Abstract

This section examines the process of budget system reform required to move from traditional, centralized input-oriented systems to more modern, devolved, performance-based systems. It identifies a strategy based on recent attempts at this reform in emerging market economies and stresses the required sequencing of steps in this process. The strategy outlined involves a three-pronged approach, requiring measures first to increase the flexibility in the agency operating environment, then to provide more certain resourcing for spending agencies, and finally to exert pressure on agencies to improve their performance. This section stresses the need to progress on all three fronts simultaneously and to base these reforms on a firm platform of agency management skills. It highlights the need to attain some basic PEM thresholds in the area of restructuring the budget and its classification system, to improve the accounting system, to develop a financial management information system (FMIS), and to strengthen internal financial management skills. At the same time, it explains that it may also be necessary to introduce changes to the institutional and regulatory framework in which budget managers operate.

This section examines the process of budget system reform required to move from traditional, centralized input-oriented systems to more modern, devolved, performance-based systems. It identifies a strategy based on recent attempts at this reform in emerging market economies and stresses the required sequencing of steps in this process. The strategy outlined involves a three-pronged approach, requiring measures first to increase the flexibility in the agency operating environment, then to provide more certain resourcing for spending agencies, and finally to exert pressure on agencies to improve their performance. This section stresses the need to progress on all three fronts simultaneously and to base these reforms on a firm platform of agency management skills. It highlights the need to attain some basic PEM thresholds in the area of restructuring the budget and its classification system, to improve the accounting system, to develop a financial management information system (FMIS), and to strengthen internal financial management skills. At the same time, it explains that it may also be necessary to introduce changes to the institutional and regulatory framework in which budget managers operate.

Stages in Budget System Development

Among the major challenges faced by emerging market economies is the need to adjust institutions to function in an increasingly market-oriented and global environment. One of the most important of these institutional reforms has been restructuring the budget system.1 The term “budget system” should be interpreted quite widely to encompass the institutional framework as well as the administrative procedures that determine the means whereby resources are transferred to government; how their use is prioritized and directed to agreed policy objectives; and how their use is subsequently managed, controlled, monitored, and reported. It is generally agreed that a modern budget system should be able to meet three main requirements: first, to ensure control over expenditures so that they are consistent with the budget law; second, to stabilize the economy through timely and efficient adjustment in fiscal aggregates; and third, to promote efficiency in service delivery through procedures that provide incentives for greater productivity.2 The European Union recently adopted such a framework for reviewing the quality of budgeting in its member countries.3

Typically, budget systems evolve by progressively assuming and placing different emphasis on these three requirements. The most basic systems traditionally focus on the first objective—ensuring compliance with the annual budget law—and are generally associated with detailed line-item budgeting. While meeting basic compliance requirements, traditional budget systems usually are later modified to accommodate the government-wide stabilization objectives and the need to control fiscal aggregates. This usually involves a top-down approach to ensure that fiscal policy can be harmonized with monetary policy, through the introduction of procedures to enable the government both to plan, control, and monitor spending effectively and to adjust fiscal aggregates to meet fiscal targets which are increasingly set in a multiyear framework. After budget systems are capable of handling compliance and stabilization objectives, increasing emphasis is typically placed on the third objective, ensuring the efficient and effective use of government resources. Putting in place mechanisms to meet this objective has progressively become the focus of interest for OECD budget managers over the last two decades. The challenge has been to ensure enough flexibility so that budget managers are given ample scope to manage, without sacrificing compliance and overall macro stabilization objectives.

The move to this third phase has been spurred by two separate developments. First, the limitations of traditional compliance-oriented budget systems became more apparent when faced with the need to constrain an ever-expanding public sector. Second, the progressive use of more flexible budget management procedures brings about an increased realization that stabilization and efficiency objectives do not necessarily compete and can be complementary. As a consequence, traditional budget systems, based on short-term and detailed control of inputs, have generally been discredited as a tool for promoting public sector performance, which by definition should focus on the outputs or results from these inputs (Box 1).

The increased suspicion that fiscal stabilization objectives were being achieved at the expense of performance led OECD countries to modify their budgets to serve as performance management instruments and not just as instruments for macro control. When they introduced performance management into their budget systems, the associated increase in managerial freedom helped make it evident that greater managerial flexibility could be viewed as a tool not only for improving efficiency but also for achieving expenditure targets. This derived partly from a realization that managers of individual programs are in the best position to decide the most appropriate mix of inputs to use for executing their programs and that providing them greater managerial freedom could assist them in achieving tighter budgetary limits—that is, improved efficiency in resource use could support stabilization targets.4

Pros and Cons of a Traditional Line-Item Budget

Pros

  • Usually provides compliance control, allowing payments to be limited to voted appropriations

  • Provides database for across-the-board cuts to control fiscal aggregates

  • Is an uncomplicated system, easy to understand, focused on “the bottom line”

  • Easy to apply in a tight timetable, i.e., annual; minimizes discussion on programs/objectives

  • Adaptable to different economic situations (being incremental as well as decremental)

  • Reporting is not demanding; accounts are prepared after year-end for statutory review and audit

  • Cash-basis accounting is relatively easier to implement and maintain

Cons

  • Budget is divided by spending unit/activity centers that may have several programs

  • Prepared annually, with year-end rush to spend

  • The typical incremental approach favors existing programs, regardless of priority

  • Based on line items of expenditure; control is on inputs rather than outputs or outcomes

  • Reports are for compliance purposes, by institution and approved cost, and are usually detailed

  • Reports for stabilization purposes and control over aggregates need additional economic classification

  • Supporting accounting system is cash based, focused only on the payment stage of the spending process

Most emerging economies are only now entering this third stage of budget system development. They find themselves facing a common set of problems which stem from their past attempts to ensure that budgetary processes delivered a satisfactory aggregate fiscal outcome in support of macroeconomic stabilization. Even when care was taken to incorporate some degree of budget flexibility, the budget systems typically were left with a complex set of restrictions. These were increasingly recognized to diminish the allocative and operational efficiency of budget execution, usually with budget managers operating with limited responsibility for results. Accordingly, there has been a growing acceptance that the next stage of reform is to provide greater inducement for managers to focus on possible improvements in allocative and operational efficiency at the program delivery level.

