This paper discusses the role of fiscal policy and fiscal institutions in managing scaled-up aid. In an environment of volatile scaled-up aid, fiscal policy formulation should be anchored in medium-term frameworks, incorporating a longer-term view of potential resource availability and spending plans. There is merit in smoothing expenditures over time so that all programs are adequately funded. The paper argues that wage-bill ceilings should be used in Fund-supported programs only in exceptional cases. The paper also discusses basic reforms for strengthening public financial management systems for effective utilization of scaled-up aid flows.

Abstract

This paper discusses the role of fiscal policy and fiscal institutions in managing scaled-up aid. In an environment of volatile scaled-up aid, fiscal policy formulation should be anchored in medium-term frameworks, incorporating a longer-term view of potential resource availability and spending plans. There is merit in smoothing expenditures over time so that all programs are adequately funded. The paper argues that wage-bill ceilings should be used in Fund-supported programs only in exceptional cases. The paper also discusses basic reforms for strengthening public financial management systems for effective utilization of scaled-up aid flows.

I. Introduction

The international community has committed to scaling up aid and improving aid delivery to low-income countries (LICs) to help them meet the Millennium Development Goals (MDGs). The March 2002 Monterrey Consensus called on donors and international financial institutions to provide additional financing, improve aid predictability, and ensure that aid is aligned with national priorities. Recipient countries, on the other hand, have committed to implementing appropriate policies, strengthening institutions, and enhancing governance to ensure that aid is used effectively. At the 2005 Gleneagles Summit, the G-8 countries committed to significantly increasing the amount of development assistance they provide to the LICs over the next decade. Specifically, donors committed to double aid to sub-Saharan Africa (SSA) by 2010.

Although official development assistance (ODA) to SSA, net of debt relief, remained broadly unchanged in 2005, some countries are receiving rising private and public flows. Preliminary data suggest that total ODA declined slightly in 2006.2 On the other hand, a wide range of other “emerging” donors are increasing their assistance to LICs. In many countries, the health sector is progressively receiving more assistance from the private sector, as well as from health funds.3 Debt relief provided under the Multilateral Debt Relief Initiative (MDRI) and the Enhanced Heavily Indebted Poor Countries (HIPC) Initiative has created space for new borrowing by LICs, and some countries (e.g., Ghana and Kenya) are using this opportunity to tap international capital markets. Remittances to LICs have increased by more than 80 percent between 2000 and 2005, totaling twice the amount of ODA in 2005.4 Moreover, many countries are benefiting from high commodity prices. Thus, resource flows to many LICs are increasing, enabling them to scale up spending.

Effective and sustainable use of these flows—both public and private—requires sound fiscal management. In an environment of scaled-up resource flows, countries need to frame their spending programs with a medium-term perspective in mind. In addition, they need to ensure that resources are used efficiently, both by ensuring alignment of budget priorities and those of donors and by strengthening critical fiscal institutions. The Fund’s Medium-Term Strategy (MTS) calls on the Fund to assist LICs to establish policies and economic institutions that help them to “absorb the projected scaling up of aid in a sustainable way” (IMF, 2005d). This paper addresses four questions that shape fiscal policy response to scaled-up aid:5

  • How should the medium-term resource envelope for the budget be assessed? Formulating spending plans in a medium-term perspective requires information about the availability, phasing, and magnitude of resource flows over the medium term. In many countries, comprehensive information on current resource flows is not available, making this particularly difficult. The task is further complicated by the increase in the number of donors—both official and private.

  • What considerations should influence the choice of a medium-term spending path for the budget? Once the resource envelope is established, countries need to decide how much and how fast available resources should be spent over the medium term. Factors influencing this decision include macroeconomic conditions, capacity constraints (both absorptive and institutional), and debt sustainability considerations.

  • How should the budget deal with aid uncertainty and volatility? Aid volatility and uncertainty have often complicated policy implementation, especially in countries where a large part of government spending is financed by aid.6 These issues are likely to become even more relevant when external flows are scaled up.

  • What fiscal institutions are key to using resources effectively and how can they be strengthened? Scaled-up but uncertain and volatile aid flows will place increased pressure on fiscal institutions in general and on public financial management (PFM) systems in particular. Strengthening fiscal institutions is therefore crucial to ensuring that spending is efficient.

The rest of the paper is organized as follows: Section II deals with establishing a medium-term resource envelope for the budget. Section III explains the considerations that influence the choice of a medium-term expenditure path and provides guidance for setting short-term fiscal targets. Section IV discusses the problems associated with volatility and uncertainty of aid flows and possible steps to mitigate them. Section V discusses basic reforms for strengthening fiscal institutions so that aid can be used more effectively, drawing on recent IMF Fiscal Affairs Department technical assistance (TA). It proposes specific measures that will assist countries in this regard, as well as factors that should be taken into account in preparing an action plan for PFM reforms in LICs.

II. Establishing a Medium-Term Resource Envelope

The first step in establishing a medium-term resource envelope is to collect information on the intentions of official and private donors. Governments typically lack information on private aid flows, and a part of the aid from official sources is also provided outside the budget. The increase in the average number of donors per country, as well as an increase in the number of aid channels, has complicated the task of gathering accurate information on external flows. The average number of donors per country has increased from about 12 in the 1960s to more than 30 during 2001–05 (World Bank, 2007a). In some sectors, such as health, aid channels have also proliferated, stretching the already weak capacity of LICs. Governments should encourage private aid organizations to strengthen their representation in recipient countries, while official donors should reach out to key private donors and invite them to participate in existing donor coordination structures.

Aid characteristics have implications for budget planning and formulation. Earmarking by donors limits flexibility in the use of budgetary resources. When aid resources are earmarked, governments cannot readily reallocate these resources in response to changing macroeconomic conditions and priorities, which hampers the implementation of expenditure plans. Similarly, the requirement for counterpart funds reduces the budgetary resources available for other purposes. The terms of financing also have implications for budget planning and debt sustainability. Grants do not require any budgetary allocation for debt service payments, whereas loans do, and thereby establish a claim on future resources.

Medium-term aid flow projections should reflect Fund staff’s best estimates. Aid flows (both loans and grants) should be projected based on all relevant and available information, including donor commitments and indications. Aid forecasts in Fund-supported programs also need to reflect debt sustainability concerns. Overly optimistic or pessimistic projections should be explicitly justified, because they may complicate fiscal management by creating mismatches between spending and available resources (IMF, 2007a). The costs of overly optimistic aid forecasts are likely to be higher than the costs of overly pessimistic ones, because aid shortfalls might entail fiscal adjustment. To mitigate such costs, spending should be anchored in a medium-term perspective, as outlined below. Aid shortfalls could then be smoothed out over time, as could fiscal adjustment.

Sustaining and increasing domestic revenue effort is critical to achieving the MDGs. Strengthening revenue-raising capacity is essential to guarding against aid volatility and preparing for an orderly exit from long-term reliance on aid. Moreover, projects financed by scaled-up aid flows will give rise to future recurrent spending, which will need to be financed by domestic resources. Insufficient growth in domestic revenues will either constrain other spending or lower the productivity of existing programs and assets through inadequate provision for operations and maintenance outlays. Care has to be taken to ensure that scaled-up aid does not weaken the incentive to mobilize domestic revenues by relaxing the budget constraint, particularly when institutions are weak (Gupta and others, 2004). However, lowering distortionary tax rates may be part of the strategy of some LICs to promote private sector-led development.

Trade liberalization is another important reason to strengthen the domestic revenue base. When trade is liberalized, aid absorption is facilitated and pressures on the real exchange rate are mitigated. However, this liberalization would lower overall revenues, because these countries on average derive one-third of their total revenue from trade taxes (Keen and Simone, 2004). Therefore, trade liberalization would need to be accompanied by a strengthening of indirect taxes. International competition in tax incentives (including those offered to investors in free trade zones) has reduced both the corporate tax revenue and its base in many LICs, making it more difficult to recover revenue lost because of trade liberalization. Governments can adapt to this new reality by improving the efficiency of value-added taxes (VATs), which can raise significant revenues in many LICs (Selassie and others, 2006). This will require reducing exemptions and broadening the tax base for VATs.

