chapter ten Budgets: Structural Aspects

A. Premchand
Published Date:
March 1989
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Every single thing's crooked

LEWIS CARROLL, Through the Looking Glass

Budget Classifications

There are several ways in which budget transactions can be classified. Some of these have been illustrated in the preceding chapters. Early in the development of budgeting and reflecting the concerns of the newly acquired legislative control, the primary consideration of budget classification was to provide a better understanding of the intentions and purposes of government for which funds were sought. As further progress was made and as legislative supervision was established in a clearer form, what influenced the budget structure was the manner in which accountability could be ensured. The objective was not only to provide information on what the government proposed to do but also to reflect an understanding between government and the legislature of the specific purposes of expenditure. The achievement of this accountability implied that there were enough safeguards within governments to accomplish the tasks inherent in the understanding. To this end, the budget structure was so devised as to indicate the full responsibility of the spending agency. The budget heads—or the nomenclature of the budget—were therefore devised to be related to each spending department. The budget structure provided accountability and a series of vantage points within government to control its own operations. Later, when for reasons of management and efficiency it became necessary to measure costs, budget structures had to be altered to take care of this additional task. Since the depression years and, more specifically, with the start of economic planning, other changes were needed in the budget structure. Major changes in the budget structure were first made for economic reasons during the 1930s, when the dual budget system was introduced in Nordic countries and later was emulated by other countries. After the introduction of economic planning, however, dual budgets acquired a new dimension and capital budgets became vehicles of development and growth. With the spread of national accounting, with the dominance of allocative efficiency concerns, and with the application of quantitative techniques of analysis, the need for redesigning budget structures for the new tasks became even more urgent. Priority planning, identification of objectives and their relationship to a function, and appraisal of the cost benefits and associated aspects exerted greater influence on evolving budget structures. To a lesser extent, requirements of international comparability also had some influence in designing the budget structures.

In this evolutionary process, due regard had to be paid to the classic principles of budget classification. The classification was to be pertinent, and was to serve not merely the legislative requirements but the changing requirements of the decision maker. It was to be consistent and uniform, for in the absence of these features, data on government operations would not be at all useful. The structure had to be practical and all objectives needed to be outlined in such a way that the many branches of bureaucracy could perform the tasks with the same degree of understanding. As governments grew and their transactions multiplied, the need for practicality became even more important. The structure had to be manageable and appropriate, but not excessively detailed or too broad in its characterization. To a great extent, these objectives were kept in mind when formulating budget structures. Given the diversity of purposes, however, no single system could have served all the objectives with equal success. Some would have been better served and some less. Where one or two objectives were dominant in shaping the budget structure, other objectives were served by supplementary or other auxiliary systems. The existence of these auxiliary systems should not detract from the merits of the overall structure but should more appropriately be viewed as a way of meeting diverse and occasionally conflicting requirements.

The budget reforms during the last three decades are in fact a history of the efforts to improve budget structures. The importance of the budget structure is more than the sum total of the above-mentioned parts. It stems from the fact that the budget structures, which aim at adapting information for the decision maker, have generated a system of values and an approach to decision making. The decisions reflected the concerns of the budget structure and many of the attributes of centralized financial control are to be found in the way in which the budget is structured. Although budget structures were originally conceived as a means, they acquired a unique status, which in due course dominated the attitudes on what is considered important and the general approaches on all matters concerning government finances. This set of attitudes became a discipline and was viewed as the single most important factor contributing to distortions in decision making. It was to remove some of these anomalies that budgetary reforms were initiated. However, technical details received less attention despite their importance. It was a matter that came to be dealt with and to be heavily influenced by the manuals on national accounts, or other accounting materials.1 In the legislatures, too, there was a feeling that it was a technical matter best left to specialists.2

The reforms in the budgetary structure achieved much. Although there are some parts of the globe where considerable progress has been achieved, there are many others where much remains to be done. This chapter deals with the changes that have been made, the issues encountered, and those that remain. The approach of the chapter is an eclectic combination of the normative and positive aspects. While there is no community where a budget has yet to be introduced for the first time, the normative aspect deals with the desirable features of a relevant system and provides a reference point for assessing classification practices. The positive aspects are more concerned with actual developments and their problems.

Current and Capital Budgets

The most important distinction in the budget structure is between current and capital transactions. The idea of separating the budget into two sections, in which the current budget—covering current expenditure—is to be financed, in principle, by taxation, and the capital budget—covering the acquisition of newly produced assets in the economy—is to be financed by borrowing, gained acceptance in the late 1930s. Since then this issue has become controversial, gaining over the years both strong supporters and opponents. Since the introduction of this distinction, several variants have been introduced such as recurring and nonrecurring, ordinary and extraordinary, revenue and capital, current and capital, current and investment, above and below the line, and development budgets. Implementation of development plans led to a frequent association of investment components with the capital budget, and there is a view that such a separate identification facilitates the formulation of plans and fiscal policy. The variations illustrate the great diversity of budget structures and the existence of many types of double budgets, and they make formidable the task of providing a common definition that captures the nuances of these structures. The approaches of national accounts systems or recent experiences do not ease the situation. Some of the industrial countries that had dual budget systems abandoned them during recent years in favor of additional analytical abilities gained in the use of national accounts. At the same time, the need for having a capital budget, as an appropriate check on the spending proclivities of government, is believed necessary in the United States; many developing countries find the use of the dual budget system advantageous and beneficial, and it is not viewed as a mere legacy of the colonial system. The current discussion provides two polar positions regarding the dual budget system—as an anachronism and as an imperative of the current situation. Depending on one's background or the specific situation, a case could be made for giving up the practice or, alternatively, for strengthening and streamlining the system. This underlines the need for a detailed discussion of the nature of the current and capital budgets, the initial influences, the economic, financial, and managerial considerations for it, and the measurement issues.

