Public Expenditure Review Clinic



1. Introduction

As a part of ongoing efforts to strengthen public expenditure management, the Royal Government of Bhutan (RGoB) seeks to implement rolling budgets and is exploring the development of a Medium Term Expenditure Framework (MTEF). To this end, a delegation from the RGoB visited the World Bank in August 2004 to participate in a workshop jointly organized with Georgia State University, and this note is a key output of the workshop.

The initiative was part of a United Nations Development Program (UNDP) project, which enabled RGoB officials to attend a three-week course on public budgeting at the Andrew Young School of Policy Studies (AYSPS) of Georgia State University. The course involved two weeks (August 2 – 14, 2004) on public budgeting and fiscal management at the AYSPS, followed by a third week (August 16 – 20, 2004) at the World Bank, focused on generating a better understanding of what would be involved, specifically in Bhutan, in preparing an MTEF. It should be emphasized at the outset, that the existing budget processes in Bhutan (and MTEFs), involve the joint effort of many RGoB staff from different departments and line agencies, while the group participating in the workshop was small and stemmed from the Department of Budget and Accounts, the Department of Planning (both of the Ministry of Finance (MoF)), and the Ministry of Home and Cultural Affairs. Hence, a deeper discussion of the possibility of preparing an MTEF in Bhutan would require wider participation, including, for example, the Policy and Planning Division, emphasizing the macroeconomic framework, or the Department of Revenue and Customs, generating revenue forecasts, or the Ministries of Education and Health, linking policies, resources and means by sector.

This note describes the RGoB’s motivation for seeking budget reforms and the possible role of an MTEF in helping the RGoB meet its PEM goals, as was discussed in some detail at the workshop. The note is presented as follows: Section 2 highlights some key budget issues in Bhutan and the RGoB’s wider budget reform effort. Section 3 provides a brief overview of MTEFs. Section 4 discusses the first step towards developing an MTEF, the preparation of a Medium Term Fiscal Framework (MTFF), and what this might look like in Bhutan, including: (i) a macro-framework, helping underpin revenue estimation, (ii) a set of strategic fiscal objectives, laying out fiscal policy over the medium term, and (iii) a resulting aggregate resource envelope, moving away from needs to an availability based budget process. Section 5 provides a review of expenditure prioritization, noting some differences between the existing five-year planning approach and the MTEF approach. Section 6 discusses what can be expected by the line ministries, and what is needed from the line ministries in order to effectively implement MTEFs. Section 7 concludes by describing the key factors of successful MTEF efforts, and some possible next steps in Bhutan.

2. Budgeting Issues in Bhutan

The Ministry of Finance (MoF) constantly strives to improve the budget process in Bhutan. To this end, the single volume Financial Manual of 1988 was revised and expanded into separate manuals on budgeting, accounting, procurement, and revenue and property management, which together comprise the Financial Rules and Regulations 2001 (FRR-2001). The revised budget manual seeks to link the five-year plans more closely with the annual budget process through the adoption of three-year rolling budgets. Although the RGoB has not yet been able to implement rolling budgets, the step is viewed as central to helping the RGoB address several concerns, including: (i) strengthening macro-fiscal sustainability, (ii) improving resource allocation, (iii) ensuring an appropriate split between recurrent and capital expenditures, (iv) implementing the RGoB’s decentralization plans, and (v) bolstering donor engagement.

2.1 Macro-fiscal Stability

In recent years, the fiscal deficit has been the equivalent of 5-10 percent of GDP, and in 2003/04 and the budget for 2004/05, the RGoB has been unable to meet its long held objective of covering recurrent expenditures through domestic revenues. Domestic financing for the budget deficit is raised through the use of overdraft facilities and the issuance of government bonds. The Bank of Bhutan extends overdraft facilities to the government through the Ways and Means account, and together with the Bhutan National Bank and the National Pension Provident Fund, it purchases government bonds. This may be crowding out the private sector (by reducing the availability of bank finance for private investments), and could eventually lead to inflation. In addition, the RGoB is concerned about the attendant debt dynamics. Although most of the growth in debt stocks is associated with the development of the Tala hydropower project, the public debt rose from 41 percent of GDP in 2000 to about 74 percent of GDP in 2004. Moving to multi-year budgets and setting long-term fiscal policy goals would help ensure continued macro-stability in Bhutan.

