The recent crisis left many G-20 countries with significant fiscal consolidation needs. There is evidence that well-designed budget institutions can help countries to plan and deliver successful fiscal adjustments. A 2010 internal IMF study identified ten budget institutions which can support the consolidation process, assessed their strength in each G-20 country, and identified priorities for institutional reform. Following consultations with all G-20 countries and using a revised evaluation framework, this paper: (i) reports on progress in strengthening their budget institutions; (ii) analyzes their impact on post-crisis fiscal performance; and (iii) makes recommendations for further institutional reform

Abstract

The recent crisis left many G-20 countries with significant fiscal consolidation needs. There is evidence that well-designed budget institutions can help countries to plan and deliver successful fiscal adjustments. A 2010 internal IMF study identified ten budget institutions which can support the consolidation process, assessed their strength in each G-20 country, and identified priorities for institutional reform. Following consultations with all G-20 countries and using a revised evaluation framework, this paper: (i) reports on progress in strengthening their budget institutions; (ii) analyzes their impact on post-crisis fiscal performance; and (iii) makes recommendations for further institutional reform

Introduction

1. The economic and financial crisis that began in 2008 left many G-20 countries with large and long-term fiscal consolidation requirements. There are many factors that determine the success or failure of fiscal consolidations. These could include the political context, the macroeconomic environment, the balance of the consolidation effort between expenditure and revenue measures, and the support received from monetary and structural policies.1

2. However, there is also substantial evidence that strong budget institutions can assist in developing and delivering effective fiscal policy adjustments. In 2010, IMF staff prepared an internal study, which examined the contribution of budget institutions to fiscal adjustment. The study: (i) identified a set of ten budget institutions (Figure 1) which were shown to support the fiscal adjustment process; (ii) evaluated the extent to which those institutions were in place in each G-20 country; and (iii) made a series of general and country-specific recommendations regarding priorities for institutional reform. In this context, budget institutions were defined as the structures, rules, and procedures that govern the formulation, approval, and execution of government budgets. Subsequently, the staff consulted with G-20 country authorities to discuss the methodology, findings, and initial recommendations and learn about their institutional reform plans.

Figure 1.
Figure 1.

Twelve Budget Institutions

Citation: Policy Papers 2014, 041; 10.5089/9781498343541.007.A001

*Moved from phase B to Aⵙ Green: New or amended institutions

3. Based on these consultations, this paper takes stock of G-20 countries’ progress in strengthening their budget institutions, assesses the extent to which these institutions have supported their fiscal adjustment efforts, and identifies priorities for further institutional reform. The updated analysis benefits from a revised evaluation framework on the role of budget institutions in supporting fiscal adjustment. In addition to refining the ten budget institutions, two new budget institutions have been incorporated into the evaluation framework with a view to capturing intergovernmental fiscal arrangements and the unity of the annual budget. The paper also provides a more detailed, empirical analysis of the relationship between budget institutions and the success of G-20 countries’ fiscal adjustment strategies in the five years since the onset of the crisis. This analysis is undertaken without assigning overall letter grades to each country’s institutional arrangements while placing greater emphasis on country-specific factors raised by country authorities.

4. The paper is structured as follows:

  • Part II discusses refinements to the 2010 study’s methodology for assessing the strength of budget institutions following feedback from G-20 country authorities;

  • Part III reviews progress in strengthening budget institutions across the G-20 since 2010;

  • Part IV assesses the contribution of budget institutions to G-20 countries’ fiscal performance since the crisis;

  • Part V concludes with a set of recommendations for further strengthening budget institutions in G-20 countries in light of the foregoing analysis;

  • Appendix I sets out the revised evaluation framework used to assess the strength of countries’ budget institutions and how this differs from the 2010 framework;

  • Appendix II describes the methodology for assessing countries’ fiscal adjustment performance; and

  • A Supplement provides updated summaries of the state of each G-20 country’s budget institutions, prepared in consultation with relevant country authorities, which highlight reforms undertaken since 2010 and identifies priorities for further improvement.

Refinements to the Evaluation Methodology

A. The Original Evaluation Framework: A Summary

5. While there are many factors that determine the success of countries’ efforts to restore their public finances to a sustainable position, there is evidence that strong budgetary institutions can support the fiscal adjustment process. An earlier review of the theoretical and empirical literature on the relationship between the institutional arrangements for fiscal decision-making and the success of fiscal adjustment identified ten institutions, summarized in Figure 1, which increase the probability of success at three key stages of the adjustment process: (i) understanding the scale and scope of the fiscal challenge; (ii) developing a credible fiscal adjustment plan; and (iii) implementing the plan through the budget process.2 These institutions and their key design features provided the basis for a 41 question evaluation which assessed the strength of each G-20 country’s budget institutions.

Feedback from G-20 Country Authorities

6. Staff consultations with each G-20 country over the past three years on the results of this evaluation yielded the following feedback:

  • most countries found the analysis of their institutional strengths and weaknesses to be fair and a useful guide for prioritizing their institutional reform efforts;

  • many countries questioned the uniform weighting given to each institution within the framework and called for more analysis of different institution’s relative contribution to the fiscal adjustment effort;

  • some countries suggested that country-specific factors be better reflected, such as the structure of the political system or the role of the legislature;

  • some countries proposed inclusion of other budget institutions relevant to the adjustment process; and

  • some countries questioned the value and validity of the overall letter grades assigned to each country’s institutional arrangements.

C. The 2014 Evaluation Framework

  • Based on this feedback, this update includes a number of refinements to the budget institution evaluation framework, which are summarized in Figure 1 and Appendix I.