The meaning of the capital budget varies in the countries where it is in use. Broadly, it reflects, on the revenue side, proceeds from the sale of government property, or taxes that are presumed to be paid from private capital as distinct from income such as death duties and capital levies, and, where practical, in the real sense of the capital budget, depreciation allowances and proceeds from borrowing. The capital expenditure budget has two approaches—a capital expenditure budget comprising outlays on the acquisition of newly produced assets that are a part of a nation's gross investment for the period, and a finance budget comprising depreciation allowances and acquisition of previously produced assets that do not affect the volume of production but that involved a periodic valuation of government assets. The assets may be both real or financial, the latter reflecting government lending operations and other financial assets acquired. A capital budget may also be used to denote, on the receipts side, the foreign aid received, and on the expenditure side, projects and programs that are covered by foreign aid. In a number of developing countries, capital budgets are used to reflect the plan programs and investments and their scope and operations are coterminus with development plans, even if some of those activities do not result in acquisitions of assets. Notwithstanding this divergence, the principal accepted feature of a capital budget is that it primarily consists of the proceeds of borrowing, which are then used for the acquisition of assets, leaving the net worth of government unaltered.

During the 1930s, borrowing to build assets was considered acceptable. The increase in government liabilities was matched, in the event, by an increase in assets. But the position would change, however, if the proceeds of borrowing were to be used for financing current expenditures as that would reduce net assets. Viewed in terms of net worth, a distinction became necessary between expenditures that led to the creation of assets and those that did not. As capital expenditures meant an equal and balancing increase in assets, budgetary deficits and surpluses became associated with the deficits and surpluses on the current account.

The equation of borrowing with asset-creating expenditures is derived from commercial practices. The most important way for a commercial firm to maximize its profits would be for its receipts, in addition to covering its operational expenditures, to also cover expenses representing the use of capital. The surplus on its current account would reflect its capacity to augment its net worth and is its measure of profitability. Application of this principle to government, however, is fraught with technical and philosophical issues that are difficult to resolve. In technical terms, the application of the commercial approach to government would need the maintenance of depreciation or amortization for all assets. In turn, this would involve an enormous outlay on people and time with benefits that are, at best, doubtful. More practically, it is found that even in countries with separate capital budgets, no depreciation is made in the budget.3 Moreover, the assets in government have multiple uses and because their purpose is to serve as public goods that are not marketable, their valuation becomes intractable.4 Also, the private sector practice of allocating costs over time cannot be extended to government. In the private world, outlays on the purchase of real assets, for example, plant and equipment, are capitalized in the year in which they are acquired and are written off over the life period of that asset in the form of depreciation allowances. The phasing of these allowances over a period reduces the volatility in reporting costs and the net income of the firm. In government, the real cost cannot be passed on to future generations and when the timing, as well as the magnitudes of capital outlays, is irregular, as is true during a period of planned development, the inclusion of both capital and current outlays at the time they are incurred will complicate the problem of compiling annual costs and benefits,5 Moreover, capital equipment in government may have multiple uses and it is difficult to allocate costs for its various uses. Philosophically, it is argued that asset creation tends to relegate the role of government from provision of social services to a lower level and that, in any event, asset creation by itself cannot be an adequate justification for government borrowing.6 Decisions concerning the resources over which the government seeks control are based on wider considerations. While depreciation would provide for the extension and replenishment of fixed assets and liabilities, it appears that the analogy of the private sector should not be overextended. As the Crick Committee noted three decades ago “the concept of solvency” as applied to a government defies precise definition and, in any event, should not be judged by the tests ordinarily applicable to a business undertaking.7 Notwithstanding these inherent limitations in the analogy of the private sector, the technique gained easy acceptance because it provided a way out of the depression and also facilitated political agreement.8

Economic Considerations

Several economic considerations favor the dual budget system. Briefly, these are that the structure clearly shows the current and capital outlays, that it provides a clear identification of borrowing and its utilization, and that it delineates information on the actual capital formation. Implicit in the plea for the separation of current and capital outlays is the above-mentioned belief that current expenditures should be financed from taxation and that surpluses thereon should be used, together with borrowing, for financing capital outlays. This has contributed to the emergence of the balance on the current account as a key variable in economic policy. As noted earlier, the attitude that loan funds are less acceptable for current expenditures has led to the adoption of a more stringent approach toward their review and inclusion in the budget. Some contend that the use of current balance as an indicator of development or tax effort has become a theology, and that in the process, the larger purposes of the budget have come to be neglected. For example, from the stabilization point of view, it is the size of the overall deficit and the pattern of its financing that are far more important. Similarly, it is suggested that the application of the current account system on the same basis as an operating surplus in a commercial firm might imply that a deficit on the current account was due to extravagance or wasteful expenditure. It may thus introduce biases in the allocation of resources. Further, the existence of two budgets and the appearance of a balance in them might pose a psychological barrier to adequate taxation during periods of inflation. Various considerations discussed earlier suggest that the need for capital budget should be seen not merely as a rationalization of borrowing but, in the wider context of the formulation of fiscal policy, in terms of overall expenditures and the appropriate mix of taxation and borrowing relevant for the purpose. Expenditures should be subjected to broader tests rather than rushing to facile conclusions that expenditures on the current account do not contribute to the development of the national product. It could also be argued that some of these contentions are based on exaggerated fears on the use of the distinction and that, within limits, the dual budget system offers a rule of thumb or a first approximation. It is only when the system goes beyond a certain stage and becomes an obsession that some of the ill effects are generated. The capital budget has the inherent feature of ensuring outlays that are financed by loans yielding a return higher than the cost of raising them. From a managerial point of view, capital budgets so organized force the decision maker to evaluate the prospective returns and recognize implicitly the capital shortage and the need for its apportionment to obtain the highest returns. The capital budget enables a better determination of the responsibility within government and provides an implicit separation of funds, phased over a period, to be spent on a project. The critics of the dual budget system argue that the need for a return, either in the limited financial sense or in the broader context of the social return, is a view that needs to be applied over a wider spectrum of public expenditure and not confined to capital budget only. Also, borrowing-spending can always be more expansionary than taxation-spending, and persistence of high government borrowing may reduce the funds available for private investment and contribute to raising the interest rates.

As for providing information on capital formation in the government sector, those who favor a budget without these distinctions suggest that the required information should more appropriately be compiled on a supplementary basis rather than on a separation of the budget.9 Indeed, such calculations are made as a part of the periodic reports on national income. But then it could be argued that the existence of capital budget (properly organized in terms of the national income accounts), while not a prerequisite, will facilitate the quick compilation of national accounts. During the period when national income accounts are still being refined, as is happening in several developing countries, such a separately organized capital budget may prove a valuable asset. In industrial countries, where national income accounts are forecast and published regularly, the need for such a budget may be less keenly felt.

