China has made modernizing its fiscal framework a key reform priority. This comes at a critical time as the country continues to move toward a more market-based allocation of resources and a greater role for the private sector. A modernized fiscal framework will allow the government to more effectively manage the economic cycle and signal that fiscal policies are sustainable, that expenditure policies over the medium term are focused on strategic and equitable development, and that resources are spent effectively and efficiently.
China has made modernizing its fiscal framework a key reform priority. This comes at a critical time as the country continues to move toward a more market-based allocation of resources and a greater role for the private sector. A modernized fiscal framework will allow the government to more effectively manage the economic cycle and signal that fiscal policies are sustainable, that expenditure policies over the medium term are focused on strategic and equitable development, and that resources are spent effectively and efficiently.
A key part of the fiscal reforms will be to move forward in implementing a medium-term expenditure framework, or MTEF. This objective was already reflected in the conclusions of the Third Plenum of the 18th Party Congress in late 2013. An MTEF will require a significant strengthening of technical and institutional capacity of the Ministry of Finance, the National Development and Reform Commission (NDRC)—China’s planning ministry—and the spending ministries and agencies. It will also require a greater emphasis by policymakers, including those at the highest level, such as at the State Council and in the National People’s Congress (NPC), on deciding and managing public finances with a more medium-term perspective on the financial impact and outcomes of government policies. A pilot MTEF document has already been produced, covering 2015–17, which will evolve and be refined over the coming years, if international experience is any guide.
At present, the strategic direction of government policies is set through the five-year plan (the 13th Five-Year Plan was approved by the National People’s Congress in March 2016), while spending is determined for only the coming year in the annual budget. These tools are no longer adequate for managing the economic transformation and structural reforms aimed at rebalancing the economy away from investment- and credit-led growth, expanding social safety nets, reforming intergovernmental fiscal relations, and coping with an aging population.
At present, a gap exists between the strategic direction of the five-year plan and allocation through the annual budget. The five-year plan is aspirational and focused on capital expenditure projects, but not always subject to realistic resource constraints. The annual budget is largely incremental, less attuned to changing policy priorities, and focused on recurrent expenditure and transfers. Moreover, it only covers central government spending. Neither instrument is sufficient to ensure the fiscal discipline, the strategic allocation of resources, and the improvement of spending efficiency needed for sustainable and stable development of the public sector as a whole.
Three issues, specific to China, call for introducing an MTEF. First, overall fiscal expenditure, deficits, and public debt levels that should concern policymakers are considerably larger than those in the central government budget (the State Budget). This is because China’s public expenditure is heavily devolved to lower levels of government that greatly depend on transfers from the central government. Some 65 percent of overall government expenditure takes place through local government (Figure 4.1, panel 1), while over 70 percent of central government expenditure consists of intergovernmental transfers. Public investment is even more heavily skewed toward local government (see Chapter 6 on local government debt and fiscal risks).
At the same time, China does not have a fiscal framework that covers all government expenditure at all levels. This has limited the ability of policymakers to ensure overall fiscal discipline and mitigate fiscal risks. Even though central government deficits have remained in the range of 2–3 percent of GDP, those of “augmented” general government—a concept that incorporates the off-budget fiscal activity of China’s local government financing vehicles—have been between 7 and 10 percent of GDP over the past few years (Figure 4.1, panel 2). Similarly, official general government expenditure and debt are still below other Asian emerging market economies, but exceed their average if the augmented definition is used (see Figure 4.1, panels 3 and 4). An MTEF will help manage the fiscal policy stance of the general government as a whole, and should include any remaining off-budget fiscal activity.1
Second, social spending pressures are likely to increase in the coming years as the population rapidly ages. This implies that ensuring the effectiveness and efficiency of expenditure will increase in importance, so that room can be created for needed spending on pensions and health care (see Chapter 5 on social security and Clements and others 2015). The MTEF will let spending departments and lower government levels plan and execute their expenditure programs more efficiently.
Third, an MTEF will help improve spending discipline both in ministries and departments and at provincial and lower government levels. Imposing hard budget constraints on spending has sometimes been problematic, especially at the local government level. The MTEF will promote development of more realistic and targeted expenditure policies. It will support local governments in adjusting their policies to resource envelopes rather than, as in the past, relying on informal borrowing arrangements. The introduction of formal local government borrowing and a halt to informal borrowing over the next few years will harden budget constraints on local governments. An MTEF at the central government level will signal the level of transfers to be expected and require local governments to cope with their budget constraints more decisively. Development of MTEFs at the provincial level, currently underway, will further help lower-level local governments deal with their fiscal constraints.
This chapter starts with a discussion of the international experience with MTEFs and the main issues to consider in their development. The major improvements achieved in China’s budget planning process in recent years are discussed, as well as the limitations of the current annual budget process. The various types of MTEFs are then defined in more detail, and their use by other countries is explained, as are the main building blocks of the MTEF process and the typical stages in its development. A number of important design choices that Group of Twenty (G20) countries have chosen to incorporate in their MTEFs are reviewed. The chapter subsequently takes a look at who in government is best placed to prepare the constituent parts of an MTEF, and how to sequence the overall MTEF introduction. These issues are linked to the possible implications for China. The chapter concludes with a number of recommendations.
China is not alone in reorienting fiscal and budgetary policies toward the medium term. The MTEF trend is international; already by the end of 2008, some 132 countries were in the process of introducing some form of medium-term fiscal framework (Figure 4.2). The three types of MTEF identified in the figure are discussed later in this chapter.
