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PP5504 Public Finance & budgeting

Budget Balancing Exercise



Liki, The Administrator Timons, The Budget Director Assistant Budget Director, Policy Memo for Balancing Kimu Countys Budget 22 June, 2012

1 Background
Kimu Countys revenue base has been squeezing since the downturn of the apparel industry and there is a dismal projection of 1.5Million deficit by the budget office for the next fiscal year in the absence of any additional revenue sources. The budget committee proposed five different courses of action to the County administrator. This memo tries to recommend certain policy recommendation after duly analyzing, weighing and juxtaposing the available policy options in the given context. In doing so, the undersigned heavily drew upon general principles for balancing the budget. An elaborate decision matrix and the subsequent discussion helped inform this policy proposal. Great circumspection was observed in accounting for strengths and weaknesses of each option and an earnest attempt was made to rationalize the decisions to opt or discard different alternative courses.

2 Policy Recommendation
This policy recommendation is informed by both the long term goal of a burgeoning economy and diverse revenue resource base and contraction of fiscal policy space in short term due to exigency of

revenue short fall and impending budgetary deficit in the backdrop of an already dried up Rainy day fund.

It is, therefore, recommended that besides the proposed sin tax raise and prison privatization, only 0.25% increase be effected in Sales Tax and a new property tax be levied upon the top 1 % estate/property holders. This will amount to roughly $1.5 million which not only help bail the county economy out of its fiscal woes for the present but it will also help diversify and expand the revenue base in the long term. The decision of neither taxing the visitors nor slashing the capital investments will augur well for the county economy in years to come.

DECISION MATRIX FOR BUDEGTARY POLICY No Policy Options Make across the Board Cuts: 5% across the board Cut without Strengths (Favoring Interests) (saving=$0.99mil) Weaknesses (Political risks & Opposing Interests)

Decision: Dont Opt

1. No safeguards for high priority programs 2. Resentment in organized labor including police Rationale: A blunt fiscal instrument with uncertain economic and
social impact, but also potential damage to the efficient delivery of services. Therefore it must be avoided.

Impose new taxes on outsiders: Taxing nonlocals and visitors; taxing hotels, motels, shopping malls and local theme parks

1. Non-local incidence, 2. less controversial 3. Politically feasible, 4. Short run efficiency

Long run drop in tourism and tax revenue

Decision: Dont Opt

Rationale: In the long run not only visitors will be diverted but revenue receipts will also plummet. To expand economy in long term goal it is not advisable to tax services & tourism as it would make mobile factors of production flee the county.

Downsize the County workforce: a-hiring freeze and lay-offs in Corrections Dept. b-Privatizing prison


1. Opposition from AFSCME, Corrections dept. & ACLU 2. Ethical Issues

Decision: Opt B (Try to negotiate a privatization deal where the buyer/contractor takes the employees along so as to avoid lay-offs and increase political feasibility)

Rationale: If fundamental policy changes/structural changes cannot be achieved, the goal must be reductions only consistent with the pursuit of outstanding policy goals. This prison privatization will result in a decrease in public sector employees wholl be working on the same facility as private workers. This will improve the alignment of public and private sector wages. When budget constrains keep focus on revenue production to the exclusion of other social, moral or economic objectives.

Temporarily increase sales and sin taxes: a-0.5% increase in Sales tax b- Sin tax raise

1. Saving
( a= $1.4; b=$0.25mil)

Decision: Partly Opt (b in toto but a


2. Tax Severity mitigated by immorality of Sin 2. 2. High Visibility goods Rationale: Due to high visibility of sales tax, its better to make only a quarter % age point increase in it and even that should also be earmarked for some popular subject like health or education as to make it more acceptable.

