Politics Matter…But PFM Reforms Do Too.

Managing the budget is more than a technocratic process

By now, it is common knowledge that development and policy objectives are more likely to be achieved if budgets are realistic and funds are allocated on a timely basis to agencies and projects. Projects can only be reasonably implemented if budgets are stable and managers can forecast the flow of funds to be available over the year. Efficiency and effectiveness can only be achieved if the budgetary systems help to allocate the money to the most valuable projects and reward results. Deep and informed debates during approval, and thoughtful and detailed evaluations after project completion help to accomplish this too. Budget institutions that assign responsibilities to those who have the incentive to keep finances under control have been shown to reduce the likelihood of inflated budgets and runaway deficits. Hence, they reduce the probability and depth of crises that could derail countries from achieving their development objectives.

Still, despite the hundreds of books, research papers and technical assistance notes published on best practices, an achievement gap persists. For example, over and under estimation of revenues and expenditures is still very common. In a sample of 16 Latin American countries between 2006 and 2010, some countries under-executed the budget by almost 40 percent, while others spent 15 percent more than originally planned. [1]

As those figures suggest, the execution phase of the budget process does not mechanically follow the allocations approved in the budget (as is assumed in many academic papers). On the contrary, budgets suffer from continuous reallocations over the year, with funds flowing from some projects to others without clear and pre-identified patterns. Such reallocations can reach up to 30 percent of the budget for the sample of Latin American countries noted above. [1] Budget rigidities have also increased. For example, the proportion of earmarked revenues in Brazil has increased from 30 percent to 90 percent of the budget during the last 30 years. [2] These substantial changes have serious adverse implications for the efficiency and effectiveness of budgetary outcomes.

Those in charge of relevant stages in the budget process, moreover, do not always play their assigned role and their actions are not always correlated to their formal prerogatives. In many countries, the legislature rubberstamps the budget proposal sent by the executive without major debate about the country’s priorities or about how relevant the budget is for solving current problems. Usually, these same legislatures play little role in the execution of the budget. Supreme audit institutions sometimes look the other way too, leaving an important evaluation and control function unfulfilled. [2]  

Part of these flaws of the budget process can be explained by a lack of basic managerial capacities. However, that is not the whole story: countries with relatively high capacities have problems too. Examples include repeated failures by the U.S. Congress to approve the budget on time; lack of a proactive approach by the Congress in Argentina in scrutinizing the budget proposed by the executive; large discrepancies between the approved budget and the outturn in Brazil; [1] and lack of stringency in the budget institutions of Colombia. [3][4]

Interestingly, there is a positive correlation between changes in political institutions and the workings of the budget process. The current dynamic in the US was preceded by changes in the balance of political forces in Congress, and by modifications to campaign finance laws that have affected political party discipline and induced ideological polarization. Colombia’s constitutional reform is another example of changes in political institutions that had a direct effect on the workings of the budget process. The reform brought increasing political participation, higher fragmentation in Congress, and greater power of local authorities. In this new political context, passing budgetary reforms became more challenging. [4]

Therefore, while it’s important to invest in government capabilities for reaching better budget outcomes, it is also important to understand the incentives arising from the political process (e.g., coalition building) and the prerogatives of each actor in the budget process (e.g., discretionary powers).

Why do politics matter?

Nearly all government laws affect present or future expenditures, and thus have implications for budget negotiations. In turn, budget negotiations enable politicians to cement support and compensate losers. In fact, it has been long accepted that some reforms can be achieved only during budget negotiations. For example, in Uruguay policy reforms have been traditionally tied to the budget discussions. After the budget window has closed there is little hope that any controversial policy measures can be passed. [2]

Budget decisions are not made by social planners. Instead, they are the result of a collective process involving a variety of political actors, each with their own motivations and incentives. For example, legislatorsmay have the incentive to bring benefits to their district, line ministersto foster public projects in their area of domain, and the presidentto increase expenditures before an election to boost his popularity.  As such, budget outcomes depend directly on the institutions and political structure of the country. Electoral laws, party discipline, campaign finance laws, etc., are all intrinsic determinants of the negotiations that take place through the budget process.

