1. Reform to Budget Institutions in Latin America Carlos Scartascini Senior Research Economist Inter-American Development Bank An Introduction to the Open Budget Initiative The International Budget Project Washington, DC - May 29 th, 2007 Opinions expressed in this presentation do not necessarily reflect the view of Bank management or member countries.

2. The Budget Process The budget is the main tool for allocating scarce public resources. The budget is the main tool for allocating scarce public resources. The budget process is the arena where decisions regarding the use of public funds take place, where society faces trade-offs regarding the use of its resources and (ideally) allocates them to their most efficient uses. The budget process is the arena where decisions regarding the use of public funds take place, where society faces trade-offs regarding the use of its resources and (ideally) allocates them to their most efficient uses.

3. APPROVAL LEGISLATIV O Legislative Branch Executive Branch DRAFTING Executive Branch Finance Ministry Line Ministries Legislative Branch Finance Ministry EXECUTION & CONTROL The Budget Process Budget Project Approved Budget Line Ministries Executive Branch Legislative Branch Control Entities Executed Budget Changes

4. The Budget Process Budget decisions are the result of a collective process involving a variety of political actors, each with their own motivations and incentives. Budget decisions are the result of a collective process involving a variety of political actors, each with their own motivations and incentives. –For example, legislators could have the incentive to bring benefits to their district to increase their chance of reelection. –Finance Ministers could be interested in keeping expenditures under control. –Line Ministers could be interested in fostering public projects in their area of domain. –Interest groups could lobby for obtaining transfers from government.

5. The Budget Process Given the prevailing preferences of the participants, under some institutional arrangements, the budget process may lead to a number of potential problems Given the prevailing preferences of the participants, under some institutional arrangements, the budget process may lead to a number of potential problems Electoral budget cycles Electoral budget cycles Short time horizon of politicians Short time horizon of politicians Principal-agent problems (private benefits of those who participate in the process) Principal-agent problems (private benefits of those who participate in the process) The common pool problem The common pool problem

6. The Common Pool Problem Stems from combination of two key features of public budgets: Stems from combination of two key features of public budgets:  Government programs generate concentrated benefits, but are financed from common pool of resources.  The budget is the result of a collective decision-making process, involving a variety of agents (legislators, the finance minister, spending ministers, etc.) Since most of these agents represent geographical or sectoral interests, under some institutional arrangements the budget process may lead to over- utilization of the common pool, thus to excessive spending or deficits. Since most of these agents represent geographical or sectoral interests, under some institutional arrangements the budget process may lead to over- utilization of the common pool, thus to excessive spending or deficits.

7. The Role of Budget Institutions The way the actors interact in the budget process is affected by the nature of budget institutions, which impose restrictions on their actions, and define the rules of engagement among them. The way the actors interact in the budget process is affected by the nature of budget institutions, which impose restrictions on their actions, and define the rules of engagement among them. Budget Institutions are the set of rules, procedures and practices according to which budgets are drafted, approved and implemented (Alesina and Perotti, 1996). Budget Institutions are the set of rules, procedures and practices according to which budgets are drafted, approved and implemented (Alesina and Perotti, 1996). These rules may take various forms, like numerical rules, procedural rules, and transparency rules. These rules may take various forms, like numerical rules, procedural rules, and transparency rules.

8. The Role of Budget Institutions Numerical rules: laws and/or regulations which establish ex ante constraints on deficits, debt, and/or expenditures. They may be conducive to fiscal discipline by forcing agents to internalize the budget restriction. Numerical rules: laws and/or regulations which establish ex ante constraints on deficits, debt, and/or expenditures. They may be conducive to fiscal discipline by forcing agents to internalize the budget restriction. Hierarchical procedures: norms and regulations that give primacy in the bargaining over the budget to a particular agent (set of agents). They may be conducive to fiscal discipline by given more power to those agents with political incentives to keep finances under control. Hierarchical procedures: norms and regulations that give primacy in the bargaining over the budget to a particular agent (set of agents). They may be conducive to fiscal discipline by given more power to those agents with political incentives to keep finances under control. Transparent procedures: norms and regulations that establish the conditions under which budgets are prepared and presented to society. They may be conducive to fiscal discipline by increasing the chances of enforcement. They may also limit agency problems by increasing accountability to voters. Transparent procedures: norms and regulations that establish the conditions under which budgets are prepared and presented to society. They may be conducive to fiscal discipline by increasing the chances of enforcement. They may also limit agency problems by increasing accountability to voters.