Measurement Issues

The matter of the choice between dual budgets and a unitary budget is also influenced by the more practical considerations relating to the criteria to be used to determine items for inclusion in the current and capital budgets. The formulation of the criteria, however, has been a matter of as yet unresolved dispute, which again illustrates the difficulty in evolving economic principles for daily application. As borrowed funds are the primary means of financing the capital budget, it is natural that an important criterion should be the productivity or the revenue producing capability of the proposed expenditures. Outlays have been classified, for this purpose, into “self-liquidating,” covering those projects that provide an adequate revenue feedback for paying interest as well as the repayment of the principal, and “self-financing” projects consisting of those that can only pay interest charges. The application of this principle to government operations is rendered difficult, partly because revenue receipts form a part of the general pool and partly because most expenditures at the central government level are in the form of transfers to other levels of government and assets, if any, may be created there. 10 Also, while assets may be created, they may not necessarily be revenue producing or they may have an uncertain future. The creation of the asset implies an expectation of income or services but their outcome may be at an indeterminate point of time. A rigorous application of this principle may reveal that expenditures that pass this test should be small.

Yet another suggested criterion is that the classification should be done with reference to the life expectancy of the asset and assets with a life span longer than one year should be included in the capital budget. A strict application of this would result in the inclusion of too many items of daily use to be within manageable limits. It is for this purpose that a combination of the asset features and life expectancy have been used for defining the criterion for inclusion. The system of national accounts, for example, views this in terms of capital formation measured by expenditures on tangible assets—“on additions of new durable goods to the stock of fixed assets.” The emphasis on tangible assets has, however, been criticized because many development activities that might increase future income may not lead to the creation of tangible assets. The approach of the national accounts system follows the traditional Keynesian lines that were mainly concerned with the stock of capital. The empirical findings of Kuznets11 and others have demonstrated, however, that capital accumulation per se was not too significant for the rate of growth, and a greater part of growth was to be ascribed to the increase in the use or efficiency of productive resources. Outlays on family planning, research and development, or the training of civil servants have all the innate potentials of contributing to economic growth. Such potentials are not captured in the tangible or durable goods approach of national accounts. Development economists believe to be appropriate an approach that emphasizes investment for purposes of increasing future income, regardless of tangibility. An extension of this approach is the implicit suggestion that a new set of definitions and conventions should be worked out as a part of the national accounting system.12

The definition provided by the System of National Accounts (SNA), however, excludes expenditures on military facilities, including barracks, transportation, and equipment, from tangible assets, presumably in the belief that these outlays are not productive, that they have a high rate of obsolescence and an uncertain future.13 More problematic is its treatment of outlays on repairs. In terms of SNA approaches, outlays on current repair are those that keep the assets “in proper working order,” while capital outlays on repairs are those that “lengthen the expected normal lifetime use of fixed assets or increase the productivity of these goods significantly” and that, in order to be classified as capital, the outlays should be “substantial.”14 Net capital formation is derived from gross capital formation by subtracting the consumption of fixed capital, which is that part of the gross product that is required to replace fixed capital. In computing net capital formation, no consumption of fixed capital is allowed for assets of government, such as dams and roads, as outlays on their repair and maintenance are assumed to maintain the assets in their original condition.

There are several problems in the measurement of capital items in terms of national accounting concepts. Apart from the conceptual difficulty associated with the narrow scope of tangible assets, the one-year longevity consideration would contribute to discrepancies, if rigidly adhered to, between quarterly and annual accounts. The distinction between repair and maintenance is arbitrary and, in the last analysis, would imply substituting the judgment of the national accounting statistician for that of the budgeteer. 15 The measurement becomes more difficult in a context of uneven application of the criteria.

The issue is frequently raised whether capital budget is developmental or whether the development budget is a capital budget. This has arisen because, as pointed out earlier, these terms have sometimes been used interchangeably and also because a major part of development outlays are met from the capital budget. Development outlays are clearly much broader and ideally would include several elements of capital expenditures and expenditures on the development of human beings and related matters. The capital budget is narrower and inclusion of items in that part of the budget is not necessarily in terms of their development character. Moreover, development outlays as a concept is rather amorphous and ambiguous. It is hard, therefore, to draw demarcation lines between these expenditures. Much is dependent on the time element, for what is developmental today might be a capital asset tomorrow.16

Country Experiences

The implementation of capital budget reveals several approaches that can be illustrated from the experiences of the United Kingdom, Sweden, the United States, and India. In the United Kingdom there was no formal capital budget but, in the presentation of exchequer accounts, a distinction was made between “above-the-line” and “below-the-line” items. The former consisted predominantly of current outlays and the latter comprised payments for which the Treasury had power to borrow. The absence of definite criteria complicated matters and in presenting the budget for 1948–49, the Chancellor recognized that some capital items were being charged to the revenue side and that the meaning or the significance of the emerging deficit or surplus was far from clear,17 For a better understanding of the situation, however, an alternative classification in the form of analytical statements was appended to the annual budget. The purpose of these statements was to facilitate economic analysis rather than for administrative convenience, while the conventional distinction of below the line and above the line continued in the budget document. With the gradual development of national income concepts, the practice of supplementary alternative classification was abandoned. Finally, in implementing a wide-ranging accounting reform in 1963, it was recognized that it was preferable to focus on the preparation of economic tables that are capable of interpreting general economic developments than to become involved in the legalistic distinctions between current and capital outlays.18 Its current practice is to use the national accounting framework, and the economic classification of the budget provides an expenditure analysis of consumption expenditures and capital formation.

In Sweden the capital budget was formally introduced in 1937 as a part of the budget reform that envisaged the balancing of the budget over the business cycle, thus permitting borrowing during a depression and a budget surplus during a boom period.19 In the new budget system, only revenue producing or profitable investments were considered as assets and non remunerative investments were written off on the current budget.20 The capital budget was primarily a listing of investment authorizations for government undertakings and funds. The current budget did not provide for annual depreciation allowances, which were provided in the respective budgets of undertakings and funds. Beginning with the draft budget for 1980/81, the dual presentation of the budget was abandoned and revenues and expenditures were presented in a single budget system,21 The capital funds maintained earlier were replaced by uniform balance sheets and, for enterprises or undertakings, the balance sheets were supplemented by profit and loss accounts for the year. The reason for giving up the dual system was that the emphasis that had been on the net worth of government had been transferred to macroeconomic aspects. The introduction of the balance sheet procedure, however, implied more of a change in the form of accounting in that assets with a minimum span of three years and above a monetary limit would be considered for capital appraisal even if they were not financed by investment appropriations hitherto included in the capital budget. Inventories and related assets, however, would still be written off in the budget outlays.22 In a way, therefore, capital accounting continues but has ceased to be a policy tool.