Beyond the letter of the law

From the discussion above, it is easy to see that political institutions, such as whether or not the president can seek reelection, or whether legislators are elected in large districts under proportional representation or in small districts under majority rule, may affect the incentives of budget participants and thus have a large impact on budget outcomes. For example, the concentration of budget power in the hands of the president may exacerbate electoral budget cycles. Yet a decentralized budget process in which legislators have considerable power may lead to excessive spending if programs with local benefits are financed from a common pool of resources. Similarly, budget institutions that lay out the rules of interaction of the different participants in the budget process, or place constraints on budget outcomes, can also influence these outcomes. Not surprisingly, there is ample literature that examines the impact of political and budgetary institutions on fiscal outcomes. This literature tends to find that political and budget institutions do matter for explaining fiscal outcomes. [3]

However, while reform of these institutions may help, it does not mean that they always work. When they do succeed is because a political equilibrium exists in which institutions are respected and investments in the institutions of enforcement are made. The success of the Fiscal Responsibility Law in Brazil is a good example.

This law changed some aspects of the policymaking process by bringing additional players into the budget process that supported the law, such as the Tribunais de Contas, which had not had a strong budgetary role before. Most importantly, the actors themselves in the process had an incentive to see the law succeed. For the states, the law gave the executive enforcement mechanisms to address the common pool resource problem. The governors of the states were better off if they cooperated under this arrangement than if they defected. The executive in Brazil wanted to see the reform succeed because it meant the end of routine executive bailouts of the provinces. A similar law did not work in Argentina. [5] A change in the rules is not a sufficient condition for modifying the results when they come into conflict with the rules of political interaction of the agents involved.

The way forward…

Politics matter! But it doesn’t mean that PFM reforms are a lost cause; quite on the contrary. Even though it raises the bar regarding the type of analysis that has to be performed before a reform can be considered relevant and implementable, it also brings plenty of opportunities for designing reforms that help the budget process and can bring at the same time some much needed help to the workings of the political system.

Certain budget institutions may reduce discretion at the hands of the executive. As such, they may help to increase the credibility of the promises made by the government. In some countries, budget discretion is abused so much that the budget cannot be used to cement agreements because any promise can be easily undone during the year. Reducing discretion in this context could help the executive to conduct political bargaining. [5] Of course, there is a fine line that should not be crossed. In Brazil, discretionary powers have allowed the executive to cement coalitions at a relatively low cost, particularly during Cardoso’s presidency. [2][5] If such discretionary power is reduced, other “tokens of exchange” for building coalitions should be provided, or the electoral system, which favors high fragmentation, should be reformed. Otherwise, the executive may find it impossible to pass any laws or the cost of doing so would be tremendously high.

Consequently, PFM reforms should take into account the political equilibrium in which they are going to be embedded. Such reforms affect the budget process but they also affect the political process. As such, it is important to understand which ones are incentive incompatible and could generate virtuous cycles. For example, some reforms that increase transparency may also help the government to enforce and maintain its political agreements with third parties.

“Politics matter” does not mean that any PFM reform is doomed unless it focuses on reforming political institutions. It means that PFM reforms can bring benefits even beyond their narrow confines. It also means that development partners such as the World Bank, the IDB and the IMF need to make assessments of political institutions as well as technical issues when offering advice to LDCs on reforms favored by the governments concerned. In turn, these organizations need to supplement the abundant professional skills they have built up in economics and accountancy with other skills – notably political science and change management - relevant to the topics discussed in this note.

References

[1] Filc, G. and C. Scartascini. 2012. "Budgeting for results in Latin America: Conditions for its deployment and development”. Policy Brief No. 160. Washington, DC, United States: Inter-American Development Bank.

[2] Hallerberg, M., C. Scartascini, and E. Stein. 2009. Who Decides the Budget? A Political Economy Analysis of the Budget Process in Latin America. Washington, DC: IDB and DRCLAS, Harvard University.

[3] Filc, G. and C. Scartascini. 2007. "Budget Institutions", in The State of State Reform in Latin America, Eduardo Lora (ed.) Stanford, CA: Stanford University Press.

[4] Lora, E., and C. Scartascini (eds). 2009. Consecuencias Imprevistas de la Constitución de 1991: La Influencia de la Política en las Políticas Económicas. Bogotá, Colombia: Alfaomega.

[5] Filc, G., C. Scartascini, and E. Stein. 2005. "Decentralization, Budget Processes, and Feedback Effects", in The Politics of Policies. Harvard University Press.

[6] Hallerberg, M. and C. Scartascini. 2011. “Economic Crisis and Fiscal Reforms in Latin America.” Working Paper No. 235. Washington, DC, United States: Inter-American Development Bank. 

*Carlos Scartascini is a Principal Economist at the Research Department of the Inter-American Development Bank (IDB). This note summarizes work with several colleagues over the years. In particular, it draws extensively on Hallerberg, Scartascini, and Stein (2009). The opinions expressed in the note are those of the author and do not necessarily reflect the views of the IDB, its Board of Directors, or the countries they represent. For more information on the author and his publications, see www.cscartascini.org. 

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.