9. Do Budget Institutions affect fiscal performance? International experience suggests that they do International experience suggests that they do US: States with more stringent balanced budget rules have better fiscal outcomes (lower deficits, lower debt, adjust more quickly to adverse shocks) (Poterba, 1995) US: States with more stringent balanced budget rules have better fiscal outcomes (lower deficits, lower debt, adjust more quickly to adverse shocks) (Poterba, 1995) EU: J. von Hagen (1992, 1995) built an index of Budget Institutions and found that more hierarchical Budget Institutions reduce deficits and debt, without affecting capacity to stabilize output. EU: J. von Hagen (1992, 1995) built an index of Budget Institutions and found that more hierarchical Budget Institutions reduce deficits and debt, without affecting capacity to stabilize output. Looking at the role of budget and fiscal institutions has provided invaluable insights for understanding fiscal results for Latin America. Looking at the role of budget and fiscal institutions has provided invaluable insights for understanding fiscal results for Latin America.

10. The Latin American Experience First studied by AHHS (1996): more restrictive, hierarchical and transparent budget institutions are associated with smaller deficits First studied by AHHS (1996): more restrictive, hierarchical and transparent budget institutions are associated with smaller deficits Result confirmed by recent work by Filc and Scartascini (2005, 2006) using a much broader index of budget institutions for a sample of 18 Latin American countries, as well as one of 29 developing countries. Result confirmed by recent work by Filc and Scartascini (2005, 2006) using a much broader index of budget institutions for a sample of 18 Latin American countries, as well as one of 29 developing countries. The impact of Budget Institutions is robust, and economically important The impact of Budget Institutions is robust, and economically important

11. Filc and Scartascini (2005) México Argentina Bolivia Chile Colombia Uruguay Perú Brasil El Salvador Surinam Paraguay Venezuela Guatemala Ecuador Panamá Costa Rica Honduras Nicaragua Republica Dominicana -0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.06 Primary balance of general government (% of GDP) The Latin American Experience Index of Budget Institutions

12. Reforms to Budget Institutions Results found in the literature suggest that countries would benefit from reforming their budget institutions by adopting more restrictive rules, more hierarchical procedures and more transparent practices. Results found in the literature suggest that countries would benefit from reforming their budget institutions by adopting more restrictive rules, more hierarchical procedures and more transparent practices. During last two decades, countries in Latin America actively engaged in process of reform. Reform efforts have come in different waves During last two decades, countries in Latin America actively engaged in process of reform. Reform efforts have come in different waves –Early 1990s, main feature was adoption of integrated financial administration systems, which improved transparency, as well as the flow of information available to the budget authorities –Since 2000, one of the main features has been the adoption of numerical fiscal rules, often within the context of broader fiscal responsibility laws (7 countries adopted FRL’s in this period) –More recently, increased emphasis on performance budgeting (shifting the focus from fiscal sustainability to efficiency of public expenditures)

13. Reforms since 1990 Source: Filc and Scartascini (2006) R(X,Y) means that the Fiscal Responsibility Law included restrictions to X and Y.