2.2 Resource Allocation

The RGoB does not have a systematic set of resource allocation criteria, nor does it have an equalization method to apply in deciding budget ceilings. The RGoB currently resorts to detailed budget reviews and makes provisions on a line-item basis. This method of resource allocation to line ministries is cumbersome and time consuming, and the line ministries do not have flexibility in utilizing their budget. Budget allocations are determined on an incremental basis, undermining sectoral prioritization since most projects run for several of years. It should also be noted that the capital budget is almost entirely donor funded, resulting in budget allocations based on donor commitments. Moving to multi-year budgets would help strengthen donor coordination and engagement.

2.3 Capital and Recurrent Expenditure

The RGoB has given high priority to capital expenditure, as it seeks to expand infrastructure and access to public services. For example, capital expenditures in the health and education sectors are to absorb about 50 percent of these sectoral budgets in the current fiscal year. As these sectors typically require subsequent large recurrent expenditures in order to make full use of the newly created assets, the current spending pattern raises questions about the sustainability of ambitious government programs. As noted above, the RGoB is finding it difficult to meet its objective of financing recurrent expenditures from domestic revenues, a trend that may intensify in future. The RGoB anticipates that implementing rolling budgets will help ensure that the recurrent cost implications of making public investments are duly considered.

4. Decentralization

Fiscal decentralization provides greater opportunities for establishing policy priorities and planning through consultative budget formulation processes, and can improve the efficiency of resource allocation. By virtue of their proximity, Dzongkhags have superior information on local needs for public services and are better placed to respond. To effectively implement the decentralization policy of the RGoB, the Dzongkhags will need sufficient authority to manage district level budgets, and predictable inter-governmental transfers. Rolling budgets will be helpful in this regard.

5. Donor Engagement

Donor assistance to Bhutan has increased dramatically over the past two decades, both in the number of projects and the amount of funding, and donor financial and technical resources are important to the successful implementation of national plans. As noted above, most donor financing is used for investment projects, lasting several years. Multi-year budgeting will help improve expenditure prioritization, mobilize donor support for some recurrent costs, strengthen established ties, and help seek new areas of cooperation with potential new donors. Indeed, the initiative for implementing rolling budgets came from the Department of Aid and Debt Management (DADM) of the MoF to help mobilize external assistance.

3. The MTEF Approach

As described in the World Bank’s Public Expenditure Management Handbook (1998, p. 46):[1]

An MTEF is a whole-of-government strategic policy and expenditure framework within which ministers and line ministries are provided with greater responsibility for resource allocation decisions and resource use. The key to a successful MTEF is that institutional mechanisms assist and require relevant decision makers to balance what is affordable in aggregate against the policy priorities of the country. The MTEF consists of a top-down resource envelope, a bottom-up estimation of the current and medium-term costs of existing policy and, ultimately, the matching of these costs with available resources. The matching of costs should normally occur in the context of the annual budget process, which should focus on the need for policy change to reflect changing macroeconomic conditions as well as changes in strategic priorities of the government. Conservatively defining the medium-term aggregate resource envelope should help change the psychology of budgeting from a "needs" to an "availability" mentality as well as enhance the predictability of resource flows and policy over the medium and short term.

This process can be divided into several steps or stages, and the workshop presented the preparation of an MTEF in five steps:

• Step 1. Macroeconomic and public sector envelopes.

• Step 2. High-level policy: aligning policies & objectives under resource constraints.

• Step 3. Linking policy, resources, and means by sector.

• Step 4. Reconciling resources with means.

• Step 5. Reconciling strategic policy and means.

These steps are described in greater detail in the workshop materials, the Handbook and elsewhere, and will not be repeated here. Instead, the following sections describe the main features of some of the first steps for the case of Bhutan.

4. The First Step: Preparing a Medium Term Fiscal Framework

The first step noted above is typically referred to as a Medium Term Fiscal Framework (MTFF), and is central to the subsequent development of a full MTEF linking policy objectives, means and expenditures by sector. Preparing an MTFF involves establishing a macroeconomic framework, estimating revenues, issuing a statement of strategic fiscal policy, and establishing a budget envelope, all for the MTEF period (typically 3 years).

4.1 Macro-framework

The development of a macro framework is a useful exercise in its own right, strengthening policy and helping to foster development. It also underpins sound revenue forecasts, as many sources of revenue depend heavily on particular factors. Revenues from customs depend on imports; revenues from corporate and income taxes depend on GDP growth; and revenues from tourism taxes depend on the number of tourist arrivals, among other factors. Hence, maintaining a model of the Bhutanese economy that provides a macroeconomic framework and generates forecasts of key variables like imports and tourist arrivals, is central to making revenue projections and developing an MTEF.