1. Anti-tax interest groups and politicians

Postpone spending on capital improvement s:Funds Diversion from capital to operating budget

Politically Feasibility

Increased future Capital improvement costs

Decision: Dont Opt

Rationale: Reckless measures, like freezes in new/ongoing public sector capital projects cause longer-term damage to the economy

Other Options
A- Levy property tax (only
upon top 1 % property holders)

Best tax choice for collecting autonomous local govt. revenue Progressive, Efficient, Optimal policy; discriminates b/w most & least efficient policy; Less decrease in high priority health/education programs and more in unproductive outlay

Opposition from big estate holders; Discretion in value determinations & administration Time pressure and lack of information favors reductions by dept (or across board) and economic category, respectively, representing only a rough justice

B- Reductions by program /policy

instead of dept. or economic category

C- Borrow Money

(only for capital spending)

Exploring Options: Balancing Budget in Recession

3.1 Rainy Day funds

3.2 Cost Reducing Measures

How are changes in expenditure plans to be targeted?

Fiscal adjustment through reductions in planned expenditures often prove problematic. Changes in expenditure plans, relative to the authorities' original intent, are usually implemented in ways that disruptive the budget execution making it unsustainable in the long run. Although such a cost cutting produces short-run savings at long-run cost--for example, by cutting needed capital expenditure or by so severely contracting maintenance expenditure that the capital stock was partially consumed. Where planned expenditure reductions have failed (in the sense that outturn expenditure was above the revised budget), they have typically led to payment arrears, and/or to excess spending above appropriations. This has damaged both the private sector economy (its bills are unpaid) and the credibility of the government in financial markets. A fundamental problem is that changes in the budget are often proposed at too late a stage in budget preparation. Yet, whatever the time constraints, proper evaluation of expenditure policy options is vital. Those preparing the budget may be tempted to grasp quick solutions. However, budgets must represent an objective estimate of the costs of stated and agreed (within government) expenditure policies. Correspondingly, the only sustained (and sustainable) changes in expenditure plans are those rooted in changed expenditure policies. Thus, expenditure reductions planned under a revised annual budget are not likely to be successful where: 1. they are made in appropriations without accompanying changes in the underlying expenditure policies. Just changing the estimates makes the budget provision less than objective; the likely consequence is

overspending against appropriation and/or the emergence of payment arrears; 2. estimates for open-ended, demand-led programs are revised downward; again this is typically the triumph of hope over past experience; 3. inconsistent agreements are made between the ministry of finance and several line ministries to reduce the budget provision for certain line items, but with a "nod and wink" that access will be granted in-year to the contingency reserve; this reserve tends to become overcommitted when real contingencies arise; 4. "revised" economic assumptions on the exchange rate or inflation rate are invoked as justifying lower provision; 5. overoptimistic assumptions are made on "efficiency savings" through reductions in the number of civil servants and cuts in equipment purchases, utility charges, or fuel bills; and 6. reductions are made in transfers to lower-tier governments--this just passes on the problem. Planned expenditure reductions are also not likely to be successful, if they are essentially reliant on administrative actions in the budget execution process, where: 1. they are imposed by the ministry of finance through cutbacks in planned appropriations (often at a late stage in the budget preparation process) without the concurrence, or over the heads of, line ministries; 2. the appropriations are not themselves changed but rather the ministry of finance undertakes to control total spending within the appropriated sum--for example, through controls in-year on monthly cash allocations to line ministries; and 3. they are to be accomplished by creative accounting measures--greater use of suspense accounts, the establishment of new or additional extrabudgetary funds, etc. (such transactions should, in any case, be consolidated within fiscal tables). When presented with specific expenditure proposals (increases or reductions), it is necessary to examine both expenditure policies and expenditure management aspects. In terms of expenditure policies, the important questions include: Are the proposed expenditure policies soundly based? (Guidance here is contained in the IMF's Expenditure Policy Handbook). Do the proposals fit in with existing established policy priorities as laid out in any published medium term strategies of the government? Will they be rejected by parliament?

In terms of expenditure management: Are the cost estimates for the new proposals accurate? Will the proposals achieve the projected adjustment? Is there an important quantitative difference between their immediate and longer-term costs (e.g., do they just have a short-term benefit rather than representing some fundamental fiscal adjustment)? How would they be enforced (through revised appropriations or cash allocations)?

