Reform of the Public Financial Management System in Korea

Reform of the Public Financial Management System in Korea

May 2005

Youngsun Koh

Korea Development Institute

Contents

Introduction

Background of the Reform

Limitations of the Previous System

Main Characteristics of the Reform

National Fiscal Management Plan

Top-down Budgeting

Main Contents of NFMP 2004-2008

Improvements Required

Introduction

The Korean government strengthened its efforts to overhaul the financial management system after the crisis of 1997

The new government introduced a medium-term expenditure management framework (MTEF) together with a top-down budgeting system in 2003

MTEF provides for a mechanism to reflect policy priorities in budgeting and facilitate a strategic decision-making.

The budget for FY 2005 was prepared under the new system.

The introduction of “program budgeting” and “performance management system” is in progress

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Changing environment

The size of the government spending increased from 57 billion won in 1960 to 118 trillion won in 2004.

The structure of budget is getting more complicated.

There is an increasing emphasis on “autonomy and devolution” and “accountability and performance” as the guiding principles of government.

Limitations of the previous system

Centered on a single budget year

Relied excessively on a bottom-up approach in budgeting

Focused on the general account

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Background of the Reform


Centered on a single budget year

Little consideration is given by the central budget office and the parliament to the out-years beyond the budget year.

Medium- to long-term planning is also quite weak in line ministries.

As a result, it is difficult to identify and cope with the trend increase in spending.

Without a medium-term strategy for fiscal management, public spending has been on a rising trend since the mid-90s.

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The counter-cyclical role of fiscal policy is constrained.

The current principle of “balanced budget in each year” has the potential to produce a pro-cyclical fluctuation in spending.

The so-called “automatic stabilizer” can be strengthened when spending increases at a pre-determined, constant rate and the balanced budget is pursued over the medium term.

Revenue

Expenditure

Surplus

Revenue

Expenditure

Surplus

Deficit

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Excessive reliance on a bottom-up approach

At the initial stage of budget preparation, the central budget office makes rough estimates of the total size and the sectoral allocation of the next year’s budget.

But the estimates are not transmitted to line ministries and therefore cannot guide line ministries in preparing their budget requests.

In reviewing the budget requests by line ministries, the central budget office focuses on the microscopic spending control of individual programs.

The sectoral allocation and the total size of the budget are determined at the last stage of budget preparation by aggregating the expenditures on individual programs.

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As a result, the control of inputs assumes the major importance in budget discussions and little attention is paid to outputs or outcomes.

The central budget office has little scope to review and analyze policies themselves, and the linkages between budgeting and policy-making are very weak.

The accountability and autonomy of line ministries in preparing and managing their budget is severely limited.

Line ministries usually request unrealistically large amount of budget, and massive cuts are inevitable.

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Centered on the General Account

The central budget office spends most of its time on reviewing and preparing the budget of the General Account.

Less attention is paid to Special Accounts and Funds.

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Main Characteristics of the Reform

A medium-term perspective “National Fiscal Management Plan,” covering the

current year, the budget year, and three out-years. Top-down budgeting

Line ministries given greater discretion in the preparation of budget requests within the ceilings set by MPB.

Performance management Introducing a system similar to the Program

Assessment Rating Tool (PART) of the U.S. federal government.

Program budgeting Adopting a program structure in budget accounts.

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Main features

Covers 5 years on a rolling basis.

Includes the General Account and various special accounts and funds.

Sets out major policy directions, fiscal aggregates, and the sectoral resource allocation.

Prepared through an intensive policy dialogue involving line ministries and other interested parties.

Closely linked to annual budgeting.

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Timetable

Setting out the framework (Jan. - early Apr.)

Line ministries submit medium-term spending projections to MPB by the end of January.

Sectoral taskforces (composed of staff from MPB and relevant line ministries and private-sector experts) are organized to discuss sectoral policy directions and spending priorities.

Taskforces present their results in a series of public hearings in March - April.

