(Originally published in September 2008 on the IMF's PFM Blog)
We often hear it said that medium-term expenditure ceilings for ministries or sectors are an essential part of good medium-term budgeting. Spending ministries, it is said, know what budget funding they will receive not only this year, but next year and the year after. The funding certainty this will give them will improve their planning and management, thereby boosting service delivery. Such increased funding certainty, the line runs, is the #1 objective of medium-term budgeting.
This is, with respect, wrong. Multi-year funding certainty for spending ministries is something which only the most advanced countries can aspire to. And while reduced funding uncertainty is a goal of medium-term budgeting, it is not the most fundamental goal.
Very few countries successfully set medium-term spending ministry budgets. This is because the preconditions for setting medium-term ceilings are very demanding, and include:
Excellent forward projections (estimates) of revenue and expenditure,
Reasonable macroeconomic stability,
A strong expenditure review and prioritization mechanism,
Sustainable aggregate fiscal policy settings.
Take the first point. Without a capacity to make excellent medium-term revenue forecasts, there is the danger that unrealistically high multi-year expenditure ceilings will be set. Down the track, when revenue turns out to be below-forecast, the government will be faced with the difficult choice between withdrawing its budget commitments to spending ministries or finding additional revenue.
It’s also worth looking closer at the third point. The UK is perhaps the most striking example of a country which has successfully implemented multi-year budgets for spending ministries. But in the UK’s case, these expenditure ceilings are set only after very thorough spending reviews. The detailed review and resetting of expenditure priorities which the Spending Review involves is possible only because the Treasury (finance ministry) has developed very strong policy and performance analysis skills, and is supported in its work by a system of performance information (indicators and evaluations) which is very well developed by international standards. This information and analytical basis took some decades to develop. Indeed, the move towards multi-year budgets in 1997 came after a long period of medium-term budgeting without multi-year expenditure ceilings.
Many—perhaps most—countries lack good mechanisms to scrutinize and reprioritize expenditure. The great danger is that without such processes, making medium-term budget commitments to spending ministries will simply increase expenditure inflexibility, and make it harder to reallocate spending over time to the areas where it is likely to deliver greatest benefits. With only limited capacity to review expenditure, the Ministry of Finance would find itself forced to recommend to the government multi-year ceilings largely based on the status quo rather than on critical analysis of the status quo. Under such circumstances, ministries which should have the budgets reduced could easily find themselves protected from scrutiny for a number of years at a time.
The preconditions for the adoption of multi-year ministry or sectoral budgets take considerable time to develop. As they develop, it is better to continue to determine ministry/sector budget allocations on an annual basis. This provides an opportunity to incrementally improve the prioritization of expenditure each year, using the gradually improving analytical capacity and information set which will be developed.
Some might object that to dispense with multi-year expenditure ceilings would be to rip the heart out of medium-term budgeting. But this is surely not true. The real essence of medium-term budgeting is something quite different. It is about improving the consistency of expenditure and revenue policies with fiscal policy. The key tool for this purpose is good forward estimates: that is, projections which indicate with a considerable degree of accuracy what the costs of current expenditure policies (and new initiatives) will be over the next three or four years, as well as the revenue which can be expected from the maintenance of current revenue policies. Such estimates indicate the aggregate fiscal outcomes—aggregate expenditure, total revenue, and the resultant deficit—which can be expected to result from current tax and spending policies. If these are inconsistent with fiscal targets, there will be a need to adjust current spending and/or tax policies or, possibly, the fiscal targets themselves. If, for example, the maintenance of current tax/spending policies will produce a deficit higher than targeted, then it will be necessary to do one or a combination of three things: cut spending, raise taxes or adjust the deficit target itself in the event that the forward estimates were to make it clear that the spending/tax policy changes required to meet it were not feasible. Such a process can certainly help to reduce the uncertainty which spending ministries face about future budget funding levels. But it is not one which gives them commitments about medium-term funding. Government retains the right to change next year’s projected funding if it needs to do so.
The #1 objective of medium-term budgeting, from this point of view, is not funding certainty. It is, rather, improved capacity to stick to sustainable fiscal policy.