Policies for broadening the tax base and strengthening revenue administration are critical to raising additional revenues in LICs. Low revenues are not, in most cases, a reflection of low tax rates—in fact, tax rates are high in many LICs—rather, they reflect narrow tax bases and weak administrative capacity.7 A tax-to-GDP ratio of at least 15 percent is considered a reasonable target for most LICs (Selassie and others, 2006). The UN Millennium Project (2005) estimated that LICs could mobilize additional domestic revenues equivalent to 4 percent of GDP. Improved organizational structure of revenue administration, strengthened audit capacity, and fair tax enforcement all contribute to the expansion of the tax base. Revenue administration reforms are a particularly high priority in many countries in SSA.

III. Choosing an Expenditure Path

The Fund’s advice and program design encourages aid recipients to fully and effectively spend all aid. How much and how fast scaled-up aid should be spent over the medium term is a function of the following:

  • Time profile of expected aid;

  • Macroeconomic, sectoral, and administrative capacity of the country to absorb higher aid inflows;

  • Likely impact of spending on growth and debt sustainability; and

  • Spending efficiency.

Time profile of aid

Aid flows to a country can assume different time profiles. They may be compressed over a short period, they may be volatile around a constant or rising trend, or they may rise and remain stable at that level. In the first case, a country may choose to spread higher aid-financed spending over a longer period by saving part of the initial surge in aid inflows. In the second case, the country would need to take aid volatility into account in its spending plans by smoothing fluctuations through domestic borrowing and reserve accumulation in a manner that is consistent with macroeconomic stability. In the third case, the country could have a rising spending profile depending on its absorptive capacity. The choice of a particular spending path will depend on a number of other country-specific factors, which are discussed next.

Absorptive capacity constraints

Overall macroeconomic conditions determine how much aid can be spent immediately. For instance, an initially high rate of inflation and low level of foreign reserves may call for a gradual scaling up of spending. In contrast, countries that have reached a mature stage of macroeconomic stabilization are better positioned to use scaled-up aid inflows rapidly (Selassie and others, 2006). Postconflict countries that have not yet stabilized their macroeconomy and have weak institutions may need to save the initial surge in postconflict aid until their absorptive capacity has improved over the medium term.8 Aid provided in the context of humanitarian relief (e.g., food aid) to postconflict countries would need to be spent as soon as their security situation stabilizes.

The ability to absorb aid at the sectoral level may be limited in the short term. The country may not have sufficient teachers or health workers to expand service provision. In this regard, some LICs are considering innovative approaches to overcome these supply-side constraints, such as Ethiopia’s program to rapidly train and deploy semiskilled workers to address basic health care needs.

Limited capacity to effectively design and administer spending programs can further constrain aid spending. The share of education and health spending devolved to subnational governments is increasing, but the capacity of these governments to implement programs and to ensure that scaled-up resources reach the intended users may be limited. In some SSA countries, subnational governments are responsible for about 70 percent of poverty-reducing expenditure.9 However, accountability for social and economic outcomes is often weak, and internal controls, auditing, and monitoring and evaluation are hampered by weak accounting, manual procedures, and human capital constraints.

The implication is that some aid may need to be saved in the short term. Studies of recent aid surges in SSA indicate that many countries saved part of the aid (Aiyar, Berg, and Hussain, 2005; and Foster and Killick, 2006). The remainder of the higher aid flows boosted public savings, which was used in many cases to retire domestic debt. However, there are limits to the scope for saving: donors are reluctant to continually provide aid that is saved, and there are pressures in the recipient country to spend higher aid in an effort to improve economic and social outcomes. Furthermore, aid tied to specific projects is difficult to save. Ultimately, the capacity of governments to utilize aid effectively needs to be strengthened over time.

Some aid might be delivered in a regional context. This could be the case for regional institutions, such as the West African Economic and Monetary Union (WAEMU).10 In this instance, member countries would still channel aid through their domestic budgetary systems, but they would need to be cognizant of the convergence criteria set in the monetary union.11

A preferable approach would be to smooth spending over the medium term. A stable spending path as a share of GDP is viewed as the optimal response to an increase in anticipated resources (Barro and Sala-i-Martin, 1995). An expenditure smoothing approach would imply that spending increases to a new, higher level that is calibrated to be sustainable indefinitely, given the expected value of new aid inflows. This approach would allow for higher spending in the face of natural disasters and national emergencies. Public spending could be front-loaded if there is evidence that (1) the returns to public investment are high;12 (2) investment is subject to increasing returns, for example, because of “poverty traps” that require a large boost in public spending to overcome multiple, interconnecting barriers to development at once (Azariadis and Stachurski, 2005); or (3) the benefits of government consumption are significantly higher today than in the future, for example, during a famine or health crisis (Box 1). However, both expenditure smoothing and front-loading could entail borrowing from the domestic banking system, which may not be consistent with the government’s macroeconomic and debt sustainability objectives. Poverty reduction strategies that incorporate a front-loaded approach in public spending would be most appropriate if underpinned by front-loaded aid commitments from donors to reduce fiscal risks.

Choosing an Expenditure Path When the Resource Envelope Is Expanding

A key decision in medium-term fiscal frameworks (MTFFs) relates to the choice of an appropriate spending path. In general, three specific stylized options are available: “smoothing,” “front-loading,” and “saving.”

  • The expenditure smoothing approach would imply that governments keep spending fairly stable as a share of GDP. In a scenario of scaled-up aid, the smoothing approach would imply that spending increases to a new, higher level when aid is scaled up. The new spending level is calibrated to be sustainable indefinitely, given the expected present value of the new aid inflows. The figure below presents a stylized case of this approach in which aid jumps to a new, higher level for a few years and diminishes in the long run. Part of the temporary aid surge is spent, but part is saved, reducing debt. Interest savings from lower debt allow stable spending as a share of GDP even after the aid surge diminishes.

  • The front-loaded approach would have spending increase rapidly when aid is scaled up, gradually declining thereafter as a share of GDP, either because spending is reduced in real terms (relative to the smoothing approach) or because real GDP grows faster as a result of increased public investment. Front-loading is most appropriate when absorptive capacity is not a bottleneck, government investment is subject to high or increasing returns, or the benefits of government consumption are significantly higher today than in the future, for example, because of a famine or a temporary medical crisis. However, front-loading also entails considerable risks. If future aid flows or the impact of government spending on economic growth turn out to be lower than expected because of poor quality of spending or waste, the approach may lead to unsustainable spending levels that may trigger debt distress or abrupt adjustments, particularly when countries already have high debt.

  • The saving approach would imply that most additional aid would initially be saved, with spending rising only gradually while reserves are built up (or debt is reduced). Spending as a share of GDP would then gradually rise over time, eventually stabilizing at an even higher level than under the smoothing approach, because the higher assets (or lower debt) would increase interest income (or lower interest spending). The approach may be appropriate in situations in which macroeconomic stability is yet to be achieved or spending efficiency is low and expected to increase only over time. However, there are limits to the approach. In particular, donors may not be willing to provide aid to build up reserves rather than increase spending for achieving the Millennium Development Goals and other social or economic objectives. Therefore, a pure saving approach can only be a temporary solution while low-income countries’ governments strengthen their capacity to spend aid efficiently.

UF1

The Smoothing Approach

(In percent of GDP)

Citation: IMF Working Papers 2007, 222; 10.5089/9781451867862.001.A001

Source: IMF staff calculations.

Spending and debt sustainability

The expenditure path chosen should also be consistent with debt sustainability. Higher aid inflows entail broad macroeconomic effects, including on the real exchange rate and interest rates. These, in turn, have consequences for debt sustainability through their effect on domestic interest rates and the exchange rate. For instance, if aid inflows are largely sterilized to prevent Dutch disease effects owing to a real exchange rate appreciation, then domestic interest rates could increase significantly, putting pressure on public debt dynamics. On the other hand, a sudden decline in aid inflows could result in a real depreciation, increasing the burden of the external debt. Moreover, the need to ensure a sustainable public debt path becomes even more essential to the extent that scaled-up aid inflows are provided as loans, even on concessional terms. Sustainability can also be affected by the impact of spending on growth, which is in turn related to its composition and efficiency.

