## _wp07222 ## Source details **Canonical URL:** [_wp07222](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07222.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07222.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07222.pdf.json) --- ### Executive Summary — Major findings on fiscal policy and scaled-up aid - Sound fiscal policies are critical for handling aid volatility and for making effective use of scaled-up aid and other flows. - Scaled-up resource flows ease resource constraints and allow LICs to increase spending aimed at enhancing growth and reducing poverty, but they create macroeconomic challenges, many of them fiscal. - Expenditure plans financed by scaled-up aid flows should take a medium-term perspective and be consistent with available financing from all sources—public and private. - Given volatility and uncertainty of aid flows, a key objective is to smooth the expenditure path so that all programs undertaken are adequately funded. - Use the overall fiscal balance, including grants, to monitor short-term fiscal developments; complement with other fiscal indicators as needed. - Wage bill ceilings: - Should be used selectively in Fund-supported programs only when warranted by macroeconomic considerations, justified in program documents, sufficiently flexible to accommodate spending of scaled-up aid, and reassessed at program reviews. - Some aid may need to be saved temporarily because limited absorptive capacity—macroeconomic, sectoral, and administrative—may constrain effective short-run use. - Strengthening domestic revenue mobilization is integral: broadening the revenue base by eliminating exemptions and improving revenue administration is emphasized. - Other exit-strategy elements: strengthen debt management capacity and fiscal institutions. ### Institutional and PFM reform priorities - Effective PFM systems: - Promote transparency and governance, reduce waste and misappropriation, and lower transaction costs of meeting donor requirements. - Help countries track public spending and shift programs toward priority areas. - Reform sequencing and priorities: - Short-run priorities: improve the budget classification system; strengthen internal controls on budget execution, accounting, and reporting; develop capacity to prepare sectoral ceilings and estimates. - Medium-term priorities: strengthen treasury systems, debt management, and PFM systems in subnational governments; link PFM reforms to broader public sector and governance reforms; strengthen national audit offices. - Most LICs will require substantial technical assistance (TA); coordinate with other donors and leverage partnerships with the World Bank and other providers. ### Context and recent trends in resource flows to LICs - Commitments and pledges: - Monterrey Consensus, March 2002: scale up aid and improve delivery to help meet the MDGs. - 2005 Gleneagles Summit: G-8 committed to significantly increasing development assistance and to double aid to sub-Saharan Africa (SSA) by 2010. - Recent flows and actors: - ODA to SSA, net of debt relief, remained broadly unchanged in 2005; preliminary data suggest total ODA declined slightly in 2006. - Private aid doubled during 2001–05 to US$14.7 billion. - The Bill and Melinda Gates Foundation has provided more than US$6 billion for health programs. - Global funds to combat HIV/AIDS are estimated to reach US$9 billion in 2007. - Remittances to LICs increased by more than 80 percent between 2000 and 2005, totaling twice the amount of ODA in 2005. - Debt relief and commodity prices: - MDRI and Enhanced HIPC Initiative have created space for new borrowing; some countries (e.g., Ghana and Kenya) are tapping international capital markets. - Many countries benefit from high commodity prices, increasing resource flows that enable scaling up of spending. ### Four central policy questions addressed - How should the medium-term resource envelope for the budget be assessed given lack of comprehensive information and donor proliferation? - What considerations should influence the choice of a medium-term spending path (macroeconomic conditions, capacity constraints, debt sustainability, spending efficiency)? - How should the budget deal with aid uncertainty and volatility? - What fiscal institutions are key to using resources effectively and how can they be strengthened? ### Key guidance on establishing a medium-term resource envelope - First step: collect information on intentions of official and private donors; recognize governments typically lack information on private aid flows and part of official aid is provided outside the budget. - Donor proliferation: average number of donors per country increased from about 12 in the 1960s to more than 30 during 2001–05. - Aid characteristics affecting budget planning: - Earmarking limits flexibility. - Counterpart fund requirements reduce budgetary resources available for other purposes. - Grants do not require budgetary allocation for debt service; loans do and establish claims on future resources. - Aid projections: - Medium-term aid flow projections should reflect Fund staff’s best estimates, using donor commitments and indications. - Aid forecasts in Fund-supported programs must reflect debt sustainability concerns. - Overly optimistic or pessimistic projections should be explicitly justified; costs of overly optimistic forecasts are likely higher than costs of overly pessimistic ones. - Domestic revenue and absorptive capacity: - Sustaining and increasing domestic revenue effort is critical to achieving the MDGs and to guard against aid volatility. - Scaled-up aid-financed projects generate future recurrent spending that must be financed domestically. - Trade liberalization implications: - LICs on average derive one-third of total revenue from trade taxes. - Liberalization should be accompanied by strengthening indirect taxes, especially improving VAT efficiency by reducing exemptions and broadening the VAT base. - Revenue administration and targets: - Low revenues mainly reflect narrow tax bases and weak administrative capacity rather than low tax rates. - A tax-to-GDP ratio of at least 15 percent is considered a reasonable target for most LICs. - UN Millennium Project (2005) estimated LICs could mobilize additional domestic revenues equivalent to 4 percent of GDP. ### Choosing an expenditure path — scenarios and policy implications - Determining factors: - Time profile of expected aid; macroeconomic, sectoral, and administrative capacity to absorb inflows; likely impact on growth and debt sustainability; spending efficiency. - Stylized time-profile responses: - Compressed short period: save part of initial surge to spread higher aid-financed spending. - Volatile around constant/rising trend: smooth fluctuations through domestic borrowing and reserve accumulation consistent with macro stability. - Rise and remain stable: potentially allow rising spending profile depending on absorptive capacity. - Absorptive capacity constraints: - Macroeconomic (e.g., high inflation, low foreign reserves) may require gradual scaling up. - Postconflict countries without stabilization may need to save initial surges until capacity improves; humanitarian relief requires immediate spending when security stabilizes. - Sectoral shortages (e.g., teachers, health workers) may require innovative responses such as rapid training and deployment of semiskilled workers. - Subnational implementation limits: in some SSA countries, subnational governments are responsible for about 70 percent of poverty-reducing expenditure. - Saving vs smoothing vs front-loading: - Many countries saved part of aid surges in SSA; higher aid flows often boosted public savings used to retire domestic debt. - Preferred approach: smooth spending over the medium term—stable spending path as a share of GDP calibrated to be sustainable indefinitely given expected value of new aid inflows. - Conditions that may justify front-loading: - Returns to public investment are high; - Investment subject to increasing returns (e.g., poverty traps); - Benefits of government consumption are significantly higher today than in the future (e.g., famine, health crisis). - Risks of front-loading: borrowing from domestic banking system may conflict with macroeconomic and debt sustainability; if future aid or spending impacts underdeliver, front-loading can lead to unsustainable spending and abrupt adjustments. - Poverty reduction strategies with front-loading should be underpinned by front-loaded donor commitments to reduce fiscal risks. - Regional delivery considerations: - Regional aid (e.g., WAEMU) still channeled through domestic budgets but must consider convergence criteria of monetary union; alternative criteria under consideration. ### Spending, debt sustainability, and growth - Macro effects and risks: - Aid inflows affect the real exchange rate and interest rates, influencing debt dynamics. - Sterilizing aid to prevent Dutch disease can raise domestic interest rates, pressuring public debt dynamics. - Sudden aid declines can cause real depreciation, increasing external debt burden. - Loaned aid: - Sustainability important even when aid is concessional loans. - Spending composition and growth: - Public investment can “crowd in” private investment via improved infrastructure; evidence of complementarities exists. - Cross-country econometric estimates of growth response to higher public investment range from no impact to an increase of 0.7 percentage points. - Growth effects of education and health spending are difficult to estimate; literature suggests a 1 percent of GDP increase in such spending can have a long-term effect ranging from 0.5 to [text truncated in source]. ### Box 1 — Stylized expenditure path options when resource envelope expands - Smoothing: - Keep spending fairly stable as a share of GDP; with scaled-up aid, spend part and save part to reduce debt; interest savings allow stable spending after surge diminishes. - Front-loading: - Spending increases rapidly when aid is scaled up, then gradually declines as share of GDP; appropriate where absorptive capacity is sufficient and returns are high; risks of unsustainable spending if impacts underdeliver. - Saving: - Most additional aid initially saved; spending rises gradually while reserves are built or debt reduced; eventual spending share may stabilize at even higher level due to higher assets or lower debt; limits include donor reluctance to fund reserve buildup. ### Spending efficiency — empirical assessment and implications - Core findings: - Inefficient spending increases future debt burdens without commensurate improvement in outcomes. - Improving economic and social outcomes requires both more spending and more efficient spending. - Appendix II empirical results (health and education): - Significant variation across countries and regions in relative efficiency of health and education spending. - Good governance and quality of fiscal institutions have a strong positive correlation with higher relative efficiency scores (analysis limited to health spending due to data). - Volatile aid flows have not generally been passed through into public spending, contributing to relatively stable efficiency scores; as long as aid volatility does not translate into higher spending volatility, relative efficiency is not affected. - Multivariate results (health efficiency): - CPIA fiscal indicators average is consistently significant, indicating importance of fiscal institutions for expenditure efficiency. - Specific regression results (selected specifications): - Specification 1: Prevalence of HIV coefficient = 0.008* (0.108); CPIA fiscal indicators average = -0.018** (0.026); Constant = 1.106 (0.000); Sigma = 0.025; N = 40. - Specification 2: Prevalence of HIV = 0.002** (0.022); CPIA fiscal indicators average = -0.018** (0.027); Adult literacy rate = -0.001** (0.014); Constant = 1.139 (0.000); Sigma = 0.024; N = 32. - Specification 3: Prevalence of HIV = 0.001* (0.051); CPIA fiscal indicators average = -0.012* (0.096); Access to improved sanitation facilities = -0.001** (0.020); Constant = 1.109 (0.000); Sigma = 0.023; N = 40. - Limitations: - Outcomes influenced by many factors beyond spending; methodology focuses on quantifiable inputs and outcomes; efficiency measured in relative terms. ### Fiscal targets, Fund-supported programs, and PRGF experience - Use of fiscal indicators: - Medium-term spending path should anchor the fiscal framework. - Typical approach: target fiscal balance consistent with sustainable public debt and macro stability; derive public expenditure ceiling residually given forecast domestic revenues and