Sustainable Public Financial Management

Doug Hadden, VP Products

Why is budget formulation important in government?

• Profitability is the key concept in the private sector. Budget is the key concept in government. In business the budget is only an internal document. In governments and not-for-profits, the budget is the key fiscal document.
• Budgeting in the public sector is fundamentally different from budgeting in the private sector. At the heart of the difference are the absence of a bottom line and the presence of a shared and limited source of funding.
• Governments operate using “commitment accounting” where budgets control expenditures. The budget is the government’s key policy document:  the legal embodiment of government policy.
• Budget formulation, or budget preparation, is the process by which governments produce budgets. An effective budget pursues three (partially competing) objectives: maintaining fiscal discipline, allocating resources in accordance with policy priorities and efficiently delivering services, or ‘value for money’. Budgets should be comprehensive, transparent and realistic.
• Budget formulation needs to be aligned with budget execution which is the way in which spending is managed and in-year budget changes are enabled.
• Budgeting in the public sector is a complex exercise. It involves the combination of information from multiple sources, bringing together different perspectives and dealing with diverse interest groups, all influencing complex decisions.

How is the quality of government budget management evaluated?

The Public Expenditure and Financial Accountability (PEFA) Performance Measurement Framework highlights the four objectives for budget formulation:

• Credibility of the budget – The budget is realistic and is implemented as intended
• Comprehensiveness and transparency – The budget and the fiscal risk oversight are comprehensive and fiscal and budget information is accessible to the public.
• Policy-based budgeting – The budget is prepared with due regard to government policy.
• Predictability and control in budget execution – The budget is implemented in an orderly and predictable manner and there are arrangements for the exercise of control and stewardship in the use of public funds.

What is the budget formulation process?

Budget formulation differs among countries and levels of government. The budget formulation process typically starts economic analysis and prediction for government revenue. The process follows sets of budget rules during a budget calendar that includes a broad set of financial information.

How does budget planning fit into PFM processes?

Government budget planning begins during the fiscal year and leverages historical and current revenue and expenditure information.  Budget planning processes align, in theWorld Bank Treasury Reference Model, with economic forecasting, debt management and treasury systems. Liquidity and cash management is critical to understanding the expected revenue and expenditure variations in government.

What budget categories are used by governments?

Budget planning categories differ among countries. The processes used can be different depending on the categories. Typical categories include:

• Separation of capital expenditures from operating or recurrent expenditures.  Experience shows that in the absence of properly organized capital budgets, governments resort to borrowing without due consideration of the sustainability aspects, assets are inadequately maintained, and major projects suffer from overall poor management and performance
• Special budgets for procurement (procurement planning) and Public investment planning (PIP), particularly national infrastructure projects
• Separate planning for debt and aid that informs the budget planning process
• Human resources and payroll planning can be a special categories because salaries make up the greatest portion of the expenditure budget

How do budget classifications enable budget formulation across categories?

Government budget formulation software can adapt to the planning workflow and categories used by governments through budget classifications. Government budget classifications, often called Charts of Accounts (COAs), represent the underlying meta data for Public Financial Management (PFM).

The COA is made up of a number of hierarchical data segments and is considered the lynchpin of a government’s accounting and reporting system and serves as a key tool to meet its business requirements.

The COA, although appears to be just concerned with classifying and recording financial transactions, is critical for effective budget management, including tracking and reporting on budget execution. The structure of the budget—in particular the budget classification—and the COA have a symbiotic relationship.

The COA structure can be used within the budget formulation software to map:

• Users and roles to elements in the COA to ensure that planners are only able to see the correct sub-section of data
• Workflow processes and that the budget formulation process follows government standards for different budget preparation categories
• Revenue sources such as donors (aid), debt and government revenue can be shown in “fund” source segment or included in the accounting codes
• Capital, recurrent and salary categories are typically modeled in the accounting (or object) codes
• Program segment and can be combined with object codes can be used to model public investment projects
• Organization or location segment can be used to control decentralized budgets across line ministries, government owned enterprises and sub-national governments

What are the major trends in government budget preparation?

• Analysis: government budgeting is transitioning from a ceremony where more time was spent creating a budget than analyzing it to more rigorous thinking to rethink action plans including techniques such as macro-fiscal frameworks, zero-based budgeting and spending reviews
• Benchmarking: many government agencies began emulating private-sector best practices by integrating benchmarking activities into planning and budgeting processes
• Decentralization: enabling bottom-up budget proposals from those who are closer to citizens
• Multiple year: use of multiple-year planning to develop more credible budgets
• Performance: Budget formulation and execution was traditionally focused primarily on resource allocation and input control is maturing “towards a focus on results” or government performance.
• Participation: use of participatory budgeting outreach to citizens and civil society, particularly at the local and regional levels of government
• Policy: techniques that align government policy and objectives to budget categories
• Transparency: use of open data and budget reports throughout the budget cycle to be more responsive to citizen needs by encouraging advocacy

How does budgeting differ among developing and developed country governments?