Spending and growth

The composition of public spending can influence growth.13 The higher aid-financed public spending could affect both growth and the sustainability of public debt (see above). Expenditure composition can potentially affect growth, for example, by “crowding in” private investment with increases in public infrastructure spending, but also via other channels that relate to social spending on health and education. The crowding-in effect has been identified using different data sets and approaches in the literature, and reflects complementarities between public infrastructure and private investment.14 The empirical link between public investment and overall growth is sensitive to the methodology and data used.

For instance, estimates of the response of growth to higher public investment range from no impact at all to an increase of 0.7 percentage points in cross-country econometric studies (Gupta, Powell, and Yang, 2006; and IMF, 2005a). However, these studies might not shed adequate light on the short-term impact of higher public investment or capture the potential impact of a substantial scaling up of public investment.15 The success of higher public investment ultimately depends on introducing effective institutions to channel resources into projects that eliminate growth bottlenecks. The growth effects of education and health spending, which have a long-term impact, are more difficult to estimate. The estimates in the literature suggest that a 1 percent of GDP increase in such spending can have a long-term effect, ranging from 0.5 to 1.0 percent of GDP, provided resources are spent efficiently and fiscal institutions are strong.

Different aid-financed spending programs can have different consequences for growth. Aid flows can be broadly categorized according to whether the associated activities (1) can be reasonably expected to enhance growth over the short to medium term, (2) are focused on long-term growth, and (3) are not directly related to growth.16 External project assistance for infrastructure can boost growth over the short to medium term provided that sound capital budgeting procedures to prioritize projects with high rates of return are adopted as described above. Increased public spending to halt environmental degradation, support better governance or judicial systems, and improve health and education outcomes would act indirectly to increase long-run growth through higher labor productivity. On the other hand, spending associated with humanitarian aid sustains consumption following negative shocks. In this manner, the modality for scaling up aid can affect the allocation of public spending, and thereby growth and the sustainability of public debt. However, appropriate caution is required in projecting growth effects of spending in Debt Sustainability Analyses (DSAs),17 especially in countries where fiscal institutions are weak.

Spending efficiency

The relative efficiency of public spending can also affect growth and debt sustainability. Inefficient spending only adds to future debt burdens without a commensurate improvement in social and economic outcomes. Furthermore, improving economic and social outcomes through scaled-up aid requires both spending more and spending more efficiently. In this context, an initial analysis of health and education spending found significant room for increasing efficiency in many LICs (Appendix II). Three results stand out:18

  • There is significant variation across countries and regions in the relative efficiency of health and education spending.

  • Good governance and the quality of fiscal institutions have a strong positive correlation with the efficiency of spending.19 Countries with better governance and fiscal institutions have higher relative efficiency scores.

  • Volatile aid flows have not generally been passed through into public spending, contributing to relatively stable efficiency scores. This evidence suggests that as long as aid volatility does not translate into higher volatility in spending, the relative efficiency of spending is not affected.

Expenditure path and fiscal targets

The medium-term spending path should anchor the fiscal framework. Typically, medium-term fiscal planning begins with a target for the fiscal balance that is consistent with a sustainable path of public debt and macroeconomic stability. In this situation, the ceiling on public expenditure is derived residually, given the forecast for domestic revenues and a sustainable fiscal balance. Scaling up of aid increases the available resources, creating a range of spending paths that are consistent with the medium-term fiscal framework (MTFF). Countries should choose a stable medium-term spending path that is consistent with absorptive capacity constraints and debt sustainability.

Annual fiscal balance targets should be consistent with the medium-term expenditure path. The choice of the precise fiscal indicator to be targeted should be decided on a case-by-case basis (see Box 2 for a discussion on fiscal targets in Fund-supported programs). Focus on the overall balance, including external grants, would allow scaled-up aid to pass through into higher public spending without deterioration in the reported fiscal position. However, it is useful to complement this indicator with other measures of fiscal sustainability.20 For instance, the overall balance excluding grants is a key indicator of fiscal policy’s effect on aggregate demand. In addition, countries should carefully monitor the debt-stabilizing primary balance to avoid incurring an unsustainable debt burden during the scaling-up process. The domestic balance is another fiscal indicator that is used in several countries to anchor the fiscal framework.21 However, the domestic balance may be problematic, because scaled-up aid would result in higher domestic spending in priority areas (e.g., health and education), which would in turn result in a significant deterioration of the reported domestic balance. This may indicate the extent to which the import component of spending should be increased to facilitate the absorption of scaled-up aid.

Fiscal Targets in Fund-Supported Programs

Fiscal targets in Fund-supported programs have been criticized for preventing faster progress toward achieving the Millennium Development Goals. In particular, some critics contend that Fund-supported programs that include targets on the fiscal deficit excluding grants have prevented countries from increasing spending when grant financing exceeds program assumptions, even though such spending would not add to the debt burden. Moreover, the use of asymmetric adjustors in Fund-supported programs has also been criticized, because they prevent spending from increasing when aid inflows exceed projections by reducing domestic financing pro tanto, while allowing for only a partial increase in domestic financing when aid inflows are below projections, thereby requiring spending to be reduced.1/

The evidence from Fund-supported programs is more varied in this regard:

  • Often, program design accommodated all programmed aid flows. A recent independent review of Fund-supported programs in sub-Saharan Africa (IEO, 2007) noted that, in countries with low inflation, programs were designed flexibly to spend almost all of the anticipated aid.

  • Most programs did not constrain capital spending financed by project-related grants (see table below).2/ However, these programs usually did not allow additional aid to be used for current spending. Fund-supported programs also included a ceiling on net credit to government, sometimes as a complement to the fiscal balance target and sometimes independently. In these programs, the degree to which additional external financing could be spent depended on the design of fiscal adjustors.

Looking ahead, program design should continue to use fiscal balance targets and adjustors that respond best to country-specific conditions when aid is scaled up. Where macroeconomic conditions permit, fiscal targets should allow maximum flexibility for spending additional aid. Adjustors in Fund-supported programs should be designed to avoid having to cut back priority expenditures in response to aid shortfalls.

Short-Term Fiscal Targets in PRGF Countries 1/

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Source: IMF staff reports.

Data are based on the latest staff reports for 43 countries with Poverty Reduction and Growth Facility (PRGF) programs approved in 2002–06, and only cover performance criteria on fiscal balance, net domestic financing (NDF), or net credit to the government (NCG) from the banking sector in program conditions. Countries are grouped according to coverage by IMF departments: AFR-African Department; APD-Asia and Pacific Department; EUR-European Department; MCD-Middle East and Central Asia Department; and WHD-Western Hemisphere Department.

Adjustors exist for excesses and/or shortfalls in external assistance relative to program baselines.

The adjustors for excesses or shortfalls in external assistance differ.

1/Goldsbrough (2007) summarizes the key arguments of the IMF’s critics and the IMF’s response.2/ Findings are based on the most recent staff reports for 43 PRGF-supported programs approved by the IMF’s Executive Board during 2002–06. In 14 out of 22 PRGF arrangements with fiscal balance targets, all foreign-funded investment was excluded from the targets. For seven countries, the targeted balance included grants (and the investments financed by these grants). The various programs used a variety of deficit concepts, and only six included a ceiling on the overall fiscal deficit. Twelve countries targeted the primary balance, and four targeted the basic balance (also called the current balance, i.e., excluding capital revenues and expenditures). For a review of how aid has been accommodated in PRGF programs, see IMF (2007a).