Those preparing the budget need to prepare and analyze options. This is not an easy task, especially in countries that have inherited budget systems designed for compliance control (rather than macroeconomic or financial management). Budget execution has traditionally been seen as ensuring that spending is carried out according to the budget approved by the parliament. Some budgets are so strongly driven by the wishes of the executing institution (line ministry or spending agency) that the ministry of finance may not be well-placed to suggest a likely scope or targeting for changes to the spending plans. Also, the budget classification systems in many countries are weak and may inhibit a satisfactory analysis of options for changes in government expenditures. While there are no hard rules about how planned public expenditure can best be adjusted, experience suggests some guidelines. Three broad approaches can be reviewed: (1) changes by program and policy; (2) changes by individual ministry; and (3) changes by economic category. 1. Changes to budget plans by policy or program are the optimal (though not always achievable) approach. Governments should use--or develop--mechanisms for identifying the most and least efficient and effective expenditure policies and programs, and target expenditure changes accordingly. (In this context, a number of more advanced countries are moving toward output-oriented budgeting.) In practice, country programs agreed with the IMF and the World Bank may include commitments for increases in expenditure in, say, health and education, together with reductions in unproductive expenditures. Outside such agreed priority (or nonpriority) areas, the ministry of finance should, in principle, assess the costs and benefits of alternative policy packages. In many cases, however, it will not be possible to review individual functions or policies, even in cases where good expenditure classification exists. Time pressures will often force consideration of other approaches. 2. Changes in expenditure plans by an individual ministry may be considered, for example, where there is a lack of information by economic category (see next item). Such an approach can be helpful in supporting or expanding initiatives in areas like health and education (albeit on a

ministry rather than sectoral basis). Reductions, where needed, can be targeted elsewhere; for example, where one or more line ministries or spending agencies has a record of poor expenditure control or in support of a policy decision that affects only a few ministries. A common variant of this approach is "across-the-board" reductions by ministries, in response to a call for lower than planned expenditures. By allowing each ministry to decide how to cut a fixed percentage off its expenditure plans, it often seems attractive and broadly equitable. But there are many drawbacks to such an approach. Despite the apparent fairness, in reality across-the-board reductions avoid consideration of priorities and leave individual ministries to allocate among line items, with not only an uncertain economic and social impact, but also potential damage to the efficient delivery of services. Such reductions also may all too often be seen as temporary, so line ministries apply them in areas that allow payment arrears to build up (e.g., payments to utility companies). Across-the-board reductions should be avoided, therefore, with preference given to adjustments by economic category (if changes by specific policy or program are not achievable). Changes in expenditure plans by economic category may have to be made where budgetary pressures emerge at a late stage in budget preparation. Again, they have the appeal of representing rough justice (e.g., if all ministries are asked to reduce their wage bill by a fixed percentage)--even though they do not imply proportionally equal aggregate changes by ministry. Adjustments based on this economic classification enable someeconomic analyses of expenditure patterns and prescription. Moreover, they can be targeted at wider expenditure policy objectives, such as reducing the wage bill or the number of civil servants, reining in travel costs, or cutting back generalized price subsidies to consumers or subsidies to industry. But they also have a downside. Often, they do not encompass any judgment about priorities between programs. Also, some of the measures applied tend to be simplistic (because they are "last-minute"), such as wage standstills or freezes, or percentage cuts in purchases of supplies. They are thus necessarily a blunt instrument, best seen as interim in nature, pending a deeper review of policy options. They may have short-term benefits but long-term costs--for example, increasing the financial cost of completing a capital project and postponing the benefits. Again, they may be seen as temporary, rather than representing a structural fiscal adjustment.

3.2.1 adjustment of spending 3.2.2

Temporary Structural change Privatization Back Service Level

The most favourable way for the budget balancing is cutting the expenditure either through hiring freeze/layoffs, delaying or cancelling the capital projects, cuts in other services, modification in health benefits opting across the board cuts or cuts in public safety programs either through renegotiating the debts or even through cuts in human services. In this scenario it is recommended that the: 2.1.1 Selective Program Cuts Across the board 5% cut is not wise able solution although it is estimated that it would save up to $990,000.


3.3 Revenue Enhancing Measures

3.3.1 Looking For Additional Revenues increase Additional Grant Funds Sources of revenue



revenue accounts borrowed resources extrabudgetary mechanisms multiple funds contingency funds special funds

Any legislative limits on:


deficit? borrowing? carryover of spending authority to next year?