  • Two new budget institutions have been added. The first relates to intergovernmental fiscal arrangements. Given the large and growing fiscal importance of sub-national governments inG-20 countries, the institutional arrangements for the coordination of financial decision-making between levels of government are an increasingly important factor in the success of whole of government adjustment strategies. The second concerns the unity of the annual budget. The existence of significant extra-budgetary funds, earmarked or statutory expenditures, and tax expenditures authorized outside the annual budget can complicate and potentially undermine fiscal adjustment plans. The revised evaluation framework therefore includes an assessment of the extent to which the annual budget covers all central government revenue and expenditure.

  • The key design features of a number of other institutions have also been refined. In particular: the fiscal objectives and rules institution has been augmented to include questions as to whether fiscal rules account for the economic cycle and whether they include escape clauses;the evaluation of independent fiscal agencies has been moved from Phase B (Planning) to Phase A (Understanding) to reflect the greater importance of this institution to understanding the fiscal challenge; and (iii) the separation of current versus new policies in budgetary projections has been moved from macroeconomic forecasting to the medium-term budget framework (MTBF) institution to reflect its greater relevance to the planning process.

8. Using this revised framework, the twelve budget institutions of each G-20 country are subjected to an updated, systematic evaluation. 3 A detailed list of the evaluation questions is provided in Appendix I. Countries are grouped into three categories (strong, medium, and weak institutions) of roughly equal size (six or seven countries) for analytical purposes based on the evaluation results for each institutions and phase of the adjustment process.4 This analysis is based on qualitative reviews of each G-20 country’s institutional arrangements, including reforms introduced since 2010, the findings of which are summarized in a supplement to this paper.

9. Based on this evaluation, the relationship between the strength of these institutions and the success of G-20 countries’ fiscal adjustment efforts since the crisis is also assessed. The contribution of various budget institutions to fiscal performance at each of the three key stages of the consolidation process is assessed based on a set of ten indicators of the success of fiscal adjustment. These indicators of adjustment performance include the share of adjustment need addressed to date, the credibility of economic and fiscal forecasts, the timeliness of consolidation/adjustment planning, and the composition of the adjustment delivered. The list of all ten fiscal adjustment indicators is provided in Box 1 and their calculation is described in more detail in Appendix II.

Fiscal Adjustment Indicators

A. UNDERSTANDING THE FISCAL CHALLENGE

1. Data Revisions: Revisions to reported general government debt in 2009

2. Macroeconomic Forecast Errors: Average absolute difference between one year-ahead forecast and actual GDP growth (2004-12)

3. Macroeconomic Forecast Bias: Average difference between one year-ahead forecast and actual GDP growth (2004-12)

B. DEVELOPING A CONSOLIDATION PLAN

4. Fiscal Effort: Share of illustrative fiscal adjustment need addressed by the government’s plan (2010-15)

5. Timeliness of Adjustment Planning: Time between the crisis and announcement of consolidation plan

6. Growth-Friendliness: Change in public investment as a share of government expenditure (2010-12)

7. Sub-National Adjustment: Percent reduction in central vs. sub-national fiscal deficits (2009-11)

C. IMPLEMENTING THE CONSOLIDATION PLAN

8. Plan Implementation: Share of planned fiscal adjustment delivered (2010-12)

9. Budget Credibility: Difference between approved annual budget and actual expenditure (2010-12)

10. Response to Shocks: Impact of macroeconomic shocks on fiscal effort and budget execution (2010-12)

10. While this analysis allows some general conclusions to be drawn regarding the link between budget institutions and fiscal performance, some limitations should be acknowledged. In particular:

  • The period under analysis is brief, just three years, and can provide only a snapshot of countries’ ongoing institutional reform efforts and post-crisis fiscal performance. Many countries are planning further reforms to their budget institutions which are not captured here. Many countries have also only just embarked upon a sustained period of fiscal adjustment aimed at reducing public debt over time. It is therefore difficult to say anything definitive about the composition, profile, and long-term impact of these adjustment plans. The analysis presented in this paper should thus be seen as preliminary and a first attempt to review reform progress and gauge the impact of budget institutions on post-crisis fiscal performance.

  • The sample of countries, 19 in total, is small. This means that the scope for utilizing more sophistical statistical techniques such as multi-variate regressions or Granger causality tests is limited. While there is ample evidence that budget institutions can help shape fiscal outcomes,5 the analysis presented in this paper does not necessarily establish causality between the two. The best it can do is point to a series of relationships between the strength of different budget institutions on the one hand and various measures of fiscal performance on the other. It is possible that, in some cases, fiscal outcomes affect the way budget institutions are reformed (e.g., a strong fiscal performance can encourage governments to improve their fiscal reporting). Alternatively, improvements in both fiscal outcomes and budget institutions may, in some cases, be driven by the same underlying political economy factors (e.g., a change in government).

Progress in Reforming Budget Institutions

A. Overall Institutional Reform Trends

11. Budget institutions have noticeably strengthened across the G-20 over the last three years, although there remains considerable scope for improvement. As shown in Figure 2a, the original evaluation identified the need for countries to strengthen their fiscal reporting, macro-fiscal forecasting, and MTBFs in particular to enable them to respond to the fiscal challenges they faced in the wake of the crisis. Institutional changes introduced since then have partly reflected these recommendations, with particular improvement in the areas of independent fiscal agencies, fiscal objectives, and MTBFs. Overall, about a third of the 100 recommendations made in the 2010 evaluation have, to some extent, been addressed by country authorities in their own reform efforts.

