chapter three Functional Approach to Budgeting

A. Premchand
Published Date:
March 1989
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The budget, strange fish and monster vast To which from all sides the hook is cast.


The art of budgeting consists of several ingredients and this chapter is devoted to a discussion of the current state of the art, its problems and prospects. The chapter, therefore, covers a wide area. It considers first the scope of the budget, its boundaries and tasks, followed by a discussion of the practical determinants of expenditures and revenues, approaches to their inclusion in the budget, and the nature and role of various constraints. It concludes with a description of the nature of the impact of the budget on the economy and the techniques in use for assessing it.

Scope of Government Budget

The scope of the government budget has been a source of debate over the years. With the spread of government activities and the growth of multilevel decision making, on the one hand, and the emergence of earmarking and debudgetization aimed at reducing the uncertainty from the legislative overview, on the other, the debate has gained added importance. Determination of the scope of the budget is dependent on the scope of government and on the purposes of the budget. Both have exerted strong influences on the shape of the government budget.

Governments are classified, for purposes of national accounts, into central government and general government.1 The former essentially comprises the departments and agencies at the central level, while the latter consists of all units at the central, provincial, regional, state, local, municipal, county, and village levels. Two aspects of government organization, however, have proved somewhat difficult. How should nonprofit organizations and public enterprises be treated? The area of public enterprises is a complex one with some definitional problems and is treated in some detail in Chapter 14. For brevity of discussion, however, these are units that are either owned or controlled by government, that may be organized as a part of government budget or outside it, that may have a corporate, statutory, or company form, and that are engaged in the production or sale of goods and services to the public. Nonprofit institutions are those that engage in quasi-governmental activities and are largely funded by government. They have a separate organizational entity. Both these types of organizations generally have their own budgets and specified means of legislative accountability. Government budget transactions in this regard are normally restricted to transfers to and from government.

An enlarged definition of government, seeking to reflect all the financial decision-making centers, is provided in the term “public sector.” Although the definition is not free from ambiguity and there is a likelihood of numerous borderline cases, the public sector consists of (a) producers of government services—government departments and ministries, social security schemes, and nonprofit institutions; (b) departmental enterprises organized as a part of the government budget and engaged in the production and sale of goods and services to the public; (c) nonfinancial public enterprises engaged in the production and sale of goods and services and having budgets of their own; and (d) public financial institutions, including central banks, commercial banks, and insurance institutions. (Of these, treatment of social security systems is considered separately.) Although the scope of the definition is comprehensive, administrative problems arise in setting criteria for the inclusion of nonprofit institutions in the public sector. The framers of the United Nations' A System of National Accounts recommended that the criteria should be (a) whether the institution has a function that the government would otherwise have carried itself, and (b) whether more than half of its expenditures are financed on a continuing basis by government. It is generally recognized that difficulties arise in determining whether government would have assumed the functions of nonprofit institutions or is merely giving help to an essentially private group activity. The financial criterion also bristles with problems, in that government provision of half of the nonprofit institution's resources would make it governmental and inclusion of such institutions in the public sector may defeat the purposes for which they were set up. Another practical problem is that these bodies may be too numerous to permit economical data collection and, in most cases, their overall impact on financial decision making may be trivial. The scope of the public sector would change from time to time, if, owing to resource stringency, financing by government is reduced to less than half of the total requirements of the nonprofit institution. The concept of the public sector is therefore dynamic and changes over time.

Budget Boundaries

The issue is raised whether the government budget should be comprehensive and should include all levels of operations funded by it. Those who seek an expansion in the government budget argue in terms of the need for comprehensiveness for purposes of technical competence and for purposes of better decision making. (For this purpose the issue of earmarking is isolated and considered in Chapter 5.) It is argued, for example, that a government budget should include all important information on public sector transactions and that a unified budget would provide the decision makers and budget administrators with a comprehensive picture of public sector transactions.2 Similarly, it is suggested that the exclusion of the operations at subordinate levels of government from the central budget reduces its comprehensiveness and, more significantly, tends to reduce its capacity to implement public sector development programs.3

In considering the validity of these criticisms, a distinction needs to be made between the formal, legal, and legislative purposes of government budget and its overall policy function. It is not, however, the intention here to suggest that there are conflicts between the two functions but to suggest that they may be served in different ways. In meeting the legal purposes, the government budget will have to confine itself to its own juridical entity and cannot extend to other levels such as the state governments and public enterprises, which have their own juridical functions. Legal purposes have an overwhelming influence in the determination of the boundaries of government budget and must be given their due weight. Where extensive legal separations have been made at one level of government in the form of autonomous entities, as is the case in several Latin American countries, an appropriate alternative would be to seek remedies at a legal level through the abolition of entities that reduce the effectiveness of government budget. Caution also needs to be exercised to ensure that the budget is not full of superfluous transactions and needless complexity. For purposes of policy, however, the legal and formal considerations can be ignored and supplementary mechanisms can be adopted for establishing the degree of comprehensiveness needed for the budget. Toward this end, Latin American countries evolved, during the early 1950s, a national economic budget, consisting of the economic, financial, natural, and human resources of the country. With the adoption of formal planning, this purpose was served by the development plans. Later, from the mid-1960s, medium-term public expenditure forecasts undertaken by governments, took into account the transactions of regional and local governments, as well as the operations of public enterprises. Econometric models employed for buttressing policy analysis have used the data so generated for achieving a better understanding of the impact of the budget on the economy. While the supplementary efforts are not yet as well refined as they ought to be, it appears that these pragmatic approaches have proved useful in establishing an overview of public sector operations, thus minimizing the resort to legal mechanisms.

Budgeting in Practice

Although budgets are for specific financial years, in practice budgeting is continuous and is so undertaken in the spending agencies and in the ministries of finance or planning. Budgeting involves the interplay of several forces and, to gain a proper perspective, may be distinguished from expenditure controls. The distinction may in some sense be arbitrary, but it is useful. Budgeting is viewed here in a wider connotation to deal with institutional factors, recognition of economic environment, formulation of relevant policies, patterns of legal accountability, and responsibilities of the central and spending agencies. Expenditure controls, which are much narrower, refer to techniques that are utilized at selected stages of budgeting for the review of programs and their financial estimates and, at a later stage, for ensuring that the formulated budget estimates are adhered to in practice.

Budgeting involves different tasks on the expenditure and revenue sides. On the expenditure front, it involves the determination of the total size of the budget, size of the outlays on different functions, and the magnitude of outlays on various programs that are part of a function. On the receipts side, the size of the overall revenues and foreign aid, where applicable, needs to be decided. A decision is also needed on the size of the deficit, components of its financing, and the likely ownership of public debt.

These tasks are common to all countries, irrespective of their political ideology, economic status, experience as an independent country, or level of moral responsibility.4 Moreover, all of them require an explicit recognition of the policy parameters discussed in Chapter 1.

The three functions of the modern budget—allocation, stabilization, and distribution—imply the need for making a budget through a budgetary process, comprising the five stages shown in Chart 1. The components and tasks involved and described therein may be examined here in terms of their economic aspects and the administrative steps to be taken.

Budgetary Tasks: Economic

From an economic point of view, the budgetary process implies that concerns of allocative efficiency, stabilization, and distribution are given due consideration at each stage. Allocative efficiency, as noted previously, consists of the allocation of resources between the public and the private sectors, resource allocation among competing demands within government, and assessment of the trade-off between allocational and other objectives. Performance of these subfunctions requires assignment of weights to the various objectives, methods for ascertaining collective preference, formulation of judgments on the broad relations between the public and private sectors and on how the proposed revenues, expenditures, and financing would affect them, and—in the light of that analysis—allocation of the resources to the agencies of government. In making the allocation, the budget agency is ideally expected to balance the marginal losses of welfare to the community from tax payments against the marginal gains from public expenditures and to ensure that the marginal benefits from each monetary unit of expenditure within government are the same. In practice, as there is no single way in which such a review can be done, reliance must be placed on proxies, intuitions, and other substitutes for market signals.5

The stabilization function requires a more precise assessment of the economic impact of government operations on the economy and a consequent adjustment in the budget. Over a period of years, a number of concepts and techniques have come to be used for the purpose. Reliance on national accounts, utilization of forecasting techniques, and closer coordination with monetary authorities are a few examples. As an integral part of this effort, contingency plans need to be formulated to provide for increases or reductions in taxes and expenditures to meet sudden or unforeseen changes in the economy. More stringent plans for controlling expenditures would be needed if the budget is to achieve a specified degree of restraint or a specific stimulus in the economy. If controls are slack and if government spending increases at a rate higher than scheduled, or if tax collections are less than expected, then restraint or stimulus cannot itself be controlled with any precision and the budget will become a destabilizing factor.

Distributional imperatives require attention to the incidence of public expenditures and the income groups that are expected to be served. Alternatives such as cash payments in lieu of services may have to be envisaged, or programs may have to be redesigned to meet the needs of specified income groups. In endeavoring to meet these objectives, conflicts of an economic and administrative nature arise. What is the ideal distribution for the public and private sectors? What is the optimal distribution among competing demands in government? What is the trade-off between allocation and stabilization and between stabilization and distribution? Answers to these questions are not easy. They constitute the hard core of public policy. It is also not expected that formulation of policies in these spheres is the exclusive responsibility of the budget office. It is inherent in the budget process that distributional concerns would be the primary responsibility of the administrative or spending agencies and that the responsibility of the finance and planning agencies would lie more in the allocation and stabilization functions. The fiscal responsibility is a joint one that covers the whole range of government. The perception of the spending agencies is, however, likely to be different from those of central agencies in regard to allocation and stabilization functions, in that their awareness of the resource realities and the issues in economic management will be less than has been assumed, or at any rate less than that of central agencies. Budgeting requires as a precondition that there is adequate communication on these matters during the process of the determination of annual budgets or medium-term financial plans.