While use of the MTEF is widespread, both Japan and the United States, due to a variety of domestic issues, have been unable to implement the instrument beyond its most basic form, that is, the medium-term fiscal or budgetary outlook. These two countries project expenditures over the medium term, either in aggregate (fiscal outlook) or as detailed lines of expenditure categories (budgetary outlook). But such outlooks, useful as they may be, do not qualify as a “framework” because no (political) decisions are made on policy measures to reconcile the expected revenue envelope with the targeted fiscal stance. Outlooks give information on trends of expenditure, but are unreliable as forecasts. This dichotomy between outlooks and frameworks highlights that MTEFs are not a straightforward reform. In fact, MTEFs have been designed differently in different countries, often focused on the policy and institutional priorities that the annual budget process could not address.2
International experience suggests China will need to analyze what aspects of the present budgeting system are unsatisfactory, including perhaps some of the issues described above, and to make this a driving factor in the MTEF design process. China will need to develop its own brand of MTEF in the coming years. Among the essential building blocks are (1) setting medium-term fiscal policy targets, covering both local and central governments, consistent with fiscal sustainability and stability; (2) adopting top-down medium-term macroeconomic and fiscal forecasting; (3) developing a bottom-up “baseline” expenditure forecasting methodology; and (4) developing a strategic decision-making phase in the budget process to decide on the use of the “fiscal space” (or lack of it) available to the government. These building blocks are explained in detail later in this chapter.
These are, however, only the main ticket items of the reform process. In addition, MTEF design should consider the following:
macro-fiscal forecasting capacity
the part of the government or public sector to be covered by the MTEF
anchoring the framework to a possible fiscal rule
the time horizon of the framework
whether the MTEF should be “fixed” or “rolling”
the time schedule of MTEF preparation within the budget cycle
the way and the format in which the MTEF is used for State Council and National People’s Congress decision making
the rollover of the framework from one year to the next
the linkage of the MTEF to the five-year plan and to the annual budget
the division of institutional responsibilities for MTEF preparation (both within the Ministry of Finance and with other players, such as the NDRC)
the sequencing of the introduction of the instrument
How the MTEF is used for decision making is especially important. Aside from the many technical requirements, the Chinese authorities need to introduce the reform in a way that policymakers will actually use to decide on fiscal and budgetary policies over the medium term. In many developing and emerging market economies MTEFs have remained a technocratic, outlook-focused exercise, delinked from the budget process and with no real effect on political decision making—an outcome that China will want to avoid.
The Budget Process—Great Improvements in Recent Years
China has made great strides in reforming budget management in recent decades. Until the early 2000s, the annual budget was based on a functional classification, which was helpful in understanding the spending purpose of resources. In practice, however, it left too much uncertainty about the budget entity that would actually spend the resources. For example, education expenditure could be spent by various sectors/ministries: to support agricultural development, to train military specialists, or to strengthen educational programs of the Ministry of Education and Sciences. The introduction of departmental budgets assigned resources to individual departments and greatly improved transparency and the predictability of resource allocation.
Introducing elements of program budgeting strengthened this further. The departmental budgets were split into “basic expenditure,” classified mostly along economic lines, and “projects,” which are a mix of expenditure programs and capital investment projects. Given the split between basic and project expenditure, the programmatic classification in China does not yet cover all departmental expenditure. This means that programs do not contain all overhead or salary expenditures, still leaving the budget as an imperfect tool for deciding allocations.
The Ministry of Finance faces capacity constraints in assessing the realism of budget requests from departments, which reinforces the tendency to increase budget lines incrementally during the preparation of the annual budget, or to use standard costs that are not a good representation of actual costs given the diversity of costs in China. Despite these shortcomings, the introduction of program budgeting is a major step in better aligning expenditures with policy objectives, and has strengthened the policy focus of budget allocations.
From the Ministry of Finance’s point of view, establishing departmental budgets has hardened their budget constraints. Under the functional budget system, the precise allocation for departments was often decided through in-year negotiations between the ministry and departments. The adoption of departmental budgets has also helped develop performance accountability: what level of resources would be used for achieving which results. In recent years, China has added a basic performance monitoring framework to the departmental budgets.
Other improvements to the budget process in the 2000s included wider coverage of the State Budget through the joint presentation and approval of its various components: the State Budget comprises the General Funds Budget (which covers expenditures and revenues of central government departments), the Government-Managed Funds Budget (which comprises the extrabudgetary funds), the State-Owned Enterprise Fund Budget, and the Social Security Fund Budget. Within the General Budget, the current and capital budget are now presented jointly, although China, in many ways, still has a dual budget process, with the Ministry of Finance responsible for recurrent and small capital expenditures and the NDRC responsible for the major capital projects.
While program budgeting and integration of current and capital expenditure planning can be improved, the most pressing obstacle to modern fiscal and budget management is the annual nature of the budget framework. The main limitations of the annual budget in China are the following:
The coverage and time horizon of the annual budget limits application of fiscal discipline and the identification of fiscal risks in the wider government sector. As discussed, the coverage of the State Budget has improved and now includes all of the central government. However, an MTEF could be based on a fiscal framework that covers all of general government (including subnational government) and identifies risks three to four years into the future. This would provide a better understanding of the fiscal stance of government as a whole, the possible adjustment needed from the central government to accommodate the fiscal position of local government, or to negotiate a sharing of the fiscal space among layers of government (see Box 4.1).