sustainable fiscal balance. - Focusing on the overall balance, including external grants, allows scaled-up aid to pass through into higher public spending without deterioration in reported fiscal position; complement with other measures like overall balance excluding grants. - PRGF program evidence: - Short-term targets reviewed for 43 PRGF countries approved in 2002–06; regional counts: Total 43; AFR 25; APD 4; EUR 2; MCD 6; WHD 6. - In 14 out of 22 PRGF arrangements with fiscal balance targets, all foreign-funded investment was excluded from the targets. - For seven countries, the targeted balance included grants (and investments financed by these grants). - Deficit concepts used across programs: - Only six programs included a ceiling on the overall fiscal deficit. - Twelve countries targeted the primary balance. - Four targeted the basic/current balance (excluding capital revenues and expenditures). - Wage bill ceilings: - Incidence: share of PRGF-supported programs with wage bill ceilings declined from 40 percent during 2003–05 to about 30 percent as of May 2007. - Typical coverage: overall government; no instances defined for a specific sector. - Recommended conditions for use: - Clear macroeconomic justification and transparent program documentation. - Limited duration; address root causes such as civil service reform and payroll management. - Sufficient flexibility to accommodate donor-financed employment in priority sectors (education, health). - Periodic reassessment at program reviews. - Program design guidance: - Continue using fiscal balance targets and adjustors that respond to country-specific conditions when aid is scaled up. - Where macroeconomic conditions permit, fiscal targets should allow maximum flexibility for spending additional aid. - Adjustors should be designed to avoid cutting back priority expenditures in response to aid shortfalls. ### Dealing with aid uncertainty and volatility — diagnostics and mitigation measures - Key facts: - Aid flows are 40 times more volatile than tax revenues and significantly more volatile than remittances. - Aid volatility has increased over time and can translate into expenditure volatility. - Mitigation measures: - Conduct stress tests on baseline projections; subject MTFs and DSAs to periodic stress tests to identify short-term financing risks. - Build reserve buffers to sustain spending if shortfalls materialize: - Buffer size should be case-by-case but could vary from 50 to 100 percent of annual aid-financed spending. - Identify priority spending to safeguard from cuts in event of aid shortfall; use PRSPs and strengthened PFM systems to monitor. - Build flexibility into spending programs (e.g., temporary/flexible employment contracts; contracting out services). - Include appropriate adjustors in Fund-supported programs to accommodate aid volatility; design adjustors to avoid cutbacks of critical spending. - Donor actions to reduce volatility: - Longer-term donor commitments can reduce aid volatility; Paris High Level Forum (2005) pledged more predictable and multiyear commitments. - Examples of longer-term commitments cited: - United Kingdom provided a 10-year commitment on development assistance to Rwanda and Ethiopia. - DFID agreed to provide six-year program support for the health sector in Malawi. - International Financing Facility for Immunization (IFFIm) aims to provide “front-loaded, reliable funding over a number of years.” - Partnership arrangements and joint monitoring (examples: Mozambique, Tanzania, Ghana, Burkina Faso) facilitate predictability. - Strategic objective: avoid long-term reliance on aid by strengthening domestic revenue bases, debt management capacity, and fiscal institutions including PFM systems. ### Strengthening institutions to promote effective utilization of aid (PFM) — diagnostics and priorities - Diagnostics of PFM weaknesses: - HIPC-AAP: 2004 assessment concluded 19 of 26 countries still required substantial upgrading of PFM systems; budget execution and tracking of poverty-reducing expenditures especially weak. - Fewer than one-third of countries surveyed had budget outturns close to the budget as adopted. - 90 percent of African countries surveyed failed to complete final audited accounts within 12 months of the fiscal year end. - PEFA (12 PRGF-eligible countries, 2005–06): median score about 2.0 against international good practice standard of 4.0. - Fiscal ROSC, World Bank CPIA, and Fund TA evaluations highlight weaknesses in comprehensive credible budgets, effective audit, accounting, payments, and fragmented institutions. - Short-term priorities (Box 5 highlights): - Ensure ministry of finance has adequate control over fiscal aggregates. - Comprehensive, coherent annual budget preparation linked to PRSP priorities. - Establish budget classification consistent with international good practice. - Introduce basic accounting with some automation; ensure timely fiscal reports reconciled with banking data. - Improve cash flow planning and control, and establish simple system for recording donor aid commitments and disbursements. - Strengthen payroll management and internal control; Ghana example: Integrated Payroll and Personnel Database in 2006. - Strengthen public procurement: standard bidding documents, computerize bid/award records, publish contract information, move toward e-procurement. - Integrating donor aid: - On average, only 37 percent of external aid is channeled through country PFM systems. - Extrabudgetary flows complicate fiscal management; earmarking can introduce inefficiencies and hamper smoothing. - Extrabudgetary aid may be warranted short term in fragile and postconflict states. - Results orientation and tracking: - Move gradually toward results-oriented budgeting: identify program objectives, outputs, responsibility centers, pilot performance evaluation in ministries. - Use Public Expenditure Tracking Surveys (PETS) and audits to identify leakages and assess quality of cash management. - Example: Uganda’s PETS found 87 percent of nonwage resources were diverted following a dramatic increase in primary education spending. - Formulating and sequencing PFM action plans: - Base on comprehensive diagnostics such as PEFA; use platform approach sequencing core building blocks before advanced reforms. - Political economy factors matter; informal practices can undermine formal rules. - Typical platform timing for budget formulation: Basic System (1–2 years); Intermediate System (3–5 years); Final System (6–10 years). - TA effectiveness and coordination: - Common problems: inadequate diagnostics, overloaded agendas, poor sequencing, political constraints, poor expert selection, insufficient coordination. - Recommended improvements: effective TA monitoring, encourage PEFA use, strengthen coordination among TA providers, emphasize country ownership, enhance Fund–World Bank collaboration. - Key implementation statistic: About 60 percent of the 78 PRGF-eligible countries either have a PFM reform plan in place or are in the process of preparing such a plan. The Fund has provided technical support in more than half of these countries. ### Medium-term fiscal frameworks, MTBFs, and MTEFs — capacity and practice - Instruments: - MTFFs: project broad fiscal aggregates consistent with macro variables and fiscal targets; reexamine and update at least annually. - MTBFs: allocate overall spending envelope across sectors in line with PRSP priorities. - MTEFs: outline sectoral allocation across programs/projects with detailed costing and performance objectives. - Current practices and shortcomings (Box 4 findings): - Out of 31 LICs examined: 3 had full-fledged macrofiscal frameworks; 5 had relatively comprehensive frameworks; 13 had basic frameworks; 10 had no MTF. - Only 10 of 21 LICs with an MTF systematically aligned yearly budgets with these frameworks. - Common shortcomings: unrealistic medium-term projections; implicit or missing macroeconomic assumptions; lack of quantification of fiscal effects under scenarios; medium-term expenditure estimates that do not reflect priorities or rolling adjustments. - Sequencing and timing principles: - Incremental reforms linked to annual budget cycle are preferred. - Identify main constraints early and include constraint analysis in diagnostics and TA terms of reference. - Leadership and donor coordination mechanisms (e.g., donor partnership in Mozambique) recommended. - Short-term action plan priorities: - Focus on capacity to prepare sectoral ceilings and estimates, improve classifications, strengthen internal controls on budget execution, accounting, and reporting. - Decompose reforms into functional components with indicators of success for stage transitions. - Medium-term reform areas: - Develop treasury, cash management, debt management, capacity at subnational levels, link PFM to broader public sector reforms, and build accountability institutions. ### Appendix I — Statistical properties of aid flows and country experiences - Sample and means (panel data from 51 PRGF-eligible countries, 1990–2004): - Full sample means: Revenue/GDP = 12.2; Aid/GDP = 13.8. - Africa (about 60 percent of sample): Revenue/GDP mean = 9.4; Aid/GDP mean = 16.0. - Selected time-series means and standard deviations (percent of GDP) — Full sample total aid: - 1990–94: Mean = 16.9; Std. Dev. = 4.1 - 1995–99: Mean = 12.6; Std. Dev. = 3.6 - 2000–04: Mean = 11.9; Std. Dev. = 3.2 - Full sample loans: - 1990–94: Mean = 3.9; Std. Dev. = 2.6 - 1995–99: Mean = 2.7; Std. Dev. = 2.2 - 2000–04: Mean = 2.0; Std. Dev. = 1.7 - Full sample grants: - 1990–94: Mean = 12.9; Std. Dev. = 3.3 - 1995–99: Mean = 9.9; Std. Dev. = 2.6 - 2000–04: Mean = 9.9; Std. Dev. = 2.9 - Africa total aid: - 1990–94: Mean = 19.5; Std. Dev. = 4.6 - 1995–99: Mean = 14.3; Std. Dev. = 4.0 - 2000–04: Mean = 14.2; Std. Dev. = 3.9 - Aid and spending relationships: - Capital spending rises with total aid; relationship stronger for grants than loans. - Current spending increases with grants and tends to rise more than capital spending. - Health spending positively correlated with grants (parameter very small); no significant effect of aid aggregates on education spending. - Institutions and volatility: - Countries with better fiscal institutions tend to experience less aid volatility. - Improvements in budget execution ratings associated with increased capital spending and reduced current spending. ### Appendix II — Expenditure efficiency empirical assessment (detailed) - Methodology: - First stage: DEA to estimate relative spending efficiency (inputs: per capita health and education spending in PPP dollars; outputs: health and education outcomes). - Second stage: correlation coefficients and multivariate truncated regressions to relate efficiency scores to control variables. - Health first-stage results: - Median per capita income in sample: $1,457 in PPP terms. - Percent of countries in top half of health efficiency distribution by income: - GDP Per Capita ≤ 1,457: Infant mortality 40.0; Child mortality 40.0; Maternal mortality 37.5 - GDP Per Capita > 1,457: Infant mortality 60.0; Child mortality 60.0; Maternal mortality 62.5 - Education first-stage results: - Percent of countries in top half of education efficiency distribution by income: - GDP per capita ≤ 1,457: Primary school enrollment 33.3; Youth literacy 64.3 - GDP per capita > 1,457: Primary school enrollment 66.7; Youth literacy 35.7 - Robust correlations with health efficiency (selected coefficients, N, significance): - Prevalence of HIV: 0.30** (N = 44) with immunization, measles; 0.29* (N = 44) with infant mortality; 0.39** (N = 43) with child mortality. - Adult literacy rate: -0.35** (N = 36) with infant mortality; -0.43** (N = 36) with child mortality; -0.28* (N = 36) with maternal mortality. - Improved sanitation facilities: -0.25* (N = 50) with infant mortality; -0.26* (N = 50) with child mortality; -0.43** (N = 46) with births attended by skilled staff. - ICPR governance rating: -0.40** (N = 50) with immunization; -0.30** (N = 50) with infant mortality; -0.26* (N = 50) with child mortality. - CPIA fiscal indicators average: -0.40** (N = 50) with immunization; -0.31** (N = 50) with infant mortality; -0.25* (N = 50) with child mortality. - Second-stage multivariate truncated regressions (selected specs already stated under Spending efficiency). - Policy implications: - Strengthening fiscal institutions is crucial for enhancing expenditure efficiency and achieving MDGs. - Scaled-up aid utilization requires improved governance, PFM systems, and revenue mobilization. *Source: Executive Summary, Section IV, Boxes 1–7, Appendix I, Appendix II, and other excerpts from the IMF working paper _wp07222.