In the United States there were periodic recommendations for the introduction of a capital budget23 but this never materialized, primarily because it might tilt the resource allocation in favor of “brick and mortar” projects.24 However, the budget documents present a special analysis of investment expenditures, which include outlays on “other developmental purposes,” that is larger in scope than the tangible asset approach. This analysis is for information only and has no accounting or other implication for the budget structure.

In India the capital budget was introduced in 1946–47 in the context of increasing budget deficits. Separation of capital items facilitated the immediate achievement of a surplus on the revenue account. Items are included in the capital account for two reasons—longevity of assets and size of outlays. The productivity criterion is not applied nor is any depreciation considered. Over the years a case law has been evolved to provide an operational guide for inclusion of items in either budget.25

Problems: Alternatives

The lack of a settled view on what constitutes capital has contributed to the emergence of a variety of practices. Three main problems are experienced. First, a multiplicity of budget categories that extend beyond the current and capital divisions has developed. Second, comprehensive criteria are rarely articulated for the classification of revenues and expenditures. Third, there is a lack of consistency in the application of the criteria. Thus, terminological confusion has arisen, which in turn generates issues in the compilation of accounts and more significantly in policy formulation. Classification limitation prevents the government from having a clear understanding of the magnitude and composition of investment outlays and of their implications for future resources and their utilization. It may even have contributed to distortions in policymaking. These issues are serious enough to warrant a new look at the available alternatives. An idea that has gained some support since the early 1970s, following the recommendations of the U.S. President's Commission on Budget Concepts, has been the unified budget. The recommendation had its origin in the conflicting coverages and conclusions of the administrative, cash, and national income budgets then in vogue in the United States. In considering the relevance of this approach to countries with dual budget systems, the main issue is whether the unification of budgets would avoid the conceptual problems referred to above. The need for information on capital formation, it is believed, can be met from the national accounts and the limitations of the tangible asset approach of the national accounts can be compensated for by classifying expenditures into (a) consumption, (b) investment in tangible assets, and (c) expenditure on future benefits not resulting in the acquisition of assets.26 Other limitations on the concepts of maintenance and repair could be similarly refined.

It could also be argued that the use of national accounts does not provide the managerial facility associated with capital budgets. Capital budgets meet this requirement and, notwithstanding conceptual limitations, extended practice over the years has contributed to an understanding among practitioners. For many budgeteers, the provision of funds for the budget categories is the language they understand. National accounts, while essential for policy purposes, are not the basis for allocation of funds or for recording accounts. This is not to deny the need for more improvements. The issue then is should efforts be made to improve the system by refining the classification or should it be abandoned in favor of national accounts? Answers to this are dependent on the pragmatic combination of the relative roles of economic policy and managerial considerations and the status of the national income accounts.

Classification of Revenues

In order of importance, the classification of revenues and expenditures follows the approaches to the dual budget and reflects, to an extent, the features pertaining to the current and capital budgets. Revenues are first divided into two categories—tax revenues reflecting the compulsory nature of the levy, and nontax revenues that are in the form of charges for services provided. The classification of revenues could be based on several premises and raises some broad questions. Should revenues be classified in terms of the legal base, for example, tax on income? or should they be classified with reference to the administrative agency responsible for their collection? To what extent can the economic effects or the final location of payments be used for classification purposes? How are capital receipts to be shown? How should proceeds from foreign aid be classified? Should the activities of the trading agencies be shown on a net or on a gross basis?

The UN System of National Accounts classified revenues into direct and indirect taxes, property income, fees, and related categories. Direct taxes are levied on individuals and others by public authorities on income from property, employment, or any other source and paid by individuals and others. Indirect taxes are assessed on producers in respect of the production, sale, or use of goods and services that are charged to the expenses of production. A major limitation of this approach, however, is that it implicitly assumes that direct taxes are paid by individuals and are not shifted forward. Present knowledge of the actual nature of incidence and shifting is not determinate. Consequently, many international and national approaches have avoided the controversy and preferred detailed itemization of revenues.27 Revenue categories, in practice, generally revolve around the character or legal base of the tax. Thus, taxes on income are separate from those on property, expenditure, goods and services, and international trade and transactions. In some instances, capital receipts covering the sale proceeds of fixed capital assets are also shown.28 These categories provide for a good deal of disaggregated detail and can be used as building blocks to analyze the economic or administrative aspects. In general, however, it is observed that the approaches to revenue classifications reveal some common features noted here. First, because of the widely differing bases (regardless of the classification), some categories present problems by having features that make them eligible for inclusion in more than one category and thus an arbitrary judgment has to be made about their final location. Second, the classification should reflect the importance of specific sources of revenue. For example, taxes on income or on domestic transactions may have no place in the budgets of oil producing and exporting countries. These sources are important in other countries—and the respective classifications indicate the relative place of the major sources of revenue. Third, the classification of revenues may more often reveal their base rather than the administrative agency responsible for their collection. In some countries this is resolved by indicating the groups of taxes (with reference to their base) under the concerned administrative agency (for example, in some countries the Commissioner of Revenue could also be responsible for the collection of customs duties).

A frequently encountered issue relates to the treatment of trading or enterprise activities in the revenue budget. Those arguing in favor of gross presentation of their activities suggest that this will better indicate the aggregate value placed on the services provided by their organization, that netting conceals the factors that have an important economic significance, and that netting tends to understate the total size of the budget relative to the national economy.29 It is evident, however, that gross presentation tends to overstate receipts (not all of which accrue finally as revenues) and that such inclusion may impose unnecessary rigidities on the operations of the enterprise. As for macroeconomic policy the size of the surplus or deficit remains the same in either event.

