Chapter

5 Structural Adjustment: A Multifaceted Phenomenon

Author(s):
A. Premchand
Published Date:
March 1993
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These macroeconomic prescriptions may seem straight forward, but putting them into practice rarely is.

WORLD BANK, World Development Report, 1991

During the seventies and eighties, the lack of requisite institutional support, particularly in the area of public expenditure management, was recognized both as part of countries’ own efforts to improve their fiscal policy formulation and implementation and as part of the structural lending adjustment programs of international financial institutions. More recently, during the transition to the market of former centrally planned economies (CPEs), the lags in institutional development and the difficulty in adapting the institutions to the new tasks became more apparent. Another facet of international cooperation at regional levels showed the inadequacies of public expenditure management institutions in sustaining the goals of such cooperation. These three facets, which at first may seem distinctive yet have many common threads, illustrate the issues encountered in implementing macroeconomic prescriptions and in strengthening fiscal institutions so that they will have the capacity to sustain proper fiscal policies.

The problems faced in the seventies in the developing countries were recognized in the pursuit of policies aimed at stabilization and growth. Although these goals remain the same for the former CPEs, the context and urgency for achieving transition show another aspect of adjustment. Also, the starting points for the developing countries and the former CPEs differ. For the former, it was just another phase of institutional adjustment to the new economic realities, although their journey had started much earlier, and for some, as early as the fifties. For the former CPEs, the transition started after a relatively long period of institutional stagnation or complacency (where it was mistaken for institutional strength). The issues surfacing in regional cooperation, which are more a phenomenon of the nineties (though they had arisen earlier), reflect the growing recognition of economic interdependence among countries. Pacts of regional cooperation such as the Gulf Cooperation Council (GCC) and among members of the European Community stress the pursuit of common expenditure policies and fiscal policies that should be monitored for the level of budget deficit and the cumulative level of outstanding public debt. The fiscal policies that a member country pursues should reflect its needs while harmonizing with the policies of contiguous member countries. Implementation of these goals requires at least a new orientation for some of the instruments of expenditure management. They have to be transparent while achieving greater congruence with the systems and approaches of the other members of the pact.

In all three cases, structural adjustment emphasizes the adaptation and rationalization of the expenditure management machinery to different goals. Such adjustment involves eliminating a few institutions, systems, and techniques, or providing a new charter, or installing new systems, or strengthening the human resources rather than the machinery; the type and degree of adjustment is directly related to the problems experienced. Adjustment is thus country specific and situation specific. The discussion in the following sections is, however, more general, as the overall direction of change, the problems in achieving it, and the ways in which those problems could be avoided or minimized get more attention than does their relevance for a country. It also seeks to illumine the different contexts of structural adjustment and the kind of issues likely to be faced in the nineties and possibly beyond. One point should be made to establish or disprove the link between structural institutional adjustment and a successful fiscal policy: the success or failure of a policy depends, in addition to the institutional factors, on a whole range of external factors and the intrinsic merits of the policy. A well-organized institutional framework would normally be able to compensate in part for some of the policy shortcomings. Weak machinery (judged by some specified criteria) would on the other hand accentuate the policy failures and worsen the situation. The identified or perceived linkage between an economic policy goal and an organizational instrument is emphasized here.

The chapter is divided into three sections. Section I deals with the problems of institutional adjustment in the developing world; Section II discusses the transition of the former CPEs to the market; and Section III discusses the issues relating to regional cooperation and their implications for expenditure management in the governments of the member countries of a region.

I. Perspective on Developing Countries’ Experience

By the beginning of the sixties, developing countries had realized the merits of the dictum attributed to Catherine the Great—”that which stops growing starts to rot.” Soon after independence, many countries recognized the basic inadequacy of the government expenditure management systems that were oriented toward expenditures for law and order and the interests of a colonial power. As development became the countries’ goal, expenditure management machinery had to be reoriented to the tasks of development. Accordingly, many developing countries introduced reforms to install capital or investment budgets (reflecting the development plans), foreign exchange budgets, and resorted to the use of techniques for investment appraisal.1 Also, since the input-oriented budgeting system was of limited use for overall economic management, forms of program and performance budgeting systems were introduced in various countries with varying success.2 These efforts, while laudable for the spirit in which they were undertaken, did not, if later reviews are considered accurate, have the desired results. Governments fail not so much because of lack of effort, but as Lewis (1955) has pointed out, because they do too little or too much or too late. It is also suggested that, for all the efforts at adaptation, the underlying approaches to expenditure management remained the same. Historians argue that in general there may be a case of semiotic topology (drawn from a branch of mathematics). It suggests that fundamental characteristics of a structure remain unaltered despite outward transformation (see Chaudhuri, 1990, p. 430).

These underlying features prompted more ad hoc reactions to the economic crises that predominated after the oil price increases in 1973. Thereafter, governments adopted a kind of crisis budgeting whose features were frequent adjustments to resource ceilings, an uncertain budgetary process, ad hoc or across-the-board expenditure reductions, central restrictions on payments, accumulation of arrears, circumventing rules and regulations to accommodate political interests temporarily, and an overall strain on financial managers. “The deterioration,” as a World Bank report noted in 1984, “can be described in terms of inappropriate policies and programs: emergence of large macroeconomic imbalances; erosion of incentives…; overprotection of industry; over-expansion of the public sector, especially public employment…; poor project selection; inadequate maintenance of the capital stock.” It added, “there are serious weaknesses in the institutions on which development depends—central ministries losing budgetary and financial control…. The capacity to formulate and implement economic policies and programs has itself deteriorated” (p. 25). (The remarks were addressed to sub-Saharan African countries, but they reflected the general situation in many developing countries.) Although it was recognized that efforts had been made to address these problems, the impact had been negligible owing to the resort to crisis budgeting. Moreover, reform is a continuous process and not a once-for-all change. It was felt that the public sector institutions were contributing to rigidities, inefficiencies in the allocation and use of resources, and preventing rather than facilitating sustainable growth. This led to more focused consideration of the adjustments needed in public expenditure management.3

Many developing countries, in their own way and at their own pace, have aimed at institutional improvement. However, as lending based on structural adjustment gained influence in the operations of international financial institutions, more attention was focused on strengthening those institutions. The analysis in this section is restricted to the institutional improvement that was a part of that structural adjustment.

The reforms envisaged as part of structural adjustment cover a wide area—trade and fiscal policies, public sector management, financial sector, anti-poverty policies, and improvements in specific sectors such as agriculture and industry.4 The reforms in each case are jointly identified by the authorities of the countries and by the staff of the international agencies, and subsequently they also agree on a strategy of approach and a broad implementation plan. These agreements are then formally included in a policy framework paper (PFP), which becomes the basis for structural adjustment loans from the World Bank and for arrangements supported by the structural adjustment facility (SAF) and the enhanced structural adjustment facility (ESAF) of the IMF.5 A survey of the PFPs shows that a substantial share of the institutional improvements is in the fiscal sector (estimated at 60–70 percent of the total) with particular attention to public expenditure planning, budgetary structure and process, budget implementation, accounting and financial reporting, public expenditure operations,6 and related areas.7Table 6 shows these features and the extent of their applicability.

The countries that have these arrangements are from Africa, Asia, the Caribbean, and Central and Latin American regions. Although they may not be fully representative of the problems experienced in all developing countries, the types and the dominant issues faced are covered in the table. For example, introduction of foreign exchange budgets, consolidation of accounts, and internal and external audit are somewhat limited in their incidence. Public investment review, improved procedures for release of funds, commitment controls, control of personnel expenditures, and public debt management are aspects that have clearly demonstrated their importance in the overall design of structural improvement. It is also evident that the introduction of a type of program and performance budgeting is, along with rolling expenditure planning, valuable in strengthening public expenditure management. Similar improvements were launched by some countries, while a few others (for example, India and Malaysia) progressed further in implementing program and performance budgeting. These changes were expected to contribute to improved resource allocation and increased resilience to uncertainty, and also to reduce micro- and macroeconomic distortions and provide greater incentives for efficiency by managers in government.

Managing Change

How do institutions behave? Do they favor growth? And, as discussed in the preceding sections, if they had avoidable rigidities and became dysfunctional, is there a long-term view that explains institutional behavior? How do they help the management of change of an ambitious program of structural adjustment undertaken by several developing countries? While such questions cannot be answered conclusively, some previous inquiries by economists and organizational theorists help us to gain a better perspective.

Lewis (1955) was one of the pioneering economists to examine not only the theory of economic growth but also the behavior of public sector institutions in achieving it. After recognizing that institutions do not necessarily evolve cumulatively in directions favorable to growth, he suggested that cyclical theories of institutional change may be explained in terms of biology, social attitudes, and social groupings (pp. 159–63). In biological explanations, movements take place in both directions and in each case they are attributed to the efforts of the types of people involved. Thus, when “progressives” are in power they may exert growth in favor of institutions. When “nonprogressives” are in power, may adopt attitudes that favor neither growth nor institutions. Similarly, the theory of social attitudes suggests that they shift between those promoting growth and those against it and that social institutions alter in the same way. Some individuals may seek change for political, economic, or other reasons. At the same time there may be other groups that stand to benefit from the status quo and therefore favor the existing institutional framework. The cyclical theory approach in terms of social groups suggests involvements or attachments shift in favor of or against change. Whichever mood prevails, it overwhelmingly influences the pattern of institutions and their role in economic development. The desire for change may be determined by the economic interest of the group seeking or opposing it. Those who reach power on the basis of their advocacy for change may in due course have to contend with opposition, and people may begin to revolt against the preceding order. When change takes place, and when the new group that resisted it comes to power, it may simply abandon the interests and the institutions of the previous group. The response then is not creative but pseudocreative because the advocacy for change is not so much for a new form as for abandoning the previous regime. Lewis recognized that these cycles of organizational change were not inevitable but might happen.

