HUNGARY: REFORMS IN PUBLIC FINANCE MANAGEMENT
Hana Polackov[a]
Introduction
Public finance reform initiatives in Hungary have repeatedly called for reform of the fiscal institutions as a priority government task since 1987. For a long time, and despite some attempts, it remained obvious that the budget system and process were excessively decentralized and failed to provide a foundation for government prudence, accountability, and responsiveness. The government, much less the public, hardly knew where and how public moneys were spent, how many people the state employed, and what services the public sector delivered. The 1995 public finance institutional reform proposal attempted to bring some balance to the system. It was built around four crucial objectives: enhancing the transparency and political viabilityof government decisions; securing aggregate fiscal control and macroeconomic stability in the medium term; improving public expenditure equitability and allocative efficiency, and promoting operational efficiency and cost-effective use of public moneys.
The Government has decided to sequence the reforms. A small group of professionals was put in charge to lead the efforts, in a coordinated manner with reforms in public expenditure policies. First, in 1996, the Government worked to establish a fully functional Treasury system with the objective to improve aggregate fiscal control and available information about government cash flows. The Treasury system was to make all government payments from a single account, to control ex-ante any such payment against budget appropriations, and to record them in the general ledger. These steps have limited the scope for overspending and misuse of government funds and—by keeping the cash centrally available at the single account and, thus, reducing public borrowing needs,—have improved the efficiency of cash management. The treasury system has tremendously improved the quality of information and accounting basis available for budgeting. As a necessary condition to overall fiscal discipline, the government dissolved over 30 extra-budgetary funds and earmarked revenues in a more comprehensive state budget, and made a larger share of its expenditures subject to review through the regular budget process.
In reforming the budget system, Hungary has also taken several important steps toward improving transparency of off-budget commitments and toward containing fiscal risks. Hungary generally has made the implicit liabilities accumulated in the past and the costs of transition from socialism to a market explicit, and paying these costs in current budgets, as well as establishing institutions which would ensure transparency in the future. It has reformed the pension system, once for all consolidated the banking sector and privatized most banks and enterprises, resolved the risks of inter-government finances, detached public spending and debt from the books of the National Bank of Hungary, and modernized its budget management and tax systems. These measures have brought public finances on a path sustainable in the long term. In effect, Hungary has cut most of its past losses, enabling both the Government and entrepreneurs to build new economic institutions that bode well for the country’s future.
Transparency is expressed in a number of policies and actions: the risks and costs of past policies should be explicit, and, where appropriate, funds should be set aside to pay for them. For example, the commitments embedded in social security benefits should be measured and financed in the budget. Moreover, when the Government takes on new risks, prospective costs should be estimated. In upholding transparency, the Government released the National Bank of Hungary from its earlier responsibilities for financing of fiscal deficits and parts of the (unreported) public debt. Sometimes the government has appeared to be taking on new risks when all it has done has been to set aside resources to finance previously hidden commitments. For example, bank consolidation was paid from the budget and sovereign debt issues; and in reforming the pension system, the Government has budgeted resources to cover unfunded “accrued” obligations of workers who switch to the new partly privatized system.
The Government has contained many old risks by liquidating them. In privatizing enterprises and financial institutions, the Government has had to disclose losses and liabilities and either pay these off or transfer the obligation to the new owners. Subsequently, bank privatization and tight bank regulation and supervision have enabled the government to contain major contingent fiscal risks of the banking sector. The government also contained the spill-overs of obligations from subnational governments to the national level by making the at least the sizeable subnational governments subject to the state audit, legal borrowing limits and strict bankruptcy law. The pension reform has reduced the accrued benefits in the public pension system and the total size of government pension liabilities in the medium and long term. To prepare for dealing with possible fiscal risks, the government has created multiple reserve funds, such as deposit insurance reserve fund, guarantee fund for pension funds, state guarantee fund in the state budget, etc. The State Audit Office is responsible for supervising the adequacy of these reserve funds. Containment also applies to new risks taken by the Government during the transitional period. The Public Finance Act requires that guarantees be set forth in the budget which limits the amounts that may be tendered during the financial year and also provides for the costs of existing guarantees that may be called during the year.
Institutional arrangements and methodologies for budget management remain on the reform agenda, mainly to secure long-term fiscal stability, and widen the extent to which public spending reflects policy priorities and is subject to public scrutiny. In the budget process, the government is moving from annual ad-hoc, wish-list driven spending decisions toward a framework of strategically planned expenditures that are predictable in a multi-year perspective. Through a pilot approach, some features of a medium-term budget analysis and more result-oriented budgeting to enhance the linkage between budgeting and policy work, have been introduced. Furthermore budget evaluation and reporting have been made an important component of the budget process. Major government decisions, legal adjustments, and down-to-earth work are, however, still needed before the 1995 reform objectives can be fully accomplished. Eventually, the Government intends to link budget reforms with other public sector reforms, particularly to enhance responsibilities and accountability of managers in the public sector.
