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CENTRAL PHILIPPINE UNIVERSITY

COLLEGE OF BUSINESS AND ACCOUNTANCY
Iloilo City, Philippines 5000
Tel. No. (63-33) 3307262 / 3307264
Website: http://www.cpu.edu.ph | Email: businessad@cpu.edu.ph
Academic Year 2024-2025
First Semester

FIN 4014 (PUBLIC FINANCE & GOVERNMENT PROCUREMENT)

LECTURE NOTES
Chapter 7 – Expenditure Policy and Reform
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Government expenditures include all expenditures for government activities. While
government encompasses a wide range of activities, from spending programs to
regulation, conventional expenditure policy has concentrated on spending programs
that impact aggregate demand and, eventually, aggregate supply.

Rationales for Government Expenditure:

Main Economic Rationale: To provide goods and services that private firms and
households cannot be expected to provide efficiently, or in amounts commensurate with
public demand.
What does a government do? The aforementioned problems contribute to the
justification of a vast array of government operations, including monetary, fiscal, and
regulatory policy as well as several particular expenditure initiatives.
Allocate public goods.
Public goods are goods and services that, by definition, are available to everyone
if anyone has them. Typical examples include general security, an efficient and
effective legal system, public health services, 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 policy.
Establish a sound framework within which private markets can operate.
Because of inherent conflicts 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

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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, government
(as a party charged with representing the “public interest”) is needed to address
the consequent market failures through appropriate regulation of the financial
sector 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 and taxing large inheritances and gifts can be added, if desired,
to address further distributional inequities.
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 (factor) income from abroad and can be useful for countries with large
earnings from overseas investments.
Whether measured as a percentage of GDP or GNI, government expenditure varies
considerably among countries. In general, government expenditure in high income
countries exceeds that in countries with lower incomes per capita.
Reason:
1. Higher-income countries have generally proved more successful in raising revenue,
particularly for social welfare programs such as state-provided health insurance and
pensions. Nevertheless, expenditure levels differ considerably among high-income
countries.
2. The composition of government expenditure also differs considerably across
countries, even within the same region. Countries also differed in the extent of their
subsidy programs.
3. Research offers no advice on the optimum size of government expenditure as a
percentage of GDP. The size of government depends heavily on the ability and
willingness of countries to finance government through tax and non-tax revenues.
4. Governments must ensure that higher spending during emergencies, such as wars
and severe economic recession, do not lead to permanently higher spending.

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5. When considering government expenditure, less visible forms of spending must also
be considered.
6. Quasi-fiscal expenditures represent still another form of hidden government outlays.
Quasi-fiscal expenditures are expenditures by off budget public agencies that look and
function like regular budgetary outlays.
7. Government tax laws, expenditure programs, and regulation all impose costs, often
substantial, on the private sector.
8. Many expenditure programs contain hidden taxes, in the form of reducing benefits as
income rises.
Main Categories of Government Expenditure
The main components of government expenditure can be classified in two ways:
economically, and by function.
Economic Function three broad types of outlays: (1986 Manual on Government Finance
Statistics)
1. current expenditure,
2. capital expenditure, and
3. net lending (which represents net outlays — loans minus the repayment of
principal — for government lending programs that serve policy purposes).
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.
Military outlays are usually included in current expenditure, except for identified
outlays for military bases.
Capital expenditure comprises all outlays for long-term projects, such as
infrastructure, and spending for military installations (but not weapons or
armaments).
The 2001 Government Finance Statistics Manual classifies most government
outlays as either part of “Expense” or as “Net Acquisition of Nonfinancial Assets.”
The main categories of Expense, which resembles current expenditure under the
1986 classification, comprise compensation of employees, the use of goods and
services, interest, subsidies, grants, social benefits (which together were similar
to “transfers” under the 1986 classification), and other expense.
Expense includes the depreciation of government assets, called “consumption of
fixed capital.”

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Functional
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 (or police and fire services at the sub-national level), 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

1. 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.
Examples:
a. In India, a non-trivial part of the government's employment
budget goes to hire short-term employees (sometimes called “day
workers”) for menial and low-skilled positions and the large number
of such workers causes a 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.
b. Mauritania during the early to mid-1980s, have guaranteed
government jobs to university graduates that loaded government
payrolls with highly educated but not always useful employees.
Many university graduates had degrees in the humanities that did
not equip them with the quantitative and technical skills needed for
high-level government positions.
Besides job guarantee programs, many countries suffer from rigid
employment structures and limited wage scales that make it hard
governments to attract and retain highly skilled workers for positions in
which the government competes with the private sector.

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Frequently government wage scales limit salaries for such positions as tax
attorneys and bank examiners, making it hard for government to retain
talented and experienced workers.
Example: Similarly, in the United States many business economists
start their careers at the Federal Reserve Board and are then hired
away, at much higher salaries, by investment banks.
Low wage scales also create incentives for bribery among officials
charged with law enforcement and regulation.
Example: Singapore has established unusually high salaries for
ministers and senior civil servants. The salaries for ministers are
typically set at a certain percentage of the average core earned
income of the top four earners in six professions: accounting,
banking, engineering, law, local manufacturing firms, and
multinational corporations, following the recommendation in a White
Paper issued in 1994. Senior civil servants also receive unusually
high salaries.
When considering programs, governments need to remember their
staffing needs. Governments must take into account the changing mix of
skill needs among civil servants.
Accordingly, governments have had to adjust the composition of
employees, expanding the number of bank examiners and skilled financial
regulators while reducing positions for less essential staff.
2. 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 reduced, at great cost to the quality of
government services.
Examples: Many developing countries have endured schools with
teachers but too few textbooks and health centers with nurses but
shortages of medicines and other equipment.
In some countries major reductions in malaria have resulted not
from government programs, but from the massive distribution of
mosquito nets by nongovernment organizations financed by foreign
aid and charitable contributions from high-income countries.
Expenditures for maintenance pose similar challenges. Financially-
strapped governments often find it attractive to defer maintenance
expenditure. As a result, government facilities deteriorate faster, and

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buildings and installations must be replaced more often, usually at greater

expense over the long run.
Examples: Many developing countries have sizable numbers of
schools, highways, and hospitals that have deteriorated
substantially, as a result of deferred maintenance.
Similar problems plague some high-income countries, including the
United States, where a large share of highways and bridges has
been classified as deficient — nearly 27 percent in 2004.
Inadequate maintenance has led to dramatic events, such as the
collapse of a major bridge spanning the Mississippi River in
Minnesota during 2007 and the earlier collapse of abridge along the
Connecticut Turnpike in the Northeast.
Government procedures for purchasing comprise 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.
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.
3. Subsidies and Transfers
Subsidies and transfers can be provided in many ways:
a. for government to produce and sell (or provide) goods and
services directly, at a below-market price, through state-owned
enterprises.
b. governments can provide subsidies or transfers for beneficiaries
to purchase goods and services produced by private firms.
c. if the government provides funds to a public institution, such as a
university, that charges lower fees as a result.
d. 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.
Subsidy and transfer programs can also involve one-time or continuing
measures.

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Examples: Many countries provide continuing subsidies for

selected food items or gasoline (“petrol”) and tax subsidies for
contributions made to approved charitable organizations.
The United States enacted a tax credit for energy-saving home
improvements set to expire at end- 2010, which triggered extensive
purchases of replacement windows and more energy efficient
furnaces and air conditioners during the last half of 2010.
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.
3.1. Consumer versus producer subsidies
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 subsidized items.

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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
• if the goal is to help specific producers, such as low-income
farmers, provided that they can be identified and other producers
excluded
Unless aggregate demand rises as a result, however, the producer
subsidy will likely lead to a reallocation of resources toward producing
the subsidized item, and away from producing other items.
Although targeting subsidies is always difficult, it is probably easier to
target consumer subsidies on the intended beneficiaries. Governments
can limit access to those who are issued special identification cards, or
to households and individuals that can prove qualifying income.
3.2. General issues in subsidy design
When developing subsidy programs, governments need to address
the following issues:
a. Whether to provide subsidies explicitly or implicitly (for example,
through government provision and supply).
b. Whether and how to target benefits.
c. How to set the duration of the program.
d. How to finance the program.
e. How to increase transparency and controllability.
f. How to minimize distortions created by subsidies.

