This technical note analyzes the importance of a budget classification system. It highlights that budget classification is one of the fundamental building blocks of a sound budget management system, as it determines the manner in which the budget is recorded, presented and reported, and as such has a direct impact on the transparency and coherence of the budget. The note describes the main features of a sound budget classification system, structuring of a budget classification system, and the relationship between budget classification and the chart of accounts.

Abstract

This technical note analyzes the importance of a budget classification system. It highlights that budget classification is one of the fundamental building blocks of a sound budget management system, as it determines the manner in which the budget is recorded, presented and reported, and as such has a direct impact on the transparency and coherence of the budget. The note describes the main features of a sound budget classification system, structuring of a budget classification system, and the relationship between budget classification and the chart of accounts.

This technical note1 addresses the following main issues:

  • Why is a budget classification system important?

  • What are the main features of a sound budget classification system?

  • How should a budget classification system be structured?

  • What is the relationship between budget classification and the chart of accounts (COA)?

  • What are likely to be the critical steps and milestones in the reform of budget classification?

  • What are the preconditions for successful implementation of a new budget classification system?

I. Why Is a Budget Classification System Important?

Budget classification is one of the fundamental building blocks of a sound budget management system, as it determines the manner in which the budget is recorded, presented and reported, and as such has a direct impact on the transparency and coherence of the budget.

In countries where the budget nomenclature is weak, upgrading the budget classification system should itself be considered a basic step—indeed a precondition—before embarking on other reforms of public financial management (PFM) such as introducing a computerized financial management information system, a medium-term expenditure framework (MTEF), or a results-based budgeting system.

A budget classification system provides a normative framework for both policy decision making and accountability. Classifying expenditures and revenues correctly is important for (1) policy formulation and performance analysis; (2) allocating resources efficiently among sectors; (3) ensuring compliance with the budgetary resources approved by the legislature; and (4) day-to-day administration of the budget. Once established on a sound basis, a classification scheme should not be substantially changed unless there are strong reasons; a stable classification facilitates both the analysis of trends in fiscal policy over time and intercountry comparisons.

II. What Are the Main Features of a Sound Budget Classification System?

In order to meet the requirement of providing accurate information to policymakers, government managers, the legislature, and the broader public, the primary aim of a classification scheme should be to ensure that the budget complies with three key principles of sound budget management:

  • The principle of comprehensiveness requires that the budget cover all government entities and institutions undertaking government operations, and present a consolidated and complete view of these operations.

  • The principle of unity requires that the budget include all revenues and expenditures of all government entities undertaking government operations. This principle is important to ensure that the budget is effective in constraining total and sectoral government expenditure, and in promoting greater efficiency in the allocation of resources.

  • The principle of internal consistency between different components of the budget requires, in particular, that the current expenditure needed for the operations and maintenance of past investment projects be fully reflected in the budget. Moreover, this principle implies that there should be a unitary budget system in which responsibilities for preparing and executing the budgets for current and capital (or development) spending are consolidated within a single central fiscal agency, usually the ministry of finance.

Different approaches to budgeting often have a strong influence on the structure and organization of the classification system. For example, compliance budgeting focuses on ensuring that the collection and use of resources are consistent with the budget laws, which in turn depend on having an accurate classification of these transactions and the organizations responsible for receiving revenues or incurring expenditures. Policy formulation and allocative efficiency concerns are the basis of a classification of expenditure by function and program. A detailed classification of programs by activity or output is required if operational performance is being assessed. Fiscal control requires at least an economic classification based on clear concepts (e.g., separating borrowing from receipts). Meeting these different and sometimes conflicting requirements calls for a pragmatic and flexible approach.

A sound system of budget classification should at a minimum comprise a classification of revenues into various categories, and administrative, economic, and functional classifications of expenditures.2 The administrative classification identifies the entity that is responsible for managing the public funds concerned, such as the ministry of education and health or, at a lower level, schools and hospitals. The economic classification identifies the type of expenditure incurred, for example, salaries, goods and services, transfers and interest payments, or capital spending. The functional classification categorizes expenditure according to the purposes and objectives for which they are intended. All three classifications are essential for users of budget information.

Many countries use additional classification schemes to enhance transparency and accountability and to better manage their finances (for further details, see Section IV below). However, it is necessary to be careful in expanding the different types of classification to be used. Such an expansion could possibly lead to unreliable information, due to the complexity of the budget nomenclature. It also requires more capacity and resources to generate the required information and maintain the system. Some of these analytic needs can be addressed through ad hoc data calls rather than hard-coding them directly into the budget classification.