Table 6.Structural Adjustment in Public Expenditure, 1988–90
CategoryManagementNumber of

Countries (22)
I.Public Expenditure Planning
Program and performance budgeting10
Rolling expenditure planning12
Development of public expenditure planning in macroeconomic framework17
Public investment review19
Introduction of public investment budget7
II.Budgetary Structure and Process
Improved budget classification16
Link between annual plan and budget10
Foreign exchange budgets1
Rationalization of extrabudgetary accounts1
III.Budget Implementation
Improved procedures for release of funds18
Commitment control10
Identification, measurement, and clearance of arrears17
Improved financial management in spending agencies9
IV.Accounting and Financial Reporting
Treasury operations improvement14
Consolidation of general and special accounts1
Reconciliation with bank accounts2
Improvement of foreign aid accounts4
V.Special Areas
Census of government employees8
Control of personnel expenditures21
Public debt management19
Internal and external audit2
Change in composition of public expenditure6
VI.Support Measures
Administrative reorganization of government12
Civil service reform20
VII.Public Enterprises
Rationalization/privatization18
Review of enterprise budgets9
Monitoring flows between government and enterprises12
Improved assessment of enterprise performance14
Improved government supervision and control14
Sources: Country policy framework papers and related documents.

In applying these cyclical approaches to organizational change in the evolution of public expenditure management, it appears that the search for reform or change resulted partly from an explicit recognition of the inadequacy of the existing system for the new tasks that was partly abetted by a review of the comparative experience of other countries. In individual life, people look for role models to learn from their experience. In public life, countries look at the experience of others that have had similar problems. The desire for change does not seem to have been motivated by individuals or elites wanting to leave their indelible imprint on institutional development. Rather, most reforms in public expenditure management originated more from pragmatic considerations than from the dominant vision of an individual or group. On the other hand, experience also shows that many a reform died at birth, or was mutilated unrecognizably soon after it was introduced, or the benefits expected did not emerge owing to lack of support caused by satisfaction with the status quo. Therefore, the issue is how should change be managed when a section, dominant or otherwise, does not believe in change, owing partly to its uncertainty, and partly to aversion to risk.

Strategies originating primarily in military and diplomatic areas to secure effective organizations in peace and wartime have always existed. Some of the basic principles of military leaders from the time of Alexander and the diplomatic strategies of Chanakya and later-day Machiavelli have been modified or adapted to organizations in both government and corporate spheres. Alexander’s emphasis on the clarity of goals, or the more recent expositions of Clausewitz on the need for clear major objectives and a few central principles that can create, guide, and maintain dominance in the fog of war, or Napoleon’s emphasis on the need for planned flexibility are as relevant today as they were earlier.8 Within the framework of these broad principles, some approaches have been formulated, notably by Quinn (1980), Eden and Huxham (1988), and (Hage and Finsterbusch 1987 and 1989), regarding the management of change. Although these approaches were drawn mainly from experience in the corporate world, they are applicable to organizations in general and to government organizations also.

Quinn suggests that organizational change is easier when there is a strategy that seeks to integrate the major goals of each organization and the sequence of actions into a cohesive whole. The strategy aims at delineating the overall direction of the enterprise and a goal in the light of “predictable, unpredictable and the linkable changes that may occur.” The changes in direction are not always the result of power-political interplays and may have more humble origins in that each organization and each of its subsystems may set up their own goals in the light of their own cognitive limits and the limited functions of that organization. Such goals set up at each subsystem’s level may have a strong internal logic of their own, and together they may constitute a logical incrementalism. It is not a grand design conceived by a visionary but a plan that has all the components blended into a harmonious whole. Such a design should, however, have the capacity to deal not merely with the unpredictable (whose impact can be minimized through the formulation of contingent scenarios) but also with the linkable. Here Quinn suggests the importance of flexibility so that the strategy provides purposely built-in resource buffers and dimensions for flexibility. The strategist should review from time to time the emerging patterns and use them as feedback for altering the strategy wherever appropriate. The intent of the strategy is not to specify infinite detail about what needs to be done but to provide a framework within which a decision maker can refine his own judgment. Notwithstanding the importance of an articulated strategy, the limits of formal planning of change should also be noted. Too specific planning (as abundantly illustrated by the experience of the CPEs) may foreclose internal innovation and drive out important goals that cannot always be quantified. In an extension of Quinn’s approach, Eden and Huxham argue that an important ingredient in the success of any strategy is to gain the involvement and commitment of those whose actions will secure the organization’s future, rather than to produce perfect plans. Planning is often viewed as boring and as a ritualistic dance by many, and so long as the focus is on the methodologies that seek an outcome, organizational change is bound to run into bottlenecks. Rather, the focus should be on the process—on getting a management team to agree—to internalize the outcomes and generate commitment. The means of achieving this participatory approach is through strategic management workshops in which the various elements of the organization could join.

The analysis of Hage and Finsterbusch, which is oriented to government organizations in developing countries, suggests that change has largely been accomplished by four methods: (1) the decree approach—reflecting a one-way communication from the top; (2) the replacement approach—replacement of senior officials by another set with different views or skills; (3) the structural approach—modification of the internal processes and hierarchical relationships within an organization; and (4) the group decision approach—group members participate in the selection and implementation of alternatives specified by others who identify the problem, and the group agrees on a course of action from available alternatives.9 In all the approaches, however, the factors contributing to performances and outputs are identified that are at variance with those intended. When those factors are examined, many organizational theories appear to have emphasized one of the facets shown in Chart 5.

It is argued that any effort aimed at organizational change that is substantial (as distinct from a mere procedural change) and with a profound and enduring impact on how an organization conducts its affairs should take into account all the four groups shown in Chart 5. As for the approaches to make these changes, the research of Hage and Finsterbusch finds that the structural approach (modifying the hierarchical relationships and processes) with enough emphasis on experimentation and training offers a viable route, particularly in the developing world.

Chart 5.Four Approaches to Organizational Change1

1 Adapted from Hage arid Finsterbusch (1987).

In applying to public expenditure management the above theories and approaches to organizational change, two explanations are necessary. First, the debate over the last two decades has indicated broad agreement on the goals of change. The change has always been aimed at securing a greater degree of convergence between intent and outcome and at avoiding institutional rigidities so that the public sector institutions could perform efficiently. But the means or the timing involved in achieving that change has not been agreed. For example, opinion differed on the applicability of commercial accounting to government departments. Similarly, the issue was not about the introduction of rolling expenditure planning but about the amount of reserve to be set apart for management by central agencies. The issue in regard to program or performance budgeting was not about the relevance of the techniques but about the phasing of implementation. Second, should these changes be made in a context of economic stability when focus could be on the extent of the change to be achieved or should they be made to coincide with other major changes aimed at securing sustainable economic growth? In some cases, the strong relationships between policy and institutional changes may be such (as has been true with structural adjustment) that no option may exist. The theories considered above enable greater understanding of the anatomy of organizational change, the pitfalls of uncoordinated work as well as of too detailed planning, and the environmental factors involved. Change is still a matter of judgment and the theories considered here offer the prospect for making more informed judgments.

Progress in Implementation

A review of the progress actually achieved in implementing the improvements illustrated in Table 6 reveals a mixed picture. There have been numerous successful efforts at rationalizing extrabudgetary accounts, improving financial reporting and monitoring (including reconciliation with bank accounts), and streamlining public investment budgets. These in turn may have had a catalytic role in reducing the size of budget deficits in countries with SAF and ESAF programs. (The reduction is often the result of greater mobilization of revenue resources as well as expenditure adjustments, in particular in the area of subsidies.) The definitive contribution of institutional improvement is more difficult to assess. However, there is an overwhelming impression that progress may have been much slower. For example, a World Bank report (1988a) observed that “few of the reforms have had substantial impact on planning, policy analysis… in the public sector” (p. 45). Another study (Paul, 1990, p. iii) on institutional development in World Bank projects concluded that institutional development performance had declined during the eighties. While some few improvements have occurred, the general impression both in countries and among international agencies is that fundamental fiscal institutional reform to sustain growth or even to minimize waste and profligacy in government spending has been insignificant.

Two interrelated issues arise in this context. What are the factors contributing to this hiatus in institutional reform in general and in public expenditure management in particular? Why is institutional reform so glacial? The answers are to be found in the constraints of institutional reform, and the strategic, environmental factors, and management styles.

Constraints of Institutional Reform

The experience gained from institutional reform specifically aimed at economic development and stabilization over the last two decades shows that a number of constraints affect implementation of reforms. The first is the type and extent of government commitment to reform. Far too often this commitment is only skin deep, aimed more at impressing the donors than at achieving results. Even where firm commitments are made, they are interrupted by political changes or upheavals. Each of these changes affects progress in implementation. As Lewis pointed out, the cycle may be such that protagonists of reform may be followed by those antagonistic to institutional improvement. While political changes cannot be safely and easily predicted, they clearly have a substantial impact on implementation. In turn, this suggests the need for a more broad-based consensus on the scope and content of reform.