A Three-Track Path to Reform

The shift within OECD countries over the past two decades toward performance or results-based budgeting has involved more than merely changing the way governments prepare budgets. While it is true that these reforms place much greater emphasis on performance information in the budget process, the innovation—almost a revolution—has been the abandonment of highly centralized forms of budget management and the adoption of more decentralized forms of management. The degree of decentralization has varied among countries, but all have attempted to create an environment that will ensure better performance in resource use by providing budget managers incentives that let them manage and also make them manage. In this way, the reforms seek to optimize the perceived tradeoff between tight fiscal control and effective program execution. In a large number of OECD countries, the result has been a fundamental shift away from traditional, centralized decision making toward decentralized decision making based on a reformulated accountability framework that focuses on objectives and specifies expected performance in terms of outputs or, in some cases, outcomes.

An examination of the trends in OECD budget reforms reveals that countries have pursued a three-track path in creating this new budget management model.

OECD Practices: Flexibility in Budget Management

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Source: OECD (2003, Tables 3.2.a, 3.2.b, 3.3.b, 3.4, 4.1).

Track One: Flexibility in Managing Resources

This involves providing increased flexibility to spending agencies in their access to budget funds and the uses to which funds can be put. The focus of increased flexibility has mainly been on the ability of spending agencies to reallocate funds within controls on budget line items. Changes are directed at giving organizations and managers greater freedom in operational decisions and removing unnecessary constraints on resource management. In return, organizations and managers are more directly accountable for results. The degree to which this approach has been adopted among OECD countries is indicated in Box 2. Australia, New Zealand, and the Nordic countries have led reforms in this direction, and Canada and the United Kingdom reflect the same approach. There are still a number of OECD countries that resist giving increased powers to public servants on the suspicion that over-spending will be the result. Thus, in the United States, Congress continues to exert firm control over spending by the executive branch,5 and in some countries such as France, while controls on operating expenditures have been freed, there is still central control over staffing.

Reduction of line-item specificity in the budget has been a general feature of such reforms, although increased flexibility has been provided in different ways. A first step is usually consolidation of detailed appropriation items into wider bands of expenditure categories. Portfolio budgeting, a more pronounced form of this approach, gives ministries greater flexibility and incentive to reallocate resources within portfolio allocations and to reflect changing priorities. A few countries have also introduced greater end-of-year flexibility by allowing a carryover of unused appropriations and the use of net appropriations to encourage the generation of nontax revenues to finance specific types of spending. For example, the Australian and New Zealand systems allow the sale or acquisition of fixed assets. However, these approaches are still regarded as radical by most countries. All such approaches are founded on two main preconditions: a tight budget constraint which agencies observe; and adequate capacity in the central budget office to monitor developments and intervene if necessary.

Track Two: Greater Certainty in Resourcing

The goal is to provide greater certainty about the operating environment of spending agencies, particularly in regard to the availability of funds. There is usually the need to take parallel steps to increase the certainty of budget funding. Forward medium-term expenditure frameworks (MTEFs) represent an important step in this direction. Medium-term budget planning has been a major development in OECD countries, with fiscal targets set on a three- to five-year basis rather than on a traditional one-year basis. Different approaches are evident. Australia, as a pioneer in this area, has perhaps carried the approach further than most in developing a forward estimate system in which refined forward estimates become estimates of future spending rather than simply forecasts of existing policies. In this way, there has been a transition to medium-term budgeting. A comprehensive medium-term budgeting system complements the increased flexibility given to agencies by allowing carryover of funds between years.6 However, in some countries budget planning occurs only at the aggregate—rather than at the agency or ministerial level—where plans are just that and are not used to give indicative allocations or limits to individual agencies and programs.7

Track Three: A System of Rewards and Penalties

The goal is to put increased pressure on agencies to pursue improvement in program results. Within the OECD, there has been an increasing reorientation of central budget offices away from compliance issues, based on detailed control over inputs, toward more performance-oriented managerial issues, focusing on outputs. In part this reflects greater concern for improving resource allocation than for meeting fiscal stabilization objectives, but it also reflects a recognition that improved program performance is as important for macro control as detailed controls over inputs. Hence, in recent years, there have been increased attempts to integrate budgeting with other management processes; require agencies to measure performance and evaluate the results of their operations; develop new guidelines and methods for holding managers accountable; and develop the information bases and reporting systems that can enforce this accountability. As a whole, this approach is often termed performance budgeting, or budgeting for results.

Some Anglo-Saxon countries have attempted to employ formal contractual arrangements to ensure performance (e.g., New Zealand’s purchase agreements for outputs between ministers and agencies, or the United Kingdom’s annual performance agreements between a minister and an executive agency).8 This is an attempt to connect budget provision directly to performance. Recognizing the many methodological and practical problems of performance measurement, other countries (Canada, Denmark, Finland, Sweden, and the United States) have introduced initiatives to promote improved performance without tying this directly to budgeting. These have taken the form of developing performance indicators, formalizing requirements for program evaluation, and enhancing the role of external review agencies such as supreme audit institutions. It has been recognized that there are limitations to the ability of performance indicators to capture all relevant factors that dictate performance. For example, it is easier to devise and identify outputs rather than outcomes, which are more relevant to performance. Nor is it always clear what should be the budget implications of poor performance—how to achieve the linkage between performance and budgeting remains largely unresolved.

An Integrated Strategy

What does appear clear is that each of the three tracks is essential and should be followed to ensure the overall success of the reform process. In particular, increasing flexibility for spending agencies without pressure to improve performance could increase rather than reduce inefficient use of budget funds. Similarly, provision of a more certain operating environment without increased pressure on agencies to deliver results could reduce aggregate fiscal control without generating improved program outcomes. It is therefore considered essential to proceed down these three tracks in a highly coordinated manner.

