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1 Luc Leruth was Section Chief of the Fiscal Transparency Unit of the IMF when this paper was started; Elisabeth Paul is FNRS (Fonds National de la Recherche Scientifique) Research Fellow at the University of Liege. The authors would like to thank their colleagues at FAD and the World Bank for very useful discussions, as well as D. Bouley, B. Chevauchez, A. Corhay, J. Diamond, I. Jelovac, A. Jousten, B. Jurion, J. Lawarée, P. Mauro, S. Nsouli, T. Prakash, C. Roehler, D. Ross, V. Tanzi, and H. Tulkens for helpful comments on earlier versions of this paper. The authors would also like to thank Ms. Dyer for her secretarial assistance. The usual disclaimer applies. Elisabeth Paul is grateful to the FNRS for financing her visit to the IMF in March-May 2005.
However, there is a growing literature on performance, program, and output budgeting, which basically aims to improve the information available on the effectiveness of public expenditure, and hence helps improve performance through enhanced accountability.
More recently, several bilateral donors and multilateral institutions have set up the Public Expenditure and Financial Accountability (PEFA) Program. It aims to build a strategic and collaborative approach to assessing and reforming partner countries’ public expenditure, procurement, and financial accountability systems, and identifies a set of performance indicators and benchmarks, in order to help address developmental and fiduciary objectives. It has developed a Public Financial Management (PFM) performance measurement system, and assesses PFM systems against six critical objectives: budget realism; comprehensive, policy-based budget; fiscal management; information; control; accountability and transparency. The sixteen criteria are presented in Appendix I.
This interpretation is consistent with that of political and social sciences, which refer to the broader notion of “rent capture” rather than corruption.
In some countries, such as Belgium and Lebanon, the court of audit may also perform some ex ante control. In this paper, we restrict our attention to the functions of ex ante versus ex post controls, irrespective of the institution performing them.
The “mise en débêt” is a tool to make public accountants personally responsible for financial wrongdoings discovered in their management of public funds by the court of audit or similar body.
Note that assuming a strict agency relationship between the MoF and the LM is a simplification of realities. A powerful LM could often play a very important role in budget negotiations, simply because it has more knowledge about requirements in its own area than the MoF. This could be particularly true at the time of budget preparation, where the LM could consider itself as an equal partner to the MoF.
This is in line with the approach adopted for instance in the Australian budgeting system, where so-called Service and Resource Allocation Agreements are prepared and implemented (NSW Treasury, 2000).
For example, if the health system in a country does not perform well, say in terms of vaccination ratios, it can be because the health ministry focuses on other things (and could do those efficiently). It could also be because the money appropriated for the purchase of vaccines gets “lost” in the system. A weak PEM system would generally refer to the latter. See for example Gupta and Verhoeven (2000).
To quote a very practical definition from the New South Wales Treasury: “Output budgeting involves the Executive Government explicitly ‘purchasing’ outputs from program and service delivery agencies (the ‘providers’) in order to achieve desired Government outcomes […]. With performance budgeting, the Executive Government funds (or ‘purchases’) an agency’s program and delivery plan (a set of program and delivery strategies) which the agency has developed in order to achieved desired Government outcomes” (NSW Treasury, 2000, p. 13).
Ideally, these objectives are defined in the context of a medium-term (three-year) framework and based on a comprehensive macroeconomic model. A multiyear budget framework has the potential to improve incentives, for instance by allowing the introduction of intertemporal competition across agents (Ahmad and Martinez, 2004). Although we will not address this issue in the context of the paper, it is important to note that the lack of a proper framework for medium-term budgeting has also been identified by the IMF and the World Bank as an area that requires substantial strengthening.
The PRSP approach was launched in 1999 in the context of the HIPC initiative. A PRSP describes a country’s macroeconomic, structural, and social policies and programs to promote growth and reduce poverty, as well as associated external financing needs. Its preparation and implementation now often condition the release of aid funds and debt relief.
Hereafter we use the term “informational rent” when referring to the supplementary premium that the LM is deliberately granted as an incentive to exert high effort. We use the term “cheating rent” to refer to the amount illegally diverted, notably through corruption.
