Budget Process

A. THE BUDGET PREPARATION PROCESS OBJECTIVES OF BUDGET PREPARATION During budget preparation, trade-offs and prioritization among programs must be made to ensure that the budget fits government policies and priorities. Next, the most cost-effective variants must be selected. Finally, means of increasing operational efficiency in government must be sought. None of these can be accomplished unless financial constraints are built into the process from the very start. Accordingly, the budget formulation process has four major dimensions:1 †¢Setting up the fiscal targets and the level of expenditures compatible with these targets. This is the objective of preparing the macro-economic framework. †¢ Formulating expenditure policies. †¢ Allocating resources in conformity with both policies and fiscal targets. This is the main objective of the core processes of budget preparation. †¢ Addressing operational efficiency and performance issues. This chapter focuses on the core processes of budget preparation, and on mechanisms for aggregate expenditure control and strategic allocation of esources. Efficiency and performance issues are discussed in chapter 15. Operational efficiency questions directly related to the arrangements for budget preparation are discussed in Section D below. B. THE IMPORTANCE OF A MEDIUM-TERM PERSPECTIVE FOR BUDGETING The need to address all three objectives of public expenditure management–fiscal discipline, strategic resource allocation, and operational efficiency—is emphasized in chapter 1. This calls for a link between policy and budgeting and for a perspective beyond the immediate future.Of course, the future is inherently uncertain, and the more so the longer the period considered. The general trade-off is between policy relevance and certainty. At one extreme, government â€Å"budgeting† for just the following week would suffer the least uncertainty but also be almost irrelevant as an instrument of po licy. At the other extreme, budgeting for a period of too many years would provide a broad context but carry much greater uncertainty as well. 2 In practice, â€Å"multiyear† means â€Å"medium-term,† i. e. , a perspective covering three to five years including the budget year.Clearly, the feasibility in practice of a multiyear perspective is greater when revenues are predictable and the mechanisms for controlling expenditure well- developed. (The U. K. , for example, has recently moved beyond a multiyear perspective to an outright three-year budget for most budgetary accounts. ) These conditions do not exist in many developing countries. 3, The dilemma is that a multiyear perspective is especially important in those countries where a clear sense of policy direction is a must for sustainable development, and public managers are often in sore need of some predictability and flexibility. The dilemma that a multiyear perspective is especially needed where it is least feas ible cannot be resolved easily, but must not be ignored. On the one hand, to try and extend the time horizon of the budget process under conditions of severe revenue uncertainty and weak expenditure control would merely lead to frequent changes in ceilings and appropriations, quickly degenerate into a formalistic exercise, and discredit the approach itself, thus compromising later attempts at improvement.On the other hand, to remain wedded to narrow short-term â€Å"management† of public expenditure would preclude a move to improved linkage between policies and expenditures. In practice, therefore, efforts should constantly be exerted to improve revenue forecasting (through such means as relieving administrative or political pressures for overoptimistic forecasts), and strengthen the linkages between policy formulation and expenditure, as well as the expenditure control mechanisms themselves. As and when these efforts yield progress, the time horizon for budget preparation ca n and should be lengthened. Because revenue-forecasting mprovements and the strengthening of policy-expenditure links and expenditure control mechanisms are important in any event, efforts to achieve these can yield the double benefit of improving the short-term budget process at the same time as they permit expanding the budget time horizon to take account of developmental priorities. Therefore, although in almost all countries government budgets are prepared on an annual cycle, to be formulated well they must take into account events outside the annual cycle, in particular the macroeconomic realities, the expected revenues, the longer-term costs of programs, and government policies.Wildavsky (1986, p. 317) sums up the arguments against isolated annual budgeting as follows: short-sightedness, because only the next year’s expenditures are reviewed; overspending, because huge disbursements in future years are hidden; conservatism, because incremental changes do not open up lar ge future vistas; and parochialism, because programs tend to be viewed in isolation rather than in comparison to their future costs in relation to expected revenue. Specifically, the annual budget must reflect three paramount multiannual considerations: The future recurrent costs of capital expenditures; †¢ The funding needs of entitlement programs (for example debt service and transfer payments) where expenditure levels may change, even though basic policy remains the same; †¢ Contingencies that may result in future spending requirements (for example government loan guarantees (see chapter 2). A medium-term outlook is necessary because the time span of an annual budget is too short for the purpose of adjusting expenditure priorities and uncertainties become too great over the longer term.At the time the budget is formulated, most of the expenditures of the budget year have already been committed. For example, the salaries of permanent civil servants, the pensions to be pa id to retirees, debt service costs, and the like, are not variable in the short term. Other costs can be adjusted, but often only marginally. The margin of maneuver is typically no more than 5 percent of total expenditure. This means that any real adjustment of expenditure priorities, if it is to be successful, has to take place over a time span of several years.For instance, the government may wish to switch from blanket provision of welfare services to targeted provision designed for those most in need. The expenditure implications of such a policy change stretch over several years, and the policy therefore can hardly be implemented through a blinkered focus on the annual budget. Medium-term spending projections are also necessary to demonstrate to the administration and the public the desired direction of change.In the absence of a medium-term program, rapid spending adjustments to reflect changing circumstances will tend to be across-the-board and ad hoc, focused on inputs and a ctivities that can be cut in the short term. (Often, these are important public investment expenditures, and one of the typical outcomes of annual budgeting under constrained circumstances is to define public investment in effect as a mere residual. ) If the expenditure adjustments are not policy-based, they will not be sustained.By illuminating the expenditure implications of current policy decisions on future years’ budgets, medium-term spending projections enable governments to evaluate costeffectiveness and to determine whether they are attempting more than they can afford. 