The aim of this three-track strategy is to allow agencies to use scarce budget funds more flexibly and effectively, while also putting pressure on them to do so. This encourages a reallocation of funds from less effective to more effective uses within each agency. It also has advantages for the central agencies, enabling stronger aggregate expenditure control through the ability to identify and more easily withdraw funds from unproductive activities currently hidden in agencies’ baseline budgets. But perhaps most important, these steps are also directed at setting up a clear accountability framework for budget managers that is the basis of the new performance budgeting model. Agency heads are given the degree of managerial autonomy they need to achieve the tasks assigned to them, and in return they are required to meet certain conditions. This accountability framework is based on some key elements: a clear ex ante specification of the performance expected of each agency head; agreed arrangements for collecting all the information required to assess performance; incentives and sanctions to encourage agency heads to act in the government’s interests; and a clear performance assessment process involving ex post reporting of actual performance against the initial specification.

Operationalizing this accountability framework, in turn, requires putting in place a reformulated PEM system. First, this requires some restructuring of the budget to clearly define programs with identifiable objectives that are set in a strategic framework. Second, it requires resolving the many technical problems related to measuring these objectives and hence agreeing on indicators of performance. Third, mechanisms need to be put in place for creating service contracts; procedures need to be established for monitoring performance against contracted obligations; and a system of penalties and rewards must be agreed. Many of these elements are to be found in recent Russian reform initiatives (Box 3).

The Steps toward Reform

How then to move traditional budget systems toward these new objectives, along the three reform tracks? What are the options for introducing these changes as part of a coherent program of budget system reform? To answer these questions, what follows is an outline of the approach followed by some emerging economies, which will be explored in greater depth in this study.

Flexibility in the Agency Operating Environment (Track One)

Moving away from detailed line-item budgets is not easy to engineer. Line-item specificity exists for a number of good reasons. It reduces the scope for spending units to make unproductive reallocations, either in pursuit of bureaucratic interests or under the influence of personal inducements.9 Detailed controls also reduce the chance that appropriations are inadvertently overspent in the aggregate. Finally, a high level of specificity enables central agencies to identify underspending at the end of the budget year at the detailed operational level and to reduce funding or take remedial action.

Russian Budget System Reforms

Reforms in budget procedures were introduced with the Budget Process Reform Concept Paper for 2004–2006, whose main principles were agreed in April 2004. The declared objective of the reforms is to move from a system of budget management focusing on costs to a system of management by results.

There are five main elements of this reform:

  • Reform of the budget classification and accounting.

This involves a move away from excessive detail in budget nomenclature, and toward the approval of main items contained in the Budget Code. This is consistent with a single chart of accounts (CoA) for government institutions, closer to internationally approved standards, that will allow a phased transition to accrual accounting. The main changes proposed to the budget classification affect the functional classification and are intended to reduce the current 27 categories to 11.

  • A clear differentiation between existing and new policy commitments when preparing the budget.

Recognizing that 90–95 percent of commitments are already “locked in” and that new programs only occupy 5–10 percent of the budget, a differentiated treatment is proposed for approval of a baseline budget and approval of new policies, which will further lock in the budget in the future.

  • Introduction of medium-term budget planning as part of the 2006 budget covering the period 2006–08.

A move away from the annual approach to budgeting to the approval of an indicative rolling budget framework for three years, broken down by government department.

  • A streamlining of the budget process.

Most notably, the number of readings for the budget is reduced from four to three. The first reading will only discuss the broad parameters and the committed “old policy” budget; the second reading will discuss new policy; and the third reading will be a general review of the entire budget with detailed annexes for each main budget institution. The existing practice of approving the detailed budget classification under a separate federal law is replaced by a law fixing only the main codes of the classifications that are mandatory for all budget levels.

  • Introduction of program and performance budgeting methods.

Introduced as a two-year “experiment,” budget institutions were invited to prepare and execute their budgets on a results-oriented basis for the 2005 and 2006 budgets. Specifically, there is a requirement for budget institutions to report on results and to develop mechanisms for monitoring efficiency in resource use. This implies that federal “earmarked programs” for large investment, research, and structural projects will be restructured to reflect efficiency objectives (and their number will be reduced). Departments will also introduce “targeted programs,” smaller in scale and focused on extension of services or projects, along with agreed procedures that emphasize objectives, indicators for these objectives, and measures of results. Budget institutions will be required to submit annual reports on the results of their main activities, with an assessment of the efficiency of spending by previously determined indicators and with agreed powers and responsibilities for different management units for each activity.

Given the case for detailed budgets, specificity should be reduced only where spending agencies have the internal financial and management skills to take responsibility for control in these areas. The devolution of financial flexibility should be viewed as an important carrot in persuading agencies to develop improved internal resource allocation procedures and controls.

Further freedom in transferring funds within the existing line-item structure, or moving that structure toward broader expenditure category bands, should not be granted until a review has been made of the quality of internal financial control, coordination, and planning mechanisms in spending agencies. This should involve a case-by-case examination of the capabilities within the accounting, budgeting, and planning units of spending agencies and the interaction among these units.

The granting of further flexibility in budget allocation should be made conditional on clearly defined capacity-strengthening activities in spending departments which will benefit from such flexibility (the carrot and stick principle). Further flexibility should be granted on an agency-by-agency basis, as specified levels of internal control standards are met by each agency.

Providing a More Certain Environment for Spending Agencies (Track Two)

There is often an initial reluctance in middle-income countries to commit publicly to medium-term fiscal plans, because of the danger that they may be regarded as a commitment of future resource availability and use. One cannot dispute that this is a risk, but it is one that other countries have faced and largely overcome. The important point is that if managers are to be empowered to manage effectively, they cannot be constrained to a one-year time horizon. It is usually agreed that the typical rush to spend before the end of the fiscal year and the resultant waste of resources, which are features of traditional budgets, are to be avoided. Moreover, one advantage of investing time to prepare more detailed forward estimates is that the government may be better able to plan or articulate in advance the details of how it will achieve its fiscal targets—improving both credibility and fiscal management.

