Joint FM/PRMPS Public Financial Management Course Nataliya Biletska, PRMPS

Joint FM/PRMPS Public Financial Management Course Nataliya Biletska, PRMPS

Budget Classification

1. Overview

The budget not only serves as a financial basis for the functioning of government and implementation of public policies, but also as an instrumentfor strategic planning, policy formulation, decision making, and accountability. A budget classification system lies at the core of these budgetary properties. It is usually considered a fundamental step preceding major public financial management reforms, notably an integrated financial management information system (IFMIS), a medium-term expenditure framework (MTEF), and a performance-oriented budgeting.

This session will review the definition and various types of the budget classification system, focusing on the differences between the IMF’s Government Finance Statistics Manual (GFSM) 1986 and 2001, as well as advantages and implementation challenges of the more recent Government Finance Statistics (GFS) 2001. Then it will examine the linkages between the budget classification system and a Chart of Accounts (COAs). Finally, it will discuss whether the budget classification system based on the GFS 1986 or 2001 is sufficient to meet Bank’s project reporting requirements.

1. Defining Budget Classification

Budget classification is a systemic way of categorizing and structuring budgetary information which is provided to government managers, policymakers, the legislature, and the general public. It establishes the format for the budget preparation, presentation and reporting, and thus determines the coherence and transparency of the budget. Primary objectives of a well designed budget classification system are to produce meaningful and accurate information, and to be capable of modification as needed in the future. They are essentially embedded in the coding system that supports the budget classification structure. Therefore, the budget code for each transaction identifies all relevant information for that transaction under a specific category.

In order to ensure that the budget classification system provides reliable information, it needs to adhere to the following principles of budget management:

• Comprehensiveness: All government entities are included in the budget.
• Unity:All revenues and expenditures of entities performing government operations are incorporated.
• Internal consistency: Current expenditure for operation and maintenance of capital investments is provided.

1. Types of Budget Classification

A soundsystem of budget classificationincludes revenues with a breakdown into various categories and a classification of expenditures depending on the purpose, such as forpolicy decision-making and performance analysis, efficient resource allocation, compliance with the budgetary resources approved by parliament, and budgetadministration.

With the growing complexity of fiscal policies and public financial management, however, there has been an increasing demand for comprehensive and analytically useful public finance data that can also assist cross-country comparisons in fiscal analysis. Thus there were developed international standards for compilation and presentation of fiscal statistics.

The relevant international classification systems are the United Nation’sClassification of the Functions of Government (COFOG), published in the System of National Accounts 1993 and revised in 1999, and the IMF’sGovernment Financial Statistics. The 2001 version of the IMF’s Government Financial Statistics Manualwhich is based on accrual basishas replaced the cash-based 1986 GFSManual. The current GFS is therefore harmonized with the System of National Accounts 1993 (SNA 1993) which allows utilizing government finance statistics together with other macroeconomic statistics. Therevision of the GFSManualinvolvedsignificant changes in the underpinning analytical framework but preserved,with some modification,the revenue and expenditure classifications.

The classification of revenuesincludes tax and other than tax revenues, and the classification of taxes is organized by the tax base on which the tax is levied.On the expenditure side, there are two main classifications – economic and functional. The economic classification of expenditures is based on the type of expenditure incurred, whereas the functional classification reflects the intended objectives of expenditures.

The updated IMF’s Government Finance Statistics Manual (GFSM 2001) offers a standard framework for the budget classification system which can be used for developing a new system or improving an existing one. It is important to note, however, that the GFSM 2001 similar to the GFSM 1986 provides guidelines on budget classification for reporting only. It was developed primarily as a statistical model and hence its scope is much boarder—it isa reporting framework for financial transactions in the general government sector.Since a system of budget classification is also a tool for policy decision making, budget management and accounting, the revenue and expenditure classifications provided in the GFSM 2001 are not sufficient and need to be adapted to assist a country’s budgeting process.

In order to facilitate policy formulation and transparency and accountability in the budget administration, many countries employ various additional budget classifications. The most commonly used are:

• Administrative classification is organized by a government entity responsible for managing the allocated funds (e.g. ministry, department, etc.), whether from the central budget or its own revenue.
• Program classification indicates a set of specific policy objectives to be achieved with the provided resources.
• Classification by source of financingis aimed to differentiate the on-budget spending and extra budgetary funds, as well as government own financing and counterpart funds.
• Classification by geographical locationmay apply to the administrative units, taxpayers or recipients of government transfers and subsidies.

On the other hand, it is important to be cautious when introducing different types of classification. They may lead to information overload and unnecessary complexity of the budget structure. Moreover, each additional classification requires resources and time to process information and to maintain the system. Overstretching technical and financial capacity may result in poor quality data for the overall system of budget classification.