* ### Executive Summary ...................................................................................................... ### _wp07222 - Executive Summary ### Major findings on fiscal policy and scaled-up aid - Sound fiscal policies are critical for handling aid volatility and for making effective use of scaled-up aid and other flows. - Scaled-up resource flows ease resource constraints and allow LICs to increase spending aimed at enhancing growth and reducing poverty, but they create macroeconomic challenges, many of them fiscal. - Expenditure plans financed by scaled-up aid flows should take a medium-term perspective and be consistent with available financing from all sources—public and private. - Given volatility and uncertainty of aid flows, a key objective is to smooth the expenditure path so that all programs undertaken are adequately funded. - The overall fiscal balance, including grants, should be used to monitor short-term fiscal developments; this allows full spending of external grants while preventing buildup of an unsustainable debt burden. It would be useful to complement this measure with other fiscal indicators. - Casting the spending path in a medium-term context obviates the need for a ceiling on wage spending; wage bill ceilings have tended to persist despite being designed as short-term fixes. In Fund-supported programs, such ceilings should be used selectively: only when warranted by macroeconomic considerations, justified in program documents, sufficiently flexible to accommodate spending of scaled-up aid, and reassessed at program reviews. - Some aid may need to be saved temporarily because limited absorptive capacity—macroeconomic, sectoral, and administrative—may constrain effective short-run use. Saving part of aid to finance higher expenditure later may be appropriate for some LICs. - Closely monitoring spending is important for ensuring debt sustainability. Achieving the MDGs will require both more spending and more efficient spending; inefficient spending will add to debt burdens without significantly improving outcomes. - Good governance and the quality of fiscal institutions have a strong positive correlation with the efficiency of spending; strengthening fiscal institutions would help improve spending efficiency. - Strengthening domestic revenue mobilization should be integral to the fiscal policy response to scaled-up aid. Higher revenues are essential to avoiding long-term reliance on aid and maintaining fiscal sustainability. In most cases this can be best achieved by broadening the revenue base by eliminating exemptions and improving revenue administration. - Other elements of an exit strategy include strengthening debt management capacity and fiscal institutions. ### Institutional and PFM reform priorities - Improving the efficiency of spending in LICs requires further strengthening of fiscal institutions, including PFM systems. - Effective PFM systems promote transparency and governance, reduce waste and misappropriation, and lower transaction costs of meeting donor requirements while assuring donors that funds are used for intended purposes. - PFM systems help countries track public spending and shift programs toward priority areas. - Countries should develop appropriately sequenced reform plans for strengthening PFM systems based on a comprehensive diagnostic and consistent with local capacity. - Short-run priorities: improve the budget classification system; strengthen internal controls on budget execution, accounting, and reporting; develop capacity to prepare sectoral ceilings and estimates. - Medium-term priorities: strengthen treasury systems, debt management, and PFM systems in subnational governments; link PFM reforms to broader public sector and governance reforms; strengthen key accountability institutions such as national audit offices. - Most LICs will require substantial technical assistance (TA), including from the Fund, to strengthen PFM systems. - Given limited Fund resources and specialized expertise in core areas, coordinating with other donors is essential to avoid wasteful overlap and mixed messages. The Fund should leverage staff resources and explore financing and partnership arrangements with the World Bank and other providers. ### Context and recent trends in resource flows to LICs - The international community committed to scaling up aid and improving aid delivery to LICs to help meet the MDGs (Monterrey Consensus, March 2002). - At the 2005 Gleneagles Summit, the G-8 committed to significantly increasing development assistance to LICs over the next decade and specifically to double aid to sub-Saharan Africa (SSA) by 2010. - Official development assistance (ODA) to SSA, net of debt relief, remained broadly unchanged in 2005; preliminary data suggest total ODA declined slightly in 2006. - Emerging donors and the private sector have increased assistance to LICs; private aid doubled during 2001–05 to US$14.7 billion. - The Bill and Melinda Gates Foundation has provided more than US$6 billion for health programs. - Global funds to combat HIV/AIDS are estimated to reach US$9 billion in 2007. - Remittances to LICs increased by more than 80 percent between 2000 and 2005, totaling twice the amount of ODA in 2005. - Debt relief under the MDRI and Enhanced HIPC Initiative has created space for new borrowing; some countries (e.g., Ghana and Kenya) are tapping international capital markets. - Many countries are benefiting from high commodity prices; resource flows to many LICs are increasing, enabling scaling up of spending. ### Four central policy questions addressed in the paper - How should the medium-term resource envelope for the budget be assessed? Challenges include lack of comprehensive information on current resource flows and an increase in the number of donors (official and private). - What considerations should influence the choice of a medium-term spending path for the budget? Factors include macroeconomic conditions, capacity constraints (absorptive and institutional), and debt sustainability. - How should the budget deal with aid uncertainty and volatility? Aid volatility and uncertainty complicate policy implementation, especially where large shares of government spending are financed by aid. - What fiscal institutions are key to using resources effectively and how can they be strengthened? Scaled-up, uncertain, and volatile aid flows increase pressure on fiscal institutions and PFM systems; strengthening these is crucial for spending efficiency. *Source: Executive Summary, _wp07222 - Executive Summary* ### Section IV discusses the problems associated with volatility and uncertainty of aid flows and ### _wp07222 - Section IV discusses the problems associated with volatility and uncertainty of aid flows and ### Establishing a medium-term resource envelope - First step: collect information on intentions of official and private donors; governments typically lack information on private aid flows, and part of official aid is provided outside the budget. - Donor proliferation complicates data gathering: - Average number of donors per country increased from about 12 in the 1960s to more than 30 during 2001–05 (World Bank, 2007a). - In some sectors, such as health, aid channels have proliferated, stretching LIC capacity. - Recommended coordination actions: - Governments should encourage private aid organizations to strengthen representation in recipient countries. - Official donors should reach out to key private donors and invite them to existing donor coordination structures. - Aid characteristics affecting budget planning: - Earmarking limits flexibility and hampers reallocation in response to changing macroeconomic conditions and priorities. - Counterpart fund requirements reduce budgetary resources available for other purposes. - Grants do not require budgetary allocation for debt service; loans do and establish claims on future resources. - Aid projections guidance: - Medium-term aid flow projections should reflect Fund staff’s best estimates, using donor commitments and indications. - Aid forecasts in Fund-supported programs must reflect debt sustainability concerns. - Overly optimistic or pessimistic projections should be explicitly justified; costs of overly optimistic forecasts are likely higher than costs of overly pessimistic ones because aid shortfalls might entail fiscal adjustment. - To mitigate costs, spending should be anchored in a medium-term perspective so that aid shortfalls can be smoothed over time. - Domestic revenue and absorptive capacity: - Sustaining and increasing domestic revenue effort is critical to achieving the MDGs and to guard against aid volatility and orderly exit from aid reliance. - Scaled-up aid-financed projects will give rise to future recurrent spending that must be financed domestically; insufficient domestic revenue growth will constrain other spending or lower program productivity via inadequate operations and maintenance. - Care is needed to ensure scaled-up aid does not weaken incentive to mobilize domestic revenues (Gupta and others, 2004). - Trade liberalization implications: - Trade liberalization facilitates aid absorption and mitigates pressures on the real exchange rate but lowers overall revenues because LICs on average derive one-third of total revenue from trade taxes (Keen and Simone, 2004). - Liberalization needs to be accompanied by strengthening indirect taxes, especially improving VAT efficiency by reducing exemptions and broadening the VAT base (Selassie and others, 2006). - International competition in tax incentives has reduced corporate tax revenue and base in many LICs. - Revenue administration and tax base broadening: - Low revenues mainly reflect narrow tax bases and weak administrative capacity rather than low tax rates. - A tax-to-GDP ratio of at least 15 percent is considered a reasonable target for most LICs (Selassie and others, 2006). - The UN Millennium Project (2005) estimated LICs could mobilize additional domestic revenues equivalent to 4 percent of GDP. - Reforms needed: improved organizational structure of revenue administration, strengthened audit capacity, fair tax enforcement. - Revenue administration reforms are a particularly high priority in many countries in SSA. ### Choosing an expenditure path - Factors determining how much and how fast scaled-up aid should be spent: - Time profile of expected aid; - Macroeconomic, sectoral, and administrative capacity to absorb higher aid inflows; - Likely impact of spending on growth and debt sustainability; - Spending efficiency. - Time profiles of aid and policy implications: - Compressed short period: save part of initial surge to spread higher aid-financed spending. - Volatile around constant/rising trend: smooth fluctuations through domestic borrowing and reserve accumulation consistent with macro stability. - Rise and remain stable: potentially allow rising spending profile depending on absorptive capacity. - Absorptive capacity constraints: - Macroeconomic conditions (e.g., high inflation, low foreign reserves) may require gradual scaling up of spending. - Countries with mature macroeconomic stabilization can use scaled-up aid more rapidly (Selassie and others, 2006). - Postconflict countries without stabilization may need to save initial aid surges until capacity improves; humanitarian relief aid needs immediate spending when security stabilizes. - Sectoral constraints: shortages of teachers, health workers—examples of innovative responses include rapid training and deployment of semiskilled workers (Ethiopia). - Subnational implementation limits: - Share of education and health spending devolved to subnational governments is increasing. - In some SSA countries, subnational governments are responsible for about 70 percent of poverty-reducing expenditure. - Weak accountability, internal controls, auditing, monitoring and evaluation, and weak accounting/manual procedures/human capital constraints limit effective use. - Saving versus smoothing versus front-loading: - Many countries saved part of aid surges in SSA; remaining higher aid flows often boosted public savings used to retire domestic debt (Aiyar, Berg, and Hussain, 2005; Foster and Killick, 2006). - Limits to saving: donors reluctant to continually provide aid that is saved; pressures to spend higher aid; project-tied aid is difficult to save. - Preferred approach: smooth spending over the medium term—stable spending path as a share of GDP calibrated to be sustainable indefinitely given expected value of new aid inflows (Barro and Sala-i-Martin, 1995). - Conditions that may justify front-loading: - Returns to public investment are high; - Investment is subject to increasing returns (e.g., poverty traps) (Azariadis and Stachurski, 2005); - Benefits of government consumption are significantly higher today than in the future (e.g., famine, health crisis). - Risks of front-loading: borrowing from domestic banking system may conflict with macroeconomic and debt sustainability; if future aid or spending impacts underdeliver, front-loading can lead to unsustainable spending and abrupt adjustments. - Poverty reduction strategies with front-loading should be underpinned by front-loaded donor commitments to reduce fiscal risks. - Regional aid delivery: - Some aid may be delivered regionally (e.g., WAEMU); member countries still channel aid through domestic budgets but must consider convergence criteria of monetary union. - WAEMU is considering alternative convergence criteria to accommodate expenditure financed by aid flows. ### Spending and debt sustainability - Higher aid inflows have broad macroeconomic effects on the real exchange rate and interest rates, with implications for debt sustainability via domestic interest rates and exchange rate movements. - Examples of risks: - Sterilizing aid inflows to prevent Dutch disease (real exchange rate appreciation) can raise domestic interest rates, pressuring public debt dynamics. - A sudden decline in aid inflows can cause real depreciation, increasing external debt burden. - Importance of sustainability when aid is provided as loans, even on concessional terms. - Spending composition and efficiency affect growth and thereby sustainability. ### Spending and growth - Composition of public spending can influence growth; higher aid-financed public spending affects growth and public debt sustainability. - Public investment may “crowd in” private investment by improving infrastructure; evidence of complementarities between public infrastructure and private investment exists. - Empirical growth impact estimates are sensitive to methodology and data. - Cross-country econometric estimates of growth response to higher public investment range from no impact to an increase of 0.7 percentage points (Gupta, Powell, and Yang, 2006; and IMF, 2005a). - These studies may not capture short-term impacts or the potential effects of substantial scaling up of public investment. - Success of higher public investment depends on effective institutions to channel resources into projects that eliminate growth bottlenecks. - Growth effects of education and health spending are more difficult to estimate; literature estimates suggest a 1 percent of GDP increase in such spending can have a long-term effect, ranging from 0.5 to [text truncated in source]. ### Box 1 — Stylized expenditure path options when the resource envelope is expanding - Three stylized options in MTFFs: - Smoothing: - Keep spending fairly stable as a share of GDP. - With scaled-up aid, spending increases to a new, higher level calibrated to be sustainable indefinitely given expected present value of new aid inflows. - Part of a temporary aid surge is spent, part saved, reducing debt; interest savings from lower debt allow stable spending as a share of GDP after surge diminishes. - Front-loading: - Spending increases rapidly when aid is scaled up, then gradually declines as a share of GDP (either via lower real spending or faster real GDP growth from public investment). - Appropriate when absorptive capacity is not a bottleneck, investment has high/increasing returns, or current benefits greatly exceed future benefits. - Risks: if future aid or spending impact is lower than expected, approach may lead to unsustainable spending and debt distress. - Saving: - Most additional aid initially saved; spending rises gradually while reserves are built or debt reduced. - Spending share of GDP eventually stabilizes at an even higher level than under smoothing because higher assets (or lower debt) increase interest income (or lower interest spending). - Appropriate when macro stability is not yet achieved or spending efficiency is low and expected to rise over time. - Limits: donors may be unwilling to fund reserve buildup rather than spending to achieve MDGs; pure saving can only be temporary while capacity to spend aid efficiently is strengthened. *Source: IMF staff text in the provided content unit.* ### 1.0 percent of GDP, provided resources are spent efficiently and fiscal institutions are strong. ### _wp07222 - 1.0 percent of GDP, provided resources are spent efficiently and fiscal institutions are strong. ### Aid modalities and growth effects - Aid-financed spending programs are categorized by their expected impact on growth: - (1) activities reasonably expected to enhance growth over the short to medium term; - (2) activities focused on long-term growth; - (3) activities not directly related to growth. - External project assistance for infrastructure can boost growth over the short to medium term provided sound capital budgeting procedures to prioritize projects with high rates of return are adopted. - Increased public spending to halt environmental degradation, support better governance or judicial systems, and improve health and education outcomes would act indirectly to increase long-run growth through higher labor productivity. - Humanitarian aid spending sustains consumption following negative shocks and is not directly growth-enhancing. - The modality for scaling up aid can affect the allocation of public spending, growth, and the sustainability of public debt. - Caution is required in projecting growth effects of spending in Debt Sustainability Analyses (DSAs), especially in countries where fiscal institutions are weak. ### Spending efficiency - Inefficient spending increases future debt burdens without commensurate improvement in social and economic outcomes. - Improving economic and social outcomes through scaled-up aid requires both spending more and spending more efficiently. - An initial analysis of health and education spending found significant room for increasing efficiency in many LICs (Appendix II). Three highlighted results: - There is significant variation across countries and regions in the relative efficiency of health and education spending. - Good governance and the quality of fiscal institutions have a strong positive correlation with the efficiency of spending. Countries with better governance and fiscal institutions have higher relative efficiency scores. - Volatile aid flows have not generally been passed through into public spending, contributing to relatively stable efficiency scores; as long as aid volatility does not translate into higher volatility in spending, the relative efficiency of spending is not affected. - Caveats in interpreting the results: - Sectoral outputs/outcomes depend on more than just sectoral spending—some factors can only be partially captured through control variables. - The focus on quantitative inputs and outputs/outcomes fails to fully account for qualitative factors. - In a cross-country analysis, efficiency is measured in relative terms: a country with a better “efficiency score” is only relatively more efficient than others—not necessarily in an absolute sense. - Note: the part of the analysis linking governance and efficiency was limited to health spending because of data limitations. ### Expenditure path and fiscal targets - Medium-term spending path should anchor the fiscal framework. - Typical medium-term fiscal planning begins with a target for the fiscal balance consistent with a sustainable path of public debt and macroeconomic stability; the ceiling on public expenditure is then derived residually given forecast domestic revenues and the sustainable fiscal balance. - Scaling up aid increases available resources and creates a range of spending paths consistent with the medium-term fiscal framework (MTFF). Countries should choose a stable medium-term spending path consistent with absorptive capacity constraints and debt sustainability. - Annual fiscal balance targets should be consistent with the medium-term expenditure path. - Choice of the precise fiscal indicator to be targeted should be decided case-by-case. Considerations: - Focusing on the overall balance, including external grants, allows scaled-up aid to pass through into higher public spending without deterioration in the reported fiscal position. - Complementing the overall balance including grants with other measures of fiscal sustainability is useful. For instance, the overall balance excluding grants is a key indicator of fiscal policy’s effect on domestic financing. - If grants are volatile and countries smooth expenditures, the overall balance including grants could be a relatively volatile indicator; in such circumstances, more stable fiscal indicators should also be monitored. ### Box 2 — Fiscal targets in Fund-supported programs (findings and guidance) - Criticisms of fiscal targets in Fund-supported programs: - Targets on the fiscal deficit excluding grants can prevent countries from increasing spending when grant financing exceeds program assumptions, even if such spending would not add to the debt burden. - Use of asymmetric adjustors has been criticized for preventing spending increases when aid inflows exceed projections, while allowing only partial increases in domestic financing when aid inflows are below projections. - Evidence from Fund-supported programs: - Often, program design accommodated all programmed aid flows. An independent review of Fund-supported programs in sub-Saharan Africa (IEO, 2007) noted that, in countries with low inflation, programs were designed flexibly to spend almost all of the anticipated aid. - Most programs did not constrain capital spending financed by project-related grants. However, these programs usually did not allow additional aid to be used for current spending. - Programs also included a ceiling on net credit to government, sometimes complementing the fiscal balance target and sometimes independently. The degree to which additional external financing could be spent depended on the design of fiscal adjustors. - Guidance for program design going forward: - Program design should continue to use fiscal balance targets and adjustors that respond best to country-specific conditions when aid is scaled up. - Where macroeconomic conditions permit, fiscal targets should allow maximum flexibility for spending additional aid. - Adjustors in Fund-supported programs should be designed to avoid cutting back priority expenditures in response to aid shortfalls. ### Short-term fiscal targets in PRGF countries (summary of coverage) - Data are based on the latest staff reports for 43 countries with Poverty Reduction and Growth Facility (PRGF) programs approved in 2002–06, covering performance criteria on fiscal balance, net domestic financing (NDF), or net credit to the government (NCG). - Aggregate counts shown in the source for fiscal balance targets and other targets (as presented in the source table): - Total: 43 - AFR: 25 - APD: 4 - EUR: 2 - MCD: 6 - WHD: 6 - Further table columns in the source indicate counts for specific target types and adjustor usage (reported in the source text as NCG, NDF, Adjustor, Asymmetric adjustor, and counts by region). *Source: Excerpt from the PDF chapter titled "_wp07222 - 1.0 percent of GDP, provided resources are spent efficiently and fiscal institutions are strong."