ECONOMIC vol I NSTITUTE DEVELOPMENT. Teaching Notes. EDI Case Studies. of the World Bank. Public Expenditure Analysis

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Expenditure Analysis A Case Study of Lafrasia Vinaya Swaroop and Holley Ulbrich vol ECONOMIC DEVELOPMENT I NSTITUTE of the World Bank EDI Case Studies Teaching Notes

2 PUBLIC EXPENDITURE ANALYSIS A Case Study of Lafrasia TEACHING NOTE Vinaya Swaroop EDI Case Studies The World Bank Washington, D.C.

3 Copyright ( 1997 The International Bank for Reconstruction and Development/The World Bank 1818 H Street, N.W. Washington, D.C. 2433, U.S.A. The World Bank enjoys copyright under protocol 2 of the Universal Copyright Convention. This material may nonetheless be copied for research, educational, or scholarly purposes only in the member countries of The World Bank. Material in this series is subject to revision. The findings, interpretations, and conclusions expressed in this document are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or the members of its Board of Directors or the countries they represent. If this is reproduced or translated, EDI would appreciate a copy. E

4 Contents Acknowledgments Lafrasia Instructor's Guide Background Objective Execution of the Case Contents of the Case: Points to Remember - Iij -

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6 Acknowledgments This teaching note was prepared by Vinaya Swaroop, Policy Research Department, the World Bank. The author gratefully acknowledges the contributions of Shanta Deverajan and Sanjay Pradhan.

7 Lafrasia Instructor's Guide Background This case was written in 1992 for a training course for World Bank staff on public expenditure analysis. This training course is offered once each year at the World Bank to assist staff in learning how to do better public expenditure reviews in their client countries. There are usually twelve sessions, spread over three full days, and the case is discussed in a two-and-one-half-hour session at the end of the course. Lafrasia, the fictitious country in this case, is a composite of several developing countries in Latin America, Africa, and Asia. Although the country is a synthesis of several countries, the problems facing Lafrasia are real. Objective The objective of this case is to provide participants with an opportunity to apply some of the key messages from the various sessions on public expenditure analysis and to sensitize them to the kinds of issues and pressures that might arise in the public expenditure decisionmaking process. To this end, the case is discussed in a class that attempts to simulate a budget policy session. The overall strategic direction of the budget in Lafrasia-within and across the major sectors and areas-is discussed. Execution of the Case Below we describe a workable system for presenting and discussing the case. Based on the comments received from participants of the past seminars at the World Bank, we find this method to be quite useful. Grouping Participants are divided into the groups that receive significant budget allocations in Lafrasia. These include: 1. Ministry of Agriculture (MOA) 2. Ministry of Transport (MOT) 3. Ministry of Education (MOE) 4. Ministry of Health (MOH) 5. Civil Service Commission (CSC) 6. Ministry of Planning (Public Investment Program) -1 -

8 Public Expenditure Analysis: A Case Study of Lafrasia-Teaching Note 7. Ministry of Finance (MOF) 8. Ministry of Defense (MOD) 9. State-Owned Enterprises (SOEs) 10. University Grant Commission (UGC). These ten groups participate in the mock budget-making process. The president, the prime minister, and the president of the majority political party (usually the administrators of the session) have the overall responsibility for managing the session. Each ministry or agency is represented by a team of officials (a few of the seminar participants), with the minister or head to be chosen by the group. This person makes a three-minute presentation of the general proposals for expenditure allocation or the strategic direction of expenditure policy for his or her ministry or agency. Each group should take as its starting point the budget share for its sector or category ( , in this case). If the group recommends an increase in its share, it should also indicate which agency(ies) /ministry(ies) will be subject to a corresponding decrease in funding. Similarly, if the group recommends a decrease in its budget share, it should identify where the corresponding increase should be directed. Following the brief presentation by the minister/head, there is a five-minute discussion period to allow all the other ministries to question the proposal being presented. The minister of finance coordinates the discussions, with the party president and the prime minister intervening as necessary All members-not just the ministers/heads-should be encouraged to participate in the discussions. After the presentations and discussions by all groups, the minister of finance presents a fiveminute summary of the ministry's recommendations for the overall budget. Following this presentation, there is a general debate among the participants on the budget policy proposals, with each group giving its reactions in a free-for-all discussion. Preparation Groups should be formed well in advance so that participants can discuss the case as a team. Each team should carefully read the case, meet in groups to discuss its strategy, and prepare its final presentations. Contents of the Case: Points to Remember PARTICIPANTS SHOULD KEEP IN MIND THE APPROPRIATE ROLE OF THE STATE IN THE EcoNoMY. This role willprovidethebasic framework for organizing their thoughts. In practice, however, very few participants do this. In outlining this framework, it is important to emphasize that the state should: * Facilitate economic growth led by the private sector. * Maintain law and order and provide an appropriate environment of prudent economic policies and necessary regulation. * Improve human resources and provide a safety net for the poorest. -2--