The treatment of foreign aid has been more complex reflecting the wide varieties and forms of aid. Aid is often given in kind and may not enter the budget ordinarily. Most countries receiving aid have developed a tradition of showing in their budget the monetary equivalent of the aid received for purposes of accountability.30 This includes the valuation of bilateral and multilateral aid and suppliers' credits. A distinction is made between grants and loans in all these spheres and generally only grants are shown in revenues.31

Classification of Expenditures

The purposes of expenditure classification have grown over the years and have generally kept pace with the growth and increasing complexity of public expenditures. Moving from accountability to management and to planning, classifications were improved for several reasons. The need for uniformity in the structures and better synchronization with other classifications, on one hand, and the introduction of program budgeting, on the other, have contributed to major changes in the classification of expenditures.

Expenditures were originally classified in terms of organizations and the objects of expenditure, i.e., the goods and services bought by appropriated funds. Their primary purpose was to provide a basis for fund requests and for controlling operations. Since then, budgets have moved a long way and terms such as functional, program, and activity classifications have become commonplace. Although there was a considerable debate about the virtues of each system and the superiority of one over the other,32 there is now greater acceptance of these classifications, notwithstanding varying use of the terms. Behind these developments, however, are a series of efforts both national and international to improve budget structures, the impetus for which came from the experience of the United States with program budgeting systems, and the growth of national accounting systems. These developments, which spanned a period of three decades, may best be analyzed in terms of the experience of the 1950s and the 1960s.

Developments During 1950s

The major break from the traditional or the line-item budget came in the late 1940s and early 1950s with the implementation of the recommendations of the First Hoover Commission in the United States, which recommended the refashioning of the budget by classifying government transactions into functions, activities, and projects. The emphasis in the new system was that the budget should be structured to serve as a basis for the review of accomplishments. Accordingly, the U.S. Budget and Accounting Procedures Act of 1950 provided for a budget based on the functions and activities of government. Proposals for requests for funds were formulated in terms of programs, their objectwise classification, and sources of financing. The object classification (e.g., wages), which was the bulwark of the line-item budget, continued but was used as a secondary classification. It was also envisaged that there would be complete synchronization of organizational structures and budget classifications. If the new budget presentation constituted a significant improvement, its implementation revealed some nagging problems. Should the classification be evolved with reference to the character or the objectives of programs or should the organizational structure continue to dominate?33 The contemporary experience was that the practical world did not lend itself to neat and discrete categories as required under the new approaches. In practice, classifications were either too broad or too narrow to reveal significant activities or to provide a comprehensive overview facilitating the annual budgetary decision making. There was also the fear that, in the process of evolving the new classification, management considerations were not given their due. This experience was reviewed by the Second Hoover Commission in 1955, which reiterated the submission of the budget to be based on functions, activities, and projects and suggested that further steps be taken to synchronize the “organization structures, budget classifications, and accounting systems.” This approach to the classification of expenditure has continued since then, although further refinements were made during the 1960s.

Meanwhile, the data requirements of economic and social policies for development purposes were becoming clearer and the recognition that most governments provide common services led to the identification of functional categories that could be used with variation by countries. If the classification of the budget were to serve as a reliable instrument for policymaking, it should be capable of indicating the purposes achieved and incidence of burdens and benefits of government expenditure. In particular, the classification should facilitate priority planning and decision making on the desirability of spending more or less on a particular service. The result of this recognition was the UN publication of A Manual for Economic and Functional Classification of Government Transactions (1958). The Manual divided government functions into 15 functions and grouped them into 5 major clusters—General Services, Defense, Social and Community Services, Economic Services, and unallocable expenditure. The Manual also provided an economic classification that, in conjunction with functional classification, would serve policy purposes. The Manual was discussed and refined in a series of international meetings during 1957—64 and won a substantial following in a number of countries. The implementation itself, however, reveals a mixed picture. The Manual provided an enlightened understanding of the inadequacies of the traditional budget but its functional categorization was too aggregative to adequately serve policy requirements and most governments used it as a supplementary analytical table to show the disposition of expenditures rather than for operational purposes for budget making.

Refinements During 1960s

The introduction of the functional and program classifications in the United States in the 1950s very soon proved to be less than adequate for the growing requirements of budget management. By the mid-1960s, it was felt that the budget should measure money costs for achieving a program objective, should facilitate the comparison of alternatives and future cost implications, and should generate the economic data needed for policymaking. The budget structure, it was felt, continued to be a comptroller's one rather than one oriented to managerial or economic purposes. It did not help to clarify the relationship between the financial and physical aspects or the relationship of one budget function with another. At an operational level, the terms “program, performance, activity, and function” were all used more or less interchangeably and there was no consistent understanding of program categories.34 The avoidance of these problems became the primary objective of the planning, programming, and budgeting systems introduced throughout the federal government in 1965. Specifically, it was felt that the program structure should be so devised as to provide a framework defining far more clearly alternative choices to be made and an information system to assist in measuring costs in relation to accomplishments.35 The programs, therefore, were to be classified in order to allow a cost-benefit analysis.

The translation of these ideas into budget routines took time and were refined over a three-year period.36 First, it was recognized that the new budget classification should adhere to the character of the activity and would therefore be different from the prevailing organizational structure. Later, it was recognized that program categories should provide an appropriate framework for policy consideration for each agency and that each agency was responsible for formulating its own program structure and thus a link was sought with organizational structures. In its final phase, still caught between the conflicting claims of organizational responsibility and the broader purposes of policy formulation, the instructions noted that program structure “must cut across organization lines, appropriations, and other classifications.” But as “pursuit of absolute uniformity and consistency in development of a program structure will, however, be counterproductive,”37 it was decided that the Bureau of the Budget “will continue to work toward development of a government-wide program structure.” The development of such a classification of budget expenditures was, however, only partially successful. The classifications developed by agencies differed widely in quality and usefulness.38 The new classifications did not form a basis for decision making, which continued to revolve around the appropriation structure of the budget, i.e., object classification. The efforts were not, however, without benefits as, in some cases, they opened up productive lines of inquiry.

The overall emphasis on improved classification also found expression in the United Nation's A Manual for Programme and Performance Budgeting (1965b) and A System of National Accounts (SNA) (1968). The former outlined the approaches that formed part of the performance and planning, programming, budgeting systems introduced in the United States. The System of National Accounts took a broader view and its classification of government activities, while being consistent with the International Standard Industrial Classification for all economic activities, was evolved to show separately (a) the services intended for the community as a whole, (b) the services to households, and (c) the services for promoting and assisting economic activity. The classification proposed in the SNA divided expenditures into nine groups (General Public Services, Defense, Education, Health, Social Security and Welfare Services, Housing and Community Services, Other Community and Social Services, Economic Services, and other purposes) and subdivided these into categories that were equivalent to programs, to permit a better measure of the costs. These categories have been clearly influenced by the principles of classification of planning, programming, and budgeting systems.