Experience suggests that there are practical difficulties in bringing the influence of these three concerns on budgeting simultaneously. Countries that have formulated development plans appear to have paid more attention to allocative aspects and less attention to distributional concerns. Although it has been recognized in several countries that the financing of plans through money creation would be inflationary, the impact of such financing on allocation and stabilization did not appear to have been given due importance. Later, with the emergence of inflation as a major problem, greater attention was devoted to the stabilization function at some expense to considerations of allocation and distribution. The persistent occurrence of these problems implies a policy gap as well as an institutional one. The direction for the improvement of the budgetary process lies in minimizing the ad hoc approaches and in providing an integrated outlook. It is tautological to say (although this is not often recognized) that an effective fiscal policy requires an effective budgetary process that integrates the economic, financial, and program analyses as a feature. Ideally, economic analysis should include long-range fiscal plans, establishment of resource needs, formulation of alternative fiscal strategies, assessment of the proposed budget's impact, and planning of tax and expenditure adjustments. Financial analysis should consist of the evaluation of competing demands within each function and their contribution to the allocation and stabilization purposes. Program analysis comprises detailed analysis of program needs, incidence of expenditures and benefits, analysis of service standards, estimates of the volume of activities, phasing of outlays, and the guarantee of an adequate allocation of resources.

An important task of budgetary policy is also to promote growth. It can be accelerated through additional expenditures in desired sectors either through direct outlays or through an appropriate strategy of development of infrastructure that, in turn, will induce further investment. Tax incentives and the provision of credit, depending on their need, direction, and structure, play a useful role in promoting economic growth. Implementation of a strategy of growth is reflected in the allocation of budgetary resources to those sectors whose projects and programs have been reviewed and are considered to have an impact on growth. Such a strategy is an integral part of an agricultural, industrial, or transportation policy rather than the mainstream of fiscal policy. The importance of the latter consists of ensuring that the resource realities and the impact of the proposed outlays on the economy are fully taken into account. Specifically, the budgetary tasks in a growth context involve a financial and economic review of the outlays and an assessment of the impact of growth on future expenditures and revenues. These aspects merit detailed consideration in the formulation of medium-term strategies and in the annual budget.

The determination of the actual tasks at any given stage will involve conflicts and trade-offs. In an ideal situation, with the availability of full information and reasonable control on exogenous factors, it would be expected that the budgetary process would be so organized as to permit a simultaneous determination of all major budget questions. In reality, such complete control is not feasible. With that aim, however, the process is organized as an iterative one with sequential steps. Being iterative could itself contribute to a potential problem, in that conclusions that are independent of the sequence may be reached or may depend heavily on the sequential procedure adopted. Problemsolving approaches generally refer to simultaneous scanning or selective scanning. Although a simultaneous scanning of issues and their interrelationships is frequently aimed at, because of the numerous issues and time constraints, in practice only selective focusing may be achieved. Such selective scanning is not a goal but a convenient rule of thumb of the administrator when other methods prove difficult to apply.

Determination of Public Expenditures

The budgetary process is only a conduit for the identification of the parameters that influence decisions on the magnitude of expenditures. Primary concerns at this stage are the allocative efficiency of resources between public and private sectors and among the various services within government. Determination of total expenditure takes place in two ways. In a model of devolution, such totals would be decided by the central finance or planning agency and communicated to all other agencies. In an aggregative model, the individual expenditure requirements of each program would be compiled and then consolidated. A combination of these two approaches is found in practice. Central agencies that are charged with fiscal management need to determine the appropriate level of expenditure in the light of the resources available and the permissible levels of deficit. These initial levels of expenditure are usually notional and are used as a basis for discussion with spending agencies. By their very nature, these notional magnitudes cannot cover the millions of government programs in detail and they are considered, with some justification, as tentative benchmarks. Viewed thus, the normal limits of expenditure may be determined in the following manner:

This equation will have different emphasis in countries that are traditionally dependent on foreign aid. In such cases (Revenues) + (Foreign aid) + (Deficit) = (Total government expenditure). In countries that have annual surpluses in the government budget such as countries that are members of the Organization of Petroleum Exporting Countries (OPEC), or in contexts where surpluses are aimed at as a matter of policy, it will be (Revenues) − (Surplus) = (Total expenditure). Thus, even if only aggregative expenditures are to be adopted for purposes of initial budget compilation, they will have to be adjusted to available revenues and permissible levels of deficit.

There are other variations of this approach. For example, it is argued, based on the experience of the United States, that the major determinants of public expenditure are estimates of total revenue and the desired level of defense spending. Revenues and deficits are considered as economic policy instruments, and nondefense expenditures are thought of as a remainder after defense needs are attended to.6 Such broad groupings of expenditure may and do facilitate political preferences in some countries. On an analogous basis, it could be argued that, in developing countries, the primary determinant of expenditure is the share of development expenditure, with non-development expenditures treated as a remainder. In reality, however, such dichotomous approaches do not appear to be prevalent in developing countries and, in any event, may reflect some oversimplification of the actual process.7 In a context where most countries have development plans or medium-range and long-range expenditure forecasts, it cannot be said that any single division of expenditure would be the major determinant of the budget. In wartime, however, it is almost certain that defense expenditures would be the major item in the budget, and the dimensions of defense spending would depend on the outlook for war.

The determinants of expenditure in the day-to-day world may be classified into endogenous and exogenous factors. For this purpose, the government as a whole is treated as a single homogeneous entity. It is to be noted that within government an endogenous factor to some may be viewed as an exogenous one. Endogenous factors comprise continuing outlays reflecting expenditure from recent or previous legislation and costs of services. Approved policy goals and organizational capabilities are a part of this group. Exogenous factors include policy revisions reflecting changed conditions, growth of population and changing patterns of clientele, technology of services, price factors, and, above all, the resource availability factor. In addition to these tangible factors, there may be some environmental ones that may influence the pattern and growth of expenditures. For example, it is the general belief that there is an innate urge in the government to spend more and that the desire to do good is endless in government. The custom of upholding prestige or related hedonic preferences may also be at work, and they may collectively work from within to contribute to increased expenditures. Externally, greater availability of resources, particularly through inflation-induced taxation, could lead to increased spending. Further, a resort to deficit financing could in itself induce a rapid increase in government spending. Some of these assertions are debatable. Whether increased needs lead to higher mobilization of resources or whether the latter would induce the former is an ontological question, and categorical answers are hard to find. The absence of an immediate resource constraint does not in itself induce expenditures when they may have to be stabilized in the light of other major economic constraints. Final levels of expenditures are, therefore, the result of several complex forces at work, and attribution of these forces to any single factor could be misleading.

Expenditure Estimates: Preliminary Considerations

Formulation of a budget involves making a forecast of the next year's requirements. Informal and preliminary forecasts undertaken by the spending and central agencies are useful in charting their requirements and needs. Usually the forecasts take into account (a) continuing needs for which commitments were made on a long-term basis, (b) changes in the costs of these services, (c) announcements of new expenditures or legislation affecting the expenditures enacted during the year, (d) share of outlays for continuing projects, and (e) outlays on new projects or programs. Such estimates will also take into account any decisions made during the year to wind up or abandon some government activities. The important aspect for decision making is the determination of the new outlays, their magnitude and allocation pattern, and changes in the outlays for continuing activities, involving reallocation of those margins to others and determination of their requirements during the year. The estimates also take into account the previous relationships between estimates and the actual expenditures, performance ratios and factors contributing to their variations, and commitments made during previous years but requiring cash payments during the current year. These estimates are routinely compiled by the administrative agencies and the finance ministry.8

The allocation of expenditures among programs is determined through the normal decision process used by administration. The process is characterized by the application of convenient rules of thumb, cost-benefit or feasibility studies for new projects, and bargaining. The extent to which one or all of these are utilized varies with the nature of the expenditure and the administrative system. Traditionally, British and Commonwealth systems distinguish between continuing charges and new services. Continuing charges include “consolidated” or “nonvoted” expenditures reflecting the salaries of the heads of government, judiciary, and other units that have no defined cut-off period and that are not subject to undue variation.9 Other charges, such as interest payments, are also included in continuing charges. New services or new items represent proposed outlays on policies that have not yet received the approval of the legislature. In a similar fashion, French budgets make a distinction between services votés (continuing charges) and mesures nouvelles (new measures)—which can be both positive or negative. In countries that have formal development plans, new projects are, with only a few exceptions, drawn from the current plan. If the purview of the plan is, however, limited to capital projects or outlays of an investment type, new measures will cover current or routine activities. Plan projects, in theory, are expected to have been subjected to an investment appraisal and it is therefore assumed that their allocative efficiency has received due attention. Appraisal of new projects cannot include a comparison of their merits over the wide spectrum of functions but such a comparison may be undertaken within a function.

It is believed that, since a large part of annual outlays are for continuing projects, the attention of the budgetary process is focused only on marginal additions.10 In practice, however, marginal changes occur even within continuing outlays. Changes in the existing outlays, as well as marginal additions, receive the same attention and pass through the same administrative process. If the marginal addition is important to an agency that is already assured of its continuing outlays, retention of some of the existing allocations may also be important for another agency. In either event, the forces at work for obtaining allocations are the same. Given the tight time schedule for the budget, only a scanning may be possible for some new proposals. Those that have already been accepted in principle or have been included in the development plan may receive only a financial review in terms of the accuracy of estimates, while totally new proposals are likely to be subjected to economic, financial, and program analyses.

The task of formulating estimates of expenditure for the next year tends to be easier when a medium-term expenditure forecast is available. Given such forecasts, the task for the annual budget is to adjust for exogenous factors, such as changes in economic climate (which may involve more or less subsidies or public works outlays), changes in cost factors (rate of inflation), or changes in demographic profiles (e.g., net additions to the number of pensioners could entail more pension payments). Attention could then be focused on new proposals. In the absence of such medium-term expenditure forecasts, the above factors would need to be given detailed consideration in the expenditure estimates, involving a deeper probe into the expenditure categories. For personnel expenditures, the net additional posts created, the gap in filling them, and the consequential savings, if any, would be important. Similarly, projects that are usually included in a capital budget need more attention. Performance during previous, years, availability of materials for the next year, and the likely emergence of bottlenecks and their impact on the pace of construction would need to be reviewed. Experience of industrial and developing countries alike indicates that current expenditures are usually underestimated, while capital outlays are overestimated. The latter may in part be due to the visibility attached to capital projects and, in developing countries, a number of projects may be included with a view to obtaining more foreign aid.

Annual estimates for capital projects must take into account the nature of the budget provision. In countries that have an obligation-based budgetary system, all funds necessary for the life of the project may need to be shown in the budget. Supplementing such a presentation, data on annual cash outlays are provided separately. In the British and Commonwealth systems, two practices are followed. A token provision may be made in the estimates to obtain legislative approval. This provision implies that supplementary estimates indicating the actual amounts needed would be submitted later. Alternatively, funds are appropriated annually, signifying the project outlays for that year. In the latter case, supplementary information delineating the full costs of the project may be provided. In the French system, a distinction is made between autorisation de programme, which constitutes the upper limit of funds that ministries can commit for projects, and crédit de paiement, representing payments that can be made in any year under the approved authorization.

