Expenditure Policy and

Reform
Module 10 – Public Finance
 Introduction
• Government expenditures comprises the outlays for everything
that government undertakes. While government involves a broad
array of activities, from spending programs to regulation,
expenditure policy has traditionally focused on spending
programs that affect aggregate demand and, over time, aggregate
supply.
 Rationales for Government Expenditure: A
Brief Review
• The main economic rationale for government activity is to provide goods
and services that private firms and households cannot be expected to
provide efficiently or in amounts commensurate with public demand. Thus, a
case can be made for governments to do the following:
1. Allocate public goods;
2. Stabilize the economy;
3. Establish a sound framework within which private markets can operate;
4. Address problems of information asymmetry; and
5. Address concerns about the distribution of income.
• ALLOCATE PUBLIC GOODS. Public goods are goods and
services that, by definition, are available to everyone if anyone has
them and whose consumption by one person does not diminish
consumption opportunities for others.
• Typical example include general security, an efficient and effective
legal system, and effective governance (lack of corruption and
effective government services).
• STABILIZE THE ECONOMY. Because private firms rarely benefit from
acting contrary to current trends in economic activity, only government can
effectively implement countercyclical monetary and fiscal policies.
• ESTABLISH A SOUND FRAMEWORK WITHIN WHICH
PRIVATE MARKETS CAN OPERATE. Because of the inherent
conflict of interest between private parties, only a disinterested third party,
such as government, can establish “rules of the game” to encourage optimal
levels of commerce. This includes the provision of effective means for
dispute resolution, such as courts and arbitration systems, and measures to
ensure effective competition, including the regulation of natural monopolies.
• ADDRESS PROBLEMS OF INFORMATION ASYMMETRY.
Because the financial sector, health care, and some other activities exhibit
adverse selection, moral hazard, and other market imperfections arising from
asymmetric information, it is essential that the government address the
consequent market failures through appropriate regulation of the financial
sector, health care, and other activities, such as food safety.
• ADDRESS CONCERNS ABOUT THE DISTRIBUTION
OF INCOME. Because markets inevitably lead to wide variances
in income, a case can be made to create a social safety net for the
poor, elderly, and disabled. Progressive income taxation, additional
income support, and taxing large inheritances and gifts can be
added, if desired, to address further distributional inequalities.
 Expenditure Levels and Composition- An
International Comparison
• To indicate the relative size of government activity in an economy, government
expenditure is typically measured as a share of gross domestic product (GDP).
However, it can also be measured as a share of gross national income (GNI), which
includes net income from abroad and can be useful for countries with large earnings
from overseas investments.
• In general, government expenditure in higher income economies exceeds that in
economies with lower per capita incomes. One reason is that higher income
countries have generally proved more successful in raising revenue, particularly for
social welfare programs such as state provided health insurance and pensions.
• Government tax laws, expenditure programs, and regulation all impose costs,
often substantial, on the private sector. These costs do not count as
government expenditures. Yet, they represent part of the “burden” of
government on an economy.
• For example, Government building codes impose additional costs on
contractors, businesses, and homeowners. Paying taxes and complying with
tax regulations also involve substantial amounts of time and expense for
firms and households.
 Main Categories of Government Expenditure

• The main components of government expenditure can

be classified in two (2) ways:
• Economically; and
• By function.
• The ECONOMIC classification of government expenditure identifies three broad types of
outlays:
• Current expenditure;
• Comprises outlays for wages and salaries (compensation of employees), purchases of other goods and services
(non-wage outlays for operations and maintenance), interest payments, and subsidies and transfers.
• Capital expenditure; and
• Comprises all outlays for long-term projects, such as infrastructure, and spending for military installations.
• Net lending.
• Represents net outlays – loans minus the repayment of principal – for government lending programs that serve
policy purposes.
• The FUNCTIONAL classification of government expenditure represents
the breakdown of government spending across program areas. Most
government budgets report planned and historical expenditure by function.
• A functional classification of expenditure typically includes outlays divided
among categories such as general public services (or public administration),
defense, public order and safety, economic affairs, environmental protection,
energy, commerce, agriculture, transportation, housing and community
amenities, health, education, social protection, foreign affairs, and recreation,
culture, and religion.
• Functional classifications will differ across countries, depending
on the nature of government programs and how their purposes
are viewed in the country.
 Issues Affecting Specific Categories of
Expenditure
• Wages and Salaries;
• Purchases of other goods and services;
• Subsidies and transfers;
• Interest expenditure; and
• Capital expenditure.
 Wages and Salaries
• In many countries, long-standing rules about tenure and the desire to make
government an employer of last resort have led to serious inefficiencies in
the government workforce.
• In some countries such as India, a non-trivial part of the government’s
employment budget goes to hire short-term employees for menial and low-
skilled positions. Although wage payments are small, the large number of
such workers causes significant fraction of the government’s wage bill to be
spent on such employees, adding expense and constraining the government’s
ability to hire more expensive, highly skilled workers for analytical, regulatory,
and policy positions.
• Many countries suffer from rigid employment structures and limited wage
scales that make it hard for governments to attract and retain highly skilled
workers for positions. Low wage scales also create incentives for bribery
among officials charged with law enforcement and regulation.
• When considering programs, governments need to remember their staffing
needs. Some flexibility in civil service arrangements will allow governments
to reallocate employees across programs and even ministries as programs and
policies change.
 Purchases of other goods and services
• Fiscally constrained governments often target purchases of other goods and
services for budget cuts, because of the difficulty of reducing government
employment. As a result, spending for operations and maintenance has often been
cut, at great cost to the quality of government services. Thus, countries need to
resist the urge to close fiscal gaps by cutting operations expenditure, as opposed to a
more general review of outlays to identify unproductive spending.
• Expenditures for maintenance pose similar challenges. Financially strapped
governments often find it attractive to defer maintenance. As a result, government
facilities deteriorate faster, and buildings and installations must be replaced more
often, usually at greater expense over the long run.
• Government procedures for purchasing present a third issue in this area. Despite
calls for reform, many countries continue to allow sole source contracts and select
contractors without competitive bidding to provide goods and services, often raising
costs and reducing quality. In addition, surveys suggest that bribery in public
procurement and other interactions with government is widespread in many
countries, especially in the developing world. Ensuring that competitive bidding
rules apply to government contracts can reduce opportunities for corruption, lower
costs, and improve the effectiveness of services.
• The resulting decline in corruption may also allow a reallocation of funds to
operations and maintenance, by reducing unproductive spending on public
investment projects.
 Subsidies and Transfers
• Subsidies and transfers can be provided in many ways. One option is for
government to produce and sell (or provide) goods and services directly, at a below-
market price, through state-owned enterprises. A subsidy also occurs if the
government provides the service at a cost-covering price lower than what a profit-
making private firm would have to charge.
• Alternatively, governments can provide subsidies or transfers for beneficiaries to
purchase goods and services produced by private firms. Subsidies can involve
rebates to consumers when they purchase specific items; payments to firms, on
condition that the items are sold at an approved price; and subsidies for loans,
typically payments to financial institutions that allow them to lend at lower interest
rates.
• Subsidies also result if the government provides funds to a public institution,
such as a university, that charges lower fees as a result.
• Subsidies can also involve tax expenditures, in the form of deductions from
taxable income or profits for specified expenditures or credits against tax
liability set at a specific percentage of qualifying expenditures.
• Ongoing programs that provide benefits to households or individuals
meeting certain conditions are called ENTITLEMENTS, because those
meeting the requirements are automatically eligible to receive benefits, if they
apply.
• Entitlement programs are an important part of the social safety net in many
high-income countries. However, planned benefit levels and inadequate
funding have made many of these entitlements a source of long-term fiscal
concern.
• A key issue for subsidy programs is choosing between consumer and
producer subsidies. CONSUMER SUBSIDIES benefit consumers directly,
while PRODUCER SUBSIDIES do so indirectly, lowering production
costs so that producers can sell an item more cheaply.
• Consumer subsidies directly reduce the price of a good or service, making it more
affordable. However, subsidies usually increase the demand for subsidize items.
