Top-down Budgeting A Tool for Central Resource Management December 15, 2006 Korea Institute of Public Finance John M Kim, PhD 2006 OECD Asian SBO

2 1.What is it? 2.Why do it? 3.How to do it? 4.Caveats Outline

3 What is Top-down Budgeting? It is not: Bottom-up Budgeting It is not: Bottom-up Budgeting –Traditional way of budgeting –Sum of ministry budgets Total budget Difficult to control aggregates (total budget, deficit)Difficult to control aggregates (total budget, deficit) Difficult to control allocation among major sectorsDifficult to control allocation among major sectors –Defense vs. pollution control vs. infrastructure, etc. –Additional Problems Focus on annual numbers (myopic)Focus on annual numbers (myopic) Inefficient processInefficient process –Iterative negotiations (game-playing & adjusting for totals) –Inability to utilize ministries expertise

4 What is Top-down Budgeting? (2) It is: Budgeting in 2 Steps It is: Budgeting in 2 Steps Ceilings (aggregate numbers) Ceilings (aggregate numbers) 1)Decide total spending & deficit levels (agg. ceiling) 2)Decide allocation among major policy areas (sectoral ceilings: about 30) –Defense vs. pollution control vs. infrastructure, etc. Intra-sectoral allocations (details) Intra-sectoral allocations (details) 1)Ministry/agency budgets

5 What is Top-down Budgeting? (3) It is: A Division of Roles/Responsibilities It is: A Division of Roles/Responsibilities Ceilings (aggregate numbers) Ceilings (aggregate numbers) 1)Final decision by PM & Finance Minister 2)Focus on Aggregate fiscal management Medium-term perspective (multi-year ceilings) Policy priorities Intra-sectoral allocations (details) Intra-sectoral allocations (details) 1)Ministries formulate their own budgets 2)But must follow rules

6 What is Top-down Budgeting? (4) It is: It is: Effective for fiscal consolidation Effective for fiscal consolidation A key tool for enforcing MTEF (NFMP) decisions A key tool for enforcing MTEF (NFMP) decisions (ceilings are often multi-year limits) (ceilings are often multi-year limits) Ensures spending is aligned with priorities Ensures spending is aligned with priorities Efficient in time and effort Efficient in time and effort Utilizes ministries expertise Utilizes ministries expertise

7 1.What is it? 2.Why do it? 3.How to do it? 4.Caveats Outline

8 Urgency of Reform? Huge deficits ca.1990 in many OECD countries forced them to adopt major fiscal reforms Huge deficits ca.1990 in many OECD countries forced them to adopt major fiscal reforms Fiscal Balance (% GDP) Fiscal Balance (% GDP) Australia Australia Canada Canada Denmark Denmark Korea Korea Netherlands Netherlands Sweden Sweden Utd. Kingdom Utd. Kingdom OECD OECD

9 Different Motivation for Korea Top-down adopted as key part of 4 fiscal reforms Top-down adopted as key part of 4 fiscal reforms 1)Need for longer-term perspective Anticipate need for controlling future spending growth in social welfare, etc. 2)Efficiency a.Need to focus on broader policy priorities b.Eliminate unproductive games in budget negotiations c.Utilize ministries expertise 3)Need to focus on performance management, rather than controlling inputs

10 (What are Koreas 4 Reforms?) 1.National Fiscal Management Plan –Medium-term (5-year) fiscal plan for 14 sectors 2.Top-Down budgeting –Tier 1: Fixed spending envelope for each sector/ministry –Tier 2: Autonomy for line ministries in own budgets 3.Performance Management –Assess performance of spending programs –Enhance link between performance and budget 4.Digital Budget and Accounting System –Program Budgeting –Accrual Accounting –Computerization of accounting system

11 (Why the 4 Reforms?) Anticipate fiscal difficulties driven by aging & other socioeconomic changes Anticipate fiscal difficulties driven by aging & other socioeconomic changes –Population aging and low fertility rate Old population (65 and above): 7.2 (2000) 14.4(2019)Old population (65 and above): 7.2 (2000) 14.4(2019) Total fertility rate: 6.0(1961) 2.1(1982) 1.19(2003)Total fertility rate: 6.0(1961) 2.1(1982) 1.19(2003) Less workers must support welfare of more elderly people Public pensions and health care financing will suffer most Less workers must support welfare of more elderly people Public pensions and health care financing will suffer most –Society demands better quality of life (social welfare, education, culture, environment) –Economic growth slowing down so will tax revenues –Emphasis on participation and transparency Spending growth may outrun revenue increase, so try to get fiscal system in good shape before its too late Spending growth may outrun revenue increase, so try to get fiscal system in good shape before its too late