• Budget performance: Government deficits caused by weak revenue mobilization, profligate government spending and anticipatory spending, including anticipation of donor inflows. Poor budgetary discipline will raise demand-pull inflation, crowding out the private sector from the financial market because of high interest rates and unsustainable debt profiles, all of which slow private sector growth and reduce business confidence in the economy.
• Resource Shocks: Low-income countries are inevitably subject to the risk of resource shocks.
• Short term focus: In migrating from underdeveloped to highly developed countries, fiscal sustainability has shifted in focus from the near term to the distant future. In less developed countries, the immediate concern is whether the government will be able to service its debt if capital flees, the currency depreciates, and interest rates surge.
• Under spending: In developing countries, and particularly in fragile states, under spending is frequently as much of a problem as overspending.  A failure to spend funds in a timely manner and in accordance with the budget points to a failure to deliver planned services. It is therefore useful to consider the budget execution responsibilities of spending agencies
• Unreasonable Expectations: Even in developed countries with access to significant resources, such systems have taken many years to implement, and not always successfully. Indeed, some developed countries themselves see the challenge and complexity of say, implementing accrual budgeting as too great, preferring instead to adopt a modified accrual methodology. So to expect small developing and middle-income countries to implement such systems seems to be overly ambitious and more often than not doomed to failure. Where implementation fails, the effect can be to set back process reform many years.

What is fiscal sustainability?

Governments need to develop credible budgets to ensure that long-term spending is sustainable.  Credible budget planning takes into account the four dimensions of fiscal sustainability:

• Solvency – the ability of government to pay its financial obligations.
• Growth – fiscal policy that sustains economic growth.
• Stability – the capacity of government to meet future obligations with existing tax burdens.
• Fairness – the capacity of government to pay current obligations without shifting the cost to future generations.

How are credible budgets achieved?

• Policy: linking  policy and resources including the presentation of budget priorities to align budgets with government objectives
• Economic analysis: linking  macroeconomic framework with revenue forecasts to provide realistic projections of tax and other revenue sources and reducing the need for additional debt
• Risk: identification and determining  risk and risk mitigation strategies  to identify potential deviations from the forecast of the key economic assumptions underlying the budget
• Trend analysis: analyzing past outturns to predict future budget needs to ensure that programs are neither overfunded or underfunded
• Multiple year perspective: planning for multiple years identifies medium term costs for programs
• Comprehensive financial budgets: articulating all details for capital and recurrent expenditures,  information on budget financing, debt and the government’s financial position to ensure that supplemental budgets are not necessary under regular conditions and all activities aligned to government priorities in a unified budget
• Controls: linking of the legal budget allotments and appropriations with budget execution controls in the public finance management system

What are Medium Term Expenditure Frameworks (MTEF)?

MTEFs represent rolling plans, normally over three to five years, which move forward each year with the first year representing the budget and the “outer” years representing projections of spending. The purpose of MTEFs is to enable more credible budgets, address fiscal sustainability and better link policy, planning and budgeting for meaningful shifts in spending priorities. However, although there is widespread recognition that this is a promising way forward, in practice establishing MTEFs is difficult, and implementation takes longer than is often anticipated.

MTEFs differ among countries depending on the fiscal context, capacity and tradition. MTEF is an aggregate term that can include:

• Medium Term Macroeconomic Frameworks (MTMF) to provide a multiple year view on expected and relevant economic activity that can drive
• Medium Term Fiscal Frameworks (MTFF) to predict the government revenue and expenditure envelop to inform
• Medium Term Budget Frameworks (MTBF) that provide the basic structure of expenditures based on government priorities that can include
• Medium Term Sectoral Strategies (MTSS) of specific programs designed to improve economic sectors whose performance can be managed by
• Medium Term Performance Frameworks (MTPF) that align budgets with desired performance outputs and outcomes

Why are MTEFs challenging?

Traditional approaches to budget reform – multiyear budgeting, output based and accrual budgeting – have been particularly difficult to implement in developing countries and the development landscape is littered with failed reform strategies. Challenges to effective MTEF implementation include:

• Accounting: poor accounting processes and bad execution data can lead to poor plans
• Economic stability: high uncertainty in terms of their terms of trade and hard-to-predict commodity price earnings, as well as in the predictability of aid)
• Off-budget: donor funding and government-owned enterprise budgets can be “off-budget” where governments are unaware of the full revenue and expenditure footprint for effective planning
• Overloading: doing too much at once can overload human capacity prevent progress on all reforms
• Political will: unwillingness to change policy to reflect macroeconomic analysis or performance measures
• Fiscal sustainability: focus on the medium-terms makes the process not attuned to long-term issues

How does government budget planning software meet unique requirements?