Any earmarking? special or hypothecated funds constitutional or legal commitments on specific public services (education, health)

Box 3. Pros and Cons of Extrabudgetary Funds Pros Can increase efficiency by simulating private market conditions where levels and standards of service are linked directly to fees or charges. Can provide more consistent source of funds for expenditures that yield high benefits yet do not get much recognition (road maintenance expenditures are a primary example).

Cons Can result in a loss of aggregate expenditure control; such expenditure may be outside the control of ministry of finance. Can distort allocation of resources by circumventing the budget process and review of priorities. Earmarked revenues can become entrenched so funding is no longer based on priority needs. Less transparency may lead to inefficiency and/or misuse of funds. Can facilitate rent-seeking and abuse of monopoly power. Leads to less flexibility at the margin to reallocate when budget is under stress. Is incompatible with good cash management practices.

Borrowing Money

Fiscal logic accepts that capital budgets may be nanced (that is, paid for by issuing debt), so that the facility is being paid for throughout all the years of its life, whereas operating expenditures need to be paid from revenues received during the current year.

The fundamental objectives of debt management are effectiveness (the ability to meet the medium- and long-term needs for the nance of infrastructure development); efciency (borrowing at lowest possible net cost); equity (distribution of infrastructure cost fairly across generations); and accountability (adequate disclosure of debt and debt service program to ofcials, citizenry, and relevant third parties). Debt management avoids imprudent debt structures and strategies that might threaten scal sustainability and future access to debt markets. Although borrowing can be an excellent way to nance the development of long-life capital infrastructure, it does carry a longterm rst claim on public revenues and can create continuing problems for scal sustainability if localities borrow to nance continuing operations. Furthermore, local government borrowing can conict with a national macroeconomic stabilization policy that is designed to constrain inationary pressures. Such borrowing is selflimiting, in the sense that doubts about the ability to service debt will ultimately exclude the government from debt markets. Misuse of borrowing can put the scal viability of a government in jeopardymisuse meaning the use of borrowing to nance operating expenses of government (an operating decit) and expansion of debt for capital infrastructure that exceeds the debt service capacity of the government. Nonetheless, debt issuance is an appropriate mechanism for nancing long-life government capital assets. Because the proper use of borrowing is the nonrecurring acquisition of long-life capital infrastructure, it is normal that there be a close link between development of the local capital (or development) budget and debt management. Long-term debt should be used only to acquire capital infrastructure that has a useful life longer than the maturity of the debt. Debt should not be renanced to extend its maturity (although it may be renanced to take advantage of lower interest rates). Nonrecurring revenue should be used for capital spending or debt reduction rather than for operating expenditures. Short-lived capital assets should be nanced with current revenue rather than by borrowing. Local governments should integrate capital asset planning and nancial planning to ensure the affordability of long-term infrastructure programs. Debt should be issued on a competitive basis. Localities should practice complete, comprehensive, and clear debt reporting.

Within those principles, debt managers should manage borrowing and debt to minimize the interest, issuance, and servicing cost of debt.

2.2.1 Balancing Budget Deficit (-)Low Priority (2.1.1) Millions 1500000 Program cuts


Building Public & Political Support for the Proposal

, which is usually identied as

the budget deficit must not exceed investment or capital expenditure, that is, borrowing only for capital spending.

budget advisors are best advised to: make any revisions to emerging budget plans as soon as possible (last-minute changes tend to be ineffective); seek, as a starting point, expenditure changes that are in line with previously agreed decisions or views on expenditure policy priorities--this is especially important where there is room for additional spending; be sure that cost estimates for new expenditure proposals are realistic and accurate, not just for the year ahead but over the medium term, and that the proposals can be implemented at the political level;

be wary of the individual ministry or agency approach, except where this is consistent with pre-agreed policy priorities or to address glaring past failures to exercise proper control; avoid "across-the-board" cuts; where expenditure plans need to be scaled back, use reductions by economic category if fundamental policy changes cannot be achieved. The first target should be any reductions consistent with the pursuit of outstanding policy goals, and ideally within the context of ongoing wider reforms--for example, measures to reduce civil service numbers or changes in wage policies to improve the alignment of public and private sector wages; and be cautious in reaching for the obvious but overly simplistic targets, like freezes in new or ongoing public sector capital projects or in public sector wages; or percentage reductions in the purchase of goods and services (unless and until the longer-term damage to the economy or to overall government operations is assessed as bearable).

