Budgeting of investments

Eivind TandbergBrasilia

April 25, 2005

April 25, 2005

Overview Why is it difficult to budget

government investments? Common problems Objectives and priorities Budget process and timetable Roles of different institutions Key budget process issues Summary of recommendations

April 25, 2005

Why is it difficult to budget government investments?

Time consistency problems Budgets have short-term focus

Valuation of benefits No market prices Demand side uncertain

High preparation costs Trade-off quality and cost

Complex process and organization

April 25, 2005

Common problems I Budget management focuses on crises and short

term decisions. Imbalances between current and capital costs in the budget.

Timing of investment planning is poorly matched with the budget process

Separate budgets for current and capital spending Sometimes managed by different ministries

Investment proposals inadequately developed Difficult to ensure that most productive projects are realized

No clear decision process Decision process does not reward good project design.

April 25, 2005

Common problems II Decisions mainly based on first-year budget

impacts Incentives to adjust implementation plans

Cost estimates change as project progresses Incentives to under-estimate initial costs Incentives to over-estimate initial costs

Operating costs are under-budgeted Maintenance costs for existing capital are

under-budgeted Investment projects disproportionately targeted

for budget cuts Yield significant cuts through single decisions

April 25, 2005

Budget management objectives

Objective Short term focus Medium-term focus

Cost-effective service delivery

Cost minimization Modernization

Efficient allocation Static efficiency Dynamic efficiency

Fiscal control Ex-ante controlsTransaction controls

Ex-post accountabilityAggregate controls

April 25, 2005

Budget time perspective General agreement (?):

Medium-term perspective most appropriate Budget system should not only promote fiscal control, but

also efficient resource allocation and cost-effective service delivery

This agreement is often not reflected in practices! Continued overwhelming focus on annual budgets Medium-term budgets often ritualistic

Often result of difficult economic circumstances Countries in fiscal crisis must handle immediate problems Attempts to introduce advanced reforms can be counter-

productive More stable countries are in better position to

introduce medium-term budgets and emphasize performance

April 25, 2005

Medium-term budget frameworksKey elements

Clear fiscal policy statement Medium-term macroeconomic forecast Realistic revenue estimates for the plan period Estimates of expenditures beyond the budget

year All multi-year projects reflected Formal status to “forward” estimates Basis for preparation of following year’s

budget Figures for individual ministries become hard

budget constraints in cash terms

April 25, 2005

Budget management process Investment planning process

Budget year – 2

Develop new projects

Budget year – 1

January Roll over MTBF for existing policies, projects

Update capital estimates

February Macroeconomic framework Screening of new proposals

March Update MTBF

April Cabinet budget meeting I:Decisions on MTBF, room fornew initiatives and projects,ministry spending envelopes

Decide on which projects to putforward to Cabinet

May External quality assurance

Budget timetable I

April 25, 2005

Budget management process Investment planning process

June Cabinet budget meeting II:Decisions on new initiatives and investment projects

July Update estimates:- Capital and operating costs for new investments- Capital and operating costs for ongoing investments- Maintenance costs

August Detailed budget proposals

September Cabinet budget meeting III:Decisions on detailed budgetsDecisions on guarantees

October Budget to Parliament

December Budget approved Detailed implementation plans

Budget timetable II

April 25, 2005

Budget management process Investment planning process

Budget year

January - Execute budget Implement investment projects

July Mid-year budget review Update estimates:- Capital and operating costs for new investments- Capital and operating costs for ongoing investments- Maintenance costs for other capital

December Year-end technical adjustments

Determine carry-over to next budget year

Budget timetable III

April 25, 2005

Institutional responsibilities

MOF and planning ministries Separate current and capital budgets? Fragmentation, coordination problems Largely abandoned in OECD countries

The role of the Cabinet Separate technical and political considerations MOF manages the technical process Cabinet takes political decisions Increases the legitimacy and credibility of the

budget

April 25, 2005

Analysis of proposals Investment proposals are inadequately analyzed

Missing or inadequate standards Standards not properly enforced. Political pressure, “urgency”

First-best: refuse to consider non-compliant projects

Enforceable? May be legitimate need for exceptional procedures

Clear exceptional procedures Limit as much as possible Same decision-making mechanism as other projects Covered by same budget allocation

April 25, 2005

Partly user-financed projects

Full user financing, no state guarantee or other fiscal risk – outside budget

Partially funded off-budget - subject to same requirements for development, costing and analysis as other projects (Most PPPs)

Decisions should follow same procedures and timetable as other projects

Budget decisions based on budget impacts over project life-time

Budget documents should also disclose total costs, financing modalities and fiscal risks

Explicit or implicit guarantees related to project subject to same decision-making and disclosure requirements as other state guarantees.

April 25, 2005

Decision criteria for investments

As part of the MTBF, cabinet decides on aggregate allocations for new policy initiatives and investments

Covers whole MTBF period Line ministries put forward proposals to be

financed within this allocation Pre-screening to ensure quality and realistic volume Disclose budget impacts beyond MTBF period

Following cabinet decision on which projects to finance, line ministries incorporate the detailed cost estimates in their draft budgets

Multi-year appropriation for major projects Competition improves quality of decisions

April 25, 2005

Cost estimates Cost increases absorbed in annual budget

updates Incentives to under-estimate initial costs Make line ministries responsible for cost overruns Real reduction in other costs not extension of

investment period. Cost reductions reallocated to other activities

Incentives for efficient project implementation Also incentives to over-estimate initial costs Allow ministries to retain part of cost reductions

Changes in rational implementation pace Allow limited carry-over/”borrowing” between years

April 25, 2005

Operating and maintenance costs

Operating costs for new projects under-budgeted

Required detailed disclosure of expected operating costs Indicate how accommodated or financed Condition for consideration of project

Under-budgeting of maintenance costs for existing capital also persistent

Limited incentives to maintain “political” projects Ensure that all projects have clear net value Require plan for financing long-term maintenance costs

at the time of approval Sufficient maintenance financing for existing capital

could be condition for new investment proposals

April 25, 2005

Budget amendments Investment projects highly susceptible to budget

cuts Large, discrete budget components Significant budget reductions through single decisions

Can seem reasonable in the short-term Over time: under-funding of investment and maintenance Given very real needs for budget adjustments, no simple

solutions MTBF provides basis for realistic assessment of

implications Cut in maintenance costs or delay in investments

provides temporary respite Other budget cuts may yield permanent improvement

April 25, 2005

Conclusions I Medium- to long-term time perspective Medium-term budget framework (MTBF) Credible annual budget process requires time Budget timetable with clear phasing MOF full responsibility for managing budget

preparation Cabinet responsible for political decisions Clear standards for investment planning Exceptional procedures close to general

standards MTBF should include allocations for new policy

initiatives and investments

April 25, 2005

Conclusions II Mechanisms for pre-screening and prioritization of

proposals to balance proposals and available funds Partially funded projects subject to same

requirements as other projects. Decisions based on net impacts over life-time Full disclosure of total costs and risks

Costs and benefits of approved projects disclosed in budget material

Incentives to prepare realistic cost estimates and implement projects efficiently

Cost overruns covered by real reductions in existing budgets

Cost reductions can be (partly) reallocated to other activities.

April 25, 2005

Conclusions III Multi-year appropriations for major investments

Full costs reflected in MTBF and the budget Hold ministries accountable for implementation

Mechanisms for carry-over and “borrowing” Can improve the quality of investment budget

management Investment project proposals should include a detailed

disclosure of expected operating costs and indicate how these will be financed.

MTBF specification of maintenance of existing capital

Condition for making new investment proposals. MTBF basis for assessment of budget cuts