It is difficult to take into account shifts in expenditure trends within the central government looking only at an annual budget. Such shifts can make fiscal discipline and sustainability over the medium term problematic, even for the central government. Trends in expenditure programs are often not stable. Especially in the social sector, programs may start slowly, but then increase rapidly. This leaves policymakers with little time to react. This has been the experience of many advanced economies as they developed the welfare state in the 1960s and 1970s. A number of emerging market economies in southeast Asia are already starting to experience pressures on recurrent expenditure induced by demographics, new social spending programs, and decreasing growth rates.3Figure 4.1, panel 3, shows the considerable increase in the size of government in Association of Southeast Asian Nations countries over the past 10 years (over 5.5 percent of GDP). An MTEF would provide an early warning to policymakers to make necessary policy changes in a gradual manner.
What Is Fiscal Space?
Fiscal space refers to the room for new policy initiatives, or—if fiscal space is negative—the need for spending cuts or additional revenue, given the government’s fiscal targets.1 In a medium-term expenditure framework, fiscal space is estimated over the medium term and can be calculated as the difference between the macro revenue estimates plus the deficit target, minus the baseline of expenditure. The baseline of expenditure is estimated as the total expenditure on all government policies and activities assuming no change in policies relative to the present budget. Of course, in some cases, the government will want to make reallocations between sectors or spending units or to reduce the budget of one or more spending units to create more fiscal space for new proposals of other units.
Implementing countercyclical fiscal policy over the economic cycle is challenging if it is merely based on an annual budget. It is difficult to judge the cyclical and structural components of economic growth in an annual context. A medium-term budget should allow policymakers to better plan and execute stimulus and consolidation strategies by identifying fiscal space and possible policy measures over a medium-term horizon.4
Annual budgets are not well suited for providing strategic direction to expenditure. In annual budgeting, attempts at strategic decision making are basically repeated every year, maximizing the opposition to change by stakeholders. In principle, China’s five-year plan should give strategic direction to program expenditure. However, the plan does not translate directly into sectoral expenditure allocations given its public investment focus. Further, the five-year plan is not based on the latest macroeconomic forecasts, but rather on macroeconomic targets. Thus it lacks the prioritization under realistic resource constraints that defines the budgeting process.
As discussed, annual budgets do not provide budget managers in departments and at lower levels of government enough planning certainty. This often means that programs may not be prepared and executed well. Together with variability in funding this can lead to stop-go expenditure policies and an associated decrease of expenditure efficiency. Especially for local governments and for public investment, such uncertainties can have a considerable negative impact on expenditure effectiveness and efficiency.
How Does an Mtef Work?
China is not the only country to experience the limitations of annual budgeting. The MTEF was developed in the late 1970s and early 1980s in countries such as Australia, the Netherlands, and New Zealand. Larger Organisation for Economic Co-operation and Development countries followed. The United Kingdom introduced its MTEF in the late 1980s. For European countries in the euro area, an MTEF became a requirement with the establishment of the single currency.
An MTEF can be defined as an institutional mechanism for setting multiyear objectives for fiscal policy and budget expenditure and ensuring that these are respected in budget formulation, approval, and execution. Three categories of MTEF are commonly defined in the literature, aligned with their stage of development: (1) the medium-term fiscal framework (MTFF), (2) the medium-term budget framework (MTBF), (3) and the medium-term program framework (MTPF). MTEFs encompass all three of these categories, although the literature is not always fully consistent on this point, and sometimes equates MTEFs just with MTBFs or MTPFs. This chapter follows the World Bank (2012) in usage of the term, which is that an MTEF encompasses all three categories. Figure 4.3 shows that MTBFs and MTPFs are quite common in advanced economies, but are still quite rare in Asia.
The MTFF is focused on fiscal aggregates and seeks to reconcile fiscal policy objectives (usually for the overall fiscal deficit) with aggregate expenditure and revenue estimates over the medium term. Policy measures presented are high level; for example, new tax rates, salary increases of civil servants, or introduction of significant legislation. These measures are reconciled to equate the resource envelope and fiscal targets with the top-down expenditure estimates over the time horizon of the MTFF. This is usually the first stage of MTEF development.
In the second stage, the MTBF goes through the same process but details expenditure at the level of the annual budget. This requires the reconciliation process to identify basically all expenditure and revenue measures at the same level of detail as in the annual budget. The MTBF requires preparation of annual budgets over the time horizon used, in practice, usually three to four years.
The MTPF encompasses both an MTFF and an MTBF but adds two features. First, the MTPF presents annual and out-year budgets in a programmatic format; second, these programs are linked to medium-term output and outcome targets. For example, Australia includes statements of objectives, deliverables, and key performance indicators for all major spending programs covering the full period of its MTEF. An MTPF is obviously a much more labor-intensive exercise than an MTFF. In addition, an MTPF requires a level of advanced decision making that many countries may not be ready for.
Coinciding with these three stages of development are the three main purposes for which MTEFs are usually introduced: (1) to enhance aggregate fiscal discipline, (2) to improve strategic allocation, and (3) to strengthen the effectiveness and efficiency of expenditures. To clarify what an MTEF implies, it is useful to separate the process of preparing an MTEF into four components:
First comes the setting of fiscal policy objectives over the medium term. Fiscal policy sets targets for deficit, debt, or other fiscal aggregates based on objectives for sustainability and macroeconomic stability. In contrast with the annual budget, MTEFs are always driven by fiscal policy. In countries with only annual budgets, especially those that are prepared incrementally from year to year, budgets often drive fiscal policy, not the other way around, which can easily derail public finances. Very important in setting medium-term fiscal objectives is the realization that the impact of government on the economy is driven by general government, not just the central government. If the MTFF part of the MTEF covers only budgetary central government, and local government is a substantial part of overall government, fiscal policy will not reflect the actual influence of government on the macro economy.
