Changing the Financial Management of the Defense Sector in Chile: Leaving Expenditure Earmarks Behind
Posted by Israel Fainboim
Currently, almost all defense expenditure in defense material and capital goods in Chile are financed with earmarked funds from a tax of 10 percent applied on the exports of copper and its by-products by Codelco, the biggest state enterprise. In the past years, with the substantial increase in international copper prices, the armed forces have received important sums from this source, which were mostly spent on modernizing their military equipment. As mentioned by the Stockholm International Peace Research Institute (SIPRI), Chile was the largest importer of conventional weapons in Latin America, the second largest importer in the Americas for the period 2004-08 and the 11th largest in the world, up from 36th place for 1999-03. Chile's defense budget almost doubled between 1997 and 2007 in real terms, to fund major arm acquisitions. The modernization process occurred at a very high pace and as a result, some SIPRI analysts have indicated that by 2010 Chile could become the only country in the region that has armed forces equipped according to NATO standards.
In PFM the use of earmarks in any sector contravenes both single point decision-making on overall expenditure and the common pool principle for managing budget resources. Separating resources from expenditure prioritization provides for sub-optimal allocation decisions that do not reflect societal priorities, and therefore decrease allocative efficiency. The military expenditures do not compete with other sectors for funds and the amounts spent each year do not necessarily reflect the government priorities and sectoral strategies. Very few governments around the world finance defense expenditures with earmarked resources, although many countries, including NATO countries, have in the past targeted a percentage of GDP for defense spending. The latter can be seen as a more loose form of earmarking.
Due to the high volatility of copper prices, the earmark used in Chile is a very volatile source of revenue for the defense sector, exacerbating the divorce between sectoral needs and its source of funds. The sector can end up spending much more (or much less) than what the government would want in an unconstrained situation. To limit the downside risks for the defense budget, the Chilean legislation established a floor for defense spending on material and personnel, which obliges the government to cover the difference between the earmarked revenues and the floor established for these expenditures when export revenues are under that floor; in addition, a floor was established for expenditures other than defense material and personnel expenditures.
During the last decade the government has managed to restrict the annual level of investment spending by the armed forces by imposing a ceiling on them in order to guarantee that their expenditures are consistent with the structural fiscal balance limit. However, the ceiling does not reduce the amounts received by the armed forces; any surpluses are accumulated in the bank accounts of the defense sector.
The earmark was created through a “reserved law”, or secret law, (Copper Reserved Law or Ley Reservada del Cobre) in 1958 and modified in 1973, during the dictatorship of Augusto Pinochet. Obviously, the law cannot be make public. Each year Codelco deposits the earmarked resources in dollars in three secret accounts at the Central Bank of Chile (one account for each of the armed forces). These accounts are maintained outside the treasury single account, fragmenting it and impeding obtaining the benefits of managing all government cash in a centralized way.
As mentioned above, each of the armed forces receives a third of the resources. This distribution is a mechanical rule that does not reflect the different needs of each of the forces (and the different equipment costs) and thus does not facilitate the development of a balanced and coordinated defense strategy. Some flexibility has been introduced by the sector in the last years regarding the distribution of resources, but not much has changed with regard to this mathematical rule..
In addition to the suboptimal allocation process, there is also almost no oversight and accountability on the use of the earmarked funds. The resources are not included in the budget and the detailed distribution of the material expenditures (i.e. the arms purchased) is maintained secret (the purchases are approved through reserved Decrees). This applies also to any temporary financial investments made with the surpluses in the armed forces bank accounts. In addition, the procurement process for military equipment is a closed process. As stated by SIPRI, “Chile’s arms procurement process is almost entirely under the armed forces’ control and takes place with little or no civilian political involvement” .
The State Controller’s office does review the defense sector’s financial accounts, but these are not published and the Controller does not provide an opinion on them. Congress does not have the authority to oversee the military investments, and all other defense expenditures have been discussed by the legislature mostly in closed sessions in the last years.
The secrecy on defense spending is not in line with practices in most developed countries, where the budget process and financial accounting of the defense ministry are largely in line with other government ministries. In most NATO countries, what is kept secret is the development of new arms and intelligence operations (but not the aggregate budget for these items). But even in these cases, the defense sector must often report to specialized committees of the legislature about the detailed budget and activities in these areas.
A bill to Improve Public Financial Management of the Defense Sector
The situation just described may change soon. In September 8, 2009 the government presented to Congress a bill that modifies most of the rules regarding the earmarked resources. The bill proposes to eliminate the earmark and to include all defense expenditures in the budget (Art. 2, transitory). The earmark will last for three more years, the period considered necessary to generate fiscal space in the budget to finance the military expenditures. During this period, the earmarked revenues will flow through the government’s treasury system.
All the sector's expenditures will be financed by the budget and approved annually by Congress. Budget preparation will take into account a medium-term perspective. To guarantee the medium-term needs for financing defense investments, the bill establishes planning cycles of 12 years for the sector’s material expenditures, divided in four-year periods that coincide with the government mandate; at the beginning of each period the 12-year plans will be updated and approved by the President through a Decree endorsed by the ministries of Defense and Finance. With this proposal the government recognizes that the defense sector needs will be properly addressed only within a medium-term framework, prepared on a 4-year rolling basis. Each year each armed force will prepare its budget taking into account a non-rolling 4-year horizon; the draft budget will be accompanied by a projection of expenditures for the remaining years.