The second constraint is the administrative capacity of the country itself. Administrative systems have often undergone policy and personnel changes too rapidly over too short a time. In addition to engendering administrative instability and the lack of a traditional or organizational culture, such changes erode the basic capacity of governments. Where such erosion occurs, the feasibility of reform, regardless of its scale, should be assessed more carefully. The third constraint is macroeconomic performance. Where macroeconomic conditions are stable, they contribute to organized efforts for institutional improvement. But where stability, despite policymakers’ efforts, has become difficult to achieve, their attention becomes focused on the policy instruments contributing to stability, and thereby, administrative improvement becomes a matter of lower priority. Also, economic fragility contributes to political fragility, which in turn may prevent pursuit of administrative development. The role of political leadership may even sometimes be suspect.

The pace of reform is a fourth constraint. Should reforms be implemented radically or gradually? While both have their appeal, and, recognizing that there are no two steps to jump a stream, radical approaches may often have unintended and unanticipated consequences; on the other hand, where reform is too gradual, its benefits might not be discernible, and therefore the reform movement might not be able to sustain the support that it received previously. In either event, where the content of reform lacks boldness, clarity, or relevance, the pace of reform becomes secondary and cannot compensate for what is lacking in content. Experience shows that boldness in design and its relevance to the problems can be sustained even when the pace of implementation is deliberately structured gradually. The fifth constraint is a commonly accepted notion that institutional reform is slow. Although this view has no underlying empiricism, much less a logical explanation as to why it should be so, it has gained considerable currency and has almost come to be considered tautological. It is based on the belief that changing deep-rooted values and education tend to take time. At the same time, there is nothing in history to show that where the objective is appropriate, relentless efforts will not produce the desired results within a specified time frame. Experience with preparations for war has time and again demonstrated that institutional adaptation need not be slow. But the permeation of the notion that it is slow has contributed to an air of pessimism that in turn constrained implementation.

As for the strategic factors, no firm strategy existed for implementing the proposed reform,10 nor was there a strategy for follow-up. Therefore, reforms lost their credibility and could not be sustained. Also, not enough resources have been provided to sustain reform and the systems were overstretched, called upon to do a variety of tasks, all within a short time. In a few cases, as the phasing of reforms was not addressed comprehensively, some elements of the package were implemented without taking into account their linkages with other elements. Meanwhile, as the expected benefits from those implemented did not emerge, disillusionment crept in. Those with the responsibility for implementing reform also have the additional task of sustaining the enthusiasm of those who are involved. Leadership can sustain such enthusiasm only for a limited time. Experience also indicates that where a strategy existed, selectivity or the enclave approach (critical agency approach) was ignored. In some cases, the uncertainty of future budget conditions was also not adequately internalized in the strategy.

Environmental factors were also not properly considered. Reform is more than an adoption of a new system or the installation of a new technique. Fundamentally, it is change in the prevailing (and often deep-rooted) values. Those values do not change by administrative decree. Rather, a strenuous effort to educate is required along with the forging of a broad consensus. In several cases the need for reform was taken for granted, as were the benefits to accrue from it. Where such efforts were launched, benefits were too few and spread too thinly. Inevitably, “business as usual” took over. Alternatively, the changes were only on the surface, while the deep-seated problems were large and unidentified. Further, the approaches were generally reactive, rather than proactive: the systems were not geared to anticipate problems but to deal with them as and when they arose. Also, because government administrators do not bear the costs of delay or even of failure, those with responsibility for implementation had no incentive to do better.11 The responsibility for implementation was often not established in any new agency, but it was expected—unrealistically—that each agency concerned would be responsible for improving itself along the lines indicated in the PFPs. In addition to the consequent lackadaisical effort, it also meant that the responsibility for implementation was too diffused to permit cohesive implementation.

The slow pace of implementation cannot be explained only by strategic and environmental factors or by the constraints but has also to be seen in terms of more intangible factors such as management styles. Montgomery (1987) points out, referring to the African experience, that administrative reform “would have to be an act of individual leadership; it cannot occur as a byproduct of conventional social exchanges… personalism in African administration is collective” (p. 924). He also states that officials seldom act alone even in the personalistic system prevalent in Africa. While leadership is clearly an important factor, how it can be forged is less clear. Leadership in reform will have to be—to use the analytical framework of (Burns 1979)—transforming rather than transactional.12 Specifically, leadership is to provide a definition of the mission, infuse the organization with purpose, resolve internal conflicts, and do this flexibly and adaptably.13 While these features may be specified, in a number of countries institutions and institutional leadership were neglected in the personal and personalized rule at the top. Inevitably, then, institutions are underutilized and more concern may be shown for the process than for issues relating to the direction of reform. An important but preliminary step to reform is to restore the institutions to their expected capacity so that leadership can emerge and positive management styles prove constructive.

Two other related factors also seem to have contributed to the slow implementation of adjustment. A number of countries depend on technical assistance—on a multilateral and bilateral basis—for implementing reforms. But the impermanence of technical assistance arrangements may also have led to a less-than-expected performance. The proper exercise of conditionality by international institutions would have provided stimulus for accelerating the pace of implementation. Mosley, Harrigan, and Toye (1991) argue, for example, that given the option between disbursement of project loans and the exercise of conditionality (that is, nonperformance of agreed goals would stop disbursements), the aid agencies preferred the former. In the circumstances, implementing structural reforms was bound to be slower.

II. Institutional and Systemic Adjustment to Market

The amplified echo of the failure of some CPEs had become abundantly clear as the presidential guidelines in the then Soviet Union declared in 1990, “the budget deficit and the solvency of the government are now at critical levels.”14 The CPEs had started addressing the issues of the transition to a market economy almost a decade earlier. While the economic policies to be pursued by these countries had been much debated, there was little or no discussion until recently about the implications of the market economy for institutions engaged in public expenditure management.15 This brings an additional element of urgency for an informed debate about the future shape and tasks of public expenditure management institutions.

Two explanations should be noted, however, at the outset. First, CPEs comprise, in addition to the 15 now independent republics of the former Soviet Union and other East European countries, Algeria, Angola, Benin, China, the Congo, Cuba, Ethiopia, Guinea, the Lao People’s Democratic Republic, Mongolia, Mozambique, Myanmar, Somalia, Tanzania, and Viet Nam. Most of these countries have been engaged for some time in adjusting their budget and expenditure management systems and have made varying progress. For the discussion here, however, the former CPEs are considered a generic category. In an extension of this approach, no distinction is made about the degree of freedom in the market. (A market is not an economic abstraction. It is a reflection of an institutional and legal framework, and each law, in spite of its laudable objective of facilitating the functioning of property rights, may also sometimes limit or encroach on the freedom of the market.) Second, the existing systems are not described here,16 and instead the emphasis is on the direction and composition of the change needed. Given the variety of countries and their different levels of background and development, it is difficult to be specific about the form and content of expenditure management systems. As Robert M. Solow observed, “there is not some glorious theoretical synthesis of capitalism that you can write down in a book and follow. You have to grope your way.”17 The discussion here is intended to facilitate this search.

Any effort to improve the systems should start by identifying the systemic factors that are unique to CPEs and that have contributed to the state of fiscal insolvency of many of them. Four aspects distinguish these systems from other systems. The systems in CPEs basically reflect a value chain that distinguishes itself in these four aspects. First is the assertion that there is no financial constraint. Resources are expected to grow continuously and therefore the possibility of a budget deficit is remote in both the short and the long terms. The absence of a financial constraint unleashes forces in the government that are pro-expenditure.18 Each year’s level would become a base for racheting expenditures upward in the following year. As a corollary, this contributes to what is commonly described as a “spending mentality” or to a situation where achievement consists of aiming for and securing higher expenditure growth. Second, primacy is attached to the development plan. The plan is the basis for the budget, and the budget is the plan estimates in physical terms translated into monetary terms at prices that are determined centrally. As resource shortage is not envisaged, and to the extent that prices are determined centrally and administratively, the budget is viewed more as a framework for spending and accounting than as an instrument of fiscal policy. (Fiscal policy objectives are already presumed in the plan.) Inasmuch as programs are determined as part of the plan, no corroborative effort is made either in the ministry of finance or in the spending agencies. In fact, the plan engenders a sense of vertical integration of all agencies—each assigned a role in the central plan.

Third, the enduring impact of the centralized direction is significant, as, to use Fukuyama’s (1992) analysis, the agency may come to fear “freedom in favor of security and to affirm the goodness of [its] chains even in the absence of coercion” (p. 24). Extended centralization tends to corrode the basic approaches of an agency. This is inherent in the feature of so-called “democratic centralism”—a phrase that would normally be considered an oxymoron but for its extended use. Under this approach, the budgets of regions, provinces, and other levels of local government are included in the national budget. The distinction does not lie in the nature and magnitude of the expenditure tasks to be performed at different levels but in the territory under each one’s administration. The territory is often determined on ethnic and political grounds and may not involve any legitimate rights of ownership of property. The fourth aspect is the role played by public enterprises. These enterprises work mostly as appendages of government departments for administrative purposes but draw their finances from the budget, the plan, and from a credit budget approved by the government. The credit budget indicates the amount of credit that enterprises can draw from the specialized and commercial banks, also owned by the government. These agencies provide credit not only for investment purposes but also for a variety of subsidies, in particular those relating to the procurement of grain from the collectives, cooperatives, and individual farms. In addition, losses incurred by enterprises are routinely financed by credit from the central bank. Because of the large public enterprises, the credit budget thus became a kind of parallel budget. In some cases, the budget itself is separated into many extrabudgetary accounts that perform budgetary tasks without being governed by the discipline associated with the budget itself.