In any case, an MTEF document should always contain a statement of fiscal strategy. This statement would clarify the fiscal objectives of government, such as fiscal sustainability, stabilization of the macro economy, size and economic composition of the public sector (that is, the balance of recurrent and capital spending), and possibly issues of intergenerational equity. The statement would then clarify how these high-level objectives are to be achieved (debt reduction, expenditure control, revenue mobilization, and so on). Specific targets for the main fiscal aggregates would be specified over the medium term. These can be qualitative and/or quantitative. If the government has translated its fiscal policy objectives into a numerical rule or rules, as many advanced and emerging market economies have done, the implications would be specified here.
The second component in the development of the MTEF is top-down forecasting. An MTEF is based on a medium-term macroeconomic framework. This consists of a set of forecasts of key macroeconomic parameters, GDP growth, and the GDP deflator being the most important. The forecast should reflect a genuine forecast for the economy, not an aspirational target. Basing an MTEF on the latter usually leads to overestimation of the resource envelope, and the MTEF would not have the desired impact on fiscal discipline, and key budgetary decisions would still be postponed until they appear in the annual budget. It is the aspirational nature of strategic planning instruments, including their macroeconomic underpinnings, that has prompted many countries to introduce an MTEF.
Once medium-term macroeconomic forecasts have been developed, the next step is to forecast revenue and expenditure at an aggregate level, again over the medium term. Given the fiscal targets and the revenue and expenditure forecasts, the aggregate fiscal space for new policy measures can now be calculated (Box 4.1). As discussed, planned cutbacks and revenue measures can increase fiscal space over the medium term even further to make space for additional expenditure priorities.
The third step of the MTEF, developing the expenditure baseline, applies primarily to MTBFs and MTPFs. The baseline consists of the bottom-up projection of expenditures at the level of detail of the budget under the assumption of no policy change. The expenditure estimates are no longer calculated based on macroeconomic equations, but on aggregating all departmental budgets and line items in those budgets, with the assumption that no new policy is approved. In MTBFs and MTPFs, fiscal space is then calculated based on the difference between revenue forecasts and the baseline plus the fiscal deficit target (as borrowing increases fiscal space). This is a much more detailed and accurate estimation of fiscal space than in the MTFF, which uses a top-down forecast of ongoing expenditures.
While the bottom-up forecasting under unchanged policies sounds straightforward, in practice it is not. Good baseline estimates require that the annual budget be costed accurately and that the implication of existing policies for expenditures can be forecast in the out-years with some confidence. In practice, that is no easy task, especially the latter. Some budget lines may be forecastable for the out-years of the MTEF based on simple formulas, or established limits, but expenditure programs will usually evolve with their cost base. Social expenditure programs, for example, will often depend on the state of the economy or on demographic factors. Estimates of capital investment will require the expenditure pattern for existing projects, but also for projects to be initiated in the out-years. Developing baseline estimates will require numerous assumptions to be made on costing the forward years, and detailed instruction must be provided to line ministries, to be assured that the underpinnings of the baseline are similar across line ministries.
Often ministries of finance make simplifications in that process that lead to inaccurate baseline estimates. For example, in many developing and emerging market economies, the baseline is calculated by multiplying the annual budget by the GDP deflator (constant program effort) or nominal GDP growth (constant program effort relative to the size of the economy). Both simplifications are often far from what actually transpires. In many cases, the macroeconomic forecast of aggregate expenditures is a better estimate of the baseline than one based on a crudely developed bottom-up baseline methodology. In practice, good baselines cannot be developed by the Ministry of Finance alone, as it is unlikely to have a full insight into the cost drivers of line ministry budgets. Input from line ministries, and perhaps also the planning ministry if it has spending responsibilities, becomes essential. For this reason, the transition from MTFF to MTBF requires full involvement of spending departments in the MTEF reform.
Once a sound baseline for existing policy is established, the resultant budget estimates should be projected through the agreed economic parameters. When deciding the appropriate parameters for inflation, a number of countries apply a charge on the baseline, referred to as an efficiency dividend. This can offer significant microeconomic benefits and strengthen overall fiscal discipline, as described in Box 4.2.
The fourth step of the MTEF process is the decision-making phase. This comprises the development of a package of policy measures, estimated over the medium term on the expenditure and revenues side, that allows usage of available fiscal space or, put differently, that balances expenditure and revenue estimates to achieve fiscal targets. This reconciliation phase requires the costing of new policy measures over the medium term or of the expansion or reduction of existing policies. This can be even harder than estimating the baseline, as little experience has been gained yet with the new policies being considered. The policy package would contain the estimates for the new policies of the coming budget. In the most advanced MTEFs, policy reforms to be initiated in later years would also be added to the package of policy measures. It is, in any case, quite common to leave a planning reserve for new policy initiatives in the out-years. Doing so leaves larger uncertainty over expenditure and revenue policies, but in dynamic economies it provides room for the introduction of new government policies without cutbacks in existing programs.
A major challenge of the fourth step is how to stage the MTEF for political decision making, as part of the overall budget process. Countries that have successfully integrated their MTEF into the budget process have usually done so by deciding on the main elements of the MTEF a number of months ahead of decision making on the annual budget. In this prebudget or strategic budgeting phase, decisions are made on the fiscal targets over the medium term, main elements of new policy and their costing, and expenditure ceilings for the annual budget and in some countries for the outer years of the MTEF as well.