For the purpose of discussion, a rudimentary macroeconomic framework was prepared in the workshop (Table 1).

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After reviewing recent economic developments, estimates were made about what the next few years might look like in Bhutan. Economic growth may accelerate from the 6-7 percent range in the last few years to more than 8 percent for the remaining years of the Ninth Plan (the fiscal years 2005/06 and 2006-07). This is predicated on faster private sector development, largely related to tourism, and the coming on stream of the Tala hydropower plant. Following an acceleration of growth in exports and imports in 2002/03, both are expected to expand by 5 percent or more in the coming years. The current account deficit was equivalent to 10.7 percent of GDP in 2002/03, and is likely to remain at these levels before falling in the last two years of the MTEF period (2005/06 and 2006/07). With monetary policy aimed at maintaining the ngultrum-rupee parity, the expectation is that the rate of inflation as reflected by the consumer price index will follow that of India, currently projected at 5 percent over the medium term, taking due account of the deceleration in Bhutan of inflation to 1.3 percent in the year to December 2003. Largely as a result of continued strong donor support, foreign reserves continue to grow, and it is assumed that the RGoB will be able to maintain reserves at the equivalent of about 20 months imports over the medium term.

4.2 Multi-year Revenue Projections

Indicators like those noted above, and others, form a central part of the revenue forecasting exercise. It is worth noting that the existing revenue projections prepared by the Department of Revenue and Customs of the MoF for the subsequent budget year have exhibited two positive features: they have tended to be conservative and reasonably accurate. In order to implement an MTEF, this exercise would need to be extended by two years to cover a three-year MTEF period.

Several revenue forecasting methodologies and their associated data requirements were discussed as a part of the workshop, including macro-based modeling, micro simulation, monthly tax receipts modeling, the input-output approach, and the aggregate national accounts approach. Future dialogue in this area should focus on the existing methodology used by the Department of Revenue and Customs, and possible areas where the process could be improved. For the purpose of discussion, the workshop looked at budget data for 2003/04, which show that about 80 percent of total revenues and grants are raised from four categories: grants (46.1%), dividends (14.7%), the business profits tax (11.9%), and the Bhutan sales tax (6.7%). Grants from abroad have shown some volatility in recent years, especially as a result of the large fall in budget support from India in 2002/03 (since resumed), and forecasting this dominant category will be challenging. Revenues from dividends reflect the exports of hydropower to India from Chukha, which have grown substantially (Table 2).

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Revenues from the business profits tax and the Bhutan sales tax will depend strongly on the buoyancy of economic activity, with forecasts drawing upon projections of GDP and perhaps some of the key sectors, like construction and transportation. Although the tourism sector has yet to return to the levels seen prior to the 9/11 terrorist attacks, revenue from tourism comprises about 6 percent of total revenues and grants, and is an area with strong potential (Table 3).

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Implementing an MTFF would require preparing forecasts of some of these key indicators for the MTFF period, typically 3 years (as noted above). Such projections would also be important to studying the implications of policy choices, such as the recent lowering of the personal income tax in mid-2004.

For the purpose of discussion, some illustrative projections of the central government budget were made as a part of the workshop (Table 4). These are based on the indicators forecasted in the macroeconomic framework above (Table 1), assuming 7.5 percent GDP growth in the current fiscal year, accelerating to over 8 percent in 2005/06,and 2006/07. Both the revenues from Chukha Hydro Power Corporation (CHPC) and tourist arrivals are projected to grow at 8 percent over the MTFF period. The projections show some fall in grants, as Tala comes on stream, leaving overall revenues and grants slightly lower at around 30 percent of GDP (IMF format).

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4.3 Statement of Strategic Fiscal Policy Objectives

Establishing an overall budget envelop requires a government commitment to a clear set of strategic fiscal policy goals. This could involve targeting the current deficit (excluding grants), the overall deficit (including grants), or the level of debt stocks, all expressed as percentages of GDP (shaded in Table 5).

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The RGoB outlined several broad fiscal objectives in the Poverty Reduction Strategy Paper (completed in July 2004):

• Limit government expenditure to less than 40 percent of GDP.

• Reduce the overall budget deficit to no more than 4 – 5 percent of GDP.

• Devote about 55 percent of total spending to capital expenditure, financed through external assistance, largely grants.

• Finance recurrent expenditures from domestic revenues.