* ### 06. In 14 out of 22 PRGF arrangements with fiscal balance targets, all foreign-funded investment was excluded from the t ### _wp07222 - 06. In 14 out of 22 PRGF arrangements with fiscal balance targets, all foreign-funded investment was excluded from the t ### Fiscal targets and treatment of aid in PRGF programs - In 14 out of 22 PRGF arrangements with fiscal balance targets, all foreign-funded investment was excluded from the targets. - For seven countries, the targeted balance included grants (and the investments financed by these grants). - The programs used a variety of deficit concepts: - Only six programs included a ceiling on the overall fiscal deficit. - Twelve countries targeted the primary balance. - Four targeted the basic balance (also called the current balance, i.e., excluding capital revenues and expenditures). - The domestic balance is used in several countries to anchor the fiscal framework, but: - The domestic balance excludes external grants, foreign interest payments, and externally financed project spending. - The domestic balance may be problematic because scaled-up aid that raises domestic spending in priority areas (e.g., health and education) can produce a significant deterioration of the reported domestic balance. ### Wage bill ceilings: incidence, rationale, and guidance - Incidence and trends: - The share of PRGF-supported programs with wage bill ceilings declined from 40 percent during 2003–05 to about 30 percent as of May 2007. - Wage bill ceilings have typically covered the overall government; in no instances have they been defined for a specific sector. - In some cases, priority sectors such as education have been excluded from the wage bill ceiling (example given: Benin). - Debated effects: - Critics argued ceilings prevented countries from expanding employment in social sectors even when concessional financing was available, with adverse implications for meeting the MDGs. - A review (Fedelino, Schwartz, and Verhoeven, 2006) indicates wage bill ceilings reflected valid macroeconomic concerns and provided flexibility to expand employment in priority sectors when external financing was available; ceilings are regularly adjusted as resource availability and priorities change. - Recommended conditions for using wage bill ceilings (use only in exceptional cases; second-best option): - Clear justification: rationale guided by macroeconomic considerations; program documentation should justify use transparently, including consistency with the MDGs. - Limited duration: temporary device; governments should address root causes such as civil service reform and strengthened payroll management. - Sufficient flexibility: accommodate spending of scaled-up aid, particularly donor-financed employment in priority sectors such as education and health. - Periodic reassessments: need and rationale reassessed at program reviews. - Expectation: Over time the need for wage bill ceilings will decline as medium-term frameworks (MTFs) and effective budget and payroll systems are developed. ### Updating baseline and alternative scaling-up scenarios - Baseline projections should be updated as new information becomes available. - The medium-term fiscal policy framework should be informed by authorities’ projections for external aid, domestic revenue, expenditure, and public debt. - Management of aid shortfalls and windfalls: - Small, temporary shortfalls can be smoothed through additional domestic borrowing or drawing down buffers. - A substantial aid shortfall calls for revising the expenditure path by cutting low-priority outlays. - As anticipated aid inflows change, baseline expenditure projections should be updated to maintain a sustainable public debt profile. - Alternative “scaling-up scenarios”: - Enable recipient countries to assess implications of higher recurrent spending and sustainability of the fiscal framework. - Help identify policies required to alleviate Dutch disease effects, skills shortages, and other bottlenecks. ### Dealing with aid uncertainty and volatility - Key facts on volatility: - Aid flows are 40 times more volatile than tax revenues (Bulíř and Hamann, 2006) and significantly more volatile than remittances. - Aid volatility has increased over time and can translate into expenditure volatility. - Two reasons volatility issues may worsen: - Larger aid volumes make a larger portion of budgetary spending subject to volatility. - Shifts in composition of aid away from project aid toward budget support and program loans may increase volatility because donors may be unable to make long-term commitments for budget support. - Measures to mitigate aid volatility and uncertainty: - Conduct stress tests on baseline projections and subject MTFs (and DSAs) to periodic stress tests to identify short-term financing risks and assess impacts of aid shortfalls on the budget. - Build up reserve buffers to sustain spending if shortfalls materialize: - The size of the buffer should be case-by-case but could vary from 50 to 100 percent of annual aid-financed spending (Eifert and Gelb, 2005). - Such buffers supplement other reserves for imports or short-term debt and help smooth expenditures without costly bridge financing from domestic banking systems. - Building buffers requires strategies to invest and manage reserves efficiently during aid windfalls. - Identify priority spending to safeguard from cuts in the event of an aid shortfall; easier when spending is defined in PRSPs or similar documents and when PFM systems can monitor allocations and outturns. - Build flexibility into spending programs so they can be scaled up or down in response to fluctuating aid disbursements (e.g., temporary/flexible employment contracts; contracting out services). - Include appropriate adjustors in Fund-supported programs to fully or partially accommodate aid volatility: - Evidence indicates LICs adjust domestic financing and expenditure asymmetrically: aid shortfalls lead to cuts in domestic investment spending while governments do not increase such spending in response to aid windfalls. - Adjustors should be designed to avoid cutbacks of critical spending, such as domestic investment, when aid falls short of program projections. - The degree to which shortfalls should be financed and windfalls saved depends on macroeconomic stability, absorptive capacity, and debt sustainability. - Reducing volatility via donor actions: - Long-term donor commitments can reduce aid volatility; international community pledged more predictable and multiyear commitments (Paris High Level Forum, 2005). - Examples mentioned of longer-term donor commitments: - The United Kingdom provided a 10-year commitment on development assistance to Rwanda and Ethiopia. - DFID agreed to provide six-year program support for the health sector in Malawi under the Sector-Wide Approach. - Initiatives such as the International Financing Facility for Immunization (IFFIm) aim to provide “front-loaded, reliable funding over a number of years.” - Certain arrangements facilitate long-term commitments: simple, formalized partnership agreements and donor groups that jointly monitor commitments and disbursements within a predefined performance framework (examples: Mozambique, Tanzania, Ghana, Burkina Faso). - Strategic objective: Countries should strive to ultimately avoid long-term reliance on aid by strengthening domestic revenue bases, debt management capacity, and fiscal institutions including PFM systems. ### Strengthening institutions to promote effective utilization of aid (PFM) - Rationale for strong PFM systems: - Increase prospects of achieving key economic and social priorities. - Support transparency and accountability—ensuring government responsibility and donor/taxpayer access to information on allocation and use of funds. - Reduce transaction costs of meeting aid-related donor requirements. - Weaknesses of existing PFM systems in LICs (diagnostic summaries): - HIPC Assessments and Action Plans (HIPC-AAP): - Covered 23 eligible LICs in 2001 and 26 in 2004. - 2004 assessment concluded 19 of the 26 countries still required substantial upgrading of PFM systems. - Budget execution and ability to track poverty-reducing expenditures were especially weak. - Fewer than one-third of countries surveyed had budget outturns close to the budget as adopted. - 90 percent of African countries surveyed failed to complete final audited accounts within 12 months of the end of the fiscal year. - Fiscal ROSC assessments (sample of 28 PRGF-eligible countries): - Performance in some areas of fiscal transparency is not out of line with more advanced economies. - Performance generally weak in many areas important to PFM: comprehensive and credible budget, effective audit procedures. - PEFA assessments (early results from 12 PRGF-eligible countries, 2005–06): - Pattern of relatively poor performance across key areas of budget preparation and execution. - Median score of about 2.0 against the international good practice standard of 4.0. - World Bank CPIA ratings (27 countries reviewed in OECD (2006b)): - Scores ranged from 2.0 (weak) to 4.5 (moderately strong). - Evaluations of the Fund’s TA activities in LICs: - Budget plans often based on unrealistic assumptions, not comprehensive, lacked medium-term focus. - Accounting and payments systems and other areas of budget execution weak. - Budgetary institutions fragmented; weak legislative oversight and poor accountability of senior budget officials common. - Civil conflict exacerbated problems in some countries. - Lessons and priorities: - Progress on PFM reforms has been uneven; some countries (Ghana, Mali, Mozambique, Uganda) have shown rapid improvement. - Important to prepare realistic, well-structured action plans with appropriate prioritization and phasing. - Critical to focus on strategic PFM reforms and sequence them consistent with country capacity. - Continued capacity building in public debt management is crucial to develop Medium-Term Debt Strategy (MTDS). - Special challenges for postconflict and disaster-affected countries: - Large injections of aid can overwhelm weakened PFM systems or logistics for handling sudden inflows. - Sudden influx of foreign experts to run central fiscal institutions is common until national staff take over, altering focus and perceived weaknesses. - PFM reform priorities and sequencing may differ in these contexts. ### Overall strategic planning and budget integration - Strategic planning should be anchored in the budget process to achieve medium- and long-term objectives defined in PRSPs and MDGs. - Key elements: - Strengthen relationship between planning and budgeting cycles. - Strengthen role of the cabinet in strategic decision making. - Closer integration of recurrent and development budgets. - Consolidate responsibility for preparing and executing the budget within the finance ministry. - Increase coverage of donor-funded development projects in the budget. - Develop “top-down” budgeting that starts with cabinet agreement on overall resource envelope and broad sector allocations, followed by negotiation between finance ministry and line ministers on detailed allocations. - Requirements and timeline: - Top-down budgeting and medium-term approaches require sufficient capacity and effective cabinet coordination. - Some reforms will take many years to become fully effective. - Where planning and finance functions are in separate ministries, strong coordination is required. *Italic: Source: _wp07222 - 06. In 14 out of 22 PRGF arrangements with fiscal balance targets, all foreign-funded investment was excluded from the t* ### Box 3. Strengthening Public Financial Management in Postconflict and Disaster- ### Box 3. Strengthening Public Financial Management in Postconflict and Disaster-Affected Countries ### Challenges and special circumstances in postconflict and disaster-affected countries - Greater need to consider PFM reforms within the context of emerging political and constitutional debates; early PFM reforms may favor greater centralization of control, while political forces may pull in the opposite direction. - Potential loss of physical and institutional infrastructure can greatly increase capacity constraints; regime change and international experts filling key government positions can dilute local capacity. - Large off-budget donor expenditures can increase the volatility of aid revenues as the emergency phase recedes; changes in donor priorities and withdrawal of support can lead to large projects suddenly being brought on-budget, crowding out other budget items and leading to ad hoc changes in appropriations. - Need to strike a balance between slow, thorough approaches and fast, pragmatic solutions; emergency situations make rigorous reviews and strategic sequencing of PFM reforms harder. - Postconflict countries often have a larger, concentrated donor presence, which can facilitate coordination of priorities and systems, if well managed. ### PFM reforms likely to require priority attention in postconflict countries - Establishing/strengthening the central budgetary institution. - Preparing a credible annual budget with clear and reliable estimates; the first step in many cases is the formulation of an emergency budget, rapidly constructed and subject to revision. - Developing a clear government accounting system that can track the use of budget appropriations, produce clear reports on outturns, and support the government’s financial reporting obligations. - Undertaking a review of the legal and regulatory framework for budget preparation and execution (which may be necessary if regime change leads to rejection of the existing legal framework). - Taking initial steps to harmonize the medium-term fiscal and strategic planning framework so that it transparently shows both donor commitments and planned transfers to the government’s budget. ### Developing a medium-term approach to