Annual expenditure estimates must pay particular attention to two other elements whose importance has grown considerably in recent years: (1) government lending operations, and (2) the spillover of the effects of operations of revolving funds and trading accounts. A cursory analysis of government operations indicates that lending to government agencies and to the public has been growing. In developing countries, such growth in transactions partly reflects the international borrowing channeled through government budgets. The lending operations imply that the social and economic purposes of government are carried out by autonomous or other agencies and that their activities are financed by loans. Annual estimates for these need the same attention as other estimates. Decision making on loans is different from other decisions in that it is not restricted to marginal adjustments but revolves around the old as well as new loans, and final decisions are based on the capital market conditions and the purposes of lending. Specific attention would be needed for the estimation of the element of subsidy involved in lending.

Revolving funds, which were originally restricted to trading operations and are expected to be self-financing, have exceeded their original intentions. They are now widely used and have often ceased to be self-financing. Government trading activities, particularly in the procurement and distribution of foodgrains, have expanded significantly in a number of countries. As they are vastly undercapitalized, their deficits become a charge on the general budget. If such activities are not anticipated, they could change the budget outcome significantly. Estimates of trading activities imply detailed calculations of prices and quantities, which can be complex in a fast-changing commodity environment. These factors underline the need for greater care and comprehensiveness in the formulation of expenditure estimates.

Revenue Estimation

Revenue estimation can be viewed in terms of the formulation of both the immediate year's estimates and those over the medium term. The latter aspect is considered in Chapter 6.

Estimates of revenues for the following year must be made before expenditure ceilings can be conveyed to spending agencies. Preliminary estimates, which are based on existing taxation may change over time and, eventually, as the final estimates of proposed expenditures emerge, it may be necessary to take discretionary measures for mobilizing additional revenues if the level of deficit is to be maintained or curtailed. Revenues and levels of deficit represent the policy variables that, as shown above, determine the broad level of expenditures. Revenue estimates facilitate the consideration of expenditure policy options and therefore are to be formulated with care. Each expenditure program cannot be viewed against revenues except for expenditures financed from earmarked funds. The aggregate expenditures are determined in that light, and in the iterative process adjustments are made in expenditures to be within the revenue limits.

Revenue estimates for the next year are formulated in two ways. First, an accounting approach of forecasting receipts, based on the rate of growth recorded in previous years, may be adopted for each major source of revenue. In this exercise, a distinction is made between autonomous growth and the yield from discretionary measures. Buoyancy, reflecting the overall growth of taxes, and elasticity, representing the effects of discretionary action, are calculated and forecasts made. The approach, however, has limitations in that the relationships with the rest of the economy are not explicitly recognized and are taken as a part of the rate of growth of previous years. Second, a more organized approach is to provide for an explicit recognition of national economic parameters, including the likely increase in GNP, the rate of inflation, and the impact of increased government expenditure on taxation. Specific variables can be introduced, depending on the revenue structure, to reflect the activities of major sectors, such as international trade. In countries which derive most of their revenues from the sale of a few commodities, such as minerals and oil, revenue estimation may be less complex. In such-cases, production and price schedules of the commodities shape the revenues. In other export economies, particularly where agricultural products dominate and where foreign markets have been volatile, estimation of revenues is more complex. In a number of developing countries, foreign aid, as noted earlier, is an important part of the revenue, sometimes constituting more than a fourth of total receipts. Estimation of foreign aid has generally proved difficult and is dependent, among other things, on intangible factors, such as political approaches.

Experience with revenue estimates reveals that organizational and attitudinal factors have generally impeded the usefulness of revenue forecasts. Organizationally, revenues are estimated by agencies that ate responsible for revenue collection and thus are conservative, partly because of a desire to show a better actual performance. Such conservative estimates are also preferred by the budgeteer, as they provide a margin when higher expenditures must be financed during the course of the year. Conservative estimates also encourage the spending agencies to believe that revenues will cover expenditures. In some countries, revenue estimation is carried out crudely, without adequate attention to the impact of government expenditures on taxation or the feedback effects of previous changes in taxation. In a few countries, the distance between the revenue and budget agencies is a real and physical one. Estimates are often provided at too late a stage to permit an appraisal of expenditures. In some cases, the revenue estimates are formulated, processed, and printed without the consideration of expenditures.

Revenue estimation, if it is to be a meaningful input to the budget, must be better organized and better integrated into the budget cycle. Also, to protect against undue volatility and a consequent rush in expenditure adjustments, revenues must be planned on varying assumptions. Just as expenditures are planned in a zero-base budget system on different assumptions of resource availability, revenue forecasts—including foreign aid—could similarly be formulated on different assumptions.11 In undertaking such estimation, a reciprocal adjustment is made between expenditures and revenues. From the expenditure side, revenues may be assumed to be as given, and plans may be formulated either for expenditure adjustment or for further discretionary revenue measures. From the revenue side, the level of expenditures could be assumed, and different packages of additional revenues could be formulated. Additions to revenue may accrue from several sources—new measures, improved tax collection, and enforcement being among the options available to decision makers. Given that each new tax has an effect on production and consumption, formulation of different packages provides an opportunity to assess the merits of each package.

Aggregative and Devolution Styles

Budgeting, as an iterative process, involves a two-way movement—information moving from agencies to the center (aggregative approach) and from the center to field agencies Revolutionary approach). An ideal situation would demand an appropriate combination of these approaches. In practice, only one would appear to be followed, with each situation contributing to avoidable problems. Although some problems have been mitigated with the adoption of medium-term expenditure planning, many still persist, particularly in countries where no detailed expenditure planning is undertaken.

Under the aggregative approach, each agency and enterprise acts as an independent decision-making unit. Its primary motive, which is partly aggravated by a lack of awareness of resource constraint, is to obtain as high an allocation of resources as possible. Amounts equivalent to the current year's budget are viewed as “floors,” and a shopping list of projects and programs that are still at an early stage may be included. Part of this attitude stems from viewing the size of the budget allocation as a measure of power and part from viewing unkindly efforts at saving money or making only minimal demands for allocations.12 In such a context, the proposals of the spending agencies are reviewed and consolidated with reference to ad hoc benchmarks before the budget is formulated. Admittedly, this procedure, which is in vogue in several developing and some industrial countries, has contributed to problems over the years. First, in the absence of policy guidance, expenditure programs are often ill-judged and poorly timed. Objectives of government then tend to depend on the budgetary outcome rather than being a starting point for the formulation of programs. This also leads to problems in what the Plowden Committee called the “indeterminate area between policy and administration.”13 Alternatives to government expenditures may not be explored, and expenditures may continue to be incurred even after the original objective has ceased to be meaningful. By the same token, the allocative, stabilization, and distributional concerns of government remain unfulfilled, as the budget is not specifically used for those purposes. Second, the whole process of budgeting becomes negative because the central agencies spend their time in pruning what they consider to be “padded” estimates. When budgets are formulated by agencies to meet external constraints, a great deal of doctoring of expenditure estimates takes place. Experiences of this type are to be found in everyday life in the transactions between subordinate agencies and administrative ministries, between administrative ministries and finance, between local and central governments, and—in a federal setup—between state and central governments. Inevitably, the budgetary process, which has the positive purpose of allocation of the funds, and building up a partnership for economic management, leads to incessant administrative wrangling. Exaggerated caricatures of officials involved (“inverted unsmiling macabres sitting in the Treasury with scalpels ready”) and the continuous search to shift the blame for failure are a consequence of this approach. Review in such circumstances may focus on minute and trivial details, reflecting a triumph of technique over purpose. More significantly, such attempts at control may be viewed as substitutes for good budgeting and, as the final budgets may not reflect the actual requirements, correctives must be introduced throughout the budget year. Thus, the far-reaching effects of this approach permeate the entire government.

The alternative to the aggregative approach is the devolutionary approach, which should not be viewed as a statutory process of distributing the proceeds to those who are entitled to them. Rather, it is viewed as a process where a central agency undertakes advance planning for the requirements of the government and indicates what these are to the spending agencies as initial ceilings for their budget. Inevitably, details of such an exercise pose problems. Detailed enumeration of projects and programs is, in any administrative context, the responsibility of the administrative agencies. The task of the central agency in formulating and indicating the amounts likely to become available is to promote awareness of resource realities, priority planning, and a more coherent relationship between objectives and programs. The purpose of the process is to ensure a firm bridge between intentions and actions. The quality of indications is dependent on the capability of the organization to look forward and on its own unbiased formulation of estimates.

In practice, however, the working of indicative or devolutionary methods has not been as successful as expected. This is due partly to attitudinal factors and partly to difficulties in estimation. Attitudinal factors involve the tendencies on the part of the finance and planning agencies to formulate the ceilings arbitrarily, unilaterally, and as a bargaining base for budget negotiations. Spending agencies thus feel that they have not been consulted and that no policy directions other than indications of amounts have been given and, consequently, they have resorted not to priority planning but to bargaining strategies.14 To an extent, this result was due also to the fact that the spending agencies were more familiar with bargaining practices and sometimes lacked facilities for undertaking priority planning; they therefore found a continuation of the previous practices more convenient. Technically, the ceilings might be set without proper adjustments for the expected rate of inflation or for the maintenance outlays required for completed projects, making the spending agencies more apprehensive. Experience suggests that while devolutionary approaches are purposeful and positive, their success is dependent on the care taken in the formulation of ceilings and the attention devoted to building up a dialogue with spending agencies.

Review and Evaluation

The discussion in this chapter has thus far been primarily concerned with the mechanics of formulation of estimates and the factors influencing the estimates. The different elements that are brought together in the budgetary process are, in turn, influenced by the structural aspects of the process and therefore merit consideration. It is suggested, although infrequently, that one reason for expenditure growth is the budgetary process itself.15 While it is likely that the budgetary process alone does not foster profligacy or encourage spending increases unless these are warranted by the economic climate, some aspects of the process may unwittingly contribute to increased expenditures or to outcomes substantially different from budget estimates. The outcome is the result of the influence of several complex phenomena, of which only a few can be anticipated and measured with precision. However, it can be stated that the degrees of variation are dependent on the recognition of constraints in the budgetary process, the instruments chosen, the time span of the budget, and the treatment of uncertainty.