The chosen fiscal path needs to be consistent with the RGoB’s desired macroeconomic path (inflation, external accounts, available finance), and with the RGoB’s overall strategic policy goals, such as the size of government as a share of GDP, given that fostering private sector led growth is a stated pillar of the Ninth Plan.

4.4 Completing an MTFF

Finally, in order to move away from needs based budgeting to an availability based budgeting process, an MTFF table, like Table 5 above, needs to be prepared. Following the projection of revenues (underpinned by a sound macroeconomic framework), and a statement of strategic fiscal policy objectives, the overall expenditure envelope can be determined. For example, if total revenues and grants are forecast to be the equivalent to 34 percent of GDP in 2005/06, and the RGoB aims to limit the overall deficit to below 5 percent of GDP, then total spending must be kept below 39 percent of GDP. Alternatively, other indicators may become the binding constraint, such as goals for limiting the growth in debt stocks, or specifying the source of financing, domestic or foreign. Ultimately, the credibility of the MTFF depends critically on the degree of commitment to specific targets, as reflected in the changes in spending or other contingency plans that would be pursued in the event of a shortfall in revenues. This commitment is central to the effectiveness of establishing a top-down spending envelope for sectoral ministries. If commitment at the highest levels of government is weak, then the overall spending limits (the budget envelope) will also be weak. If commitment is strong, such that policy corrections are swiftly implemented when some revenues fail to materialize as expected, then the strategic fiscal policy goals of the MTFF gain credibility, and the MTFF can be an effective tool in managing the spending demands at different levels of government. A credible MTFF is critical to developing a sound MTEF.

5. Expenditure Prioritization

Once an MTFF has been prepared, the subsequent steps of an MTEF aim to provide a linking framework that drives expenditures by policy priorities, disciplined by budget realities. Within a top-down resource envelope given by the MoF, the line ministries would need to submit bottom-up expenditure estimates, reflecting sectoral policies and activities, and emphasizing the optimization of intra-sectoral allocations.

The workshop discussed several expenditure prioritization paradigms, and noted some key differences between stylized MTEFs and the current 5-year planning process in Bhutan. In the Ninth Plan, planners articulated the development strategy based on 4 goals, and called for sector plans to achieve these goals. Although the process in Bhutan is highly participatory, planners effectively set priorities by determining relative sector outlays, and annual budgets are to be guided by plan outlays and content. Indeed, the Ninth Plan allocates about 28 percent of spending to the social sectors (largely pro-poor spending to improve access to health and education services), while agriculture and roads are provided with 11 percent each, followed by energy with 9 percent allocation. Allocations are also made to reach decentralization objectives, with 75 percent, 21 percent, and 4 percent of spending being channeled through the Center, the Dzongkhags (Districts), and the Gewogs (Blocks), respectively. Agency project units are to keep the direction of the budget in line with the Ninth Plan. In addition, the Ninth Plan appears to be organized by sector, rather than ministerial/agency portfolio (essential for locating managerial responsibility), and is driven largely by development needs, rather than resource availability.

The MTEF approach is typically somewhat different. The budget ministry (MoF) has no formal view on spending priorities, focusing instead on fiscal aggregates like total revenues, expenditures, and the strategic fiscal policy goals of the overall deficit and the evolution of public debt. Line ministries are given resources to fund existing policy, and have the flexibility to reallocate within their ministry to achieve agreed outputs or outcomes. The decision on how to allocate the “headroom” (the gap between existing policy allocations and total expenditures) is made collectively by the cabinet. It is worth noting, however, that in practice, MTEFs in many developing country are more top-down. The RGoB may wish to review some of these features of expenditure prioritization under an MTEF.

6. The View from the Line Ministries

As noted above, the preparation of an MTEF requires strong participation from the sectors/line ministries, reconciling differing perspectives between the line ministries and the MoF. In many countries, weak implementation, poor service delivery, weak client orientation, a lack of accountability, and the like, lead to dissatisfaction both at the MoF and the concerned ministry. From the line ministries’ perspective, there can also be an array of problems: budgets are allocated incrementally based on bargaining, rather than needs; funding is inadequate; funds flow is unpredictable; procurement is difficult; ministries lack control over programs; accountability for results is weak. An MTEF could help address such issues, some of which are manifest in Bhutan. While MTEFs typically bring some advantages for line ministries, however, they also involve some additional responsibilities.

6.1 What Should Line Ministries Expect From An MTEF?

The main benefits to line ministries from the adoption of an MTEF are greater budget predictability, more freedom/authority to formulate sector programs and set priorities, increased flexibility in fund management, and stronger accountability for program delivery. Ideally, an MTEF would eventually move to program budgeting or block allocations, which line ministries would prioritize, allocate, and manage - all to deliver contracted outputs/outcomes for which they are accountable. Reaching this point, however, will require perseverance and effort over the medium term.