Even from the central management viewpoint, there appears to be a need for a medium-term planning framework. Typically, emerging economies have had to undertake extensive investment programs aimed at competing globally by upgrading their institutions, human capital, and basic infrastructure. Such investment produces substantial debt service burdens and future recurrent spending, at the same time that these countries typically must also resolve the legacy of many medium-term budget commitments arising from entitlements and other laws. Preparing and operating an MTBF appears beneficial simply because it spurs a process of assessing the medium-term macroeconomic consequences of such commitments, checking the consistency of the resource envelopes, and meaningfully discussing future priorities.

While the introduction of an MTBF is recommended, this falls far short of preparing forward estimates, because there is no implied legal commitment of resources and because an MTBF is produced primarily for information purposes. The MTBF should be a coherent and sustainable forward plan for spending two to three years ahead, based on present budget policies and expected new policies. It should be revised on a rolling basis and should form the basis of public discussions on future budget policies (although it could be only a spending plan, conceivably with no revenue estimates). This framework could then be used in a number of ways:

  • In developing the forward estimates of expenditure, the first stage should be on the forward estimates of existing policy commitments, and only, say, for the third year should an attempt be made to program in new policy commitments.

  • The scope for proactively using the MTBF for cutting into baseline allocations should be actively pursued. This could involve the application of an annual “efficiency dividend” to personnel services and maintenance and operating expenditures,10 or the assignment of selective savings targets to individual departments through a reduction in specific components of their forward estimates. The resulting pool of savings could be assigned to fund new policy measures or applied to reducing the deficit, as the need arises.

  • A high priority should be given to ensuring that the cost analysis underpinning future outlays programmed into the MTBF be sufficiently rigorous to be of “budget quality” (assisting the transfer between the MTBF and annual budget preparation processes).

As a long-term goal, there should perhaps be the aim of automatically loading the forward estimates of expenditure into the starting point of successive annual budget preparations. This will require action to restrict the existing forward estimates to previously approved expenditure measures. It will also require that budget deliberations be confined to changes in the forward estimates (rather than the reconsideration of expenditures already contained in the estimates). Estimates of the out-year costs of approved measures will need to be firmed up to budget quality standards by excluding “gambit claims” or overgenerous resourcing.

Increasing the Pressure on Agencies to Perform Better (Track Three)

Along with providing budget managers with a more flexible operating environment and a more stable resource base, there is a concurrent need to pressure managers to take advantage of this new environment in a positive way—that is, to improve their performance. The concern is to ensure that agencies actually use their increasing management discretion to improve program outcomes rather than either to maintain the status quo or to pursue goals of a more bureaucratic or personal nature.

At the most fundamental level, putting pressure on agencies to perform better under the new arrangements requires a high degree of transparency in their operations. This raises questions about the adequacy of government financial information systems, an issue made more pressing by any move toward decentralizing spending authority. A beginning step could be to require agencies to report on their achievements in terms of performance indicators against budget targets. However, such reports are unlikely to have much impact if there is no enforcement mechanism and if resources are neither increased nor withdrawn on the basis of performance. As indicated, connecting performance to budgeting is not easy, and a dual approach is perhaps more effective: applying pressure from above as well as increasing capacity from below. This implies that the MoF would encourage a reevaluation of agency activities and put pressure on managers to economize their resource use and, at the same time, boost the capacity of agencies to manage their resources more flexibly and efficiently.

Three Preconditions for Reform

Adopting this three-track approach requires three preconditions: first, an adequate level of PEM capacity; second, reorganizing government institutions to work in this new environment; and third, providing a facilitating external environment.

Some Basic PEM Thresholds

Budget system reform requires that the existing PEM system have some basic threshold capacities. It is possible to interpret recent Chinese budget reforms as geared to reaching these basic thresholds (Box 4). Some of these requirements can be identified.

Restructuring the Budget and Its Classifications

Traditional budgets are usually characterized as line-item budgets—budgets that focus on cost items or inputs such as wages and salaries, other goods and services, and spending on capital items (see Box 1). Such budgets are typically subdivided on the basis of departments or activity centers, each of which may operate several programs. Budgets are constructed (usually on an annual basis) by comparing the previous year’s expenditures and adding increments (or subtracting decrements). There tends to be a bias in favor of existing programs, and new programs must compete with each other for limited resources. Budget control is primarily exercised on inputs, rather than outputs. Recurrent and capital expenditures often are budgeted separately. The focus is on compliance with the details set out in appropriations. To enforce such compliance, the budget classifications also reflect detailed inputs and the corresponding departments and cost centers that utilize them.

Restructuring the budget involves a shift in emphasis away from inputs and toward the outputs associated with these inputs. This approach, broadly termed program budgeting, attempts to identify amounts allocated to individual services and programs. It is used to counter the irrationality of using the previous year’s budget as the basis for the current budget and for only arguing for or against increments (decrements). It counters splitting the budget into recurrent and capital spending by recognizing, first, that both types of spending can contribute to the same program, and second, that capital expenditures generate future recurrent costs. Budget control is thus reoriented, away from the narrow perspective of limiting expenditures to those amounts and items included in the annual appropriations and toward ensuring a more efficient and effective use of resources over the medium term. To support the latter objective, it is usually necessary to add a meaningful program classification system to the budget. Thus one important precondition for moving to the next stage of reform is a suitable budget structure with a supporting program classification. It is also recommended that other classifications be compatible with international government finance statistics (GFS) standards.

Chinese Budget Reforms: Strengthening Basic PEM Systems

  • Review the legal and regulatory framework for the budget.

The 1994 organic budget law, recognized as having weaknesses, is under review. While imposing identical budget procedures at all five levels of government, the procedures are hierarchical across levels, causing considerable delays in approving lower-level budgets. Current and development expenditures are split, with oversight under different agencies and with different rules for their preparation. There is no medium-term budget framework and no performance information.

  • Improve budget preparation and classification systems.

Budget remains a small summary document. Recently, this increased in size and was supplemented with detailed departmental budgets, including the expenditure of “self-raised funds.” The MoF has enlarged and improved its projects database, with a focus on new projects. Classification does not specify costs to a sub-item level and is insufficient for detailed cost analysis and accounting control. Recent reforms involve deepening economic objects classification, with financing items moved below the line. Although still some way from international standards, there is improvement.