1. Economic, Functional and Program Classifications of Expenditures

The three most useful expenditure classifications for budgetary decision making pertaining to strategic allocation of resources and efficient service delivery are functional and economic classifications, provided in the GFS Manual, and program classification which is often used to boost operational performance. In the 2001 GFS system the term “expense” replaces “expenditure” from the 1986 GFSM because the economic classification is defined using the accrual principles of recording and excludes transactions in nonfinancial assets. (The distinction between expenditure and expense is explainedin more detail in Box 1.)

Box 1. Distinction Between Expenditure and Expense
In the 1986 GFSM, the term expenditure is associated with the cash basis and involves recording of transactions as close to the payment stage as possible. There is one caveat for disaggregated expenditure which is recorded at the stage between delivery and payment to represent the most accurate reporting of actual government operations.Thus expenditure includes all nonrepayable payments by government, whether requited or unrequited, and whether for current or capital purposes.In the 2001 GFSM, the term “expense” is associated with the accrual principleswhich imply that the time of recording is when the activities, transactions, or other events occur that create the unconditional obligation of government units to make payment. Expense means a decrease in net worth resulting from a transaction and therefore excludes transactions in nonfinancial assets. The economic classification identifies the types of expense incurred for such activities as production of goods and services by a government unit itself for distribution, purchase of goods and services from a third party for distribution, or transfer of cash to households so that they can purchase goods and services directly. The functional classification indicates the purpose for which an expense was incurred but is not limited to expense transactions. Because acquisitions of nonfinancial assets can also be classified based on the functional classification, the 2001 GFSM uses the term “outlays” or “expenditure” for the functional classification.

Economic Classification:The economic classification of expenditures is determined by the kind of expenditure incurred (e.g., wages and salaries, interest payments or capital spending). In the revised 2001 GFS Manual, all line items in this classification are equally applicable to the accrual and cash bases with the exception of a new line item such as consumption of fixed capital.The major types of expense are listed below. Codes for economic classification of expense begin with 2.[1](Table1 in Annex shows the economic classification of expense as provided in the GFSM 2001.)

21 - Compensation of employees

22 - Use of goods and services

23 - Consumption of fixed capital

24 - Interest

25 - Subsidies

26 - Grants

27 - Social benefits

28 - Other expense

The 2001 economic classification also retains the distinction between current expenditures and capital expenditures which is fundamental for assessing operational efficiency in public expenditure management and the impact of fiscal polices. Compared to the 1986 classification, it includes current expenditure and capital transfers but excludes capital expenditure. This important departure from the GFSM 1986 means thatthe acquisition of fixed capital assets, purchases of stocks, land and, intangible assets are recorded as transactions in nonfinancial assets. For instance, the construction of a road is recorded in this waysince it does not affect net worth and thus is not an expense. It rather changes the composition of the balance sheet. But when ownership of a capital asset is given up without any compensation, the expense is recorded as a capital transfer, namely capital grant, because the net worth has decreased. Operation and maintenance (O&M) spending is treated as an expense, while major improvements are considered to be acquisitions and added to the existing value of an asset.

The economic classification of expenditure is independentof the administrative classification, although the latter can incorporate economic categories for each government organization and its subdivisions.

Functional Classification:As mentioned earlier, the functional classificationcategorizes government activities based on their broad objectives (e.g., education, health, and social protection), and thus facilitatesthe analysis of resource allocation among sectors. It is also especially useful in analyzing the impact of fiscal policies. This classification is distinct from the administrative structure of the government. The GFSM 2001 functional classification is fully integrated with the UN COFOG which is considered to be a widely accepted international standard.It consists of 10 major government functions which are then divided into groups and subgroups.All COFOG classification codes begin with 7. (Table 2 in the Annex shows the detailed table of the functional classificationas presented in the GFSM 2001.)

701 - General public services

702 - Defense

703 - Public order and safety

704 - Economic affairs

705 - Environmental protection

706 - Housing and community amenities

707 - Health

708 - Recreation, culture and religion

709 - Education

710 - Social protection

Many countries apply the COFOG system but adapt it to their particular policy issues and actual program structures. The 2001 GFS system accommodates this by requiring a mapping table between COFOG and the functional classification used in a country, or between COFOG and the country’s organizational classification and COFOG.

Program Classification:The functional classification of expenditure is often accompanied by program classification which implies the grouping of expenditure by common policy objective, for instance child nutrition or transportation research and development. Thus governments employ program classification for the following purposes: (1) to establish specific goals for budgetary spending and (2) to improve operational performance by adopting performance measures. A “program” is a set of activities that constitute homogenous categories (e.g., speed rail project).

In contrast to the functional classification, the program classification takes into account concrete policy objectives and how they are going to be implemented.By design it needs to be capable of capturing cost information in order to link economic inputs to program results. Therefore, the programmatic structure incorporates also the object/economic classification which identifies in this case both current and capital inputsof a particular program.The 2001 GFS system based on the accrual principles allows determiningfull cost of programs.