Figure 2.
Figure 2.
Figure 2.

Progress in Strengthening Budget Institutions

Citation: Policy Papers 2014, 041; 10.5089/9781498343541.007.A001

Source: Fund staff estimates.Source: OECD (2011); national budget documents; and Fund staff estimates.

12. While advanced countries, especially those in Europe, have seen the most comprehensive reform efforts, emerging countries have led the way in some areas. As shown in Figure 2b, advanced countries have generally been more active in reforming their budget institutions than emerging market countries. This reflects, in part, the emphasis that the European Union has placed on improving national budget frameworks among its Member States to safeguard the integrity of the Eurozone in the wake of the recent crisis (Figure 2c). The range of institutional reforms mandated by the EU’s Fiscal Compact is discussed in more detail in box 2. At the same time, some emerging market countries have also made significant improvements in their budget institutions, especially Mexico, South Africa, and China. Indeed, emerging market countries have been more active than advanced countries in strengthening their fiscal risk management, performance budgeting, budget unity, and intergovernmental fiscal arrangements.

The European Union’s Reforms to Fiscal Governance

The rapid deterioration of the fiscal positions of European countries in the wake of the recent crisis, which at one stage threatened the viability of the Eurozone, has, since 2011, led the EU to introduce a number of reforms to strengthen Member States’ fiscal discipline and enforcement of the Stability and Growth Pact (SGP). The SGP requires that general government deficits not exceed 3 percent of GDP and public debt must not exceed 60 percent of GDP. By 2011, 14 of the 17 euro area countries had violated the deficit rule and the crisis had pushed debt to historic highs. To strengthen the fiscal framework underpinning European monetary union, a new Fiscal Compact came into force in January 2013 as part of the Treaty on Stability, Coordination, and Governance in the Economic and Monetary Union. Formally 20 countries (18 euro members plus Denmark and Romania) are party to the Compact which adds to and reinforces the SGP. The Fiscal Compact builds on the earlier “Six Pack” of five new EU regulations and one EU directive designed to strengthen the SGP, which took effect in December 2011. Finally, in February 2013 agreement was reached on the “Two Pack” which added two additional regulations to strengthen surveillance mechanisms for the euro area. The reforms mandated by these instruments include:

Revised Fiscal Rules: The Fiscal Compact requires signatories to modernize their fiscal frameworks by giving effect in national legislation to a structural balance budget rule, an automatic correction mechanism to be triggered in the event of deviations from the rule, and an escape clause for exceptional economic circumstances all by January 2014. The structural budget balance rule must limit annual structural deficits to a maximum of 0.5 percent of nominal GDP and ensure convergence towards the country’s medium-term budgetary objective (MTO) assessed by the European Commission. Among the G-20, France, Germany, and Italy have all incorporated these provisions in their constitution or legislation. The Fiscal Compact and the “Six Pack” also introduced two additional guidelines to ensure consistency with supranational fiscal rules: a debt reduction rule and an expenditure benchmark. Under the debt reduction rule, countries with debt above the 60 percent of GDP limit are required to continuously reduce their debt levels by at least 1/20th of the distance between the current level and 60 percent of GDP until the latter is reached. The expenditure benchmark requires that countries which have reached their MTO keep annual growth of primary expenditure (excluding unemployment benefits) at or below long-term nominal GDP growth.

Reformed National Budgetary Frameworks: Recognizing that rules require supporting budget institutions, the “Six Pack” requires improvements to countries’ national budgetary frameworks including making medium-term budget frameworks more binding, preparing budgets in a more top-down sequence, and frequent, timely, and comprehensive reporting on general government fiscal developments and risks.

Improved Surveillance and Monitoring: The “Two-Pack” requires that a national independent institution either produces or endorses official macroeconomic forecasts and monitors the government’s compliance with the fiscal rules. In addition to the existing surveillance mechanism under the SGP, the “Two Pack” introduces a new ex ante procedure. All euro area countries must submit their draft budgets prior to enactment to the European Commission to ensure appropriate integration of euro area policy recommendations. If the Commission finds that a draft budget is not compliant with the SGP, it will issue an opinion to ask for revisions before it is enacted.

Enhanced Enforcement: The European Court of Justice can impose a financial penalty (up to 0.1 percent of GDP) if a country fails to properly implement the legislative changes required by the Fiscal Compact. The Compact and “Six Pack” also strengthened the excessive deficit procedure (EDP) for sanctioning non-compliance with the fiscal rules. In cases of non-compliance of a Euro Area Member State with the deficit rule, a recommendation of the Commission is required to be supported by other Euro Area Member States in the European Council, unless a qualified majority votes against it. Fines are imposed progressively starting at 0.2 percent of GDP and can reach 0.5 percent of GDP.

Fiscal Rules and the Crisis

Fiscal rules are numerical limits or targets on budgetary aggregates which are intended to impose lasting constraints on fiscal policy and promote fiscal discipline. Rules can be enacted in national legislation, the constitution, international treaties or by a political commitment. It is important that fiscal rules strike the right balance between ensuring long-term credibility and maintaining flexibility to adjust to changing economic conditions.

Fiscal Rule Trends: The number of countries with fiscal rules has grown from five in 1990 to 83 in 2013, including 11 G-20 countries. The main types of fiscal rules are deficit rules, debt rules, expenditure rules, and revenue rules. These rules can apply to some or all of central government, general government, or the public sector. Since each type of rule has its limitations, countries increasingly combine fiscal rules so that more than one fiscal objective, for example, fiscal sustainability and stability, can be achieved. The most common combination of rules is a debt and a deficit rule.