Content of Classification

The classification of expenditures now involves the division of government transactions into categories that would serve the accumulated purposes of the previous three decades. Basically, it involves the formulation of functions, programs, activities, and cost elements. The function is a major division of government and its purpose is to provide a distinct and public service. It may be administered by several agencies but the aggregation would show the linkages with other services and would permit a better comprehension of the aggregate objectives of expenditures. This planning function will have to be supplemented by the management function, as categories will have to indicate their organizational responsibilities. Ideally, a congruence between organizations and functions would be desirable. In reality, however, it is different. A classification system does not warrant a reorganization of the government but will have to be dovetailed to the existing structure. This has been done in practice in each case to reflect a combination of aggregative and organizational features. Also, there are some functions, for example, public debt, that do not lend themselves to organizational apportionment and are, therefore, best maintained as separate functions.

The functions are subdivided into programs that are technically viewed as segments of functions with major end objectives. Preferably, they should be adaptable to cost-benefit analysis treatment, compilation of accounts, and computation of costs. Two conflicts that emerged in evolving these programs were in relating them to the agencies, as distinguished from the transactions of the government as a whole, and in according the necessary priority for the application of cost-benefit analysis. In practice, programs are largely evolved within the parameters of an agency, and where considerations of cost-benefit analysis and its implications for the program structure conflict with other factors, separate and generally more specific programs are formulated for cost-benefit analysis. The programs are further subdivided into homogeneous categories of activities, each of which is divided, in turn, into cost elements that correspond to the line items of the conventional budget. In its pure form there is congruence between budget structures and the organizational form of government as illustrated in Tables 18 and 19.

Tabla 18.Budget Structure and Government Organization
FunctionMinistry or department
ProgramBureaus, directorates, etc,
ActivityField agencies or divisions of bureaus
Table 19.Budget Structure: An Illustration1
ProgramsInstitutional and nonresidential buildings
Residential accommodation
Other works
Administration and supervision
ActivitiesInstitutional and nonresidential buildings
Public health buildings
Educational buildings
Office buildings
Cost elementsWages and salaries
Materials and equipment
Other equipment
Supplies and utility
Maintenance of equipment
Other expenses

The integrated budget structure emerging from the application of the above principle is illustrated here with reference to construction as a function.

The integrated budget structure emerging from the application of the above principle is illustrated here with reference to construction as a function.

The budget structure discussed above has the inherent potential of meeting the accountability requirements (elements of expense), planning requirements (programs and activities), and operational and managerial requirements (programs and cost elements). In addition, it also eliminates current and capital classification and permits a composite view of the programs.

Economic Classification of Expenditures

The performance and program budgeting systems have mostly emphasized the planning and policy requirements of the budgets. As the operations of government grew, attention also had to be focused on measuring the impact of the government budget. To achieve this objective expenditures are classified in economic categories as envisaged by the UN System of National Accounts—consumption, subsidies, transfers, and capital formation. These categories, while useful in providing an aggregate picture of the national economy, need additional details to be useful in policymaking. The components of wages and salaries, transactions within the domestic economy and with the external sector, types of transfers and the prospective recipients, categories of capital formation (existing or new assets—financial or physical—additions to stocks) require to be provided in greater detail. In a way, the traditional line-item budget provides a nucleus for the economic classification through its specification of the objects of expenditure but it does not fully anticipate the requirements of economic policymaking. This task was carried forward in the UN Manual for Economic and Functional Classification of Government Transactions and was further refined in the IMF Manual on Government Finance Statistics. Most government budgets now have an economic classification, although the extent of detail varies among them.39

Classification of Financing

The growth of budget deficits made more urgent the need for a clearer delineation of the methods of financing deficits. This effort received further stimulus from another source; the coordination of fiscal and monetary policies require a comprehensible estimation of the sources and magnitudes of financing the budget deficit. Financing transactions are examined from two angles: (a) the instrument of indebtedness and (b) the potential holder of the debt instrument. Provision of further details in this regard in budget documents is vitiated by the fact that governments are reluctant to reveal their full borrowing plans and specify them in chosen budget categories. More often they announce the extent of the deficit and the amount of foreign loans that would be received and imply that the gap is to be financed by short- or long-term borrowing from the domestic sector. In developing countries, the issue of debt is dealt with in close consultation with the central banks, and the choice between short- and long-term securities and the potential holders depend on the market situation and the attractiveness of government securities in relation to private sector debentures. Where there are no developed capital markets, the debt issued by government may be taken, as noted earlier, in its entirety by the central bank itself. As these arrangements are partly confidential and also because of uncertainty, firm budget estimates by holders are not indicated. More information is provided for previous years on the type of the debt instrument and the holder. In countries where the entire issue of debt may be financed by the proceeds from the captive funds (e.g., pension funds), which are also managed by governments, the details of these transactions may be shown in the budget documents. In practice, the use of detailed classification of the sources of financing is limited to a presentation of data for the past, while for the future, budgets show only broad aggregates for domestic and foreign borrowing.

Implementation: Some Experiences

The growth of improved classifications soon became popular and over the years several governments have made efforts to introduce revised classifications.40 Among the developing countries that have introduced major changes in their budgetary structures are the following: in Asia—India, Korea, Malaysia, Nepal, the Philippines, Sri Lanka, and Thailand; in the Caribbean—Barbados, Guyana, and Jamaica; in Africa—Burundi, Egypt, Ghana, Malawi, South Africa, and Tanzania; and in Latin America—Argentina, Chile, Mexico, Colombia, and Costa Rica. Austria, France, the Federal Republic of Germany, Greece, the Netherlands, Portugal, Sweden, and the United Kingdom are the industrial countries that have undertaken changes in their budget structures.41 These changes were part of the reforms that revealed three different approaches. In industrial countries the reform followed the tradition of national accounts and reflected the desire to ensure a greater degree of synchronization between budget structures and national accounts. In the developing countries the reform was, to a major extent, undertaken as part of the introduction of performance and program budgeting systems. In some French-speaking African countries the improvements were largely influenced by the General Accounting Plan (which also aimed at coordination with national accounts) that had been introduced in France. The philosophy behind the introduction of these improvements was in a progressive direction, as this enabled the budget structures to keep up with other developments in the economy.

