Introduction

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.
Fragmentation is inevitable between the center and the line, between planners
and financial managers, between budgeting and implementation, and between
different types of spending. Over time, methods to deal with difficult choices,
complexity, and fragmentation have developed within budgeting systems. This
presentation provides a perspective on the problems of budgeting that different
methods and practices are designed to address and then discusses a number of
approaches that have developed over the past 30 years to address these
problems.

Nature of the problem

Tragedy of the commons
The tragedy of the commons is an economic theory of a situation within a
shared-resource system where individual users acting independently according
to their own self-interest behave contrary to the common good of all users by
depleting that resource through their collective action.
Whenever many spending units depend on one source of income, each
dependent unit will consider its own expenditure increases to be too small to
affect the total significantly and will feel free to pursue its own interests without
considering the effect of its actions on the source.
It is for this reason that constraints on the aggregate level of spending are
critical. Without such constraints, just adding together the total claims of
ministries to produce a budget would result in unsustainable deficits or tax
burdens.

Choosing among different claimants of funds

Choosing among the different claimants, however, introduces a whole separate
set of budgeting problems. There is not a single objective measure or reliable
objective methodology by which trade-offs can be made.
Politicians often make funding choices on the basis of what they believe will keep
them in office. In mature political systems, where the connection between public
policy, budgetary performance, and political survival is stronger, politicians make
choices that are based on their constituencies preferences. In countries where
this connection is weak, the budget shares for which politicians fight may have
more to do with power, political deal making, and access to resources than with
optimal policy outcomes related to stated country priorities. In these, budgeting
and spending outturns remain misaligned with stated priorities.

High transaction costs

Mapping expenditures to perceived preferences and getting feedback from civil
society on whether the mapping is true carry high transaction costs. The costs of
mapping, however, are not the only transaction costs associated with negotiating
trade-offs. Decisions about budgets are rarely made in a single office by a single
individual. Budget processes involve complex institutional arrangements for
sequenced and often collective decision making.

Information asymmetry
An important feature of budgeting in the public domain is that those who hold
the best information on spending programs are not those who decide whether
one program or another should be funded.
Spending agencies have better information on how best to allocate resources
within their sectors to achieve given objectives, but it is often not in their interest
to divulge this information in a competitive budgeting environment because
doing so means that they may get penalized. This information asymmetry is at
the root of many policy failures in government.

Satisficing
Traditionally, budgeting systems have coped with these problems by what is
called satisficing. Instead of evolving budgeting practices that meet these
problems head on to produce the best possible outcomes, budget decision
makers satisficethat is, they satisfy and suffice. Instead of maximizing, the
strategy is to behave in ways that allow the system to get by, come out all right,
and avoid the worst. Incremental line-item budgeting practices offer well-
established methods for satisficing within a time-delimited budget process.

Incremental Line-Item Budgeting

Incremental budgeting is budgeting based on slight changes from the preceding
period's budgeted results or actual results. This is a common approach in
businesses where management does not intend to spend a great deal of time
formulating budgets, or where it does not perceive any great need to conduct a
thorough re-evaluation of the business.

Advantages
Simplicity. The primary advantage is the simplicity of incremental
budgeting, being based on either recent results or a recent budget that
can be readily verified.
Funding stability. If a program requires funding for multiple years in order
to achieve a certain outcome, incremental budgeting is structured to
ensure that funds will keep flowing to the program.
Operational stability. This approach ensures that departments are
operated in a consistent and stable manner for long periods of time.

Disadvantages
Incremental in nature. It assumes only minor changes from the preceding
period, when in fact, there may be major structural changes that call for
much more significant budget changes.
 Fosters overspending. It fosters an attitude of "use it or lose it" in regard
to budgeted expenditures, since a drop in expenditures in one period will
be reflected in future periods, too.
Budget review. When the budget is carried forward with minor changes,
there tends to be little incentive to conduct a comprehensive review of the
budget, so that inefficiencies are automatically rolled into new budgets.
Variance from actual. When the incremental budget is based on a prior
budget, there tends to be a growing disconnect between the budget and
actual results.
Perpetuates resource allocations. If a certain amount of funds were
allocated to a specific program in a prior budget, then the incremental
budget assures that funding will be allocated there in the future, too -
even if it no longer needs as much funding, or if other areas require more
funding.
Less Risk taking. Since an incremental budget allocates most funds to the
same uses every year, it is difficult to obtain a large funding allocation to
direct at a new activity. Thus, incremental budgeting tends to foster a
conservative maintenance of the status quo and does not encourage risk
taking.