9 Public Expenditure Analysis: A Case Study of Lafrasia-Teaching Note The participants should think of an overall reform agenda for the government of Lafrasia with these mandates in mind. THE PUBLIC SECTOR SHOULD RAVE THE RIGHT MDr OF HUMAN RESOURCES AND SKILLS TO IMPLE- MENT AND ENFORCE PUBUC POLICiES. This is not always the case. For example, in Lafrasia, the public sector has been the employer of last resort, which has led to overstaffing at lower levels. Such political economy issues should be enunciated. PARTICIPANrs SHOULD BE ABLE TO COME UP WITH AN APPROPRIATE LEVEL AND COMPOSMTION OF PUBLIC SPENDING. In Lafrasia, public spending is inappropriately allocated. For example, despite the political objective of providing electricity to every household, the level of investment required to reach this goal cannot be sustained. At the same time, only 2 percent of the budget is allocated for agricultural programs, even though agriculture is the major component of GDP, exports, and employment, and research and extension services are needed, especially to help poor farmers. This allocation for agriculture is bad fiscal policy. Most participants pay undue attention to the level of public spending, but they rarely look at its composition, particularly as influenced by intersectoral and intrasectoral issues. THE STANDARDEFINTON OF PUBLIC INVESTMENT DOES NCOT CAPTURE THE DIFFERENCE BETWEEN CAPITAL STOCK (PHYSICAL AS WELL AS HUMAN) ENHANCEMENT AND PURE CONSUMFIION EXPEN- DITURES. For example, one could argue that all public spending on education should be treated as part of public investment as opposed to consumption. In addition, there are several components of the government's consumption expenditure, such as operations and maintenance, that may have higher rates of return than investment expenditure. Participants generally make policy recommendations based on current and capital expenditures. Giving excessive attention to current and capital expenditure, and relying too heavily on these categories, however, could be misleading. INTERSECTORAL AND INTRASECTORAL ALLOCATIONS OF RESOURCES ARE EQUALLY IMPORTANT. In this context, interpretation of the aggregate sectoral level of expenditures requires caution. Channeling more public resources toward the social sectors may not yield high social returns if the increases do not provide benefits to the poor. Restructuring expenditures in favor of primary education, preventive health services, and safety nets offers substantial scope for improving the human capital and earning potential of the poor in the long rtun. EXPORT TAXES ARE DISTORTIONARY AND OFTEN DISCOURAGE DOMESTIC PRODUCERS FROM SELL- ING ABROAD. In the case of a small open economy, such taxes make the country's exports noncompetitive abroad. The case of Lafrasia (for example, export taxes on cocoa) is no exception. Before making any changes in the tax laws, however, it is advisable to think of alternative sources of revenue. Unless the country has no fiscal problems (which is extremely rare in developing countries) and there are no pressures on the budget, revenue neutrality should be part of the tax reform exercise. This is an important point that few participants realize. -3--

10 Public Expenditure Analysis: A Case Study of Lafrasia-Teaching Note THE LAFRASIAN EXPERIENCE SUGGESTS THAT COST RECCVERY FOR ROADS, IRRIGATION, THE SO- CIAL SECTORS, AND SOES IS EXTREMELY LOW. Tariffs have been revised infrequently, and the families in the upper-income groups are the major beneficiaries of such services. Experience from developing countries suggests that public enterprises, such as highway authorities and electrical, telecommunications, and water systems, should be required to cover a major portion, if not the entirety, of their costs. Moreover, the design of user charges should be flexible enough to provide a balance of efficiency, distributional equity, and cost-recovery objectives. Very few participants think of such a balance of objectives-most simply argue that user charges should be increased. -4-

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