The implementation of reforms in the budget structure reveals some aspects that emphasize the need for further attention. First, the introduction of reforms has been problematic. In some countries there was opposition from the legislature to the revised structures, under the impression that the shift from object classification would erode the traditional legislative control over appropriations.42 Adjustment to the legislative wishes contributed to truncated reforms, with reliance partly on previous structures and partly on new structures. Second, the form of the revised budget structures themselves in several countries left a lot to be desired. There are far too many ill-defined items. Lack of standardization is a common handicap. Programs often do not show the cost elements. The classification itself often is an amorphous collection of organizations, objects, and programs thrown together to form a potpourri that would somehow sort itself out. Also, there is a feeling that improved budget structures, once developed would be appropriate for all future years and there has been little improvement in program classifications, which have clearly been overtaken by time and events. Third, reforms have often been introduced without the necessary administrative preparation and with a lack of detailed phasing plans that aggravated some of the difficulties. Fourth, because of the weaknesses enumerated above, the structures failed to achieve some of the major objectives of the classifications. Available evidence does not suggest that either cost compilation or the facility to apply quantitative techniques has been achieved. Meeting these diverse tasks appears to need greater detail in the budget structure. Fifth, the requirements of budget policymaking have not also been fully met because of the fact that needed changes in the supplemental accounting systems were not made. This again prevented the full utilization of the budget structures and, finally, pending the improvement in the budget structures, more reliance had to be placed on national income data and as these were not well-developed in developing countries, policymaking continued to be conjectural rather than factual.

Social Security

The issue relating to social security insofar as budget structure is concerned is not one of classification but of treatment. Is the contribution to social security a tax to be included as a separate category in revenues? or is it a contribution that is held in trust by the government and is, therefore, to be shown as a source of borrowing? The implications of the treatment are obvious in that the former may obscure a deficit and the latter could accentuate it. The answer is dependent on the type of social security system prevalent in a country.

Definitions of social security systems are generally avoided, in view of the great variety of services and programs that contribute to the social security system and also in view of the varying concepts and methods used in different countries. Two considerations have been proposed for the determination of a social security system—(a) the objective of the system must be to grant medical care or maintain income in the event of loss of earnings and (b) the system must have been set up by legislation attributing the power of administration to a public body.43 Following these criteria, the system is considered to consist of compulsory social insurance, certain voluntary social insurance schemes, family allowance schemes, special schemes for public employees, public health services, and public assistance and benefits granted to war victims. Within this sphere, three major approaches, each commonly regarded as a form of social security, are discerned: social insurance, public service, and social assistance.44 The social insurance program, the most common form of social security, is generally financed by contributions from employers and employees, is operated as a separate authority, and benefits that are linked to contributions or coverage are paid from the fund. Public service primarily consists of the direct provision of a service or a cash payment from the general budgetary funds to members of the community who are within a defined category. Usually, payment of pensions, maternity grants, and family allowances are covered under this approach. Benefits under this program do not have any bias toward contributions and are not covered by social insurance programs. The third approach of social assistance consists of payments that are also made from the budget to recipients whose financial status is subject to investigation in order to determine the need and the amount of assistance they receive. Old-age and unemployment assistance are covered by this approach. In addition, there are quasi-social security measures that include provident fund systems, which are prevalent in many Asian countries. These funds comprise contributions by employers and employees and are paid with interest in the event of a contingency, for example, old age, invalidity, or death.

The integration of the social security system with government budget is suggested for several reasons. First, social insurance contributions represent a kind of wage tax and benefit payments are not distinguishable from expenditures for similar purposes; second, the motivation of government-regulated insurance is different from private insurance; third, the inclusion of social security contributions is important for measuring the economic impact of the budget; and fourth, these programs are imposed, controlled, and financed to a large extent by general revenues and should, therefore, appropriately be considered as part of the budget.

The other view is that, although contributions by employers and employees can be altered, depending on the fiscal policy requirements, in lieu of income taxes, they differ from taxes in that there is a direct quid pro quo and services are provided in relation to the rates of contribution. The rights of individuals to benefits are either derived from or in some way linked with the coverage of the program and contributions constitute deferred liabilities to the program. It is for this reason that the programs are administered separately. Inclusion of such liabilities in government budget would mask the correct financial status of the government. The purposes of economic analysis could be met by appropriate aggregation for analytical purposes and do not necessarily require integration with the budget. This approach is followed, for example, in the United States, where social insurance is organized as a separate trust fund. For purposes of calculating the effect of federal government activities on the level of income and employment in the country, the flows of the fund are taken into account. At the same time, there is also separate trust fund accounting and the investment of surplus funds in government securities is shown separately.

On balance, therefore, the treatment of social security depends on the nature of the program, its financial status, and the approaches to economic analysis.45

Most books on budgeting do not deal with classification problems. A major exception, however, is Jesse Burkhead (1956). Even this, however, does not deal with the developments since the mid-1960s. Over the years, a number of useful manuals have been published by international organizations. In chronological order, these are Organization for Economic Cooperation and Development, A Standardized System of National Accounts (1958); United Nations, A Manual for Economic and Functional Classification of Government Transactions (1958), A Manual for Programme and Performance Budgeting (1965b), A System of National Accounts (1968), A Manual for Government Accounting (1970); and International Monetary Fund, A Manual on Government Finance Statistics (Draft) (1974).

Writing about the United States, Arthur Smithies (1955) observed “public comprehension of the budget is greatly hampered in its bewildering terminology. On the expenditure side, the terms of appropriation, obligation, and expenditure cannot be avoided and are confusing enough” (p. 191). It was his view that the “immediate complexity” was largely the result of attempts at concealment.

It is, however, imputed in the national accounts. But, as discussed later, this is not without conceptual difficulties.

In addition, there are problems relating to the valuation of art museums, roads, and battleships, see Richard Goode and Eugene A. Birnbaum (1956), p. 27.