budgeting - Key challenge in an environment of scaled-up aid: ensure additional spending helps achieve the MDGs and maintain macroeconomic stability. - Achieving the MDGs requires ambitious spending programs spanning several years; financing requirements may exceed immediate aid commitments. - Countries need a longer-term view of spending needs and potential resource availability—both domestic and external—in fiscal policy formulation. - This can be achieved by anchoring fiscal policy in an MTF.33 - MTFs help align the budget with medium-term planning goals, such as progress toward the MDGs and the PRS. ### Instruments and their functions - Medium-term fiscal frameworks (MTFFs): - Outline the fiscal framework based on projections for broad fiscal aggregates consistent with key macroeconomic variables and fiscal targets. - Broad fiscal aggregates (e.g., revenues and expenditures) are projected based on the expected evolution of macroeconomic variables (e.g., growth and inflation) and policy measures. - Projecting a realistic path for scaled-up aid is essential to underpin overall spending growth. - MTFF should be reexamined and updated at least annually to reflect recent developments and shocks to the macroeconomic outlook. - Medium-term budget frameworks (MTBFs): - Allocate the overall spending envelope across sectors (e.g., health and education), based on the country’s development priorities as set out in the PRSP. - Medium-term expenditure frameworks (MTEFs): - Outline the sectoral allocation of spending across programs and projects according to government priorities, based on detailed costing from sectoral analysis. - Include a more detailed indication of performance objectives and measures. ### Capacity and sequencing considerations for MTFs and MTEFs - Most LICs lack adequate capacity to adopt a comprehensive MTEF; many have rudimentary MTFF and MTBF in place. - Countries that lack MTFFs could draw on macroeconomic scenarios developed in the context of DSAs for a basic MTFF. - Steps to develop MTBFs include: - Strengthening government strategic decision-making procedures regarding the budget (e.g., involving the cabinet). - Improving the relationship between national planning and budget processes and between ministries of finance and planning. - Strengthening capacity to prepare sectoral ceilings and estimates based on improved economic and functional classification of budgetary revenues and expenditures. - Designing and implementing an MTEF is complex and should be approached cautiously and step-by-step. Successful adoption requires: 1. Capacity for making realistic forecasts of macroeconomic variables over the medium term. 2. Procedures for estimating fiscal developments beyond the current and upcoming fiscal years. 3. A review of decision-making processes of government and associated institutional arrangements. 4. Enhanced coordination between the finance ministry, planning ministry, other central agencies, and line ministries through the cabinet or cabinet committees.34 - An IMF review concluded that developing an MTEF can be effective when circumstances and capacities permit; otherwise it can consume resources and distract from immediate needs such as improving annual budget execution processes.35 - In Africa, premature introduction of MTEFs where preconditions were not met resulted in largely paper exercises, failing to recognize the political nature of budget bargaining.36 - For countries whose detailed MTEFs have failed, a simplification process should be encouraged.37 - Examples of simplification: pilot major new spending initiatives before full-scale implementation; develop expenditure tracking surveys; assess costs and benefits of new programs on a pilot basis (possibly using randomized trials); involve donors, NGOs, and academics to carry out evaluations where capacity is strained. ### Box 4: Current medium-term fiscal planning practices (high-level findings) - While most LICs do not have an MTF in place, even where an MTF exists it is often not well integrated with the budget and not used for analytical purposes. - Out of 31 LICs examined, only 3 had a full-fledged macrofiscal framework in place, 5 had a relatively comprehensive framework, 13 had a basic framework, and 10 had no MTF. - Only 10 of the 21 LICs that had an MTF systematically aligned their yearly budgets with these frameworks. - Common shortcomings observed: 1. Medium-term fiscal projections and macroeconomic assumptions were often unrealistic and therefore lacked credibility.2/ 2. Underlying macroeconomic assumptions for forecasts were often not explicit; fiscal ROSCs suggested that 9 out of the 21 LICs with an MTF did not explicitly state key macroeconomic assumptions. 3. Fiscal effects of different macroeconomic scenarios were often not quantified. 4. On occasion, long-term policy scenarios were not prepared. 5. Medium-term expenditure estimates often did not reflect expenditure priorities or changing priorities and were not adjusted in a rolling fashion. ### Strengthening budget execution and reporting - Short-term focus for low-capacity countries: “getting the basics right”—relatively simple reforms summarized in Box 5.38 - Emphasis on building capacity in budget execution and reporting to avoid ad hoc decision making and frequently encountered problems such as expenditure arrears and low-quality and untimely fiscal reports. - Maintenance of an adequate and coherent accounting framework is essential for tracking spending, enforcing accountability, and meeting donors’ fiduciary requirements. - A minimum functioning accounting system should include: 1. Regular bank account reconciliation with accounting records. 2. Double-entry accounting procedures, with both general ledger and supporting subsidiary ledgers. 3. A chart of accounts that facilitates reporting according to the budget presentation. 4. Periodic and timely in-year consolidation of accounts, where accounting is decentralized. 5. Maintenance of adequate accounting records. 6. Preparation of appropriate manuals and training for accounting staff (Box 5). - Accounting information should be comparable across years and between the approved budget and data on realized expenditures. - Any changes in the accounting basis and principles should be clearly specified and necessary adjustments made to ensure that the data are consistent. *Source: IMF working paper content (Box 3 and related Box 4 and discussion).* ### Box 5. Short-Term Priorities for Public Financial Management Reform ### Box 5. Short-Term Priorities for Public Financial Management Reform ### Short-term priorities for PFM system reform - Ensure that the ministry of finance or central budget authority has adequate control over the fiscal aggregates and that budgetary spending is in line with the approved budget. - Ensure that the process of preparing the annual budget is comprehensive and coherent, follows a sensible timetable, and is adequately integrated with the priorities-setting process of the national plan or Poverty Reduction Strategy Paper. - Establish a budget classification, for administrative and economic categories initially, that complies with international good practice. - Introduce a basic accounting system, with some level of automation, to process receipt and payment transactions, record information, and produce timely fiscal reports reconciled with banking data, at least for the main aggregates. - Take steps to ensure reasonable cash flow planning and control of spending at key points of the spending chain and at the commitment stage. - Establish a simple system for recording donor aid commitments and disbursements and tracking poverty-reducing expenditures. - Ensure that staff manuals on budget preparation and expenditure authorization procedures are in place. ### Government banking, cash management, and accounting - Government banking arrangements need strengthening to improve cash management and accounting and to reduce fiduciary risk. - A consolidated banking arrangement—ideally in the form of a treasury single account—improves the quality of accounting data through effective and timely bank reconciliation. - Care should be taken during scaling up to ensure that the number of bank accounts does not proliferate and further overload the low capacity of systems in LICs to keep track of the increased volume of transactions passing through the banking system. - Over time, donors’ bank accounts should be integrated with the treasury’s accounts to avoid problems with cash management, and their respective accounting and banking records should be reconciled in a timely manner. ### Fiscal reporting and coverage - Regular and timely fiscal reporting is necessary to assure donors, policymakers, legislators, and other stakeholders that the government is on track in implementing its annual budget. - In countries where subnational governments account for a significant portion of government spending, fiscal reporting should cover these entities also. - Where capacity constraints limit the coverage of fiscal reports, the main requirement should be for timely and reliable reporting of the central government budget. - Although many countries have some form of monthly reporting, the coverage and quality of such reports continue to be weak. - Donors should provide full information to the authorities on their planned and actual aid disbursements, whether in cash, in-kind, or by direct disbursement to suppliers, particularly when these are not reported through the treasury. ### Internal control and payroll management - A sound system of internal control is necessary to provide reasonable assurance that public expenditure is executed in accordance with the approved budget and the established regulatory framework. - The effectiveness of budget execution does not necessarily increase by adding multiple layers of redundant control; the control function should be clearly articulated and assigned, understood by controllers, and consistently applied to all transactions. - Given that payroll expenditure forms a substantial part of public expenditure in many LICs, improving payroll management and control should be a priority. - Ghana adopted a new computerized Integrated Payroll and Personnel Database in 2006 and is finalizing the integration of this data into the budget (example of progress in payroll systems). ### Public procurement - Weak or inadequate public procurement systems are one of the main sources of corruption. - Strengthening procurement is essential to maintain donor confidence in continued funding through the budget and is one of the key measures identified in the 2005 Paris Declaration. - Steps to strengthen procurement include developing standard bidding documents, streamlining and computerizing the system for recording bids and contract awards, publishing such information in the official gazette, and later developing an e-procurement system. - Recent efforts, spearheaded by the World Bank, have resulted in a significant number of LICs enacting new procurement legislation and establishing procurement regulatory authorities, though substantial capacity building remains to be done. ### Integrating donor aid and managing extrabudgetary flows - Aid disbursed through extrabudgetary channels should be coordinated with budget priorities. - On average, only 37 percent of external aid is channeled through country PFM systems (OECD, 2006b). - Extrabudgetary flows complicate fiscal management and can affect the composition of spending (examples: “3 by 5 Initiative” expansion from 400,000 in 2003 to around 2 million in 2006; PEPFAR provision for US$15 billion over five years beginning in 2004). - Earmarking of aid can introduce inefficiencies, strain weak PFM systems, reduce government flexibility to reallocate resources, and hamper expenditure smoothing. - Extrabudgetary aid and expenditure might be warranted in the short term in fragile and postconflict states where resources cannot be channeled through institutions efficiently. ### Strengthening PFM capacity and tracking poverty-reducing spending - Emphasis should be on building capacity in budget execution and reporting: budget classification, accounting, public procurement, payroll management, and internal control systems. - Strengthening PFM systems, promoting transparency, improving budget procedures and reporting, and preparing MTFs should reassure donors and encourage more aid channeled through the budget. - Special attention is needed to track poverty-reducing public spending to ensure it reaches intended recipients. - Techniques such as Public Expenditure Tracking Surveys (PETS) and audit reports can identify weaknesses in the