12 (Some Background: Current Fiscal Status) Up to the financial crisis, Koreas public finances were solid, thanks to two decades of balanced budgeting Up to the financial crisis, Koreas public finances were solid, thanks to two decades of balanced budgeting Some deterioration resulted from coping against crisis (national debt more than doubled), but fiscal situation remains better than most other OECD countries Some deterioration resulted from coping against crisis (national debt more than doubled), but fiscal situation remains better than most other OECD countries What does this mean for the 4 Reforms? Koreas reforms are not driven by an immediate crisis, but this may end up somewhat undermining the momentum of the reforms Koreas reforms are not driven by an immediate crisis, but this may end up somewhat undermining the momentum of the reforms

13 Top-down vs. Bottom-up Comparison of Bottom-up & Top-down Approaches Bottom-upTop-down Ministry-by-ministry analysis that ignores economic forecasts Macro-oriented fiscal analysis based on economic forecasts Annual, myopic time horizon Multi-year perspective, especially for investments Time-consuming negotiationsDelegated authority Ownership of proposals is more agency-specific Creates joint ownership of proposals ReactiveProactive

14 Top-down vs. Bottom-up (2) Approaches to Determining Expenditure Ceilings Top-Down Approach Bottom-Up Approach Overall Ceiling Sectoral Ceiling Overall Ceiling Sectoral Ceiling Program Review Sweden-- Netherlands- Utd. Kingdom - Denmark- Korea- Canada-- Australia-- Chile-- : actively used, : used as reference, - : not used Top-down and bottom-up methods are complementary Information for evaluating new initiatives Program reviews for monitoring programs/activities

15 Results? No more excessive budget requests No more excessive budget requests –Increase rate of budget requests in the general account dropped significantly: 30.8%(04) 11.7%(05) 7.0%(06) Self-initiated restructuring of spending by line ministries Self-initiated restructuring of spending by line ministries –Restructuring of multi-year programs and introduction of new programs have nearly doubled

16 1.What is it? 2.Why do it? 3.How to do it? 4.Caveats Outline

17 Example of Linking Multi-year Plans to the Annual Budget (Sweden) Current Year (n) Plans for Future Years n+1n+2n FY 2005 Total Ceiling FixedTotal Ceiling Fixed Finalize 27 sect. ceilings and annual budgetFinalize 27 sect. ceilings and annual budget FY 2006 Total Ceiling FixedTotal Ceiling Fixed Adjust 27 sect. ceilings using budget marginAdjust 27 sect. ceilings using budget margin FY 2007 Total Ceiling FixedTotal Ceiling Fixed Set 27 Sect. CeilingsSet 27 Sect. Ceilings + budget margin + budget margin 2005 FY 2006 Total Ceiling FixedTotal Ceiling Fixed Finalize 27 sect. ceilings and annual budgetFinalize 27 sect. ceilings and annual budget FY 2007 Total Ceiling FixedTotal Ceiling Fixed Adjust 27 sect. ceilings using budget marginAdjust 27 sect. ceilings using budget margin FY 2008 Total Ceiling FixedTotal Ceiling Fixed Set 27 Sect. CeilingsSet 27 Sect. Ceilings + budget margin + budget margin 2006 FY 2007 Total Ceiling FixedTotal Ceiling Fixed Finalize 27 sect. ceilings and annual budgetFinalize 27 sect. ceilings and annual budget FY 2008 Total Ceiling FixedTotal Ceiling Fixed Adjust 27 sect. ceilings using budget marginAdjust 27 sect. ceilings using budget margin FY 2009 Total Ceiling FixedTotal Ceiling Fixed Set 27 Sect. CeilingsSet 27 Sect. Ceilings + budget margin + budget margin

18 Budget Formulation in Bottom-up vs. Top-down Systems Budget Requests ( by line items) Budget Requests ( by line items) Budget Formulation (line item-oriented) Budget Formulation (line item-oriented) Y+1Y+1 NFMP Total Ceiling Sectoral Ceilings Total Ceiling Sectoral Ceilings Budget Formulation Within Ceilings Budget Formulation Within Ceilings Consultation and Review Consultation and Review Y+1Y+1 Y+5Y+5 Strategic resource allocation emphasized Strategic resource allocation emphasized Line Ministries MoF Cabinet Meeting Line Ministries MPB NowNow BeforeBefore

19 Determining Expenditure Ceilings Overall Ceiling Overall Ceiling Prudent Economic Assumptions (Growth, etc.) Prudent Economic Assumptions (Growth, etc.) –Sensitivity analysis –Independent panel or private sector forecasting –Built-in bias for lower growth rate Fiscal Rules for Good Discipline Fiscal Rules for Good Discipline –Sweden: structural surplus of 2% GDP –Chile: Structural surplus of 1% GDP –UK: Balance current budget over econ. cycle –Surplus automatically goes to repaying debt