The following features are considered to be critical to a system of budget classification if it is to generate useful, timely, and reliable information:3

  • Distinction between administrative and economic classifications. The economic and administrative classifications provide different kinds of information. The former provides data on types of revenues or expenditures (for example, salaries or goods and services), while the latter provides data on the public sector organizations that incur expenditures or receive revenues. An administrative classification of expenditure is needed to identify responsibilities for the main blocks of public expenditure and for day-to-day administration of the budget. Expenditures may be divided into separate subcategories for each ministry, department, or public entity.

  • The independence of economic and administrative categories. It is important to the soundness of a classification system that the economic and administrative categories be independent of each other. For example, the economic classification may be used to indicate whether government receipts derive from tax revenues or the sale of goods or services, but not whether this income should be attributed to a central government ministry or department, or to a subnational entity4

  • The use of the functional classification. A “functional” classification organizes government activities according to their broad objectives or purposes (e.g., education, social security, housing, etc.). It is independent of the government’s administrative or organizational structure. Such a classification is especially useful in analyzing the allocation of resources among sectors. It may also be used for tracking poverty-reducing expenditures. A sound and stable functional classification is required to generate the data that are necessary to produce historical surveys

  • Mutual exclusivity. Every line item in a well-designed budget classification system should be independent of all other line items, as explained in the following section.

III. The Structure of a Budget Classification System

The detailed structure of a budget classification system needs to be well designed if meaningful and reliable information is to be extracted and the system is to be capable of modification in the future. These core features are embedded in its coding system. The IMF’s Government Finance Statistics Manual (GFSM 2001) provides a standard framework for developing a new budget classification structure or improving an existing one (see Box 1).5

The GFSM 2001, however, was developed primarily as a statistical reporting framework and is generally not sufficient for the purposes of developing a budget classification system. It focuses on revenues, and economic and functional reporting for statistical purposes, while a budget classification system is also an instrument of policy formulation, administration of the budget, and accounting. As a result, the classification system for both expenditures and revenues may need to be adapted to meet the needs of budget preparation and execution. Some countries (e.g., Brazil) have developed satisfactory budget classifications, adapted to their needs and constraints, without using the GFS framework.

Classification of Revenues6

Following the GFSM 2001 framework, revenue is classified according to the following categories: (1) taxes, (2) social contributions, (3) grants, and (4) other revenues. For taxes, the classification scheme is determined mainly by the base on which the tax is levied (e.g., income, expenditure, property assets, savings, etc.).

The GFSM 2001 framework allows revenues to be recorded on an accrual basis; that means creating a future claim or entitlement for the government to receive taxes or other types of revenue at the time that activities, transactions, or other events occur. The application of this general rule to the various types of revenue should be indicated in each section of the classification as necessary7

Using the Government Finance Statistics Manual (GFSM 2001) to Design Budget Classifications

The GFSM 2001 provides some specific guidance on certain desirable features of economic and functional classifications:

  • The GFSM 2001 economic classification is presented in Annex III. GFSM 2001 is defined on an accrual basis with a view to creating statistical comparability between fiscal reports and national accounts. However, with the exception of the consumption of fixed capital, the line items in the economic classification of government operations, as presented in GFSM 2001, apply to the cash and the accrual bases equally.1 In a number of cases, the standard GFS tables include net items. Such items can be sufficient for the purpose of macroeconomic analysis, but not for budget formulation and management. In the government accounts, gross flows should be recorded. Thus, from the policy formulation point of view, the acquisition of financial assets for new policy purposes (e.g. lending to public enterprise) should be separated from the repayments of loans, which are the result of previous policy decisions.

  • The GFSM 2001 functional classification2 corresponds to the United Nations Classification of the Functions of Government (COFOG).3 Adopting COFOG instead of a customized classification presents some advantages. Such an approach is already established and well documented in the GFS manual. It facilitates international comparisons. Many countries may decide, however, to expand the COFOG system to accommodate their actual program structures and deal with specific policy issues. This is recognized in the GFSM 2001.4 In such cases, a mapping table between COFOG and the functional (and program) classification used in a particular country, or between that country’s organizational classification and COFOG, should be established in order to prepare reports that may be required using the COFOG system.