expenditure chain and assess quality of cash management and internal control systems. - An example: Uganda’s PETS found that 87 percent of the nonwage resources were diverted to other uses following a dramatic increase in primary education spending that failed to boost enrollments. - Lessons from PETS in multiple countries show poor resource management can result from excessive discretion in budgetary procedures in environments with weak internal controls, imperfect information, and vested interests. - All poverty-reducing spending should be monitored because of fungibility; recipient countries can offset scaled-up aid by lowering their own spending in those areas. - Determining a counterfactual (what government would have spent absent higher aid) complicates assessment of aid impact. - Substantial earmarking by vertical funds requires sustained support to maintain programs over time. ### Moving toward results-oriented budgeting - A gradual move toward a results-oriented budget would help strengthen accountability and assess program effectiveness. - Advanced forms of results-oriented budgeting are not appropriate for LICs, but initial steps can include: - identifying key program objectives and associated “responsibility centers”; - defining intended program outputs; - strengthening the link between performance and rewards/sanctions; - implementing pilots in performance evaluation and results-oriented budgeting in selected ministries such as health and education. - Burkina Faso, Ghana, Mali, and Ethiopia are cited as LICs that have made progress in implementing program and performance budgeting. ### Formulating and sequencing PFM action plans - LICs should prepare an action plan for strengthening PFM systems based on a comprehensive diagnostic study such as the PEFA framework. - Reforms should be sequenced in line with government capacity using a “platform approach” so core building blocks precede more advanced reforms; indicators of success for each stage determine when to move to the next stage. - The action plan may need tailoring for postconflict countries that face weak legal and regulatory frameworks, ill-defined fiscal authority, and inappropriate PFM systems. - Political economy factors are important for successful implementation; informal practices can distort budgetary rules and procedures. - Studies of PFM reforms in Ghana, Malawi, and Mozambique show that sound rules can be undermined by informal practices; demand for better governance and accountability is a key driver of change. - Examples of platform timing and sequencing for strengthening budget formulation in a typical LIC: - Initial System - First Platform: Basic System (1–2 years) - Second Platform: Intermediate System (3–5 years) - Third Platform: Final System (6–10 years) - Key functional elements across platforms include Macrofiscal Forecasting Capacity; Planning Instruments and Budget Process; Capital and Recurrent Budgeting; Performance Budgeting; Budget Classification and Chart of Accounts; Donor Aid Coordination; Capacity of Government to Manage Scaled-Up Aid. ### Box 6. Illustrative expenditure tracking mechanism - Budget classification system conforming with the international standard is the essential component for tracking poverty-reducing expenditures: - At a minimum, a basic economic and administrative classification of expenditure should be put in place to allow aggregation into sectors for broad tracking. - A functional classification of expenditures would provide better indication of allocation within a sector or subsector and improve tracking against poverty-reducing priorities. - A simple program classification would provide additional information for detailed policy analysis and evaluation of aid effectiveness. - For aid delivered directly by donors outside the budget, donors should provide timely reports to government on disbursements: - At a minimum, reports should include information on aggregate disbursements by sector (aligned with government definition) and geographical location. - If possible, data should be provided on expenditures according to their economic classification; the most basic requirement is a distinction between recurrent and capital expenditures to allow adequate medium-term planning. - Eventually, donors should report against the functional or program classification of expenditures adopted by the government. *Box 5. Short-Term Priorities for Public Financial Management Reform* ### Introduction of program budgeting linked to MTEF. ### Introduction of program budgeting linked to MTEF ### Context and compatibility - Classification fully compatible with international good practice. - Donor aid estimates incorporated in MTFF and budget; aid flows executed by the treasury. - Note: GFSM = Government Finance Statistics Manual; MTEF = medium-term expenditure framework; MTFF = medium-term fiscal framework; MoF = ministry of finance, MoP = ministry of planning; NDP = National Development Plan; PRSP = Poverty Reduction Strategy Paper. ### Principles for sequencing and timing of PFM reforms - Incremental reforms are more likely to be successful than “big-bang” approaches, especially those that seek to incorporate models of reform imported from other countries. - PFM reforms need to be linked to the annual budget cycle for two main reasons: - (1) budget offices are especially busy at certain points of the year and have little time to focus on new reform initiatives at such times; and - (2) certain reforms, for example, a change in the timetable for budget preparation or the budget classification, can only be introduced at the beginning of a fiscal year. - In some countries (e.g., Tanzania), formal consideration of new reform initiatives has been institutionalized as part of the regular budget calendar and involve consultation with TA providers and other stakeholders. - The main constraints to reform should be identified early on and means should be found to eliminate or reduce their impact. Such constraints may include the absence of a suitable legal framework, technical issues (e.g., the absence of a good budget classification), institutional weaknesses (e.g., rivalries among different ministries, agencies, or departments over managing the budget process), or political factors. - It is often useful to include an analysis of constraints within the terms of reference of diagnostic studies or TA missions, and to discuss with the recipient government methods of dealing with them. ### Leadership, coordination, and donor roles - Mechanisms should be put in place to promote effective leadership and coordination of the reform program among the authorities, donors, and other stakeholders. - Some countries have established formal mechanisms for coordination such as the donor partnership developed in Mozambique. - Key roles and responsibilities of donors as indicated in Box 7. Box 7. Role of Donors in Promoting Effective Public Financial Management Reform - Donors should encourage the national authorities to establish institutional arrangements that facilitate effective communication between the ministry of finance, the ministry of planning, and other agencies (e.g., the prime minister’s office) involved in the process of planning and disbursing official aid. - Donors should play their part in producing realistic projections of donor disbursements of aid. Although project aid often suffers most from unrealistic projections, IMF-supported programs in low-income countries are often affected by late disbursements of general budget support by the multilateral donors. - Donors should resist earmarking aid for specific purposes. Donors often give less attention to the budget priorities of the recipient country, and instead disburse money on their own schedule for projects they conceive to be useful. In other cases, national producers are rewarded by tying aid to national products and services. - Donors should ensure that full information is provided on actual aid disbursements, whether in cash, in-kind, or by direct reimbursement to suppliers, and to the extent possible, attempt to satisfy their national authorities’ requests for such information by using the recipient countries’ own reporting and accounting system. - Donors should ensure that, once funds are disbursed, the accounting and banking records of donors’ own bank accounts are reconciled in a timely manner. Ideally, donor accounts should be integrated with the government’s treasury system. - Donors can do much to encourage transparency, participation, and accountability in public budgeting by supporting meaningful and regular reporting, timely disclosure of financial information, and external oversight of the budget process. They need to be more aware of the political economy factors that influence the behavior of partner governments, including the potential impact of their own behavior on domestic processes. ### Short-term action plan priorities - Focus on key PFM areas for aid utilization. These include the capacity to prepare sectoral ceilings and estimates based on improved functional and budget classifications and strengthened internal controls on budget execution, accounting, and reporting at the central level. - Decompose reforms into a core set of functional components. Where appropriate, PFM reforms should be broken down into functional blocks, such as the core design elements, required changes to legislation, information technology procedures, and training. Monitoring progress in each area is essential so that problems can be addressed before they become obstacles to the overall reform process. - Take initial steps to give the budget a results orientation. This would allow the governments to get a sense of whether scaled-up spending is having the desired effect on economic and social outcomes. ### Medium-term reform areas requiring gradual implementation - Developing capacity in treasury systems, cash management, and debt management to strengthen budget execution and help countries build their own MTDS. - Strengthening the capacity of subnational governments: delivery of services such as education, health, and sanitation is increasingly being delegated to subnational governments, whose PFM systems are typically weaker than those of the national government. Effective use of aid for such services would require strengthening PFM systems at the subnational level also. - Linking PFM reforms to broader public sector reforms: reforms of PFM systems can be strengthened if they are part of a broader public sector reform of the civil service, governance and transparency, and the legal framework. - Gradually increase the role and capacity of accountability institutions, such as the national audit authority, whose mandate should include undertaking value-for-money audits of key expenditure programs. ### Role and challenges of technical assistance (TA) - Recent evaluations of the TA provided by the IMF and World Bank have highlighted common problems in reform programs supported by donor TA. These include inadequate diagnostic assessments, overloaded reform agendas, improper sequencing of reforms, political-economy constraints, poorly selected experts and inadequate quality control of their work, and insufficient coordination among different TA providers. - In some cases, there have been significant deficiencies and gaps in the design and implementation of TA programs. - TA recommendations require sustained follow-up by donors to monitor progress on achieving short- and medium-term goals. Recommended actions to improve TA effectiveness - Establish effective measurement systems for monitoring both TA delivery and improvements in PFM systems. Tools such as the PEFA framework can be useful in this regard. - Encourage the PEFA initiative despite current concerns about the quality of the diagnostic assessments carried out under the PEFA framework. - Strengthen effective coordination between TA providers and the authorities. Country authorities should ultimately be responsible for coordinating donor activities, but limited capacity or scarce human resources can require that a major donor assume this role. - Enhance collaboration between the Fund and the World Bank to support PFM reform in a group of African countries—including Burkina Faso, Ghana, Malawi, Mozambique, Rwanda, and Tanzania—using a range of lending instruments and TA operations. - Emphasize country ownership of reforms; apply lessons learned to use TA more effectively; make effective use of external finance and partnership arrangements with the World Bank and other TA providers, where appropriate; and leverage the resources of staff from headquarters and the Regional Technical Assistance Centers. Key implementation statistic - About 60 percent of the 78 PRGF-eligible countries either have a PFM reform plan in place or are in the process of preparing such a plan. The Fund has provided technical support in more than half of these countries. *Source: Introduction of program budgeting linked to MTEF.