Research Handbook on Public Financial Management (Elgar Handbooks in Public Administration and Management) 1800379706, 9781800379701

Table of contents :
Front Matter
Copyright
Contents
Contributors
Foreword
Preface
Acknowledgments
Introduction to the Research Handbook on Public Financial Management
PART I THE CHANGING LANDSCAPE OF PUBLIC FINANCIAL MANAGEMENT
1. Foundations of public financial management: theories and concepts
2. Managing public finances during major crises
3. Emerging ideas for fintech applications in public finance
PART II GOVERNMENTAL ACCOUNTING, AUDITING, AND FINANCIAL REPORTING
4. Theories informing public sector accounting and financial management changes in the era of new public management
5. Governmental accounting and financial management in practice: current trends and country experiences
6. Future directions for research in governmental accounting, auditing, and financial reporting
PART III BUDGETING
7. The road to entrepreneurial budgeting and beyond: a reconceptualization of the development of budget innovations in the United States
8. Public budgeting in developed and developing countries
9. Future directions for research in national and subnational government budgeting
PART IV TAX REVENUE MANAGEMENT
10. Foundations of government taxation and revenue management
11. Tax revenue management and reform in the digital era in developing and developed countries
12. Instruments and management of public revenue
PART V EXPENDITURE MANAGEMENT
13. Foundations of public expenditure management: theories and concepts
14. Future directions for research in public expenditure management
PART VI DEBT MANAGEMENT
15. Foundations of subnational public debt management: theories, concepts and policy lessons
16. Emerging research issues in subnational government debt management
17. Emerging research issues in sovereign debt management
PART VII GOVERNMENT PROCUREMENT AND CONTRACT MANAGEMENT
18. Foundations of public procurement
19. Future directions for research in public procurement and contract management
PART VIII A PATHWAY FOR MANAGING PUBLIC FINANCES IN THE YEARS AHEAD
20. Great ideas in behavioral public financial management
21. New insights for managing the public finance aspects of climate-resilient infrastructure systems
22. Teaching public budgeting and finance to the next generation of scholars
Index

Citation preview

RESEARCH HANDBOOK ON PUBLIC FINANCIAL MANAGEMENT

ELGAR HANDBOOKS IN PUBLIC ADMINISTRATION AND MANAGEMENT This series provides a comprehensive overview of recent research in all matters relating to public administration and management, serving as a definitive guide to the field. Covering a wide range of research areas including national and international methods of public administration, theories of public administration and management, and technological developments in public administration and management, the series produces influential works of lasting significance. Each Handbook will consist of original contributions by preeminent authors, selected by an esteemed editor internationally recognized as a leading scholar within the field. Taking an international approach, these Handbooks serve as an essential reference point for all students of public administration and management, emphasizing both the expansion of current debates, and an indication of the likely research agendas for the future. Titles in the series include: Handbook on Performance Management in the Public Sector Edited by Deborah Blackman Research Handbook on E-Government Edited by Eric W. Welch Handbook of Theories of Public Administration and Management Edited by Thomas A. Bryer Research Handbook on HRM in the Public Sector Edited by Bram Steijn and Eva Knies Handbook on Gender and Public Administration Edited by Patricia M. Shields and Nicole M. Elias Research Handbook on Motivation in Public Administration Edited by Edmund C. Stazyk and Randall S. Davis Handbook on the Politics of Public Administration Edited by Andreas Ladner and Fritz Sager Handbook on Local and Regional Governance Edited by Filipe Teles Handbook on Asian Public Administration Edited by M. Shamsul Haque, Wilson Wong and Kilkon Ko Handbook on Ministerial and Political Advisers Edited by Richard Shaw Handbook on Strategic Public Management Edited by Carsten Greve and Tamyko Ysa Research Handbook on Public Financial Management Edited by Komla D. Dzigbede and W. Bartley Hildreth

Research Handbook on Public Financial Management Edited by

Komla D. Dzigbede Associate Professor, Department of Public Administration, State University of New York at Binghamton, USA

W. Bartley Hildreth Professor Emeritus, Andrew Young School of Policy Studies, Georgia State University, USA

ELGAR HANDBOOKS IN PUBLIC ADMINISTRATION AND MANAGEMENT

Cheltenham, UK • Northampton, MA, USA

© Komla D. Dzigbede and W. Bartley Hildreth 2023

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2023939580 This book is available electronically in the Political Science and Public Policy subject collection http://dx.doi.org/10.4337/9781800379718

ISBN 978 1 80037 970 1 (cased) ISBN 978 1 80037 971 8 (eBook)

EEP BoX

Contents

List of contributorsviii Forewordxviii Roy Bahl Prefacexx Acknowledgmentsxxii Introduction to the Research Handbook on Public Financial Management xxiii PART I

THE CHANGING LANDSCAPE OF PUBLIC FINANCIAL MANAGEMENT

1

Foundations of public financial management: theories and concepts Robert S. Kravchuk

2

Managing public finances during major crises Rahul Pathak, Justina Jose and Komla D. Dzigbede

18

3

Emerging ideas for fintech applications in public finance Majid Bazarbash, Naomi Nakaguchi Griffin, Gerardo Una and Alok Verma

31

PART II

2

GOVERNMENTAL ACCOUNTING, AUDITING, AND FINANCIAL REPORTING

4

Theories informing public sector accounting and financial management changes in the era of new public management Robert Ochoki Nyamori

58

5

Governmental accounting and financial management in practice: current trends and country experiences Qiushi Wang and Shaodong Zhu

77

6

Future directions for research in governmental accounting, auditing, and financial reporting Yulianti Abbas

95

PART III BUDGETING 7

The road to entrepreneurial budgeting and beyond: a reconceptualization of the development of budget innovations in the United States Robert L. Bland, Michael R. Overton and Valencia Prentice

v

117

vi  Research handbook on public financial management 8

Public budgeting in developed and developing countries Julius A. Nukpezah, Aisha S. Ahmadu, Kingsley Ukwandi, Edmund Poku Adu and Romeo Abraham

136

9

Future directions for research in national and subnational government budgeting154 Jinhai Yu and Zhiwei Zhang

PART IV TAX REVENUE MANAGEMENT 10

Foundations of government taxation and revenue management Whitney Afonso

11

Tax revenue management and reform in the digital era in developing and developed countries 202 Jorge Martínez-Vázquez, Eduardo Sanz-Arcega and José Manuel Tránchez Martín

12

Instruments and management of public revenue Justin M. Ross

PART V

179

226

EXPENDITURE MANAGEMENT

13

Foundations of public expenditure management: theories and concepts Simanti Bandyopadhyay and Harsahib Singh

238

14

Future directions for research in public expenditure management Travis St. Clair

258

PART VI DEBT MANAGEMENT 15

Foundations of subnational public debt management: theories, concepts and policy lessons Heidi Jane M. Smith and Alfonso Mendoza-Velázquez

16

Emerging research issues in subnational government debt management Dario Cestau

287

17

Emerging research issues in sovereign debt management Teresa Ter-Minassian

300

273

PART VII GOVERNMENT PROCUREMENT AND CONTRACT MANAGEMENT 18

Foundations of public procurement Spencer T. Brien

326

19

Future directions for research in public procurement and contract management 341 Benjamin M. Brunjes, Sawsan Abutabenjeh, Lachezar G. Anguelov, Ana-Maria Dimand and Evelyn Rodriguez-Plesa

Contents  vii PART VIII A PATHWAY FOR MANAGING PUBLIC FINANCES IN THE YEARS AHEAD 20

Great ideas in behavioral public financial management Kenneth A. Kriz

21

New insights for managing the public finance aspects of climate-resilient infrastructure systems Can Chen

22

Teaching public budgeting and finance to the next generation of scholars Bruce D. McDonald, III

Index 

369

385 402 415

Contributors

Editors Komla D. Dzigbede is an Associate Professor and Chair in the Department of Public Administration at the State University of New York at Binghamton, USA. Komla is an expert in state and local public finance and international economic policy. His research covers topics in government debt management, financial market regulation, budget sustainability, and economic development and has been published in leading academic journals. Komla has extensive experience in the international public sector from working as an economist at the Central Bank of Ghana and consulting for international development agencies. He received bachelor’s and master’s degrees in economics from the University of Ghana and a doctorate in public policy from the Georgia State University. Komla is currently the editor-in-chief of Public Finance & Management journal. W. Bartley Hildreth is Professor Emeritus and a former Dean in the Andrew Young School of Policy Studies at Georgia State University in Atlanta, USA. He is also Professor Emeritus at Wichita State University where he was the Regents Distinguished Professor of Public Finance (including Interim Dean of the business school). His research and publications include over 50 articles, 25 books, and 40 book chapters. He is a Fulbright scholar, a fellow of the National Academy of Public Administration, a former city finance director, a recent public member of the Board of Directors of the Municipal Securities Rulemaking Board, the long-time Editor-in-Chief of Municipal Finance Journal, and the recipient of the Aaron B. Wildavsky Award for lifetime scholarship in public budgeting and finance. Managing Editor Justina Jose is an Assistant Professor in the School of Public Affairs at San Diego State University, USA. Her research interests lie in public financial management with a special focus on public debt management. Justina is interested in examining intergovernmental relationships and their impact on local government fiscal outcomes. Justina recently received her PhD from the Andrew Young School of Policy Studies at Georgia State University with a specialization in public budgeting and finance. Contributors Yulianti Abbas is currently a faculty member and the Chair of the Accounting Department at the Faculty of Business and Economics, Universitas Indonesia. Yulianti received her doctoral degree in Public Affairs from the O’Neill School of Public and Environmental Affairs, Indiana University – Bloomington under a Fulbright scholarship. In 2018 she received the Outstanding Dissertation Award from the American Accounting Association – Government and Nonprofit Section. Her current research interest includes tax policy, municipal market, governmental accounting, and public budgeting and financial management. Romeo Abraham is an Assistant Professor in the Department of Public and International Affairs at the University of North Carolina Wilmington, USA. His research interests include viii

Contributors  ix local government finance, human resources management, emergency management, sustainability, and nonprofit management. He has published in Review of Public Personnel Administration, Public Personnel Management, and Public Integrity. Sawsan Abutabenjeh is an Associate Professor of Public Policy and Administration in the Department of Political Science and Public Administration at Mississippi State University, USA. Her research areas include public procurement, supply chain management, economic forecasting and policy analysis, public finance, gender, and complex system governance. Her research has appeared in several journals including Journal of Public Procurement, International Journal of Procurement Management, International Journal of System of Systems Engineering, International Journal of Public Administration, International Journal of Public Sector Performance Management, Public Works Management & Policy, and Journal of Public Budgeting, Accounting & Financial Management. Edmund Poku Adu is a PhD student in public administration and management at the University of North Texas (UNT), USA. He holds BA in political science with English and MPhil in public administration degrees from the University of Ghana. He worked as a research assistant and tutor at the University of Ghana for three years before starting his PhD in public administration and management at UNT in Fall 2021. His current areas of research interest are public policy, social equity, technology policy, and development. Whitney Afonso is an Associate Professor at the University of North Carolina at Chapel Hill’s School of Government, USA. Whitney’s research focuses on state and local public finance with an emphasis on local sales taxes. Her work has appeared in journals such as the National Tax Journal, Public Budgeting & Finance, Public Finance Review, Public Administration Review, and Journal of Public Policy. Whitney won the Burkhead Award for best manuscript published in Public Budgeting & Finance in 2015. She has served on the executive committee of the Association for Budgeting and Financial Management since 2018. In addition to her traditional research and teaching, her position at UNC engages her with elected officials and practitioners within the state. She is the liaison for the North Carolina Local Government Budget Association and collaborates and consults with the North Carolina General Assembly’s fiscal research staff on issues of tax policy. Aisha S. Ahmadu is an Assistant Professor in the College of Humanities and Social Sciences at Sam Houston State University, USA. Her research interests are in public finance, resource allocation, disaster science, and federalism. She has published articles in leading journals including Public Administration Review, International Journal of Public Administration and Public Administration Quarterly. Lachezar G. Anguelov is an Assistant Professor at The Evergreen State College, USA. His research areas include public management, collaborative governance, contract management capacity of public organizations, and institutional arrangements governing local government service delivery. Dr. Anguelov’s studies have been published in International Public Management Journal, Review of Policy Research, and Journal of Strategic Contracting and Negotiation. Simanti Bandyopadhyay is currently a Professor of Economics in School of Management and Entrepreneurship, Shiv Nadar University (Institution of Eminence) Delhi-NCR, India. She worked as a Senior Economist, National Institute of Public Finance and Policy, New Delhi for

x  Research handbook on public financial management more than a decade. She specializes in applied development economics and has keen interest in many areas including public economics and policy. She has completed her PhD in economics on a University Grants Commission, India, fellowship from the Centre for Economic Studies and Planning, Jawaharlal Nehru University, India and has been an International Centre for Tax and Development (ICTD) Post-doctoral Fellow at the Andrew Young School of Policy Studies, Georgia State University, USA and Institute of Development Studies, University of Sussex, UK. She has visited various universities and research institutions of repute in India and abroad for assignments on research, teaching and research guidance and has also been a recipient of a MacArthur Foundation Award. A regular contributor of research articles and an external reviewer to a number of international journals on economics, operations research and public policy, she has led important projects and has worked with organizations such as the World Bank, ADB, UNDP, IFMR, ICRIER, Planning Commission and different Ministries and Commissions in Government as an area expert. Majid Bazarbash is an economist at the International Monetary Fund (IMF), currently at the Monetary and Capital Markets (MCM) Department, USA. His recent research has focused on fintech and financial inclusion and generated well-received publications. His co-authored publications on “The Promise of Fintech: Financial Inclusion in the Post COVID-19 Era” (2020) and “FinTech in Financial Inclusion: Machine Learning Applications in Assessing Credit Risk” (2019) have been highly cited by other studies in the field. During his tenure at MCM, he has worked on financial sector analysis and policies for fragile and low-income countries in Asia, Pacific Islands, Africa, and South America. He received his PhD in economics with a minor in finance from the Tepper School of Business at Carnegie Mellon University. Robert L. Bland is Endowed Professor of Local Government in the Department of Public Administration and Faculty Director of the Center for Public Management at the University of North Texas, USA. He teaches courses in tax policy, governmental accounting, and budgeting. He is the author of several books, all published by the International City/County Management Association (ICMA) including, with Michael Overton, A Budgeting Guide for Local Government (4th edition). He writes about the municipal bond market, property taxation, tax increment financing, local government investment pools, municipal budgeting, and city management. He is the recipient of the first Terrell Blodgett Academician Award from the Texas City Management Association, the Stephen B. Sweeney Academic Award from ICMA, and a fellow in the National Academy of Public Administration. In 2017, he was elected an Honorary Member of ICMA and in 2022 he served as chair of the Association for Budgeting and Financial Management. In 2023, he received the UNT Foundation Eminent Faculty Award, UNT’s highest faculty honor, for this lifetime contribution in teaching, research, and service. Spencer T. Brien is a faculty member at the Evergreen State College, USA. Dr. Brien researches public fiscal administration at the federal, state, and local levels. His recent work examines the impact of federal continuing resolutions on Department of Defense procurement activity. His research has been published in various journals including Public Administration Review, The American Review of Public Administration, Public Budgeting & Finance, Public Finance Review, and Journal of Public Procurement. His work has been financially supported by the Naval Postgraduate School Acquisitions Research Program and the Department of Defense Office of People Analytics. Prior to entering academia, he worked for eight years as a program analyst for the Internal Revenue Service.

Contributors  xi Benjamin M. Brunjes is an Assistant Professor in the Daniel J. Evans School of Public Policy and Governance at the University of Washington, USA. Ben’s research is focused on how to design and implement complex forms of modern governance, including contracts, grants, and collaborative networks. His recent studies have been published in Public Administration Review, Journal of Public Administration Research and Theory, and International Public Management Journal, among others. A former practitioner, Ben holds a BA in American politics from the University of Virginia, and an MPA and PhD in public administration and policy from the University of Georgia. Dario Cestau has a PhD in economics from Tepper School of Business, Carnegie Mellon University, USA. His research interests include public finance, asset pricing, political economy, and municipal bonds. His work has been published in top economic and financial journals, including Journal of Monetary Economics, Journal of Political Economy, and Review of Financial Studies. He has held an Assistant Professor in Finance position at IE Business School since 2014. He teaches corporate finance, advanced finance and financial markets in master’s programs. Can Chen is an Associate Professor in the Andrew Young School of Policy Studies at Georgia State University, USA. His main research interest is state and local infrastructure finance and policy. He serves as the chair for the American Society of Public Administration (ASPA) Section on Transportation Policy and Administration (STPA) for 2021–2023. He is a certified research associate at Mineta Transportation Institute. He has published widely in journals on public budgeting and finance, public management and policy, and transportation. His research was supported by grant funding from the World Bank, Governmental Accounting Standards Board (GASB), International City/County Management Association (ICMA), Lincoln Institute of Land Policy, and Open Government Partnership. He is the Associate Editor of Journal of Infrastructure, Policy and Development (JIPD) and International Review of Public Administration (IRPA), and the Public Budgeting and Finance Section Editor in Chinese Public Administration Review (CPAR). Ana Maria Dimand is an Assistant Professor of Public Policy and Administration in the School of Public Service at Boise State University, USA. She recently completed her PhD and a Graduate Certificate in public finance, procurement, and contract management, at Florida International University, Miami. She holds a Bachelor of Laws (LLB) from the Romanian-American University, Bucharest, Romania. Ana has extensive practitioner experience in government contracting. Prior to her graduate studies, she served as a legal advisor for a central government organization in Bucharest, Romania, specializing in public procurement. Ana’s research focuses on public management, government contracting, environmental policy, sustainability, innovation, and collaborative governance. Naomi Nakaguchi Griffin is a Division Chief of the IMF’s Monetary and Capital Markets (MCM) Department, USA. She has led or participated in several Financial Sector Assessment Programs (FSAPs), including for France, China, and the Russian Federation, and managed the IMF’s capacity development programs on financial sector issues for low-income and lower-middle income countries. She has also worked on several emerging market economies in the IMF’s Western Hemisphere Department. Prior to joining the IMF, she was a principal analyst at the US Congressional Budget Office (CBO) and an Adjunct Professor of Economics at the Johns Hopkins University’s School of Advanced International Studies (SAIS). She

xii  Research handbook on public financial management received her PhD in economics from the University of Maryland and master’s degree in international affairs from the Johns Hopkins University, SAIS. Robert S. Kravchuk is Emeritus Professor of Public Affairs in the Indiana University O’Neill School of Public & Environmental Affairs, USA. His research focuses on public finance and budgeting, US federal finance and monetary economics. He is the author of numerous academic journal articles on public finance, budgeting, and public administration. He has taught at LeMoyne College, University of Hartford, University of Connecticut, Ukrainian Academy of Public Administration and University of North Carolina-Charlotte. Kravchuk has served as Undersecretary (deputy director) in the State of Connecticut budget office. He has been a member of numerous US Treasury Department expert missions to former Soviet and Eastern European countries, Ukraine in particular. Kravchuk holds a PhD from the Maxwell School of Citizenship and Public Affairs at Syracuse University. Additionally, he holds an MBA in finance and business economics from Columbia University in New York. He is a certified management accountant and a certified internal auditor. Kenneth A. Kriz is Interim Vice Chancellor for Finance and Administration at the University of Illinois at Springfield, USA. Dr. Kriz conducts research focusing on subnational debt policy and administration, public pension fund management, government financial risk management, economic and revenue forecasting, and behavioral public finance. A nationally recognized scholar for his work on public finance and quantitative data analysis, Dr. Kriz has published three academic books and over 50 journal articles and book chapters. Dr. Kriz has consulted with several public and nonprofit organizations on financial and economic matters. Dr. Kriz served as Vice-Chairperson of the City of Omaha, Nebraska Civilian Employees Retirement System from 2006 to 2011 and on the Board of Trustees of the Wichita, Kansas Police & Fire Retirement System and on the Joint Investment Committee for the city’s pension funds from 2014 to 2018. Jorge Martínez-Vázquez is Regents Professor of Economics Emeritus at Georgia State University, USA and founding director of the International Center for Public Policy. He has published over 25 books and numerous articles in academic journals, such as Econometrica and Journal of Political Economy. He has advised federal and state agencies in fiscal policy in the USA and over 95 countries including China, Russia, Pakistan, Indonesia, Mexico, Brazil, South Africa and Argentina, and directed numerous fiscal reform projects, including the GSU $20 million USAID Fiscal Reform Project in Russia (1997–2000). He is a member of the IMF panel of fiscal advisors and has consulted often with the World Bank, IBRD and ADB. He is the recipient of numerous prizes and awards, including Honorary Doctor by the University of Vigo, and he has directed or participated in over 100 doctoral dissertations. Bruce D. McDonald, III, is a Professor of Public Budgeting and Finance at North Carolina State University, USA, editor-in-chief of Public Administration, and the co-editor-in-chief of both Journal of Public Affairs Education and Public Finance Journal. He has served as the MPA director at both North Carolina State University and Indiana University South Bend. He received his BA in communications from Mercer University, his MA in international peace and conflict resolution from American Military University, his MSc in economic history from the London School of Economics, his MEd in instructional design from North Carolina State University, and his PhD in public administration and policy from Florida State University. His research focuses on public budgeting and finance in the context of the fiscal health of local governments.

Contributors  xiii Alfonso Mendoza-Velázquez is Director of Research at CIIE-UPAEP, Puebla, Mexico. He holds a PhD in Economics from the University of York, UK, where he later worked as a post-doctoral teaching fellow. Dr. Mendoza is a Fulbright Visiting Researcher in the University of Washington, Seattle, USA and has been a visiting researcher in the Bank of England and the Central Bank of Turkey. The National Council for Science and Research (CONACYT) has granted him the distinction of National Researcher Level 2 for his contributions to applied economics. Dr. Mendoza has been an affiliate of the Microeconomics of Competitiveness Course on Competitiveness (MOC) at the Institute for Strategy and Competitiveness at Harvard since 2010. He has produced several research papers to address finance and fiscal federalism of local governments, regional competitiveness, productivity, and economic development in Mexico from a bottom-up microeconomic perspective. He is the editor of the book The Perverse Incentives of Fiscal Federalism in Mexico: The Need of a New Fiscal Arrangement. Julius A. Nukpezah is Associate Professor of Public Policy and Administration and Dean’s Eminent Scholar in the College of Arts & Sciences at Mississippi State University, USA. His current research focuses on state and local government finance and management, and he has published articles in leading journals including Public Administration Review, The American Review of Public Administration, Administration & Society, Public Performance & Management Review, Public Administration Quarterly, Public Organization Review, International Journal of Public Administration, and International Journal of Public Sector Management. He has also published in Public Budgeting & Finance, Public Money & Management, Municipal Finance Journal, and Journal of Public Budgeting, Accounting and Financial Management. Robert Ochoki Nyamori is an Associate Professor in Accounting at UAE University whose work has focused on how accounting is implicated in governing, especially in the context of the public sector. His work has been published in Critical Perspectives on Accounting, Accounting, Auditing and Accountability Journal, and Journal of Accounting and Organizational Change, among others. Nyamori is also an occasional commentator in the Kenyan press on public policy and administration in Kenya. He has taught in numerous universities including UAE, Qatar, Massey and La Trobe. His principal teaching interests are in management accounting in both the private and public sector contexts. Michael R. Overton is an Associate Professor of Public Administration at the University of Idaho, USA. His research on local governments explores competition among local governments, economic development, municipal fiscal health, and data science in the public sector and has been published in Public Administration Review, The American Review of Public Administration, State and Local Government Review, International Journal of Public Administration, Municipal Finance Journal, and Teaching Public Administration. His research into these areas has been funded by the US Department of Housing and Urban Development, the Lincoln Institute of Land Policy, SMART Transit, and the North Central Texas Council of Governments. In 2015, he received UNT’s Toulouse Dissertation Award in Social Science. In 2016 he was selected for the Emerging Scholars Award by the Lincoln Institute of Land Policy, and in 2017 he was selected as a Founders Fellow by the American Society of Public Administration.

xiv  Research handbook on public financial management Rahul Pathak is an Assistant Professor of Public Budgeting and Financial Management in the Marxe School of Public and International Affairs at the Baruch College, City University of New York (CUNY), USA. His primary research interests lie at the intersection of public finance and social policy, with a particular focus on strengthening the functioning of subnational governments. He received his PhD in public policy from the Andrew Young School of Policy Studies at Georgia State University. Valencia Prentice is an Assistant Professor in the Levin College of Public Affairs and Education at Cleveland State University, USA. She previously was a teaching fellow at the University of North Texas where she completed her PhD. Her research focuses on the economic impact of expenditures by local governments and nonprofits on property values and their effect on the redistribution of property wealth. She has presented her research at the Southeastern Conference for Public Administration, Association for Budgeting and Financial Management, Association for Research on Nonprofit Organizations and Voluntary Action, and the Conference of Minority Public Administrators. She was a 2022 Founders’ Fellow of the American Society for Public Administration. Previously, Valencia was a Finance Officer in the Ministry of Finance and Deputy Accountant General in the Treasury Department, Anguilla, West Indies. She also was a consultant in the Ministry of Finance for the Federation of St. Kitts and Nevis, WI. Evelyn Rodriguez-Plesa is an Assistant Professor of Public Administration at North Carolina Central University (NCCU), USA. Her research interests include public management, policy analysis, government contracting, socio-economic equity, and local government administration. Her research focus is inspired by and draws from her ten years of practitioner experience in local government and serving in the US Army Reserves. She currently serves as the faculty advisor for the International City/County Management Association Student Chapter at NCCU. She is also the Treasurer of the American Society for Public Administration’s (ASPA) Section on Procurement and Contract Management. Additionally, she serves as the President-Elect of ASPA’s South Florida Chapter. Justin M. Ross is Professor of Public Economics at Indiana University’s Paul H. O’Neill School of Public & Environmental Affairs. The bulk of his research puts government itself at the center of the analysis to understand how it evolves or responds to incentives and constraints. His research is featured in outlets like the National Tax Journal, Journal of Public Economics, Journal of Public Administration Research & Theory, Public Administration Review, and many others. He has been with Indiana University since completing his doctorate in economics at West Virginia University in 2008. Eduardo Sanz-Arcega is Tenured Lecturer of Economics at the University of Zaragoza, Spain. He holds a PhD in economics and a PhD in law and has published several book chapters and over 20 articles in academic journals, such as Constitutional Political Economy and European Journal of Law and Economics. He served as Editorial Assistant for Hacienda Pública Española/Review of Public Economics and was a Visiting Scientist at the Joint Research Centre (European Commission, Seville, Spain) and at the Spanish Institute for Fiscal Studies. His main research interest is in public finance, especially on sociology of taxation and law and economics.

Contributors  xv Harsahib Singh is a doctoral student at the School of Management and Entrepreneurship, Shiv Nadar University (Institution of Eminence), Delhi-NCR, India. His doctoral research is on the circular economy and its impact on the electronics industry in India. He graduated from Panjab University in Chandigarh with a master’s in public policy and administration. He is a recipient of the prestigious Maulana Azad National Fellowship awarded by the University Grants Commission of India and has qualified for the National Eligibility Test for Lectureship in India. He has presented his research at international conferences of repute. Heidi Jane M. Smith is a Professor in the Economics Department at the Universidad Iberoamericana in Mexico City. She has a PhD in public affairs from Florida International University (FIU) in Miami, a master’s in public policy from American University in Washington, DC and a BA in political science from the University of Wisconsin (Madison). Dr. Smith’s research focuses on expanding capital markets, comparative public finance of subnational debt, local policy decision-making and the concept of social equity in developing countries in particular in Mexico, but also in Korea and China. This research has been published in English, French, Chinese and Spanish in journals such as World Development, Public Administration Review, Governance, and the International Review of Administrative Science, among many other academic outlets. In the fall of 2016, the Mexican National Research System CONACyT nominated her to the 2nd level (SNI II) for her academic production. Travis St. Clair is an Associate Professor of Financial Management and Public Policy at the Wagner Graduate School of Public Service at New York University (NYU), USA. His research focuses on two main themes: (1) the long-term fiscal challenges facing state and local governments in the United States, which include unfunded pensions, growing healthcare costs, and aging infrastructure; and (2) how fiscal institutions, such as debt restrictions or financial reporting requirements, affect the ability of governments and nonprofits to provide effective public services. St. Clair received a BA and a master’s degree from Harvard and a PhD in public policy from George Washington University. Prior to joining NYU, he was an Assistant Professor in the School of Public Policy at the University of Maryland and a post-doctoral fellow at Northwestern University’s Institute for Policy Research. Teresa Ter-Minassian holds degrees in law from the University of Rome (Italy) and in Economics from Harvard University. She joined the IMF in 1972, working in the European (EUR), Western Hemisphere (WHD) and Fiscal Affairs (FAD) Departments, where she led missions to, among others, Italy, Spain and Greece, and program negotiations with Argentina, Brazil and Portugal. She was the director of the IMF’s Fiscal Affairs Department from 2001 to 2008. Following her retirement from the Fund, she is currently an international economic consultant, working in particular on fiscal issues in Latin America. Mrs. Ter-Minassian has published more than 40 papers and books on fiscal issues, especially in the macro-fiscal and intergovernmental fiscal relations areas. José Manuel Tránchez Martín is Associate Professor (Tenured) at Applied Economics and Public Management Department (Universidad Nacional de Educación a Distancia-Spain). He also has worked as Technical Advisor at the Research Area of the Institute for Fiscal Studies (Ministry of Public Finances-Spain) (2004–2011) and as external advisor in projects for Spanish Agencies, the World Bank and the Inter-American Development Bank. He holds a PhD in economics and Bachelor’s degrees in law and business administration. He has published several book chapters and numerous articles in academic journals such as Regional

xvi  Research handbook on public financial management Studies, Hacienda Pública Española/Review of Public Economics and Revista de Economía Aplicada with special dedication to research topics such as fiscal policy, fiscal federalism and public finances. Kingsley Ukwandi is a PhD candidate in the Department of Public Administration at the University of North Texas, Denton, USA. His research interests include urban reform, local governance and inter-local collaboration, local government finance, public policy, financial management and sustainability. Gerardo Una is a senior economist at the Fiscal Affairs Department (FAD) of the International Monetary Fund, USA. He provides technical assistance to governments in Latin America and the Caribbean, Africa, and South Asian countries on treasury management, public investment management, financial management information systems (FMIS), and digital solutions to improve fiscal management. Currently, he is leading digital innovations and public financial management initiatives at the FAD. He has recently published two IMF Special Series on COVID-19 notes on digital solutions for direct cash transfers and enhancing digital solutions to implement emergency responses. He is also the secretariat of a Working Group responsible for designing 2022–2027 FAD Capacity Development Strategy. Prior to joining the IMF, he worked at the Ministry of Finance of Chile, the Ministry of Finance of Argentina, and the Ministry of Finance of Paraguay. He holds a bachelor’s degree in economics from the University of Buenos Aires in Argentina. Alok Verma is a Technical Assistance Advisor at the Fiscal Affairs Department of the International Monetary Fund (IMF), USA. He provides technical assistance to governments in Europe, Africa, and Middle East. Prior to joining the IMF, he worked at the Ministry of Finance of India and was the resident PFM advisor in the Kingdom of Eswatini. In India, while leading development of PFM digital solutions, he worked closely with financial institutions to introduce fintech innovations to implement seamless electronic payments, cash transfer platform, revenue collection, and bank reconciliation. He holds a bachelor’s degree in computer engineering from Govind Ballabh Pant University of Agriculture and Technology in India. Qiushi Wang is a Professor in the School of Government and deputy director of the Center for Chinese Public Administration Research at Sun Yat-sen University, China. His research interests include public pension management, municipal bonds, debt policy, government accounting, and nonprofit finance. Among others, he has published in Public Administration Review, American Review of Public Administration, Public Budgeting & Finance, and Public Finance Review. Jinhai Yu is an Assistant Professor in the School of Public Policy, University of Connecticut, USA. He received a PhD from the Martin School of Public Policy and Administration, University of Kentucky. His research focuses on budgeting politics and debt policy. He has published in Journal of Public Administration Research and Theory, Public Administration Review, National Tax Journal, Public Management Review, and other peer-reviewed journals. Zhiwei Zhang is an Associate Professor in the Department of Political Science, Kansas State University, USA. He holds a PhD in public administration from the Martin School of Public Policy and Administration, University of Kentucky. Dr. Zhang’s research focuses on public budgeting and finance, public procurement and outsourcing, donors’ philanthropy behavior, and nonprofit finance and management. His work has appeared in such scholarly journals as

Contributors  xvii Public Administration Review, Public Performance and Management Review, and Public Administration Quarterly. Shaodong Zhu is a master’s student at the School of Government, Sun Yat-Sen University, China. His research interests include fiscal transparency, local government debt, and government performance management.

Foreword Roy Bahl

A tax expert at the International Monetary Fund (IMF) famously said “tax administration is tax policy” (Casanegra de Janscher, 1990). Her intent was to make the important point that how a tax is administered can be a significant determinant of the impacts that it will have. The interesting and well-developed set of essays in this book underlines this idea. Public financial management (PFM) practices can shape the impacts of fiscal policies, and possibly lead to a better allocation of resources. This volume surveys the present state of research on important questions about PFM and lays out a future agenda for research in this still emerging field of study. PFM is not a new area of research, as the essays in this book point out. Nor is interest in PFM limited to governments in rich countries that have the resources to upgrade their fiscal administrations. In fact, a consortium of international donors and countries has been giving assistance to countries for more than two decades, with some impressive results (World Bank, 2020). The Public Expenditure and Financial Accountability (PEFA) program provides a framework for assessing and reporting on the strengths and weaknesses of PFM systems. Numerous other institutions have focused on specific outcomes of PFM systems, for example, the work of Transparency International on corruption. Finally, there is a wealth of research reported in the academic journals and country reports. Despite the considerable gains that have been made in managing public finances, much remains to be done: low income countries are stuck at a level of tax revenue mobilization too low to satisfy their public service needs, tax burdens in many countries are too regressive and often distort resource allocation, the shadow economy is too large, expenditure delivery systems can be inefficient, some governments are unable to absorb the new technologies available, confidence in government is less than it should be, and more. But, as the chapters in this book tell us, many such problems might be addressed, at least partly, by improvements in the public financial management system. Thus, the objective of this volume: to report on the knowledge about the critical challenges involved in managing public finances, and in evaluating improvements to the present PFM systems. This Research Handbook makes a solid contribution to knowledge on this under-researched area. The important areas of PFM research are more than can be covered in one volume, but the editors have made good decisions about what to include. The book includes two chapters related to theoretical frameworks for PFM, which raise some new research questions. The three chapters on financial accounting deal with important foundational issues and also raise important research questions about the transparency and quality of government financial information. Two chapters on budgeting practices review long-term developments in industrial and low-income countries, and a third is focused on the prospects for new innovations. Two chapters focus on the research agenda for PFM in the area of public procurement, and another two on public financing innovations that have grown out of crisis management, such as COVID-19 and climate control. All of these chapters report on the state of research with respect to public finance management practices, and on what might come next. The last chapter of the book xviii

Foreword  xix raises the question of what should be taught to students in a graduate public administration program to prepare them to be good consumers of research in the PFM area. This Handbook includes three sectoral issues that are of great interest to policymakers: revenue management, expenditure management and debt management. These chapters focus on areas where much research has been done, but where the development of public budgeting and finance approaches remains in its early stages. For example, in the case of revenue management, the chapters outline what we do know about selecting the right tax instruments, but also what we do not know, including how to effectively use digitalization, how to best enforce taxes, and how to weight compliance costs in the final makeup of a tax administration strategy. The presentations in this volume benefit from the diverse research interests of the authors, which range from theoretical concerns to the practice of budgeting and purchasing. But, as might be expected from research scholars who are mostly drawn from an interdisciplinary field, the chapters have in common an interest in the ability of governments to absorb new approaches such as financial technologies, digital governance, and the uses of big data to sharpen tax audit and collection efficiency. Roy Bahl Regents Professor and Founding Dean Andrew Young School of Policy Studies, Georgia State University January 2023

REFERENCES Casanegra de Jantscher, M. (1990). Administering a VAT. In M. Gillis, C. Shoup, and G. Sicat (eds.), Value Added Taxation in Developing Countries. Washington, DC: World Bank. World Bank (2020). Global Report on Public Finance. https://​www​.pefa​.org/​global​-report​-2020.

Preface

The architecture of public financial management has become more complex and sophisticated in the last few decades. Many recent developments have reshaped the traditional ways of managing public finances and raised the need for new perspectives on managing current and future problems. These developments include sweeping regulatory reforms in financial markets and the proliferation of new financing mechanisms for government business. In addition, major crises like the COVID-19 pandemic have made managing public finances even more complex. The scope and depth of the COVID-19 crisis, and the resulting impact on public finances worldwide, has required that government policymakers adopt innovative strategies to promote economic recovery and resilience to future crises. While the field of public financial management has evolved dramatically in recent decades, research has not kept pace as much with developments in the field, and only a few books existing today combine new insights on the foundational themes with expert perspectives on emergent issues in public financial management. This Handbook fills that need in public financial management research and practice. The purpose of the Handbook is to pool together, in a single volume, expert knowledge on the critical challenges involved in managing public finances, offer new insights on traditional questions, concepts, tools, methods, and frameworks, and provide fresh perspectives on emergent topics and prospects for research and practice. Readers will gain new insights on traditional topics in public financial management, including government accounting, budgeting, taxation, spending, and debt management. The reader will also gain valuable insights on emergent topics in public financial management, including the public finance aspects of climate-resilient infrastructure systems, and management of public finances during global crises like the COVID-19 pandemic. The insights presented in this volume should serve not only as a reference point for more advance research, but also as a repository of expert knowledge on contemporary public financial management and accessible to a wide audience. Only a limited number of books on the market today focus exclusively on public financial management. Even the few books on public financial management tend to focus more on the foundational topics in the field (e.g., government accounting, budgeting, and debt management) and give less attention to emergent topics that have reshaped the traditional ways of managing public finances, including climate change, financial technology (fintech), and major economic crises. In addition, some of the existing books focus extensively on public financial management at the national level and give limited attention to subnational public financial management. Also, most of the existing volumes on public financial management are designed as textbooks for undergraduate and graduate students and are not readily aligned with the needs of researchers, practitioners, and policymakers. Furthermore, existing handbooks on public administration, public management, and public policy have discussed aspects of public financial management but not to the extent of a volume dedicated exclusively to public financial management. This Handbook stands apart from competing books on public financial management as it expands knowledge on foundational and emergent topics in the field and offers valuable insights for policymakers, practitioners, academics, and students. xx

Preface  xxi The primary audience for this book will be academics, practitioners, and policymakers seeking innovative insights on the foundational issues confronting public financial management, as well as fresh perspectives on emergent issues that will shape the future of public financial management. A secondary audience will consist of instructors and students of public financial management, public administration, public management, and public policy, both at the undergraduate, masters, and doctoral levels, who will find the text useful for gaining a comprehensive overview of public financial management. Federal, state, and local government departments and agencies, and international financial organizations like the World Bank and International Monetary Fund will also benefit from this Handbook. The editors of this Handbook bring to their roles many years of experience teaching and conducting research in public financial management. Dr. Komla Dzigbede is an associate professor in the Department of Public Administration in the State University of New York at Binghamton. Komla is an expert in state and local public finance and international economic policy, and his research is of high value to local, state, and national governments. His research spans a variety of topics, including government debt management, budget system effectiveness, financial market regulation, and sustainable economic development in developed and developing countries. Dr. Bart Hildreth’s career as a public finance scholar spans 40 years of research and teaching in business and public policy schools. He is professor emeritus in the Andrew Young School of Policy Studies at Georgia State University as well as professor emeritus at Wichita State University where he held the Regents Distinguished Professorship in Public Finance. Dr. Hildreth recently completed a three-year term as a public member on the Board of Directors of the Municipal Securities Rulemaking Board, which the US Congress created to promote a fair and efficient municipal securities market. Dr. Hildreth is a recipient of the Aaron B. Wildavsky Award for lifetime scholarly achievement in the field of public budgeting and financial management as well as a Fellow of the National Academy of Public Administration. Komla D. Dzigbede W. Bartley Hildreth October 2022

Acknowledgments

We are grateful to Edward Elgar Publishing for the opportunity to compile this Research Handbook on Public Financial Management and to disseminate to a global audience. Daniel Mather, Senior Editor at Edward Elgar Publishing worked patiently with us to complete this finished product. We are also indebted to the authors of the chapters in this Handbook. The authors are subject matter experts from different countries and regions of the world and their high-quality contributions have produced an excellent resource that expands the scope and depth of knowledge on public financial management. Similarly, we appreciate the contributions of all the anonymous peer reviewers that provided comments and feedback on the chapters to ensure that each chapter meets the highest standard and rigor of academic peer review. In addition, the diligent work of Dr. Justina Jose, our Managing Editor, is much appreciated. Justina did exceptionally well in managing the workflow for the Handbook, compiling the peer-reviewed and revised chapters, and making sure that every piece of content meets the goals and standards of the Handbook. Finally, we are deeply indebted to our family members for all the support they gave us as we worked diligently as editors to complete this Handbook.

xxii

Introduction to the Research Handbook on Public Financial Management

This Handbook presents state-of-the art research and analyses from leading scholars and is a vital reference point for advanced research in public financial management. Public financial management is an important aspect of public administration, management, and policy (Kioko et al., 2011). It focuses on how local, state, and national governments, as well as public service organizations working with governments, secure and use financial resources in an accountable, effective, efficient, equitable, and transparent manner to benefit current and future generations (Miller, 1991; Finkler et al., 2019). Accordingly, public financial managers perform a critical role in overlapping and evolving economic, institutional, legal, and political environments to balance budgets, stabilize finances over time, achieve competitive advantage, provide timely and quality service, make appropriate market disclosures, maintain adequate public communications, and promote intergenerational equity (Hildreth, 1996). The Handbook provides a broad overview of research in public financial management. It offers a forum for new insights on foundational research themes in public financial management as well as a platform for critical examination of emergent and underexplored topics. The Handbook presents innovative and frontier research on foundational themes in public financial management, including governmental accounting and auditing, budget process and methods, expenditure management, tax administration, revenue forecasting, debt management, and procurement management. In addition, it examines new research studies that explore how major crises, such as the COVID-19 pandemic, have complicated the perennial challenges of public financial management and caused governments to learn, innovate, and adapt to new strategies for managing financial resources (Ross et al., 2015; Dzigbede, 2016; Maher et al., 2020). Also noteworthy are the global issues related to climate change, which have defined new and evolving roles for the contemporary public financial manager and provided new avenues of research in public financial management, including the financing of climate-resilient infrastructure systems. The Handbook consists of twenty-two chapters grouped into eight parts. These parts cover the traditional themes in public financial management, namely (1) governmental accounting, auditing, and financial reporting, (2) budgeting, (3) tax revenue management, (4) expenditure management, (5) debt management, and (6) government procurement and contract management. In addition, two of the parts present scholarly work on (7) the changing landscape of public financial management, and present (8) a pathway for managing public finances in the years ahead. Importantly, each main part comprises a set of chapters that address three generic sub-themes, namely: great ideas, theoretical concepts or history; unanswered research questions; and international and/or comparative dimensions. The chapters have undergone double blind peer-review and meet the highest standards of academic scrutiny. Part I discusses the changing landscape of public financial management. It begins with a discussion in Chapter 1 about the theoretical foundations of public financial management. This chapter argues that the scope of public financial management needs to be extended to include concerns about money and credit available to governments, monetary sovereignty, xxiii

xxiv  Research handbook on public financial management and the use of synthetic financial instruments to overcome traditional limits on local, state, and national budgets. Chapter 2 considers how the traditional foundations of public financial management have become even more complicated due to the incidence of major crises, including the COVID-19 pandemic. The chapter examines the policy tools that countries have utilized to manage the economic impacts of the crisis and develops a typology of policy tool use during a major crisis that can inform policymaking in future crises. Finally, this part concludes with a discussion in Chapter 3 about financial technology innovations within the changing landscape of public financial management. The authors discuss how financial technology applications could be used to improve treasury payments, revenue collections, and debt management in the public sector, and they explore the potential benefits of financial technology applications for fiscal transparency and forecasting, budget planning and execution, and cash management. Part II focuses on governmental accounting, auditing, and financial reporting. In Chapter 4, the author examines the theories underpinning public sector accounting and financial management. The chapter considers the changes that have transformed the role and structure of government accounting and financial management systems over the years. Chapter 5 proceeds with a detailed discussion of current trends and international experiences with governmental accounting and financial management. Chapter 6 concludes this part with a discussion about future directions for empirical research in governmental accounting, auditing, and financial reporting. In Part III, the focus is on public budgeting. Chapter 7 explores the development of budget innovations in the United States. The authors reconceptualize the development of budget innovations across distinct eras based on the public’s perceived role, and they discuss the client era, the constituent era, and the consumer era. In addition, the authors conjecture that the public’s role is transitioning to a new era – the subscriber era – where customers also become subscribers of public services who can customize and bundle service packages to suit their own needs within a digitized system of governments service provision. Chapter 8 examines public budgeting in developed and developing countries. It considers the evolution and spread of budgetary practices across different countries and regions of the world as well as the impacts of budget reforms on national budget systems. The authors offer lessons for improving public budgeting practices worldwide. In Chapter 9, the authors present future directions for research in public budgeting. They discuss several important research topics, including gender-based budgeting and the budgetary impacts of environmental shocks and major crises like the COVID-19 pandemic. The authors recommend that future research in public budgeting should maintain an interdisciplinary perspective, take a forward-looking perspective, (3) foster an international perspective, and balance relevant theory with causal inference in research design and methods. The Handbook discusses government tax revenue management in Part IV. Chapter 10 presents the foundations of government taxation and revenue management. It focuses on five criteria for assessing government taxation and revenue management, namely efficiency, equity, adequacy, transparency, and feasibility. The chapter uses examples from the United States and other countries to discuss the different ways equity can be conceptualized, the ease of revenue administration, and revenue diversification and stability. Chapter 11 provides an intriguing discussion on tax revenue management and reform in developed and developing countries. It surveys best practices across national tax systems in developed and developing countries and presents lessons for improving the efficiency and effectiveness of revenue collection and enforcement in a digital era. Chapter 12 concludes this part with a discussion of

Introduction  xxv future directions for research in government taxation and revenue management. The chapter provides a critical review of strategies and indicators in government revenue management. It examines how popular strategies such as revenue diversification and volatility management can be misapplications of planning in the private sector that may not be suited for the public sector. It also suggests some indicators for evaluating the performance of revenue sources. Part V consists of two chapters on public expenditure management. Chapter 13 discusses the foundational theories and concepts in public expenditure management. It discusses these theories and concepts based on their focus on four different themes, namely macroeconomic performance, public economics, political systems, and budgetary targets. The chapter also discusses the challenges related to estimating expenditure needs and optimal allocation of government resources. Chapter 14 then presents future directions for research in public expenditure management. It discusses the new avenues in research using new sources of data, new empirical methods, and analyzing emerging budgetary challenges facing national governments, including climate change, demographic shifts, healthcare, income inequality, and infrastructure. In Part VI, the chapters examine public debt management. The authors of Chapter 15 present the theoretical foundations of subnational debt management. They discuss debt management and related concepts such as credit ratings, credit guarantees, and intergovernmental fiscal relations using examples from China, Korea, Mexico, and the United States. The authors also discuss potential pitfalls for public debt management when fiscal rules fail, or fiscal imbalances persist. Chapter 16 focuses on subnational government debt management and describes some emerging research issues that should engage the attention of scholars in the future. Specifically, the chapter highlights the need for an adequate framework to measure the credit risk of a municipal bond. It also explains the need for more research on the effect of underwriters’ market power on primary market municipal bond yields. Moreover, the chapter examines the impacts of the COVID-19 crisis and climate change on bond yields and government debt. Chapter 17 concludes this part with a focus on sovereign debt management and the future directions for research in this area. It explores the opportunities for future research focusing on sovereign debt sustainability assessment, policy options to address the risks of sovereign debt unsustainability, and the effective management of public debt to achieve long-term sustainability. Part VII covers the theoretical foundations of government procurement and contract management as well as the future directions for research in this area of public financial management. In Chapter 18, the authors discuss the “make or buy” decision in government contracting, explain the Principal Agent Theory and its application to contracting incentives, and explore the concept of “hollowing out” in the context of outsourcing procurement and contracting activities. In addition, the authors discuss contracting for complex services and how governments can design procurement structures to enhance efficiency and effectiveness while supporting businesses and organizations run by minorities, women, and other targeted groups. The future directions for research offered in Chapter 19 focus on three important gaps in the academic literature related to vendor solicitation, contract management, and contractor performance. Finally, Part VIII presents leading research on some of the emergent themes in public financial management in recent years. Chapter 20 focuses on behavioral public financial management and traces the historical development of the conceptual ideas in this field of study. The chapter examines the theoretical concepts on individual behavior, heuristics and biases

xxvi  Research handbook on public financial management and discusses their applications to a variety of topics, including tax compliance, tax salience, and willingness to pay for government services. This chapter concludes with a discussion of the opportunities for future research in behavioral public financial management. Chapter 21 is on infrastructure systems. The chapter presents new ideas for managing the public finance aspects of climate-resilient infrastructure systems. It explains the importance of building climate-resilient infrastructure systems and describes the public investment needs of these systems. The chapter also identifies emerging trends and future challenges in financing infrastructure systems to support resilience. Future directions for research on this topic are also discussed. Finally, Chapter 22 explores the issue of teaching public financial management to the next generation of scholars. The chapter provides an overview of public financial management courses taught in masters and doctoral programs in public administration and public policy. It also compares the expected learning outcomes with the resources available for teaching courses and suggests innovative pedagogical approaches to enhance learning outcomes for students.

REFERENCES Dzigbede, K. D. (2016). Whither are we bound? New insights on American economic policymaking. Policy Studies Journal, 44(S1), S14–S27. Finkler, S., Smith, D. and Calabrese, T. (2019). Financial Management for Public, Health, & Not-for-Profit Organizations, 6th edition. London: Sage. Hildreth, W. B. (1996). Financial management: A balancing act for local government chief financial officers. Public Administration Quarterly, 20(3), 320–342. Kioko, S. N., Marlowe, J., Matkin, D. S., Moody, M., Smith, D. L., and Zhao, Z. J. (2011). Why public financial management matters. Journal of Public Administration Research and Theory, 21(suppl_1), i113–i124. Maher, C. S., Hoang, T., and Hindery, A. (2020). Fiscal responses to COVID-19: Evidence from local governments and nonprofits. Public Administration Review, 80(4), 644–650. Miller, G. J. (1991). Government Financial Management Theory. New York: Marcel Dekker. Ross, J., Yan, W., and Johnson, C. (2015). The public financing of America’s largest cities: A study of city financial records in the wake of the great recession. Journal of Regional Science, 55(1), 113–138.

PART I THE CHANGING LANDSCAPE OF PUBLIC FINANCIAL MANAGEMENT

1. Foundations of public financial management: theories and concepts Robert S. Kravchuk

INTRODUCTION This chapter explores the antecedent and evolving foundations of public financial management as a self-aware academic discipline and field of professional practice. A critical observation is that the public sector pursues its objectives in concert with private actors, in markets that are largely operated as private institutions, albeit subject to public regulation. Financial interactions across sectors is therefore a vital concern of public finance theory and practice. Any such discussion must begin by recognizing and exploring the common foundations of public and private finance within the US mixed market economy. Our discussion will summarize their divergent concerns, and distinct approaches. For public and private finance may be said to be “similar in all unimportant respects” (with apologies to Wallace Sayre, 1958). In order to properly characterize recent developments in finance, and how they impact public finance specifically, we will need to take account of certain concepts and literature that have not heretofore been part of the traditional corpus of public financial management. We will argue that difficulties in the development of a clear and coherent theory of public financial management stem from deeper problems in conceptualizing the public and private sectors as separate and distinct realms. This author argues for an expansion in the scope of public finance to include concerns that reach into adjacent fields, including the conditions of money and credit open to governments, national monetary sovereignty, regional and local government subordination to national governments (even in federal systems), the effects of budget constraints across levels of government, and use of synthetic financial instruments as means to stretch, or otherwise overcome traditional budgetary limits.

CONCEPTUALIZING PUBLIC FINANCIAL MANAGEMENT “Public financial management lacks a coherent framework,” write two prominent authorities on the subject (Khan and Hildreth, 2004: ix). Most late twentieth-century approaches to conceptualizing the field of public financial management emphasize one or another aspect of the field’s diversity. In a review of the most prominent texts at the time, one authority (Miller, 1994) concluded that different ideational commitments had produced a broad assortment of competing viewpoints.1 Some well-regarded texts place the emphasis on functions and activities. As a prominent example, one classic text (Coe, 1989: 1; see also Coe, 2007: 1) conceives public financial management as a set of activities. This is also essentially the way in which another (Miller, 1991, 2012) defines the subject, albeit with a “twist”: public finance as largely a matter of social construction.2 Yet another text (Steiss, 1989: 2) notes that, “Financial management in the public sector borrows liberally from the tools and concepts of business 2

Foundations of public financial management  3 management.” In this regard, they note that many financial functions are common to both the public and private sectors (Steiss, 1989: 3–25; Coe, 2007: 3–6). There is a certain appeal to the activity-based approach taken by some, but their taxonomies fail to adequately distinguish that which is truly unique to public sector finance.3 One prominent authority (Frank, 2006) offers no definition of the field that a reader might readily discern. In a departure from prior discussions, one text (Reed and Swain, 1990: xi) emphasizes the public nature of the field, with a significant nod towards the nonprofit sector. This approach is more nuanced than others, in that, “careful consideration of public finance administration as a topic is necessary because it currently lacks any clear-cut technical or common-sense definition.” Thus, these authors eschew defining the field at all, preferring to spend as much space describing what public financial management is not, as on what it is. The discussion is advanced, however, by highlighting constitutional and other legal constraints, politics, public goods and other factors having a distinctly “public” character, as that term is understood within the American tradition. This Handbook assumes a more comprehensive perspective, defining public financial management as “the body of theories, concepts and practices that promote the efficient and effective use of financial resources to achieve an equitable, accountable, and sustainable public service.” This Handbook’s definition goes beyond the US context, to encompass public service financing in broad comparative perspective. What is interesting to the US-based finance professional, however, is that this definition contemplates all three major sets of values that characterize the modern American administrative state: the managerial values of efficiency, economy and effectiveness; the political values of representation, responsiveness and accountability; and the judicial values of equal protection of the laws, due process and protection of citizens’ substantive rights (Rosenbloom, 1983; Kravchuk, 1992).4 The overriding private sector value is efficiency, with other values assuming a more secondary role. Public sector finance must therefore embrace and serve a broader set of values than its private counterpart. This most basic difference is one from which other differences stem. Mainstream neoclassical economic theory focuses primarily on the effects that public finance activity has on private exchange and wealth, with distinct emphases on the patterns of public expenditure, the excess burden and deadweight loss derived from taxation, and the crowding out of private investment by public borrowing, among others. Discussion of these topics is beyond the remit of this chapter, which is more foundational in focus. We note only that these macro-financial concerns find expression in the received concepts and tools of fiscal administration that have come to dominate academic research and instruction, as well as professional practice. Examples are cost-effectiveness studies, benefit-cost analysis, program evaluation, optimal tax design, and the principles of sound finance to control public debt levels. Such tools and techniques are principally reflections of a given government’s awareness and management of its inherent fiscal constraints, as discussed below.

PUBLIC AND PRIVATE SECTORS It is vital at the outset to distinguish the public from the private in our discussion of financial principles, methods and practices. For while there is considerable overlap, important distinctions remain. A useful working conception of the public sector (i.e., nonbusiness activity) is provided by the Financial Accounting Standards Board (FASB). According to FASB Concepts

4  Research handbook on public financial management Statement No. 4 (1980: 1), the major distinguishing characteristics of nonbusiness organizations include prominent non-exchange transactions, absence of profit motives, and ambiguous ownership rights: (a) receipts of significant amounts of resources from resource providers who do not expect to receive either repayment or economic benefits proportionate to resources provided, (b) operating purposes that are primarily other than to provide goods or services at a profit or profit equivalent, and (c) [an] absence of defined ownership interests that can be sold, transferred, or redeemed, or that convey entitlement to a share of a residual distribution of resources in the event of liquidation of the organization.5

In the US “mixed market economy,” there have been historically significant proportions of both private and public sector activity (Samuelson, 1973: 41). The sectors have different concerns, which sometimes diverge. Considerable tension may, at times, be present. The objective of private firms is shareholder/owner wealth maximization; this involves optimizing the market value of the firm’s debt and equity securities, in terms of the mean and variance of their returns. By contrast, the objectives of public entities largely concern the provision of public services – especially those goods and services that cannot be provided in efficient quantities by markets – and correcting for certain market failures and externalities (Musgrave, 1959). The notion of public and private sectors having separate domains is not always as clear and workable in practice as it may appear in theory. In strictly theoretical terms, the conception that clear boundaries exist between the two is grounded in two unfortunate dichotomies. The first is the conceptual separation of politics as distinct from economics; the second is the view that human activity can be cleanly separated into public and private realms. Both are fraught with difficulties. Regarding the conceptual distinction between politics and economics, the political sphere concerns the organized, legitimate exercise of power through governmental institutions. Politics intimately concerns the relationship between states and citizens. Citizens generally are diverse in outlook, needs and desires, so that disagreement on policy matters is inevitable. Democratic governments ideally resolve policy disputes through representative institutions, wherein each person has the right to participate on the basis of their citizenship. This is considered to be a moral imperative. Citizens rarely participate directly in the details of policy making and administration, however; fiscal decision-making, for instance. Politics thus concerns the institutions of social choice through representative bodies that set broad policy goals. In the ideal, every citizen has an equal voice and influence. Concerning the economic realm, market participants are able to pursue their aspirations, needs and desires privately, through interactions with large numbers of others mediated by prices and signals that provide useful information about what may be the optimal allocation of the individual’s scarce resources. Market economies embrace certain foundational values, including personal liberty, individual sovereignty, and the security of one’s person and property. Each individual, however, has as many “votes” as they possess money to spend. Promotion of these values is held to increase market efficiency, which remains supreme. The two realms of politics and economics are thus viewed as largely separated, each with different concerns, emphasizing different sets of values. Essentially, what one may be unable to achieve through collective interaction in the political realm, one may pursue in the economic realm.

Foundations of public financial management  5 The two spheres define conceptually two realms of human activity and interaction in the modern mixed market economy. The second dichotomy, that between the public and the private, is based on the neoclassical theory of markets, where the private sector is held to be the sole source of value-added and wealth in society. In private markets, economic order emerges spontaneously from entrepreneurial efforts (Hayek, 1973, 1976, 1979). The public sector is regarded as either siphoning off private income and wealth, and therefore largely wasteful of economic resources, or at least not as efficient as private activity. Free market ideology does not see government as a source of much value to the society. In more extreme versions of the free market narrative, governments may become leviathans that, if left unchecked, will distort the natural state of markets (Buchanan, 1975). The private market realm is held to be sacrosanct; public bodies may intrude upon private market activity rarely, and then only with sound justification. Both dichotomies represent paradigm cases of dualistic reasoning, and their related fallacies (Lovejoy, 1930). The point is that modern society is an amalgam of roughly autonomous, but overlapping spheres of activity, some of it organized, some emerging spontaneously. Dualistic theories of public and private have limited practical usefulness in the world of public affairs. Understanding the relationships both between and within these dualisms reveals vast swathes of mixed activity: grey areas where public and private activity are mixed. The sometimes troubled interactions between and among them are reflections of a more general process of seeking their optimal combination. The separate but overlapping concerns of public and private finance may thus be viewed as reflecting the deeper tensions between the public and private sectors in a mixed market economy.

PUBLIC AND PRIVATE FINANCE Finance is central to the modern market economy. As the late Hyman Minsky (1967: 33) observed, “Capitalism is essentially a financial system, and the peculiar behavioral attributes of a capitalist economy center around the impact of finance upon system behavior.” Finance and credit have been employed in trade and commerce for millennia. Personal and commercial loans are mentioned in many ancient texts. Finance has helped to both meet one’s short-term liquidity needs, and to greatly expand commerce in the long run. In the modern era, financial markets have evolved, and now operate quite differently (Pistor, 2013). Multiple financing sources are available, and often several are used in combination. Each transaction, no matter how large, involves “making bets” on an inherently uncertain future; the outcomes are either risky or completely unknown. Both calculable risk and unmeasurable uncertainty are present, to one degree or another. They are reflections of the human condition. Such concerns obviously pertain across the sectors. The entire economic system is engaged in finance and financial processes, both the public and private sectors. Steiss is thus essentially correct in his observation that public and private finance share many concepts, methods and techniques between them. In the first instance is the so-called neoclassical survival constraint: organizations must remain solvent, in order to achieve fiscal sustainability. In practical terms, this requires that outlays be offset by revenues in the long run. The survival constraint is regarded as binding on both the public and the private sectors. It is the origin of the so-called household metaphor, which views government finances as if they

6  Research handbook on public financial management were a “family checkbook.” Public finance has largely adopted the private sector imperative that budgets be balanced in the long run, in present value terms. This is the guiding principle of “sound finance”: the government’s intertemporal budget constraint cannot be violated in the long run. (Fiscal prudence is another key principle; of which, more will be said, below.) Further, according to the requirement of Ricardian equivalence, all current debt is economically equivalent to the present value of future revenues (Barro, 1974).6 Since taxes are the main source of public revenues, all public debt represents anticipated future taxes, discounted at some appropriate interest rate. Insofar as it represents tax burdens imposed on future generations, the public debt must therefore be strictly constrained. In mainstream discussions of financial management, the principle of sound finance assumes a central place. This is certainly true of private organizations (households and firms), and subnational governments (states and localities), as well as many less-developed countries. However, monetarily-sovereign national governments have greater flexibility, and more fiscal options. In a recent article, Eric Tymoigne (2020: 49) summarizes the significance of monetary sovereignty: Monetary sovereignty means at its core that the government has control over the official monetary system of the country. Within contemporary governments, the fiscal and monetary powers have been assigned respectively to the national Treasury (and Congress) and the central bank so the implementation of monetary sovereignty involves a high degree of coordination between these two entities. This coordination ensures that the government can always finance its activities while keeping the interest rate on the public debt under control and maintaining the stability of the payment system.

Monetary and fiscal sovereignty have for millennia been attributes of the territorial sovereignty of states (Pistor, 2017). Monetarily-sovereign governments are those that possess the following attributes (Wray, 1998; Kravchuk, 2020). They: ● ● ● ● ●

issue and control their own currency; possess their own central bank; issue debt in their currency of choice; operate within a freely-floating exchange rate system; and have an open capital account with the rest of the world; there are minimal or zero currency and/or capital controls.

These attributes describe, in fairly precise terms, the US Federal Government, and the national governments of the United Kingdom, Canada, Japan, and – within the Eurozone – Germany (but not one of the other members of the European currency union).7 These and other countries can be arrayed along a spectrum, from more to less sovereign.8 It should be clear that no subnational, regional, or US state or local government can be monetarily sovereign. As currency users, rather than currency issuers, their fiscal options are greatly constrained (Kelton, 2020). For national governments that possess monetary sovereignty, the body of principles which are known collectively as “functional finance” may better describe the practical reality of fiscal management. Functional finance holds that there is no stable or necessary relationship between taxes and expenditures, even in the long run (Lerner, 1943, 1944). The fiscal turnout should be free to seek any level that is necessary to provide the private sector with the amount of liquid assets that it demands (Wray, 1998, 2015, 2018). It is obvious that sound finance and functional finance hold far different implications for the theory and practice of public finance than does the other. In order to reconcile these two principles within a unified and coherent

Foundations of public financial management  7 theory of public finance, it is imperative to make explicit the connections between finance and budgets. That will require a theory of budget constraints.

FINANCE AND THE THEORY OF BUDGET CONSTRAINTS Budget constraints may be either “hard,” in that they are difficult to overcome, or “soft,” and thus easy to work around. Budgetary “hardness” influences and conditions the level of a government’s expenditure potential. Borrowing capacity – the ability to spend beyond one’s current revenues – is dependent upon the general conditions of money and credit that confront a given government (McKinnon, 1992, 1994, 1997a, 1997b). Monetary and fiscal arrangements together determine the relative “hardness” of budgets. The received wisdom in mainstream economics is that a given government’s spending in the short run is constrained by its current tax revenue and other receipts, its access to credit (ability to incur debt), and the willingness of the public to accept ever larger amounts of “new money issue” (seen as a direct consequence of accumulating debt at levels beyond what taxpayers are willing to fund).9 Further, mainstream economists generally hold that budget constraints implicitly recycle income through the private sector via taxation and expenditure programs, both of which are inherently redistributive. Consequently, activist government policies are to be restrained by imposing greater budgetary “hardness”; the notion is that, the “harder” the budget constraint, the better. The basic requirements of a “hard” budget constraint are: 1. Limited borrowing. Borrowing is to be strictly confined to capital items. Borrowing to finance current expenditure on consumables is eschewed as efficiency-reducing.10 2. “Watertight” finances. Intergovernmental revenue sharing, grants and subventions and/ or intermingling of revenues with other governments’ revenues is either prohibited or must be insignificant.11 3. Open borders. There is free movement of people (labor) and capital across jurisdictional boundaries, without hindrance. 4. Intergovernmental competition. Competition among governmental jurisdictions for industry, labor, capital, tourism, etc. is unrestricted. Relatively few governments meet all of the requirements of a “hard” budget constraint; most subnational government budgets may be seen as “nearly-hard” in nature, however, with strictly limited access to alternative sources of liquid assets; others are “semi-soft” on a continuum.12 An important source of subnational fiscal transfers are grants and subventions from national budgets, which permit spending beyond a government’s current own-source revenues.13 Derived from the work of Kornai (1992), McKinnon (1992, 1994, 1997a, 1997b), Vickrey (1996), and Weingast (1995), “soft” budget constraints imply the absence of a credible threat of bankruptcy. Soft budgets are associated with both the direct and indirect availability of alternative means of financing expenditure (i.e., “backdoor,” off-budget, or shift-able expenditures or risk). Monetarily-sovereign governments among the advanced, industrialized countries face soft budget constraints. Monetary conditions since the 1980s have permitted such governments to access capital markets in ways that would have been unthinkable in the early twentieth century; specifically, to incur debt to finance both capital items and current consumption of goods and services. For instance, the US Federal Government has easy access

8  Research handbook on public financial management to national capital markets, but this hasn’t always been the case. By the mid-twentieth century, the American federal budget constraint had become considerably “soft.” Economist Randall Wray (1998: 138–139) explains that, The US abandoned the gold convertibility standard during the Great Depression, although it was restored internationally after World War II. However, at the end of the 1960s, and into the early 1970s, fears of a run on the US dollar led the federal government finally to abandon convertibility. Since that date, gold reserves could never again constrain deficit spending.

In 1929, on the eve of the stock market crash of that year, the US Government’s debt level was relatively small by contemporary standards – about 16.3 percent of GDP. Until that time, the national debt would ebb and flow, mainly in response to wartime finance. Once wars ended, however, the debt would fall as a percentage of GDP. Until the depression decade of the 1930s, the Federal Government exhibited behavior consistent with a hard budget constraint. Savage (1990) and White and Wildavsky (1991) attribute the shift in the Federal Government’s fiscal stance since mid-century to the political erosion of the “balanced budget norm.” However, it is much more likely that President Roosevelt’s abandonment of the gold standard in 1933 had more to do with the softening of the federal budget constraint.14 The fiscal implications of a strict gold standard are that federal spending would be constrained by the amount of gold that the US Federal Government could redeem. The gold standard would therefore operate much like a hard balanced budget amendment in the long run – and one that could not be so easily side-stepped. Concerns over the persistent gold drain and the perceived decline in US global competitiveness prompted President Nixon to close the gold window in August 1971, and to devalue the dollar against other major currencies. Thus a new regime of floating exchange rates was ushered in, and with it a dramatic softening of the previous monetary restraint on US fiscal policy. From the historical record, economist Randall Wray concludes that “the universal abandonment of the gold standard by all of the large economies has eliminated all rational barriers to deficit spending” (1998: 124). Owing to the dollar’s role and history as the primary international reserve currency, and the economies of scale necessary to achieve this status, the US dollar is dominant in international debt transactions. This dominance confers on the US the privilege of always being able to issue debt denominated in its own currency. The US therefore borrows as readily abroad as it does domestically. There is therefore little that international investors can do to impose fiscal discipline on the US Federal Government. The US Government possesses its own central bank, controls the value of its own money, and can borrow virtually unlimited sums denominated in its own currency. These combined features mean that the US Federal Government faces what can only be described as an “ultra-soft” budget constraint. The US Government cannot be compelled to default against its will.15 This has enabled the Federal Government to deficit spend, virtually at will, on the social programs that have been at the source of its structural deficits. Thus the US Federal Government’s increasingly soft budget constraint since the early 1970s has enabled the United States to escape the discipline of the capital markets, and to issue debt as necessary to meet its policy objectives (Fullwiler, 2020). The important point for present purposes is that monetary sovereignty entails a greatly expanded set of fiscal options, or fiscal policy space. Capital markets remain strictly binding on state and local governments, however. The main reason is that budget constraints on US state and local governments remain relatively “hard.” For such governments, increasing debt levels, beyond some threshold, brings increasing risk

Foundations of public financial management  9 of default. States and localities generally are compelled by bond investors to strictly limit debt financing to capital projects, ensuring a degree of investor safety. In macro terms, states and local governments are not monetarily sovereign. Only the US national government has that privilege.

SYNTHETIC FINANCE: ESCAPE FROM FISCAL CONSTRAINTS Both private and public actors may be expected to seek means to escape their fiscal constraints. “Doing more with less” – or better, yet – “doing more with more,” has long been considered desirable, regardless of sector. We argued above that the relative “softness” of a budget constraint will be a function of the conditions of money and credit that an economic actor confronts. In this vein, the emergence of financial engineering – synthetic finance – has enabled actors to spread risk, reallocate burdens, and otherwise work to overcome their fiscal constraints (Lozano, 2014). The profitable opportunities presented by derivative securities generally have been more commonly pursued in the private sector, however. This is principally due to the public ethic of prudence in financial management, which places the public trust, in the form of wise stewardship of public monies, at the core of its financial practice. It is considered to be an inviolable ethical imperative. This is not to say that securitization of cash settlements has not been of benefit to public entities. (The securitization by state governments of the tobacco settlement monies is a prominent example.) Rather, the single-minded pursuit of monetary returns is not an attribute that fits well with the mission of public service organizations. This highlights an important distinction between public and private finance that is well worth further discussion. In a short 1970 University of Chicago working paper of singular genius, Fischer Black argued for the theoretical and practical separation of the risk and return of financial assets. In “Fundamentals of Liquidity,” Black essentially established the principle that, owing to the possibility of stripping away the risk from financial assets via derivative contracts, a liquidity premium need no longer be a component of total asset returns. Indeed, informed and skillful investors can structure their finances in such a manner as to render much more definite their cash flows, and the precise form in which they will receive them. Hence was born a significant step forward in the management of financial risk; new forms of insurance against adverse financial movements became possible.16 Along the way, finance itself has been rendered a mere commodity, to be bought, sold and traded as any other. With respect to private finance, the ability to pass risks on to mature and informed third parties (“counterparties”) who are willing to bear them – at a price – permitted a considerable degree of value enhancement. These possibilities were precisely those that former Federal Reserve Chair Alan Greenspan lauded prior to the onset of the Global Financial Crisis (GFC) in 2007–2008.17 The GFC demonstrated the “double-edged” nature of synthetic finance, however: where employed as insurance against adverse future events (such as inconvenient reversals in interest rates), derivative contracts can add value through loss protection; but where employed ambitiously and aggressively in the pursuit of financial returns, extensive use of derivative contracts can induce serious systemic crises, such as became manifest in 2008. A complex web of positive feedbacks may emerge, which can accelerate a financial contagion in response to some triggering event, which can be trivial in itself. Head-spinning crises of

10  Research handbook on public financial management the variety experienced a decade ago become possible and, some would argue, likely (Keen, 2017). The commodification of finance has not been of one-sided benefit to society.

COMMODIFICATION OF FINANCE Commodification has brought with it the financialization of the US economy (Krippner, 2005; Palley, 2007, Orhangazi, 2008, Foroohar, 2016). The significance of financialization is that the tenure of debt settlement can now extend far beyond the immediate present (through either barter or cash settlement). Debt actually can become virtually limitless in duration. In terms of prudent public finance, it is anathema to burden taxpayers with debt service for the acquisition of commodities or services with useful lives, or service benefits, that are greatly exceeded by the terms of the associated debts. Viewed in this way, financialization of the economy appears as a perversion of finance; part of its “dark side” (Shiller, 2012). It has the effect of placing financial activity, as opposed to productive activity (i.e., provision of goods and services), at the heart of economic activity. This has made liquidity provision – the fundamental requirement of a market built on promises – the very foundation of economic life (Culham, 2018: 232–234; 2020). Finance, rather than output or service activity, reigns supreme. The means of capitalism has become its end (Amato and Fantacci, 2012, 2014). The costs of this inversion of means and ends may be quite large. Portfolios of standard, generic financial securities, and their derivative avatars, which have been synthetically separated from exposure to the idiosyncratic operating and financial risks of their issuers, become increasingly difficult for investors to understand, and to price properly. Black would argue that investors do not need to understand the risks, for there is no good reason for anyone to bear unwanted risk. The presumption is that all risk can be engineered away, shifted, or otherwise transferred via insurance. Securities stripped of their operating and financial risks are divorced from the essential character and purposes of the issuing body. As the relationship between debtors and creditors is severed, financial commodification intensifies, as only the generic attributes of securities, such as the expected return, are considered to be relevant. This process holds great potential to enhance efficiency, to be sure. But it also involves the danger that originators of financial contracts become less careful when underwriting risk at the source. If originators can ultimately slough risk off onto secondary market participants, a process akin to “beggar thy neighbor” may set in. Caveat emptor! In “commodified” finance, investors may have little or no “skin in the game”; they would share little or nothing of the operating or financial risk of the issuer. Indeed, they wouldn’t have to care much about the issuer’s circumstances at all. Black’s principle means that they do not need to be concerned, insofar as they can be completely “immunized” against the issuers’ risks. In theory, therefore, synthetic securities can be engineered to provide a nearly “pure” return; in practice, however, they are hardly as risk-free as their proponents argue. For, a complex web of financial derivatives actually can increase systemic risk, as the experience of 2007–2008 compellingly demonstrates. Columbia University Law Professor Katharina Pistor (2013, 2019) asks that we consider an alternative conception of financial markets, including derivative markets, and the returns that accrue to such securities. She notes that all financial markets are legally created and sustained. “Apart from state issued money,” she writes, “every financial asset is a creature of contract law” (2013: 3). Pistor counsels that we should not perceive modern financial markets as the

Foundations of public financial management  11 products of some spontaneously-ordered process of social exchange. Rather, they are products of human design, cast in the image and structure provided for by law, that most powerful source of human artifice, and expression of state sovereignty. The law has transformed standard finance and generic debt instruments into the current configuration of contemporary global finance, complete with the synthetic means to reduce risk, as well as to concentrate risk in the hands of the unsuspecting. Certainly, the law has enabled financial market independence, reduced costs of market transactions, and reduced informational asymmetries, especially as they pertain to unsystematic factors (idiosyncratic factors pertaining to individual issuers). But systemic elements remain; there is evidence that systematic risk has intensified (IMF, 2009). System-wide risks have also been exacerbated by the COVID-19 global pandemic (IMF, 2020). The market environment has become more volatile. Deriving mainly from systemic elements, uncertainty in understanding and pricing both standard and synthetic securities has brought with it considerable liquidity volatility. With increased volatility has come greater government intervention in financial markets; in the case of the United States, transforming the Federal Reserve’s traditional role from “lender of last resort,” to that of “securities dealer of last resort” (Mehrling, 2011). It is, perhaps, ironic that the freedom and security of contract that has enabled expansion of global finance should have made markets more dependent on state intervention, rather than less. It is clear by 2021, however, that the combined effects of uncertainty and liquidity volatility have made markets less stable. This has brought in its wake efforts to shift risks onto others. With the onset of more sophisticated financial engineering, system stability has been eroded. Here lies the basis for the increased regulation of synthetic asset creation. The important point for present purposes is that traditional, standard, generic public sector securities overwhelmingly retain their issuer’s character – the idiosyncratic, issuer-specific operating and financial characteristics, with the generic security (say, a bond) bearing risks that are implicit to the issuer. This aspect of public security issues is at the origin and purpose of the principle of prudence. This tenet of public financial management is fundamental to the theory and practice of sound finance, and is intended to protect the interests of issuers, investors, and taxpayers alike. Where such tenets are violated, prominent financial scandals have emerged. Examples of default were noticeable across the United States (Rassel and Kravchuk, 2012). The much publicized bankruptcy of Vallejo, California in 2008 was the largest municipal default in fourteen years. It is instructive to note that the most significant defaults have been on special obligation bonds and variable rate debt, which involved placing bets on uncertain revenue streams and the movement of interest rates. Many municipal defaults involved land development and facilities projects. Jefferson County, Alabama from March 2008 to June 2009, was unable to pay even the interest cost on its $3.2 billion of sewer bonds (Reuters, 2011). For many projects, investors settled for a mere fraction of their original investment. One $5.8 million Kansas Development Finance Authority issue involving apartment buildings, recovered 87.5 cents on the dollar, not a large loss, but a loss. In another instance, certificates of participation (COPs) sold by Arvin, California to build a $7.8 million golf course recovered only 28 cents. Investors in a taxable $690,000 Bell County, Texas nursing home project lost their entire investment (Mysak, 2010). Recent research on US state government use of financial derivatives, however, reveals that relatively few states employ interest rates swaps, for instance, and those only for the very

12  Research handbook on public financial management limited purpose of insuring against adverse movements in interest rates (Luby and Kravchuk, 2013). It would seem that the principle of fiscal prudence is deeply-rooted in the American public sector. However, fiscal prudence is a matter of ethical choice, of policy, and not necessarily one of law. To avoid repeating the prominent financial missteps of the recent past, vigilance will be required on the part of citizens and financial watchdog agencies.

CONCLUSION This chapter has explored the antecedent and evolving foundations of public financial management as a self-aware professional area of practice and academic discipline. It began by exploring the common foundations of public and private finance within the US mixed market economy, but quickly moved on to a more thorough discussion of their divergent concerns. A critical observation was that the public sector pursues its objectives in concert with private actors, in markets that are largely operated as private institutions, albeit subject to public regulation. Financial interaction across sectors is a critical concern of public finance theory and practice. Mainstream neoclassical and general equilibrium theory thus focuses primarily on the effects of public finance on private exchange and wealth, with distinct emphases on the returns from public expenditure, the excess burden and deadweight loss due to taxation, and crowding out of private investment by public borrowing, among others. These macro-financial concerns find expression in the tools and concepts of fiscal administration at the more micro-levels of government fiscal operations. Examples are cost-effectiveness studies, benefit-cost analysis, program evaluation, proper tax design, and control of public debt levels. Such tools and techniques are employed principally by governments to remain within their inherent fiscal constraints. We noted that neither the private nor the public sector are immune from the propensity to escape their fiscal constraints. The relative “softness” of an actor’s budget constraint is a function of the conditions of money and credit that it confronts. In this vein, the emergence of financial engineering as a prominent subfield within finance, and the innovative financial products that have accompanied its emergence – principally, financial derivatives and other products of synthetic finance – have enabled actors to spread, allocate, and work to overcome their fiscal constraints. Synthetic financial products are double-edged, however, giving rise to the possibility of systemic crises, such as the snowballing of minor issues into major avalanches as a consequence of positive feedback effects. The use of synthetic finance, as opposed to standard finance, differs to some considerable extent as between the public and private sectors, owing principally to their divergent objectives and values. Public financial management, in theory and practice, continues to embrace the values of soundness and prudence that have provided stability and balance for many decades. The values of sound finance and prudence in the conduct of government finance are therefore likely to remain at the core of public financial management in the foreseeable future.

Foundations of public financial management  13

NOTES 1.

2. 3.

4.

5.

6.

7.

8.

9.

In a subsequent exchange, Miller (1996), and two others (Reed and Swain, 1996) differed concerning the marketing of different approaches to different segments of the textbook market. Miller’s point, in this writer’s opinion, was the stronger one: It matters a great deal what we teach the next generation of financial managers, and how we teach it. This is most likely due to Miller’s (1991, 2012) obvious interest in phenomenology. To be fair, Steiss (1989: 2) does note that, “The [inter-sectoral] transfer of techniques cannot be complete, however, because of the basic nature of services provided by government,” especially as regards public safety and the common good. The basic criticism stands, however, insofar as Steiss, Coe and others fail to distinguish more explicitly between the public and private sectors as domains of social activity. A careful reading of nearly any classic US textbook reveals how these cherished values of American governance and public administration are reflected in the theory and practice of public financial management. For instance, Steiss (1989) conceives of successful financial management in terms of its effectiveness: “In the public sector in particular, the effectiveness of [financial management] must be measured by the results achieved and by the people served; that is, in terms of performance.” The notion of “performance suggests a melding of the basic management objectives of efficiency and effectiveness. In this context, efficiency can be equated with doing things right, whereas effectiveness involves doing the right things” (1989: v). Steiss explicitly links effectiveness to responsiveness, as “the time required to make critical adjustments when things go wrong.” In the case of public entities, to this list we may add the sovereign nature of state action, as well as the state monopoly on legitimate coercion and violence. In this vein, taxation is to be regarded as the exercise by a government of its legitimate sovereign powers to compel payment for government services from those who would otherwise choose not to contribute. Thus conceived, enforced taxation overcomes the collective action problem generally associated with the financing of public goods and services (Olson, 1965). More precisely, the Ricardo Theorem holds that citizens are forward-looking, present-value discounters, and so will work to internalize the government’s own budget constraint (the upper limit on tolerable taxation) when making their future consumption decisions. This implies that, for a given level and pattern of government spending, the method of financing expenditure does not affect agents’ consumption decisions, since governments have the choice of either taxing now, or taxing later. An important macroeconomic implication is that such knowledge on part of taxpayers will negate government efforts to stimulate demand via spending; that is, the government spending would not change aggregate demand. Apparently, David Ricardo himself did not believe that the concept had any practical effect! (see Ricardo, 1888). He argued, instead, that taxpayers do not evaluate taxes with an eye to the future, since government policies are changeable. In particular, taxpayers suffer from recency bias, and so take a myopic view of the tax path, changing their expectations about future tax burdens only adaptively, in response to events as they occur. (For a full and stimulating discussion, see Churchman, 2001.) The basic problem with the Eurozone is that it lacks a central budget. There is no known example in history of a monetary union surviving over the long haul that was not also a fiscal union. The Euro member states are therefore in a very tough bind: they are users of a “foreign” currency, and thus subject to a hard budget constraint. The problem stems from the financial architecture of the Euro area, the limited powers of the ECB, and the continuation of member states’ responsibility for their own fiscal affairs, and debts. (See also Bell and Nell, 2003.) The United States is unique in possessing the world’s only truly international reserve currency, which confers a considerable advantage. But the reserve status of the US dollar is not the source of American monetary sovereignty; rather, America’s preeminent monetary sovereignty is the basis of the dollar’s international status. See, for example, Tcherneva (2016), who ranks modern monetary regimes along a six-level scale. Operationally, modern governments, such as the US Federal Government, do not generally “spend money into circulation.” Rather, they will issue currency and coins only to meet the demand which may be generated when households and firms convert bank deposits into cash. The money that is created as the US Government spends consists today of bank reserves, in the form of private bank

14  Research handbook on public financial management

10. 11.

12.

13.

14.

15. 16. 17.

deposits at the Federal Reserve. These exist mainly in electronic form. Such deposits are functionally equivalent to money, insofar as they are used by the Fed to settle interbank accounts, most of which arise when households’ and firms’ transactions are settled between them. Just as is the case with paper currency and coins, bank reserves are liabilities of the Federal Reserve, and are denominated in the official money of account. In the United States, these are dollars issued in the form of Federal Reserve Notes. Reserves are created when, for instance, the US Treasury expends funds. (In 2009, 2010, 2013, and again in 2020, the Federal Reserve purchased massive amounts of outstanding Treasury securities and other financial assets as means to infuse liquidity into the economy. This served as a non-traditional form of bank reserve creation, known popularly as “quantitative easing.”) Self-funded (sometimes called “self-liquidating”) capital or current account items may be exceptions, however, subject to severe restrictions. This requirement presumes that there is a preexisting optimal coincidence of the benefit area (the geographic extent of the benefits of a given governmental program) with the tax area of the jurisdiction that provides the program (Oates, 1972). If the two do not coincide, then some amount of equalization funding from above, or horizontal cross-subsidies from peer governments may be necessary. If the extent of such cross-subsidization (either from above, or laterally) is significant, then there may exist a prima facie case for merging political units, insofar as at least one government’s budget is “soft,” and can be “hardened” through combination. An important, and often overlooked aspect of hard budgets is that they constrain subnational governments, placing them in competition with one another for firms, jobs, labor talent, and economic development, generally, with the effect of preserving the citizens’ economic rights and political liberties (Weingast, 1995; McKinnon, 1997a, 1997b). Wray suggests that, owing to its greater fiscal capacity, the US Federal Government, in consequence of its monetary sovereignty, should equalize fiscal resources per capita across the states, in order to provide greater equality in budgetary capacity, especially in regions where it is most needed. Obviously, more research and modeling of this intriguing idea are necessary. President Roosevelt took the US off the gold standard in order to avoid the worsening debt-deflation that held the economy in its grip at that time. By so doing, the president effectively relaxed the US federal borrowing constraint, and more or less permanently loosened the US Government’s budget constraint, for no longer would the US gold supply place limits on its available fiscal policy space. See Wray (2015: 158–192). See also note 15. Some authorities regard FDR’s action as a de facto default on the national debt (Edwards, 2018). Note that this does not mean that the US Government would not de facto default by inflating the currency, or default through policy mistakes. The point is that involuntary default is not currently a realistic possibility. For an excellent in-depth discussion of Fischer Black and his contributions to modern finance, see Perry Mehrling’s masterful intellectual biography of the man (2005). Greenspan later changed his views, admitting to a “fundamental flaw” in his model of how markets worked, in testimony before the Financial Crisis Inquiry Commission (April 7, 2010). In his subsequent book (2013), he attempted to work out a new economic theory that would account for the kind of meltdown that occurred in 2008.