Incremental Budgeting Practices

in Developing Countries
Line-item incremental budget systems include an array of institutionalized
behaviors that detract from good budget outcomes. There are a number of
departmental strategies common to budget practices in these countries.
Although the research was conducted in the 1970s, practitioners will recognize
some, if not all, of the strategies as still part and parcel of practice today.

Always asking for more

First is the practice at line ministry level whereby budgeting means requesting
resources equal to what spending ministries perceive their real needs to beand
then some. Instead of budgeting being the practice of planning for available
resources, agencies perceive that there is always more money available and that
the initial budget ceiling they receive is merely a device to limit the number of
requests with which the ministry of finance has to contend.
Overstating needs and highlighting the unavoidability of expenses are well-
known strategies to guard against the impact of macroeconomic uncertainty. In
an incremental system, the informal rules of the game concern agencies
strategies to maximize their share in the budget pie, countered by the ministry of
finances strategies to bring requests down to manageable numbers and size.

Ritualistic cycles of padding and cutting

A classical strategy of agencies is to pad their requests on the assumption that
the ministry of finance is likely to affect cuts as a matter of course. Estimates are
rarely prepared well, with the result that the ministry of finance, lacking sufficient
information and, often, sufficient capacity to cut in a refined manner, resorts to
percentage decreases across spending agency budgets.
In an incremental system with ritualistic cycles of padding and cutting, spending
agencies that do not leave room for cuts disconcert their examiners. The larger
the request and the number of proposals, the more the ministry of finance can
cut while still giving a department additions to its previous total. A department
that submits a high number of projects is at an advantage because it is likely to
receive more.

Under-budget for high-priority expenditure

Agencies with superior information also routinely under-budget for high-priority
expenditure or for expenditure driven by legislative requirements. During the
spending year, ministries of finance have little choice but to provide provisional
funding to cover shortfalls. Another version of asking for less than what is
required occurs when spending agencies in an annual budget system provide low
first-year estimates of project costs. Once the project is approved, future-year
expenses are much higher, with the government committed to finishing what it
has started.

Industrial vs Developing Countries

Less information asymmetry
Finance ministries in industrial countries usually also have more accurate
information on what is being spent and what is required to fulfill policy
commitments, thereby putting them in a better position to penalize with
confidence when spending agencies inflate bids.

Prioritizing for wrong intentions

Typically, a lot of attention would be paid to the detail of relatively small items of
expenditure, often connected to development partners that bring in external
resources, while large expenditure issues remain unexamined. In practice,
priority setting in developing countries can be determined by the availability of
donor funds, rather than by overarching domestic priorities.

Changing nature of budgeting in

developing countries
New perceived purpose of budget
During the past three decades, budgets have ceased to be a complementary tool
whose primary functions are to deliver on governments financial objectives and
to ensure fiduciary accountability. Today there is a much better realization that
they are at the heart of policy-making and the only real avenue to translate a
countrys developmental goals into results. This realization has resulted in
several efforts to change budget methods and practices.
Change in relationship between government institutions
The relationship between finance ministries and spending agencies is a typical
agency problem, subject to the hidden information and hidden actions. The
prospect of using agents or spending ministries own self-interest to overcome
information asymmetry has generated new thinking about how to approach the
budget process. A combination of incentive alignment and the traditional
hierarchical coercive mechanisms of monitoring and sanctioning has become the
staple of many budget reform programs.