As elsewhere, for an effective decision-making phase based on a new MTEF, strong collaboration among ministries in China will be critical, especially between the Ministry of Finance and the NDRC. Also, to ensure that fiscal targets are met over the medium term, approval by the State Council and the National People’s Congress of a package of policy measures covering the entire period will be needed. Implementing an MTEF can in the initial years be quite taxing. Line ministries will often retain their traditional focus on the coming budget year, and the quality of the out-year costing could then be a concern. For this reason, countries usually start with an MTFF, which requires neither a bottom-up expenditure baseline nor costing of all budget lines. An MTFF requires agreement on fiscal targets over the medium term and the main elements of a package of measures that will make fiscal targets achievable.
A number of countries, such as Australia and Sweden, have introduced a charge against the baseline forecast for most agencies. This charge—often called an efficiency or productivity dividend—has become an integral component of some budget estimation methodologies.
Such dividends aim to do the following:
Provide managers specifically and agencies generally with the incentive to continually seek new or more efficient means of undertaking ongoing government business.
Allow government to redirect a portion of efficiency gains to higher-priority activities, be they tax reductions or other expenditure priorities.
Increase the predictability of funding through providing a baseline that is affordable.
Show clearly that, like the rest of the economy, the public sector can generate efficiencies resulting from improvements in management and administrative practices.
The arithmetic of applying an efficiency dividend is most compelling. The compounding of the savings over time means that, after five years, a 1.5 percent dividend annually will reduce running costs by 7.3 percent in real terms, or as much as 9.3 percent assuming annual inflation of 5 percent.
A crucial part of the MTEF is how the instrument is rolled over from one year to another. If used for decision making over the medium term, then the first out-year of the present MTEF should become the budget year of the new MTEF. MTEFs are adjusted for changes to the macroeconomic forecasts and new costing of the baseline. However, such adjustments should be clearly traceable from one year to the next, with the effect of linking the MTEF in one year with the MTEF in the next.
What often happens, however, especially in developing economies, is that MTEFs are not connected and not properly rolled over from year to year, that is, the MTEF exercise is basically redone every year. This can have multiple causes. Most common is that too little effort is made negotiating out-year budget lines between the Ministry of Finance and line ministries (which in the case of China would also involve the NDRC), because policy priorities change or the macro forecasts had large errors. Under these circumstances, redoing the MTEF makes sense, but then the country does not really have an expenditure framework for the medium term. Instead it could be viewed as having a medium-term outlook, either at the fiscal or the budget level. Such fiscal or budget outlooks have their uses, but line ministries soon lose interest in their preparation as it does not lead to meaningful decision making over the medium term. Figure 4.4 presents the typical development path of an MTEF.
What are the MTEF Design Choices for China?
MTEFs differ from country to country. Nonetheless, some requirements are common to any MTEF, and others can be chosen based on the priorities for improving fiscal and budget management. Below, some of the issues that the Chinese authorities may want to address are discussed.
Macro-Fiscal Forecasting Capacity
For a successful MTEF, China’s macro modeling and forecasting capacity needs to be strengthened. The macro framework for the five-year plan is prepared by the NDRC. This framework, however, is aspirational in character. It consists of targets not forecasts. For keeping an MTEF up to date, countries usually update the macro framework twice a year. At present, the macro framework for the five-year plan is updated only once in its whole term. Macro forecasts are prepared annually for budget preparation purposes. The time horizon of the macro forecast would need to be at least equal to that of the MTEF. Who should undertake this task in the Chinese context is one of the institutional issues discussed later in this chapter.
The Ministry of Finance prepares the medium-term fiscal outlook presented in the five-year plan. For the MTEF, it will need to be done on the basis of regularly updated macro forecasts. The accuracy of the fiscal forecast will need to improve, as the MTEF will be used as a tool for medium-term decision making. Large forecast errors will undermine the credibility of the framework and diminish the interest in its use. Weak forecasting capacity is the main reason countries get stuck in the fiscal or budgetary outlook phase of MTEF development.
In principle, an MTEF functions best as an instrument of fiscal policy and discipline if it covers as large a part of the public sector as possible. Only then are limits on spending shared by all. But there are practical limitations to this principle. The central government can in practice have no authority over local government spending. Also, the inclusion of extrabudgetary funds can be problematic as they often provide for mandatory expenditure programs that cannot be curtailed. International experience has shown that the possibility of noninclusion of expenditure in the framework will provide incentives to spending departments to set up extrabudgetary channels or offload spending responsibilities to the subnational government. There is extensive literature on how planning mechanisms such as the MTEF create an incentive to engage in off-budget expenditure, creative accounting, fiscal escape routes, and so on.5 Private financing guaranteed by the state and public-private partnerships are examples of often-used escape routes for government spending.
One way to obviate such inadvertent use would be to have the medium-term fiscal framework cover all of general government. Now that the authorities have “opened the front door” of (formal) local government finance and “closed the back door” of (informal) borrowing (through local government financing vehicles), the central government can set the fiscal target for general government and divide the borrowing quota between central and local government. This means that the resource envelope for central government is based on its expected revenues plus a deficit target that implies sustainability for the entire government.
However, when expanding the MTEF to the detail required in an MTBF or MTPF, the government would be well advised to limit the MTEF to the coverage of the State Budget. It is these detailed expenditures that are under its control and worth planning for within a medium-term framework.
Anchoring the Framework to a Fiscal Rule
This discussion is linked to the issue of coverage. Any MTEF will have a set of fiscal targets over the medium term; otherwise the resource constraint is not a hard one and no expenditure ceilings are set by the framework (which means the framework is not a framework, but an outlook). However, a fiscal rule implies that fiscal targets over the medium term are set not based on judgment and discretion, but by a formal or informal rule, which can be either nonnumerical or numerical.