  • Strengthen the technical basis of budget preparation, introducing a performance orientation.

There is a push for greater transparency. with departments splitting their budgets between “basic” expenditures and “projects.” Budgets are compiled using manpower and other input-based norms, with project evaluations including expected outputs. Emphasis is on planned activities rather than last year’s budget, with input norms developed for clusters of similar operations. The approach is termed “zero-based.” A spur to improved budgeting is increasing the importance of “preliminary scrutiny” of the Finance and Economics Committee and its subcommittee. The MoF now prepares annual three-year fiscal rolling outlooks, but these are not yet integrated into the budget preparation.

  • Establish a treasury system, based on a Treasury Single Account (TSA).

A new Treasury Department was created in 2000, replacing the People’s Bank of China’s (PBC’s) treasury system which was based on a multitude of bank accounts and was viewed as a source of corruption. A parallel PBC system continues, with the budget executed using credit limits at spending units’ bank accounts that are reimbursed through the PBC branch network (“quota system”). The Treasury Department also developed its own direct payments system through a TSA at the PBC. The latter has caused elimination of thousands of bank accounts and a reduction of government float. Capital construction expenditures are executed centrally through the Accounting Division of the MoF Budget Department using an account at the China Construction Bank that transfers funds to the accounts of spending units that pay suppliers. Along with improved central cash management, the emphasis has been on improved agency financial management, focusing on internal controls and procurement.

  • Introduce a government financial management information system (GFMIS).

There is no integrated information system across the central government. In parallel with the increasing use of the TSA, the MoF has developed specifications for a countrywide GFMIS and by mid-2003 had introduced a pilot system based on a mixture of five systems developed in-house and three Oracle Financial™ packages (general ledger; payment accounting; and cash management, which is used for reconciliation of payment orders). The authorities are working on an appropriate information technology strategy as the basis for a more advanced GFMIS in the future.

Source: Brumby (2005).

Strengthening Internal Financial Management

Before attempting to give agencies wider responsibilities in resource allocation, it is essential to ensure they are operating within an effective financial management framework. Good internal control is an important feature of this framework.11 Without satisfactory controls, management may not detect serious errors and irregularities, and both the work of the central oversight agencies and any external audits become more difficult. An internal control framework should be designed to provide reasonable assurances that three basic objectives are achieved: compliance with laws and regulations; reliability of financial data and reports; and effectiveness and efficiency of operations. In the first two areas, problems are typically clustered around control over the payroll and effective procurement procedures, which usually account for a large part of an agency’s expenditures and present special problems of internal control. In strengthening and ensuring quality control over internal financial management, the emphasis is usually on collecting information needed to support internal control and on ensuring its relevance, timeliness, and objectivity. Internal audit has also been recognized as making a substantial contribution to quality control in internal financial management.

Improving the efficiency and effectiveness of agencies’ operations usually involves a change in mind-set and takes more time. Under a traditional type of budget system, there is little emphasis on performance. With the budget focused on inputs and with detailed line-item controls on expenditures, agencies focus on obtaining spending approvals and utilizing them within the year. There is little emphasis on nonfinancial performance and few sanctions for poor performance (as well as few rewards for good performance). Managers in line agencies, therefore, are not used to subjecting new policy proposals to critical analysis, nor to managing expenditures to achieve a budgeted outcome because these functions are tightly controlled by the center. There is a need, therefore, to develop such evaluation skills among agency managers and to establish a supporting information system based on indicators of output and performance.

Developing an FMIS

With the ever-growing volume and complexity of government financial operations, it is clear that fiscal managers have a critical need for timely management information reports, in a usable form. Producing such reports requires improved classification systems to identify programs so that costs can be allocated to individual activities and compared with the outputs of these activities. Similarly, moving to an accrual-based accounting system has obvious benefits to resource managers by providing a more complete picture of an agency’s financial position. Tailoring such reports to management needs through a computerized accounting system has been a general PEM reform undertaken by a number of countries in various parts of the world.

The need for an integrated and computerized FMIS becomes more urgent as the transition is made from centralized controls over spending to a devolved fiscal management regime. If agencies have relative freedom in determining the inputs required to achieve the outputs expected from them, then managers must be able to track inputs used and to develop output indicators. Furthermore, as budget horizons extend under an MTBF, the information system will have to support agencies’ needs to align their resource allocation strategies with the performance targets over a multiyear expenditure plan. These are ambitious reforms for many emerging economies but reflect current practice in most OECD countries. For these reforms to succeed, a crucial prerequisite is a well-conceived FMIS that provides access to a shared information database by all participating financial managers.

Establishing a Cost Accounting Capacity

Apart from the financial aspects of a budget institution’s operations, additional information will be required from an FMIS in a performance-based budget system. Greater emphasis needs to be paid to programs and activities approved by the legislature, and results from the use of resources allocated to these activities must be described in physical and not just financial terms. This has resulted in an increased emphasis on the costing methodology so that the full costs of programs and activities can be captured and meaningfully related to their outputs and outcomes in order to derive measures of program performance. Unfortunately, such skills are often scarce in government and must be developed. At the same time, there are limits on the extent to which costing systems, however sophisticated, can provide meaningful information unless backed with an adequate accounting system that captures and records the total costs of operations. Government accounting systems, typically cash based, have often been considered deficient from this viewpoint.

Improving the Accounting System

The typical government accounting system, even if conceptually well defined and internally consistent, has the drawback of being cash based. The traditional emphasis on voted costs, the last stage of spending, may be adequate for the compliance and stabilization objectives of the MoF at the center, but they are less relevant for budget managers in individual government departments. A precondition for moving to the next stage of budget system development is to upgrade the accounting system.

Traditionally, a government accounting system is required to serve two distinct objectives. First, the system must compile a formal/legal annual financial report of the government’s position in the form and content prescribed by statute and amenable to external audit. Second, the accounting records of primary financial transactions must form a part of a comprehensive and fully classified database capable of providing contemporary, accurate, and appropriate management reports required by financial managers in the government departments, including central MoF departments, to monitor and control government fiscal operations. Recognizing these two basic objectives, upgrading a government accounting system has typically followed two paths.