The budgetary process and related decision making would be considerably facilitated by the recognition given to economic and political constraints. It should be noted, however, that a classification of constraints into neat categories is difficult. In practice, the constraints may not be distinct and may be imposed partly or wholly in the realization of economic objectives.16 Most economic solutions may become political problems, and most political solutions may become economic problems. In the area of public policymaking, good economics may be bad politics and vice versa. Notwithstanding the ambiguity involved, the constraints at work in the budgetary process are summarized in Table 5.

Table 5.Economic, Institutional, and Budgetary Constraints
1. Economic Policies
a. Income, employment, and inflation goals
b. Exchange rate policies
c. Monetary policies
d. Fiscal policy
1. Resource mobilization
2. Rate of expenditure growth
3. Investment expenditures
4. Subsidies
5. Budget deficit
2. Institutional
a. Consultation and coordination among levels of government
b. Coordination within government
c. Organizational rigidities
d. Noneconomic considerations urged by political elements
e. Administrative capability
3. Budgeting
a. Approaches to revenue and expenditure estimation
b. Flexibility in fiscal action
1. Levels of expenditure already committed
2. Facility in the levy of new or revision of existing taxes and rates
c. Constraints of the budgetary process
1. Time
2. Information: approaches of financial control; inadequate funding
d. Financial management
1. Poor timing of release of funds
2. Cost overruns
3. Lack of flexibility in the utilization of funds
e. Personnel constraints

Economic and Budgetary Constraints

The factors shown in Table 5 are common to most government organizations. Their applicability for a national government differs according to the responsibilities of government in national economic management. For state and local governments, the amount of resources transferred to them from the central government is a significant constraint, while for the central government, the transfer of resources may be a constraint only in the implementation of selected aspects of the budget. The economic policy constraints shown in Table 5 are, in theory, expected to be taken care of in the development plans and medium-term expenditure forecasts. The success of plans and forecasts depends to a large extent on the degree of realism shown in the treatment of the constraints and on the responsiveness shown by the budgetary process to changing economic situations. It is necessary to note that mere recognition might not be adequate and might be a hazy step in the long budgetary process. To be fully operational, constraints must be recognized formally and explicitly. Otherwise, policies tend to miss goals (which in most events may not be specified) and the participants tend to engage in transactions that, while leading to a budget, release forces that will reduce the relevance of the budget.

The budgetary process should also explicitly recognize the relevance and limitation of each instrument. If it is assumed, for example, that governments are clear about their economic goals, the budgetary process should facilitate an appraisal of the different instruments for achieving those goals. The government's objective of providing housing could be achieved through direct expenditures, loans, or tax policies. Similarly, industrial pollution may be reduced through regulations, tax relief, or direct expenditure. The practical consideration of these alternatives has not yet made much headway owing to organizational and conceptual problems. Organizationally, the budgetary process has been viewed in a narrow way, as being confined to allocations to spending agencies. Furthermore, governments are so organized that each instrument may form part of the responsibilities of agencies that rarely come together. In the process, each instrument tends to be considered as a universe in itself. Yet another factor is that major activities may remain outside the purview of the budget. Moreover, the quantification of some instruments, such as tax concessions and regulations, is not easy and much is dependent on the actual response of each taxpayer. Similar difficulties have afflicted the choice between loans and direct expenditures within government and between government and commercial banking system.17 If the fiscal policies and particularly their industrial components are to be meaningful and to present a unified picture, it will be necessary to envisage a broad budgetary process in which all the different instruments can be considered. Part of the problem could be met at the initial policy planning stage by considering the alternatives, and the budgetary process could then, as in previous years, be devoted only to the determination of allocations. These improvements are still awaited. A first requisite in this direction is clearly one of compiling an inventory of the major policy instruments now in use and of potential instruments to serve as a basis for policy formulation. It is probable that, in the absence of such efforts, concerned government departments will continue to envisage policy measures on traditional lines and will contribute to the perpetuation of the present processes.

The consideration of the budget is also influenced by the span of the budget and the duration of the budget-making process itself. While the latter aspect is considered in the following pages, it appears that the annuality of the budget may generate policies oriented to a very short term and create a tendency to postpone to a future period significant expenditure or revenue increases. Such an approach will contribute (as it has already contributed) to the adoption of an “ostrich” attitude, which still cannot avoid the economic realities of life. As this attitude affects the whole tenor of fiscal policies, it is appropriate to envisage the budgetary process in a long-term context within which annual budgets can be formulated.

The effectiveness of the budgetary process is influenced by the treatment accorded to uncertainty. All policies in the public realm must be formulated against considerable odds, such as the direction of the economy, price movements and expectations, and several other variables. The revenue constraints arise partly from uncertainties which influence expenditures in an asymmetrical way. If guidelines are not available in regard to revenue constraints, the approaches of spending departments will differ from the normally expected rational pattern. As noted earlier, underestimation of revenues serves as a safety valve at the political and executive levels. Overestimation of revenues, however, can induce spending departments to make more liberal expenditure estimates and can severely strain fiscal and monetary policies at a later stage. In the long run, it may be a blessing to underestimate rather than to overestimate revenues. More important, the budgetary process should provide explicit avenues for promoting strategic planning at various levels of resource availability in order to minimize uncertainty. Along with this, control techniques will also need to emphasize a greater degree of review and evaluation of public expenditures so as to minimize evasive approaches adopted by spending agencies. Uncertainty is inevitable in a budgetary context, but the process should provide ample opportunities for its recognition and minimization. Such opportunities depend on the financial management capabilities within departments and on the initiative shown by central agencies.

Budgetary review may be distinguished from evaluation. Review is a more specific task and, in the immediate context of the budgetary process, implies a program analysis consisting of the internal consistency of each element of expenditure and its relevance to the overall framework of action contemplated in any year. Evaluation is a larger concept. Although it is traditionally used to convey a postevent appraisal, in a prospective way it implies the formulation of strategies for the realization of goals at no extra cost. Specifically, it has four basic elements: operationally defined goals; a set of indicators—output, cost, productivity, or accomplishments that indicate the extent to which a program objective is being met; the specification of the range of instruments for achieving program objectives; and an analysis of the relationships between* policy instruments and indicators. Evaluation presupposes strategic planning as illustrated in Chart 1. In the ultimate analysis, both have the same purpose—namely, given a certain amount of resources, what can be achieved? Alternatively, given a specific goal, what are the resource requirements? Both of these questions raise the issue of cost and value of services and of the values attached to them in government. If financial planning is done on a need basis, budgeting will be an exercise of computing the values of needs and of providing necessary amounts. However, where planning is resource based and resource ceilings are indicated to departments, budgeting will be an exercise in providing relevant services for those amounts. In the case of public authorities, a combination of these approaches is followed.

The budget process is intended to reduce conflict and to permit decisions that are acceptable to the participants. As noted earlier, the participants have different interests—the spending agencies seeking greater allocations and the central agencies endeavoring to restrict the allocations to manageable levels. To that extent, budget review involves, on the part of the central agencies, reduction of the demands generated by spending departments. The ability with which such demands are resisted depends on three assumptions. First, it is assumed that broad decisions of financial policy are settled either by the Cabinet or similar bodies. But, within the limits laid down, there is still much to be decided. The determination of such issues forms part of the budgetary process. By the same token, it is implied that issues avoided or deferred by the policymaking body cannot be solved in the give and take of the budgetary process. Second, the success of the central agency depends on its location and the support it receives from the policymakers. Any battles that it proposes to wage must be carefully planned, for the loss of a few battles could lead to losing the war. The analogy might imply the need for the adoption of aggressive policies by the budget agency. On the contrary, it is to be emphasized that the policies themselves should be realistic in order to induce conformity rather than to encourage battle lines. A central location and strong support obviously cannot compensate for the apparent inadequacies of policies. Third, much depends on the techniques used for the review of budget estimates. There are, however, many techniques, some of which are limited in their application to specific types of expenditures.

Review Techniques

A technique that is in extensive use in developing countries is variation analysis. This approach implies that the agencies will first identify the program or its cost elements, representing increases or reductions over the previous year's budget. Following this identification, the annual review by the budget agency focuses mainly on the variations, with greater emphasis on increases in outlays. This approach is based on the belief that the items continuing in the government budget merit further extension and will be reviewed only when special situations demand it. The budgets of previous years will then represent a threshold point beyond which no research is needed. Budget review will in part become a folk rite with inbred complacency in regard to the policies that are already there. The technique has several weaknesses, but the most pernicious is that such approaches are accepted as conventional wisdom, supported not by their content or relevance but by history, and that they become impediments to the revitalization of government financial management.

An equally conventional technique that continues to be practiced is the item-by-item review, which involves a review of the annual budget requests in terms of specific objects such as wages and related payments and materials. A general problem associated with this otherwise powerful approach is that it tends to concentrate on the minutiae and thus, in the process, neglects the more important policy issues. The technique has a wide following and has withstood the test of time—two factors that add to the instant appeal of the technique. As discussed later in Chapter 11, the aim of budgetary reform has been to move away from this approach.

With the advent of planned economic development, and with efforts at the introduction of performance budgeting, some change took place in the application of techniques of budgetary review. Planning implied the adoption of a language of priorities by the spending agencies. Specifically, for projects and programs, the spending agencies indicate their priorities, which are then analyzed by the budget agency. Performance budgeting implies an evaluation of the requests in terms of workload, costs of activities, standards of performance, and related criteria. Variations of this technique have since dominated budget reviews and have led to partial adoption of the evaluation approach described earlier.

More recently, improved techniques have been adopted in specific recognition of the growth in expenditures and their complexity, the change in economic environment, and shortcomings in the prevailing budget systems. These techniques may be grouped into three categories: (1) improved budgetary systems, including the introduction of zero-base budgeting, multiyear budgeting, budgeting in volume terms, and “sunset” legislation; (2) budget techniques for demand management, consisting of government approaches to bring about short-term changes in approved expenditures to meet demand management requirements; and (3) supplemental management systems and evaluation techniques, comprising improved data systems to facilitate analysis of selected areas. As most of these are discussed in greater detail in Chapter 11, it is sufficient to recognize here that budgetary techniques have been responsive to change. A caveat should be noted. These techniques reflect only the range available to government and are not necessarily typical of all situations or all countries. In practice, no single technique is used exclusively, but a combination of approaches is likely to be adopted.