* ### Appendix I. Country Experiences with Aid Scaling Up ### Appendix I. Country Experiences with Aid Scaling Up ### A. Some Statistical Properties of Aid Flows - Sample and broad patterns - Analysis based on panel data from 51 PRGF-eligible countries during 1990–2004. - Full sample means: Revenue/GDP = 12.2; Aid/GDP = 13.8. - African countries (about 60 percent of the sample): Revenue/GDP mean = 9.4; Aid/GDP mean = 16.0. - Aid levels expressed as a share of GDP have declined in many countries when the sample is broken into five-year intervals. - Volatility and composition - Aid flows have been substantially more volatile than revenues, particularly in African countries. - Grants are much more volatile in absolute terms than loans. - Time-series patterns and durability - Past aid surges have been relatively short‑lived; achieving the MDGs would require aid inflows that are smoother and more sustained than historical norms. - Selected time-series means and standard deviations (percent of GDP) - Full sample total aid: - 1990–94: Mean = 16.9; Std. Dev. = 4.1 - 1995–99: Mean = 12.6; Std. Dev. = 3.6 - 2000–04: Mean = 11.9; Std. Dev. = 3.2 - Full sample loans: - 1990–94: Mean = 3.9; Std. Dev. = 2.6 - 1995–99: Mean = 2.7; Std. Dev. = 2.2 - 2000–04: Mean = 2.0; Std. Dev. = 1.7 - Full sample grants: - 1990–94: Mean = 12.9; Std. Dev. = 3.3 - 1995–99: Mean = 9.9; Std. Dev. = 2.6 - 2000–04: Mean = 9.9; Std. Dev. = 2.9 - Africa total aid: - 1990–94: Mean = 19.5; Std. Dev. = 4.6 - 1995–99: Mean = 14.3; Std. Dev. = 4.0 - 2000–04: Mean = 14.2; Std. Dev. = 3.9 - Africa loans: - 1990–94: Mean = 4.8; Std. Dev. = 2.6 - 1995–99: Mean = 3.1; Std. Dev. = 2.7 - 2000–04: Mean = 2.4; Std. Dev. = 2.0 - Africa grants: - 1990–94: Mean = 14.7; Std. Dev. = 3.1 - 1995–99: Mean = 11.3; Std. Dev. = 2.7 - 2000–04: Mean = 11.8; Std. Dev. = 3.6 ### B. Aid Flows, Government Spending, and Fiscal Institutions - Predictability and persistence of aid - Panel regressions show that only revenues and lagged values of aid consistently explain aid flows, and explanatory power is relatively weak. - The lagged dependent variable coefficient is significantly smaller-than-unity, implying aid is mean reverting and large aid spurts seldom persist. - Event studies indicate large increases in aid have consistently been followed by a tapering off of aid. - Correlations with revenues and political risk - Own revenues are correlated positively with loans and negatively with grants. - Adding a political risk indicator yields positive and statistically significant coefficients: countries with better political institutions and lower risk tend to be associated with higher revenue collection. - The negative contemporaneous correlation between grants and revenues does not necessarily imply grants induce reduced tax effort; it may reflect donors giving more grants to less-developed, fiscally constrained countries. - Impact of aid on spending (main regression results) - Capital spending: - Rises with total aid; the relationship is more robust for increases in grants than for loans. - Does not increase proportionately with more aid: the squared aid‑to‑GDP term is negative but small. - Current spending: - Increases with grants and tends to rise with aid flows by more than capital spending does. - Social spending (health and education): - Health spending is positively correlated with grants (parameter very small). - No statistically significant effect of aid aggregates on education spending. - Countries with better political risk ratings are associated with higher levels of health and education spending. - Interpretation: lack of responsiveness of health and education spending to aid flows may reflect government attempts to protect these spending items despite volatile funding. - Fiscal institutions and aid volatility - Countries with better fiscal institutions tend to experience less aid volatility. - Scatter plots (standard deviations of aid flows vs. HIPC-AAP scores) suggest higher institutional quality scores are associated with lower aid volatility. - Similar results when replacing HIPC-AAP scores with the fiscal portion of the World Bank CPIA ratings for a larger group of countries. - Institutional improvements and spending composition - Countries that improved budget execution ratings tended to reduce current spending while increasing capital spending. - Using two HIPC-AAP surveys separated by a few years: - Five out of seven countries with a deterioration in budget execution ratings during 2001–04 increased current spending relative to GDP. - Countries that improved budget execution ratings during 2001–04 also increased capital spending on average, although only slightly. *Source: Appendix I. Country Experiences with Aid Scaling Up, _wp07222 - Appendix I. Country Experiences with Aid Scaling Up.* ### Appendix II. Expenditure Efficiency—An Empirical Assessment ### Appendix II. Expenditure Efficiency—An Empirical Assessment ### Overview - Purpose: Assess how a sample of PRGF-eligible countries transform inputs (per capita health and education spending in PPP dollars) into outcomes (health and education indicators used to monitor progress toward the MDGs). - Methodology: - First stage: Data Envelopment Analysis (DEA) to estimate relative spending efficiency (countries on best-practice frontier vs. distance from frontier). - Second stage: Correlation coefficients and multivariate truncated regressions to relate relative efficiency scores to control variables. - Sample: PRGF-eligible countries in September 2006, excluding island economies and transition countries and those without available data on health and education spending. (See Table AII.1 for the list of countries.) ### First-stage results — Health - General finding: Large variances in spending efficiency; higher spending does not always translate into better outcomes. - Income and efficiency: - Median per capita income in the sample is $1,457 in PPP terms. - Table AII.3: Percent of countries in top half of the efficiency distributions for health by income level: - GDP Per Capita ≤ 1,457: Infant mortality 40.0, Child mortality 40.0, Maternal mortality 37.5 - GDP Per Capita > 1,457: Infant mortality 60.0, Child mortality 60.0, Maternal mortality 62.5 - Interpretation: Countries with the lowest per capita incomes tend to have the lowest efficiency scores for health. Overall, only about 40 percent of the countries in the poorest half of the sample ranked in the top half with respect to their outcome efficiency scores. - Outcomes analyzed: infant mortality, child mortality, maternal mortality. - Robustness: First-stage efficiency scores computed with the three health outcome indicators are strongly correlated. ### First-stage results — Education - Indicators used: primary enrollment rate and youth literacy rate. - Table AII.4: Percent of countries in top half of the efficiency distribution for education by income level: - GDP per capita ≤ 1,457: Primary school enrollment 33.3, Youth literacy 64.3 - GDP per capita > 1,457: Primary school enrollment 66.7, Youth literacy 35.7 - Interpretation: Only one-third of the poorest countries are in the top half on primary enrollment efficiency; results are more favorable for youth literacy, where 64.3 percent of the poorest countries are in the top half. ### Second-stage analysis — Control variables and correlations - Analysis limited to health spending efficiency because of data constraints. - Control variables considered (Table AII.5) include: - Income and human development: GDP (in PPP dollars per capita), Prevalence of HIV, Adult literacy rate, Infant mortality rate - Conflict: Country at war 1995–2005, Military expenditure (percent of GDP) - Infrastructure: Improved sanitation access (percent), Improved water source access (percent), Urban population (percent) - Level and volatility of aid: Total ODA, technical cooperation, development food aid, emergency aid, other aid, total loans (net), grants; volatility measured by standard deviation, coefficient of variation, relative variance of aid to revenue - Governance and fiscal institutions: ICPR governance rating; CPIA 12, 13, 15, 16; CPIA 12–16 average - Robust correlations with health efficiency (Table AII.6): - A negative sign means more of the control variable is negatively correlated with the efficiency score and hence positively correlated with level of efficiency. * and ** denote significance at the 10 and 5 percent levels, respectively. - Selected correlation coefficients (coefficient, N, significance): - Prevalence of HIV: 0.30** (N = 44) with immunization, measles; 0.29* (N = 44) with infant mortality; 0.39** (N = 43) with child mortality - Adult literacy rate: -0.35** (N = 36) with infant mortality; -0.43** (N = 36) with child mortality; -0.28* (N = 36) with maternal mortality; -0.31* (N = 35) with births attended by skilled health staff - Improved sanitation facilities: -0.25* (N = 50) with infant mortality; -0.26* (N = 50) with child mortality; -0.43** (N = 46) with births attended by skilled health staff - ICPR: Governance rating: -0.40** (N = 50) with immunization, measles; -0.30** (N = 50) with infant mortality; -0.26* (N = 50) with child mortality - CPIA 12: Property Rights and Rule-Based Governance: -0.33** (N = 50) with immunization, measles; -0.30** (N = 50) with infant mortality; -0.29* (N = 50) with child mortality - CPIA 15: Quality of Public Administration: -0.40** (N = 50) with immunization, measles; -0.33** (N = 50) with infant mortality; -0.31** (N = 50) with child mortality - CPIA 16: Transparency, Accountability, and Corruption Control: -0.29** (N = 50) with immunization, measles; -0.24* (N = 50) with infant mortality; -0.27* (N = 46) with maternal mortality - CPIA fiscal indicators average: -0.40** (N = 50) with immunization, measles; -0.31** (N = 50) with infant mortality; -0.25* (N = 50) with child mortality - Interpretation: - Governance and quality of fiscal institutions have a strong positive correlation with health spending efficiency: on average, countries with better governance and fiscal institutions achieve higher health outcomes at lower levels of spending. - The level of aid and aid volatility are not correlated with health efficiency scores. - Health spending efficiency is positively correlated with education outcomes and infrastructure, and negatively correlated with prevalence of HIV/AIDS. ### Multivariate truncated regression results (Table AII.7) - Dependent variable: efficiency scores for infant mortality (negative sign means higher control variable implies higher efficiency). - Three specifications with coefficients, p-values in parentheses: - Specification 1: - Prevalence of HIV: 0.008* (0.108) - CPIA fiscal indicators average: -0.018** (0.026) - Constant: 1.106 (0.000) - Sigma: 0.025 - N: 40 - Specification 2: - Prevalence of HIV: 0.002** (0.022) - CPIA fiscal indicators average: -0.018** (0.027) - Adult literacy rate: -0.001** (0.014) - Constant: 1.139 (0.000) - Sigma: 0.024 - N: 32 - Specification 3: - Prevalence of HIV: 0.001* (0.051) - CPIA fiscal indicators average: -0.012* (0.096) - Access to improved sanitation facilities: -0.001** (0.020) - Constant: 1.109 (0.000) - Sigma: 0.023 - N: 40 - Interpretation: - Coefficients for prevalence of HIV, adult literacy rate, access to sanitation, and CPIA fiscal indicators average are significant and of the expected sign across specifications. - The CPIA fiscal indicator is significant in each of the three specifications, indicating the importance of fiscal institutions for expenditure efficiency. ### Limitations and cautions - Outcomes are influenced by many factors beyond spending that can be only partially captured by controls. - Methodology focuses on quantifiable inputs and outcomes and only partially captures harder-to-measure factors such as quality. - Efficiency is measured in relative terms; in small samples, being on the frontier may introduce bias. - Findings are consistent with broader literature on expenditure efficiency. ### Fiscal policy implications for scaled-up aid - Two important implications: - Improving efficiency of spending in LICs is critical to achieve the MDGs. - Effective utilization of scaled-up aid in most LICs will require further strengthening of fiscal institutions to enhance spending efficiency. *Source: Appendix II. 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