The bill proposes some changes regarding transparency of investment expenditures. According to the bill, the “Identification Decrees” by which each investment is approved will remain “reserved” and will be issued by the Ministry of Finance and endorsed by the Minister of Defense (previously, they were approved without participation of the Ministry of Finance). The Decree could include payment projections for an horizon that exceeds the 4-year budget projections. Auditing by the Comptroller’s office will be performed in a reserved way (as is currently done) and the audit reports will be reserved, but they will have to be submitted to the Executive and the Presidents of the Defense Committees of each chamber.
Finally, the bill also proposes to create a Contingency Fund with the existing balances at the central bank, in order to finance defense expenditures during emergencies. The Fund will be managed by the treasury. The Fund resources will be used to cover military equipment that need to be replaced as a result of contingencies such as wars or international crises that gravely affect the external security of the nation, and natural disasters. The Fund will have to be replenished if its resources are spent to cover for these contingencies.
The bill proposed by the government is a very important step to improve the financial management of the Chilean budget and the defense sector resources. The government bill could improve allocative efficiency, as the sector will compete for resources with other sectors and the resources allocated could reflect better the government priorities. It could also improve the predictability of resources for this sector in the medium-term (but not for other sectors).
The bill also increases transparency and accountability to some degree. It will strengthen the role of the external audit office and guarantee the provision of detailed information on the purchase of military equipment to the Ministry of Finance and information on the aggregate investments and on the external audits to Congress. This adds to measures taken in the past to reduce reserved expenditures.
 Bromley, Mark, Paul Holtom, Sam Perlo-Freeman and Peter D. Wezeman, 2009, “Recent Trends in the Arms Trade”, SIPRI Background paper, April, page 6; and Mark Bromley, 2009, “Arms Transfers to the Americas”, SIPRI Background Paper, June 2009, page 3. Both papers were consulted in November 20.
 See Stalenheim, Petter, Damien Fruchart, Wuyi Omitoogun and Catalina Perdomo, “Military expenditure”, Chapter 8 of SIPRI Yearbook 2006, page 315.
 According to the information collected by the IMF, only four countries finance some defense expenditures through earmarked resources, usually from a tax on/or royalties from a natural resource: Chile (copper), Peru (gas), Ecuador (oil) and Brazil (oil).
 The floor established by the Copper Reserved Law was USD 180 millions, a figure that according to the law should be adjusted annually by changes in the USA Wholesale Price Index. Currently the floor amounts to around USD 300 millions. In addition, the floor for all sector expenditures different from investment and personnel expenditures currently amounts also to approximately USD 300 million. These two floors obviously imply that the sector must receive currently at least USD 600 million from the government for expenditures other than personnel expenditures. The revenues received by the sector in the last years from the earmark substantially exceed these figures.
 Reserved Law No. 13.196 of 1958, modified by the Reserved Law No. 18.445 of 1973.
 By request of the Superior Council of National Defense (Consejo Superior de la Defensa Nacional -CONSUDENA), an amount can be taken from the earmark and deposited in a fourth account opened for this Council, which can be allocated by it to any of the forces (and common projects). Even though this decision has modified the distribution of resources in some years, it has not changed it on average in the medium term.
 According to the Fiscal ROSCs and other public information, apparently there are very few countries where the defense sector budget is not included in the annual government budget, or it is included only partially: Chile, Armenia, Brazil, Colombia, Egypt, Spain, Estonia, France, Malawi, Mongolia and Zambia. Of these countries, only in Chile and Zambia the sector budget is presented incomplete. In some developed countries the most important investments are described in detail in the government budget presented to the legislature, while en very few developing countries they are described in detail. In some developed countries usually a small percentage of the defense budget is presented in an aggregate form, corresponding generally to the intelligence expenditures or expenditures on research for the development of new arms.
 Recently a modification to the Copper Reserved Law obligated CONSUDENA to submit to DIPRES an annual report on revenues and expenditures of each reserved account. However, CONSUDENA only reports aggregate figures to DIPRES.
 According to Roberts (2007), “complete openness would compromise efforts to collect intelligence about looming threats and to plan for national defense or investigate criminal behaviour” (page 314).
 A caveat to be mentioned here is that there is an important difference between the horizon for defense investments by developed nations, who in many cases order the production of new weapons to the main international producers and therefore the procurement and production cycle is usually long, and the horizon for developing nations, who usually order ready made weapons or buy second hand equipment and the procurement cycle is therefore much shorter.
 Long-term planning in the defense sector is quite common in most developed countries and in some emerging market and developing countries. Germany, the United Kingdom and Brazil prepare 10-year plans; Slovenia’s plans are for 8 years; and the USA prepares 6-year plans.
 The Chilean budgetary process has available a mechanism to commit resources for investments in the medium term, denominated “Decree of Identification of the Project”. Even though it does not mean the approval of multiyear budgets for these projects, with them the government commits himself to appropriate resources in the future for the projects. The number of years that are covered by these Decrees has no limit (it obviously depends on the estimated length of execution of the investment project). These Decrees, which are approved for each investment, establish the annual expenditures for each project. The Decrees have to be signed by the Minister of Finance and the respective line Minister.
Bromley, Mark, 2009, “Arms Transfers to the Americas”, SIPRI Background Paper, June 2009, page 3.
Bromley, Mark, Paul Holtom, Sam Perlo-Freeman and Peter D. Wezeman, 2009, “Recent Trends in the Arms Trade”, SIPRI Background paper, April, page 6.
Roberts, Alisdair, 2007, “Transparency in the Security Sector”, Chapter 10 of Florini, Ann, The Right to Know. Transparency for an Open World, Columbia University Press, New York, pages 309-336.
Stalenheim, Petter, Damien Fruchart, Wuyi Omitoogun and Catalina Perdomo, “Military expenditure”, Chapter 8 of SIPRI Yearbook 2006, page 315.