The Ministry of Finance has in the past used an informal numerical fiscal rule that general government should not have a deficit higher than 3 percent of GDP (in practice the rule applied to the central government, as until 2014 local governments were not allowed to borrow). The National People’s Congress formally approved the rule in 2015 as part of the annual budget, but this decision could be amended from year to year. A general discussion about the cost and benefits of fiscal rules is beyond the scope of this chapter, as is the question of whether China should adopt a fiscal rule enshrined in law, what type of rule is best, or what limit it should have.6 It is a positive step, however, that the authorities have clarified that a fiscal rule governing general government should guide fiscal policy and MTEF formulation.
Whatever the basis for fiscal policy, fiscal policy objectives will translate into expenditure ceilings over the medium term. An important design element of an MTEF is how such medium-term ceilings will be applied to government expenditure. Some OECD countries for example have excluded mandatory expenditures such as social security and interest payments, given that these expenditures cannot be changed without entitlement reform or are difficult to forecast over the medium term. Most countries have taken some intermediate position, excluding some but not all mandatory expenditure. The reason is that excluding too much expenditure from the ceiling determination will require much larger adjustments to discretionary expenditure. Including mandatory expenditure to some extent will force entitlement reform if it really becomes necessary.7
Time Horizon of the Framework
This practical aspect of MTEF design is usually guided by several factors. First, the volatility of the economy can make forecasting four to five years out difficult. Some countries keep their framework limited to three years (or even two years in a very few cases). Second, the political priorities of government can change considerably. Third, the term of government can be used to set the duration of the MTEF. This implies that the government policy agenda is represented by the MTEF in the first year of the administration.
Finally, in China, the alignment of the MTEF with the five-year plan would have benefits. To have the five-year plan fully costed and prioritized against the available resource ceiling could strengthen the link between plan and medium-term budget. Further discussion on this topic is necessary, but given the limits to macro forecasting and of costing of out-year policy measures, China may want to consider a time horizon of only three years. This would help increase the credibility of the MTEF. It would also point out that strategic planning documents, such as the five-year plan, have a different aim than the budget. Linking the two directly would probably have only limited benefits and may actually make the preparation of both more difficult.
Fixed or Rolling MTEF
This also alludes to the time horizon, but in a different way. Under a fixed system, the framework would be established for the term of the administration or of the duration, for example, of the five-year plan. Every year the MTEF would become a year shorter. The out-years that are not part of the MTEF would have the character of a fiscal or budgetary outlook.
The rolling MTEF, on the other hand, would gain a new year, every year, so the length of the MTEF would always be the same. Rolling frameworks are internationally the most common. They have the benefit of not leaving large uncertainty between planning periods.
Embedding the MTEF in the Budget Process
As noted above, the MTEF and the budget should be closely integrated. One of the main reasons MTEFs fail to have an effect is because the ministries of finance treat them as two separate documents, sometimes prepared by two different teams within the ministry. For an advanced MTEF, an MTBF, or an MTPF, the budget should represent the first year of the period covered by the MTEF. The MTFF presents the fiscal targets, outlook, and agreed main policy measures for the medium term, and for the annual budget.
MTEFs are usually prepared at least once, but often twice, per year. If once a year, the MTEF is prepared and approved together with the budget. In many advanced economies, the MTEF is prepared twice a year. The first time allows for a strategic phase in the budget process. Assuming a budget calendar that follows the calendar year, this phase usually takes place around March–April and allows for the main strategic allocation decisions to be made before the detailed budget is prepared.8 In the strategic phase, the overall deficit and expenditure ceiling is set to reflect the fiscal policy stance. In the case of an advanced MTEF, expenditure ceilings per ministry are set both for the budget year and for the out-years of the MTEF. If no ceilings are set for the out-years, no decisions can be made on allocations in the out-years, and the MTBF or MTPF reverts to a medium-term budgetary outlook.
A Real or a Nominal MTEF
This, again, is a design element in which countries have made different choices. Most countries define the MTEF in nominal terms, using estimates for price inflation and other cost drivers to estimate the baseline and new expenditure that can be implemented within the resource envelope. This has the benefit of expenditure ceilings being set in nominal amounts. Price shocks are then not compensated automatically by the framework.
A number of countries define the MTEF in real terms. This makes it much easier to see whether expenditure programs are scheduled to increase in real terms, stay constant, or decrease. However, the implication of an MTEF in real terms is that every year an inflation adjustment is automatically made to expenditures. In countries with substantial inflation rates, say higher than 3–4 percent, setting the framework in nominal amounts decreases the risk of public finances getting out of control by the automatic accommodation of inflation shocks.
The design choices discussed here have to some extent already been taken by the Ministry of Finance in its pilot MTEF prepared for internal use in 2014. The choices made include a time horizon of three years (2015–17), updating of the MTEF on a rolling basis, presentation in nominal terms, a focus on a framework for fiscal aggregates, and an outlook on detailed program expenditures. The latter part includes central government expenditures, including, importantly, all transfers to subnational governments. The MTEF also includes all anticipated policy decisions in the forward years.
This is an ambitious start, which reflects the authorities’ strong commitment to a multiyear approach to budgeting. Given the rapid introduction of the MTEF pilot, it is likely that some aspects of the design need to be further developed. Other countries have typically gone through a period, often lasting a number of years, of adjusting the MTEF design in order to obtain maximum benefit. Therefore, it is to be expected that the nature and performance of the MTEF in China will evolve over the coming years.
Who Should be Responsible for Development of the MTEF?
The above discussion assumes that that developing the MTEF is the work of the Ministry of Finance. In most countries around the world, ministries of finance are responsible for fiscal policy and for the budget, so it is only logical that they would have the lead in developing medium-term fiscal and budgetary frameworks. As in other countries with planning ministries, however, we believe that in the Chinese context the NDRC would also need to play an important role. Line ministries also have their role to play in the MTEF once it moves beyond the MTFF phase.
