Why flexible caps on government budgets work better

May 25, 2012

Rigid top-down limits on budgets for social services imposed by treasuries and donors has become something of a rude word to activists. One example of the condemnation of these ‘caps’ on budgets is the well-known 2007 research done by Action Aid on the impact of caps on wage bills in the education sector in Malawi, Mozambique and Sierra Leone. A recent debate in New Zealand shows more flexible ways to use these budget caps that may control government spending without cutting into essential services.

In the era of structural adjustment, this debate played out in Africa and other developing regions. When these governments started running out of money, their ministries of finance would, often on advice from donors, determine ceilings within which each government department had to prepare its budget. In some cases these limits would also be apply to specific categories of expenditure such as salaries. Since the global financial crisis, the debate on budget caps has ironically shifted to Europe and the United States. But the question of how much is enough and how to curb unbridled growth in government spending is never far away. As soon as economies, and consequently government income, slows down, it returns to center stage.

 It ain’t what you do; it’s the way that you do it

Despite ideological differences, most people would agree that there needs to be some limit, however generous or stingy, on government spending. So the most interesting question about budget caps is not whether they should be used or not, but rather how they should be used. “The debate in New Zealand (reported on in the IMF’s PFM blog) has brought to the fore some innovate and flexible ways of working with budget caps.

The first important lesson to learn from New Zealand is that they don’t follow a one-size-fits-all approach, but rather use different kinds of caps for different categories of expenditure. Some caps make provision for adjustments for inflation and population growth. These kinds of caps can keep expenditure within broad limits, but also accommodate spending pressures that come from things like rising fuel prices or growth in learner numbers.

The Kiwis also distinguish between caps on capital and operational spending. The reason for this distinction is that operational spending is recurrent in nature. If more teachers are employed or a new social grant introduced, government is compelled to continue incurring these expenses over the medium to long-term. So if new operational spending commitments are made, government should also be sure of recurring tax and other revenue to finance this. By contrast infrastructure and other capital spending are once off in nature. Governments can therefore fund such spending from less renewable sources such as debt or revenue windfalls.

 Guidelines or laws?

The New Zealand debate has also focused on how rigid budget caps should be. Should they take the form of flexible guidelines or should they be written into the finance act? Interestingly the  PFM blog  refers to research that shows that in  countries where quantitative fiscal rules have been embedded in legislation, there have been many failures and few successes. Evidence from the State of Colorado suggests that the reductions in tax and spending that resulted from legally imposed budget caps had a negative impact on the state’s economy.  These reductions in expenditure resulted in worsening health and education outcomes between 1992 to 2005, when law was finally suspended. While legal limits may look like an attractive instrument for controlling spendthrift governments, their lack of flexibility tend to be harmful in the long run.

 Your experience?

What has your experience with budget caps been? Are any of the above ideas relevant to your country? Do you have any other ideas for how to work with budget caps in a flexible manner?

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