1 In the GFSM 2001 economic classification, the acquisition of a nonfinancial asset by purchase or barter does not affect net worth, and the transaction is not an expense. It is a transaction in nonfinancial assets. When ownership of an asset is given up without receiving anything of value in return, the net worth of the unit has decreased and the expense is recorded as a type of capital transfer, such as a capital grant.2 The GFSM 2001 functional classification is presented in Annex IV.3 The GFSM 2001 functional classification is not limited to expense transactions. Acquisitions of nonfinancial assets can also be classified using the functional classification. In addition, the economic and the functional classification can be cross-classified to show the type of transactions engaged in to carry out a given function.4 However, this does not mean that it is acceptable for a country to mix up different functions, or misclassify an education function as, for example, immigration, or to create multiple functions to capture what GFSM 2001 considers as a single function.

Classification of Expenditures

Expenditures are typically recorded against the administrative, economic, and functional classifications. The budget code for each transaction should present, in specific categories, all relevant information regarding that transaction. Table 1 provides an illustrative example of a classification scheme for expenditures, comprising the three main classifications, eight subclassifications (title, chapter, etc.), and thirteen characters. The names assigned to these subclassifications can differ from one country to another.

Table 1.

Illustrative Budget Classification Scheme for Expenditures

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The fundamental principle of the classification scheme for expenditure, illustrated in this table, is that each classification has defining characteristics that are different from, and independent of, the other two. It is important that every expenditure item and transaction be attributed to each of the three classifications shown above clearly and unambiguously, without duplication, overlap or repetition.

IV. Additional Forms of Budget Classification

In addition to the administrative, economic, and functional classifications, other forms of classification may provide complementary information, in particular:

  • Classification by geographical location of the administrative unit, taxpayer, or the recipient of government transfers and subsidies;

  • Classification of the beneficiaries of government transfers and subsidies;

  • Classification of the sources of financing and counterpart funds used for recording external loans and grants.8

Table 2 illustrates the integration of these additional segments in the previous classification scheme, thus creating a code that comprises 24 characters.

Table 2.

Incorporating Additional Features into the Budget Classification Scheme

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Using the Budget Classification Scheme to Track Poverty-Reducing Expenditures

A sound budget classification scheme should make it possible to determine the budget lines affected by poverty-reducing expenditure. In many countries the poverty-reducing strategy program (PRSP) or other government documents define pro-poor expenditures. The task is, therefore, to relate poverty-related spending identified in a PRSP to the government’s existing budget classification scheme, so that timely and periodic accounting reports can be prepared for tracking purposes. Ideally, a program classification should be used for this purpose or, if this is not available, a functional classification (at least to the subfunction level). A challenge to this approach may be the level of detail to which a PRSP identifies spending: in some cases, the spending categories may be too general or broad for the intended purpose (e.g., “primary education” or “improved health”); in other cases, they may be too narrow (e.g., “a new bore-hole in village Y”).

Based on the PRSP, pro-poor spending may be identified by using a binary rating system for each transaction (e.g., by assigning the score “0” for nonpoverty-reducing expenditures, and “1” for poverty-reducing expenditures). However, the use of such a system gives only global information. It must be combined with the other classifications in order to give relevant data on poverty-reducing expenditures.

The use of the functional classification has several advantages for tracking poverty-reducing expenditures. Such expenditures can be clearly identified from the budget data, and the links between the PRSP and the annual budget can be analyzed. The identification can be made by using a bridge table that links the data in the PRSP and the functional classification. Table 3 gives an illustrative example of the identification of poverty-reducing expenditures using such an approach.9

Table 3.

Example of the Identification of Poverty-Reducing Expenditures

Using a Bridge Table between the PRSP and the GFMS 2001 Functional Classification

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Program Classification10

A program is a set of activities that meets specific policy objectives of the government (e.g., preprimary education or the development of crop production). In contrast to a functional classification, a classification by program takes into account the government’s policy objectives and how these policies will be implemented. Programs may be subdivided into homogeneous categories called activities (e.g., the vaccination activity within a disease prevention program), which in turn may encompass a series of related initiatives and projects.

Classifying expenditures by program can serve two purposes: (1) identifying and clarifying the goals and objectives of government spending and (2) monitoring operational performance through performance indicators, which may relate to the inputs, outputs, or outcomes of a particular program.11 A classification by program can contribute to improved transparency and accountability, and help link inputs to objectives or outcomes.

When establishing a program classification, it is important to ensure that (1) clear responsibility for managing the program, and accountability for its results, are allocated to a specific unit and program manager within the ministry or department concerned12 and (2) the requirements for data collection and analysis are kept within reasonable bounds. A programmatic approach has the advantage of encouraging managers in each organization to clearly define their objectives and to consider what results have been achieved. It is thus often linked to the development of a performance-related approach to budgeting. As for the administrative classification, there is no specific international norm for codifying the programs. The program classification depends on the needs in each country.