Two other less important features also need to be noted. Accounting in government in CPEs, which is not substantially different from enterprise accounting, is primarily intended to provide the needed information for formulating development plans. Consequently, it is little used either for building up cost data or for related monitoring. Another aspect is the preference for rule through administrative decrees. Excessive reliance is placed on these for communicating with the vast network of agencies. As decrees, they represent decisions already made and do not dwell on the rationale for the decision or the factors contributing to it. As they are too numerous and too frequent, institutional memory in those who are expected to comply with them tends to be limited to the more recent ones. Although they strengthen the role of the central planning agency, the agencies are prevented from building up their own capability.

The transition to the market involves fundamental and not cosmetic changes. The republics that were previously part of the Soviet Union have become independent countries. In graduating from a republic to an independent country with its own juridical rights and responsibilities, each has also been compelled to build up new institutions of public expenditure management that provide transparency and accountability for transactions in a manner consistent with the objectives of political freedom. These institutions will go through the inevitable phases of growth and will have to clear numerous obstacles before they become operational. Their design is a priority in these economies. They have to be built in a context where fiscal policy itself will be moving from the artificial security of a five-year plan to an economy that is open and at the crossroads of many changes. Realistically, therefore, they have to reorient themselves to a framework that informs them about the direction of the economy and the impact of the linkages between the economy and the budget. As an integral part of this effort, attention will have to be focused on the inertial or other factors that have contributed to the growth in expenditures and, thus, to a state of financial insolvency. The absence of resource constraint can no longer govern the future. Instead, an explicit recognition of that resource constraint should govern expenditure determination. If the composition of expenditures is unsustainable (owing to the high level of subsidies and related populist measures and high defense expenditures), any additional effort to mobilize resources will be both costly and futile. The options may lie in altering that composition.

The transition may also be characterized by high inflation rates. As prices and markets are liberalized, prices tend to increase steeply in a short time. These increased price levels in turn exert pressure on expenditures because, to absorb price increases, new expenditures may have to be incurred to ameliorate their impact on the traditional and new classes of the poor. This factor also has to be reckoned with as part of the adjustment to the market.

The establishment of new countries and governments requires a clear delineation of the fiscal tasks and responsibilities of each level of government.19 While, as Oliver Wendell Holmes observed more than a century ago, “a constitution is not intended to embody a particular economic theory” and is made to accommodate fundamentally differing views, it has an obligation to specify the powers of taxation, spending, and the nature and size of budget deficits. In addition, it (or associated legislation) has the obligation to specify a framework for reaching agreement on macroeconomic objectives, assumptions, and practical measures to coordinate budgetary decisions between different levels of government. These aspects would be more important in a framework of regional cooperation.

Design of Institution

The role of three types of institutions would be transformed in a move to a market-oriented system. The first two are in the broad realm of the executive wing of the government and the third concerns the functions of the legislature in the management of the public finances of the country. In the executive, importance is to be attached to realigning the roles of the ministry of finance and the spending agencies on the one hand and the central bank on the other.

It is assumed that with the determination to move to a market-oriented economy the kind of central planning that provided a framework for the conduct of government affairs and related judgments will be abandoned and that macroeconomic management of the country will become the responsibility of the ministry of finance.20 The ministry will have to undertake several tasks previously not undertaken in CPEs. The first is to ensure that the budget has fully achieved a macroeconomic orientation. The interactions between the economy and the budget and between the budget and the economy should be analyzed. In turn, an understanding of the broad effects of different macroeconomic scenarios has to be developed, especially the impact of major deviations from the assumed inflation rate (if inflation is the main problem) on both spending and overall budget balance. The overall budget balance will have to be arranged so that revenues and borrowing can be distinguished. Although the budget is always balanced in an accounting sense in that inflows are equivalent to outflows (excluding accumulated payment arrears), economic analysis requires a rearrangement of the categories of revenue so that the deficit financed by domestic and foreign borrowing and associated means can be clearly ascertained. In addition, it is essential to identify the impact of inflation rates on taxes and nontax revenues allowing for lags in collection.

Similarly, expenditures may be divided into several modules to permit a deeper analysis of the impact of changes in price levels and exchange rates (for example, transfers—subsidies dependent on prices and quantities, interest payments—rates of interest and exchange and impact of indexation, wages, social expenditures, and capital investments). These categories are illustrated in more detail in Table 7. Without reliable national accounts, it may only be feasible in the first stage to establish simple relationships between readily observable economic variables such as prices and interest rates and budget aggregates. For example, a ten-point increase in the price index could mean a specified ruble (or other currency) increase in mandatory payments. Similar calculations would be feasible for changes in interest rates. Over the longer run, the relationships of budget categories to a system of national income and product accounts can be refined and used for formulating budgets. For expenditures, it is essential to recognize that public spending objectives would follow from decisions about the size of the deficit and the related financing plans, including measures to mobilize additional resources. Following from this, an achievable expenditure strategy over a period of two to three years should be laid out, requiring detailed expenditure planning in cash terms. For countries that have had central planning for more than four decades, and where the phrase “planning” had become derogatory, this may seem like a variant of planning. In reality, however, expenditure planning in a market-oriented economy is different. It is not intended so much to be a blueprint for future operations as to provide an understanding of the continuing and future financial implications of policies already in force so that the margins available for expansion/freedom can be ascertained. It seeks to provide an in-depth analysis of the factors at work in the expenditure profile of major programs so that increases in costs can be determined. It is generally made on a rolling basis so that each year’s forecasts could be adjusted in the light of the latest developments. It also generally contains a contingency provision of varying magnitudes to accommodate likely changes. It is thus a framework for illuminating the issues, choices, and decisions.

Second, it is expected that the ministry of finance will provide guidance to the spending agencies on the resource constraints and the consequent limitations either for increasing or reducing expenditures. To provide such guidance, the ministry of finance must have a strong analytical capability to examine the trends in the economy and in government programs. Such guidance may, in the light of the above type of expenditure planning, also cover the programs to be abandoned or intensified in the light of the changing economic situation.21 The budget guidance, although akin to central planning procedures, should be a vehicle for communicating resource ceilings to the spending agencies so that they can be given the operational flexibility to choose appropriate programs within those ceilings. It is also an opportunity for administrative agencies to reassess their own programs.

A third step is to establish a responsibility in the ministry of finance to undertake an analysis of programs, such as what principles should guide defense and investment budgets in the new context. The defense budget would cease to be governed by the polemics of the cold war, and with privatization, greater reliance may have to be placed on procurement rather than on in-house production. Amounts may have to be provided not for the fabrication but for the dismantling of the existing arsenal. Similarly, the choice of investment (which will increasingly be limited to infrastructure activities) and the consistency of the chosen level with the macroeconomic framework and the future maintenance requirements will have to be assessed. Subsidies, which previously covered large areas of the economy and which have been open-ended, need to be reassessed in the market context. This examination of the undercurrents of programs should be institutionalized and made an integral part of the budgetary process.

Table 7.Impact of Market Orientation on Government Budget
Budget ItemsCPE SystemMarket-Oriented EconomyInformation for