The MTEF is a document intended to fill the gap between the national plan, the five-year plan in China, and the annual budget. For many countries, the MTEF was developed in situations where the national plan had been discarded and ministries of planning had been disbanded (or merged into the Ministry of Finance). The lack of multiyear planning was in many OECD countries one of the reasons for developing the MTEF. In most emerging market and developing economies, planning ministries still play a crucial role in providing strategic direction to government policies and in reviewing, selecting, and monitoring capital investment projects. In China, the NDRC has this role, and the five-year plan is a prestigious and influential document. For this reason, it will be important to ensure that the MTEF and five-year plan are consistent in the first year of the five-year plan, and in the year of the five-year plan update. However, on the use of the requisite macro framework, the MTEF should not compromise. It should be based on realistic macro forecasts, not on aspirational targets.
What concrete roles should the Ministry of Finance, the NDRC, and line ministries carry out with respect to the MTEF? The following could be considered:
Macro forecasting. Although it is advisable that the Ministry of Finance develop its own macro-forecasting capacity, the lead institution in preparing the macro framework could be the NDRC. The NDRC currently prepares the framework for the five-year plan and the annual projections for the budget. It could be tasked with making the medium-term forecasts for the macro economy. Assignment of this responsibility to another part of government is not uncommon in many countries. The Ministry of Finance should develop macro-forecasting capacity in parallel, to be able to discuss the feasibility of the NDRC’s projections. Most macro frameworks prepared for MTEFs are dubbed “cautious, but realistic.” It has been argued repeatedly here that forecasts should not be aspirational, but it is equally important not to be too cautious as this will lead to systematic underestimation of revenue, and supplementary budgets would be required during budget execution every year. This disrupts the budget process and to some extent negates the multiyear planning of expenditures.
Investment programming. China has a large public investment program, and it is essential that a central institution play a supervisory and coordinating role. The NDRC would seem best placed to develop a costed and prioritized multiyear pipeline of projects that would be integrated into the MTEF. The Ministry of Finance would set the overall ceilings for investment expenditure over the medium term, just as it does for the annual budget now, and the NDRC would review and select, with input of the Ministry of Finance on costing, the projects aligned with the five-year plan, and with the highest benefit to the Chinese economy. The MTEF would also require coordination between the Ministry of Finance and the NDRC on the integration of recurrent and capital budgets, that is, allocating funds to the recurrent budget to ensure full productivity of past and current capital outlays. The MTEF is specifically used by countries to better allocate maintenance and operational expenditure for capital assets. In many countries, such integration is lacking, harming the efficiency of public investment.
Setting multiyear fiscal policy. Developing the fiscal policy statement, including multiyear targets for the main fiscal aggregates, is mainly a task for the Ministry of Finance. Usually, finance ministries set up separate fiscal policy offices, either inside their budget office or parallel to them. This choice usually comes down to the existing focus of the budget office. If the focus is very detailed and engaged in the budget preparation of many first-level spending units, it usually makes sense to develop a separate fiscal policy office. If the budget office has already delegated much of the detailed budget preparation to line ministries, and has taken a more strategic role in preparation of the budget, a fiscal policy unit can be integrated into the budget office. Many ministries of finance in Asia have chosen to set up separate fiscal policy offices (Indonesia, Malaysia, Thailand). Establishing separate units for fiscal and budgetary policy carries coordination risks in that the MTEF and budget may not be well integrated.
Fiscal forecasting. The Ministry of Finance will also need to make top-down multiyear estimates of fiscal aggregates on the basis of the NDRC’s macro forecasts. Good forecasting requires in-depth understanding of existing tax policy and revenue administration and an understanding of major expenditure programs, especially the mechanics of expenditure sensitivity to the business cycle (that is, the automatic stabilizing properties of various programs such as social welfare and unemployment insurance schemes) and benefit programs (such as pensions) whose funding is determined by the number of eligible individuals. Internationally, revenue forecasting is often done by a separate unit within the Ministry of Finance, which interacts closely with tax policy and administration entities.
Baseline estimates of expenditure programs. Once the MTEF moves beyond the MTFF stage, the baseline of expenditure should be prepared by the budget office, the Budget Department in the Chinese context, but in cooperation with line ministries and agencies. Often the initial estimates are made, or should be made, by the line ministries, given their much deeper understanding of the cost structure of their programs. Accurately estimating program expenditure for the annual budget is quite taxing by itself. Baseline estimates of expenditure programs over the medium term can have the additional difficulty of being influenced by exogenous variables, as discussed earlier. For this reason, introducing baseline estimates for decision making is often only done after extensive piloting in cooperation with selected line ministries.
Reconciliation of resource envelope, baselines, and new policy measures. Development of new spending and revenue packages is clearly a responsibility of the Ministry of Finance—specifically, its budget office. Just as with the annual budget, inputs from policy departments within the Ministry of Finance, the NDRC, and line ministries will be extremely important. Costing of annual and medium-term expenditure cutbacks on existing programs, of new taxation initiatives, and the introduction of new program expenditures will be for the Ministry of Finance to estimate and present to the State Council.
Sequencing the Introduction of the MTEF to Make it a Success
Many MTEFs globally have not lived up to expectations. In some countries, the basic public financial infrastructure for MTEFs is lacking. The list of prerequisites for successful MTEFs includes a credible annual budget, effective fiscal reporting and cash management, and reliable budget execution. Capacity in macro forecasting, planning and budgeting, and sectoral policy analysis can be added to this list.
Two more considerations can either make or break an MTEF. First, the commitment of the policymakers to using the instrument. In the Chinese context, without support from the NDRC and State Council for the new budget management tool, effective implementation will be difficult. Second, the MTEF document needs to be clear and provide insight into the fiscal and budgetary objectives, strategy, and concrete policy measures of government over the medium term. For initial support not to dwindle, benefits from using the instrument should be evident. Benefits such as more effective fiscal policy, enhanced budget predictability and discipline, better insight into expenditure trends, and improved strategic direction will all depend on the clarity, accuracy, and dependability of the exposition in the MTEF document.
For these reasons, sequencing of MTEF reform is important. Too many countries attempt to produce an MTBF or even an MTPF too quickly. It would seem more appropriate for China to start with an MTFF. This would not require the support of the line ministries. It would allow fiscal policy to be placed in a medium-term perspective, and set fiscal policy of general government at a sustainable level and attuned to the business cycle. It would focus on bringing the augmented deficit under control. That should be a policy priority of government. The reconciliation process of bringing fiscal space into equilibrium with new policy measures would be based on major expenditure programs and tax measures only. This means that the technical requirements would lie mainly in the sphere of fiscal policy, macro and fiscal forecasting, and costing of major policy proposals.
The introduction of an MTFF could coincide with presentation of a budgetary outlook, a forecast of expenditure at the level of detail presented in the budget based on expenditure planning foreseen by the Ministry of Finance. The MTFF plus budget outlook would need only limited support of line ministries. The extension of the MTFF to a full MTBF or even an MTPF, while tempting for its promise of improved expenditure planning, allocation, and predictability, would need to wait until extensive piloting and development efforts have been done by the Ministry of Finance and line ministries. It should be noted that countries such as Australia did not disclose their MTEF and related projections in the early years of its MTEF development for fear of political repercussions. Only when sufficient confidence has been achieved in developing a baseline methodology for bottom-up expenditure forecasting, in costing new policy proposals at a detailed level, and in being able to connect this year’s MTEF to the previous year’s and the following year’s should that next step in the reform process be attempted.
China has recognized a need to strengthen its budget planning instruments by setting itself the goal of developing a medium-term expenditure framework. The 2014 revised budget law that came into force in early 2015 is a landmark achievement that directs this reform and will set China’s fiscal and budgetary management on a much sounder footing.
At present, the budget is still determined on an annual basis, which is not well aligned with the aspirations of medium-term expenditure planning and aggregate fiscal management. The strategic direction of government policies needs to be couched within realistic expenditure constraints, which are not always provided through the five-year plan. Despite significant progress in modernizing the annual budget process, the authorities quite rightly intend to take the next step in budget process reform. This step will help ensure fiscal discipline and identify fiscal risks at an earlier stage. At the same time, it will facilitate countercyclical fiscal policy and help plan government expenditure programs more effectively and efficiently.
In the coming years, China will need to develop its own MTEF. Among the essential capacity-building prerequisites are formulating medium-term fiscal policy targets that are based on sustainability and stability objectives, strengthening top-down macroeconomic and fiscal forecasting, establishing a bottom-up expenditure baseline, and developing a strategic decision-making phase in the budget process on the use of fiscal space over the medium term.
Importantly, preparation of the MTEF will require setting fiscal policy objectives over the medium term for the whole of general government. As the surge in public investment has shown over the past decade, it is important to be able to direct, but also to control, the impact of fiscal policy of both central and local government on the economy. The MTEF will also need to be based on a sound medium-term macroeconomic framework, reflecting the real economic outlook rather than economic targets.
The MTEF will present policy measures over the medium term to allocate available fiscal space to achieve its fiscal targets. Rolling over the MTEF from year to year is crucial, adjusting for changes in macroeconomic forecasting and new costing. The time horizon of the MTEF could start with three-year time horizons to gain traction.
Finally, it is essential to incorporate the MTEF into the budget process and into political decision making to reap its full benefits. International experience suggests that without political support, the MTEF could remain a largely technocratic exercise, and will not get serious consideration from spending departments.
Moving toward an MTEF is a substantial, multiyear reform. It will require collaboration across ministries. International experience suggests that while finance ministries are key for its development and operation, other line ministries, such as the NDRC in China, will also play important roles.
Sequencing of the reform process is important. China could start with a limited MTEF, an MTFF, that places fiscal policy in a medium-term perspective, particularly bringing off-budget local government spending in check. A medium-term budget outlook could present details on expected expenditures as foreseen by the Ministry of Finance. China could then gradually fill in other components of the MTEF to move toward a full medium-term budget framework over the medium term. Success in establishing the MTEF will provide a very necessary bridge for policymakers over the current gap between the national strategic five-year plans and the annual budget process.
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The IMF, in its analysis of Chinese general government finances, has used the terms “augmented” deficit and “augmented” debt to indicate the sum of formal general government borrowing (which includes borrowing by central government, pilot borrowing by local government before 2015, and formal local government borrowing since 2015) and borrowing through local government financing vehicles, which can be considered off-budget/informal local government borrowing because local government directs this borrowing and is liable for it. A full discussion of the “augmented” concept can be found in Appendix III of the China 2014 Article IV Consultation Staff Report (IMF 2014).
According to a United Nations projection, both east and southeast Asia are experiencing a rapid deceleration of fertility, with their shares of the 65+ age cohort set to quadruple and triple, respectively, by 2050.
Given that China’s fiscal year is from April through March, the strategic phase of budget preparation, that is the discussion by the State Council of the first MTEF in the annual cycle, would be around June—July of the prebudget year. A second, updated version would be included in the budget documentation in March.