Some Poverty Reduction and Growth Facility (PRGF)-supported programs have included ceilings on government wage bills as an instrument to promote macroeconomic stability and to improve the quality of government spending, but their incidence is on the decline. The share of such programs with wage bill ceilings declined from 40 percent during 2003–05 to about 30 percent as of May 2007. Critics have argued that ceilings on the government wage bill have prevented countries from expanding employment in social sectors, even when concessional financing was available, and that this has had adverse implications for meeting the MDGs. However, a recent review indicates that the use of wage bill ceilings reflected valid concerns regarding macroeconomic stability and the need to keep critical nonwage spending, such as medicine, books, and public investment, in line with budget priorities (Fedelino, Schwartz, and Verhoeven, 2006). Moreover, they provided sufficient flexibility to expand employment in priority sectors when external financing was available. As such, they can be and are regularly adjusted in Fund-supported programs as resource availability and priorities change.

Wage bill ceilings have typically covered the overall government. In no instances have wage bill ceilings been defined for a specific sector, such as education or health. Indeed, in some cases, priority sectors, such as education, have been excluded from the wage bill ceiling (e.g., in Benin).

Wage bill ceilings should be used in Fund-supported programs only in exceptional cases. These are a second-best option for controlling wage spending. In particular, their use should be based on the following:

  • Clear justification. The rationale for wage bill ceilings should be guided by macroeconomic considerations. Program documentation should justify their use in a transparent manner, including their consistency with the MDGs.

  • Limited duration. Wage bill ceilings are a temporary device. Governments should tackle the root causes of wage-related fiscal problems, such as the need for civil service reform and strengthened payroll management.

  • Sufficient flexibility. Wage bill ceilings should be sufficiently flexible to accommodate spending of scaled-up aid, particularly for sustainable donor-financed employment in priority sectors, such as education and health.

  • Periodic reassessments. The need and rationale for wage bill ceilings should be reassessed at the time of program reviews.

It is expected that over time the need for wage bill ceilings will decline further. Although wage bill ceilings may still be needed on occasion, the use of medium-term frameworks (MTFs) and effective budget and payroll systems will gradually obviate the need for them. Countries, in collaboration with donors, are putting considerable efforts into strengthening such systems.

Updating baseline and alternative scenarios

The baseline projection should be updated as new information is obtained. The medium-term fiscal policy framework (see Section IV) should be informed by the authorities’ projections for external aid, domestic revenue, expenditure, and public debt. Small, temporary shortfalls in aid can be smoothed out through additional domestic borrowing or drawing down buffers, but a substantial aid shortfall calls for revising the expenditure path by cutting low-priority outlays. As anticipated aid inflows change, baseline expenditure projections should be updated to ensure that the medium-term expenditure path remains consistent with a sustainable public debt profile.

Countries may want to develop alternative “scaling-up scenarios” to facilitate more ambitious aid inflows compared with baseline expectations. Alternative scaling-up scenarios enable recipient countries to assess the implications of higher recurrent spending and the sustainability of the fiscal framework. They also can help countries identify the policies required to alleviate Dutch disease effects, skills shortages, and other bottlenecks.

IV. Dealing with Aid Uncertainty and Volatility

Aid volatility complicates fiscal policy implementation. Aid flows are 40 times more volatile than tax revenues (Bulíř and Hamann, 2006) and significantly more volatile than remittances. Moreover, such volatility has increased over time and can translate into expenditure volatility (see Appendix I). This problem is likely to worsen, for two reasons. First, even if the volatility of aid does not change, a larger aid volume implies that a larger portion of the budgetary spending would be aid financed and thus subject to volatility. Second, the volatility of aid itself may increase because of shifts in the composition of aid away from project aid and toward budget support and program loans. A rising share of budget support can aggravate aid volatility because of the inability of donors to make long-term commitments for budget support.

Aid recipient countries can take several steps to mitigate the effects of aid volatility and uncertainty:

  • Conduct stress tests on baseline projections to assess the impact of aid volatility. Subjecting MTFs (and DSAs) to periodic stress tests can help identify short-term financing risks. The impact of aid shortfalls on the budget should be assessed regularly through such tests.

  • Build up reserve buffers to sustain spending if shortfalls materialize. Countries can also self-insure against aid volatility by accumulating reserves that can be drawn down in the event of a temporary aid shortfall. The size of the buffer should be determined on a case-by-case basis but could vary from 50 to 100 percent of annual aid-financed spending (Eifert and Gelb, 2005). Such a buffer would supplement other reserves that countries might accumulate to provide cover for imports or short-term debt, and enable countries to smooth expenditures without recourse to costly bridge financing from their domestic banking systems in the event of an aid shortfall.22 However, building up reserve buffers also requires that countries have in place appropriate strategies to invest and manage the reserves efficiently during aid windfalls.

  • Identify priority spending to be safeguarded from cuts in the event of an aid shortfall. This would ensure that critical programs are not starved of funds in the face of aid volatility. This policy is easier to adopt when such spending is defined in the Poverty Reduction Strategy Papers (PRSPs) or similar country documents, and when the PFM systems are capable of monitoring budgetary allocations to specific spending programs and their outturns.

  • Build elements of flexibility into spending programs. Designing spending programs so that they can be scaled up or down in response to fluctuating aid disbursements can mitigate the adverse effects of aid volatility. For example, wage spending could be made more flexible by using temporary and flexible employment contracts; contracting out services could be another option.

  • Include appropriate adjustors in Fund-supported programs to fully or partially accommodate aid volatility. Recent studies have shown that LICs respond to aid volatility by adjusting domestic financing and expenditure, but that this response appears to be asymmetric—in particular, aid shortfalls lead to cuts in domestic investment spending while governments do not increase such spending in response to aid windfalls.23 Accordingly, adjustors in Fund-supported programs should be designed to avoid a cutback of critical spending, such as domestic investment, when aid falls short of program projections. The degree to which shortfalls should be financed and windfalls saved depends on country-specific considerations, such as macroeconomic stability, absorptive capacity, and debt sustainability.

Long-term donor commitments can reduce aid volatility. The international community has pledged to provide more predictable and multiyear commitments on aid flows (Paris High Level Forum, 2005). Implementing the agreed-upon steps would help reduce the uncertainty and volatility of aid. Some bilateral donors are moving toward longer-term aid commitments. For example, the United Kingdom has provided a 10-year commitment on development assistance to Rwanda and Ethiopia. Similarly, the Department for International Development (DFID) has agreed to provide six-year program support for the health sector in Malawi under the Sector-Wide Approach. In addition, initiatives such as the International Financing Facility for Immunization (IFFIm), which is designed to provide “front-loaded, reliable funding over a number of years,” can reduce aid volatility.

Certain types of arrangements facilitate long-term donor commitments. Simple, formalized partnership agreements between aid-recipient countries and donors help to deliver multiyear aid commitments in a systematic fashion. Recent examples of such successful collaboration are donor groups in Mozambique, Tanzania, Ghana, and Burkina Faso. Typically, such donor groups serve to jointly monitor both aid commitments and disbursements regularly, within a predefined performance framework. This has improved aid predictability and fiscal programming in these countries.

Countries should strive to ultimately avoid long-term reliance on aid. Besides strengthening the domestic revenue base, other elements of this strategy include strengthening countries’ debt management capacity and fiscal institutions, including PFM systems (see below). This would ensure that resources are used both efficiently and effectively.

V. Strengthening Institutions to Promote Effective Utilization of Aid24

Ensuring efficient public expenditure calls for strengthening fiscal institutions, including PFM systems.25 Sound and effective PFM systems are important for several reasons: (1) to increase the prospects of achieving key economic and social priorities; (2) to support transparency and accountability—that is, to ensure that the government is held responsible for managing public resources and that donors and taxpayers have access to information about the allocation and use of such funds; and (3) to reduce the transaction costs of aid-related donor requirements. Weaknesses in PFM systems can undermine budgetary planning, execution, and reporting and result in leakage of scarce public resources.

Weaknesses of existing PFM systems in LICs

A number of recent diagnostic studies have evaluated the quality of fiscal institutions and PFM systems in LICs.26 The results of these assessments are summarized below.

