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February 20, 2008

Capital Budgeting and Public Financial Management -- Part I

Primer on Systems and Issues: Context and Definitions

Posted by Bill Dorotinsky

Public investment is an important potential contributor to economic growth and achievement of social development objectives. In addition to the level of investment and the sectoral allocation, the capital budgeting process is an important determinant of the quality of investment projects and their implementation.

Recent years have seen renewed attention to capital investment for economic growth and development. In particular, much attention has been given to finding fiscal space for increasing capital investment. But, absent good processes for using existing or new funds, the impact of capital investments will not yield the expected results. This post provides an overview of selected issues regarding capital budgeting and capital budgeting systems as an aid in understanding what goes wrong and what might be done about it. The post draws directly from a chapter written by the author for a World Bank Public Expenditure Review entitled Ukraine Creating Fiscal Space for Growth: A Public Finance Review (World Bank, 1996).

Public financial management (PFM) and capital budgeting

Countries commonly adopt special processes for addressing capital or investment spending given the size of the expenditures, their long-term costs and benefits, and their importance for public service delivery and economic development. The special treatment of capital goes beyond simple budgeting to capital asset management.

Despite the importance of special attention to capital assets, the capital budgeting process cannot be considered outside of the over-all public financial management system. Capital spending is only one component of spending, and needs to be considered within the context of government-wide and sector-specific multi-year strategies and objectives. The capital budgeting process must be fully integrated into the general budgeting and public financial management process.

Defining Capital

While seemingly a straightforward question, governments around the world, and even within a country, may define capital’ differently. Capital spending is generally about physical assets with a useful life of more than one year. But it also includes capital improvements or rehabilitation of physical assets that enhance or extend the useful life of the asset (as distinct from a repair or maintenance, which assures the asset is functional for its planned life).

Capital spending is sometimes equated with investment or development spending, where expenditures have benefits extending years into the future. Under this definition, governments may include physical assets for government use (e.g. office buildings), physical assets of a public good nature that also enhance private sector development (e.g. roads, water systems), and intangibles (e.g. education, research). It can be quite difficult to distinguish between investment and non-investment expenditures, and if investment spending receives favored treatment in the annual budgeting process, nearly all spending, whether recurrent or not, will end-up being classified as investment.

Every government establishes some arbitrary cut-off point to distinguish capital from current expenditures. For budgeting purposes, the relevant distinction is between capital and current or operating expenditures. Current expenditures are purchases of assets to be consumed within one year, regardless of expenditure size. Small expenditures (e.g. less than US$25,000) are generally considered current, regardless of useful life.

Some countries use the IMF 1996 Government Finance Statistics as the basis for their budget classification system, including defining capital expenditure. The 1996 GFS defines capital expenditure as: “Capital expenditure.Expenditure for acquisition of land, intangible assets, government stocks, and nonmilitary, non-financial assets, of more than a minimum value and to be used for more than one year in the process of production; also for capital grants. Capital expenditure is frequently separated (in some cases along with certain revenue) into a separate section or capital account of the budget or into an entirely separate budget for capital expenditure. That is, the capital budget. This separation may sometimes follow different criteria, however.” While allowing intangible assets and government stocks, it does not standardize “minimal value,” allowing countries to specify a value.

The important issues are to have a clear criterion, use it consistently, and that the threshold value captures the type of capital spending that government and spending ministry management want to monitor. Some countries are tempted to set too low of a threshold value, meaning reported ‘capital’ spending is misleading, capturing many small items from office supplies and office furniture to roads and schools. Some may also include capital transfers or subsidies to state-owned enterprises, again creating a misleading picture of capital formation in the country.

Capital Asset Condition and Maintenance

Rather than only examining funding, it is important to examine other aspects of capital spending performance, such as condition of facilities and adequacy of maintenance spending. These are important inputs and outputs of the capital budgeting process, and affect both decision-making and efficiency of capital spending. A central or sector ministry registry of current assets and their physical condition is a useful tool to support budget formulation, execution, and management. Many countries do not have such registries, and they can demand much human capital to maintain current data, let alone use the data for decision-making and management.

Even where no central registry of capital assets and their condition exists, countries may have information on asset depreciation and years of service. These can give some indication of potential investment needs. But, they are relatively crude measures telling more about facility age than current condition, and not a satisfactory way to estimate maintenance costs or need for various types of capital investment. The absence of better data should raise serious questions of whether more investment in a sector is justified, or would be properly maintained and serve its full useful life.

Elements of a sound capital asset management process

As noted in the introduction, good capital budgeting should be an integral component of a sound over-all budgeting system. While there are some important elements of the process specific to capital spending, a robust public finance system and budget process are as important to sound capital management as the capital budgeting elements themselves.