Working of Techniques

If the techniques are used as expected, how is it that budgetary outcomes differ from the estimates? The answer is to be found partly in the working of the institutions and partly in the approaches that govern the application of the techniques. Granted that revenues are underestimated purposely, what can be said about the underestimation of current expenditures and the overestimation of investment or development expenditures? Underestimation of current expenditures is ascribed to the general philosophy that spending less on the current account would provide for investment and, regardless of the merits of the view, spending agencies often pay lip service by understating the realities. In some respects, particularly in regard to demand-related expenditures, available techniques of forecasting do not permit estimates with minimal errors. Departments also have a persistent upward bias in their estimates, so that the estimates tend to become self-fulfilling prophecies. Institutionally, apathy and lack of facilities within agencies have caused less attention to be paid to major issues and, in the process, the burden has shifted to the techniques of budget review. This shift contributed partly to the adoption of arbitrary approaches for the review of estimates. Hartle contends that judgments in budget formulation are basically arbitrary and that the budget-making process legitimizes these decisions.18 In a way, Hartle's comment is an extreme one and implies a paradox. It must be recognized that arbitrary approaches have serious limitations and can be applicable only for brief periods.

It is hardly necessary to emphasize that the adoption of mechanistic approaches without a philosophy toward budget making would alone not be fruitful. The philosophical aspects of budgetary approaches have been analyzed by several political scientists, notably Caiden and Wildavsky, Crecine, and Cowart and Brofass.19 These studies primarily hypothesize that the approaches to budget making are linear and predictable. Although several propositions have been subjected to limited empirical tests, some of the more important ones may be noted. It is argued that the approaches would be one of the following five: (1) requests at last year's levels would generally be approved by the budget agency; (2) any increase in the allocations over the previous year's levels is dependent on the influence or power of the spending agencies and the magnitude of revenue likely to be available during the next year; (3) the budget review tends to be superficial in the context of greater availability of resources; (4) in the event of a likely budget deficit, an attempt will be made to balance the budget through reduced allocations; and (5) when a surplus is likely to be available, more fringe benefits are likely to be approved for government personnel. These approaches, while based on practical experience, also reflect oversimplification of realities. To be sure, the applicability of these propositions will differ in terms of the levels of government and will vary with the economic environment. The approaches imply that budgeting is purely a bargaining process, that merits of programs do not determine their eligibility, that there is no government policy, and that governments do not distinguish between economic and financial constraints and that, in short, the budgetary process has ceased to have a policy function. In conveying these implications, analysts have tended to generalize on limited bases, and they may have confused symbols with substance. At the same time, it cannot be said that the propositions are entirely untenable, for they are partially true. The danger consists in believing in their universal applicability and in assuming that the budget is the result of a unilateral approach. The analysis in the preceding sections illustrates the complexity of budget making, and it also demonstrates the role of numerous forces at work. The success of the budget review and the associated budget-making process, to summarize then, is dependent on (1) explicit recognition of the constraints; (2) recognition of the economic forces at work and the role of the budget in changing them, including the time lags with which budgetary policies come into effect; and (3) recognition that the budgetary process should assign appropriate weights to planning and management.

Economic Analysis of the Budget

The central role of the budget in economic management has been emphasized earlier. To recapitulate the discussion, although political views and views on the role of the state differ and important differences are to be found between interventionist and noninterventionist policies of government, a common factor is the recognition of the budget as a significant instrument of economic management. Over the years, there was greater recognition of the impact of the budget on the economy and the economy's impact on the budget. In these matters, annual decisions both within and outside the government relate to the amount of stimulus or restraint to be exercised on the economy. Indicators of employment, prices, economic growth, and balance of payments have become important in determining appropriate annual expenditures, but they have not been given the emphasis due in the traditional literature on government budgeting. To a certain degree, this lack of emphasis reflected the apathy found in bureaucracies, as the budgeteer considered the economic aspects as alien to his day-to-day activities. Such an isolationist approach led to serious differences between budgetary policies and the formulation of budgets. On occasion, it looked as if there was no significant connection between the budget speech and the accompanying documents and as if they were brought together hurriedly. This stage has largely been overcome, and experiences in industrial and developing countries reveal that economc analysis has become an integral part of budgeting. While organizational differences between the role of the economist and the budgeteer still persist, the new realities are that each acts as a parameter and as a disciplining force to the other. The budgetary process has also been facilitated by the growth of macroeconomic theory to allow causal relationships between major economic aggregates. Research techniques that permit a greater quantification of variables in the formulation of fiscal policies and, in particular, in the analysis of alternative policies have also become available. The major issues are whether the effects of the budget are in the right direction and are of sufficient magnitude. In providing answers to these questions, consideration should be given to (1) the theory selected to explain the macroeconomy, (2) the nature of the economy (industrial or developing), and (3) the type of measures chosen to assess the budget impetus.

Theoretical Approaches

The growth of Keynesian economics has, as noted in Chapter 1, had a profound effect on the development of fiscal policy in industrial countries. The major goal after World War II was to achieve full employment in these economies, and it was believed that this could be carried out through the management of demand. It later became clear, however, that full employment could not be achieved in this manner without accompanying price instability and balance of payments problems. Later, by the 1960s, the belief was that demand management coupled with incomes policies would reduce pressures on prices. This approach, which stresses aggregate demand as an essential aspect of stabilization policy, is based on the premise that a stimulus to aggregate demand leads to an increase in demand and thus contributes to the growth of GNP. The stimulus, in turn, can be provided through increased government expenditures. Expenditures of government create incomes and stimulate demand, and revenues reduce the purchasing power or the demand of the community and—in a context where expenditures grow at a higher rate than revenues—they have the capacity to add to real resources. Conversely, an increase in government revenues reduces the purchasing power of the community and releases real resources for the public sector. In the process, demand pressures are also reduced. This framework of aggregate demand management continues to play a major role in fiscal policy, although its efficacy is debatable. Another approach labeled as monetarism suggests that real wages and real interests in the economy are determined by the forces of supply and demand. According to monetarists, a government budget deficit (as the difference between total expenditure and revenue) that is financed by borrowing from the central bank induces substantial credit expansion and contributes to increased prices. Further, advocates of monetarism suggest that a deficit that is financed by government borrowing “crowds out” private expenditure and contributes to higher interest rates and that the employment level, which is the basic concern of government, is basically unaffected. After crowding out private sector operations, government activities supplant them but may not add any new employment capacity in the economy. At the same time, however, price increases occur. Monetarism implies that the economy is basically stable and that fiscal intervention through higher deficits has durable effects on liquidity. However, if the assumption of basic stability of the economy is relaxed, then a greater role may be indicated for the budget. The demand management and monetarist approaches emphasize, respectively, the fiscal and liquidity impact of the budget on the economy. In practice, budgetary impact on the economy includes both fiscal and liquidity effects. Fiscal effects are transmitted through purchases of goods and services that represent a net claim on real resources or GNP, and taxes and transfer payments to households and the corporate sector in the budget affect the buying power of the community and, thus, spending for consumption and investment. Liquidity effects flow from government operations affecting the size and composition of government debt.

These broad approaches reflect the framework within which the impact of the budget must be analyzed. The degrees of emphasis and areas of adjustment differ, depending on the situation. One major area of particular concern to open economies is the impact of government operations on balance of payments. In particular, in the context of floating exchange rate systems, the movement of a country's money supply relative to other countries has a significant effect on its exchange rate.20 It is implied that if there is a contraction in public spending and in the domestic money supply, an improvement in the domestic inflation rate is achieved only if the exchange rate is allowed to appreciate. Conversely, the exchange rate depreciates when the public expenditure and money supply are expansionary. The exchange rate is an indicator of the stance of fiscal and monetary policies in terms of a country's dealings with the rest of the world.

The different theories must recognize the structural differences between industrial and developing countries. It can be argued that the basic tools of analysis are the same regardless of the income or economic levels of countries. However, there are well-recognized differences that imply varying degrees of applicability for fiscal and monetary tools. In industrial countries, fiscal policy or demand management within the Keynesian framework consists of reducing unemployment and stimulating demand through deficit spending. In budgetary terms, goals of the developing world are focused on growth and capital formation. Indeed, the key problem for budgetary analysis is one of channeling the available resources for capital formation.

Nature of Effects

It has been noted that government revenues tend to have an income-reducing impact on the community, while government spending has an income-stimulating effect. However, while the underlying philosophy is accurate, the same may not be said about every source of revenue or type of expenditure and borrowing. Much depends on institutional arrangements and, in respect of debt, on monetary policy. It is therefore appropriate to discuss the broad considerations governing budget categories. In doing so, however, it is recognized that there are certain common budgetary features. First, economic analysis implies an agreed definition of the government sector. The budget includes not only the administrative budget, which for various reasons may be limited, but the operations of the government sector as a whole. Although, as discussed earlier in the chapter, the definition of general government and public sector has ambiguities, the national accounts systems offer a useful starting point. Second, economic significance is to be found in the impact of the budget on the economy during the period for which the budget is computed, implying the need for ascertaining the cash flows inherent in the proposed budget. Items that involve incurring obligations but no cash outlays need to be excluded.21 Third, attention needs to be paid to the timing of changes in taxes or expenditures, as there may be lags before their effects are realized. Fourth, the concern here is with the first-round effects of the budget and not with the subsequent chain of events. Although the subsequent impact is also important, its measurement is problematic as it hinges on the lags and empirical relationships between income, consumption, and saving.

The impact of each budget category is unique. Without making an extensive and detailed analysis of each component, it is appropriate to consider certain broad behavioral properties, which are summarized in Table 6. Taxation, by assumption, results in a reduction of consumption. But certain taxes, such as capital levies, estate taxes, and revenues derived from existing assets (as distinct from newly'created assets) may not be paid from current income and therefore may not curtail consumption. In reconstructing the budget for purposes of economic analysis, it would be ideal if transactions that do not impinge on current income could be treated separately for measuring the true inflationary impact of the budget.22 Similarly, the impact of business income taxes is difficult to measure, as part of these taxes would accrue in the form of individual income taxes and therefore would be deflationary. But, in part, business income taxes also represent potential investment. Indirect taxes, including excises and sales taxes, would need specific assumptions in regard to their incidence and shifting. If they are paid by the producer, such payment would represent a reduction in income and would be treated like income taxes. When the tax incidence is on the consumers, however, payment of excises and sales taxes does not affect disposable income but may affect the propensity to save or consume as it is influenced by the real income. Indirect taxes, including duties, add to the cost of materials and raise prices. The effects of taxes on consumption must therefore be carefully balanced by their contribution to higher prices and inflation.