Problems with Pre-1996 Budget Management: Freedom with Little Control
The budget system and budget management in Hungary have witnessed several reform movements going back to the 1968 New Economic Mechanism—each of which increased decentralized decision making and proliferation of budgetary institutions. Through the 1980s, general government agencies were independent in legal terms, obtaining earmarked revenues on own revenue account[s, freely engaging themselves in commercial activities to supplement their budgetary resources, borrowing independently from commercial banks, or issuing securities when needed, and spending without much reporting from their own expenditure accounts. The government, thus, became heavily involved in commercial activities—as did the National Bank of Hungary, which held the agencies’ accounts. It was never asked why government agencies rather than the private sector should be involved in particular activities. And the information about agency operations, revenues, and expenditures available to the Ministry of Finance and line ministries was very inaccurate. The Ministry of Finance, thus, ended up with very little effective control over Hungary’s overall budget, expenditures, and debt. ]
Allocative and Operational Inefficiencies: The extent of fiscal decisions made outside the state budget, and not necessarily reflecting overall government policy priorities, increased in the early 1990s. Since the state budget faced financing problems, agencies, beginning with social security programs, acquired the right to identify their specific functions and establish extra-budgetary funds to collect own earmarked revenues. The Law on Public Finances, adopted in 1992 after a long period of preparation, was a first attempt to specify institutional responsibilities and core procedures in the budget system, but left agencies the right to collect, retain, and spend revenues above the budgeted amounts. Moreover, this fragmented fiscal system made only the previous year’s budgeted figures—rather than actual revenues and expenditures)—available as the basis for the budget proposals, and any reallocation of budgetary resources was extremely difficult. The total revenues and expenditures proposed by the government in the budget process approved by Parliament, thus, served purely as indicative targets, rather than an instrument to implement government policies.
While budgetary institutions and funds had total discretion over about half of public revenues (collected through earmarking and extra-budgetary funds) outside the central budget, the central budget became increasingly tight. Out of general government revenues of about 55 percent of GDP of in 1993, 12 percent of GDP was collected and spent directly by social insurance funds, about 6 percent by local governments, and about 4 and 3 percent directly by the extra-budgetary fund and central budgetary institutions. In an attempt to establish some control, the government launched an open book budget process, requiring that all budgetary institutions provide Parliament with detailed descriptions of their purposes and tasks to justify their budgetary resources for the following fiscal year. In practice, however, budgetary institutions were not required to link tasks to their budgets or their actual expenditures. Overall budgeting remained driven by the numbers of employees and wage bills, and as from policy intentions as ever.
The system gave extensive fiscal powers and rights to budgetary institutions, but it neither encouraged the right incentives nor allowed adequate means of control. It produced incentives for agencies to be entrepreneurial in finding revenue sources, but not to use the resources efficiently, or toward government policy priorities. Government agencies were partly allowed to carry over their excess revenues across fiscal years, and use them for salary supplements. In such a framework, the State Audit Office restricted itself to safeguarding public moneys against massive embezzlement. Agencies continued putting public moneys into any activity they wished, reflecting the general assumption that the government should be directly involved in everything unless there were strong reasons against it, and having no incentive to do so efficiently. In effect, the government was in competition with the private sector. For example, hospitals used their laundry facilities for commercial purposes, road construction crews used their equipment and materials for private sector projects, and research institutes provided services to private customers for fees. These operations were subsidized at least partly from the central budget, which covered salaries, utilities and some investment in equipment. Agencies mingled budget allocations and public services with their own commercial revenues and market activities, often displacing competitors from the private sector. The 31 chapters of the budget included the National Press Agency, the Hungarian Radio, and the highly profitable Hungarian Television which collected about one-third of the government’s commercial revenues in 1994[.]
Loss of Control Over Aggregate Fiscal Balance: Not surprisingly, the devolution of fiscal decisions in an environment of improper incentives, minimal control, and freedom to borrow, had disastrous effects on Hungary’s overall fiscal outlook. First, allocating budget resources to government agencies based on their financing requirements above estimated own revenues gave agencies no incentive to raise revenues—and incentives to under-report estimated revenues. The agencies, in effect, unilaterally increased their allocated budgets, distorting the political decisions reflected in the national budget. The State Audit Office pointed out that the government financing system scheme generated very soft budget constraints and incentives toward fiscal expansion (IMF, 1994).