Estimation and Analysis
A. Revenues:Analysis requires estimates of buoyancy and elasticity of revenue items against relevant revenue bases.
1. Taxes on nonagricultural cooperatives and private sectorPrivate sector’s role not significant in economy; revenues are negligible.Importance of private sector activities will dominate economic activity. Income taxes will gradually increase in importance and become major revenue source.Income taxes collected can be projected by using proxies for growth in GDP, wages, and consumer prices.
1.a Turnover taxValue of turnover constrained by price controls; revenues stagnant.Free market pricing will ensure buoyancy of turnover taxes if rates are ad valorem.Value of turnover should be projected according to price projections and factor for market demand changes.
1.b Profit taxProfits are regulated; revenues are stagnant.Profits determined by market demand conditions and corporate profit taxes will increase in importance as market expands. Tax administration should be developed to avoid lags in payment and evasion.Data on turnover and proxy for profit margins by sector can be used.
1.c Commodity taxesSales taxes on goods and services constrained by price controls.Sales taxes are collected on monthly basis. Highly elastic with price developments and could be reliable source of revenue.Sales taxes can be projected using price indices.
2. Agricultural taxInsignificant and cumbersome as it was partly paid in commodities. Difficult to value.Income taxes on agriculture are difficult to assess, but indirect levies such as land taxes or sales taxes are easier to collect in cash rather than in commodities.Projections on agricultural output and prices and exports should be used.
3. Trade taxesRevenues constrained by artificial transfer prices from Council for Mutual Economic Assistance (CMEA), and distorted exchange rates did not reflect scarcity value of traded goods.Market-related exchange rates help dampen excess demand, and taxes on international trade are very important sources of revenues. Difficult to evade and easy to collect, and elastic if rates are ad valorem.Data on values of imports, exports, and projections of exchange rate changes and price changes of major groups.
4. Taxes and transfers from state-owned enterprises (SOEs)Lags in price adjustment reduce profits; most important source of taxes—based on turnover. Taxes collected reflected extent of subsidized inputs.Nonprofitable SOEs will be subject to restructuring. Profits will be affected by autonomy of enterprises on decisions of production, pricing, and investment. Switch to corporate profit taxes may imply decline in relative contribution of SOE during transition, as surpluses of SOEs will no longer reflect input subsidies that were eliminated.Information on profit and turnover, and changes in cost structure and market demand indicators.
5. Crude oil exportsLocal value depends on exchange rate paid by special trading agreements.Free market price and appropriate exchange rate will provide full value for exports.Price of oil, exchange rate.
6. Nontax revenuesFees set at artificially low levels.Inflation adjustment of fees, and cost recovery measures will improve receipts.Projected inflation rate.
B. Expenditures:Analysis uses measures of expenditures in real terms, movement in relation to prox) indicators such as GDP.
1. Wages and salaries
1.a Basic wagesFixed wages supplemented by commodity rations.Automatic adjustments indexed. If wage adjustments not fully indexed with inflation, wage bill can be controlled in real terms.Expected average wage increase; change in size of labor force.
2. Transfers
2.a Social security fundNone because prices are subsidized.Social security funds will cost government in short run but cost will be much less than provision of subsidies under CPEs.Payroll information on salary level, structure, and changes.
2.b Transfers for working capital of SOEsSOE losses and working capital requirements automatically covered irrespective of efficiency considerations. Open-ended subsidies ofVery limited. Reliance on banking system finance encourages financial discipline and more efficient utilization of resources; lower outlays.For selected SOEs, data on expected costs (current capital) and sales revenue projections.
3. SubsidiesMajor expenditure items. Production subsidies to cover SOE losses and consumption subsidies result from prices set at below cost. If costs cannot be reduced, subsidies are open ended and inefficiencies increase government expenditures and contribute to inflation and cost hikes in vicious cycle.Subsidies for production by SOEs eliminated. Open-ended subsidies for consumption goods abolished. Prices will improve resource allocation and solve problem of excess demand. Limited subsidies to essential inputs can be phased out as markets develop.Breakdown of projected costs and recoveries for each subsidized item.
3.a Food procurement
3.b Production
3.c Exports
4. InterestDepends on size of debt (domestic, foreign); interest rates and exchange rates held down artificially reduced outlays but had serious distortive effects on economy.Depends on size of debt; interest rate reform and free exchange rates will increase outlays, but should encourage more responsible borrowing for more clearly productive uses.Projected interest rates, schedules of repayments, and exchange rate projections.
5. Goods and services



Administrative expenditures Operating and maintenance expenditures

Services (education and health)
All purchases determined according to plans and reflect dominant role of public sector. Costs do not reflect market value and thus do not encourage efficient utilization of goods and services.Volume of purchases will decline in real terms as more activities are taken over by private sector. But costs will reflect market prices, which will require higher unit cost. Value-for-money considerations should be encouraged to improve efficient use of outlays.Information on import consent, (direct and indirect) exchange rate, information on special purchases, e.g., petroleum and projected prices; cost inflation proxy, e.g., consumer price index.
6. Other (including security and military)Depends on size of operations; lack of correct valuation of resources may encourage excessive outlays.Depends on size of operations; private contracting for supplies will eventually reduce outlays; exchange rate changes will increase outlays for import content.Policy decision on growth rate in real terms and cost of import content.
7. Capital expendituresLarge outlays; determined according to material balances in plan. Evaluations distorted by artificial prices, interest rates, exchange rates, which may result in wrong priorities for investment. Excessive emphasis on heavy industry, self-sufficiency, and protection.Much smaller outlays limited primarily to infrastructure, as private sector takes responsibility for investment in economy guided by markets. Appropriate prices and interest cost will guide investments to most competitive and efficient sectors.Detailed public investment programs (PIP) showing individual project costs (domestic and foreign); multiyear profile and priority ranking important supplementary Information for complete PIP.
C. Fiscal deficit (excluding grants) and government financing requirements:Deficit determined according to plan. Excessive fiscal deficits should be avoided but if they occur, not considered economically significant since price changes are controlled; thus excess liquidity (monetary balances) generated from government dissavings will have to be offset by “forced” household savings. Manifested in shortages of supplies relative to demand at official prices.Fiscal deficit is critically important to economic management throughout year. Size and financing of deficit affect economic activity and money supply. Deficit financing is most important cause of inflation as prices are free to move and excess liquidity chasing limited supply of goods represents excess demand. To curtail excess demand, deficit financing (particularly printing of money) will have to be reduced by control of deficit. Choice of fiscal deficit financing requires delicate coordination with monetary policy instruments (domestic debt management) and external sector policies (external debt management).Important indicators or targets are deficit/GDP ratio, and deficit ratio to revenues or expenditures. For analysis, deficit excluding foreign interest (primary deficit), current savings (i.e., excluding capital expenditure), and other indicators of deficit can be used for macro fiscal analysis.
Foreign borrowing (net)
Former trade blocs within CPEsBarter trade transactions are means of payment. Relative competitiveness of different countries is not measurable; loans have large implicit grant element determined by noneconomic factors such as solidarity.Trade and loans among all countries are denominated in convertible currencies. Since repayment will be in hard currency, true international competitiveness of utilizing borrowed funds will determine purchasing power of domestic currency.Foreign financing has to be consistent with balance of payments projections of loans and grants.
Convertible currenciesBudgetary impact is dependent on amount of debt contracted.All debt is contracted and repaid in convertible currencies. Flexible exchange rate implies constant revision of debt revalued in local currency cover, which has to be mobilized even when there are external payment arrears.Has to be consistent with balance of payments analysis.
Domestic borrowingUsually determined as target, which has to be consistent with projected level of monetary growth and projected inflation.
Banking systemBalancing item by default in financial plan; affecting monetary balances held by public with no outlet but savings at banking system. Fully accommodating monetary policy ensures inflationary financing of deficit; but inflation not immediately recognized in state-owned sectors.Of critical importance to level of credit in economy. Liquidity in economy increases by multiplier effect at commercial banks and directly results in inflationary pressures (as more money chases limited supply of goods). This excess demand also spills over to external sector as excess demand for imports, which causes deterioration in balance of trade. With flexible exchange rates, price of foreign currency (exchange rate) will also depreciate. Short-term monitoring of bank borrowing by government is critical condition for financial management and stabilization program.
Nonbank borrowingNot practiced.Important stabilization policy instrument for short-term financial management. Interest rates will have to be remunerative. Instrument draws down liquidity from economy for short period to allow fiscal measures to take hold (usually with a lag). Without correcting the fundamental fiscal problem, interest payments by government add to deficit and liquidity soon after.Determined in context of monetary and macro policy, which should be reflected in projected interest rates.

Interest costs would increase future expenditures.
ArrearsRegarded as accounting problem.Regarded as form of credit with same monetary implications. Nonpayment to government of liabilities by taxpayers or borrowers has the same effect as government lending to them in terms of liquidity in economy and inflation. Arrears are an inflationary instrument of financing. External arrears are inflationary unless their value is sterilized in blocked accounts and frequently contribute to eroding real value of currency.Detailed schedule for reduction of arrears (domestic and foreign) required.
Below-the-line accounts and contingent liabilitiesNot significant, as whole economy is largely public sector.Domestic banks lending to SOEs, or foreign banks lending for projects will seek to reduce their exposure to swings affecting market conditions through acquiring lower risk of sovereign debt. Unless uses of loans were efficient, contingent liability will turn to real expenditure by government in due course. Control of government guarantees is a financial management practice.Detailed schedule of contingent liabilities should be analyzed to understand level of risk to budget and to alert policymakers.

A fourth step is to rationalize the focus of the credit budget. Formerly, this budget represented an amorphous collection of projects that were funded (or pressured to be funded) by the banking system. They often represented the projects of public enterprises or other projects of a pork barrel nature, launched by the local party organization. These are funded by credit in name, but in reality they are a charge on the national budget through the operations of the central bank. As this has come to represent a major leakage of the control framework, all advances and other loans to enterprises and other agencies must be organized as part of the credit or lending part of the budget. The intent of this integration is to ensure that the credit budget is subjected to the basic financial discipline of the country.

Fifth, the relationships between the government and public enterprises (such as those continuing after privatization) need to be redelineated. The traditional cord between the government and enterprises would need to be delinked, and dependence on the government budget would have to be replaced by banking institutions and market borrowing. The constraints or the lack of them on the operations of enterprises would be market induced and not determined by administrative caveats. This liberalization would involve several changes in all the financial relationships between the government and enterprises, as illustrated in Table 8.

The role of the ministry of finance during budget implementation should also be strengthened in line with the requirements of macroeconomic management. Previously, the role of the ministry of finance in CPEs during this phase had been passive and confined mostly to compiling periodic reports about progress in budget implementation. Compliance was then more accidental than a deliberate strategy followed by the ministry of finance. In a market context, however, such a detached attitude would be inadequate and therefore problematic. Noncompliance, as noted in Chapter 4, could be too costly. The ministry of finance may therefore have to install, in addition to the work and financial plans to be submitted by the spending agencies, an apportionment system so that releases can be made periodically with reference to the flows of revenues and the borrowing program. Also, whenever appropriate (and particularly when the inflation rate contributes to higher fiscal slippages), a system of cash limits may be utilized. The ministry of finance will therefore have a continuing role to monitor budget implementation and to take corrective action.