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Foundations of public financial management  15 Black, F. (1970). “Fundamentals of liquidity.” Graduate School of Business, University of Chicago. http://​www​.rasmusen​.org/​special/​black/​Funda​mentalsofL​iquidity70​.pdf. Accessed July 16, 2021. Buchanan, J. M. (1975). The Limits of Liberty: Between Anarchy and Leviathan. Chicago: University of Chicago Press. Churchman, N. (2001). David Ricardo on Public Debt. New York: Palgrave Macmillan. Coe, C. K. (1989). Public Financial Management. Englewood Cliffs, NJ: Prentice-Hall. Coe, C. K. (2007). Governmental and Nonprofit Financial Management. Vienna, VA: Management Concepts. Culham, J. (2018). “A conceptual framework for a theory of liquidity.” PhD thesis, Federation University Australia, Ballarat, Victoria. https://​researchonline​.federation​.edu​.au/​vital/​access/​manager/​ Repository/​vital:​13283. Accessed July 21, 2021. Culham, J (2020). “A taxonomy of liquidity.” International Journal of Political Economy 49(3): 188–202. Edwards, S. (2018). American Default: The Untold Story of FDR, the Supreme Court, and the Battle Over Gold. Princeton, NJ: Princeton University Press. Financial Accounting Standards Board (1980). “Objectives of financial reporting by nonbusiness organizations.” FASB Concept Statement No. 4. Norwalk, CT: Financial Accounting Standards Board, December. Foroohar, R. (2016). Makers and Takers: The Rise of Finance and the Fall of American Business. New York: Crown/Archetype. Frank, H. A. (ed.) (2006). Public Financial Management. Boca Raton, FL: CRC Press. Fullwiler, S. (2020). “When the interest rate on the national debt is a policy variable (and ‘printing money’ does not apply).” Public Budgeting & Finance 40(3): 72–94. Greenspan, A. (2013). The Map and the Territory: Risk, Human Nature, and the Future of Forecasting. New York: Penguin. Hayek, F. (1973, 1976, 1979). Law, Legislation, and Liberty, 3 vols. Chicago: University of Chicago Press. International Monetary Fund (2009). Global Financial Stability Report: Responding to the Financial Crisis and Measuring Systemic Risks. Washington, DC: IMF. https://​www​.imf​.org/​en/​Publications/​ GFSR/​Issues/​2016/​12/​31/​Global​-Financial​-Stability​-Report​-April​-2009​-Responding​-to​-the​ -Financial​-Crisis​-and​-22583. Accessed July 22, 2021. International Monetary Fund (2020). Global Financial Stability Report: Markets in the Time of COVID-19. Washington, DC: IMF. Keen, S. (2017). Can We Avoid Another Financial Crisis? (The Future of Capitalism). Cambridge: Polity Press. Kelton, S. (2020). The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. New York: Public Affairs Press. Khan, A. and Hildreth, W. B. (eds) (2004). Financial Management Theory in the Public Sector. Westport, CT and London: Praeger Publishers. Kornai, J. (1992). The Socialist System: The Political Economy of Communism. Princeton, NJ: Princeton University Press. Kravchuk, R. S. (1992). “Liberalism and the administrative state.” Public Administration Review 52: 374–379. Kravchuk, R. S. (2020). “Post-Keynesian public budgeting & finance: Assessing contributions from modern monetary theory.” Public Budgeting & Finance 40(3): 95–123. Krippner, G. R. (2005). “The financialization of the American economy.” Socio-Economic Review 3: 173–208. Lerner, A. P. (1943). “Functional finance and the federal debt.” Social Research 10(1): 38–51. Lerner, A. P. (1944). The Economics of Control: Principles of Welfare Economics. New York: Macmillan. Lovejoy, A. O. (1930). The Revolt Against Dualism: An Inquiry Concerning the Existence of Ideas. Chicago: Open Court Publishing. Lozano, B. (2014). Of Synthetic Finance. London and New York: Routledge.

16  Research handbook on public financial management Luby, M. J. and Kravchuk, R. S. (2013). “An historical analysis of the use of debt-related derivatives by state governments in the context of the Great Recession.” Journal of Public Budgeting, Accounting & Financial Management 25(2): 276–310. McKinnon, R. I. (1992). The Order of Economic Liberalization. Baltimore: Johns Hopkins University Press. McKinnon, R. I. (1994). “Market-preserving fiscal federalism: The conditions of money and credit.” www​ .scribd​ Ohlin Lecture, Stockholm School of Economics. Unpublished manuscript. https://​ .com/​doc/​252303343/​Market​-Preserving​-Fiscal​-Federalism​-The​-Conditions​-of​-Money​-and​-Credit. Accessed July 13, 2021. McKinnon, R. I. (1997a). “Market-preserving fiscal federalism in the American Monetary Union.” In M. I. Blejer and T. Ter-Minassian (eds), Macroeconomic Dimensions of Public Finance: Essays in Honor of Vito Tanzi. London and New York: Routledge, pp. 73–93. McKinnon, R. I. (1997b). “The logic of market-preserving federalism.” Virginia Law Review, Symposium: The Allocation of Government Authority 83(7): 1573–1580. Mehrling, P. (2005). Fischer Black and the Revolutionary Idea of Finance. New York: John Wiley & Sons. Mehrling, P. (2011). The New Lombard Street: How the Fed Became the Dealer of Last Resort. Princeton, NJ: Princeton University Press. Miller, G. J. (1991). Government Financial Management Theory. New York: Marcel Dekker. Miller, G. J. (1994). “What is financial management? Are we inventing a new field here?” Public Administration Review 54(2): 209–213. Miller, G. J. (1996). “Reply to Reed and Swain.” Public Administration Review 56(6): 616–617. Miller, G. J. (2012). Government Budgeting and Financial Management in Practice: Logics to Make Sense of Ambiguity. Boca Raton, FL: CRC Press. Minsky, H. P. (1967) “Financial intermediation in the money and capital markets.” In G. Pontecorvo, R. Shay, and A. Hart (eds), Issues in Banking and Monetary Analysis. New York: Holt, Rinehart, & Winston, pp. 33–56. Musgrave, R. (1959). The Theory of Public Finance: A Study in Public Economy. New York: McGraw-Hill. Mysak, J. (2010). “Bond default is about too much debt, too little time.” Bloomberg.com, January 27. https://​www​.bloomberg​.com/​news/​articles/​2010–07–21/​bond​-default​-means​-too​-much​-debt​-too​ -little​-time​-commentary​-by​-joe​-mysak. Accessed January 15, 2022. Oates, W. E. (1972). Fiscal Federalism. New York: Harcourt Brace Jovanovich. Olson, M. (1965). The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge, MA: Harvard University Press. Orhangazi, Ö. (2008). Financialization and the US Economy. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing.. Palley, T. I. (2007). “Financialization: What it is and why it matters.” Working Paper 525. Levy Economics Institute of Bard College. https://​www​.levyinstitute​.org/​pubs/​wp​_525​.pdf. Accessed July 21, 2021. Pistor, K. (2013). “The state, the market and rule of law: A restatement.” Paper presented at the INET Annual Conference, Hong Kong, April. Pistor, K. (2017). “From territorial to monetary sovereignty.” Theoretical Inquiries in Law 18: 491–517. https://​scholarship​.law​.columbia​.edu/​faculty​_scholarship/​2279. Accessed July 16, 2021. Pistor, K. (2019). The Code of Capital: How the Law Creates Wealth and Inequality. Princeton, NJ: Princeton University Press. Rassel, G. and Kravchuk, R. S. (2012). “Good debt, gone bad: The 2007–09 crisis in municipal debt markets.” In J. Justice, H. Levine, and M. Scorsone (eds), Handbook of Fiscal Health. New York: Jones & Bartlett, pp. 505–533. Reed, B. J. and Swain, J. W. (1990). Public Finance Administration. Englewood Cliffs, NJ: Prentice-Hall. Reed, B. J. and Swain, J. W. (1996). “Response to Gerald Miller’s review of financial management texts.” Public Administration Review 56(6): 615. Reuters (2011). “Factbox: Timeline on debt crisis in Alabama’s Jefferson County.” July 28. https://​ www​.reuters​.com/​article/​us​-usa​-alabama​-jeffersoncounty​-factbox/​factbox​-timeline​-on​-debt​-crisis​-in​ -alabamas​-jefferson​-county​-i​dUSTRE76R4MT20110728. Accessed January 15, 2022.

Foundations of public financial management  17 Ricardo, D. (1888). “Essay on the funding system.” In The Works of David Ricardo. With a Notice of the Life and Writings of the Author, ed. J. R. McCulloch. London: John Murray. Rosenbloom, D. H. (1983). “Public administrative theory and the separation of powers.” Public Administration Review 43: 219–227. Samuelson, P. A. (1973). Economics, 9th ed. New York: McGraw-Hill. Savage, J. (1990). Balanced Budgets and American Politics. Ithaca, NY: Cornell University Press. Sayre, W. (1958). “Premises of public administration: Past and emerging.” Public Administration Review 18(2): 102–105. Shiller, R. J. (2012). Finance and the Good Society. Princeton, NJ: Princeton University Press. Steiss, A. W. (1989). Financial Management in Public Organizations. Pacific Grove, CA: Brooks/Cole Publishing. Tcherneva, P. R. (2016). “Money, power, and monetary regimes.” Levy Economics Institute of Bard College. Working Paper No. 861. http://​www​.levyinstitute​.org/​publications/​money​-power​-and​ -monetary​-regimes. Accessed July 14, 2021. Tymoigne, E. (2020). “Monetary sovereignty: Nature, implementation, and implications.” Public Budgeting & Finance 40(3): 49–71. Vickrey, W. (1996). “Fifteen fatal fallacies of financial fundamentalism: A disquisition on demand side economics.” Unpublished typescript. October 5. http://​www​.columbia​.edu/​dlc/​wp/​econ/​vickrey​.html. Accessed July 13, 2021. Weingast, B. R. (1995). “The economic role of political institutions: Market-preserving federalism and economic development.” Journal of Law, Economics & Organization 11(1): 1–31. White, J. and Wildavsky, A. (1991). The Deficit and the Public Interest: The Search for Responsible Budgeting in the 1980s. Berkeley, CA: University of California Press. Wray, R. L. (1998). Understanding Modern Money: The Key to Full Employment and Price Stability. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Wray, L. R. (2015). Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems, 2nd ed. New York: Palgrave Macmillan. Wray, L. R. (2018). “Functional finance: A comparison of the evolution of the positions of Hyman Minsky and Abba Lerner.” Economics Working Paper Archive wp_900, Levy Economics Institute of Bard College. http://​www​.levyinstitute​.org/​pubs/​wp​_900​.pdf. Accessed November 17, 2019.

2. Managing public finances during major crises Rahul Pathak, Justina Jose and Komla D. Dzigbede

INTRODUCTION The world has experienced many crises since the beginning of the twenty-first century. Countries have scrambled to adjust to the impacts of financial, climate-related, military, political, humanitarian, and public health crises. A crisis may be concentrated in a particular country, but the interconnected nature of the global economy leads to the spread of its impacts across many countries. The most recent example is the COVID-19 virus, which was first identified in Wuhan, China but soon spread globally, bringing the economy of almost 223 countries to a standstill. The COVID-19 pandemic typifies a major crisis and wicked problem in public policy (Schiefloe, 2021). Wicked policy problems have no proven solutions, rapidly spin out of control, do not allow enough time for traditional problem-solving processes, and require new strategies and policy interventions that can have incalculable and irreversible consequences (Rittel and Webber, 1973; Levin et al., 2012). Major global crises, like the COVID-19 pandemic, have spawned a significant amount of research on the economic impacts of crises in national economies as well as the implications of government responses to the crises. There are three major streams of research on financial and economic crises. The first set of studies identifies different economic and financial crises, their causes, and the impacts on economic output (Bernanke, 1983; Bordo et al., 2001; Kaminsky and Reinhart, 1999). The second stream of research focuses on the reasons for governments’ policy choices and the extent to which economic recovery differs across countries depending on how each government responds to the crisis in their economy (e.g., Romer and Romer, 2018). The third stream focuses on various fiscal and monetary policy tools that governments have used in their responses to major crises as well as the effectiveness of these tools (see Auerbach, 2012). These strands of research present several empirical challenges because each country is different and every major crisis has unique characteristics; therefore, the findings from these studies usually lack external validity. This is true for even major events like the Great Recession (2007–2009), which affected countries like the US and Greece much differently than it affected other countries like Australia and South Korea. On the contrary, the COVID-19 pandemic was a unique global event that affected every country almost simultaneously. The crisis and its management, therefore, present an opportunity to systematically examine the various ways that governments around the world responded to the crisis and the specific policy tools they deployed to manage the economic impacts of the crisis. In addition, the differences in governments’ crisis response efforts make it possible to develop a typology of policy tools to understand the policy tools that governments commonly used in low-, middle-, and high-income countries to manage the economic effects of the crisis. Such a typology of policy tool usage can inform government decision-making about tool choice during major crises in countries with similar economic capacities and levels of economic development. 18

Managing public finances during major crises  19 Research shows that governments in the United States and Europe relied on a variety of policy tools in the aftermath of the Great Recession, including temporary tax cuts, transfers and grants, and government purchases (Auerbach, 2012). These measures were expected to influence household consumption and business investment and boost aggregate demand in the longer term. However, in the case of the COVID-19 pandemic, economic activity came to an instant halt, and it required governments to respond promptly with policy strategies that continue to raise concerns about their long-term implications. Accordingly, the Organisation for Economic Co-operation and Development (OECD) recommended that governments’ fiscal responses should aim to stabilize the economy, and not only initiate rapid recovery, but also support long-term sustainable recovery. It is critical for government policy strategies to preserve the drivers of long-term growth in the economy and support the shift toward a stronger economy in the aftermath of a major crisis. When governments’ policy responses to major crises do not consider the long-term perspective, it can push their economies into an era of public spending cutbacks and fiscal austerity. In this context, this chapter reviews the global responses to the COVID-19 pandemic across low-, middle-, and high-income countries using the International Monetary Fund’s (IMF) policy response data. The chapter examines various policy tools that countries deployed around the world to deal with the economic ramifications of the crisis. The analysis considers the type of policy tool (e.g., monetary versus fiscal policy), the function of the policy tool (e.g., short-term versus long-term measure), the tool’s related instruments (e.g., waivers and deferrals versus targeted spending) and the extent of usage of the tool (e.g., low, medium, or high usage). This typology of policy tool usage offers a useful framework for government policymakers in low-, middle, and high-income countries to understand the commonly used tools for managing the immediate and long-term impacts of major crises in national economies. Finally, the chapter focuses on economic recovery from the COVID-19 crisis and discusses the policy actions that governments need to undertake to sustain recovery after the crisis and enhance resilience to future crises.

THE COVID-19 PANDEMIC AND GLOBAL POLICY RESPONSES The rapid spread of the Sars-Cov-2 forced governments to take extreme measures, including movement restrictions and business closures, which resulted in the loss of livelihoods, income, and savings and reduced economic activity across countries. COVID-19 triggered the most serious economic crisis of the twenty-first century thus far. Initial reports by the World Bank suggested that global economic growth will decelerate from 5.5 percent in 2021 to 4.1 percent in 2022 and 3.2 percent in 2023. In emerging markets, economic growth is expected to decrease from 6.3 percent to 4.6 percent by 2023 (World Bank, 2021). In response to the COVID-19 economic crisis, governments across the world implemented measures to mitigate the negative effects of the crisis on economic growth while operating in a context of high uncertainty about the full impacts of the crisis. Countries at different levels of economic development and capacity responded with different combinations of fiscal and monetary policy tools to stabilize the economy. Figure 2.1 shows the variation in crisis response strategies in advanced (or high-income) economies, emerging economies, and low-income countries. The information is based on the IMF’s Fiscal Monitor Database which compiled governments’ crisis response announcements

20  Research handbook on public financial management from the beginning of the pandemic to September 2021. The variation in crisis response across the countries is significant and seems to be related to economic resource endowments of the countries. Table 2.1 reports the summary statistics for different country groups based on the type of government spending in response to the crisis. Advanced economies in the sample spent, on average, about 12 percent of their GDP on fiscal measures, including additional budgetary spending and forgone revenues, and another 12 percent on central bank liquidity-enhancing measures. However, there is significant variation among the 21 advanced economies in the sample; for example, Denmark spent 3.5 percent of their GDP on additional fiscal measures whereas the United States spent more than 25 percent of GDP on additional fiscal measures. In emerging economies, total government spending on fiscal measures in response to the crisis amounted to 4.8 percent of GDP on average, and the spending on liquidity-enhancing measures totaled about 3 percent of GDP. In the case of low-income countries, additional fiscal measures accounted for only 2.6 percent of GDP for a sample of 15 countries. These IMF statistics on low-, middle-, and high-income countries are comparable to other sources of data. For example, the United Nations estimated that emerging economies leveraged only 4 percent of their GDP as fiscal stimulus in response to the COVID-19 crisis whereas low-income countries used about 1.6 percent of their GDP (United Nations, 2020).

Source:

International Monetary Fund, Washington DC.

Figure 2.1

Variation in COVID-19 crisis response across country-income categories

Managing public finances during major crises  21 Table 2.1

COVID-19 policy responses across country groups (Updated until September 27, 2021)

  Advanced Economies

Obs

Mean

Std Dev

Min

Max

Additional Spending

21

11.85

6.07

3.46

25.45

Liquidity Emerging Economies

21

11.83

9.26

1.65

35.25

Additional Spending

26

4.75

3.08

0.65

14.10

Liquidity Low-Income Countries

26

3.03

2.93

0.00

11.75

Additional Spending

15

2.64

1.55

0.72

6.70

Liquidity

15

0.53

0.58

0.00

1.82

Note:  Data are from the International Monetary Fund. Amounts are expressed as percent of GDP, on average, among the country groups.

The immediate policy responses in different countries put additional pressure on their government finances. The policy responses entailed higher spending on health services and unemployment benefits as well as direct transfers and tax relief to protect households, firms, and vulnerable populations. These extra-budgetary expenditures combined with reduced revenue from taxation and exports (due to the slowdown in economic activity) put immense pressure on government budgets such that deficits and borrowing increased as a share of GDP and reached their highest levels across countries (OECD, 2021). As an example, government debt constituted more than one-half of GDP in 81 countries prior to the pandemic (IMF, 2018). However, after the pandemic, more than 96 countries reported government debt as constituting more than one-half of GDP (IMF, 2020). In addition, low interest rates kept debt servicing costs at a manageable level in the short-term during and after the pandemic, but in the longer term as interest rates increase, governments would face the challenge of servicing an unsustainable amount of borrowing. In the meantime, some countries have defaulted on their debt while other countries, especially low-income economies, are at high risk of government debt distress (World Bank, 2021). Many countries also experienced significant shrinkage in fiscal space prior to the pandemic and this worsened the impacts of the crisis in their economies despite their policy responses. Nigeria, for example, was slowly emerging from the effects of a recession in 2016 when the pandemic hit in 2020. The country’s high reliance on the oil sector for its revenue made it vulnerable to the slump in oil prices in the first quarter of 2020, leading to a weakened Nigerian economy (Ejiogu et al., 2020). Similarly, prior to the pandemic, South Africa was facing a stalling economy and a widening budget deficit which made the country unprepared for the revenue shortages and unexpected costs associated with the pandemic (De Villiers et al., 2020). In order to fund their initial responses to the pandemic, governments made timely decisions without the necessary deliberations required to assess the fiscal soundness of their policy actions. In South Korea, for example, the average time to pass a supplementary budget decreased from 48 days to 14 days during the pandemic (Kim, 2020). At the peak of the pandemic, researchers warned of the long-term effects of the fiscal actions of national governments. As a result of the urgency of the crisis response, many countries utilized existing contingency or reserve funds, virements, supplementary budgets, emergency decrees as well as adjustments in fiscal institutions (e.g., expenditure ceilings) to fund their policy response. There was also a surge in public debt mostly in emerging markets and developing economies

22  Research handbook on public financial management (World Bank, 2021). The flexibility of governments to use extra-budgetary funds was important to respond adequately to the pandemic; however, the lack of fiscal safeguards and controls combined with high levels of borrowing, especially in developing countries, sparked concern about the long-term sustainability of these policy responses.

THE TOOLS OF CRISIS RESPONSE Policy tools may be defined as the identifiable methods that policymakers use to structure collective action and address public policy problems (Salamon, 2002). These tools provide a mechanism for policymakers to transform their goals and strategies into specific actions that promote the public good. A policy tool may be classified as direct or indirect depending on whether a governmental entity uses the tool to perform various functions without involving other levels of government or semi-autonomous agencies, nonprofit organizations, community groups, hospitals, and commercial banks (Salamon, 2002). A direct policy tool is one that makes it possible for the same governmental entity to authorize, fund, or deliver public activities without involving other levels of government or third parties (Howard, 1995; Smith and Ingram, 2002). Examples of direct policy tools include direct government service provision, direct loans, government corporations, information campaigns, and economic regulation. On the other hand, an indirect policy tool is a method in which a governmental entity divides the core functions of governance among various parties such that these parties maintain a level of autonomy and discretion in carrying out governmental functions for the authorizing government. Some examples of indirect policy tools are grants, tax expenditures, contracts, loan guarantees, insurance, fees and charges, vouchers, social regulation, and government-sponsored enterprises. Another important dimension of policy tools is the assumption that their design and use depend on the behavioral characteristics of individuals who should comply with policy rules, utilize policy opportunities, make decisions, and take actions that promote policy goals (Salamon, 2002; Peters, 2018). This dimension of policy tools makes it possible to identify five broad types of tools for policy action, namely authority, incentive, capacity, symbolic, and learning tools (Schneider and Ingram, 1990). Authority tools rely largely on individuals’ duty and commitment to obey laws. On the other hand, incentive tools rely on the notion that individuals are utility maximizers and will change their behavior based on net tangible payoffs. Additionally, capacity tools provide information, education, and resources to individuals, enabling them to make decisions and engage in actions that align with policy goals. As for symbolic tools, they manipulate symbols and influence beliefs and values in cultural and social contexts such that people are motivated to make decisions and take policy actions that are consistent with their beliefs. Finally, learning tools promote learning and consensus building among constituents to enhance knowledge about policy actions and to influence people’s behavior to be consistent with policy goals. A policy tool’s impact may be assessed using several criteria (Salamon, 2002). One important criterion is effectiveness, which measures the extent to which a policy tool achieves its intended objectives. Another criterion is efficiency, gauging the extent to which a policy tool uses the least resources to achieve expected goals. However, when measuring the impact of a policy tool, the most efficient tool may not necessarily be the most effective tool, but the most desired tool is one that achieves an optimal balance between costs and benefits.

Managing public finances during major crises  23 A third criterion is equity. It assesses whether a policy tool facilitates the distribution of program benefits evenly among all those eligible. In addition to effectiveness, efficiency, and equity, policy tools may be assessed based on their implementability and political feasibility. Implementability examines the ease or difficulty involved in utilizing a policy tool to achieve its intended policy outcomes, whereas political feasibility considers whether a policy tool would draw support from policy actors and interest groups as needed for a policy to be successful. All these criteria established in the academic literature provide a means to assess the impacts of policy tools across different policy domains. The design, use and impact of policy tools have gained much attention in recent years due to the incidence of major crises and governments’ use of diverse tools aimed at mitigating the impacts of crises. In the case of the COVID-19 crisis, governments pursued aggressive policy strategies aimed at mitigating the negative effects of the crisis in their national economies. The range of policy tools that governments deployed in dealing with the coronavirus crisis varied significantly across high-, middle-, and low-income countries, and governments used both direct and indirect policy tools, including tax cuts, tax credits, direct spending, bank bailouts and recapitalization, and loan and deposit guarantees. The tools varied in terms of magnitude and design where some countries relied heavily on fiscal tools, such as spending on public health and unemployment benefits as well as support for small businesses, while others relied on monetary tools such as liquidity provision in the economy. These fiscal and monetary policy tools were expected to raise activity in different sectors of the economy, given that the pandemic caused major economic shocks from a variety of factors, including the disruption in global supply chains, weaker global demand for imported goods and services, decrease in international tourism, and decline in business travel (OECD, 2020). The types of policy tools governments used in different parts of the world to mitigate the effects of the COVID-19 economic crisis require systematic analysis to develop a typology of policy tool usage across countries. This type of analysis is feasible due to the availability of detailed data on global policy responses to the COVID-19 pandemic. The IMF’s database on Policy Responses to COVID-19 provides a detailed summary of governments’ policy announcements in response to the pandemic. This chapter conducted a content analysis of the announcements for all countries for which data are available to identify the specific policy tools that different countries used in response to the pandemic (Kirti et al., 2022). As Table 2.2 shows, the policy tools that countries deployed in their management of the crisis can be classified into three main types, namely fiscal policy tools, monetary policy strategies, and regulatory policy initiatives. In addition, some countries used the pandemic as an opportunity to undertake specific structural reforms to support economic recovery. Importantly, a large number of countries relied on short-term one-time measures such as additional spending on health and social services and targeted tax breaks for specific services and sectors. Targeted assistance to households and businesses was another common policy tool across different countries. In some instances, governments leveraged the existing social protection programs (such as the public works program in Uganda and India) to expand the social safety net. In other cases, governments provided waivers for selected services (like the utility bill waivers in Ghana and Uruguay). Similarly, government assistance to businesses took the form of direct payments, short-term loans, and paycheck protection programs. National governments also provided additional funds to subnational units such as municipalities, schools, and hospital systems to help them respond more adequately to the crisis. It is also noteworthy that central banks in different countries used a variety of monetary policy

Targeted assistance

Direct assistance

Future preparedness

Freezing credit downgrades, allowing withdrawal of pension funds (Chile)

Unemployment benefits, social security benefits Reallocating spending to humanitarian relief Reduction in corporate income tax (Chile), asset disinvestment (Jamaica)

Automatic stabilizers

Reallocation

Tax reforms

health system (Portugal)

Creation of the National Emergency Mitigation Fund (Colombia), support to the

Tax deferrals (Ukraine), loan deferrals (Bahamas)

and export tariffs, payroll tax suspension (Belgium)

Easing borrowing restrictions

Budget spending

High

Medium

Low

Low

High

Medium

Medium

High

Medium

High

Medium

High

High

High

Usage

Low

Low

Medium

Low

Medium

High

Temporarily suspending VAT collection (Algeria, Costa Rica), suspending import High

Deferrals

Waivers and suspensions

Invoking escape clause on fiscal rules (Brazil)

Source:   Summarized from the International Monetary Fund, Policy Responses Tracker.

Structural Reform

deferrals

Rapid liquidity facility in Dominican Republic

Rapid liquidity Corporate debt restructuring

Credit support to small businesses, microcredit to households (Bangladesh)

Credit support

Escape clause on fiscal rules

Support to small and medium enterprises

Employment specific credit

Economic regulation Debt restructuring

Bond purchases by the Central Bank

Regulation

Loan guarantees (Turkey)

Purchasing bonds

purchases

banks, expanding eligible currencies counting towards foreign reserves, asset

Sovereign Guarantees

Monetary policy

Liquidity Infusion

Cutting repo rate, lowering reserve requirement, reducing cash reserve ratio for

Funds to school for decentralized response (Bolivia)

entities

Short-term jobs, paycheck protection, direct payments

(Uganda, India)

(Ghana, Uruguay), rent assistance (Bahrain), expansion of public works programs

Free/subsidized goods such as food, water (India, Trinidad), utility bill waivers

pension amounts (Cameroon)

Assistance to families with children, disabled population, etc. (Bolivia), raising

business operations (Bahrain exempted setting up e-stores)

Health equipment tax breaks, tourism, waiving government fees for selected

Additional support to government

Monetary Policy

Waivers and

Country examples Health spending

Business assistance

Household level assistance

Targeted tax breaks

measures

Instrument

Function

Short-term one-time Grants, targeted spending

Tools

Key policy tools deployed by governments in COVID-19 response

Fiscal Policy

Table 2.2

24  Research handbook on public financial management

Managing public finances during major crises  25 tools to manage the economic impacts of the crisis. These monetary policy strategies included cutting the repo rate, lowering reserve requirements, and reducing the cash reserve ratio. Other liquidity-enhancing measures that governments undertook included credit guarantees, low-interest loans, and specialized programs for expanding liquidity (such as the creation of a rapid liquidity facility in the Dominican Republic). Table 2.2 also shows that many governments relied on regulatory changes, such as easing borrowing restrictions to increase liquidity in the economy. A common low-cost policy tool that governments worldwide used during the pandemic was the deferral of dues in the form of revenue collections and loan payments. Some governments used the pandemic as an opportunity for more structural reforms such as the reallocation of budget spending, expanding the social safety net, and tax reforms. Figures 2.2 and 2.3 provide more insight on the differences in policy tool usage across countries based on IMF data that codes governments’ policy announcements by broad fiscal categories, namely grants, tax deferrals, public loans, tax relief, equity, and guarantees. Thus, Figures 2.2 and 2.3 plot the composition of fiscal support in emerging economies and advanced economies, respectively. In addition, Table 2.3 provides summary statistics for the sample of countries in the database.1 The table and figures show that advanced economies relied most on grants, followed by guarantees, tax deferrals, public loans, equity, and tax relief. On the other hand, emerging economies relied relatively more on public loans and equity-enhancing measures than on tax deferral and tax relief. This difference in policy tool usage across advanced and emerging economies may be explained by the difference in tax structures between these two groups of economies; emerging economies tend to rely more on consumption taxes, and tax deferrals and relief would not have been effective for this group of countries in the low-consumption environment of the pandemic. Table 2.3

Average share of COVID relief by fiscal category, 2020

 

N

 

Emerging Economies

Mean

Std Dev

Min

Max

Grants

43

Tax relief

43

2.08

1.71

0.00

7.30

0.20

0.37

0.00

Tax deferral

1.70

43

0.27

0.52

0.00

2.39

Equity

43

0.41

0.76

0.00

3.35

Public loan

43

0.98

1.28

0.00

5.02

Guarantee

43

1.34

2.14

0.00

9.38

 

Advanced Economies

Grants

30

5.52

3.27

0.25

12.33

Tax relief

30

0.64

0.94

0.00

4.09

Tax deferral

30

1.90

2.26

0.00

8.31

Equity

30

0.68

1.02

0.00

4.03

Public loan

30

0.86

1.11

0.00

4.45

Guarantee

30

5.42

5.32

0.00

20.08

Note:   Data are from the IMF’s database of government fiscal measures in response to the COVID-19 crisis. Amounts are expressed as the share of GDP on average among the total number of countries (N) in the country-income group.

26  Research handbook on public financial management

Figure 2.2

Composition of fiscal support in emerging economies

Figure 2.3

Composition of fiscal support in advanced economies

Managing public finances during major crises  27

“AFTER” THE CRISIS Countries differ in the extent to which major crises linger in their economy. In some countries, the effects of major crises linger for a long time in the economy whereas in other countries the effects are moderate and do not last as long. For example, the Great Recession in 2008 had a large and lingering effect on the United States, United Kingdom, and Greece, but it had only a moderate impact on countries like Australia and South Korea. Romer and Romer (2018) argue that the degree of monetary and fiscal policy space prior to financial distress significantly influences economic conditions in the aftermath of a crisis. Using data from post-war OECD countries, Romer and Romer found that countries with favorable measures of monetary space (e.g., low interest rates) and fiscal capacity (e.g., low debt-to-GDP ratios) prior to the crisis experienced less than 1 percent decline in GDP in the aftermath of the crisis, whereas countries that did not have favorable measures of monetary and fiscal space experienced about 10 percent decline in economic output. In the case of the COVID-19 pandemic, recovery from the crisis fluctuated significantly across countries due to the uncertainty associated with the coronavirus. In June 2021, the IMF projected that the global economy would grow by about 6 percent, the highest growth rate since 1980. The IMF attributed this robust growth projection to the aggressive spending by advanced economies and the acceleration of vaccine rollouts, which would increase economic activity gradually worldwide. However, the actual economic recovery from the crisis has been uneven across countries. The United States and China have experienced significant growth in their economies while other advanced economies like Germany, France and Japan are not expected to experience any significant changes in their economic outlook. For emerging market economies, economic growth was projected to increase but after the resurgence in COVID-19 cases in late 2021 and early 2022, the growth outlook was revised downward to 4.4 percent. In 2022, growth is projected to slow down to 2.3 percent in the United States, 3.3 percent in China, and 2.6 percent in the Euro area. In the most recent edition of the World Economic Outlook, the IMF stated that three main forces would shape the gloomy outlook for 2022, namely high inflation, the economic slowdown in China, and negative spillovers from the Russia–Ukraine war (IMF, 2022). These factors are likely to hamper the global economic recovery, especially in emerging markets and developing economies. The fiscal policies implemented by countries during the COVID-19 pandemic were necessary to prevent declines in employment, income and output. However, as a result, countries now face their highest levels of debt in relation to GDP. During the pandemic, interest rates were at relatively low levels and this gave countries the opportunity to increase borrowing at a lower cost. However, as major central banks increase their interest rates to bring inflation back to their policy targets, countries with weakening growth prospects might face widening interest rate spreads and this would lead to high borrowing costs. In more than 60 percent of emerging markets and developing economies, the share of foreign currency denominated government debt has risen above pre-pandemic levels and in more than half of these countries, the share of nonresident-held government debt has increased, making the countries vulnerable to currency depreciation and international investor sentiment. In an environment of unfavorable economic growth, high interest rates, and increasing debt, emerging markets and developing economies would need to pursue fiscal consolidation of about 7 percent of GDP to stabilize their government debt and enhance long-term sustainability (World Bank, 2021).

28  Research handbook on public financial management Russia’s war with Ukraine has further complicated global macroeconomic conditions. The war has disrupted supply chains and commodity markets leading to higher prices for energy and staple foods. In April 2022, the amount of Russian pipeline gas supplied to Europe decreased to about 40 percent of the level supplied in the previous year. According to the World Economic Outlook (IMF, 2022), the ban on Russia’s crude oil would cause about two-fifths of the total decline in global GDP. The soaring commodity prices due to the war are expected to cause lasting damage to the economies of low- and middle-income countries since 36 of these countries rely on Russia and Ukraine for their wheat imports. This number includes some of the world’s poorest countries. Furthermore, with high prices for basic staple foods such as wheat and cooking oil, millions of people are expected to be pushed into poverty. The United Nations estimates that about 1.7 billion people living in 107 countries were exposed to disruptions in food, energy, and finance systems due to the Russia–Ukraine war (United Nations, 2022). The combination of high commodity prices, rising interest rates and a stronger US dollar may cause economies to decline further into debt distress. However, governments can use well-targeted policy tools and strategies to sustain economic recovery and promote long-term resilience to future crises. The G20 countries, for example, have introduced strategic initiatives to help countries manage the impacts of the COVID-19 crisis on long-term debt sustainability. The initiatives include the Debt Service Suspension Initiative (DSSI) and the Common Framework for Debt Treatments to help low-income countries manage their debt more sustainably. With the DSSI, bilateral creditors would suspend debt service payments for 73 middle- and low-income countries (IMF, 2021). This initiative would benefit countries by helping them to increase their fiscal space and free up money that they can use to mitigate the human and economic impacts of the COVID-19 crisis on their economies. More than 60 percent of eligible countries made requests for debt service suspension when the G20 introduced the initiative, and from May 2020 to December 2021, the initiative suspended $12.9 billion in debt service payments owed by participating countries to their creditors. The suspension is in addition to other support packages for countries, including concessional financing, capacity development, and a new Special Drawing Rights allocation. Similarly, the Common Framework for Debt Treatments is the G20’s special initiative for countries in need of deeper debt relief. This initiative helps to facilitate debt restructuring on a case-by-case basis and supports burden sharing across creditors. It offers countries the option to defer portions of their debt service payments or reduce debt service payments significantly when they experience severe debt distress.

SUMMARY AND CONCLUSION The COVID-19 pandemic was a test of the financial management systems of countries across the world. It caused a severe strain on different sectors of the economy, and in many countries economic activity came to a standstill almost instantly. At the same time that governments were dealing with a major decline in revenues, they also faced budgetary pressure to deliver emergency support to different sectors of the economy that were affected by the pandemic. This chapter examined the broad set of policy tools that governments deployed in dealing with the COVID-19 pandemic. It used data from the IMF’s COVID-19 policy response tracker and found that governmental responses to the crisis varied significantly across

Managing public finances during major crises  29 country-income groups both in terms of the amount of resources and the types of policy tools. High-income countries used a significant amount of resources to counter the adverse impacts of the COVID-19 economic crisis whereas middle-income and low-income countries with limited fiscal space relied on low-cost interventions focused on humanitarian relief and health services. Also, there is a significant variation within country-income groups in terms of how much they spent on crisis response. Furthermore, the policy tools that governments used to manage the impacts of the crisis differed according to the countries’ levels of economic development and resource capacity. Advanced economies relied largely on grants, guarantees, tax deferrals, public loans, equity, and tax relief to boost economic recovery whereas emerging economies used mainly public loans and equity-enhancing strategies rather than tax deferral and tax relief. At any rate, the policy tools that governments used varied in terms of magnitude and design where some countries relied heavily on fiscal tools such as public health spending, unemployment benefits, and funding for small businesses while other countries used monetary policy tools to provide liquidity in the economy. Governments demonstrated significant budget flexibility in responding to the economic impacts of the pandemic, but the lack of fiscal controls and safeguards as well as the large increases in government borrowing, especially in developing countries, raises much concern about the long-term sustainability of governments’ policy actions. The current research on the budgetary impact of the pandemic is still evolving and most research has focused on prospective analysis of short-term trends. As more years of data become available, future research could focus on the factors that determine the differences in policy tool choices across different country-income groups. It would also be useful to examine how post-crisis economic recovery varied in countries that followed one set of policy tools compared to other groups of countries that used a different set of policy tools. In addition, theoretical work could focus not only on developing a typology of policy tools across countries dealing with a major crisis, but also evaluate the effectiveness of specific policy tools and the extent to which these tools would enhance equity across different groups in the national economy.

NOTE 1. The fiscal support estimates in these charts may not match those from Figure 2.1 since they exclusively focus on 2020 estimates and the sample of countries is also different.

REFERENCES Auerbach, A. J. (2012). The fall and rise of Keynesian fiscal policy. Asian Economic Policy Review, 7(2), 157–175. Bernanke, B. S. (1983). Nonmonetary effects of the financial crisis in the propagation of the Great Depression. American Economic Review, 73(3), 257–276. Bordo, M., Eichengreen, B., Klingebiel, D., and Martinez-Peria, M. S. (2001). Is the crisis problem growing more severe? Economic Policy, 16(32), 52–82. De Villiers, C., Cerbone, D., and Van Zijl, W. (2020). The South African government’s response to COVID-19. Journal of Public Budgeting, Accounting & Financial Management, 32(5), 797–811. Ejiogu, A., Okechukwu, O., and Ejiogu, C. (2020). Nigerian budgetary response to the COVID-19 pandemic and its shrinking fiscal space: Financial sustainability, employment, social inequality and

30  Research handbook on public financial management business implications. Journal of Public Budgeting, Accounting & Financial Management, 32(5), 919–928. Howard, C. (1995). Testing the tools approach: Tax expenditures versus direct expenditures. Public Administration Review, 55(5), 439–447. International Monetary Fund (2018). World Economic Outlook Database. https://​www​.imf​.org/​en/​ Publications/​WEO/​weo​-database/​2018/​April. International Monetary Fund (2020). World Economic Outlook Database. https://​www​.imf​.org/​en/​ Publications/​WEO/​weo​-database/​2020/​April. International Monetary Fund (2021). Questions and Answers on Sovereign Debt Issues. IMF. https://​ www​.imf​.org/​en/​About/​FAQ/​sovereign​-debt​#DSSI. International Monetary Fund (2022). World Economic Outlook 2022. https://​www​.imf​.org/​en/​ Publications/​WEO/​Issues/​2022/​10/​11/​world​-economic​-outlook​-october​-2022. Kaminsky, G. L. and Reinhart, C. M. (1999). The twin crises: The causes of banking and balance-of-payments problems. American Economic Review, 89(3), 473–500. Kim, B. H. (2020). Budgetary responses to COVID-19: The case of South Korea. Journal of Public Budgeting, Accounting & Financial Management, 32(5), 939–947. Kirti, D., Liu, Y., Peria, S. M., Mishra, P., and Strasky, J. (2022). Tracking Economic and Financial Policies During COVID-19: An Announcement-Level Database. IMF. https://​www​.imf​.org/​en/​ Publications/​WP/​Issues/​2022/​06/​03/​Tracking​-Economic​-and​-Financial​-Policies​-During​-COVID​-19​ -An​-Announcement​-Level​-Database​-518896. Levin, K., Cashore, B., Bernstein, S., and Auld, G. (2012). Overcoming the tragedy of super wicked problems: Constraining our future selves to ameliorate global climate change. Policy Sciences, 45(2), 123–152. OECD (2020). The Territorial Impact of COVID-19: Managing the Crisis across Levels of Government. https://​www​.oecd​.org/​coronavirus/​policy​-responses/​the​-territorial​-impact​-of​-covid​-19​-managing​-the​ -crisis​-across​-levels​-of​-government​-d3e314e1/​. OECD (2021). Tax and Fiscal Policies after the COVID-19 Crisis—OECD. https://​read​.oecd​-ilibrary​ .org/​view/​?ref​=​1112​_1112899​-o25re5oxnb​&​title​=​Tax​-and​-fiscal​-policies​-after​-the​-COVID​-19​ -crisis. Peters, B. G. (2018). American Public Policy: Promise and Performance. Thousand Oaks, CA: CQ Press. Rittel, H. W. and Webber, M. M. (1973). Dilemmas in a general theory of planning. Policy Sciences, 4(2), 155–169. Romer, C. D. and Romer, D. H. (2018). Phillips Lecture – Why some times are different: Macroeconomic policy and the aftermath of financial crises. Economica, 85(337), 1–40. Salamon, L. M. (ed.) (2002). The Tools of Government: A Guide to the New Governance. Oxford: Oxford University Press. Schiefloe, P. M. (2021). The Corona crisis: A wicked problem. Scandinavian Journal of Public Health, 49(1), 5–8. Schneider, A. and Ingram, H. (1990). Behavioral assumptions of policy tools. The Journal of Politics, 52(2), 510–529. Smith, S. R. and Ingram, H. (2002). Policy tools and democracy. In L. M. Salamon (ed.), The Tools of Government: A Guide to the New Governance. Oxford: Oxford University Press, 565–584. United Nations (2020). Financing for Development in the Era of COVID-19 and Beyond. https://​www​.un​ .org/​en/​coronavirus/​financing​-development. United Nations (2022). Global Impact of War in Ukraine on Food, Energy and Finance Systems (Global Crisis Response Group, Brief 1). https://​news​.un​.org/​pages/​wp​-content/​uploads/​2022/​04/​UN​-GCRG​ -Brief​-1​.pdf. World Bank (2021). What the Pandemic Means for Government Debt, in Five Charts. https://​blogs​ .worldbank​.org/​opendata/​what​-pandemic​-means​-government​-debt​-five​-charts.

3. Emerging ideas for fintech applications in public finance Majid Bazarbash, Naomi Nakaguchi Griffin, Gerardo Una and Alok Verma1

Financial technology (fintech) is broadly defined as the innovative technology-enabled transformation of financial services, aiming to benefit users through higher speed, convenience, security, and transparency. Fintech business models often expand access to financial services to the mass market. Similarly, the public sector could utilize private sector-led fintech developments to improve public finance processes and outcomes. This chapter studies how adopting fintech models in the public sector could benefit public finances, in particular public financial management (PFM). While the literature has broadly explored the impact of digitalization on delivering public services (for example, Gupta et al., 2017), there is no specific study that explores the implications of fintech applications for PFM. To present how fintech applications could be valuable in public finance, we conceptually explain the main ideas behind major fintech models in payments, credit, and investment. Since some of the fintech models are emerging and yet to be fully tested under different circumstances, the fintech applications in certain areas of public finances discussed here should be treated as options to be explored rather than actionable recommendations. Fintech as a contemporary phenomenon in finance builds on three waves of digital technology advancements.2 First, the development of user access to digital platforms (cellular and internet networks) has facilitated cheap and convenient outreach to a widespread population, including the unbanked population (Sahay et al., 2020). Second, digitization – converting analog information such as hand-written documents, sounds, and pictures to computer-readable format – has enormously expanded data on users, suppliers, and markets. Digitization has both expanded information by generating new data from digital footprints and made otherwise outdated information available to analyze. Digitization services are provided by businesses that interact with fintech companies in the back end, most notably biometrics (Bertoni et al., 2021; Bollaert et al., 2021; D’Acunto et al., 2019). Third, advances in big data analytics, machine learning, and artificial intelligence have facilitated analyzing a large amount of data and incorporating the analysis in financial decision-making (Bazarbash, 2019). Building on these developments, fintech companies have adopted digital strategies that have fundamentally shifted the delivery of financial services (Gobble, 2018b). Digitalization goes beyond digitization – a technical process of generating digital data – and involves making the best use of digital technology to transform digital data into economic value (Gobble, 2018a). By adopting a digital strategy and not the technology per se, fintech has fundamentally changed the consumer experience and reshaped the business management approach to meet customer needs (Hanelt et al., 2021; Kane et al., 2015). Integrating fintech in public finance could occur at different levels and depend inter alia on the development of governments’ financial management information systems (FMIS), the digital infrastructure, and the state’s approach to digitalization. To reap the most benefits, 31

32  Research handbook on public financial management governments should develop a digitalization strategy tailored to their specific circumstances with a holistic perspective that informs how intended changes advance the efficiency of public finance, strengthening at the same time the core public sector information systems. The public sector digitalization strategy could guide the choice of different fintech models to be adopted in public finances. Although the topic of developing and deploying a digitalization strategy is beyond the scope of this chapter, we provide helpful insights into the benefits of fintech models that could be potentially incorporated in a public sector digitalization strategy. Fintech companies have sought to leverage digitalization to innovate in the entire spectrum of finance. These innovations cover payments, debt or equity financing, investment and asset management, insurance, accounting and budget, tax services, and regulatory and compliance (Bank for International Settlements, 2018; Goldstein et al., 2019; He et al., 2017). At the same time, the so-called GovTech solutions – various ways in which digital technology is changing government fiscal operations and the design of policies – present new opportunities and challenges for public finance. GovTech offers the possibility of substantially enhancing data collection and storage, increasing the speed of transactions, and facilitating governments’ interactions with citizens. With the quick adoption of technology worldwide, governments are looking to use these new digital technologies to develop better fiscal policies, improve service delivery, and enhance fiscal transparency. Some of these objectives could be achieved through modernizing processes in PFM and revenue administration agencies, harnessing technology to accelerate the adoption of international standards, making better use of data, and adopting digital money to improve fiscal operations. In this chapter, we focus on fintech models in payments, credit, and investment. We describe the key ideas of these models in the next section. As illustrated in Table 3.1, we explore fintech’s potential utilization in public finance, covering treasury payments, revenue collections, public debt management, and public investment. We then discuss potential benefits of integrating fintech applications in the public sector for PFM. The benefits are twofold. First, there are operational gains because of fintech’s superior efficiency and greater ability in reaching people, especially the unbanked, and businesses. Integrating fintech could augment the efficiency of specific PFM functions, for example, making social transfers, collecting public revenues, attracting funds for public investments, and deepening the public debt market. Second, there are informational gains because of the digital footprints of fintech users that can be used to strengthen fiscal transparency, enhance macro-fiscal forecasting, improve budget planning and execution, and upgrade cash management. We discuss these issues in the third section. Finally, the fourth section presents the main conclusions of our research.

FINTECH DEVELOPMENTS IN THE PRIVATE SECTOR Different fintech models have been developed to enhance critical financial services in payments, credit, and investment. Fintech payments have been the most popular, including innovation in emerging and advanced economies. Fintech payment acts as a foundation for other fintech developments thanks to the prevalence of payments in economic activities. We discuss mobile money, internet-based payments, digital banking, and digital money as major fintech models under fintech payments. Digital credit and investment platforms are more advanced fintech developments that are newly evolving and rapidly growing. The development of these services has facilitated financial inclusion by expanding their coverage to the previously

Emerging ideas for fintech applications in public finance  33 underserved mass market, underscoring their significant potential for the public sector. Sahay et al. (2020) show that fintech-led financial inclusion has accelerated in recent years across the globe and played a crucial role in making financial services accessible during the COVID-19 pandemic. Fintech Payments Fintech solutions contribute to the payment system in several ways. First, fintech plays the role of aggregator by developing digital payment platforms with access to a large user base that enable the users to transact with various counterparts. The network effect crucially depends on the quality of service and adoption rate by the population.3 Second, as money is stored and accessed digitally on fintech platforms, customers can hold digital money balances to store value especially when the value of digital money is linked to strong currencies. Third, fintech provides digital wallet accounts that function as a one-stop account for providing a whole slew of payment services to users. Finally, building on the transaction activity and digital footprints of the users of digital payment platforms, fintechs provide data services and facilitate customer due diligence, and business, industry and market analysis. Such data services could be used to offer more advanced financial services. The three main operational steps involved in executing a payment are identification, authorization, and settlement or finality of the payment. Once the platform receives an authorization by the payor, it verifies the identities of the sender and the recipient and the corresponding outgoing and incoming accounts and checks whether the payor holds sufficient funds in their account or has sufficient credit limit in case of a credit at the time of transaction. After verification of the identities, it is checked whether the payment authorization is legitimate. Lastly, the payment becomes final when the funds are debited from the payor’s account and credited into the payee’s account. These operational steps also apply to public sector payments. The platform should keep a record of transaction data and customer information that is used for compliance with various payment system regulations, such as demonstrating compliance with anti-money laundering / countering the financing of terrorism (AML/CFT) regulations. Mobile money Mobile money is a payment account on a user’s phone which enables users to deposit, transfer, and withdraw funds without necessarily owning a bank account (Jack and Suri, 2011). Mobile money therefore differs from mobile banking, which provides access to the user’s bank account through a mobile phone. The idea behind mobile money was inspired by the prepaid airtime service offered by telecom companies, also called mobile network operator (MNO), in which a customer prepays for using a defined limit of telecom services such as making calls, messages, and data. By analogy, a mobile money account is created when a customer pays cash to an MNO agent in exchange for balances – called e-money – in their mobile money account (less the associated commissions and fees). E-money is defined as an electronic store of monetary value on a technical device without necessarily involving a bank account that may be widely used for making payments to entities other than the e-money issuer (European Central Bank, 2016). At the time of account registration, the agent identifies the customer by collecting basic customer information along with a government-issued ID card – serving the equivalent of Know-Your-Customer (KYC) rules. The customer can cash out their e-money balances with an MNO agent. To meet customer demand for cash-in and cash-out, the mobile

 

collection and aggregate level of social programs spending) Better information for resources allocations in the planning phase and improved budget execution for social cash transfer programs by utilizing fintech app to deliver the payments

Improving budget

planning and execution

(mainly cash transfers

cash position

management

Source:  Authors’ elaboration.

Establishing and strengthening treasury single account (TSA), and managing daily

Upgrading cash

social programs)

Better and high frequency data to predict fiscal variables (e.g., non-tax revenue

forecasting

transparency

applications in PFM

 

High frequency reliable data in public domain utilizing fiscal transparency portals

 

fees  

 

non-tax revenues

services charges, public procurement

categories of

agricultural

Potentially, all

(G2P)

supplies) (G2B) Passports fees,

services, cash transfers

providers (such as food Highway tolls

 

(mainly CBDC)

Digital money

e-vouchers for health

banking

payments Payments to goods

Online and mobile

Internet-based

Enhancing macro-fiscal

Strengthening fiscal

Benefits of fintech

Public investment

 

 

Public debt

management

entrance fees

programs (G2P)

Social cash transfer

collection

Treasury payments

Adoption of fintech

Mobile money

Payments

Natural parks

 

 

Fintech applications in the private sector

Non-tax revenue

 

applications in PFM

 

 

Fintech applications in public financial management and their benefits

 

Table 3.1 Credit

 

 

 

projects

infrastructure

Financing small

 

 

 

Crowdfunding

Investment

 

 

 

 

to financing

 

 

 

 

shortage

treasury cash

short-term debt risk oversight

Issuing

 

 

platforms

eTrading

guarantees fiscal

SOE’s

 

 

Digital lending

34  Research handbook on public financial management

Emerging ideas for fintech applications in public finance  35 money agent should maintain sufficient liquidity, which is an inventory of e-money and cash or money in a bank account with immediate access (Suri, 2017). The MNO agent is, therefore, an inexpensive alternative for most teller services without requiring a bricks-and-mortar bank branch, an ATM, or internet connection. The mobile money agents may have shops or other main businesses while offering mobile money services, which further reduces the fixed cost of agency services.4 As a result, the number of agents in a region could far exceed bank branches and agents could even be at locations in which it is economically unviable to build a bank branch. Mobile money is a popular payment option, especially in emerging markets and developing economies (EMDEs), where access to banking services or internet connections is limited. Mobile money has successfully expanded access to the payment system for the underbanked and unbanked in EMDEs. The main characteristics that make mobile money desirable in these economies are the already extensive network of phone users and the possibility of developing payment services based on messaging capability (Espinosa-Vega et al., 2020). Some of the most successful mobile money deployments in EMDEs are M-Pesa in Kenya by Safaricom, GCash in the Philippines by Globe Telecom, and EasyPaisa in Pakistan. The mobile money model faces growth limitations due to challenges in delivering large payment services and customer due diligence for AML/CFT purposes. By structure, the branchless network of mobile money relies on mobile money agents that often have limited capacity to hold cash and e-money stock. This limitation is partly because, unlike bank branches, mobile money agents have a less developed security infrastructure in place to allow them to hold large amounts of liquidity. Consequently, this limits the network’s capacity to absorb heightened liquidity demand for cash-out requests, especially in geographically remote areas. In addition, to service mass-market customers, mobile money providers are often allowed to follow less stringent KYC, or customer due diligence (CDD) measures compared to banks. However, the simplified due diligence is allowed when exposure to risk is limited, implying that the functionality of the mobile money accounts for sending and receiving e-money also must be limited (Shust and Dostov, 2020). Internet-based and app-based payment providers Internet-based payment methods, or e-payments, can process large transactions without being subject to the structural limitations of mobile money. This alternative fintech platform can process much larger transactions building on internet network and digitization.5 E-payments were developed as a safe and easy way to make online purchases and payments following the rapid growth in the online presence of many businesses. E-payment providers establish business relationships with banks, credit card providers, and payment processers, and support a wide variety of devices. For retail customers, the onboarding process is initiated by the customer’s agreement to a digital contract followed by digitally collecting customer information. The customer provides personal information for verifying their identity and financial account information, such as bank account or credit card, used for making transactions. Account holders can send money to individuals or businesses who hold accounts with different banks, at different jurisdictions (international remittances), and in different currencies.6 For businesses, the e-payment provider offers the merchant account a “payment gateway” that acts as a secure bridge between the merchant and the customer. Like a point-of-sale terminal at a physical cash register that reads a payment card’s chip to ensure the validity of the

36  Research handbook on public financial management card and legitimacy of the payment, the payment gateway carries out these functions for online payments without the need for physical presence. When a customer makes an online purchase on the merchant’s website, their payment information is sent to the gateway, which encrypts that information and shuttles it to a series of approved payment processes and networks for authorization. Once the payment is accepted, the gateway sends the transaction to payment processors, who transfer the money from the customer’s bank account to the merchant account. In a similar vein, platform business models – called BigTechs – have expanded by integrating online payment processing services in their existing platforms (Frost et al., 2019). Digital platforms provide various value propositions to connect independent actors from demand and supply sides, including individuals and businesses (Bakos, 1998). Notable examples are e-commerce platforms like Alibaba and Amazon, payment platforms like PayPal, AliPay and Visa, social media platforms like Facebook, LinkedIn and Twitter, communication platforms like WhatsApp, WeChat and Skype, peer-to-peer sharing economy platforms like Airbnb and Uber, search platforms like Google, and crowdfunding or crowdsourcing platforms like InnoCentive and Kickstarter (Wirtz, 2020). They have a distinctive advantage to enter the fintech space since they have already developed a fully functional digital platform with many users and often apply data analytics to analyze users’ activities to offer services. Benefiting from the synergies in offering financial services is a natural step for most platforms. Many fintechs have developed mobile apps with a user-friendly interface and convenient access that facilitate making online payments. Even though payment apps are primarily launched on smartphones, they are classified under e-payments rather than mobile payments because the technology builds on the internet network rather than cellular. Payment apps tailor their services to their target clients. This includes small peer-to-peer payments, international payments, and small businesses including freelancers. The payment is made nearly real-time and at a lower fee compared to alternative traditional methods. These apps conveniently offer a variety of additional services such as comprehensive transaction tracking over time, digital receipt keeping, expense management, automatic follow-up on invoices, identity security through multi-factor authentication, and extensive interoperability. A digital wallet aims at replacing physical wallets by securely storing all of a consumer’s payment information in one place, allows for storing funds, making transactions, and tracking payment histories. A digital wallet may be used jointly with mobile payments, bank accounts and other payment platforms. Consequently, digital wallets can serve as a reliable source of consumer data that can be used to evaluate the consumer’s purchasing habits and turnover of funds (Kagan, 2021). Mobile and online banking Traditional banks have responded to fintech developments outside the banking sector by adopting digitalization strategies in their business models to augment the productivity of their services. To this end, banks have taken two important steps. First, they have collaborated with fintechs through partnership or acquisition to take advantage of complementarities with their business models and technological solutions. Fintech payment platforms could bring in a new class of users that banks traditionally do not target and act as an aggregator and connector to banking services, while banks leverage their expertise and experience in regulatory compliance and scaling up (Sahay et al., 2020). Second, banks have developed mobile and online portals in-house to increase digital access of their clients to almost any services traditionally offered in branches and thereby curtail expenditure on bank branches, ATMs, and front-line workers

Emerging ideas for fintech applications in public finance  37 who deal with routine customer business.7 Online banking, also called internet banking or web banking, allows a user to deposit checks, transfer funds between accounts and to others, view account information, and make online bill payments. Automated alerts of account activity and automatic payments are enabled via mobile and online banking further increasing the convenience of holding an account with banks.

Source: Both charts from Statista. Left chart: survey by the Financial Brand (Digital Banking Report 2020) displays share of respondents who identified the item among their top three priorities for 2020. Right chart: share of spending in new technologies in total IT spending in US and European banks (Deloitte, 2020). The data for 2020 and 2021 are forecasts.

Figure 3.1

Digitalization in global banking

Investing in digitalization has remained a strategic priority for banks. A survey of a panel of global financial services leaders for their top three priorities in 2019 and 2020 shows a clear focus on digitalization to improve users’ online experience, strengthen analytical capabilities, and reduce operational cost, in which automation plays a key role (Figure 3.1). With the advent of digital technologies such as mobile and online banking, customers can access their funds to make online payments. As a result, bank deposits are effectively a form of digital money in the banking system. Digital money Digital money, as the name suggests, is a means of payment that exists digitally. Its digital nature is therefore not exposed to limitations of handling physical money such as cash and checks but should deal with the cybersecurity of the medium in which it exists. Various forms of new digital money have been developed in the fintech space and are competing with traditional means of payment such as cash and bank deposits (Adrian and Mancini-Griffoli, 2021). Common forms of digital money include e-money, cryptoassets, stablecoins, and Central Bank Digital Currency (CBDC). E-money is a cash-equivalent balance on a digital platform as defined in the previous section. Cryptoassets (also called cryptocurrency) and stablecoins are privately issued digital money that are built on a set of technologies called the distributed ledger technology (DLT) for safely recording digital transactions and keeping transactions anonymous. Cryptoassets’ minting and burning rely on a specific algorithm and a consensus mechanism among the network of par-

38  Research handbook on public financial management ticipants who can add and verify information. Cryptoassets prices are currently highly volatile because of the uncertainty about regulations across different jurisdictions regarding production and use of cryptoassets. Stablecoins are backed by (a) cash (also known as fiat backed), (b) financial assets, such as government and corporate bonds (similar to money-market mutual funds), or (c) an algorithm that reacts to supply and demand pressures by minting and burning coins. Stablecoins issued by BigTechs called Global Stablecoins (GSCs) have the potential to grow rapidly especially as an acceptable means of payment on the platform. CBDCs are digital equivalents to cash issued by central banks with different policy intents, such as making the payment system more cost-effective, enhancing financial inclusion, and improving cross-border payments (Adrian, 2021). CBDCs as a public form of digital money and liability of the central bank come in two forms: retail CBDC, which is available to all domestic users, and wholesale CBDC, which is only available to selected financial institutions. The Bahamas’ Sand Dollar issued in October 2020 and Cambodia’s Bakong are currently the only operational retail CBDCs. The Sand Dollar collects daily transaction information including income and spending, which can then be used to support applications for micro-loans. Bakong enables users to receive real-time remittances from Malaysia up to $2500 (Ledger Insights, 2021). The circumstances of a country’s payment system and the design and implementation of a CBDC are among important factors that affect the success of CBDC in filling payment system gaps and justifying public investment in the technological infrastructure and its operation. In countries with an underdeveloped banking sector and a large informal sector where the use of cash is dominant, CBDCs could have greater potential to create social value and enhance financial inclusion by lowering the transaction costs associated with payments. Likewise, CBDCs could be a good solution in small states where there is little room for the private sector to achieve returns to scale. In some situations where customer due diligence is challenging for the private sector, a well-designed CBDC could enhance financial integrity and limit illicit activity. Additional considerations for CBDCs include anonymity of transactions, operational requirements, and competition with private banks (Box 3.1), as well as the impact of adopting CBDC on the fiscal operations and its coordination with monetary policy.

BOX 3.1 ADDITIONAL CONSIDERATIONS FOR CBDC The design of CBDC may have implications for the anonymity of transactions. CBDC may be account-based, which involves establishing an account with the central bank to make payments much like a commercial bank account. In this case, the central bank can eliminate the cost of opening and maintaining an account especially for the underbanked or unbanked population to enhance financial inclusion. Alternatively, token-based CBDC provides users with a serial number for a valid token – that is one that has not been used for making a payment yet. Once a transaction is made, the receiver receives a new serial number from the central bank – to avoid double spending in the system – that contains the transaction value. As settling transactions requires external verification of tokens, the extent of anonymity depends on whether the wallets of payor and payee are registered and if transaction information is recorded (Mancini-Griffoli et al., 2019). CBDC should meet operational requirements for a large payment platform that could expose the central bank and the payment system to risks and challenges. On the operational

Emerging ideas for fintech applications in public finance  39 side, CBDC requires investing in and maintaining a seamless technological infrastructure that can interface with customers, ensure security of transactions and customer information, monitor transactions to detect fraudulent transactions and violations of AML/CFT, and operate compatibly with other platforms – for example, when providing cross-border payment services and with other payment service providers. The failure to satisfy any of these requirements could have significant consequences for users and their trust in the payment system. A wide adoption of CBDC could mean migration of bank deposits to CBDC, which puts pressure on the funding sources of banks. The impact on liquidity and profitability of banks is likely much more significant if the banking system is underdeveloped.8 Moreover, limited deposit funding would indirectly impact other services offered by banks – notably lending – as it limits banks’ ability to monitor their clients using their transaction data. Therefore, the central bank should keep monitoring that the intended social benefits from CBDC in the payment system are achieved and that it does not unfairly affect private payment service providers. Digital Credit and Investment More advanced financial services, such as digital credit and digital investment, have been developed in fintech, albeit at a lower scale than digital payments. Fintech credit services primarily expand the availability of financing for people and businesses that are otherwise disconnected from traditional credit markets. They bring new ways to connect retail and institutional investors with small borrowers more effectively. Digital investment is the other side of the coin. This increases the participation of retail investors in capital markets and makes fresh capital available to financial instruments such as government debt. Digital credit Digital credit aims to fill the credit gap for individual and business borrowers by alleviating credit market imperfections and improving lender–borrower matching. Credit extension is often impeded by market imperfections arising from a lack of reliable and affordable access to information and weak incentive mechanisms to generate lenders’ trust in the borrowers’ capacity and motivation to repay the loan. Traditional lenders often find credit assessment of small businesses too expensive because of their limited risk-taking capacity and high complexity. This is while small businesses account for a large share of economic activity particularly in low-income and emerging economies. Lack of trust in the financial system, low financial literacy, lack of documentation, and expensive borrowing costs limit lending to individuals. Fintech credit models may be classified based on the source of funding (lenders), the fundraiser type (borrowers), and the technology medium (Bazarbash and Beaton, 2020). Marketplace lending or peer-to-peer (P2P) or platform lenders use an online platform open to retail lenders and retail borrowers. Households can take out personal or mortgage loans and business borrowers can finance account receivables, working capital, or capital expenditure from a P2P lending platform.9 Other fintech credit models, not open to retail investors, are funded by institutional investors such as private equity and banks. Loans can be extended through basic mobile phones, apps on mobile phones, or online platforms.

40  Research handbook on public financial management While major drivers of credit gaps are beyond the scope of technology, digital credit innovations have excelled in expanding credit and businesses by increasing the loan process efficiency and improving credit assessment. Fintech credit uses digitization of documents and communication by user-friendly interfaces to make digital collection of information rapid and convenient. By efficiently communicating borrowers’ risk profile and their loans’ expected returns with investors, lending platforms have substantially expanded the number of their platform users and benefited from economies of scale in search and matching. The platforms leverage machine learning tools to analyze big data from lenders and enhance credit analysis. BigTech platforms use their informational advantage on the business activities of their clients to identify creditworthy borrowers more accurately and offer credit to them. For example, e-commerce platforms have access to transaction activities of small business users on their platforms and can significantly overcome credit frictions involved with small business lending. The supply of global digital credit has been continuously and significantly increasing from less than $40 billion in 2013 to about $800 billion in 2019. BigTech credit that was twice as large as marketplace lending in 2019 grew rapidly in Asia and some African and Latin American countries. The marketplace lending activity declined in 2018–2019 due to strict regulatory measures and market developments in China that alone accounted for more than 80 percent of global marketplace lending. However, the overall size of the sector is still small accounting for less than 1 percent of global private credit in 2019 (Cornelli et al., 2020). It is important for the government to ensure the conduct of business is orderly and user rights are protected. For example, in the case of platforms that provide risk scoring of loans based on machine learning, it is imperative to monitor robustness of their risk models through credit and macroeconomic cycles. Machine learning based credit scoring often contains many indicators some of which may trigger discrimination and lead to digital financial exclusion and redlining. For example, indicators such as gender, race and religion could cause bias and should be excluded from models (Bartlett et al., 2019; Bazarbash, 2019; Fuster et al., 2022). Other common problems include commingling of funds (between those of lending platforms and lenders) and lack of financial literacy among retail investors and underpricing of risks that they are exposed to. Digital investment On the investment side, in addition to crowdfunding, online trading platforms, also called “eTrading” platforms, have been developed in fintech to enable retail investment in a wide range of financial products that were previously only available to institutional or high wealth investors. Retail investors can take positions in government bonds, treasury bills, money market instruments, and other financial assets traded in major international exchange markets. An eTrading platform acts as an online broker with free or minimal commissions and allows small investment in financial assets. The eTrading platforms are accessible on smartphones and the web. Retail investors can expand their investment position by using margin account services offered by some platforms. A margin account is effectively a secured loan issued by the broker to the customer backed by the traded position.10 The platform provides real-time updates on prices, trade volumes, news, disclosures, and other information depending on the sophistication of their target investors. To start using the platform for trading, the user’s identity is verified, and the investor should deposit a small starting balance. Accordingly, online trading platforms have substantially increased investment inclusion in financial markets. The global online trading market was $8.28 billion with

Emerging ideas for fintech applications in public finance  41 the number of users of platforms rapidly increasing from around 1 million in January 2017 to 16 million in July 2021 (Figure 3.2).

Source: Statista and Airnow data.

Figure 3.2

Active users of the leading eTrading platforms

Another way that fintech has expanded investment opportunities for retail investors is through mobile phones. The government can use the mobile money network to allow investing in government securities for mobile money account holders. For example, the government of Kenya issued tax-free infrastructure bonds, called M-Akiba, available to mobile money users with an affordable minimum investment requirement that is significantly lower than holding bonds through capital markets – 3,000 Kenyan Shillings versus 50,000 Kenyan Shillings.

POTENTIAL FINTECH APPLICATIONS FOR PUBLIC FINANCE Fintech applications could be adopted in various PFM areas such as treasury payments, non-tax revenue collection, public investment, and debt management. Fintech adoption could further improve macro-fiscal forecasting, cash management, budget planning, fiscal transparency, and accountability. The gains from integrating fintech solutions depend on the prevailing circumstances and structural factors such as maturity of the government’s existing FMIS, its readiness to adopt new digital technologies, institutional capacities, and enabling conditions. We discuss some of the advantages and limitations of these ideas in this section. While our

42  Research handbook on public financial management focus remains on PFM topics, we make some reference to fintech applications and benefits in tax administration. As the area is evolving and these emerging applications have not been fully tested, the ideas presented in this section should be treated as exploratory suggestions rather than prescriptive recommendations. Utilization of Fintech Applications in Public Financial Management Treasury payments Utilization of fintech solutions could yield higher efficiency for treasury payments, particularly in countries where fintech has filled the financial inclusion gap left by the traditional banking system, as in some emerging economies and developing countries. Depending on the development level and fintech payments adoption in a country, the government payment system could leverage the mobile money network to make transfers to the unbanked and underserved population and use the channel to enhance government-to-person (G2P) and government-to-business (G2B) payments. Likewise, for larger transactions where businesses are involved, such as large payments related to supply of products and services, where mobile money may be limited as discussed earlier, the government could leverage payment platforms provided by online fintech payments and digital banking solutions instead of cash or checks. G2P payments facilitated by fintech have been at the center of governments’ responses to the COVID-19 pandemic. Many governments provided direct cash transfers to protect vulnerable households in response to the pandemic, adopting mobile money, e-payments and online banking solutions to deliver these transfers. Figure 3.3 depicts the expansion of cash transfer programs across regions during the pandemic. The utilization of mobile money payments played an instrumental role in reaching large populations while maintaining social distancing measures during the pandemic (Bazarbash et al., 2020). Across developing countries, during 2020 more than 155 programs leveraged digital payments for the delivery of at least one new or expanded social assistance program (Gentilini et al., 2021). In India, the government transferred funds to almost 500 million beneficiaries under COVID relief packages directly to their bank accounts using online banking platforms in 2020. To enable these payments, India leveraged its existing beneficiaries database in the Public Financial Management System (PFMS), and other IT systems, including commercial bank systems, as well as accessing beneficiary data from various welfare schemes that also operate through the PFMS (Verma and Raj, 2020). In Brazil the number of beneficiaries of direct cash transfers surged from 14 million to 50 million, leveraging the scalability of a cloud-based solution in fintech payments applications (Una et al., 2020b). Eswatini also migrated from cash and check payments to pay elderly grants (old-age pension payments) to digital payments using mobile money solutions leveraging a strong cash-out network and national identity system.11 Digitalizing government payments offers several operational benefits including more timely payments, reducing cost of transactions, and better service delivery to the citizens, for example, by avoiding travel costs to post offices or banks to collect cash or check (Klapper and Singer, 2014). In addition, the experience of various countries underscores the economic gains from digitalizing government payments. In Niger, the application of mobile money to transfer cash mitigated logistical challenges and had a noticeable antipoverty impact. The effect is estimated to reduce the variable administrative costs by 20 percent compared to manual cash transfers attributed to travel and wait time saved by program recipients (Aker et al., 2013, 2016). Mexico transitioned to electronic payments when the federal government spending was

Emerging ideas for fintech applications in public finance  43

Note: Adequacy is the total transfer amount received by beneficiaries as a share of pretransfer total income and coverage denotes the share of population that receives social assistance. AP: Asia and Pacific; EMs: emerging markets; EUR: Europe; LAC: Latin America and the Caribbean; LIDCs: low-income developing countries; MENA: Middle East and North Africa; SSA: sub-Saharan Africa. Source: International Monetary Fund (2021b).

Figure 3.3

Social safety nets, before and during the COVID-19 pandemic

highly decentralized in mid-1990s, and the payment process involved long delays and confusion. This was partly due to required paperwork to show entitlement and the wide discretion used on the timing of executing payments because of a lack of centralized guidelines. The shift to digital payments that began in 1997 is estimated to yield cost savings of $1.27 billion annually or 3.3 percent of total expenditure on salaries, pensions, and social transfer programs (Babtaz, 2013). More recently, the IMF has been providing support to Costa Rica for improving the payment system for cash social programs and promoting financial inclusion amongst beneficiaries, especially women. Through a hackathon12 carried out in 2019, digital prototypes to centralize these payments at the National Treasury and ensure their traceability by adopting digital payment means (for example, e-wallet and mobile banking) were developed. Costa Rica has implemented a prototype in 2021 and started to process social payments through a platform called SUPRES13 in 2022. Innovations in digital money, including the use of cryptocurrencies and CBDCs as acceptable media of exchange, could create new opportunities and challenges for PFM: ● Private cryptocurrencies: El Salvador became the first country to adopt a private cryptocurrency, Bitcoin, as a legal tender alongside the US dollar. In June 2021 a law was enacted establishing that the US dollar will be used as a reference currency for accounting purposes, mandating the acceptance of Bitcoin by economic agents in exchange for goods and services. The law also guarantees automatic conversion from Bitcoin to US dollars, through a trust fund. As the International Monetary Fund (2021a: 2) stated, “initiatives to improve financial inclusion are welcome, but Bitcoin use carries significant risks and

44  Research handbook on public financial management Bitcoin should not be used as an official currency with legal tender status. Narrowing the scope of the Bitcoin law will contain some of the macroeconomic risks. Strict regulation and supervisory oversight are needed to mitigate remaining fiscal, financial integrity and financial stability risks.” Adoption of cryptocurrencies may also create new PFM challenges for governments (Box 3.2). ● CBDC: The programmability aspects of CBDCs could be built in where a particular digital currency can be spent by a particular individual (digital identity), for a particular purpose and/or geographical region. Such programmability could be used to address income and regional disparities and could be another tool to design and implementing new fiscal policies. Moreover, the large transactions data collected by the public sector entities could unlock new insights into public policy implementation. However, depending upon how the rollout of CBDCs unfolds, governments will need to maintain a fine balance between the expenditure targeting and individual data privacy. ● Digital money in the form of e-vouchers: The government could issue e-vouchers to pay for a particular type of service. For example, the National Payments Corporation of India14 (NPCI) e-voucher concept is being discussed to pay for health services. The users of this seamless one-time payment mechanism will be able to redeem the voucher without a card, digital payments app or internet banking access, at the merchants accepting Unified Payments Interface (UPI) e-Prepaid Vouchers. The e-RUPI by India’s National Health Authority would be shared with the beneficiaries for a specific purpose or activity by organizations via SMS or QR code. Such a payment mechanism will allow the government to make payments to beneficiaries directly, therefore better targeting the subsidies or social sector payments as well as preventing leakages.

BOX 3.2 POTENTIAL PFM CHALLENGES IN IMPLEMENTING DIGITAL MONEY • Storing cryptocurrencies in government treasuries: Cryptocurrencies may be stored and managed in different ways such as privately managed crypto exchange, mobile wallets, or cold stored (e.g., offline wallet-ledger, Trezor). Depending upon the type of solution, managing the private key is very complicated and requires a high level of personal accountability. Losing the private key could mean permanent loss of public resources and there may not be ways to restore assets. In addition, protecting this type of digital asset from cybercrime will require sophisticated technologies and high technical capabilities within the government treasury in particular and the public sector in general. • Transaction management: The government banking arrangements allow the public sector to actively manage transactions and in case of error these transactions could be rolled back. In case of fraud, banks cooperate with the government and often such bank accounts with stolen funds are frozen and stolen assets are recovered. However, in the case of cryptocurrencies, error in transactions cannot be reversed because transactions executed on the blockchain create an immutable record. Therefore, if the beneficiary database is not updated properly with the beneficiary information, irreversible erroneous payments could occur. Beneficiaries may prefer individual addresses for each

Emerging ideas for fintech applications in public finance  45 transaction posing further challenges to a centralized beneficiary database management which is central to large scale cash transfers. • Maintaining a TSA and cash management: High volatility in the exchange rate of cryptocurrencies might lead to unpredictable cash requirements – a challenge for cash management. It could also disrupt a decentralized model of TSA and add to complexity by adding numbers of cryptocurrencies addresses over and above hundreds of bank accounts. The public sector could also face issues around protocols to create a new invoice/address to send and receive funds from individual and business. • Government accounting: Measurement issues may arise in accounting due to high volatility in exchange rate and affect payments depending on the timing of conversion. In general, accounts depicted in non-cryptocurrency may not reflect a true and fair picture of a government’s financial position. • Internal and external oversight: Internal and external audit departments should develop the necessary institutional capacities to analyze the cryptocurrencies ecosystem, including nodes and transactions. Wider adoption of fintech payments applications would also allow the government treasury to digitalize almost all its payments operations. Currently, in many developing and emerging economies with a relatively large informal sector, where the degree of banking of the general population and business remains low, the government treasury (including regional and municipal administrations) still relies on cash and checks to make general payments. As the unbanked population and businesses adopt fintech applications, the government treasury would have a viable option to digitalize almost all its payments (Una and Langhoff, 2021). The government treasury should play a central role in adopting fintech applications for public sector payments to maintain and increase the treasury single account (TSA) coverage The TSA is a prerequisite for modern cash management and utilizing digital means of payments. The TSA is an effective tool for the treasury to establish oversight and centralized control over government cash resources by setting up a unified structure of government bank accounts (Pattanayak and Fainboim Yaker, 2011). Government banking arrangements are critical for ensuring that (i) all tax and non-tax revenues are collected, and payments are made in a timely manner, and (ii) government cash balances are optimally managed to reduce borrowing costs (or to maximize returns on surplus cash). Adopting fintech payment solutions should not involve moving funds out of the TSA coverage to be managed by the line ministries or agencies individually. By contrast, fintech payments should facilitate the inclusion of all public resources in the TSA by automating their transfer and the fund reconciliation process, keeping a TSA key role in the performance of government cash management. Non-tax revenue collection The public sector has also leveraged payment gateways, e-payments and online banking to facilitate online real-time non-tax revenue collections (e.g., in Senegal, Box 3.3). In general, these revenues reflect the fees for goods and services provided by the government, such as natural parks entrance fees, passport issuance, agricultural services charges, fines, and public procurement fees among others. The public sector treasuries have either developed their own payment gateways or integrated with the settlement systems by external service providers to facilitate online non-tax revenue collections. For example, in India, non-tax revenue portal has been integrated with the banks and aggregators to provide a single platform for the users

46  Research handbook on public financial management to pay for non-tax revenues. A similar solution was adopted in Dominican Republic to collect payment related to different type of non-tax revenues by utilizing online and mobile banking applications.

BOX 3.3 FINTECH APPLICATIONS IN SENEGAL FOR TAX COLLECTIONS In Senegal, the IMF 2016 hackathon led to several digital initiatives, including mobile payments. M-Tax is a hackathon IT solution used by small businesses and individuals to declare and pay tax using SMS, Unstructured Supplementary Service Data (USSD) and interactive voice server channels. In addition to M-Tax, the Senegalese tax administration continued to develop and implement digitalization solutions across the administration, including: electronic filing solutions designed specifically for small businesses, and other solutions designed for medium and large taxpayers; electronic filing of annual financial statements; electronic monitoring of tax audit activities; a datawarehouse system; automatic validation of taxpayer location to validate registration; and electronic purchase of tax stamps using a single-use QR code. Between 2016 and 2019 there have been visible compliance improvements, including the following: • M-Tax – small businesses declaring and paying taxes rising from 0 to 70 percent; • E-Tax – online declarations and payment for large taxpayers’ growth from 1 to 100 percent, and medium taxpayers from 0 to 65 percent; • Electronic filing of annual financial statements rising from 0 to 91 percent (large taxpayers) and 42 percent (medium-size taxpayers); and • Electronic monitoring of audit activities increasing from 0 to 100 percent. In the case of Rwanda, there is a comprehensive GovTech solution for government services, called IremboGov, that was introduced in 2015 allowing users to apply and pay for a range of public services, including community-based health insurance, driving test registration, and visas, using digital means of payments, such as mobile money. In early 2020, about 300,000 service requests were successfully processed each month through the platform. IremboGov both facilitates access of users to government services and improves government revenue collections while cutting costs by reducing leakage, improving transparency, and decreasing administrative expenditures. The revenue administration agency and accounting authorities also collaborated to seamlessly integrate tax collection, accounting, and reconciliation without any manual interface, which can be facilitated by fintech applications. Closer integration between information systems of different organizations requires alignment of data definitions, coding of organizations, and revenue collections codes. Brazil is adopting an innovative digital platform to collect non-tax revenues called PagTesouro. This platform was developed by the National Treasury and operated over the Brazilian Payment System (SPB) managed by the Central Bank. It allows public agencies to collect different types of fees (such as fees for sanitary inspections), educational services, and fines, among others. The PagTesouro platform exchanges information with the accounting system and the treasury system, to register the revenues automatically in the general ledger and to receive the funds in the TSA. Despite this experience, the

Emerging ideas for fintech applications in public finance  47 relationship between different data codification structures remains a challenge for seamless integration of various non-tax and tax, treasury, and banking information systems. Public debt management Fintech credit capabilities in improving credit assessment of borrowers could be used as an example to develop an oversight and assessment model of debt guarantees. Such guarantees are often provided by the government treasury to other public sector entities, mainly state-owned enterprises (SOEs) or subnational levels of governments. Following the experience of fintech credit models, the corresponding public sector model would include specific characteristics of the public enterprises and at the same time make digital collection of financial indicators information, for example from SOEs, more rapid and convenient. Similarly, machine learning tools could be leveraged to analyze big data from other entities of the public sector to enhance the fiscal risk analysis and oversight of the treasury guarantees, which has become a key function of finance ministries. Another area where fintech digital credit could be utilized in PFM is to issue short-term debt to finance treasury cash shortage. For example, government treasury could integrate short-term investment opportunities, such as treasury bills, into fintech investment platforms, bring the superior experience and reduce administrative burden in the existing processes. Brazil and Mexico have started this process by allowing citizens to directly invest in public debt through specific digital applications developed by their treasuries. Public investment Fintech investment applications could provide opportunities for public investment project-based crowdfunding. In the public sector, crowdfunding is a way of financing small investments projects through a large number of small contributions from citizens, rather than from government revenues. Some countries have used crowdfunding to finance public projects, especially at the local government level. For example, Travis County in Texas, USA, crowdfunded a part of court program costs. The City of Berkeley in California is exploring opportunities to utilize fintech investment applications to issue micro bonds with a barrier entry of $25. These micro bonds will finance equipment in the short term and green energy and housing in the long term. The public crowdfunding platforms could allow the government to call for public participation in resource allocation to community projects, reaching out to citizens and providing opportunity to participate beyond payment of taxes. Fintech investment applications applied to crowdfunding initiatives could also facilitate transparency and accountability as projects’ financial and physical progress could be updated and monitored through online fintech applications. Benefits of Fintech Applications in PFM Strengthening fiscal transparency Fintech payment applications could improve fiscal transparency and accountability by improving the reliability of budget execution data and enforcing controls over the financial transactions. Digitalization of government payments along with robust beneficiary identification and management, and strong bank reconciliation provide high frequency, reliable budget execution data which could be published in the public domain, therefore enhancing fiscal

48  Research handbook on public financial management transparency. Transaction-level information on payments in a centralized database could be easily audited for control purposes. The centralized database with full audit trail that can keep track of past activities and disclose information on the individuals who created, authorized, and edited financial records is a good platform to enforce accountability. Fintech payment applications could also improve the decentralization of financial operations to line ministries, while strengthening centralized controls and fiscal transparency. Moreover, execution of payments and collection of revenue can be delegated more freely to line ministries as long as FMIS controls are adhered to and complied with. This opens up new opportunities for more decentralized operations at the level of line ministries to better integrate financial management with the policy execution, while strengthening the budget execution and payments controls through the FMIS. To take advantage of these opportunities, however, it is important to achieve progress in other areas of government, such as authenticating policy target groups (via Digital ID) and ensuring that targeted groups can receive payments digitally through the establishment of unified end-beneficiary databases that can be accessed by line ministries and treasury. Enhancing macro-fiscal forecasting Developing sound medium-term macroeconomic perspectives that anchor the annual budget formulation requires timely, relevant, detailed, and reliable information. This includes preparing and updating the macroeconomic framework and macro-fiscal forecast models, which link the government’s budget and the aggregate economy, including forecasting of the likely revenue envelope available for spending. In addition, during the budget execution phase, nowcasting techniques could enhance the efficiency of the fiscal policy by generating more timely projection of key macro-fiscal variables, such as revenue projections. Nowcasting15 facilitates fiscal surveillance and management, short-term prediction of economic activity, and key analytical macro-fiscal research, such as estimating the size of fiscal multipliers (Misch et al., 2017).16 Granular and timely data on revenue collection in general, and on non-tax revenues in particular, as well as payment data related to specific expenditures, such as cash transfer social programs or health suppliers payments, generated by fintech applications could be an important source of information to improve the quality of medium-term fiscal projections plus the reliability of nowcasting exercises during the budget process. Currently, countries across different regions face problems for the government treasury to capture timely and reliable information on non-tax revenues, which are in general collected by sectorial ministries and public agencies in cash or checks. This situation could generate reconciliation delays at the TSA, if it was adopted, or under other government banking account arrangements. Regarding expenditures, for some types of payments (e.g., payments of primary schools’ scholarships), in some countries the FMIS only registered a bulk transfer from the treasury to the social agency. Later the social agency processes the beneficiaries’ payments though its own commercial bank accounts. This situation hampers the access of reliable information on the effective payment dates to treasury and could generate possible idle resources outside the TSA. In the case of revenue projections, where fintech payments through mobile money, e-payments, and online banking platforms are used for collecting them, especially non-tax revenues, disaggregated and reliable information about revenue collection, including accounting classification, could become available almost real-time, as was indicated in the case of Brazil previously. Also, the quality of historical data could be improved based on more reliable

Emerging ideas for fintech applications in public finance  49 information, identifying for example historical trends for some specific income. This data on non-tax revenues could be an important input to improve the revenue projections as part of the macro-fiscal forecasting. This is particularly beneficial in low-income developing countries and fragile states where a large fraction of non-tax revenue collection is still carried out manually, leading to long delays in availability of funds collected in the treasury bank accounts and in detailed and reliable accounting information. Besides, the information generated by fintech applications could also be utilized to update the non-tax revenues projections as a part of nowcasting exercises during the budget execution phase to monitor and adjust its expected performance. In the case of expenditures, the granular information related to some types of payments, for example cash transfer social programs, could be an important input for nowcasting exercises to evaluate and to project the deployment of emergency support provided in response to shocks such as the COVID-19 pandemic. Based on these exercises timelier budget reallocations, or the request of supplemental budgets, could be adopted. Improving budget planning and execution (mainly for cash transfer social programs) Adopting fintech payment applications can support better cash transfer social programs targeting, by helping to reduce leakage and take-up problems. In addition, utilizing fintech payments to deliver cash transfer social programs produces as a benefit the generation of better information for these social programs’ resource allocation in the budget planning and improved budget execution as discussed below. Lack of good quality and timely information on the beneficiaries can lead to leakages as well as inefficient and untargeted spending through fraud, corruption, or errors in coverage. The design of income-support programs exposes the government to two main challenges (International Monetary Fund, 2018): ● Exclusion errors: when eligible individuals do not, or only partially, receive benefits to which they are entitled – also called non-take-up problems; and ● Inclusion errors: when knowingly or not, individuals are appropriating social benefits or services to which they are not entitled – also called the leakage problem. In the case of non-take-up problems, as demonstrated during the COVID-19 emergency, fintech payments applications were a key instrument to reach the unbanked population, especially in low-income developing countries through mobile money, e-payment, and mobile and online banking solutions, despite severe challenges to properly identify the beneficiaries and the necessary adjustment in government information systems, including the FMIS (Una et al., 2020a). In the same way, by increasing transparency and control over the emergency response measures, by publishing better information in fiscal transparency portals related to payments, fintech payments adoption helped to mitigate take-up challenges. An impressive example is the Novissi17 program in Togo. At the start of the COVID-19 pandemic, in just 10 days during April 2020, the Togolese government built and launched a digital mass payment platform, allowing beneficiaries to enroll and receive mobile money payments within 120 seconds via basic mobile phones – without internet. During its first phase, Novissi used an occupation-based targeting approach by taking advantage of the recently updated voter ID database. To further improve the targeting of the most vulnerable people, mainly informal workers, in its second phase, the program leveraged satellite imagery, cellphone metadata, and machine learning to identify the most vulnerable individuals within the 200 poorest districts.