Lessons of the Crisis for Fiscal Rules: In the decade leading up to the crisis, fiscal rules were not always successful in bringing about fiscal discipline. Despite relatively favorable macroeconomic conditions, advanced country governments ran structural deficits, rules were not enforced, sanctions were not imposed, and deficits limits came to be regarded as acceptable or normal deficits. At the peak of the crisis, most G-20 countries breached at least one of their rules. In response, some suspended their rules (Argentina, India, Russia) or did not enforce them, others extended the date for achieving targets (the Euro Area) or invoked escape clauses (Mexico, UK), and some abandoned them (Turkey). The crisis highlighted the need to make fiscal rules more responsive to the economic cycle and resilient to economic shocks. It also underscored the need for fiscal rules to be part of an integrated fiscal framework with supporting budget institutions which ensure the credibility and transparency of macroeconomic and fiscal data, forecasts, policies, and plans.

Next Generation of Fiscal Rules: Fiscal rules have increased in both number and sophistication in the wake of the recent crisis. Since 2010, ten G-20 countries have introduced at least one new fiscal rule. The new generation of fiscal rules explicitly combines sustainability objectives with more flexibility to accommodate cyclical effects and exogenous shocks. Such flexibility can be achieved by expressing rules in structural terms and including well-defined escape clauses which allow governments to temporarily deviate from their stated fiscal objectives in the face of exceptional shocks. In the last three years, France, Germany, Italy, and the UK have all introduced structural budget balance rules in line with EU requirements. Australia, Japan, Russia and the United States have all adopted new expenditure rules. This next generation of rules strikes a better balance between sustainability and flexibility goals than older rules. However, they are also more complex, creating new challenges for implementation, communication, and monitoring. For this reason, many countries that have introduced these more sophisticated rules have also taken steps to improve their fiscal reporting, strengthen their medium-term budget frameworks, and establish independent fiscal agencies charged with evaluating government’s fiscal forecasts and performance. The EU’s role in promoting these complementary reforms is discussed in box 2.

Sources: IMF Fiscal Rules Database, Budina and others (2012), and Cangiano, Curristine, and Lazare eds. (2013).

13. The concentration of institutional reforms among advanced economies likely reflects their more pressing fiscal consolidation needs. Advanced G-20 economies entered the crisis with stronger budget institutions than emerging markets but also faced larger consolidation needs in the wake of the crisis. As shown in Figure 2d, the pressure to develop and announce a comprehensive and credible fiscal consolidation plan appears to have also been a catalyst for further strengthening of their budget institutions. The relative health of the public finances of emerging markets in the wake of the recent crisis, coupled with country-specific factors, has meant that both pressure for and progress in strengthening their budget institutions has generally been less intense. As a result, as shown in Figure 2f, the gap between the strength of advanced and emerging market countries’ budget institutions appears to have grown over the past three years. This gap is a concern, as emerging market countries face increased fiscal vulnerabilities as cyclical conditions worsen and headline balance figures remain significantly higher than pre-crisis levels.6

14. Finally, it is noteworthy that both advanced and emerging countries have so far focused on institutional reforms that are relatively easy to deliver. For example, it tends to be simpler to establish fiscal councils or legislate for a fiscal rule than to increase the coverage of fiscal reports or strengthen budget execution controls. The latter reforms require sustained and systematic changes in organizational arrangements and human capabilities across government ministries and agencies. Constitutional differences may also help to explain differences in the pace of institutional reforms which appear to have been more extensive in unitary states than in federal ones, as shown in Figure 2e.7 The remainder of this section discusses in more detail the institutional reform trends at each of the three phases of the adjustment process.

B. Improving the Understanding of the Fiscal Challenge

15. Efforts to improve G-20 countries’ understanding of their fiscal position and prospects have focused on the establishment of new independent fiscal agencies. Since 2010, five countries—Australia, France, Italy, South Africa, and the UK—have established new fiscal councils to provide independent oversight of macro-fiscal forecasting, policy, and performance. The idea that well-designed fiscal councils can promote more accurate economic and fiscal forecasting and help improve fiscal discipline is supported by a recent paper8 as well as the experience of the UK in the wake of the crisis (box 4).

The UK’s New Office for Budget Responsibility

The UK established a new fiscal council—the Office for Budget Responsibility (OBR)—in 2010 to address the perceived optimism bias in the macroeconomic and fiscal forecasts produced by previous UK administrations. Like many other fiscal councils, the OBR is tasked with assessing the government’s progress in achieving fiscal targets, analyzing long-term fiscal sustainability, and scrutinizing the government’s costings of tax and welfare policies. However, unlike other councils, the OBR also produces the official macroeconomic and fiscal forecasts used by the government in setting fiscal policy and budgets, a mandate shared only by the Dutch Central Planning Bureau. Other fiscal councils may produce their own forecasts, but these are only for the purposes of comparison with the government’s official projections.

A clear benefit of the introduction of the OBR has been greater forecast transparency. The OBR’s forecasts provide greater detail than previous official UK forecasts, including on the economic drivers of revenue and expenditure and the impact of new policies. It also provides extensive risk analysis including sensitivity analysis, alternative macroeconomic and fiscal scenarios, and forecast fan charts. This transparency widens public understanding of the fiscal position and should bolster the credibility of the forecasts.