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4. 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.
5. 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.
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.
Special Expenditure Issues
Governments need to heed the following special expenditure issues:
1. Unproductive expenditure
Government budgets in many countries include sizable amounts of
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 heading include the following:
a. military expenditure that exceeds a reasonable cost estimate for
maintaining national security;
b. public investment projects with negative net present value;
c. poorly targeted subsidy programs;
d. 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).
Unproductive expenditure includes both capital and current outlays, and
capital projects are not always more productive than current expenditure.
Unproductive expenditure can be very costly.

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In addition to reducing poorly targeted subsidies, other strategies are

available to reduce unproductive expenditure. These include:
a. Changing the mix of programs within a category of expenditure.
b. Imposing appropriate user charges.
c. Ensuring an appropriate balance among complementary
programs.
d. Focusing expenditures on the intended population.
2. Quasi-fiscal expenditure
Quasi-fiscal expenditures are expenditures by off-budget public agencies
that look and function 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.
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:
a. Lending to non-bank institutions.
b. Providing exchange rate guarantees.
c. Funding deposit guarantees.
d. Sterilizing capital inflows.
3. Mandatory vs. Discretionary expenditures
Mandatory expenditures are outlays that are made automatically, as a
matter of law, without need for appropriation or legislative approval during
the formal budget process.
Entitlements represent the most common mandatory expenditure
programs.
Discretionary expenditures, by comparison, must be approved each year,
allowing the government to set the level of spending as conditions
warrant.
By definition, discretionary expenditures are easier to control than
mandatory spending programs.

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Governments should carefully monitor and consider limiting entitlement

programs and other mandatory expenditures.
4. Contingent expenditures
Contingent expenditures represent spending obligations that arise if
specific events happen.
Contingent expenditures include the following:
a. Loan guarantees.
b. Bank failures.
c. Catastrophe-related expenditures.
Contingent expenditures also include future outlays triggered by
foreseeable events.
Example: certain age-related expenditures, such as rising outlays
for health care and public pension programs, can be considered
contingent expenditures, because they will materialize as the
population ages.
To maintain control over the budget, governments should anticipate
contingent expenditures and limit them where possible.
For example:
a. Loan guarantees should be limited to the most creditworthy
borrowers and used only for projects with a clear public purpose.
This could mean, for example, restricting loan guarantees to public
enterprises, and then only for investments that the government has
approved.
b. Programs should avoid incentives for early retirement, which can
impose long and costly expenditure obligations. Thus, programs
allowing miners or military officers to retire after a fixed period of
service, such as 20 years, regardless of age, deserve careful
scrutiny.
c. Retirement programs should not allow women to retire at a
younger age than men. Because women typically live longer than
men, such provisions inflate the cost of pension programs.
d. Governments should avoid implicit guarantees for bank deposits
and limit explicit insurance to the deposits of small savers, to avoid
encouraging banks from undertaking risky behavior.

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5. Public-Private Partnerships
Public-private partnerships (PPPs) involve the use of private firms to
supply public infrastructure or infrastructure services.
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.
Research indicates that PPPs can prove beneficial under certain
conditions. These include:
1. the ability to contract for service quality;
2. the ability to transfer a significant share of risks to the private
operator;
3. the existence of incentive-based regulations or competition;
4. a strong institutional and legal framework;
5. sufficient technical expertise in government to oversee such
contracts; and
6. satisfactory disclosure of PPP commitments and any related
government guarantees, in government financial statements (and in
debt sustainability analyses).
PPPs can also be advantageous if they allow the government to benefit
from the resources, technology, managerial skills, and access to credit
that a private contractor can offer.
PPPs have risks. For the public sector, these include the government's
ability to use a PPP to bypass spending controls and move spending off
budget; problems with accounting for PPP spending; and the difficulty of
developing and maintaining adequate control procedures over PPP
decision-making and PPP projects, because of their technical nature. For
the private contractor, a variety of political, economic, and financial risks
can arise.
Governments should recognize that PPPs, rather than being a panacea,
raise many challenging issues.