  • The HIPC Assessments and Action Plans (HIPC-AAP), prepared jointly by the IMF and World Bank, covered 23 eligible LICs in 2001 and 26 in 2004.27 These assessments provided the first opportunity to undertake periodic PFM assessments in LICs aimed at measuring progress over time. The 2004 assessment concluded that 19 of the 26 countries assessed still required substantial upgrading of their PFM systems. Budget execution and the ability of countries to track poverty-reducing expenditures were especially weak (Figure 1).28

  • The fiscal Report on the Observance of Standards and Codes (ROSC) assessments for a sample of 28 PRGF-eligible countries suggest that, in certain areas of fiscal transparency, the performance of LICs is not out of line with that of more advanced economies. However, their performance is generally weak in many other areas that are important to a well-functioning PFM system, such as a comprehensive and credible budget and effective audit procedures (Figure 2).

  • The Public Expenditure and Fiscal Accountability (PEFA) assessments, which only began in 2005, cover just 12 PRGF-eligible countries, although the coverage is expected to expand quite rapidly. Early results suggest a pattern of relatively poor performance across the board in key areas of budget preparation and execution, with a median score of about 2.0 against the international good practice standard of 4.0 (Figure 3).29

  • The World Bank’s Country Policy and Institutional Assessment (CPIA) ratings also display a picture of relatively poor performance by many LICs. These ratings are based on an assessment of whether the countries concerned have a comprehensive and credible budget, effective financial management of revenues and expenditures, and timely and accurate fiscal reporting. For 27 countries reviewed in OECD (2006b), scores ranged from 2.0 (weak) to 4.5 (moderately strong) (Figure 4).

  • Recent evaluations of the Fund’s TA activities in LICs reached a similar conclusion. One evaluation concluded that, in many countries, budget plans were based on unrealistic assumptions, were not comprehensive, and lacked a medium-term focus; accounting and payments systems and other areas of budget execution were weak; budgetary institutions were fragmented; and broader institutional problems such as weak legislative oversight and poor accountability of senior budget officials were common.30 In some countries reviewed, civil conflict had added to these problems.

Figure 1.
Figure 1.

HIPC-AAP: PFM Performance by Key Categories

(The number of countries meeting benchmarks in percent of total)1/

Citation: IMF Working Papers 2007, 222; 10.5089/9781451867862.001.A001

Source: IMF and World Bank estimates.1/Total number of assessed countries in each year is given in brackets.
Figure 2.
Figure 2.

Fiscal ROSC Assessments from 1999–2005

Fiscal transparency Performance in PRGF Eligible Countries 1/

(the share of countries with storng performance in total)

Citation: IMF Working Papers 2007, 222; 10.5089/9781451867862.001.A001

Source: IMF estimates.1/Based on IMF fiscal ROSC assessments for 28 PRGF eligible countries between 1999 and 2005.
Figure 3.
Figure 3.

PEFA Assessments Undertaken During 2005–06

Citation: IMF Working Papers 2007, 222; 10.5089/9781451867862.001.A001

Source: Data provided by the PEFA Secretariat.
Figure 4.
Figure 4.

CPIA: Quality of Partner Country PFM Systems in 20051

Citation: IMF Working Papers 2007, 222; 10.5089/9781451867862.001.A001

Source: World Bank Country Policy and Institutional Assessment (CPIA sub-component 13), 20051/OECD (2006b).

The broad conclusion is that, despite sustained efforts in many countries—supported by the IFIs and donors—to undertake PFM reforms, progress has been uneven. Some countries, such as Ghana, Mali, Mozambique, and Uganda, have shown capacity for quite rapid improvement in their PFM systems, especially those that have promoted reforms in budget management and given incentives to civil servants for better performance (World Bank, 2006). However, reform of PFM systems in many other countries has stagnated. Another important lesson is that countries have not always prepared an action plan for reform that is well structured and realistic about the prioritization and phasing of reform measures, given the countries’ limited capacity.

It is therefore critical that countries focus on strategic PFM reforms and sequence them appropriately, consistent with the country’s capacity to undertake them. Continued capacity building in public debt management, to help countries develop their own Medium-Term Debt Strategy (MTDS), is also crucial.31 The PFM measures described below are those judged to be especially important in the short term. Work on implementing many of these measures, however, will need to be sustained over a period of years if they are to become fully effective.

Countries that are emerging from conflicts or have suffered major disasters face special challenges in strengthening their fiscal institutions.32 These countries have generally received large injections of aid resources that their PFM systems often are not able to cope with, either because of the logistics of handling a sudden increase in inflows of aid, or because institutions and PFM capacities have been significantly weakened and cannot respond adequately or meet donor expectations. In the experience of many postconflict or disaster-affected countries, there is often a sudden influx of foreign experts to work alongside national staff or sometimes even run the central fiscal institutions until national staff can take over. In such cases, both the focus of PFM reforms and the perception of where the main weaknesses are concentrated may be different from what has been described above. These issues are highlighted in Box 3.

Overall strategic planning

The strategic planning process should be anchored in the budget process to help the government achieve its medium- and long-term policy objectives, as defined in the PRSP and MDGs. This includes strengthening the relationship between the planning and budgeting cycles, strengthening the role of the cabinet in strategic decision making, closer integration of the recurrent and development budgets, consolidating responsibility for preparing and executing the budget within the finance ministry, and increasing the coverage of donor-funded development projects in the budget. Another important issue is the development of a “top-down” budgeting approach that focuses on the correct sequencing of budget decisions—starting with agreement by the cabinet on the overall resource envelope and broad allocations to sectors, and followed by negotiation between the finance ministry and line ministers on detailed expenditure allocation by chapter or line item. Top-down budgeting is often associated with the development of a medium-term approach to budgeting described in the following section, and both require sufficient capacity, and effective coordination of decision making through the cabinet, to achieve good results. Some reforms are likely to take many years to become fully effective and functional. In cases in which the planning and finance functions are managed by separate ministries, strong coordination between the two is needed.

Strengthening Public Financial Management in Postconflict and Disaster-Affected Countries1/

Postconflict countries provide insight into the challenges and opportunities that scaling up aid on a wider scale may pose to their public financial management (PFM) systems. The countries concerned may also display special circumstances that affect PFM issues and priorities, such as the following:

  • There is a greater need to consider PFM reforms within the context of any emerging political and constitutional debates. Postconflict countries are often in a state of political and constitutional flux. Early PFM reforms may favor greater centralization of control to increase efficiency, whereas political forces may pull in the opposite direction.

  • Potential loss of physical and institutional infrastructure can greatly increase the capacity constraint faced by the recipient country. Postconflict countries have often experienced some form of regime change, and key government positions may be filled by international experts, diluting local capacity.

  • Large off-budget donor expenditures can increase the volatility of aid revenues as the emergency phase recedes. Changes in donor priorities and withdrawal of support can lead to large projects suddenly being brought on-budget. In the short run, this can crowd out other budget items and lead to ad hoc changes in appropriations.

  • The right balance must be struck between slow, thorough approaches and fast, pragmatic solutions. In emergency situations, it becomes harder to undertake rigorous reviews to tackle fundamental issues and a strategic approach to planning and sequencing PFM reforms.

  • Postconflict countries often have a larger, concentrated donor presence, which can facilitate coordination of priorities and systems, if well managed.

PFM reforms that are likely to require priority attention in postconflict countries include the following:

  • Establishing/strengthening the central budgetary institution.

  • Preparing a credible annual budget with clear and reliable estimates. The first step in many cases is the formulation of an emergency budget, which is by necessity rapidly constructed and subject to revision.

  • Developing a clear government accounting system that can track the use of budget appropriations, produce clear reports on outturns, and support the government’s financial reporting obligations.

  • Undertaking a review of the legal and regulatory framework for budget preparation and execution (which may be necessary if regime change leads to rejection of the existing legal framework).

  • Taking initial steps to harmonize the medium-term fiscal and strategic planning framework so that it transparently shows both donor commitments and planned transfers to the government’s budget.

1/ Countries such as Rwanda (1994), Bosnia and Herzegovina (1995), Kosovo (1999), Timor-Leste (1999/2000), Sierra Leone (2000), the Islamic Republic of Afghanistan (2001), the Democratic Republic of the Congo (2002), and Iraq (2003) experienced sharp increases in the volume of aid flows following the cessation of periods of conflict. In others, such as Honduras (1998) and Sri Lanka (2004), the international community provided support following devastating natural disasters.