After only three years in operation, it is too early to fully assess the OBR’s forecast performance relative to the past, but early signs are encouraging. Under previous administrations, the UK government’s forecasts were perceived to be consistently more optimistic than independent forecasters suggesting an ex ante optimism bias. The chart below compares the UK’s official GDP growth forecasts with those in the IMF’s World Economic Outlook (WEO). Before the OBR, the UK government’s forecasts had been more optimistic than the WEO’s in every year except one since 1999. However, the OBR’s forecasts since 2010 have been less optimistic than the WEO in two years out of last four, suggesting ex ante forecast bias has been reduced. Moreover, the OBR’s own analysis of its forecast accuracy shows that its fiscal forecasts have on average been more accurate than those produced by the UK Government over the previous twenty years.1

uA01fig01

UK Official Real GDP Forecast vs. WEO forecast

(percent)

Citation: Policy Papers 2014, 041; 10.5089/9781498343541.007.A001

Sources: WEO; Country data.
1Office for Budget Responsibility. Forecast Evaluation Report 2013, Annex B, October 2013.

16. These enhancements to the scrutiny of the fiscal position and outlook have not been matched by improvements to underlying arrangements for fiscal reporting and forecasting despite developments in international standards (IPSAS, EPSAS, GFS manual).9 Only around half of G-20 countries’ fiscal statistics are produced by a fully independent statistics agency, and since 2010 only Turkey has taken steps to enhance the integrity of its fiscal statistics by transferring responsibility for their production to the independent Statistics Turkey. While three-quarters of countries produce fiscal statistics covering the revenues and expenditures of the general government, only half produce a comprehensive balance sheet and only three countries (Australia, Canada, and the UK) produce fiscal reports covering the whole of the public sector. Since 2010 only two countries (Turkey and the UK) have significantly expanded the coverage or scope of their fiscal reports. The most significant improvement in fiscal forecasting has been in the area of fiscal sustainability analysis, with Canada joining the four other G-20 countries which regularly produce long-term fiscal projections and South Africa preparing to do so.

17. Despite the sizable sovereign financial exposures revealed by the financial crisis, the reporting and management of fiscal risks remains an area of institutional weakness in most G-20 countries. Only three countries (Australia, Brazil, and Indonesia) provide a comprehensive statement of fiscal risks alongside their budget, while only seven (Australia, Canada, Germany, Italy, Mexico, the UK, and the US) show the fiscal implications of alternative macroeconomic scenarios alongside their main forecasts. Furthermore, only three countries have made significant reforms in this area since 2010: India has introduced new requirements to report on contingent liabilities; Korea requires additional reporting on the risks from state-owned enterprises; and the UK now publishes more extensive analysis of the risks around the official macroeconomic and fiscal forecasts.

C. Strengthening the Credibility of Fiscal Planning

18. G-20 countries’ efforts to improve the credibility of their medium-term fiscal and budgetary plans have focused mainly on enhancements to their fiscal objectives and MTBFs. Since 2010, in emerging markets, Russia has implemented a new fiscal rule, and South Africa has introduced a set of qualitative principles to guide fiscal policymaking. A number of advanced countries have looked to improve the design of their existing fiscal rules by adopting so-called “second generation" fiscal rules, discussed in more detail in box 3, which allow for greater flexibility to accommodate shocks while maintaining the government’s commitment to medium and long-term fiscal sustainability. All four European countries (France, Germany, Italy, and the UK) have taken steps to enshrine their fiscal rules in law. Other G-20 countries, including Australia, Canada, Japan, and Korea, have put more clearly specified fiscal policy objectives and/or rules in place without feeling the need to embed them in the legislative framework. Fiscal rules are also increasingly supported by more comprehensive and binding medium-term expenditure frameworks. Since 2010, Indonesia introduced medium-term ministerial budget estimates for the first time while Germany, Italy, and the UK have strengthened their MTBFs by either improving their institutional coverage or introducing stricter multi-year expenditure limits.10

19. Efforts to enhance the performance orientation of budget decision-making have been concentrated in emerging markets. While many emerging market governments already present their budgets on a program basis, since 2010 a number have implemented reforms designed to link these allocations to performance. Both China and India have established quantitative output and outcome performance indicators for each of their line ministries’ expenditure programs. From 2014 annual reporting on the achievements and efficiency of each government program will be a requirement in Russia. By contrast, since 2010 the UK has removed centrally-imposed and monitored performance targets on line ministries, which could make it more difficult to assess the impact of expenditure reductions on public service delivery.

20.Despite their growing importance, intergovernmental fiscal arrangements have not been a focus of the reform over the last three years. Among the nine G-20 countries with fiscal objectives covering the general government or wider, only six clearly identify the contribution of each level of government to the targeted balance and debt position in their fiscal plans. Only four countries have taken steps to strengthen the fiscal oversight of their sub-national governments during this period. The Government Accounting Law in Mexico, as amended in 2012, increased oversight of federal funds at the sub-national level by harmonizing accounting and budget codes across all levels of government. Some minor improvements were made to reporting on sub-national finances in Indonesia and Italy and to the monitoring and control of sub-national finances in China.

D. Tightening Controls over Budget Approval and Execution

21. Relatively few countries have taken steps to strengthen the institutions that support the implementation of their fiscal strategies. Of the few reforms initiated in this area since 2010, most have focused on strengthening top-down budgeting, particularly among EU Member States, including France, Germany, and Italy. Only the UK has taken steps to strengthen budget execution controls since 2010 by tightening the rules around the carryover of underspending between years. No G-20 country has introduced reforms which alter the respective roles of the legislature and executive in formulating and approving the annual budget, although the US experience since the crisis has highlighted the potential costs associated with a lack of effective cooperation between branches of government. The lack of reforms to the legislative process may be due to the fact that, by contrast to reforms to administrative arrangements with the executive, reforms that could alter the balance of power between the executive and the legislature require potentially complex negotiations between the two branches and, in some cases, amendments to national constitutions.