• Producer subsidies are designed to make goods more affordable by lowering costs
to the producer, on the assumption that producers will pass their cost savings onto
consumers. A producer subsidy can be useful if the subsidized item is in short
supply. In this case, subsidizing consumers may only raise prices, rather than making
the good more accessible. A producer subsidy may also be useful if the goal is to
help specific producers, such as low-income farmers, provided that they can be
identified and other producers excluded.
• It is usually more efficient for governments to use consumer
rather than producer subsidies, if the goal is to benefit specific
groups of consumer.
 Interest Expenditure
• Governments must ensure that interest on public debt is paid, to
avoid default and keep financial markets willing to buy and hold
government securities.
• Special problems arise when debt is issued in foreign currency.
Interest on such debt bears currency risk, meaning that interest
payments in local currency can rise if the exchange rate
depreciates.
 Capital Expenditure
• Ideally, governments should reserve a substantial share of government spending for
capital expenditure, to ensure adequate infrastructure and public facilities to support
private sector activity.
• Rapidly growing countries typically devote at least 25% of GDP to investment, with
government investment in infrastructure, plus human capital development,
representing about one-third of that amount.
• To maximize the productivity of public investment spending, projects should be
selected using cost-benefit analysis to identify those with the greatest net present
value. Governments should beware of projects whose main value appears to be
political, for example, costly projects providing limited benefits to a small group of
people.
 Special Expenditure Issues
• Governments need to heed the following special expenditure
issues:
• Unproductive expenditure;
• Quasi-fiscal expenditures;
• Mandatory vs. discretionary expenditures
• Contingent expenditures; and
• Public-private partnerships.
 Unproductive Expenditure
• The IMF has defined UNPRODUCTIVE EXPENDITURE as the difference
between actual spending for a particular program, or category of good or service,
and the reduced amount of spending that would yield the same social benefit with
maximum cost-effectiveness.
• Activities falling under this include the following:
• Military expenditure that exceed a reasonable cost estimate for maintaining national security;
• Public investment projects with negative net present value;
• Poorly targeted subsidy programs;
• Prestige programs with few beneficiaries, such as a costly hospital in the capital city, that
crowd out expenditures benefiting a much larger population (e.g., rural health centers)
• Strategies are available to reduce unproductive expenditure. These
include the following:
• Changing the mix of programs within a category of expenditure;
• Imposing appropriate user charges;
• Ensuring an appropriate balance among complementary programs; and
• Focusing expenditures on the intended population.
• CHANGING THE MIX OF PROGRAMS WITHIN A CATEGORY
OF EXPENDITURE. For example, in many developing countries,
reallocating funds from universities to primary education will likely increase
the number of students benefitted and do more to address illiteracy. In
higher income countries, raising university tuitions and allocating the
resulting savings to need-based scholarships will focus educational benefits
more on low-income students.
• IMPOSING APPROPRIATE USER CHARGES. Imposing
modest tolls for bridges, tunnels, and expressways will help
allocate the costs for these infrastructure projects to their users.
However, governments should avoid imposing charges that would
preclude access to critical public services for low-income
households.
• ENSURING AN APPROPRIATE BALANCE AMONG
COMPLEMENTARY PROGRAMS. Where hunger and
malnutrition are prevalent, school breakfast or lunch programs
may be needed to ensure the effectiveness of public education.
Similarly, public health programs may be important to limit school
absences from contagions such as malaria and dengue fever.
• FOCUSING EXPENDITURE ON THE INTENDED
POPULATION. In most developing countries, a subsidy for bus
fares will aid low-income households more than fuel subsidies,
because high-income households represent the bulk of vehicle
owners.
 Quasi-fiscal Expenditure
• Quasi-fiscal expenditures are expenditures by off-budget public agencies
that look and functions like regular budgetary outlays. Being off-budget, they
are less transparent and far harder to control than regular budgetary outlays.
• Many quasi-fiscal activities take place at monetary authorities, in particular
central banks. Monetary authorities generally have funds available, because
they earn profits from many of their core activities*. Thus, monetary
authorities are an ideal place for governments to use in financing budget-like
activities without having to show the expenditures on the government
budget.