Table 6.Scheme of Economic Analysis of the Budget
Budget CategoriesEffects on Aggregate Demand
1. Receipts
Tax revenues Nontax revenuesBroadly deflationary in view of the possible reductions in demand. Several qualifications operate and much is dependent on whether these payments are made from the current stream of income or from balances
GrantsNet impact is neutral when grants are spent abroad
2. Expenditure
Current expenditure on goods and services and capital formationGovernment expenditures add to aggregate demand and involve net claims on resources. (Purchase of existing assets is excluded from capital formation)
Transfer paymentsGenerally reflect additions to the money income of households. Subsidies add to the real income of households, and their overall impact is dependent on the nature of subsidies and their incidence on producers and consumers
Net lendingGenerally expansionary as they increase aggregate demand; but the impact of fiscal offsets such as increase in revenues or reduction in expenditure has to be taken intc account
3. Deficit (1–2)
4. Financed by
1. Foreign debtGenerally has an expansionary impact but a favorable and countervailing impact on balance of payments
2. Domestic debt
a. Nonbank borrowing (private households)Contractionary in view of the implied reduction in purchasing power and demand. No significant impact on aggregate demand is likely if contributions are from idle balances
b. Commercial banksNo expansionary effect if adjustment is made through curtailment of credit to the private sector. However, where participation by commercial banks becomes possible through additional credit accommodation by the central bank, it would have an expansionary effect on aggregate demand
c. Central bankExpansionary impact on demand through increased income and through additional liquidity

The impact of grants, which is sizable in the budgets of developing countries, needs to be identified separately. Grants represent only a part of the overall package of foreign receipts, which include foreign borrowing. In Table 6, a distinction is made between grants, which are shown along with tax and nontax revenues, and borrowing from abroad, which is shown in the financing part. Foreign receipts when spent abroad are neutral in their impact on GNP and the balance of payments, as they constitute no demand on the real resources of the economy. When foreign receipts are spent within the domestic economy, they constitute a demand on the resources and as such have an expansionary impact on GNP and a favorable impact on balance of payments.

Expenditures encompass a wider variety of components than do revenues, but the major consideration in analyzing the budget impact is the extent to which spending by government creates a demand on the supply of resources becoming available from domestic output and imports. Various categories of expenditures have different implications. In measuring the impact of expenditures, their classification into current and capital expenditures is not relevant. {That concept may be needed for ascertaining the government's contribution to the financing of growth, which is considered later in this chapter.) The classification of expenditures depends on the purposes of the analysis. Expenditures have important effects on output, income, and balance of payments, as well as on distribution of benefits. In view of the diverging policy goals, each broad objective of economic policy may need a different classification. For example, government's requirements of goods and services may exert a strong influence on the structure and location of industry, as is true for defense purchases in industrial countries. In some cases, commodity purchases by government would be helpful in ascertaining the draft on scarce resources. In some countries, particularly in developing ones, it may be necessary to show the import or foreign exchange component of expenditures, with a view to determining and budgeting the needed foreign exchange resources.23 For convenience, however, expenditures are classified into money spent on goods and services, which constitute direct claims on resources; transfer payments, which are indirect claims on resources; services comprising outlays on wages and salaries, which on average constitute more than half of expenditures in developing countries; and gross capital formation, which includes new additions as well as increases in stocks. Excluding the taxes paid in the acquisition of goods and services, outlays on goods and services cause, almost one to one, corresponding increases in demand and inflationary pressure. Transfer payments comprise a large variety of transactions, ranging from interest payments, pensions, and subsidies to households and productive sectors to grants to individuals. When such transfers lead to additional money income, further demand pressures would be created, depending on the propensity to consume. The demand so created will not, unlike goods and services, have a direct relationship in terms of demand and will differ according to the nature of the transaction. If proper analysis is to be made, the impact of each must be identified separately.24

Another category of importance is government lending. It is generally accepted that government is not in the business of lending money to make profits like a banking or financial institution. Lending is undertaken by government to further a policy objective that is not served by normal expenditures and is of two types—aid to other countries and lending within the economy. Lending to countries, when given in the form of tied or conditional spending in the country extending aid, should more appropriately be considered as expenditure.25 Loans given to infant industries, small landholders, and a variety of other recipients constitute an increase in the aggregate demand, although the impact may be less than that of direct claims but more than that of transfer payments.

Government borrowing offers a different problem because it is the area where the liquidity impact of the budget and the links with monetary policy become clear. Borrowing from individual households, which may not be a sizable amount, could imply a contractionary effect in some situations. Public participation in the government borrowing program is not compulsory as is taxation. Taxes reduce consumption by impinging directly on the stream of income. Willing purchase of government bonds by the public implies that the monies come from previous savings and not from current income. However, a reduction in the purchasing power and demand could be implied if bond purchases come from current income and are induced by high interest rates and related tax concessions offered by government. Once the matter of interest rates is introduced, several possible results need to be considered that involve a more extended consideration of monetary policy.

Government bonds are also bought by commercial banks. Banks may extend credit to government by reducing the credit allotted to the private sector. When this adjustment of credit is within a fixed amount, there will be no impact on aggregate demand. However, when credit is extended by banks from excess reserves or accommodation by the central bank, additional liquidity will be injected into the economy, with a resulting expansionary impact on aggregate demand. The same phenomenon arises when the central bank provides credit for financing the budget; the greater the reliance on the bank the greater the impact on aggregate demand is likely to be.

The identities in Table 6 show the broad trends of the impact of the budget. A balance between revenue and expenditure does not necessarily mean that the stimulating effects of expenditure and the restricting influences of taxes are neutralized. Fiscal policy considerations do not end with the accounting balances in one year but are concerned with the change from the previous year and the directions of that change. The budget balance is affected not only by what the government does but also by changes in the economy. Even if the budget is not altered, it undergoes changes from year to year. Tax revenues, reflecting the progressivity of the system, may be more than expenditures when economic activity is high, or expenditures may be higher than revenues because of automatic stabilizers when economic activity is low.

Concepts of Deficit or Surplus

Central to the whole economic analysis is the concept of deficit in presenting budgetary data. Budget deficits were considered in the past to be reprehensible and to indicate bad financial management. The cardinal rule was to balance the budget—a rule that continues to dominate budget making in several countries. In Japan, Indonesia, and the Philippines, for example, it is a constitutional requirement that the budget should be balanced. The balance specified is an accounting balance that requires receipts to be equal to outlays. In practice, such insistence necessitates procedures that include borrowing in the overall receipts. An accounting balance alone does not indicate the underlying economic currents, for, by definition, the totals on both sides of the balance sheet are equal.

In reorganizing the entries on the receipt and expenditure sides of the budget, the basic aim is to facilitate the formulation of economic policy. For this purpose, over the years several measures have been advanced, which may be categorized as (a) single measures, (b) the component approach, and (c) cyclical measures. A common feature for all three approaches is the reliance on and use of national accounts. The single measure's reliance on national accounts is much less and is of recent origin, as will be illustrated below.

The single measure's approach has grown over the years, reflecting the tasks of economic management and the changing economic philosophy. Four distinct concepts have been developed, each one reflecting the demands of economic analysis: (1) the public debt concept of deficit, (2) the net worth concept of deficit, (3) the overall deficit, and (4) the concept of domestic budget deficit.

The public debt concept of the deficit is illustrated in Table 7, where the measure of budget deficit is defined as the difference between revenue (A) on the one hand, and current expenditures (C) and net acquisition of assets (D), on the other. This measure (A − C + D) is equal to net borrowing (B), adjusted for any changes in cash holdings of government. However, as cash holdings are likely to be insignificant, the budget is considered to be balanced if net borrowing remains unchanged from previous years or is equal to zero.26 The public debt concept offers an illustration of the pre-Depression prudent fiscal policies that emphasized balanced budgets and considered debt as an extravagance on the part of the government and as having no justification except in wartime. The implementation of such a budget meant a rigorous discipline but lacked flexibility for economic stabilization purposes. The public debt concept implied that the best fiscal policy consisted of restricting spending to the amount of tax revenues. Later, however, when active fiscal policy had become an imperative, it was felt that the government could borrow as long as the consequent liabilities were matched by an increase in assets. This led to the development of the net worth concept of deficit. In terms of the illustration in Table 7, net worth is defined as the difference between current expenditures and revenues (C — A), which is equal to the excess of net borrowing over the net increase in assets (B — D — E). Implicit in the measurement of pet worth is the requirement of the division of the budget into current and capital expenditures, with the latter being financed by borrowing.

Table 7.A Typical Budget Balance
A. Revenue (tax and nontax)C. Current expenditures
B. Net borrowingD. Acquisition of real and financial assets other than cash
E. Increase (+) or decrease in cash holdings
A + B= C + D + E

A variation of this approach is the concept of current account surplus. The current surplus seeks a measure of the savings that a government manages either by mobilizing more revenues or by limiting current expenditures. The use of the concept has several implications that may be examined in terms of resource effort and budget management. The latter aspect, which is primarily concerned with structures of the budget and their implications for budget making, is considered in Chapter 10. From the point of view of resource effort, the concept is useful in ascertaining the extent of resources shifted from the community to the government. In developing countries, this measure is used for assessing the magnitude of public saving and its contribution to the overall development effort. Frequently, the measure is also used by donors of aid to ascertain the extent to which a community is sacrificing its current needs for future purposes. The concept, however, does not illustrate the impact of the budget, and its usefulness is limited to being an exercise in the mobilization of resources.

Overall Balance

The concept of the overall deficit or balance has several connotations and methods of construction.27 For the purpose of this discussion, the overall deficit is the one illustrated in Table 6, which shows revenues, expenditures, and borrowing as distinct groups, each of which could be used singly or collectively to assess the impact of the budget.28 Each budget category may be related to economic activity by computing it as a ratio of GNP. The overall budget balance or overall deficit, expressed as a percentage of GNP, provides a first approximation and an important single measure of the impact of government fiscal operations. To the extent that it is formulated in advance and revised concurrently during the preparation of the budget, it shows the likely demand effects, as well as the liquidity effects from financing, that are flowing from the budget. However, if the balance is formulated after the budget activity is completed, as is the case in a number of developing countries, its usefulness is only ornamental. More significantly, it implies that the budget is prepared mainly as an accounting exercise and that any economic policy is incidental rather than a guiding spirit.