Table 4 gives an illustrative example of a budget classification scheme by program, which replaces the administrative classification shown in Table 2. In this example, each program is assumed to be managed by a specific ministry, which is the easiest way to introduce program budgeting to ensure accountability and to track the relevant expenditures. When a program covers several ministries,13 this approach cannot be used, however, and complex bridge tables are necessary to identify which part of the program each ministry is responsible for.

Table 4.

Illustrative Budget Classification Scheme Including the Program Classification

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V. The Relationship between the Budget and Accounting Classifications

In most countries, it is generally considered to be good practice for the budget classification and the accounting classification (otherwise known as the financial reporting classification or “chart of accounts”) to be completely integrated.14 An integrated budget and accounting classification would incorporate relevant asset and liability accounts. These mainly comprise financial accounts— recording government operations with the central bank, commercial banks, and other financial entities—and suspense accounts. Such an approach is used in particular in the Anglophone countries, where the chart of accounts (COA) is a coding framework for recording budgetary and financial data in the government accounts.15 An example of such an approach is illustrated in Annex I.16

In some countries, however, the accounting and budgeting classifications are entirely separate,17 or only partially integrated.18 In particular, they can differ in terms of structure and information content.

In such cases, the absence of one-to-one correspondence between entries (or transactions) recorded against the budget and accounting classifications generates a loss of information. It is then impossible to identify with certainty the accounting implications of a given budgetary operation; and reciprocally, identical accounting transactions may not reflect systematically equivalent budgetary operations.

In practice, this issue can be solved in many different ways, including the following:

  • Implementing a central database for recording budgetary and accounting transactions, so that any entry in the budgetary classification is systematically associated with an entry in the accounts.

  • Introducing a separate presentation in the accounting classification to ensure the proper recording of budgetary transactions (through a specific class of operations).19

  • Harmonizing the structure and coverage of both classifications, and developing bridge tables between them.20

VI. Preconditions for the Successful Implementation of a New Budget Classification

Political Ownership

Without commitment and leadership at a high political level, it is unlikely that the reform will be successfully implemented. The support of the legislature is also desirable, not only to ensure passage of any new financial management regulations that may be required to implement the reform, but also to endorse and utilize the changed budget presentation and financial reporting that will follow.

Technical Capacity

Building capacity to implement the reform is another critical success factor. If the finance ministry has insufficient skilled and trained staff and other resources, a new budget nomenclature is unlikely to be effective. Strengthened capacity within the budget departments of line ministries and other budgetary institutions (e.g., the treasury, the external audit authority, and the national professional accounting bodies) is also an essential requirement. Outside consultants may be used to supplement in-house resources to develop the new systems and procedures, but are not a substitute for building adequate internal capacity.

IT Systems

Although a modern budget classification scheme can be implemented manually, in practice it is preferable to make use of an electronic system (which does not need to be sophisticated). Computer processing of budgetary transactions permits a reclassification of entries according to the main classification schemes, and strengthens functionality in areas such as administrative accounting and reporting. In many countries, a revision of the budget classification has been introduced as part of the development of an integrated and automated financial management information system (IFMIS).

VII. Critical Steps and Milestones in the Budget Classification Reform Process

Depending on the scope of the reform, and the conditions prevailing in a country, a reform of the budget classification can be a lengthy process, in particular to achieve full integration of the budget classification and the COA. Changes are likely to be required in the legal and regulatory framework for the budget, the government’s financial management and information system, and training and outreach programs to raise awareness and upgrade the skills of staff in the ministry of finance and other government entities.

An illustrative timetable for introducing a new budget classification scheme is shown in Table 5. Sufficient time should be allowed for making preparations and implementing the various steps. In most countries, work on preparing the new classification should be completed at least six months before the start of the budget year and, in the case of the COA, at least two months before its implementation.21

Table 5.

Suggested Timetable for Implementing a New Budget Classification, Integrated with the COA, in Fiscal Year N

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A transitional period of sufficient length should be allowed before the new classification system is fully operational, so that (1) the new system can be reviewed by key stakeholders, such as line ministries, the external audit authority, and the legislature; (2) operational guidelines can be developed and training performed for staff in line ministries, local budget institutions, and other entities involved in the reform; and (3) the legal framework can be amended, if necessary. Transfer of knowledge and ownership are key elements if the new classification is to be used as a foundation for preparing and executing the budget.