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

Bill Dorotinsky

March 10, 2008

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:

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.

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.