A variant of the overall budget deficit concept is the domestic balance concept, which came into prominence after the oil price increases in 1973—74. In countries that had large revenues, expanded incomes from government expenditures placed strains on the domestic economy and spurred inflationary pressures. In such cases, budget surpluses, which are expected to have contractionary effects, have in effect proved to be expansionary. The overall budget deficit or surplus concept would be misleading as a policy tool in such a context. To meet the specific requirements of oil producing exporting countries, and other countries in similar circumstances, the technique of splitting the budget into domestic and foreign components has been advocated. Under this approach, the domestic balance is the component of the overall balance from which external budget transactions have been excluded. To illustrate, if country X has a surplus external balance of 500, and if its overall budget surplus is 200, it has a domestic deficit of 300. These aspects need to be analyzed further in terms of the liquidity effects of the budget but this measure indicates broadly the nature of the impact on the domestic economy. The usefulness of the technique lies in revealing the element that would otherwise remain hidden in the aggregative approaches to the overall balance.

These last two techniques have both conceptual and operational limitations. First, the operations and tasks of government are too complex to be satisfactorily captured in a single statement. While this is true, the advantage of the overall balance is that it provides the basic information in a useful format. Second, the technique of the overall balance is an unweighted exercise, implying that all budget items have the same absolute value, and to that extent it oversimplifies a problem rather than trying to solve it. Third, as already noted, the overall concept does not recognize the domestic and foreign components separately. But if it is supplemented by the domestic budget balance concept, the policy purposes are better served. The operational problem lies in evolving appropriate criteria for the separation of the domestic and external sectors and in maintaining budgetary data in terms of domestic and foreign expenditures. For example, salaries paid in foreign embassies may be repatriated or goods bought from local stores may actually have been imported. While these concepts do not give the final answers to the budget question, they provide a method of calculation that is perhaps a significant step beyond the intuitive approaches prevalent in the past. The major problem continues to be one of integrating these analytical processes with the budgetary process.

Other Concepts

To compensate for some of the shortcomings of the aggregative approach of the overall balance concept, a component or weighted balance approach to the budget has been formulated.29 This approach involves the assignment of weights to different categories of revenue and expenditure. The balance derived from the sum of the products reached by multiplying each budget category by its coefficients is considered to be indicative of the budget impact. The choice of weights is based on extensive empirical work, as otherwise there is the danger that they would reflect prima facie judgments on the nature of financial transactions. The use of the concept has not been very extensive, partly because of this danger and also because the coefficients vary over time and among categories. It is difficult to evolve a schedule without specific time limits, given that the economy itself is in a state of flux. The technique, where used, has been helpful in ascertaining the impact on the balance of payments. In countries where increased incomes generally translate into increased demand for imports, this approach is a useful guide.

The overall balance approach and the other approaches described here mainly seek a relationship with the GNP. Three major concepts, with varying degrees of success and applicability that have developed during the last four decades seek to relate the budget deficit to the stage of the business cycle and they involve the separation of the budget effects on the economy from those of the economy on the budget. The three concepts developed in the United States, the Federal Republic of Germany, and the Netherlands, respectively, are the full employment surplus or balance concept, the cyclically neutral balance concept, and the structural budget margin concept. These concepts have complex features and have been the subject of considerable academic study in recent years.30 The following discussion aims at presenting the main features of the concepts, their limitations, and current use.

Full Employment Budget

The full employment budget concept was evolved in the late 1950s and found acceptance in 1972 when the President of the United States used it in his annual budget message. In essence, it represented a budget in which the expenditures would not exceed the revenues generated by the economy at a full employment level, which was defined for the purpose as equivalent to 4 percent unemployment of the work force. The message noted that the “full employment budget is in the nature of a self-fulfilling prophecy. By operating as if we were at full employment, we will help to bring about that full employment.”31 The concept is a hypothetical construction designed to show the estimates of revenue at an assumed full employment level of output for the existing or assumed structure of taxation and the existing or projected levels of government expenditure. Inasmuch as it is related to an economy moving on the path of full employment, it differs from the actual budget and is also independent of the short-term fluctuations of the economy. The concept is quantified by projecting revenues as a part of GNP on the basis of the existing or desired levels of taxation, and expenditures are adjusted for unemployment benefits that would be paid at the level of 4 percent unemployment. The other government expenditures are assumed to be unaffected by deviation from full employment levels. The size of the full employment budget surplus or deficit is calculated by ignoring the part of the actual budget margin that is due to cyclical factors or to the divergence of the economy from full employment. The full employment budget surplus or deficit varies therefore, not with the level of economic activity but with reference to the level of expenditure and pattern of unemployment benefits, on the one hand, and the rate of taxation, on the other. The concept has been utilized primarily as a presentational tool to demonstrate the need for cyclical deficits, use of countercylical policy, and acceptance of actual budget deficits. This had some initial appeal in justifying the actual deficits in terms of the surplus at full employment level, but tended to be viewed later in some quarters as a self-fulfilling prophecy for greater and continuing deficits.

The full employment concept itself was subjected to debate on a broad level in terms of being a diversion of attention from the actual budget to more detailed criticisms of its clinical aspects. The principal use of the concept to demonstrate the need for deficit in a period of recession was generally accepted, but what was questioned was the methodology used. If the concept were to serve as a norm, what would be the appropriate level of the surplus in the long run when the cyclical factors are eliminated? As a cyclical measure, it presented several difficulties. For one thing, it consists of an unweighted exercise; for another, it extrapolates actual effective tax schedules without proper weight to changes in the shares of taxes consequent to budget changes. Also, the rate of price increase to be used for computing money incomes and tax collections at full employment levels does not appear to have been given due weight. For these reasons, the concept did not achieve full operational effect and remained useful only for educational purposes.

Cyclically Neutral Budget

A different measure was developed in the Federal Republic of Germany, in which the budget norm is divided into “neutral” and “cyclical” elements. Under this norm, the actual government expenditures are considered neutral when they remain a fixed proportion of potential output or GNP and when the ratio of tax revenues to actual GNP is the same as in a base year. For this purpose, 1966 was chosen as the base year in which the neutral expenditure ratio was 28.5 percent and tax revenues were 22.9 percent. The neutral deficit in subsequent years was one that resulted when expenditures grew at the same rate as potential output and revenues at the same rate as actual output. The objective of the exercise is to ensure that government expenditures do not grow at a higher rate than the potential output and thus claim more real resources for the economy. In the short run, the concept implies that, when the actual GNP falls short of potential output, neutral revenue is reduced in proportion to the GNP shortfall while cyclically neutral expenditure remains unchanged. The concept is applied by relating expenditures to potential output and revenues to actual GNP values at the same rates as are found in the base year. The actual budget balance in each year is tested against the computed neutral balance and, if the actual deficit is more than the neutral year deficit, it is considered to be expansionary. If the actual deficit is higher in a boom year, it would exacerbate inflationary pressures, while in a year characterized by recession, it would be countercyclical.

The German concept was evolved at a stage when the economy was growing and was intended to minimize the revenue-induced expenditures that would otherwise take place. It was also based on the feeling that the base year represented a norm. The concept itself, however, had some limitations in that, like the full employment surplus, it did not distinguish among the categories of expenditure, nor did it provide for the separation of the impact of the economy on the budget. Also, if it had been used, it would have meant that the base-year approach would have become a new orthodoxy, with all the rigidity implied. The German authorities have not used the concept in their official publications, as it is considered that the concept needs further refinement.

Structural Budget Margin

A variation of the neutral budget concept is to be found in the structural margin concept developed by the Netherlands authorities about the same period. The concept is related to the automatic revenue increase resulting from the capacity real growth in the economy that is considered as the budget margin that could be utilized either for tax cuts or increasing expenditures. The concept had its origins in an attempt to restrict the tax burden. The use of the concept consists of testing the annual revenue and expenditure decisions against a structural standard that is derived from the trend of growth of national output and the tax system. For purposes of calculating the “margin,” it is expected that budget revenues and expenditures would increase at the same rate as the structural increase in national income. If tax rates are not lowered and, given the progressivity of the system, tax revenues will increase faster than national income. The sum of the margin is then calculated as the sum of the proportional increase of government expenditures and the trend-based growth of tax and nontax revenue. This algebraic sum is then used either for reducing taxes or increasing expenditures, but both types of adjustment must remain within the sum. For operational purposes, the Netherlands authorities established a norm for the structural budget balance, starting from a base year in the mid-1960s in which employment and the balance of payments were considered to be in equilibrium. For assessing the medium-term budget policy, this norm of the budget balance is used as in the case of the cyclically neutral budget concept. To mitigate the overall impact of the progressivity of the tax system and inflation, a partial system of indexation of personal income tax was introduced in 1971. On the expenditure side, the budget is divided into relevant and nonrelevant expenditures. The latter include debt repayments, contributions to international financial institutions and related expenditures and are excluded from budget analysis. The margin arrived at on these bases is then used for “impulse analysis,” which is designed to determine the net stimulative effect of the actual budget on the level of aggregate demand and thus is more concerned with cyclical fluctuations in the economy.

The implementation of the technique, which was in use for some years, ran into difficulties in the mid-1970s, both in technical and political terms. Technically, it was recognized that a budget norm evolved for the purpose of maintaining a budget balance and the choice of a base year in the 1960s was no longer appropriate in a changed context where the aims of the budget policy are to prevent a decline in the real medium-term growth and increase in unemployment. The deficit or balance norms are now derived from a medium-term macroforecasting model. The Netherland authorities also changed the acceptable budget margin deficit from an absolute amount to a constant percentage of income. In a context in which private investment was growing slowly, it was considered acceptable for the actual financial deficit to exceed the fixed percentage of national income. This, however, led to a rapidly rising deficit and very soon severe problems were encountered in financing it. In turn, this led to the introduction of a procedure known as the “emergency brake,” which consisted of setting an upper limit for the deficit as a percentage of national income. Operationally, the structural budget margin emphasized the margin or deficit rather than the desirable volume of spending, which, in principle, could be widened or narrowed as desired by means of fiscal measures. Also, as higher-than-expected inflation led to an increase not only in public expenditure but also in revenue, the concept did not exercise any downward pressure on the budget. In political terms, it appears that the concept was used by the coalition of parties in power, either to increase revenue or to reduce expenditure.32 For these reasons, the use of the technique was temporarily abandoned in preference to a macroforecasting model. (The features of these measures are summarized in Table 8.)