6.2 What is Needed from Line Ministries in Order to Implement an Effective MTEF?

Implementing an MTEF would entail more explicit or new line ministry responsibilities. These include:

• Living within funding constraints or sector ceilings.

• Setting sector goals, strategy and policies to achieve agreed national development goals.

• Reviewing all sector programs, projects and activities.

• Reorienting from focusing on inputs to emphasizing the delivery of agreed outputs and services.

• Aligning sector programs and activities accordingly, and prioritizing all activities.

• Preparing estimates of expenditure needs for three years and updating them annually (“rolling” multi-year budgets).

• Undertaking “costing” of goals, as practicable.

These elements can be challenging, and some of them, like costing, may not be an immediate priority and can be undertaken later. The RGoB may wish to consult on some of these aspects across the government to ensure sufficient support from the line ministries, if an MTEF is to be implemented effectively.

Section 7: Conclusions and Next Steps

International experience with MTEFs shows that they do not solve all budget problems, and that effective implementation requires sustained effort over several years. They can be useful processes for catalyzing budget reform, however, and significantly improve public expenditure management. As noted in the Public Expenditure Management Handbook (1998, p. 54):

Success hinges on a variety of factors, which include:

• political commitment and endorsement at the highest level to make and abide by the difficult decisions involved in the restructuring of expenditures (Some ministries may need to scale back their activities so that more resources can be directed to higher priority sectors.);

• strong management of donors to ensure that they operate within the framework of the MTEF;

• willingness to subject policy decisions with financial implications, made outside the budget process, to the discipline of the MTEF;

• understanding of, and commitment to, the difficult decisions at the sector ministry level;

• commitment at all levels to abide by the budget decision so that new expenditure decisions are not introduced during budget implementation that would require reallocation of resources (These new decisions mean that the priorities set when the budget is approved by Parliament are often overturned.);

• improvements in expenditure control so that the decisions are not undermined by over-expenditures and reallocation of funds during budget implementation;

• improved macroeconomic management and revenue collection so that revenue shortfalls do not necessitate adjustments to the budget estimates;

• briefings of politicians and senior management during implementation;

• improvements to expenditure reporting on results;

• development of a computerized accounting system.

As noted by the delegation from Bhutan in the concluding session of the workshop on next steps, the RGoB faces three options: (a) continue with the present system, (b) seek relatively small improvements in the current system, or (c) pursue an MTEF. Option (b) would likely focus on forecasting and budgeting techniques, identifying areas where improvements might be made, but not substantially altering the budget process. Option (c) would entail greater effort, involving sensitizing the rest of the RGoB about MTEFs, studying the MTEF process and other intermediate steps in greater detail, strengthening forecasting and analytical capacity, improving coordination and information sharing, assessing broader capacity needs, reviewing institutional and procedural arrangements, and analyzing the financial implications.

One possible set of steps under option (c) that was discussed at the workshop includes:

• Seeking to complement the Ninth Plan with an MTEF.

• Developing an MTFF focused on budget aggregates, based on projected resource availability and the chosen fiscal strategy.

• Dividing the MTFF into portfolio envelopes, initially top down, which would

i) provide sufficient finance to cover existing commitments,

ii) shape the MTEF portfolio frame to reflect political priorities,

iii) seek to program aid flows through dialogue with donors.

• Regarding the Ninth Plan as an articulation of sector policies and strategies, which feed into an MTEF, as a ‘clearing house” for the annual budget.

• Paying more attention to the recurrent side of the budget by estimating how the total costs of policies/programs will evolve over the Ninth Plan period – and adjust as needed.

• Holding back a planning contingency of 5-10% of the budget, as part of the MTEF.

The August 2004 workshop held at the World Bank sought to help the RGoB make progress towards its PEM goals by generating a better sense of what would be involved in implementing an MTEF. The workshop emphasized that MTEFs are not a panacea and would need strong participation from across the government, including the line ministries. The MoF may wish to consult with other parts of the RGoB and study the MTEF and other options for budget reform further, and as an output from the workshop, it is hoped that this note will contribute to the dialogue.

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[1] Available at: .

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Medium Term Expenditure Framework Note

Prepared as a Part of the

Bhutan Public Expenditure Management

Workshop

August 16-20, 2004

Bhutan

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