The first upgrade is typically to reformulate the accounting system to be able to capture all stages of the expenditure process in the accounts, namely: (i) appropriation; (ii) obligation incurred; (iii) verification of supply of goods/services; (iv) obligation due for liquidation; and (v) obligation liquidated (i.e., cash payment). A pure cash-based system only recognizes the final stage (v) with controls placed on ensuring that cash payments do not exceed the levels indicated in the first stage (appropriation). The problem of arrears, where the government has unmet obligations due for payment (stage iv), which has arisen when controls are placed solely on cash spending, has caused governments to focus on prior stages of spending, and in particular to realize there can be no true expenditure control without controlling commitments made (stage ii). Thus typical amendments introduced to pure cash reporting include the provision of information on payment arrears and various noncash transactions to provide a better indication of the total resource use by the government and its future cash requirements.

The second major reform of the accounting system recognizes that tracking the different stages of spending is not enough. For a comprehensive approach to budget management, which stresses performance, there is also a need to account fully for government assets and liabilities, to include all costs of providing services, and so to move government accounting closer to private sector accounting, with similar types of financial statements. Australia, Iceland, and New Zealand have already adopted accrual-based accounting for their whole-of-government financial statements and budgets, and others, such as the United Kingdom, have moved substantially in this direction. Some, such as Canada, Finland, Sweden, and the United States, have adopted accrual accounting principles for whole-of-government financial reporting, while others are adopting accrual accounting standards on a pilot basis on a limited scale—for example, Germany, Ireland, and the Netherlands. Still other countries, including some emerging economies, already prepare limited balance sheets, but these typically leave out a large component of the government’s assets in common infrastructure and “heritage assets.”

In the next stage of reform, but over time, these countries should move to a full accrual system, where all assets are included, progressively, in the balance sheet, and their valuation is shifted from an indexed historical cost to a replacement basis. The migration from cash basis to accrual basis through modified accruals will be discussed in some detail in Section VI, particularly, how this makes it possible to meet the reporting standards of the 2001 Government Finance Statistics Manual, or GFSM 2001 (IMF, 2001a), which formally adopts an accrual-based recording to supplement, rather than substitute for, the cash-based system used in most countries. Despite the importance of the accrual system in terms of properly stating the magnitude and timing of financial operations, it should be acknowledged that it is difficult to value certain government assets and thus determine net worth, as well as that it is impracticable for many countries to implement this change.

Institutional Framework for Devolved Management

There are two defining characteristics of performance budgeting: the greater emphasis on performance data in making resource decisions, and the more decentralized form of budget management. Adopting this new management orientation creates parallel pressures for reorganizing government operations, resulting in a number of innovative institutional arrangements. For expository convenience, in this study institutional arrangements are ordered by degree of decentralization, here characterized as the five “Ds”—deconcentration, decentralization, delegation, devolution, and divestment. Each of the Ds involves a progressive shift of decision making away from the centralized traditional model, and each in turn has involved different institutional arrangements for managing public resources. The latter three Ds are perhaps the most characteristic of the new performance budgeting approach.

Two aspects of these new arrangements are highlighted in this study: the role of contracting within government to establish accountability for managers at arm’s length and the choice and design of decentralized institutions, with special focus on the role of the “agency.” Both these institutional innovations have their problems.

Problems with making the contract approach effective often stem from difficulties in defining performance and devising operational measures of that performance. Even if these problems can be resolved, additional constraints often include the increased level of management expertise required to make the contract approach effective and the limited availability of adequate management tools. Similarly, the effectiveness of devolved agencies cannot be divorced from the existing level of PEM expertise. The case for the agency model is enticing: it separates policymaking tasks from implementation, better defining responsibilities and leading to better service delivery. As always, the practice has been less simple than the theory, with concerns over establishing adequate accountability. The need for “institutional clarity” on the exact status of these devolved institutions has often been neglected, even in OECD countries. That experience suggests the need to define very carefully the degree of autonomy of these institutions, as well as to clarify their accountability arrangements. It is important not only to buttress this with strengthened PEM procedures, especially with regard to their reporting requirements and the skills required of managers, but also to ensure that the level of governance in the country is sufficient to support this level of devolved decision making.

Countries have also experimented with various options for divestment, using models of devolved management that go closer to, but stop short of, outright privatization. These arrangements all aim for a higher level of commercialization in the provision of public services by giving customers a greater purchaser role. Two of the most popular approaches are competitive tendering and the use of concessions or private-public partnerships (PPPs), both of which also present challenges from a PEM viewpoint. While efficiency gains are generally associated with contracting in or contracting out, these often must be counterbalanced by high transaction costs, problems of quality control, and the need to ensure that the benefits to society are adequate and sustainable. Concessions and PPPs generally raise the level of PEM requirements even higher than contracting. This arises from the problems of defining outputs, issues related to concession design, and the need to set the form, level, and structure of payments, as well as to create the mechanisms to regulate the concession. Needless to say, the successful operation of these arrangements is heavily dependent on the government having the necessary specialized skills for their negotiation and supervision.

While the pace of such reforms has varied by country, OECD countries generally have adopted a phased approach in introducing these more devolved forms of resource management. This is partly in recognition that institutions should be progressively prepared for the shift to performance budgeting. This preparation generally entails significant upgrades to management and control systems and changes in the internal culture of government institutions, which inevitably take time. Often reforms cannot proceed until there is a change in an organization’s legal status, which again takes time. Of course, the longer the time horizon, the higher the chance that reforms are derailed and the greater the importance of effective steering and managing of the reform process.

Managing the Change Process

The three tracks of the reform strategy should stay in phase to ensure that the devolution of financial freedoms does not run ahead of the ability of agencies to put these new freedoms to good effect. Typically, the emphasis is on the top-down management of the performance improvement process. However, experience shows that there is a parallel need for refocusing efforts on “bottom-up” capacity building in line agencies. Unfortunately, the task of building this capacity is often well beyond the existing technical resources of traditional budget offices. External assistance from other agencies is likely to be necessary if the coherence of the reform strategy is to be preserved.