In this paper, we use indifferently performance payment (contingent on observable/verifiable results) and informational rent, although the latter is, in principle, more general (the difference between the expected utility of an agent with private information and his reservation utility).
Incentive schemes may be used in public companies (see, for instance, the regulation theory following Laffont and Tirole, 1993) and also, to some extent, in customs administrations (on the theoretical side, see, for instance, Besley and McLaren, 1993).
A model close to ours, which combines adverse selection and moral hazard, predicts that monitoring the agent’s action is strictly preferable to auditing private information (Kessler, 2000).
As we shall see, the effort level required from the LM should be optimal with respect to the contracted output. It is thus implicitly defined. This problem is a case of “false moral hazard” where the observation of the variable does not allow to perfectly disentangle the agent’s “type” and effort level (Laffont and Martimort, 2002).
In practice, the MoF would try to maximize the joint output of several LMs. By restricting the model to one LM, we assume the MoF treats all LMs equally. The case of several LMs is indirectly handled when the probability of audit is below one (notably in the mixed strategy equilibrium), which may be interpreted as follows: the MoF can possibly audit only a certain number of LMs, and each LM chooses its cheating level considering that probability of being audited.
Superscript “*” stands for first-best values.
This could be interpreted as an absorptive capacity constraint: when the state of nature is high, the LM must work harder to absorb a larger appropriation.
To be complete, we should also define
For example, if a government is not allowed to use an overdraft facility with the Central Bank, the rule can be interpreted as a safeguard.
Assuming the auditor is paid only when reporting cheating is not relevant in a PEM system, although there are many instances where a bonus is given when cheating is detected (for example, customs employees detecting a fraud have a right to a portion of the tax recovered in many countries).
The maximum deterrence principle (Baron and Besanko, 1984), which implies that the principal would choose the upper bound penalty level, does not always apply, especially in models where the agent may be punished by mistake and thus must be compensated ex ante for that risk (e.g., in some regimes of Kofman and Lawarrée, 1993). While this is irrelevant in our framework, we could have a situation (dubious and unlikely) where the principal’s benefit from the penalty is higher than the audit cost, so that it is preferable for the MoF to allow cheating than to deter it. Finally, the traditional result stating that with infinite penalty, cheating is deterred and the first-best solution is reached, could apply but, as we argue later, it is not of practical relevance for our purpose.
We use a terminology similar to that of Eskeland and Thiele (1999) who refer to collusion-proof and collusion-inducing regimes, as we refer to cheating-proof and cheating-inducing regimes.
This may seem a little remote from reality. However, the revelation principle characterizes the optimal payoffs and can be seen as the “truth-telling map” of a complex mechanism where cheating and punishments occur (Kofman and Lawarrée, 1993, p. 648).
If there are several LMs, the latter situation could correspond to the case where the MoF announces it will audit a certain number of LMs—so that each LM knows, ex ante, with which probability it will be audited at the end of the year.
The probability of cheating and the expected penalty do not enter the principal’s objective function as, under this regime, cheating is deterred. However, the expected penalty appears in the IC constraint.
To be complete, one should also introduce an IC(L) constraint, aimed at preventing the LM from producing the high output when productivity is low. This would take the form
Note that, from the specification of that Lagrange multiplier (see Appendix II), one observes that the higher the cost of audit and/or the probability of low productivity, and the lower the penalty, the harder it is to deter cheating.
Our results are consistent with the analysis of Kofman and Lawarrée (1993) with a truthful auditor. There are some slight differences however: (i) we assume the principal cannot earn a penalty out of a complying agent; (ii) we assume a fixed penalty; (iii) our specification of the production and disutility of effort functions differ, which hampers tractability. The labels also follow Kofman and Lawarrée (1993).
The random audit case may be interpreted in a context with several LMs, where γ represents the probability, for each LM, to be audited, in the framework of the general auditing policy of the MoF.
The latter results are explained by the fact that if the MoF is not able to deter cheating, it is not worth incurring further distortions and agency costs.