Budget Institutions and Fiscal Performance

22. The relationship between fiscal institutions and performance is complex, causality is difficult to establish, and the strength of institutions is only one of many factors that impact on fiscal performance. The level of development, macroeconomic environment, political context, and market pressures also play important roles in shaping fiscal outcomes. However, the experience of G-20 countries since the crisis lends further support to the idea that institutions matter. For analytical purposes in this paper, countries are divided into three groups (strong, medium, and weak) according to the strength of their budget institutions overall and at each phase of the adjustment process.11 Their relative adjustment performance, both overall and at the three key phases of the adjustment process, is assessed based on the fiscal adjustment indicators described in Appendix II.

A. Overall Adjustment Performance

23. Countries with stronger budget institutions overall have tended to plan and deliver more fiscal adjustment. Figure 3a shows that countries with strong institutions had delivered on average a 2¼ percent of GDP reduction in the general government cyclically-adjusted primary balance between 2010 and 2012 and plan to address 45 percent of their overall illustrative adjustment need by 2015. At around ¾ percent of GDP per year over this period, this is slightly less than the 1 percent average annual fiscal adjustment viewed as appropriate by Fund staff. 12 By contrast, countries with weak institutions delivered cumulatively only ¼ percent of GDP adjustment over the three-year period and plan to address only 10 percent of their overall adjustment need by 2015. The timelines and growth-friendliness of this adjustment and its distribution between central and sub-national government varied across countries and was also a function of the strength of the relevant institutions. The contribution of budget institutions to the success of the adjustment process at each stage is discussed in more detail below.

Figure 3.
Figure 3.
Figure 3.

Fiscal Performance by Strength of Institutions

Citation: Policy Papers 2014, 041; 10.5089/9781498343541.007.A001

Sources: OECD (2011); national documents; Fiscal Monitor; WEO; and Fund staff estimatesSource: IMF WEO; MAP Data; National documents; and Fund staff estimates.

B. Understanding the Fiscal Challenge

24. Countries with stronger “understanding” institutions13 had a better grasp of their fiscal position at the start of the crisis. The 2012 paper on Fiscal Transparency, Accountability, and Risk14 highlighted the role that fiscal transparency failures played in the deterioration of governments’ fiscal positions in the immediate aftermath of the crisis. The role that robust fiscal disclosure arrangements have played in supporting the credibility of countries’ efforts to consolidate their fiscal position in the wake of the crisis can be seen Figure 3b which shows that G-20 countries with strong institutions in these areas saw the smallest absolute revisions to the level of general government debt in 2009. However, the relationship between institutions and performance is not as clear cut as in other areas as countries with weak institutions also saw relatively small revisions. This may be due to the fact that many countries with weak fiscal reporting institutions do not routinely revise their initially reported fiscal data to reflect new information or changes in statistical methodologies.

25. Stronger understanding institutions were also associated with more accurate macroeconomic forecasts. Figure 3c shows that between 2004 and 2012 the average absolute year-ahead forecast error for real GDP was 1½ percent of GDP for countries with strong institutions, compared to 2½ percent for countries with weak institutions.15 As discussed in box 4, in the UK the new independent fiscal council has played an important role in improving forecasting performance. It is, however, notable that while countries with strong understanding institutions had more accurate GDP forecasts, they also had more optimistic GDP forecasts than those with weaker institutions. This suggests that the institutional reforms in this area have not yet been fully effective in addressing the upward bias in official macroeconomic forecasts.

C. Developing a Credible Adjustment Plan

26. Countries with stronger planning institutions16 have generally been quicker in formulating and adopting comprehensive fiscal adjustment strategies. As early as September 2009, G-20 countries committed themselves to the preparation of fiscal exit strategies designed to restore their public finances to sustainability over the medium term.17 As shown in Figure 3d, countries with strong planning institutions developed and presented comprehensive medium-term consolidation plans within 15 months of January 2009 while those with weak institutions took an average of 27 months to publish their plans.

27. Countries with stronger planning institutions have also tended to protect public investment spending to a greater degree during the fiscal consolidation process. In periods where fiscal consolidation is required, capital expenditure can be a tempting target given the limited immediate social or political impact from delaying or cancelling public investment projects relative to other expenditure items such as wages, benefits, or pensions.18 However, cutting public investment in times of consolidation may have a negative impact on medium-term growth prospects.19 While most G-20 countries reduced the share of public investment in total expenditure over the last three years, as shown in Figure 3e, those with strong planning institutions have seen the smallest reduction in this share. One reason for this could be that planning institutions such as MTBFs help draw attention to the unsustainability of adjustment strategies that rely on deferring or cutting investments rather than tackling cost drivers on the recurrent side of the budget.

28. Countries with strong intergovernmental fiscal arrangements have seen the largest reductions in sub-national deficits, which were not always matched at the central level. Countries with strong institutions for fiscal oversight of sub-national administrations saw an almost 75 percent reduction in local deficits while those with weak institutions saw only a 36 percent reduction between 2009 and 2011 (Figure 3f). At the same time, there was no clear relationship between the distribution of the adjustment burden between central and sub-national levels of government and the strength of intergovernmental fiscal arrangements, with sub-national government delivering a proportionally larger share of the overall reduction in the general government deficit than central government in most G-20 countries.20 Brazil’s efforts to strengthen the institutional arrangements for fiscal cooperation between Federal, State, and Local governments following a succession of sub-national debt crisis in the 1980s and 1990s is discussed in box 5.