14. Numerical Restrictions

15. Procedural Rules

16. Transparency Rules

17. The Path of Reforms Source: Filc and Scartascini (2006). Figure 5.1 The path of the reforms 1990199119921993199419951996199719981999200020012002200320042005 Evolution of Institutions Fiscal Rules Procedures Rules Transparency Rules Situation 1990 Situation 2005 Source:Authors' calculations

18. Examples of Some Recent Reforms Not every country has had the same rate of success with their reforms. Not every country has had the same rate of success with their reforms. For example, Argentina, Brazil, Chile, and Peru introduced numerical restrictions in order to improve their fiscal results. For example, Argentina, Brazil, Chile, and Peru introduced numerical restrictions in order to improve their fiscal results. While AR, BR, and PE did it using Fiscal Responsibility Laws, Chile introduced a Structural Balance Rule. While AR, BR, and PE did it using Fiscal Responsibility Laws, Chile introduced a Structural Balance Rule. Brazil adopted a very comprehensive FRL, imposing constraints not only at national level, but also at the subnational level of government. Brazil adopted a very comprehensive FRL, imposing constraints not only at national level, but also at the subnational level of government.

19. Evolution of the Index of Budget Institutions

20. Results have been mixed at best Chile has had the most success using the less stringent type of norm. Chile has had the most success using the less stringent type of norm. Brazil: may be too early for definitive conclusions, but so far results have been encouraging. Brazil: may be too early for definitive conclusions, but so far results have been encouraging. Argentina and Peru: Numerical rules component of FRL’s has only recently been complied (partially) with. Argentina and Peru: Numerical rules component of FRL’s has only recently been complied (partially) with. For example, Peru has complied with the deficits rule the last couple of years but has yet to comply with the rule that limits the real increase of expenditures. Other aspects of the law (e.g. multi-annual macro program, increased transparency and budget cycle) have changed the dynamics of the budget discussions.For example, Peru has complied with the deficits rule the last couple of years but has yet to comply with the rule that limits the real increase of expenditures. Other aspects of the law (e.g. multi-annual macro program, increased transparency and budget cycle) have changed the dynamics of the budget discussions.

21. Electoral Budget Cycle in Peru

22. Argentina: Deficits and the Fiscal Solvency Law 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 19992000200120022003 Central government deficit (% of GDP) Actual central government deficit Deficit limit according to 2001 Fiscal Solvency Law Deficit limit according to 1999 Fiscal Solvency Law

23. Budget Institutions Reform: some lessons learned Lesson 1: The business of reforming BI is is not an easy one. Lesson 1: The business of reforming BI is is not an easy one. Lesson 2: When it comes to the design of reforms, the devil is in the details. Lesson 2: When it comes to the design of reforms, the devil is in the details. In Argentina and Peru, some aspects of the law were very poorly designed.In Argentina and Peru, some aspects of the law were very poorly designed. ordinary law rather than special law (as in Brazil)ordinary law rather than special law (as in Brazil) no enforcement mechanisms (in Brazil there are severe penalties including jail for non-compliance, and automatic trigger mechanisms to adjust behavior when targets are approached)no enforcement mechanisms (in Brazil there are severe penalties including jail for non-compliance, and automatic trigger mechanisms to adjust behavior when targets are approached) conditions for escape clauses in rules not clearly specified.conditions for escape clauses in rules not clearly specified.

24. Budget Institutions Reform: some lessons learned Lesson 3: While it may be tough to get these reforms passed, it is even tougher to make them stick. Lesson 3: While it may be tough to get these reforms passed, it is even tougher to make them stick. Adequate implementation and enforcement requires an external enforcer (such as a capable and independent judiciary) or stakeholders interested in enforcing the rules, and powerful enough to do so.Adequate implementation and enforcement requires an external enforcer (such as a capable and independent judiciary) or stakeholders interested in enforcing the rules, and powerful enough to do so. Lesson 4: The success of reforms depends on the institutional context in which they are embedded. Lesson 4: The success of reforms depends on the institutional context in which they are embedded. A good understanding of the policymaking process (i.e., of the key political actors, their incentives and capabilities, the ways they interact, the political transactions they engage in) is a key ingredient for the successful design and implementation of reforms. A good understanding of the policymaking process (i.e., of the key political actors, their incentives and capabilities, the ways they interact, the political transactions they engage in) is a key ingredient for the successful design and implementation of reforms. Understanding the Political Economy of the Budget Process is our current research agenda. Understanding the Political Economy of the Budget Process is our current research agenda.