Developing a medium-term approach to budgeting

In an environment of scaled-up aid, a key challenge for LICs is to ensure that additional spending helps to achieve the MDGs and maintain macroeconomic stability. Achieving the MDGs will require undertaking ambitious spending programs spanning several years. Financing requirements for such programs may exceed immediate aid commitments. Consequently, countries need to take a longer-term view of their spending needs and potential resource availability—both domestic and external—in fiscal policy formulation. This can be achieved by anchoring fiscal policy in an MTF.33 Such frameworks can help align the budget with the government’s medium-term planning goals, such as progress toward the MDGs and the Poverty Reduction Strategy (PRS). In general, MTFs set the overall spending limit, allocate the annual spending envelope across different sectors, and then allocate sectoral spending across different programs and projects. The instruments corresponding to these three tasks are as follows:

  • Medium-term fiscal frameworks (MTFFs): The MTFF outlines the fiscal framework based on projections for broad fiscal aggregates that are consistent with key macroeconomic variables and fiscal targets. Broad fiscal aggregates (e.g., revenues and expenditures) are projected based on the expected evolution of macroeconomic variables (e.g., growth and inflation) and policy measures. Projecting a realistic path for scaled-up aid is essential to underpin overall spending growth. As noted earlier, the MTFF should be reexamined and updated at least annually to reflect recent developments and shocks to the macroeconomic outlook.

  • Medium-term budget frameworks (MTBFs): The MTBF goes further than the MTFF by allocating the overall spending envelope across sectors (e.g., health and education), based on the country’s development priorities, as set out in the PRSP.

  • Medium-term expenditure frameworks (MTEF): The MTEF outlines the sectoral allocation of spending across programs and projects according to government priorities, based on detailed costing from sectoral analysis. The MTEF also involves a more detailed indication of performance objectives and measures.

Most LICs lack adequate capacity to adopt a comprehensive MTEF, but many have the rudimentary form of an MTFF and MTBF in place. Those countries that lack MTFFs could draw on the macroeconomic scenarios developed in the context of DSAs for a basic MTFF. To develop MTBFs, important steps include strengthening the government’s strategic decisionmaking procedures regarding the budget (e.g., by involving the cabinet), improving the relationship between the national planning and budget processes (and between the ministries of finance and planning), and strengthening capacity to prepare sectoral ceilings and estimates on the basis of an improved economic and functional classification of budgetary revenues and expenditures.

Designing and implementing an MTEF, however, is a complex and challenging process that needs to be approached cautiously and on a step-by-step basis. Successful adoption of an MTEF requires, among other things, the following: (1) a capacity for making realistic forecasts of macroeconomic variables over the medium term; (2) procedures for estimating fiscal developments beyond the current and upcoming fiscal years; (3) a review of the decision-making processes of government and associated institutional arrangements; and (4) enhanced coordination between the finance ministry, the planning ministry, and other central agencies and line ministries through the cabinet or cabinet committees. For these reasons, MTEFs have proved difficult to implement in many developing countries: necessary institutional adjustments have not been made and the MTEF has not been fully integrated into the annual budget process34 (Box 4). A recent IMF review concluded that developing an MTEF can be effective when circumstances and capacities permit; otherwise, it can be a great consumer of resources and may distract attention from immediate needs such as improving the annual budget execution process.35

In Africa, in cases in which the preconditions were not right, the MTEF was introduced prematurely and turned out to be largely a paper exercise, partly because it failed to recognize the essentially gritty and political nature of the budget bargaining process, which cannot be reduced to a technocratic exercise.36 For countries whose detailed MTEFs have failed, a simplification process should be encouraged.37

Current Medium-Term Fiscal Planning Practices

While most low-income countries (LICs) do not have a medium-term framework (MTF) in place, even where an MTF exists, it is often not well integrated with the budget and not used for analytical purposes. Out of 31 LICs examined,1/ only 3 had a full-fledged macrofiscal framework in place, 5 had a relatively comprehensive framework, 13 had a basic framework, and 10 had no MTF (see figure below). Only 10 of the 21 LICs that had an MTF systematically aligned their yearly budgets with these frameworks. In addition, (1) medium-term fiscal projections and macroeconomic assumptions were often unrealistic and therefore lacked credibility;2/ (2) the underlying macroeconomic assumptions for forecasts were often not explicit, with fiscal ROSCs suggesting that 9 out of the 21 LICs with an MTF did not explicitly state key macroeconomic assumptions; (3) the fiscal effects of different macroeconomic scenarios were often not quantified; (4) on occasion, long-term policy scenarios were not prepared; and (5) medium-term expenditure estimates often did not reflect expenditure priorities or changing priorities and were not adjusted in a rolling fashion.

UF2

MTF Rating by Category

(Number of countries in each category)

Citation: IMF Working Papers 2007, 222; 10.5089/9781451867862.001.A001

Source: IMF, fiscal ROSC reports for 31 countries in Africa, Asia, Europe, and Latin America.
1/ Based on information collected from the fiscal module of the Report on the Observation of Standards and Codes (ROSC). The country sample includes Albania, Armenia, Azerbaijan, Bangladesh, Benin, Burkina Faso, Cameroon, El Salvador, Equatorial Guinea, Georgia, Ghana, Guatemala, Guyana, Honduras, India, the Kyrgyz Republic, Malawi, Mali, Mauritania, Moldova, Mongolia, Mozambique, Nicaragua, Pakistan, Papua New Guinea, Rwanda, Samoa, Sri Lanka, Tanzania, Uganda, and Zambia.2/ Some LICs even invite spending agencies to draw up their own macroeconomic assumptions to determine expenditure levels for the annual budget, which are not in line with the budget document.

Strengthening budget execution and reporting

In the short term, countries with low capacity should focus on “getting the basics right”— relatively simple reforms of the kind summarized in Box 5.38 The emphasis should be on building capacity in budget execution and reporting. This will help countries avoid both ad hoc decision making on the allocation of budgetary resources and frequently encountered problems, such as expenditure arrears and low-quality and untimely fiscal reports. This will also facilitate efficient and effective use of resources and better tracking of poverty-reducing expenditures.

The maintenance of an adequate and coherent accounting framework is essential for tracking spending, enforcing accountability, and meeting donors’ fiduciary requirements. At a minimum, a functioning accounting system should include (1) regular bank account reconciliation with accounting records; (2) double-entry accounting procedures, with both general ledger and supporting subsidiary ledgers; (3) a chart of accounts that facilitates reporting according to the budget presentation; (4) periodic and timely in-year consolidation of accounts, where accounting is decentralized; (5) maintenance of adequate accounting records; and (6) preparation of appropriate manuals and training for accounting staff (Box 5). Accounting information should be comparable across years and between the approved budget and data on realized expenditures. Any changes in the accounting basis and principles should be clearly specified and necessary adjustments made to ensure that the data are consistent.

Short-Term Priorities for Public Financial Management Reform

The following short-term priorities should be considered for public financial management system reform:

  • Ensure that the ministry of finance or central budget authority has adequate control over the fiscal aggregates and that budgetary spending is in line with the approved budget.

  • Ensure that the process of preparing the annual budget is comprehensive and coherent, follows a sensible timetable, and is adequately integrated with the priorities-setting process of the national plan or Poverty Reduction Strategy Paper.

  • Establish a budget classification, for administrative and economic categories initially, that complies with international good practice.

  • Introduce a basic accounting system, with some level of automation, to process receipt and payment transactions, record information, and produce timely fiscal reports reconciled with banking data, at least for the main aggregates.

  • Take steps to ensure reasonable cash flow planning and control of spending at key points of the spending chain and at the commitment stage.

  • Establish a simple system for recording donor aid commitments and disbursements and tracking poverty-reducing expenditures.

  • Ensure that staff manuals on budget preparation and expenditure authorization procedures are in place.