The wide-ranging nature of budget system reform, which involves not just central budget units but all government spending agencies, implies a significant resource cost not only in enhancing capacity but also in monitoring the responsiveness of departments and ministries to the enhanced flexibility to ensure that the reforms are sustained. The cost in terms of scarce management skills is perhaps the most significant for emerging economies. Even within OECD countries, reform programs have had to be engineered—a reform plan formulated, an implementation strategy agreed, and the implementation process successfully managed—to achieve the objectives and sustain the reform initiative. This raises the questions of whether there is sufficient capacity to engage on all three tracks simultaneously and whether there exist adequate change-management skills within government.12 In many emerging economies, a major reservation about the efficacy of the budget reform process often relates less to the overall approach to reform, or to the nature of the specific changes proposed, than to doubts concerning a viable “execution strategy.” To counter these doubts, it has often been considered important to nest budget system reforms within wider governance reforms stressing transparency and reinforcing the legal framework of budget management—as indeed has been the approach of pioneering OECD countries.

The Wider Framework for Budget Reform

Increased Emphasis on Fiscal Transparency

Transparency in government operations is increasingly regarded as an important precondition for good governance and sustainable economic growth; however, for the emerging economies, it is also an essential aspect of sustaining confidence in government and, through this, sustaining support for the democratic system and economic advancement. The latter has become particularly acute with the exposure of fiscal policies to international financial markets arising from the increasing use of market financing of deficits. Such exposure has required many governments to modify past policies and so has assisted in achieving fiscal discipline and improved resource allocation and, in turn, has supported reform of the budget system.13

One source of fiscal discipline is more transparent fiscal targeting. Box 5 indicates a wide variety of fiscal targets that have been adopted.14 This is already a fact of life for most OECD countries. Their current budgetary goals are typically expressed as specific quantitative targets rather than general statements of intent. The benefits derived from providing an unambiguous message about the government’s financial objectives to the markets is felt to outweigh the curtailment of the government’s ability to subsequently adjust its strategy for expediency, especially when the targets are specified for several years ahead.15 Most targeting has focused on the budget balance, with secondary emphasis on stabilization or reducing the level of debt, and less often on reducing outlays or the level of taxation. The convergence requirements of the 1993 Maastricht Treaty on European Economic and Monetary Union (deficit not to exceed 3 percent of GDP and gross debt not to exceed 60 percent of GDP) are fiscal targets that drive much of the fiscal strategy of EU members. In a few countries, fiscal targeting is focused on balanced budget requirements (for example, the United States and Switzerland), while many governments have followed the “golden-rule” approach—no borrowing except for capital purposes, supplemented by a limit on this borrowing or deficit as a percentage of GDP. New Zealand also targets net worth (as well as the budget balance and expenditure, taxation, and debt as a percentage of GDP).

Major Types of Fiscal Policy Rules

Balanced budget or deficit rules

  • Balance between government revenue and expenditure (i.e., prohibition on government borrowing), or limit on government deficit as a proportion of GDP

  • Balance between structural (or cyclically adjusted) revenue and expenditure, or limit on structural (or cyclically adjusted) deficit as a proportion of GDP

  • Balance between current revenue and current expenditure (i.e., borrowing permitted only to finance capital expenditure)

Borrowing rules

  • Prohibition on government borrowing from domestic sources

  • Prohibition on government borrowing from central bank, or limit on such borrowing as a proportion of past government revenue or expenditure

Debt or reserve rules

  • Limit on stock of gross (or net) government liabilities as a proportion of GDP

  • Target stock of reserves of extrabudgetary contingency funds (e.g., social security funds) as a proportion of annual benefit payments

Source: Kopits and Symansky (1998).

Fiscal transparency is difficult to enforce if a large proportion of government transactions takes place “off budget.” Improved resource allocation has been assisted by addressing a number of issues to increase the coverage of the budget. Many countries have large extrabudgetary funds set up with earmarked tax revenues, which escape budget discipline. For example, a large number of countries have public pension schemes, partly financed by employer contributions (a payroll tax) and employee contributions, which operate outside the budget. Many of these schemes give a distorted position of the government’s true position if their balances are measured on a “pay as you go” cash payments basis and not a full accrual (actuarial) basis. There is a similar need to identify and include quasi-fiscal transactions. A wide range of government activities often are not captured in government spending but rather are channeled through government financial institutions (e.g., concessional lending), central bank profits (or losses) on foreign exchange currency transactions, government bailouts of insolvent financial institutions, and “social expenditures” of the state-owned enterprises (e.g., employing more staff than commercially justified). The fiscal impact of public enterprises on the budget is another area that often requires greater transparency.

In many countries, public enterprises in such “strategic” areas as defense, transport, and government finance impose significant costs on the government, with neither the total costs nor the individual financial position of such undertakings clearly reported. Taxation concessions (or tax expenditures) should be regarded as a form of expenditure, but these often escape scrutiny, as do the resource costs of regulating the private sector, which are often a nontransparent alternative to public expenditure programs. Usually, there is no estimate of regulatory costs imposed on the private sector nor are estimates made when deciding whether to use such an instrument rather than a more transparent, direct government program. The pursuit of greater fiscal transparency, therefore, in addressing these problems has provided an important impetus to reform budget systems and is an important challenge for emerging economies seeking to institute similar reforms. Box 6 summarizes good practices in this area.

Is There Need for a New Legal Framework?

A number of countries’ budget system reforms are legally based, often in the form of fiscal responsibility laws, to force governments to commit credibly and to assuage governance concerns. The basic idea is to create rules and procedures that impose costs on governments for deviating from fiscal responsibility. The pioneer in this field was New Zealand, which passed the Fiscal Responsibility Act in 1994. This laid down principles of responsible fiscal management as a framework and ensured that these principles were upheld by defining necessary fiscal procedures, fiscal targets, and fiscal reporting. The need for greater transparency in fiscal management was an overarching objective of this legal framework. Not only are governmental bodies required to specify and adopt agreed fiscal targets, but they are required to explain the policies underlying their pursuit and, when deviating from this policy commitment, are required to explain not only the rationale but also planned future corrective action. Much emphasis has been placed on best practice procedures and much less on numerical objectives. The Australian Charter of Budget Honesty and the United Kingdom’s Code for Fiscal Stability have also adopted this approach, albeit in different forms. Recently, some emerging economies have adopted this approach, including Brazil (Box 7). The adoption of such legal frameworks is useful in anchoring budget reforms but should not be considered a precondition for successful reform.