20 Determining Expenditure Ceilings (2) Sectoral Ceilings Sectoral Ceilings –Must not affect overall ceiling –Usually overlaps with ministerial boundaries (good program budget design) New initiatives may be required to be funded from savings from existing programsNew initiatives may be required to be funded from savings from existing programs

21 Determining Expenditure Ceilings (3) Operating/Capital Ceilings Operating/Capital Ceilings –Ministries tend to favor operating expenses –Denmark: separate ceilings for current & capital expenses Sub-ceiling for salaries/wages in operating ceilingSub-ceiling for salaries/wages in operating ceiling UKUK Current expenses: Golden RuleCurrent expenses: Golden Rule Capital expenses: Sustainable Investment RuleCapital expenses: Sustainable Investment Rule

22 Determining Expenditure Ceilings (4) Number of Ceilings Number of Ceilings –Korea (200+) vs. Sweden (27) Optimal number is around 30Optimal number is around 30 More ceilings make budgeting decisions politically difficultMore ceilings make budgeting decisions politically difficult Need to give ministries room to exercise autonomy to ensure their proactive participationNeed to give ministries room to exercise autonomy to ensure their proactive participation This means Budget Office needs better tools:This means Budget Office needs better tools: Performance management Information system to monitor execution Enhanced analytical capacity for policy assessment

23 Determining Expenditure Ceilings (5) Buffers against Contingencies Buffers against Contingencies –Built-in buffers in prudent forecasts Windfalls (repay debt, tax cut, etc.) Windfalls (repay debt, tax cut, etc.) Budget MarginBudget Margin Overall Ceiling = Sect. Ceilings + Budget MarginOverall Ceiling = Sect. Ceilings + Budget Margin Covers unexpected changes (forecasts errors, etc.) and institutional reforms after ceilings were fixedCovers unexpected changes (forecasts errors, etc.) and institutional reforms after ceilings were fixed Usually does not cover new policy initiativesUsually does not cover new policy initiatives

24 Determining Expenditure Ceilings (6) Expenses in or excluded from ceilings? Expenses in or excluded from ceilings? 1)Discretionary expenses usually included 2)Mandatory expenses (social security entitlements, etc., mandated by law) Sweden, Korea, Chile, Netherlands: includedSweden, Korea, Chile, Netherlands: included Canada, Denmark: excludedCanada, Denmark: excluded 3)Interest on debt Sweden, Denmark: excludedSweden, Denmark: excluded Chile, Netherlands, Korea: includedChile, Netherlands, Korea: included

25 Determining Expenditure Ceilings (7) Funding for new policy initiatives Funding for new policy initiatives Sweden: must come from existing ceilingsSweden: must come from existing ceilings Most countries have review process to judge new initiatives adjust ceilingsMost countries have review process to judge new initiatives adjust ceilings Australia, Canada: Cabinet committeesAustralia, Canada: Cabinet committees Netherlands, Denmark: simply verify fit with coalition agreementNetherlands, Denmark: simply verify fit with coalition agreement Chile: pooled Bidding Fund from savings on obsolete or poorly performing programsChile: pooled Bidding Fund from savings on obsolete or poorly performing programs

26 1.What is it? 2.Why do it? 3.How to do it? 4.Caveats Outline

27 Conditions for Top-down Budgeting Good monitoring system to compensate for delegation of authority to ministries Good monitoring system to compensate for delegation of authority to ministries –Performance & program reviews –Information system to monitor execution Enhanced policy capacity + Behavioral change Enhanced policy capacity + Behavioral change –Budget Office: better forecasts & projections, must be able to defend fiscal rules, but work better together with line ministries –Ministries: need to learn internal allocation decisions Strong PM & Finance Minister Strong PM & Finance Minister Commitment to rule-based budgeting (Fiscal Rules) Commitment to rule-based budgeting (Fiscal Rules) –Remove arbitrariness in budgeting decisions, but leave room for flexibility and judicious discretion/autonomy Support from the legislature Support from the legislature

28 Remaining Tasks (Korea) Areas for improvementAreas for improvement –Consensus and understanding on the top-down system –Ex-ante consultations with line ministries when setting spending ceilings –Further expansion of autonomy at line ministries –Insufficient preparation and guidelines by MPB Future plansFuture plans –Surveys and consultations with line ministries –Sectoral and ministerial spending ceilings set after sufficient discussions –Active use of performance assessments to restructure spending programs –Detailed budget formulation guidelines

29 This ends the presentation Thank You!