Second, spending and commitments by government agencies were disconnected from the overall economic and fiscal analysis. In the early 1990s, when the economic slowdown and outsourcing of profitable activities from government to new private companies caused a shortfall of budget revenues (discussed in chapter 16) requiring supplementary budgets to finance core government functions, many government agencies continued committing funds generously to new investments. Thus, in 1993-94, it became apparent that the incremental and fragmented approach to fiscal decisions, coupled with the soft budget constraints, was not sustainable.
Third, the complexity and information deficiency of the system, which obstructed both budget preparation and control, also hampered forecasting of government financing needs and cash management, requiring excessive government borrowing. While 3,000 accounts of budgetary institutions continually maintained positive cash balances at their own accounts at the National Bank and in commercial banks, the government had to issue debt at market interest rates to cover its other agencies’ financing gaps. In addition, some government agencies issued securities to cover occasional deficits. Other government agencies, which happened to have excess cash, legally purchased government securities or deposited excess in interest-bearing accounts in commercial banks, retaining the interest income. These processes led to excessive government borrowing pushing interest rates beyond 30 percent and crowding out private investment[. In addition, efficiency was lost because of the excessive number of unnecessary financial transactions with the state budget paying market interest to other parts of the government. ]
At the beginning of 1995, the dynamics of fiscal deficits and public borrowing became unsustainable and the government accelerated public finance management reform. The government admitted that institutional and technical deficiencies were at the root of its inability to reveal the transfers and final use of public moneys, prevent over-commitment of public funds by budgetary institutions, avoid excessive public borrowing, and provide decision makers with the relevant, accurate, up-to-date and adequately detailed information needed for policy decisions. The government acknowledged that more effective and reasonable use of the taxpayers’ money could be achieved only through comprehensive institutional reform and modernization of the entire system of public finances and public administration (Government Decree, 1996). The main problems in Hungary’s fiscal management prior to 1995 are summarized in Table 1.
Table 1. Problems, Effects and Possible Remedies in Public Expenditure Management
in Hungary Before 1995
Problem / Effects / Possible RemediesLack of strategic planning
across sectors
across investment projects
across government agencies and funds
across fiscal years / Needs-driven policy decisions and wish-list budgets without proper consideration of affordability
Ad hoc incremental budgeting;
increasing size of the public sector
Opaque fiscal, economic, and social effects of public policies / Rigorous economic and fiscal analysis to estimate revenues and expenditures in the medium term
Analysis of medium-term fiscal, economic and social effects of proposed policies prior to policy decisions
Flexibility in reallocating scarce public resources to priority needs by bringing extra-budgetary and earmarked funds into the budget
Linking strategic planning, policies and budgeting through improved institutional arrangements, budget analysis, budget structure, and incentive mechanism in the budget process
Evaluation of previous year’s budget outcomes
Lack of accountability in:
budgetary decisions and their medium-term effects
commitments and expenditures
cash and resource management
monitoring and control / Overbudgeting
Overcommitting
Spending above the budget
Unsustainable fiscal policies
Costly government financing, excessive state borrowing, and deteriorating borrowing terms
Costly service-delivery / Defined responsibilities in budget preparation and implementation processes
Medium-term budget compliance mechanism
Financial accountability
Managerial accountability (for efficient use of public moneys and service delivery)
Integrated accounting and reporting of revenues, commitments, expenditures, fiscal risks and liabilities to the public
Monitoring and control mechanism
Clear punishment for breach
Lack of transparency in:
the functions of the state
linkages between the macroeconomic developments, fiscal policies, and the budget
budget classification
budget coverage
decentralized decision-making processes
revenue and expenditure figures
government financial transactions and accounts / Excessive number of budgetary institutions offering various services
Budgeting above revenue levels
overcommitting
Spending unrelated to policy priorities; public moneys spent on commercial activities
Lack of information about the final use of public moneys, commitments, and arrears
Earmarked and extra-budgetary revenues spent beyond government control
Idle money balances innumerous government accounts / Defined role, objectives and priorities of the state
Definition and classification of public revenues and expenditures, adequately detailed budget structure reflecting government programs
medium-term expenditure framework
Bringing earmarked and extra-budgetary revenues into the budget
Opening the budget process and improving parliamentary oversight
Accounting standards and reporting requirements
Establishing mechanisms for effective budget control, treasury system and treasury single account
empowering the State Audit Office
Regular monitoring and public disclosure of budget policies, budget outcomes, and audit results
Section 2. The Establishment of the Hungarian State Treasury: Bringing the Budget Under Control