(Originally posted 28 April 2010)
As countries move to restore their public finances in the wake of the financial crisis, firm control of aggregate expenditure has become more important than ever before. Part of this is ensuring that, after an aggregate expenditure ceiling is set, it is respected throughout the budget preparation process. This is what top-down budgeting seeks to achieve. In practice, however, it is not easy. The central difficulty is how to divide the aggregate expenditure ceiling into ministry ceilings. This is an issue that I will discuss in this and a series of subsequent blog pieces.
The simple version of top-down budgeting proposes that the division of the aggregate ceiling between ministries should be an entirely top-down process, decided by the center early in the budget process without any consideration of spending ministry claims. I have previously critiqued this approach as undesirable and, other than in the very short term, unworkable. It is an approach which in large measure ignores the importance, in setting ministry ceilings, of good expenditure prioritization. It assumes that the center is in a position to determine the optimal allocation of resources without hearing any spending ministry views – an assumption more characteristic of the Soviet planning mentality than modern budget practice.
It is also an approach which is inappropriate during significant fiscal consolidations. This is because it forces a quick and hasty decision at the start of the budget process on how to allocation cuts between spending ministries, encouraging recourse to the easy and arbitrary route of across-the-board cuts.
A much better approach is to conduct serious spending review during the budget preparation process in order to make the cuts as selective and discriminating as possible. Carefully targeting spending cuts will not only reduce their social impact, but also make fiscal consolidation more durable. It is during fiscal consolidations that spending review becomes most important, and it is a mistake to think that spending review can be effectively carried out entirely at, or prior to, the beginning of the budget process.
The challenge is how to design the budget preparation process so that it allows full scope for spending review while firmly respecting the aggregate ceiling. An effective solution to this – on which I’ll elaborate in later pieces – is a budget process based on two key principles. The first is the separation of decisions on net new spending – i.e. new spending initiatives and expenditure cuts – from decisions about baseline funding for continuing programs. The second is the imposition throughout the budget process of the constraint that net new spending must not exceed than the aggregate expenditure ceiling minus baseline funding.
Two points of clarification are worth making at this stage. Firstly, one should not equate the top-down budgeting aim of ensuring respect for the aggregate spending ceiling during the budget preparation process with the setting of an expenditure rules. Expenditure rules have been defined as “permanent limits on total, primary, or current spending in absolute terms, growth rates, or in percent of GDP”, although the term is also used by some to describe to the setting of multi-year quantitative aggregate ceilings in countries such as Sweden, Netherlands and Finland. Any country with an expenditure rule will clearly need to be able to ensure that the aggregate ceiling set by the rule is observed during the budget process. But even if there is no expenditure rule, and the aggregate expenditure target is subject to discretionary determination each year, it remains essential to be able to ensure that the target is respected during the budget preparation process.
Secondly, the principle that the aggregate ceiling set at the start of the budget process should be respected should not be interpreted as meaning that that ceiling is completely set in concrete. If, during the budget preparation process, macroeconomic forecasts change, it may be reasonable to make some modification to the aggregate ceiling. The key objective is to avoid the type of upward drift in aggregate expenditure during budget preparation which bottom-up budgeting tends to generate, as a result of the government decisions to accept new spending proposals which are inconsistent with the initial aggregate expenditure ceiling.