Government banking arrangements need strengthening to improve cash management and accounting and to reduce fiduciary risk. A consolidated banking arrangement—ideally in the form of a treasury single account—also improves the quality of accounting data through effective and timely bank reconciliation. Care should be taken during scaling up to ensure that the number of bank accounts does not proliferate and further overload the low capacity of systems in LICs to keep track of the increased volume of transactions passing through the banking system. Over time, donors’ bank accounts should be integrated with the treasury’s accounts to avoid problems with cash management, and their respective accounting and banking records should be reconciled in a timely manner.

Regular and timely fiscal reporting is necessary to assure donors, policymakers, legislators, and other stakeholders that the government is on track in implementing its annual budget. In countries where subnational governments account for a significant portion of government spending, fiscal reporting should cover these entities also. Where capacity constraints limit the coverage of fiscal reports, the main requirement should be for timely and reliable reporting of the central government budget. Although many countries have some form of monthly reporting, the coverage and quality of such reports continue to be weak. To ensure that these fiscal reports and statements are complete, donors should provide full information to the authorities on their planned and actual aid disbursements, whether in cash, in-kind, or by direct disbursement to suppliers, particularly when these are not reported through the treasury.39

A sound system of internal control is necessary to provide reasonable assurance that public expenditure is executed in accordance with the approved budget and the established regulatory framework. The effectiveness of budget execution does not necessarily increase by adding multiple layers of redundant control.40 What is required is that the control function or task should be clearly articulated and assigned, understood by controllers, and consistently applied to all transactions.41 Given that payroll expenditure forms a substantial part of public expenditure in many LICs, improving payroll management and control should also be given priority.42

Weak or inadequate public procurement systems is one of the main sources of corruption. Strengthening procurement is essential to maintain donor confidence in continued funding through the budget and is one of the key measures identified in the 2005 Paris Declaration. Developing standard bidding documents, streamlining and computerizing the system for recording bids and contract awards, publishing such information in the official gazette, and, later in the process, developing an e-procurement system are some of the steps countries can take to strengthen public procurement. Recent efforts, spearheaded by the World Bank,43 have resulted in a significant number of LICs enacting new procurement legislation and establishing procurement regulatory authorities. Although useful progress has been made, much capacity building remains to be done.

Integrating donor aid in the budget process

Aid disbursed through extrabudgetary channels should be coordinated with budget priorities. According to a recent survey, on average, only 37 percent of external aid is channeled through country PFM systems (OECD, 2006b). This complicates fiscal management. For example, the “3 by 5 Initiative”44 mobilized substantial extrabudgetary resources to expand the number of HIV/AIDS patients receiving antiretroviral drug treatment from 400,000 in 2003 to around 2 million in 2006 (WHO, 2007), and the U.S. President’s Emergency Program for AIDS Relief (PEPFAR) has a provision for US$15 billion over five years (beginning in 2004) largely for NGOs with spending increased in line with local implementation capacity. Donor preferences for specific programs affect the composition of health spending, although these programs are targeted to diseases that have high mortality.45 In addition, earmarking of aid could introduce inefficiencies in expenditure allocations as noted earlier, straining the capacity of already weak PFM systems, reducing the flexibility of governments to reallocate resources in response to changing conditions and priorities, and hampering the implementation of expenditure smoothing.46 Extrabudgetary flows hinder comprehensive budget planning and could lead to duplication and waste in the absence of a well-functioning coordinating mechanism. However, extrabudgetary aid and expenditure might be warranted in the short term in fragile and postconflict states, where resources cannot be channeled through institutions in an efficient and effective manner.

Strengthening PFM systems, including their capacity to track poverty-reducing spending

The emphasis should be on building capacity in budget execution and reporting to ensure efficient and effective use of resources. This capacity includes budget classification, accounting, public procurement, payroll management, and internal control systems. Such reforms will help countries avoid ad hoc decision making on the allocation of budgetary resources and frequently encountered problems such as expenditure arrears and low-quality and untimely fiscal reports. Efforts to strengthen PFM systems, promote greater transparency, improve budget procedures and reporting, and prepare MTFs should also reassure donors that aid will be used effectively and encourage them to channel more aid through the budget.

Special attention needs to be paid to tracking poverty-reducing public spending to ensure that it reaches the intended recipients (Box 6).47 The key PFM areas identified above are critical to achieving desired expenditure allocations. Techniques such as the use of Public Expenditure Tracking Surveys (PETS) and audit reports can help identify persistent weaknesses in the expenditure chain by estimating the amount of public funds that actually reaches front-line service delivery units through the budget system.48 These techniques can be helpful in assessing the quality of cash management and internal control systems, can focus attention on the need for reform in these areas, and, eventually, can strengthen mechanisms of internal and external audit. Uganda initiated a PETS to assess potential leakage of funds following a dramatic increase in primary education spending that failed to boost enrollments. The survey found that 87 percent of the nonwage resources were diverted to other uses (World Bank, 2004). Several lessons emerge from similar tracking surveys in Ghana, Honduras, Madagascar, Mozambique, Papua New Guinea, Rwanda, Senegal, Tanzania, and Zambia. In particular, poor resource management can result from excessive discretion in budgetary procedures in an environment with weak internal controls, imperfect information, and vested interests.

All poverty-reducing spending should be monitored because of fungibility in resource use. If resources are fungible, then a recipient country can offset the scaled-up aid that is intended for additional poverty-reducing programs by lowering its own spending in those areas.49 This problem is compounded by the difficulty of determining a counterfactual, that is, what a government would have spent on poverty reduction in the absence of higher aid flows. Moreover, substantial earmarking of resources for certain poverty programs by vertical funds would require their sustained support to ensure that these programs are maintained over time.

Illustrative Expenditure Tracking Mechanism

The essential component of an effective mechanism for tracking poverty-reducing expenditures is a budget classification system that conforms with the international standard:

  • At a minimum, a basic economic and administrative classification of expenditure should be put in place. This would allow administrative units to be “aggregated” into sectors that allow poverty-reducing expenditures to be tracked at a broad level;

  • A functional classification of expenditures would provide a better indication of the allocation of expenditures within a sector or subsector, and hence allow improved tracking against the government’s poverty-reducing priorities; and

  • A simple program classification would provide additional information for more detailed policy analysis and evaluation of aid effectiveness.

In addition, for aid that is delivered directly by donors outside the budget, donors should provide timely reports to government on disbursements:

  • At a minimum, such reports should include information on aggregate disbursements by sector (aligned with government definition) and geographical location;

  • If possible, data should be provided on expenditures according to their economic classification. The most basic requirement would be a distinction between recurrent and capital expenditures, which would allow the government to adequately plan for the medium term; and

  • Eventually, donors should report against the functional or program classification of expenditures adopted by the government.

A gradual move toward a results-oriented budget would help strengthen accountability and help assess the effectiveness of different programs. Advanced forms of results-oriented budgeting are not appropriate for LICs. Still, some initial steps in this direction can be useful, such as identifying key program objectives and associated “responsibility centers,” defining the intended program outputs, strengthening the link between performance and rewards/sanctions, and implementing pilots in performance evaluation and results-oriented budgeting in selected ministries, such as health and education, where much donor aid has been focused. Burkina Faso, Ghana, Mali, and Ethiopia are examples of LICs that have made progress in implementing program and performance budgeting.

Formulating and implementing PFM action plans

LICs should prepare an action plan for strengthening PFM systems based on a comprehensive diagnostic study such as the PEFA framework. Reforms should be sequenced in line with government capacity, for example, by following a properly defined “platform approach” so that core building blocks precede more advanced reforms. The platform approach entails identifying indicators of success for each stage of the overall reform process to determine when to move on to the next stage (Table 1). This approach strengthens the linkage between the functional components of the reform.50 The action plan may also need to be tailored to the unique circumstances of postconflict countries, which usually face weak legal and regulatory frameworks (e.g., tax and budget laws), an ill-defined fiscal authority (e.g., the ministry of finance), and inappropriate PFM systems.51

Table 1.