Rather than allow the levy of one or two productive taxes, localities are allowed a multitude of unproductive taxes In this context, transparency, accountability, and openness of appeal are crucial for acceptable administration and for some assurance to taxpayers of equitable treatment. The inseparability of policy and administration is far more pronounced for revenue administration than for any of the other tasks of local scal administration. Local expenditure and taxation programs may be fashioned to distort the movement of resources from one region to another create intercounty competition for mobile factors of production, which creates considerable economic inefciency. Local governments, either through formal legal assignment or through practice and tradition, are normally responsible for the services that relate closest to people and property, which may include social services (education, public health); infrastructure (roads, water, sewerage, waste management, housing, heating, telecommunications); the environment; social safety nets; and protective servicesin varying shares, with private responsibility for some of them. Such services are where the potential advantage of local responsibility is the greatest. One important issue involves balance between revenue availability and expenditure assignment. As Sevilla (2005: 10) summarizes: A certain bal-

ance between subnational competences and allocated nancial resources is necessary to avoid additional problems and funding shortages in public service delivery that sooner or later would create budget decits.Clarity of assignment and balance between expenditure and revenue are important conditions for orderly local scal administration.

There are three patterns of borrowing constraint: 34 1. Capital market discipline. This logic allows localities free access to capital markets. Borrowing is limited by lender willingness to loan. 3. Legal borrowing limits. The simplest approach is to forbid local borrowing, but this policy rules out a potentially sensible tool of fiscal administration. A less stringent control is a rigid ceiling on outstanding local debt.

Debt Administration Debt administration is the management of government borrowing and of servicing of the outstanding debt. In general, local governments may be permitted to borrow for legitimate infrastructure purposes if they have the capacity to service their debt without requiring assistance from higher governments. A pattern of scal imbalance will emerge with almost any local tax source, although this will happen to a greater extent for certain sources (natural resource taxes are one example) than for others and where the geographic scope of the localities is smaller. Of course, if local government nances are not supported by local resourcesin other words, if they are nanced exclusively by transfers from a higher tier of governmentthe horizontal imbalance problem will not arise, unless the higher-tier government is insensitive to imbalance in its transfer programs.

However, local governments lose a considerable degree of fiscal autonomy when they lose the ability to adjust the size of their budgets and the distribution of program costs among the population. Resource Allocation Local scal administration should provide a structure for choosing policies and for identifying trade-offs in the use of government resources. Resources are limited, opportunities for provision of useful government services are broad, and the budget process should provide a structure for ensuring that resources are allocated to the uses of greatest importance for the citizenry. Because not all worthwhile services will be affordable with the resources available, the scal process needs to include a balanced system for making choices from among the several alternative uses of those resources. The choices will emerge largely from political deliberations, not scientic analysis, so the process must be structured to allow as much open identication of alter- natives and trade-offs and exibility for response as possible to improve the chances that broad citizen interests will have bearing on the nal choices. Local budgeting provides the greatest opportunity for obtaining direct citizen input into the allocation of these resources, because the decision process is closest to the people and input can be obtained at relatively low cost.

At the local level, transparency provides the means of communication between government and citizenry regarding priorities, plans, decision making, and evaluation of results and, hence, can become an important foundation for responsive, responsible, and effective public services. Published budgets that include both plans and results in transparent language are important for encouraging local citizen input. A provision for local citizen input is one of the great advantages of making fiscal decisions at the local level, and transparency is the tool for achieving the advantage of citizen participation in the fiscal process. How much information is provided and how usable it is depends on local political will, the cost of providing information, and higher-tier legal requirements. Communication (a) budget data must be classied in ways that are meaningful to the citizenry; (b) the budget needs to be prepared in a way that is accessible to the citizenry; (c) the budget must clearly communicate the core responsibilities of ofcials; and (d) the budget must clearly report crucial features of scal operations (outlays, revenues, decits or surpluses, performance outcomes, and so on).