• Quasi-fiscal activities often imposed on monetary authorities
include the following:
• Lending to non-bank institutions;
• Providing exchange rate guarantees;
• Funding deposit guarantees; and
• Sterilizing capital inflows.
• LENDING TO NON-BANK INSTITUTIONS. Countries sometimes
force monetary authorities to lend to specific sectors or borrowers, often at
below-market interest rates. Such loans provide subsidies to the borrowers
and typically reduce the authorities’ profits. Thus, they diminish the funds
that monetary authorities can transfer to the budget.
• By favoring sectors or groups that may be less productive or profitable than
others in the economy, the loans may also distort the allocation of resources,
promote unviable activities, and ultimately lead to non-performing assets.
• PROVIDING EXCHANGE RATE GUARANTEES. When the exchange rate
depreciates, many importers who have ordered goods for domestic resale at fixed
prices may incur losses if contracts are honored at market exchange rates. Thus, the
monetary authority may face pressure to sell foreign exchange at a more favorable
(less depreciated) rate. Doing so amounts to an off-budget, non-transparent agree to
those participating in the program. If the authorities agree to provide unlimited
amounts of foreign exchange at this rate, the subsidy is also incontrollable.
• Exchange rate guarantees generally create losses for the monetary authority,
reducing its profits and thus the revenue it can transfer to the government budget.
• FUNDING DEPOSIT GUARANTEES. If a country does not have a formal
deposit insurance program, or if the program’s resources are insufficient, a
monetary authority may be asked to “bail out” depositors by covering their losses at
failing banks. If it does, the monetary authority provides a non-transparent, hard-to-
control subsidy to depositors that reduces its own profits and, thus, the revenues it
can provide to the government budget.
• As with a program of unlimited deposit insurance, funding deposit guarantees, or
serving as a back-up to an existing program, can create a moral hazard for the
banking system, because bankers no longer fear the consequences of bad loans that
can lead to bank failure.
• STERILIZING CAPITAL INFLOWS. Many monetary authorities try to
limit the impact of capital inflows on their economies through sterilization.
STERILIZATION involves selling government securities, or the authority’s
own securities, to commercial banks, to offset the impact of additional
foreign exchange on the money supply.
• Sterilization generally reduces the monetary authority’s profits and, thus, the
revenues it provides for the budget.
Mandatory vs. Discretionary Expenditures
• MANDATORY EXPENDITURES are outlays that are made
automatically, as a matter of law, without the need for appropriation or
legislative approval during the formal budget process.
• Entitlements represent the most common mandatory expenditure programs.
Similar programs include pensions for prior government employees and
certain subsidy programs that governments have committed to pay.
Discretionary expenditures, by comparison, must be approved each year,
allowing the government to set the level of spending as conditions warrant.
• Discretionary expenditures are easier to control than mandatory spending
programs.
 Contingent Expenditures
• CONTINGENT EXPENDITURES represent spending
obligations that arise if specific events happen. Contingent
expenditures include the following:
• Loan guarantees;
• Bank failures; and
• Catastrophe-related expenditures.
• To maintain control over the budget, governments should anticipate
contingent expenditures and constrain them where possible.
 Public-Private Partnerships
• PUBLIC-PRIVATE PARTNERSHIPS (PPPs) involve the use of private
firms to supply public infrastructure or infrastructure services. They offer
benefits similar to privatization, if successful, and can be considered
analogous, in the field of capital spending, to contracting out public services
such as waste management.
• PPPs appeal to many governments because they can reduce the cost for
providing infrastructure. They may also bring better service delivery, if the
private operator performs well.
• In many projects, a private contractor agrees to design, build, finance, and
operate a public facility, such as a highway or electricity plant, in return for
receiving operating income, although the government may contribute to
project financing. Often the contractor owns the facility for a specified
period and transfers ownership to the government at the end of the contract.
• While the government does not operate the facility, it bears ultimate
responsibility for substandard service. Thus, the government faces financial
risks form poor performance and from cost overruns.
END