Brazil’s Intergovernmental Fiscal Arrangements

Brazil’s 1988 Federal Constitution grants sub-national governments (SNGs)—26 States, a Federal District and over 5,500 Municipalities—political, administrative, and financial autonomy. The constitution and subsequent legislation delegated key fiscal responsibilities to SNGs and set out rules for increasing revenue sharing, the main source of intergovernmental transfers.

During the 1980s and 1990s, Brazil experienced several SNG debt crises resulting in the federal government providing five bailout operations between 1983 and 1995. In 1997-98, the federal government negotiated debt restructuring agreements with 25 states. These agreements established repayment programs and made financial aid conditional on accepting fiscal adjustment programs and compliance with fiscal targets.

In reaction to these crises, the Brazilian government transformed its intergovernmental fiscal arrangements. Over the last decade, the new arrangements have successfully contributed to promoting fiscal discipline at the SNG level. The current arrangements have two main pillars (i) the laws and procedures introduced under the states’ fiscal restructuring and adjustment program; and (ii) the 2000 Fiscal Responsibility Law (FRL). The fiscal restructuring programs are established for three years and revised annually. Each state government negotiates with the Federal Ministry of Finance on six main fiscal targets and commitments. There is monthly monitoring and the Federal Ministry of Finance conducts an annual assessment. Penalties can be imposed for failure to meet the debt and/or deficit targets and include prohibition on new borrowing and fines.

The 2000 FRL was introduced following the Federal government’s renegotiation of State debts. Based on the law the Federal Senate established maximum limits on the level of debt for States (twice its annual net current revenue) and for municipalities (1.2 times its annual net current revenue). In addition, the FRL establishes maximum limits on personnel expenditure (60 percent of net current revenues for both states and municipalities). The law also includes extensive provisions for monitoring and reporting on budget execution. There are penalties for failure to provide fiscal reports in a timely manner or breaching the requirements of the law. These can include institutional and/or personal sanctions such as fines, being refused access to banking credit, incarceration for the officials responsible, or prohibitions on political leaders from running for election.

D. Implementing the Adjustment Plan

29. Strong implementing institutions21 seem to have helped G-20 countries to stick to their adjustment plans. Figure 3g shows that countries with strong institutions in these areas have delivered around two-thirds of the adjustment envisaged in their original plans while countries with weak institutions have delivered less than one-fifth. Part of this success can be attributed to the fact that countries with strong implementing institutions faced less slippage against their annual budgets. As shown in Figure 3h, on average countries with weak institutions for preparation, approval, and execution of their budgets overspent against their budgets by almost 10 percent between 2010 and 2013 while countries with relatively strong institutions overspent their annual budgets by less than 2 percent on average. Another part of the explanation has to do with how countries with relatively strong institutions responded to the inevitable shocks to their initial fiscal adjustment plan, a topic discussed further below.

30.While most G-20 countries’ consolidation plans were blown off course by adverse macroeconomic shocks during implementation, how they reacted was partly a function of their budget institutions. For the ten G-20 countries where macroeconomic developments turned out worse than expected between 2010-12, Figures 4a and 4b decompose the unexpected increase in net debt into four components: (i) revisions to the starting fiscal position in 2010; (ii) impact of the macroeconomic shock on revenue and spending; (iii) change in fiscal effort in the wake of the shock;(iii) over/under execution of the annual budget; and (iv) other factors. This analysis highlights two sets of experiences in countries that faced adverse shocks to their fiscal plans:

  • Countries with stronger institutions which experienced a negative shock to their macroeconomic prospects tended to respond to this shock with actions designed to offset the shock and maintain their original fiscal adjustment plans. These actions took the form of additional fiscal effort and under-execution of approved budgets. As a result their net debt in 2012 was on average close to their original plans, despite the weaker-than-forecast macroeconomic position.

  • A second group of countries with relatively weak institutions which experienced a negative shock to both their starting debt position in 2010 and their macroeconomic prospects generally did not attempt to counteract these adverse shocks through additional fiscal effort. Moreover, this group of countries also tended to overspend against their approved budgets. This meant that actual general government net debt-ratio in 2012 was nearly 6 percent of GDP higher on average than envisaged in their original adjustment plan.

31. This experience underscores the need for countries’ budget institutions to strike a balance between multi-year discipline and near-term flexibility in the face of temporary shocks. Overall, durable institutional arrangements tend to combine commitment to a medium-term fiscal objective (to maintain fiscal credibility and reduce sovereign risk) with mechanisms which allow for some countercyclical response to shocks (to safeguard macroeconomic stability and protect vulnerable social groups).22 For example:

  • Second generation fiscal rules tend to be expressed in structural terms which enable governments to pursue countercyclical fiscal policy without undermining their commitment to medium-term fiscal sustainability. These rules also tend to include escape clauses which allow governments to temporarily deviate from their stated fiscal objectives in the face of exceptional shocks which cannot be accommodated through prudent fiscal policy adjustments.

  • Medium-term budget frameworks often exclude cyclically-sensitive expenditure items, such as interest expenses and unemployment benefits, from multi-year spending ceilings to allow full operation of the automatic stabilizers on the expenditure side of the budget.

  • Annual budgets typically set aside an unallocated contingency reserve which can be used to fund unanticipated spending pressures without recourse to a supplementary budget.