Expenditure Control Framework

As discussed earlier, all the relevant controls on the operations of agencies and enterprises in CPEs were exercised through the plan framework, which also provided instructions on the norms applicable for each sphere, including the personnel and materials needed. The basic tool used was the concept of “standard costs,” a monetary reflection of the physical aspects. Financial controls, if exercised, primarily related to reviewing payments that were mostly made through the commercial banking network, which was also owned by the government. In this framework there was little incentive for the agencies, regional governments, or enterprises to be economical or efficient, and consequently, financial awareness or action was not required in the agencies. Even the accounting responsibility was somewhat remote and the decision makers in agencies had only to ensure that the amounts allotted were spent. In fact, more of their energies were devoted to laying claims for more funds than to managing them prudently.

In a market orientation, such an approach, if allowed to continue, could pave the way for fiscal distress quite quickly. The ability to formulate prudent budgets depends on the quality of guidance provided to the spending agencies and on their capacity to comply with that guidance. This in turn requires strengthening their financial management capability for compiling costs, formulating estimates and contingency plans, reformulating spending priorities when confronted with shortfalls in revenue resources, avoiding excess expenditures over allotted amounts, and using resources economically. As the agencies become equipped with an internal control structure of the type discussed earlier, incentives and penalties to ensure compliance with prudent financial management would be required.

To enable the agencies to perform their new tasks better, budget classification (which has grown haphazardly in CPEs) should be revised to serve the needs of agencies’ internal management as well as those of legislative oversight. At the agency level, budget classification has to be revised to meet the needs of computing costs of programs. The role of an appropriate classification system in prudent house management and in providing transparency can hardly be overemphasized.

The accounting system should also be strengthened to reflect user needs.22 Reporting has to be prompt and classified to serve as a window on government operations, while also being suitable to address the problems of the agencies in cost measurement and containment. Its role will thus have to be reoriented from that of a conduit to a statistical system of central planning to that of an information supplier to the immediate decision maker, to the general public, and ultimately to influence the decisions on expenditure control.23

Table 8.State-Owned Enterprise Control Framework
CategoriesCPE SystemTransition to Liberalized System
1. Regulatory frameworkCommand economic system based on planned production quotas and material balances; expected enterprise surpluses are transferred to government on basis of production and price levels set by plan.SOE formulates own plans with limited guidance from government. New approaches permit SOEs to organize own production, output, and sale prices. Taxes on turnover, profits, and royalties are estimated on basis of enterprise plans but are collected on basis of actual financial performance of the SOE in market. No performance contract system but costs are monitored by parent ministry and tax department.
In monopolies (e.g., energy sector), output prices are still regulated on basis of social policies of government. Some other input prices (e.g., cement and roofing for construction) are also subject to selective controls. State Pricing Committee sets prices for controlled items and acts as occasional arbitrator of input prices between SOEs.
2. Information requirementsDetailed information on prices for every input and every output are required economy-wide for analyses and consolidation by regulatory agencies. Determination of input-output relationships is complex, not easy to revise when mistakes are made, and rigid. Effects of wrong decisions in one area are compounded by generation of misleading information for decisions in other areas. Excessive microeconomic information did not result in better decision making at macro level.Apart from indicative policy changes, on macro level, financial decisions and management are left entirely to SOE. No micro level information needed outside SOE. Flexibility of SOE management to make quick decisions or changes of cost and prices as market conditions develop. Unified corporate accounting system based on balance sheets will help investment analyses and tax assessment.
3. Inputs
a. WagesSet by ministry of labor and social services for all sectors.General wage guidelines for sectors recommended. Only minimum wage is set by ministry of labor and social services; bonuses and management remuneration can be used to supplement reward system in SOEs; hiring and firing decisions taken by enterprise management.
b. Raw materials (domestic)Supplied by SOEs according to planned levels. Prices very low, which resulted in shortages and hoarding.Supplied through market pricing closer to international prices; higher prices discourage wasteful utilization and hoarding or leakages (smuggling).
c. Imported raw materialsAvailability based on socialist bloc protocols; prices were lower than nonsocialist international prices.Critical imports of fertilizer, cotton, steel, and petroleum fell sharply from former U.S.S.R. and socialist bloc. Imports in convertible currencies at international prices are obtained from all countries. Difficult transition problems require new technology to raise quality of outputs to international competitive standards.
d. Credit or capital from governmentAccumulation of capital through acquisition of fixed assets was determined by plan according to socialist criteria and input-output considerations in support of other sectors. Working capital was provided on financial plan (budget), and SOE losses were automatically covered by budget.Limited working capital selectively provided to infant industries. SOEs are responsible for their own investment decisions on basis of financial performance. SOE capital financing will be sought from banking system, which is left with responsibility of risk assessment according to alternative uses of funds and interest rates. Foreign shareholders are encouraged by guarantees from government.
4. Outputs
Level of production and pricesAccording to plan of material balances and controlled prices.All prices are determined by market demand conditions; production levels up to SOE management in conjunction with market demand. Low-quality products that cannot compete with imports will suffer loss of market share and will be less profitable. Excessive capacity cannot be fully utilized unless quality allowed opening up of export markets.
5. Fiscal
a. Taxes payableTaxes based entirely on production and price levels stipulated by plan. Actual collection depended on negotiation of tax liability by SOE ex post, taking into account slippages in plan, performance problems, and other factors.

Tax based on turnover. Taxation drains all excess income from enterprise since decisions on investment are made disjointly from earnings.
Tax reforms: (a) replaced tax system based on decrees with system based on legislation and tax laws; (b) uniform tax treatment for SOE and private sector; (c) tax base diversity introduced by new tax laws on business income (turnover), profits, special consumption (excise) taxes, revisions to export and import duties, personal income taxes, natural resource taxes, and new agricultural tax law; (d) balance sheet treatment of depreciation and retained earnings and carry forward of losses against future profit taxes.
Tax assessment is not easy to calculate and depends on several factors. Tax laws work as incentive system for generating income
b. Monitoring lossesLosses covered automatically by budget. If enterprise produced several products that could not be sold, stocks stockpiled and enterprise received more funds to cover operating losses. Monitoring based on material balances; financial considerations did not trigger quick change in production plans.Loss-making enterprises not given any subsidies or transfers from budget. Measures to resolve their problems and increased efficiency left to SOE. Dissolution procedures put into effect, and parent ministries receive financial reports from SOEs.
c. Monitoring financial and physical performancePhysical financial monitoring done by reporting to enterprise unions, parent ministry, and provincial tax office.Physical performance monitored by SOE management in consultation with parent ministry. Monthly reporting to parent ministry, and tax monitoring by department of taxes. Inspection visits by parent ministry and department of taxes.
d. Capital expendituresProvided for in financial plan according to material balances plan.Very little provided from budget to new SOEs of strategic importance. Most of financing should be from banking sector, and retained earning and depreciation. Capital budget limited to infrastructure.
e. Debt managementExternal debt according to financial plan. Little domestic borrowing.SOE can draw external funds from joint ventures. Bank borrowing is an important source of working capital.

Central Bank

A major change is also required in the nexus between the government and the central bank. Although discussion of the autonomy and related aspects considered essential for effective functioning of the central bank are beyond the scope of this work, two features merit particular attention. First, the central bank (as elsewhere) acts as a fiscal agent of the government. In CPEs, however, this role is even stronger in that the central bank covers deficits either from its own resources or through inflationary financing. The costs of borrowing are not felt within either the agencies or the government as a whole. As a corollary, there is also no organized cash management either in the government or in the central bank to achieve a greater degree of convergence between resources and expenditures. Second, the central bank also functions in some CPEs as an accounting agency of the government and in that capacity furnishes its consolidated accounts. But these accounts, as is to be expected, are on an aggregate level and are therefore less useful for day-to-day internal management within the agencies.

Neither of the above functions are appropriate for a central bank in any setting and even less so in a market-oriented economy where the market is expected to induce improved financial discipline in the government. Although the central bank should continue to be the government’s fiscal agent for selected purposes, it will have to cease providing finances automatically and also divest itself of its responsibility as an accounting agency. Cash and debt management may have to be shifted to the ministry of finance, and the accounting responsibility to the government, so that standards of accounting appropriate to public authorities can be prescribed and monitored.

Legislative Institutions

The newly acquired political freedom in several former CPEs shows the need for legislative institutions to be built up in public expenditure management to provide for transparency and accountability and to contribute generally to improved governance. These institutions or their equivalents previously had no specified role in approving the budget, enacting appropriations, or approving completed accounts. The draft budget laws in a number of former CPEs suggest that the legislative wing would like to acquire powers to approve budgets and any changes therein and to review accounts. Enforcing these laws, once they are completed, would provide a framework for exercising their functions. Although experience in this regard is only short, more attention is required to the following aspects.

First, macro and micro management should be distinguished. The former is appropriately the responsibility of the legislature. Any excessive involvement of the legislature in the latter is likely to prove counterproductive. A framework of delegated legislation is therefore essential to specify the delegated responsibilities of the executive. It would prevent needless interference by the legislature while endowing it with powers of review.

Second, specifically in regard to approval of the budget, consultative procedures both in an annual and medium-term framework between the legislature and the executive should be formulated. The issuing of unilateral decrees by the executive or passing financial legislation on its own initiative by the legislature, as happened just after some countries had become independent republics, is unlikely to lead to smooth functioning. These consultative procedures would permit the legislature to exercise a constructive role.

Finally, the shape of independent institutions, such as a legislative budget office, an accounting agency, and an audit agency, would also have to be determined.24 The smoothness or friction between the legislature and the executive in the future will depend on the care taken in delineating these agencies’ functions.

Managing Transition

“Revolution,” Ortega y Gasset noted, “is not the up-rising against the existing order, but the setting-up of a new order contradictory to the traditional one.” This new order covers a wide area and is therefore bound to strain the administrative capacity of the former CPEs. Where the understanding of the new systems or techniques is relatively small and where the nostalgia for a bygone order is great, any slight change is bound to strain administrative capacity. But change is inevitable and necessary. Managing change therefore has to minimize the disruption while serving the purposes of the larger and revolutionary changes in economic policies. Notwithstanding the extensive debate on the “big bang” or the gradual approach, there seems to be greater acceptance of the approach that stresses the importance of macro stabilization and social safety nets in the short term over a concurrent but longer-term implementation of institutional reform.25 Such reform will have to be tailored to meet the immediate needs while undertaking the medium-and longer-term strengthening of ministries of finance, spending agencies, and accounting and audit agencies. To avoid overstretching the administrative machinery, the legislative institutions should also be strengthened only over the medium term.

Although the specifics of reform in any country will depend on the macroeconomic setting and its administrative capacity, macroeconomic stabilization is likely to be the priority when inflation is high and balance of payments deficits unsustainable. There, adjustment of the machinery will face a twofold task: strengthening the machinery to ensure formulation of the appropriate budget (reflecting market orientation and inflation); and a management system that can sustain implementation of the budget as formulated. The former would require explicit recognition of the existing and prospective levels of inflation in formulating estimates and formulation of a contingency budget to restrict expenditures through policy measures and to integrate the credit budget with the main budget. Moreover, during budget implementation, particular attention would have to be paid to the changing composition of expenditures as a result of introducing social safety nets. In addition, budgetary outcomes are likely to differ from estimates because of changes in policy and changes in macroeconomic assumptions relative to those used in building the budgetary estimates. As actual inflation rates turn out to be higher than estimated, a system of cash limits would be essential to avoid a full and automatic neutralization of the effects of inflation. Cash limits would force the agencies to make adjustments in their operating programs. Effective monitoring systems would also be needed, especially with regard to the social safety nets, so that only the targeted groups benefit from them.

Other structural improvements may have to be made during less strenuous periods. However, the environment for change will be significantly affected by the success achieved in the pursuit of macro stabilization, which in turn is totally dependent on the functioning and effective contribution of strengthened fiscal machinery.

III. Institutional Implications of Regional Obligations

Regional collaboration among member countries in fiscal policy has many implications for the institutions and systems engaged in public expenditure management and the associated aspects of government administration. Experience in this regard is rather limited, but more is likely to be achieved in the future since two regional pacts that emphasize fiscal policy coordination have been established or are envisaged. The United Economic Agreement of the Gulf Cooperation Council (GCC) envisages coordination of fiscal policies among its member states. Although it covers both revenue and expenditure policies, the analysis below is limited to the latter. The European Commission Treaty of 1991 (formally signed in 1992 but not fully ratified) envisages a good deal of cooperation among its member countries. More specifically, it envisages limits on the extent of budget deficits and cumulative levels of public debt. Similar restrictions were envisaged in the West African Monetary Union (WAMU) in that the credit that could be drawn by the member countries to finance their budget was limited.

The implementation of these regional pacts inevitably affects the functioning of fiscal institutions and public expenditure management policies. The pacts also raise different types of issues. For GCC countries, coordination is needed more during prebudget formulation to determine the composition of expenditures. For EC and WAMU countries, emphasis moves from the agreed intent to budget implementation and to ensuring full compliance with the intent of the regional pacts. Another issue is whether to fulfill these intentions the expenditure management machinery should be modified to achieve convergence or whether the same purpose can be achieved through compensatory mechanisms. (The experience of WAMU shows that a common identity in institutions does not necessarily ensure policy coordination.)

Coordination, Cooperation, and Harmonization

Coordination refers to decision making that promotes joint welfare26 and implies shared objectives as well as responsibilities for implementation of policies. It assumes a clear vision of the future, a coherent and well-articulated set of principles, a range of policy instruments adequate for the purpose, and sufficient legitimacy and authority to carry the measures through. Although the objectives of coordination have not been spelt out in detail in the Unified Economic Agreement of the GCC, they include the elimination of severe imbalances and the promotion of the right conditions for stability in the member states as well as common investment strategies through equal treatment of the factors of production and encouragement of their mobility. In a broader framework, this will include such instruments as budgetary expenditures and credit and incentive policies. Coordination also heightens the importance of understanding how expenditure policies are implemented, and the key to the success of any policy is to be found in the structure of institutions and the range of relative capability of instruments.

Cooperation is a broader concept, which has grown to reflect the interdependence among countries. This interdependence has become more intense, in turn emphasizing the need for cooperation, reflecting the enormous growth in cross-border economic transactions. Economic policies in general and fiscal policies in particular can no longer be pursued only on a national basis. Governments are obliged to consider the impact of policies of the contiguous countries on their own economies and to explore avenues for economic cooperation. This cooperation, as distinct from coordination, may be ad hoc, and may often take the form of exchange of information or consultation. Sometimes, such as in fighting environmental pollution, a common, but independently executed, policy front may emerge as a result of cooperation. An associated but less frequently used concept relates to convergence, which refers to closer movement of variables over time.27 Experience suggests that cooperation may have more visible payoffs during crises, when common needs compel governments to avoid conflicts.28 Cooperation implies an implicit or explicit acceptance by countries that their benefits are greater when countries unite and pursue common goals together rather than independently.

Harmonization is in a way an institutional extension of cooperation and refers to the development of a common framework and use of similar instruments in similar situations so that transactions have some transparency. In addition, such a synchronization of systems and techniques provides a basis for continuous monitoring of the goals agreed to as part of cooperation.

Coordinating Expenditure Policies in GCC States

Article 22 of the Unified Economic Agreement requires member states of the GCC to coordinate fiscal policies and to cooperate with one another. Specifically, Articles 10 and 13 of the agreement require development plans and joint ventures to be coordinated to achieve economic coordination. In considering the implications of government expenditures, due attention is to be paid to the instruments chosen by the public bodies to serve public purposes. Expenditure policies, reflecting the sizable growth in government activities since the early seventies, have become complex and cover a wide range of activities. The analysis of such policies, which is an implicit first step in coordination, calls for understanding of institutional features and of the role of institutions in policy formulation and implementation. An analysis of these institutions’ features, their distinct characteristics, legal aspects, approaches to decision making, and related aspects shows that practices in the countries differ.

The analysis of the institutional features of the GCC countries illustrates that, if cooperation in expenditure policies is to be achieved, much preparatory action will be needed to harmonize the institutions, systems, and instruments. This harmonization does not necessarily imply uniformity of approach but may indicate the need for an explicit differential treatment to allow for differences among member states. These details (some of which are illustrated below) need to be addressed as an integral part of the overall goal of regional cooperation.

Developing a system to harmonize efforts clearly and substantively depends on improving two key aspects of the financial management system: timing of the fiscal year and coverage and classification of budget expenditures. The problems of comparing fiscal data and expenditure policies can be reduced if the data are related to the same time frame. Three approaches are possible. One is simply to accept the available data in the fiscal time frame that applies to each country. Second, these data can be converted to a standard fiscal year for comparison. The third, and perhaps more debatable, approach is for member states to agree to adopt a standard fiscal year.

The issue of budget coverage and classification is even more central to efforts to improve coordination of expenditure. Unless budget categories are transparent, it is difficult to have any meaningful discussion of the relative fiscal position and direction of fiscal policy within the region. Neither the main budget aggregates nor many of the items within these aggregates mean the same throughout the GCC member states.

Similarly, different approaches can be adopted to overcome difficulties arising from different budget coverage and classification methods. Some kind of reclassification of budget data is necessary, however, for even the most basic kind of comparative fiscal analysis. Appropriate classification can be achieved either by converting existing data or by changing the budget classification and charts of accounts.

Agreement needs to be reached on a standard form of analysis for public enterprises—or at least those enterprises directly within the budgetary process (that is, those in receipt of budgetary transfers or other forms of incentive or otherwise considered subject to direct government involvement in public expenditure decisions).

In the longer run therefore the GCC states should consider adopting a standard chart of accounts as the basis for classifying budget transactions. Undoubtedly, difficulties exist in standardizing approaches at the basic accounting level. Since administrative requirements differ among countries, a completely unified system would be impractical if it was to be attempted in detail. What should be attempted is correspondence of primary classification of transactions in all countries to an agreed standard economic classification. Over time, individual countries could correct any major deviations in their chart of accounts, if such changes were compatible with internal administrative requirements. The aim of adopting such a program is to make the economic analysis of budgetary transactions a primary rather than a subsidiary focus of budget reporting within the GCC states.

Implications and Requirements of Expenditure Policy Coordination

Defining more precise aims and ways of achieving coordination of expenditure policies is possibly best addressed by considering two specific policy areas: the elimination of severe imbalances and the promotion of an atmosphere of stability in the member states; and the development of common investment strategies through equal treatment of factors of production within the GCC.

The pursuit of economic stability in the face of fluctuating oil income is obviously the foremost concern of all GCC countries. Each country is investigating ways of effectively reducing its budget expenditures in line with reduced revenue expectations. It is clearly desirable in these circumstances that member states should jointly discuss their proposed policies and should monitor their implementation. Discussions initially would have to be in very broad terms—but any significant progress would depend on developing reasonably precise, standard definitions of the main aggregates of fiscal spending, revenue, and financing.

Sharing information on expenditure policies could have benefits extending across a wide range of economic policy. Policies on civil service salaries and the level of employment in the civil service could be explored in a broad regional context. Likewise, comparisons of expenditures on social services, such as education and health, among GCC states would be very useful, particularly if individual states undertook detailed studies of the cost of providing these services and related indicators. Shared experience on construction costs of similar large projects would also be beneficial for planning and controlling expenditures within each country.

Various forms of support for domestic enterprises are provided by budgetary and extrabudgetary means by GCC states. This support includes direct subsidies for the production or import of certain basic foodstuffs, equity participation, low-interest loans to domestic companies, loan guarantees, and the provision of public utility services below the cost of production.

Harmonizing aspects of these incentives could be approached in one of three ways: (a) equalization among member states; (b) differential treatment, allowing for differences among member states; or (c) a standard approach, centering policies on individual states around a standard investment law. Complete standardization of the treatment of subsidies and the support of enterprises through the budget would, of course, be more difficult to achieve than uniformity in tax treatment.

Cooperation may be achieved at a political level, but the conversion of this cooperation into everyday tasks requires institutional adjustment to the new realities.

Experience of WAMU

If the GCC Charter points the way to the future, the experience of WAMU illustrates how avowed objectives may not be achieved if the participating countries choose of their own volition to circumvent a treaty rather than apply it.

The principal legal means of fiscal coordination in the WAMU is the statutory limit on government credit set by the banking system, which was fixed at 20 percent of the previous year’s tax revenue.29 Although the adequacy of this instrument for achieving fiscal coordination could be debated, the practice shows the main inadequacies of this approach. The credit limit could, for example, be circumvented by resorting to external borrowing, a build-up in payment arrears, use of public enterprises to channel some consumer subsidies that would otherwise be met through the budget, and other means. The monitoring of these activities has been difficult owing to the diversity in practices despite inheritance of a common institutional background (treasury systems of the French type). The scope of government operations varied, as did the consolidated treasury accounts, reflecting the centralization of government activities. Also, no reliable data existed on payment arrears. Available data show, however, that the limitations on bank credit did not contribute to any reduced fiscal deficits. Indeed, most deficits were financed by resort to foreign borrowing. Experience suggests that there was little evidence of coordination of fiscal policies among WAMU countries, raising the issue of whether more could have been achieved through more vigilant monitoring and enforcement machinery.

European Community (EC) Countries

The EC treaty on economic and monetary union envisages a gradual elimination of excessive deficits in its member countries. Specifically, it envisages restricting the size of the budget deficit relative to its national income and the level of the outstanding public debt (both external and internal). Fulfillment of these objectives is dependent not merely on the formulation of appropriate policies, but also on ensuring that the policies have been carried out. This, in turn, requires an examination of the procedures operating in member countries and the extent of convergence among the procedures, so that a well-orchestrated pursuit of fiscal policies may be undertaken. These procedures may also be examined in terms of constraints on budget deficits, adequacy of transparency in budgets, and general procedures for the treatment of excess expenditures. The observance of the fiscal policy goals also depends on the role played by the legislature in these countries. While this role varies, following the approach indicated in earlier chapters, the role of the legislature is not considered.

Even now, several members have political, legislative, and administrative limitations on the size of budget deficits.30 For example, in Germany, the net borrowing of the Government is not allowed to exceed its investment budget. Some of the other countries have periodic policy goals aimed at reducing expenditure as a ratio of GDP, or stabilization of debt/GDP ratios, or a zero public sector borrowing requirement over the medium term (or even net repayment), or broad balance of the current budget of the central government over the medium term. Some of these aims cover the public sector, while a few others are limited to the central government. Although most of these goals are publicly discussed and are highly visible, they may not have the requisite legal backing or the force of rule that becomes automatically enforceable. The intent of these goals is rather to serve as a disciplining force in budget formulation.

The influence of the disciplining force in turn depends on the framework used to formulate the budgets. Whereas most countries prepare multiyear estimates, the status of the estimates varies among countries. In some, they reflect coherent government macroeconomic policies; in some, they are considered indicative and broad expressions of intent, while in at least one country, such projections are basically used for internal purposes. Similarly, the coverage, the basis of the budgets, and their linkages with national accounts vary. Although the coverage of the budget is fairly complete, some special funds and related operations are excluded. Guarantees given by the government are published as part of budget documents in some cases while in a few others no data are published. The basis of the budget (and therefore the accounts) is, in most cases, cash, while in some cases it is a mixture of cash and accrual (the definition of accrual is not necessarily uniform among the member countries). Thus, the budgetary systems vary in many features.

Deficits are the net result of the forces at work in revenues and expenditures. In most cases, however, the major factor contributing to a higher-than-estimated deficit is excess expenditure rather than revenue shortfall. The procedures for treating these expenditure excesses differ among countries. In operational terms, an excess in a particular chapter may be financed by savings from another without legislative approval but with the consent of the ministry of finance. In some cases, the overruns may be financed from reserves or by processing supplementary estimates. In some cases, such as the United Kingdom, some excess expenditure may be regularized by the legislature on a post hoc basis. In some cases, particularly where the cash basis is used for budgetary purposes, some expenditure commitments may be carried over and therefore may not influence the visible size of the deficit.

The range of the above differences shows that uniform observance of the stated goals of economic and monetary union requires some changes at the technical and operational levels as well as changes in political practices. Although it can be argued that human ingenuity can overcome procedural bottlenecks, it is also clear that a set of transparent and commonly observable rules facilitates greater uniformity in compliance. These rules in turn require institutional and systemic adjustment. The management of this change may however be a difficult issue and depends on final ratification of the treaty and the machinery established for enforcement.

1

For a detailed discussion of these aspects, see Premchand (1973) and (1983).

2

For a discussion of the experience of five Asian countries, see Dean and Pugh (1989).

3

Structural adjustment is easily distinguishable from governance. The latter, as discussed previously, is wider in coverage and includes both tangible and intangible factors.

4

For a more detailed discussion of these aspects, see World Bank (1988a).

5

During 1988–90, the World Bank concluded agreements valued at more than $1.5 billion for nonproject and technical assistance loans and about $41 million for the improvement of public expenditure management. (The nonproject and technical assistance loans also frequently include components of public expenditure management.) The IMF concluded about 22 agreements with as many countries in support of structural adjustment.

6

The institutional improvement in public enterprises is considered part of public expenditure management.

7

Many of these aspects are specifically provided for in structural adjustment lending and technical assistance loans by the World Bank; see World Bank (1988a). Such conditionality in technical assistance is facilitated because it is part of loans.

8

See Quinn (1980) for a description of these classic principles and their application, p. 155 ff.; (Anthony’s 1965) approach to planning and control was influenced by military approaches. For a more recent discussion of the relevance of military experience on the management of organizations, see Wilson (1989).

9

Hage and Finsterbusch identify five other ways of achieving change, but they are not considered here as they are less relevant.

10

See, for example, Bery (1990), Thomas and Grindle (1990), Paul (1990), and World Bank (1988a) for an extended discussion of this aspect.

12

The transactional leaders approach followers with an eye to exchanging one thing for another: jobs for votes, etc. Transforming leaders seek to satisfy the higher needs of the community.

13

See Leonard (1987), p. 903.

16

A description is available in Premchand and Garamfalvi (1992).

17

Quoted in Uchitelle (1991), Section IV, p. 1.

18

The only other situation where less importance is given to resource constraint is in a war. During such periods, greater importance is attached to the quality of the product and its role in the overall strategy than to cost. See Devons (1950) for an illustration of planning during the Second World War.

19

The former Soviet Union had a long history of the working of both centrifugal and centripetal forces. Immediately after the revolution many areas that later became a part of the union declared independence. After seven decades of “democratic centralism,” there is a recurrence of centrifugal tendencies.

20

In some cases, the name has been changed after central planning was abandoned to ministry of economy and finance, as happened with Russia at the end of 1991.

21

This has contributed to the introduction of “core” and “noncore” programs (in Russia, called “protected” and “unprotected” expenditures).

22

Much of the recent literature on this subject is devoted to enterprise or commercial accounting rather than government accounting. See, for example, Organization for Economic Cooperation and Development (1991). For case studies on government accounting (China and Poland), see Premchand (1990).

23

For a more detailed discussion of how government accounting should be in the current context, see Staats (1990) and Appendix II.

24

Among the CPEs, China has already established an audit agency, which functions as an integral part of the Prime Minister’s Office.

25

See Fisher and Gelb (1991), pp. 75–77.

28

An extended discussion of these aspects is provided in Bryant and others (1989).

29

Detailed discussion is available in Bhatia (1985).

30

These details are provided in Premchand (1990), Table 3, pp. 108–121. Also see country notes in Organization for Economic Cooperation and Development (1987) and (1990), and Premchand and Burkhead (1984).

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