An idealized, rational policy-making process

An idealized, rational policy-making process consists of rational individuals and
institutions following sequential steps of establishing goals for solving problems,
exploring alternative strategies for reaching those goals, setting out the
significant consequences of each goal, and, finally, selecting the option that best
solves the problem or solves it at least cost.
The model centers on a set of simplifying and focusing stratagems that public
managers use to deal with complexity:

The analysis is limited to a few somewhat familiar policy alternatives,

which differ only marginally from the status quo.
Analysis of policy goals is intertwined with empirical aspects of the issue
at hand and with other implicit values.
A higher focus is placed on ills to be remedied than on positive goals.
A sequence of trials, errors, and revised trials takes place over several
budget years.
Analysis of consequences is limited.
The analytical world is fragmented among many partisan public policy
participants.

A series of innovative approaches to budgeting

Further analytical models were developed subsequently to describe the way in
which policy decisions are made, in practice the debate that the models sparked
on how public policy choices should be made resulted in a number of
experiments to change policymaking and budgeting methods, notably the
introduction of a planning-programming-budgeting (PPB) system and of zero-
based budgeting into federal-level budgeting in the United States.
Elsewhere, however, the idea that incentives and better information can improve
purely incremental budgeting practices produced a series of innovative
approaches to budgeting that focused on better information and alignment of
incentives. Modern budgeting systems (and reform programs to shift more
traditional systems) often include various elements of these approaches.
Beyond Incrementalism:
Rationality and Incentives in
Budget Methods
Program Budgeting Systems
Programming, or the subdivision of the government budget for information
purposes into programs and activities representing identifiable units with
similar aims or operations
Identifying the operational aims of each program and activity for the
budget year
Budgeting and accounting so that the separate costs and revenues of each
program are shown
Measuring the outputs and performance of activities so that these can be
related to the activities costs and to operational aims
Using the relevant data to establish standards and norms so that costs and
performance can be evaluated and government resources can be used
more efficiently.

Planning-Programming-
Budgeting System
1. Program memoranda describing the agencys strategy and comparing the cost
and effectiveness of major alternative programs
2. Special analytic studies that looked at selected current and long-term issues
3. Program and financial plans that summarized program choices in terms of
their outputs and costs over a five-year period.

Advantage and disadvantages of

PPB
One positive aspect of program budgeting approaches, including PPB, is the
recognition that public sector organizations are interdependent. PPB attempts to
bring clarity about the goals of government and seeks cost-effectiveness by
assessing various courses of action. A number of problems, including lack of
training, shortage of skills, inadequate phasing and too ambitious an application,
disillusionment with paperwork, and non-use of the information (or its use for
strengthened central control) contributed to the failures of these early forms of
program budgeting.
Zero-Based Budgeting
Advantages
In complete contrast to incremental budgets, zero-based budget systems
assume a zero base at the
the beginning of each budget cycle. All spending agencies are therefore required
to develop a fresh request for funding every year, which is based on a total cost
analysis for each program. Continuation of programs is not guaranteed. Such an
approach would, in principle, facilitate the discontinuation of programs that are
no longer required.

Disadvantages
First, like the PPB approach, it generates masses of paperwork for which there is
neither the time nor the human capacity in budgeting systems.
Second, it is not necessarily true that lower-priority programs will receive less
funding or be discontinued: the approach fails to take into account the realities of
institutional and public politics that drive budgets.
Third, some public policy areasfor example, those that are driven by legislation
do not lend themselves to dismantling and re-evaluation. In reality, most state
programs are not amenable to the annual evaluation, because even if they are
not required by legislation, they involve multiyear contractual relationships with
service providers, not to mention public officials.
And fourth, it is not self-evident what is maximized if zero-based budgeting is
adopted in its classical form.