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National Fiscal Management Plan- 11 -

Timetable

Preparing the draft (Apr. - early May) MPB prepares a draft NFMP, which includes among others the

tentative ceilings on sectoral spending.

At the end of April, a two-day cabinet meeting is held to discuss and finalize the ceilings.

In May - June, line ministries prepare their budget requests for the next year based on the ceilings.

Finalizing the NFMP (May - early Oct.) In July - September, MPB negotiates with line ministries on their

budget requests, prepares the draft budget, and revises the NFMP.

After approved by the cabinet, the NFMP is tabled at the National Assembly together with the draft budget in early October.

Top-down Budgeting- 12 -

Main features

Line ministries prepare their budget requests within the ceilings set out in NFMP.

Ceilings are set for 14 spending areas such as social infrastructure, agriculture, education, and environment and then disaggregated into 56 programs.

For example, social infrastructure has 7 programs, including roads, railways, subways, ports, airports, housing, and water resources.

Separate ceilings are also set within each program for the general account and various special accounts and funds.

Top-down Budgeting- 13 -

Progress to date

Pilots on four agency-level organizations for FY 2004

Government-wide implementation for FY 2005

A smaller increase in budget requests by line ministries above the previous year’s budget: 11.7% for FY 2005 vs. 30.8% for FY 2004

Larger reallocation of budget across programs: cutting back 2.7 trillion won on existing ones and introducing new ones worth 3.0 trillion won for FY 2005

The same numbers for FY 2004 were 1.6 and 1.5 trillion won, respectively.

Main Contents of NFMP 2004-2008- 14 -

Fiscal aggregates

In 2004-2008, the economy is expected to grow 5% p.a. in real terms and 8% p.a. in nominal terms.

The total revenue grows by 7.4% p.a. and the total spending by 6.3% p.a.

The target balance will record a small deficit (within 1% of GDP) in 2004-2007 but the deficit will be eliminated by 2008.

The target balance refers to the consolidated budget balance excluding the social security funds and the transformation of financial-sector restructuring bonds into treasury bonds.

The debt-to-GDP ratio will increase slightly in 2004-2006 but stay at the 2006 level afterwards.

Main Contents of NFMP 2004-2008- 15 -

Resource allocation

Priority areas

Improving the growth potential: R&D and education

Strengthening the social integration: Welfare

Meeting the challenges for national security: Defense

Areas that needs readjustment

Social infrastructure: Greater use of public-private partnership

Agriculture: Promote structural changes following the market opening

Industry and SMEs: Focus on R&D and human resource development

Improvements Required- 16 -

Clarifying the medium-term targets

Presently, it is not clear which variable the government is targeting in the medium term; the budget balance, the total spending, or the debt-to-GDP ratio.

An ideal target would be “a balanced budget over the business cycle,” given the low level of debt-to-GDP ratio in Korea.

In this scenario, a lower-than-expected growth will produce deficits and a higher-than-expected growth surpluses, with deficits and surpluses averaging out over the cycle.

And the debt-to-GDP ratio will decline slowly over the years.


Setting out the annual operational targets

There are two types of operational targets commonly employed -- budget balance and total spending.

Total spending is a superior choice because

it is less influenced by the cyclical position of the economy and therefore easier to target; and

it assists in a counter-cyclical management of fiscal policy by leaving the balance to fluctuate over the cycle.

Presently, the Korean government intends to keep the annual spending totals unchanged in successive NFMPs, and thus appears to have the total spending as annual targets.


Analyzing the risk factors

Risk analysis is being called for that studies the impacts of

the projected medium-term growth rates and other macroeconomic variables on the government financial position;

the various contingent liabilities of the government; and

the changing demography on the long-term fiscal sustainability and on the public pension system.


Introducing “program budgeting”

The Korean government is currently redesigning the structure of its budget accounts around functions, administrations, and programs.

The resulting program structure will make it easier to allocate resources according to the national priorities and set ceilings on sectoral spending.

“Programs” will also act as the basic units of performance management in the future.

Reform of the Public Financial Management System in Korea

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