In a way, depreciation allowance does not alter the basic cash position of government. It is a contra-entry in the budget shown as an expenditure on the current account and a receipt on the capital account. But the computation of the costs is difficult. The irregularity in the phasing of outlays is an additional complication. In a perfectly stable program, depreciation allowances could be equal to the new capital outlays, provided annual outlays for new capital outlays had been constant for a period of years equal to the average depreciable life of the assets, see Goode and Birnbaum (1956), p. 28. This procedure is adopted in the computation of the general government sector in the national accounts of the United States, in which the new outlay is equal to the annual depreciation.

United Nations, Budgetary Structure and Classification of Accounts (1951), p. 12. In the early stages, however, dual budgets were evolved, even if not entirely convincingly, to serve as a rationalization from government borrowing; see also Jesse Burkhead (1956), p. 182.

See United Kingdom, Final Report on the Form of Government Accounts (1953), p. 45.

The United States, which adopted the New Deal policies, did not use the technique of capital budgets.

The President's Commission on Budget Concepts argued for depreciation and other financial statements at enterprise and program levels, but added that “[t]his is by no means the same thing as instituting a separate capital budget, separately financed, for the Government in the aggregate” (United States, 1967a, p. 34).

This has frequently given rise to the suggestion that in order to facilitate the identification of the revenue feedback, these projects may be organized as autonomous public undertakings, see United Nations (1951), p. 16.

The System of National Accounts was fully cognizant of the oft-repeated demand that capital formation should include the investment of human capital (a suggestion that has been repeated since originally made by Irving Fisher and A. C. Pigou in the 1920s). The authors of the UN system observed “in the development of national accounting emphasis has been placed on the distinction between what can be observed and measured and what can only be inferred on the basis of some theory or convention,” United Nations, A System of National Accounts (1968), p. 15.

It could be argued that the indirect benefits of military outlays could contribute to growth and some of them should be included in the capital account. In Sweden, during the early years of experience with capital budget revenue producing assets (for example, military housing) were included in the capital budget, see United Nations, Budgetary Structure and Classification of Accounts (1951), p. 17.

Ibid., p. 113.

The “saving” computed from the application of the above criteria is different from the current account surplus or deficit discussed earlier. Saving is a balancing item in the national income accounts, see United Nations, A System of National Accounts (1968), p. 130.

For purposes of its analytical studies, India adopts the distinction between development and nondevelopment outlays. The former includes outlays on social and community services and economic services, and the latter includes collection of taxes, audit, administrative services, and defense. In Bangladesh and Pakistan, as well, the nomenclature of development expenditures is used in the budget analytical documents and includes both recurrent and capital outlays.

See U.K. Financial and Economic Statement, April 1948. To some extent this concern was generated by the pioneering study made by J. R. Hicks (1948).

United Kingdom, White Paper on Reform of the Exchequer Accounts (1963).

The write-offs were of two types—unproductive expenditures and unsettled losses.

Sweden (1980), pp. 139–40.

See Sweden (1974), pp. 106–17.

See Jesse Burkhead (1956), Chap. 8. The Hoover Commission, for example, recommended the introduction of a capital budget. For an extended discussion, see Seymour E. Harris (1963).

This view does not reflect well on the capabilities of budgeteers and assumes the allocative process to have little rationality about it.

A. Premchand (1966b), pp. 144—49. The capital budget continues to operate and major changes were made in its classification in the early 1970s, see India (1973), Vol. I, pp. 26–35.

For national accounts only category (b) would be relevant. For those interested in the wider developmental implications, categories (b) and (c) would be useful.

United Nations, A Manual for Economic and Functional Classification of Government Transactions (1958) distinguished taxes with reference to their character rather than incidence. Practices in the United Kingdom and the United States, as well as in a number of developing countries, reveal that itemization is preferred to the classification of direct and indirect taxes.

For a fuller identification of the categories, see International Monetary Fund (1974), pp. 159–61.

See, for example, United States, The Federal Budget as an Economic Document (1962).

The valuation of aid presents accounting problems. For example, should food aid be valued at the prices prevalent in the exporting country, the importing country, or at an international price level? What exchange rate should be used? Economists would argue in favor of a rate that shows the scarcity value. Accountants appear to prefer more solid approaches.

There are several exceptions to this, however

To some extent, the debate continues in some quarters. See, for example, Aaron Wildavsky (1979), pp. 61–78. Wildavsky's principal concern is with the approaches to traditional budgeting rather than with the structure of the budget.

Adherence to organizational structure implied that different programs could be run by different agencies for meeting the same objectives and their interrelationships would be lost in the program overlap; to that extent, a major purpose of classification would be in jeopardy.

For an interesting enumeration of these defects of the traditional budget, see David Novick (1965), pp. 5, 11, 13, 19, 35, and 43.

Ibid., p. 18.

See Graeme M. Taylor (1969), pp. 52–47.

United States, Bureau of the Budget Bulletin No. 68-9 (April 12, 1968). Also relevant are Bulletin No. 66-3 (October 12, 1965) and Bulletin No. 68-2 (July 18, 1967).

See United States, The Analysis and Evaluation of Public Expenditures: The PPB System (1969), Vol. 2, pp. 620–21.

In the early years, economic classification was undertaken as a supplementary exercise by the central banks in their annual review of government finances. Later, with the ascendancy of economic considerations, economic classification of expenditures was presented as an analytical table and was shown separately in the budget document for information purposes. During the 1970s, however, with greater importance on the assessment of the economic impact, many countries introduced economic classification of expenditures in the main budget documents.

Bangladesh and Pakistan are among those that continue the inherited budget structures. In both countries, the budgets are largely based on the system that was introduced in composite India in 1935. Since then some minor changes have been made in the budget structure to accommodate the changes in the respective Constitutions.

Japan has not made any changes in its budget structure. Increased use has, however, been made of national accounts.

The introduction of performance classification in the United States, although it was undertaken ostensibly to improve the legislative understanding of the budget, did not become the basis of annual budgetary legislation. In the Philippines, the budget classification was improved but the basic structure of the budget with five accounts was retained. In Nepal, when a substantially abridged version of the object classification was introduced, it had to be withdrawn in less than a day because of severe opposition from the legislature. For an account of the Nepalese experience, see John C. Beyer (1973).

See United States, Social Security Administration, Social Security Programs Throughout: the World (annual, Washington, various issues).

For purposes of national accounting, however, social security transactions are included in the general government sector. When social security is administered separately, it implies that employer and employee contributions can be used only to finance benefit payments and therefore cannot be considered as a part of general revenues.

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