50  Research handbook on public financial management Despite the absence of a national social registry, Togo managed to distribute $34 million across the two phases, to a quarter of its adult population (Chowdhury et al., 2022). Box 3.4 summarizes some of the benefits and challenges of adopting fintech solutions in public finance management.

BOX 3.4 PUBLIC SECTOR INSTITUTIONAL CAPACITIES AND CHALLENGES TO ADOPT FINTECH APPLICATIONS Public sector institutional and technological capacities should be strengthened in order to adopt fintech solutions. Some countries’ PFM IT systems have structural weaknesses that could hamper the adoption of fintech solutions. For example, it is quite common that the FMIS and other public finance related IT systems, such as payroll systems and public investment systems, work in silos hampering information exchange (Una et al., 2019). A well-functioning FMIS provides timely, reliable, and comprehensive reports that support implementation of the government’s fiscal policies and fiscal rules, and the formulating, controlling, monitoring, and executing of the budget. The architecture of FMIS has undergone a transformation since these systems were first developed in the 1980s. Rather than attempting to cover all or most PFM functions, many FMIS now focus on a few core functions such as accounting and reporting, budget execution, and cash management. Yet a survey of 46 countries shows that many face severe challenges in transforming their FMIS into an effective tool of fiscal governance. These challenges relate to weaknesses in the system’s core functions, its institutional coverage, the information technology platforms it uses, and the ease of sharing data with other IT systems. Una et al. (2019) discuss how to address these challenges. Replacing an FMIS with an entirely new system may not be an optimal strategy. By utilizing the latest technology, a better approach may be to update or replace one or more core modules of the system: the so-called modular approach. Implementation of an effective FMIS, however, depends on two critical preconditions: strong political motivation and commitment, and the system’s ability to meet ongoing and anticipated PFM needs (Una et al., 2019). Also, FMIS frequently does not have the technological capabilities to automate the data exchange with the fintech sector. Secondly, authentication of citizens and businesses in connection with establishing digital payment solutions may prove difficult. Therefore, a strategy to promote the adoption of fintech applications in the public sector should include initiatives to strengthen the treasury’s institutional and technological capacities. On the other hand, the main sources of cyber risks in implementing fintech solutions come from cybercrimes, biases in automated decision making, breaches in data privacy, and new avenues for tax evasion and fraud. Criminals target government PFM systems to steal digital assets, seek ransoms (using ransomware), and undermine government interest and disrupt financial services. Fraud is also a common way to exploit weaknesses in internal controls and steal funds from poorly designed public financial management systems, as experienced by Malawi and Kosovo. Privacy concerns may limit the full exploitation of fintech in the public sector. Through PFM IT systems, government treasuries collect sensitive information on suppliers, public employees, cash transfer beneficiaries, and taxpayers. For example, programmability of CBDC to better track and target government expenditure requires striking a balance between efficient delivery of service and maintaining user privacy.

Emerging ideas for fintech applications in public finance  51 Examining the benefits of generating better information for the resource allocation to these social programs adopting fintech payments, in coordination with digital identity18 and socio-economic information database initiatives (Prady et al., 2020), could generate more reliable and timely data on the total number of expected beneficiaries, which could be impacted by the reduction of non-take-up problems. Based on factual data, the social agencies and the ministry of finance can estimate more precisely and therefore allocate the appropriate budget resources to cover the eligible population. Likewise, adopting fintech payments to deliver cash transfer social programs increases operational efficiency during budget execution as presented for the Togo case above, avoiding some of the cumbersome issues of in-person registration and cash payments. Upgrading cash management By adopting fintech payment applications, the treasury’s cash position could be established more easily and precisely. The fintech systems facilitate expanding the coverage of TSA by discouraging opening of new bank accounts. Fintech applications facilitate direct operation of TSA by removing intermediary bank accounts. Adopting fintech payment applications and expanding the coverage of the TSA are important steps towards fully automating the payment workflow, including bank reconciliation, which is a key functionality to establish the treasury cash position. Real-time knowledge of cash position allows more active management of TSA surpluses and deficits. In addition, this situation allows to maintain all controls within the umbrella of the FMIS, which strengthens commitments control – for instance, the FMIS could be configured to disallow a payment where the purchasing order module has not been used to set up a commitment – and ultimately strengthens compliance with the PFM legal framework. Payments utilizing fintech applications should not jeopardize treasury’s cash position in the TSA. The treasury must assure that when utilizing new digital instruments, such as mobile money or e-payments, public resources will not be sitting idle with the operator of the mobile wallet or e-payment platform. The same argument applies with regards to payment of different types of revenue into the TSA using fintech channels. For example, in Nigeria, the treasury’s objective of avoiding idle funds outside of the treasury’s bank accounts was achieved through the Central Bank of Nigeria and Nigerian Communication Commissions regulatory framework for Mobile Money Services requiring that the settlement of mobile money transfers shall leverage the Nigerian Interbank Settlement System infrastructure and the Central Bank of Nigeria Funds Transfer System to facilitate instant payment to end-users directly from the TSA. This approach reduced the idle funds usually kept in bank accounts for mobile money operations.

CONCLUDING REMARKS Financial technology innovations provide new opportunities to enhance the delivery of financial services and increase affordable access to the underserved population and businesses. New information generated through the digital footprints of fintech users creates new possibilities to strengthen data-reliant financial services in the private and public sectors. Fintech can expand the scope of financial services to remote locations and vulnerable citizens, and enable governments to provide cash transfers and lifeline support more securely and rapidly. A case in point is the fiscal response to the COVID-19 pandemic. Fintech applications could be adopted in various public finance areas to increase operational efficiency and effectiveness

52  Research handbook on public financial management by including, for example, a larger set of beneficiaries and using the information to inform on more accurately identifying beneficiaries, leading to better policy design. We study how fintech developments in the private sector in payment, credit, and investment could be incorporated in public financial management. We conceptually describe how fintech innovations have built on opportunities provided by digital technological advancements to mitigate financial frictions and increase access to alternative finance. Building on this analysis and considering the early experience of some countries, we explore the adoption of fintech applications in PFM. We specifically focus on the value of adopting fintech payment in treasury payments and non-tax revenue collections and fintech credit and investment in public debt management and public investment. Fintech developments are still emerging, and their implications for financial development, financial stability, and economic growth have not been fully materialized yet. As the sector and applications evolve, new opportunities and subtle challenges will emerge that require authorities’ and policy makers’ vigilance and timely and appropriate responses. To adopt fintech, governments need to overcome internal challenges of legacy systems, possibly inconsistent data, limited institutional capacity, change management, and new governance and need to deal with operational risks, notably cyber risks and data privacy issues. However, despite its significance, such discussion is beyond the scope of this chapter. Assuming successful adoption and integration of fintech applications in public finance, we discuss its implied benefits for PFM. Increased efficiency and effectiveness of resource allocation and fiscal policy implementation (such as cash transfer social programs) in light of fintech could lead to better budget planning and execution. Fiscal transparency could be strengthened by using reliable high-frequency data from the activity of fintech users. Similarly, such data could advance macro-fiscal models’ forecasting power that is crucial for medium-term budget planning, as well as improving the reliability of nowcasting exercises. Finally, integrating fintech payments with the treasury account could make managing daily cash positions possible and result in upgraded cash management practices. The adoption of fintech in public finance has already started, and as well as in other areas of the economy, these innovations will bring benefits that governments need to be ready to promote, but at the same time challenges that should be faced. This chapter is an initial step in highlighting the complex issues involved.

NOTES 1. The views expressed in this article are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. We have no other known conflict of interest to disclose. 2. Fintech is not new. Technological advances have had a long history in transforming financial services (Arner et al., 2015). Well-known examples in the past fifty years are credit cards in the 1960s, messaging services in the 1970s, automated teller machines (ATMs) in the 1980s, electronic trading in the 1990s and digital banking in the 2000s (World Economic Forum, 2016). 3. The experience of mobile money in sub-Saharan Africa, notably Kenya, Tanzania and Uganda, is a stark example. Consequently, fintech is emerging as an important driver of financial inclusion particularly in low-income and emerging economies (Espinosa-Vega et al., 2020; Khera et al., 2021; Sahay et al., 2020). 4. To avoid legal connotations with the term “agent,” in some jurisdictions they are called “merchant” or “retailer” (GSMA, 2010).

Emerging ideas for fintech applications in public finance  53 5. For example, when writing this chapter, a verified PayPal account linked to a bank account or a credit card can send any amount in total with a single transaction limit of $10,000 (PayPal, n.d.-c). 6. For example, in August 2021, PayPal had a presence in more than 200 countries/regions, supported 25 currencies, with more than 400 million active users and had processed more than 4.7 billion transactions (PayPal, n.d.-a, n.d.-b). 7. Some large banks, like Barclays and Lloyds, have invited fintechs to develop their in-house incubators and innovation labs. 8. On the other hand, increased competition in a concentrated market could prompt improved services by banks. 9. When the platform significantly contributes to funding loans on its platform, the model is called “balance sheet lending.” 10. If the value of underlying financial asset drops below a threshold called a maintenance margin, the broker makes a margin call to the investor, which requires the investor to increase their cash position within a short period either by depositing funds to the account or liquidating other positions. Otherwise, the underlying position is closed and liquidated. Margin calculations and calls are automated in online investing platforms. 11. Eswatini’s prime minister’s statement, April 1, 2020. 12. A hackathon is a competition to innovate or provide a solution to a defined challenge within a very short period (24 to 48 hours) by participants with different backgrounds. 13. Sistema Único de Pago de Recursos Sociales. 14. National Payments Corporation of India (NPCI) is an umbrella organization for operating retail payments and settlement systems in India. 15. Prediction of economic activity for the present, the near future, or the recent past. 16. Misch et al. (2017) refer to nowcashing, to indicate the use of daily fiscal data, that are mostly collected on cash-based systems, for different types of real-time macroeconomic analyses. 17. “Novissi” means solidarity in the Éwé language. 18. Digital identity systems are an important component of the public infrastructure to facilitate the adoption of digital means of payments as the cases of Aadhaar in India, MyInfo in Singapore and e-identity in Estonia show.

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56  Research handbook on public financial management Una, G. and Langhoff, S. (2021). Treasury Management and Digital Payments. Latin America Treasurers Forum – FOTEGAL. Verma, A. and Raj, A. (2020). PFM blog: PFM solutions in India to combat the COVID-19 pandemic. Public Financial Management Blog, April 13. https://​blog​-pfm​.imf​.org/​pfmblog/​2020/​04/​india​-pfm​ -covid​.html. Wirtz, J. (2020). Master Class: Platform Business Models. https://​www​.youtube​.com/​watch​?v​=​A​ _G91QynhVk. World Economic Forum (2016). The future of financial infrastructure: An ambitious look at how blockchain can reshape financial services. World Economic Forum. https://​www​.weforum​.org/​reports/​ the​-future​-of​-financial​-infrastructure​-an​-ambitious​-look​-at​-how​-blockchain​-can​-reshape​-financial​ -services/​.

PART II GOVERNMENTAL ACCOUNTING, AUDITING, AND FINANCIAL REPORTING

4. Theories informing public sector accounting and financial management changes in the era of new public management Robert Ochoki Nyamori

INTRODUCTION There is general understanding that the nature of the public sector – its role, structure and financial management systems – has changed especially since the early 1980s with the advent of New Public Management (NPM) (Hood, 1995; Olson et al., 1998, 2001). These changes have been informed by shifts in the assumptions and knowledges that underpinned the public sector since the Progressive era. The distinction between the public and private sector has been blurred. The public sector increasingly looks like the private sector, especially in the type of financial management technologies adopted by the public sectors of many countries. While much study has been devoted to the changes which are discerned, less attention has been paid to an understanding of the theories and concepts which underpin these changes. This chapter seeks to achieve four objectives. First, it explores whether the public sector is now more or less like the private sector following NPM. Second, it examines how the organization, structure and financial management systems of the public sector have changed following NPM. Third, it outlines the key theories and concepts which inform these changes with a specific focus on their influence on public sector accounting and financial management. Fourth, it speculates on future developments in public sector financial management. The chapter is based on a thematic review of the secondary literature on public sector financial management. The chapter is structured as follows: the second section analyses the differences between the public and private sectors. The chapter questions whether the described changes have obliterated the boundaries between the two sectors. The third section examines the changes to the structure while the fourth section describes the changes to public financial management systems following NPM. The fifth section explains the theories which inform the changes described in section three and four. The sixth section speculates on future directions in public sector financial management while the seventh section concludes the chapter.

BLURRING OF THE BOUNDARIES BETWEEN THE PUBLIC AND PRIVATE SECTOR Even before the advent of NPM, the distinction between the public and private sectors – and how they should be managed (or administered) – was a subject that elicited serious debate among scholars (e.g. Hood, 1995; Antonsen and Jorgensen, 1997). Two polar positions had emerged, namely, those who argued that the sectors are different (e.g. Sayre, 1958) and those who argued that the two are not (e.g. Moe, 1990). The implication of this polarization is that 58

Theories informing public sector accounting and financial management changes  59 when we claim that the boundaries between the public and private sectors have blurred, we have to contend with those who argue that such boundaries never existed in the first place. The first group argues that the public sector is different from the private sector in a number of important ways. Firstly, while the private sector is owned by shareholders (or partners or sole proprietors depending on the business type), the public sector is owned by a collective – namely, all citizens. Secondly, the levers of control in the public sector lie in the political system, while those for the private sector lie in the market. Put differently, the public sector is not governed by the laws of supply and demand nor by the resultant prices. Thirdly, while the public sector is funded by the collective via taxes, the private sector is funded by individual owners via capital injection or share purchases. Fourthly, the public sector is a creature of laws: it is laws that define what is public and what is private. So the law has defined the public sector as being public (Bozeman and Bretschneider, 1994). The above reasons might be viewed as the core differences between the public and private sectors, but there are also differences to do with the two contexts (Boyne, 2002). These are that public sector organizations have a diversity of stakeholders who place different demands and constraints on public administrators. These demands are evidenced by the multiplicity of goals – some of which are conflicting. While public sector organizations have distinctive goals and purposes, these goals are often vague because they emanate from a political process which seemingly prefers ambiguity over clarity (to avoid upsetting some constituencies). Research thus suggests that public sector administrators often have to balance between the accountability demands of these different constituencies (Sinclair, 1995). This situation is contrasted with the private sector which ostensibly has a single stakeholder group whose major goal is profit maximization. While some assertive groups in companies are pushing for additional action and performance relating to the social and the environment, it is still argued that private sector organizations have a far more limited constituency to deal with. Related to the above is the question of what the raison d’être of the public sector is compared to that of the private. Proponents of differences between the two sectors hold that the private sector has a single goal: profit maximization. Economist Milton Friedman famously argued that businesses should not pursue any other objective other than profit maximization (Friedman, 1970). One might argue that there are public sector organizations which are structured to make profit – such as state-owned enterprises (SOEs) – but then the counter to that would be that often these entities are required to achieve social objectives as well and so failing to make a profit is not fatal to their going concern status. Instead, the focus of old public administration was providing public services efficiently (Hood, 1995). Public sector organizations were argued to be permeable to the demands of their constituencies. This permeability is necessary to ensure services are responsive to public needs. Public sector organizations are therefore considered to be open to incessant demands for accountability from a diversity of sources – demands which are often backed by freedom of information laws. The public sector has created forums – especially Parliament – where public administrators are often required to account for what is happening in their domains. Other such offices include that of Ombudsman. This scrutiny means that public sector organizations are easily influenced by external events. These events include elections that incumbents want to win through a demonstration of results during their incumbency which they use to woo voters in the next election. The nature of the public sector is also such that often it occupies a monopoly position. This might be because government is seen as a provider of last resort and so is set up to provide

60  Research handbook on public financial management public services where the private sector would not. Providing postal services or a health centre to a rural community in a far-flung place are examples. Sometimes, the public sector entity might not be the only one providing the service, but often they tend to occupy a dominant position vis-à-vis the private sector. Where there is more than one public sector organization in a place providing similar services, it is not expected to view the other as a competitor (though in reality that might happen): rather the two are expected to collaborate, not compete. Within these differentness, there are some who argue that public servants are different from private sector employees in that the former are not motivated by profit but by a greater sense of wanting to serve the public interest. Yet others argue that public servants have lower commitment to the public sector largely due to inflexible personnel and procedures, often encumbered by the law and bureaucratic red-tape. The poor link between work and performance is characterized by lower pay compared to their private sector counterparts. Furthermore, these employees are accorded lower managerial autonomy, which hampers their ability to quickly respond to changes in the environment. These are often the reasons advanced to justify transformation of the public sector in the image of the private sector (e.g. Osborne and Gaebler, 1992). There were also assumptions during the Progressive era that the public sector is pure compared to a private sector that is tainted with corruption (Hood, 1995). The public sector therefore has to be protected through the use of different administration methods compared to those used in the private sector (Hood, 1995). These methods traditionally included: limiting managerial discretion through rules and procedures; selection of devoted public administrators who imbibe community values; and building relationships based on high trust so as to lower transaction costs. The focus on high trust implied that there was less emphasis on technologies of trust such as accounting. Accounting was only considered useful at the boundary where the public sector encountered the corrupting external forces of the private sector (Hood, 1995). The differences between the public and private sectors have spawned a different conception of how the two sectors should be structured and governed. Referred to as Progressive era administration (PPA), the public sector prior to NPM was designed to focus on the delivery of public services in the most efficient manner for the benefit of the collective (Hood, 1995). Government was trusted as an agent of good for the benefit of everyone – as opposed to a few individuals. The public was structured on the basis of Max Weber’s principles of bureaucracy, where observance of set rules and procedures was expected to deliver efficient government. Within this structuring, politics and administration were separated with politicians crafting policy and civil servants delivering on the same. Government agencies delivered public services internally. Citizens were viewed as voters, clients or constituents. Government was characterized by a hierarchical superior–subordinate structure, administered by a professional civil service where rank was cherished. Public administrators were expected to evince the values of sacrifice and commitment to serving the public interest – a Jesuit de Corps (Hood, 1995). The civil service was subject to political direction and its purpose was to fulfil the functions of the state (Ostrom and Ostrom, 1971). This neat characterization probably applied more in theory than in practice. Governments often hived off certain functions to be performed by some quasi-commercial entities such as SOEs. But even then, the SOEs were under political direction and were established to achieve social objectives alongside commercial ones. Regarding financial management, cash basis accounting was the dominant form of accounting. In its simplest form, cash accounting is based on the notion that we recognize revenue in the accounting records when it is received in cash and expenses when they are paid in cash. Cash accounting records reveal how much cash is received, how much is paid and what the

Theories informing public sector accounting and financial management changes  61 remaining balances are. Cash basis accounting also includes preparing budgets on the basis of cash to be received, expenditures to be incurred and balances to be held. This form of accounting has traditionally enabled a comparison to be made between the actual cash expenditure and budgeted cash expenditure (Guthrie, 1998). This comparison is particularly pertinent in view of the link between cash accounting and appropriation laws. Traditionally, resource allocations (or appropriations) have been made to certain line items (e.g. salaries and wages) in different government ministries or departments. The appropriations are backed by laws known as Appropriation Acts. These cash allocations have been the fulcrum of accountability in the Westminster system where comparisons are made between actual cash expenditure on specified line items and the appropriated amounts. Cash accounting enables government entities to be held to account for both legality (Appropriation Acts) and efficiency (variance between actual and budgeted amounts) (Christiaens and Rommel, 2008). Cash accounting thus enables monitoring between receipts and payments against appropriations by Parliament. Subsequently, annual reports are prepared which enable Parliament to hold agencies to account. While this form of accounting continues to be used by many governments, its use has come under sustained attack in the push towards NPM. There is, however, a third school of thought – the dimensional approach – which argues that there is no organization that is wholly public or private (Bozeman, 1987; Bozeman and Bretschneider, 1994). Instead, both public and private sectors can be arranged on a continuum of publicness where location on this dimension of publicness is an empirical question. The proponents of this approach argue that the essence of publicness is political control and so some private organizations are more public by dint of being more compliant with laws and regulations compared to some rogue public sector ones. These proponents argue that publicness is a matter of values, not legal classification or task performance (Antonsen and Jorgensen, 1997). The claimed distinctions between the public and private sectors have, however, come under sustained attack especially since the early 1980s with the rise of NPM (Hood, 1995). NPM is based on the second school of thought which argues that there should be no difference between the public and private sectors. Any perceived failures in the public sector are blamed on its differentness – whether in terms of the way it is structured, the values it evinces or even the accounting systems it has adopted. Thus where such differences exist, NPM seeks to eliminate these differences through requiring the public sector to recreate itself in the image of the markets. Such a re-imaging is expected to transform the performance of the public sector. We next examine some of the changes which have been introduced in order to blur the distinction between the two sectors or to entrench any lack of difference between the two sectors following introduction of NPM type changes.

CHANGING THE ORGANIZATIONAL STRUCTURE OF THE PUBLIC SECTOR NPM as indicated above has sought to remake the public sector in the image of the market. Whereas the old public sector sought to provide public services to everyone in need in the most efficient manner, NPM introduced the three Es – Economy, Efficiency and Effectiveness. The subsequent structures of the public sector seek to achieve these three Es. Great emphasis is placed on achieving efficiency and effectiveness (Bryson et al., 2014). Different forms of

62  Research handbook on public financial management organization have emerged that greatly blur the distinction between the public and private sectors. Some of the key structural changes include disaggregating public sector organizations with their own products and each separately managed. For example, power companies in Victoria, Australia, were broken into producers and distributors. Measures to enhance competition between public and public and public and private were introduced. In this arrangement, the role of the public sector was – not to provide – but to procure a certain level and standard of products and services for the public. There was greater borrowing of private sector practices and a greater focus on efficiency. Public administrators – now called managers – were accorded the right to manage. This enhanced autonomy was expected to encourage them to innovate to achieve results. NPM has therefore been marked by a shift towards more explicit ex ante standards of performance through adoption of results-based management systems (Hood, 1995). Meanwhile, the citizen has been repositioned as a customer. Many governments in liberal democracies have divested from public enterprises with numerous enterprises now in private hands. Public sector organizations are being internally reorganized into purchasers and providers so as to mimic the market internally. In this arrangement, purchasers – being the public sector – can buy from internal or external providers. The expressed aim is to create commercial tension where purchasers choose the cheapest and best quality providers and providers seek to be the most competitive in price and quality – thus achieving efficiency (Nyamori, 2009). In other instances, services that were formerly provided by the public sector are now being contracted out to the private sector, with private sector providers tied to performance contracts (Heinrich, 2002; Barton, 2006). Public–private partnerships (PPPs) have emerged where private sector entities build and manage public assets for a sufficient period for them to recover their investment and then transfer their ownership and management back to the government (Heald and Georgiou, 2011). More recently, public–public partnerships (or government-to-government partnerships) are emerging where governments enter into contracts with other governments akin to PPPs. This later development has been associated with mostly Chinese public enterprises (e.g. the Standard Gauge Railway in Kenya). These new forms and practices point to what Kurunmaki and Miller (2010) refer to as hybridization. These structural changes are complemented by novel accounting and financial management systems which we discuss next.

CHANGES TO PUBLIC FINANCIAL MANAGEMENT SYSTEMS Shift from Cash to Accrual Accounting Following NPM, cash accounting came under sustained scrutiny. Cash accounting was criticized as omitting many items from the accounting records. This curtailed a comprehensive management of government assets and liabilities. Cash accounting could not establish the full costs of government services which curtailed efficient management while at the same making the public sector look more competitive compared to the private sector (see Guthrie, 1998). The inability to determine full costs also negatively impacted on general equity (Ball et al., 1999). This scrutiny came on the back of a push to adopt accrual accounting in the public sector – and essentially blur the boundaries between the public and private sectors that we have discussed earlier.

Theories informing public sector accounting and financial management changes  63 The basis of accrual accounting is that transactions should be recorded when they occur, not when cash exchanges hands. Thus under accrual accounting, revenues should be recorded when earned and expenses when incurred. The story does not stop here, however: accrual accounting extends to the accounting reports which are prepared, namely, the profit and loss of the entity (Christiaens and Rommel, 2008). This then means that accrual accounting accounts for the public sector in the same way as for private sector accounts. This is a major departure because notions of profit and loss were traditionally alien to the public sector. The justification for this shift is that accrual accounting would improve transparency and accountability by matching real costs with outputs produced, enabling better evaluation of performance and, combined with continuous reporting and additional commentary, enable parliamentary scrutiny (Ball et al., 1999; Christiaens and Rommel, 2008). Accrual accounting consists of a number of elements (Guthrie, 1998): these are accrual financial reporting, accrual accounting management systems, whole of government reporting and accrual budgeting. First, accrual financial reporting consists of financial statements which are prepared on the basis of accrued financial data. For example the Commonwealth Government of Australia requires preparation of “an operating statement; a program statement; a statement of assets and liabilities; a statement of cash flows; a statement of transactions by funds; and additional accounting notes, disclosures and certificates of the chief executive and the Auditor General” (Guthrie, 1998: 2). The purpose of accrual financial reporting was stated as to enable economic decision-making and accountability. Second, accrual accounting management systems capture and accumulate accrual data on revenues, expenses, assets, liabilities and equity. Third, whole of government reporting seeks to produce consolidated financial statements for an entire jurisdiction, for example the Australian Government since 1994. Fourth is the accrual budget which makes appropriations and resource allocation on the basis of an accrued number, e.g. depreciation (Guthrie, 1998: 2). In spite of the adoption of accrual accounting, its implementation has been rather non-uniform across countries and even within countries (Christiaens and Rommel, 2008). In particular, governments have found it difficult to implement it for accountability purposes in the traditional government contexts (Ball et al., 1999; Christiaens and Rommel, 2008). Some governments have therefore retained elements of cash accounting while adopting accrual accounting. Cash accounting is preferred for accountability purposes because appropriations have traditionally been made on a cash basis. For example, it is harder to justify and account for appropriations to depreciation accounts – which are a product of accrual accounting (Guthrie, 1998). In this situation, accrual accounting may be adopted for the business-like parts of government where it can inform decision-making (Christiaens and Rommel, 2008). The challenge of implementing a pure accrual accounting system has seen governments – e.g. that of the United States (Ball et al., 1999) – adopt a mix of cash and accrual accounting systems. The modified cash accounting system accounts for events when cash is received or expended while at the same time recording events occurring in the current period but which result in cashflows the following period. The modified accrual accounting system accounts for items with a shorter time horizon on a cash basis while items with a longer time horizon are accounted for on an accrual basis; non-financial items such as depreciation are not matched to the period in which they are consumed (IPSASB, 1996). The introduction of accrual accounting in the public sector has been underpinned by the adoption of accounting standards which mirror those of the private sector. These standards include those developed by the Governmental Accounting Standards Board (GASB) and the

64  Research handbook on public financial management International Public Sector Accounting Standards Board (IPSASB). Both of these standards require government entities to prepare their accounts on an accrual basis. The expressed aim of GASB standards is to provide “useful information to taxpayers, public officials, investors, and others who use financial reports” (GASB, 2020: 1). While GASB has a US focus – for local and state governments – the IPSASB develops International Public Sector Accounting Standards (IPSAS) to guide preparation of public sector financial reporting for governments and public entities worldwide. It is instructive that both GASB and IPSASB are private entities – though with governmental presentation – underlining the influence of the private sector on governmental financial reporting. These standards seek to complement the decision-usefulness of financial accounting in the private sector with an accountability focus in the case of the public sector. The justifications for accrual accounting are that it would hold managers accountable for the full cost of operations, reveal long-term obligations and provide a comprehensive financial position (Ball et al., 1999; Guthrie, 1998: 2). Accrual accounting is argued to provide a more accurate view of the cost of government thus enabling a greater focus on efficiency and cost control. However, some have argued that accrual accounting is a mechanism for remaking the public sector into a commercial business-oriented kind of entity (Guthrie, 1998). In spite of the claimed benefits of accrual accounting, questions continue to be raised regarding the efficacy of this form of accounting regarding heritage assets (e.g. Anessi-Pessina et al., 2019) and more generally on the traditional non-business functions of government (Christiaens and Rommel, 2008). These misgivings notwithstanding, other accountings whose aim is to provide more accurate cost data have been adopted to buttress the shift to accrual accounting. Greater Emphasis on Accurate Costing The focus on efficiency under NPM has seen widespread adoption of novel cost accounting systems by governments. New systems of cost measurement such as activity based costing are being adopted to provide more accurate cost data (Arnaboldi and Lapsley, 2003) to enable an assessment of efficiency. The aim of the new cost accounting systems is to provide more accurate costing information for activities, services and products so as to enable accountability for efficiency and decision-making and control. The most prominent costing method is activity based costing (ABC). ABC seeks to measure the cost of activities as a basis for determining the cost of products and services. The assumption is that it is activities that drive costs: if an entity knows which activities are consuming the lion’s share of resources, then it becomes more efficient by managing these activities. ABC has been implemented in UK local government and health (Arnaboldi and Lapsley, 2003, 2005). The other novel costing system which has been introduced by some governments is the capital charge. The capital charge system involves establishing the opportunity cost of capital assets. In this system, an interest rate is employed to calculate the cost of holding capital assets. The thinking is that if public sector administrators were made aware of the cost of holding capital assets, then they would act differently towards these assets. For example, they would not hold on to idle assets but instead sell them or find alternative uses for them (Ball et al., 1999). The capital charge regime aims to direct the conduct of public administrators towards acting as business people would in respect to capital assets. Both the costing systems and the capital charge regime aim to blur the boundary between the public and private sectors by for example revealing the true cost of public services. Underlying this aim is a drive to even the

Theories informing public sector accounting and financial management changes  65 playing ground between the public and private sectors by erasing any advantages the former enjoys over the latter. These systems have been complemented with novel systems to enhance the accountability of public administrators as we see next. Shift from Input and Process to Results-Based Management Systems The cash basis accounting described above enabled accountability on the basis of inputs. Since it was anchored in appropriation laws, it also enabled accountability on the basis of legality and procedures. These forms of accountability came under increasing scrutiny following introduction of NPM. A major issue raised with input and process-based accountability was that these systems did not reveal what the resources expended produced (outputs) and the impacts (outcomes) of this expenditure. This questioning became associated with introduction of result-based management systems (RBMS). RBMS define the outputs (results) to be produced and then resources the entity to achieve these outputs. The public administrators are accorded the discretion over the means to achieve these outputs (Ball et al., 1999). In Australia, introduction of the Outcomes and Outputs Framework (OOF) (Department of Finance & Administration, 2000; ANAO, 2007; Carlin, 2006) followed substantial financial management reforms in the Australian public sector characterized by the increased use of private sector originated practices (Scheers et al., 2005; Barton, 2006; Robinson, 2002). The new framework requires that money be appropriated to agencies on the basis of outcomes, which are defined as the impacts or effects the government wishes to achieve (Department of Finance & Administration, 2000). The agencies are also required to specify specific performance targets for the outputs and report on the basis of this framework (Department of Finance & Administration, 2000). The specified aim of this change is to “improve the agencies’ corporate governance and enhance public accountability” (Department of Finance & Administration, 2000: 2). Public administrators are held to account for outputs through systems of performance contracting where they contract to achieve specified outputs. Performance indicators are developed to enable measurement of achievement of these outputs. This system has been in operation in New Zealand since the 1980s, among other countries (Ball et al., 1999). The system of performance contracting has been extended to emerging economies such as Kenya, India, Ghana and Tunisia, among others (Nyamori, 2021). Kenya for example adopted a system of performance contracting through which individual ministries, departments and authorities (MDAs) came up with performance targets. The targets were vetted by a government appointed ad hoc entity made up of experts and then signed with a Performance Contracting Department established to sign on behalf of the government. These performance targets were then cascaded down the organization to individual departments and to employees within these departments. The MDAs and the employees were required to periodically measure and report their performance which became a basis for their performance appraisal (Republic of Kenya, 2012a, 2012b). A variation of this system but with a similar name has been widely adopted and involves government or private sector organizations being contracted by a government entity to achieve specified outputs against which the contracted amount is paid (e.g. Heinrich, 2002). RBMS have been extended to the budgeting system through introduction of performance-based budgeting systems (PBBS). PBBS is aimed at enhancing the performance of the public sector by funding government agencies on the basis of defined outputs and their contribution to outcomes (results). Government agencies are required to specify what outputs

66  Research handbook on public financial management they will produce and the impact of these outputs to society. Performance information on the actual results is then employed to hold them to account (Robinson and Last, 2009). The rationale for RBMS is that it could improve financial control besides “maximising efficiency and effectiveness in the delivery of services to the community” (Robinson, 2002: 81). Firstly, the specification of outputs and the appropriation of money to agencies on the basis of these outputs is suggestive of an attempt to introduce some form of internal market with the government as purchaser and the agency as provider. Such an internal market would compel public agencies to seek to be more efficient, although Robinson cautioned that the result would depend on the delinking of the revenue base from expenses. Secondly, holding the agencies accountable on the basis of outcomes is suggestive of assigning greater autonomy to managers to manage their departments so as to maximize their bottom-line results. Robinson suggested that the expected autonomy might not have eventuated, with financial control replaced by greater administrative and legislative controls (Robinson, 2002). But he also suggested that such managerial autonomy could be a threat to parliamentary control. Thirdly, the greater flow of information would enhance transparency and accountability. Introduction of RBMS has also been associated with adoption of strategic planning and management technologies in the public sector. Greater Emphasis on Strategic Planning and Management Strategic planning and management is a relatively recent introduction into the public sector (Johnsen, 2015; Llewellyn and Tappin, 2003). Previously, governments developed national policies, often led by politicians, while decisions were made at the department level. These policies, however, were not suitable for devolving responsibility to local level administrators who made daily decisions on service delivery. The outcomes of these decisions were, however, the responsibility of politicians. A need to assign responsibility to those making daily decisions – the civil servants – was thus one of the antecedents of strategic planning in the public sector. It was hoped that strategic planning would help prioritize and hence allocate resources and thus enable political control over civil servants. Beside the need for control, adoption of strategic planning and management was driven by NPM’s modernizing agenda and especially the transformations of government that it spawned (Llewellyn and Tappin, 2003). NPM emphasizes adoption of market-based practices, including management, instead of professional control. NPM has also been accompanied by greater scrutiny of public sector finances with tighter financial control and greater managerial discretion over financial sourcing. Strategic planning is viewed as a way in which public sector agencies can make their aims and objectives transparent to potential external funders and thereby secure funding – whether from internal or external sources (Llewellyn and Tappin, 2003). There is, however, a distinction between strategic planning in the public sector and in the private sector. Within the private sector, strategic planning and management are drawn upon in the context of winning against the competition. While NPM has sought to engender greater competition in the public sector – as part of its ideology of choice – strategic planning and management is employed in the context of prioritization and resource allocation (Llewellyn and Tappin, 2003) and as a means for providing better services. Strategic planning is therefore a useful complement to RBMS and in the case of Kenya, preceded adoption of performance contracting (Nyamori, 2021). Strategic planning has become a mechanism for introduction of other management technologies – one of which is RBMS described above. In this context,

Theories informing public sector accounting and financial management changes  67 strategic planning is seen as a mechanism through which the government’s broad aims and objectives – as expressed in national policy documents – can be more comprehensively and cohesively articulated. Once so coded in the strategic plans, government departments – and subsequently individuals – at different levels – can draw on these aims and objectives to derive their performance targets which become the basis for performance contracts. This way, the departments can demonstrate that they are contributing to the national aims and aspirations (Nyamori and Gekara, 2016; Nyamori, 2021). Strategic planning has been employed as a mechanism for engendering democracy especially in local government. Within the local context, strategic planning is mobilized to know the wants of the local population and to enshrine them in the vision, mission and strategic objectives of local authorities, and then prioritize these wants and allocate resources to these priorities accordingly. Strategic planning has therefore been coded in legislation in countries such as New Zealand (Nyamori et al., 2012). For example, the Local Government Amendment Act (No. 2) 1989 enshrined strategic planning in local government in New Zealand. This Act heralded reforms to local government which continued with the Local Government Act (No. 3) 1996 and later the Local Government Act 2002. These legislations ushered in a number of SPMS, namely, the annual plan, the long term financial strategy (LTFS) and later the long term council community plan (LTCCP). These plans were to arise after consultation. These plans were to catalyze the adoption of a range of voluntary strategic mechanisms within local authorities in New Zealand that included a city vision, a strategic plan and business plans for each of their departments. Local authorities sought to link these plans into a coherent web of objectives that became linked to the daily work of each organizational member (Nyamori et al., 2012). Strategic planning’s role in democracy can be linked to the public participation movement which seeks greater involvement of the citizen in public financial management. This movement includes participatory budgeting which seeks to make public financial management democratic by inviting and facilitating members of the general public to have a say in planning and budget setting (Ebdon and Franklin, 2006). Citizen involvement in the budgetary process portends a number of advantages key of which is nurturing democracy (Tanaka, 2007) and more equitable allocation of resources. Depending on how it is organized, participatory budgeting can meet the needs of democracy by offering voice to different groups and subjecting the accounting of different priorities to contestation. This is different from previous public sector budgeting which has often been the preserve of a bureaucracy that is far removed from the public the budget is supposed to be aimed at. First introduced in Brazil (Wampler, 2000), participatory budgeting has increasingly been adopted by many governments the world over. While a diverse range of logics informs its adoption – depending on the context – an enduring rationale for its adoption is revitalizing democracy through enabling citizens to have a say in the way that governments plan and budget for public resources (e.g. Ebdon and Franklin, 2006; Aleksandrov et al., 2018). Strategic planning in government defines how the government intends to provide its goods and services to citizens, so performance measurement is a logical outcome. While there are many mechanisms of performance measurement which governments have adopted, a prominent one drawn from the private sector is the Balanced Scorecard (BSC) (Kaplan and Norton, 1992). The BSC ostensibly draws its strategic objectives from the strategy – which is in turn developed, at least in theory, from strategic planning processes. Through articulation and measurement of the strategic objectives as enshrined in the strategy, the BSC is expected to

68  Research handbook on public financial management reveal whether the organization is improving on those dimensions or perspectives included in the BSC – and which ostensibly link to the strategic plan. Besides measuring performance on multiple perspectives, the BSC is able to capture financial and non-financial performance on these perspectives – a broader achievement when compared to traditional performance mechanisms. Within the public sector, the BSC is expected to render accountability on multiple dimensions including on democracy. A related performance management system is triple bottom line reporting which seeks to measure performance on three dimensions: economic, social and environmental. We next examine some of the theories informing the changes we have described in the above sections.

EXPLANATORY THEORIES OF PUBLIC SECTOR ACCOUNTING AND FINANCIAL MANAGEMENT A knowledge of the sources and specific forms institutions have taken requires attention to the theories informing these changes (Moe, 1990). There are many theories that inform the kind of public sector accounting and financial management described above. Here we focus on five key theories, namely, neo-liberalism, agency theory, public choice theory, property rights theory and transaction cost economics. This list is by no means comprehensive. Neo-liberalism Neo-liberalism may be viewed as the meta-theory that informs recent public sector transformations. Neo-liberalism is not so much a theory as an amalgam of theories and concepts but which are united by a few doctrines. Firstly, neo-liberalism sees the market as the panacea to social issues – and therefore it seeks to extend market organization to every sphere of human life. Neo-liberalism therefore seeks to remake the public sector in the image of the private one. Within the neo-liberalism agenda, individual freedom and entrepreneurship – instead of the collective – is privileged as the means to societal success (Pendenza and Lamattina, 2019). The concept of autonomy in neo-liberalism is associated with a notion of an enterprising subject who pursues personal gain and whose freedom is guaranteed by the market (Pendenza and Lamattina, 2019). Neo-liberalism is an ideology that seeks to replace political decisions and traditional forms of public service delivery with economic and market-based ones. This ideology seeks to impose competition on public providers while constructing citizens as customers (Davies, 2016; Burchell, 2006; Lapsley and Miller, 2019). Within neo-liberalism the role of the state is to promote and oversee competition in the name of efficiency and choice (Davies, 2016; Burchell, 2006; Lapsley and Miller, 2019). The boundaries between the public and private sector become blurred with private sector practices becoming the preferred mechanisms and corporate entities becoming the preferred organizational form for the public sector (Lapsley and Miller, 2019). It is evident that neo-liberalism draws on a corpus of theories, some of which we explain below.

Theories informing public sector accounting and financial management changes  69 Agency Theory Agency theory has been hugely influential in the way the public sector has been structured and the kind of accounting and financial systems that have emerged. Agency theory argues that relationships within firms are governed by a nexus of contracts. Agency relationships define contracts between a principal (or owner) and an agent (e.g. manager) where the latter is contracted to undertake certain tasks. Both of these parties are assumed to be utility maximizers so each would pursue their own selfish interest. To ensure that the agent pursues the interest of the principal, the principal does two things: incentivize the agent and establish monitoring mechanisms. In certain situations, the agent is compelled to incur bonding to assure the principal that s/he will pursue the interests of the principal (Jensen and Meckling, 1976). The construction and separation of purchasers and providers and public–private partnerships in what was once the public sector can be interpreted as an attempt to construct principal agency relationships. The separation can be viewed as constituting the public as a principal who buys goods and services from an agent or provider. The government as the purchaser of goods and services on behalf of citizens is expected to incentivize providers through the price mechanism while at the same time monitoring them through performance contracts (Nyamori, 2009). This arrangement has been replicated in employment relations where supervisors hold subordinates accountable on the basis of ex ante defined performance targets. Under this regime, there are many instances where one part of the public sector is constituted as a principal while the departments and authorities are constituted as agents (Nyamori and Gekara, 2016; Nyamori, 2021). Relationships between the government (principal) and government entities such as state corporations are cascaded down the organization hierarchy and in the process constituting multiple principal–agency relationships – with supervisors as principals and subordinates as agents (Nyamori, 2021). Property Rights Theory Property rights theory can be viewed as a critique of the traditional public sector which emphasizes common ownership of resources. The theory argues that common ownership leads to reduced efficiency in the public sector, mostly because no single person has the incentive to control and monitor government officials. This claimed inefficiency is contrasted with the private sector where managers are incentivized to control and monitor the private entity because they own shares in the entity and their pay is linked to their performance. The other criticisms of collective ownership are that since these organizations receive funding from political sponsors, they are subject to political control by too many masters with different conflicting interests and are therefore unlikely to be responsive to the needs of those who receive their services – namely, the citizens. The solution according to this theory is to constitute resources into discrete property rights with each right assigned to individuals and/or entities who can claim and exercise ownership of these rights – with the attendant advantages that such ownership accrues. Property rights theory holds that economic activities can be divided up into property rights, which are “the rights to use, to earn income from … to transfer or exchange the assets and resources … [and] to change the structure or form of the asset” (Libecap, 1989: 226). Under this theorization, resources are partitioned into property rights which are assigned to different parties, so each party holds a bit of the whole. This is akin to a company which is divided up

70  Research handbook on public financial management into shares with different people owning a share of a resource. But central to property rights theory is that each resource is partitioned for a certain use and the rights to property are defined by legal and social conventions. In this arrangement, there is no need for government, for the basis of order is that once property rights are created, anyone wanting to use them must pay. All that is required is a legal system to arbitrate and resolve disputes. The legal system is complemented by informal institutions such as customs, taboos, etc. which define accepted behaviour and thus allow people to use property rights (resources) for the accepted uses. The assumption in property rights theory is that resources are demarcated into property rights on the basis of economic logic with appropriate incentives being created for owners of each bundle of property rights to ensure that they can use each property right efficiently (Kim and Mahoney, 2005). The hiving off of parts of the private sector into agencies (agentification) or authorities, privatization of what were once public enterprises, and the break-up of entities such as power companies into producers and distributors could be viewed as an outcome of property rights theory. Electricity companies in Victoria, Australia, for example. were broken up into producers and distributors. These entities were then privatized. Both of these changes involve demarcating what were public resources into defined uses and then assigning ownership of these resources to specific “owners” – who are expected to more efficiently use and monitor their use and performance. Public Choice Theory Public choice theory is a critique of bureaucracy and representative democracy. The theory argues that government has inbuilt inefficiencies due to its monopolistic position (Boyne, 1998). This is partly because public administrators exercise inordinate control over the government where they pursue their own interests to the detriment of citizens, i.e., they are “budget maximizing bureaucrats” (Aucoin, 1990: 116). Since the majority of citizens tend to not be actively involved in the political process, public administrators would exercise the discretion to expand public expenditure and especially to their benefit (bureaucracy). Politicians would tend to focus on expending on areas of own interest that would enhance their chances of being elected (Boyne, 1998). The sum of these claims is that governments being monopolies and bureaucrats occupying a privileged position will use that advantage to benefit themselves to the detriment of citizens. These criticisms undermine the claims of representative democracy to represent and promote the interests of citizens. The solution as far as public choice theory is concerned is to empower individuals to make their own choices. Public choice theory conceives the individual as the decision-maker (not the economic man in classical economics) and places him/her as the unit of analysis (Ostrom and Ostrom, 1971). The individual is assumed to be self-interested and rational and to evaluate and rank preferences and choose those strategies that maximize his/her benefits. The theory assumes three states of information, namely, certainty, risk and uncertainty and assumes that the individual will test and learn so as to reduce the level of uncertainty (Ostrom and Ostrom, 1971). The concern of the theory is how different decisions or decision-making arrangements affect the production of public goods. The individual would confront opportunities and challenges in production of public goods and would pursue different strategic advantages offered by different decision processes and structures, i.e., s/he would choose the best decision to achieve efficient production of public goods to his or her advantage. The theory argues that

Theories informing public sector accounting and financial management changes  71 each individual would maximize his/her net benefit if he or she takes maximum advantage of a public good at minimum cost to himself/herself. Such an individual has no motivation to do anything that would improve or maintain a public good. He/she may not even disclose his/her preferences for a common good if others make an improvement. The individual is inclined to avoid paying and instead would take advantage of any improvements made by others (Ostrom and Ostrom, 1971). Many of the reforms undertaken in the name of NPM have sought to enhance individual decision-making and choice. Public choice theory has sought to promote mechanisms that would enhance the power of the individual to decide. These measures are two pronged: the first are those that focus on whittling down the power of politicians and public administrators; the second are those that seek to enhance the power of the citizen to choose. The first of these measures include shrinking government through privatization and indirect provision accompanied by a plethora of techniques to know and control the conduct of public administrators such as results-based management systems, value for money audits, accrual accounting, etc. The second of these mechanisms include those that seek to enable citizen choice through buttressing different forms of markets and competition but also through introduction of direct forms of democracy. Within the UK, reforms were introduced to enable citizens to choose schools, housing and social services to name but a few (Bailey, 1993). The government sought to expand markets into formerly internally produced services such as health and education through purchaser/provider splits and compulsory competitive tendering. The role of the government was consigned to facilitating provision of desired standards and levels of goods and services (Bailey, 1993). There have been greater efforts to enhance citizen participation through shifts from representative democracy to direct involvement in decision-making (Bailey, 1993). Transaction Cost Economics Transaction cost economics (TCE) is concerned with understanding how to constitute the most efficient organizational form. TCE conceives the organization as being a nexus of contracts and its focus is how to govern these contracts so as to minimize transaction costs. While acknowledging that contracts are never complete, TCE recommends that attention be paid to both ex ante design and ex post governance arrangements. TCE is therefore concerned with how to govern contracts. The theory argues that different governance arrangements are possible, ranging from the market to insourcing (hierarchy). The most efficient form of economic organization is that which economizes on transaction costs – where these costs consist of both production costs and transaction costs (Williamson, 1979). Williamson asserts that: “The predictive action turns on the following proposition: transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competence, in a discriminating – mainly, transaction cost economizing – way” (Williamson, 1998: 38). TCE therefore argues that in choosing the organizational form, attention should be paid to the transaction costs associated with different forms and the form that minimizes the transaction costs chosen. While two organization forms are identified, namely, markets and hierarchy, other forms are possible such as a hybrid of these two. TCE argues that the different organization forms are influenced by the institutional environment (e.g. property rights, laws, customers, etc.) and the character of the actors involved (individuals). The institutional environment defines the “rules of the game” (Williamson,

72  Research handbook on public financial management 1998: 23) such that changes in these institutions could induce changes in the comparative cost of different governance arrangements and thus necessitating a reconfiguration of the economic organization. Changes in governance could in turn induce changes in the economic environment (e.g. changes in laws, etc.). Just like most of the theories informing NPM, the individual is assumed to be rational. TCE, however, assumes that individual action is limited/bounded by for example imperfect information or inability to process all available data. Thus individuals can be opportunistic, i.e., they can use what advantage they have – including guile – to pursue their individual selfish interests. These behavioural attributes in turn have the potential to affect governance arrangements. TCE recognizes that governance arrangements could also affect the individual through, for example, advertising or education in what Williamson (1998: 25) refers to as an “endogenous preference formation”. The individual is also subject to the institutional environment which could also affect his/her individual conduct through social conditioning. Transactions also have the potential to affect how different governance forms adapt to changes in their environment over time. TCE is therefore also concerned with how the economic organization adapts over time. These adaptations can be autonomous (e.g. based on supply and demand) or cooperative (e.g. hierarchy where people cooperate to achieve common ends). The capacity to adapt – and the form of adaptation – differs between the different forms of economic organization – whether market, hybrid, or hierarchy. Each mode of governing is informed by its own logic and attributes and each mode is supported by a distinctive form of contract law (Williamson, 1998). The influence of TCE in NPM is discernible in the latter’s promotion of different organization forms other than hierarchy. Since NPM has tended to privilege market or pseudo-market forms of organization, it could be argued that NPM has not faithfully stuck to the arguments of TCE. NPM has favoured market governance arrangements which include privatization, or the creation of internal markets in addition to the adoption of private sector management practices. Great effort has been expended to constitute the citizen as an active player in the markets. NPM assumes that market forms of organizational are more efficient compared to hierarchical or public sector ones. In the next section, I provide some thoughts on the future of public financial management.

FUTURE DIRECTIONS IN PUBLIC SECTOR ACCOUNTING AND FINANCIAL MANAGEMENT NPM has been hugely influential but its inspired changes have not been without controversy. Recent research indicates that aspects of NPM may have enhanced managerial accountability but diminished moral responsibility (e.g. Nyamori and Boyce, forthcoming). The mixed fortunes associated with NPM reforms led Lapsley (2009) to aptly wonder whether NPM was “Man’s cruellest invention”. There have therefore been calls for a shift from NPM to Public Value Governance (PVG). PVG seeks to recalibrate focus away from efficiency and effectiveness and toward public values, with the government positioned as a guarantor of these values. Unlike NPM which seeks to transfer service provision to the private sector, PVG views the public sector as critical to providing service to the public. PVG places greater emphasis on citizenship and democratic and collaborative governance and not on the notion of the customer.

Theories informing public sector accounting and financial management changes  73 The citizen is placed at the centre of defining public values through a process of dialogue and deliberation. In this process, the citizen is presented as having the capacity to define the values s/he wants. PVG further seeks to centre the citizen in the governance process through civic learning and capacity enhancement and through involvement in dialogue and deliberation (Bryson et al., 2014). PVG is not anti-NPM as such but recommends considering the full amalgam of possible approaches to delivering value based on pragmatic criteria – and not ideological ones such as is the case with NPM. While NPM seeks to confer greater autonomy on public administrators, PVG argues for constraining managerial discretion through law and public values. With PVG, multiple accountabilities are promoted instead of the dominantly market based ones in NPM. One cannot miss establishing a linkage between PVG and the participatory democracy approaches which have been embraced by a number of countries which we described earlier. Participatory approaches place emphasis on decentralized forms of government, the notion of the citizen and citizen centrality in defining the objectives of government. A PVG approach does not promote jettisoning NPM entirely; instead it recommends adopting what is good and discarding what is not – where the citizen is central to defining what is good. PVG therefore has a number of ramifications for public financial management. The citizen would play a significant role in defining what s/he wants and instruments such as strategic planning would continue to grow in influence in capturing and articulating these wants but also in ranking these wants into priorities that the government should emphasize and fund. This hearkens to greater prominence for a dialogical form of accounting – which emphasizes pluralism and the embrace of difference (e.g. Brown, 2009). Now that the workings of a hybridized approach have been experienced, it would be difficult to go back to emphasizing public sector provision of goods and services. Instead, a mixed approach where both the public and private sectors play key roles is likely to be emphasized with greater concern placed on who – in different situations – would provide the best goods and services. While funding for public goods and services would continue to rely on taxation, other sources of funding would continue to increase in importance. For example, emerging economies are increasingly relying on government-to-government arrangements to fund infrastructure projects with Chinese SOEs playing a prominent role in the funding and completion of these projects. Systems of accounting and accountability that capture and reveal these hybridized modes of service provision will continue to be sought and developed. There is much to excite public sector accounting and financial management researchers in this blended public sector.

CONCLUSION This chapter explored the changes to public sector accounting and financial management and especially with a focus on NPM. While the difference between the public and private sectors has been contentious prior to NPM, there is reason to assert that the boundaries between the two sectors have become murkier. The public sector has embraced many of the practices of the private sector; markets have been inserted into the public sector even as private providers play an increasingly prominent role even in social sectors such as health, housing and education. The increasing importance of the private sector in formerly public sector provision is driven by an ideology of neo-liberalism which is guided by a motley of theories. The core idea of neo-liberalism is that social life should be organized into market exchanges – and that this

74  Research handbook on public financial management organization is the most efficient. In this arrangement where people can exercise their choices unencumbered by their social bonds they can experience individual fulfilment. Thus NPM has sought to de-emphasize the public sector while emphasizing the private – whether through privatization, compulsory competitive tendering, performance contracting or purchaser/provider splits. Private sector financial management practices such as accrual accounting, cost accounting, RBMS, strategic planning and management have been embraced to enable NPM type changes to be effected. While NPM has been associated with far reaching changes in the public sectors of many countries, these changes have not been without controversy. There are some who think that community values have been sacrificed in the pursuit of efficiency and market ideals. Proposals for a new form of governance that emphasizes public values have been proffered. PVG seeks to re-centre the citizen in charting the kind of public sector he or she wants and champions a reassertion of democracy. Future public sector accounting and financial management researchers will need to grapple with the kind of public financial management including accounting and accountability systems that would be needed in this citizen-centred public value-led future.

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76  Research handbook on public financial management Nyamori, R. (2021). Pursuing results: Results-based management in the Kenyan public sector. In Z. Hoque (ed.), Public Sector Reform and Management in Emerging Economies (pp. 1–29). New York: Routledge. Nyamori, R. and Boyce, G. (Forthcoming). Performance contracting and moral blindness: A study of autonomy and moral responsibility in Kenyan public enterprises. Critical Perspectives on Accounting. Nyamori, R. O. and Gekara, V. (2016). Performance contracting and social capital formation in the Kenyan public sector. Critical Perspectives on Accounting, 40, 45–62. Nyamori, R., Lawrence, S., and Perera, H. (2012). Revitalising democracy: A social capital analysis in the context of a local authority in New Zealand. Critical Perspectives on Accounting, 23, 572–594. Olson, O., Guthrie, J., and Humphrey, C. (eds.) (1998). Debating International Developments in New Public Financial Management: The Limits of Global Theorising and Some New Ways Forward. Oslo: Cappelen Akademisk Forlag. Olson, O., Humphrey, C., and Guthrie, J. (2001). Caught in an evaluatory trap: A dilemma for public services under NPFM. The European Accounting Review, 10(3), 505–522. Osborne, D. and Gaebler, T. (1992). Re-inventing Government: How the Entrepreneurial Spirit is Transforming the Public Sector. New York: Addison-Wesley. Ostrom, V. and Ostrom, E. (1971). Public choice: A different approach to the study of public administration. Public Administration Review, 31(2), 203–216. Pendenza, M. and Lamattina, V. (2019). Rethinking self-responsibility: An alternative vision to the neo-liberal concept of freedom. American Behavioral Scientist, 63(1), 100–115. Republic of Kenya (2012a). Public Finance Management Act 2013. Government Printer, Nairobi. Republic of Kenya (2012b), The County Governments Act. Government Printer, Nairobi. http://​ constitutionnet​.org/​sites/​default/​files/​the​_county​_government​_act​_2012​.pdf. Robinson, M. (2002). Financial control in Australian government budgeting. Public Budgeting & Finance, 7(2), 80–93. Robinson, M. and Last, D. (2009). A Basic Model of Performance-Based Budgeting. Washington, DC: Fiscal Affairs Department, IMF. Sayre, W. S. (1958). Premises of public administration: Past and emerging. Public Administration Review, 18(2), 102–105. Scheers, B., Sterck M., and Bouckaert, G. (2005). Lessons from Australian and British reforms in results-oriented financial management. OECD Journal of Budgeting, 5(2), 133–162. Sinclair, A. (1995). The chameleon of accountability: Forms and discourses. Accounting, Organisations and Society, 20(2–3), 219–237. Tanaka, S. (2007). Engaging the public in national budgeting: A non-governmental perspective. OECD Journal on Budgeting, 7(2), OECD. http://​www​.oecd​.org/​gov/​budgeting/​43412013​.pdf. Wampler, B. (2000). A Guide to Participatory Budgeting. International Budget Partnership. http://​ internationalbudget​.org/​wp​-content/​uploads/​A​-Guide​-to​-Participatory​-Budgeting​.pdf. Williamson, O. (1979). Transaction-cost economics: The governance of contractual relations. Journal of Law and Economics, 22(2), 233–261. Williamson, O. (1998). Transaction-cost economics and organization theory. In G. Dosi, D. J. Teece, and J. Chytry (eds.), Technology, Organization, and Competitiveness: Perspectives on Industrial and Corporate Change (pp. 17–66). Oxford: Oxford University Press.

5. Governmental accounting and financial management in practice: current trends and country experiences Qiushi Wang and Shaodong Zhu

Government accounting differs from business accounting because it serves entirely different purposes in society. Specifically, governmental and not-for-profit organizations are primarily financed by taxpayers, donors, and those who do not expect benefits proportional to the resources they provide (Wilson et al., 2010). Therefore, the need to report public managers’ accountability and budgetary planning to citizens, creditors, oversight bodies, and other external users has played a central role in government accounting and reporting practices. The emergence of government accounting in the UK and the USA in the late nineteenth century coincided with the expansion of government services at the national level from national defense to public welfare, with a parallel increase in welfare provision at subnational levels (Jones and Pendlebury, 2000). Over one hundred years of development, government accounting has grown from relatively simple cash-basis budget accounting into a complex accrual-based system, including payables, receivables, assets, debts, and fiduciary activities. In the last four decades, the New Public Management (NPM) movement, which aims to improve public service efficiency by making it businesslike, has exerted a strong influence on the ideology and practices of government accounting. Therefore, despite significant variations across the world, the modern government accounting system has become an indispensable tool for governments to plan for public spending, manage available assets and resources, monitor the performance of the public sector, prevent corruption and provide accurate information for decision-making. However, as a result of the global financial crisis and the subsequent sovereign debt crisis in 2008 and the ongoing COVID-19 global health crisis, governments and other public sector entities around the world are facing a significant amount of financial pressure due to restricted budgets, significant debts, and stagnant economies. This context has created a severe challenge for all governments and public entities to improve the management of resources and report high-quality information to the general public. As a result, more than ever, public sector entities and their stakeholders need to understand the whole, long-term economic impact of their decisions on financial performance, financial position, and cash flows. Situated in this changing global context and recognizing the great diversity in accounting practices worldwide, this chapter overviews current trends in government accounting and country experiences in four broad categories. This chapter aims to provide the reader with a brief yet holistic view of the current development of public accounting practices globally.

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DEVELOPMENT OF INTERNATIONAL GOVERNMENT ACCOUNTING STANDARDS The development of international government accounting standards primarily resulted from the need for creating and comparing financial statistics and reports for the government by international organizations such as the UN, IMF, and World Bank. Over several decades of gradual evolvement, the Government Finance Statistics Manual (GFSM), the European System of Accounts (ESA), and the International Public Sector Accounting Standards (IPSAS) have been the main outputs of multiple rounds of studies carried out by the three international organizations. Government Finance Statistics Manual (GFSM 2001 and GFSM 2014) The IMF’s government finance statistics system has gone through a long process of gradual development and improvement. The initial work on developing international standards for government finance statistics began in the 1970s, but it did not take shape until 1986. The GFSM 1986 soon became the most authoritative and recognized standard of practice for government finance statistics. However, the Mexican financial crisis in 1994 and the Asian financial crisis in 1997 revealed the fatal flaw of the GFSM 1986 – its failure to promptly detect the first signs of economic or financial crises. Therefore, the revision of GFSM 1986 resulted in the release of the GFSM 2001, which radically changed the theoretical and methodological approach to government finance statistics based on a systematic review of the two crisis experiences. According to the IMF, the 2001 edition of GFSM “describes an integrated statistical system that is harmonized, to the extent possible, with the 1993 edition of the System of National Accounts (1993 SNA).” While both the GFSM and SNA include systematic recording and presentation of assets and economic flows and can be partially compiled from one to the other, the two systems differ in the treatment of productive government activities.1 In this sense, “the GFSM 2001 is intended to be a reference volume describing the GFSM system,” covering “concepts, definitions, classifications, and accounting rules” and providing “a comprehensive analytic framework within which the statistics can be summarized and presented in a form appropriate for analysis, planning, and policy determination” (IMF, 2001). Compared to its predecessor, GFSM 2001 has several apparent advantages and has significantly impacted government finance statistics since its publication. First, the reform in the basis of recording is one of the most significant changes. Unlike the previous versions, GFSM 2001 recommends that countries adopt accrual-based accounting, i.e., record economic events when they occur, which leads to a fundamental change in the scope and timing of recording economic events in government finance statistics. Second, GFSM 2001 introduces the integrated balance sheet approach to government finance statistics, forming a closed analysis framework of flows and stocks, accurately reflecting the revenues, expenditures, deficits, surpluses, and stocks of government activities and their changes. Moreover, GFSM 2001 increases the number of fiscal analysis indicators, which can more timely identify the root causes of vulnerability of government finance operations. Last, GFSM 2001 is more coordinated with other international economic statistical systems, including the 1993 SNA and the IMF 5th edition of the Balance of Payments, International Investment Position Manual (BPM 5), and the Monetary and Financial Statistics Manual (MFSM). The first, published by the United Nations, is an overar-

Governmental accounting and financial management in practice  79 ching standard set of recommendations for the national and international reporting of national accounts. The other two are specialized manuals designed to provide accounting standards for the balance of payments reporting and analysis for many countries. As the global social and political economy unfolds, the twenty-year-old GFSM 2001 has gradually revealed some problems and shortcomings in accounting and reporting practices across different countries. In particular, the international financial crisis in the wake of the 2008 recession calls for improved recording and methodological treatments of various types of accounting events. Moreover, the continued efforts by international organizations to harmonize statistical reporting and financial reporting have led to additional needs to make changes to the GFSM 2001. The main changes in the GFSM 2014 include an expanded list of general finance statistics items and more detailed data on revenue, expenses, transactions in assets and liabilities, and balance positions in general government and its subsectors (IMF, 2014). However, the GFSM 2014 inherits the fiscal statistics system established by GFSM 2001, with the classification, the aggregates, and the balancing items remaining essentially the same. GFSM 2014 also follows GFSM 2001 in promoting accrual-based accounting but retains some cash-basis data. Overall, GFSM 2014 does not make any fundamental changes to the underlying economic and statistical reporting principles that have been established in GFSM 2001. It should be noted that SNA, BPM, GFSM, and MFSM are distinct but interrelated economic accounting systems. These standards are created by different international organizations, and each of them has its own areas of adaptation and focus. Generally speaking, SNA and BPM are more comprehensive, encompassing almost the entire spectrum of economic activities. Their main purpose is to achieve international comparability and facilitate analysis of different economic units worldwide. In contrast, GFSM and MFSM mainly focus on two specific areas: government and currency. The GFSM is possibly the most influential accounting standard because the governmental entities that it primarily deals with are usually in the leading and regulatory position in a national economy. European System of Accounts (ESA 95) Economic governance within the European Union is designed according to the information from national accounts, which are harmonized by the European System of Accounts 1995 (ESA 95). ESA 95 is a study prepared by the EUROSTAT to establish the statistical standard behind many macroeconomic indicators such as gross domestic product (GDP), budget deficit, and public debt, and a set of macro-accounting rules, allowing its member states and candidate states of the European Union to compare and consolidate financial statistics. The framework of ESA 95 consists of two basic tables (sector accounts and input-output and industrial accounts), and the accounts are classified into three main categories: current accounts, saving (capital) accounts, and balance sheets (EUROSTAT, 1999). The emergence and evolution of ESA 95 are inextricably linked with the process of European integration. Compared to other accounting systems, ESA 95 heavily focuses on the provisions of the European Union and the information and data required for European integration. ESA 95 also unifies the concepts and classifications of various economic and social statistics, such as employment statistics, production statistics, and foreign trade statistics. As a result, ESA 95 serves as a core reference for the European Union and member states and provides crucial insight into key fiscal risks and the public sector’s financial position. The

80  Research handbook on public financial management adoption of ESA 95 represents a significant step forward and a quality leap to accomplish the reforms in the accounting field and achieve the critical requirements for European integration. International Public Sector Accounting Standards (IPSAS) To enhance the comparability of public sector accounting across different countries, the International Federation of Accountants (IFAC) created the International Public Sector Accounting Standards Board (IPSASB) in 2004 to promulgate the International Public Sector Accounting Standards (IPSAS). The most crucial mission of IPSAS is to strengthen public financial management globally through increasing the adoption of accrual-based IPSAS and establishing internationally harmonized public sector accounting standards to provide references for public sector accounting reforms (IPSASB, 2021a). So far, IPSASB has developed and issued thirty-eight accrual-based standards and three recommended practice guidelines to help countries transition from cash-based to complete accrual-based government accounting standards. The scope of IPSAS includes accounting standards for application by national governments, regional governments, local governments, and related governmental entities. However, IPSAS does not apply to government business or business-like enterprises. The objectives of IPSAS are to provide information about their sources, assets, and changes and the results of the government’s work and to provide the data necessary to analyze potential cash flows in the future. Most IPSAS principles are based on the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board. To the extent possible, IPSAS adapts IFRS to a public sector context and maintains the accounting treatment and original text unless there is a significant public sector issue (IPSASB, 2021b). Although IPSAS is not a mandatory accounting standard, it is welcomed and favored by many international organizations such as the IMF, World Bank, and OECD. Besides, these organizations have explicitly expressed their support for implementing IPSAS in member countries or the countries under their supervision. Some empirical studies have appeared to show that using IPSAS to prepare general-purpose government financial reports can bring about some advantages in practice (Gomes et al., 2019), and that countries with these standards in place have improved their fiscal transparency and accountability in the public sector (Brusca and Martínez, 2016; Muraina, 2020). While several governments, including the USA, UK, and China, claim they are introducing IPSAS into their government accounting system, almost all consider it is not worth the actual costs of fully adopting the standards. In addition, a few other countries have openly refused to adopt the IPSAS because their current standards, such as the GFSM 2014 or ESA 95, have similar applications in terms of government statistical coverage and account delineation (Schmidthuber et al., 2020).

RECENT REFORMS AND TRENDS According to the PwC IPSAS survey of 2015, there are at least three notable trends in government accounting worldwide (PwC, 2015). First, the trend towards accrual accounting is evident. Second, budgets remain mainly on a cash basis, but an upward trend towards accrual budgeting is identified. Third, while most governments mainly focus on compliance and control, they have shown a strong desire to improve their finance functions and efficiency,

Governmental accounting and financial management in practice  81 especially in cost accounting, performance management, fixed assets management, and long-term planning. Consistent with these trends, some countries have developed their own accounting standards, like the consolidated financial statements (CFS) in New Zealand and Australia and the WGA in the UK, that have been adapted from IPSAS or its equivalent to better suit their own financial reporting needs with different emphases. This section provides an overview of the most recent trends and reforms in government accounting across different countries. Transition from Cash-Based to Accrual-Based Accounting Government accounting practices generally fall into four categories: cash accounting, modified cash accounting, modified accrual accounting, and accrual accounting. Cash accounting has been the dominant method used in the public sector for many years, but many governments have converted to an accrual-based or a hybrid accounting framework. According to the International Monetary Fund (IMF, 2016), by 2015, 41 governments had completed the transition to accrual accounting, and 46 other countries had modified their cash/accrual accounting. Meanwhile, approximately 114 countries still operate under a pure cash accounting standard. The 2018 survey by the International Federation of Accountants (IFAC) and the Chartered Institute of Public Finance and Accountancy (CIPFA) revealed that 30 countries had adopted IPSAS directly, and another 32 countries have employed IPSAS as the key reference for public sector accrual accounting standards (IFAC, 2018). In the near future, the most significant move to accrual-based accounting is expected in Africa, while this trend is also evident in Asia, the Middle East, and Latin America, where accounting reforms are either in process or planned. Accrual-based comprehensive government financial reporting is consistent with the concept of NPM and provides the basis for establishing more effective management processes and controlling costs; it helps to evaluate fiduciary responsibilities of government public services, and produces a more coherent picture of government liabilities and other commitments. In addition, accrual-based accounting can give access to better funding sources, reduce the risk of fraud and corruption, which are more highly valued in developing countries, and limit public officials’ tendency to monopolize information and maximize discretionary budgets (Giroux and Shields, 1993). Overall, accrual-based government accounting is valuable for improving the measurement of public entities’ financial performance and financial position and provides more accurate information about the sustainability of government. Some empirical evidence has emerged to suggest that accrual-based government accounting has contributed to better national governance and improved the evaluation of the government’s financial position (Newberry, 2011). However, the scope, purpose, and presentation of financial statements have changed over the past few decades. For many governments, the financial statements and the accompanying notes, disclosures, and statistical sections are now being prepared and presented beyond a mere explanation of line items. Instead, they are being compiled to reveal risks, contingent liabilities, fiduciary responsibilities, cash liquidity, and other important information for both short-term and long-term decision-making. Some governments have previously implemented a government accounting system with limited functionality. However, accrual-based accounting is fundamentally different from cash-based or modified-accrual accounting in terms of the scope, depth, and rationale of information collection. In this sense, switching from cash-based to accrual-based accounting systems may present a major challenge for these governments

82  Research handbook on public financial management to comprehensively view their assets and liabilities, financial performance, and cash flows and reconstruct their reporting framework to keep pace with other countries. For various economic, political, and even cultural reasons, the difference in accounting basis is likely to persist for a long time. Consolidated Financial Statements (CFS) CFS are financial statements of an entity with multiple divisions or subsidiaries. For example, in the private sector, the US Financial Accounting Standards Board defines CFS as reporting of an entity structured with a parent company subsidiary. In general, the consolidation of financial statements involves financial statements of the current assets, liabilities, equity, income, expenses, and cash flows of a parent and its subsidiaries (IFRS, 2021). Both the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have set some specific guidelines for public companies who choose to report consolidated financial statements with subsidiaries. Along with the increasing adoption of accrual accounting standards, the public sector has also widely accepted CFS. Since the first popularization of these accounting reforms in New Zealand and Australia in the late 1980s, governments worldwide have quickly followed suit and experimented with consolidated government accounts on an accrual basis. In this context, the IPSASB issued IPSAS 6 in 2000 to specifically deal with CFS and accounting for controlled entities. It later issued IPSAS 35 in 2015 to amend and supersede some of the requirements in IPSAS 6 regarding CFS (IPSAS, 2015). Basically, “the standard lays out requirements for the preparation and presentation of CFS of a public entity … contains guidance on the scope of a consolidated group of a public entity … [and] presents rules on accounting for public sector subsidiaries [and] jointly controlled public sector entities” (Berger, 2018: 108). According to the principles outlined in the IPSAS 35, CFS should contain three elements. The first is a consolidated budget report, which includes the budgets of all entities in the group, and is intended to control and monitor the use of resources of all government entities. In many EU countries, this information is prepared using a modified cash standard. The second is consolidated national accounting, which is developed in compliance with such national accounting standards as the European National and Regional Accounting System. The entities included in the governments at different levels (central, regional or local) should report information from three sectors: the general government sector, the public non-financial corporations’ sector, and the public financial corporations’ sector. Then each sector prepares a consolidated statement. Therefore the general government sector can include information on all institutional units that are non-market producers and are mandated to be financed by units belonging to other sectors (in particular, central and local governments and social security funds). The third is accrual consolidated statements aggregated from individual accrual financial statements of all entities controlled by the primary entity. CFS are often considered as one of the most crucial accounting techniques for the public sector reforms, and many governments agree that there are sufficient reasons to prepare and present CFS (Chan, 2003). On the one hand, CFS can provide a more complex and overall image of the financial position, economic obligations, and performance of public institutions as a whole, which cannot be provided by individual financial statements of each entity forming the group. On the other hand, CFS also constitute a more reliable and helpful source than aggregated figures calculated from individual statements or estimations taken from national

Governmental accounting and financial management in practice  83 accounts. As such, CFS can facilitate comparisons between countries, making it easier for national governments to improve their decision-making by learning from other countries. Nevertheless, the opponents of CFS usually emphasize the heterogeneity of the financial statements prepared by different levels of governments and controlled units, the peculiarities of the public sector, the shortage of accounting professionals for implementation of CFS, and the lack of binding force to prepare and present CFS. Given that more countries have started implementing accrual-based accounting systems in the public sector, many international organizations and some European Union members may move quickly toward CFS (Benito et al., 2007). In this regard, standard-making organizations like IPSASB are expected to play a leading role in overcoming the opposition to the reform. Whole of Government Accounts (WGA) Similar to CFS, the Whole of Government Accounts (WGA) is also an integral part of the NPM-inspired government accounting reform, culminating in implementing consolidated accrual-based public sector accounts. “A central idea behind the introduction of unified accounts across the entire spectrum of government and its subsidiaries is to encourage greater accountability through greater transparency of links between government bodies and the amalgamation of financial obligations across the various bodies into one single figure” (ACCA, 2014). To date, the UK, Australia, and New Zealand have adopted WGA on a wider scale, whereas a few other countries, such as Canada and Sweden, have adopted smaller-scale consolidation that only covers part of their public sector (ACCA, 2014). In the UK, for instance, the WGA consolidates the audited accounts of over 1,500 organizations across the entire public sector to produce a comprehensive, accounts-based picture of the fiscal position in any one year (HMT, 2020). In general, the UK’s WGA “includes a consolidated Statement of Revenue and Expenditure, a consolidated Statement of Financial Position showing public sector assets and liabilities, a consolidated Cash Flow Statement and a Statement on Internal Control.” The WGA “complements the National Accounts figures from the Office for National Statistics (ONS), by providing a set of financial statements based on standards familiar to users of private sector accounts” (HMT, 2020). Although there has been limited evidence of its usefulness, WGA is assumed to have several beneficial effects on government finances and fiscal planning. First, by adopting consistent accounting policies, integrating information from resource accounting and other accrual accounts, and centralizing and auditing at the public sector-wide level, WGA can enhance the quality and transparency of information and the sustainability of government investments across the public sector. Second, macroeconomic policy formulation and monitoring are enhanced through more consistent financial reporting across entities. At the same time, aggregated information on government holdings facilitates more granular analysis and decision-making on funding decisions, capital planning, resource allocation, long-term spending, tax policy, etc. Third, providing comprehensive information on government revenues and expenditures, assets and liabilities, and cash flows allows Parliament to understand better the importance of government spending, tax and loan programs and facilitates effective parliamentary scrutiny of fiscal policy. Finally, WGA makes it easier and more effective to measure government performance, communicate between different public entities, and compare performance data across different entities (Chow et al., 2007).

84  Research handbook on public financial management However, the long-term goal of the WGA is to establish a single data collection system. This goal can only be achieved if two things are in place: successful implementation of GAAP-based WGA and audits and the technology to receive and consolidate data from multiple platforms and process data for multiple reports. Since these technical and environmental requirements may constitute an insurmountable obstacle for many governments, the use of WGA has been minimal. Even in the five countries that have already adopted WGA, there are multiple definitions of what constitutes a government bottom line and little uniformity in how consolidated accruals accounting models should be developed (ACCA, 2014). In many cases, it is still unclear who the intended users of WGA reports will be, nor is there any indication of how useful those reports will be. As a result, debates about WGA’s definition, scope, design, effectiveness, and many other vital aspects will likely persist.

IMPORTANT CHANGES IN THE EXTERNAL ENVIRONMENT Accounting is susceptible to environmental influences. While accountants and scholars hope that accounting information can influence decision-making and policies, at most, its effect occurs at the organizational or micro level. In the larger scheme of a country or a political system, accounting ideas and practices reflect more than affect particular political, economic, and social changes in the short- and intermediate-term. Over a longer time horizon, however, policies and practices that insist on accurate financial record-keeping, systematic financial management, and openness can induce a culture of accountability and transparency. Therefore, it is crucial to examine the external environment because government accounting reform cannot proceed faster than government reform. The economic recession of 2008 not only swept through North America, the European Union, Japan, and other developed economies but also had a massive impact on emerging economies. Its consequences on government accounting are multifaceted and far-reaching. On the one hand, the severe crisis gave rise to much skepticism over such NPM principles as managerial control systems, performance measures, and focuses on external reporting. The fact that the implementation of these principles has delivered less than promised and sometimes reverse results has led many to argue that typical NPM-inspired regulations and policies can result in institutional fragmentation, incoherent policy-making within countries, poor policy coordination and financial control, and more difficult central scrutiny. As a reaction to these NPM “failures,” several post-NPM paradigmatic approaches have arisen. These approaches include the New Public Governance, which proposes a focal shift towards the governance of more complex structures, and the Neo-Weberian State, which melds the key traits of the Weberian model of public administration with greater openness and transparency, citizens’ consultation and involvement, and the professionalization of public services (Mussari et al., 2021). On the other hand, some scholars contend that the emergence of the fiscal crisis has led to an intensification of the neoliberal assumptions underlying the NPM diagram. Therefore, despite the shortcomings and local variations, NPM still represents the prevailing theoretical reference framework for studies in government accounting reforms. Since crises usually prevent radical policy changes, there will be a long period of paradigmatic vacuum that precedes the affirmation of newer public management models. To some extent, the fiscal crisis of 2008 may play a decisive role in shaping the design and implementation of the ongoing government accounting reforms. However, the direction of the post-crisis reforms is still not clear.

Governmental accounting and financial management in practice  85 Another important event that may have a considerable impact on current government accounting reforms is the open government data (OGD) movement. This movement is an international phenomenon aiming at making government data (“data produced or commissioned by government of government-controlled entities”) publicly and freely available in digital formats for use, reuse, and redistribution (Zhu, 2017). The main reasons for opening government data are attributable to the basic NPM principles like transparency, collaboration, and participatory governance (Attard et al., 2015). The OGD movement has quickly become a major worldwide administrative reform within a relatively short period. It has inspired numerous initiatives across different countries, such as US President’s Obama open data initiative in 2009 and the G8 Open Data Charter in 2013. Most citizens, stakeholders, and accounting professionals believe that more and better government data would enable external users and public media to cover government activities more thoroughly and make public officials more accountable to the public. In particular, the OGD movement strongly advocates public access to complete and primary data collected at the source instead of partial, aggregated, or modified data that are frequently seen in the public sector. This stress on openness and completeness poses a severe challenge to those countries that still use cash-basis budgetary accounting without reporting government-wide activities. In addition, the OGD movement also insists on the supreme audit institution being independent of the executive (OECD, 2009), while the supreme audit institution of most countries is a branch of the central government. Moreover, the OGD movement also emphasizes citizens’ participation in the budget-making process, but the extent to which these innovative measures have been implemented varies significantly across different countries due to economic, political, and cultural reasons. The OGD movement reiterates the NPM principles and values in many ways, but it sets even higher and stricter standards and requirements. How the OGD movement will affect government accounting reforms remains to be seen. More recently, the COVID-19 crisis has put governments’ financial management to the test. While the COVID-19 crisis is still ongoing, it has already become evident that timely and quality information is essential for better assessing governments’ financial health and communicating the financial consequences of the pandemic to all stakeholders. Some initial lessons on government accounting and reporting have already emerged. First, Ministries of Finance need to ensure the necessary systems and procedures such as Integrated Financial Management Information System (IFMIS), are in place to facilitate the recording of transactions and preparation of financial statements. Second, financial statements should include information on long-term fiscal stability and be utilized fully. Third, strong coordination between the Ministry of Finance and accounting/auditing agencies is critical for regularly conducting continuity assessments to prepare governments to face emergencies without detrimental effects on their operating activities. Lastly, annual and interim financial statements should be prepared on time (OECD, 2020a). These lessons have called for higher standards for government accounting reforms. There is some initial evidence showing that previous reform efforts in the wake of the Great Recession of 2008 seem to have already paid off. In countries where the framework of financial risk management is in place, like the Netherlands, France, Australia, and New Zealand, “decisions on new guarantee schemes have been better channelled” (OECD, 2020b). In those countries with a performance budgeting system in place, “the identification and tracking of COVID-19 spending was facilitated” (OECD, 2020b). In other countries where accrual accounting has been adopted, “stocks and flows of loans and guarantees that were a significant component of fiscal packages are being tracked and measured as part of the regular accounting

86  Research handbook on public financial management processes” (IPSASB, 2020). To some extent, the COVID-19 pandemic has changed how governments operate and provided timely justifications for continuing and deepening financial management and reporting reforms.

CURRENT INTERNATIONAL EXPERIENCES This section selects four countries that can serve as representatives of the four major government accounting categories: (1) the United States for modified accrual accounting type under GASB; (2) the United Kingdom for accrual accounting type under IPSAS; (3) New Zealand for adopting some elements of accrual accounting; (4) China for cash-basis or modified cash-basis under a blend of GASB and IPSAS. The United States The American public budgeting and accounting system is profoundly influenced by the federalist framework provided for by its Constitution (Chan, 2002). The evolution of government accounting in the US can be summarized by the constant effort to improve government accounting rules at the federal level and the effort to incorporate NPM ideology into financial management at the state and local levels. However, underlying the different reforms is the unchanged central theme to ensure financial integrity, improve government efficiency, and fight corruption (Chan and Zhang, 2013). At the federal level, the development of government accounting is represented by the struggle between the legislative and executive branches over the power to set accounting rules. The Constitution of the United States effectively provided Congress with the preeminent role in financial matters among the three branches of government. During the Progressive era, however, the reformers attempted to advance the idea of an executive budget system under which the chief executive would prepare and implement the budget upon the legislature’s approval. After years of political maneuvering and debates, the idea of executive budgeting was realized with the passage of the 1921 Budget and Accounting Act. Nevertheless, the fact that the 1921 Act required the Comptroller General to be responsible for both the accounting and auditing functions continued to be a contentious issue over the next seventy years. Finally, in 1990, Congress passed the Chief Financial Officers (CFO) Act to authorize the appointment of a CFO for the entire Federal Government and to require federal agencies to prepare and issue audited financial reports. The need to establish a consistent set of federal accounting and financial reporting standards eventually prompted the three federal agencies, the GAO, OMB, and CBO, to agree to jointly sponsor the Federal Accounting Standards Advisory Board (FASAB) to set accounting standards for both the executive branch of government and the Congress. The current structure of accounting rule-making entities in the US is summarized in Figure 5.1. At the state and local levels, the latest evolution in American government accounting has been to embrace the NPM ideology and promote government accountability and transparency. In 1984, the GASB was formed as a companion board to FASAB due to a private- and public-sector joint effort. Since its establishment, GASB undertook its research project on user needs to determine a set of financial reporting objectives with a strong emphasis on accountability and usefulness of information for decision-making purposes. Later in 1986,

Governmental accounting and financial management in practice  87

Source: Wilson et al. (2010: 4).