Effective government budget planning software can be configured to meet unique requirements. There are numerous budget management software applications available but, in practice the World Bank and aid agencies have funded the introduction of private sector financial systems, which do not include core budgeting functionalities.

Government budget formulation software must support:

• Financial functions including the ability to develop budgets in any combined top-down/bottom-up process. Effective budget preparation software can take previous data and adjust by formula (such as reduce by 5% all revenue categories or increase the cost of oil by 10%). The software enables linking budget justification directly with the budget classifications. The budget passed by the legislature, often called the “organic budget law” or “the vote” is automatically integrated with the budget execution/accounting system to ensure proper budget controls.
• Content. Budget formulation software needs to use data from other sources including importing spreadsheet data directly to the financial budget plan, attaching narrative to budget requests and referencing documents.
• Workflow: Flexible workflow functions are necessary to follow the government budget calendar and address budget categories. Multiple budget versions are required.
• Performance: Governments with higher capacity can integrate output and outcome data to the COA and develop scorecards.

Component model for budget formulation automation software.

What are the inputs for government budget software?

Inputs in the budget formulation process include:

• Financial transactions from previous years (and the active fiscal year) including the tracking of multi-year commitments that roll-over to subsequent years
• Budget variances from previous budgets including changes that occurred to the budget during operation such as budget transfers and virements to provide trend information
• MTEF year 2 and 3 budget estimates to provide a baseline for the working budget
• Macroeconomic data that predicts government revenue, identifies risks, and creates baseline budget assumptions such as currency exchange rates
• Cost drivers or established estimates for products and services so that budgets use credible assumptions and align with scenario planning such as analyzing the impact of changing energy costs and currency fluctuations
• Documents like budget justification, policy information and reports
• Integration with underlying systems and spreadsheets

What are the outputs for government budget software?

Outputs in the budget formulation process include:

• Budget controls to be integrated with the treasury system components of the Government Resource Planning (GRP) software for commitment accounting including support for warrants, supplemental budgets, continuing resolutions
• Scenario plans that enables government to quickly adjust budgets should risk factors come to fruition during the fiscal year
• Documents generated from the system such as budget books

Why are flexible controls required?

Flexible controls in GRP software are critical for governments to match regulations and enable modernization:

• Budget laws address high-level budget items in the COA. Therefore, strict control at details or “line item budgeting” is not material to the law
• Capacity is critical when determining decentralization and needs to be flexible to support more discretion in spending and budget transfers to improve results
• Allotments, appropriations, warrants and cash controls differ among countries based on legal frameworks, traditions and liquidity
• Treasury departments provide more value to governments by managing liquidity and adjusting allotments based on surplus and deficit forecasts than approving commitments and transferring amounts among budget line items

What budget control functions are necessary in GRP software?

• Multiple Controls: numerous controls can operate simultaneously such as cash warrants and annual appropriations
• Periods: different controls can be active for different time periods, typically from a month to a year
• Aggregate: controls can operate from detailed line item to high level and where the total of detailed line items could equal or not equal the total for the high level controls
• Tolerances: discretion enabled for some controls such as the ability to overspend some monthly controls by a fixed amount or a percentage as long as aggregate controls are not overspent
• Commitment Controls: where tolerances can be applied to commitments and obligations
• Segregation of Duties: workflow controls to ensure proper separation of duties for spending approvals, payment approvals and budget transfer approvals that meet government fiscal regulations
• Organization Configurations: support of different control schemes for different government organizations reflecting legal status and organizational capacity

Why not use spreadsheets or simple web applications for budget preparation?

Spreadsheet and simple web applications do not provide sufficient control, error management and integration for budget planning:

• Version management and approval: versions of budgets and approvals for budgets require more sophisticated software that uses workflow control
• Controls: budget formulation software is required to create controls, manage segregation of duties integrate with commitment accounting
• Errors: validation on data input is not sophisticated in spreadsheet and simple web applications resulting in mistakes
• Historical information: integrated budget preparation and budget execution software provides accurate analytical information for budget planners

What are good practices for budget formulation?