Table 8.Selected Features of Measurement Concepts

of Concept
RevenuesExpendituresBudget BalanceStatus of Concept
Overall budget deficitGenerally relates revenues as a ratio of GNPRelates expenditures as a ratio of GNPEmphasizes the level of the overall deficit (or total borrowing) as a ratio of GNP. If the movement is positive from the previous year, it is considered to be expansionaryNormally utilized as a first approximation of the effect of fiscal activities on income, but measurement is less precise. A useful benchmark in budgeting and facilitates a quick identification of the changes in total borrowing and their implications to cash management. A general rule of thumb for those engaged in fiscal policy formulation
Component approach
Weighted budget balance approachWeights are attached to various types of revenue under assumptions of incidence and shifting of taxes to measure their first-round impact on GNPWeights are also attached to categories of expenditures to assess the first-round impact on GNP and direct effects on balance of paymentsThe sum of the products derived by multiplying each budget category by its weight is considered as the weighted budget balance. Its impact on GNP is considered as a reliable indicator rather than overall budget deficitThis approach is used in formulating econometric models to ascertain the directions of macroeconomic policy; it is also used to assess the impact of expenditures. Overall utilization of the technique has been rather limited
Cyclical measures
Full employment surplus budget conceptProjects tax revenues on the basis of actual effective tax schedules implicit as shares of GNP at full employment, which is defined as a constant rate of employment at 4 percent of the working forceIt is assumed that expenditures will not vary much except for unemployment compensation corresponding to the full employment of laborFull employment surplus represents the difference between estimated full employment revenue and full employment expenditure. Change in balance is used as an indication of cyclical impact of fiscal policyThe concept is used primarily as a presentational device and to demonstrate the need for cyclical deficits. The concept is not used for medium-term fiscal planning in the United States
Cyclically neutral budget conceptCyclical neutral revenue is calculated by multiplying the base year ratio to actual GNP and then multiplying the subsequent actual GNP values by the same ratioCyclically neutral expenditures are calculated by multiplying the base year ratios of expenditure to potential outputActual government expenditures are considered to be neutral when they remain constant as a ratio of potential output or GNP capacity. The neutral balance is one where the share of actual government expenditure in potential GNP and the ratio of tax revenues to actual GNP are the same as in a base full employment equilibrium year (1966). The main objective was to restrain the growth of expendituresThe concept is used for informal policy guidance in the Federal Republic of Germany but has no official sanction
Structural budget marginProjections made on the assumption that revenues would show the normal rate of growth if output grew on a specified path. The margin is equal to the expected GNP trend-based growth of tax and nontax revenues.Expenditures are estimated to grow at the same rate as structural GNP.Tax revenues increased by inflation are to be partly neutralized through partial indexation of income tax. The remainder of the margin is to be used for increasing expenditures or for reducing tax rates.Primarily used in the Netherlands, the norms for the margin were derived from a base year in the mid-1960s when employment, investment, and balance of payments were considered inappropriate for the current situation. The use of the concept was given up during the late 1970s in favor of a macroeconomic forecasting model, but it was revived in 1980.

Some of the shortcomings of the techniques have already been discussed. If the overall budget deficit is a simple and straightforward initial assessment, the component approach, while offering a more detailed look, also implies a static and linear picture of the economy. The cyclical concepts offer useful hints of the direction of the economy but are less than precise in measurement and are in need of refinement.33 These aspects do not, surprisingly, militate against economic analysis but they do indicate the continuing need for more work in this area. Their application to developing countries has not been possible because of the structural differences noted earlier. Further, these concepts emphasize the estimation of potential output, the computation of which is rendered doubly difficult in view of the uncertainty of the crop outcome in these economies. In some cases, application has been achieved by substituting trend incomes as related to potential output. In a few cases, calculations are made as integral parts of an econometric model, but their reliability is no more than that of the model itself. There is still much progress to be made.

The primary need of developing countries is often interpreted as the measurement of the growth impact of the budget rather than the liquidity impact. This aspect is, however, not served by the current account surplus concept. Measurement of growth lies in the impact of the outlays in different growth sectors, which cannot be fully reflected in income-based measures such as national accounts. To compensate for this, efforts are being made to evolve a series of human, economic, and social indicators to reveal nutritional levels, education, housing, water supply, sanitation standards, and life expectancy.34 These aspects concentrate on the outcomes of government expenditures, the measurement of which is, however, appropriately a part of performance budgeting. The development of economic analysis in developing countries is contingent on up-to-date national income accounts and priority must be accorded to that.35

General government is a concept used in national accounts and is distinct from the more technical use of the term in government budget where it is used as a synonym for General Account. See also Chapter 13.

A. Waterston (1965), p. 210, et seq.

Writing in 1956, Jesse Burkhead observed that the nature of budgeting and related problems is different in developing countries, for “there is a shortage of accounting and administrative skills; there are gaps in the administrative organization; there is an inadequate sense of moral responsibility for the conduct of government affairs” (Burkhead, 1956, p. 455). Some of these are common, although in varying degrees, also in industrial countries. In any event, it is difficult to measure the adequacy of moral responsibility of a government.

In some cases, it is very difficult to determine the market prices of resources. Niskanen cites the electromagnetic frequency spectrum and the air space as two areas for which no user fees are paid and for which no prices exist either within the government or the private sector (Niskanen, 197), p. 35).

For a survey of these aspects, see John P. Crecine (1971), pp. 210–61; and Steiner (1974), pp. 241–357.

Also, to the extent that outlays on defense or development are reduced as a proportion of the budget, their importance will also decline. In some countries, current expenditures may be viewed as the major determinant of the budget, with investment expenditures being a sort of residual.

The estimates are to be treated as instruments of overall budget policy and should have some flexibility. To that extent, analysis of aggregate estimates to establish linear relationships between legislative and executive branches or the pattern of allocations for agencies to predict budget outcomes, or to postulate models for describing the aggregate budgeting process of a government may have certain limitations. Studies made by Davis, Dempster, and Wildavsky have offered some explanation (see Byrne, 1971, pp. 292–375) of these relationships but in the process have tended to assume typical behavior for executives and legislators. Sensible executives are always responsive to legislative needs, for they are expected to reflect collective preferences of the community. This behavior is, however, contingent on the merits of the program and the general financial situation. The analysis in these studies is too aggregative and excludes consideration of the revenue position and its impact on estimates. Budgets are seen merely as compilations of expenditure proposals, with no foundation in economic purpose. The main limitation of the approach by Davis, Dempster, and Wildavsky is the implication that determination of agency requests is always done in terms of previous experience rather than a useful rule of thumb resorted to in the preliminary stages of an iterative process. Models and statistical studies are obviously more useful when exogenous factors are taken into account.

The system of continuing charges occasionally leads to misleading practices. In some cases, military expenditures are included in the expenses of the President.

This approach known as incrementalism is considered in detail in Chapter 4.

Leslie Chapman says that any civil servant who is bent on saving will find that he has few friends and that he naturally adopts a “play for safety” philosophy (Chapman, 1979), p. 55.

It was a common experience in several OPEC countries for spending agencies to feel that they were not given their due share of oil surpluses, while in fact the finance ministries were trying to restrain inflation by containing expenditures.

Douglas Hartle contends that a significant factor in the growth of government expenditure is the budgetary process itself, although this is not the only factor. In support of this claim, he refers to the conventional belief that politicians resort to the easier option of increasing expenditures rather than raising revenues and that governments believe in increasing expenditures. At the process level, he argues that insufficient attention is given to several important problems that underlie expenditure growth and that these can be fully solved only when there is political will and recognition about the role of expenditures, not in collecting votes but in stabilizing the economy. Hartle tends to overemphasize the political aspects. While their importance is not a matter of debate, the concern here is more with the systemic factors at work within a political system that may be assumed to have specified its economic and social preferences. The role of a system is to lend clarity and facilitate the appraisal of political goals. See Douglas G. Hartle (1978), p. 6.

The consideration of a loan appears to be determined by the accounting technicality that it forms part of the borrowed funds of government and that its repayment would impose a certain financial discipline on the recipient. Whether loans and direct expenditures have different allocative effects is an aspect that has not received much attention, except to provide the general dictum that both must endeavor to produce benefits equivalent to their opportunity costs.

The new Cambridge School, as it has come to be known, contends that fluctuations in balance of payments are primarily attributable to changes in the government budget deficit and that the appropriate policy stance would be to set public expenditure and taxation at the level required for balance of payments at full employment level. Its studies are based on the experience of the United Kingdom. For a detailed but nontechnical account of this approach, see the Ninth Report from the United Kingdom's Expenditure Committee, Public Expenditure, Inflation and the Balance of Payments (1974b).

The choice of the base of accounting that would best reflect the budget impact has been a matter of some debate and is considered in Chapter 13.

One of the earliest clinical approaches for the measurement of the impact of the budget categories was by William H. White (1951), pp. 355–78.

In Australia, government budget expenditures show the domestic purchase component and foreign expenditures.

Several countries have formulated estimated demand weights for categories of expenditure. For an illustration in the United Kingdom, see the Expenditure Committee's report, Public Expenditure and Economic Management (1972b).

In the United States, transactions shown as loans in the budget are treated in the national accounts as expenditures in the form of grants, in view of their tied nature and long amortization and grace periods.

For an extended discussion of the evolution of the concepts of budget deficits, see Economic Commission for Asia and the Far East (1956), pp. 11–25.

For an illustration of the practices in the late 1960s, see United States, President's Commission on Budget Concepts (1967a). For a more recent survey, see United Kingdom, Expenditure Committee, Memoranda on the Control of Public Expenditure (1978a).

For an extended discussion of this approach, see International Monetary Fund (1974). Categories shown in Table 6 differ from those in the Manual in matters of detail. For a discussion of the relationship of this concept to national accounts, see Poul Høst-Madsen (1979).

For a selective discussion of these concepts, see Sheetal K. Chand (1977), pp. 405–49; Arnold H. Packer (1971), pp. 139–49; Joergen Lotz (1971), pp. 3–31; Thomas F. Dernburg (1975), pp. 825–57; Daryl A. Dixon (1973), pp. 203–26, and (1972), pp. 615–46; and Theo A. Stevers (1968), pp. 44–73.

United States, The Budget of the-United States Government, Fiscal Year 1972 (1971), p. 7.

See Th. A.J. Meys (1982), pp. 242–66.

Also they do not offer any useful guidance on the monetary consequences of the financing of the budget, which need to be studied separately.

National income analysts suggest that national incomes of developing countries are often understated. Implicitly, this may overstate the extent of fiscal impact. In the short term, adjustment of this factor depends on the policymaker's judgment.]

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