The Quality of Public Finances

504 Pages·2008·3.24 MB·English

by  Michael Thöne

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ISBN 978-92-79-08371-6
doi: 10.2765/25008

© European Communities, 2008
THE QUALITY OF PUBLIC FINANCES
Findings of the Economic Policy Committee-Working Group (2004-2007)

Edited by:
Servaas Deroose
(Director, Directorate Macro economy of the euro area and the EU,
Directorate-General Economic and Financial Affairs)
Dr. Christian Kastrop
(President of the Economic Policy Committee of the EU.
Chairman of the EPC-Working Group "Quality of Public Finances" (2004-2008).
Deputy Director General "Public Finance and Economic Affairs", Federal Ministry of Finance,
Germany)

March 2008

Abstract:
Improving the quality of public finances has become a key policy challenge for European policy
makers. While maintaining sound budget positions remains the linchpin of the European Union's fiscal
framework, rising pressures from globalisation and ageing populations are calling to improve also the
qualitative aspects of fiscal policy with a view to supporting economic growth. This includes to better
target public resources, raise the efficiency of public spending, modernise public finance institutions
and budget administration, create supportive fiscal frameworks and establish efficient and growth-
enhancing revenue systems. The need for such a comprehensive approach to strengthen public
finances is laid out in this collection of papers prepared by the EPC Working Group on the Quality of
Public Finances between 2004 and 2007. It also highlights the challenges that come along with policy
implementation by drawing on a number of country case studies.

Key words: Public finances, fiscal policy, public spending, expenditure composition, fiscal
governance, fiscal rules, public administration, expenditure efficiency, health expenditure, innovation
policy, revenue systems, taxation, COFOG
JEL classification: E01, E62, H11, H20, H30, H50, H51, H61, H83

CONTENTS
Foreword............................................................................................................................................................5
I. FRAMEWORK AND DATA ISSUES
1. Introductory Note ...................................................................................................................................11
2. Restructuring Public Expenditure – Challenges and Achievements. Key Issues on the Quality of
Public Finances
Economic Policy Committee...................................................................................................................13
3. Report on Quality of Public Finances Issues – Work Accomplished and Way Forward
Economic Policy Committee...................................................................................................................21
4. Quality of Public Finances and Growth
António Afonso, Werner Ebert, Ludger Schuknecht and Michael Thöne ..............................................39
5. Possible Ways to Implement a Dataset to Analyse the Quality of Public Expenditure
Economic Policy Committee...................................................................................................................61
II. FISCAL GOVERNANCE
1. Introductory Note ...................................................................................................................................89
2. National Numerical Fiscal Rules for Sound Public Finances
European Commission ...........................................................................................................................91
3. The Role for Fiscal Agencies
Xavier Debrun, David Hauner and Manmohan S. Kumar (International Monetary Fund).................129
4. Design Choices for Fiscal Policy Rules
Barry Anderson and Joseph J. Minarik (OECD)..................................................................................149
5. Improving Public Sector Efficiency: Challenges and Opportunities
Teresa Curristine, Zsuzsanna Lonti and Isabelle Joumard (OECD)....................................................179
6. Modernising Public Administration: Initiatives to Improve the Efficiency and Effectiveness of
Public Spending
European Commission..........................................................................................................................209
7. Expenditure Ceilings and Fiscal Policy – Swedish Experiences
Urban Hansson Brusewitz and Yngve Lindh (Ministry of Finance Sweden)........................................223
8. Program Budgeting and Performance Management in France: The 2001 Reform of the
Constitutional Bylaw
Frédéric Bobay (Ministry of Economy, Finance and Industry France)...............................................235
III. COMPOSITION AND EFFICIENCY OF EXPENDITURE
1. Introductory Note..................................................................................................................................249
2. The Efficiency and Effectiveness of Public Spending
Economic Policy Committee and European Commission.....................................................................251
3. Impact of Public Expenditures to Boost Innovation
Rikke Lilienthal (Ministry of Finance Denmark)..................................................................................257
4. Public Sector Efficiency: Evidence for New EU Member States and Emerging Markets
António Afonso, Ludger Schuknecht and Vito Tanzi.............................................................................279
5. Relative Efficiency of Health Provision: A DEA Approach with Non-Discretionary Inputs
António Afonso and Miguel St. Aubyn..................................................................................................309
6. Austrian Approach towards the Quality of Public Expenditures
Ulrike Mandl (Federal Ministry of Finance Austria)...........................................................................327
7. Improving Innovation Policy: The Search for Knowledge about its Effectiveness
Marco van Hengel and Niek Nahuis (Ministry of Finance The Netherlands)......................................333
IV. COMPOSITION OF REVENUE AND EFFICIENCY OF TAX SYSTEMS
1. Introductory Note .................................................................................................................................347
2. Structure of Tax Revenue and the Quality of Public Finance
Christian Valenduc (Federal Ministry of Finance Belgium)................................................................349
3. Tax Revenues in the European Union: Developments and Economic Issues
European Commission..........................................................................................................................363
V. CASE STUDIES ON IMPROVING THE QUALITY OF PUBLIC FINANCES:
"REDIRECTING SPENDING AND IMPROVING FISCAL INSTITUTIONS
1. Introductory Note .................................................................................................................................393
2. Public Finance Reform in the Czech Republic
Ministry of Finance of the Czech Republic...........................................................................................395
3. Finnish Experiences on Redirecting Public Expenditures
Ministry of Finance Finland.................................................................................................................403
4. German Experience on Redirecting Public Budgets
Federal Ministry of Finance Germany.................................................................................................415
5. Redirecting Public Expenditure in Italy
Danila Malvolti and Mauro Mare (Ministry of the Economy and Finance Italy)................................431
6. Malta: Redirecting Public Expenditure
Ministry of Finance Malta....................................................................................................................445
7. Public Finance Reform − Polish Experience
Ministry of Finance Poland .................................................................................................................459
8. Redirecting Public Expenditure in Portugal
Ministry of Finance and Public Administration Portugal....................................................................467
9. Spanish Experience in Redirecting National Public Budgets
Ministry of Finance Spain ....................................................................................................................475
10. Re-directing Public Expenditure − The UK Experience
HM Treasury ........................................................................................................................................487
FOREWORD

