressure of new spending may be reduced, and more emphasis placed on weeding-out ineffective spending within the ministry.

Some of these changes are subtle, but on the margin, start changing incentives and leading to better resource use, improving the marginal productivity of spending. Some countries that have introduced indicative or hard ceilings (imperfect as they may be) have seen line ministry spending requests dropping from some 25-30 % above prior year’s budget to more around 5 % --- ministries are being more selective in asking for new money, and focusing more on finding resources internally, being more efficient. And lower spending pressure may contribute more to macro-fiscal stability than just focusing on macroeconomic forecasting and fiscal policy.

The assumption that ceilings are ONLY about assuring minimal funding levels is, it should be clear, wrong. Yes, that is one argument in favor of ceilings, but only one. Setting such forward estimates does, at some level, become a performance target for ministries of finance to try to deliver, and line ministries to try to question ministries of finance should the numbers be far off the mark. It can serve as the basis for intra-governmental accountability for performance. Ceilings need not be perfect to start moving PFM systems in the direction of more stable resource flows to sectors – and we know the costs of unstable flows in terms of lost operational efficiency and impact on service delivery.

So, in short, ceilings are not essential for medium-term budgeting. But they can be a useful addition. To be effective, macroeconomic forecasts do not need to be highly accurate. And medium-term budgeting is more than just macrofiscal stability.

[Marc Robinson]

Response:

What my piece is about is medium-term funding commitments by the government to spending ministries. I stand by my position that it is inappropriate in most countries for the government to make such commitments. Bill seems to agree to the extent that he is unwilling to defend what he calls “hard” ceilings. He does, however, mount an eloquent defence of “indicative” ceilings.

The notion of indicative ceilings seems pretty vague and problematic to me. It seems to imply a commitment which is, well ...not really a commitment. So let me ask: does an “indicative” ceiling imply some level of commitment, or does it not? If not, how do you stop the spending ministries interpreting the ceiling as a commitment—particularly if you want them to plan on the basis of it? And if you are making some type of commitment, how much commitment? (Surely you’d want to give spending ministries an idea of what types of circumstances—e.g. macroeconomic shocks—might force you to walk away from that commitment. Leaving it vague would serve no purpose at all.)

It seems to me that in most countries, we’d be better off if we stopped talking about ceilings—with the implication of commitment—and talked instead about estimates. Medium-term expenditure estimates tells the government what each spending ministry will need to receive if existing spending policies are continued. They enable the government to adjust spending policies to ensure that they are compatible with fiscal policy, and to change spending policies if they are not.

Good medium-term estimates can reduce the uncertainty which spending ministries face about their future budgets, while not committing the government or preventing it from making expenditure policy improvements in each budget. They do this because, by facilitating the reconciliation of fiscal policy and spending policy in the medium-term, they tell spending ministries that their existing spending policy are affordable. Expressed differently, they reduce the risk of programs suddenly needing to be cut because the government will otherwise breach its fiscal targets.

Oh, and finally, I did not suggest that improved fiscal policy performance was the only objective of medium-term budgeting. What I said was that it was the most fundamental one—and that giving spending ministries budget certainty was not.

[Bill Dorotinsky]

The piece comes across as a more general opposition to ceilings. Few countries have moved towards any type of guarantee via ceilings. Globally, I've not heard actually forward commitments through estimates or ceilings as on the agenda, so the opposition, while reasonable, is not a current issue. The increased ‘certainty’ for sectors from MTEFs in fact comes from (1) better macroeconomic estimates and policy and (2) from these top down estimates, multi-year estimates/ceilings for ministries. The ministry or sector estimates/ceilings are no more a guarantee than the over-all consolidated budget estimate.

Now, on ceilings. You seem to agree forward estimates are good, ceilings bad. Semantics, really. But in your response, you suggest estimates are bottom-up needs of ministries. As I suggested, these are likely to far exceed available resources. Hence, not useful. Ceilings are top-down, whether just indicative or estimates by MoF allocating available spending envelopes, or harder, cabinet approved ceilings. They are ceilings -- maximums. Not floors (guarantees).

Forward estimates, based on good sound macroeconomic, expenditure, and revenue forecasts, allocated to sectors/ministries, are useful devices. Of course, ministries will generally assume these are guarantees, even if not formally stated as such. That is true for ‘estimates’ as well as ‘ceilings.’ Having hard ceilings (cabinet approved), does not make them guarantees either. It simply firms up the limits, making it more difficult for individual ministries to breach the budget targets without another high-level discussion.

A challenge, true for any scenario or semantics, is when high-levels of estimated spending come down rapidly (falling commodity prices) or spending rises rapidly and consumes more (e.g. food subsidies). These rapidly adjust the sectoral allocations, and raise debates over relative shares. But this is appropriate, and the type of discussion necessary when facing retrenchment or rapidly changing economic and fiscal conditions.

For some programs, countries such as the US have of course gone beyond estimates to create mandatory spending or entitlement spending (e.g. Medicaid health insurance for the poor). Annual estimates are just estimates, as the budget does not control the actual spending. These types of guarantees are hazardous to fiscal discipline, especially for poor countries. They require very good program administration and internal control frameworks, extensive regulation, and other features to keep them running well. Good oversight and analysis as well.

In essence, we are in heated agreement. Multi-year forward estimates/ceilings are useful -- call them what you will.

[KLRao]

Given that the MTEF has three critical objectives as said by Bill Dorotinsky: 1. Macrofiscal stability
2. Strategic allocation
3. Operational effeciency;
in more than 29 countries where MTEF has been tried it can be observed that the motivation was to bring in macrofiscal stability, without which the next two objectives cannot be attained and would not have any 'sanctity'. Given that the year to year allocations conveyed through ceilings are not adhered to due to lack of macrofiscal stability, the line department’s donot have incentive in preparing their yearly budget estimates scientifically given the uncertainty of the final budget allocations.
Given this scenario and the early stage experience at Sub-national level in India, the following five points are worth considering in deciding about the efficacy of ceilings:

1. Initial conditions at the time of introduction of MTEF should determine the goals that MTEF seeks to attain.
2. Most of the countries where MTEF has been taken up (90% of the cases during 1997-2001), the objective was macrofiscal stability hence the ceilings are critical in that sense in these cases.
3. In emerging economies, given the macrofiscal stability is not as severe as those in African countries where MTEF was introduced; the next two objectives are significant.
4. In the emerging economies (or at the Sub-national level in India) the focus should be on allocative and technical effeciency. As has been seen in India, for a long time after Liberalization in 1991, the agriculture sector has been neglected and which has seen a decline in investment from the state, which has adversely affected the sector and lead to agriculture distress and farmers suicide. With the intervention of the current Prime Minister a massive infusion of funds is taking place in the sector, which is a result of change in strategic allocation. Now the line department does not have the capacity to absorb the funds. This brings us to the last point.
5. After setting the sector strategies in place, the focus should be on technical efficiency. Here again there are lot of issues with regard to need for change in mind set so as to bring into focus service delivery aspects and realignment towards outputs.

Hence the initial conditions play a significant role in deciding about the efficacy of expenditure ceilings.
I agree with Marc Robisons views to a large extent as a practioner.

[Albert van Zyl]

We have been trying to kick start debate at the Open Budget Blog for some time, so I was delighted to see a little 'rumble' on your blog. Fantastic, even though it is a 'domestic quarrel', as it were.

It is a pity that the debate boils down to semantics, as Bill rightly points out. Ceilings are never as firm or as fluid as they seem.

Let me try and push the debate a little further: In my experience most poor countries do not have 'expenditure review and prioritization mechanisms', as Marc rightly points out. In the absence of such capacity, these countries can't use MTEFs to ensure alignment between budgets and policy goals.

What MTEFs do come down to in the South, is expenditure control by another name. Even in South Africa with its much lauded Treasury and Minister of Finance, MTEF ceilings have largely been used as barriers to extravagant budget demands my departments.

This is in line with a broader trend that most treasuries in the South are not interested in policy at all (OK, I'm generalizing). Where they have any muscle at all, they use it to police deficit targets for the donor community.

No wonder citizens and citizen organizations are intensely skeptical of MTEFs. They can see that MTEFs are almost always about blind expenditure cuts, rather than about spending money on the right things.