Priorities for Further Institutional Reform

32. Despite significant progress since the crisis, there remain significant weaknesses in budget institutions across G-20 countries. Strengthening institutional arrangements in these areas will be critical to supporting the fiscal consolidation efforts underway in advanced economies and to ensuring emerging market countries are equipped to weather the consequences any potential fiscal storms on the horizon. The country case studies in Supplement I include recommendations for further institutional reform in each G-20 country based on their specific country circumstances. However, the foregoing analysis of institutional reform trends and adjustment performance underscores the following priorities for further institutional reform across the G-20 (see Table 1 on the main reform themes for advanced and emerging G-20 countries).

Table 1.

Strengthening G-20 Budget Institutions: Main Reform Themes

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33. Fiscal disclosure has improved since the crisis, but many G-20 countries still do not have a complete and reliable picture of their fiscal position and prospects. As a result, many G-20 countries saw their fiscal adjustment plans blown off course by revisions to outturn or forecast data. Reforms in several areas are critical to ensuring that G-20 countries have a comprehensive understanding of the financial position of the public sector.

  • While most advanced G-20 countries regularly publish financial data covering the general government, the coverage of their fiscal reports needs to be expanded to consolidate public corporations, especially those engaged in quasi-fiscal activity. Emerging market countries need to expand the coverage of their fiscal reports to encompass the entire general government, publish monthly fiscal statistics within one month and annual accounts within six months, and ensure that they are validated by independent statistics agencies and supreme audit institutions respectively.

  • Newly established fiscal councils in advanced economies have focused greater attention on the credibility of official macroeconomic and fiscal forecasts. However, independent scrutiny of fiscal forecasts remains the exception among emerging markets and more can be done to improve the frequency, transparency, and time horizon of the forecasts themselves.

  • Both advanced and emerging market countries need to boost their fiscal risk management capacity. Emerging markets need to explore the fiscal implications of alternative macroeconomic scenarios, while all G-20 countries need to improve the disclosure, analysis, and management of contingent liabilities and other specific fiscal risks.

34. Fiscal adjustment plans are increasingly underpinned by comprehensive medium-term fiscal and budgetary frameworks, but these need to be supported by mechanisms which combine multi-year discipline with responsiveness to shocks. Countries with sound institutional frameworks for multi-year fiscal and budget planning have generally been quicker in formulating and adopting comprehensive fiscal adjustment strategies and better at protecting public investment during the consolidation process. Enhancing the credibility of these plans going forward will require reforms in a number of areas.

  • While most G-20 countries now have precise and time-bound fiscal rules or objectives in place, both advanced and emerging countries need to improve the design of these rules or objectives to ensure they allow for the operation of automatic stabilizers and include clearly defined escape clauses to deal with exceptional exogenous shocks that cannot be accommodated through prudent fiscal policy adjustments.

  • The MTBFs underpinning these fiscal objectives have become more widespread and detailed over the past three years. However, their disciplining effects would be enhanced if their coverage was expanded to include all discretionary, non-cyclical central government expenditure and if they imposed restrictions on the future path of that expenditure through the inclusion of binding medium-term aggregate and annual sectoral expenditure ceilings.23

  • Program and performance budgeting are now the norm in both advanced and emerging G-20 countries. However, countries need to make more systematic use of expenditure reviews to ensure that information on the efficiency and effectiveness of expenditure programs actually informs decisions about their future budgetary allocations.

  • While the scope of fiscal rules, especially in advanced countries, has in many cases been extended to general government, such rules need to be supported by more effective planning, coordination, and enforcement mechanisms between the different levels of government.

35. While procedures for preparing and executing annual budgets are relatively strong across G-20 countries, more can be done to improve budget coverage, engage legislatures, and limit the scope for budget overruns. Since the crisis, countries with more comprehensive and top-down approaches to the formulation and approval of their annual budget have seen much less slippage in the implementation of their fiscal adjustment plans than those with more fragmented and bottom-up budget processes. Further reducing the scope for slippage against fiscal plans and budgets will require efforts in several areas.

  • Fragmentation of the budget remains a considerable problem, especially in emerging market countries, and there is a need to eliminate extra-budgetary funds and reduce the size of mandatory and earmarked expenditures.

  • Most G-20 countries now take a top-down approach to budget preparation within government. However, further effort is needed to ensure that all major fiscal decisions are taken as part of the annual budget process and clearly reflected in the budget documentation.

  • By contrast, the sequence of budget debates and voting continues to follow a bottom-up approach in most G-20 legislatures. There remains a need to modernize parliamentary procedures so as to give lawmakers a greater opportunity to scrutinize the government’s overall fiscal strategy and a greater obligation to respect that strategy when approving the annual budget. This could be achieved through the adoption of two-stage budget approval processes, whereby the legislature decides on the aggregate level of revenue and expenditure in an initial budget orientation debate before going on to debate and approve detailed appropriations for each ministry or program.

  • While budget execution controls are generally strong across the G-20, countries need to tighten up rules around supplementary budgets, put in place larger and better managed contingency reserves, and establish firmer controls over multi-year commitments.

36. Institutional reforms in the above areas need to be coordinated across the budgeting cycle and between branches and levels of government to maximize their impact on fiscal decision-making and performance. Budgeting is, by its very nature, a complex process in any country. The impact of reform at any one stage of the process on fiscal behavior depends on the integrity of the system as a whole. Efforts to strengthen budget institutions in G-20 countries in the wake of the recent crisis have, in many cases, been pursued in a piecemeal manner which has, in some cases, reduced their potential impact. Going forward, these countries should develop more systematic and sustained institutional reform programs aimed at addressing the key weaknesses at each phase of the fiscal policymaking process.

Budget Institutions in G-20 Countries - An Update
Author: International Monetary Fund