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April 05, 2010

New Index Measures Strength of Budget Institutions

Posted by Era Dabla-Norris, Tej Prakash, and Richard Allen[1] 

A recently published IMF Working Paper constructs a new index that measures the quality of budget institutions in low-income countries. The quality of budget institutions—defined as the structures, formal and informal rules and procedures that govern budget planning, approval and implementation— is assessed against a list of wide-ranging criteria that measure key characteristics of the budget process in low-income countries.

A sizeable literature has attempted to measure the quality of budget institutions in advanced and middle-income countries by defining quantitative indices and examining their effect on fiscal performance. The present study is the first, however, to focus attention primarily on low-income countries. It develops a composite index of the quality of budget institutions for 72 low- and middle-income countries drawing upon empirical studies, budget survey databases and assessment reports such as the Public Expenditure and Financial Accountability (PEFA) framework, supplemented by data from the IMF, the World Bank, and donors engaged in capacity building in low-income countries.

The paper demonstrates that sound budget institutions are vital if low-income countries are to implement effective fiscal policies. In particular, the global financial crisis has reinforced the key role of budget institutions in enhancing the effectiveness of fiscal policy as a stabilization tool. However, for low-income countries, the importance of sound budget institutions transcends the current crisis. Such institutions help ensure government accountability and prevent leakage of public funds; increase efficiency of scarce public resources; and improve the prospects of maintaining fiscal stability and meeting social development needs.

The budget institutions index

The index breaks new ground by recognizing the multi-faceted nature of budget institutions and is broader in scope than other available indicators. It records the quality of budget institutions along a two-dimensional framework (see Figure 1 below). The first dimension covers the various stages in the budget process (planning and negotiation, approval, and implementation). The second dimension reflects five cross-cutting characteristics of the budget process, with particular emphasis placed on the specifics of the budget process in low-income countries.

The criteria assessed include, for example, the comprehensiveness of budget coverage, as measured by inclusion of information on donor-financed projects, and the size of off-budget expenditures; the degree of centralization of budgetary decision-making; whether the budget is subject to effective rules and operational controls; the ability of the legislature to scrutinize the budget; and whether there is an effective system of internal and external audit. 

Differences across country groups

The index allows for benchmarking against the performance of middle-income countries, across regions, and according to different institutional arrangements that deliver good fiscal performance. Some important differences emerge across countries and regions:

· Across regions, transition economies followed by countries in Latin America and the Caribbean have relatively more developed institutions (see Figure 2 below).

· Despite considerable heterogeneity, low-income countries, on average, have weaker budget institutions as compared to middle-income countries.

· Budget institutions in Sub-Saharan Africa were particularly weak in areas of budget planning and implementation, reflecting fewer checks and balances in the budget process, and less public dissemination of information on the budget.

What the results show

Using the constructed indices, the paper provides some preliminary econometric evidence of the relationship between budget institutions and fiscal performance in low-income countries. The results suggest that:

· Sound budget institutions help foster more responsible fiscal policies, as measured by higher primary balances and lower debt in the period before the crisis.

· Countries with stronger fiscal institutions have better scope to use fiscal policy as a stabilization tool.  In fact, fiscal accommodation during the current crisis was higher for countries with stronger institutions.

· The most significant institutions are those related to planning and implementing the budget, and to the sustainability, comprehensiveness, and transparency of the budget process.

Conclusions—and proposals for further research

· While the index seems preferable to other publicly available measures (e.g., the PEFA framework) that present an incomplete picture of the complex dimensions of budget institutions, the methodology outlined in the paper could be usefully extended to other dimensions, to broaden country coverage, and to introduce a time dimension into the analysis.

· The indicators may also be useful in guiding countries toward areas of the budget process that require technical assistance for building stronger institutions.

· Preliminary results from the econometric analysis suggest that further strengthening transparency and comprehensiveness of the budget process in low-income countries are particularly important; and that well developed procedures for external monitoring and audit of the budget are likely to be more effective than those which rely on government self-monitoring.

Figure 1. The Budget Institutions Index

Figure 1 

Figure 2. Overall Index Score, by Region and Country Groups 

Figure 2

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[1] Era Dabla-Norris is the Deputy Unit Chief of the Strategy, Policy, and Review Department (SPR). Tej Prakash is a Senior Economist in FAD’s Public Financial Management 2 division. Richard Allen, currently a consultant for the World Bank, was the Deputy Division Chief of the FAD’s Public Financial Management 1 division when the working paper was written.

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Comments


You might be interested to know that an econometric study to investigate "the extent to which technical assistance provided by the IMF, the World Bank, and others has helped to strengthen PFM institutions" is currently being conducted by the Overseas Development Institute (ODI) funded by DFID, DANIDA and SIDA (in partnership with the African Development Bank). Terms of reference for the study are available from j.asquith@afdb.org. The study will be followed by detailed case studies in five African countries to understand more fully what factors drive or constrain the process of change in PFM institutions, and how technical assistance and other forms of aid can best be designed to support reform.

This Woking Paper on budget institutions and fiscal outcomes develops a comprehensive index of fiscal institutions for a sizable number of low and middle income countries. It represents a major research effort that enhances the empirical evidence needed to assess fiscal institutional implications and reforms.
It is widely known that one of the major weaknesses of the institutional variables commonly used in applied work is the lack of a neat link between institutional improvement and policy measures (see, for instance, T. Besley and R. Burgess, “Halving Global Poverty”, 2003). By identifying a concrete policy framework to improve budget institutions, the evidence provided in the paper contributes to opening a new dimension of institutional reforms that are both operational and highly correlated with the overall institutional settings of the nations (Governance Indicators, Table 4).
I have two main comments related to the estimations presented in the paper. First, although the reasons for excluding developed countries from the analysis are explained, this has a cost in terms of sample variation of a crucial explanatory variable and, therefore, in the precision of estimating a no less crucial parameter. This could be an important issue. For comparison, let’s take the variable “Expropriation risk” widely used in applied institutional work. In this case, if we take out of the sample the nations having a per-capita income level higher than 9 in logs, the coefficient of variation of the variable declines by 10 %.
Second, the paper addresses the potential problems of endogeneity, omitted variables and measurement errors. In addition, the empirical literature on economic growth makes us suspect that it could be an important association between the budgetary institutions index and the variable Initial GDP per capita; an association that, perhaps, could also be present with the variable Growth. This could imply large variances for the estimated parameters.

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