The relevance of quality of public finances
Improving the quality of public finances has become a key policy challenge for European policy
makers. While maintaining sound budget positions is the linchpin of the European Union's fiscal
framework, rising pressures from globalisation and ageing populations have put additional demands
on fiscal policy with a view to supporting economic growth. In particular, the upward pressures from
age-related expenditure require public spending in other areas to become more efficient to free up
resources so as to avoid a further increase of the already large public sectors and high tax burdens in
many EU Member States. More generally, greater public spending efficiency is an objective that is
independent of the size of government sectors and has therefore received much attention recently.
Modernising public finance institutions and budget administration as well as creating supportive fiscal
frameworks can help achieve this objective and have therefore been another focus of the work on
quality of public finances (QPF). At the same time, public resources can be better targeted toward
“growth-enhancing” areas, for example R&D and education. These challenges should be tackled hand
in hand with creating revenue systems that are apt to the challenges of today's globalised markets. In
particular, efficient tax structure should keep in check the disincentives for the provision of capital and
labour and thereby potentially damaging growth prospects.
The role of the Working Group on Quality of Public Finances
Responding to the importance of quality of public finance, the Working Group on Quality of Public
Finances was formed in 2004, as a sub-committee to the Economic Policy Committee (EPC). Its
objective is to analyse the links between public finances and long-term potential growth. Since QPF
comprises many dimensions, the Working Group decided to follow a step-by-step approach and over
time focus on the various aspects of QPF, including by presenting and discussing country
experiences.1
Members of the Working Group include expert staff of the Member States, the European Commission,
Eurostat and the European Central Bank. Moreover, the OECD and the IMF participate as observers
and have provided input. The Group has also regularly invited experts from academia and national and
international administrations for an exchange of views.
The main issues discussed and the main findings
The key aspects of QPF, which the Working Group has discussed since 2004, are presented in this
collection of papers. Unfortunately, only a subset of the large amount of work can be included here
due to space constraints. It should also be noted that the papers reflect the state at the time when they
were presented at the Working Group. That means, especially for the country case studies, policies and
institutions may have changed since, which is not reflected in the papers.
The papers are structured into five sections broadly covering the key topics of the Working Group.
The main issues and findings are as follows:
Framework and data: The first focus of the Working Group was to define a concept of quality of
public finances and identify data needs to conduct cross-country studies. Quality of public finances