Figure 5.1

Government accounting rule-making entities in the United States

the American Institute of Certified Public Accountants (AICPA) recognized the GASB’s authority to set generally accepted accounting principles (GAAP) for state and local governments in the United States. To this date, the GASB has promulgated ninety-seven standards of varying breadth and depth on diverse state and local financial topics. Many of these standards urge state and local governments to adopt the accrual basis to a fuller extent and produce government-wide financial statements. However, the GASB still requires fund financial statements to ensure that state and local governments comply with their legal and budgetary obligations. The American experience shows that financial accounting standards can fully develop when the standard-setting entities are relatively independent and not strictly constrained by finance-related laws and regulations. Typically, legislators and budget authorities set public finance rules for their own purposes, and public accounting personnel are not in a position to disobey or overturn those rules and regulations. Therefore, separate rule-setting and implementing bodies with clearly defined responsibilities, like GASB, FASAB, and GAO in the US, have enabled government accountants to be both law-abiding civil servants and GAAP-observing professionals (Chan, 2000). Another lesson from the American experience is that the federal and subnational governments should stay within one jurisdiction. The more or less peaceful coexistence between the FASAB and the GASB during the past three decades has shown that it is possible to have generally accepted government accounting principles that fit most of the needs of all governments. Three essential features characterize the American experience in government accounting. First, the accounting and financial reporting standards are no longer dominated by budget concepts and practices, and the accrual basis is the commonly preferred measurement method. Second, institutional fragmentation has created a mosaic of similar initiatives and approaches that have converged in many ways (Chan, 2002). Third, the financial status of the whole government is given priority in external reporting so as to provide a context for detailed disclosure and to facilitate user comprehension. In the wake of the COVID-19 crisis, the GASB will take a comprehensive look at financial reporting for state and local governments, focusing on the financial reporting model, revenue and expense recognition, and conceptual/disclosure framework (GASB, 2018). These changes were scheduled to be officially announced in 2022. They are expected to have a profound impact on how a government budgets its resources and reports its government-wide and proprietary funds.

88  Research handbook on public financial management The United Kingdom The UK is one of the countries that are active and early in adopting NPM ideas (Pollitt and Bouckaert, 2011). During the past two decades, four high-profile accounting reforms have been implemented in the UK’s central government to improve how the public and Parliament scrutinize the government’s use of public money and hold departments accountable for the financial decisions they make. These reforms are Resource Accounting and Budgeting (RAB) and Whole of Government Accounts (WGA), the adoption of International Financial Reporting Standards (IFRS), and the implementation of the Clear Line of Sight Alignment Projects (CLOS). During the 1980s and 1990s, the themes of greater accountability and improved performance dominated in the UK, and so did the belief that the technical language of accounting could help facilitate these goals. Thus, driven by economic, ideological, and pragmatic motives, the UK’s public sector accounting reform was initiated and guided primarily by NPM principles (Stewart and Connolly, 2021). The main appeal of NPM is that policy-making is decentralized and market-oriented, so the public sector service delivery is usually more efficient and accountable (Christensen and Laegreid, 2011). Under the leadership of Margaret Thatcher, the Conservative Government launched a series of high-profile financial and performance management changes, including the Financial Management Initiative in 1982 and the Next Steps Initiative in 1986. Following those changes, the proposal to adopt RAB, which replaced cash-basis accounting with a system that monitors and reports public expenditure using accrual-basis accounting and budgeting principles, was announced in 1993 (HMT, 1994). This proposal constitutes an important step for the UK to move from the traditional bureaucratic public administrative methodologies to embrace approaches that could radically improve accounting and financial reporting procedures. Theoretically, RAB would provide better information and thus help the government plan and control expenditure, improve service delivery, and enhance decision-making. In 1998, the government also introduced WGA, which consolidates more than 8,000 public organizations, including central and local government departments, executive agencies, the National Health Service, and non-departmental public bodies, into one set of financial statements (HMT, 2019a). In between the adoption of WGA and its implementation in 2010, the UK government further decided to replace UK GAAP in the 2007 Budget with IFRS so as to follow “private sector best practice.” In the same year, Her Majesty’s Treasury (HMT) published The Governance of Britain, which announced the implementation of CLOS to align the reporting of budgets, estimates, and accounts which had developed differently over time resulting in significant misalignment of figures (HMT, 2019b). The UK’s recent public sector accounting reforms are still ongoing, with each subsequent reform being announced as the former is/are still being implemented and before there is sufficient evidence to assess the outcome of each reform. While international evidence is similar to that of the UK, notable documented benefits of NPM-oriented accounting reforms include improved comparability with what existed before and in similar governments and enhanced accountability and transparency (Nakmahachalasint and Narktabtee, 2019). In contrast to their counterparts, the public accounting reforms in the UK appear to be more radical because the adoption of accrual-basis accounting, consolidated accounting, and IFRS/International Public Sector Accounting Standards (IPSAS) all took place at the same time. They also appear to be more determined because there was a very tight schedule for implementing these reforms. It is still too early to judge whether the UK’s accounting reforms are destined to succeed or

Governmental accounting and financial management in practice  89 fail. However, the current evidence emphasizes the practical implementation difficulties and fundamental behavioral change required to sustain such reforms. Given the current economic uncertainty amidst the ongoing COVID-19 pandemic, reporting government expenditure and liabilities more accurately and in a more comparable fashion has become more important than ever. In the foreseeable future, the UK is likely to persist with NPM-style accounting reform initiatives along with some other countries, but what new changes and adjustments would be made to the current accounting framework await to be seen. New Zealand While many countries shifted from cash to accrual-based government accounting globally, others did not fully adopt the trend but still advocated its benefits. New Zealand serves as an excellent example of this path in reforming its government accounting systems. The government department in New Zealand began to shift to an accrual basis in the issues of budgeting and accounting as early as 1991, when many other countries were still in the designing or conceptual phases (OECD, 1993). One year later, New Zealand became one of the first countries to produce government accounts on an accrual basis. It also established a government-wide reporting system in 1993 to include more than 3,000 institutions ranging from large state-owned enterprises to small primary schools. One year later, the Liability Insurance Act of 1994 continued to make new adjustments to the operation of New Zealand’s budget system. This act allowed the country to combine budgetary plans encompassing the ministries in six strategic areas (education, health, social aid, social security, environmental protection, and economic development) after 1995 (Richardson, 1996). When the new financial management system was established, New Zealand experienced critical changes in its budgeting and accounting practices in at least three aspects. First, the adoption of many principles of accrual basis accounting enabled the government to prepare consolidated balance sheets in accordance with the widely accepted principles of accounting and calculate the actual value of its assets for the first time. The new financial management system also made it possible to produce new series of integral government financial reports within the scope of the government branches by creating accounting policies, collecting and analyzing information from departments, government institutions, and state economic enterprises, and presenting and communicating financial statements. Second, the conformity with GAAP in New Zealand facilitated studies for improving government financial management. For example, analyses of the accounts and contents of the “financial status account” (assets and liabilities of the government), “cash flow account,” “borrowing and commitment account,” and “receivable account” have led to continuous adjustments in creating government accounts and preparing accrual statements (OECD, 1993). Third, the implementation of GAAP practices has also led the New Zealand government to grant authority to an independent third-party institution to oversee the execution and application of the new accounting standards across different government departments (Warren, 1994). China From the beginning of the twenty-first century, the concept of NPM started to gain popularity in China, echoing similar ideas articulated by Western scholars on public sector accounting (Christensen et al., 2019). During the following two decades, an increasing number of

90  Research handbook on public financial management Chinese scholars criticized the cash-based budgetary accounting system and called for a new accrual-based financial reporting system in order to better monitor the flow of funds (Wang, 2004), improve the quality of information for decision-making (Carlin, 2005), and reduce corruption by increasing government transparency (Zhang, 2008). On the other end of the spectrum, some specific concerns about the transition from cash-based to accrual accounts, such as the complex matching principle for government income recognition, high operating costs, technical competency of accounting practitioners, and the increased potential for creative accounting practices, were also raised (Beijing Finance Bureau, 2006). To some extent, the common attitude in China was not to reject cash-based accounting altogether but to take a cautious approach to adopt a partial accrual principle with Chinese characteristics (Chen, 2011). After the global financial crisis in 2008, concerns about inadequate information to monitor and prevent systematic fiscal risks were heightened in China. As a result, the Chinese Ministry of Finance launched an experimental program in 2010 in many provinces and municipalities to prepare accrual-based whole-of-government financial statements. These statements were produced mainly by converting cash-based account balances (Chan, 2015). Then in December 2014, the State Council, the highest executive authority in the Chinese government, approved and circulated the government accounting and financial reporting reform proposal by the Ministry of Finance, ordering its implementation in central and provincial governments. It might seem somewhat surprising that the Chinese government decided to adopt accrual-based and the whole-of-government practice in just a few years after so many years of debate and hesitation. However, this decision was obviously embedded in the context of improving budgetary management to monitor and reduce the risks of government borrowing. Under the reforms introduced between 2014 and 2020, public service units (e.g., hospitals and universities) must adopt the full accrual basis. However, administrative units must adopt a combination of a modified cash basis (in transactions with non-government entities) and a legal basis (for budgetary resources received and used). Furthermore, general budget accounting still employs a mixture of legal, accrual, and modified cash basis (Chan, 2016). In contrast to Western democracies, all legislative, executive, and judicial powers in the PRC are under the direct control of the Chinese Communist Party (CCP) through the central government. As a result, Chinese public officials and scholars are more concerned with the usefulness of the accounting information for control or “central supervision” rather than cost-saving, efficiency, and transparency (Chang, 2016). Moreover, the principle of “unified leadership and hierarchical management” is seen as the overarching principle of the fiscal budgetary management system, and the main driving force for information disclosure is to enhance financial supervision by higher-level governments. Therefore, while influenced by the NPM movement and the global trend in government accounting, China’s government accounting has exhibited distinct patterns regarding the objectives and functions of government as compared to the experiences of international organizations or developed countries. Looking forward, China’s recent decision to adopt accrual-based whole-of-government financial reports in the government sector will align government accounting practice in China with many other countries in the way public finance is managed and reported. However, China’s experiences may constitute a unique case and contain deeper insights into the institutional processes and conditions that have facilitated the widespread programs of NPM accounting reforms.

Governmental accounting and financial management in practice  91

CONCLUSION This chapter has briefly reviewed recent government accounting reforms and their impact on government financial management in the global context. While it is difficult to make a clear judgment about the development stage of government accounting reforms, some common trends and features have become evident in both developed and developing countries. First, a major shift to accrual accounting in government-wide and fund accounts is taking place worldwide, with internationally recognized standards such as IPSAS or its equivalents serving as a common reference point. More importantly, this shift seems unlikely to be slowed or reversed, despite the decade-long debate over the feasibility and usefulness of accrual-based accounting in the public sector. Second, budgets remain mainly on a cash basis or a modified cash basis in many countries. This phenomenon is partly due to the long tradition of budgetary accounting focusing on short-term revenue and expenditure. However, more governments have begun to realize the importance of accrual budgeting which can provide better insight for decision-making. Third, consolidated and government-wide accounting and reporting are gaining popularity in many countries with multi-layers of governmental entities. While there are still many unsolved problems, a few countries (e.g., the UK and New Zealand) have already taken firm steps to implement such a system in their government fully. Finally, reforms in other vital areas of government accounting and financial management such as cost accounting, performance management, fixed assets management, and long-term planning and forecasting are somewhat falling behind (PwC, 2015). Improving these key areas will contribute to the overall objective of enhancing service performance and the long-term health of public finances, but the road is still very long. In general, many NPM principles have been adopted and implemented in government accounting and public financial management over the past few decades. It has been widely accepted that better accounting and reporting practice will provide better information for decision-making and better use of public resources, which will, in turn, lead to greater transparency and accountability. However, there is still great diversity in accounting practices due to political, economic, and cultural reasons. While it is not possible for all countries to reach a consensus about accounting standards in the foreseeable future, there is an urgent need to practice sound and transparent accounting in all governments. It is expected that countries will continue to evolve based on many of the current practices and make significant adjustments according to IPSAS and other international standards. Harmonization of high-quality public sector accounting standards on the international level not only will enhance the credibility of government financial statements but will also facilitate comparison within the global public sector. Even in a country like China, where the political system is different from most other countries, the government accounting reform towards accrual-based practice has achieved significant progress, and the influence of international accounting standards has become evident. It will not be surprising that many post-NPM innovations keep emerging, but the common themes identified in this chapter, such as improving transparency and efficiency, enhancing accountability and facilitating the use by external users, etc., will continue to dominate future government accounting and public finance reforms. This brief overview offers several useful lessons for decision-makers and public financial managers. In the first place, accounting practices can be profoundly influenced by management ideology such as NPM. As such, it is unwise to deal with accounting problems as pure technical issues. Instead, government accounting should be treated under a holistic view as

92  Research handbook on public financial management a key link in a public finance system. Moreover, accounting practices can also be significantly impacted by the external political and economic environment. For example, the recent financial crisis and the ongoing global pandemic will both contribute to the future shape of government accounting which is likely to be more comprehensive and systematic and possibly more regulated and disciplined as well. Finally, there is probably no such thing as a universally accepted and single best government accounting standard. Instead, each government should develop its own accounting standards that best suit its financial management needs while learning from international standards to keep pace with the accounting practice of other countries. After all, government accounting is a never-ending business where reform is probably the only constant theme.

NOTE 1. For a detailed discussion on the differences between GFSM and SNA systems, see IMF (2001: 164–165).

REFERENCES Association of Chartered Accountants (ACCA) (2014). Whole of government accounts: Who is using them? https://​www​.accaglobal​.com/​gb/​en/​technical​-activities/​technical​-resources​-search/​2014/​ september/​whole​-of​-government​-accounts​.html. Attard, J., Orlandi, F., Scerri, S., and Auer, S. (2015). A systematic review of open government data initiatives. Government Information Quarterly, 32(4), 399–418. Beijing Finance Bureau (2006). A research report on the establishment of Chinese government accounting standards. Accounting Research, 3, 34–44 (in Chinese). Benito, B., Brusca, I., and Montesinos, V. (2007). The harmonization of government financial information systems: The role of the IPSAS. International Review of Administrative Sciences, 73(2), 293–317. Berger, T. M. M. (2018). IPSAS Explained: A Summary of International Public Sector Accounting Standards. Chichester: John Wiley & Sons. Brusca, I. and Martínez, J. C. (2016). Adopting International Public Sector Accounting Standards: A challenge for modernizing and harmonizing public sector accounting. International Review of Administrative Sciences, 82(4), 724–744. Carlin, T. M. (2005). Debating the impact of accrual accounting and reporting in the public sector. Financial Accountability & Management, 21(3), 309–336. Chan, J. L. (2000). Reforming American government accounting in the 20th century. In K. T. Liou (ed.), Handbook of Public Management Practice and Reform (pp. 97–121). New York: Marcel Dekker. Chan, J. L. (2002). Government budget and accounting reforms in the United States. OECD Journal on Budgeting, 2(1), 187–223. Chan, J. L. (2003). Government accounting: An assessment of theory, purpose, and standards. Public Money & Management, 23(1), 13–20. Chan, J. L. (2015). New development: China promotes government financial accounting and management accounting. Public Money & Management, 35(6), 451–454. Chan, J. L. (2016). Government accounting with Chinese characteristics and challenges. Public Money & Management, 36(3), 201–208. Chan, J. L. and Zhang, Q. (2013). Government accounting standards and policies. In R. Allen, R. Hemming, and B. Potter (eds.), The International Handbook of Public Financial Management (pp. 742–766). Basingstoke: Palgrave Macmillan. Chang, L. (2016). Research on the internal control of government financial reporting based on the revolution of accrual basis. Accounting Research, 3, 15–20 (in Chinese).

Governmental accounting and financial management in practice  93 Chen, Z. (2011). Build a new governmental budgetary accounting in China. Accounting Research, 1, 17–23 (in Chinese). Chow, D. S. L., Humphrey, C., and Moll, J. (2007). Developing whole of government accounting in the UK: Grand claims, practical complexities and a suggested future research agenda. Financial Accountability & Management, 23(1), 27–54. Christensen, M., Newberry, S., and Potter, B. N. (2019). Enabling global accounting change: Epistemic communities and the creation of a “more business-like” public sector. Critical Perspectives on Accounting, 58, 53–76. Christensen, T. and Laegreid, P. (2011). Democracy and administrative policy: Contrasting elements of New Public Management (NPM) and Post-NPM. European Political Science Review, 3(1), 125–146. EUROSTAT (1999). The European system of accounts: ESA 1995. https://​ec​.europa​.eu/​eurostat/​ documents/​3859598/​5826305/​CA​-15–96–001​-EN​.pdf/​aeec2852​-bed2–46​d2–9534–58​59d3c911d5​?t​ =​1421233881000. GASB (2018). Up close with the big three. Giroux, G. and Shields, D. (1993). Accounting controls and bureaucratic strategies in municipal government. Journal of Accounting and Public Policy, 12(3), 239–262. Gomes, P., Brusca, I., and Fernandes, M. J. (2019). Implementing the International Public Sector Accounting Standards for consolidated financial statements: Facilitators, benefits and challenges. Public Money & Management, 39(8), 544–552. Her Majesty’s Treasury (HMT) (1994). Better accounting for the taxpayers’ money: Resource accounting and budgeting in government (CM 2626). London: HMSO. Her Majesty’s Treasury (HMT) (2019a). Whole of Government Accounts for the year ended 31 March 2018 (HC 2164). London: HMSO. Her Majesty’s Treasury (HMT) (2019b). The Governance of Britain (CM 7170). London: HMSO. Her Majesty’s Treasury (HMT) (2020). Whole of Government Accounts. https://​www​.gov​.uk/​ government/​collections/​whole​-of​-government​-accounts. IFAC/CIPFA (2018). The international public sector financial accountability index. https://​www​.ifac​ .org/​knowledge​-gateway/​supporting​-international​-standards/​publications/​international​-public​-sector​ -financial​-accountability​-index​-2018​-status​-report. IFRS (2021). IFRS 10 consolidated financial statements. https://​www​.ifrs​.org/​issued​-standards/​list​-of​ -standards/​ifrs​-10​-consolidated​-financial​-statements/​. IMF (2001). Government finance statistics manual 2001 (GFSM 2001). https://​www​.imf​.org/​external/​ pubs/​ft/​gfs/​manual/​. IMF (2014). Government finance statistics manual 2014 (GFSM 2014). https://​www​.imf​.org/​external/​ np/​sta/​gfsm/​. IMF (2016). Implementing accrual accounting in the public sector [Technical notes and manuals]. Washington DC: International Monetary Fund. IPSAS (2015). IPSAS 35, consolidated financial statements. https://​www​.ipsasb​.org/​publications/​ipsas​ -35​-consolidated​-financial​-statements​-1. IPSASB (2020). COVID-19 Intervention Assessment Tool, International Federation of Accountants. https://​www​.ifac​.org/​knowledge​-gateway/​supporting​-international​-standards/​publications/​covid​-19​ -intervention​-assessment​-tool. IPSASB (2021a). https://​www​.ipsasb​.org/​about​-ipsasb. IPSASB (2021b). Handbook of international public sector accounting pronouncements. Jones, R. and Pendlebury, M. (2000). Public Sector Accounting, 6th edition. Harlow: Pearson Education. Muraina, S. A. (2020). Effects of implementation of International Public Sector Accounting Standards on Nigeria’s financial reporting quality. International Journal of Public Sector Management, 33(2–3), 323–338. Mussari, R., Cepiku, D., and Sorrentino, D. (2021). Government accounting reforms at a time of crisis: The Italian governmental accounting harmonization. Journal of Public Budgeting, Accounting & Financial Management, 32(2), 138–156. Nakmahachalasint, N. and Narktabtee, P. (2019). Implementation of accrual accounting in Thailand’s central government. Public Money & Management, 39(2), 139–147. Newberry, S. (2011). Whole of government accounting in New Zealand: A review of WGA financial reports from 1993 to 2010. Abacus, 47(4), 501–524.

94  Research handbook on public financial management OECD (1993). Accounting for what? The value of accrual accounting to the government sector. Occasional Paper on Government Management. Paris: OECD. OECD (2009). Open government: Beyond static measures. https://​www​.oecd​.org/​gov/​46560184​.pdf. OECD (2020a). Government financial management and reporting in times of crisis. OECD (2020b). Transparency, communication, and trust: The role of public communication in responding to the wave of disinformation about the new Coronavirus. Paris: OECD Publishing. http://​www​ .oecd​.org/​coronavirus/​policy​-responses/​transparency​-communication​-and​-trust​-bef7ad6e/​. Pollitt, C. and Bouckaert, G. (2011). Public Management Reform: A Comparative Analysis, 3rd edition. Oxford: Oxford University Press. PwC (2015). Towards a new era in government accounting and reporting (2nd edition). Richardson, R. (1996). Opening and balancing the books: The New Zealand experience. Perspectives on Accrual Accounting IFAC Occasional Paper 3. New York: Public Sector Committee. Schmidthuber, L., Hilgers, D., and Hofmann, S. (2020). International Public Sector Accounting Standards (IPSASs): A systematic literature review and future research agenda. Financial Accountability & Management, 38(1), 119–142. Stewart, E. and Connolly, C. (2021). Recent central government accounting reforms: Claimed benefits and experienced outcomes. Abacus, 57(3), 557–592. Wang, Q. (2004). Study on structuring of China’s non-business accounting system. Accounting Research, 4, 3–7 (in Chinese). Warren, K. (1994). Implementing accrual accounting in government: The New Zealand experience. IFAC Occasional Paper, 1, 1–19. Wilson, E. R., Reck, J. L., and Kattellus, S. C. (2010). Accounting for Governmental and Nonprofit Entities, 15th edition. New York: McGraw-Hill Irwin. Zhang, G. (2008). Construction of government accounting system in China. Accounting Research, 3, 11–18 (in Chinese). Zhu, X. (2017). The failure of an early episode in the open government data movement: A historical case study. Government Information Quarterly, 34(2), 256–269.

6. Future directions for research in governmental accounting, auditing, and financial reporting Yulianti Abbas

INTRODUCTION There have been continuing concerns about the availability and the quality of government financial information (see e.g., SEC, 2012; GAO, 2012). The last decade marks a significant development in the government accounting and financial reporting standards in the US. The Governmental Accounting Standard Board (GASB) has issued around forty new accounting standards since 2010. Some of these standards caused significant changes in government financial reporting, such as the more detailed requirements for valuation and reporting of pension and OPEB (Other Post-Employment Benefits) obligations, the reclassification of government assets and liabilities into deferrals, and the use of fair value to measure investments. The new accounting standards are expected to improve the quality of government financial reports as the source of government accountability. Additionally, the last decade also marks a significant change in the municipal market’s information environment. The inception of Electronic Municipal Market Access (EMMA) in 2009 provides the public not only access to bonds and trade information but also access to government financial information. Municipal market participants, who have long been considered the primary users of government financial reports, benefit from the central repository by gaining access to information that was previously unavailable to them. The repository also levels the playing field for most market participants. Finally, the 2009 credit crunch and the collapse of the bond insurance market created greater needs for a systematic means to assess government issuers’ credit quality. All the changes in government financial reporting and information environment that have happened in the last decade provide unique opportunities for additional research in the area of governmental accounting, auditing, and financial reporting. This chapter starts with a bibliometric analysis of papers indexed on the Web of Science (WoS) to understand the trend of past governmental accounting, auditing, and financial reporting research and a brief introduction on the government financial reporting in the US. The chapter continues by laying out the past research under two main areas: (1) financial reporting adoption and practices, and (2) the relevance of governmental accounting and financial reporting. This part of the chapter explores what prior research has taught us by discussing several notable research avenues in the literature. The findings and contributions of the prior studies will be explored. Some suggestions for future research under each area will also be discussed.1 Finally, the last section in this chapter presents future research opportunities. Questions on the usefulness of financial information continue to be the center of research in governmental accounting, auditing, and financial reporting. However, questions still arise on how “usefulness” can be defined or measured. As government organizations evolve, questions arise as to whether the current financial reporting is adequate to measure government performance. 95

96  Research handbook on public financial management Learning from the studies in the private sector’s financial reporting as well as recent critiques on government financial reporting, the last part of this chapter lays out the unanswered questions as well as challenges and opportunities for researchers interested in governmental accounting, auditing, and financial reporting research.

TRENDS IN PAST RESEARCH To identify existing research in governmental accounting, auditing, and financial reporting in the US this chapter uses bibliometrics analysis. The database used was the Web of Science (WoS) and the analysis involves all papers indexed on the Social Science Citation Index (SSCI) and Emerging Science Citation Index (ESCI) of WoS. The analysis starts from filtering articles with these characteristics: (1) research articles or early access, (2) written in English, and (3) published between 1980 and now. The keywords used were government* accounting, government* auditing, government* financial report*, government* financial statement, municipal* accounting, municipal* auditing, municipal* financial report*, municipal* financial statement, public sector accounting, public sector auditing, and municipal* disclosure. Second, the search was based on specific domains, such as economics, business, finance, and public administration. The initial search retrieved a total of 700+ publications. The next step involved assessing the relevance of selected articles. Each article’s title and abstract were scrutinized. If needed, the contents of the article were carefully examined to make sure the articles met the following criteria: 1. The focus of the paper had to be on government financial reporting, accounting, or disclosure issues. 2. The focus is on the government accounting, auditing, and financial reporting in the US, or general discussion on international public sector accounting standards. The search criteria resulted in 157 articles of which about 30 articles specifically discuss the international public sector accounting standard. Figure 6.1 shows the annual scientific production over time. There was a spike in the governmental accounting, auditing, and financial reporting research around 1990–1993 that marked the early studies on US state and local government financial reporting. After a period of low research production, the trend started to go up around the year 2002. This was the period when government started implementing the GASB standard No. 34. A significant shift to accrual basis accounting has been a major research topic in governmental accounting and financial reporting research in the subsequent periods. The scientific production trend continues to go up over time. The trend indicates a growing interest in governmental accounting, auditing, and financial reporting issues.

BASIC CHARACTERISTICS OF GOVERNMENT FINANCIAL REPORTING The Governmental Accounting Standards Board (GASB) establishes accounting and financial reporting standards for US state and local governments. These standards are intended to create financial reports that are useful to assess government accountability. The financial

Research in governmental accounting, auditing, and financial reporting  97

Figure 6.1

Trend in annual research publications

report required by the GASB standard is called the Annual Comprehensive Financial Report (ACFR). The reports provide more detailed financial information for financial statement users compared to other reports. GASB concept statement no. 1 states that the ACFRs are intended for users who need a broad range of information. The three primary users of government financial reports are citizenry, legislative and oversight bodies, and investors and creditors (GASB, 1987). As quoted from the GASB concept statement about the use of financial reporting in a public organization: The concept of accountability for public resources is inherent in our nation’s governing process. Legislators and other government officials, and the public want to know whether (1) government resources are managed properly and used in compliance with laws and regulations, (2) government programs are achieving their objectives and desired outcomes, and (3) government programs are being provided efficiently, economically, and effectively. (GASB, 1987)

For a financial report to meet its intended purpose, the GASB concept statement lists six basic characteristics of financial reporting, which are understandability, reliability, relevance, timeliness, consistency, and comparability (GASB, 1987). The basic characteristics ensure effective communication that helps financial statement users make informed decisions (Table 6.1). Table 6.1 Understandability

Basic characteristics of a government financial report A financial report can be understood by its users. It should have explanations and interpretations that are needed for users to understand the information provided.

Reliability

The information provided in a financial statement should be verifiable, free from bias, and representing the truth. It should properly explain estimates/assumptions made in the reports.

Relevance

The information can make a difference in a user’s assessment of a problem, condition, or event.

Timeliness

A financial report must be issued soon enough after the reported events.

98  Research handbook on public financial management Consistency

A financial report presents information using the same set of assumptions and methods, any changes should be properly disclosed.

Comparability

A financial report helps users compare governments’ financial condition with themselves (time series) or with other governments (cross-sectional).

Source:

GASB (1987).

Over the years, GASB has issued various standards to improve government financial reporting. The most revolutionary change in the governmental accounting standards in the US is the GASB statement 34 (GASB 34) Basic Financial Statements – and Management’s Discussion and Analysis – for State and Local Governments. GASB 34 requires the use of accrual method accounting in measuring governmental activities. Under accrual basis accounting, financial reports should present not only current assets and liabilities but also long-term assets and liabilities (such as capital assets and general obligation debt). Governments are also required to report all revenues and all costs of providing services each year, not just those received or paid in the current year or soon after year-end. This new financial reporting model is expected to provide financial statement users with a more complete understanding of a government’s financial position and increase the value relevance of governmental financial reports. Since the inception of GASB 34 in 1999, GASB has issued more than 60 new standards. During the 2015–2021 period, GASB issued 25 new standards that require specific measurement and reporting in government financial reports.2 The usefulness of financial reporting is central in government accounting, auditing, and financial management research. The governments bear the costs of both implementing the standards and providing financial reports, which are then passed to the citizens and taxpayers. The lack of tangible benefits of financial reporting thus contradicts the public interest. Similarly, users of government financial reports incur costs associated with the time and effort required to obtain and analyze information. Relevancy, as stated in the GASB concept statement no. 1, refers to whether the information can make a difference in a user’s assessment of a problem, condition, or event (GASB, 1987). To be relevant, information should have a logical relationship with the purpose for which it is needed (GASB, 1987). As financial statement users might need the information to make various kinds of decisions, such as economic, social, and political decisions, whether and to what extent government financial reports inform their assessments of government accountability and make informed decisions is an empirical question.

FINANCIAL REPORTING ADOPTION AND PRACTICES Adoption and Implementation of GASB Standard The Federal government cannot mandate the use of Generally Accepted Accounting Principles (GAAP) to state and local government. The states may require the use of a particular accounting standard for their municipalities although the standards do not have to be the GAAP. Early studies in government accounting research thus focus on whether the existence of mandates impacts the quality of financial reporting (e.g., Ingram and DeJong, 1987; Gore, 2004). These studies focus on the differences in financial reporting quality between governments that adopt (or mandate) the GAAP and those that do not. Ingram and DeJong (1987) find no significant

Research in governmental accounting, auditing, and financial reporting  99 differences, while Gore (2004) finds that GAAP disclosure levels are significantly higher in the regulated state than in the unregulated state. Gore’s (2004) study was conducted in the periods after the inception of GASB 34, implying that the standard has improved government financial reporting. There has been greater attention on GASB 34 adoption and implementation because the standard significantly changes government financial accounting and reporting. More particularly, GASB 34 changes cash basis accounting into accrual basis accounting. Some studies thus put more emphasis on specific accounting provisions in GASB 34 that have a significant impact on government financial reporting. For example, GASB 34 requires a government entity to report all capital assets, including infrastructure assets, in the government-wide statement of net assets and report depreciation expense in the statement of activities. GASB 34 also requires governments that use the modified approach for reporting infrastructure assets to provide additional disclosures in the Required Supplementary Information (RSI) section. Some studies focus specifically on the infrastructure assets accounting requirement in GASB 34 (e.g., Vermeer et al., 2011; Jones et al., 2012). Vermeer et al. (2011) and Jones et al. (2012) discuss the implementation of the standard and find a variation in the methods and assumptions as well as the level of disclosures provided by governments in implementing the infrastructure assets. Jones et al. (2012) explain the variations by suggesting that the physical condition of the infrastructure, the importance of the infrastructure, and the financial impact in acquiring and maintaining infrastructure influence governments’ decisions. GASB 34 also requires a government to present a Management Discussion and Analysis (MD&A) in their financial research. A prior study focuses specifically on the implementation of the MD&A in government financial statements and finds inadequate disclosures about governments’ finances and financial conditions in municipalities’ MD&A sections (Yusuf and Jordan, 2017). Another significant stream of research in government accounting standard focuses on pensions and OPEB (e.g., Coe and Rivenbark, 2010; Vermeer et al., 2012; Matkin and Krivosheyev, 2013; Hallman and Khurana, 2015; Rich and Zhang, 2015; Naughton et al., 2015; Nejadmalayeri et al., 2017). The magnitude of the government’s underfunded pension and OPEB have indeed raised an important concern for public policy. Underfunding future pension and OPEB obligation means future taxpayers will have to make up the benefits for previous generations of state employees, causing intergenerational inequity. Unfunded obligations can also cause fiscal pressure in the future as future government officials might have to pay for the obligations by restructuring their fiscal performance, such as cutting expenditures or raising additional revenues. Transparent and accurate reporting is thus critical for pensions and OPEB. There have been plenty of accounting standards issued over the years addressing pensions and OPEB reporting, such as the GASB statements 43, 45, 50, 67, 68, 71, 73, 74, 75, 78, and 82 (these standards were issued after the inception of GASB 343). GASB statements related to pensions and OPEB generally require governments to actuarially determine the unfunded amount and present it as a liability on the financial reports. The standards also regulate the assumptions and methods used to determine the unfunded liability amounts. Issues raised in studies on the implementation of the pensions and OPEB standards are the characteristics that underlie governments’ decisions to adopt the standard (see e.g., Vermeer et al., 2012), the implementation and management of GASB standard requirements (see e.g., Coe and Rivenbark, 2010; Matkin and Krivosheyev, 2013; Yusuf and Musumeci, 2012), the factors associated with the use of discretion in applying GASB rules (see e.g., Naughton et al., 2015),

100  Research handbook on public financial management and the factors associated with the size of underfunded defined benefit pension plans (see e.g., Mortimer and Henderson, 2014; Rich and Zhang, 2015). These prior studies suggest that government characteristics have a significant association with the decision to adopt and follow GASB statement requirements. As underfunded pensions and OPEB continue to be a problem in the US public sector, there are still plenty of questions related to the pensions and OPEB accounting standards. GASB Statement No. 67 and No. 68, which were issued in 2012, significantly changed accounting and financial reporting for pensions. GASB Statement No. 67 “Financial Reporting for Pension Plans” changes existing guidance for the financial reports of most pension plans and GASB Statement No. 68 “Accounting and Financial Reporting for Pensions” establishes new financial reporting requirements for most governments that provide their employees with pension benefits. The two standards require government agencies to address the difference between total pension liability and the assets in their financial report. Pension liabilities are measured with the present value of the projected benefit payments to employees based on past services, while the assets are the investments set aside to pay retirees and current employees. Governments must also disclose the changes in economic and demographic assumptions used to project pension benefits, differences between assumptions and actual experiences, and the effects of differences between expected and actual investment returns. The use of assumption and estimation in calculating projected pension benefits can raise an important question on whether the amount presented in the financial report is accurate and reliable. Prior studies indeed find that the amount of underfunded pension or OPEB liability is associated with the economic and political conditions, such as fiscal stress (Naughton et al., 2015), direct citizen participation in the legislative process (Rich and Zhang, 2015), and public officials’ recent recall attempt (Rich and Zhang, 2015). Implementation of Good Financial Reporting Another important stream of research in governmental accounting and financial reporting focuses on the drivers of good financial reporting. Good financial reports are those that are useful for the users of the statements. However, it is not easy to measure good financial reporting as users of government financial reports have different purposes to measure government performance and accountability. The two measures that are commonly used to measure good financial reporting are the completeness and the timeliness of financial reports. Both are considered important determinants of effective financial reporting. Completeness comprises a combination of understandability, reliability, and relevance dimensions, and measures whether the information is adequate for decision-making. Timeliness measures whether the information is available on a timely basis to make an informed decision. In measuring financial statement completeness, prior studies commonly use indexes to measure whether a government presents or discloses a set of financial information in its financial reports (see e.g., Ingram and DeJong, 1987; Gore et al., 2004; Gore, 2004). These studies list a set of financial reporting requirements – generally from the accounting standards – and assess whether a government entity provides the specified information in its financial reports. The challenge in measuring completeness is to identify the information that is relevant for users of financial reports. The amount of information provided does not automatically imply usefulness. However, completeness may send a positive signal that a government does not hold back certain information (see e.g. Evans and Patton, 1987; Gore, 2004).

Research in governmental accounting, auditing, and financial reporting  101 Timeliness, which measures whether information is available on a timely basis, is commonly proxied by information delay (see e.g., Edmonds et al., 2017; Abbas, 2022). The longer the information is delayed, the less relevant the information becomes for decision-making. Prior studies propose a more specific distinction of the timeliness measure. Edmonds et al. (2017) divide the information delay into audit delay and post-audit delay. Audit delay is the period between the fiscal year-end and audit completion date, while post-audit delay is the period between the audit completion date and bond issuance. Abbas (2022) calls the information delay “information staleness” and divides the information delay into filing delay and post-filing delay. Filing delay is the period between fiscal year-end and financial report filing on the information distribution platform,4 while the post-filing delay is the period between the financial report filing date and the bond issuance. In their studies, both Edmonds et al. (2017) and Abbas (2022) identify investors as the potential users of financial statements and measure the association between timeliness and market reactions. Public managers’ decisions to provide quality financial reporting are affected by the relative power of political groups in the municipalities. The early theory stresses the relationship between a public sector manager and his or her constituents (see e.g., Zimmerman, 1977), political competition (see e.g., Ingram, 1984; Baber and Sen, 1984; Evans and Patton, 1987; Giroux, 1989; Cheng, 1992), and the needs of a public organization to engage and rely on their environment to provide support or fulfill their needs (Pfeffer and Salancik, 1978). Zimmerman (1977) suggests that the welfare of public sector managers depends on the likelihood of reelection, advancement, and current and future income, while voters’ welfare is influenced by the public sector managers’ decision, e.g., levying taxes or determining the services provided. As both public sector managers and voters are assumed to be rational self-interested individuals, public managers might not always act in the voters’ best interests. The voters will then have the incentives to monitor the behavior of public managers to ensure a certain level of performance has been achieved or pursued. If public managers are concerned with the likelihood of reelection, they will voluntarily disclose performance information if doing so increases their probability of being reelected. Public managers in wealthy municipalities thus have greater incentives to disclose information, as they want to send positive signals about their good performances and increase their chances for reelection (see e.g., Baber, 1983). The relationship between voters and public sector managers can thus be a driver for higher quality financial information. However, individual voters’ willingness and ability to monitor public properties are restricted. Later studies try to identify a group of voters that have greater incentives to monitor government performances. These studies adopted the median voter view and found that cities with higher median income voters are more likely to report performances (e.g., Giroux, 1989; Cheng, 1992). The median income is a proxy for socioeconomic conditions. Voters in a higher socioeconomic bracket are likely to pay more tax (while receiving fewer services), creating higher incentives for them to monitor government performance (Giroux, 1989). Political competition affects public managers’ chances for reelection. When public managers are confronted with higher political competition, they have the incentive to supply information about their performances, showing their supporters that they keep their pre-election promises. On the other side, the opposition will have to monitor the behavior of the public to maximize the number of votes in an election. Several classical studies have empirically tested this proposition and found a positive relationship between political competition and quality

102  Research handbook on public financial management of disclosure (Ingram, 1984; Baber and Sen, 1984; Evans and Patton, 1987; Giroux, 1989; Cheng, 1992). The Resource Dependence Theory (Pfeffer and Salancik, 1978) can be used to explain the incentives to exercise good financial reporting practices. If a public organization requires certain resources from its environment, it will have the obligation to comply with the requirements of the resource providers. For example, if a public organization depends heavily on external funding in financing its operation, it will be more willing to make the necessary efforts to report performances and reduce the cost of financing. More recent studies rely on this theory to find drivers for good financial reporting practices in government (see e.g., Cuny, 2016; Abbas and Johnson, 2022). These studies focus on government entities that issue bonds in the municipal market and are therefore affected by market pressure to provide information. Cuny (2016) found that the government’s level of disclosure is higher after EMMA inception. EMMA (Electronic Municipal Market Access) was established in 2009 and municipalities that issue bonds in the municipal market are required to file financial information on EMMA.5 Abbas and Johnson (2022) focus on the SEC enforcement on EMMA disclosure by looking at disclosure compliance and timeliness in the municipal market after the Municipalities Continuing Disclosure Cooperation (MCDC) Initiative. The MCDC Initiative shows an increase in SEC’s regulatory enforcement on continuing disclosure. The study finds that increased regulatory enforcement has a significant impact on continuing disclosure compliance, but not on the timeliness of financial reports (Abbas and Johnson, 2022). Both Cuny (2016) and Abbas and Johnson (2022) utilize government policies in the municipal market as a driver of good disclosure practices. As financial disclosure continues to be a great concern in the municipal market, there are still unanswered questions on how much government intervention is needed to ensure a quality financial disclosure in the municipal market.

THE RELEVANCE OF FINANCIAL REPORTING Value relevance analysis for financial reporting requires “users” that benefit from financial reports. However, a government financial report is part of the governance systems in demonstrating government accountability to the public for the provision of services and stewardship of public resources. The provision of services and stewardship of public resources will be difficult to measure objectively because it involves multiple users and purposes. For that reason, plenty of studies refer to private sector accounting research that commonly uses a capital market setting to measure the usefulness of accounting information. The assumption is: if accounting information is a useful tool in monitoring borrowers of capital’s performance, the release of accounting information (that reflects borrower’s operational condition) should affect the capital market. Similarly, in governmental accounting research, creditors are often considered the primary users of financial statements. The focus on the municipal market to measure value relevance is indeed important given the role of the municipal market as a source of financing for governments. It is also easier to measure the market responses (e.g., yield differences, rating changes) to proxy for the value relevance of information.

Research in governmental accounting, auditing, and financial reporting  103 Value Relevance of Accounting Standard Adoption Studies focusing on government decisions to adopt financial reporting standards generally hypothesize that governments that comply with financial reporting standards have lower information risk. Early studies (see e.g., Benson et al., 1984; Baber and Gore, 2008) use a simple measure of accounting standard adoption (i.e., whether a government follows standards with more stringent requirements). For example, Benson et al. (1984) divide states based on stringent and non-stringent accounting requirements. A state is classified as having stringent accounting requirements if it has a requirement of uniform accounting principles and a standardized report format. Baber and Gore (2008) divide municipalities based on whether the states they are located in mandated GAAP. Both studies measure value relevance using municipal borrowing costs and find that more stringent accounting regulations are associated with lower borrowing costs. After the GASB introduced GASB 34, a new stream of research emerged. GASB 34 introduced a new government reporting model that revolutionized government financial reporting. GASB 34 was expected to substantially increase the value relevance of governmental financial reports by providing users with a more complete understanding of the government financial performances. Plenty of studies after GASB 34 inception focus on whether the information provided by the new government financial reporting model benefits financial statement users (Johnson et al., 2012; Plummer et al., 2007; Pridgen and Wilder, 2013). The earlier studies (Johnson et al., 2012; Plummer et al., 2007; Pridgen and Wilder, 2013) focus more on the use of accrual basis accounting and analyze whether the accrual basis information is valuable for financial statement users in the municipal bond market. These studies find that the information provided in the government-wide statements using the accrual basis of accounting is incremental to that provided by the governmental funds statements in assessing governments’ default risk (Johnson et al., 2012; Plummer et al., 2007; Pridgen and Wilder, 2013). Studies by Kim and Ebdon (2017), Kim et al. (2018) and Rich et al. (2021) focus on specific requirements in the GASB 34. Kim and Ebdon (2017) and Kim et al. (2018) focus on the requirement to measure and record infrastructure assets in GASB 34. Kim and Ebdon’s (2017) study finds an increased capital spending after GASB 34, although there is no significant change in maintenance expenditures. The later study, Kim et al. (2018), finds the implementation of GASB 34 improved state highway infrastructure quality. The study also analyzes a specific accounting treatment for valuing infrastructure assets in GASB 34 by comparing states that use the modified approach in valuing infrastructure assets and those that use depreciation accounting. The study finds that the improvement of highway infrastructure quality is higher for states using the modified accounting approach. Rich et al. (2021) focus on the relevancy of MD&A. Using content analysis, the study analyzes the tone in the government’s MD&A section. The study finds that a more negative MD&A tone is associated with higher future debt costs and greater future disagreements among bond rating agencies (Rich et al., 2021). Research on the value relevance of accounting standards also focuses on the adoption of specific GASB standards. Nejadmalayeri et al. (2017) find that states that do not follow the GASB 45 recommendation of OPEB obligations experience a greater increase in the yield spread. Hallman and Khurana (2015) assess the discount rate provision in calculating pension liabilities and find that the difference between the state’s expected rate of return and the municipal bond return is associated with lower credit ratings and higher interest costs.

104  Research handbook on public financial management In sum, prior studies looking at the value relevance of accounting standards indicate a positive impact of GASB standards. Most of these studies measure value relevance by focusing on the municipal market (Johnson et al., 2012; Plummer et al., 2007; Pridgen and Wilder, 2013; Kim and Ebdon, 2017; Rich et al., 2021) and address the issue of whether the implementation of an accounting standard or a specific accounting provision benefits municipal market participants (e.g., investors, rating agency). Value Relevance of Good Financial Reporting Practices As the prior section lays out research that specifically addresses the value relevance of accounting standards, this section focuses more on the value relevance of the information provided in government financial reports and the value of good financial reporting practices. Value relevance of the information content of financial reporting Accounting information is intended to provide market participants with relevant and reliable information regarding an entity’s performance and risk attributes. If accounting information is useful, it will be associated with financial statement users’ decisions. The pioneering governmental study in this area was Wallace (1981) who shows that cross-sectional differences in accounting variables significantly reflect variation in the net interest cost. Plenty of other studies was conducted during the 1980s–1990s period (see e.g., Ingram, 1983; Benson et al., 1984, 1991; Wilson and Howard, 1984). The results are consistent – that accounting-based financial measures explain the variation in borrowing costs and interest rate premium. These earlier studies, however, suffer from the lack of reliable financial measures as government financial reports are yet to be standardized. Nevertheless, these studies lay a foundation for research focusing on the value relevance of accounting information in the governmental capital market. After the revolutionary change of government financial reporting standards with the inception of GASB 34 in 1999, several studies try to analyze the value relevance of information measured using the new accounting standard (see e.g., Plummer et al., 2007; Wang et al., 2007; Johnson et al., 2012; Pridgen and Wilder, 2013). Plummer et al. (2007) oversee the benefits of financial statement information by analyzing Texas school districts’ bonds rating. The study found that statement of net assets was relevant compared to fund-based measures like fund balance, but the accrual “earnings” measure from the statement of activities is not informative relative to fund-based earnings measures. Wang et al. (2007) use four financial condition dimensions in cash, budget, long-run, and service-level solvencies and show that financial statement measures based on government-wide financial reports are useful in evaluating government financial condition. Johnson et al. (2012) use a variation of financial ratios from the government-wide financial statements and find the accounting ratios are reflected in the credit ratings. Pridgen and Wilder (2013) provide evidence of the association between three financial indicators (change in net assets/total net assets; total liabilities/total assets; current assets/ current liabilities) and bonds credit ratings. The research also finds that accrual-based indicators provide information incremental to the fund-based indicators. The four studies mentioned above provide empirical evidence on the relevance of financial statement information measured under GASB 34 for investors in the municipal market. The accrual measures of financial information are indeed relevant and add value to the existing financial reporting models. The studies above, however, use a variety of measures for governments’ financial

Research in governmental accounting, auditing, and financial reporting  105 condition. Compared to research in the corporate accounting setting, there seems to be a lack of consensus in the governmental and financial reporting research regarding the best proxies for measuring government financial conditions. Questions remain on which information is the most important for financial statement users, whether users treat all information the same way, and whether a certain type of information is more relevant for a particular user or a particular decision. Value relevance of financial information quality Information asymmetry is commonly used to explain why financial information quality has value relevance in a capital market. Borrowers tend to have more information about their products compared to lenders. The underlying premise is that borrowers have the incentive to withhold information if it might lead to higher borrowing costs for them. Lenders are aware of this problem and ask for higher interest to compensate for the risk unless they have ways to assess borrowers’ credibility. Borrowers with good quality products then have the incentive to signal their quality to lenders by providing good financial reporting quality. In the municipal market, quality financial disclosure is viewed as a self-certification mechanism that sends a positive signal about the issuer’s quality (see e.g., Evans and Patton, 1987; Gore, 2004). Quality disclosure signals that borrowers do not hold back certain information from the market. Disclosure timeliness signals the above-average managerial quality (Evans and Patton, 1987). One of the early studies (Ingram, 1983) finds that the completeness of information in financial reporting has a direct association with credit ratings. Other studies identify quality financial reporting as compliance with specific financial reporting requirements. Studies in this area find that municipalities located in states that have financial reporting requirements have lower borrowing costs compared to those located in states without such requirements (see e.g., Baber and Gore, 2008; Benson et al., 1984, 1991; Copeland and Ingram, 1982; Fairchild and Koch, 1998). Other studies focus on the timeliness of financial reporting to measure quality (e.g., Ingram et al.,1989; Reck and Wilson, 2006). These studies on information timeliness fail to find a meaningful association between the release of financial information and market reactions. More recent studies, however, find a more meaningful association between information timeliness and market reactions (see e.g., Edmonds et al., 2017; Henke and Maher, 2016; Abbas, 2022). Edmonds et al. (2017) find that total information delay, audit delay, and post-audit delay in an official statement are associated with higher bond yields. Similarly, Henke and Maher (2016) find that the number of days needed to issue a financial statement was associated with lower bond ratings and higher interest costs. The researchers claim that information availability reduces information asymmetry. Abbas (2022) suggests two types of information asymmetry in the municipal market. The first type of information asymmetry measures the information gaps between issuers and investors. The second type of information asymmetry measures the information gaps among investors. Studies looking at the association between quality disclosure and bond yield (or bond yield premium) deals with the first type of information asymmetry (e.g., Edmonds et al., 2017; Henke and Maher, 2016). These studies propose that quality disclosure is used by bond issuers to certify their quality, reducing information asymmetry between issuers and their potential investors. Studies dealing with the second type of information asymmetry measure the price discrepancies among investors (see e.g., Cuny, 2018; Abbas, 2022). Cuny (2018) uses markup premiums to measure the information asymmetries among municipal market investors. Using the creation of EMMA to measure the availability of information, Cuny

106  Research handbook on public financial management (2018) finds that small-trade markup premiums decreased after EMMA. Additionally, she finds that the decrease in small-trade markup premiums was greater for municipal issuers who file their financial statement within six months after the fiscal year-end. Abbas (2022) uses bond-price dispersion to measure information asymmetries among investors in the municipal market. The study finds that the closer the financial statement filing to the issuance of a new bond (post-filing delay), the lower the bond-price dispersion. Contrary to much older studies that fail to find a specific association between information quality and market reactions (e.g., Ingram et al., 1989; Reck and Wilson, 2006), more recent studies find that financial information quality is associated with lower information asymmetry between issuer and investor (e.g., Edmonds et al., 2017; Henke and Maher, 2016), and among investors (e.g., Abbas, 2022). The significant improvement in the municipal market’s information environment may be the cause of these differences. There has been a significant improvement in the information environment in the municipal market since the inception of EMMA in 2009. Before EMMA was created, municipal market participants could obtain bond issuer information (including financial disclosures) from the Nationally Recognized Municipal Securities Information Repositories (NRMSIRs). The information was not free, hindering some market participants from gaining similar access to information. Prior accounting studies thus struggle to separate the differences in the access to information from the quality of the information in explaining their results. With EMMA now working as the single, centralized, free-of-charge disclosure platform, there is ample opportunity for researchers to analyze how much the quality of financial information impacts municipal market participants. Municipal Audit The main objective of the municipal audit is to ensure government’s accountability to the public. In a principal–agent relationship, public managers as the agents need to guarantee that they will not take certain actions that might cause harm to the principal. Similarly, principals (financial statement users) also need guarantees that the information they received is accurate and reliable. Audit on financial reports facilitates this monitoring process and is thus valuable in reducing agency costs. Municipal audit research focuses heavily on measuring audit quality and its impacts. DeAngelo (1981) defines audit quality as the probability that an auditor will discover and report an error in a client’s financial reporting. The higher the audit quality, the higher the probability errors or misstatements are found before the financial information is published. In other words, the higher the audit quality, the greater the possibility that the financial reports are free from errors or misstatements. The most common measure of audit quality is auditor size. Deis and Giroux (1992) use quality control review (QCR) conducted by the Audit Division of the Texas Education Agency to assess the characteristics of audit firms that are associated with municipal audit quality. The study finds that auditor size has a negative association with the level of auditor’s failure to comply with professional standards, meaning bigger audit firms have higher audit quality. On the contrary, Lowensohn et al. (2007) find that auditor size is not uniformly associated with audit quality but has a positive association with audit fees. Other characteristics that are used to define audit quality in the public sector are auditor specialization (e.g., see Jensen and Payne, 2005; Lowensohn et al., 2007) and audit rotation (e.g., see Elder et al., 2015). Both are associated with higher audit quality. Studies looking at the value relevance of municipal audit generally find that higher audit quality is viewed pos-

Research in governmental accounting, auditing, and financial reporting  107 itively by financial statement users. Copley (1991) finds that higher audit reputation (higher audit quality) has a direct association with better higher financial disclosures. Wallace (1981) finds that compliance with auditing standards lowers interest costs and increases bond ratings (Wallace, 1981). Compared to corporate audit research, research on municipal audits is still very limited. The use of proxies that are commonly used in the corporate sector to measure quality (e.g., auditor size, audit rotation) might work differently in the public sector. For example, some municipalities are audited by government auditors, which makes the auditor size and audit rotation variables irrelevant. Municipal audit research, thus, must take the institutional characteristics of a government into consideration.

FUTURE RESEARCH DIRECTIONS Based on each major theme in the previous section, this section summarizes what prior studies have done, the challenges, and future research directions. Financial Reporting Adoption and Practices Early studies on financial reporting standards focus on the existence of a formal mandate for financial reporting (e.g., Ingram and DeJong, 1987). After the inception of GASB 34, the focus was shifted toward assessing how and why governments implement GASB 34 provisions (e.g., Gore, 2004: Vermeer et al., 2011; Jones et al., 2012; Yusuf and Jordan, 2017). With the growing number of new accounting standards issued by GASB after the implementation of GASB 34, plenty of research focuses on standards related to pensions and OPEB (e.g., Coe and Rivenbark, 2010; Vermeer et al., 2012; Matkin and Krivosheyev, 2013; Hallman and Khurana, 2014; Rich and Zhang, 2015; Naughton et al., 2015; Nejadmalayeri et al., 2017). These prior studies generally find that accounting standards improve government financial reporting, and a meaningful association exists between government characteristics and their decision to implement accounting standard provisions. Other studies also indicate that the government’s decision is influenced by the environment, such as fiscal stress (Naughton et al., 2015) or political motive (Rich and Zhang, 2015). Although it has been more than 20 years since the inception of GASB 34, the question of how governments implement accounting standards is still an important issue for future research. Not only have there been plenty of new standards issued by GASB over the years, but also the use of accrual basis accounting raises important questions on whether and to what extent government officials exercise discretion over financial reporting. Accrual basis accounting allows substantial discretion while recognizing revenues and expenses, and the reporting of assets and liabilities. These accounting discretions may be managed by public managers to convey certain information about government financial performance. Research in private sector accounting has long talked about aggressive financial reporting, which deals with the use of accruals by managers to manipulate the financial statement numbers to show good financial performances. The practice, which is commonly called earnings management, has not been explored much in the current government accounting and financial reporting research in the US. Some prior studies have indeed found a sign of earnings management in the government financial reporting practices. For example, Kido et al. (2012) find that

108  Research handbook on public financial management employment-related liabilities are systematically lower in the election year and are correlated with proxies for the incumbent’s incentives and ability to manipulate their accounting reports. The study concludes that in the election year state governments manipulate accounting numbers to show better financial performances. Other studies focusing on pensions and OPEB obligations also find that economic and political pressures are associated with lower unfunded liabilities (Naughton et al., 2015; Rich and Zhang, 2015). Prior studies by Kido et al. (2012), Naughton et al. (2015), and Rich and Zhang (2015) focus on specific accruals that are related to pension and OPEB. One study, Beck (2018), analyzes general accruals (the total accruals in government financial reports) and finds that municipal governments use accruals to avoid reporting deficits. In sum, prior studies have found an indication of earnings management practices in government financial reporting. However, there is not yet any consensus regarding the types of accruals used or the way to measure aggressive financial reporting in the public sector. Referring to the earnings management research in the private sector, researchers interested in this area need to identify the incentives or pressures that lead to aggressive financial reporting practices. Questions then can be raised, under the given circumstances, as to how much discretion in the current accounting standards is used by public officials and whether public managers will trade financial report quality with their performances. Another less-explored research avenue related to accounting standards is the challenges faced by a government entity in implementing an accounting standard. The GASB continues to work on various new standards to improve financial reporting and promote government accountability. As discussed in the previous section, implementing an accounting standard might be costly as it requires the use of public resources. How many difficulties government officials encounter in implementing accounting standard provisions will provide feedback to the standard-setter, particularly GASB, regarding governments’ costs to implement a new accounting standard. Since there is no available data, research in this area might need to gather primary data through a survey, interview, or focus group discussion. Researchers might want to work with GASB to conduct the research. Every year the GASB offers a research grant for researchers interested in doing research in areas GASB is working on and provides support for the implementation of the study. Lastly, studies looking at the adoption and implementation of good financial reporting practices still need to define what is a “good” financial reporting practice. Completeness (the amount of disclosure) and timeliness are commonly used to define financial report quality (e.g., Ingram and DeJong, 1987; Gore et al., 2004; Gore, 2004; Edmonds et al., 2017; Abbas, 2022). In these studies, creditors are considered the primary users of governmental financial statements. Studies looking at the implementation of good financial reporting mainly focus on the municipal market since it is easier to measure the reaction of creditors to information provided by government financial reporting. The existence of a central information repository (EMMA) allows researchers to collect data on financial information provided by governments in the municipal market. There are still some open questions on the quality of the information provided on EMMA. Prior studies looking at the quality of information on EMMA analyze whether a government entity files financial information on EMMA (Cuny, 2016), the compliance and the timeliness of information (Abbas and Johnson, 2022; Abbas, 2022), or the existence of budget information (Abbas, 2022). There is still a lack of measurement about the quality of information (i.e., the content of the financial reports filed on EMMA) and the existence of a variety of financial information on EMMA (e.g., the material event disclosures, the interim financial reports). Additionally, future municipal market studies may want to focus

Research in governmental accounting, auditing, and financial reporting  109 on the institutional setting, more particularly on the initiatives from the SEC. The SEC, as the municipal market regulator, has been attempting to improve the quality of financial information in the municipal market. Cuny (2016) analyzes the inception of EMMA in 2009 and Abbas and Johnson (2022) analyze the MCDC initiative in 2014. The studies find improvements in information quality after the SEC initiative. However, compared to the corporate equity market, the SEC has less authority to regulate government financial reporting. Despite finding an increase in disclosure compliance after the MCDC Initiative, Abbas and Johnson (2022) indeed find that less than half of the municipalities in their sample filed the financial statement on EMMA within a six-month period or less. Whether quality financial information exists in the municipal market is thus still an open question. The Relevance of Financial Reporting As discussed in the previous section, research on the value relevance of financial information focuses on the municipal market. More recent studies tend to provide stronger evidence of the value relevance of financial reporting compared to older studies, which might be caused by the improved information environment in the municipal market. The availability of a centralized information repository allows researchers to separate the disparate access to information from the quality of information in assessing investors’ reactions to financial information. However, there is still a lack of consensus in research measuring the value relevance of good financial reporting, which opens the possibility of future research. Which accounting information is relevant? Studies using financial statement information find that accrual-based accounting information provides additional value (e.g., Johnson et al., 2012; Plummer et al., 2007; Pridgen and Wilder, 2013; Plummer and Patton, 2015). These studies, however, identify different ratios to measure government conditions. Thus, there is still a lack of consensus on which accounting-based measures should be used to measure government conditions. Additionally, current governmental accounting and financial reporting research still puts greater emphasis on the information presented on the basic financial reports. There are other reports and information that are provided in the annual financial statement, such as the MD&A, the Required Supplementary Information (RSI), or the Budgetary Comparison Schedule (BCS). Prior studies looking at the MD&A, such as Rich et al. (2021) find that the tone in MD&A has a significant association with market measures. Future studies can also focus on the information content of MD&A such as whether the MD&A discusses the financial conditions reflected in the accounting numbers in a consistent manner, or whether the governments use boilerplate language in the year-over-year MD&A modifications. The BCS can also be a useful source of information for research in government budgeting. The BCS provides information about the legally adopted budget, the actual financial reports, and the budget revisions, which can be used to evaluate the government’s budget process and results of operation. Some prior studies have used the BCS to measure budget variances, such as Callahan and Waymire (2015), Jordan et al. (2017), and Kioko and Lofton (2021). Kioko and Lofton (2021) suggest that the information in the BCS is more accurate to estimate fiscal outcomes compared to the data published by the US Census Bureau. Moreover, the BCS is a required component of governments’ annual financial reports, thus the information will be publicly available for all governments that adopt the GAAP. Researchers interested in

110  Research handbook on public financial management measuring government performance and accountability can thus use the BCS to measure their budget-related variables. How to measure value relevance? The municipal market research commonly estimates the value relevance of accounting information using bond-related measures. One of the most popular measures is bond rating. Although bond rating might not be a predictor of default in the municipal market (see e.g., Yang and Abbas, 2020), researchers can rely upon bond rating to rank municipalities in terms of default probabilities. Research before the 2009 credit crunch commonly used bond rating to measure credit because, at that time, most municipal bonds were insured. If a municipal bond is insured, its principal and interest payments are guaranteed by the insurer and its price (and yield) will be adjusted by the improved credit risk. Based on this situation, yields of insured municipal bonds are viewed to be inappropriate for assessing government’s default risk (see e.g., Gore et al., 2004). Researchers thus use the underlying credit rating, which is the debt issue’s credit quality absent credit enhancement, to measure credit risk (see e.g., Plummer et al., 2007). Even after the credit crunch when bond insurance is no longer dominant in the municipal market, researchers still rely on credit rating information to assess the value relevance of accounting information (see e.g., Johnson et al., 2012; Pridgen and Wilder, 2013). More recent studies focus on bond yield to measure the value relevance of accounting information (see e.g., Edmonds et al., 2017; Henke and Maher, 2016) and the secondary market efficiency measures (see e.g., Cuny, 2018; Abbas, 2022). The existence of EMMA as the central information repository in the municipal market and the availability of reliable municipal bond issuance databases (e.g., Bloomberg, IPREO) enable recent researchers to focus on the behavior of bond market participants (other than rating agencies). The available data also allows researchers to utilize trade information in measuring value relevance. Abbas (2022) suggests that in measuring value relevance, researchers should separate the two types of information asymmetry in the municipal market. Currently, most studies looking at the value relevance of quality financial reporting focus on yield and yield premium, which portray the information asymmetry between investor and bond issuer. The second information asymmetry problem that deals with the information asymmetry among investors has not been much discussed. Measures that have been used to measure this second type of information asymmetry are trade premium (Schultz, 2012; Cuny, 2018) and bond-price dispersion (volatility) (Downing and Zhang, 2004; Abbas, 2022). However, there is still limited evidence on how and to what extent these measures are associated with the financial information provided in the government financial reports. Cuny (2018) focuses on the introduction of EMMA, and Abbas (2022) focuses on the timeliness of financial statement filing on EMMA. Neither study discusses specific accounting measures or content-related measures of quality financial information. With the rapid changes in governmental accounting standards, additional work remains crucial concerning the value relevance of information required by the new accounting standards. How about the other users of accounting information (other than the municipal market participant)? Referring to GASB Concept Statement No. 1, primary financial statement users are the citizenry, legislative and oversight bodies, and investors and creditors. As discussed in the previous section, most studies on the value relevance of accounting information focus heavily

Research in governmental accounting, auditing, and financial reporting  111 on investors and creditors, while there are indeed other users of government financial reports. Some studies have attempted to address the value of financial information for the citizenry, such as Copley and Douthett (2014) and Kim and Ebdon (2017). Copley and Douthett (2014) find an association between government financial measures and residential property values. More specifically, the study finds that surplus and changes in outstanding debt reported in government financial reports are associated with changes in housing values. Kim and Ebdon (2017) find that the implementation of GASB 34, more particularly the use of infrastructure accounting, affects resource allocation decisions. The study finds an increase in capital spending after the implementation of GASB 34. Although we cannot automatically infer a causal effect for Copley and Douthett’s (2014) and Kim and Ebdon’s (2017) results, a move towards identifying variables or measures that are relevant for the citizenry and legislative bodies is a positive sign. Some accounting standards indeed regulate the measurement and recording of transactions that are of interest to citizenry or legislative bodies, such as pensions and OPEB. Questions thus can be raised on whether the accounting standard implementation improves government decision-making and accountability (e.g., whether the provision in the accounting standard changes the way governments manage their pensions and OPEB obligation). Other Research Avenues Changes in economic conditions might impact the incentives for a government to adopt and implement financial reporting practices. For example, during economic downturns will public managers have greater incentives to exercise more accounting discretion (i.e., aggressive financial reporting)? How much disclosure is provided by a particular government (i.e., in the MD&A or in the notes to the financial statement)? Similarly, the economic and political conditions might impact how financial statement users value and use financial information. For example, do investors turn to financial statement information to gain a better understanding of the future repayment prospects of government bond issuers? Which financial statement information has a greater value for market participants during an economic downturn? As the economy is recovering from the COVID-19 pandemic, questions thus arise as to whether the understanding we gleaned from previous studies holds during the current severe economic situation.

CONCLUSIONS After years of studies in governmental accounting, auditing, and financial reporting, there are still questions that are left unanswered. Researchers in this area suffer from limited access to data and a lack of a structured database. Hand-collected data thus are very common in governmental accounting and financial reporting research. Additionally, government accountability is a very wide concept, involving multiple stakeholders and multiple government functions. Answering a basic question on the value relevance of accounting information can thus be challenging. A thorough understanding of a government institution, its activities, the environment in which it operates, and the related stakeholders is central in developing ideas in governmental accounting, financial reporting, and auditing research. There are two approaches that a researcher can pursue in researching governmental accounting, auditing, and financial reporting, as follows:

112  Research handbook on public financial management 1. Theory-driven: Theory can be the center of research in governmental accounting, auditing, and financial reporting. For example, Agency Theory explains most of the phenomena surrounding accounting practices. Accounting information has been viewed as an important solution to the agency problem, by reducing the information asymmetry problem between agent and principal. Researchers interested in measuring the value relevance of accounting information can thus test Agency Theory by assessing the different levels of information asymmetries and parties involved in the agency problems. 2. Policy-driven: Federal governments have limited abilities to regulate state and local governments’ accounting practices, while state governments can regulate their municipalities’ accounting, auditing, and financial reporting practices. However, some conditions may influence financial reporting and auditing practices. For example, municipalities that receive federal money are subject to a single audit by the Federal government, and municipalities that issue municipal bonds are bounded by the market regulation on disclosures. Studies in governmental accounting, auditing, and financial reporting can focus on the differential requirements that apply to certain municipalities in assessing accounting practices. Similarly, any changes in the governmental accounting and financial reporting requirements raise an important and potential research topic.

NOTES 1. Note that this chapter is not intended to provide a complete literature review on governmental accounting, auditing, and financial reporting research. Some papers that are discussed in this chapter are selectively chosen as examples of a particular research topic. 2. Additionally, there are two other standards issued by GASB during the period that did not specifically change financial reporting practices, which are GASB 98 which changed the title of government financial report to ACFR, and GASB 95 that postponed the effective date of certain GASB standards. 3. There are also GASB statements related to pensions and OPEB that are issued before the inception of GASB 34, such as GASB statement 5, 12, 25, 26, 27. However, before the use of accrual basis accounting, governments were not required to report future obligations in the financial statement. 4. The study focuses on governments that issue bonds in the municipal market, thus are required to provide information on EMMA. 5. Municipalities are required to state, in the offering statement, the kind of financial information they will file on EMMA. Abbas (2022) found that the most common financial information stated in the bond’s official statement is the ACFR. More than 99 percent of the municipalities in her sample stated that they will provide ACFR on a continuing basis on EMMA.

REFERENCES Abbas, Y. (2022). Financial statement timeliness and bond-price dispersion in the municipal market. Public Budgeting & Finance, 42(1), 66–97. Abbas, Y. and Johnson, C. L. (2022). Does regulatory enforcement improve continuing disclosure? The municipal securities market case of the Municipalities Continuing Disclosure Cooperation (MCDC) initiative. Journal of Public Budgeting, Accounting & Financial Management, 34(2), 257–291. Baber, W. R. (1983). Toward understanding the role of auditing in the public sector. Journal of Accounting and Economics, 5(3), 213–227. Baber, W. R. and Gore, A. K. (2008). Consequences of GAAP disclosure regulation: Evidence from municipal debt issues. Accounting Review, 83(3), 565–591.

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114  Research handbook on public financial management Ingram, R. W. (1983). Importance of state accounting practices for creditor decisions. Journal of Accounting and Public Policy, 2(1), 5–17. Ingram, R. W. (1984). Economic incentives and the choice of state government accounting practices. Journal of Accounting Research, 22(1), 126–144. Ingram, R. W. and DeJong, D. V. (1987). The effect of regulation on local government disclosure practices. Journal of Accounting and Public Policy, 6(4), 245–270. Ingram, R. W., Raman, K. K., and Wilson, E. R. (1989). The information in governmental annual reports: A contemporaneous price reaction approach. Accounting Review, 64, 250–268. Jensen, K. L. and Payne, J. L. (2005). The introduction of price competition in a municipal audit market. Auditing: A Journal of Practice and Theory, 24(2), 137–152. Johnson, C. L., Kioko, S. N., and Hildreth, W. B. (2012). Government-wide financial statements and credit risk. Public Budgeting & Finance, 32(1), 80–104. Jones, S., Hensher, D. A., Rose, J., and Walker, R. G. (2012). Infrastructure asset reporting options: A stated preference experiment. Accounting Horizons, 26(3), 465–491. Jordan, M. M., Yan, W., and Hooshmand, S. (2017). The role of state revenue structure in the occurrence and magnitude of negative revenue variance. The American Review of Public Administration, 47(4), 469–478. Kido, N., Petacchi, R., and Weber, J. (2012). The influence of elections on the accounting choices of governmental entities. Journal of Accounting Research, 50(2), 443–476. Kim, J., Chen, C., and Ebdon, C. (2018). Effects of the GASB No. 34 infrastructure reporting standards on state highway infrastructure quality: A panel data analysis. Journal of Public Budgeting, Accounting & Financial Management, 30(2), 191–210. Kim, J. and Ebdon, C. (2017). Have the GASB No. 34 infrastructure reporting requirements affected state highway spending? Journal of Public Budgeting, Accounting & Financial Management, 29(3), 347–374. Kioko, S. N. and Lofton, M. L. (2021). Balanced budget requirements revisited. Public Finance Review, 49(5), 635–672. Lowensohn, S., Johnson, L., Elder, R., and Davies, S. (2007). Auditor specialization, perceived audit quality, and audit fees in the local government audit market. Journal of Accounting and Public Policy, 26, 705–732. Matkin, D. S. and Krivosheyev, A. Y. (2013). Recognizing and responding to retirement obligations: Other postemployment benefits in Florida cities and counties. The American Review of Public Administration, 43(5), 558–580. Mortimer, J. W. and Henderson, L. R. (2014). Measuring pension liabilities under GASB Statement No. 68. Accounting Horizons, 28(3), 421–454. Naughton, J., Petacchi, R., and Weber, J. (2015). Public pension accounting rules and economic outcomes. Journal of Accounting and Economics, 59(2), 221–241. Nejadmalayeri, A., Faircloth, S., Wendel, J., and Chelikani, S. (2017). GASB mandatory disclosure rules and municipal bond yield spreads. Review of Quantitative Finance and Accounting, 49(2), 379–405. Pfeffer, J. and Salancik, G. R. (1978). The External Control of Organizations: A Resource Dependence Perspective. New York: Harper & Row. Plummer, E., Hutchison, P. D., and Patton, T. K. (2007). GASB No. 34’s governmental financial reporting model: Evidence on its information relevance. Accounting Review, 82(1), 205–240. Plummer, E. and Patton, T. K. (2015). Using financial statements to provide evidence on the fiscal sustainability of the states. Journal of Public Budgeting, Accounting & Financial Management, 27(2), 225–264. Pridgen, A. K. and Wilder, W. M. (2013). Relevance of GASB No. 34 to financial reporting by municipal governments. Accounting Horizons, 27(2), 175–204. Reck, J. L. and Wilson, E. R. (2006). Information transparency and pricing in the municipal bond secondary market. Journal of Accounting and Public Policy, 25(1), 1–31. Rich, K. T., Roberts, B. L., and Zhang, J. X. (2021). Linguistic tone of management discussion and analysis disclosures and the municipal debt market. Journal of Public Budgeting, Accounting & Financial Management, 33(4), 427–446. Rich, K. T. and Zhang, J. X. (2015). Unfunded public pension liabilities and local citizen oversight. Accounting Horizons, 29(1), 23–39.

Research in governmental accounting, auditing, and financial reporting  115 Schultz, P. (2012). The market for new issues of municipal bonds: The roles of transparency and limited access to retail investors. Journal of Financial Economics, 106(3), 492–512. SEC (2012). Report on Municipal Securities Market. http://​www​.sec​.gov/​news/​studies/​2012/​ munireport073112​.pdf. Vermeer, T. E., Patton, T. K., and Styles, A. K. (2011). Reporting of general infrastructure assets under GASB Statement No. 34. Accounting Horizons, 25(2), 381–407. Vermeer, T. E., Styles, A. K., and Patton, T. K. (2012). Do local governments present required disclosures for defined benefit pension plans? Journal of Accounting and Public Policy, 31(1), 44–68. Wallace, W. A. (1981). The association between municipal market measures and selected financial reporting practices. Journal of Accounting Research, 19(2), 502–520. Wang, X., Dennis, L., and Tu, Y. S. (2007). Measuring financial condition: A study of US states. Public Budgeting & Finance, 27(2), 1–21. Wilson, E. R. and Howard, T. P. (1984). The association between municipal market measures and selected financial reporting practices: Additional evidence. Journal of Accounting Research, 22(1), 207–224. Yang, L. and Abbas, Y. (2020). General-purpose local government defaults: Type, trend, and impact. Public Budgeting & Finance, 40(4), 62–85. Yusuf, J. E. and Jordan, M. M. (2017). Accessibility of the management’s discussion and analysis to citizen users of government financial reports. Public Budgeting & Finance, 37(4), 74–91. Yusuf, J. E. (Wie) and Musumeci, T. (2012). Changing and/or funding OPEB promises: A typology of local government responses to GASB 45 and the realization of OPEB liabilities. Journal of Public Budgeting, Accounting & Financial Management, 24(3), 369–396. Zimmerman, J. L. (1977). The municipal accounting maze: An analysis of political incentives. Journal of Accounting Research, 15, 107–144.

PART III BUDGETING

7. The road to entrepreneurial budgeting and beyond: a reconceptualization of the development of budget innovations in the United States Robert L. Bland, Michael R. Overton and Valencia Prentice1

For over a century, the processes and methods used to prepare, approve, and implement a budget have been the subject of inquiry by public administration scholars. Budgets legitimize the scope and scale of public services and the role of government in the social order. From the Progressive Era forward, scholars along with front-line managers have experimented with a host of budgeting methods that reflected the democratic, social, and economic values of the era. Periodically, leading thinkers have taken stock of the progression of those budget innovations and their impact on both policy makers and the public they serve (Rubin, 2014). Allen Schick (1966) in his seminal work on “The Road to PPB: The Stages of Budget Reform” provided an interpretive assessment of the progression of innovations in public budgeting up to that time. He identified the changing needs of policy makers as the key driver in the progression of innovations. Drawing on Robert Anthony’s (1965: 16–18) work, Schick synthesized the historical development of budgeting into three distinct orientations – control, management, and planning – each shaped by the overarching political values of that era. Since Schick’s interpretive assessment, both the process and content of budgeting have undergone retooling multiple times in response to the evolving needs of policy makers and public managers. This chapter resynthesizes the progression of innovations in public budgeting over the past century by setting them in the context of three underlying purposes: (1) providing a rationale for allocation decisions, (2) pursuing productivity improvement in the delivery of public services, and (3) adapting budget deliberations and decisions to the expectations of the public2 and their elected representatives. Reexamining the evolution of budget innovations through these three lenses provides a better understanding of why innovations emerged when they did, how they contributed to legitimizing the role of government in society, and the innovations in the budget process that we can anticipate in the near future.

PURPOSES OF BUDGETS Budgets serve multiple purposes. They represent a de facto contract between the public and their government for the quantity and scope of public services (Schick, 2011). They give governments legitimacy to collect and spend money (Bland and Overton, 2019). They provide accountability for the acquisition and uses of those funds. And they establish policy priorities (Rubin, 2019). The public budgeting process is not merely a technical exercise but central to the orderly functioning of a democracy and those charged with administering its operations. 117

118  Research handbook on public financial management Underlying these public purposes, however, are three pragmatic functions that budget processes fulfill: an allocation function, a productivity improvement function, and a public engagement function (Figure 7.1). Budgets operationalize the powers granted to governments by their constitutions and charters. And the process that produces the final budget provides the forum where public problems are identified, prioritized, and resolved or at least deferred. We categorize budget deliberations as falling into two broad areas: those involving policy ends and those concerning administrative means. Budget deliberations that concern the “ends” of government – who gets how much of what – involve decisions on matters of resource allocation. Those deliberations that concern the “means” of government – how, who, and where goods and services are produced – involve decisions on the production of services. The two processes are distinct but complementary. Politically, the decisions that result from these processes provide legitimacy with the public on who receives services, who pays for them, and how those services are delivered. Over the past century, engagement by the public in the governing process has steadily evolved and with it so, too, have the public’s expectations for both the ends and means of public services. This evolution in the engagement by the public has driven more than a century of innovations in the budgeting process.

ORIGINS OF THE ALLOCATION AND PRODUCTION FUNCTIONS Since the emergence of modern public administration, elected and career policy leaders have used the budget process to identify processes that assure delivery of services at a specified cost (Wilson, 1887). Productivity improvements seek to contain the cost of producing and delivering public goods and services. If governments through their budget processes successfully reduce or otherwise limit increases in costs, those resources can be reallocated for other spending priorities or for reductions in taxes and fees. The budget process provides a recurring forum for identifying productivity improvements that expand the benefits of public expenditures. The past century has seen the introduction of numerous innovations, often as management improvements, that are merged into or adapted to the budget process. However, early scholars understood that public budgeting was not only concerned with the cost of services but also with choices on what services to provide and to whom. In other words, one of the primary functions of a budget is deciding how limited resources are allocated among competing interests. In another seminal work, V. O. Key (1940) posed his now familiar rhetorical question, “On what basis shall it be decided to allocate x dollars to activity A instead of activity B?” Many budget innovations introduced over the past century have emerged as tools to provide better data for making allocation choices. As the demand for public services has outpaced the resources available to meet those needs, the allocation function has risen in prominence. Resource allocation and service productivity pursue distinct but interrelated paths. Disentangling allocation and productivity improvements can be difficult in a practical sense because one feeds into the other quite naturally. We recognize the blurred conceptual and operational lines between the two purposes. However, for the purpose of this chapter we reconceptualize the evolution of budget innovations because most innovations in the budget process primarily target either improving the production or allocation of public services. Schick alluded to these two dimensions of the budget process in his 1966 article when he notes that “the plain fact is that planning is not the only function that must be served by

The road to entrepreneurial budgeting and beyond  119 a budget system” (Schick, 1966: 244). Budgets also fulfill a control function in ensuring that funds are used for intended tasks “effectively and efficiently,” and a management function that ensures funds are used to accomplish the intended objectives “effectively and efficiently.” Schick focused on the information used in budget preparation and implementation to explain the progression of budget reforms. Our construct broadens the focus to assess the effect of innovations on three basic functions of public budgeting – allocation, that is optimizing the size of the public sector to achieve a Pareto optimum; productivity, that is delivering public services cost effectively; and legitimization, that is adapting budget processes to serve the changing roles and expectations of the public in the governance process. The budget reforms of the past century have sought to introduce innovations that promoted these purposes. For example, the reforms launched in the early years of the twentieth century by the Good Government Movement focused primarily on improving productive efficiency by formalizing the recording and reporting of financial information. Luther Gulick (1937: 13), writing for the Brownlow Commission, coined POSDCORB as the most efficient way to organize executive level functions. The implementation of planning, programming, budgeting systems (PPBS) in the 1960s, on the other hand, was primarily concerned with allocation, ensuring that funds were allocated to achieve the greatest economic benefit. Both innovations sought to increase government’s legitimacy by adapting its decision-making processes to the perceived expectations of the public it serves.

THE CHANGING ROLES OF THE PUBLIC The common thread in the progression of budget reforms over the past century has been the evolution in the public’s role in the governance process. The quest for allocative fairness and productive improvements in public budgeting occurs within a political context – specifically a quest for processes and data that legitimize budget choices with the public. The progression of budget innovations has closely tracked the changes in the role of the public in the political discourse on budget decisions, creating interaction effects best depicted as a double helix (Figure 7.1). Budget innovations have always been shaped by the political values of the day as policy leaders sought to respond to public preferences, or at least the perception of those preferences, to legitimize government choices, and to ultimately garner approval at the ballot box. As the roles of the public in governance evolved, public expectations changed accordingly for both the services provided by government and how those services were delivered. New budget innovations emerged to provide the necessary data to guide budget deliberations and the decisions that followed. Prior to the emergence of more democratic forms of government, monarchs and patriarchs ruled their subjects who were obligated to the sovereign for protection, sustenance, and their wellbeing. Subjects acquiesced to the social order as a condition for receiving the benefits that came with their allegiance. The emergence of democratic institutions elevated the populace, at least initially males who owned land, to a new position of authority, albeit sharply limited. Constitutions ushered in a new order by empowering a limited electorate to legitimize and even alter the institutions of government. In the case of the United States, the Constitution originally sharply limited the revenue raising powers of the government (Article I, Section 8, Clause 1). However, it granted a broader spending mandate to the Congress:

120  Research handbook on public financial management No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time. (Article I, Section 9, Clause 7)

Politically, the public had become clients of government that provided public services that were largely the choice of those in power. Empowered by the success with direct election of senators and women’s suffrage, by the second decade of the twentieth century the Good Government Era ushered in an awakening of an expanded role of the public as constituents.

Figure 7.1

The evolving role of the public in budget innovations

The public was gaining a voice in policy matters, at least through their elected representatives. Depictions of organizational pyramids placed the public at the top. By mid-century, budget

The road to entrepreneurial budgeting and beyond  121 deliberations routinely included public hearings and greater participation by constituents through a federal mandate for “maximum feasible participation” in how grant awards were allocated. Then in 1978, the landslide approval of Proposition 13 by California voters kindled latent antipathy for what some believed was the unchecked expansion of government. The presumption was that, if controls could be placed on the revenue side of the budget, the inevitable outcome would be a reduction in the cost of public services without reducing the level of those services, although for some that, too, was an objective. The property tax was an easy target for the public who were transitioning from mere constituents to now consumers of public services. The lines between public services and the plethora of private goods and services became increasingly blurred as governments increased their use of outsourcing, contracting out, public–private partnerships, and privatization in the production of their services. While consumers took as given the public services that were provided, they voiced concern with the seemingly unchecked increase in the cost of those services and, where available, acted on those concerns through their expanded access to the tools of direct democracy. By the end of the twentieth century, the relationship between the governed and those governing was undergoing yet another major transformation. Restive voters had found their voice and were now pressing for more choices in public services. They were no longer just consumers of public services, but had transitioned to customers who expected choices in the quantity and quality of public services (Osborne and Gaebler, 1992). Public administrators had added entrepreneurship to their duties, producing public services for customers who expected, even demanded, choices in the quantity and quality of those services. Entrepreneurial budgeting (Cothran, 1993) gained traction as managers experimented with a host of innovations using surrogate market processes such as managed competition, vouchers, and responsibility-centered management to prioritize, produce, and deliver public services. What role for the public should we expect in the coming decades, and what are the ramifications for budget processes? We propose that residents will transition to become subscribers of public services, or what Dennis Linders (2012: 453) characterized as a transition from customers to partners in the co-production of public services. The confluence of technology and refinement of quasi-market processes will enable local governments, in particular, to customize services to neighborhood and even individual household demands. Contracting out will emerge on the demand side of the production curve as smart cities gain acceptance and capability and governments become adept at providing public services on demand or on a subscription basis with premium options for those willing to pay for them. The following sections explore the development of budget innovations through these three lenses (Table 7.1). We use the two overarching objectives – increased production efficiency and politically responsive allocation of resources – to understand the motivation for the budget and management innovations introduced during each of four eras. We benchmark each era’s timeframe using pivotal events or publications. We recognize the somewhat arbitrary nature of the categorization of these eras and that transitions from one era to the next occur gradually. Furthermore, the institutionalization of innovations tends to be cumulative with those introduced in one era often being integrated into the budgeting fabric in successive eras. Budgets still use line-items, an innovation institutionalized during the client era. Governments have always contracted with private providers but those partnerships took on new and expanded forms during the consumer era. Each era adds information and data, with the budget process and document reflecting the cumulative contributions of successive eras.

122  Research handbook on public financial management Four eras representing the progression of budget innovations, along with an approximate timeframe for each, are proposed: the client era (1900–1949), the constituent era (1950–1978), the consumer era (1979–2000), and the customer era (2001–present). A fifth era is proposed as poised to emerge – the subscriber era – emanating out of the transition of consumers to subscribers of public services (Table 7.1).

CLIENT ERA The formative years of modern budget processes and the information they produced were bounded at the outset by Woodrow Wilson’s 1887 call for a politically neutral administrative branch outside the political arena and at the back end by the 1949 Hoover Commission Report on the Organization of the Executive Branch. This period was dominated by initiatives designed to strengthen the production of public services through spending controls and enhancing the administrative capacity of the executive branch. It was an era where clients entrusted those in power to make budget decisions in their interest. Legitimacy was achieved by building the administrative capacity of the executive branch and, in particular, its control over the budget. Budget reforms in this era aimed to strengthen the executive branch on the assumption that it was the branch that “could think in terms of the institution as a whole” (Cleveland quoted in Schick, 1966: 246). The locus of budget and management innovations was in the executive branch, although the legislative branch was a presumed beneficiary of the administrative innovations. In Schick’s typology, this era was segmented into the control orientation (roughly 1920 to 1935) and the management orientation (roughly 1936 to 1950s). Building on the momentum from the Good Government Movement, reformers set about to formalize how budgets were prepared and implemented, focusing their efforts on bringing greater accountability to administrative processes. Engagement with the public was limited because they were clients of government. It was government’s duty to provide them with the services that their leaders thought best. It was an era where improving production and delivery of services took center stage (Rubin, 1990: 179), and it laid the foundation for successive waves of budget reform that aimed to use the budget process to improve productivity in the public sector. The early twentieth century was a fertile period for innovation in government. Central to the plethora of innovations was the introduction of an executive budget and its institutionalization at the federal level with the passage of the Budget and Accounting Act of 1921. Reformers sought to empower the executive branch at all levels of government with the responsibility for preparing a spending plan and ensuring adequate revenues to pay for that plan. As executive budgeting gained acceptance, the need for generalist professionals emerged with knowledge of public policy and public administration to staff newly established budget offices. Governments added budget manuals to standardize the data used in deliberations. By the 1930s, governments experimented with separating out capital spending into its own budget to better track the use of bond proceeds and document the cost of big-ticket projects (Burkhead, 1956: 183). Concurrent with the introduction of the executive budget was the adoption of line-item classification of spending. Popularized by a 1917 report prepared by the New York City Bureau of Municipal Research, line-item classification continues as the mainstay in budgets to this day (National Center for Education Statistics, 2009: 13). In a 1909 speech to the American

(Future)

Subscriber Era

(2001–present)

Customer Era

(1979–2000)

Consumer Era

(1950–1978)

Constituent Era

3.  The public as subscribers

neighborhoods

allocation to households and

2.  Market-driven production and

reveal citizen preferences

1.  Use of quasi-market processes to

2.  The public as customers

viding choices in public services

1.  Improved allocation through pro-

2.  The public as consumers

working smarter

1.  Increased productivity through

3.  The public as constituents

inseparable

– growth of smart cities that provide on-demand services

– direct contracting with subscribers for services

– premium subscription for services

Building budget capacity by applying quasi-market processes to budget choices through

– bounded benefits (TIFs, PIDs, HOAs, crime control districts)

– entrepreneurial budgeting

– public choice, vouchers, pricing public services, deregulation, managed competition

Building budget allocation capacity by revealing customer preferences through

– National Performance Review

– restricting discretion (Proposition 13; balanced budget sequestration; truth-in-taxation; TABOR)

Building executive and legislative budget accountability through

– ZBB; MBO; target base budgeting

– cost/benefit, cost-effectiveness analysis

– 1974 Congressional Budget and Impoundment Control Act

– public input, public hearings, public choice

2. Politics-administration

– PPBS, budgeting toward planned goals

strategic use of resources

Building budget analytical capacity through

– emergence of budget office in executive branch

– separate capital budget, budget manual, long range forecasts

maximize social benefits through

1.  Allocation of resources that

3.  The public as clients

rated from administration)

2.  Executive centered (politics sepa-

– executive budget, line-item detail, fund accounting

Building budget control in the executive branch through

control of spending

1.  Gains in productivity through

(1900–1949)

Focus of budget innovations

Predominant values

Client Era

Eras of budget innovations

Budget eras

Table 7.1

The road to entrepreneurial budgeting and beyond  123

124  Research handbook on public financial management Statistical Association, New York City Comptroller Herman Metz (1910) lauded the procedural innovations introduced by the Bureau: the bureau of municipal investigation and statistics, with its staff of twenty-eight employees, goes over in detail, first at the office and later in the various departments themselves, the statistics submitted by the departments, plus such reasons for this increase or disclosed by statistical comparison do not lend themselves easily to statistical presentation. (Metz, 1910: 72)

Ratification of the 16th Amendment in 1913 meant a new and increasingly important source of revenue – the individual income tax – for the federal budget and with it an expectation for greater accountability in the use of those funds. Revenue forecasting became integral to the budget office’s duties as governments broadened their revenue sources to consumption and income tax bases. The balanced budget requirement, enshrined in statutory or constitutional law of most states and many local governments, made revenue forecasting an essential and overriding consideration in budget deliberations. Budget analysts were developing an ever broadening range of tools for their administrative toolbox. The client era saw the introduction of purchasing systems and the promulgation of the first accounting guidelines in 1936 by the National Committee on Municipal Accounting (Gauthier, 2012: 24). The emergence of fund accounting, charts of accounts, financial reporting and independent auditing added a level of accountability that could not be achieved with line-item budgeting. It gave administrators, and ultimately legislators, the capability to track spending and revenues and to periodically compile a report comparing, at the line-item level, the spending authorized in the budget with the actual amount. This added layer of financial accountability freed up the budget process to serve broader purposes for improving the production of public services (Schick, 1966: 249). This formative period of modern budgeting began with innovations to increase the accountability of the budget process then pivoted mid-century to innovations designed to improve the capacity to manage those public programs created by that process (Downs and Larkey, 1986: 148). While Schick saw these as two distinct eras, we see them as a continuation of a common thread of administrative innovations designed to increase the productivity of government on behalf of its clients. The era culminated with the Hoover Commission’s 1949 report calling for the development of performance budgeting that, in turn, launched the quest for methods to measure, manage, and evaluate performance. The budget now included measures of performance initially to connect inputs to the outputs and later to the outcomes, or results, of public services. While performance measurement has focused attention on improving the productivity of public programs, it was less concerned with promoting allocation that maximized economic benefits. The problem is that performance measures link inputs to outputs, and only weakly link inputs to outcomes. But allocative decisions originate from fundamentally different questions of the relative value of program outcomes. Performance measures do not provide the data that policy makers need to make allocative judgments. Those innovations have their intellectual origins in Key’s (1940) seminal article that anticipated the emergence of allocative innovations that dominated the next era, namely the constituent era.

The road to entrepreneurial budgeting and beyond  125

CONSTITUENT ERA The post-war economy ushered in a period of growing prosperity and opportunity and with it, greater engagement by the public in policy matters. This constituent era approximates Schick’s planning era when budget innovations shifted to providing information that would better legitimize the allocative choices made by legislators in their budget deliberations. The era began in the 1950s with local then state governments experimenting with PPBS and culminated with Congress reasserting its power over the federal budget with the passage in 1974 of the Congressional Budget and Impoundment Control Act. The era was shaped by the belief that politics and administration were inseparable and that economic growth could be achieved through the strategic allocation of resources. In his opening sentence, Key articulated the shift in emphasis in budget deliberations to allocation: “On the most significant aspect of public budgeting, i.e., the allocation of expenditures among different purposes so as to achieve the greatest return, American budgetary literature is singularly arid” (1940: 1137). Anticipating the focus on allocation choices, Key called for “keen analyses” and a better understanding of the “role of the legislature” in his lament at the lack of a budget theory. The call did not go unheeded. By the early 1960s, a new budget methodology – PPBS – caught the attention of the Secretary of Defense, Robert McNamara. Here, at last, was a method that provided policy leaders in the Department of Defense with information on the relative value of options for the budget, and with a budget process that, on the surface, answered Key’s question. This era was characterized by budget choices driven by bold goals – placing a human being on the moon by the end of the decade, a decent and affordable home for every American family, a war on poverty, the civil rights movement, and a Cold War. It was an era where budget innovations used economic analyses, under the rubric of cost-benefit analysis, to legitimize allocative choices. It was an era dedicated to preparing analyses of the costs and benefits of options for meeting a goal, and then using those analyses to identify the option that maximized economic benefits. The early 1960s also saw the emergence of another call for more rational allocation of budget choices for public services – public choice theory. Led by political economists James Buchanan and Gordon Tullock (1962), they called for injecting market choices, such as school vouchers and outsourcing, to more efficiently allocate resources to and within the public sector. Their view was that government monopolies were inherently inefficient and that the result was over production of public services from what the public really wanted. Economic theory holds that the political process produces less than economically optimum amounts of public services. The solution was to expand governments’ use of quasi-market mechanisms such as toll roads, vouchers for public education, contracting out public services, and increased privatization of government-provided services. The impact of public choice on budget innovations continued into successive budget eras and has been the genesis for the emergence of entrepreneurial budgeting. The quest for the optimum allocation of funding in budget choices spilled over into the community of public administration scholars. The 1968 Minnowbrook Conference produced a call for a new public administration in which administrators took a more proactive role in shaping policy choices (Marini, 1971). That call fit well as the public was transitioning into constituents – a recognition that in a democracy voters are at the top of the organizational

126  Research handbook on public financial management chart and are the ultimate source of authority for government action. They were now more than clients of the public sector. They were stakeholders in the choices about the services they paid for and received. Public hearings became a common step in budget adoption. Opinion surveys grew in popularity as legislators wanted to know the spending preferences of their constituents. State legislatures adopted open meeting laws compelling their agencies and local governments to conduct more of the public’s business in view of that public. At the federal level Congress passed the Economic Opportunity Act of 1964 that called for “maximum feasible participation” by stakeholders in the creation and funding of community action programs. Residents were no longer “wards of government” but stakeholders whose voice was important in making budget choices. But public participation meant developing methods to ensure that their voices were heard in the legislative process. Opinion surveys, for example, were undertaken to better inform the legislature in its allocative deliberations. Representative government, for the moment, was secure, although the seeds of direct democracy had been planted. Another noted scholar of the era, Aaron Wildavsky (1964), popularized the idea that budget preparation was incremental, that allocation decisions were largely locked into the status quo. Wildavsky challenged the conventional wisdom put forth by advocates of PPBS that viewed allocation decisions as part of a rational process where all available choices are known and cost-benefit analysis was employed to determine the course of action that maximized economic benefits. However, according to Wildavsky few changes should be expected in the allocation choices of governments because decision-making proceeded in small incremental changes, never large quantum leaps. By 1984, Wildavsky had abandoned his incremental argument following major changes in the federal budget process that ensued in the wake of President Nixon’s resignation (Rubin, 1990: 185). However, Wildavsky had refocused attention on the central role of legislatures in budget allocation decisions. The culminating event of the constituent era was played out in Washington, DC, following Watergate and the resignation of a sitting president as Congress and the president battled over primacy in budget deliberations (Rubin, 1990: 186). The result was passage of the 1974 Congressional Budget and Impoundment Control Act. This legislation superimposed a process, along with the institutional support in a new Congressional Budget Office (CBO), to analyze the economic impact of and to set targets for federal spending, revenue, deficits, and debt before deliberating on specific appropriation bills. The act significantly limited the president’s previously unchecked prerogative to impound budget authority without Congressional approval. Allocation decisions were once again firmly lodged with the Congress. By the late 1970s, the era was fading into yet another new era brought on by a grassroots tax revolt that began in California and quickly spread across the nation.

CONSUMER ERA The consumer era emerged in 1979 following ratification of Proposition 13 by California voters. It was an era where production and delivery of public services once again was the focus as the tax limitation movement forced governments to work smarter. The public had embraced consumerism. Public goods were viewed as consumables on par with the burgeoning market for privately produced goods and services. Opinion surveys now gauged consumer satisfaction

The road to entrepreneurial budgeting and beyond  127 with the quality and quantity of public goods and services. Budget documents included data comparing a city’s property tax rate with those of its competitors. Public managers looked for tools to demonstrate the price-competitiveness of their services. Using tax limitations, residents as consumers had found a powerful tool to hold both executive and legislative leaders accountable by restricting the resources available for spending. Their expectation was that by restricting resources, the cost of production could be lowered. The era culminated with an ambitious plan by the Clinton Administration to create a culture of performance-driven decision-making in federal agencies. California voters’ lopsided ratification in 1978 of Proposition 13 placed strict limits on both property tax rates and increases in the taxable value of property. Property tax revenues were cut to one-third their pre-Proposition 13 level. It was the initial action in a long line of succeeding initiatives in which the public, faced with an expanding array of consumer goods, saw public services as part of that array. As consumers, they aimed to redefine efficiency by forcing government to work smarter. A smarter government meant an increase in their discretionary income available for consumption. It was an era where budget reform meant reinventing government (Osborne and Gaebler, 1992). Working smarter meant improving the productive efficiency of government by constraining the options of its leaders and holding them more accountable for the cost of producing those services. All levels and all branches of government were being reshaped by the consumers of public services. Following Proposition 13, the Hancock Amendment in Missouri subjected essentially all local revenue changes to voter approval. And in 1992, Colorado voters approved the most restrictive of tax limits in the nation, the Taxpayer’s Bill of Rights (TABOR), requiring the state to provide refunds to taxpayers for excessive revenues. Other states, such as Texas, took a less top-down approach to tax limitations by giving local voters the option to limit property tax rates rather than mandating a state-wide cap on tax rates. In Texas, truth-in-taxation gave voters in each local taxing jurisdiction the discretion to roll back extraordinary increases in the property tax rate. States also experimented with limiting government discretion through dedicated taxes and capping increases in the growth of budgets. At the national level, renewed calls for a balanced budget amendment gained traction in Congress throughout the 1980s and 1990s but fell short of the necessary support to send it forward to the states for ratification. With the passage of the Balanced Budget and Emergency Deficit Control Act in 1985, commonly known as the Gramm-Rudman-Hollings Act, a new term entered the budget glossary – sequestration. With sequestration, cuts in appropriation authority took effect automatically if Congress exceeded the deficit target for that fiscal year, protecting members of Congress from the politically distasteful task of cutting favored programs and projects. At the state level, public leaders were subjected to increased scrutiny on the definition of a balanced budget, the use of the line-item veto, and limits on the issuance of debt. Disenchanted voters had found powerful tools to rein in government spending. The zenith of the consumer era came with the launching of the National Performance Review (NPR) in 1993 by President Clinton. Under the leadership of Vice President Gore and five seasoned public administrators, NPR sought to create a new culture in the federal workforce that valued customer service, innovation, interagency and intergovernmental cooperation, and streamlined the central administration of agencies. The NPR staff issued a series of reports subtitled “Creating a Government that Works Better and Costs Less,” a phrase that captures the underlying values of the era.

128  Research handbook on public financial management Productive efficiency was front and center in this era as public administrators searched for innovations to contain the cost of providing public services. Performance budgeting provided the intellectual foundation for a number of innovations that gained popularity in this era. Cost accounting, for example, was being used in a few cities to build budgets. The cost of every task was determined from historical data and then a budget line-item was costed based on the number of task units that would be produced that year. Sunnyvale, California, was an exemplar in this approach to budget preparation. Total quality management had been used in the private sector for several decades but in the 1980s attracted the attention of some city and county executives. Benchmarking of public services was another innovation that captured the attention of some public managers who hoped that it could provide an effective tool for demonstrating their government’s success at containing costs and a competitive position in the quest for business investment. Outsourcing of the provision of public services gained increased acceptance among consumers, public administrators, and even public employees. Governments have always relied on contacts with private suppliers for providing raw materials and completing construction projects. What emerged during the consumer era was an expansion of the role of outside providers to include outsourcing of direct services to the public, mixed delivery for more risky ventures, and partnerships with private (or nonprofit) vendors where financial risks were shared (Bland and Overton, 2019: 7). Governments even took the rare step of privatizing previously publicly provided services, such as the state of Washington selling all of its liquor stores to private investors. Some local governments have considered selling some of their basic utility services such as water and electric power services. States have outsourced management and even ownership of their toll roads, prisons, and public assistance programs. An interesting variation of this quest for productive efficiency is managed competition, a productivity tool inspired by public choice theory. Initially introduced into the public sector by the city of Phoenix in the late 1970s, the city of Indianapolis used it effectively in the 1990s to demonstrate the merits of empowering public employees to participate in the development of a bid for vehicle maintenance services. Managed competition has become a widely used tool for government agencies to demonstrate their commitment to cost containment. However, it fails to provide guidance on the other side of the budget coin, that of allocating resources. Performance-based innovations designed to contain costs of production are incapable of providing the information that policy leaders need for making value-laden allocation decisions. Reformers of the consumer-based era quietly hoped that innovations in performance measurement would ultimately yield a rubric for making allocation choices much like the cost-based budget of Sunnyvale. Such a rubric would guide budget policy to allocate more (or less) for agencies performing well above a benchmark level. But that begs the question – how should performance that is above or below the benchmark be treated? What inherently justifies giving a successful agency even more money and reducing funding to the underperformer? Would such a rationale hold for police or fire services? A library? A public health clinic? By the end of the twentieth century with the shift rightward in American politics, rational allocation of resources once again emerged as the focus of budget reforms.

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CUSTOMER ERA The current customer era emerged late in the twentieth century as the public’s expectations migrated from that of consumers to customers. While consumers value the market for its discipline in containing the cost of goods and services, including those produced by government, customers also value the market for the choices it provides. Customer-driven budgeting looks to markets to improve allocative decisions for public services and relies less on the legislative process (Jung, 2010). Customers make their choices using vouchers, premium services, or institutional arrangements, such as homeowners’ associations (HOAs), offering bounded benefits (Bland and Overton, 2016). When preparing their budgets, governments experiment with integrating processes, such as budgeting for outcomes, designed to reveal customers’ preferences through competition. The culmination of this era likely will emerge with the customization of both the quantity and quality of public services to the preferences of households or geographically defined areas. While the research shows mixed results on the success of the tax revolt in limiting growth in state and local budgets (Sun, 2014; Seljan, 2014), the entrenchment of consumerism among the public shaped both the study and practice of public administration. While consumers rely on competition to contain costs, customers expect choices in the quantity and quality of services available to them. With choices consumers become customers who have an array of products and services from which to choose. Such is the era that emerged in the late twentieth century and now dominates public discourse. Consumers had become customers of public services, and public managers have added “entrepreneur” to their job descriptions. Resource allocation has reemerged as of paramount importance to legitimizing public budget choices. Now, however, rather than relying on analyses to identify the policy options that maximize social benefits, such as with PPBS, reformers of this era have picked up the mantle of public choice and reinventing government and look to the tools of competition to guide budget deliberations. Public administrators, especially in local government, have been at the forefront in experimenting with innovations that provide market signals to customers’ preferences. Markets that were historically the sole province of governments, from charter schools to investor-owned toll roads, have been opened to private vendors. Public administrators increasingly find themselves competing with other suppliers in the provision of services (Nukpezah and Bland, 2017). Customers of public services in the public market era expect choices. Budget innovations in the current era aim to reveal customer preferences. Entrepreneurial budgeting broadly describes a variety of innovations designed to introduce quasi-market mechanisms into the discourse on spending priorities (Cothran, 1993). Many of these innovations have the added benefit of increasing productive efficiency by providing public managers with an incentive to contain production costs. For example, responsibility-centered management (RCM) has been used as a budget and management tool among some major universities. Funding for each college, and in some cases even departments, is determined by the revenue generated by the academic unit from tuition, fees, and, in the case of public universities, state appropriations. The level of student demand drives the college’s budget. Central administration and other indirect services are funded by a “tax” on the academic units. Under RCM, allocation is the result of market-driven signals. Budgeting for outcomes (BFO) and priority-based budgeting (PBB) both embrace entrepreneurial solutions to budget allocation. The Government Finance Officers Association has been

130  Research handbook on public financial management at the fore in advocating adoption of PBB that blends elements of zero-based budgeting (ZBB) with managed competition and performance budgeting (GFOA, 2011). In the case of BFO, the generic approach involves these steps. The local government establishes broad community outcomes that reflect the public’s preferences. The overall level of spending is set, typically as a percentage of the personal income of a city’s residents. Requests for results (RFRs) are then prepared for the initiatives selected for each of the community outcomes. A quasi-competitive bidding process follows as coalitions of internal agencies, nonprofits and for-profit organizations submit bids for each RFR. The bids are then ranked by city staff, something analogous to the ranking process used in ZBB, and the top-ranked RFRs are funded up to the predetermined level of spending. The website for Fort Collins, Colorado, which has been at the forefront in implementing BFO for its biennial budget, has the following statement on the benefit of BFO: “Final output is a budget that reflects citizen priorities and delivers service efficiently.” Public–private partnerships have expanded in popularity and creativity during the customer era. So, too, has the use of special districts designed to contain the benefits of public services to those within its borders. Neighborhood institutions have become markets that allow entry and exit based on customers’ preferences for public services (McCabe, 2005). For example, HOAs provide their customers with bounded benefits (Bland and Overton, 2016). Such benefits may include streets, water, sewage, and other infrastructure in addition to recreation facilities such as swimming pools and tennis courts (McCabe, 2005). The additional charges or fees incurred by property owners provide funding for premium subscription services available exclusively to those willing to pay for them. Those benefits are capitalized into property values, further elevating the value of the bounded HOA. The creation of similar types of institutions with premium services has greatly expanded in the past two decades to include crime control districts, public improvement districts, tax increment financing districts, charter schools, municipal utility districts, and managed toll lanes. While a number of innovations seek to replicate a competitive market in the production of public services, public managers continue to develop and test quasi-market measures to gauge public preferences for public services. For example, the city of Austin, Texas, introduced a budget board game to obtain data on the service priorities of its residents. Communities have experimented with virtual town hall meetings and online budget scenarios. The common denominator to these innovations is the choices they provide to customers who, if offered and if they can afford the extra cost, can choose to purchase the additional quantity of public service. The world of public budgeting continues to undergo transformation as policy leaders search for measures that provide the information needed to better match the allocation of public funds to the preferences of customers. This transformation has ushered in an era that is changing the way government provides services and the way those services are administered. The emerging economy is one where public service delivery is more segmented geographically and socio-economically, and residents, individually or in clusters, can opt to contract for the quantity of services needed and at the time they are needed.

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SUBSCRIBER ERA Several trends have emerged from the past century of budget and management innovations that provide a basis for making projections for the near future. The combination of advances in technology applications and new institutional arrangements portend a new era of resident– government relations where residents are not only customers of public services but subscribers who can customize packages of services. Public service provision will increasingly look like that of the private sector with allocation choices made directly by customers and less by legislative bodies. Several trends currently in progress may usher in this subscriber era. First, the public sector offers a tantalizing arena for the application of information and communication technology (ICT). Data collected from ICTs enable governments to provide premium and customized subscription for some public services. The cost of tracking, capturing, and predicting individual behavior using data from ICTs in combination with digital activity is low and will continue to decrease with the proliferation of these technologies (Goldfarb and Tucker, 2019). The ability to convert this data into customized premium subscriptions is limited by an organization’s vision and start-up costs (Cockburn et al., 2018). Already neighborhoods may contract with a city for additional police patrols. Smart public transit is being tested in some European cities to better meet commuters’ needs during peak periods of demand. Charter schools offer educational options that target the preferences of parents and the interests of students. The CareFlight ambulance service is available in some metropolitan areas as a subscription service. Premium subscription services will likely emerge for such public services as parks, recreation, energy, communications, internet, and public safety. Subscriptions also raise significant issues of equity and affordability that fundamentally change the nature of public goods. Of particular importance is the potential of the internet of things – physical objects with electronic sensors that collect and transmit data through the internet to a central source. The technology is already in use to manage traffic signals and the flow of traffic. The internet of things enables public managers to remotely, but accurately, measure the consumption of public goods. This development combined with predictive machine learning algorithms of artificial intelligence (AI) create the potential for improving both the allocation of public funds and the productivity of their delivery. Second, institutionally governments will expand their creative use of public–private– nonprofit partnerships (PPNPs). Not all partnerships and collaborative ventures are successful, but those that are take advantage of each partner’s strengths to better address complex policy issues (Weber and Khademian, 2008). As governments and their partners gain experience at collaborating, new applications will be developed and existing partnerships refined. PPNPs can lead to dramatic improvements in productive efficiency when partners leverage various economies of scale, improved task specialization, and mutual learning opportunities (Bovaird, 2004). Unfortunately, preliminary studies on budgeting in PPNPs suggest that current budgeting processes lag behind the actual development of PPNPs (Mitchell and Thurmaier, 2016). Third, advances in both ICT and various public engagement protocols enable more meaningful and frequent resident–government interaction in addition to the increased likelihood of improved personalization of public services. Public managers will operate in an increasingly blurred world as public entrepreneurs must balance individual customer needs with those of the community. The increased “customerization” of American democracy will foster the expansion of quasi-markets into new service areas, facilitating both resource allocation that

132  Research handbook on public financial management targets customer preferences and increased productive efficiency as they choose among competing service providers. As the subscriber era emerges, bundles of public services will be more customizable. Technology and new institutional arrangements will allow disaggregation of public services into more discrete packages that residents can choose to purchase as needed. Public services, especially premium-level services, will increasingly be provided only on demand and in preferred quantities. Public transit, education, health care, utilities, and public safety hold the potential for bundling services especially as ICT is adapted to public services. The marginal cost of premium services will be shifted to the marginal customer who subscribes to a preferred package of public services. The emergence of the smart city initiative, which has gained traction particularly in the European Union, offers a glimpse into the future of public services (Department for Business Innovation & Skills, 2013). In its background paper on Smart Cities, the British Department for Business Innovation & Skills notes that “the concept of a Smart City goes way beyond the transactional relationships between citizen and service provider. It is essentially enabling and encouraging the citizen to become a more active and participative member of the community” (Department for Business Innovation & Skills, 2013: 7). ICT makes possible the provision of more public services on demand. A number of services, such as emergency ambulance services, are already provided on that basis. Other services such as energy, public transit, education, air and water quality monitoring, traffic management, and even disaster response hold the potential for adapting service levels to market demand (Executive Office of the President, 2016). And offering premium subscriptions for additional fees opens a new world for public administrators. Smart cities rely on big data sets to develop models capable of tracking demand and adapting public services to strategically target their resources. The role of the budget office will change accordingly. Budget analysts will be the point of reference in using these data and in allocating resources to meet changing customer preferences. The subscriber era likely will usher in a greater acceptance of experiments to gauge the impact of funding changes on programmatic outcomes. Resident-subscribers who contract with governments for a package of services likely will encounter an expanded role for budget offices that monitor how changes in funding affect the outcomes of programs. The increasing role of technology and the greater service customization has its pitfalls. First, the use of these tools requires limited public input to achieve increased levels of improved service provision. Residents become passive consumers – revealing their preferences for public services through quasi-market venues without participating in the democratic process. If a resident’s needs for public goods can be monitored from afar through censors and analyzed through predictive algorithms, why vote, or engage in any deliberative process? Their needs are being met without any direct participation. Certainly, the resident-subscriber described above would require someone directly involved in the customization of their service bundle. The passive consumer is just an alternative possibility (maybe even a simultaneous possibility). Second, both the passive consumer and resident-subscriber assume that technology and data analytics enable local governments to have an unprecedented level of sensitivity to the preferences of individual residents. While this increases productive efficiency, it has the potential of shifting the focus away from community needs and toward individual preferences. Residents preoccupied with customization are less concerned with the welfare of the community.

The road to entrepreneurial budgeting and beyond  133 Third, the issue of equity and fairness across neighborhoods, regions, and economic enclaves will become even more contentious. What constitutes a fair distribution of funding for public services? Should those neighborhoods that can afford premium services be given those services? How much redistribution of wealth should occur on the expenditure side of the local budget? Despite these concerns, actions can be taken now to preserve an actively engaged and community-based budget process. While technology may foster passive participants, it can also enable easier and more frequent communication as social media has proven. Using purposeful public engagement techniques, such as citizen juries, can help improve both active participation and community sentiments. Through strategic use of technology and administrative technics, the emerging budget processes can significantly elevate the public sector’s responsiveness, accountability, transparency, and meaningful engagement with the public.

CONCLUSIONS The evolution of innovation and creativity in local government finance has followed two complementary threads of development – a quest for responsive allocation of resources and a quest for increased productivity. The underlying catalyst for these innovations has been a remarkable transition over the past century in the role of the public in American democracy – from clients to constituents to consumers to customers and now an emerging role as subscribers. This emerging role creates several significant challenges for the public administrator. The smart city initiative puts technology front and center in local government. ICT holds the promise of opening up new applications in city services that are as yet unimagined. Who should pay for the development of that technology? How will the costs and benefits be distributed among neighborhoods? Increasingly, decisions on the choice of public services will devolve from legislatures and be vested in neighborhood associations, nonprofit boards, and even private investors. While representative government will remain the mainstay of American society, ICT will bring a new variation of direct democracy. It will fall to those in professional leadership roles to protect the public interest in this new era of private government. Those of us in public administration carry a particularly heavy responsibility for protecting the credibility of the public interest in this emerging era of government-by-subscription.

NOTES 1.

Portions of this chapter have been previously published in Robert L. Bland and Michael R. Overton, A Budgeting Guide for Local Government, 4th edition, ICMA, 2019; and Bob Bland and Michael Overton (February 2020), “A Century of Budget Innovation,” PM Magazine, ICMA. 2. Discussion of “the public” here is not meant to characterize social equity and inclusiveness of budget deliberations as that is beyond the scope of this chapter.

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The road to entrepreneurial budgeting and beyond  135 Rubin, I. (2019). The Politics of Public Budgeting: Getting and Spending, Borrowing and Balancing. Washington, DC: CQ Press. Schick, A. (1966). The road to PPB: The stages of budget reform. Public Administration Review 26(4), 243–258. Schick, A. (2011). Repairing the budget contract between citizens and the state. OECD Journal on Budgeting 11(3), 1–27. Seljan, E. C. (2014). The limits of tax and expenditure limits: TEL implementation as a principal-agent problem. Public Choice 159(3), 485–501. Sun, R. (2014). Reevaluating the effect of tax and expenditure limitations: An instrumental variable approach. Public Finance Review 42(1), 92–116. Weber, E. P. and Khademian, A. M. (2008). Wicked problems, knowledge challenges, and collaborative capacity builders in network settings. Public Administration Review 8(2), 334–349. Wildavsky, A. (1964). Politics of the Budgetary Process. Boston: Little, Brown. Wilson, W. (1887). The Study of administration. Political Science Quarterly 2(2), 197–222.

8. Public budgeting in developed and developing countries Julius A. Nukpezah, Aisha S. Ahmadu, Kingsley Ukwandi, Edmund Poku Adu and Romeo Abraham

INTRODUCTION The first formal public budget was introduced in England by drafting the Magna Carta – a Royal Charter in 1215 – to elicit government accountability (Lee et al., 2020: 8–9; Theiss, 1937). It supported public participation in approving revenues through taxation to fund government operations. Several other European countries, including Germany, France, and Sweden also championed the budget idea spreading it globally through trade relations and colonialism in Africa, America, and Asia. Although the early budget systems were imperfect and experimental, they continued to evolve due to the influence of politics, economic ideologies, public management theories, citizen participation, transparency, and accountability requirements. In addition, non-European developed countries, such as Australia, Canada, New Zealand, and the US initiated budget innovations that have had an enduring influence on budgetary systems globally. For instance, budget innovations such as the introduction of multi-annual budgets, performance budgeting, budget transparency, and accountability continue to have strong impacts on how budgets are prepared. Although the interconnectedness of the global community makes the spread of the budget idea easier, countries differ regarding their levels of development. Therefore, a comparative study offers lessons in policy and management for improving global public budgeting practices. The categorization of countries based on their level of development is traditionally examined from a macroeconomic perspective (Sen, 1998). Countries reporting high gross domestic product (GDP) and gross national income (GNI) are developed. Conversely, countries with low GDP and GNI are developing (Chang, 2002). Increasingly, the role of the living conditions of citizens has become prominent in these classifications. Because of the need for an indicator that reflects the economic conditions at the micro-level, per capita estimates and the population must correlate with GDP (Schumpeter and Backhaus, 2003; Sen, 1998). Access to resources must increase with population growth. In effect, per capita benchmarks seemingly capture the landscape of a country in terms of access to public goods and services. Several classifications exist, including one that places countries into high-income, middle-income, lower-middle-income, and low-income countries based on GNI per capita (UN, 2021). Another classification groups countries into developed economies, economies in transition, and developing economies. Also, there are continuing debates among writers on the appropriateness of benchmarks for the classification of countries and whether it is helpful to categorize countries along the lines of development (Schumpeter and Backhaus, 2003; Barbier, 1987). 136

Public budgeting in developed and developing countries  137 This research appropriates the classifications made by the United Nations (2021) using the three enlisted in the World Economic Situation and Prospects (WESP) paper for comparison. Developed countries include the European Union member states, Iceland, Norway, Switzerland, the United Kingdom, and non-European countries such as Australia, Canada, Japan, New Zealand, and the US (UN, 2021). Developing countries include all African countries and several countries in Asia. Seventeen countries are classified as economies in transition. The present chapter examines budgeting in developed and developing countries. It is organized as follows: the first section examines how public budgeting in Europe spread to the rest of the world due to trade relations and colonialism. The second section discusses innovations such as line item, performance-based, program-based, zero-based, and entrepreneurial budgeting across time and space among developed and developing countries. This is followed by a discussion on participatory budgeting and citizen budget innovations in public budgeting. The next section discusses the determinants of public budgeting innovations in developed and developing countries. This is followed by a comparison of budget transparency in developed and developing countries using data from the 2019 survey of countries’ budget practices conducted by the International Budget Partnership. The conclusion summarizes the management and policy implications of a comparative approach to public budgeting and offers insight into future directions for studies involving multinational approaches.

HISTORICAL DEVELOPMENT OF PUBLIC BUDGETING: A GLOBAL PERSPECTIVE Modern public budgeting as a tool for controlling and evaluating government receipts and spending can be traced to historical developments in Britain, France, and Germany (Theiss, 1937). These countries share similar budget patterns concerning the establishment of sound budget systems and financial institutions, which influenced the framework of modern budgets (Allen, 2009). Preoccupied with the need to fund war efforts and survive interstate competition, England and Germany developed strong financial institutions to keep government spending under control and to maintain accountability to stakeholders on how public resources are utilized (Spoerer, 2010; Anderson, 1974). The formal public budget introduced in England by Magna Carta supported public participation in approving revenue collection through taxation to fund government operations (Lindbeck, 2016; Golembiewski, 1997; Tilly, 1992). This was followed by France and Germany, and the practice continued to evolve due to the influence of several dynamic factors, including citizen participation, desire for transparency and accountability, political and economic ideologies and public management theories (Caiden, 2010). France’s fiscal budget in the nineteenth century was a masterpiece; it took into account annual revenues and expenditures categorized by departments as a mechanism to control government spending and waste (Riley, 1987). The French budget system was well structured for effective revenue collection and spending, and as a result, other European powers sought to model their fiscal systems on France’s (Bonney, 1998; Riley, 1987). Although England was ahead of France in developing a modern budget with legislative authority presiding over appropriations, the early English budget system was sustained by adopting a series of reforms

138  Research handbook on public financial management to address inherent budgetary problems, including budget inconsistencies and the lack of coherence (Allen, 2009). Similar to budget practices in England, the early years of budgeting in the US were also prepared haphazardly. Congress played a major role by voting on public funding for government operations (Tyer and Willand, 1997). The states and local governments also lacked sound and coherent budget systems. However, the growth of cities due to massive waves of immigration from 1880–1920 coupled with the need to expand public service delivery fostered the development of contemporary budget practices (Tyer and Willand, 1997). At the forefront of budget innovations – along with Britain and France – was Germany which popularized centralized control of public spending managed by a finance department. Germany’s slow unification of more than three hundred territories into a nation-state between 1789 and 1871 hindered the development of a more formal and unified budget system (Spoerer, 2010). Each territory had autonomous control over revenue collection and expenditure. However, the advent of the Napoleonic Wars led to the reform of Germany’s public finance systems by ensuring that German territories adopted a constitution, which supported the preparation and enforcement of a formal budget (Spoerer, 2010). German states in the south including Bavaria, Baden, and Württemberg were strongly influenced by France’s budgeting style mimicking its organized and well-structured revenue collection of property and business taxes (Spoerer, 2010). Other non-European developed countries such as New Zealand and Australia also initiated budget innovations that have had an enduring influence on budgetary systems on a global scale (Allen, 2009; Schick, 2001). Over the years, the growth of fiscal resources compelled Australia to establish a more formal system to control expenditures through legislation, structural changes, and policy implementation (Blöndal et al., 2008). In the 1980s New Zealand adopted similar budget innovations to Australia designed to enhance budget efficiency and ease deficits (Caiden, 1994). More specifically, the reforms adopted by New Zealand aimed at (1) improving efficiency in resource allocation, (2) extensive public sector privatization, and (3) the reinforcement of mechanisms to control public expenditure (Schick, 2001; Caiden, 1994). During the 1980s, Australia passed several legislative measures including the White Paper Budget Reform of 1984 to transform its budget system from a centralized controlled budget using line-item to a more flexible expenditure budget that utilized advanced quality information and effective communication technology to improve performance (Blöndal et al., 2008; Caiden, 1994). Aside from the innovation to the budget document, a more dominant change has been the embrace of neoliberalism, a reformist idea based on the New Public Management (NPM) principles of a more business-like and quasi-competitive approach to public spending (Andrew et al., 2020). As a way to strike a balance, the Labor Party triggered Australia’s motivation to further reform its budget systems, and subsequent party coalitions have continued to expand on these reforms introducing other advanced features such as accrual budgeting, increased levels of openness, budget transparency, and accountability across all government operations as described in the Charter of Budget Honesty Act of 1998. The reforms emphasized varying aspects aimed at promoting flexibility in public spending which required institutional changes – including the introduction of multi-annual fiscal budgets, the appointment of cabinet committees that identify budgetary priorities and promote fiscal discipline, and the adoption of budget innovations from subregional governments (Blöndal et al., 2008). Other economic mechanisms such as granting full independence to the

Public budgeting in developed and developing countries  139 Central Bank, flexible labor markets, privatizing public enterprises, and widening the tax base, were types of reforms adopted and implemented in the Australian budget system. Although Australia has extensive experience with budget reforms, there are a few significant challenges with their system. The reliance on budget projections for future budgets could make the budget process a mechanical exercise – a problem the government seeks to avoid through its reforms. Furthermore, the experiment with accrual budgeting was a failure since government financial reports and budget formulations carried out in Parliament are exclusively done on a cash basis (Blöndal et al., 2008). Nevertheless, thanks to path dependency, Australia is reluctant to abandon its accrual system due to its enormous investment. The budget idea gradually spread globally due to trade relations and colonialism in Africa, Asia, and elsewhere in the world (Stammer, 1967). More specifically, Britain’s shift from a monarchical-controlled budget to budgetary decisions made by elected representatives in the legislature and executive was mimicked by several of its former colonies, including the US, Nigeria, and Ghana (Garuba and Oghuma, 2018; OECD, 2009). The influence of these relationships may be viewed from the conventional budget cycle comprising four essential elements or stages, namely (1) budget preparation and submission performed by the executive branch, (2) legislative approval and appropriations, (3) budget execution and program implementation, and (4) audits and performance assessments (Hackbart and Ramsey, 1999), which remain largely the same. Although legislative and executive control of budgets continue to vary depending on the constitutional separation of responsibilities and the system of government in operation (Garuba and Oghuma, 2018), country-constitutional realities regarding the specific provisions of responsibilities of the executive and legislative branch fundamentally guide the budgeting, appropriation, and expenditure control processes. For instance, in the US, both the legislative and executive branches play a key role in the budget process from the preparation stage to its execution and audit phase. However, in most African countries, including Nigeria, the executive branch exerts more dominance over the budget process. Scholars and practitioners have called for the expansion of legislative involvement in the budget process by intensifying oversight functions and ensuring that public resources are invested in projects that are of economic worth (Garuba and Oghuma, 2018). In comparison, Mexico’s transformation from a single-party state to a presidential democracy established Congress as an independent branch of government with oversight functions, to actively supervise agency performance and increase participation in reform initiatives that improve overall budget practices (OECD, 2009), which appears more progressive. Furthermore, countries with robust economies through trade exports experienced rapid development of formal budgeting due to growth in revenues and government expenditure (Birnberg and Resnick, 1975). For instance, Ghana’s (Gold Coast) increase in public revenues due to cocoa exports promoted economic stability and the growth of fund reserves for domestic policies; hence, it strengthened the efficacy of sound budget practices (Frankema, 2011). Also, Kenya’s experience with the influx of European settlers due to the growth of agricultural and commercial activities, including railway transportation, increased the need for formal budgets (Frankema, 2011). Nevertheless, the foundation of public budgeting, including a comprehensive budget, audit, accountability and openness, among others established in many colonized countries, subsequently declined when the colonies gained independence (Allen, 2009). The newly independent colonies neglected the formal rules of budgeting, depended more on foreign donors, and lacked the knowledge and skills required to fill the vacuum created by the exit of the colonial masters (Allen, 2009).

140  Research handbook on public financial management Over the years, public budgeting evolved into a more formal system with complex expenditures, constituting a larger proportion of the economy (Renzio, 2013). While countries raised revenues from income tax and trade activities among others, government expenditure gradually increased over the centuries, especially in the nineteenth century, due to funding of military operations, municipal administration, and maintenance of public infrastructure (Spoerer, 2010). Other expenditures, including education, utilities, and social welfare, also gained importance due to their positive impact on society (Spoerer, 2010). It became imperative for nations to balance revenue collection and expenditure to address inefficiencies in resource utilization and improve budget stability. Moreover, by 1985, most developing countries had incorporated elements of organized planning into their budgetary systems and adopted market-friendly policies for economic development, especially in Communist countries (Premchand, 2001). Nonetheless, despite efforts at uniform practices, annual budgeting, and control, comprehensiveness in public budgeting in developing countries is often challenged by fiscal constraints, which impose a drag on the economy and restrict improvement in the quality and quantity of public services delivered to citizens (Bahl and Bird, 2008). Slow growth in revenues affects future economic planning and investments in infrastructure, human capital, and welfare. Developing countries are often overwhelmed with the agenda of eradicating poverty, paying off debt, overcoming economic stagnation, and finding innovative ways to decrease dependence on a single export commodity (Caiden, 2006). The inability to raise sufficient revenues leads to uncertainty in revenue collection and spending, undermines budget innovations, and forces countries to resort to earmarking, repetitive budgeting, and padding. Repetitive budgeting exists where annual expenditures are reconfirmed throughout the year because resources tend to deplete at unforeseen intervals (Caiden, 2006). On the other hand, budget padding is a practice that involves both a deliberate attempt to inflate or misrepresent budget estimates and a lack of willingness to disclose them (Mittendorf, 2006). This practice which significantly undermines transparency by inducing budget slack used to be common in nascent democracies such as Nigeria and Ghana, and also in other corporate cultures with a less robust regulatory environment (Andre et al., 2016). Nevertheless, advancements in technical knowledge and training in budgetary practices and decision-making coupled with quality financial institutions in low and middle-income countries have helped improve revenue collection and budget performance (Allen, 2009; Bahl and Bird, 2008).

EARLY INNOVATIONS IN PUBLIC BUDGETING IN DEVELOPED AND DEVELOPING COUNTRIES Public budgeting has evolved from a complex blend of past decisions incorporating political and economic changes, trends, values, and shifts in community attitudes (Lindblom, 1959). As a result of the constantly changing operational environment and increasing need for accountability, public budgeting has experienced various reforms, innovations, and increased citizen involvement. Caiden (1980) asserts that innovations in the budget process should emphasize: (1) a foresighted budget informed by long-term budget planning, (2) response to changing conditions, (3) credibility through clear and consistent information, (4) instrument of control, (5) tools for policymaking, (6) a logical framework for initiating decisions, and (7) multi-year

Public budgeting in developed and developing countries  141 budgeting. Caiden’s (1988) normative theories of budgetary reform have consequently influenced budgetary theory and practice in developed and developing countries. Although advances in budgeting theory and practice started in Europe, the US is now at the forefront of budget innovation and change. Budgeting in the US evolved over the past century, beginning with financial control at its early stage, and moving through to management orientation principles during the New Deal and post-Second World War period, and then to planning in the 1960s (Tyer and Willand, 1997). In the early decades when the budget idea was conceived in the US, much emphasis was placed on centralized control to guard against administrative abuses, thus line-item budget was adopted as a control mechanism (Rubin, 2010; Wildavsky, 1978; Schick, 2002 [1966]). The line-item budget relied on detailed appropriation or objects of expenditure using incremental decision techniques. The cost-benefit principle it introduced assisted administrators in prioritizing projects based on levels of expected benefits, thus increasing accountability on public expenditure. The line-item budget centralized the control of money thereby making it easier for budget cuts to be implemented easily (Schick, 1971). Line-item budgeting is linked to the executive idea of budgeting popularized by the Taft Commission and supported by prominent budgeting scholars, including Cleveland (1865–1946), Goodnow (1859–1939), and Willoughby (1867–1960), who saw the budget as central to public policy implementation rather than just a tool to deter waste and inefficient government (Sych, 2011; Schick, 2002 [1966]; Cleveland, 1909; Goodnow, 1900; Willoughby, 1917). The executive budget idea strengthened the participation of the executive branch in preparing budget proposals and submitting them for approval to a legislative body (Tyer and Willand, 1997). The line-item budget emphasized control and accountability over public money, operations, and programs with budget amounts linked to each unit based on performance (Rubin, 2010). The executive budget idea remains enduring at the federal level; the president prepares and presents a budget to Congress for approval accompanied by an outline of policy proposals and a summary of financials. However, the line-item or legislative form of budgeting became problematic. For example, the desire to revive the economy from the effects of the Great Depression through diverse programs proposed by the New Deal made it difficult to keep track of the various objects contained in the line-item budget. Furthermore, there have been calls to reject the line-item budget in favor of the executive budget which appropriated considerable funding to programs based on performance. The paradigm shift from control to management functions of budgeting was assumed as the best way to manage large programs and organizations (Rubin, 2010). Although line-item budgeting continues to influence budget preparation and adoption process globally, in the last several years, each decade is marked by a particular reform proposal: (1) performance budgeting (1950s), (2) program budgeting (1960s), (3) zero-based budgeting (1970s), (4) automatic control budgeting that informed entrepreneurial budgeting (1990s) (Jones and McCaffery, 2010). In the 1950s, normative performance budgeting was generally recognized as a legitimate budget practice and adopted by many government agencies and departments (Ho, 2019). The growing emphasis on performance information and operational analysis required to justify the allocation of certain levels of resources to departments signaled the shift to performance-oriented budgeting. Performance budget documents are prepared to include functions and objectives of the agencies and departments of government, rather than the objectives of expenditure and the organizational units involved (Seckler-Hudson, 2002 [1953]).

142  Research handbook on public financial management Therefore, performance budgeting has the merit of emphasizing what is to be accomplished, thus justifying the output of government spending on programs. The introduction of new economic policies aimed at reviving the US economy from depression created an avenue for the dramatic change in budget practices. More specifically, the New Deal era pushed for the practice of performance budgeting as it provides for more coverage of programs and greater options for evaluating the output of government operations compared to a line-item budget (Rubin, 2010). Performance budgeting prioritized planning and transcended politics to measure what citizens cared about in terms of accountability and the efficient performance of government operations, services, and programs. A second normative theory of the budget process is Novick’s (2002 [1970]) program budgeting. Program budgeting entails ten interrelated activities: (1) defines organization objectives in specific terms, (2) determines the program to be implemented, (3) identifies major issues to be resolved, (4) sub-divides issues into planning, programming, and budgeting steps to ensure an ordered approach, (5) continually examines program results, (6) recognizes issues and other problems that require more time than is available, (7) analyzes programs and alternatives, (8) develops analytical tools necessary for measuring costs and benefits, (9) develops a multi-year program and financial plan, and (10) adapts to the existing and statistical reporting system (Novick, 2002 [1970]). Program budgeting is often perceived as the second wave of performance budget reforms implemented during President Johnson and the Nixon administrations (Ho, 2019). The goal of the reform was to expand the focus of budgeting beyond spending controls and managerial efficiency to include elements of planning, cost-benefit analysis, and program resource allocation. The successful implementation of program budgeting in the Defense Department paved the way for its expansion to other federal agencies. Different models and approaches to performance budgeting have been implemented across Europe (Curristine et al., 2007). For instance, presentational performance budgeting operates in Estonia and Poland (Raudla, 2016; De Jong, 2016). This unique kind of performance budgeting allows governments to include performance targets or results in financial documents to enhance transparency, accountability, and budgetary decisions (Bonomi et al., 2019). In addition, performance-informed budgeting is practiced in the Netherlands, France, and Australia (Moynihan and Beazley, 2016). This form of budgeting demonstrates an indirect connection between the allotted financial resources and anticipated performance goals (Bonomi et al., 2019). In general, performance-based budgeting has received considerable attention and recommendation for adoption in developed and developing countries. However, developing countries encounter limitations in implementing this approach. This is because of several challenges such as the establishment of sound financial management systems, cash management practices, institutional capacity, reliable accounting and financial reporting, effective compliance audits, and budget controls – all of which help in the adoption and implementation of performance-based budgeting (Clark et al., 2018; Andrews, 2006). Other challenges include human and financial capacity, and the lack of sophisticated analysis beyond those afforded by the traditional line-item budgets (Andrews, 2006; Moynihan, 2003). Program budgeting provides a formal systemic method to improve decision-making concerning the allocation of resources and recognizes what is to be done and at what cost (Novick, 2002 [1970]). The program budget is similar to the performance budget because it has stipulated objectives and operates based on the result. However, it involves some layering

Public budgeting in developed and developing countries  143 or categorization, restructuring, and reorganization of programs and sub-programs, including providing answers to policy questions regarding how best to allocate resources to them (Bland, 2013). Program budget depends heavily on planning as it evaluates alternative approaches and best funding options, compared to a zero-based budget (Goertz, 1993). Thus, these features contribute toward improved transparency and accountability of the program budget. Nevertheless, the program budget has faced criticisms from both state and local governments on its complexity, especially the planning, programming, and budgeting system (PPBS), which contributed to the emergence of management by objective (MBO). MBO incorporates elements of participatory decision-making, goal-setting, and objective feedback to the budget process (Tyer and Willand, 1997; Rodgers and Hunter, 1992). However, MBO was short-lived because it was perceived as a return to performance budgeting, emphasizing agency performance and governmental program effectiveness. Nevertheless, MBO became a widespread budget practice among subordinate governments because it was flexible and less complex than PPBS; therefore some elements of MBO remain enduring at the local level (Khan and Hildreth, 2002). A third normative theory introduced in the 1970s was zero-base budgeting (ZBB). ZBB entails constructing the current budget without referencing the previous one (Taylor, 1977). It is based on a fundamental reappraisal of purpose, methods, and resources. It focuses on total budget requests, where the current spending level is not regarded as an inviolate base and immune from detailed scrutiny (Taylor, 1977). ZBB places a premium on offering decision-makers a range of choices among alternative funding levels (Taylor, 1977). Theoretically, ZBB requires the justification of program budgets repeatedly. Public managers are scrutinized to provide estimates of different levels of funding (below minimum levels of support, maintenance of current level, or higher levels of support), explaining the impact of funds on the department at the different levels described. Although ZBB has seen widespread use in developed countries, including Great Britain and the US, it requires a more detailed budgeting exercise wherein fund allocation for each program is examined and re-justified each year. ZBB therefore requires an inordinate number of administrative personnel responsible for decision packages, prioritizing procedures, and monitoring programs, which could be very expensive to institutionalize in developing nations (Dhameja, 2002). However, ZBB is selectively adopted in lower tiers of government and departments to improve program effectiveness; nevertheless, the problem of unreliable data coupled with financial and administrative demands exert excessive pressure on the management capacity of many local governments in developing nations (Igbara et al., 2016). A fourth normative theory in the 1990s was entrepreneurial budgeting (Cothran, 1993). The shift towards entrepreneurial budgeting was driven by the idea to revolutionize government by adopting new management perspectives to support innovative enterprising and cost-saving techniques. Entrepreneurial budgeting preserved most of the goals of previous budget reforms; however, it introduced two qualities – centralization and decentralization (Perrow, 1977). The allocation of funding for broad functions is made by central policymakers, who then appropriate these funds to subordinate authorities to use their discretion to maximize the use of public resources to improve program performance (Cothran, 1993). Therefore, within the bounds of centrally determined expenditure limits, entrepreneurial budgeting provides an approach for program managers to exhibit greater productivity in spending public resources in the way that they deem best. Furthermore, entrepreneurial budgeting allows program managers to carry over unspent money to the next fiscal period. About

144  Research handbook on public financial management 30 to 50 percent of localities in the US have the privilege to roll over excess funds to the new fiscal year for future investments in public programs. Entrepreneurial budgeting draws on new public management principles, which emphasize the increased achievement of objectives based on managerial discretion over the use of funds (Moynihan, 2006). The departure from traditional budgeting, which was very rigid, was to grant public managers the ability to be enterprising to improve the efficacy of government. However, entrepreneurial budgeting was not popular in developing countries because these economies were often characterized by weak fiscal conditions and budget controls. Moreover, budget innovation tends to be low in developing countries due to the society’s financial and social issues (Caiden, 2006). The discussion on the early innovations of budget practices indicates that policymakers endeavor to achieve several objectives. These include the central control of spending to curtail waste, ensure accountability, enhance productivity, and decentralize funding decisions to subnational authorities to promote flexibility in resource utilization (Schick, 1990). While developed countries foster budget innovations, developing countries exhibit low levels of budget innovation practices due to weak fiscal conditions, institutional capacity, and management practices.

CONTEMPORARY INNOVATIONS IN PUBLIC BUDGETING IN DEVELOPED AND DEVELOPING COUNTRIES Public budgeting has embraced several innovations, including the adoption of a citizen participatory budget approach, transparency, and government accountability (Renson, 2018; Park, 2019). The involvement of citizens in budget deliberations can be traced to the emergence of citizen-based management approaches that originated in the Great Depression era in 1932 when civil society organizations founded the Citizens Budget Commission to advocate new revenue sources and cost reduction techniques (Bilge, 2015; Denhardt and Denhardt, 2015). Some scholars use participatory budgeting and the related citizen budget interchangeably; however, there are nuanced differences (Bilge, 2015; Uysal Şahin and Şahin, 2013). Participatory budgeting connotes the involvement of citizens in the budget process. Brazil’s adoption of participatory budgeting in the 1980s allowed residents in the southern city of Porto Alegre to participate in establishing city spending priorities before appropriations were made, establishing citizen participatory budgeting as a contemporary budget innovation (Birskyte, 2013). On the other hand, the citizen budget relates to the direct or indirect participation of citizens in all phases of the budgeting processes of approval, implementation, evaluation, and supervision (Uysal Şahin and Şahin, 2013). Hence, citizens are able to participate in the budgetary process and gain a fair level of budget literacy (İpek, 2018). The literature on citizen budgets indicates that policymakers engage citizens in decision-making based on three incentives (Renson, 2018; Fung, 2003). First, policymakers incorporate citizens’ input in the budget process based on juridical mandates. Second, they engage citizens based on the moral argument that it ought to be so. Third, the collaboration between policymakers and citizens in making budgetary decisions facilitates responsiveness to the public interest (Renson, 2018). The citizens’ budget relates to the actual results from the public budget process and implementation, which is often dominated by political bargaining and decision-making to ensure

Public budgeting in developed and developing countries  145 that budgetary allocations serve the interest of stakeholders (Niskanen, 1971). The benefits derived from citizen participation in the budget process include (1) better decision outcomes, (2) improved legitimacy of decision processes, (3) growth in social learning, (4) improved organizational performance, and (5) increased trust between government and citizens (Park, 2019; Renson, 2018). The adoption of budget transparency through participatory and citizen budgets highlights contemporary innovations in public budgeting in developed and developing countries. Budget transparency enhances full disclosure of the budget process and diminishes fiscal illusion (Sedmihradská, 2019; Grimmelikhuijsen and Welch, 2012), a theory that explains why the cost of government may seem less than it truly is, due to the complexity of tax structures (Oates, 1988). Increased citizen participation in budgeting therefore contributes to budget transparency — “the full disclosure of all relevant fiscal information in a timely and systematic manner” (OECD, 2001: 7) – thus raising the possibility for citizens to obtain a complete and accurate understanding of the budget (Ott and Bronic, 2010). When policy intentions are not open or freely accessed, budget transparency is undermined, thus leading to a high likelihood of fiscal illusion (Oates, 1988). In most developed economies such as the US, citizen participation in public budgeting manifests in charters requiring that governments hold budget hearings to engage citizens at the budget preparation stage. Citizen participation via the ballot box is considered a civic duty and assists policymakers in decision-making regarding tax limits and budget appropriations. However, in developing countries/democracies of Africa such as Nigeria, citizen participation is primarily conceived in terms of voting in elections, rather than actual input of citizens in budget preparations. Citizen-based budgeting is practiced around the world and includes various descriptions and styles or formats. Examples of these are the Budget Summary Citizen Guide (Kenya), Budget Guide for Citizens (Croatia), Basic Facts for Taxpayers (New Zealand), and Social Guide for Budgeting Practice (South Africa), to mention a few. However, the International Budget Partnership (IBP) uses the Open Budget Index to evaluate public access and accountability of the budget system worldwide (Şeker and Beynam, 2013).

FACTORS THAT INFLUENCE PUBLIC BUDGETING INNOVATIONS IN DEVELOPED AND DEVELOPING COUNTRIES Budget innovations have helped governments improve efficiency in public financial management through increased reliance on data and technology (Renson, 2018; Park, 2019). While certain universal factors affect public budgeting globally, unique social norms also influence budget innovations in developed and developing countries. One of these is administrative culture – the summative beliefs, values, and attitudes that an administration subscribes to. Poor administrative culture is prevalent in most developing countries and can impact the adoption of budget innovations. For example, developing countries tend to spend more resources on policymaking and design but fail to attain the desired results due to administrative and policy implementation challenges (Rahman et al., 2013). Other studies demonstrate that deeply rooted social norms such as the culture of late budget presentation, passage, and assent, including the late release of funds, persist in developing countries and contribute to poor capacity utilization (Ehigiamusoe and Umar, 2013). Furthermore, the attitudes of key public

146  Research handbook on public financial management officials in terms of resistance to change are among the major factors that hinder effective budget implementation (Avwokeni, 2016). Second, social, political, and cultural norms shape attitudes and affect budgetary outcomes and information disclosures. A nation’s political ideals significantly affect budget transparency (Albalate del Sol, 2013). Democratic societies have a high tendency to encourage citizen engagement and increase the demand for government accountability and transparency (Bellone and Goerl, 1992). While democracy is entrenched in developed countries such as the US, Germany, Australia, France, and the United Kingdom, it is still burgeoning in developing countries of Africa, South America, and the Middle East. The proliferation of democratic values within a nation likely creates an avenue to experiment with budget innovations to meet the needs of society. Moreover, a well-educated citizenry contributes to better outcomes in citizen budget participation (Meyers and Rubin, 2011). Understandably, developed democracies adopt citizen participation approaches to incorporate citizen inputs in budget processes to diminish distrust and cynicism among citizens (Ebdon and Franklin, 2006). Third, fiscal and economic conditions, including the level of debt (Birskyte, 2019), revenues (Royed and Borrelli, 1999), size of intergovernmental transfers, and aid receipts from other levels of government (Guillamon et al., 2011), influence budget innovations and outcomes. The prevalence of revenue shortfalls in developing countries coupled with cutback management strategies in hard times such as retrenchment hinders budget innovation since governments are limited by financial and human resources to engage citizens and achieve desired budget outcomes (Levine, 1978). Fourth, population growth increases the demand and delivery of public goods and services with greater efficiency, thus giving rise to performance-based and other data-driven budgets. An increasing number of international studies have found demographic characteristics, including population size (Albalate del Sol, 2013), age (Piotrowski and Van Ryzin, 2007), and dependency rates (Birskyte, 2019; Esteller-More and Polo Otero, 2012), to have a positive relationship with budget transparency. However, economies experiencing high levels of unemployment and low productivity diminish opportunities for budget innovations (Esteller-More and Polo Otero, 2012). Fifth, the quality of public institutions affects budget innovation. Weak institutions reduce the formalization of government decisions (Mattes and Mereno, 2018), especially regarding budgeting. This also makes the government unreliable and unpredictable, and increases the prevalence of public sector corruption, which reduces opportunities for foreign investments (Brouthers et al., 2008). The prevalence of weak institutions in developing countries makes public officials susceptible to bribery, embezzlement, and abuse of delegated authority (Zouaoui et al., 2022; Hope Sr, 2017; Park, 2013).

COMPARING BUDGET TRANSPARENCY IN DEVELOPED AND DEVELOPING COUNTRIES Since 2006, the International Budget Partnership (IPB) has conducted biennial multinational surveys, with a few exceptions, that track budget transparency across multiple countries. The 2019 survey of countries’ budget practices collected data from 117 countries based on responses to 145 scored questions. The questions covered the availability of budget informa-

Public budgeting in developed and developing countries  147 tion to the public, opportunities to participate in the budget process, and the legislature’s role in the budget process. Other questions covered the supreme audit institution’s role in ensuring compliance with the budget process and recognizing citizen interests. The budget transparency score varies from 0 to 100. Countries with a score higher than 81 percent provide extensive information, while those with scores between 61 percent and 80 percent provide substantial information. Countries scoring between 41 percent and 60 percent provide limited information, while those with scores that range between 21 percent and 40 percent report minimal information. Countries scoring below 21 percent provide scant to no budget information. Table 8.1

Budget transparency scores for developed, transitioning, developing, and regions of the world

Categorization & regions

Observations

Mean (%)

Max (%)

Min (%)

SD

Developed countries

21

67

87

40

12

Transitioning economies

11

52

81

17

19

Developing countries

85

38

87

0

22

Western Europe, US, & Canada

10

72

86

53

9

Eastern Europe

15

67

74

33

11

Latin America & Caribbean

18

57

82

0

22

Central Asia

6

55

81

17

24

East Asia & Pacific

16

53

87

19

20

South Asia

6

42

50

28

9

Sub-Saharan Africa

36

33

87

0

19

The Middle East & North Africa

10

22

61

0

21

 

117

45

87

0

23

Table 8.1 reports the budget transparency scores for the 117 countries surveyed. Developed countries (67 percent) report 29 percent higher budget transparency scores than developing countries (38 percent). Economies in transition (52 percent), that is, countries whose development lags that of developed countries but leads over developing ones, report scores between the two. Whereas the difference between developed and developing countries is 29 percent, that between developed and transition countries is 15 percent, and the difference between developing and transition economies is 14 percent. The findings suggest that the more developed a country is, the higher its budget transparency scores. Since the level of development is also based on regional and geopolitical factors, budget transparency scores are computed for eight regions, as shown in Table 8.1. Western Europe, the US, and Canada (72 percent) report the highest scores, followed by Eastern Europe (67 percent) and Latin America and the Caribbean region (57 percent). Sub-Saharan Africa (38 percent), the Middle East, and North Africa (22 percent) report the lowest scores. Based on IPB criteria, developed countries, Western Europe, the US, and Canada provide substantial information in the budget development process. Transition countries, Latin America and the Caribbean, Central Asia, East Asia, and the Pacific follow and provide limited information. Lastly, developing countries, sub-Saharan Africa, the Middle East, and North Africa provide minimal information on public budgeting. Developed countries report lower standard deviation scores suggesting lower variation among countries regarding budget transparency scores. For example, developed countries report standard deviation scores of 12 percent, Western Europe, Canada, and the US region

148  Research handbook on public financial management report 9 percent. However, developing countries and sub-Saharan African regions report 22 percent and 19 percent, respectively. Transparency in public budgeting is enhanced by resource adequacy, stability, and growth (Caiden, 1980). There is a need for budgetary appropriation to involve citizens in budget deliberations. However, in developing countries, such conditions are lacking. Some are pulled further down by unavoidable foreign debts with very stringent requirements. Understandably, budget transparency scores are lower in these countries. Although there have been improvements in legislative oversight functions in many developing countries, instances of corruption, poor revenue structure, and revenue instability from over-reliance on nontax, single revenue sources abound. These contribute to harsh budgetary experiences in developing countries (Ehigiamusoe and Umar, 2013; Duncombe and Schroeder, 1988).

CONCLUSION Since the introduction of the first formal public budget in Britain, the budget idea continues to evolve to better serve the interest of citizens within the context of developed and developing countries. The constant change in operational environments, shifts in community attitudes, and the increased need for accountability and transparency necessitate budget reforms and innovations. In the early decades of budget innovation, line-item budgeting proposed the centralized control of public funding to curtail waste and improve accountability. Although line-item budgeting was widely adopted, other budget innovations, including performance budgeting, program budgeting, zero-based budgeting, and entrepreneurial budgeting, influenced budget practices differently in developed and developing countries. Public budgeting has also embraced several contemporary innovations, including adopting a citizen participatory budget approach, government transparency, and accountability. Since the breakthrough experiment of citizen participation in Brazil as a contemporary budget innovation, participatory budgeting has spread to many parts of the world. Whether in the form of citizen budgets or participatory budgets, innovations have helped governments improve efficiency in public financial management and revenue performance through increased reliance on data and technology (Renson, 2018; Park, 2019; Nukpezah et al., 2022). Participatory budgeting allows civil society, citizens, and public administrators to jointly determine spending limits and priorities through shared decision-making measures (Sgueo, 2016). Although citizen participation is viewed as politics of accommodation or a means of depoliticization in decision-making (Michels, 2006), participatory budgeting as its by-product advocates an Anglo-Saxon attitude towards governance due to its strong Western democratic norms (Uddin et al., 2019). Expectedly, former British colonies, whether developed or developing countries, appear most influenced by participatory budgeting, including promising signals of a new hybrid model that may continue to emerge and expand in the coming years (Sintomer et al., 2013). Despite the wide adoption, budget complexity and citizen disinterest hinder robust citizen participation in the public budgeting process (Ebdon and Landow, 2012). As such, rather than the innovative, change-driven, and reformative participatory budgeting that originated in Brazil, the adoption trend in some countries mirrors participatory budgeting that is rather symbolic, carried out to placate their population and international donors (Sintomer et al., 2013).

Public budgeting in developed and developing countries  149 Most developing and underdeveloped countries in Africa and Asia may be in this category where a clear gap exists between program objectivity and adoption reality. Public budgeting is a core function of government and reveals economic and political priorities. Developing nations can strengthen their fiscal systems to eliminate setbacks in public budgeting. Countries with high budget transparency scores are perceived as nations that better serve the interest of their citizens due to embracing budget innovations and the effective utilization of public resources to promote the general welfare. However, several economic, political, and cultural conditions stand as barriers to budget innovations in developing nations. Transparency in public budgeting is enhanced by several factors, including resource adequacy, stability, and growth, which are often lacking in developing nations. The chapter uses a frequency table to illustrate differences in budget transparency score of countries given their level of development using data from the 2019 survey of countries’ budget practices conducted by the International Budget Partnership. Although the frequency table is devoid of multivariate analysis with sufficient controls, the statistics suggest developed countries are more likely to report higher budget transparency scores than developing or transitioning countries. Moreover, the underlying drivers of development such as freedom, accountability, democracy, political stability, geopolitics, and quality of institutions, among others, may need further attention in quantitative empirical studies to inform policy recommendations for budget innovation and budget transparency.

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9. Future directions for research in national and subnational government budgeting Jinhai Yu and Zhiwei Zhang

Recent years have witnessed numerous challenges to national and subnational government budgeting. It is an understatement that the US federal government’s budgeting system is not functioning, and a careful examination and reform are long overdue. At the national level, the scenario for political elites in Congress to find common ground seems like a fairytale. Their inability to compromise resulted in gridlock in the budgeting process and relying on the continuing resolution (CR) became a new norm (McClanahan et al., 2019). CR, by definition, maintains the policy status quo by providing funding at current levels. There are some serious consequences of relying on CR in the long run. First, maintaining the status quo takes away the federal government’s ability to steer national spending and investments strategically. More importantly, such a path is not sustainable as federal outlays have outgrown revenue at an increasing pace. It is also worth noting that the US aging population (Medicare and Medicaid expenses) and ever-expanding national debt (interest expenses) contribute to higher mandatory spending that cannot be easily reversed, which adds more pressure to reduce federal discretionary spendings such as investments on infrastructure and education. At the subnational level, reduced discretionary spending from the federal government means state and local governments facing fiscal challenges in the form of reduced intergovernmental transfers. Additionally, frequent natural disaster occurrences and the global COVID pandemic highlight the vital importance of well-balanced fiscal reserves and being fiscally responsible. Thus, how to budget for the rainy-day fund is a common challenge faced by many state and local government officials. Additionally, “budgetary institutions at the local level serve to allocate community resources consistent with community preferences” (Shah, 2007: xiii). But the negative sentiments toward local tax increases could hamper the fiscal stability of cities and counties, let alone mirroring community preferences through public service deliveries. How state governments respond to those fiscal constraints is vital for local governments (see Pew Research Center, 2021 for more details). Outside of Western democracies, many developing countries are not equipped with a sound fiscal administration system. How to weave financial accountability, transparency, and promoting social equity into budgetary institutions is a common challenge to all. This chapter reviews the emerging trends in national and subnational government budgeting and maps directions for future research. First, we briefly summarize the budgeting literature from multiple disciplines. Budgeting research is not only published in public administration journals but also regularly appears in journals in political science and public economics. Second, we discuss four emerging budgeting topics on the research agenda: budgeting and equity, roles of budgeting agencies and budget managers, budgeting and environmental shocks, and budgeting and fiscal sustainability. Third, we outline several directions for future research on budgeting and call for a research perspective that is interdisciplinary, forward-looking, comparative, and international. We also advocate balancing good theory 154

Future directions for research in national and subnational government budgeting  155 with causal inference methods in future budgeting research. Finally, we pose a challenging question: Does budgeting face an “identity crisis”?

BUDGETING RESEARCH FROM A MULTIDISCIPLINARY PERSPECTIVE Budgeting Research in Political Science Budgeting has been a conventional research topic in political science. V. O. Key (1940: 1138) proposes the well-known “key” question of budgeting, “On what basis shall it be decided to allocate x dollars to activity A instead of activity B?” Key (1940) compares two approaches to answering this question, including the marginal utility analysis in public economics and the political analysis of the budgeting allocation process. The marginal unity analysis maintains that “resources should be so distributed among different uses that the marginal return of satisfaction is the same for all of them” (Key, 1940: 1139). Key (1940: 1143) points out that the economic approach is unrealistic because “the most advantageous utilization of public funds resolves itself into a matter of value preferences between ends lacking a common denominator.” He recommends the political analysis approach since “the question is a problem in political philosophy; keen analyses in these terms would be of the utmost importance in creating an awareness of the problems of the budgetary implementation of programs of political action of whatever shade” (Key, 1940: 1143). From the perspective of political science, budgeting is a game of allocating fiscal resources, allowing one to observe which political actors get what, when, and how (Lasswell, 2018). Since most, if not all, government policies are involved with public money, the budgeting processes are core to the political and policy decision-making processes in general. Political scientists study budgeting for the dual purposes of understanding both the budgeting itself and the policymaking processes in the case of budgeting. Wildavsky’s seminal work on the politics of budgetary processes seems to emphasize more the budgeting itself, though the “politics” part, i.e., incrementalist decision-making, may be taken as generalizable to non-budgetary decision-making. His study builds empirical-oriented theories based on surveys, interviews, and documents on federal budgeting (Wildavsky, 1964; Wildavsky and Caiden, 1988). His research helps open the black box of budgetary bargaining among Congress, the President, OMB (Office of Management and Budget), and spending agencies. Two theories exemplify the budgeting research in political science literature that emphasizes general policymaking processes. One is budgetary incrementalism, which maintains that budgeting allocation can be best approximated by the formula of “base plus increment” due to bounded rationality and institutional constraints on political actors (Davis et al., 1966). Another is the punctuated equilibrium model (PEM) of budgeting, which deviates from budgetary incrementalism by arguing that budget changes are not always incremental; big changes are an integral part. The PEM scholars describe budgetary changes as “a general empirical law” that features highly incremental changes occasionally punctuated by large changes (Jones et al., 2009). Unlike budgetary incrementalism, the PEM scholars argue that big changes in budgets do not result from the random walk but should be explained just as small changes (Baumgartner et al., 2009; Jones et al., 2009). They explain small changes (budget stability) and big changes (budget punctuations) with the same processes. Due to institutional friction

156  Research handbook on public financial management and cognitive limits, political actors have limited attention to respond to the high demand for policy changes, which results in policy (and budgetary) outputs featured by periodic inactions punctuated by drastic actions. While both theories are built upon the context of budgeting, they are meant to explain general policymaking processes. More recent budgeting research in political science has touched upon a variety of budgeting topics, such as the politics of budgetary revenues, spending, deficits, and debt (Alt and Lowry, 1994), political budget cycles (Alt and Lassen, 2006), budgetary delay (Klarner et al., 2012), revenue forecasting (Krause et al., 2006), and budgetary tradeoffs (Berry and Lowery, 1990; Yu et al., 2019). In many cases, budgeting variables are framed as a proxy for a broader concept or theory appealing to a general political science audience. For instance, the various budgetary outputs (e.g., revenues and spending) are taken as indicators of policy changes that reveal policy preferences of political actors, the budgetary delay is taken as a case of legislative gridlock, and budgetary tradeoff reflects policy priorities. This line of research shows how budgeting provides an empirical context conducive to theory building and can complement the budgeting research in public administration that focuses more on the question of “how” than “why.” Given the many differences between public and private organizations, budgeting scholars may attend more to the political side of budgeting to better understand the administration or management side of public budgeting. Budgeting Research in Public Administration As Kelly (2005: 89) puts it, “a theory of budgeting is a theory of political cycles driven by changing public opinion about the proper role of government.” Looking back at the pre-Progressive era, without a monarchy, the public placed their faith in the general election and believed accountability could be achieved by placing good and honest people in public offices. Thus the US did not follow suit with their European counterparts to adopt public budgeting until it became obvious that “elections alone cannot ensure government accountability if proper budgetary institutions are absent … elected officials would be equally able to abuse taxing and spending power” (Ma and Hou, 2009: 53). As a result, after navigating the country’s administrative control without a budget for more than a century, urban reform became a focal point during the Progressive era. Modern public budgeting reform started out at the municipal level in the 1880s and 1890s. The pursuit of improving administrative and financial efficiency led Boston and New York to take drastic steps (i.e., Boston transferred executive power to the mayor; New York created a new budget system), and their success triggered a national response. The need for a national budget led to the creation of the Commission on Economy and Efficiency by President William Howard Taft in 1911, which recommended the adoption of a national executive budget system. And the passage of the Budget and Accounting Act of 1921 marked the official formulation of the executive branch budget and the birth of the Bureau of the Budget (now the OMB). In this historical period, budgeting was considered in the context of cost control, enhancing accountability, and tackling widespread misuse of public resources and corruption (Cleveland, 1913, 1916, 1919; Kahn, 1997). Hence the development of line-item budgeting. This budgeting format is straightforward, establishes budgetary control, facilitates monitoring and oversight for managerial decision-making, and ultimately enhances financial and political accountability (Ma and Hou, 2009). Those studies dated back to the early twentieth century when early budget reformers tackled “the spoils system that involved the budgeting system

Future directions for research in national and subnational government budgeting  157 dominated by legislatures associated with corruption and inefficiency” (Rhee, 2009: 6). In short, the first budget reform “was a reflection of the desire for efficiency in government fostered by the Progressives” (Kelly, 2003: 313). Although budgeting is inherently political and “for many, budget theory, incrementalism, and Aaron Wildavsky are nearly synonymous” (Frank, 2018: 228), its complicity renders it impossible for any one set of theoretical propositions to explain or to offer valuable insights to budgetary actors, scholars, and practitioners alike (Frank, 2018). Scholars such as LeLoup (1978), LeLoup and Moreland (1978), and Rubin (2019) have long been challenging the analytical usefulness of incremental thinking. LeLoup’s (1978) criticism regarding budgetary incrementalism stems from the fact that “its self-fulfilling nature renders incrementalism nearly useless for social science theory and the main biases of incrementalism are toward stability and against change” (LeLoup, 1978: 492). In fact, LeLoup and Moreland’s (1978) investigation of agency-level budgetary outcomes concludes that agencies that hold an effective and aggressive campaign for more budget increases do find their way of getting it. Similarly, Rubin (2019) argued that incrementalism’s ability to discern strategic budgetary behavior at the agency level is limited because aggregated budgets might still show up as “incremental” in nature. Further, the relevance of using incrementalism as an explanatory force to explain budgeting decisions is diminishing as rapid turnover in agency heads impedes the very premise that incrementalism requires long-term and stable relationships among those who provide agency services and those who appropriate funding to service providers. As Bailey puts it, “we cannot improve what we cannot describe and explain” (Bailey, 1968: 131). Thus, public budgeting studies in the realm of public administration tend to focus on “the internal resource allocation process of the public organization” (Gianakis and McCue, 2002: 158) and provide utility for public managers. Taylor’s (1911) seminal work on scientific management penetrates the public sector and gives rise to performance budgeting studies (Schick, 1966; Cozzetto et al., 1995). To enhance administrative efficiency, Willoughby (1918) contends that the executive budget should be used as a means to achieve better legislative and executive cooperation and provides a detailed description of budgetary legislation in the different states. Similarly, Schick (1966: 249) advocates using the budget as a tool to promote “fiscal and organizational resources for the attainment of benefits.” Those early budgetary reform movements resulted in a slew of official budget reforms aiming at better aligning resources to managerial goals or outcomes. In 1949, the first Hoover Commission (Commission on Organization of the Executive Branch of the Government) officially introduced the name “performance budgeting,” albeit the performance aspect only applies to the direct provision of specific goods and services. Such introduction signals the executive branch’s focus on improving public work efficiency and shifting the managerial style from control-oriented to management-oriented (Schick, 1966; Williams, 2004). Although performance budgeting was short-lived and replaced by program budgeting in the early 1960s, the main components of performance budgeting remain in the budgeting system. The Planning-Programming-Budgeting-System (PPBS) originated from the Department of Defense in 1961 and gained popularity and momentum rapidly throughout the public sector and was mandated for all agencies in 1965. According to the US General Accounting Office (GAO, 1997), its superiority over performance budgeting is evident. PPBS establishes long-term planning objectives and offers comparative views to identify alternatives that could best contribute to the objectives, and programs can be viewed through the lens of

158  Research handbook on public financial management budgets and long-term projection (Rhee, 2009). The critics of such theory, however, focus on the fact that the expertise and data collection, and processing capacity needed to make PPBS worthwhile is often lacking in the public sector. Additionally, advocates for PPBS oversell the benefits and do not fully comprehend its feasibility, including the fact that the appropriation timeline from Congress does not coincide with the long-term view set forth by the PPBS (Mosher, 1969). To deal with the deficit of the federal government in the 1970s, Zero-Base Budgeting (ZBB) was perceived as a valid response (Schick, 1966). ZBB requires an agency to start from “zero bases” (ground level) to formulate their cost by identifying cost centers within an organization and ranking those centers based on priority level. Such practice was adopted by a first-term governor of Georgia, who later became the thirty-ninth president of the United States. President Carter made ZBB the main budgetary and planning device throughout the executive branch in 1977. As explained by President Carter himself, the system “strips down the budget each year to zero and starts from scratch, requiring every (activity) that spends the taxpayer’s money to rejustify itself annually.” The system was appealing to many, but the enthusiasm soon faded away because the sheer workload to create measurable goals and justify all the programs is simply unattainable. Agencies were only able to reveal a small portion of the programs or set arbitrary funding levels as a percentage of the previous budget. As a result, ZBB did not really change the way agencies budget. What is even more disappointing is that ZBB failed to make a major impact on reducing spending (Draper and Pitsvada, 1981). The Program Assessment Rating Tool (PART) is a continuous pursuit from the federal government to improve accountability and efficiency through performance-based budgeting innovations. PART links funding to federal departments and agencies’ performance and accomplishments in budget review and seeks to “overcome issues in the Government Performance and Results Act implementation such as insufficient use of performance information in budget decisions” (Wang and Biedermann, 2012: 2). The literature, however, failed to produce a verdict on whether such a review improved department efficiency and effectiveness (Gilmour and Lewis, 2006; Dull, 2006; Moynihan, 2006). In addition, it is worth noting that public budgeting scholars and practitioners have made efforts to improve fiscal transparency and promote best practices of budgeting over the past decades. It is believed that fiscal transparency contributes to “better governance, improved economic performance, and increased civic participation in government decision making” (Arapis and Reitano, 2017: 1). At the international level, the Code of Good Practices for Fiscal Transparency was released by the International Monetary Fund (IMF) in 1998; the Organisation for Economic Co-operation and Development (OECD) published the Best Practices for Budget Transparency in 2002; and the nonprofit International Budget Partnership (IBP) has constructed the Open Budget Index (OBI) since 2006 (Ríos et al., 2016; Arapis and Reitano, 2017). In the US, the Government Finance Officers Association (GFOA) routinely publishes best practices in accounting and financial reporting, budgeting, capital planning, debt management, economic development, etc. Overall, public administration has framed budgeting as one function of administrative processes. Much research has focused on budgeting reforms or budgeting techniques. Future research could extend to how to reap the benefits from the best practices of budgeting, the managerial innovations and diffusion of budgeting, and continue to explore managers’ and citizens’ perspectives on budgeting in such areas as performance budgeting, participatory budgeting, and budgetary transparency.

Future directions for research in national and subnational government budgeting  159 Budgeting Research in Public Economics Public choice theory applies microeconomic tools, logic, and a key assumption of economics (individuals’ needs are unsatisfiable and allocate resources to make themselves as well off as possible) to politics and public affairs. Public choice theory lends its analytical framework to study many subjects within the public arena, such as voting, international relations, macroeconomic policy, and public budgeting (Bartle, 2003), and “is concerned with nonmarket decision making” (Gallagher, 1993: 94). Although public choice theory exerts influence on many areas of public affairs, this section focuses on its influence on public budgeting theory and practice. Public choice theory tends to de-contextualize budgetary actors and regards them as economic actors seeking to maximize their own self-interest rather than their agency or public interest (Bartle, 2003); hence the notion of the budget maximizing bureaucrat (Gianakis and McCue, 2002). In Niskanen’s (2017) seminal work, he developed an original and comprehensive theory of the public good supply model and concluded that the agency head enjoys the information advantage over sponsors (taxpayers) and intentionally inflates the supply level to maximize his/her agency budget. The study certainly generated a point of contention. First, Niskanen’s view of the agency head as a budget maximizer rejects the noble notion of serving the public interest. Such a claim displays a stark contrast to Downs’s (1967) typology of bureaucrats: ● Climbers: searching for promotions, increasing power and status of his/her current office, and seeking new opportunities above or outside the bureau. ● Conservers: motived by job security and opposing power loss but do not actively pursue more power or expansion of opportunities. ● Advocates: a partisan promoter. ● Zealots: can rarely be assigned to high-level administrative positions because of their uncompromising political ideals. ● Statesmen: misfit in office as they tend to behave like some other type (i.e., advocates). Hence, not all bureaucrats are budget maximizers, and there are mixed-motivated officials that place altruistic loyalty to public interests above self-interest (Downs, 1967). Along this line of thought, using data from the American State Administrators Project (ASAP) across four decades (1964–98), Bowling et al. (2004) categorized state agency heads as (1) abider (or minimizer, “conserver”), prefers no expansion; (2) altruist (“statesman”), expand overall level, no expansion of own agency; (3) advocate (“advocate”), expand own agency, no expansion in overall level; and (4) aggrandizer (or maximizer, “climber”), expand own agency and overall level. The empirical results confirm the budget maximizer hypothesis during the 1960s and early 1970s; starting from 1978, bureaucrats preferred moderated levels of expansion, and a large portion of public officials preferred to maintain the status quo. Similarly, Ryu et al. (2007) and Arapis and Bowling (2020) have provided evidence that not all bureaucrats are budget maximizers. Second, Wilson (2019) refutes such a claim by providing evidence that agency directors often reject funding that could potentially compromise their primary mission. Furthermore, Migué and Bélanger (1974) challenge Niskanen’s description of agency heads as output-maximizers. Instead, they view them as cost-maximizers at given output levels as “bureaucrats would welcome a higher level of output only to the extent that it brings in additional resources for their discretionary spending” (Chan and Rubin, 1987: 10). Similarly, Wyckoff (1990: 35)

160  Research handbook on public financial management argues that a budget-maximizing bureaucrat “would have to reduce the price charged to the sponsor to the level of his costs, eliminating productive inefficiency.” However, such action would defeat the very premise that “greedy bureaucrats” are trying to maximize their personal gain. Thus, they should try to maximize their budgetary slack so that they can have a higher level of discretionary spending to “increase the salary of the agency head and his or her subordinates; to increase the bureaucrat’s desire for power and prestige; and to enhance the reputation of both the agency and the agency head” (Forrester, 2002: 126). The aforementioned public choice studies also illustrate another important aspect of the decision-making process, the flow of budgetary information or budgetary transparency. It is evident that budgeting agencies enjoy an information advantage over their sponsors (i.e., the general public or taxpayers). Thus, they can exploit such information advantage to maximize their agency budget or improve their personal gains. Such phenomena can be analyzed in the principal-agent theory, where the general public and their elected officials are the principal and budgeting agencies the agents. Under this context, improving transparency, holding budgeting agencies accountable, and aligning interests between the principal and agent are the key to ensuring the efficiency and effectiveness of public spending. The empirical evidence on principal-agent theories regarding public budgeting studies is not as conclusive. Bendor et al. (1987) believe a well-designed direct monitoring system of agent behaviors would force agents to reveal the true cost, but more recent studies suggest the high cost associated with staffing, data collection, training, and information technology support impedes its feasibility to address information asymmetry (Andrews, 2005; Hatry, 2006; Joyce, 2005; Melkers and Willoughby, 2005; Ho, 2019). Additionally, establishing incentive mechanisms in government to align the interests of the principal and agent elicits no debate. How to choose and design the proper incentive structure, however, creates a point of contention. Hou et al. (2011a: 373) claim that “though in theory the design of incentive payments is very complex, incentive contracts are often linear – pay is positively and linearly correlated with output. The rationality of this linearity lies in the fact that, when certain conditions are satisfied, linear incentive contracts can provide the maximum incentives.” Ho (2019), on the contrary, argues that policymakers need to carefully evaluate the usage of monetary and non-monetary rewards to establish the incentive structure. Studies have shown non-monetary rewards (extra administrative flexibility, more autonomy, less monitoring) work well in the public sector (Heinrich and Marschke, 2010; Kasdin, 2010), and too much stress on monetary rewards tends to cause adverse effects (distortive reporting, cheating, and goal displacement) (Besley and Ghatak, 2005; Esquivel, 2013; Gao, 2015; Kalgin, 2016). Public economics can continue to offer formal modeling and rigorous empirical methods to budgeting research. To advance theories, budgeting research can borrow more from the political economy and public choice theories. Empirical rigor would be crucial to evaluate the outputs and outcomes of budgeting toward the ultimate goal of building evidence-based budgeting.

EMERGING RESEARCH TOPICS ON BUDGETING We have briefly reviewed the budgeting research in three disciplines of political science, public administration, and public economics. Drawing upon the previous studies, we focus on four emerging research topics on budgeting in this section. Specifically, we consider (1)

Future directions for research in national and subnational government budgeting  161 budgeting and equity, (2) roles of agencies and managers in budgeting, (3) budgeting and environmental shocks, and (4) budgeting and fiscal sustainability. Budgeting and Equity Participatory budgeting (PB) is a democratic process in which community members decide how to spend part of a public budget.1 As an emerging trend in public works, PB has been gaining a strong foothold around the globe since 1989 and has been “a central topic of discussion and significant field of innovation for those involved in democracy and local development” (Cabannes, 2004: 27). PB has evolved from a radical attempt to create a new variant of democracy that mixes participation and equity by a newly elected Workers’ Party (PT)2 in Porto Alegre, Brazil, to “a ‘best practice’ in the mainstream international development community’s toolkit for reducing poverty and practicing good governance” (Goldfrank, 2007: 91). What was once an experimental idea (PB) being tested in a dozen cities in South America has mushroomed to thousands of local jurisdictions implementing it as best practice around the world. The US has seen its rapid expansion as well. The first pilot process was introduced to Chicago’s 49th ward in 2009 and expanded to more than a dozen cities with more than 50 processes in just over six years. The success of PB is widely acknowledged by scholars, practitioners, and participants; they attribute revitalizing democracy and promoting equity to PB’s positive impact (Pape and Lerner, 2020). First, as a “best practice” for good governance, PB embraces trust, accountability, and effective decision-making for the democratic process (Lerner, 2014; Pape and Lerner, 2020). In addition, scholars such as Baiocchi (2001), Fung and Wright (2003), and Nylen (2002) believe PB promotes inclusion and improves equity by including marginalized groups, improving transparency and participation, and distributing funding to the neediest clients. Those actions produce tangible results and more universal, egalitarian social policies, which in turn increase local social capital (Goldfrank, 2007). However, PB is not a panacea to solve the social equity problem. For one, Kasdan and Markman (2017) point to the fact there is lacking data to confirm PB promotes more equitable funding. Although “PB transfers the authority to propose and make decisions on publicly funded capital projects from elected representatives to the public” (Shybalkina and Bifulco, 2019: 45), using a difference-in-differences design to examine the allocation of funding in the New York City council districts, Shybalkina and Bifulco (2019) find no evidence that PB increases the share of funding going to the lowest income census tracts and some even suggest PB decreases the share of funding in these tracts. In addition, “the ideological contests surrounding PB continue in the present and are likely to persist” (Goldfrank, 2007: 115), as some regard PB as an effort to reinvent socialism. Lastly, PB has been practiced predominantly at the local level, without enough funding or intergovernmental transfer to support the program. Merely practicing PB is not going to reduce property or improve the economic well-being of local jurisdictions. Also, local governments are not insulated from national macroeconomic environments. Engaging all levels of government would significantly strengthen the success rate of PB. Gender budgeting (GB) is another important topic that does not attract enough scholarly attention despite the global call to push it mainstream (Elson, 2003). Budgeting, on the surface, deals with government revenue and expenditures, and its association with gender is not immediately apparent to many. However, women often are not offered equal opportunity to men regarding labor participation, remuneration, education, health outcomes, or equal representa-

162  Research handbook on public financial management tion in top management positions (Downes et al., 2017) and “are often economically, socially, and politically unequal in relation to men” (Khalifa and Scarparo, 2021: 2; Renzetti et al., 2011). The national budget is normally formulated in a way that “ignores the different, socially determined roles, responsibilities and capabilities of men and women” (Sharp and Broomhill, 2002: 26). Thus, ignoring such budgetary impacts on women and minorities is going to further enlarge gender disparities. GB’s core scheme to address gender inequality is to: (1) promote mainstream gender issues within government policies; (2) promote greater accountability for governments’ commitment to gender equality; and (3) change budgets and policies (Sharp and Broomhill, 2002: 25). Although such a concept has been officially introduced into the public realm for more than half a century, empirical study to assess its impact and actual implementation is limited. As Nolte et al. (2021: 799) put it, “many studies remain explorative, reviewing existing content without collecting new and potentially more suitable data.” Given the lack of empirical evidence to analyze the success of gender budgeting initiatives, future research should focus more on data collection and implementation of GB in real-world settings. Budgeting, Agencies, and Managers Budgeting has long been considered both political and administrative. The politics of budgeting is a vibrant topic of study in political science, just as the various budgeting reforms are in public administration. Political science scholars like Wildavsky have collected rich data on how the budgeting negotiation unfolds among OMB and federal agencies at the US federal level (Wildavsky, 1964). Sharkansky (1968) examines the budgeting strategies by budget agencies and spending agencies at the US state level. Thurmaier and Willoughby (2014) have examined how state budget agencies work in interviews with governors and state legislatures. Budgeting scholars have also surveyed budget managers, or public financial managers, at the state and local levels to study such topics as performance budgeting (Melkers and Willoughby, 2001). In all these cases, scholars have focused on the roles of budgeting agencies or individual budget managers in the budgeting processes or the question of “the who” in budgeting. Given that Wildavsky’s research harks back to the 1960s, the study on budgeting agencies seems not to qualify as a new issue in budgeting research. However, what makes it an emerging issue is the choice of unit analysis and the need to better integrate with theories in related disciplines. Budgeting can be studied at the individual, program, agency, government, or cross-national levels. Much budgeting research seems to focus on the government level, which seems not surprising because most second-hand budgetary data are collected at that level. This leads to more knowledge about budgeting in general but not specifics about “who is doing what” in the budgeting process. Some recent studies are picking up the classic topic of studying the roles of budgeting agencies and public managers in the budgeting processes (Arapis and Bowling, 2020; Yu and Jennings, 2021). For instance, Arapis and Bowling (2020) study the spending agencies’ behaviors to test Niskanen’s theory of budget maximization. In addition, Lofton and Ivonchyk (2022) find that full-time finance directors are more likely to rely on inter-fund transfers and elevate their level in Georgia counties. To further address the imbalance in the choices of the units of analysis in budgeting research, future research should collect more first-hand data on budgeting processes at the individual, program, or agency levels.

Future directions for research in national and subnational government budgeting  163 In addition, scholars could benefit from a closer connection to the literature on public organizational theories, bureaucratic politics, and public management theories. The understanding of agency behaviors of budget agencies and spending agencies would be deeper and more meaningful through the theoretical lens of how public agencies as a public organization work in general and how they work in a political environment. At the individual level, public managers and administrators doing budgeting work may or may not act the same way as those doing human management work. Are public financial managers professionals? What are their preferences, attitudes, and behaviors in the budgeting processes? Treating budget managers as one (special) type of public manager and understanding their roles in light of public management theories could help answer these questions. This step would further help build a micro-level basis for understanding the budgeting process at the individual level. After all, budget agencies or budget managers manage the budgets daily; they deserve more theoretical and empirical scholarly attention in future budgeting research. Budgeting and Environmental Shocks In a public budgeting system, the inputs may come from natural and social-economic environments, while the outputs and outcomes often point to the economy and society. Traditionally, the inputs from natural environments have largely been overlooked. In recent decades, however, the impact of natural disasters or climate change on budgeting has received increasing scholarly attention. Natural disasters have become a prominent policy issue at the local, national, and international levels, where climate change and global warming feature media and policy agendas. Economists first examine the economic impacts of natural disasters, finding mixed effects on economic growth (Kousky, 2014). Public finance scholars have only started to examine the fiscal impacts of natural disasters in the past decade (e.g., Miao et al., 2018). The outcomes of disasters in these studies have shifted from GDP or economic growth to the revenues, spending, fiscal transfers, surplus, or deficits of government budgets. There is another shift from fiscal outcomes to fiscal management outcomes (Miao, 2018), which largely has not yet materialized but is on the horizon. For instance, scholars have studied the impact of natural disasters on government savings (Lee and Chen, 2022). Fiscal reserves such as rainy-day funds can also play a crucial role in budgeting against natural disasters (Hou, 2003; Barrett et al., 2019). In addition to natural disasters, one emerging environmental shock to the public budgeting systems is COVID-19. COVID-19 is no less than an “elephant in the room” for public budgeting, given the ongoing widespread pandemic. From a risk management perspective, COVID-19 shares lots of similarities with natural disasters, terrorist attacks, and even wars. These are all rare events with huge negative social-economic consequences that can squeeze government budgets. Like many public administration journals, public budgeting journals such as the Journal of Public Budgeting, Accounting & Financial Management have responded to the challenges of COVID-19 by publishing research that addresses fiscal and budgetary responses (e.g., Anessi-Pessina et al., 2020). Indeed, COVID-19 has slowed down economic growth, led to losses of jobs, decreased government revenues, and increased spending not only in the US but also in other countries. These consequences of COVID-19 do not seem entirely new when considering the economic cycles such as the Great Recession in 2009. What is a challenge for budgeting scholars working on this topic is to understand what

164  Research handbook on public financial management is unique to the fiscal challenges of COVID-19 and how to best configure the public budgeting systems to prepare for a similar emergency in the future. Budgeting and Fiscal Sustainability Drastic times call for drastic measures. Although a century-old annual budget format generally served us well, its inadequacy to deal with cyclical deficits cannot be more apparent during the time of the COVID-19 global pandemic. Economic slowdown causes a rapid decline in revenues, while the increasing demand for public services such as unemployment insurance and social safety net programs drives government expenditures up. Combining those factors suggests a gloomy future for government fiscal solvency. At the national level, “checking for solvency implies adopting a forward-looking approach that involves projecting future tax and spending measures—as well as a forecast of GDP growth and real interest rates—to determine whether the intertemporal budget constraint is satisfied” (Croce and Juan-Ramon, 2003: 3). And it is fiscally sustainable only as long as the budget is intertemporally balanced (Zhao and Coyne, 2013). At the subnational level, solvency is not a vital concern for state and local public officials as most state and local governments are subject to the balanced budget requirement. As such, Hou (2006) has long been a staunch advocate for state and local budget format reform. He argues that there is no way for state and local governments to deal with cyclical deficits without moving away from the annual budget format or utilizing countercyclical fiscal policy and tools. However, most states’ fiscal behavior is procyclical in nature. During economic boom years, increased revenue leads states to expand public service offerings and enact tax cuts. Such expansion is a receipt to create structural budget deficits during bust times, and the unsustainable fiscal behavior is the ultimate cause of fiscal crises (Knight et al., 2003; Moore, 1991; Schunk and Woodward, 2005; Kwak, 2014). However, not all studies support this view empirically. Mahdavi and Westerlund (2011: 953), examining a panel of 47 states from 1961 to 2006, claim “a sufficient condition for ‘strong’ sustainability is consistently satisfied for the full sample and all subsamples in relation to balances that include special funds and/or federal grants.” On the contrary, in an effort to remove the short-term impact of the business cycle, Zhao and Coyne (2013) developed a “trend gap” to measure state and local governments’ long-term ability to raise revenues to meet public service demand. Examining state and local revenue, expenditure, and pension data, the authors conclude that the nationwide per capita trend gap has been expanding steadily due to social insurance and income maintenance programs. There is no clear consensus on how to define and measure financial sustainability, but it is undeniable that fiscal sustainability is of great importance to many. To public officials and practitioners, fiscal sustainability reflects whether the current fiscal policies can be carried out with sufficient revenues or if some form of fiscal adjustments (i.e. tax increase or spending cuts) are needed. To public budgeting researchers and scholars, fiscal sustainability studies provide insights to disentangle different factors and conditions that could help or hamper sustainability within an intertemporal budget constraint (Martin, 2000). To municipal bond investors, “a severe lack of fiscal sustainability might induce investors to flee the municipal bond market, threatening the stability of the entire financial system” (Zhao and Coyne, 2013: 14).

Future directions for research in national and subnational government budgeting  165

FUTURE DIRECTIONS FOR BUDGETING RESEARCH In this section, we outline several future directions for budgeting research based on the review of previous studies from different disciplines and the emerging research topics on budgeting. We organize our observations in four categories, namely (1) maintaining an interdisciplinary perspective, (2) taking a forward-looking perspective, (3) taking an international and comparative perspective, and (4) balancing good theory with causal inference in research design. Maintaining an Interdisciplinary Perspective It is widely understood that budgeting is an interdisciplinary research subject. First, political science scholars have long considered budgeting as a key setting for observing the politics of “who gets what, when, how” (Lasswell, 2018). Since the “key” question of budgeting (Key, 1940), political science scholars have advanced the budgeting literature in such theories as budgeting incrementalism, punctuated equilibrium models, and the political economy of various budgetary institutions. Second, to public administration scholars, budgeting is one crucial element in managing public organizations, as summarized by Gulick’s POSDCORB (Gulick, 1937). Public administration research has focused on various budgeting techniques or reforms, from PPBS to performance budgeting or participatory budgeting (Kelly, 2005; Mikesell and Mullins, 2011). Third, to a lesser degree, public economics scholars have studied budgeting by focusing on the economic effects of budgetary institutions (e.g., Poterba, 1994; De Haan et al., 2013). Given that budgeting has been studied in these multiple disciplines, one future research direction is to maintain an interdisciplinary perspective, which is often advocated for creating innovative ideas. Beyond the fact that budgeting research is multidisciplinary, one question for budgeting scholars to answer is what strengths the research approach in each discipline offers and how to best integrate them toward a deeper understanding of budgeting (Rubin, 2015). That is, of course, an open-ended question. The budgeting research in public administration has largely been focused on how budgeting is implemented by the administrative branch of governments and the various ways of “getting things done.” Budgeting research in political science has the advantage of helping understand the contexts, institutions, or processes in which the budgeting is made. The budgeting research in public economics has the advantage of identifying the causes and effects of budgeting with the application of applied economic methods. The same concepts are often viewed through different theoretical lenses across disciplines. For instance, a budgetary delay is viewed as a legislative gridlock in political science (Klarner et al., 2012), a fiscal institution in public economics (Andersen et al., 2012), and a cash management problem in public administration (Yang 2020). Since the budgeting research has often been published in journals in different disciplines, it is challenging to attend to them at the same time. For budgeting scholars working in public administration, reaching out to political science and public economics literature can be a plus. One way to proceed is to design budgeting studies to balance the multiple goals of understanding political institutions and administrative implementation with the help of sound empirical research designs.

166  Research handbook on public financial management Taking a Forward-Looking Perspective Budgeting research focuses on annual changes in many cases. Budgeting is mostly an annual event. In some US states, the budgeting calendar is bi-annual, which is advocated as an innovation to reduce spending but is found to have the opposite effect of increasing state expenditures (Kearns, 1994). Most budgeting data, including the Census Bureau’s government finance surveys and the Comprehensive Annual Financial Report data, are reported in annual forms. Budgeting theories, especially incrementalism budgeting, have been sometimes criticized for focusing on short-term budgetary changes (Breunig and Koski, 2012). More importantly, a heavy focus on annual budget changes risks omitting the causes and consequences of budgeting that are more likely to unfold in a longer period. To be fair, budgeting scholars have noted the importance of a multiyear perspective on many budgeting topics (e.g., Boex et al., 2000), including counter-cycle fiscal savings, budgetary balance, and budgetary planning. In future budgeting research, it is likely to become more important to recognize the importance of a longer, forward-looking perspective (Kavanagh, 2007). The public budgeting systems have been subject to many external and internal environmental shocks that challenge fiscal sustainability (Nelson and Balu, 2014). The external environmental shocks come from both the natural environment and the social-economic environment. First, climate change, global warming, and natural disasters have been on the rise on the natural environment side. These natural environmental shocks can affect public budgeting systems indirectly and directly. When natural disasters strike, economic and social costs surge, budgetary revenues decline, and budgetary spending increases, resulting in a higher likelihood of budgeting deficits. Moreover, natural disasters may generate administrative disruptions directly for budgeting operations. Budgeting scholars have paid increasing attention to how the natural environment affects budgeting in recent years (Donahue and Joyce, 2001; Miao et al., 2018; Chen, 2020). Given the long-term trends of climate change, budgeting scholars may continue researching the economic, fiscal, and budgetary impacts of natural disasters. More specifically, scholars may move closer to how natural disasters affect the budgeting processes than the inputs or outputs of budgeting (i.e., revenues or spending). This is a demanding call because existing data, including census data on public finance and financial report data, do not allow one to directly observe how natural disasters affect budgetary decisions. Future research may collect first-hand data on how budgetary decision-makers perceive disaster risks and respond to disasters, what actions they take, and the consequences of those actions in the budgeting processes. Theoretically, the core of this research agenda can be risk management by budgetary decision-makers, which is related to emergency management and disaster research in general. Second, the external social-economic shocks to budgeting systems come from the economy. The impact of economic cycles on budgeting has been a classic research topic (e.g., Hou, 2006). Given the historical reoccurrences of economic fluctuations, it is unlikely to fade away from future budget research agendas. While scholars have attended to the significant fiscal impacts of economic crises such as the Great Recession in 2009 (Schanzenbach et al., 2016; Center on Budget and Policy Priorities, 2017), the economic shocks from the COVID-19 pandemic are unexpected. Nonetheless, the budgetary shocks from the COVID-19 are no less challenging, and budgeting scholars have just started to understand its consequences (e.g., Anessi-Pessina et al., 2020). Compared to the shocks from natural disasters, human actions seem to have a greater influence on economic crises and the effects of COVID-19. All these

Future directions for research in national and subnational government budgeting  167 external shocks point to the importance of risk management in budgeting. Budgeting research needs to draw better lessons from the past and be more forward-looking to address the fiscal challenges of these rare events that have a huge impact on public budgeting systems. Third, some societal changes are likely to affect public budgeting systems more significantly. Population aging is a prominent policy issue in many countries, often accompanied by low birth rates. Budgeting scholars have paid attention to the consequences of population aging in pension and other post-employment benefits (OPEB) research (Giertz and Papke, 2007; Marlowe, 2007; Yu, 2022). Given rising healthcare costs, the fiscal costs of an aging public sector workforce will continue to increase when more public sector workers retire in the future. Moreover, while budgeting research has focused on efficiency, the issue of equity in the distribution of budgetary resources is likely to become more important in the future (Pape and Lerner, 2020). Budgeting scholars have paid attention to the relationship between gender and budgeting (Polzer et al., 2021). Still, more work is warranted to understand how budgeting affects the vulnerable and disadvantaged social groups in a society. The roles of gender, diversity, inclusion, and social justice in budgeting need to be more fully addressed in future budgeting research. Finally, the internal environmental shocks to public budgeting systems come from the political and administrative processes in which budgeting operates. In the US, entitlement spending, budgeting deficits, and public debt at the federal level have long been recognized as tough political challenges (White, 1998; Rubin, 2007). What may make these problems even more challenging are increasing political polarization (Birkhead, 2016) and distrust of government by the general public (Ebdon and Franklin, 2006). Addressing the challenges in healthcare finances, infrastructure finance, and education finance will be more realistic in the presence of the political will to compromise or cooperate across partisan lines and a supportive body of voters that believe governments are more of the solution than the problem. For budgeting research in public administration, a better understanding of the efficiency, effectiveness, and equity of budgetary reforms would follow when considering such macro-level political factors. Taking an International and Comparative Perspective Like many other subjects of social science, budgeting research is both theoretical and practical. The goal of theoretical research is to build generalizable budgeting theories; the goal of practical research is to share local knowledge from contextualized budgeting practices. In both enterprises, going beyond one context to compare across multiple ones would be beneficial. Budgeting is both a science and an art, which shares the feature of a design science with the general discipline of public administration (Barzelay and Thompson, 2010). The contexts of budgeting can be a local government such as a city or a county, a state or a provincial government, or a national government in a federal or a unitary system. The multiple contexts of budgeting are important not only for the sake of theory building but also for the good of exchange of ideas when theory building is not yet the norm. If context matters, the implications for future budgeting research are at least twofold. First, to gain greater knowledge from multiple budgeting contexts, budgeting research will benefit from an international perspective (Guess and Savage, 2021). This call has been made for general public administration research (Hou et al., 2011b). Much of the budgeting research has been focused on the budgeting practices of developed countries such as the US and other

168  Research handbook on public financial management OECD countries. The budgeting practices of developing countries such as China and India have received increasing scholarly attention in recent decades. A comparative study of budgeting practices across nations will benefit both theoretical and practical budgeting research. The diversity of budgeting practices across nations will put budgeting theories to a more demanding test. The communication of budgeting practices across nations will help budgeting practitioners to learn best practices from a global perspective. Budgeting scholars have made considerable progress in the studies of such topics as participatory budgeting and performance budgeting (Shah, 2007; Ho et al., 2019). To build comparative budgeting theories, budgeting scholars may learn from such subjects as comparative politics, comparative public administration, or comparative public policy. Second, for a given budgeting context, the communication between academics and practitioners will remain important and relevant in the future. There are lots of reasons to stay optimistic in this regard. Major journal outlets for budgeting research, such as Public Budgeting & Finance and Public Administration Review, have long emphasized the contribution and collaboration of both academic researchers and practitioners. Budgeting has been a core subject in Master of Public Administration education in many NASPAA-accredited programs. Students often hold substantive professional experience in the field before entering classrooms. This indicates the demand for a more relevant budgeting class and the need for deeper academic– practitioner collaboration in future budgeting research. To facilitate budgeting research from an international and comparative perspective, one step to take is to encourage data sharing, transparency, and replication. There has been a recent trend in social sciences toward greater research transparency and a call for replication of empirical studies. Scholars have attended to a so-called replication “crisis” in multiple fields of social sciences (Bohannon, 2015; Walker et al., 2017; Wiliam, 2022). Major journals in political science, economics, and public administration have requested authors to share datasets in open-access platforms such as Harvard Dataverse. The flagship journals in budgeting research, such as Public Budgeting & Finance, have yet to adopt similar requirements. This can be a low-cost reform to take to encourage authors to share datasets to promote research transparency, scholarly communication across nations, and academic–practitioner collaboration. Balancing Good Theory with Causal Inference in Research Design If scholars agree on what a theory is, they often disagree on what a good theory is. Sutton and Staw (1995: 378) summarize that “theory is the answer to queries of why. Theory is about the connections among phenomena, a story about why acts, events, structures, and thoughts occur. Theory emphasizes the nature of causal relationships, identifying what comes first as well as the timing of such events.” But as Sutton and Staw (1995: 371) point out, “there is little agreement about what constitutes strong versus weak theory in the social sciences.” Sutton and Staw (1995: 371) focus on “what theory is not” because “there is more consensus that references, data, variables, diagrams, and hypotheses are not theory.” Weick (1995) argues that references, data, variables, diagrams, and hypotheses are valuable steps in the theorizing process. DiMaggio (1995) adds that there is more than one kind of good theory, including “theory as covering laws,” “theory as enlightenment,” and “theory as narrative.” Given these debates, one point of departure is to recognize the diversity of viewpoints on what constitutes a good theory. Yet, as Van de Ven (1989) famously claims, “nothing is quite so practical as a good theory.” The emphasis on theory in business administration may serve

Future directions for research in national and subnational government budgeting  169 as a good example for public budgeting research. Both fields feature the mission of delivering “usable” knowledge for professional managers or decision-makers. The heavy focus on practical knowledge amplifies the significance of theory because practices are often “local knowledge” that is subject to external validity threats. Theories represent generalizable or testable propositions that facilitate knowledge accumulation across practices of localities or nations. Budgeting scholars may continue the pursuit of theory since Wildavsky (1986). Top journals in general management (e.g., Academy of Management Journal) and public administration (e.g., Public Administration Review) usually call for a balance between a good theory and rigorous empirical tests. This can be the direction for the journals in the field of budgeting, such as Public Budgeting & Finance. In terms of research methods, one recent advancement is the pursuit of causality through causal inference methods, including experimental and quasi-experimental methods. The experimental methods are built upon the potential outcome framework by Holland (1986), and randomization is widely regarded as the “golden rule” of causal inference in social sciences. The various quasi-experimental methods rely on, instead of randomization by researchers, some sorts of exogenous sources of variation in the real world and hence have an alternative name of “natural experiments.” The estimation methods vary from case to case, but the frequently used ones include difference-in-difference models, instrumental variable regression, and regression discontinuity design (Angrist and Pischke, 2008). The methodological trend of causal inference methods has arisen in recent decades in psychology, economics, political science, public administration, and other related social science disciplines. Public administration scholars have been active in applying experimental methods, one excellent example of which is the publication of the book Experiments in Public Management Research (James et al., 2017a). An increasing number of publications have been using experimental methods in top public administration journals such as Public Administration Review and Journal of Public Administration Research and Theory (James et al., 2017b; Hansen and Tummers, 2020). Behavioral public administration is on the rise, as evidenced by the young publication Journal of Behavioral Public Administration. The study of budgeting can benefit from this trend of moving from correlation to causality in research methods. Public budgeting is considered a subfield of political science or public administration. The burgeoning literature on causal inference methods in those disciplines indicates that public budgeting research may not be immune to such methodological advancements. The idea of applying causal inference methods to budgeting research is not entirely new. Budgeting scholars have applied experimental methods to study the budgeting behaviors of legislators in the 1990s (Thurmaier, 1992). What can be new is recognizing the importance of causal inference in generating empirical evidence to support evidence-based policymaking in public budgeting. Specifically, the application of causal inference methods in budgeting research can take shape in multiple ways. First, the application of experimental methods, including lab experiments, survey experiments, and field experiments, can be pursued more actively by budgeting scholars. In terms of the subjects of the experiments, one may focus on either the decision-makers of budgeting or the constituency of budgeting, i.e., citizens. In the former case, the subjects of experiments may include legislators, executive leaders such as mayors, and public officials in budgeting agencies and spending agencies, among others. In the latter scenario, citizens’ attitudes toward and behaviors related to budgeting have been core to such topics as citizen participation in budgeting, participatory budgeting, or fiscal reporting and

170  Research handbook on public financial management transparency. It seems more feasible to conduct experiments on budgeting with citizens as subjects, as evidenced by recent work (Brunner et al., 2021). Scholars must weigh the pros and cons of ethical considerations, resource constraints, or statistical power in conducting experiments with various subjects. Second, while experimental methods are not always feasible to apply, quasi-experimental methods provide a promising step toward causality in budgeting research. In many cases, the degree to which scholars have successfully addressed causality or the so-called “endogeneity concerns” is a matter of degree. Scholars can take multiple measures to make budgeting research stronger in causal inference. One suggestion by causal inference scholars is to rely more on research design than sophisticated modeling techniques to recover causal inference (Cook et al., 2002). This means that scholars may pay more attention to causal inference at the stage of data collection or construction. For instance, scholars may attend to the construction of control groups in difference-in-difference designs (St. Clair and Cook, 2015), the search for valid instrumental variables (Park et al., 2022), or the context suitable for regression discontinuity designs (Rothbart et al., 2021). The pursuit of causality in observational studies on government budgeting can be facilitated by the decreasing costs of obtaining longitudinal data, administrative data, and big data in the future.

DISCUSSION AND CONCLUSION In this chapter, we have discussed future research directions for the budgeting of national and subnational governments. We first review briefly budgeting research in the three most relevant disciplines, political science, public administration, and public economics. The review is by no means comprehensive. It is intended to show the differences across disciplines and the unique perspective of scholars working in each field. We then take a closer look at selected studies on several emerging research topics in budgeting. Some of these emerging topics are new; some are conventional topics that may gain renewed importance. Based on the literature review in these two steps, we propose several directions for future budgeting research. We call for future budgeting research to “think big”: taking an interdisciplinary perspective to gain a wider range of insights; taking a long-run perspective in the dimension of time to address fiscal sustainability; taking an international perspective in the dimension of space to compare multiple budgeting practices; and using more causal inference methods to build up evidence-based budgeting knowledge. Throughout the chapter, we observe that budgeting is a multidisciplinary field, and budgeting research is interdisciplinary. This is not something new, given that budgeting is considered a subject within public administration, which is an interdisciplinary field. Public administration scholars have debated the “identity crisis” of the discipline (Rutgers, 1998; Raadschelders, 1999). The question then becomes: Does budgeting research face an “identity crisis”? The question is by no means unique to budgeting. It reflects a common tension and the “cost” to pay for an interdisciplinary perspective’s various strengths or benefits. The question is challenging for budgeting scholars. It is hard to come to a consensus on the answers. It seems that budgeting research does not face an “identity crisis.” An interdisciplinary perspective is more of an “asset” than a “liability” for budgeting (Vigoda, 2003). First, budgeting research benefits from the incorporation of theories and methods from related disciplines, which can be a characteristic rather than a problem. For instance, budgeting research has long

Future directions for research in national and subnational government budgeting  171 featured such theories as incrementalism decision-making or public choice theories. Further, nothing will prevent the application of causal inference methods in budgeting. Second, budgeting research in multiple disciplines is united by the phenomenon of budgeting itself. Budgeting practice is a unique field of inquiry that is part of many related disciplines. In political science, the study of budgeting processes is at the core of the politics of policymaking. In public administration, budgeting is considered a core function of administration, like human resource management or performance management. For public economics, budgeting institutions shape the economic roles of governments. These disciplines frame budgeting differently, but they all focus on some critical dimensions of budgeting practices. Third, public budgeting systems, as a critical part of administrative reforms and good governance, remain open to changing challenges such as social equity, population aging, and environmental shocks like natural disasters or climate changes. Compared to other fields in social sciences, budgeting scholars will maintain comparative advantages in addressing these questions, given the theories, methods, and field knowledge that are unique to budgeting. We acknowledge that there are several limitations of this chapter. We review the budgeting research in three disciplines: political science, public administration, and public economics. In some sense, this choice is inevitably arbitrary. We are aware that some important budgeting research is published in accounting and financial management journals.3 In a similar vein, when we discuss selected emerging research topics or future directions in budgeting, we have to omit some others that might be equally important. We remind readers to use caution to keep these limitations in mind when judging the merits of our takeaway points from the vibrant budgeting literature.

NOTES 1. Participatory Budgeting Project. https://​www​.pa​rticipator​ybudgeting​.org/​what​-is​-pb/​. 2. The origin of PB is disputed; see Goldfrank (2007) for a detailed discussion. 3. For literature reviews of budgeting research in accounting and financial management, see Anessi-Pessina et al. (2016) and Kenno et al. (2018).

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PART IV TAX REVENUE MANAGEMENT

10. Foundations of government taxation and revenue management Whitney Afonso

INTRODUCTION Governments around the globe provide numerous services for their citizens, including critical ones like education, national defense, infrastructure, and environmental protection. In fact, general government spending as a percentage of gross domestic product (GDP) ranges from almost 56 percent in France to 25 percent in Ireland, with an average of almost 42 percent in 2019 (OECD, 2021a). While the expenditures get a lot of attention, the other side of the coin, the financing of these services, is equally important. Figure 10.1 presents the average tax mix of member nations of the Organisation for Economic Co-operation and Development (OECD). It shows that almost a quarter of taxes come from income taxes, that more than a quarter are from social-security contributions, and that another fifth are generated by value-added taxes. Those three areas of taxation make up almost 73 percent of tax revenues on average for OECD member nations in 2018.

Source: OECD (2020).

Figure 10.1

Average tax mix for OECD members

Given the amount of revenues collected by governments around the globe and the various taxes and fees1 that are levied, it is critical to understand those different revenue instruments. Thus, the question becomes, by what means should we evaluate revenue instruments? It is important for government officials and academics alike to evaluate not just the legal limitations and restrictions that are in place but also the strengths, weaknesses, and consequences of the different revenue instruments available. This chapter will provide an in-depth discussion 179

180  Research handbook on public financial management of five primary criteria that should be used when examining revenues: economic efficiency, equity, adequacy, feasibility, and transparency.2 Along the way it will discuss some of the larger revenue instruments that national and subnational governments rely on and how they fare on these criteria. The unfortunate reality is that there is no perfect tax. There are always trade-offs between important values and considerations.

ECONOMIC EFFICIENCY Economic efficiency is an economic term referring to the state in which resources are optimally allocated to best serve the unit (e.g., the individual, jurisdiction, or business) while minimizing waste. When economic efficiency is achieved, any change to the price or the quantity of the resource would cause harm to at least one party. In most cases, it just means the price and quantity that the market, without government interference, would have supplied the good. There are examples of the market failing to supply the good at the efficient point. This is called a market failure (monopolies are one example). The problem with taxes is that they move resources away from the efficient point, creating a discrepancy referred to as deadweight loss or excess burden. Let’s look at this graphically.

Figure 10.2

Basic supply-and-demand curve

Figure 10.2 presents the classic supply-and-demand curve. Producers want to maximize their producer surplus (i.e., their profits). Consumers want to minimize their costs and maximize their consumer surplus (i.e., the money they could have spent but did not have to). The equilibrium point is Q. Point Q is the most efficient outcome, given these competing demands. Compare this with Figure 10.3. Figure 10.3 presents the same supply-and-demand curves as

Foundations of government taxation and revenue management  181 Figure 10.2, so Q is still the efficient point. However, taxes have been added to this good, making it more expensive and shifting the supply curve. That change in price has shifted the quantity actually purchased up to Q1. Now, less of that good is being purchased, consumers are paying more for it, and producers are being paid less for it. This means that both consumer surplus and producer surplus have decreased. Of course, now there is also tax revenue, the reason the tax was levied in the first place. The unfortunate reality, though, is that the loss in consumer surplus and producer surplus is greater than the tax revenue generated. This is the deadweight loss, labeled DWL in Figure 10.3. To maximize efficiency, deadweight loss must be minimized. It does not benefit the government, and it harms both consumers and producers.

Figure 10.3

Supply-and-demand curves with taxes and deadweight loss

Deadweight loss is an almost inevitable outcome of taxing goods and services. However, there are ways to minimize it. One is to make tax rates low. Figures 10.4 and 10.5 illustrate supply-and-demand curves affected by a low tax rate and a high tax rate, respectively. The tax revenue is greater in Figure 10.5, but the deadweight loss is much greater, too.3 In fact, you can raise the tax rate so high that it will reduce tax revenues (see Figure 10.6). The point at which higher tax rates lead to lower tax revenues is much debated and would vary considerably by revenue instruments, the good or service being taxed, and likely the population being taxed. (See also Box 10.1.)

BOX 10.1 THE LAFFER CURVE As presented in the difference between Figures 10.5 and 10.6, the tax rate can get large enough that tax-revenue collections decline. When discussing economic efficiency, the focus is on deadweight loss and excess burden, not revenue. But as the rate increases, so does the deadweight loss. At some point, the tax instrument stops generating higher tax revenues.

182  Research handbook on public financial management The most famous way this concept has been discussed is the Laffer curve. The Laffer curve is built upon straightforward intuition and is focused on income taxes. It posits that a 0 percent tax rate will not collect taxes, and neither will a 100 percent tax rate (since people will not work if the after-tax income is zero). As income tax increases, starting from 0 percent, it will discourage earned income while increasing tax revenues. But eventually, the tax rate gets so high that the disincentive to work lowers the available income to tax, leading to less government revenue (Dorfman, 2017). Economist Art Laffer, who popularized the concept, refers to that drop-off in revenue as the prohibitive range. While the Laffer curve is named for Art Laffer, the concept predates him, with even John Maynard Keynes discussing this relationship between rates and revenues (Laffer, 2004). In many respects, the Laffer curve is built on the premise that tax policy should be designed to maximize revenues, yet from an economic-efficiency perspective, the disincentives for work that stem from rate increases also cause tremendous deadweight loss.

Figure 10.4

Supply-and-demand curve with low-rate tax

Figure 10.5

Supply-and-demand curve with high-rate tax

Foundations of government taxation and revenue management  183

Figure 10.6

Supply-and-demand curve with highest-rate tax

Outside of keeping tax rates low, deadweight loss can be minimized by taxing goods where the supply or the demand is inelastic (that is, not sensitive to changes in price). If consumers’ demand for a good is inelastic, then they will buy it no matter what the cost is (within reason). This relationship is demonstrated in the following expression: dQ / Q dP / P

​ep​ ​  ​=  _ ​   ​  ​

Price elasticity is represented by ep, Q is the quantity of the demanded good, and P is the good’s price. A good is considered inelastic if theis less than one. The lower ep is, the less influence price has on demand.4 As visualized in the previous figures, more elastic demand will shift a larger share of the deadweight loss to producers and that less elastic demand will shift a larger share of the deadweight loss to consumers. Many goods with inelastic demands fall into two main categories: life-or-death necessities and goods people are addicted to. Blood donated for blood transfusions is one example of a life-or-death necessity. If you get into a terrible car accident and need a blood transfusion to survive, you are likely willing to pay any price for that blood. A government could, if it wanted to, levy a steep excise tax on blood, with little deadweight loss.5 (Whether that would serve the public interest is another question.) Typically, life-or-death goods (and services) are not taxed at high rates. In fact, only four states tax groceries at the same rate as other goods – the need for food being just as great (if not always as urgent) as the need for blood. In contrast, goods that have inelastic demand due to their addictive nature are often taxed at higher rates. Two common goods with inelastic demand induced by addiction are tobacco products and alcohol products. Excise taxes on tobacco vary considerably across the globe. For example, New Zealand imposes an excise tax on cigarette packs that increases the cost of cigarettes to thirty New Zealand dollars (twenty US dollars). In Norway, Ireland, Malaysia, Turkey, and Sri Lanka, the price of a pack of cigarettes is over ten US dollars. This contrasts with nations like Paraguay, Guinea, Sierra Leone, and Afghanistan, where the average price is

184  Research handbook on public financial management less than two US dollars and, in some cases, even less than one US dollar (Drope and Schluger, 2018). Excise taxes on goods like tobacco and alcohol are often referred to as “sin taxes.” Demand for these goods is much less sensitive to a change in price than it is for other goods, like shoes or books. Figure 10.7 presents a graph with an inelastic-demand curve to illustrate the reduction in deadweight loss. It is also worth noting, in the case of an inelastic-demand curve (as opposed to an inelastic-supply curve), that the majority of the tax burden is borne by the consumer rather than the producer. While excise taxes on alcohol and tobacco are still the most common sin taxes, there is growing interest in others such as sugary beverages and cannabis taxes.6 There are fewer examples of inelastic supply, but one is apartments for rent, at least for the short term. No matter how demand for apartment rentals changes, there is a relatively fixed number of existing apartments for rent. Therefore, if property taxes are raised and demand is elastic, then the majority of the economic incidence of the property taxes will be borne by the

Figure 10.7

Inelastic demand for goods

apartment owners because they will not be able to increase their rent prices enough to offset the higher taxes. (See also Box 10.2.)

BOX 10.2 TAX INCIDENCE There are two ways to gauge tax incidence: by the statutory incidence or the economic incidence. The statutory incidence is who remits the tax to the government or who writes the check. Second, the economic incidence. The economic incidence is who bears the burden of the tax or whose resources (which we typically measure as money) are affected by the tax. The statutory incidence does not have to be the same as the economic incidence. For example, Party A owns a home but rents it to Party B. Party A pays the property tax and bears the statutory incidence of the property tax. However, whether A bears the full economic

Foundations of government taxation and revenue management  185 incidence is a different question. In most circumstances, Party A will have factored in a portion of the property-tax burden into the rental price, so both parties share in the economic incidence of the tax. As the rental market gets flooded with available homes, A may have to reduce the rental price and bear more of the property tax’s economic incidence. Yet, if there is a shortage of rental units and they are in high demand, A can increase the rental price and shift more of the economic incidence to B. The more inelastic the supply, the greater the portion of economic incidence that will fall on the producer. The more inelastic the demand, the greater the portion that will fall on the consumer. Corporate income taxes are another example of how different the statutory incidence and the economic incidence can be. Often, corporate income taxes are depicted as a way to make wealthy pay their “fair share” and to shift the burden away from low-income workers. In the United States, approximately 70 percent of the population believes that corporations are not paying their “fair share” (Gallup, 2020). While it is clear that the statutory incidence of corporate income taxes falls on shareholders, it is much less clear who bears the economic incidence. There is a great deal of debate over how much is borne by shareholders, capital, workers, and consumers. In one study using over 55,000 firms across nine European countries, researchers argued that an exogenous rise of $1.00 in corporate taxes would decrease workers’ wages by $0.49, suggesting that on average, workers alone bear approximately half of the economic incidence of the corporate income tax (Arulampalam et al., 2012). Ultimately, deadweight loss occurs because taxes change behavior.7 As Figure 10.3 shows, the obvious response to higher prices from consumers is to buy less, resulting in lower consumer and producer surplus. However, taxing different parts of the economy differently can often change other behaviors. Online retailers like Amazon.com, for example, did not have to collect sales (or use) taxes like their brick-and-mortar counterparts. This made the same good less expensive on Amazon than it was at the neighborhood store. Evidence suggests that this difference in price affected consumer behavior (Goolsbee, 2000; Ballard and Lee, 2007; Einav et al., 2014; Agrawal, 2017) and producers’ location decisions (Whitacre, 2011). In most cases, this was not simply tax avoidance but tax evasion: in most states, use taxes must be paid whenever sales taxes are not. Other examples of behaviors that taxation can distort are how workers approach the labor-leisure trade-off and how people make locational decisions. Labor-leisure trade-off is the term for the decision of how to balance the amount of time spent working and spent on leisure. It assumes that work is an unpleasant task that is done in order to earn wages and that leisure is the preferred way to spend time. Therefore, when a tax is placed on wages, like an income tax, it reduces the value of wage work. Workers will adjust their behavior in response to this decline. Interestingly, it is unclear whether workers will choose to work more or less. There are two competing effects at play: the income effect and the substitution effect. The income effect suggests that a worker will work more hours to maintain a desired income. The substitution effect suggests that, because the relative price of leisure has decreased, the worker will choose to spend more time on leisure and to work fewer hours. There is a robust literature exploring the labor-leisure trade-offs. Slemrod (2001) presents a standard model of the impact on labor supply. Hayashi et al. (2013) use experiments to better understand these trade-offs and tax saliency, and Mocan (2019) analyzes the labor-leisure trade-off in Europe while considering differences in cultural appetites for leisure.

186  Research handbook on public financial management Taxation can also influence where consumers and businesses decide to locate or do business. If a local government has a higher sales tax than its neighbor, then consumers may choose to shop in the neighboring location, where the affected goods will be less costly (Zhao and Hou, 2008; Wang and Zhao, 2011; Burge and Piper, 2012; Afonso, 2016). This same logic applies to the impact of local property taxes on both residential and commercial properties. In fact, there is evidence that it applies to where people choose to live, especially for higher-income workers (Feld and Kirchgässner, 2001; Giertz and Tosun, 2012; Kleven et al., 2013; Afonso, 2015, 2018a). Governments sometimes try to use tax policy to change consumers’ or producers’ behaviors. In some cases, it may be an effort to correct market failures like negative externalities. A negative externality is a cost that is borne by a third party, one who is neither the consumer nor the producer and who was not a part of the transaction.8 Thus, taxes can be used to increase the cost of the transaction to capture the negative externalities. Such taxes are referred to as Pigouvian taxes. A “carbon tax,” a tax levied on carbon emissions, is an example of a Pigouvian tax. Because of the environmental effects of carbon emissions, their costs are borne by everyone, not just the firms producing the emissions and the consumers of the goods being produced. A carbon tax seeks to mitigate that negative externality by incorporating some of the cost of the pollution into the cost of the transactions that contribute to the pollution. Pigouvian taxes are often popular because they foster market efficiency by incorporating the negative externality’s cost into the transaction’s cost and, in doing so, they may decrease the demand. Excise taxes on goods like fuel, alcohol, and tobacco are other examples of Pigouvian taxes. (See also Box 10.3.)

BOX 10.3 (DE)CENTRALIZATION OF TAXATION Taxation can distort and change the behavior of firms and individuals. While some distortions, such as the labor-leisure trade-off, are present no matter the level of government levying the tax there are behavioral changes that are of greater concern when the tax is levied by a subnational government. Therefore, there is an important subfield of literature examining the centralization of public finances. The fiscal centralization literature suggests that decentralized taxes lead to greater subnational autonomy and improve the efficiency of the provision of public goods (Mikesell, 2007; Martínez-Vázquez et al., 2017; Jia et al., 2020). However, decentralized taxes also typically increase the opacity, complexity, and collection costs of taxation (Stotsky and Sunley, 1997; Ahmad and Brosio, 2006; Mikesell, 2007). An additional benefit of taxation at a higher, more centralized, level of government is that it removes many of the concerns around the mobility of capital and labor that accompanies corporate and personal income taxes, residential and personal property taxes, and cross-border shopping regarding subnational consumption taxes. For example, excise taxes such as the sugary beverages tax or “soda tax” is levied at the local level exclusively in the United States. The sugary beverages tax is intended to discourage consumption of sugar and correct for the negative externalities caused by high levels of sugar consumption like the healthcare costs associated with obesity. A tax like a sugary beverages tax may also correct for negative internalities, the self-imposed negative consequences on consumers that are ignored (Allcott et al., 2019). Therefore, it seems that a sugary beverages tax may increase efficiency.9 However, a local excise tax such as this

Foundations of government taxation and revenue management  187 one may lead to concerns about cross-border shopping. For example, Bollinger and Sexton (2018) found that approximately half of the reductions in the purchases of sugary beverages in Berkeley, California, are just being substituted with purchases made right outside of Berkeley. This same pattern has been observed in Philadelphia as well (Roberto et al., 2019; Seiler et al. 2021). If levied by the federal government, or even the state government, there would be less opportunity for tax avoidance by crossing the border and less efficiency loss. Efficiency is a critical criterion when evaluating, selecting, and structuring taxes (and fees). Ultimately, from an efficiency perspective, you want your revenue instrument to minimize the deadweight loss it creates and to change people’s behavior as little as possible. That is why the taxes with low rates and large, broad bases that tax a larger share of the economy are often considered the most efficient. However, we often choose to narrow the tax base and to increase the rate for other reasons. One of the most common reasons is equity.

EQUITY While efficiency may be the most unfamiliar concept discussed in this chapter, equity may be the most subjective and contentious. That is because equity evaluates the fairness of the tax or fee, and what one person may consider fair may be entirely different than what another person considers fair. Economic efficiency while challenging to measure, can be measured concretely, but there are many definitions of what is fair, and many different (sometimes conflicting) ways to evaluate the fairness of a tax or fee. The economic incidence of the tax, as discussed previously, should also be carefully considered when examining the equity of different tax instruments. Equity is often an underlying reason for how a tax base is defined and how rates are set. It also entails trade-offs that other considerations discussed in this chapter do not. This discussion covers two principles that address equity: the benefit principle and the ability-to-pay principle. The Benefit Principle The benefit principle is a common way of conceptualizing taxes’ equity. It considers who is using the services that the taxes or fees are financing. Government officials employing the benefit principle would want to link the revenue stream to the service and have the people who use the service pay more for it than those who do not (if those who don’t use the service pay at all). Ultimately fairness is based on the relationship between consumption and payment. This often manifests as a direct payment for services received, so it works best for services that resemble those provided by the private sector, such as water, electricity, and bus fees. Therefore, it is more common for fees to be structured around the benefit principle than taxes. Outside of normative conceptions of how individuals and governments define fairness, there may be additional benefits to benefits-based revenues. For example, choosing taxes and fees that satisfy the benefit principle helps to avoid what Mikesell (2016) refers to as the cross-subsidization of taxpayers, and it may help guide government to a more optimal level of provision (Bird, 2001; Bartle et al., 2003; Germán and Glass, 2017). One service that is often financed from benefits-based revenues is transportation, specifically roads. Financing methods

188  Research handbook on public financial management for roads include tolls, vehicle fees, and mileage-based user fees, but one of the most common is fuel taxes. Many countries, including China, Brazil, New Zealand, Israel, and the United States, use fuel taxes to finance transportation infrastructure (NC First Commission, 2020).10 One reason for the popularity of fuel taxes is that the consumption of fuel is a proxy for the use of roadways and the damage done to them, thus the goal of having those who benefit from the roadways pay for them in the approximate portion that they consume them.11 The Ability-to-Pay Principle The ability-to-pay principle dictates that people should pay taxes based on their ability-to-pay those taxes rather than the benefit they receive from government services. While that seems straightforward, there are many nuances to consider, including how to define ability-to-pay, how to assess whether this standard is being met, and how it should be applied. Ability-to-pay can be conceived in terms of horizontal equity and of vertical equity. (See also Box 10.4.)

BOX 10.4 MARGINAL TAX RATE VERSUS EFFECTIVE TAX RATE This chapter discusses tax rates from an effective tax rate perspective. A marginal tax rate is the rate that the last dollar of income you make is taxed at. An effective tax rate is the average tax rate your income is taxed. The clearest way to think about this is to use the example of a progressive personal income tax. Progressive personal income taxes are common throughout the world. For example, in 2017 France’s top marginal tax rate was 53 percent, Germany’s was 45 percent, Japan’s was 56 percent, the United Kingdom’s was 45 percent, and the United States’ was 40 percent (Alvaredo et al., 2018) with the lowest marginal tax rate being 0 percent in France, Germany, and the United Kingdom. To demonstrate the difference in the marginal tax rate and the effective tax rate, you can calculate both for a typical taxpayer. In the United States, if a worker were making $150,000 a year and filing as unmarried, then the marginal tax rate (or tax bracket) would be 28 percent. However, that rate would not apply to the worker’s entire income. The effective tax rate is lower (and this case would be 21 percent).12 This difference is even more stark at lower incomes. For example, for an income of $40,000 a year for an unmarried worker, the marginal tax rate is 15 percent and the effective tax rate is less than 10 percent. This example only considers federal taxes. Often, effective tax rates will include others, such as subnational income taxes, sales or value-added taxes, property taxes, and excise taxes. Horizontal equity Horizontal equity is the concept that people with the same ability-to-pay should pay the same amount in taxes. While this seems reasonable, the challenge lies in defining ability-to-pay. Wages and salaries play an obvious role, and most ability-to-pay measures are based on current income. However, net wealth is another, more comprehensive measure. Other factors that are often considered are the number of dependents, whether the taxpayer has debt or student loans, the cost of living where the taxpayer resides, and levels of household consumption.

Foundations of government taxation and revenue management  189 Since any definition of ability-to-pay is normative, evaluating a tax’s horizontal equity requires the analyst to return to the initial question of what it means to treat like people alike. This question becomes especially difficult when alike people behave differently. Personal income tax is a good example. The personal income tax would, without deductions and exemptions, treat like people alike if current income were the only consideration. But this is rarely the case. In most OECD nations, capital gains are taxed at a lower rate than wage income. In many countries, like Turkey, Switzerland, and Korea, capital gains are not taxed at all (Pomerleau, 2015). Therefore, in most countries, a household’s income tax burden can depend greatly on whether capital gains contribute significantly to its income. Differences in horizontal equity may get even more stark when considering overall effective tax rates that would aggregate all taxes paid. Such effective rates would be determined less by ability-to-pay than by other

Figure 10.8

Vertical equity

factors, such as investments, levels of consumption on housing and other goods, number of children, and various behaviors, like saving. Once again, much of the assessment of horizontal equity depends on how ability-to-pay is defined. Vertical equity Vertical equity considers the appropriate relationship between the relative tax burdens (or effective tax rates) and individuals with different abilities-to-pay. In some respects, it assumes that horizontal-equity concerns have been met and goes a step further by considering the share of the burden that different populations should pay. Vertical equity manifests in three ways: progressive taxes, proportional taxes, and regressive taxes. Progressive taxes increase their effective rates as ability-to-pay increases. Proportional taxes maintain consistent effective rates across differing levels of ability-to-pay. To be clear, that does not mean that the wealthy will not pay more in actual dollars in taxes, simply that the taxes that they pay is the same percentage of their income as it is for the less wealthy. Regressive taxes decrease their effective

190  Research handbook on public financial management rates as ability-to-pay increases. In most cases this will not mean that the actual dollar amount declines, just the effective tax rate. This is shown in Figure 10.8. (See also Box 10.5.)

BOX 10.5 PROGRESSIVITY OF TAX STRUCTURES IN OECD NATIONS The approach to vertical equity varies greatly across OECD nations. First, when comparing tax revenue as a percentage of GDP there is quite a bit of variation. In France and Denmark, the rate is 46.2 percent and 46 percent, but in the United States the rate is 27.1 percent (Fox, 2019). Second, the highest overall marginal tax rates in Europe (including income taxes, social-security contributions, payroll taxes, and consumption taxes) also vary tremendously. Sweden has the highest rate (76 percent), and Bulgaria the lowest (29 percent) (Lundberg et al., 2019). These high marginal rates do not necessarily mean that the underlying tax structures are more progressive. In fact, it appears that most nations with high tax revenues as a share of GDP raise those revenues through more-proportional taxes. In 2017, Denmark had a top marginal tax bracket on the personal income tax of 55.8 percent, while the United States had a top bracket of 37 percent. It may appear that Denmark’s system was more progressive, but a taxpayer earning $77,730 a year in Denmark would have been subject to its top rate, whereas the top bracket in the United States did not apply to incomes of less than $510,300. Additionally, many nations rely heavily on consumption taxes, like the value-added tax (see Figure 10.1), which are regressive. Countries like Denmark and Finland have consumption-tax revenue that is almost 15 percent of their GDP (Fox, 2019). Therefore, many “high-tax” nations structure their systems less progressively and more proportionately by including more people in their bases and taxing them at similar rates. Vertical equity concerns explain a great deal of how many taxes are structured and rates are set. For example, the United Kingdom exempts children’s clothes and most groceries from its value-added tax (Gov.uk, 2020). Similarly, Canada exempts “basic groceries,” prescription drugs, and childcare services from its goods-and-services tax (Government of Canada, 2018).13 Such exemptions make consumption taxes less regressive and help to offset the tax burden on lower-income households. Applying equity principles to tax mix and structures often leads to exemptions in the tax base and taxing services, goods, and populations differently. Equity considerations may not only create inefficiencies but also raise concerns over the adequacy of the tax revenue.

ADEQUACY Adequacy refers to whether there are sufficient funds to finance government. As John Mikesell puts it, “a tax levied for revenue is worthwhile only if it can generate meaningful revenue at socially acceptable rates” (2016: 365). Adequacy of revenues is complicated and built on the normative understanding of how big (and costly) the government needs to be. There are three ways this chapter considers adequacy: revenue production, elasticity, and stability. First, it is important to understand the government’s underlying revenue-raising capacity, or what may also be called its fiscal capacity. Revenue-raising capacity is a term that is used to describe

Foundations of government taxation and revenue management  191 the hypothetical revenue a government could raise given its economic base (Musgrave and Musgrave, 1989).14 It depends in part on the jurisdiction’s underlying economic and demographic characteristics, such as population size, incomes, natural resources, unemployment, and industry. Any individual tax instrument will have a certain amount of potential revenue production (i.e., how much revenue it can raise given the jurisdiction’s fiscal capacity). Production often explains the tax instruments we observe in practice. For example, income, consumption, and property taxes all have broad bases and high yields – though the yields are heavily influenced by the jurisdiction’s fiscal capacity. Mikesell’s characterization attributes two qualities to adequacy, both of which are subjective. The first is “meaningful revenue.” There are actual and political costs to adopting new taxes and fees. A “good” tax or fee will raise enough revenue to make those costs worthwhile. The second quality is an “acceptable rate.” As discussed in the section on economic efficiency, excessive tax rates can actually lead to lower revenues collected as modeled in the Laffer curve. This is because the relationship between the effective tax rate and the revenue yield is not a linear one and cannot simply be understood as an accounting exercise – the tax is one of the factors that determines the tax base (Inman, 1992; Mikesell, 2016). Further, by keeping tax rates at reasonable levels, a government is ideally not taxing one part of the economy at a higher rate than another. Doing that would likely lead to substitution (efficiency losses) and vertical inequity (because similar taxpayers who were making different choices would be bearing different burdens). Tax elasticity is similar to the price elasticity described in the discussion of efficiency. Tax elasticity, or the elasticity of a tax to income, is the degree to which revenue from a tax or a fee is affected by changes in the economy, typically changes in personal or household income. The relationship is expressed in this formula: ​eT​  ​  ​=  _ ​  dTR / TR    ​ dGDP / GDP

Tax elasticity is expressed by eT, TR is tax revenues, and GDP is the jurisdiction’s gross domestic product.15 A tax is considered inelastic if the eT is less than one. The lower eT is, the less elastic the tax is. If eT is greater than one, then the tax revenue is considered elastic, meaning that a 1 percent change in the GDP leads to a greater than 1 percent change in tax revenue. The estimates of tax elasticities suggest that personal and corporate income taxes are the most elastic in the long term, while taxes on products like fuel and tobacco are the least elastic; consumption taxes and property taxes fall somewhere in the middle (Bruce et al., 2006; Mikesell, 2016; Bowman and Mikesell, 1983). Of course, some of this depends on the tax base. For example, if the consumption tax includes necessities such as groceries and clothing, then it will be less elastic than a consumption tax that excludes necessities (Hawkins, 2000). Often elected officials and other policy makers prefer elastic taxes. This is because they outpace economic growth, income growth, and inflation; they require few adjustments to the rate structure; and leaders do not have to make the unpopular choice of either raising taxes or introducing new taxes as the economy grows. This preference for elastic taxes is based on the assumption – frequently correct – that the economy will grow and is not in decline. During an economic downturn, revenues from elastic taxes fall faster than GDP and income, therefore short run stability is also a consideration. A revenue’s stability is its tendency to remain predictable and at relatively constant levels. Stable revenues are easier to forecast, and stability aides long-term budgeting and planning.

192  Research handbook on public financial management Stability over a business cycle is critical for governments that cannot borrow money to fund general operations, like state and local governments in the United States. Therefore, there are cases where the desire for elastic taxes that grow with the tax base and economy conflict with the desire for stable and predictable revenue streams. These competing preferences are one of the reasons many scholars advise governments to rely on a portfolio of revenue sources rather than relying on any one source too heavily; revenue portfolios often have both elastic and inelastic taxes, striking a balance between stability and growth. (See also Box 10.6.)

BOX 10.6 REVENUE DIVERSIFICATION Revenue diversification is defined by two features: reliance on multiple revenue sources and a lack of overreliance on any single revenue source. Typically advocates of revenue diversification point to modern portfolio theory, which suggests that stock portfolios are best managed by investing in stocks with low covariance (i.e., when one stock’s value declines, others continue to remain stable or to grow) (Markowitz, 1952). The same principle can apply to revenue portfolios: public servants may consider a mix of revenue instruments that are procyclical (i.e., that will grow during economic upturns) and, ideally, counter-cyclical (i.e., that will grow during economic downturns). Few revenue sources are counter-cyclical, however, so ones that are merely stable and inelastic may be more likely options. There is evidence that revenue diversification, typically measured by a Hirschman-Herfindahl Index, increases stability at the local level (Carroll, 2009; Carroll and Stater, 2009; Jordan et al., 2017).16 Similarly, a recent study found that the cause of much of the state-level revenue volatility since the turn of the century is due to changes to tax portfolios, the shift away from state-level property taxes to increased reliance on income taxes (Seegert, 2016). Many countries in the European Union (EU) rely on a mix of inelastic and elastic taxes – though most rely heavily on elastic taxes (Bunescu and Comaniciu, 2013). Only Luxembourg has highly inelastic taxes, though nations such as Denmark and Italy have taxes that are inelastic to some degree. The majority (sixteen out of the twenty-seven) have elastic taxes, with an overall elasticity of 1.2 or greater. Furthermore, EU nations tend to favor more inelastic taxes for social contributions and more elastic taxes for the indirect taxes (Bunescu and Comaniciu, 2013).

FEASIBILITY Taxes and fees should be assessed on their feasibility in two areas, administrative feasibility and political feasibility. A tax or a fee is administratively feasible if it can be collected easily and at low cost.17 The cost and ease of administration must factor in both the costs to government agents and the costs to firms and citizens. It is ideal to spend as little as possible on the collection and administration of taxes. For many taxes, less than one percent of the generated revenue is spent on administrative costs. For example, estimates of the cost of administration for income taxes average 0.75 percent of revenue collections, and estimates for value-added taxes range from 0.32 to 1.09 percent. This is in contrast to the estimate of the cost of administering gaming taxes, which is 5.9 percent of total revenues (Mikesell, 2016). A great deal of

Foundations of government taxation and revenue management  193 the variation in the cost of administering the tax (or fee) is who bears the burden. Many taxes are structured so that a great deal of the burden of collection is borne by taxpayers and firms. A prime example of the differences of administration is the income tax in the United States versus other countries like South Africa, Estonia, Sweden, Singapore, and Chile who have pre-filled returns for taxpayers. In the United States, taxpayers are required to calculate their own taxes by providing and applying all relevant information to their tax forms and remittance. There are estimates that the compliance associated with the income tax cost the United States economy $409 billion in 2016 alone, and almost $100 billion of those costs fall on individual taxpayers, who are responsible for preparing their personal income taxes (Hodge, 2016). In contrast, Slovenia’s prefilled tax returns offer immense savings on compliance costs. It is estimated that in 2000, Slovenia’s compliance costs were $32.1 million euros and dropped to $9.1 million euros in 2007, when its program to phase in prefilled returns was fully implemented (Klun, 2009). To minimize the administrative costs, governments should seek taxes and fees with low costs to government and low compliance costs to taxpayers.18 (See also Box 10.7.)

BOX 10.7 PROPERTY TAXES IN DEVELOPING COUNTRIES The property tax is often considered a “good tax,” and many scholars, economic organizations, and civic-oriented organizations encourage developing nations to utilize the property tax to a greater extent (e.g., Ali et al., 2017; Bahl, 2009; Kelly, 2013; Monkam and Moore, 2015). There is a great deal of literature that addresses why the property tax should be used more in developing countries and the challenges of its implementation, including feasibility. For the property tax to be an equitable and efficient tax, the administration of it must be sound. The administration has many elements, but some of the most fundamental are (1) a complete tax roll, (2) sound and up-to-date record-keeping practices, (3) valuation and revaluation processes, and (4) a system of collection, enforcement and appeals (Bahl, 2009). There are large administrative costs to getting a system in place, and many nations have struggled to do so. For example, it is estimated that in Chile half of new construction is not in the property-tax rolls and that in Kenyan municipalities the tax rolls only cover 30 to 70 percent of properties (Kelly, 2000). In a developing country, this issue can be exacerbated by a low collection ratio (i.e., the ratio of collections to liability). The collection ratio is as low as 15 percent in Macedonia and only around 50 percent in countries like the Philippines, Mumbai, and Montenegro (Guevara, 2004; Bahl, 2009). Of course, many of these administrative difficulties are also made worse by political pressures, which can lead to inequitable and inefficient exemptions for the politically powerful, a reluctance to do revaluations, and a reluctance to enforce the laws in place (Bahl, 2009). Political feasibility refers to the perceived likelihood that citizens are willing to tolerate the tax. The literature is either pessimistic or pragmatic (depending on your perspective) on the willingness of elected officials to adopt unpopular positions, including additional taxes and tax increases. Political feasibility often increases under certain conditions. First, earmarking tax revenues for popular programs may increase their political feasibility (Buchanan, 1963; Bowman et al., 1992; Crowley and Hoffer, 2012). Second, less-visible taxes are generally more popular. Citizens often do not realize their full tax burden. If they are unaware of the cost of a new tax, they are less likely to reject it. The fiscal-illusion hypothesis proposes that

194  Research handbook on public financial management policy makers intentionally mislead the public by exaggerating the benefits of public services and obscuring the costs (or tax burden) of the public sector (Puviani 1903; Wagner, 1976). Whether this lack of awareness is intentional or not, the literature on fiscal illusion theorizes that some public-finance practices are more illusory.19 The three primary mechanisms that create fiscal illusions are the high cost of accurate information on tax burden for individuals, the division of the burden into multiple payments over time, and the use of multiple tax instruments (Pommerehne and Schneider, 1978). Third, the ability to export the tax burden to nonresidents makes taxes and fees more popular, or at least less objectionable. For example, many studies of local (county and municipal) sales taxes in the United States have found that the ability to export sales-tax burdens to nonresidents increases the likelihood that a jurisdiction will adopt a local sales tax – and the speed with which it is likely to do so (Sjoquist et al., 2007; Burge and Piper, 2012; Afonso, 2018b). This is meaningful because the structure of these taxes requires voter approval. (See also Box 10.8.)

BOX 10.8 THE CASE OF MEXICO Mexico has the lowest tax collection of all OECD members (18 percent of GDP, compared to an average of 33 percent among OECD countries). Mexico is low even among Latin American nations (OECD, n.d.; CEPAL, 2010; World Bank, 2013). Mexico has made many strides toward improving its tax administration, utilizing advancements in technology, but there are many issues remaining – especially at the local level. A World Bank report asserts that: many small and medium-size municipalities suffer from low institutional and administrative capacity, and local tax collection teams lack the tools, training, and systems to implement corrective actions related to key tax administration functions (tax revenue collection, enforcement, and audits). Subnational governments need incentives and assistance to improve their tax administration to increase own revenues. (World Bank, 2013: 3)

Furthermore, Mexico continues to undermine its tax capacity by having numerous and broad tax exemptions (World Bank, 2013). These administrative weaknesses have led to poor collection rates, inequities, volatility, lack of faith in the system, and uneven service delivery. Though, a recent study of Mexico City suggests that increasing tax rates rather than enforcement efforts to raise revenue is welfare-maximizing (Brockmeyer et al., 2021).

TRANSPARENCY There are numerous ways to approach transparency when structuring tax policy. At one end of the spectrum, international efforts are underway to increase the transparency of taxes on corporations in order to mitigate tax avoidance and evasion by international firms (Garde and Bhatia, 2018). On the other end of the spectrum, there are tax systems in which individual taxpayers understand their tax burdens and how their taxes are being used. In general, tax transparency can be assessed in three ways: (1) adoption, (2) administration and compliance requirements, and (3) clarity of the tax burden (Mikesell, 2016). A transparent process for the

Foundations of government taxation and revenue management  195 adoption of taxes involves open legislative processes and clear laws. Similarly, transparent administration calls for the rules surrounding assessment, collection, and remission of taxes to be unambiguous and evenly applied. Taxpayers should understand their burden, including the burden of individual taxes and fees, as well as which levels of government are levying which taxes.20 These are all challenging to accomplish because of complications such as “rational ignorance” on the part of taxpayers (Downs, 1957), complex revenue systems, and overlapping jurisdictions levying the same tax. For example, two of the primary taxes imposed by most nations are income taxes and consumption taxes (retail-sales taxes or value-added taxes).21 In many nations, more than one level of government levies these two tax instruments. In the United States, there is a personal income tax at the federal level, the state level (in most states), and in some states, the local level. It is not necessarily clear to citizens how much of their taxes are going to each government. This opaqueness is only exacerbated by income tax withholding, which already obscures the burden of personal income tax.22 There are similar issues with value-added taxes in many countries. In Canada, there is a national value-added tax as well as provincial (subnational) value-added taxes.23 In Quebec, the combined rate is 14.975 percent as of winter 2021, with 5 percent being the national value-added tax and 9.975 percent being Quebec’s provincial value-added tax. In all but one of the other provinces, there is either only the 5 percent national rate or there is a 15 percent harmonized rate combining the national and provincial rate. Furthermore, some provinces have provincial sales taxes that are excise taxes, and Ontario has its own retail-sales tax in addition to the value-added tax (Ad Valorem, 2021). This system of consumption taxes makes the transparency of the tax burden (the amount, the levying government, and the tax instrument itself) much lower than a single value-added tax would, and Canada’s tax structure is actually a simplification of the structure it used to have (Bird, 2000).

CONCLUSION Sound public financial management requires healthy, reliable, and “good” tax policies and revenues. However, assessing what is good can be a challenge that is fraught with normative assessments, competing values, and legal or practical restrictions. This is why it is critical to understand the criteria used to evaluate tax policies. This chapter presents five basic ways that scholars, practitioners, and taxpayers can evaluate tax policy: economic efficiency, equity, adequacy, feasibility, and transparency. There is a great deal of overlap and interaction between these five criteria, and often there are numerous trade-offs when policy makers must decide which criterion to prioritize over another. An excellent example of these trade-offs are excise taxes on cannabis. In the United States both state and local governments levy cannabis taxes. From an efficiency perspective, you would expect the cannabis taxes to tax all goods containing THC to maximize the tax base. However, in many states medical marijuana is excluded from the tax base to make it a more equitable tax. This choice makes the adequacy of the revenue smaller and likely encourages more people to apply for prescriptions for medical marijuana. It also, likely, leads to higher tax rates for recreational marijuana which may lead consumers to substitute it with other products such as alcohol. Relatedly, cannabis products are often subject to high taxation, which further distorts the market creating deadweight loss but also may perpetuate illegal sales of cannabis products. Furthermore, cannabis taxes are

196  Research handbook on public financial management regressive and volatile (Pacula and Lundberg, 2014; Becker, 2019), though they may help reduce negative externalities and internalities related to THC consumption. Thus, the policy choices around tax rates and tax base have important impacts on efficiency, equity, adequacy, and the fact that in many states both state and local governments levy cannabis taxes lead to reduced transparency as well. Unfortunately, there is not a simple answer to any of these questions and considerations but understanding the choices and being able to analyze their ramifications is the first step towards revenue management. Moving forward it will be critical to continue to understand and assess the quality of our primary revenue instruments like income, property, and consumption taxes, and to also understand how changing administration, policies, and structures may impact these revenues. For example, in a recent study it was found that racial minorities in the United States face higher property tax burdens than white taxpayers for the same level of public services (Avenancio-León and Howard 2022) and similarly another study has found that property tax assessments tend to over-value low-priced properties and under-value high-priced properties increasing the regressivity of the property tax in its administration (Berry, 2021). Research and scholarship must continue to examine efficiency, equity, and the other criteria presented here with the new methodologies and data that become available. It is also critical to examine new revenue sources added to public revenue portfolios like sugary beverages taxes, wealth taxes, stock transfer taxes, and gross receipts taxes on digital advertising and business services and to have informed conversations about tax policy.

NOTES 1. This chapter focuses on taxes but will discuss fees periodically. It is important to be mindful of the difference between taxes and user fees. Taxes are not considered voluntary, but user fees are. Of course, some fees are more avoidable than others. For example, park-facility rentals are more easily avoided than water bills. 2. It should be noted that these are not universally agreed upon criteria, nor are they always presented or bundled in this way. 3. These are based on the traditional Marshallian measures of excess burden. For a more nuanced discussion of other ways to measure excess burden, see Auerbach and Hines (2002). 4. In contrast, elastic demand with an ep of greater than one suggests that consumers are very sensitive to price and would reduce their consumption in response to a price increase, leading to more deadweight loss. 5. An excise tax is a tax that is levied on a specific good. Common excises taxes are fuel and tobacco taxes. 6. For more information and a review of the current literature, see Afonso (2023). 7. Chetty (2009) presents an excellent analysis of deadweight loss by examining Feldstein’s (1999) taxable income formula for calculating deadweight loss and updates it to include income elasticities, sheltering income, and other potential changes to behavior. 8. There are also positive externalities, where a third party receives a benefit from a transaction that it was not involved in. In those cases, the government will often subsidize the relevant behavior rather than imposing taxes. 9. A tax like the sugary beverages tax is also regressive leading to equity concerns (Kane and Malik 2019) and since it often does not tax naturally sweetened beverages such as fruit juice, it may simply shift consumption of sugar from one beverage to another. 10. The average fuel tax in an OECD country in 2017 was $2.24 a gallon (OECD, 2018: 152), with only Mexico having no fuel tax. However, there is evidence that OECD countries have different and higher fuel taxes than developing nations (Bahl and Bird, 2008).

Foundations of government taxation and revenue management  197 11. This relationship between consumers of fuel and roadways has become strained as vehicles, especially expensive vehicles, have become more fuel efficient. 12. This is not including standardized deductions or exemptions that many people would have in place, which would lower their effective tax rate even more. 13. These are simply examples. Both countries have other exemptions to their consumption taxes. 14. An important additional consideration is the revenue-raising effort, which is the actual revenues as a percentage of fiscal capacity. 15. Often tax elasticity will also be measured against income. 16. There is also mixed evidence on the impact that revenue diversification has on fiscal policies (e.g., Carroll, 2005; Shi and Tao, 2018; Hendrick and Degnan, 2020). Though one recent study found that tax diversification decreases fiscal health as measured by budgetary solvency and non-tax revenue diversification increases it (Jimenez and Afonso, 2022). 17. A fee for bad thoughts, for example, would not be administratively feasible (though it might have political support) because the government would not be capable of administering it. 18. For a through overview of the compliance costs and estimates of those compliance costs internationally, see Eichfelder and Vaillancourt (2014). 19. See Afonso (2014) for an overview of the fiscal-illusion hypotheses and the public-finance literature. 20. Transparency is another area where the fiscal-illusion literature is especially applicable. 21. The value-added tax is in place in 170 countries and territories and is much more common than the retail sales tax (OECD, 2021b). In fact, the United States is the only country to have a retail sales tax and not a value-added tax. One reason for the preference of value-added taxes over retail sales taxes is the ability to avoid business to business transactions. For a through overview of the value-added tax, see Charlet and Owens (2010). 22. Milton Friedman was one of the architects of the US system of withholding federal personal income taxes as a way to support wartime spending. He is quoted as saying, “I have no apologies for it, but I really wish we hadn’t found it necessary and I wish there were some way of abolishing withholding now” (Doherty, 1995). 23. Canadian provinces can set not only the rate of their value-added tax but also a separate tax base, which leads to additional compliance costs for vendors and firms. These separate tax bases increase the complexity tremendously and are critical to understanding policy changes and economic nexuses (Afonso, 2019).

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11. Tax revenue management and reform in the digital era in developing and developed countries Jorge Martínez-Vázquez, Eduardo Sanz-Arcega and José Manuel Tránchez Martín

INTRODUCTION The aim of this chapter is to offer a survey of best practices across tax administration systems in developing and developed countries, with a particular focus on extracting lessons for improving efficacy and efficiency on revenue collection and enforcement performance. The chapter puts a special focus on the deep challenges and meaningful opportunities that globalization and the digital era have brought to tax enforcement. The fundamental role of tax administrations across the globe is to raise tax revenues according to existing tax laws. An effective tax system is crucial for both developing and developed countries alike, since adequate revenue collection is an important determinant of economic growth (Matthews, 2011; Arnold et al., 2011; Akgun et al., 2017a), and is highly connected to firms’ performance (Dabla-Norris et al., 2017; Bergner et al., 2017). Moreover, in the case of developing countries, an effective tax system is also a decisive contributor to successful state-building (Fjeldstad and Moore, 2007). Three paradigms stand out as the most widely shared models for tax authorities across the globe in recent times: the enforcement paradigm, the service (or facilitation) paradigm, and the trust paradigm (Alm, 2012; Prichard et al., 2019). The first and most traditional, enforcement, prioritizes auditing and “catch and punish” activities, while the second places more weight on facilitating compliance through better information and lower compliance costs, sometimes overlapping with the third, in which emphasis is placed on building citizens’ trust in the system to reinforce voluntary compliance. All these paradigms have their own benefits and drawbacks, and are frequently best used in combination, which can significantly contribute to more efficient collections and overall higher compliance levels. This has been confirmed in recent empirical studies and laboratory experiments (Alm, 2012; Kasper and Alm, 2020). Moreover, the combined effects of these paradigms not only improve enforced compliance but also strengthen voluntary compliance, generate social and political support for fiscal reforms, and produce stronger fiscal contracts. This modern view of tax administration is being incorporated in recent tax administration reforms, such as in the case of the UK’s HMRC (HMRC, 2021). Whichever paradigm(s) is(are) prioritized by a given system, the overall efficiency and effectiveness of any tax administration also depends, not surprisingly, on its specific institutional design and organizational structure, making such design a fundamental issue meriting review and improvement. Ultimately, “tax administration is tax policy” (Casanegra de Jantscher, 1990). However, even the effectiveness of the best institutional design is also significantly conditioned by tax 202

Tax revenue management and reform in developing and developed countries  203 laws. Complex tax laws make the role of tax administration harder in terms of costlier enforcement processes, more extensive and expensive taxpayer services, and increased taxpayer compliance costs. These latter factors tend to negatively affect voluntary tax compliance and there is evidence that they can even lead to higher rates of tax fraud (Pyle, 1993; Bird, 2004; Blesse, 2021). Therefore, the simplification of tax laws is always the first and most important measure to improve tax administrations’ efficiency and effectiveness. At the same time, several recent global trends are also significantly affecting the effectiveness of tax administrations, some of which have been exacerbated by the COVID-19 crisis. The combined pressures of globalization and technological change, the growing importance of data management and the renovation of economic activities under digitalization all force a transversal rethinking and deep restructuring of business models and, as a consequence, of tax administrations themselves. Perhaps more than ever, tax administration in the era of digitalization will need to rely on financial sufficiency and managerial efficiency (Alm and Duncan, 2014). Digitalization tends to facilitate tax enforcement technology by enabling the collection of more reliable information on the economic activities of taxpayers. It can also help improve the equity-efficiency trade-off by enabling the implementation of tax measures that better target income redistribution. The potential dividend of these technological improvements is that digitalization may allow governments to lower tax rates to collect the same amount of revenue with a more effective distributional impact. From that overall perspective, it is likely that, in the near future, tax administrations will have to reorient their budgets toward larger capital expenditure to support the digitalization of tax services. At the same time, it will be necessary to increase investment in human capital to prepare existing staff for the technological challenges ahead. For obvious reasons, both physical and human capital investments will be a disproportionately large challenge for developing countries (Forum on Tax Administration, 2021). However, these deep changes of design aimed at achieving a more digitalized tax administration must be carried out in a rationalized and gradual manner over time, avoiding practices that may affect the effectiveness and efficiency of the administrative operation.1 In addition, it should not be forgotten that the digitalization process affects not only the public sector, but also the private sector. As shown by Gupta et al. (2017), digitalization may foster stronger tax avoidance and evasion and raise other behavioral responses to taxation, such as through more aggressive tax planning. All this could also raise the efficiency costs of taxation. Tax administration reform must take into account these dynamics in the private sector in order to adapt to them and provide adequate responses. In light of these changes, future assessments of tax administrations’ performance should emphasize pathways for improving new performance-core activities, such as strategic management, operational performance, and organizational structure (Crivelli, 2019). Accordingly, it is wisest for the shapers of tax policy to understand tax authorities’ budgets as an investment, rather than an expense (Sarin and Summers, 2020), even though a wide array of improvements requires no more than “political commitment to overcome vested interests among taxpayers, politicians and tax administrations themselves” (Moore and Prichard, 2017: 20). Finally, it must be pointed out that successful tax administration reforms, in a similar way to tax reforms, need adequate attention to both substance (“what to do”) and process (“how to do it”) (Bird 2008). A recent review on the past experiences with tax reform both in developing and developed countries shows a large catalogue of political economy factors leading to

204  Research handbook on public financial management successful tax reforms that can be also used for tax administration reforms (Martínez-Vázquez 2021).2 This list includes factors relating to (a) the necessary preconditions to facilitate reforms, (b) the correct choice of how reforms should be carried out, and (c) the right timing for the reforms. Specifically, in relation to tax administration reform, some of the factors that should be highlighted include: strong political leadership committing to reform at the highest level, enabling and strengthening institutions charged with the actual process, reducing or eliminating corruption to strengthen credibility of the process, the presence of a social contract that brings support from all political parties, aligning the support voters and interest groups, and, where pertinent, attracting external support by international organizations and bilateral country agreements facilitating technical assistance and financial support.3 This chapter provides an overview of the main trends in tax administration, aggregated into three large groups of initiatives that cope with the main challenges tax authorities face in order to enhance compliance: tax enforcement measures, taxpayer services, and efforts to increase voluntary tax compliance or tax morale. These three types of initiatives, if well designed and managed, have the potential to reinforce each other and produce even greater effects (Akitoby et al., 2018; Prichard et al., 2019; CIAT/IOTA/OECD, 2020). This chapter is organized as follows. In the next section, we offer an overview of successful tax administration reform in the twenty-first century under the enforcement, service, and trust paradigms. The following section devotes its attention to modern tax administrations’ organizational challenges. The final section highlights the main conclusions and lessons.

SUCCESSFUL TAX ADMINISTRATION REFORM IN THE TWENTY-FIRST CENTURY A Roadmap of Best Practices Under the Enforcement and Facilitation or Service Paradigms Tax enforcement is a worldwide challenge and is especially so in environments where both evasion and corruption traditionally have been above average (Chander and Wilde, 1992; Moore and Prichard, 2017). At the same time, the improvement of taxpayer services in order to lower compliance costs goes hand in hand with improving overall compliance.4 In the digital and globalized era, both paradigms (combined) offer deep challenges and significant opportunities for tax administrations to improve their efficacy and efficiency in revenue collection; generating research to facilitate the adoption of evidence-based tax policies is increasingly crucial (Lundberg, 2017; Moore, 2019). To review the most successful practices underway, this section follows a structure based on the main areas that comprise tax administrations’ operational tasks. In doing so, we aim to provide evidence about the links between enforcement, facilitation, and trust initiatives throughout the whole range of operational processes that define tax administration. Registration and identification A high-quality taxpayer registration and identification system is crucial for optimal tax system performance. In the digital era, tax administrations need sophisticated tools to record information about taxpayers, withholding agents, and third parties that provide information about the activity and transactions of other taxpayers. Thus, although traditionally channels

Tax revenue management and reform in developing and developed countries  205 for registering and identifying taxpayers have been taxpayers’ voluntary tax return-filing and withholdings, registrations performed by other governments agencies within the same country or by other tax administrations in foreign countries are growing sources for tax administrations to identify potential taxpayers and gain access to taxpayers’ information (OECD, 2019a). Moreover, cooperation between different government agencies plays an increasingly important role for the improvement of tax administration operations. One of the best practices to improve taxpayer registration is the use of multichannel systems, allowing taxpayers to register in person, online, or through mobile apps. What is more, this process can offer taxpayers simultaneity in their actions, allowing registration for multiple taxes at the same time or allowing both registration and payment. This system is gaining significant prominence and wide uptake; the 2020 wave of the ISORA survey5 indicates that more than 80 percent of the tax administrations surveyed use multichannel registration systems, a large share of the tax administrations consulted allow simultaneity, and only a few of them obligate users to activate separately registration and payment (OECD, 2021b). Another important practice with high uptake that many tax administrations have focused on is establishing a unique taxpayer identification number (TIN). To increase compliance, in some countries, holding and providing this number is mandatory for obtaining permits such as driver licenses and passports, thus forcing potential taxpayers to register (Martínez-Vázquez, 2021). In the same vein, another innovation to facilitate registration is maintaining current accounts between tax administrations and taxpayers that allow articulating the flow of receipts and payments between both (Martínez-Vázquez, 2021). The above being said, one well-established vehicle to enhance the registration function is the use of tax withholding through the collaboration of third parties (employers, banks, sellers, etc.). In the withholding context, the main innovations of late include: (1) advances in data processing systems, allowing the strengthening of withholdings calculations; (2) increasing use of electronic invoices as a mandatory system for recording sales, allowing improved information in the transactions for most consume taxes (Bellon et al., 2019); and (3) the requirement for sellers of goods and services to record their operations through electronic fiscal devices or duly certified cash registers (Pomeranz, 2015).6 An important challenge tax administrations face is ensuring the veracity of taxpayers’ identities and of the information provided by them. Ensuring a taxpayer’s true identity not only guarantees their rights but also avoids possible fraud. To tackle this issue, most innovative advances in tax administration performance are in the development of multi-step identification procedures and the use of biometric identification factors. In this regard, tax administrations are also improving procedures to prevent the theft of tax identities or taxpayers’ tax data that could subsequently be used fraudulently to obtain tax refunds or access to tax credits (OECD, 2019a). Digitalization and globalization have caused an unprecedented growth in the share of economic activity carried out beyond national borders. Multiple businesses models allow companies and even individuals to generate income or carry out consumption operations beyond their countries of residence, including multinational companies’ activities, online commercial activities, use of sharing economy platforms, and so on.7 Tax administrations face the challenge to capture information flows about these kind of activities beyond national borders. Different international cooperation agreements have been implemented in order to address these challenges (OECD, 2019a). The following such compacts are worth mentioning:

206  Research handbook on public financial management 1. The European Union’s Electronic Identification Authentication and Trust Services (EIDAS) agreement, which set out procedures to capture information flows and manage identity and registration issues across borders. 2. The Common Reporting Standard (CRS) which sets out the basis for countries to obtain information of fiscal interest from their financial institutions and which can be automatically exchanged with other countries. The CRS sets out the financial account information to be exchanged, the financial institutions required to report, the different types of accounts and taxpayers covered, and the common due diligence procedures to be followed by financial institutions. Assessment: information, filing tax returns, and payment A key phase in a tax administration’s operational process is the so-called “tax assessment” function. It refers to all activities aimed at ensuring that taxpayers collect the necessary tax information to file their taxes, correctly file their tax returns, and make subsequent payments of their tax liabilities. Traditionally, the burden of these activities has been on the taxpayer, which resulted in high compliance costs – tax information collection, accounting bookkeeping, filing tax returns and payments, etc. (Benzarti, 2020). In the digital and globalized era, third parties’ support is increasingly becoming crucial to tax administrations, in a similar way to the role traditionally played by withholding. For example, in EU countries, the financial system usually provides information to tax administrations on taxpayers’ bank account transactions, mortgages or savings, all of which serves to fight tax evasion, and also serves to administer the pre-filling of tax returns, where that is practiced (Artavanis et al., 2016). Moreover, especially for the self-employed and smaller companies, it has been common to count on the help of tax advisors to help with their compliance (Durán and Esteller, 2020). At the same time, tax administrations have collaborated with taxpayers by providing them with a variety of assistance instruments, either for the collection of relevant tax information, for filling tax returns, or for quicker payment of tax debts. The best practices followed by tax administrations to gain efficiency regarding different operations in this phase are related to information collections, filing, and payment, as follows. Collecting information: Regarding the collection of relevant tax information by taxpayers, tax administrations have developed multi-channel taxpayer assistance systems (face-to-face / telephone assistance / online assistance) in order to facilitate taxpayers’ tax compliance. Although, on average, the main channel of assistance is the use of telephone, in the case of higher-income countries there seems to be a growing use of digital assistance channels (email, information from websites and digital assistance applications), complementing or replacing traditional channels such as face-to-face or postal mail exchanges (Moore and Prichard, 2017; Moran and Diaz de Sarralde, 2021).8 A growing number of countries also have introduced digital applications that provide taxpayers with their tax data for proper tax compliance. This trend to expand the availability of digital channels to taxpayers has been accelerated since the irruption of the COVID-19 pandemic. Additionally, some tax administrations are exploring the use of artificial intelligence (AI) such as virtual assistant automatic response systems, chatbots, or tools and simulators on websites to strengthen this type of taxpayer assistance. For example, the Australian Tax Office (ATO) introduced “Alex,” a virtual assistant responding to information requests by taxpayers; the Norwegian Tax Administration (NTA) developed a digital tax calculation tool for personal taxpayers, integrated on the NTA website; the Kenya Revenue Authority (KRA) is implement-

Tax revenue management and reform in developing and developed countries  207 ing the Customer Relationship Management (CRM), a global platform that collects inquiries, service requests, complaints and compliments and provides a single view of taxpayers’ interactions with the KRA; and last but not least, the Canada Revenue Agency (CRA) offers multiples services, such as the “Auto-fill my return” that support taxpayers to fill their income tax returns with data already available to the CRA (OECD, 2021b). Filing process: The filing of tax returns by taxpayers has also evolved with technological changes, and physical filing has been progressively replaced by online channels. This change has meant big savings for tax administrations via reducing costs caused by face-to-face taxpayer assistance. What’s more, these changes have also vastly improved the percentage of filings in term, that is, tax returns filed correctly and in a timely fashion (Moore and Prichard, 2017; Alm et al., 2020a).9 In the same vein, great progress has been made in the development and improvement of taxpayer services, creating understandable and simpler forms with clearer information, improving phone assistance services and website instructions, and assisting in filing returns and paying taxes (Martínez-Vázquez, 2021). As an illustration, based on data provided by third parties, a successful measure that has led to a significant reduction in taxpayers’ compliance costs has been the introduction of pre-filled returns by some tax administrations (Junquera et al., 2017; Moore and Prichard, 2017; Benzarti, 2020; Moran and Diaz de Sarralde, 2021). This innovation significantly facilitates taxpayers’ compliance since taxpayers only have to review the information provided in the pre-filled return and confirm its accuracy or claim any errors with the tax administration. The success of these procedures has been based on the possibility for tax administrations to access a significant volume of electronic information offered by third parties. This fundamentally requires a legislative framework supporting the third parties’ obligation to offer accurate and in real time information on the taxpayers. Initially, this approach has focused on personal income taxes and for taxpayers in simplified tax situations or regimes, where the tax administration can reasonably have all, or almost all, relevant tax information. However, advances in data analytics and greater possibilities of sharing information between entities facilitate the further development of this approach. Thus, for example, there are countries, such as Portugal, where the pre-filling of income tax returns is almost universal and entirely automatic for taxpayers; the current system has made it possible to even enter information on tax deductions, benefits, expenditures on health and education, etc. that previously were difficult, if not impossible, to capture by the tax administration. Additionally, the growing use of electronic invoicing anticipates new possibilities to extend the pre-filled returns approach to other significant tax instruments, such as corporate income tax or value added tax (Bellon et al., 2019; Moran and Diaz de Sarralde, 2021). Payment: Tax administrations have also made significant improvements aimed at expanding taxpayers’ payment options. This not only reduces compliance costs, but it also decreases the tax administration costs associated with managing arrears and outstanding debts. The principal option to facilitate this last step in tax compliance has been to expand payment channels. Initially, besides the traditional direct payment at collection at tax administration’s offices, payments were extended through financial entities. In recent years, these systems have been improved with greater possibilities for online payments, either directly to the tax administration or through financial intermediaries and adding credit cards, mobile applications, personalized quick response (QR) codes, or other methods (Moore and Prichard, 2017; Alm

208  Research handbook on public financial management et al., 2020a). These innovations for enhancing tax payment through the expansion of allowed channels has resulted in significant improvements in on-time payment indicators.10 Verification, control and audit The “verification and control” function is a main part of tax enforcement. It includes all actions undertaken by tax administrations to verify that the information provided by taxpayers and third parties is accurate and that tax returns and payments have been correctly executed. The importance of this function is twofold. First, empirical evidence shows a positive correlation between larger controls and tax audits with increases in tax collections (Keen and Slemrod, 2017; Kasper and Alm, 2020). Second, verification and control is also crucial to support voluntary tax compliance, to the extent that taxpayers tend to be more prone to such compliance when they perceive that their tax administrations are committed to pursuing fraudulent behaviors (Beer et al., 2019). Because there are typically large numbers of taxpayers and because careful audits tend to be expensive, the verification and control function has evolved in two directions. On the one hand, there are extensive controls, applied to the whole or a large number of taxpayers, aimed at verifying the accuracy of the information provided by taxpayers with other data that tax administrations can collect themselves. These controls are supported with instruments such as “information cross checking” or “information provided by third parties” and are applied in discriminating ways to groups of taxpayers depending on the economic sector of their activity or the taxpayer category (large taxpayers, self-employed, etc.). On the other hand, tax administrations carry out intensive controls in which some groups of taxpayers are selected for deeper controls and integral tax audits. Several criteria have been traditionally employed for taxpayers’ segmentation in order to identify who should be subject to those intensive controls; those include the economic sector in which they carry out their activity, the category of the taxpayer according to the volume of collection that they should contribute, changes in the path of taxpayer behavior, information supported by the “International Exchange of Information,” etc. This segmentation of targeted taxpayers for deeper tax audit has normally been supported by “risk management models” that evaluated the probability of individual taxpayers or groups of taxpayers being more or less noncompliant. In recognizing the contribution of the tax audit function to increasing tax collections, some differences in performance and results can be highlighted between developed and non-developed countries. In developed countries tax systems work on highly formalized economies with stable and well-identified sources of employment, income and consumption, and transparent financial reporting systems. This leads to generally broader tax bases, ensuring lower levels of tax avoidance. In addition, a rather extensive coverage of third-party information reporting ensures lower levels of tax evasion (Kleven, 2014). Therefore, tax audits are usually more targeted and segmented towards certain groups of taxpayers and they are less prominent in contributing to tax collections. In contrast, in developing countries economic activity is generally less formal, tax bases (income, consumption, and wealth) are relatively narrower, and information supported by third parties is less effective due to shortcomings in withholding and information systems (Moore and Pichard, 2017). As a result, tax audits are clearly more salient in yielding additional revenue mobilization.11 To show best practices followed by tax administrations to improve the control and audit function, we can distinguish between two large groups of initiatives: taxpayer monitoring and improvements in tax administration performance, and improvements in information collection.

Tax revenue management and reform in developing and developed countries  209 Taxpayer monitoring improvements: Better access to taxpayers’ information by tax administrations is a key element to strengthen tax enforcement. Only by having access to information on taxpayers’ income, wealth, and consumption patterns can tax administrations effectively carry out the tasks of control, inspection, and fighting against tax evasion. Thus, technological change and digital developments in society at large have facilitated significant improvements in the task of monitoring taxpayers. First, technological improvements, with new instruments such as “cloud computing,” have exponentially increased the possibilities for storing and managing financial and tax information data, gathered either from the taxpayers themselves or from third parties. Second, technological advances have brought an unprecedented development in multiple instruments used by tax administrations to collect information from third parties both public and private. This yields not only a greater ability to know the amounts individuals’ incomes and companies’ profits, but also improves the knowledge of sales and operations developed between companies (Carillo et al., 2017). Similarly, the extensive use of credit cards and smartphone applications to engage in commercial activity generates a significant amount of information, leaving a digital footprint that allows an administration to follow the taxpayer’s activities and verify the accuracy of their tax reports (Alm et al., 2020a; Alognon et al., 2021). As an illustration, regarding indirect taxes, the extension of the electronic invoice and the introduction of mandatory regulated cash registers are leading to more effective control of commercial operations (Pomeranz, 2015; Bellon et al., 2019; Moran and Diaz de Sarralde, 2021). Regarding wealth taxes, better online access to information from property cadasters has led to better valuation of properties for tax assessments even as it also enhances the possibility of analyzing large datasets on real estate transactions to improve control on these sources of wealth (De Mello and Ter-Minassian, 2020). Finally, the implementation of sensors connected to public services can allow greater administrative control over their use by citizens and expand the possibilities of applying fees on users (De Mello and Ter-Minassian, 2020). Additionally, technological change has increased options to manage and share data that is already collected and held by governments. Some of these improvements include the development of data sharing across divisions within tax administration departments or even with other public agencies (Moore and Prichard, 2017; Alm et al., 2020a). A deserved special mention in this vein is the improvements developed in the field of international information exchange that have made it possible to overcome the logistical barriers that existed to sharing information in the international arena (Alm et al., 2020a; OECD and World Bank, 2018). Finally, it is worth considering that advances in data science and artificial intelligence have made possible new tools operating in real time that allow tax administrations to generate automatic reviews of tax returns and other tax information submitted by taxpayers. In doing so, many tax administrations are increasingly using “automated machine actions” that offer taxpayers automatic responses using rules-based approaches (e.g. automatically denying a claim, issuing a letter asking for more information or an additional tax return, etc.). These “automatic tools” are allowing administrations to review large quantities of data and develop verification or matching actions more efficiently than traditional “desk-based verification reviews.” For example, the Netherlands’ tax administration has developed an application based on Natural Language Processing technology in order to offer a faster and more accurate response to the simplest queries and a deeper human attention to more complex cases. The Spanish tax administration is using the so-called Automated Attachment Procedure that segments debtors into

210  Research handbook on public financial management five categories, considering the amount of debt and the complexity of the tax filing, and determining the most appropriate approach for outstanding debtors (OECD and World Bank, 2018). Tax administration performance improvements: Along with improvements in taxpayer monitoring, other important measures include developments to expand the tax administrations’ audit capacity while reducing opportunities for tax evasion and avoidance. One of the main measures aimed at optimizing the resources dedicated to audit tasks has been the use of risk selection models for better identifying cases meriting deeper audit. Risk-based audit models classify taxpayers by assigning them a score or value according to whether they are more or less likely to have noncompliance risks associated with their tax obligations. This risk assessment is typically carried out by analyzing the role played by different taxpayers’ features and characteristics. Technological advances have allowed relevant improvements in this approach. First, advances in data analytics have made it possible to improve the risk prediction models that are used to select those groups of taxpayers that should be subject to greater controls and tax inspections (OECD, 2016). Second, artificial intelligence (AI) developments have paved the way for machine learning models that generate tools capable of anticipating possible fraudulent behaviors based on past trajectories (De Mello and Ter-Minassian, 2020).12 Finally, the development of blockchain technology anticipates possible developments for better control of the operations carried out by all kinds of taxpayers (Alm et al., 2020a).13 Complementarily with technological developments, wider legislative frameworks have also been strengthened to encourage tax collectors in their audit tasks. However, there are differences according to the type of powers granted and the structure of different tax administrations. According to ISORA data for 2019, most tax administrations surveyed have been given broad powers to request information for tax purposes from both taxpayers and third parties without consent or court warrant. Likewise, there are tax administrations that themselves have powers to carry out registration operations, while others have to request them from the holders of judicial powers. However, when it comes to taking actions “without consent or court order,” the picture is more mixed, because citizens’ rights might be challenged by such actions. More than 60 percent of the administrations surveyed state that they have the ability to enter commercial premises, slightly less than half have the power to seize documents, but only 5 percent claim to have the power to enter the taxpayer’s home without consent or court order (OECD, 2019a). Collections Over recent years, tax administrations have developed great improvements in taxpayer assistance instruments for filing tax returns and paying tax liabilities, all of which have contributed to generally achieving better collection indicators. However, it is still quite usual in the international practice to find abundant cases of outstanding tax returns, tax arrears, and outstanding debts. One of the main strategies is a preventive approach, focusing on developing measures to prevent tax debt arising in the first place. This approach enhances, on the one hand, all those measures aimed at strengthening taxpayer information and assistance services, by facilitating the filing and payment by those taxpayers who are willing to do the right thing but are not always able to do it. On the other hand, tax administrations are developing empirical experiments, fundamentally based on the methodological advances offered by behavioral economics, for trying to investigate reasons why taxpayers are late in filing and paying and identifying what types of actions can encourage better compliance. For this approach, taxpayers’ fiscal

Tax revenue management and reform in developing and developed countries  211 trajectories are analyzed to identify trends and possible anomalies in behavior, as well as studying the operation of the incentive system that conditions behaviors (OECD, 2016, 2019a; Andersson et al., 2021). A second strategic approach to reduce debt accumulation is to strengthen taxpayers’ assistance programs to support them in the correct managing of tax debt or payment, as well as to facilitate taxpayers’ compliance (OECD, 2019a). Illustratively, many tax administrations do have instruments aimed to facilitate management of outstanding debts, such as the formulation of payment agreements, the possibility of offsetting debts with tax refunds of other taxes, the possibility of demanding tax settlements to receive subsidies or to contract with government, and the reduction of interest or other penalties on taxpayers. Additionally, other measures that also serve to enhance compliance and diminish tax debt arrears are being used, including: the use of third-party collection via banks and employers, garnishment orders over salaries and property, withholding government payments to tax debtors, collecting disputed tax while the disputed cases are under administrative review, and collecting tax arrears through agreements with other tax administrations. A third approach is made up of measures aimed at enforcing the payment of debts (OECD, 2019c). In this regard, tax administrations use many different tools and legal procedures, but it is important that their use be effective and proportionate. Some of these instruments include obtaining liens over taxpayers’ assets, imposing liability on company directors for certain company tax arrears, initiating bankruptcy or liquidation procedures, publishing the names of debtors, denying delinquent taxpayers access to certain government services, temporarily closing a business or withdrawing a license, and imposing restrictions on overseas travel. A more recent measure to enforce debt payment, which started in an experimental mode but has become widely practiced, is the organization of “Outbound Call Centers,” whose specialized performance has yielded significant efficiency gains in the collection of outstanding debts. Disputes and appeals Taxpayers and tax administrations do not always agree on the amount of taxes to be paid. This may be due to the different interpretation of the tax laws, misinformation, or even the concrete way an audit process may be developed. Thus, the existence of a formal procedure to resolve disputes is a necessary guarantee to protect taxpayers’ rights and to balance the relationship between tax administration and citizens. Ultimately, the fair treatment of taxpayers by the tax administration generates increased tax morale leading to higher compliance (Koumpias et al., 2021). Tax administrations regularly work on improving dispute resolution processes and the timeliness of processing objections, as further contributions to a better functioning of the tax system. Such efforts offer dual benefits: to the taxpayers, should they choose to file a claim, enhanced dispute resolution processes reduce taxpayers’ compliance costs, and for the government, the process allows the administration to achieve more effective collection of tax debts in cases of conflict. All tax administrations guarantee the right of taxpayers to challenge tax assessments and have established formal procedures for it. These procedures are usually carried out first with a review by an internal body within the tax administration itself; after that, there is the possibility of going to a subsequent judicial review. Some administrations offer taxpayers the option to request an independent review by an external body as a first step, which can help clarify

212  Research handbook on public financial management the dispute and reinforce the taxpayers’ legal security. Some administrations even have an Ombudsperson service for the increased protection of taxpayers. Almost all tax administration systems have developed these procedures through administrative courts or ad hoc offices specializing in conflict resolution. There are several important innovations that tax administrations have developed to improve the timelines involved in the taxpayer objections process. Some tax administrations (for example, Canada) have implemented a triage function for a more agile selection of disputes presented by taxpayers in certain low-complexity taxes. This function allows an optimal ordering of the challenges according to their degree of complexity, facilitates the request of additional information from the taxpayer, and prepares the claim files for a speedier resolution. Another innovative measure has been the development of a feedback loop approach that seeks to analyze and evaluate results obtained in the conflict resolution to identify reasons why they were decided in favor of taxpayers, in order to minimize future claims and improve disputes resolution procedures in the future (OECD, 2019a).

TRUST AND FURTHER CHALLENGES FOR TAX ADMINISTRATIONS’ REFORMERS ACROSS DEVELOPED AND DEVELOPING COUNTRIES Compliance levels around the globe are higher than we could expect from the predictions of the “catch and punish” paradigm (Allingham and Sandmo, 1972). Though traditional tax enforcement stands out as a completely unavoidable task to ensure lower tax fraud levels (Ariely, 2010), the fact is that evaders must have not only the opportunity and the ability to commit evasion, but also the will to engage in it (Elffers, 2000; Kleven et al., 2011). The bottom line is that, in most cases, voluntary tax compliance would appear to be higher than the traditional “rational” models of tax evasion would anticipate. So, the big question is – why? The answer, which has been extensively researched, lies in the presence of tax morale, the intrinsic willingness to voluntarily pay taxes based on social and individual norms. The link between compliance and tax morale (or why people pay their taxes voluntarily) has gained enough causal support to become one of the most accepted political economy determinants for enhancing compliance levels (Cummings et al., 2009; Halla, 2012; Luttmer and Singhal, 2014; Koumpias and Martínez-Vázquez, 2019). In other words, improving citizens’ tax morale has become the third core pillar (mutually reinforcing enforcement and facilitation) for designing modern tax administrations’ strategic tax compliance programs. For an illustration of the connections between tax morale and the enforcement and facilitation paradigms, we can focus on the importance of tax codes’ design. Simpler and more stable tax laws not only promote a more efficient auditing process and reduce compliance costs, but also enhance voluntary compliance (Bird, 2004; Jacobs, 2013a). This result seems to hold true even for small and medium enterprises (SMEs) in developed countries, for which it has been found that “administrative relief” in the form of diminishing compliance costs yielded a greater increase in voluntary compliance than did monetary tax benefits (Bergner et al., 2017).14 According to the most recent empirical literature, tax morale determinants might be ascribed to three dimensions: (i) citizens’ socioeconomic characteristics and values – gender, civil status, age, educational and levels, work status, risk aversion, financial satisfaction and even happiness, ideology, national pride, altruism, religiosity, and ethics;15 (ii) people’s views

Tax revenue management and reform in developing and developed countries  213 about others’ tax compliance behavior – that is, the general level of evasion, tax horizontal inequities, different tax evasion opportunities and tax compliance performance among social groups,16 and (iii) beliefs and opinions (including trust) about the government institutions, performance, and size. Within the latter, along with issues related to democratic participation, territorial organization, and fiscal exchange represented by the tax and benefit systems, the literature has especially emphasized how trust in government (meaning “government” in a broad sense), as well as people’s views about the tax administration itself, have the potential to influence citizens’ tax morale (López-Laborda and Sanz-Arcega, 2016; Horodnic, 2018; Koumpias et al., 2021). Though sociodemographics and social norms matter (Alm et al., 2020b), the empirical evidence on tax morale offers great opportunities for tax administrations as well as for the public sector as a whole for increasing revenues. In what follows, we focus on the empirical evidence on these two issues, bearing in mind, first, that better institutions reinforce themselves (Chang, 2010), and second, that formal institutions must be aligned with informal ones to prove successful (North, 1990). Building trust in the government in order to enhance compliance goes even beyond pure taxation issues (Dom, 2019). An uncontested result that stands out in the literature is the harm that corruption does to tax morale. Likewise, operating in the other direction, the perceived institutional quality and satisfaction with the public sector enhances citizens’ tax morale (Torgler and Schneider, 2007). In this vein, a recent paper on Tanzania emphasizes how business professionals’ satisfaction with public services promotes voluntary compliance (Fjeldstad et al., 2020).17 Moreover, Koumpias et al. (2021) provide further evidence about the superior effect of “output government institutions” – police, civil service, tax administration – over “input organizations” – such as the parliament – on tax morale.18 This result might be even stronger for countries where the informal economy plays a major role (Joshi et al., 2014). In sum, the quality of (and satisfaction with) governmental institutions as a whole has the potential of positively influencing citizens’ tax morale (and thus compliance). At the same time, the former is also a prerequisite for successfully implementing tax policy. Ultimately, a successful comprehensive tax reform may rely on the existence of an environment of trust between tax agencies and other public institutions (Fjeldstad and Moore, 2007).19 Unsurprisingly, both results hold for developed and developing countries. Along this line of reasoning, we need to highlight and focus on the different methods for enhancing trust in the tax administrations themselves. This task may be achieved through different pathways that converge in stimulating taxpayers’ perceived fairness of tax policy and how it is administered, both of which enhance tax morale. As we saw above, in the case of public institutions as a whole, avoiding corrupt practices emerges as an unavoidable prerequisite upon which citizens’ trust can begin to be built. In this regard, citizens’ perception of fairness is thus conditioned by the way taxpayers interact (or may think they interact) with tax administrations, which does make a great impact on people’s trust in the tax administration as a whole, either enhancing or eroding tax morale (Forum on Tax Administration, 2010). As an illustration, the effect of pre-filled income tax returns on Spanish taxpayers’ tax morale depends to a great extent on the citizens’ perception of how fairly this technological innovation in tax administration actually works (Martínez-Vázquez and Sanz-Arcega, 2020).

214  Research handbook on public financial management Organizational issues can also be addressed in order to reduce civil servants’ incentives to engage in corruption. As summarized by Moore and Prichard (2017: 18), “experience tells us that any organization that combines (a) a guaranteed income, with (b) the potential to intimidate individual citizens and businesses, and (c) weak public accountability, will be tempted to abuse that situation. Both corruption and organizational laziness will likely result.”20 In contrast, enhancing tax collectors’ accountability (and even kindness) leads to higher trust in tax authorities (Feld and Frey, 2007; Prichard et al., 2019), ultimately enhancing tax morale and compliance. In this regard, as it is the case for good practices under the enforcement and facilitation paradigms, the perceived fairness and simplicity of the tax code itself may reinforce or harm tax administrations’ efforts for enhancing citizens’ trust in them (Falkinger, 1988; Pyle, 1993; Andreoni et al., 1998; Alm and Gómez, 2008; Alm, 2012). In fact, tax collectors have no choice but to fairly apply whatever tax law has been enacted by government. This is an additional reason not to view in isolation any of the three modern paradigms for increasing tax compliance. Additionally, we must highlight the important role played by taxpayer financial and tax education programs to strengthen tax morale and voluntary compliance. Multiple researchers have shown how better educated citizens, with more knowledge about the tax system, experience increases in their tax morale and become more compliant taxpayers (Bahari and Ling, 2009; Kwok and Yip, 2018; Alm, 2019; Iraman et al., 2021; Abbas et al., 2021). It is broadly accepted that tax education programs are more effective when they are developed from the earliest formative ages. In this direction, an increasing number of countries have developed different tax education programs aimed at individual taxpayers, small businesses and even school children to strengthen trust in government and, thus, tax morale levels.21 Overall, in a practical sense, all the advice above on the need for improving citizens’ perceived fairness must be generally implemented in environments where deep differences coexist across groups of individuals regarding their attitudes towards paying taxes (Beer et al., 2019; Alm et al., 2020b; Battaglini et al., 2020). In other words, traditional policy design aimed at stimulating citizens’ trust in tax administrations – improving tax education, giving more information about the revenue-spending trade-off, training tax collectors’ sympathy, etc. – and even those designed for enforcement (Andersson et al., 2021) must exploit the behavioral insights gained under the trust paradigm to become more efficient. For example, there is considerable evidence that it does matter “what” and “how” is messaged to different profiles of taxpayers.22 All of these dynamics simultaneously pose two complementary challenges. On the one hand, investment in digitalization stands out as a key prerequisite for successfully figuring out the basics of accurate taxpayer profiles. On the other hand, despite the power of digital tools, deep research to disentangle taxpayers’ profiles remains a time-consuming task to be carried out by highly skilled staff. Both tracks need to rely on the financial sufficiency of tax administrations and must support one another. In the globalized era of digitalization, building trust and enhancing tax morale must be implement in tailored and targeted ways. This can only be achieved through both increasing and reorienting tax administrations’ budgets.23 Only then will the benefits of the most recent insights in tax administration operations be reaped.

Tax revenue management and reform in developing and developed countries  215

TAX ADMINISTRATION INSTITUTIONAL DESIGN The overall efficiency of tax administration services has always deeply depended on organizational design. The most recent advances introduced in the three main drivers of tax compliance (enforcement, facilitation, and trust) have also required new organizational designs with the aim of achieving an effective and fair administration of the tax system. In this way, different areas in a modern tax administration system (strategic planning, operational tasks, human resources, etc.) are in continuous readjustment, especially in changing technological environments. In recent years, the empirical evidence on tax administration shows a variety of experiences in organizational reforms. However, not all the reforms that have been introduced have proved successful. We profile some of the most common and most successful organizational patterns and reforms. Optimal Organizational Structure A broad debate has arisen on the design of the optimal organizational structure for tax administrations. Different alternatives have been tested, among which can be highlighted a structure “by types of taxes,” a “functional structure,” or a structure “by types of taxpayers” (Gallagher, 2004; Jacobs, 2013b; Junquera et al., 2017). The most traditional organizational scheme that can still be found in many countries is the “type-of-tax” structure that distinguishes separate departments for each tax (income, VAT, excises, social security, etc.). However, this scheme has shown different problems: inefficiencies due to the repetition of functions for each tax figure, fragmentation of resources for enforcement in different departments, and lack of coordination and data sharing among tax administrations’ departments. All these caveats lead to higher compliance costs, multiple registrations, and overlapping controls and audits, ultimately leading to higher tax evasion and avoidance rates. A generalized trend in developed countries, also followed by many developing ones, has been to implement a “functional structure,” with a tax administration structured by functions or type of work performed (registration, assessment, control and audit, collection, appeals, etc.). This scheme allows the grouping together of functions that require similar skills and entails a greater specialization with efficiency gains. This design has showed multiple advantages: more efficient identification of taxpayers; standardization of similar processes across all taxes and improvements in data computerization; effectiveness in collection and audit since all on a given taxpayer’s taxes could be examined simultaneously; improvement in services facilitation in each function even with segmented treatment by type of taxpayer; improvement in detection of noncompliance due a full taxpayer monitorization across types of taxes; etc. Nevertheless, this scheme has some disadvantages, such as the need for a higher level of training for officers, with staff specialized in one function. From the taxpayer’s point of view, this scheme also generates advantages, such as simpler and more standardized procedures, diminishing costs of compliance by eliminating duplication of visits, better possibilities of assistance, etc. A third option in development in many countries has been a “type of taxpayers” structure, with a tax administration organized in departments dedicated to specific categories of taxpayers (large taxpayers, small taxpayers, high-wealth individuals, pay-as-you earn individuals, self-employed persons, microbusinesses, informal sector firms, etc.). The foundation of this

216  Research handbook on public financial management scheme is to take advantage of a segmented treatment of certain groups to the extent that they present specific characteristics, varied tax compliance behavior, or different levels of risk for revenue loss. However, this scheme has showed some problems that have stopped a generalized implementation: greater administrative costs because staff and functions are repeated across taxpayer segments, fragmentation of staff specialized only in one segment, problems derived from an inconsistent application of tax laws and procedures across different taxpayer segments, etc. All in all, empirical evidence shows the predominant trend has been the progressive replacement of the most traditional “types of taxes” structure by the implementation of “functional structures” mixed with some specific segmentation of taxpayers, with a special attention to large taxpayers and businesses subject to international taxation. Tax Administrations Reforms Merger of customs and tax administration This option has had special significance in developing countries that usually rely heavily on customs duties, VAT, and excises collected on imports. An increasing number of developing countries (especially Latin American ones), following the experience of developed countries, have opted for this merger, looking to capture efficiency gains on collection due to greater sharing and exchange of information, the simplification of procedures and closer coordination. However, this trend is not generalized in all developing countries and in some areas, such as the Asia-Pacific region, this merger is not usual.24 There are many guidelines that justify an independent operation of these departments. Both administrations present important differences in their origins and foundational bases. Customs particularly differs from standard tax administration in its objectives, having the special functions in addition to collection that are related to national security and health; in its tools, procedures, and operational functioning, with tax administration functioning retrospectively and customs in real time; and in its operational features, of which customs shares some aspects similar to a police or national security department. Creation of specialized units A successful trend in tax administration design has been the creation of specialized units in certain taxpayers’ segments or activities that require special focus (Basri et al., 2021). Some examples are the introduction of “Large Taxpayers Units” (LTUs), which provide specific attention to those with high contributions to collections; “International Tax Units” (ITUs) which require specially qualified personnel both due to the complexity of the potentially audited (international) tax schemes and the need for specialized tools for the international exchange of information; the creation of centralized “Data Processing Centers” (DPCs), which allow realization of economies of scale by sharing information for several offices, such as registration, tax return processing and payments; or, finally, the introduction of “Management Risk Analysis Units” (MRAUs) which require special qualifications to manipulate large amounts of data and analytical skills to assess taxpayers’ different risk profiles. Semi-Autonomous Revenue Authorities There have been also reform initiatives aimed at promoting greater functional independence from political interference and increased professionalism in tax administrations, especially

Tax revenue management and reform in developing and developed countries  217 in country environments with inefficient and even corrupt bureaucracies. Accordingly, some Latin American and African countries have introduced “Semi-Autonomous Revenue Authorities” (SARAs), entities endowed with broad performance autonomy and partly or fully removed from the direct control of a ministry or department of finance. Their managers have great independence to manage the organization, including large capacities to alter their structure and broad powers in hiring and firing staff and offering them better salaries and work conditions. SARAs’ aim was to remain isolated from political interferences that could lead to corruption and fraud (Junquera et al., 2017; Ahlerup et al., 2015). So far, the empirical evidence for some countries is that the creation of SARAs has not always produced greater revenues in a sustained manner. The weakest point appears to be the general difficulty of keeping the autonomy of management and special conditions for the staff, with recurrent problems of corruption and politicization eventually cropping up in some of these organizations (Dom, 2019). Privatization and tax farming There have also been experiments with the privatization of some tax functions and experimentation with “tax farming methods,” especially at the local level. In some cases, the collection of smaller taxes is delegated to private entities in exchange for a percentage of the revenues collected or is held by a public agency but a collection-based remuneration scheme is introduced for tax collectors. Results of these initiatives are mixed: in general, they have achieved greater collections, but at the same time have led to different problems, such as corruption at the contracting phase, arbitrariness in the enforcement of the law, or duplicate costs. For example, Khan et al. (2016) report on an experiment for the property tax department in Punjab (Pakistan) where incentives for tax collectors boosted revenues but also led to high political cost when they exerted excessive pressure on taxpayers or used their power in a corrupt manner to obtain rents at the expense of the taxpayer. In another example, Iversen et al. (2006) report on a private tax collection scheme in rural councils in Uganda, yielding local revenue growth and stability, although there was also certain evidence of fiscal corruption, but not so much at the collection point but rather at the level of the district administration. Human resources Other initiatives have also been developed in the human resources area aimed at improving the skills and performance of tax officers. Most of these organizational reforms are accompanied by salary increases and improvements in working conditions. To the extent that revenue collection is essential for the overall country’s performance, the incentive system for tax collectors is usually more generous than in the case of other public agencies, in an attempt to encourage recruitment and performance (Schreiber, 2018). There have been also initiatives to improve staff monitoring and to reduce opportunities for collusion and corruption, such as reduction of personal interactions with taxpayers,25 automation of process and audit selection, development of tax payments online or at banks, etc. All these measures, where introduced, have generally contributed to more professional and productive tax administration organizations.

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CONCLUDING REMARKS: LESSONS FOR TAX ADMINISTRATION REFORM The processes of globalization and digitalization have introduced deep changes in the behavior of economic agents and how business is conducted (new business models, greater mobility of tax bases, etc.), which have directly challenged the effectiveness and overall performance of tax administrations around the world. At the same time, these very processes have also provided new opportunities for tax administrations to better manage compliance and tackle noncompliance. The most important challenge for successful tax administration reform to overcome may not be technical but sociopolitical. Tax administration must strive to reach a broad social and political consensus on its value and importance for society, especially for emerging and low-income countries that exhibit lower trust in public institutions (Akitoby et al., 2019; Bierbrauer et al., 2021; Dom et al., 2022; Carbajo and Collosa, 2022). This poses the need for first acknowledging the political feasibility of any future reform as a precondition for successful implementation. Bearing that in mind, tax administration reform must consider the concrete institutional framework in which the country operates. As in the case of tax policy reform, there is also always some degree of path dependence, meaning it is not possible to start the reform process from a clean slate. However, this does not mean that countries cannot innovate; indeed, the international experience offers a wealth of lessons and practices to undertake those innovations and enable the modernization of the country’s tax administration. In this vein, policy makers must rely on a well-planned course of action. First, they have to set concrete goals and monitor their achievement. Second, they must set a detailed plan for implementing the reforms needed, being flexible enough to incorporate taxpayers’ feedback. Finally, in those cases where a given policy does not work, they must avoid sticking to it. In this chapter we have described a long list of international best practices for tax administration reform under three modern paradigms: enforcement, facilitation, and trust. Overall, two issues decisively influence the outcomes of tax administration reform. First, the importance of the tax code design must be borne in mind since it is well-established empirically that, ceteris paribus, simpler and more stable tax laws facilitate compliance (even promoting voluntary compliance), as well as easing monitoring and enforcement (Bird, 2004; Jacobs, 2013a).26 Second, the three modern paradigms for improving tax compliance must not be viewed or applied in isolation from each other. The rationale for this is clear from the fact that tax evasion decisions are driven at first by a rational calculus of the pros and cons of engaging in tax fraud – the amount of money saved versus the audit probability and the potential fine that would be imposed – but the final stage of the decision process involves the cost of compliance, the information available, and also the values and social norms of taxpayers, especially the trust they have in governments and in the tax administration in particular. Encouraging citizens’ tax culture is thus an increasingly important lever within the tax compliance policy toolkit (OECD, 2021a). Overall, it is tax administrations’ institutional design that stands out as the necessary precondition for the successful implementation of reforms seeking to improve tax compliance, especially in the post-COVID-19 era that has reshaped business models and processes.

Tax revenue management and reform in developing and developed countries  219 Ultimately, the effectiveness of any reform will rest on the presence of a broad sociopolitical consensus regarding the need to increase tax collections and on the financial sufficiency and managerial efficiency of the tax agency in question.

NOTES 1. As Mayega et al. (2019: 7) show, “in tax collection, as in so many other areas of activity, the realization of the potential benefits of digital technologies can be a challenging and drawn-out process. It is not simply a matter of purchasing hardware, designing software and training staff. Systems may appear to function well, at least for some purposes, but significantly underperform in terms of accuracy, efficiency or effectiveness. Tax administrations have access to large amounts of data, but they do not always manage that data effectively.” 2. In the same vein, Akitoby et al. (2018) and (2019), using a dataset covering 55 episodes of large tax revenue increases in low-income countries, point out the relevance of these political economy factors for successful reforms – a result also derived by Junquera et al. (2017) and Moore and Prichard (2017). 3. Many recent studies (OECD, 2015; IMF et al., 2016; Junquera et al., 2017) show how international cooperation can make important contributions to tax administration reforms. International Organizations as the IMF, the WB, or the OECD can help strengthen capacity for making diagnostic studies and offer policy analysis of potential reform scenarios. Additionally, these institutions also can provide resources to implement these reforms, including further technical assistance and financial support (loans, grants, etc.). Nevertheless, typically, it is difficult to attribute outcomes to the specific assistance or cooperation provided by donors; the reform outcomes may appear only after a long period and their assessment requires robust monitoring and evaluation that not always present. Final outcomes and impacts generally depend on multiple factors and thus it is usually difficult to disentangle their specific contribution. 4. As a recent HMRC report emphasizes, simplifying registrations processes or a smarter use of taxpayers’ data that avoids taxpayers submitting information the tax administration already has are two measures that would reduce compliance costs and increase tax revenues (HMRC, 2021). 5. The International Survey on Revenue Administration (ISORA) is a multi-organization international survey that collects standardized information on tax administration at the national level. This project is conducted by five partner organizations: the International Monetary Fund (IMF), the Intra-European Organization of Tax Administrations (IOTA), the Organisation for Economic Co-operation and Development (OECD), the Inter-American Center of Tax Administrations (CIAT) and, since 2018, the Asian Development Bank (ADB). The latest edition (2020) collected information for 2018 and 2019 from tax administrations from 156 countries, accounting for 96.1 percent of global GDP and 90.6 percent of the planet’s total population. ISORA 2018 had data from 2016–2017. International precedents in the same line were the IDB/CAPTAC-RD/CIAT reports (2012), CIAT (2016), the OECD “Tax Administration Comparative Information Series” (since 2004), and the pioneering surveys of the IMF’s RA-FIT (Revenue Administration’s Fiscal Information Tool) platform (IMF, 2019). 6. ISORA data show that 32.1 percent of countries surveyed have a mandatory electronic invoicing system for some or all registered taxpayers, and that 50 percent of them require sellers of goods and services to record their operations (Moran and Diaz de Sarralde, 2021). 7. Alternative measures based in sharing information between countries are being studied in OECD working groups to ensure a greater taxation of those selling goods or services using gig economy platforms. A detailed analysis can be seen in OECD (2019b). 8. The ISORA (2020) survey shows that on average the main assistance channel used by taxpayers is the telephone (38.4 percent), followed by digital channels (assistance by e-mail, apps, websites, online) (32.2 percent), and traditional channels (face-to-face and postal mail) (29.4 percent). However, for higher income countries, the use of digital channels is about 36.8 percent while in the rest of the countries these channels do not exceed 30 percent.

220  Research handbook on public financial management 9. ISORA 2020 shows that the proportion of tax returns using electronic channels has reached the average levels of 70.7 percent for Corporate Income Tax (CIT), 63.5 percent for Personal Income Tax (PIT) and 74.1 percent for Value-Added Tax (VAT), with the share growing in recent years and already reaching 100 percent in some countries for some taxes. Not surprisingly, the higher percentages correspond to high-income countries. Using this mode of filing additionally yields acceptable degrees of compliance, although according to the tax considered the results achieved differ (64.8 percent CIT; 68.6 percent PIT; and 77.5 percent VAT) (Moran and Diaz de Sarralde, 2021). 10. ISORA 2020 indicates an acceptable level of on-time payment, with some differences between taxes with an average of 79.1 percent in the CIT, 77.7 percent in PIT and 85.8 percent in VAT. The use of electronic channels for payment represents a growing trend: 57.0 percent of global payment instances for 60.9 percent of total amount paid (Moran and Diaz de Sarralde, 2021). 11. The ISORA (2020) survey provides information of the relative effectiveness of these control procedures; thus. 67 percent of control (audit) actions carried out a positive adjustment for tax liabilities and collections. These additional collections generated represent about an overall return of 4.7 percent of net tax revenues, with different returns from the type of tax instrument: 8.7 percent (CIT), 2.8 percent (PIT) or 3.8 percent (VAT). The data also show that these interventions were much more effective in low-income countries (91.5 percent) than in higher income ones (58.1 percent) (Moran and Diaz de Sarralde, 2021). 12. A recent example in Latvia shows the potentialities of machine learning in order to classify compliant and noncompliant firms regarding labor taxes (Gavoille and Zasova, 2021). 13. ISORA 2020 shows an increasingly widespread use of these tools. Of tools that are fully implemented or in the mid-implementation phase, those related to “Data Science” are currently the most widespread at 65.4 percent of ISORA countries. In second place comes “Cloud Computing,” with implementation rates of 41.7 percent. Tools related to “artificial intelligence” and “machine learning” are used in 37.2 percent of ISORA countries. Blockchain technology seems to be the least developed, with only 8.3 percent of countries exploiting it so far (Moran and Diaz de Sarralde, 2021). 14. An additional example of this effect is found in concrete initiatives connected to technological advances, such as prefilled returns, which might positively influence voluntary compliance through diminishing compliance costs as well as enforcement and facilitation (Lee, 2016; Kochanova et al., 2020; Benzarti, 2020). 15. In a recent survey, Martínez-Vázquez (2021) emphasizes how married, older, female, more educated, and more satisfied people exhibit greater tax morale, as well as those that share personal values against evasion. 16. For example, perceived widespread tax evasion and/or horizontal tax inequities erode citizens’ tax morale (respectively, Sandmo, 2005, and Clotfelter, 1983). 17. In the same sense, this satisfaction operates on business professionals’ perception of their counterparts’ compliance levels, which poses an additional link in the chain of the interconnections between the different dimensions of tax morale determinants. 18. The same result about trust in the police was achieved by Leonardo and Martínez-Vázquez (2016). 19. In the same sense, Kristiaji and Poesoro (2013) provide evidence about the connection between governance, democracy, and SARAs’ performance. 20. In the case of India, a recent paper by Khan et al. (2016) emphasizes how tax collectors’ payment systems might condition the engagement in corruption practices. 21. A recent report by the OECD (2021a) offers a comprehensive review of the different types of tax education programs being used and targeting different collectives of the population. Here, we briefly highlight two of these programs in developing countries. The Rwanda Revenue Authority (RRA) routinely organizes training sessions for new taxpayers that introduces them to how to pay taxes. The impact evaluation of this program shows that it has drastically increased taxpayers’ understanding of the tax system and their willingness to pay taxes (Dom et al., 2022). In a more long-term approach, Indonesia’s Directorate General of Taxes has implemented since 2014 the so-called Tax Awareness Inclusion Program, which aims to build tax awareness among young people, targeting students in all levels of education, including elementary schools, middle schools, high schools, and universities. Through this program, students are expected to have more awareness of taxation, so they can be compliant taxpayers in the future (Abbas et al., 2021).

Tax revenue management and reform in developing and developed countries  221 22. An example of this would be the impact of media campaigns on compliance (see the recent evidence observed by Koumpias and Martínez-Vázquez, 2019), a result which also showed in lab experiments (Fisar et al., 2021). 23. Empirical evidence affirms the higher responsiveness of revenue total increases in OECD countries devoting more resources to tax authorities (Akgun et al., 2017b). 24. In the Asia-Pacific region, none of the 22 revenue bodies surveyed by the Asian Development Bank in 2014 had a customs administration function (ADB, 2014). 25. Okunogbeand and Pouliquen (2018) find that due to limited data sources to monitor compliance in developing countries there tend to be frequent interactions between tax officials and taxpayers, increasing the opportunity for corruption, although the introduction of electronic tax filing mitigated this risk. 26. Recent realities such as e-commerce put a huge emphasis on the importance of the quality of regulation (Agrawal and Fox, 2017).

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12. Instruments and management of public revenue Justin M. Ross

INTRODUCTION Providing public goods and services requires extractions from the productive private economy for financing. The government provides things of value to its citizens, but in order to provide them must sacrifice those citizens’ production and consumption in the private sphere to some degree. Public revenue management involves understanding and selecting revenue instruments in order to best satisfy citizen desires for goods and services produced in both the public and private sectors. This chapter begins by reviewing the normative economic theory of instrument choice which is rooted in maximizing citizen welfare against the constraints of needing to extract revenues. The cost of these extractions are distortions in the behavior of the individuals who must pay the tax. It then reviews what might be considered “organizational” considerations, but which have produced several indicators for tax revenue instruments that have merged in recent years, along with an associated literature that adopts them for evaluating systems. The literature where instruments are selected for attributes aiding organizational welfare is prevalent in both public administration and public choice literatures. The former literature, which will gather the most attention here, tends to focus on consequences for managers making active selections in revenue instruments. The public choice literature, by contrast, tends to emphasize positive institutional analysis of why some tax “regimes” will survive against selective pressures of political economy. To illustrate the contrast, Congleton (2011) argues a property tax financed local government (as opposed to a profit maximizing developer) is the emergent order of American public good provision because it offers more attractive political economy features to investors seeking to make immobile fixed capital investments. By contrast, research in public administration will describe and emphasize the appeal of the property tax’s stability and collectability to explain its widespread adoption and persistence (Mikesell and Liu, 2013).1

REVENUE POLICY AND MANAGEMENT Under what circumstances should a tax on base X be levied, and at what rate? This question is foundational and loaded with subjective philosophical propositions. Normative welfare economics provides a widely accepted route, even if it offers many wildly different destinations as an answer. This convention is to assume that the goal is to select tax bases and tax rates that maximize citizen welfare, where citizens value goods produced in both the public and private spheres. Taxes provide the government with revenues which they can use to finance public goods at the cost of inducing sacrifices of private consumption in some form. Ramsey’s (1927) optimal commodity tax paper is the commonly cited originator of this class of model that ultimately became the basis for optimal tax theory. 226

Instruments and management of public revenue  227 If maximizing citizen welfare sounds too broad as a motivating goal, then one should keep in mind that this does in fact preclude motivations sometimes advanced by fiscal officers. It did not look upon the set of instruments like a portfolio manager selecting stocks in an effort to diversify a portfolio of risk and return; Nor did it imply that the policy maker should select tax rates which maximize public revenues. This is true even if, all other things equal, there are benefits to attributes to having multiple tax instruments or if the volatility of a revenue source will impact which public services are viable. The remainder of this section will advance this line of thinking using some algebraic examples. A Simple Economic Model Let’s specify generically that a given household’s welfare can be mapped using as a function coming from the amount of two private goods (x1 and x2), public good (y), and leisure (L) they can consume.2 Let us further assume that their welfare increases at a diminishing rate in each of those elements. Diminishing returns to consumption implies, broadly, the first unit consumed for each element provides more incremental welfare than the nth unit consumed, so that they generally will prefer a mix of x, y, and L type goods. Finally, let us stipulate that they cannot directly purchase public good y, but instead y is made available for consumption by the government as a result of its own tax revenue collections. In this setting, the welfare function for the household to be maximized appears as ​U​ (​x1​  ​, ​x2​  ​, y, L) ​​. The household generates income that they can use to purchase goods x and y by refusing to take leisure out of a stock of H feasible time they could. In other words, at a wage rate of w they earn income of H-L before allowing for the possibility of taxes and public good provision: ​ (H − L) ​w  =  ​p1​  ​ ​x1​  ​ + ​p2​  ​ ​x2​  ​​. Introducing taxes in order to provide public goods alters this budget set. We therefore can say that the problem for the government is to select an amount of y and a set of tax instruments and rates that yield it. We can now add the potential for many different taxes: labor income tax (​ ​ ​τw​  )​ ​, general consumption tax on private goods ​(​ τ​ x​ )​ ​, and selective sales taxes ​(​ τ​ x1 ​  ​, ​τx2 ​  )​ ​​. The same household whose welfare is being maximized in selecting y is also the household paying the tax. Max                 ​ x1, x2, L ​ U​(​ ​x1​  ​, ​x2​  ​, y, L​)​

subject to ​ (H − L) ​​ (1 − ​τw​  ​) ​  =  (​ ​1 + ​τx​ ​)​ (​ (1 + ​τx1 ​  ​) ​ p ​ 1​  ​ ​x1​  ​ + ​(​1 + ​τx2 ​  ​)​ ​p2​  ​ ​x2​  ​) ​​ The above can be endlessly extended to include other forms of consumption and tax instruments (e.g. property, etc.). In the above, we could select numerous combinations of rates and bases, such as labor taxes only ​ (​τw​  ​  >  0, ​τx​ ​  =  ​τ​x1   ​  =  ​τ​x2   ​  =  0) ​​, general sales taxes only ​ (​τx​ ​  >  0, ​τw​  ​  =  ​τ​x1   ​  =  ​τ​x2   ​  =  0) ​​, or any other combination of positive rates. This general framework can be used to illustrate the theoretical underpinning for the prima facie case for oft refrained but frequently misunderstood “broad base with low rates” mantra in tax policy. Consider the labor-only tax budget constraint ​ (H − L) ​​ (1 − ​τW​  ​) ​  ​=  ​p1​  ​ x​ 1​  ​ + ​p2​  ​ x​ 2​  ​

228  Research handbook on public financial management and the general consumption-only tax ​ (H − L) ​  ​=  ​ (1 + ​τx​ ​) ​​ (​p1​  ​ x​ 1​  ​ + ​p2​  ​ x​ 2​  ​) ​​

are mathematically identical tax policies, which is intuitive if you recognize that expenditures equal incomes in perfect tax systems.3 That is, for a given tax on consumption there is a tax on labor that produces an identical solution to the household’s optimization problem. “Diversifying the taxes” to include both a general consumption tax and a labor income tax is using two tax instruments to accomplish what could be done with two, this is a poor rationale for “broadening” if the goal is maximizing household welfare. The gains from “broadening the base” in this setting comes from reducing margins of substitution. In the consumption-only and labor-only tax setting, the untaxed margin of substitution is leisure, and a plausible result is that households would change earn less income and take more leisure time. By contrast, let us consider a tax system with only a selective consumption tax on good 1: ​ (H − L) ​​ (1 + ​τx1 ​  ​) ​  = ​  p ​ 1​  ​ x​ 1​  ​ + ​p2​  ​ x​ 2​  ​

There is only one taxed margin, so the consumer has untaxed margins of consuming good 2 and the labor-leisure trade-off. Moreover, the narrower expenditure base implies higher rates for taxing good 1 to pay for public good y. If there are diminishing returns in consumption of good x1, then the losses to households for substituting away from good 1 is increasing at an increasing rate. In terms of citizen welfare, this is an expensive way of providing public good y and it implies its provision levels should be lower than a tax system that has low rates with few substitution margins. That is, expanding the tax from selective to general can be utility increasing by distorting fewer household choices, but taxing both labor and consumption is redundantly taxing the same choices. Redundancy often occurs when the tax base is also extended to include inputs to producing the goods being consumed, such as in a gross receipts tax, which effectively mimics a selective sales tax on goods that have multiple stages of turnover in their production process. We can close this line of analysis by moving to the second stage of the welfare optimization problem, where the government sets tax rates to produce good y for household consumption.4 Changes in income through wages or available work hours will likely imply changes in the households’ willingness to finance public goods, as will changes in the price of alternative goods. Households may therefore wish to rebalance their consumption patterns in response to volatile economic conditions; motivating the use of tax instruments that behave like automatic stabilizers (e.g. progressively structured income taxes that behave as tax cuts when incomes fall) is rooted in this traditional framework of maximizing citizen welfare. There could also be taxpayer heterogeneity, that is, a single household is not very representative in preferences or constraints of the group. Senior citizens are sometimes property rich and cash income poor, so introducing both an income tax and property tax might be justified as a way of accommodating differing budget constraints of the taxpayer to provide their desired services. Similarly, non-resident service consumers (tourists, commuters, etc.) can depreciate the stock of available public goods, and increasing reliance on taxes paid by those non-residents (e.g. selective sales taxes on hotels, fuel, etc.) can improve voter welfare. These

Instruments and management of public revenue  229 options can have the consequence of increasing the diversity of revenue instruments or affecting the volatility of revenue flows, but they are not the justification for their implementation. Summary of Lessons, Implications, and Caveats To summarize the implications of the model as advice for thinking about instrument selection: 1. The tax system should be broad in terms of avoiding tax rewards to households for changing their economic behavior; 2. The tax system should avoid redundantly taxing the same taxpayer with multiple instruments (e.g. taxing income and consumption, taxing production and sale, etc.); 3. The tax system should extract tax payments in the manner consistent with the taxpayer’s preferences as conditions change (e.g. progressive taxes as automatic stabilizers by lowering marginal tax rates as income falls); 4. Multiple instruments can be justified on the basis of differences in taxpayer resources (e.g. recognizing some consumers may be “property wealthy but cash poor” might imply a mix of property and income taxes); 5. Multiple instruments can be justified by differences in the consumers of the public services (e.g. a selective sales tax may be supported by tourists using public services); 6. Tax instruments can be justified where there are negative externalities, where citizen welfare is harmed through non-pecuniary costs arising from market transactions. The overarching emphasis is how the tax system relates to the welfare of its constituents. A common deviation from this approach employs the analogy of thinking about tax instrument selection as an organizational problem, such as when portfolio manager picking and other assets for a satisfactory risk and reward balance. This is the subject of the next section.

ORGANIZATIONAL CHOICE AND REVENUE INDICATORS Revenue indicators are useful for estimation, forecasting, planning, and identifying comparable peers. In other words, organizations find them useful for planning and managerial purposes even if they are not the motivating basis of instrument adoption. This section reviews revenue indicators employed for these purposes. Regrettably, their appearance in applied work contains relatively similar names. ● ● ● ● ●

Tax Base Elasticity Tax Buoyancy Tax Elasticity Revenue Volatility Revenue Diversification

Tax Base Elasticities, Tax Buoyancy, and Tax Elasticity Three very similar measures, sometimes described interchangeably but frequently capturing different ideas of how policy, base, and revenues fluctuate together, are distinguished here as (1) tax base elasticity; (2) tax buoyancy; and (3) tax elasticity.

230  Research handbook on public financial management Tax base elasticities relate to the change in revenue that occurs with a change in tax rates. Generically, they are: % Change in Revenue % Change in Tax Rates

​TBE  ​=  _________________       ​   ​

Their most famous application is likely the Laffer curve (see Figure 12.1), which shows that tax revenues can have a maxim point over tax rates, so that reductions in tax rates could yield revenue increases. It can be shown that the maximum point on the Laffer Curve is the point at which the tax base elasticity is −1 (unitary elastic). Tax rates above this point are more elastic (e.g. −1.5, −2.0, etc.) and therefore tax rate increases will reduce revenue; whereas tax rate increases below this point will generate more revenues because the base is more inelastic (e.g. −0.5, −0.75, etc.). It is extremely difficult to produce tax base elasticities estimates that depict a causal relationship between tax increases and their effect on revenues. In practice, taxes are not randomly adopted but are timed to occur when other factors are likely to raise their revenue production, confounding estimates based on observed data. Therefore, tax base elasticities are mostly found in the academic literature using regression analysis of the following form for applied work: ​ln​ (R) ​  ​=  α + βln​ (τ) ​ + ε​

where R represents Revenues, τ the relevant tax rate, and β the resulting tax base elasticity. The elasticity of taxable income, for example, is commonly estimated by economists because of its implications for optimal income tax rates. A low elasticity of taxable income on the top marginal income tax bracket, for example, would suggest that tax increases would be revenue productive with low efficiency costs. While the above specification has a wide life for applied, practical life, its role in optimal taxation research has carried significant interest because Feldstein (1995, 1999) demonstrated that the elasticity is a sufficient statistic for efficiency costs to citizens that motivate tax instrument choice in optimal taxation.5 Tax (or revenue) buoyancy equals the percentage change in tax revenue for a one percent change in economic activity. The general idea is: % Change in Revenue % Change in Economic Activity

​B  ​=  ______________________        ​   ​

A “very buoyant” tax sees collections rise more rapidly with economic activity (B >1), so buoyancy increases with the value of B. This is an interesting measure because it recognizes that some taxes might be more “politically sacred” than others and therefore difficult to change. For example, though many provisions of the American federal income tax code have changed in recent years, the federal excise tax on gasoline has remained fixed since 1993. Tax buoyancy estimates reflect both (1) the natural responsiveness of the tax base to economic activity; and (2) the tendency for legislation to alters the structure of the tax or its administration to change revenue from it. There is much discretion on how a specific estimate can be derived. At the national level, gross domestic product (GDP) is normally used as the measure of economic activity; personal

Instruments and management of public revenue  231

Figure 12.1

Tax base elasticities over the Laffer curve

income or other measures may be seen as more appropriate at the subnational level. Generally, buoyancy is intended be related to a broad measure of economic activity. Buoyancy estimates appear using revenue from all taxes and other sources, as well as only revenue from a particular tax, e.g., the state motor fuel tax. Their calculations may be done in real or nominal terms – this can be significant when inflation rates have been high. Measured tax buoyancy is likely to vary substantially from year-to-year, making indicators calculated as above not terribly informative. It is more helpful for policy discussions to calculate buoyancy over a number of years, possibly a decade or so. For this, regression analysis is useful because it can compute the correlation between on the logged data to find the relationship: ​lnln​ (R) ​  ​=  α + βlnln​ (Y) ​ + ε​

The parameter estimate of coefficient β is the measure of buoyancy because it is the slope coefficient between the percentage change in economic activity and revenue. This “log-log” regression specification is what allows for the percentage change interpretation. Very similar to tax elasticity is tax buoyancy. The difference between tax elasticity (TE) and tax buoyancy (TB) is that elasticity attempts to remove the portion of the response that is due to discretionary changes in law related to the tax base or the tax rate (Mansfield, 1972; Haughton, 1998; Dudine and Jalles, 2017). In other words, it looks exclusively at the impact on the standard tax base, the revenue impact if tax laws and administration had remained unchanged throughout the period of investigation. In many instances, it is a somewhat hypothetical concept because the laws do change and the actual revenues from year to year are produced by a changing tax law and not a constant tax law. However, the elasticity concept is a useful one for analysis of tax policy. ​lnln​ (R) ​  ​=  α + βlnln​ (Y) ​ + γTaxPolicy + ε​

Elasticity coefficients allow analysts to identify taxes for which collections will rise in pace with or faster than the rate of increase in economic activity, even if rates or other structures of the tax are not changed. Taxes with an elasticity greater than one allow response to increased demand for government services without the need for legislative action to increase collections. Others are less happy with high elasticity because that allows governments to increase the size of their operations without having to legislate those increases and, accordingly, to expose

232  Research handbook on public financial management their decisions to the views of the public. Elasticities (and buoyancy measures) do not involve units of measurement – they involve percentage changes – so they can be compared across taxes measured in many ways (e.g. an ad valorem value added tax against a unit tax on motor fuels) and across taxes levied in jurisdictions of widely varying size (the individual income tax in the United States, measured in dollars, with the comparable tax in El Salvador, measured in colons). An analysis using levels – the increase in the tax base per unit of increased economic activity – would make these cross tax, cross jurisdiction, comparisons more difficult to interpret. Tax elasticities are more difficult to calculate than are tax buoyancies because of the need to create a revenue series that has all rate and structural changes removed. This may be relatively simple if there are data on the tax base for all years of the analysis – for instance, if the tax is on cigarettes, there are data on cigarettes sold in the jurisdiction, and there have been no definition changes that complicate the investigation. But for many tax bases, such data are not available. The only data are for revenues collected over the years and there have been many changes in rates, base definitions, exemptions, administration, etc., over the years that have an impact on collections. In this case, elasticity measurement requires a deft touch to estimate what the constant concept base would have been over the years, adjusting everything to match the rate structure and base for a standard point in time. This is not an easy task. The need to focus on a constant base prevents estimation of an elasticity for the entire revenue structure – there is no single base concept that covers all taxes contributing to that structure and the revenue that it produces. Elasticities can be computed according to the same general approaches described for buoyancy. Most tax studies, however, employ elasticity estimates from the double-log regression approach. For the analysis, a number of years – ten or so – are necessary because of the complications and distortions that can arise from atypical data (“outliers”) from single years if the span of years is short. If tax policy changes are perfectly controlled for and measured, there is no difference between regressing on the tax base and the tax revenue. For example, if we are able to control for changes in tax rates, then finding the elasticity of economic activity with respect to the number of cigarettes sold would be the same as with respect to the revenue from cigarettes sold. Revenue Volatility Tax collections vary from year to year. Completely unchanging tax collections – perfect stability – are not desirable because the demand for government services and the need to finance those demands does increase over time. Dynamic adequacy considers the changing revenue pattern from year to year and can be examined both in regard to the particular tax and in the relationship of that tax to the total revenue stream to the government. Taxes less susceptible to dramatic annual change can permit more stable delivery of government services and are less likely to require emergency changes in fundamental tax policy to close fiscal gaps. Although most would agree that tax stability, at least for the entire revenue system, is desirable, in contrast to buoyancy and elasticity, there is no single, uniformly accepted stability coefficient to be used for categorizing taxes according to their stability. Each measure attempts to measure the spread of revenue performance from a tax or a tax system.

Instruments and management of public revenue  233 The measure that will be used here is the standard deviation of year-to-year percentage change in tax revenue or tax base:

√

_____________ T

​ (​Rt​ ​ − ​R )​̲  ​2​

​  (  ​  ​SDR  ​=   ​      ​∑    _ ​  ​  T − 1) ​ ​

t​=1

where SDR is the standard deviation of the annual percentage change in revenue or base, R is the percentage change in revenue or base in year t, T is the number of observations of change, andis mean percentage change. An application of the measure here can be found employed in Szakmary and Szakmary (1995), but similar variations can be found around the literature.6 Regardless of the specifics, the measure gauges the volatility of annual revenue change exhibited in the particular tax base or revenue flow. The higher the measure, the greater is the volatility of the base or revenue source – there is a big spread in the annual percentage change in the tax. Because the measure is based on percentage changes, the influence from the relative size of the base (or the units in which it is measured) cancels out. In other words, volatility can be compared across a large tax, like the individual income tax, and a small tax, like a tax on soft drinks. The measure may be calculated for a particular tax or for a total tax system. These measures are often also accompanied by the minimum and maximum changes in the data period, to give some extra context to the comparison. In this example, the personal income tax revenues and total revenue to the state change annually and the rates of that change differ widely across the years. There are considerable differences in annual changes, as suggested by the relatively high standard deviations. The real measures are modestly lower than the current dollar measures, showing that a considerable amount of the annual variations is the product of changes in aggregate prices. Lower SDs mean greater annual stability. But the instability or stability of a particular tax does not tell the whole story about revenue system stability. It is possible that instability of a tax may contribute to the stability of the entire revenue system if revenue from that tax moves in a fashion contrary to the movement of the remainder of the revenue system; in that case, its fluctuations would dampen the instability of the total. In the present example, the correlation between personal income tax collections and total revenue less the personal income tax is quite high: 0.781 for current dollars and 0.625 when deflated. The personal income tax may not add much stability because collections from this tax are closely correlated with those from the rest of the revenue system. Lastly, the SDR and its associated revenue statistics is a simple illustration, but again we can use regression analysis for alternative measures. We start by estimating a time trend regression on the log of the revenue instrument: ​ln​(​ ​Rt​ ​)​α + βt + ​εt​ ​

Revenue volatility (RV) is then calculated as the sum of the absolute value of the regression’s predicted error: T

​RV  = ​  ∑ ​     ​  |​​εt​ ​|​ t​=1

In some cases revenue volatility in public finance has been discussed as a trade-off to high growth instruments (i.e. those with a high mean growth rate), analogous to stock prices. It is likely that such an empirical correlation exists (see Schunk and Porca, 2005; Overton and

234  Research handbook on public financial management Bland, 2017), but unlike the stock market there is not a governing economic intuition for it. In competitive financial markets, stock prices with high variances must be offset with higher rates of return to attract investors. There is no direct reason for taxes derived from retail sales, alcohol purchases, etc. to similarly behave with this trade-off. Revenue Diversification The measures of revenue diversification have drawn from the literature on industry competition amongst firms. Industries with a single firm accounting for the entire market are “highly concentrated,” whereas a great number of different firms each in possession of a tiny share would be considered “highly competitive.” Borrowing from this, a “highly diversified” revenue structure would be one with many instruments each representing a small share of the total. The normalized Herfindahl-Hirschman Index (HHI) ranges from 0 to 1, with zero representing highly diversified and 1 being very concentrated. Let ri represent instrument i share of total revenue in a portfolio of n instruments, then the normalized HHI is calculated as ​∑n    ​r​ 2​ ​ − 1 / n​

​HHI  ​=  _ ​  i​=1 i _1       ​ 1 − ​ (n​ ​)   ​

Again, a priori revenue diversification is not a tax policy goal grounded in normative economic theory where taxes are determined as part of an objective serving citizen well-being. For this reason, there are some (arguably cynical) perspectives on why governments diversify their tax bases (e.g. Breeden and Hunter, 1985). This includes the “revenue complexity theory of fiscal illusion” where a larger set of revenue sources enable politicians to spend more freely than would be permitted under a simpler and more transparent system.7

CONCLUSION This chapter overviewed the grounding of tax theory, and how that theory advances how a particular instrument advances constituent welfare against their sacrifices. It also summarized conventional measures of revenue policy and structure. A trepidation of such measures is that they have a tendency to become targets of tax policy. This is a common error in public policy, where observing that because some measure is associated with good things the conclusion is drawn that this improving the measure must produce good things (see “Causal Goodhart” in Manheim and Garrabrant, 2019). More helpfully, these indicators are useful for generating predictions, forecasts, and finding comparable peers that are important for organizational decision-making.

NOTES 1. Although treated separately here, it should be noted that these literatures do frequently intersect, particularly in the literature on tax competition. In this setting, instrument choice is distorted due to competition between rate-setting units, with the implications for resident welfare. See Nechyba

Instruments and management of public revenue  235 (1997), Pogodzinski and Sjoquist (1993), and Bucovetsky and Wilson (1991) as examples that have inspired many subsequent modifications. 2. This approach represents a simplified version of the Corlette and Hague (1953) extension of Ramsey (1927). 3. The consumption-only tax system is the labor-only tax at the rate of w=x1+x. In other words, a 10% consumption tax is a .1/(1+.1)=.0909 or 9.09% labor income tax. 4. More formally in the normative tax literature, the household optimization of utility against budget constraint defines a indirect household utility that is a function of tax rates, wage rate, prices, and other parameters for the household’s “taste” in the competing goods of x1, x2, y, and L. 5. See Chetty (2009) for a critical review. 6. Bleaney et al. (1995) calculate where revenues are first normalized by the size of the economy, and Dye and McGuire (1991) use residuals from a revenue growth rate regression. 7. See Wagner (1976) and Carroll (2005, 2009) for discussions of the revenue complexity and revenue diversification views in the states.

REFERENCES Bleaney, M., Gemmell, N., and Greenaway, D. (1995). Tax revenue instability, with particular reference to sub-Saharan Africa. The Journal of Development Studies, 31(6), 883–902. Breeden, C. H. and Hunter, W. J. (1985). Tax revenue and tax structure. Public Finance Quarterly, 13(2), 216–224. Bucovetsky, S. and Wilson, J. D. (1991). Tax competition with two tax instruments. Regional Science and Urban Economics, 21(3), 333–350. Carroll, D. A. (2005). Are state governments prepared for fiscal crises? A look at revenue diversification during the 1990s. Public Finance Review, 33(5), 603–633. Carroll, D. A. (2009). Diversifying municipal government revenue structures: Fiscal illusion or instability? Public Budgeting & Finance, 29(1), 27–48. Chetty, R. (2009). Is the taxable income elasticity sufficient to calculate deadweight loss? The implications of evasion and avoidance. American Economic Journal: Economic Policy, 1(2), 31–52. Congleton, R. D. (2011). Why local governments do not maximize profits: On the value added by the representative institutions of town and city governance. Public Choice, 149(1), 187–207. Corlett, W. J. and Hague, D. C. (1953). Complementarity and the excess burden of taxation. The Review of Economic Studies, 21(1), 21–30. Dudine, P. and Jalles, J. T. (2017). How Buoyant is the Tax System? New Evidence from a Large Heterogeneous Panel. IMF Working Paper WP/17/4. Dye, R. F. and McGuire, T. J. (1991). Growth and variability of state individual income and general sales taxes. National Tax Journal, 44(1), 55–66. Feldstein, M. (1995). The effect of marginal tax rates on taxable income: A panel study of the 1986 Tax Reform Act. Journal of Political Economy, 103(3), 551–572. Feldstein, M. (1999). Tax avoidance and the deadweight loss of the income tax. Review of Economics and Statistics, 81(4), 674–680. Haughton, J. (1998). Estimating Tax Buoyancy, Elasticity, and Stability. USAID African Economic Policy Discussion Paper Number 11. Manheim, D. and Garrabrant, S. (2019). Categorizing variants of Goodhart’s Law. https://​arxiv​.org/​abs/​ 1803​.04585. Mansfield, C. Y. (1972). Elasticity and Buoyancy of a Tax System: A Method Applied to Paraguay. IMF Staff Papers, January. Mikesell, J. L. and Liu. C. (2013). Property tax stability: A tax system model of base and revenue dynamics through the Great Recession and beyond. Public Finance and Management 13(4). Nechyba, T. J. (1997). Local property and state income taxes: The role of interjurisdictional competition and collusion. Journal of Political Economy, 105(2), 351–384.

236  Research handbook on public financial management Overton, M. and Bland, R. (2017). Exploring the Linkage between Economic Base, Revenue Growth, and Revenue Stability in Large Municipal Governments. Lincoln Institute of Land Policy, Working Paper WP17MO1. Pogodzinski, J. M. and Sjoquist, D. L. (1993). Alternative tax regimes in a local public good economy. Journal of Public Economics, 50(1), 115–141. Ramsey, F. P. (1927). A contribution to the theory of taxation. The Economic Journal, 37(145), 47–61. Schunk, D. and Porca, S. (2005). State-local revenue diversification, stability, and growth: Time series evidence. Review of Regional Studies, 35(3), 246–265. Szakmary, A. C. and Szakmary, C. M. (1995). State lotteries as a source of revenue: A re-examination. Southern Economic Journal, 61(4), 1167–1181. Wagner, R. E. (1976). Revenue structure, fiscal illusion, and budgetary choice. Public Choice, 25, 45–61.

PART V EXPENDITURE MANAGEMENT

13. Foundations of public expenditure management: theories and concepts Simanti Bandyopadhyay and Harsahib Singh

INTRODUCTION Public expenditures can never be considered as merely a fiscal variable. The focus is rather on avoiding wasteful spending and ensuring that funds are used to achieve the objectives of the spending plan (Schick, 1998; Campos, 2001), and an optimal allocation of resources to deliver various public services while maintaining financial efficiency. An effective public administration and a nation’s sound economic planning both demand efficient public spending management. It is a complex procedure involving a thinking exercise, a fiscal plan, and an execution step, with many tradeoffs and ethical questions. Viewpoints on government spending may differ widely (Colm, 1936). While the cameralist tradition demands that the centralized economy be well-managed in the interest of the state (Backhaus and Wagner, 1987), lower government spending is the primary tenet of the classical tradition. The laissez-faire philosophy envisages that the state spending should be as little as possible. Rather than focusing on outcomes of public spending programs, traditionally, public finance concentrated on issues related to taxation and expenditure control (Premchand, 1993). Because of increased government spending in absolute terms and as a percentage of national income after the Second World War, the public expenditure management domain attracted more attention. During the 1980s, economic crises in many countries highlighted the importance of public expenditure management and the resulting public budgeting challenges (Schick, 1998; Premchand, 1993). Economic, social, and political factors, including pressures from the public and the media, impact governments’ spending decisions (Rowley and Tollision, 1994). The administration of public expenditures can be looked at from different angles (Premchand, 1993). From a policy standpoint, the focus is on developing a plan for allocating funds where governments have to spend money. The institutional background illustrates how the ministry of finance incorporates the demands of all the line ministries. The focus in the governance context is on the spending plan’s outcomes. Expenditure decisions are made in a governmental system by coordinating with several departments. Not only must adequate finances for the provision of services be found, but also it is crucial to ensure that the money spent results in desired outputs and outcomes (Campos, 2001). Theories on public expenditure were developed to address the issue of market failure associated with public goods so that economic resources can be distributed efficiently and equitably. The aspect of public spending being considered for the provision of social goods was firmly rooted in welfare economics (Musgrave, 1969). Different views provide guidelines for governmental authorities to follow while making expenditure decisions. These theories are either based on observations of situations in different nations or are theorizations of intellectual opinions and discuss the evolution, determinants, and efficacy of government expenditures. The 238

Foundations of public expenditure management  239 traditional framework uses mathematical, intuitive and logical methods to prove the theories while the empirical literature is mainly based on econometric or optimization models. The “ideal” expenditure levels prescribed by theory might not be actually spent. This may be caused by capacity constraints as well as strategic interactions of players involved in the process. Capacity constraints can be treated as pure economic reasons. The budget appropriation to different line ministries and the spending program are the two components of the agreement between the ministry of finance and the various ministries. Because of the asymmetric information, the failure to meet the budget’s targets can be attributed to causes which are beyond the control of ministries. With economics of information emerging as a prominent field, experimental and game-theoretic methods have been developed to model and test public policy applications to elicit information-sharing and other welfare-enhancing behavior. The complexities of decisions in resource allocation, resource usage, and operational efficiency by the government can be demonstrated through the principal-agent framework which explains how the public expenditure system can be characterized by a chain of principal-agent connections, elevating the risk of agency or organizational difficulties (Leruth and Paul, 2006). The line ministries may act as agents, with the finance ministry as the principal. The divergence in interests between the principal and the agent cause corruption and ineffective governance. It would be impossible to separate inefficiency resulting from a flawed public expenditure management system and that from poor program design. The principal’s challenge is to implement a contract that induces the agent to fulfill the responsibilities as directed by the contract, not ignoring the goals of the budgets. The “rent” secured by the agents is the advantage they enjoy at the expense of productive spending. As a result, the contract must specify a level of output connected with a specific degree of transfer and some control and penalty parameters that the principal will determine. The finance ministry has various tools at its disposal to curb rent-seeking activity. The literature on contract design and employee incentives offers the foundation for a potentially beneficial approach for analyzing public budgeting. Studying these linkages and agency problems can determine shortcomings in public service delivery in public expenditure management and offer useful policy prescriptions. The main objective of the chapter is to explain the major theories and concepts related to the foundations of public expenditure management. We begin with public expenditures planning by the governments, which would depend on the nature of the budget they deal with. The second section lays out the structure in which public expenditures are planned in the government budgets. The steps from planning to execution and implementation require clear guidance on the optimal spending levels. The third section describes the primary theories on public expenditures which determine the optimal spending levels of governments by providing the rationales for the intuitions. The fourth section talks about the major challenges in public expenditure management; the final section concludes.

PUBLIC EXPENDITURE PLANS AND GOVERNMENT BUDGETS The expenditure decision of the government is influenced by the budgeting methodology followed by the country. Public Expenditure Management, having gained the status of a separate discipline, recognizes the significance of the outcomes of government spending.

240  Research handbook on public financial management Contemporary budgeting includes different management and institutional arrangements for the efficient allocation of resources (Schick, 1998). To be fully effective, the government spending plan should be holistic, transparent, and feasible to achieve in terms of its target (Diamond and Potter, 1999). Revenues need to be considered together with expenditures to effectively balance the expenditure needs with the revenue generation capacity of the government (Diamond and Potter, 1999). We may have a deficit, surplus or a balanced budget depending upon the relative magnitudes of revenues and expenditures.1 A budget is a financial plan that aims to achieve objectives determined for a designated time period (Shim and Siegel, 2005). It involves systematic management and allocation of funds for various policy objectives to achieve the desired outputs and outcomes (Shim and Siegel, 2005). It is decided for a short period of time, usually one year but in present times medium and long-term interests are taken into consideration while deciding on a budget plan. Government budgeting techniques and expenditures decisions reflect the requirement of the time and situation of a particular country (Martin, 2002). Line-item budgeting is the historical form of budgeting that categorizes expenditure items (Lynch and Lynch, 2002). The broad categories of expenditures are divided into further categories. The categories are framed based on the objective of expenditure. This follows an incremental method with no major changes in the overall scheme of expenditure allocation. Incremental budgeting gave way to rational budgeting that takes various alternatives into consideration and includes program budgeting and zero-based budgeting techniques (Lynch and Lynch, 2002). Program budgeting, suggested initially by the Hoover Commission in 1949, is based on the selection of a plan among the different alternatives based on the stated developmental objectives (Hagen, 1968; Forrester, 2002). It is an extension of the line-item technique that focuses on the reasons for the money being spent for various purposes. Initially proposed by the United States Department of Defense, in 1961, the Planning Programming Budgeting System involves a systematic cost-benefit analysis of the budgeting program so as to achieve the budgeting aims in a cost-effective manner (Lynch and Lynch, 2002). Peter Phyrr developed a zero-based budgeting technique in the 1970s that requires a complete overhaul of the way budget and expenditure is planned. The budgeting technique takes the base of the budget as zero and uses the marginal utility concept to maximize the benefit with the least cost or expenditure (Lynch and Lynch, 2002). The contemporary performance-oriented approach is to design a budget that focuses on results (Kim, 2002). In their book Reinventing Government (1992), David Osborne and Ted Gaebler called for outcome-based budgeting when the country adopts principles of New Public Management (Lynch and Lynch, 2002). Performance-based efforts include doing pilot tests and proper feasibility analysis before funds are allocated to new projects (Kim, 2002). The classification of budgets and expenditure thereof is based on the objectives of the government like economic growth, financial control, and stability. In recent years, depending on the development agenda of the government, expenditure management is pursued taking the country’s long-term interests into consideration. The medium-term expenditure framework (MTEF) sets a three- to five-year expenditure strategy taking into account the risks involved (Kąsek and Webber, 2009). It gives a long-term view to the government on the public finances and specifies a development path keeping expenditures under control. Participation by different stakeholders in public expenditure management is

Foundations of public expenditure management  241 another strategy being adopted for better acceptance of the spending decisions of the government and improving social and economic outcomes (Heimans, 2002). The aim of the expenditure management process is to have a performance-based view of the budget for a medium time period that helps in the improvement of public finances (Kąsek and Webber, 2009). According to Martin (2002) none of the budgeting methodologies is holistic and capable of fulfilling the principles of outcome-based budgeting. The present focus on an outcome-based expenditure framework is a part of the overall shift toward outcome-based budgeting. To sum up, a budget gives the plan of expenditures and an optimal allocation of resources by government. Scientific budgeting methods build up the expenditure components on the basis of the social, economic and development goals the government should achieve. A mismatch in the expenditures required to meet these goals and the expenditures actually incurred would be reflected in the performance of the government and thus the outcomes of these goals. The budget is just a tool or a record keeping system behind public expenditure management, which cannot operate independently of the guidelines of the theories of public expenditures.

THEORIES OF PUBLIC EXPENDITURES Theoretical frameworks for public spending management provide the required benchmarks which help the government in making expenditure decisions. However, achieving accurate estimations of the total amount of government spending and the allocations to specific categories of expenditures included in the national budget is an uphill task. Expenditures, per se, on a particular category do not mean much unless compared with the “expenditures required” for that particular category to fulfill the objectives targeted through this spending. Empirical estimations on expenditure requirements based on data can be attempted through many techniques. But in most of the cases in public finance, the non-availability of data up to the desired levels of bifurcations plagues the process of empirical estimations. However, expenditures requirements can be derived from theoretical principles. This section explores the major theories that have influenced the field of public expenditure management. Most of these theories talk about an “ideal” level of expenditure that would be incurred by the government. Considering the principles on the basis of which these “ideal” expenditures are conceptualized, we may classify the theories into four categories. 1. 2. 3. 4.

Theories based on macroeconomic performances. Theories based on public economics. Theories based on the political systems. Theories based on budgetary targets.

Public Expenditure Theories Based on Macroeconomic Performances Public expenditures can be an outcome of different macroeconomic considerations. We mainly discuss Wagner’s Law and Peacock and Weisman’s theories in this context. Adolph Wagner proposed his hypothesis in 1893 (Peacock and Scott, 2000). Based on public expenditures of Germany, Britain, United States, France, and Japan, the theory states that government spending increases smoothly and consistently with economic growth (Colm,

242  Research handbook on public financial management 1936; Peacock and Scott, 2000). To understand this phenomenon, he categorized the expenditures into different classes (Peacock and Scott, 2000) and found that initially, expenditure grows in sync with the growth of the nation’s income; expenditure eventually outpaces the country’s economic growth. If one examines government spending on economic growth as a mathematical indicator, θ the indicator’s value will ultimately be greater than 1. This concept is illustrated in Figure 13.1 which displays the level of public spending vis-à-vis the economy’s growth.

Figure 13.1

Public expenditures and economic growth (Adolph Wagner)

The increase in government spending is primarily due to three factors: 1. Socio-political: As economic production rises, so does social advancement, and the government’s functions expand. 2. Urbanization: As the economy grows, so do the cities. Urban development, coupled with advances in science and technology put additional demands on the commitments of the government. 3. Historical: The government borrows to meet numerous contingencies due to increased government spending. As a result, the government’s debt and interest obligations rise, increasing future financial liabilities. This theory is based on simple concepts and is applicable in some cases. There is evidence to back up the claim that the relative size of the public sector has grown over time in all industrialized countries (Peacock and Scott, 2000). The application of Wagner’s Law also confirms a positive relationship between economic growth and public spending (Uzuner et al., 2017; Lamartina and Zaghini, 2011). Lamartina and Zaghini (2011) empirically analyze the government expenditure growth with respect to economic growth in 23 OECD countries. Using co-integration analysis, they found that there is a positive relationship between govern-

Foundations of public expenditure management  243 ment expenditures and the growth of the economy. However, using complex mathematical techniques to understand the relationship between public expenditure and the growth in the economy in many cases might fail to capture the real situation (Peacock and Scott, 2000). Some studies indicate no conclusive positive relationship, as the Law claims (Rauf et al., 2012; Afxentiou and Serletis, 1996). Afxentiou and Serletis (1996) discuss the connection between government consumption expenditure, transfers, and subsidies individually with economic growth for European Union countries. The Granger causality test was used but they failed to establish any relationship between aggregate expenditure and GDP for all the countries. Tuna (2013) found no significant relationship between economic growth and government expenditure for a period from 1961 to 2012. Uzuner et al. (2017) analyzed the same relationship in the context of Turkey and did not find any evidence of the relation between the country’s growth rate and public spending. Pryor (1968) analyzed the growth of government consumption expenditures in some centralized and market economies and concluded that the results do not validate the hypothesis. The work of Peacock and Wiseman (1961), Timm (1961), and Musgrave (1969) also do not support Wagner’s theory (Peacock and Scott, 2000). Wagner’s Law was based on the situation in the nineteenth century and is not comprehensive enough to be amenable for future predictions. Wagner took into account spending by public firms as well as spending by the federal and local governments. The approach used is rather narrow. The emphasis is primarily on economic issues, but numerous other drivers influence government spending decisions including the GDP of a nation. The components of financial decision-making have changed over time, and situations have become more complex. The idea may not hold in a difficult circumstance where the government is required to spend even if the economy is not developing at a desired rate. According to Keynes, when the economy is underutilizing its resources, government spending should increase to restore the virtuous cycle. Another problem is the challenge of applying this theory across different types of governments. This hypothesis may be valid in advanced economies but not in agricultural or developing economies. In the long run, the notion that public spending increases faster than the economy may not apply to countries on a fiscal consolidation path. There is no particular limit on economic progress that would increase government spending (Peacock and Scott, 2000). The fiscal policy is pro-cyclical in many developing and more corrupt countries (Alesina and Tabellini, 2005). But the nature of spending depends upon the level of government in a federal country. Based on the Public Choice Theory, Abbott and Jones (2011) show that sub-central government expenditures are pro-cyclical, meaning that they rise in tandem with rises in national income. However, the central government expenditure is counter-cyclical in that as the production gap widens, the central government becomes less hopeful about intergovernmental transfers and relies more on its spending. When society and the economy are not subject to unforeseen challenges, there is a tolerable burden of taxation and level of government expenditure (Rowley and Tollision, 1994). According to Peacock and Wiseman’s (1961) hypothesis, the level of government spending rises dramatically during times of crisis. It might be a war or a downturn in the economy. Peacock and Wiseman considered how the wars affected government spending in the United Kingdom by excluding the influence of price level changes and population growth and offered a general theory (Bird, 1972). According to them, government spending increases in a jerky step-like manner, rather than in a smooth one. Based on a statistical examination of governmental expenditures in the United Kingdom from 1890 to 1955, it was shown that the country

244  Research handbook on public financial management witnessed huge economic growth and societal changes during this period, with an increase in the number of employees working in the public sector (Hicks, 1963). Peacock and Wiseman propose three impacts of increasing public expenditures (Rowley and Tollision, 1994; Bird, 1972): 1. Displacement effect: Previous lower tax and spending rates are replaced by new, higher tax and spending rates. People are willing to pay more taxes after a period of excessive government spending. 2. Inspection effect: War or other unforeseen calamities frequently compel people and governments to seek solutions to previously neglected problems. Usually, the government examines whether its increased revenues are sufficient to meet its responsibilities. 3. Concentration effect: When an economy grows, central government economic activities tend to grow faster than state and local government economic activity. Peacock and Wiseman’s research reveals that public spending increases dramatically facing an unforeseen change in the economy. As a result, the rise in government spending curve has a kink. Figure 13.2 depicts this idea graphically.

Figure 13.2

Public expenditures and economic growth (Peacock and Wiseman)

After the calamity is over, a new level of tax tolerance arises, and the government has no motive to revert to the pre-crisis level of taxation. Additional public sector allocations in the economy displace some private sector allocation. This theory is not without limitations. The displacement impact of Peacock and Wiseman captures the quantitative changes in spending and the structural changes following a calamity in industrial nations. It might not, however, apply to developing economies where spending decisions are generally made before tax levels are decided.

Foundations of public expenditure management  245 Also, in their work, Peacock and Wiseman initially claimed that their hypothesis is dependent on an assumption that defense expenditure is decided in contention with the other expenditures influenced by the internal factors of British society. However, when the war-related defense spending was excluded, the displacement effect persisted (Bird, 1972). Further studies led to the conclusion that crisis situations like wars lead only to temporary peaks in government expenditures rather than leading to a displacement effect (Bird, 1972). In the later version of their book, Peacock and Wiseman related the displacement effect to the nature of expenditure. Further, tax rises could put the general public at risk in a crisis by lowering their purchasing power. More government spending resulting in more public goods does not guarantee that the country’s problem will be resolved. This claim is based on an analysis of the United Kingdom’s expenditure pattern; hence the theory is limited. The idea presented is somewhat vague, and lacks empirical support (Bird, 1972). Public Expenditure Theories Based on Public Economics These theories have their roots in political economy but can be analyzed through “simple properties of traditional economics.” The optimality in the distributions of benefits from public goods by the government and the optimal mix of public and private goods as reflected in the preferences of the economic agents are at the root of this class of analysis. We include the Pigouvian framework, Samuelson’s Pure Theory of public expenditures and Tiebout’s “voting with the feet” model for local public goods. We start with Arthur Cecil Pigou who proposed an economical approach to determining the composition of government expenditure and budgeting in the 1920s. The idea suggests that the government spends its limited resources on alternative services in such a way that the marginal benefit is the same across all expenditures. The theory uses the example of a person who decides to spend his income on products and services to maximize utility. According to Pigou, “Expenditure should be so distributed between battleships and poor relief in such wise manner that the last shilling devoted to each of them yields the same real return.” Dalton proposes a similar idea, stating that the government should spend in such a way that the marginal societal benefits in all directions are equal and balanced with the drawbacks of increasing public revenue (Dalton, 1920; Mayshar and Yitzhaki, 1995). The theory also calls for an optimum level of taxation that minimizes total costs and the size of the budget where marginal benefits equal marginal costs (Musgrave, 1969). The maximization of benefit with public expenditures is desirable, but implementing the theory is complex (Peacock and Wiseman, 1961; Musgrave, 1969). The benefits of spending on each item of the expenditure program are difficult to quantify (Musgrave, 1969). For example, the gain from building roads cannot be precisely defined or accurately measured. The evaluation of every government activity is difficult due to the multiplicity and complex nature of public activities. The theory posits that the government is generally concerned with enhancing service delivery. However, the community’s long-term interests are also important. Furthermore, it is impossible to rule out some expenses just because they do not provide the desired results. Expenditures on unnecessary wars or many ministry departments may have negative consequences. Spending money on a loss-making organization that serves a public purpose may be justified. The theory expects the government to be efficient in its expenditure but is silent on how the costs and benefits can be defined for the best outcome of the spending

246  Research handbook on public financial management plan (Musgrave, 1969). The cost-benefit analysis shows a partial approach as it does not provide the necessary link between the expenditure and the revenue side. Samuelson (1954, 1955, 1958), developed a new framework and a diagrammatic explanation of the efficient level of public expenditure. According to this model, individuals express their preferences for private goods through market mechanisms and their choices for public goods via the ballot box or voting habits. Samuelson derives a formula that identifies the best mix of private and public goods based on the preferences of the people. He also considers whether combining public and private goods will lead to Pareto optimality, a condition in which no one can be made better off without making someone worse off. Private consumption goods, denoted by Y, can be consumed by individuals (1, 2, …, i, …, s): ​   Y… ​ (​Y​ 1​ + ​Y​ 2​ +  …  + ​Y​ s​) ​  =

​ (13.1) ​

The collective consumption good X is consumed by all and each individual’s consumption is the same: ​X​ 1​  ​=  ​X​ 2​  ​=   …  + ​X​ s​  ​=  X…

​ (13.2) ​

Eq. (13.2) holds for all the public goods and for all the individuals in the economy. Under standard neoclassical assumptions concerning an individual’s utility function Ui (.), the production possibilities F(.) and a social welfare function, three optimality conditions were presented and the second one is considered the new element, which according to Samuelson (1954) constitutes “a pure theory of government expenditure on collective consumption goods.” This condition is known as the Samuelson-condition for the Pareto-optimal provision of public goods (Pickhardt, 2006): s

∂ ​U​ ​ / ∂ X

​∑   ​ ​  _ ​ i    ​  ​=  _ ​ ∂ F / ∂ X   ​… i​=1

∂ ​Ui​ ​ / ∂ y​ i​ ​

∂ F / ∂ Y

 ​(13.3) ​

It states that the sum of the individual marginal rates of substitutions between the public good and the private good must be equal to the marginal rate of transformation between the two goods. There is widespread disagreement both on fundamental aspects of the theory as well as on its significance for the determination of government expenditure. Colm (1956) remarks that the theory explains the distinction between the private and public sectors of the economy. Still, a view of public expenditures should help us understand why the government and others carry out some activities through private agencies in a particular economic system. The divisibility criterion does not directly distinguish between the private and public sectors of the economy. Certain public goods are provided by the government on a cost-benefit basis, while the private sector may supply some philanthropic services (Colm, 1956). According to the theory, the voter is thought to be casting his or her ballot based on maximizing personal utility. However, each individual’s preference is typically influenced by other factors not considered in the framework (Colm, 1956). Also, the idea implicitly assumes that people select between private and public benefits by considering the overall amount of both goods, as more of one will lead to less of the other. With a greater need for various public services, such as better education, recreational facilities,

Foundations of public expenditure management  247 and urban development, the possibility of a simultaneous expansion of private and public goods in an economy cannot be ruled out. Tiebout agrees with Richard Musgrave and Paul Samuelson, that the market economy cannot provide public goods (Tiebout, 1956). In a positive political theory model set in the perspective of the local economy, it demands that people’s preferences should be disclosed, after which provisions and related taxes can be determined. According to the model, a local area’s jurisdiction and people will decide on an equilibrium provision of local public goods based on people’s preferences. However, this is not straightforward because people usually understate their preferences to avoid paying taxes for services and getting a free ride on public goods. By revealing public preferences and preference aggregation in a local area, local governments can achieved efficient expenditure. The idea is that a person consumes public and private goods in the same place. When local use of available products is linked to geography, a market-like situation emerges, minimizing the need for government intervention. This involves a unique way to reach an optimal tax rate in a community known as “voting with their feet.” Consumers choose to live in those towns with the mix of taxes and public goods they prefer. People can relocate to enhance their satisfaction. Local governments select this mix to attract inhabitants. There is an allocation plan and a production plan for consumers and producers. This model is centered around the following assumptions: (a)

Consumers are fully mobile because they will choose to live where their preferences are best addressed. (b) Consumers have complete knowledge of expenditure and revenue issues and react accordingly. (c) Voters have a vast number of communities to choose from. (d) Individuals’ income is predetermined, i.e., it is exogenous. (e) The average cost of providing public goods follows a U-shaped curve. (f) Each regional government spends the same amount on public goods as it collects in taxes. (g) Each government’s spending, tax system, and population selection align with its goals. The model describes the efficiency of government spending under very restrictive assumptions (Bewley, 1981). The theory assumes that public expenditure decisions are based on a clear government objective, but that is not always the case. If local governments are democratic, they attempt to improve the welfare of their inhabitants. Tiebout equilibria may not be Pareto optimal (Bewley, 1981). The existence of equilibrium is also subject to stringent assumptions. It is presumptively true that profit-maximizing local governments are ideal competitors. Otherwise, local governments’ monopoly power could lead to equilibria that are not always the most efficient. The assumption that individuals are fully mobile may not be accurate as migration involves costs and complexities (Bewley, 1981). Furthermore, it is inapplicable to unitary states where local administrations either do not exist or are controlled by the central government. The theory cannot be construed as a general theory of local public goods (Bewley, 1981).

248  Research handbook on public financial management Public Expenditure Theories Based on Political Processes In this section, our discussion on the public expenditure theories is based on two important approaches in which public expenditures are determined as an outcome of a political process. Anthony Downs provides an examination of the role of the political process in determining the level of government spending. David Easton’s Political Systems Theory proposes a “black box” model of policy analysis to explain the government spending emerging out of a policymaking process. Downs’ model, primarily based on the American system, asserts that governments select incomes and expenditures to maximize their chances of winning elections (Downs, 1957, 1960). The model explains public spending and political party competitiveness using the political systems method. Each political party promotes ideas that it believes will garner the necessary support to beat its opponents. According to Downs, the government will give voters what they want, not necessarily what is best for the voters (Downs, 1957, 1960). The spending must increase to meet the political promises resulting in larger governments, greater bureaucracies, larger budgets, and more difficulty in finding resources to fund the budgeted expenditure. The model is based on the assumption that people are more ignorant about the benefits of government spending than the costs (Downs, 1960). As a result, in a democracy, government expenditures will be less than optimal because the budgets will be smaller than they would be if all citizens had perfect information on both benefits and costs. In some instances, the quantification of benefits becomes difficult due to remoteness of the use. The model’s methodology is based on political parties’ knowledge of voter preferences and the consistency of those preferences. The model appears to be quite persuasive when seen from a political standpoint. There are, however, some limitations. First, in many countries, voters are just as ignorant about tax costs as they are about the benefits of government spending. Second, the approach ignores the impact of the political party’s ideology on budgetary decisions. One implication of this model is that if a public good is desirable from an economic standpoint, governments will be less likely to invest money in it because it is difficult for voters to attribute a specific benefit, such as spending on police reforms. But in reality, governments need to spend on such programs, too, for the overall use of society (Downs, 1960). Some contingencies or threats force the government to spend more, as under-investing in such cases can have harmful consequences (Downs, 1960). David Easton addresses the same problem in a different way. He describes the policymaking process as a “black box” that translates societal demands into policies (Easton, 1957). According to this model, the political system is that component of society which allocates resources in society authoritatively. Policies or decisions are the outputs of the political system or policymaking bodies in the black-box model, which are based on society’s inputs, demands, and feedbacks (Pennock, 1966; Easton, 1957). The inputs are of different types, namely demand for allocation of resources, demand for certain policies, or demand for information and communication. Inputs can also be the support provided by society in the form of voting or obeying laws. The system includes the government bodies that analyze the inputs. Based on the output, society provides the feedback that influences future policy decisions. Further, system maintenance becomes costlier as the economy become more complex. Figure 13.3 depicts the idea in the schematic diagram (Easton, 1957).

Foundations of public expenditure management  249

Figure 13.3

David Easton’s black box model

From the perspective of public spending management, the model explains public expenditure by analyzing environmental conflicts. The concept is plausible because the prevalence of inequitable development in the world best explains the rise of governmental spending on human well-being. The black box paradigm is not limited to capitalist countries. In reality, countries that have not rigorously adhered to capitalism have witnessed a rise in government spending. Though a public policy model, the black box model describes government spending as a function of various classes of variables. Public Expenditure Theories Based on Budgetary Allocations This section is devoted to a discussion on the theories of public expenditures which are based on considerations of the budget of a government. We start with Clark’s hypothesis fixing a proportion of the total expenditures in an economy as the allocation for government expenditures. We also discuss the idea of budget incrementalism which asserts that government considerations would influence the management of public expenditures. American political scientist Charles Lindblom first proposed the idea of incrementalism in the 1950s and it was further expanded by Aaron Wildavsky (Berry, 1990). The critical limit hypothesis is based on the taxation tolerance level proposed by British economist Colin Clark. According to him, government spending should not exceed 25 percent of total expenditure in the economy, and the taxation level should be limited to 25 percent of the national income (Clark, 1945). Clark considered the budget and national income data for twenty years to show the increase or decrease in the value of money. Through the data, he claimed the critical limit hypothesis for countries like France, Belgium, Italy, and Britain. Any additional taxation above the tolerance threshold dis-incentivizes the economy’s activities, resulting in a drop in production and employment. High government spending generates demand, but falling production owing to excessive taxation may generate inflationary pressures (Pechman and Mayer, 1952). The aggregate limit on spending and taxation is based on a study of data from Western countries shortly after the Second World War. Clark defined this essential limit based on an argument known as “transfer of allegiance,” in which influential members of society assert that

250  Research handbook on public financial management when taxes hit the 25 percent threshold, they will cause inflation (Pechman and Mayer, 1952). Government expenditures are expected to rise less than the general price level and national income during inflation because specific components of government expenditures, such as interest on the national debt and civil service wages, are set in money terms (Clark, 1945). The government might halt spending once inflation has dropped the tax burden sufficiently below the crucial limit. While aggregate demand rises due to an increase in money supply, aggregate supply falls due to disincentives generated by increased taxation. High marginal tax rates weaken employers’ oppositions to wage demands and encourage entrepreneurs to waste money (Pechman and Mayer, 1952; Clark, 1945). The theory’s most significant problem is the 25 percent cap on government spending. Pechman and Mayer (1952) have critically analyzed Colin Clark’s claim on the limit on taxation and government spending. The idea is limited since the “critical limit” is determined solely by observing Western countries. It is impossible to apply the same limit to all countries, leading to oversimplification. Multiple internal and external variables contribute to inflation. It is primarily influenced by monetary policy. Crossing the taxation ceiling will not always result in inflation. Several countries have crossed the “critical limit” without encountering inflation. The claim that levying an additional tax will decrease the burden of fixed charges is questionable. The amount of public spending measured in monetary terms would vary across countries and has no link to the percentage of national revenue covered by taxes. Only two countries – Britain and Norway – have data supporting Clark’s views. In many countries, the goal of tax reduction is to regulate the economy’s dynamics rather than to reach a critical limit. Most countries avoid implementing inflationary policies for fear of hurting their trade balance, as rising prices could result in a drop in the economy’s exports. The claim that high taxes were to blame for post-Second World War inflation in nations like Norway, Belgium, Italy, France, and Japan proves to be invalid. Inflation was a global issue at that time. As Clark’s argument demonstrates, the idea invites confusion as to whether his limit is in terms of government expenditures or taxes. It is impossible to conclude that politicians always favor more inflation. Individuals and households who rely on a fixed income will have their purchasing power eroded by inflation. A tax increase, in this case, can be politically challenging. High tax rates tend to lower labor incentives, but this isn’t always the case. The incentive varies greatly depending on the nature of the job, individual behavior, and other factors. Furthermore, the country’s taxable capacity is determined by the level of government activities. It will be even greater if the government delivers multiple services to people. Even if the government allocates a portion of its money to “nonproductive” objectives, the incentive may be less affected if people understand the importance of the expenditure. So far, the ideas addressed have looked at how factors outside of government influence the government’s spending decisions. But demands for public expenditure may be created within it. Lindblom introduced the concept of disjointed incrementalism and successive limited comparisons, which was critiqued by the author himself later (Lindblom, 1979). In contrast to purely rational decisions, he wanted the decisions to be based on a limited number of alternatives, simple decision rules with limited policy consequences that are feasible and acceptable. Various theorists gave their interpretations of the concept and the reason for the government to follow incremental budgeting (Berry, 1990).

Foundations of public expenditure management  251 Maffeo Pantaleoni, a public finance economist, proposed the Budget Incrementalism Theory in 1964 (Klein, 1976). According to this theory, budgets are practically never evaluated in their entirety. The budget for this year is based on the budget for the previous year. The argument blames political or intra-governmental obstacles for the government’s inability to re-evaluate each item of expenditure and develop a new budget. The most practical alternative is to base the current year’s budget on the basis of the previous year’s budget and only make minor adjustments when necessary. It emphasizes the constraints that limit government spending decisions, and government budgeting follows a predictable pattern and does not fluctuate much (Klein, 1976). On the other hand, zero-based budgeting is the polar opposite of incremental budgeting in requiring a new budget to be created every year (World Bank, 1998). Many countries, however, have either not implemented or failed to implement zero-based budgeting (Schick, 1998). It is neither politically nor fiscally feasible to assess every component of the expenditure program and justify its continuance or cancellation. The theory attributes gradual behavior to organizational processes. However, economic and political restrictions on overall public spending movements have little to do with the governmental system’s administrative mechanisms that yield incremental results. The theory does not account for situations in which overall spending follows incrementalism, but specific components of the spending program undergo significant modifications (Klein, 1976). This theory does not explain different interpretations of the concept of incrementalism. The view may overlook other components of public expenditure policies, such as the program’s administrative characteristics (Klein, 1976). A few points need special mention. Even if we assume that empiricism without solid theoretical foundations is of little or no use (Sartori, 1970; Macridis, 1968), we might not necessarily be able to test theoretical models and get significant results always. Empirical validity of the theoretical models might be questioned under different circumstances and these circumstances may vary across models. Second, as far as the empirical models are concerned, their validity can be tested in different countries and also in different policy premises and the results might vary. Third, some of the conditions derived in the theoretical models are not amenable to statistical verifications due to data constraints. Nevertheless, these theories can act as general guidelines for policy design.

CHALLENGES FOR PUBLIC EXPENDITURE MANAGEMENT This section examines the difficulties encountered during the expense management process. We discuss the challenges in estimating the expenditure needs of governments which form an integral part in estimating the fiscal capacity of the government and assessing its fiscal health. This can give an idea to the higher tiers of the government about the intergovernmental transfers. We also discuss the practical challenges in resource allocation and utilization, operational and financial efficiency, and challenges of partnership with the private sector. Challenges of Estimations In a decentralized economy, intergovernmental transfers play an important role. In order to get a clear idea about how many transfers a government may be entitled to, a clear assessment of the fiscal health of the government receiving the transfers is needed. Revenue capacity2 and

252  Research handbook on public financial management expenditure needs are the two components which impact the fiscal health of a government (Bahl, 2002). One of the most important challenges in public expenditure management is finding an appropriate methodology for accurate estimations of expenditure needs (Bandyopadhyay and Rao, 2009). Expenditure need is defined as the expenditure required to be incurred by the government to provide a service at a minimum acceptable standard. Often, there are certain standard norms for each service which conform to the minimum acceptable standards. Service delivery in a region might depend on the cost conditions in the region and due to regional disparities in costs, the expenditure needs might differ. The challenges of the estimation of expenditure needs are many. First, data on service delivery levels are rarely available. Second, it is hard to get reliable estimates on regional cost indices. Third, it is difficult to determine the service level norms for a region. Fourth, it is extremely difficult to estimate capital expenditure needs as these expenditures are lumpy, not necessarily incurred on an annual basis, and sometimes the actual levels are recorded as project or grant specific investments. The extent of these challenges differs across countries and also across goods and services provided by the government. Developing countries suffer from severe dearth of data and information required by the government or researchers to carry out useful analysis and estimations. The efficacy of expenditure management depends on a clear idea about the expenditure needs. On the one hand, this would give a clear indication about how many transfers can be received, on a purely objective basis, depending upon the status of the revenue collection of the government so that the gap can be filled by the upper tiers of the government. On the other hand, an accurate estimation of expenditure needs can shed light on the extent of underspending or wastage of resources on service delivery. Also, this can indicate the extent of under-provision of services. Improper estimations of important variables guiding expenditure management can lead to operational challenges faced by the practitioners concerned. Challenges of Implementations Resource allocation on field is a problem-solving activity in which various line ministries present their spending plans to the ministry of finance, which determines the total budgetary allocation for multiple sectors of the economy. However, the budget scenarios may be overly ambitious, with revenue predictions too optimistic about financing the politicians’ enormous spending (Schick, 1998; Atkinson and van den Noord, 2001; Department of Administrative Reforms and Public Grievances, 2009). There is frequently a misalignment between the fiscal plan, budget preparation, and budget implementation (Mathur, 2001). New policies and initiatives are being implemented with little regard for resource requirements (Atkinson and van den Noord, 2001). In the long run, a cash-based budget evolves, aiming to achieve some level of cash congruence between inflows and outflows. If there are time delays in infrastructure projects due to lack of funds, the sunk cost and other cost escalation render the project ineffective. In other circumstances, the concerned line ministry refuses to reveal the project’s actual cost (Atkinson and van den Noord, 2001). There is a lack of transparency regarding the cost of government programs, utilization of money by the government, and benefits of the chosen policy (Atkinson and van den Noord, 2001). The “toe hold” approach is a strategy in which the line ministry focuses on getting funds for the program in the first year by asking for less money. The last quarter and month of the

Foundations of public expenditure management  253 fiscal year are when the majority of the annual budget is spent. Because the allocation for the following year may be determined in part by the current year’s expenditure rate, agencies work hard to use all of their funds by the end of the fiscal year. As a result, existing plans are thrown off because resources are not invested when needed, leading to wastage of resources (Atkinson and van den Noord, 2001). There are particular concerns about the operational controls imposed on expenditure agencies to improve financial and operational efficiency. Process controls, which tend to be a deterrent, dominate the structure. Intervention by central authorities can be obtrusive and thus counterproductive at times, as the systems tend to favor dysfunctional conduct due to ineffective norms (Schick, 1998; Atkinson and van den Noord, 2001). Both state and central politicians, in varying degrees in different regions, often interfere in the functioning of municipalities leading to inadequate functioning of spending plans at the local level. Furthermore, the predominant focus on spending management without regard for the budget organization’s or ministries’ internal workings may result in underfunding priority sectors (Atkinson and van den Noord, 2001). An essential precondition for the efficient provision of public services is clarity in the assignment of functions (expenditure responsibilities) to each level of government (Atkinson and van den Noord, 2001). It will depend on the capacity of the jurisdiction to provide the service, the technology available for service provision, and the extent of diversity in demand for the service, among other things. For instance, bundling of services under local governments, as claimed by Charles Tiebout in case of variation in demand, will create problems in maintaining efficiency. Lack of clarity in the assignment system is not only between the states and local bodies; there are also confusing areas of concurrence between local bodies and independent agencies delivering various services. In India, for example, parastatal bodies are founded by higher-level governments, notwithstanding the local government’s constitutional authority. These parastatal institutions report to the state or the federal government rather than the local governments, which provide essential services. This leads to issues of coordination as well as a lack of control that local governments should have. The evaluation system of the government schemes remains weak, which extends the implementation of poorly framed plans (Mathur, 2001). Significant financial investments are required to build infrastructure and provide high-quality public goods and services, creating a need for the governments to engage the assistance of the private sector to provide additional financial and management experience (Hodge and Greve, 2007). Public–private partnerships (PPPs) are employed by the federal and state governments and municipal governments for improved public service delivery or public assets for people (Bloomfield, 2006; Premchand, 1993; Hodge and Greve, 2007). There are several types of these partnerships, each about different aspects of project financing, management control, and future transfers of the assets developed. The failure of these efforts has put governments in many nations worldwide under financial strain. During the development of PPP contracts, there is a lack of collaboration among government ministries and administrative departments (Kutumbale and Telang, 2014). There is a lack of required expertise to frame long-term contracts, leading to poor quality plans (Hodge and Greve, 2007; Kutumbale and Telang, 2014). Project delays result in time and expense overruns, often not incorporated into the contract (Kutumbale and Telang, 2014).

254  Research handbook on public financial management

CONCLUSIONS Given the government’s crucial role in public policymaking and delivery, public expenditure management is very important. For public financial management to function effectively, spending must be in sync with revenues the government earns, and thus with the income of the country. We have to take into account the country’s tax administration and debt levels while chalking out the optimal spending levels. Due to limited resources and different competing objectives to spend money on, governments must assess the opportunity costs of spending on a specific program. At the heart of these calculations should be social welfare priorities, which have to be decided on the present state of affairs and the future goals. A judicious prioritization of social welfare objectives and well-designed spending plans on these prioritizations can enable the public financial system to become self-sustaining. The assurance of social welfare will enhance the faith in the government which in turn can ensure the vote banks as well as the flow of resources to finance the services through taxation and other means in a continuous manner over time. Various theories have been formulated to explain the factors affecting public expenditures. Despite all of these efforts, none of these theories proves to be complete. In practice, many of the steps such theories suggest are difficult to apply in a real-world scenario. The marginalist principles suggested by the theories demand rigorous estimations of social incremental benefits which are hard to quantify and thus cannot be estimated accurately using quantitative methods. Social benefits can be manifested in macroeconomic well-being indicators that can reflect the overall effectiveness of public expenditures. Models based on political parties deciding on expenditures which emphasize winning elections or expenditure decisions solely depending on society’s inputs and feedbacks may prove to be arbitrary and do not suggest any objective basis for expenditure planning. The guidelines on the limits on spending depending on the size of the budget or the incremental nature of budget are difficult to generalize as a country’s budgetary system is based on multiple social, economic and political factors which can vary across countries. Because of this, the practical application of these guidelines becomes difficult across different countries. A problem also arises in understanding the fine distinction between planned expenditures, actual expenditures and expenditure needs. The challenges in estimating the expenditure needs lead to inaccurate estimations of the fiscal health of the governments which lead to mis-allocation of resources. These mis-allocations can be in sector specific spendings as well as in intergovernmental transfers. Research is inadequate in the design and execution of expenditure systems. The challenges in estimations can be overcome by innovative and practically oriented research, which can overcome the challenges in implementation. Capacity building programs can improve the databases and record keeping systems, and also train personnel to handle data better. Administrative reforms can help to strengthen the government machinery and in defining the assignment of responsibilities clearly and can also address the challenges specific to an economy. This can prepare the ground for further improvements.

NOTES 1.

In this chapter we do not explicitly discuss revenues and assume them to be exogenously given.

Foundations of public expenditure management  255 2.

In this chapter we concentrate on the expenditure need aspect only.

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Foundations of public expenditure management  257 Samuelson, P. (1958). Aspects of public expenditure theories. The Review of Economics and Statistics, 40(4), 332–338. Sartori, G. (1970). Concept misformation in comparative politics. American Political Science Review, 64(4), 1033–1053. Schick, A. (1998). A contemporary approach to public expenditure management. World Bank Institute, 68(1), 2–11. Shim, J. and Siegel, J. (2005). Budgeting Basics and Beyond (2nd edition). Hoboken, NJ: John Wiley & Sons. Tiebout, C. (1956). A pure theory of local expenditures. Journal of Political Economy, 64(5), 416–424. Timm, H. (1961). Das Gesetz der wachsenden Staatsausgaben. Finanzarchiv, NF 21: 201–247. Tuna, K. (2013). Türkiye’de Wagner Kanunu’nun geçerliliğinin test edilmesi. İşletme ve İktisat Çalışmaları Dergisi, 1(3), 54–57. Uzuner, G., Bekun, F. V., and Saint Akadiri, S. (2017). Public expenditures and economic growth: Was Wagner right? Evidence from Turkey. Academic Journal of Economic Studies, 3(2), 36–40. World Bank (1998). Public Expenditure Management Handbook. http://​www1​.worldbank​.org/​ publicsector/​pe/​handbook/​pem98​.pdf.

14. Future directions for research in public expenditure management Travis St. Clair

INTRODUCTION As the public sector has expanded over the course of the twentieth and twenty-first centuries and public budgets have become increasingly complex, the need for theories and approaches to manage public expenditures and allocate public funds efficiently has become urgent. Over time, the field of public financial management has made considerable progress in addressing these challenges. In particular, the field has developed conceptual frameworks – both descriptive and prescriptive – for understanding the allocation of public funds and produced a great deal of empirical work documenting the challenges governments have faced in managing their expenditures and the successes and failures that have resulted. This chapter builds on the preceding chapters on the theory and practice of public expenditure management to explore future directions for research. Although definitions vary, by public expenditure management this chapter refers broadly to the procedures and frameworks that governments use to spend within their means and to allocate public resources in a manner that will result in the largest possible benefit for all. To explore future directions for research, the chapter will highlight recent key findings as well as emerging topics of interest, including policy areas that are expected to be a significant source of future spending pressures. The chapter is organized around the following themes: data, methods, theory, and topics of interest. The second section discusses new sources of data and the lines of research they potentially open up. The third section discusses the research methods that the field has mainly relied on to date as well as methodological developments in related social science disciplines that offer substantial opportunities to scholars working with public expenditure data. Just as the field will need to embrace new methods, the explosion of data also calls for more theories and paradigms that can organize researchers’ and policymakers’ thinking about public expenditure pressures as well as make sense of empirical findings; the fourth section suggests how such theory development might occur and areas that remain theoretically underdeveloped. The final section outlines topics – both new and enduring – that are likely to have a significant bearing on public budgets and to be of interest to policymakers, including approaches to public expenditure management as well as sources of expenditure pressures.

NEW DATA In the past, research on government finance has frequently involved painstaking collection of data from budgetary documents or other government records. While there are various compendiums of government financial data, such as those made available by the World Bank, the IMF, the OECD, and (in the United States) the Census of Governments and the National Association 258

Future directions for research in public expenditure management  259 of State Budget Officers, these datasets all suffer from various shortcomings. The international datasets contain limited line-item detail and are not easily comparable across countries. With the exception of the Census of Governments, the US datasets do not include comprehensive data on local governments and special districts. None of these sources contain comprehensive financial statement data prepared according to generally accepted accounting principles. In particular, there is a notable lack of high-quality balance sheet data. More recently, with the rise of the internet and an increased focus on transparency, governments have begun to make available online more detailed budgetary and accounting data. The Open Budget Survey, which tracks fiscal transparency around the world, documented a 20 percent increase in budget transparency between 2008 and 2019, with particular progress being made in Eastern Europe and Central Asia, East Asia and the Pacific, and Latin America and the Caribbean (International Budget Partnership, 2019). In the United States, the state of New York now makes available for download detailed financial data for local governments in the state, including asset and liability accounts such as accounts receivable and accrued liabilities.1 The California State Controller’s Office has also set up a website that makes accessible revenue and expenditure data for local governments and facilitates comparisons both between governments and within governments over time.2 These trends open up new horizons of research, particularly around the assessment of governments’ financial condition and creditworthiness. Not only does the internet make traditional accounting data more accessible, but it also facilitates novel methods of data collection. This might include web scraping of government budget documents or statutes. It might include the collection of web search data, such as is available from Google Trends, or data from social media accounts. Researchers also have the ability to remotely observe, record, or obtain transcripts from legislative sessions or board meetings in a way that would have been impossible only a few years earlier, thus enabling them to extract data in the form of video or text. These alternative methods of data collection enable research to create new sorts of datasets from old sources, such as budget documents, but they also provide a means of collecting information on policy outcomes that are downstream of government spending and are thus relevant to evaluating the allocative efficiency of government expenditures rather than just collecting information on the spending items themselves. In the past, data limitations have curbed the relevance of performance budgets, which typically identify outcomes that cannot be easily measured by standard performance metrics. For example, Baltimore’s 2021 performance budget identifies clean and healthy communities and equitable neighborhood development as key indicators of interest (City of Baltimore, 2021). By collecting data from web searches on social media accounts, researchers might be able to document trends in health outcomes or adverse housing events so as to track these indicators much more closely than would be possible using traditional methods. These trends also invite researchers to engage with new types of data, such as text as data or spatial data. Video from budget hearings may open new windows for scholars to understand the budget approval and oversight process. Spatial data may enable researchers to highlight the spatial geography of spending and its spread. Economists have already begun to exploit geographic boundaries as a means of studying institutions, particularly in the developing world (Dell, 2010), but spatial data also presents opportunities to gain new insights into topics with a geographic bent, such as budget spillovers or fiscal contagion. Recent research on fiscal contagion in the United States shows how municipal bankruptcies have the potential to affect

260  Research handbook on public financial management the borrowing costs of geographically proximate governments as well as other government borrowers with similar observable characteristics (Yang, 2019). This line of research is ripe for further exploration and analysis using more fine-grained spatial information.

NEW METHODS With more data comes the opportunity for researchers to ask different sorts of questions, explore old questions in new ways, obtain more externally valid results, and explore heterogeneity. However, these steps require the appropriate tools. In recent years, social scientists have developed extremely rigorous approaches to research design and causality. Public management has begun to embrace some of these approaches; however, in its quantitative work, it still lags behind other disciplines, and there has been little attempt to marry quantitative and qualitative approaches. A great deal of research in public financial management still relies on quantitative empirical methods that are designed to uncover correlations but that are either (1) not sufficient to make causal claims, (2) not sufficiently transparent about the assumptions needed to infer causality, or (3) not sufficiently transparent about why the reader should be interested in a correlation, if that is indeed the estimand of interest. The insight offered by the “identification revolution,” pioneered mostly in economics, is that a strong empirical study should be guided by a clear research design, and that clever analysis is not a substitute for poor design. As the Harvard statistician Don Rubin put it in the title of one of his papers, “For objective causal inference, design trumps analysis” (Rubin, 2008). Increased attention to research design and examination of the assumptions underlying the methods are already beginning to reap rewards for the field. For example, consider the body of literature analyzing Colorado’s Taxpayer’s Bill of Rights (TABOR), considered by many to be the most restrictive of the state-level TELs (tax and expenditure limitations) in the United States (McGuire and Rueben, 2006). No fewer than 17 articles were written on the law,3 all echoing Martell and Teske’s (2007: 687) conclusion that “TELs definitely limit states’ income-adjusted per capita expenditures … Colorado’s series of TELs, culminating in TABOR, have resulted in the lowest income-adjusted per capita expenditures of all the western TEL states.” In contrast, more recent work that capitalizes on the synthetic control methodology of Abadie et al. (2010) and is much more transparent about the assumptions underpinning the analysis, finds no evidence TABOR affected the level of taxes or spending in Colorado, overturning the widely-accepted conclusion that strict TELs alter budget outcomes (Eliason and Lutz, 2018). The authors instead conclude that the law was a “ratification of the state’s preference over the size of the public sector” (Eliason and Lutz, 2018: 144). These methods should not be seen per se as a rejection of past work on the topic; rather, they offer a tool for refining past conclusions and challenging assumptions that have been taken for granted. Nor are quasi-experimental methods the only path forward in quantitative research. Other methods that seek to bring increased transparency and rigor to quantitative empirical research include directed acrylic graphs (Pearl, 2009), machine learning, and causal meditation analysis (Keele, 2015). Furthermore, public expenditure management is well-suited to take advantage of recent trends in social science methodology that seek to couple quantitative

Future directions for research in public expenditure management  261 and qualitative methods, with ethnography playing a particularly important role in uncovering mechanisms (Godoy et al., 2021). This is not to suggest that the future of research in public management will necessarily involve a quantitative component. Qualitative research will remain an important vehicle for theory exploration, as I discuss further below. In fact, many of the same arguments that apply to quantitative methods apply to qualitative methods; there is a need for greater transparency in the assumptions and clarity regarding the underlying theoretical principles that are being tested. Qualitative research may also benefit from some of the improvements in data and technology discussed in the previous section, particularly as it relates to text analysis and classification.

NEW THEORIES Research on public expenditure management has remained largely empirical. Nevertheless, there have been a few important conceptual frameworks that have guided research in the field, many of which were outlined in Chapter 13. To touch briefly on two developments: In 1940, V. O. Key famously established the goalposts for the discipline – at least as it pertains to allocative efficiency – when he asked: “On what basis shall it be decided to allocate x dollars to activity A instead of activity B?” (Key, 1940). As Allen Schick wrote in 1981, “this question remains unanswered and is probably unanswerable” (Schick, 1981). Nevertheless, Schick’s 1966 article, “The Stages of Budget Reform,” made progress by linking developments in budgeting to the shifting aims of government spending and incorporating many of the terms used in the emerging field of program evaluation. Utilizing the terminology first developed by Robert Anthony (1965), Schick (1966) noted that budget reforms had evolved through distinct stages corresponding to different budget orientations: the control phase, with its emphasis on fiscal discipline associated with line-item budgeting; the management phase, which emphasized the efficiency associated with work-cost measurements; and the planning phase, corresponding to the long-term planning focus associated with the outcomes – rather than just the outputs – of the budget process. Other theoretical lenses have emerged, primarily from public administration. These include incrementalism (Wildavsky, 1964), public choice (Buchanan and Tullock, 1962), and punctuated equilibrium theory (Flink, 2017), among others. Nevertheless, few of these theories have unified the discipline. In part, this is because the field has joined the tide of empiricism and is perhaps less embedded in theoretical frameworks than in the past. It may also be due to the interdisciplinary nature of public financial management, which draws on theories from a multitude of disciplines, including economics, political science, public administration, accounting, and finance. Moreover, the significant differences between the budgetary processes in developing countries and those in wealthier countries has led to a schism between work that focuses on international topics and work that focuses on the institutional arrangements in countries like the United States. These challenges raise the question: How will new theories emerge to guide such an interdisciplinary and fragmented discipline? One place they are likely to emerge from is the same place where they have emerged from in the past: qualitative case studies and careful historical work that details the multifaceted forces at work in public decision-making. Since 2001, the OECD Journal on Budgeting has produced reviews of the budgeting systems of member countries, incorporating historical,

262  Research handbook on public financial management political, and economic analysis. The past few years have also seen several book-length case studies of municipal bankruptcies or near-bankruptcies in the United States, including Detroit Resurrected by Nathan Bomey and Fear City, by Kim Phillips-Fein (Bomey, 2016; Phillips-Fein, 2017). Although not written with an eye toward developing theory per se, these works offer various lenses through which scholars can approach and analyze fiscal discipline and allocative efficiency. Another potential source of theory from the social sciences is welfare economics, and in particular the links that have been drawn between government expenditures and cost-benefit analysis. While social scientists have long understood that cost-benefit analysis provides a useful framework for evaluating government policies, the difficulty of conducting proper cost-benefit analyses and measuring all of the pertinent outcomes has made the tools of welfare economics almost irrelevant to budget analysts. However, recent developments suggest alternative approaches to welfare analysis that are less analytically burdensome. In particular, Finkelstein and Hendren (2020) propose a framework for empirical welfare analysis that uses the causal estimates of a policy’s impact on net government spending. Hendren and Sprung-Keyser (2020) apply this framework to a wide range of historical policy changes, concluding that direct investments in low-income children’s health and education have historically had higher social returns than policies targeting adults. The methods and findings from this literature may prove useful to public management scholars trying to assess the allocative efficiency of different spending programs.

TOPICS This section moves away from the methods and analytical frameworks employed by public management researchers and explores instead topics that are likely to be consequential in the years to come. These topics include some, such as fiscal rules, accrual budgeting, performance budgeting, pensions, infrastructure, and healthcare, that have already been the subject of substantial research but nevertheless will remain topics of enduring interest. Other topics, such as climate change, participatory budgeting, equity, and globalization, are newer and will require researchers to approach them without a well-developed literature to draw upon. Enduring Topics Fiscal rules One of the most important areas of inquiry in public expenditure management is fiscal rules, sometimes referred to under the broader term “fiscal institutions.” As wealthy countries such as the United States and Japan have struggled with persistent central government deficits over the last several decades, they have increasingly turned to fiscal rules as a means of exercising control over their spending. In the United States, this has come in the form of deficit reduction targets, as in the Balanced Budget Emergency Control Act of 1985, the Budget Enforcement Act (1990), and the Budget Control Act (BCA) of 2011. In Japan, the main ratio that the government has attempted to control has been the ratio of government debt to GDP (Martínez Guzmán and Joyce, 2020). Despite the lack of success that these rules have had in reinforcing budget discipline, fiscal rules are only becoming more commonplace; in 2012, 76 central gov-

Future directions for research in public expenditure management  263 ernments had at least one national or supranational rule, compared to only five governments in 1990 (Schaechter et al., 2012). Formal fiscal rules, which include tax and expenditure limitations (TELs) and balanced budget requirements, will continue to be important areas of inquiry for the field due to the central role they play in expenditure management. Furthermore, as data proliferates, there will be increasing opportunities to use modern empirical tools to study these rules more rigorously, as the above-referenced paper by Eliason and Lutz (2018) demonstrates. Moreover, as governments come up with ways to address new spending challenges, such as climate change, they may utilize new types of funds and legal restrictions to manage their spending, creating new types of institutions to study. Accrual budgeting While there exists a substantial research literature on fiscal rules and formal fiscal institutions more generally, the literature on the format and structure of budgets is perhaps less well-developed. This is especially true for the accounting basis of budgets. (In some countries, the use of accrual budgets may be codified in law, and thus accrual budgeting can in some cases be considered a part of the formal rules that make up the budget process; however, in other places the rules that govern the format and structure of budgets are not statutory in origin.) While accrual budgets have been in use in Australia, Canada, and the UK for many years, and the vast majority of OECD countries use accrual accounting in their year-end financial statements (OECD/IFAC, 2017), there is a surprising lack of consensus and high-quality empirical work around the impact of accrual budgeting in the public sector. As central governments wrestle with how to rein in deficits, this may be a potentially fruitful avenue of inquiry; after all, accrual budgets address one of the main problems with cash budgets, which is that politicians have an incentive to offer generous benefit and spending programs, so long as the cost is borne by future taxpayers (and politicians) rather than current ones. Performance budgeting One budgeting orientation that has received a fair share of attention in the research literature is performance budgeting, which has been a subject of inquiry since at least the middle of the twentieth century. While early research on the topic confined itself to case studies or theoretical examinations of the principles involved, more recent research has examined the topic from more of a comparative perspective and used more wide-ranging data (see, for example, Martínez Guzmán, 2020 and Martínez Guzmán, forthcoming). Despite the overabundance of literature, there is still no clear-cut evidence on whether performance budgeting is effective at realizing its goals, and no widespread agreement on its efficacy. Whether performance budgeting will continue to be of interest as a research topic will depend on the extent to which it continues to be implemented and whether there exists sufficient data and exogenous variation to permit more rigorous evaluation of its merits. Pensions and old age benefits Countries around the world struggle to maintain pensions systems that adequately support citizens in their old age but that also do not put undue strain on the rest of the budget. In many developing countries, such as in Latin America, the challenge is to foster precautionary savings, especially among informal workers (Martínez Guzmán and St. Clair, 2021). Wealthier

264  Research handbook on public financial management countries, on the other hand, continue to debate funding mechanisms and the appropriate path to long-term solvency. There has also been a sizable amount of research, especially in the United States, on post-employment benefits for government workers. Many state and local governments in the United States continue to struggle with sizable pension and other post-employment benefit (OPEB) liabilities on their balance sheets. While a substantial research literature related to the challenge of funding pension liabilities has developed ever since the 2008 financial crisis, the literature on OPEB liabilities remains extremely thin. As the body of work on post-employment benefits at the US state level draws attention to many of the challenges and trade-offs with pension systems, I highlight the different strands of research. Pensions and other post-employment benefits represent “legacy” costs, i.e. a large portion of the associated liabilities are due to promises made by previous administrations that did not have to fund the benefits themselves. While the pension literature has devoted considerable attention to discount rates (Novy-Marx and Rauh, 2011), actuarial assumptions (Chen and Matkin, 2017), funding practices (Munnell et al., 2014), pension reforms (St. Clair and Martínez Guzmán, 2018), and the relationship between pensions and other forms of saving (Bosworth and Burtless, 2004; St. Clair, 2013), there remain a few promising avenues of pension research. One is related to the political nature of post-employment benefit liabilities: politicians face incentives to make promises that their successors will have to pay for. There is still a dearth of research, in political science and elsewhere, that examines how to curtail these incentives and what institutions might be helpful in addressing the political dynamics at the root of unfunded post-employment liabilities. Another fruitful avenue in which the field has recently begun to make headway is in understanding the implications of public pensions for employee recruitment and retention. After all, if governments offer generous benefits to their employees and bear the investment risk themselves, then what do they get in return for these payments? Recent research shows that generous deferred benefits do increase retention, though the effects are somewhat small and differ by worker type (Gorina and Hoang, 2017; Quinby, 2020). One tantalizing question – perhaps impossible to answer – is whether or not it makes sense for governments to continue offering defined benefit plans in light of the value that employees ascribe to them (Fitzpatrick, 2015) and their effects on retention/recruitment. OPEB in many respects presents a more complicated research topic than pensions. Healthcare benefits are not given the same degree of legal protection as pensions. Moreover, estimating pension liabilities requires discounting a stream of cash flow payments that are well-known in advance, whereas estimating OPEB liabilities requires estimating the future cost of healthcare benefits, which are subject to considerable policy uncertainty. Nevertheless, these challenges also present opportunities for researchers, as OPEB expenditures and OPEB reforms shed light on the trade-offs that legislators face in balancing expected increases in healthcare costs and retaining a healthy workforce. There is also much more OPEB data available to researchers than there has been in the past, at least in the United States. While financial reporting on OPEB has lagged financial reporting on pensions, GASB 75 placed OPEB liabilities on government balance sheets for the first time at the full present value of projected benefit payments, meaning that researchers now have access to high-quality data on government OPEB liabilities and expenditures. Calabrese and St. Clair (2021) capitalize on this change to measure, among other things, the expected annual growth in healthcare costs that state governments use in calculating their OPEB liabilities.

Future directions for research in public expenditure management  265 Healthcare Although healthcare is invariably one of the largest spending items in government budgets, the field of public financial management has perhaps focused on the subject less than is merited. One potential reason that health spending is studied primarily by health scholars or economists rather than public management scholars is that the best available data are often in the form of individual-level insurance claims, a level of observation that is several steps removed from the line-items on government budgets. Moreover, healthcare systems differ widely across countries, making it difficult to draw comparisons. In the United States, the complicated patchwork of systems – private insurance, public exchanges, Medicaid, Medicare – also frustrates attempts at systematic analysis. Nevertheless, given healthcare’s disproportionate role in government budgets, it will be necessary for public management scholars to grapple with the topic. In the United States, the federal government devotes roughly a quarter of its budget to Medicare and Medicaid, while Medicaid is the largest expense for states governments after K-12 education (Pew Trusts, 2020). To make inroads, public management scholars will need to approach the topic from a different perspective than that taken by health scholars. For example, there may be opportunities to exploit payment reforms to investigate the effect that payment schemes have on aggregate spending. There may also be opportunities to explore the effect that policy uncertain in healthcare – e.g., whether or not the United States will move to a single payer system – has on the management of present-day expenditures and liabilities. Infrastructure According to the McKinsey Global Institute, current forecasts for GDP growth require $3.3 trillion in infrastructure investment every year through 2030, which corresponds to a gap of $350 billion per year at current levels of investment (McKinsey Global Institute, 2016). The American Society of Engineers gives the United States in particular a D+ for the current state of its infrastructure, making infrastructure development a crucial domestic policy concern in the years to come (American Society of Engineers, 2017). The US federal government has proposed a number of strategies for stimulating infrastructure investment, including lowering the cost of borrowing for state and local governments, engaging in more direct spending, and encouraging private sector development. While there is bipartisan demand for infrastructure spending, paying for it remains a significant challenge, given persistent federal deficits and tight state budgets. High labor costs, due to highly specialized occupational roles and out-of-date work rules, present an especially challenging obstacle, especially in large metropolitan areas like New York City (Regional Plan Association, 2018). Nevertheless, labor costs are not the only challenge; Brooks and Liscow (2023) also point to the rise of “citizen” voice in government decision-making as a factor. Public–private partnerships (PPPs) are often touted as a solution to the challenge of infrastructure financing; however, there is still little research on the topic, mostly due to a lack of high-quality data. While the World Bank maintain a database on private participation in infrastructure (PPI), there are significant gaps in the data. Moreover, the details of PPP financing differ substantially from project to project, making it difficult to draw conclusions about the topic as a whole. The work that does exist mainly outlines the conditions under which PPPs make sense or are worth considering (Engel et al., 2013). Future questions worth exploring include: Have previous large projects financed by PPPs achieved the desired results (in terms of costs and risk) for government clients? What are the cost savings from a typical PPP project relative to financing a project through municipal bonds?

266  Research handbook on public financial management New/Emerging Topics The above topics have already been explored to some depth, even if there are certain angles and perspectives that remain unexplored. The topics below, on the other hand, have not been studied extensively from the perspective of public expenditure management. They are all at the forefront of public debate and have all been written about in other disciplines. Nevertheless, certain challenges – data limitations or the interdisciplinary nature of the topic – have prevented them from being studied by financial management scholars. As such, the topics represent untapped opportunities. Climate change As the threat of climate change becomes more pressing, its impact on government expenditures at all levels is likely to increase. While central governments will surely bear the majority of the financial costs due to the borderless nature of climate hazards, decentralized governments too will face pressure from natural disasters and necessary infrastructure improvements. Despite the enormity of this threat, this is a surprising scarcity of research on climate change expenditures and their role in government budgets. Much of the research that has appeared is in environmental journals rather than in public management or public finance journals.4 One likely explanation for this is that public management scholars are not well-versed in the technical details of climate science and consequently face difficulties in linking the scientific impacts of climate change to their impacts on public budgets. After all, climate change encompasses a complex set of phenomena that includes discrete weather-related “disasters,” such as hurricanes and wildfires, as well as chronic stresses, such as heat waves and sea-level rise, that can be difficult to trace back to individual governments. This is made even more complicated by coordination challenges among different levels of government and differences across the population in the demand for climate-related expenditures. Despite these challenges, understanding the expenditures that will be required to combat climate change – for reasons of both mitigation and adaptation – as well as the trade-offs involved represents one of the most significant challenges – and opportunities – facing the public management community. Grappling with climate change will require not just scientific expertise, but also systems of classification that will enable governments to better track and manage the expenditures. Open questions related to climate change expenditures include: Through what specific routes will efforts to combat climate change translate into government expenditures? What sorts of spending efforts will be most productive? What sorts of trade-offs will governments need to make to manage their climate spending? What is the most efficient allocation of spending across different levels of government? Equity and the distribution of expenditures As income inequality in the United States has widened in the past few decades and the country has continued to grapple with racial injustice, the social sciences have increasingly attempted to contend with the relationship between public policy and inequities across race, class, and income lines. As government budgets are the vehicle through which public policies are funded, it is natural that social scientists should also investigate how the allocation of public monies affects the distribution of wealth and opportunity. This dynamic is of course woven through all

Future directions for research in public expenditure management  267 of the topics referenced above, but nevertheless represents an ongoing public policy challenge, not to mention a source of controversy and division. While much of the discussion about income inequality and public finance centers on tax policy, the expenditure side of the budget obviously plays an equally vital role in ensuring an equitable distribution of wealth and opportunity. And while an economic approach to federalism would suggest that redistribution should primarily be undertaken by the central government given the incentives subnational redistribution otherwise creates for migration (Oates, 1972), regional differences and legislative theories of federalism suggest that state and local budgets are not exempt from addressing concerns about inequality. The field of public finance has long grappled with the interplay between allocative efficiency and redistributive concerns; however, these questions have traditionally been posed strictly in terms of income inequality. Indeed, the field has responded to concerns about widening income inequality by, among other things, developing methods for the use of social welfare weights in welfare economics that enable analysts to more flexibly consider equity concerns (Saez and Stantcheva, 2016). However, public debates increasingly center on other dimensions of equity, particularly age, race, and gender, and especially on the interplay between categories. Of these, only age has received significant attention, perhaps in part to the increasing acknowledgment that US federal spending is skewed toward the elderly. In its analysis of the distribution of federal spending, the Congressional Budget Office examines the distribution across income lines but also household types, which divide households into elderly, nonelderly with children, and nonelderly without children (CBO, 2013). On the other hand, work that examines the distribution of spending along gender and racial lines remains underdeveloped. While work on gender equality has a long history (see, for example, Rao, 2015), most of this work is prescriptive, and with better data there remain opportunities to investigate the impact and effectiveness of spending. Racial justice has gained increasing attention in recent years as a policy topic of interest, yet has received little sustained attention in public financial management research. As with work on gender, the increasingly availability of large datasets means that future work on the topic need not be only prescriptive in nature, but can also evaluate empirically the impact of government spending on racial inequality as well as the relative effectiveness of various government programs. Gale (2021) highlights parallels between the conceptual issues that arise in public finance and in the analysis of racism and proposes several useful directions for future research on the topic. He notes how the analysis of racism requires researchers to carefully measure the full incidence of policies, a measurement problem very familiar to public finance scholars. He further shows how the analysis of systemic racism – and in particular the notion that the effects of discrimination in one market inevitably spill into other markets – shares important similarities with analyses of general equilibrium effects, illustrating how the tools of public finance are particularly well-suited to analyze the effects of policies that may have potentially unintended consequences on racial disparities. Participatory budgeting One innovation in budget process that may play a role in addressing equity concerns is participatory budgeting, a direct democracy approach to resource allocation that has been used in Porto Alegre (Brazil) and in New York City, among other places. Participatory budgeting allows citizens, especially low-income residents who may frequently be left out of traditional

268  Research handbook on public financial management methods of public engagement, the opportunity to discuss and prioritize public spending projects. Most of the research to-date has examined the decision to use such participatory budgeting as well as the extent to which it affects the distribution of expenditures (Calabrese et al., 2020; Shybalkina and Bifulco, 2019). To the extent that this approach is more widely adopted, participatory budgeting may be an important angle by which to understand the relationship between direct democracy and expenditure management. Globalization While this chapter has highlighted several pieces of research that address US domestic concerns, as the world becomes more closely interlinked there is an increased need for collaboration across borders around key public policy challenges. This is perhaps most evident with the COVID-19 pandemic, whereby citizens in vastly disparate parts of the world are affected by health conditions in far-away countries. Moreover, the distribution of vaccines raises questions about the extent to which wealthy governments should internalize the costs of medical innovations which can spread benefits far beyond their borders. Similar analogies apply to climate change and immigration. Even if the United States is able to reduce its carbon footprint, it will have little impact on global temperature rise if other countries do not join in the effort. Similarly, the amount of money spent on immigration/migration depends on events occurring far from the destination country. In order to get a handle on these issues, the field will need to develop theories of global resource allocation. While comparative case studies are useful for applying lessons learned in one part of the world to another, they are not a substitute for overarching theoretical principles that can be applied more broadly. These theories will no doubt build on the existing literature on spillovers, fiscal contagion, and fiscal externalities, not to mention the equity issues raised in the previous section. But they will need to grapple with other issues that go unaddressed in the existing literature, such as how to overcome differences in political systems and culture in the context of resource sharing.

CONCLUSION This chapter has attempted to provide some sense of future direction for research in public expenditure management. By focusing separately on new data, new methods, new theory, and new topics, it has highlighted a variety of new questions that researchers may wish to ask as well as various ways they may wish to innovate and build on the existing literature. The field of public expenditure management will only become more essential as governments grapple with growing populations and the risks that come from increased globalization and technological change. To understand the trade-offs involved with government spending constraints and the allocation of public resources, the field will continue to benefit from interdisciplinary approaches that use tools from economics, accounting, public administration, and political science.

NOTES 1. See http://​wwe1​.osc​.state​.ny​.us/​localgov/​findata/​financial​-data​-for​-local​-governments​.cfm.

Future directions for research in public expenditure management  269 2. See https://​bythenumbers​.sco​.ca​.gov/​. 3. See Table A1 in Eliason and Lutz (2018) for a complete review of the TABOR literature. 4. See, for example, Bachner et al. (2019) and Gilmore and St. Clair (2018).

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PART VI DEBT MANAGEMENT

15. Foundations of subnational public debt management: theories, concepts and policy lessons Heidi Jane M. Smith and Alfonso Mendoza-Velázquez

INTRODUCTION All governments need revenue to manage their operations, implement public policies and invest in long-term projects to encourage economic growth. Therefore, many governments pursue the international bond market for additional funds when they are unable to collect enough taxes or if their intergovernmental transfers from the central government are limited or already assigned to targeted allocations. Historically, management of subnational local public debt issued by state or local governments (often called municipal or just “muni”) has been a critical issue in public finances for both developed and developing countries. As economic and financial globalization have deepened international credit markets, governments are now better adept at managing their macroeconomies with more efficient monetary and fiscal policies. Financial crises often come after over-fishing the common pool or when financial bubbles pop, so governments have had to learn strategies to lessen the economic impact. Also, governments must learn how to overcome external shocks – like the socioeconomic fallout caused by the COVID-19 pandemic. Past crises like the 2008 global financial crisis, for example, have been important lessons for countries to manage their macroeconomic portfolios for stability and growth. Yet, economic and financial openness still exposes countries to external shocks which can affect a government’s capacity to maintain its financial stability. These sorts of crises substantially affect economic growth and immediately produce a reduction of sustainable public revenues. Recent literature has highlighted a further problem with globalization of the subnational debt markets: a supply-side problem where global credit markets have large amounts of liquidity to allocate new issuances. However, many subnational governments have inadequate balance sheets to issue new credit. This is partly due to the reaction of international financial institutions to issuing credit during the COVID-19 pandemic. It may also be because the United Nations has highlighted the importance of credit to help middle and low-income countries’ quest for economic development in cities. Martell et al. (2021) suggest information resolution to increase transparency will secure more credit to local governments. The authors suggest that with increased information and disclosure statements, a market of $97 billion would increase by $12 billion. The monetary impact of this would be another $40 billion circulating in the global marketplace (Martell et al., 2021: 58). Ironically, governments can multiply information asymmetry problems created by the market and they can also apply practical solutions. Fortunately, governments create fiscal rules, regulations, and financial products that essentially make up the credit market at the local level. Whereas some authors suggest private sector credit agencies will fill in the gaps 273

274  Research handbook on public financial management where governments cannot, the reality is that governments assign value to credit rating agencies’ role in the process of credit allocation in addition to other functions of the marketplace. In this case, international norms are necessary to follow and have been created through the Basel Accords1 to regulate the banking and financial sectors. Furthermore, a recent call for independent debt management offices (DMO) at the central government level reflects a growing need to depoliticize management structures by central governments (Sadeh and Rubinson, 2017; Ballard-Rosa et al., 2021). In their pursuit of international credit, national governments often seek debt markets for their city and state governments, whereby they identify rules of the game for bank loans, issuers, institutional credit authorities and other financial actors. There has been nascent research on how central governments have borrowing privileges (Betz and Pond, 2021) to access markets. It is recommended that while subnational actors should be managed through DMOs, internal politics must be minimized with other financial management structures. This would entail creating sufficient regulatory authority over the financial system, while overcoming information asymmetries and moral hazard issues created by politicians. This chapter will review the academic literature which fashioned the “democracy premium” for hardening budget constraints by using voters to constrain overzealous politicians that overspend the common pool by voting them out of office. Next, we review how international financial institutions and analysts adapted the literature into public financial management. This was simultaneous with the Washington Consensus2 reforms which proposed fiscal decentralization to improve revenue generation and expenditure assignments to be allocated locally. But this has also crowded out the common pool of resources. Finally, the chapter presents example policy tools (i.e. federal regulation of the banking and financial sector, clearly structured financial credit instruments, credit ratings and bankruptcy laws) used in different countries as they seek to manage their subnational debt profiles. The examples help to better understand how countries have coped to the situation when the “democracy premium” is deemed less of an advantage to access global capital markets (Ballard-Rosa et al., 2021).

THE GOVERNMENT FAILURE The biggest problem of debt issuances at the subnational level is a problem of intergovernmental relations. The allocation of governmental response to a market failure can create even more government failure. Economist initially coined this a moral hazard issue where an economic (or political) actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. Financing subnational public debt creates the incentives for one local jurisdiction to overfish the common pool and access international capital markets without clear insurance of that type of loan, its expected duration and its possible macroeconomic risk to the national governments as it is responsible to guarantee the loan within the process. This phenomenon has increased due to decentralization policies implemented at the local level, where competing policy agendas exist and local politicians want to win elections (Benton and Smith, 2017; Brender and Drazen, 2005; Sakurai and Menezes-Filho, 2008; Shi and Svensson, 2006). The apparent governmental failure is when governments try to implement a public financial management strategy or a governmental resolution to this complex problem. What is unique to decentralized public expenditures, is that they are often hard to adjust since they do not depend on purely economic or financial factors but also political ones

Foundations of subnational public debt management  275 (Ouyang and Li, 2020). Local public expenditures finance an array of public policies and basic operational expenses that make up the policy agendas in many countries. New Public Management scholars guided by the Washington Consensus recommended countries to create fiscal decentralization policies which sought to allocate public expenditures at the local level. However, because of slow growth or lack of capacities to meet those expenditures with locally driven revenue projections, many countries are unable to meet appropriate revenue generation with their necessary expenses, which induced politicians and local actors to accrue too much subnational debt (Osborne and Gaebler, 1992; Babb, 2013; Hernández-Trillo, 2018). This is a particularly acute problem in developing countries, which often do not account for sufficient economic development at the local level to pay for required public investments. Also, their democratic institutions are often emerging and public management practices are still evolving. Many countries employ technical experts and regulatory quotes to avoid accruing liabilities given the impossibility to balance revenues with expenditures efficiently. Yet, governments continue to contract debt, especially since revenue decentralization pushed more political players into the decision-making of public finances (Persson and Tabellini, 2002; Smith and Revell, 2016). Aggravating the problem, using temporary debt frequently turns deficit spending into long-term contingent liabilities. Some financial mechanisms create deeply immobile capital and financial structures that governments cannot overcome. Governmental regulation and budget rules, like hardening budget constraints, make it less likely for political actors to overspend the common pool in public decision-making processes.3 This is done either through the intergovernmental system, or more likely, by implementing fiscal rules, regulations or quote laws at the national level to enforce fiscal sustainability (Burnside, 2005; Rodden et al., 2003). Essentially the government is creating the rules of the game for issuers, credit assessors, information evaluators, and market products, whether a bond is created locally, through a market or the types of currencies its traded through, etc. It is the central government in concert with its private sector and subnational entities who determine how norms are applied throughout the system of credit accumulation for long-term growth.

A GOVERNMENTAL RESPONSE Under the Washington Consensus regimen, international financial institutions (IFIs) focused on encouraging market mechanisms to manage public resources, financial systems and debt services. The first studies tried to understand the effectiveness of fiscal rules by using comparative research for federalist or unitary countries and found that rules work better in the former and not the latter (Ter-Minassian, 1997). Next, they studied how to craft government financial regulation on local governments while leaving market mechanisms in place to manage overextended subnational governments. Finally, the IFIs divide government’s management structures into three options: (a) based on financial market discipline; (b) strict case-by-case control by federal government; and (c) explicit rules to manage subnational loans. Many American scholars stressed that the reliance on market forces was the best management model for subnational capital markets (Cernuschi and Platz, 2006; Martell and Teske, 2007; Leigland, 1997). Such systems relied on international financial markets to manage subnational access to capital, based directly on when a particular local government was seeking it. The key was to access creditworthy borrowers (subnational entities of state or local

276  Research handbook on public financial management government) with private and public investors (which sought to invest in institutional funds). Based on an appetite for risk – and the inherent capacity to seek out international investments – subnational governments would determine their point of access based on the total amount of subnational debt assumed. Opening financial regulation was just one measure of local governments’ “autonomy” to seek out international markets and access capital markets for local investments in public goods. Under this system, credit rating agencies serve as a type of independent auditing system because they provide ex ante oversight and thus control over debt policy choices (Bertelsmann Foundation, 2012; Smith, 2013). The second model, direct administrative control, is based on the national treasury department either through an office within the ministry or through a more autonomous debt management office (or DMO) at the national level supervising all access to capital markets by subnational governments (Ballard-Rosa et al., 2021). It is notable that DMOs not only manage subnational debt, but also other contingent liabilities of the central government which are often invested in state-owned enterprises. If countries are also oil rich states, DMOs may invest in energy production and infrastructure, or other investments for their nation, such as nationwide transportation, telecommunication or trade infrastructure. Typically, the DMOs act as the direct conduit to international capital markets by incorporating subnational debt into a larger lump sum for the country to access. Then the national treasury distributes smaller sums to predetermined subnational governments to receive financing, such as in South Korea. This control model may be used as a loan council at the central level, as in the case of Australia, to determine which city or state project may have access to loans. This model is helpful in enforcing the golden rule of financing, which states that loans must be used for productive measures. It also provides better terms for loans in smaller countries because it creates umbrella funds, grouping several national projects into one basic fund for financial expediency. Yet, some analysts question the role and responsibilities of DMOs of balancing between national priorities and their monetary advantages and suggest DMOs should be independent, such as Central Bank Authorities (Betz and Pond, 2021; Sadeh and Rubinson, 2017; Ballard-Rosa et al., 2021). The third and final model used by national governments to access credit markets is a rule-based system.4 The national treasury generally determines which local authority can access credit markets by limiting the maximum borrowing to debt service ratios; setting the maximum of total indebtedness by creating ceilings; or allowing a restricted bank portfolio exposure to the public sector and enforcing reserve requirements, while passing and regulating bankruptcy laws at the national level. Some governments even enforced reserve requirements, while passing and regulating bankruptcy laws at the national level. Examples of this come from Brazil and Argentina after their financial crisis in the 1990s. Governments moved more towards this financial model of a rules-based approach to avoid subnational governments’ moral hazard problem and the soft budget approach to subnational governments (Kornai, 1986; Giugale et al., 2000; Martell, 2008; Hernández-Trillo, 2018). The frequency of external shocks within the economies in Latin America required the International Monetary Fund to request several governments to create these fiscal rules within their countries. Upon further analysis, analysts concluded that there is no one system that is a pure example of these ideal type models (Revilla, 2013; Liu and Canuto, 2013). Many governments, from Latin America to Eastern European countries, have used a mixture of these management models, implementing subnational rules, using bank credits from public and commercial banks for public issued loans. Most national government treasuries effectively manage their local credit markets through rule-based systems: by limiting who can access international credit

Foundations of subnational public debt management  277 markets; by setting the borrow maximum as a percentage of debt service ratios; and setting restrictions on bank’s portfolio to expose the public sector. The most important element of fiscal rules is how to constrain public managers from over-consuming the common pool either through off-budget expenditures, investments not tied to assets, or capital enhancements based on expired future revenue streams from the national government. Local government management systems need to strike a balance between central government regulation of financial markets while also concealing the gaps within the intergovernmental systems that aim to constrain the common pool problem. Notably, while most of these management schemes are implemented through top-down approaches, Ter-Minassian (1997) noted that fiscal rules do not automatically ensure adequate subnational fiscal discipline and must take time to develop and evolve. Fiscal rules may only be effective if they are created in democratic systems with sound designs, and a robust legal system based on implementation tools that include firm enforcement mechanisms. Yet meeting all these prerequisites is far from insignificant, and flaws at any one of these stages can lead to wasteful subnational spending, especially in emerging economies where institutions are often weak or recently constructed. This has led to ample analysis of the role of fiscal rules in democratic institutions (Rodden, 2006; Rodden et al., 2003; Smith et al., 2019).

THE DEMOCRACY PREMIUM The classic literature presented what is commonly known as the “democracy premium,” where the common pool resource problem of overreaching municipal debt was managed through the intergovernmental system and enforced by the political constraints of voters. Reformists and Progressive era budgeters in the United States did not want politicians to make decisions for voters and therefore voted into law state rules for constraining politicians. Basic requirements included balanced budget reforms at the state level government (which did not allow governors line-item veto power); mandated tax and expenditure restrictions (TELS) (through citizen movements like Proposition 13 in California); and established debt limitations laws approved in state legislatures (see tables published in Conlan et al., 2015 for a list of balanced budget requirements in US states). The theory suggests that voters would vote out politicians who did not abide by their consensus of a balanced budget at the state or local level. Von Hagen (1991) proposed that the principal-agent of the voter–politician relationship resembles an “incomplete contract.” This is because the system allows voters and citizens to constrain politicians, by voting them out of office if they overspend the common pool. In his view, the democratic process would lead to stronger institutions in the long run after many cycles of voting. Yet von Hagen (1991) questioned the effectiveness of these requirements and the long-term effectiveness because politicians are likely to find ways to circumvent rules, such as governors’ veto powers in the state budgets. Empirical evidence from outside the United States tested the validity of some theoretical considerations developed through economic modeling for developed and developing economies. For example, Poterba (1994) found that some national governments with subnational entities like states with harder balanced-budget rules reacted promptly to recurring revenue or spending shocks. Poterba (1994) and von Hagen (1991) found that state budget rules affect the level and composition of state debts overall. But Bails and Tieslau (2000) suggested there is

278  Research handbook on public financial management a conflict in the political science literature between the “public choice” of citizens, determining the level of debt issuances and capacity to spend federally transferred resources, and the “institutional irrelevance” of the balanced budget system. For them, the significance of state budget institutions only works when there is “political will” for balanced budgets beyond state legal frameworks enforced by citizens. Furthermore, endogeneity issues are discussed throughout the literature on how to create sound financial institutions within emerging democracies. Would institutional rules develop on their own, as happened in the United States with the balanced budget system, or would national governments be first required to craft rules and hope subnational governments adhered to them? In effect, more research seeks to find the appropriate rules to safeguard the core design of intergovernmental fiscal arrangements that are sustainable and collaborative (Smith et al., 2019). In sum, countries with high vertical fiscal imbalances (Rodden, 2002), hard budget constraints (Rodden et al., 2003) and independent audits such as those created by credit rating agencies with separate central budget offices (DMO) may also be difficult to create. Without these rules, the incentive for politicians to design public policies may lead to poor provision of public services that are unnecessary and excessive spending in the long run. While many countries have created a rule-based structure with harder budget constraints and stronger capital markets overall (Martell, 2008), administrative roles such as planners, capital budgeting and asset managers are also needed to govern the development of capital markets (Smith and Benton, 2017). Specifically, the political-economic systems that govern how public officials are elected as well as the public management systems that determine how micro-decisions are made are less understood in this debate (Benton and Smith, 2017). A central part is the context of each country’s institutions which comprise the norms and principles of how governments make financial decisions. Several academics argue that creating credit markets is necessary but may be too technical for citizens to be effectively involved in the decision-making process (Espinosa, 2013; Espinosa and Martell, 2015). Furthermore, we cannot rule out that political competition between cohort cities can create more depth for credit markets to evaluate the politics in all decision-making of governments (Benton and Smith, 2017; Garza and López-Videla, 2020; Ballard-Rosa et al., 2021). But these evolving governance systems need more research for clarity especially in a comparative context.

DEBT MANAGEMENT STRATEGIES Therefore, we identify four additional requirements for a successful debt management system: federal regulation of the banking and financial sector; clearly structured financial credit instruments; credit ratings; and bankruptcy laws. The rest of the chapter describes these instruments with examples from a number of countries. In their absence, overspending can occur as subnational actors can overfish the common pool without proper regulation or intergovernmental arrangements. Voters, citizens, politicians and even public managers may still be able to overspend, but with additional instruments, they may be constrained. This is because, while credit markets need near perfect information for evaluating risks, when governments get involved and create more levels of government, reporting requirements or requests to issuers, they may also be creating information asymmetry between similar cohort governments seeking funds. Additional bureaucracy and red tape for a government not only add costs to the transaction, but also can generate perverse incentives for voters, politicians, or government officials to

Foundations of subnational public debt management  279 be unlawful in their disclosure statements. Although credit rating agencies help to eliminate these occurrences, competition and more actors in the process always bring more complexity to the system. Therefore, contingency plans, such as bankruptcy laws, are necessary if all goes wrong regardless of the management system that the country may or may not have. Federal Regulation of the Banking and Financial Sector Even the United States has evolved its system of authority and responsibility for those in charge of implementing broader economic policy. Federal lines of authority for the banking sector were first established in earnest after the Great Depression with the 1933 Banking Act. Further amendments were made with the Glass–Steagall legislation, which led to the separation of commercial banking and investment banking. First institutional investors were separated from the banking sector. The Federal Deposit Insurance Corporation is one of two agencies that provide deposit insurance to depositors in US depository institutions. The other is the National Credit Union Administration, which regulates and insures credit unions. FDIC was an independent government agency created by Congress to maintain stability and public confidence in the nation’s banking system. Without a strong banking system, the municipal bond market in the United States would not exist. Yet, since its creation, in the aftermath of the Wall Street Crash of 1929, the US Securities and Exchange Commission (SEC), has had as its primary purpose to enforce the law against market manipulation. Other significant regulation that manages the US system is the Capital Market Regulation Legislation of 1992, which created the Municipal Securities Rulemaking Board (MSRB), a small regulatory agency that has had to face a gargantuan challenge to manage the national muni market within the US economy (Feldman and Khademian, 2002; Khademian, 2010). The quasi-independent agency (reporting to the SEC) is in charge of the regulating body that creates rules and policies for investment firms and banks in the issuing and sale of municipal bonds, notes, and other municipal securities. Because states, cities and counties issue municipal securities for a variety of reasons, the MSRB helps the process by overseeing the underwriting, trading, and selling of municipal securities that are financing public projects. The board is composed of finance representatives from state treasuries across all fifty states in the United States to manage and meet the SEC’s commitments of subnational finances. Each of the fifty states also has its own boards to monitor issuances. Specifically, the state and national boards were created as a mechanism for the regulation of municipal securities and brokers, dealers, and banks to work in concert to improve the transparency of the municipal securities business. This financial control and fiscal policy mechanism have only come to light more recently after the 2007 financial crisis in the United States that affected the globe beginning in 2008. Movements in the US banking sector and how to control them are now leading issues across the globe. The Treasury department influences subnational debt stances through aggregated yield curves and “fend for yourself” federalism with bankruptcy laws (Conlan et al., 2015). Although there have been several renegotiated debt issuances such as in Detroit and Puerto Rico in recent years.

280  Research handbook on public financial management Financial Instruments When crafting a bond market, each country can create financial instruments that symbolize the desired transaction and oversight systems. This is created through issuers, investors and underwriters of the market. Arguably governments themselves are helping to create the market by identifying jobs for the new financial industries. These professional jobs are planned for economists, system engineers, bankers, financial engineers, finance specialists, etc. Furthermore, the use of public debt, with its evaluation requirements by rating agencies, can be transformed into a way of monitoring public accounts and create jobs for public and private auditors with external and internal controls respectively. Here are some financial instrument examples from the United States, China and Mexico. Examples from the United States In the United States, there are generally three types of municipal bonds: general obligation, income and industrial development bonds (Thau, 2011). General obligation bonds are intended to finance government projects such as parks, streets, schools and public buildings. In general, they guarantee future government transfers, but still have to pay part of the debt with local taxes. Revenue bonds are issued for special purpose projects or specific use facilities such as developing or improving sewerage and water systems, public airports, highways, hospitals, housing, etc. These require payment of the fees for use, charges or the sale of a project generated from the financed project. The government agency or entity issuing the reserve bond is obligated to pay for the services of the income debt. Other instruments do exist; for example, industrial development bonds promote economic development and benefit both public and private institutions. In general, these bonds were expanded by attracting or retaining existing financing for hospitals, public services and transportation services. However, the base should include the creation of employment and the strengthening of the local tax to create a multiplier effect that helps the local economy. Examples from China The 1994 tax reform gave birth to the Budget Law of China. Under the Budget Law, subnational governments are forbidden to obtain domestic or foreign debt issuances. When a local government needs an investment that surpasses their revenues, the central government takes a command and control model to evaluate financing options. Prior to the Budget Law, members of the ministry of finance developed a comprehensive approach to analyze the fiscal situation and made specific transfers to meet these requests for distribution. In 1998, to stave off the impacts of the Asian financial crisis, the central government acted as debtor and loaned funds to subnational government as a stimulus package. The law was again revised after the 2008 financial crisis, when the national government created a deliberate state-driven stimulus program to mitigate potential economic collapse in the aftermath of the 2008 global financial crisis. Now local governments have three approaches to finance local projects. The Chinese National Audit Office (NAO) categorizes government debts into three types: direct government debt, government guaranteed, and other contingent liabilities (Chen, 2020a, 2020b, 2021). There were initially three state led models created but the third was shortly discontinued. The first approach was through bond issuance (Smith et al., 2019). Realizing the necessity to ensure local government is accountable for the quality and quantity of the loans, in April

Foundations of subnational public debt management  281 2009, a team from the Finance Ministry was formed to revise the national Budget Law. The second approach was through the establishment of the Local Government Financing Vehicles (LGFVs). LGFVs are state-owned enterprises set up by local governments to conduct infrastructure projects normally undertaken directly by the governments themselves. Local governments support the LGFVs by injecting cash into or transferring state land to them, which the LGFVs use as collateral to borrow from banks and capital markets (Chen, 2020a, 2020b, 2021). In addition to the LGFVs, local governments also borrow through the less transparent shadow-banking system. This last approach has been discontinued from the Chinese market because it was deemed too risky. Revisions have been made to monetarize the transfer systems. The lenders were nonbank financing agencies in which the borrowing is not regularly disclosed. The implicit guarantees came from the Chinese development bank and the central bank’s authority to the LGFVs (Chen, 2020a, 2020b, 2021). Examples from Mexico Since 2000, when Mexico opened its democracy to allow alternative partisan candidates, the country also started the process of developing both private and public mechanisms for municipal bonds. First, Mexico developed a more market-based approach, similar to the examples used in the United States and many European countries, and offered bond issuances by commercial bank loans and the local bond market, where institutional investors (such as a pension fund holder) invest in the sale of public debt for a marginal profit. Rating agencies are used for evaluating the debt issuance of the subnational governments often with little variation in their risk analysis. As suggested by IFIs, market-based regulation has been created by the national government and modified several times. Second, the Mexican national government has long offered a more “state” approach to offering a public bond though a public bank known as BANOBRAS that provides loans to infringed, marginalized municipal governments based on social need, which may not be able to access the market or credit agencies for ratings. The development bank often uses reporting instruments developed in conjunction with the development banks (World Bank and Inter-American Development Bank). Lastly, the national government offers trust funds. These loans bypass local political operatives by using state transfers as guarantees into “special purpose vehicles” (SPVs) as they are known on Wall Street. Therefore, the concept of “guarantee” is nuanced by lawyers and Mexican law and regulation and becomes a problem for sub-sovereign debt management at the global level. Overall, the four Mexican instruments (commercial loans, bond issuances, state public investment bank (BANOBRAS), and trust funds) create a myriad of options for subnational governments using a blend of public and private sector arrangements. The institutional arrangement creates a supply-side problem because the various options in the market often rely on the demand, knowledge and capacity of the public financial managers at the local level (Benton and Smith, 2017; Smith and Benton, 2017). Public managers must be knowledgeable about debt financing mechanisms and options within their local markets when selecting the types of public loans that best serve the public. Furthermore, the managers need to understand that loans are based on better terms and solid, guaranteed by tangible or physical assets or fees-based structures to pay back their loans within a reasonable time period. Own-source revenues, for example local tax collection efforts or fee-based structures for services, made to pay back local loans are fundamental for internal bond markets to be operational.

282  Research handbook on public financial management Credit Ratings An important tool for central government officials to manage fiscal policy made by local governments is using a credit rating system, either through their own evaluation or through independent evaluations on the market. Bond and public finance ratings are used in market-based capital markets to determine the risk premium for repayment, evaluating the local government’s financial capacity, based on such criteria as economic, liquidity, debt, finances, systems support, etc. Each rating agency has a different methodology to determine local governments’ rates and levels of risk. For example, Fitch Ratings has a two-step approach. First, a transfer and convertibility risk judgment is made to reflect the country ceiling rating and then an assessment is made of the ability of entities and transactions to survive the economic and financial stress associated with sovereign debt crises. The most important rating agencies include Standard & Poor’s, Moody’s and Fitch Ratings, but many countries also have their own commercial rating agencies. The problem with private rating agencies is that they apply their analysis based on the federal or state level guarantees. The evaluation is based explicitly or implicitly on the amount of debt accrued by the national government and is downgraded based on the sovereign national rating. Thus, sub-sovereign debt issues are susceptible to the national government’s maximum amount of debt issuances. Recent studies argue that national debt ratings also determine the investment rate grades of local governments. The three main rating agencies assign subnational risk ratings based on financial criteria at the macro level and political factors. Given the fiscal interrelations and the dependency on federal resources in some countries, Hernández-Trillo et al. (2009) point to a close relation between subnational debt ratings and the probability of bailing out. Subnational credit ratings could likely be explained by the probability of bailing out and the willingness of national governments to do so. This could explain why some studies have found a very narrow gap between national and subnational ratings, mainly in times of economic stress (Mendoza-Velázquez and García-Flores, 2019). Bankruptcy Laws Capital markets in the United States have grown by exponential rates that are based not on fiscal rules, but on their market mechanisms and the intergovernmental system (ACIR, 1987). There is considerable theoretical interest in describing how rational lenders may respond to imperfect information by rationing credit to borrowers (Bayoumi et al., 1995). Much of this literature identifies credit constraints with a market failure or describes how credit ratings happen outside formal governmental institutions. However, it has been argued that default credit constraints can play a more positive role in disciplining irresponsible sovereign borrowers (Goldstein and Woglom, 1992). This more optimistic view, called the market discipline hypothesis, has helped define the debate on the most effective way to restrain subnational governments. An important aspect of the market discipline hypothesis is an assumed nonlinear relationship between yields and debt variables. Advocates of market discipline assume that yields will rise smoothly at an increasing rate with the level of borrowing, thereby providing the borrower with an incentive to restrain excessive borrowing. If these incentives prove ineffective, however, the credit markets will eventually

Foundations of subnational public debt management  283 respond by denying the irresponsible borrower further access to credit, and the irresponsible borrower will be constrained through bankruptcy proceedings. Yet, bankruptcy is not a solution to every debt problem. Levitin (2012) argues that states’ fiscal problems are generally a structural-political problem that bankruptcy cannot be expected to fix. Accordingly, bankruptcy makes sense only as a political tool, rather than a financial-legal restructuring tool. Bankruptcy is equipped to accomplish political restructuring. However, it is not a forum in which fiscal federalism can be renegotiated. On the contrary, this is the fiscal space that is most consumed and harmful to the overall economy, where the common pool of intergovernmental relations is problematic if not managed effectively. As a result, very few cities in the United States have declared bankruptcy within and around the time of a financial crisis. Also, this is why the US federal government has seldom bailed out local or state governments. While Chapter 9 has been around for many years, some cities (New York and Atlantic City) have been bailed out by state governments. Still others have filed for bankruptcy not for taking out too many loans but as a way to renegotiate their financial contract with the city’s public employees and payments to their pension systems (e.g., Vallejo and San José in California). Finally, the most recent empirical efforts describe how clarity within the rule-making process helps eliminate information asymmetries and enables market mechanisms to operate at the subnational level. Kelemen and Teo (2014) cite literature that judiciary enforcement mechanisms (i.e. bankruptcy) in the United States and European Union have not meant strong, more robust capital markets. Instead, they argue that clarity in fiscal rules is a more effective way of strengthening capital markets.

CONCLUSIONS In contrast to this exceptional situation of the United States where autonomous states create their budget and fiscal rules that meet voter preferences, many countries in the world are still developing their contractual social relationship between the national/central governments and the subnational government (local city or state) that meets local demands with policy preferences and central budget allocations (Smith and Revell, 2016). A result which is known as the “democracy premium” for public finances is therefore still in question for credit market allocation. That is, developed democracies are more likely to pay their debts with locally generated revenues, which is overseen by the community and citizens can vote out those who do not comply. While a fully defragmented institutional arrangement from the central government – without a central budget authority – like the use of intergovernmental relations, may allow states and local managers to create independent rules unique for each country context, additional actions are necessary. Yet, many countries still tie national sovereign ratings to local credit markets especially when they do not have sufficient local revenue sources. A robust transparent system that allows credit systems and market mechanisms to work independently from budget authorities can be rare. Central government authorities therefore can access market premiums (Betz and Pond, 2021) by manipulating their prudential macroeconomy grantees. Therefore, this chapter proposes mechanisms to improve the intergovernmental system, with additional policy tools such as federal regulation of the banking and financial sector, financial credit instruments and enhancements, credit ratings and bankruptcy laws.

284  Research handbook on public financial management Fiscal rules may only be effective if they are created in democratic systems with sound designs, a robust legal system, and based on implementation tools that include firm enforcement mechanisms. Yet, the “democracy premium” of countries that are democracies and issue debt on international capital markets is becoming less statistically significant in academic studies (Mosley, 2003; Ballard-Rosa et al., 2021). Countries therefore need to have these prerequisite polices outlined here, in order to ensure that profligate subnational spending does not turn into contingent liabilities. Thus, the most important element of fiscal rules is how to constrain public managers from overconsuming the common pool either through off-budget expenditures, investments not tied to assets, or capital enhancements based on expired future revenue streams from the national government.

NOTES 1.

The Basel Accord is a set of agreements on banking regulations concerning capital risk, market risk, and operational risk. 2. The Washington Consensus is a set of ten economic policy prescriptions considered to constitute the “standard” reform package promoted for crisis-wracked developing countries by Washington, DC-based institutions such as the International Monetary Fund, World Bank and United States Department of the Treasury. 3. Kornai (1986) described softening budget constraints in socialist countries (i.e. Hungary, Eastern Europe and China) by providing subsidies, tax-exemptions, soft credits and so on to firms, which made it difficult to accurately identify pricing within a firm. 4. In the international literature the rules-based system was dominated by financial crisis in Latin America but also by the international political economy literature in the United States.

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Foundations of subnational public debt management  285 International Poverty Centre, UNDP, Brazilian Ministry of the Cities (SNSA) and the Financing for Development Office, UN-DESA, December 11–13, Brasilia, Brazil. Chen, M. (2020a). Beyond donation: China’s policy banks and the reshaping of development finance. Studies in Comparative International Development, 55(4). Chen, M. (2020b). State actors, market games: Credit guarantees and the funding of China Development Bank. New Political Economy, 25(3), 453–468. Chen, M. (2021). Infrastructure finance, late development, and China’s reshaping of international credit governance. European Journal of International Relations, 27(3). Conlan, T., Posner, P., Smith, H. J., and Sommerfeld, M. (2015). Autonomy and interdependence: The scope and limits of “Fend for yourself Federalism” in the United States. In Institutions of Intergovernmental Fiscal Relations: Challenges Ahead, ed. J. Kim and H. Blochling. Paris: OECD, 155–179. Espinosa, S. (2013). What drives the yield spreads of Mexican bonds? Latin American Policy, 4, 306–319. Espinosa, S. and Martell, C. (2015). Building bond repayment capacity in developing countries: A study on property tax collections and debt affordability in Mexico. International Journal of Public Administration, 38(3), 227–236. Feldman, M. S. and Khademian, A. M. (2002). To manage is to govern. Public Administration Review, 62, 541–554. Garza, A. D. and López-Videla, B. (2020). Political Alignment and Credit: Evidence from Local Governments in Mexico. CEGA Berkeley. https://​cega​.berkeley​.edu/​wp​-content/​uploads/​2020/​03/​ Lopez​-Videla​_PacDev2020​.pdf. Giugale, M., Hernández-Trillo, F., and de Carmo, J. (2000). Subnational borrowing and debt management. In Fiscal Decentralization in Mexico: Achievements and Challenges, ed. S. Webb and M. Giugale. Washington, DC: The World Bank. Goldstein, M., and Woglom, G. (1992). Market-based fiscal discipline in monetary unions: Evidence from the U.S. municipal bond market. In Establishing a Central Bank: Issues in Europe and Lessons from the United States, ed. M. B. Canzoneri, V. Grilli, and P. R. Masson. Cambridge: Cambridge University Press, 228–260. Hernández-Trillo, F. (2018). When lack of accountability allows observing unobservables: Moral hazard in sub-national government credit markets in Mexico. Applied Economics Letters, 25(5), 326–330. Hernández-Trillo, F., Smith-Ramírez, R., Cavallo, E., and Cordella, T. (2009). Credit ratings in the presence of bailout: The case of Mexican subnational government debt [with comments]. Economía, 10(1), 45–79. Kelemen, R. D. and Teo, T. (2014). Law, focal points and fiscal discipline in the United States and the European Union. American Political Science Review, 108(2), 355–370. Khademian, A. (2010). Bankruptcies, bailouts and the banking bureaucracy: The Bush agenda and the capacity for crisis. The Forum, 7(4). Kornai, J. (1986). The soft budget constraint. Kyklos, 39(1), 3–30. Leigland, J. (1997). Accelerating municipal bonds market development emerging economies: An assessment of strategies and progress. Public Budgeting & Finance, 17(2), 57–79. Levitin, A. (2012). Bankrupt politics and the politics of bankruptcy. Cornell Law Review, 97, 1399–1459. Liu, L. and Canuto, O. (eds.) (2013). Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets. Washington, DC: World Bank. Martell, C. R. (2008). Fiscal institutions of Brazilian municipal borrowing. Public Administration and Development, 28, 30–41. Martell, C. R., Moldogaziev, T. T., and Espinosa, S. (2021). Information Resolution and Subnational Capital Markets. Oxford: Oxford University Press. Martell, C. R. and Teske, P. (2007). Fiscal management implications of the TABOR bind. Public Administration Review, 67(4), 673–687. Mendoza-Velázquez, A. and García-Flores M. (2019). Brecha de Riesgo Creditico y el efecto de la Crisis de Estados Unidos. In Incentivos Perversos del Federalismo Fiscal en México, ed. A. Mendoza. Mexico City: Serie de Lecturas del Trimestre Económico del Fondo de Cultura Económica (FCE). