“Fiscal Headroom”: A Flawed Approach to Expenditure Prioritization

Posted by Marc Robinson

What is the best methodology for prioritizing expenditure in a medium-term context? One view is that the focus should be on the “fiscal headroom” —also referred to in francophone countries as the “marge de maneouvre.”  I’ve seen this approach up close in two countries recently. It is an approach which is not only flawed in principle, but particularly unsuited to the post-crisis fiscal circumstances of most countries.

Some background first. The core of medium-term budgeting is the idea that multi-year estimates of the affordable ceiling for aggregate expenditure (based on projections of revenue and macroeconomic conditions, as well as a clearly-specified fiscal policy) are compared with “forward estimates” for expenditure (which project expenditure on an unchanged policy basis). Any gap between trend aggregate expenditure and affordable aggregate expenditure will thereby become evident. Expenditure policy decisions can then be made with a clear understanding of their implications for fiscal sustainability.

The “fiscal headroom” approach says that expenditure prioritization should focus mainly on how to allocate the gap between the aggregate expenditure limit and the forward expenditure estimates. It is assumed that this gap will be positive, providing an amount which can be spent on new initiatives. Prioritization is then about how to spend the money available for new initiatives.

There are two things wrong with this approach.

Brazilian Congress: Time to Change the Budget Process

Posted by Helio Tollini[1]

Brazil is a country where the Congress influences the budget process significantly, both in terms of legislation and allocation of resources. The Congress undoubtedly contributed to the huge transparency improvements in the budget process over  the last twenty years. Brazil now ranks eighth in the world in the 2008 International Budget Partnership transparency evaluation. One of the strengths of the Brazilian system is the existence of specialized budget advisors in both houses of Congress (House of Representatives and Senate), which are selected through a competitive public contest. It is widely recognized that these support officials, like the Congressional Budget Office in the USA, are influential in the annual discussions of the draft budget guidelines and the budget law.

However, two less appealing features of the legislative appropriation process always strike international observers: the approval by Congress of more than ten thousand amendments each year, and the existence of a specific “reserve” for legislative allocation of about US$ 2 billion, which finances part of the approved amendments. In fact, each congressman receives a “financial quota” for his/her individual or collective amendments. While internationally uncommon, the latter process has provided some order to the pork barrel politics which seems to be inevitable in countries with strong legislative input in the budget process.

I discuss these and other issues in a paper recently published in the OECD's Journal on Budgeting, Vol. 9 (2009): Reforming the Budget Formulation Process in the Brazilian Congress.

Does the German Welfare State need another Fitness Program?

Posted by Christian Schiller, Blogger Emeritus

Despite seen by many as  still a tad overweight, the German welfare state has actually performed well  in recent years, reflecting a major reform effort. The present crisis is hiding those results, but further “weight loss” might be beneficial, and is certainly on the political agenda.

The German Government has just published a new Social Spending Report (“Sozialbericht”). The report is a comprehensive and detailed overview of the Government’s activities with regard to its social policy objectives. It is a 300 pages plus document with a wealth of information on social policies and spending in Germany. The last Social Spending Report dates back to 2006. You can find a German version of the new report on the web site of the German Ministry of Labor and Social Affairs.

Social spending accounts for roughly 1/3 of GDP in Germany. The ratio of social spending of the government and GDP is a good indicator of the redistributional efforts of a government via the expenditure side of the budget. Many OECD countries are at the same high level as Germany or even higher, such as neighboring France and the Scandinavian countries. By contrast, the United States, as is well known, has a much lower ratio. Here, government social spending accounts for only roughly 1/5 of GDP.

Nicaragua: Progress in Public Financial Management and the Road Ahead

Posted by Israel Fainboim Yaker

 Despite capacity constraints, including a limited number of staff fully familiar with modern financial management techniques, the Ministry of Finance (MoF) of Nicaragua has continued since 2005 to roll out wide-ranging public financial management (PFM) reforms. These reforms have resulted in a gradual improvement of the country’s PFM practices. The existence of a number of “champions” for reform within the MoF, including the Minister himself. and other high level officials, mostly explains this progress. Even though important challenges remain, if political reform ownership is sustained, and training widely provided, additional significant improvements are to be expected in the next few years.

A positive sign of the authorities’ commitment to carry on with these reforms is the preparation of a medium-term plan (2008-12) for strengthening PFM (Plan of Modernization of the Financial Administration System; in Spanish Plan de Modernizacion del Sistema de Administracion Financiera-PMSAF). Even though adopting such a plan was part of the IMF’s Poverty Reduction and Growth Facility (PRGF) conditionality[1] and a consultant was involved in its drafting, the MoF took a leadership role in the Plan’s preparation with a very active participation from all the MoF Directorates. As a result, ownership of the Plan is strong. The authorities have looked for financial support from multilateral institutions for funding the implementation of the plan; they have now received positive responses from the World Bank, the IADB and other donors. An agreement with these institutions could soon be reached to fund most of the Plan’s activities.

The French Doctrine on Fiduciary Risk

Posted by Franck Bessette

In light of partners’ commitment under the Paris agenda on aid effectiveness to use country systems for aid delivery and of its strategic decision to increase the share of general and sector budget support in aid modalities, France has developped a system for evaluating and ranking fiduciary risk in aid recipient countries based on the Public Expenditure and Financial Accountability (PEFA) methodology. Other bilateral donors have taken a similar approach (see PFM blog about DFID) but the French approach is somewhat different since DFID as well as other nordic countries integrate “value-for-money” in the definition of fiduciary risk. The approach in that sense is more similar to the one developped by the European Commission.

Consolidation of Central Bank Operations into the Government's Financial Statements: Practice in Selected Countries

Posted by Ian Lienert.

During the current crisis of the financial system, central banks have not only been playing their traditional role of providing liquidity to banks, but some have been playing non-conventional roles, including: exchanging liquid assets for illiquid assets such as mortgage-backed securities, accepting unusual or no collateral, or directly purchasing and guaranteeing bank issued debt. These activities carry considerable risks. Will these risks eventually be a cost to government? 

If central banks carry out quasi-fiscal activities, would it not make sense to consolidate the balance sheets of the central bank with that of the government? Such consolidation would make it easier to ascertain which institution -- the central bank or the government -- is bearing the quasi-fiscal risks of the sovereign. There is often reluctance to consolidate, given central bank independence. However, a few countries, mainly in Latin America, but also Australia and New Zealand, buck the usual practice and consolidate central bank balances into fiscal accounts.

Keeping an Eye on the Long term

Posted by Guilhem Blondy

Many OECD counties face both short- and long-term fiscal pressures. While short- and medium-term fiscal projections are usually adequately presented in the budget, this is much less the case for long-term fiscal projections. The IMF and OECD have been advising ministries of finance and/or planning agencies to present long-term fiscal projections in the budget, or attached to it, for quite some time. As long as a decade ago the IMF Manual on Fiscal Transparency described as best practice for budget and fiscal transparency that governments publish a periodic report on long-term public finances. Yet the use of these long-term fiscal projections has remained limited to a relatively small number of industrialized countries.

Barry Anderson and James Sheppard presented a paper at the 30th OECD annual meeting of senior budget officials assessing practices in 12 countries : Australia, Canada, Denmark, South Korea, the Netherlands, New Zealand, Norway, Sweden, Switzerland the United Kingdom, and the United States (Anderson, Barry, and Sheppard, James, Fiscal futures, institutional budget reforms, and their effects : what can be learned?, 30th annual meeting of OECD senior budget officials, Paris, 4-5 June 2009).

Fiscal Implications of the Crisis for the EU: The European Commission’s Latest Analysis

Posted by Andrea Schaechter

On June 23, 2009, the European Commission published its annual report on Public Finances in EMU. Now in its tenth year the report focuses on the challenges that the financial and economic crisis has brought about for EU member states’ public finances as well as the EU’s fiscal surveillance process (notably the Stability and Growth Pact). In particular, budgetary prospects are assessed as well as policy needs identified to contain the fiscal costs of the crisis.

Taking Stock: What do PEFA Assessments Tell Us About PFM Systems Across Countries?

Posted by Paolo de Renzio

Assessments based on the Public Financial Management (PFM) Performance Measurement Framework, developed by the Public Expenditure and Financial Accountability (PEFA) initiative, provide detailed accounts of the performance of PFM systems along various dimensions. A recent working paper published by the Overseas Development Institute (http://www.odi.org.uk/resources/download/3333.pdf) brings together the results of 57 PEFA assessments completed until August 2007. It looks at comparative cross-country PFM performance, overall and across the different budget dimensions defined by the PEFA methodology (out-turns, cross-cutting features, budget cycle), and analyses differences linked to certain country characteristics which might have an influence over PFM system performance, using both bivariate and multivariate analysis. It is based on a numerical conversion of the letter-scores used in the assessments, a methodology which can be considered controversial but which nevertheless yields some interesting results.

Public Financial Management (PFM): A ‘Discipline’ in Search of a Home

Posted by Tej Prakash.

Of which academic discipline is PFM a part of?  Is it economics, public administration/policy, accounting, management, or law? Or, none or all of the above.

PFM, as the name indicates, should deal with the management of both revenues and expenditures. But it does not. It deals only with public expenditures. Thus to begin with, the name itself is a bit of a misnomer.

Managing Crisis-related Fiscal Risks Borne by Central Banks: the Case of the United States

Posted by Ian Lienert.

The consolidated balance sheet of the United States Federal Reserve Banks (“the Fed”) more than doubled during 2008. The Fed’s response to the financial market crisis has transformed it from a key, though small, money market participant into the largest actor and fundamental linchpin of that market and, indirectly, of the world financial system.

What are the fiscal risks and costs of this balance sheet expansion? Could the Fed possibly make a loss? By bailing out financial institutions, including those with “toxic” assets, has the Fed taken on risks that eventually will need to be paid for from budgetary resources? Has the Fed’s role become confused with that of the U.S. Treasury, or vice versa? What exit strategy needs to be developed? A new IMF working paper examines relevant issues.

A Computerized Pacific

Posted by Suhas Joshi.

Three countries, the Cook Islands, Tuvalu, and Vanuatu, requested IMF Pacific technical assistance center (PFTAC) to assess, analyze and audit their existing financial management information systems (FMISs). In all three countries, the host nation governments were operating relatively sophisticated off-the-shelf financial software products which had been in successful operation for over 5 years. The purpose of the mission, conducted by PFM regional advisor Suhas Joshi and a consultant, John Moore, was to determine what enhancements or changes might be needed in order to develop and implement an Integrated Financial Management Information System in each of these countries.

Carlo Cottarelli, Director of the IMF's Fiscal Affairs Department (FAD) on NPR's Program "Will Overstimulating Economy Bring Inflation?"

Posted by Michel Lazare.

On June 26, 2009, Carlo Cottarelli, Director of the IMF's Fiscal Affairs Department (FAD) was interviewed by David Kestenbaum on National Public Radio's (NPR) program "Morning Edition." The general theme of this NPR segment was on the impact of fiscal stimulus and government spending on inflation and hyperinflation. Carlo Cottarelli made the point that while fiscal stimulus may be necessary at this juncture, central banks and governments should have an exit strategy and "start thinking now about how to exit when the moment comes."

Here is an excerpt from the NPR webpage summarizing this story, which also contains a shortcut to the audio:

"So are we at risk of catching a nasty case of inflation down the road? I took our U.S. economy in for a kind of doctor's office visit to a place that gives this advice out to countries all the time — the International Monetary Fund.

"What we have been telling ... not this country, but all our members, is that there is a need in the short run for macroeconomic policies to support economic activity. But there is a need for every central bank, for every government to have a strategy, to start thinking now about how to exit when the moment comes," says Carlo Cottarelli, the IMF's director of fiscal affairs.

There could be difficulties, he says.

Raising interest rates and pulling money back out of the economy is often unpopular. It's been said the role of a central bank is to "pull away the punch bowl, just as the party gets going." That time is arguably still in the future. As we all know, it's still a pretty lousy party."

 

Successful Fiscal Retrenchment - A View from the Top

Posted by Bill Dorotinsky

In the early 1990's, Sweden faced serious budget and economic woes, with deficits reaching 10 percent of GDP in 1993. After a substantial retrenchment program, Sweden had balanced its budget within about four years. A recent McKinsey Quarterly article (2009 Number 3), entitled "Reforming the Public Sector in a Crisis," by Alastair Levy and Nick Lovegrove interviews Sweden's former prime minister (and former finance minister) Göran Persson about the lessons from the retrenchment exercise. As countries look ahead towards fiscal retrenchment, the lessons from Sweden come at an opportune time.