Illustrative Platforms for Strengthening Budget Formulation in a Typical LIC

article image
Note: GFSM = Government Finance Statistics Manual; MTEF = medium-term expenditure framework; MTFF = medium-term fiscal framework; MoF = ministry of finance, MoP = ministry of planning; NDP = National Development Plan; PRSP = Poverty Reduction Strategy Paper.

Key requirements of a successful PFM reform program are as follows:

First, studies have demonstrated that political economy factors are important for the successful implementation of PFM reforms. This helps explain why such reforms are so difficult to achieve and often slow to implement.52 Recent studies of PFM reforms in Ghana, Malawi, and Mozambique demonstrate that, although sound budgetary rules and procedures may be in place, they are frequently distorted by informal practices that determine the actual distribution of budgetary resources (Santiso, 2007). The studies reveal that dysfunctions and distortions can occur at all stages of the budgetary cycle. They underscore that demand for better governance and greater accountability is a key driver of change in budgetary systems.53

They also suggest that incremental reforms are more likely to be successful than “big-bang” approaches, especially those that seek to incorporate models of reform imported from other countries.

Second, PFM reforms need to be linked to the annual budget cycle. There are two main reasons for this: (1) budget offices are especially busy at certain points of the year and have little time to focus on new reform initiatives at such times; and (2) certain reforms, for example, a change in the timetable for budget preparation or the budget classification, can only be introduced at the beginning of a fiscal year. In some countries (e.g., Tanzania), formal consideration of new reform initiatives has been institutionalized as part of the regular budget calendar and involve consultation with TA providers and other stakeholders.

Third, the main constraints to reform should be identified early on and means should be found to eliminate or reduce their impact. Such constraints may include the absence of a suitable legal framework, technical issues (e.g., the absence of a good budget classification), institutional weaknesses (e.g., rivalries among different ministries, agencies, or departments over managing the budget process), or political factors. It is often useful to include an analysis of constraints within the terms of reference of diagnostic studies or TA missions, and to discuss with the recipient government methods of dealing with them.54

Fourth, mechanisms should be put in place to promote effective leadership and coordination of the reform program among the authorities, donors, and other stakeholders. Some countries have established formal mechanisms for coordination such as the donor partnership developed in Mozambique. Key roles and responsibilities of donors as indicated in Box 7.

The action plan for short-term measures should—

  • Focus on key PFM areas for aid utilization. These include the capacity to prepare sectoral ceilings and estimates based on improved functional and budget classifications and strengthened internal controls on budget execution, accounting, and reporting at the central level.

  • Decompose reforms into a core set of functional components. Where appropriate, PFM reforms should be broken down into functional blocks, such as the core design elements, required changes to legislation, information technology procedures, and training. Monitoring progress in each area is essential so that problems can be addressed before they become obstacles to the overall reform process.

  • Take initial steps to give the budget a results orientation. This would allow the governments to get a sense of whether scaled-up spending is having the desired effect on economic and social outcomes.

Role of Donors in Promoting Effective Public Financial Management Reform

  • Donors should encourage the national authorities to establish institutional arrangements that facilitate effective communication between the ministry of finance, the ministry of planning, and other agencies (e.g., the prime minister’s office) involved in the process of planning and disbursing official aid.

  • Donors should play their part in producing realistic projections of donor disbursements of aid. Although project aid often suffers most from unrealistic projections, IMF-supported programs in low-income countries are often affected by late disbursements of general budget support by the multilateral donors.

  • Donors should resist earmarking aid for specific purposes. Donors often give less attention to the budget priorities of the recipient country, and instead disburse money on their own schedule for projects they conceive to be useful. In other cases, national producers are rewarded by tying aid to national products and services.

  • Donors should ensure that full information is provided on actual aid disbursements, whether in cash, in-kind, or by direct reimbursement to suppliers, and to the extent possible, attempt to satisfy their national authorities’ requests for such information by using the recipient countries’ own reporting and accounting system.

  • Donors should ensure that, once funds are disbursed, the accounting and banking records of donors’ own bank accounts are reconciled in a timely manner. Ideally, donor accounts should be integrated with the government’s treasury system.

  • Donors can do much to encourage transparency, participation, and accountability in public budgeting by supporting meaningful and regular reporting, timely disclosure of financial information, and external oversight of the budget process. They need to be more aware of the political economy factors that influence the behavior of partner governments, including the potential impact of their own behavior on domestic processes.

In addition, the action plan should recognize medium-term reforms where an early start is needed but change will occur more gradually, such as the following:

  • Developing capacity in treasury systems, cash management, and debt management to strengthen budget execution and help countries build their own MTDS.

  • Strengthening the capacity of subnational governments: As noted earlier, delivery of services such as education, health, and sanitation is increasingly being delegated to subnational governments, whose PFM systems are typically weaker than those of the national government. Effective use of aid for such services would require strengthening PFM systems at the subnational level also.

  • Linking PFM reforms to broader public sector reforms: The reforms of PFM systems can be strengthened if they are part of a broader public sector reform of the civil service, governance and transparency, and the legal framework.

  • Gradually increase the role and capacity of accountability institutions, such as the national audit authority, whose mandate should include undertaking value-for-money audits of key expenditure programs.

The role of TA in supporting the reform process

The international community should support implementation of the action plan through TA that targets the priority areas noted in Box 6. Recent evaluations of the TA provided by the IMF and World Bank have highlighted common problems in reform programs supported by donor TA. These include inadequate diagnostic assessments, overloaded reform agendas, improper sequencing of reforms, political-economy constraints, poorly selected experts and inadequate quality control of their work, and insufficient coordination among different TA providers.55 In some cases, there have been significant deficiencies and gaps in the design and implementation of TA programs.56 In addition, TA recommendations require sustained follow-up by donors to monitor progress on achieving short- and medium-term goals.

Action is required on several fronts to address these concerns. First, effective measurement systems for monitoring both TA delivery and improvements in PFM systems need to be established. Tools such as the PEFA framework can be useful in this regard. Although there are some current concerns about the quality of the diagnostic assessments carried out under the PEFA framework, this initiative should be encouraged.

Second, effective coordination between TA providers and the authorities is critical to the success of PFM reforms. There are often numerous donors providing TA in LICs, underscoring the need for effective coordination. The country authorities should ultimately be responsible for coordinating donor activities, but limited capacity or scarce human resources can require that a major donor assume this role. One promising initiative in this field is the enhanced collaboration between the Fund and the World Bank to support PFM reform in a group of African countries—including Burkina Faso, Ghana, Malawi, Mozambique, Rwanda, and Tanzania—using a range of lending instruments and TA operations.57

Third, the Fund is playing an important role in supporting countries as they develop and implement medium-term action plans for PFM reform, in collaboration with other development partners. The Fund has expertise in many of the areas that are critical to support the short-term capacity-building effort in LICs—for example, budget classification, accounting, internal control, and fiscal reporting. Such assistance should emphasize country ownership of the reforms; apply lessons learned to use TA more effectively; make effective use of external finance and partnership arrangements with the World Bank and other TA providers, where appropriate; and leverage the resources of staff from headquarters and the Regional Technical Assistance Centers. Good progress has been made: about 60 percent of the 78 PRGF-eligible countries either have a PFM reform plan in place or are in the process of preparing such a plan. The Fund has provided technical support in more than half of these countries.

Fiscal Management of Scaled-Up Aid
Author: Mr. Sanjeev Gupta, Mr. Duncan P Last, Ms. Isabell Adenauer, Mr. Kevin Fletcher, Mr. Gerd Schwartz, Mr. Shamsuddin Tareq, and Mr. Richard I Allen
  • View in gallery

    The Smoothing Approach

    (In percent of GDP)

  • View in gallery

    HIPC-AAP: PFM Performance by Key Categories

    (The number of countries meeting benchmarks in percent of total)1/

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    Fiscal ROSC Assessments from 1999–2005

    Fiscal transparency Performance in PRGF Eligible Countries 1/

    (the share of countries with storng performance in total)

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    PEFA Assessments Undertaken During 2005–06

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    CPIA: Quality of Partner Country PFM Systems in 20051

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    MTF Rating by Category

    (Number of countries in each category)