Mixed-strategy equilibriums have generally been used in the literature on collusion. The latter suggests that, instead of trying to systematically deter (or induce) collusion, it may be efficient to allow it to some extent (e.g., Kofman and Lawarrée, 1996; Khalil, 1997; Khalil and Lawarrée, 2003). This may be the case, for example, if there is a positive probability that the agent and the supervisor are honest, so that it may be too costly to provide incentives to systematically deter collusion. We hereafter apply a similar approach to cheating (corruption). We do not model it, but in a context with several LMs, the mixed-strategy equilibrium could also yield the optimal contract when some LMs are honest while others are corrupt, because preventing cheating as if all LMs were corrupt would be too costly.
This argument holds in one-period games. However, in the context of repeated relationships, it is probably in the MoF’s interest not to backtrack on its promise to audit with the announced probability, in order to preserve its reputation.
The efficiency result is similar to that of Khalil and Lawarrée (2003) and rests on the assumption that the penalty is independent from the transfer. The audit probability is increased until the rent is reduced to zero, and there is no reason to distort efforts. With transfer-dependent penalties, Khalil (1997) finds the agent overproduces when the productivity is low.
Our results are quite intuitive. Both the probability of audit and the probability of cheating are decreasing functions of the expected penalty. The more cheating rent the LM can capture, the more the MoF audits. The more expensive the audit is, the more the LM cheats. The cheating probability is also influenced by the relative probabilities of the productivity occurrences: to keep the MoF indifferent between auditing and not auditing, cheating is increasing with the probability of low productivity. The agency cost decreases with the expected penalty and increases with the probability of low productivity. It is also higher when the difference of production between i = H and i = L is higher.
Informational rents could be envisaged in a system of performance budgeting, as they consist of rewarding the LM for good performance (above the compensation of its effort).
This section deals with an issue not often discussed in principal-agent papers where the focus tends to be on controls run ex post.
Following Tirole (1986), that branch of the literature studies the potential for side-contracting between a privately informed, cheating agent and the supervisor hired by the principal to control him or her.
As an exception to this statement, Strausz (2006) compares the value of monitoring versus auditing. He argues that if both supervision techniques are equally efficient, auditing is (weakly) superior when the principal can commit to a verification strategy—as auditing can bring out additional information. However, when the principal’s verification behavior is noncontractible, monitoring may be optimal. This result is explained because auditing requires steeper incentives, which may be suboptimal if the agent is risk averse and/or due to higher rents. Our analysis differs from Strausz’s in that we do not assume that ex post audit and ex ante controls rely on the same technology, and we have assumed (in the cheating-proof regime) that the principal could commit to an audit strategy.
The literature on collusion adopts a similar approach when it acknowledges that hiring a collusive auditor is still useful, because it makes shirking costly for the agent, as he will have to pay a bribe to falsify the report (e.g., Kofman and Lawarrée, 1996).
For instance, in Senegal, the procedures for disbursing the Health Decentralization Fund are such that it takes on average 10 months for the resources to be at the disposal of the providers. This leaves only two months to the facility to absorb those resources (World Bank, 2004a).
The more effective controls are, the higher η (c) for any c > 0.
Under the random audit feature, λγ = 0.
We could extend the analysis to a case in which the MoF would like to implement a mixed-strategy equilibrium with respect to ex post audit, while also using ex ante controls. Compared to the case presented in subsection IV.C., the audit probability that keeps the LM indifferent between cheating and complying would be reduced by the use of ex ante controls:
This analysis and its results are very similar to that of Kofman and Lawarrée (1993) with one truthful costly auditor, at the following exceptions: (i) we assume the principal cannot earn a penalty out of a complying agent; (ii) we assume a fixed penalty; (iii) our specification of the production and disutility of effort functions differ.
These cases are similar to those found by Kofman and Lawarrée (1993), and we use the same labels as these authors.
The general formulation of the productive and disutility of effort functions do not allow us to prove that the EA and RA productive distortions are always smaller than the second-best one. For this purpose, we use an example below.
This situation can occur when the minimum level of control necessary to deter cheating,