New Public Management (NPM)

NPM approaches involve the targeting of organizational incentives to leverage
changes in how individual agencies budget and spend.
NPM is a set of broadly similar structural, organizational, and managerial
changes in public sectors. It shifts the emphasis from traditional public
administration to public management.
NPM involves the decentralization of responsibilities to lower organizational
levels, including the discretion to decide how funds will be spent and to account
for what was achieved with funds received.
By bringing the responsibility to budget closer to better information about
spending efficiency and effectiveness and by holding managers accountable for
results, NPM approaches to try to use the alignment of incentives to improve the
quality of spending decisions.
An NPM approach to budgeting includes reorganizing the budget into an output-
or product-based format or narrowly linking a traditional input-based format to
measurable targets.
Medium-term Expenditure
Framework (MTEF)
By providing a resource-constrained expenditure framework, MTEFs enable the
ministry of finance to engineer a budget process that sequences resource
allocation decisions such that spending agencies are more likely to be aware of
the real resource constraint, thus reducing the tragedy of the commons
problems.
By providing clear ceilings and resource allocation criteria to spending agencies,
MTEFs shift the burden of calculation to where there is better information.
An MTEF approach to budgeting provides a medium-term planning horizon and
should include a system for comparing the medium-term costs of competing
policies.
The expenditure framework is comprehensive when it includes all claims on
public fundsit facilitates a more comprehensive approach to budgeting.
Budgeting Methods to Expose
Choices on the Ground
Process-based mechanisms
The finance ministry seeks to point out the scope in ministerial budgets for
improvements in efficiency and effectiveness, while the spending agencies seek
to demonstrate that they are underfunded, given the level of services that are
demanded.
Finance ministries often depend on reputational effects to make this system
work: spending agencies may choose to cooperate when they will benefit over
time from building a reputation for approaching budgeting in a constructive way.
For example, spending agencies may find that if they cooperate in years when
more savings are required, they will benefit in years when more money is
available.
Finance ministries also often depend on shame-and-blame effects: if a spending
ministry and its political head are made to look bad in an early bidding meeting,
other ministries may want to avoid such treatment by preparing themselves
better.
A thorough bidding process facilitates appraisal of all spending programs over
time because ministries are required not only to defend their new spending
proposals but also to explain why they could not generate more savings from
within their own budgets to fund the spending proposals.
Under such a system, too much attention is given to scoring points rather than
cooperating to develop quality policies and spending programs. Ultimately, the
debate under such a system reverts to a discussion about inputs, rather than
outputs or outcomes.

Information-based mechanisms
Public Expenditure Review (PER)
PERs involve examining ministerial programs and activities in line with the core
functions of the ministry and identifying problems of effectiveness and efficiency
in expenditure management.
PERs that are conducted jointly by the finance ministry and line ministries
encourage honesty in the budget process and build consensus on expenditure
issues that need to be addressed and on the impact of such issues on forwarding
budgets.
PERs also have an internal function in helping ministries to link budgets and
operational performance to their policies and priorities.
Activity Based Costing
Spending agencies identify their objectives (or the changes they seek to effect in
the real world) and set outputs (or deliverables) for each objective.
The next step is simply to identify what activities will deliver each output and its
associated inputs. Inputs are required to be broken down into quantities and
frequency.

Spending Baselines, New Policy Proposals & Savings

Budgeting
Agencies are requested to first indicate their spending baseline in their
submissionnamely, the cost estimate of existing programs, including cost
escalations such as inflation and improved conditions of services for public sector
employees.
Agencies are then requested to detail proposed new spending initiatives, such as
new programs or changes in the coverage or level of existing services. This is the
new policy proposal base.
The savings base is the sum of proposed spending reductions achieved by
introducing efficiency savings, reducing service levels in lower priority programs,
or discontinuing obsolete activities.
By requesting that departments detail how they will fund their new spending
priorities from within their existing budgets before granting requests for
additional funding, the system permits the government to reprioritize spending
over time and to focus on the decisions that must be made to fund priorities
within the limit of what can be afforded.
Conclusion
The introduction of new rules for budget processes and methods does not
automatically mean that they will be applied in a meaningful way.
Budget systems of developing countries are littered with the remnants of earlier
efforts to introduce new techniques into the system.
The effectiveness of budgeting rules depends on their credibility. Their credibility
depends on several preconditions, including a capable and committed ministry of
finance, political support, and the presence of complementary reforms.
It is important to understand that budgetary reforms do not by themselves
change the fundamentally political nature of budgeting.
Budgeting practice, as it has evolved over the past few decades, has sought a
balance between the costs of incremental budgets and the improbability of
achieving comprehensive, rationale-based budgeting.