5 Finally, in purely annual budgeting, the link between sectoral policies and budget allocations is often weak. Sector politicians announce policies, but the budget often fails to provide the necessary resources. However, two pitfalls should be avoided. First, a multiyear expenditure approach can tself be an occasion to develop an evasion strategy, by pushing expenditure off to the out-years. Second, i t could lead to claims for increased expenditures from line ministries, since new programs are easily transformed into â€Å"entitlements† as soon as they are included in the projections. To avoid these two pitfalls, many developed countries have limited the scope of their multiyear expenditures estimates to the cost of existing programs, without making room for new programs. †6 Three variants of medium-term year expenditure programming can be considered: †¢A mere â€Å"technical† projection of the forward costs of ongoing programs (including, of course, the recurrent costs of investments). †¢ A â€Å"stringent† planning approach, consisting of: (i) programming savings in nonpriority sectors over the planned period, to leave room for higherpriority programs; but (ii) including in the multiyear program ongoing programs and only those new programs that are included in the annual budget currently under preparation or for which financing is certain. Such plans include only a few new projects beyond their first planned year (e. g. the Public Investment Program prepared in Sri Lanka until 1998). †¢ The â€Å"classic† planning approach, which identifies explicitly new programs and their cost over the entire period. This includes â€Å"development plans† covering all expenditures, or many public investment programs currently prepared in several developing countries, as well as expenditure plans prepared in developed countries in the 1970s. Where the institutional mechanisms for sound policy decision making and for budgeting are not in place, this approach can lead to overloaded expenditure programs.The feasibility of implementing these different approaches and their linkages with the annual budget depends on the capacity and institutional context of the specific country. However, the annual budget should always be placed into some kind of multiyear perspective, even where formal multiyear expenditure programming is not feasible. For this purpose two activities are a must: (i) systematic estimates of the forward costs of ongoing programs, when reviewing the annual budget requests from line ministries; (ii) aggregate expenditure estimates consistent with the medium-term macroeconomic framework (see section C).It is often objected that estimating forward costs is difficult, especially for recurrent costs of new public investment projects. This is true, but irrelevant, for without such estimates budgeting is reduced to a short sighted and parochial exercise. [Please see attached Figure 4. xls] C. CONDITIONS FOR SOUND BUDGET PREPARATION In addition to a multiyear perspective, sound annual budget preparation calls for making early decisions and for avoiding a number of questionable practices. 1. The need for early decisions By definition, preparing the budget entails hard choices.These can be made, at a cost, or avoided, at a far greater cost. It is important that the necessary trade-offs be made explicitly when formulating the budget. This will permit a smooth implementation of priority programs, and avoid disrupting program management during budget execution. Political considerations, the avoidance mechanisms mentioned below, and lack of needed information (notably on continuing commitments), often lead to postponing these hard choices until budget execution. The postponement makes the choices harder, not easier, and the consequence is a less efficient budget process.When revenues are overestimated and the impact of continuing commitments is underestimated, sharp cuts must be made in expenditure when executing the budget. Overestimation of revenue can come from technical factors (such as a bad appraisal of the impact of a change in tax policy or of increased tax expenditures), but often also from the desire of ministries to include or maintain in the budget an excessive number of programs, while downplaying difficulties in financing them. Similarly, while underestimation of expenditures can come from unrealistic assessments of the cost of unfunded liabilities (e. g. enefits granted outside the budget) or the impact of permanent obligations, it can also be a deliberate tactic to launch new programs, with the intention of requesting increased appropriations during budget execution. It is important not to assume that â€Å"technical† improvements can by themselves resolve institutional problems of this nature. An overoptimistic budget leads to accumulation of payment arrears and muddles rules for compliance. Clear signals on the amount of expenditure compatible with financial constraints should be given to spending agencies at the start of the budget preparation process.As will be stressed repeatedly in this volume, it is possible to execute badly a realistic budget, but impossible to execute well an unrealistic budget. There are no satisfactory mechanisms to correct the effects of an unrealistic budget during budget execution. Thus, across-the- board appropriation â€Å"sequestering† leads to inefficiently dispersing scarce resources among an excessive number of activities. Selective cash rationing politicizes budget execution, and often substitutes supplier priorities for program priorities.Selective appropriation sequestering combined with a mechanism to regulate commitments partly avoids these problems, but still creates difficulties, since spending agencies lack predictability and time to adjust their programs and their commitments. An initially higher, but more realistic, fiscal deficit target is far preferable to an optimistic target based on overestimated revenues, or underestimated existing expenditure commitments, which will lead to payment delays and arrears. The monetary impact is similar, but arrears create their own inefficiencies and destroy government credibility as well. This is a strong argument in favor of measuring the fiscal deficit on a â€Å"commitment basis†, see chapter 6. ) To allevia te problems generated by overoptimistic budgets, it is often suggested that a â€Å"core program† within the budget be isolated and higher priority given to this program during budget implementation. In times of high uncertainty of available resources (e. g. , very high inflation), this approach could possibly be considered as a secondbest response to the situation. However, it has little to recommend it as general practice, and is vastly inferior to the obvious alternative of a realistic budget to begin with.When applied to current expenditures, the â€Å"core program† typically includes personnel expenditures, while the â€Å"noncore program† includes a percentage of goods and services. Cuts in the â€Å"noncore† program during budget execution would tend to increase inefficiency, and reduce further the meager operations and maintenance budget in most developing countries. The â€Å"core/noncore† approach is ineffective also when applied to inves tment expenditures, since it is difficult to halt a project that is already launched, even when it is â€Å"non-core. Indeed, depending on strong political support, noncore projects may in practice chase out core projects. (See chapter 12 for a discussion of public investment programming. ) 2. The need for a hard constraint Giving a hard constraint to line ministries from the beginning of budget preparation favors a shift from a â€Å"needs† mentality to an availability mentality. As discussed in detail later in this chapter, annual budget preparation must be framed within a sound macroeconomic framework, and should be organized along the following lines: †¢A top-down approach, consisting of: (i) defining aggregate resources available for public spending; (ii) establishing sectoral spending limits that fits government priorities; and (iii) making these spending limits known to line ministries; †¢ A bottom-up approach, consisting of formulating and costing sectoral spending programs within the sectoral spending limits; and †¢ Iteration and reconciliation mechanisms, to produce a constant overall expenditure program. Although the process must be tailored to each country, it is generally desirable to start with the top-down approach.Implementation of this approach is always necessary for good budgeting, regardless of the time period covered. The technical articulation of this approach in the context of medium-term expenditure programming is discussed in chapter 13, for the annual budget. 3. Avoiding questionable budgeting practices Certain budgetary practices are widespread but inconsistent with sound budgeting. The main ones are: â€Å"incremental budgeting,† â€Å"open-ended† processes, â€Å"excessive bargaining,† and â€Å"dual budgeting. † a. Incremental budgetingLife itself is incremental. And so, in part, is the budget process, since it has to take into account the current context, continuing policies, and ongoing programs. Except when a major â€Å"shock† is required, most structural measures can be implemented only progressively. Carrying out every year a â€Å"zero-based† budgeting exercise covering all programs would be an expensive illusion. At the other extreme, however, â€Å"incremental budgeting,† understood as a mechanical set of changes in a detailed line-item budget, leads to very poor results.The dialogue between the Ministry of Finance and line ministries is confined to reviewing the different items and to bargaining cuts or increases, item by item. Discussions focus solely on inputs, without any reference to results, between a Ministry of Finance typically uninformed about sectoral realities and a sector ministry in a negotiating mode. Worse, the negotiation is seen as a zero-sum game, and usually not approached by either party in good faith. Moreover, incremental budgeting of this sort is not even a good tool for expenditure control, although this was the initial aim of this approach.Line-item incremental budgeting focuses generally on goods and services expenditures, whereas the â€Å"budget busters† are normally entitlements, subsidies, hiring or wage policy or, in many developing countries, expenditure financed with counterpart funds from foreign aid. Even the most mechanical and inefficient forms of incremental budgeting, however, are not quite as bad as capricious large swings in budget allocations in response to purely political power shifts. b. â€Å"Open-ended† processes An open-ended budget preparation process starts from requests made by spending agencies without clear indications of financial constraints.Since these requests express only â€Å"needs,† in the aggregate they invariably exceed the available resources. Spending agencies have no incentive to propose savings, since they have no guarantee that any such savings will give them additional financial room to undertake new activities. New programs are included pell-mell in sectoral budget requests as bargaining chips. Lacking information on the relative merits of proposed expenditures, the Ministry of Finance is led to making arbitrary cuts across the board among sector budget proposals, usually at the last minute when finalizing the budget.At best, a few days before the deadline for presenting the draft budget to the Cabinet, the Ministry of Finance gives firm directives to line ministries, which then redraft their requests hastily, themselves making cuts across the board in the programs of their subordinate agencies. Of course, these cuts are also arbitrary, since the ministries have not had enough time to reconsider their previous budget requests. Further bargaining then taxes place during the review of the budget at the cabinet level, or even during budget execution. â€Å"Open ended† processes are sometimes justified as a â€Å"decentralized† approach to budgeting.Actually, they are the very opposi te. Since the total demand by the line ministries is inevitably in excess of available resources, the Ministry of Finance in fact has the last word in deciding where increments should be allocated and whether reallocations should be made. The less constrained the process, the greater is the excess of aggregate ministries’ request over available resources, the stronger the role of the central Ministry of Finance in deciding the composition of sectoral programs, and the more illusory the â€Å"ownership† of the budget by line ministries. . Excessive bargaining and conflict avoidance There is always an element of bargaining in any budget preparation, as choices must be made among conflicting interests. An â€Å"apolitical† budget process is an oxymoron. However, when bargaining drives the process, the only predictable result is inefficiency of resource allocation. Choices are based more on the political power of the different actors than on facts, integrity, or res ults. Instead of transparent budget appropriations, false compromises are reached, such as increased tax expenditures, reation of earmarked funds, loans, or increased contingent liabilities. A budget preparation process dominated by bargaining can also favor the emergence of escape mechanisms and a shift of key programs outside the budget. 7 A variety of undesirable compromises are used to avoid internal bureaucratic conflicts—spreading scarce funds among an excessive number of programs in an effort to satisfy everybody, deliberately overestimating revenues, underestimating continuing commitments, postponing hard choices until budget execution, inflating expenditures in the second year of a multiyear expenditure program, etc.These conflict-avoidance mechanisms are frequent in countries with weak cohesion within the government. Consequently, improved processes of policy formulation can have benefits for budget preparation as well, through the greater cohesion generated in the government. 8 Conflict avoidance may characterize not only the relationships between the Ministry of Finance and line ministries, but also those between line ministries and their subordinate agencies.Indeed, poor cohesion within line ministries is often used by the Ministry of Finance as a justification for its leading role in determining the composition of sectoral programs. Perversely, therefore, the all-around bad habits generated by â€Å"open-ended† budget preparation processes may reduce the incentive of the Ministry of Finance itself to push for real improvements in the system. d. â€Å"Dual budgeting† There is frequent confusion between the separate presentation of current and investment budgets, and the issue of the process by which those two budgets are prepared.The term â€Å"dual budgeting† is often used to refer to either the first or the second issue. However, as discussed earlier, a separate presentation is needed. â€Å"Dual budgeting† ref ers therefore only to a dual process of budget preparation, whereby the responsibility for preparing the investment or development budget is assigned to an entity different from the entity that prepares the current budget. â€Å"Dual budgeting† was aimed initially at establishing appropriate mechanisms for giving higher priority to development activity.Alternatively, it was seen as the application of a â€Å"golden rule† which would require balancing the recurrent budget and borrowing only for investment. In many developing countries, the organizational arrangements that existed before the advent of the PIP approach in the 1980s (see chapter 12) typically included a separation of budget responsibilities between the key core ministries. The Ministry of Finance was responsible for preparing the recurrent budget; the Ministry of Planning was responsible for the annual development budget and for medium-term planning.The two entities carried out their responsibilities separ ately on the basis of different criteria, different staff, different bureaucratic dynamics, and, usually, different ideologies. In some cases, at the end of the budget preparation cycle, the Ministry of Finance would simply collate the two budgets into a single document that made up the â€Å"budget. † Clearly, such a practice impedes the integrated review of current and investment expenditures that is necessary in any good budget process. (For xample, the Ministry of Education will program separately its school construction program and its running costs and try to get the maximum resources for both, while not considering variants that would consist of building fewer schools and buying more books. ) In many cases, coordination between the preparation of the recurrent budget and the development budget is poor not only between core ministries but within the line ministries as well. While the Ministry of Finance deals with the financial department of line ministries, the Ministr y of Planning deals with their investment department.This duality may even be reproduced at subnational levels of government. Adequate coordination is particularly difficult because the spending units responsible for implementing the recurrent budget are administrative divisions, while the development budget is implemented through projects, which may or may not report systematically to their relevant administrative division. (In a few countries, while current expenditures are paid from the Treasury, development expenditures are paid through a separate Development Fund. ) The introduction of rolling PIPs was motivated partly by a desire to correct these problems. Thus, the crux of the â€Å"dual budgeting† issue is the lack of integration of different expenditures contributing to the same policy objectives. This real issue has been clouded, however, by a superficial attribution of deep-seated problems to the â€Å"technical† practice of dual-budgeting. For example, dual budgeting is sometimes held responsible for an expansionary bias in government expenditure. Certainly, as emphasized earlier, the initial dual budgeting paradigm was related to a growth model (Harrod-Domar et al) based on a mechanistic relation between the level of investment and GDP growth.This paradigm itself has unquestionably been a cause of public finance overruns and the debt crises inherited in Africa or Latin America from badquality investment â€Å"programs† of the 1970s and early 1980s. The implicit disregard for issues of implementation capacity, or efficiency of investment, or mismanagement, corruption and theft, is in hindsight difficult to understand. However, imputing to dual budgeting all problems of bad management or weak governance and corruption is equally simplistic and misleading.Given the same structural, capacity, and political conditions of those years (including the Cold War), the same outcome of wasteful, and often corrupt, expansion of government s pending would have resulted in developing countries—dual budgeting or not. If only the massive economic mismanagement in so many countries in the 1970s and early 1980s could be explained by a single and comforting â€Å"technical† problem of budgetary procedure! In point of fact, the fiscal overruns of the 1970s and early 1980s had little to do with the visible dual budgeting.They originated instead from a third invisible budget: â€Å"black boxes,† uncontrolled external borrowing, military expenditures, casual guarantees to public enterprises, etc. 10 Public investment budgeting is submitted to strong pressures because of particular or regional interest (the so-called pork barrel projects) and because it gives more opportunities for corruption than current expenditures. 11 Thus, in countries with poor governance, there are vested interests in keeping separate the process of preparing the investment budget, and a tendency to increase public investment spending.H owever, under the same circumstances, to concentrate power and bribe opportunities in the hands of a powerful â€Å"unified-budget† baron would hardly improve expenditure management or reduce corruption. On the contrary, it is precisely in these countries that focusing first on improving the integrity of the separate investment programming process may be the only way to assure that some resources are allocated to economically sound projects and to improve over time the budget process as a whole. 12 By contrast, in countries without major governance weaknesses, dual budgeting ften results in practice in insulating current expenditures (and especially salaries) from structural adjustment. Given the macroeconomic and fiscal forecasts and objectives, the resources allocated to public investment have typically been a residual, estimated by deducting recurrent expenditure needs from the expected amount of revenues (given the overall deficit target). The residual character of the do mestic funding of development expenditures may even be aggravated during the process of budget execution, when urgent current spending preempts investment spending which can be postponed more easily.In such a situation, dual budgeting yields the opposite problem: unmet domestic investment needs and insufficient counterpart funds for good projects financed on favorable external terms. Insufficient aggregate provision of counterpart funds (which is itself a symptom of a bad investment budgeting process) is a major source of waste of resources. Recall that the real issue is lack of integration between investment and current expenditure programming, and not the separate processes in themselves.This is important, because to misspecify the issue would lead (and often has) to considering the problem solved by a simple merger of two ministries—even while coordination remains just as weak. A former minister becomes a deputy minister, organizational â€Å"boxes† are reshuffled, a few people are promoted and others demoted. But dual budgeting remains alive and well within the bosom of the umbrella ministry. When coordination between two initially separate processes is close and iteration effective, the two budgets end up consistent with each other and with government policies, and â€Å"dual budgeting† is no great problem.Thus, when the current and investment budget processes are separate, whether or not they should be unified depends on the institutional characteristics of the country. In countries where the agency responsible for the investment budget is weak, and the Ministry of Finance is not deeply involved in ex-ante line-item control and day-to-day management, transferring responsibilities for the investment budget to the Ministry of Finance would tend to improve budget preparation as a whole. (Whether this option is preferable to the alternative of trengthening the agency responsible for the investment budget can be decided only on a country- specific basis. ) In other countries, one should first study carefully the existing processes and administrative capacities. For example, when the budgetary system is strongly oriented toward ex-ante controls, the capacity of the Ministry of Finance to prepare and manage a development budget may be inadequate. A unified budget process would in this case risk dismantling the existing network of civil servants who prepare the investment budget, without adequate replacement.Also, as noted, coordination problems may be as severe between separate departments of a single ministry as between separate ministries. Indeed, the lack of coordination within line ministries between the formulation of the current budget and the formulation of the capital budget is in many ways the more important dual budgeting issue. Without integration or coordination of current and capital expenditure at line the ministries’ level, integration or coordination at the core ministry level is a misleading ill usion.On balance, however, the general presumption should be in favor of a single entity responsible for both the investment and the annual budget (although that entity must possess the different skills and data required for the two tasks): Where coherence is at a premium, where any consistent policy may be better than several that cancel each other out, where layers of bureaucracy already frustrate each other, and where a single budget hardly works, choosing two budgets and two sets of officials over one seems strange. The keynote in poor countries should be simplicity.Designs for decisions should be as simple as anyone knows how to make them. The more complicated they are, the less likely they are to work. On this basis, there seems little reason to have several organizations dealing with the same expenditure policies. One good organization would represent an enormous advance. Moreover, choosing the finance ministry puts the burden of reform where it should be—in the budget ary sphere. 13 D. THE MACROECONOMIC AND POLICY CONTEXT 1. Macroeconomic framework and fiscal targets a. Importance of a macroeconomic frameworkThe starting points for expenditure programming are: (i) a realistic assessment of resources likely to be available to the government; and (ii) the establishment of fiscal objectives. (There follows, of course, significant iteration between the two, until the desired relationship between resources and objectives is reached. ) As noted earlier, the capacity to translate policy priorities into the budget, and then to ensure conformity of actual expenditures with the budget, depends in large part on the soundness of macroeconomic projections and revenue forecasts.Overestimating revenues leads to poor budget formulation and therefore poor budget execution. (As mentioned earlier, this may sometimes be a deliberate ploy to evade the responsibility for weak budget management and discipline. ) The preparation of a macroeconomic framework is therefore an essential element in the budget preparation process. Macroeconomic projections are not simple forecasts of trends of macroeconomic variables. Projections are based on a definition of argets and instruments, in areas such as monetary policy, fiscal policy, exchange rate and trade policy, external debt policy, regulation and promotion of private-sector activities, and reform of public enterprises. For example, the policy objective of reducing inflation normally corresponds to targets such as the level of the deficit, and the specific instruments can include tax measures and credit policy measures, among others. 14 Projections should cover the current year and a forward period of two to four years. b.Fiscal targets and indicators The establishment of explicit fiscal targets gives a framework for budget formulation, allows the government to state clearly its fiscal policy and the legislative and the public to monitor the implementation of government policy, and, ultimately, makes go vernment politically as well as financially accountable. Fiscal targets and indicators should cover three areas: current fiscal position (e. g. , fiscal deficit), fiscal sustainability (e. g. , debt-, tax-, or expenditure-to-GDP ratios), and vulnerability (e. . , analysis of the composition of the foreign debt). The summary indicator of fiscal position used most commonly is the overall budget deficit on a cash basis, defined as the difference between actual expenditure payments and collected revenues (on a cash basis) plus grants (cash or in kind). 15 The cash deficit is by definition equal to the government borrowing requirements (from domestic or foreign sources) and is thus integrally linked to the money supply and inflation targets and prospects.The deficit is therefore a major policy target to ensure that the budget will be financed in a noninflationary way and without crowding out private investment, while keeping the growth of public debt under control. The cash deficit must always be included in the set of fiscal targets. The cash deficit does not take into account payment arrears and floating debt. In countries that face arrears problems the deficit on a cash basis plus net increase of arrears is also an important indicator, and is very similar (but not necessarily identical) to the deficit on a commitment basis, i. e. the difference between annual expenditure commitments and cash revenues and grants. 16 The IMF Code of Fiscal Transparency requires at least a memorandum reporting arrears, when the country does not use accrual or modified accrual accounting (which would systematically generate reports on overdue accounts; see chapter 10). As discussed in chapter 6, the precise definition of commitment varies from one 17 country to another . Commitments include orders not yet delivered, may concern multiyear contracts, or, in some countries, be only the administrative reservation of appropriations.Therefore, when using the deficit on a commitment basis as fiscal indicator, it is necessary to specify what transactions are included in the expenditures on a commitment basis. This indicator would be meaningless if it includes multiyear commitments and commitments that are merely reservations of appropriations. Moreover, to estimate arrears more accurately, orders not yet delivered should be separated from actual expenditures (â€Å"accrued expenditures,† or â€Å"expenditures at the verification stage†). As discussed in chapters 6 and 10, this requires an adequate accounting system for tracking the uses of appropriations.The primary deficit (on either a cash or a commitment basis) is the difference between noninterest expenditures and revenues and grants. As a target for budget policy, it does not depend on the vagaries of interest rates and exchange rates, and is therefore a better measure of the government’s fiscal adjustment effort. In high-inflation countries, to take into account the impact of inflation on th e stock of debt, a frequent indicator is the operational deficit, which is equal to the deficit on a cash basis less the inflationary portion of interest payment. 18The current deficit is the difference between current revenue and current expenditure. It is by definition, the â€Å"government saving,† and thus, in theory, the contribution of government to investible resources and economic growth. However, since the current spending of a government may be as important for growth as capital spending, the macroeconomic meaning of this indicator should be interpreted with care. Depending on the circumstances, it may also be necessary to isolate once and for all the fiscal results from other operations, as, for instance, the sale of public assets, or a special recovery of tax arrears. 9 [Please see attached Table 2. xls] It is essential to underline that the broad objective of fiscal policy is not a specific level of deficit, per se, but a fiscal position that is sustainable in li ght of policy goals and likely resource availability. Indicators of fiscal sustainability include the ratio of debt to GDP, tax to GDP, net unfunded social security liabilities. The calculation of the deficit on an accrual basis and the assessment of the net worth of the government allows a etter assessment of liabilities and therefore their impact on sustainability (see chapter 10). However, huge movements in net worth can be caused by valuation changes in assets such as land, that the government has no immediate intention of liquidating. Hence, â€Å"net worth measures could be dangerous if used as indicators for near-term fiscal policy. â€Å"20 An assessment of fiscal vulnerability is also needed, especially in countries that benefit from short-term capital inflows.Especially relevant to Asian countries affected by the financial crisis that began in 1997; such an assessment could be based on the analysis of the maturity of government debt, the volume of usable foreign exchange reserves, etc. There is no question that the standard deficit measures may indicate a healthy fiscal situation which is in reality fragile. However, as shown by recent developments, guidelines for assessing fiscal vulnerabilities are doubtful and unclear. This question is related to the perennial and difficult issue f â€Å"early warning systems† to predict the probability of an impending fiscal or financial crisis. It may well be that such early warnings are feasible and appropriate. Among the thorny difficulties, however, there is the risk of a self-fulfilling prophecy, where the early warning itself could cause financial markets to become concerned and hence spark a crisis. Thus, on the â€Å"balance† of the debate, against any real crisis that an early warning system has predicted accurately, one should place other crises, that might not have happened were it not for the warning itself. . Preparation of a macroeconomic framework A macroeconomic framework typically includes projections of the balance of payments, the real sector (i. e. , production), the fiscal accounts, and the monetary sector. It is a tool for checking the consistency of assumptions or projections concerning economic growth, the fiscal deficit, the balance of payments, the exchange rate, inflation, credit growth and the share of the private and public sectors on external borrowing policies, etc. 21 Preparing a macroeconomic framework is always an iterative exercise.A set of â€Å"initial† objectives must be defined to establish a preliminary baseline scenario, but the final framework requires a progressive reconciliation and convergence of all objectives and targets. Considering only one target (e. g. , the fiscal deficit) in this iterative exercise risks defining other important targets as de facto residuals. â€Å"General government† (see chapter 2) should be considered when preparing the fiscal projections and defining the fiscal targets, but the fiscal tar gets should also be broken down between central and local government.In some decentralized systems, by law a fiscal target cannot be directly imposed on subnational and local government. In those cases, it is necessary to assess the feasibility of achieving it by means of the different instruments under the control of the central government (such as grants, control of borrowing). However, the constraints on running fiscal deficits are typically much tighter on subnational entities than they are on central government. The main reason is the central government’s capacity to regulate money supply. Therefore, in some federal systems (e. . , the U. S. ) many states have their own constitutionally mandated requirement of an annual balanced budget. Fiscal projections should cover the consolidated account of the general government and quasi-fiscal operations by the banking system. Future expenditures related to contingent liabilities as a result of government guarantees should be ass essed (see chapter 2). In a majority of developing countries, it is desirable to prepare â€Å"consolidated accounts of the public sector,† to identify financing requirements for the public sector as a whole.Very often, however, only the central government is included, giving a misleading fiscal picture and the temptation to â€Å"download† the fiscal deficit onto local government entities. This practice is conducive neither to sound fiscal policy nor to the subsidiarity structure appropriate to the specific country. Unfortunately, governments and international financial institutions have paid insufficient attention to this problem. The degree of sophistication of fiscal projections depends on the technical capacities within the country and the availability of data and appropriate tools. Sophisticated odels can be useful. Nevertheless, since the major objective is to set a general frame for formulating macroeconomic objectives and checking their consistency, the prepar ation of a macroeconomic framework does not necessarily require sophisticated modeling techniques. On the contrary, these techniques may give a sense of misplaced concreteness and a â€Å"forecast illusion† which may hamper the practical value of the framework. Using simple â€Å"quasi-accounting† models would already represent significant progress in many countries. 22 Such models include mainly accounting relations (e. g. GDP plus net imports equals consumption plus investment) and only a limited number of behavioral relations defined by simple ratios (e. g. , consumption, income), without resorting to econometric techniques. The models are also easier to use in discussions on fiscal policy, whereas the outputs of a sophisticated econometric model depend on the approach adopted by the modeler, and the process is necessarily more opaque. In any case, forecasting revenues should be based on detailed analyses and forecasts by individual tax rather than on the aggregate outputs of a macroeconomic model.The problems revealed by the projections (e. g. , lack of consistency between economic growth targets and monetary policy) must be discussed among the agencies involved in macroeconomic management. The preliminary baseline scenario gives the macroeconomic information needed for preparing sectoral and detailed projections, but these projections usually lead in turn to revising the baseline scenario. Such iterations should continue until overall consistency is achieved for the macroeconomic framework as a whole. The iteration process is not only necessary for sound macroeconomic and xpenditure programming, but is also an invaluable capacity-building tool, to improve the awareness and understanding of involved agencies—and therefore their cooperation in formulating a realistic budget and implementing it correctly. [Please see attached Figure 5. xls] The preparation of a macroeconomic framework should be a permanent activity. The framework needs t o be prepared at the start of each budget cycle to give adequate guidelines to the line ministries. As noted, it must then be updated throughout the further stages of budget preparation, also to take into account intervening changes in the economic environment.During budget execution, too, macroeconomic projections require frequent updating to assess the impact of exogenous changes or of possible slippage in budget execution. In addition to the baseline framework, it is important to formulate variants under different assumptions, e. g. , changes in oil prices. The risks related to unexpected changes in macroeconomic parameters must be assessed and policy responses identified in advance, albeit in very general terms, of course. The importance of good data cannot be underestimated. Without reliable information, the macroeconomic framework is literally not worth the paper it is written on.This includes the collection of economic data and the monitoring of developments in economic condi tions (both of which are generally undertaken by statistics bureaus) as well as the monitoring and consideration of changes in laws and regulations that affect revenue, expenditure, financing and other financial operations of the government. 2. Aggregate expenditure estimates Typically, a macroeconomic framework is at a very aggregate level on the expenditure side, and shows total government wages, other goods and services, interest, total transfers, and capital expenditures (by source of financing).Assumptions and underlying policy objectives therefore concern the broad economic categories of expenditures, rather than the allocation of resources among sectors. Moreover, transfers or entitlements are not reviewed in sufficient detail and assumptions on future developments are not compared with continuing commitments. Thus, when elaborating a fiscal framework on the basis of the overall macroeconomic framework, estimates of the impact of the assumptions and the aggregate fiscal targe ts on the composition of expenditure, by sector or economic category, are required to assess whether the fiscal targets are realistic and sustainable, and to etermine the conditions to meeting these targets. Therefore, the preparation of aggregate expenditure estimates could help in assessing the sustainability of expenditure policy, and thus improve the budget preparation process (notably when defining expenditure ceilings for the various sectors). These estimates could cover: (i) the forward costs of large investment projects; (ii) projections for the more important entitlements; and (iii) aggregate projections of other expenditures, by function and broad economic category.These estimates are less demanding in terms of capacity and institutional process than the formal Medium-Term Expenditure Framework (MTEF) described in chapter 13, but could be a step toward the implementation of a comprehensive MTEF. Indeed, this step is mandatory if some sectoral multiyear expenditure programm ing exercise is carried out (covering only investment or a few sectors), to prevent inconsistency between the sectoral program and the macroeconomic framework, or the crowding out of expenditure in noncovered sectors or categories.Focusing only on technical issues while neglecting the fundamental question of the division of administrative responsibility inevitably produces a weak or inoperative macroeconomic framework. Some major considerations in this respect are discussed in chapter 5. 3. Consolidating the fiscal commitments a. Making the macroeconomic projections public While the iterative process leading to a realistic and consistent macroeconomic framework must remain confidential in many of its key aspects, when the framework is completed it must be made public.The legislature and the population at large have a right to know clearly the government policy objective and targets, not only to increase transparency and accountability, but also to reach a consensus within civil soci ety. While such a consensus may take additional time, and require difficult debates, it will also be an invaluable foundation for the robust and effective implementation of the policy and financial program. A good example is provided by the government of Hong Kong, China, which annexes its medium-term forecast to the annual budget speech (box 16 and annex VII). Box 16Medium-Range Forecasts: The Example of Hong Kong, China The Medium Range Forecast (MRF) is a projection of expenditure and revenue for the forecast period based on forecasting assumptions and budgetary criteria. To derive the MRF, a number of computer-based models that reflect a wide range of assumptions about the factors determining each of the components of government’s revenue and expenditure were used. As summary is shown here, a fuller description is in Annex VII. Assumptions relating to developing expenditure and revenue forecast over the mediumterm period are the following: †¢ estimated cash flow of c apital projects forecast completion dates of capital projects and their related recurrent consequences in terms of staffing and running costs †¢ estimated cash flow arising from new commitments resulting from policy initiatives †¢ the expected pattern of demand for individual services †¢ the trend in yield from individual revenue sources †¢ new revenue measures in 1998-1999 In addition to these assumptions, there are a number of criteria against which the results of forecasts are tested for overall acceptability in terms of budgetary policy: †¢ †¢ †¢ †¢ Maintain adequate reserves in the long-termExpenditure growth should not exceed the assumed trend growth in GDP Contain capital expenditure growth within overall expenditure guidelines Revenue projections reflect new measures introduced in this year’s budget To summarize, the MRF of Hong Kong is shown below: (in $Hk billion) 1998-1999 Revenue 192,680 Expenditure 182,480 Surplus 10,200 To tal public expenditure 288,890 Gross domestic product 1,497,880 Growth in GDP (nominal) 12. 9 (real) 5. 0 Public expenditure as a percentage of GDP 19. 3 Forecast years 1999-2000 2000-2001 211,390 242,900 200,740 227,830 10,650 5,070 315,830 354,060 1,690,740 1,908,420 12. 9 12. 9 5. 0 5. 0 18. 7 18. 6 2001-2002 271,330 258,570 12,760 393,980 2,154,130 12. 9 5. 0 18. 3 Source: Medium Range Forecast of Hong Kong, The Internet, August 8, 1998. In some countries, government projections are submitted to a panel of independent and respected experts to ensure their reliability, while preserving the confidentiality required on a few sensitive issues. In other countries, the projections are validated by the Auditor General (e. g. , the United Kingdom and the Canadian province of Nova Scotia23).The independence of the Auditor General adds credibility to the projections. However, any other form of participation of audit offices in the budget formulation process would be questionable. In any e vent, manipulation and alteration of forecasts would soon reduce the government's credibility and hence its influence. b. Binding fiscal targets? Several countries have laws and rules that restrict the fiscal policy of government (â€Å"fiscal rules†). 24 For example, an earlier golden rule stipulated that public borrowing must not exceed investment (thus mandating a current budget balance or surplus).In some cases, the overall budget must be balanced by law (as in subnational government in federal countries). In the European Union, the Maastricht Treaty stipulates specific fiscal convergence criteria, concerning both the ratio of the fiscal deficit to GDP and the debt/GDP ratio. (The former has been by far the more important criterion. ) One frequent criticism of such rules is that they favor creative accounting and encourage nontransparent fiscal practices. When they are effectively enforced, nondiscretionary rules can also prevent governments from adjusting their budgets t o the economic cycle. 5 Aside from the special case of European integration, one may generally consider that, in countries with fragile coalition governments, fragmented decision making, and legislative committees acting as a focus for periodic bargaining, setting up legally binding targets may be appropriate. In other countries, however, binding targets could in effect predetermine the budget before its preparation even begins. 26 In contrast with an approach based on rigid targets, other countries (e. g. , New Zealand) do not mandate specific fiscal targets, but refer to criteria such as prudent levels and reasonable degrees.It is left to the government to specify the targets in a Budget Policy Statement, which presents total revenues and expenses and projections for the next three years. This statement is published at least three months before the budget is presented to Parliament, and is reviewed by a Parliament committee but not formally voted by Parliament. 27 Box 17 The New Z ealand Fiscal Responsibility Act Enacted in 1994, the New Zealand Fiscal Responsibility Act offers a comprehensive legal framework for formulation and conducting fiscal policy in general, and for incorporating a long-term orientation in the budget process in particular.While many OECD countries have similar practices in place, the Fiscal Responsibility Act is an example of these practices being enacted into law. The primary objective of the Fiscal Responsibility Act was to entrench sound fiscal policies and make it difficult for future governments to deviate from them. There are two provisions of the Act: (i) a regime for setting fiscal objectives that focuses attention on the long term; and (ii) an extensive system of fiscal reporting with unique mechanisms to ensure its credibility and integrity. The extensive reporting required by the act serves two purposes.First, it serves to monitor the consistency of the government’s fiscal actions with its stated fiscal objectives. Se cond, it brings general transparency to government finances by mandating the disclosure of all relevant fiscal information in a timely manner. The act requires two specialized reports: the Fiscal Strategy Report and the PreElection Economic and Fiscal Update. The Fiscal Strategy Report, which is presented to Parliament along with the budget, assesses the consistency of the policy framework contained in the budget with the short-term fiscal intentions and long-term fiscal objectives outlined in the Budget Policy Statement.The Pre-Election Economic and Fiscal Update contains the threeyear forecasts of all key economic and fiscal variables. Both reports contain two statements of responsibility, one by the Minister of Finance and one by the Secretary to the Treasury (a civil servant). These statements of responsibility aim to clarify the roles of politicians and civil servants in producing reports and give a greater role to civil servants in producing them, thereby increasing the overal l credibility of the reports. Source: â€Å"Budgeting for the future,† OECD working paper, 1997.More important than specifying ex-ante targets and general criteria is to ensure that institutional arrangements and processes favor coherence among resource constraints, fiscal objectives, and expenditure programs. This broader issue involves the mechanisms for policy formulation, the budget preparation process, the role of the Ministry of Finance in budgeting, and the development of appropriate instruments for reviewing expenditures within a longer period than the annual budget. Box 18 A Good Macroeconomic Coordination Practice: The â€Å"Gang of Four† in Thailand The Thai system of budgeting is highly centralized.It embodies a longstanding set of arrangements, rules, and procedures that together help exert discipline on aggregate fiscal management. It grants very little autonomy to line agencies over their budgets, and imposes weak accountability on them for their perform ance. The hallmark of the Thai budgeting system is aggregate fiscal discipline. A â€Å"gang of four† interacts to control the level of spending and thus the deficit: the National Economic and Social Development Board (NESDB), the Ministry of Finance (MOF), the Bank of Thailand (BOT), and the Bureau of the Budget (BOB) in the Prime Minister’s Office.The gang of four is responsible for formulating the macroeconomic framework that serves as the basis for the aggregate expenditure ceiling. It also determines for the most part the ministerial ceilings. Prioritization is largely a function of the gang of four. It ensures that the budgetary requests of line agencies are consistent with the objectives of the five-year development plan. The gang of four’s control over aggregate allocations to agencies and to expenditure categories implies that it exerts considerable leverage over priority setting.In Parliament, the Budget Scrutiny Committee chaired by the Minister of Fi nance evaluates the government’s proposal. Cabinet members can propose amendments to the government’s proposal but seldom make significant changes in allocations to line agencies because of limited technical capability to evaluate such proposals. Politicians can alter the allocation of line agencies. After a series of deliberations and negotiations, the committee submits the budget bill to Parliament. The Parliament almost always accepts the bill.Source: Campos and Pradhan, â€Å"Budgetary institutions and expenditure outcomes, 1996. 4. Policy formulation a. Importance of policy formulation The budget preparation process is a powerful tool for coherence. The budget is both an instrument of economic and financial management and an implicit policy statement, as it sets relative levels of spending for different programs and activities. However, policy decision making is complex and involves different actors in and outside the government.It is a technocratic illusion to e mbed all policy formulation within the budget process (as to some extent was the ambition of the PPBS; see chapter 3). However, a coherent articulation should be sought between the policy agenda (which should take into account economic and fiscal realities) and the budget (which should accurately reflect the government's policy priorities). The budget process should both take into account policies already formulated and be the main instrument for making these policies explicit and â€Å"operational. However, policies must be defined outside the pressure of the budget process. Making policy through the budget would lead to a focus only on short-term issues and thus to bad policy, since the policy debate would be invariably dominated by immediate financial considerations. (This is frequently the unfortunate outcome in developing countries with weak capacity faced with financial difficulties. ) In earlier times, medium-term development plans were intended as the instrument for setting up government strategy. However, these plans were rigid, invariant, and usually out of sync with financial realities.Paradoxically, therefore, they indirectly led in practice to the same dominance of short-term financial considerations. Organizational arrangements are discussed in chapter 5. b. The policy-budget link A bridge between the policy making process and the budget process is essential to make policy a breathing reality rather than a statement of wishes. For this purpose at least two clear rules must be established. 28 The resource implications of a policy change should be identified, even if very roughly, before a policy decision is taken.Any entity proposing new policies must quantify their effects on public expenditure, including the impact both on its own spending and on the spending of other government departments. The Ministry of Finance should be consulted in good time about all proposals involving expenditure before they go into ministerial committee or to the cent er of the government and certainly before any public announcements are made. Within the budget formulation process, close cooperation between the Ministry of Finance and the center of government is required, at both the political and the technical level.The role of the center is to ensure that the budget is prepared along the lines defined; to arbitrate or smooth over conflicts between the Ministry of Finance and line ministries; and to assure that the relevant stakeholders are appropriately involved in the budget process. (This is a major challenge, which can only be mentioned here but requires care and commitment on a sustained basis. ) An interministerial committee is needed to tackle crosscutting issues and review especially sensitive issues.And, most importantly, each entity involved in the budget process must perform its own role in a responsible fashion, and be given the means and capacity to do so. c. Reaching out: The importance of listening Consultations can strengthen leg islative scrutiny of government strategy and the budget. Legislative hearings through committees and subcommittees, particularly outside the pressure environment of the annual budget, can provide an effective mechanism for consulting widely on the appropriateness of policies (issues related to the role of the legislature are discussed in chapter 5) .The government should try to get feedb