While the program classification is inherently disconnected from government’s organizational structure and can exist without a standard functional classification, a recent trend in budget reforms has been to define programs within the existing agency structure and thus place each program under a single ministry and align it with the functional classification. (Table 3 in the Annex gives an example of such arrangement.) This budget classification scheme ensures clear assignment of responsibility for managing a program and accountability for its results because they are allocated to a particular unit and program manager within the ministry or department. The main advantage is that it provides an incentive to managers in each government organization to clearly specify their goals and to consider what have been accomplished. That's why the programmatic structure is often introduced in the context of the performance budgeting reform. In some cases, however, narrowing the scope of a program creates disconnect with government policy objectives. Then such a program is implemented by several agencies responsible for these policy objectives. (A more detailed discussion on different approaches to the program structure is provided in another module in the context of performance budgeting.)

1. Differences Between GFS 1986 and GFS 2001 Budget Classifications

The revised 2001 GFS system represents substantial differences compared to the 1986 GFS Manual which pertain to the coverage, recording basis, definitions, classifications and balancing items. Three fundamental changes are:

• General government sector
• Accrual basis of recording
• The analytic framework

General Government Sector: The 2001 GFS system in line with the 1993 SNA is focused on the general government sector which consists of all resident government units and all resident nonprofit institutions that are controlled and financed by government.[2]Conversely, the coverage of the 1986 GFS Manual is defined on the functional rather than a unit basis and thus effectively excludes transactions that do not involve the implementation of fiscal policy, for instance transactions of the monetary authority and other depository financial institutions.

Accrual Basis of Recording: While the 1986 GFS Manual is based on cash accounting, in the 2001 GFS system, flows are recorded on an accrual basis and nonmonetary transactions are fully included. The accrual principles imply that revenues are recognized when earned and expenses are recognized when incurred, whereas in the cash-based accounting system, transactions are recorded when cash is received or paid. There are several substantive differences ensuing from the accrual basis of recording used in the 2001 GFS Manual:

a)Broader coverage of economic events – all transactions affecting assets, liabilities, revenue, or expense rather than just cash transactions (e.g., in-kind transactions).

b)Introduction of net worth and balance sheet to government operations – all stocks of financial assets, nonfinancial assets, liabilities, and net worth of government are included rather than only stock of certain debt liabilities.

c)Integration of flows and stocks – allows reconciliation of differences between the opening and closing balance sheets. In the 1986 GFSM, a reconciliation of the stocks of the debt liabilities required the collection of additional information.

d)Valuation – assets and liabilities are valued at current market prices rather than nominal value, including debt securities.

e)Definition of revenue and expense – correspondingly an increase or decrease in net worth resulting from a transaction and thus excludes proceeds from or purchases of nonfinancial assets.

f)Classification – revenue categories are substantially revised and include taxes, social insurance contributions, grants, and other revenue while, in the 1986 GFSM, they are comprised of tax, nontax, or capital revenue, and grants. A detailed discussion of changes to the expenditure classification is presented above. There is a new classification introduced for transactions in nonfinancial assets, as they no longer fall into revenue or expense categories.

The AnalyticFramework:Although the 1986 GFS Manual is focused on a single balancing item such as the overall deficit/surplus, the 2001 GFS system provides a number of new balancing items sincethe analysis of general government or public sector requires a variety of considerations. Two important balancing items are included in the Statement of Government Operations. The net operating balance which is the difference between revenue and expense measures the change in net worth resulting from transactions. Net lending/borrowing is defined as the net acquisition of all financial assets less the net incurrence of all liabilities from transactions. In the GFSM 1986, a similar item was lending minus repayments but it was treated as expenditure.The 2001 GFS system makes provision, however, for the overall balance which is net lending/borrowing with an adjustment in treating transactions in assets liabilities designated for policy purposes. This measure is the equivalent of the overall deficit/surplus in the 1986 GFSM but determined on the accrual basis. Other balancing items in the GFSM 2001 are net worth, net financial worth, the change in net worth, and the change in net financial worth (all related to balance sheet), as well as the cash surplus/deficit, the change in net worth from other economic flows, the primary balance, and saving.

The 2001 GFS system based on accrual recording offers significant advantages for the analysis of government operations and its fiscal policies. First, it provides a comprehensive picture of the financial performance, financial position, and liquidity of the general government because flows and stocks are fully integrated. Second, the introduction of net worth and balance sheet gives valuable information about the stock of capital assets. Often governments resort to selling capital assets as a one-off measure in order to reduce the budget deficit. Third, earlier time of recording economic events allows capturing past-due obligations (e.g., arrears). Whereas there are many other advantages, these are among the most notable for public finance analysis.

1. Key Issues in Implementing GFS 2001 Budget Classification System

Implementation of the new GFS system is a lengthy and challenging process and, similar to other budgetary reforms, requirespolitical support and adequate technical capacity. Political commitment at a high level is critical for ensuring approval ofthe likely needed changes to the budget legal framework, sustainability of the reform, as well as effective utilization of the adopted budget classification and financial reporting.On the other hand, technical skills of the staff in the ministry of finance, the budget departments in line ministries, and other budgetary institutions (e.g., the treasury, the external audit authority), as well as a reliable electronic system are also important for successful implementation.