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Tools for Controlling Expenditure

Governments have many resources to help control expenditure and achieve fiscal
objectives.
1. General Management Tools
Governments can control spending more effectively with more comprehensive
information about fiscal activities.
Governments should:
A. Consolidate fiscal accounts to the extent possible
This includes:
a. monitoring off-budget as well as regular budgetary operations; including
in the budget the activities of any special funds, such as trust funds for
road construction and public pension programs; and
b. maintaining estimates of tax expenditures, quasi-fiscal operations, and
contingent liabilities.
B. Use effective budgeting procedures and expenditure control systems
Governments need formal budget procedures.
In addition, many countries have found that fiscal rules limiting the size of
the budget deficit or “pay go” rules that require the cost of new programs
to be covered by offsetting revenue increases or cuts in other spending
help contain total expenditures.
Performance budgeting
➢ involves setting broad goals and assessing how well particular
programs achieve them
➢ this approach works only when policy-makers view the budget in
terms of broad policy objectives, have tools to identify ineffective
and low-priority programs, and are willing to change or abandon
them in favor of other programs that better meet spending priorities
Zero-Based budgeting
➢ can also be useful if policy-makers are willing to terminate
programs that are shown to be unproductive, under which sending
for each program must be “justified anew” in the budget cycle,
rather than simply reviewing requests for additional outlays

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Having a budget office with evaluation capability – can also help restrain
expenditure along with some control over the spending of other agencies
2. “Rules of Thumb” that can help control expenditure; fiscal space
Certain “rules of thumb” can also help with expenditure control.
For example:
Governments should avoid converting discretionary spending into
mandatory programs.
➢ This will help maintain adaptability and allow outdated programs to
be phased out in favor of new activities better attuned to current
priorities.
➢ If expenditure commitments do not rise over time, the natural
tendency for revenues to rise in a growing economy will provide
room for the government to finance new activities.
➢ This, in turn, underscores the importance of maintaining fiscal
space in the budget.
Fiscal space
➢ “availability of budget resources to finance worthwhile activities without
prejudicing the government's financial position.”
➢ Assessing fiscal space requires reviewing the budget, to see what room is
available for new programs. This involves taking account of their medium-
term, as well as immediate, costs and consequences.
➢ Fiscal space can be created through a combination of revenue increases
and cuts in existing, low-priority programs.
➢ Debt relief can also provide fiscal space, and many low-income countries
have obtained fiscal space for new health care, education, and
infrastructure programs by using debt relief from bilateral donors and
international organizations.
3. Short-term measures to improve expenditure control
In the short-term, governments have several ways to curb outlays and improve
control over outlays.
a. Marginal services can be cut, to protect core functions of an
expenditure program.
b. Similar programs can be consolidated, to achieve economies of scale.
c. Appropriate fees can be imposed for activities that are currently free, or
for which fees have not kept pace with inflation.

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d. The government can require co-financing for certain activities, to help

reduce budget outlays.
e. The government can improve the targeting of benefits for specific
programs, where feasible.
f. Governments can postpone less essential capital projects while
preserving spending to maintain existing facilities.
4. More fundamental expenditure reforms
Besides the above measures, more fundamental reforms can be used to improve
expenditure control.
a. Adopting a medium-term budgeting framework.
One strategy many countries have taken involves adopting a medium-term
budget framework (MTBF). An MBFT establishes medium-term objectives
for fiscal policy and uses those as a way of guiding annual budgets and
the choice of specific spending programs.
The main feature of a MTBF is that annual budget preparation is carried
out within a framework which takes into account the resources expected to
be available to the government over the medium term.
The main objectives of the MTBF are to:
➢ Strengthen fiscal discipline, by creating an orderly framework for
management of the annual budget over the medium term;
➢ Strengthen the allocation of federal resources to the government's
strategic priorities;
➢ Improve operational efficiency, by strengthening the capacity of
federal line ministries to prepare and manage their budgets
effectively.
b. Privatizing certain activities.
A second strategy involves privatizing activities for which government
management or operation offers no comparative advantage.
c. Reviewing pay and employment policy.
A third strategy involves a more thorough review of government pay and
employment policy.

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