1. Budgets are the legal embodiment of government policy and is critical in public financial management
2. Budget formulation practices should match country conditions and human capacity
3. The Chart of Accounts is critical for effective budget processes
4. Budget formulation software can help to create more credible budgets that provide fiscal sustainability and internal controls

Part 4: Sustainable Planning

Value of medium-term budget planning

Doug Hadden, VP Products

This is Part 4 of 6 parts detailing the content in my Financial Management Institute of Canada lunch presentation What can we learn about Sustainability from Developing Nation Governments?

“Alphabet soup” of Government of Canada planning

We often accuse the American government of having an incomprehensible list of acronyms. An “alphabet soup”. We’re falling behind in the acronym arms race in the Government of Canada. Consider the following set of planning and regulatory concepts:

• Strategic and Operating Review (SOR)
• Administrative Services Review (ASR)
• Federal Accountability Act (FAA)
• Financial Administration Act (FAA)
• Management Accountability Framework (MAF)
• Management Resources and Results Structure (MRRS)
• Program Activity Architecture (PAA)

The state-of-the-art of budget planning in the Federal Government includes strategic tools like MAF, MRRS and PAA that attempt to connect objectives with programs and performance. There is standard bottom-up budgeting to maintain existing programs. And, there are different review methods to cut expenditures: reviews looking for efficiencies, reviews to reconsider strategic priorities, reviews to cut costs. It’s difficult to “connect the dots” among these frameworks, structures, architectures and reviews. Even more difficult to connect government objectives with policy, budgets and outcomes across these frameworks, structures, architectures and reviews.

Sustainable planning in developing countries

“Medium term” planning is considered the best practice in developing countries. This is typically a rolling 3 year budget plan. This might sound a bit like the return to the 5 year plans used for central planning, primarily in Communist countries. Medium term planning uses rolling plans rather than separate 5 year discrete plans that operate in series.

The outcomes from government programs often take more than a fiscal year to accrue. Single year budget planning is too short a horizon to affect change. Results can be evaluated and programs adjusted to meet objectives. Medium term planning also takes into account multiple year commitments such as capital expenditures and subsequent recurrent costs. This introduces financial sustainability calculations into budget plans. Developing nations may receive grants for capital expenditures but may not have the operating budget to sustain those capital assets. Long-term financial implications become better understood to policy-makers.

Medium Term Expenditure Frameworks (MTEF) aligns economic realities with revenue and expenditures.

Peaks and valleys of government spending

The Government of Canada has fiscal space. We have a good credit rating and reputation for good fiscal management. The government debt to GDP ratio is manageable. Yet, it wasn’t that long ago that the Wall Street Journal referred to the Canadian dollar as the “peso of the north”.

Political realities often encourage short-term thinking. The focus on inputs: the amount spent in a particular riding or Province rather than long-term performance thinking. This short-term thinking can also result in creating financially unsustainable programs.

Short-term thinking often means not considering the real lifetime costs of major government initiatives. The current debate in Canada over the F-35 acquisition by the Royal Canadian Air Force has resulted in the fall of a government for “contempt of Parliament”. The press continues to torment the government about alleged underestimated budget miscalculation or deliberately misleading the House of Commons.

The emergence of a crisis such as the recent financial market melt-down can also introduce short-term cuts that cannot be sustained. For example, cuts to some programs may result in not meeting legal minimum levels of citizen services. So, spending increases in subsequent years. Cuts to other programs may result in high initial costs to dispose of property or for civil service severance.

Long-term financial sustainability is better achieved when fiscal sustainability is built into the process.

“Medium term” alphabet soup

There is no lack of acronyms for medium planning. Medium Term Expenditure Frameworks (MTEF) can consist of  MTMF, MTFF, MTBF, MTSS and MTPF. Governments apply some of these methods. The methods used typically depend on the government context, for example, countries with lower capacity will typically not use MTPFs. The methods are adapted for the country context – these are frameworks.

Frameworks link the economic realities (MTMF) to revenue and expenditure realities (MTFF) to budget planning (MTBF) to achieve objectives in multiple programs and sectors (MTSS) in the most effective ways (MTPF).

The advantages of this approach in a developed country like Canada include:

• Improved long-term planning
• Aligning government objectives and sector strategies across departments and agencies
• Exposing the impact of economic impact to revenue and results during the fiscal year and during planning
• Performance feedback loops that also show impact of economic changes on results
• Integration of economic factors in planning and performance factors directly into the Chart of Accounts

The big advantage of the MTEF approach is to integrate strategy and review into day-to-day management and periodic planning. The alignment of performance to economics will enable the Government of Canada to model the effects of any major economic change to performance results. To service delivery. The decision of where to cut expenditures with the least negative impact and optimizing positive impact becomes less of a mystery. And, less of a complex management exercise. That is easier to communicate to citizens.