Summary of Good Practices in Institutional Transparency

Overall structure and functions

  • Clear demarcation of functions between public and private sectors

  • Delineation of the boundaries of the operations of state-owned nonfinancial enterprises and financial institutions from those of the general government and provision of information on the costs of quasi-fiscal activities performed by such enterprises and institutions, as well as any financial resource operations funded by the government

  • Clear assignment of responsibilities and resources among national and subnational levels of government (limiting the scope for case-by-case negotiation)

  • Clear statement of the rationale and extent of extra-budgetary fund operations

  • Independent review agency with wide investigative authority over government operations

Budget process

  • Detailed public explanation of fiscal targets and priorities in draft budget

  • Open legislative debate and authorization

  • Transparent execution and control (including procurement, contracting, employment)

  • Public disclosure of performance and financial audits

Tax treatment

  • Explicit statutory basis (instead of discretionary tax concessions or negotiated tax liabilities)

  • Clear administrative procedures, information requirements, taxpayers’ rights and obligations, tax officials’ code of conduct

  • Estimates of tax expenditure budget

Financing operations

  • Disclosure of the terms (interest rates, maturity) and sources of government deficit financing

  • Specification of the policy criteria as well as terms and conditions of government lending decisions

Regulation

  • Open legislative and administrative process (hearing, approval)

  • Clear and simple statutes and implementation

  • Estimates of regulatory costs

Source: Kopits and Craig (1998).

A key element in these frameworks is a transparent medium-term fiscal strategy. This adds credibility to fiscal policy by demonstrating its sustainability. Thus, Australia issues a Fiscal Strategy Statement, New Zealand publishes an annual Fiscal Strategy Report, and the United States publishes an Economic and Budget Outlook. For EU countries, a number of medium-term reporting requirements are embodied in the Maastricht Treaty and the Stability and Growth Pact. Since 1993, EU member states have been obliged to publish medium-term convergence programs, which are scrutinized by the Council of Economics and Finance Ministers of the European Union (ECOFIN) and which contain medium-term projections of countries’ fiscal and debt positions, their main assumptions, and the measures that are contemplated to achieve the stated objectives in the Stability and Growth Pact.

Elements of the Brazilian Fiscal Responsibility Law, 1999

  • Specifies the principles of responsible fiscal management.

  • Benchmarks focus on:

    • – Restrictions on public indebtedness

    • – Disciplining the growth in long-term spending, especially on social security

    • – Limits on increases in personnel expenditure

    • – Prudential limitations on credit operations and financial and asset management

  • Defines necessary fiscal procedures to meet these principles (i.e., how restrictions, discipline, and limits will be imposed), consolidating existing laws and regulations.

  • Requires fiscal reporting and enables transparency to ensure principles are upheld.

  • Requires explanation of deviations from principles, future corrective action to remedy deviations, and any penalties to ensure accountability of governing authorities and managers.

  • Covers all levels of government (federal, state, and municipal).

To recognize the need for this wider framework for successful budget reform is to recognize that the latter should not be regarded merely as a technical exercise. Budget system reform represents a fundamental institutional shift not only in techniques of public expenditure management—in the procedures used to plan, control, and use public resources effectively—but in the wider context of a society’s view of the role of the state and the citizens’ rights and expectations vis-à-vis the state. Insofar as the budget system reflects society’s view of such fundamentals, its reform cannot be pushed further or faster than society’s perceived need for change.

1

A parallel and related area, the reform of tax systems in transitional economies, has received much more attention. See Tanzi and Zee (2000); Martinez-Vazquez and McNab (2000).

2

See discussion by Schick (1998, 2001).

4

In one OECD study, greater managerial flexibility was associated with a positive aggregate fiscal outturn. Allowing managers greater freedom resulted in less emphasis placed on aggregate spending caps and increased the success of spending cutting exercises. See Strauch (2000).

5

While agencies in the United States do not have the same flexibility as departments in Australia, it should be recognized that flexibility does exist through various mechanisms such as the authority to reprogram funds up to specified limits without congressional approval, the use of revolving funds, and multiyear appropriations.

6

This circumvents the perverse incentive of “use it or lose it” that is inherent in annual budgeting.

7

On a somewhat parallel line, a few countries (Italy, Norway, and the United States) have published intergenerational accounts using the methodology developed by Auerbach, Kotlikoff, and Leibfritz (1999). This approach relies on a number of rather difficult assumptions, and there appears to be considerable reservation about the clarity of the message that is conveyed.

9

With broader allocations, there is more scope for underspending in one area to be dissipated through spending sprees in other areas.

11

This is discussed more fully in Diamond (2002b).

12

This aspect of the reform process, the exercise in change management, is dealt with in Diamond (2001).

13

“Global commercial liberalization and the free flow of capital are exerting new pressures on systems of public governance. Recent experience shows starkly that the quality of public institutions and the trust in which they are held by economic players can have very demonstrable effects on the behavior of these markets. Public sector governance systems that induce loss of market trust impose costs not only directly on their domestic economies, but more generally as they reduce global growth rates below potential.” (Brumby, 1999)

14

The approach of different countries, with a discussion of the usefulness of fiscal rules, is contained in Kopits (2001).

15

Transparency is increasingly regarded as important in improving the quality of forecasts. Economic forecasting is an area where there is now general acceptance of such transparency. The economic forecasting models used in Australia, Sweden, and the United Kingdom are public. Independent forecasting panels which meet in public are now a common institutional arrangement in Germany, Sweden, the United Kingdom, and the United States, encouraging contestability in forecasts.

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