Sound over-all PFM process

A country’s PFM process has three main objectives:

  1. aggregate fiscal discipline -- allowing budgets to be set consistent with a realistic macroeconomic framework and a sustainable fiscal program, and brought in on target;
  2. allocative efficiency -- requiring that resource allocations reflect the policies and priorities of the government’s program; and,
  3. technical efficiency -- requiring that resources are utilized efficiently and effectively towards to the purpose for which they have been allocated. The table below sets out the features of effective PEM systems relative to these objectives.

Element

Budget Formulation Features

Budget Execution Features

Aggregate Fiscal Discipline

ü    Multiyear macrofiscal framework used to set public revenue, expenditure and debt policy within realistic economic framework, supporting anticipation of crises, measured restructuring.

ü    The total budget envelope should be:
(i)  explicit and set prior to determining ind­iv­­id­ual spending allocations;
(ii) consistent with the broad­­er macro­ec­on­omic framework; and
(iii) sustainable over the medium term.

ü    Current policies, laws, and normatives and programs reconciled in annual budget to assure affordability.

ü    New policies with expenditure or revenue implications adopted during year only if affordable in medium-term framework, sources of financing identified, and supplemental budget approved to finance within budget targets.

ü    Budget is comprehensive, accurate, annual, authoritative, and transparent.

ü    Commitment control system limits commitments to available resources, supporting avoidance of arrears during retrenchment.

ü    Treasury cash management further supports matching of expenditures to revenues.

ü    Treasury payment system and internal controls support proper payments.

ü    Accounting system and Financial Management Information System (FMIS) support comprehensive, timely and accurate information on spending and revenues for government and line ministry management.

ü    Fiscal and banking accounts regularly reconciled.

ü    Annual accounts closed in timely manner.

ü    Debt management assures sustainable debt policy, timely issuance of debt for cash flow management and reaching the spending target.

ü    Internal audit detects and corrects fraud, waste, and abuse; assures integrity of financial information.

ü    External audit assures fairness and accuracy of financial reporting, effectiveness of internal audit and control systems.

Allocative Efficiency

ü    Expenditure allocations between and within sectors are consistent with government policies and priorities.

ü    Sectoral ceilings set early in expenditure process to encourage ministry prioritization.

ü    Current policies, laws, and normatives and programs reconciled in annual budget to assure prioritization of resource use, possible program restructuring.

ü    Resources are reallocated from lesser to higher priority programs and from less to more effective programs, across and within sectors.

ü    Commitment and Treasury controls execute the budget as approved.

ü    Formal, transparent procedures used to amend budget if necessary.

ü    Frequency of FMIS reporting allows management action to correct deviations from approved budget.

 

Technical efficiency

ü    Budget planning (within resource ceilings and supported via execution of budget as approved) support productivity improvements and management/program development.

ü    Budget process supports analysis and review of performance, structure, staffing and organization, policy, normatives.

ü    Program classification structure within ministries supports focus on objectives, results.

ü   Basic program performance information allows linking of resources with results, pressure for increased efficiency.

ü   Program evaluation supports occasional review of program impact, effectiveness.

ü   Budget execution (commitment and cash controls) limits critical expenditures, but supports flexible resource use at program level (e.g. across non-personnel economic classifications, with respect to seasonal spending patterns) for efficiency (controls are not excessively detailed to prevent management of program).

ü   FMIS supports program managers.

ü   Civil service system supports quality public staff, flexibility in reallocating staff resources, restructuring workforce.

ü   Procurement system supports competitive, efficient, timely contracting.

ü   Internal audit may identify options for improved economy and efficiency.

 

Source:  Adapted from World Bank - Albania Expenditure and Institutional Review – April 2001

Additionally, five general principles of public finance have emerged over the years to guide developments in public expenditure systems.  These are important preconditions for an effective PEM system. If elements of these principles are missing, the PEM system cannot serve as an effective tool for establishing and managing policies, holding agencies accountable for results, and more generally managing the public sector.

  • Comprehensiveness: all revenue and expenditure, and all government agencies, are included in the budget; all government agencies are integrated into the public expenditure management system
  • Accuracy: actual transactions and flows are recorded
  • Annuality: the budget covers a defined period of time (e.g., one year)
  • Authoritativeness: spending is carried out only as authorized by law
  • Transparency: information on spending is publicly available, on a timely basis, in an understandable or common format.

A sound over-all public financial management system supports each element of the system, including capital spending. Good multi-year planning supports over-all fiscal balance, with more stable spending patterns for ministries and programs, and for their capital planning and execution. Good budget execution and procurement enable timely, within-budget completion of projects (assuming good program and project management). Financial management information systems support the financial and program management needs of the President and Cabinet of Ministers, Ministries of Finance and Economy, spending ministries and program managers (all budget users).

A second blog post will explore the capital budgeting process directly.

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