A Review of Capital Budgeting Practices

Posted by Davina Jacobs

In general, government capital budgets have multiple roles: as instruments of fiscal policy, to improve the net worth of government, and—particularly in the area of economic infrastructure—as vehicles for economic development. This is usually achieved through greater reliance on debt or external aid than on such conventional sources of financing as taxation. Governments have introduced capital budgets to serve all these objectives, singly or collectively, depending on the context. In some cases, more attention has been paid to capital budgets as a way to reduce deficits caused by an excess of recurrent expenditures versus revenues.

Notwithstanding the seeming virtues of capital budgets, opinions continue to be divided, as they have been during the past seven decades, about their utility in governments. In the present context, in which some more advanced countries have budgetary surpluses and use them to reduce levels of public debt, there is little incentive to revive the debate about the need for capital budgets. In the developing world, however, where many governments operate on the edge of financial instability, the debate about capital budgets and their equivalents continues.

Previous blog postings by Bill Dorotinsky on March, 3, 2008 focused on the capital budgeting process itself, while another post on February 20, 2008 discussed capital budgeting in the context of the over-all PFM system, and addressed defining capital and measuring some aspects of efficiency and effectiveness. This post summarizes the recent IMF Working Paper by Davina Jacobs on “A Review of Capital Budgeting Practices”

Download a_review_of_capital_budgeting_practices1.pdf

The text of the working paper is also available by clicking on this link.

A key challenge in government budgeting is to define an appropriate balance between current and capital expenditures. Budgeting for government investment also remains not well-integrated into the formal budget preparation process in many countries. Experience shows that in the absence of properly organized capital budgets, governments resort to borrowing without due consideration of the sustainability aspects, assets are inadequately maintained, and major projects suffer from overall poor management and performance.

It is arguable whether these poor results could have been prevented by the establishment of capital budgets. Moreover, for countries that continue to depend on debt finance as a major instrument of budgetary resources, the issue arises whether capital budgets promote an improved process of decision making and an overall management culture that permits continuing attention to the government’s net worth. For both these reasons, it is important to revisit the debate about capital budgets. More specifically, it is important to consider whether capital budgets provide an improved framework for allocating, using, and accounting for resources.

The paper provides an overview of the evolution of past and current budgeting practices for capital budgets. An interesting feature of the paper is the comparison between the capital budget practices between low-income countries (LICs) and more advanced countries, and the paper makes a series of useful recommendations to ensure more efficient integration of public investment planning and budget management in LICs.

LIC Reform Strategy Development for Integration of Investment Planning and Budget Management

Several recent studies such as Lienert (2003) and Sarraf (2005) have had some discussion on low-income countries’ progress in integrating their recurrent and development budgets, which to date has been very limited. One factor that helps maintain the status quo is antiquated economic development theory, emphasizing capital spending for faster economic growth.

Another is institutional incentives. Donor practices have also tended to reinforce dual budgeting practices. Donors have traditionally focused on capital investments, and a desire to attract donor funding gives a country a strong incentive to maintain a separate development budget process, even though donors’ use of budget support over project aid and multi-donor involvement in financing recurrent expenditures may increasingly change that incentive. The failure to ensure resources for ongoing maintenance of capital investments gives some agencies an incentive to seek earmarked or extrabudgetary revenues (e.g., road funds). On the other hand, some ministries pursue activities through the development budget that would otherwise be treated as recurrent spending, due to the budgetary incentives that are at work.

Finally, the simple dynamics of separate ministries for finance and for development or planning, with their own domestic constituencies, and governments’ general reluctance to reduce the number of ministerial portfolios, also work against the integration of recurrent and development budgets.

It seems that some practical recommendations for achieving budget integration in low-income countries would be useful. In summary, the following benchmarks for budgeting for public investment are suggested by Jacobs, however it should be noted that these recommendations represent what LICs might be able to attain over a period of years—in most cases LICs would only be able to focus their reforms on a few key areas.

Key Benchmarks for Capital Budget Planning, Prioritization and Implementation

Determining the resource envelope:

Capital expenditure decisions should be based on a consolidated budget approach, incorporating all revenues and expenditures, in particular foreign-financed projects and extrabudgetary funds with investment activities.
Capital expenditure decisions should be based on a medium-term budget perspective.
Decisions regarding capital expenditures should be taken in the context of a hard budget constraint. There should be explicit ceilings for guarantees and commitments beyond the budget year.
Governments should have clear policies regarding which capital expenditures should be financed by the budget, which may be realized through public-private partnerships and which should be handled by public or private enterprises. These policies should reflect the cost structure of the activities and the possibilities for user-financing, as well as political priorities.

Efficient prioritization and selection:

The budget calendar and the procedures for integration of capital expenditures in the budget must be clear, transparent and stable. Development and analysis of capital investment proposals should largely be completed before the budget preparation process starts.
All projects should be subject to cost-benefit analysis. If the subjection of all projects to cost-benefit analysis is too costly, the focus could firstly be on the larger projects, with using a simplified methodology for smaller projects.
A public investment agency, with strong links to the Ministry of Finance, should prepare guidelines for project development and analysis. This agency should review project proposals to ensure that they are adequately prepared and analyzed, and have the authority to reject projects that do not meet the established technical standards. (Most Latin-American countries have a “National System for Public Investment (SNIP)” whose key feature is an “investment project bank or database,” where the information on investment projects that were evaluated and considered economically viable is recorded).
The Ministry of Finance should give the cabinet recommendations for which investment projects should be realized within the available resource envelope. Ministries should compete for investment funds based on the net social value and political priority of their investment proposals.
The decision to implement an investment project should be independent of the financing and procurement modalities for the project. PPPs can improve risk allocation, but the benefits must be substantial to compensate for increased financing and transaction costs. Decisions regarding PPPs should be an integral part of the budget process, and PPP arrangements should be fully disclosed in budget documents.

Efficient implementation:

Rules for budget adjustments should give incentives for realistic initial capital cost estimates. Cost overruns during project implementation should be partly covered by reallocation within ministry’s existing budgets. In the case of real cost reductions, ministries should be allowed to retain part of these.
Capital investment project proposals should only be considered when they include a detailed disclosure of the expected operating costs, indicating how these will be accommodated within existing resource envelopes or making an explicit proposal for additional financing of the operating costs.
Capital investment project proposals should only be considered after the ministry has explained how it will fully cover the maintenance of its existing capital stock.
Governments should avoid excessive targeting of capital expenditures for budget cuts. Decisions on budget cuts should be based on the medium-term budget and take full account of future expenditure pressures as a result of under-funding.
There should be project completion reports for all capital expenditure projects. These should form the basis for cross-sectoral analysis and methodology development, and for continuous improvements in the investment process.

In summary, an effective capital budgeting process should form an integral component of a sound over-all budgeting system (see Dorotinsky’s blog entries for February 20, 2008, and March 3, 2008, cited above). A well-designed public financial management system supports each aspect of the system, including capital spending. Good multi-year planning furthermore supports overall fiscal balance, with more stable spending patterns for ministries and programs, and for their capital planning and execution. Good budget execution and procurement will enable timely, within-budget completion of projects (assuming good program and project management). Financial management information systems will support the financial and program management needs of the executive, ministries of finance and economy, spending ministries and program managers. In addressing these aspects, LICs should continuously aim to improve not only their capital budgeting processes, but also their public financial management systems overall.