1 The original EPC mandate from May 2004 was accompanied by specific ECOFIN mandates of January 2006,
October 2006 and June 2007.
5
has commonly been viewed as a concept with many facets. An EPC note (2007) defined QPF as “a
broad concept which refers to the conduct and organisation of budgetary policy and its potential
impact on long-term growth of the economy.” As summarised in the EPC notes from 2006 and 2007
and the paper by Afonso et al. (2005), presented in Section I, empirical evidence suggests that public
finances can contribute to this objective by well-targeted expenditure and more efficient use of scarce
public resource which also allows lowering the overall size of governments and the tax burden. Sound
budget positions are key for these objectives and can be helped by fiscal rules and institutions.
Since meaningful and comparable data are key for the cross-country analysis of quality of public
finances, the Working Group paid much attention to identifying and filling data gaps, in particular on
public spending. The paper by the EPC from 2004 describes that the Classification of Functions of
Government (COFOG) was agreed to be the most useful starting point in this respect as it allowed
splitting up government expenditure by functions rather than by economic classification. The former
lends itself better for studying the productivity and efficiency of expenditure. By now, these data are
available for all EU Member Sates through the Commission services' AMECO database. However,
since the aggregation level was still too high to assess, for example, the role of R&D spending for
growth, the work was advanced on providing second-level data (COFOG-II). This work is ongoing
and data are envisaged to be made publicly available soon.
Fiscal governance: Fiscal governance cuts through all dimensions of quality of public finances, but
particularly helps ensure sound budgets and sustainability. A paper by the European Commission
(2006) provides a comprehensive overview of the numerical fiscal rules in the European Union and
documents their rising importance. Moreover, it finds empirical evidence that strong fiscal rules with a
wide coverage of budgetary items are linked to better budgetary outcomes. A paper by Anderson and
Minarik (2006) compares deficit and expenditure rules and clearly recommends the latter in terms of
best accomplishing the multiple objectives of the budget. Another institutional option to lower the
deficit bias are fiscal institutions (also called fiscal agencies) which provide independent analysis,
forecasts or judgements as shown in the paper by Debrun, Hauner and Kumar (2007). The work by
Curristine, Lonit and Joumard (2006) focuses on the role of budgetary procedures, in particular
performance-based budgeting, in improving public efficiency. Country experiences in this area and
modernising public administrations more generally are surveyed in the European Commission note
(2007). Instructive are the country examples of fiscal governance frameworks. The paper by Hansson-
Brusewitz and Lindh (2005) details the Swedish experience with medium-term expenditure rules,
while the paper by Bobay (2005) describes the French budget reform from 2001 that introduced a new
budget structure along with goals and performance indicators.
Composition and efficiency of expenditure: Initially the Working Group paid much attention on
reviewing the composition of public expenditure given the links between some spending components
and growth (see for example an overview of the literature in the 2004 Public Finance Report). Two
country cases, Austria and the Netherlands, are presented in this section, describing the experiences
with shifting expenditure in support of growth (more country examples can be found in Section V).
The particular role that public expenditure can play in boosting innovation is assessed in the paper by
Lilienthal (2004).
Given the pressures to reduce public spending, another focus has been on how to assess and improve
the efficiency of public expenditure. The main challenges for such analysis, such as the measurement
of inputs, outputs and outcomes to obtain efficiency indicators, and the main reform avenues, such as
structural and institutional reforms, are summarised in a joint EPC/European Commission note (2007).
Comparative estimates of efficiency of public expenditure and overall public sector performance for
new Member States are provided in the paper by Afonso, Schuknecht and Tanzi (2005). This study
builds on their earlier paper on efficiency, covering the old Member States. While the paper stirred
some critical discussions on the methods used, it opened the door for further efficiency studies, which
explicitly take into account the determinants of efficiency such as the one by Afonso and St. Aubyn
(2006) on health provision.
6
Composition of revenue and tax systems: The structure of revenues can impact long-term growth,
mostly by affecting the allocation of labour and capital. While there is some evidence that
consumption taxes create fewer disincentives for growth than direct taxes, the detailed structure of
such taxes need to be carefully considered. Valenduc (2005) explains these challenges for assessing
the quality of tax revenue systems and focuses particularly on the choice of indicators which he
applies in an analysis of the Belgian tax system. In addition to minimising distortions from tax systems
for economic growth, the Member States of the European Union also face important challenges in
maintaining robust tax bases. Firstly, aging will reduce the labour tax base. Secondly, the increased
mobility for labour and capital that globalisation is bringing could complicate their reliability as tax
basis. And thirdly, the desire to shift taxation away from labour “to make work pay” requires finding
alternative tax basis. The paper by the European Commission (2007) reviews the recent trends in
taxation in the European Union and discusses several ways in light of these rising challenges.
Case studies on improving the quality of public finances: The last section is devoted to detailed
country studies. The examples of the Czech Republic, Finland, Germany, Italy, Malta, Poland,
Portugal, Spain and the United Kingdom summarise expenditure trends and review reforms in the
public sector with the aim of improving the efficiency of spending and strengthening fiscal
institutions. The emphasis of policies reflects the country-specific circumstances, for example fiscal
consolidation in the Czech Republic through an expenditure and revenue-based approach; the
introduction of spending limits for a whole electoral period in Finland; a three-pronged approach
(structural reforms, tax cuts and consolidation) to foster growth in Germany; budgetary institutional
reforms in Italy to raise public sector productivity; the reduction of the government sector and public
employment in Malta; rebalancing fiscal positions in Poland and Portugal largely from the expenditure
side, while at the same time raising efficiency; in Spain shifting spending to those items with the
largest impact on medium and long-term potential growth; and the implementation of a new public
spending framework for improving the quality and cost-effectiveness of public services in the United
Kingdom.
The way forward
The objective of raising the quality of public finances remains pertinent. The re-launched Lisbon
Strategy from 2005 provides a foundation for future work,2 which was recently reiterated by the
ECOFIN Council in its meeting on 9 October 2007. It specifically gave the Commission and the EPC
a mandate to continue its work in this area as the Council conclusions included the following
statement: “It invites the EPC and the Commission to step up their efforts to improve the analysis,
methodology and measurement of the quality of public finances, including the efficiency and
effectiveness of public expenditure and revenue structures, as well as of major public sector reforms.
Ministers also re-iterated their June 2007 request for Member States to step up efforts in the provision
and subsequent analysis of COFOG, level II data (…).” Following this mandate, the Working Group is
aiming to make quality of public finances operational as part of the Lisbon strategy and against the
background of strengthening the coordination and surveillance of fiscal and economic policies. Based
on a comprehensive conceptual framework, work is envisaged to continue on the efficiency and
effectiveness of specific expenditure categories, the efficiency of revenue systems and the role of
fiscal governance. The Working Group will also continue, together with the Commission, to conduct
cross-country studies and exchange country experiences in the various dimensions of quality of public
finances and their macroeconomic links to growth.

2 Integrated Guideline No. 3 of the re-launched Lisbon Strategy states: "To promote a growth- and employment-
orientated and efficient allocation of resources, Member States should, without prejudice to guidelines on
economic stability and sustainability, re-direct the composition of public expenditure towards growth-enhancing
categories in line with the Lisbon strategy, adapt tax structures to strengthen growth potential, ensure that
mechanisms are in place to assess the relationship between public spending and the achievement of policy
objectives, and ensure the overall coherence of reform packages."
7
Words of appreciation
The work on quality of public finances that is summarised in this collection of papers reflects the joint
efforts by all members of the Working Group. Even if only an excerpt of papers can be shown here,
we are most grateful to all contributors to the Working Group since 2004. While we cannot name all
people individually, let us nevertheless point out some who have been instrumental in setting up the
Working Group and advancing its work. From the European Commission, we are particularly grateful
to Elena Flores Gual, Fabienne Ilzkowitz, Joaquim Ayoso Casals, Giuseppe Carone, Adriaan Dierx,
Ulrike Mandl, Laurent Moulin, Gaëtan Nicodème, Jan-Host Schmidt and Peter Wierts, who have been
key contributors by providing numerous important issues notes and advancing the discussions over
time. From the EPC, we would like to thank Heinz Scherrer and Olaf Prüßmann for their excellent
support to help keep the Working Group stay on track. We also greatly appreciate the ongoing support
from the European Central Bank and particularly from António Afonso whose conceptual work has
given indispensable stimulus to the Working Group. From Eurostat, our thanks go to Eduardo Barredo
Capelot and his team for the instrumental work on COFOG data. In that respect, our special thanks
also go to Raffaele Malizia (Italian participant in the Working Group) for the comprehensive work on
indicator developments based on COFOG and Werner Ebert and Tanja Burckardt (Ministry of
Finance, Germany) who played an important role in developing the conceptual and strategic work of
the Working Group.
Last but not least, we would like to thank the team that has made the publication of this collection of
papers possible. We are greatly indebted to Werner Ebert and Andrea Schaechter as the project leaders
who have assembled this book in a very short period of time. They received excellent editorial
assistance by Anna Rauch, help by Olaf Prüßmann and support in the production process by
Dominique Marchalant.

Brussels, 5 February 2008 Servaas Deroose
Christian Kastrop
8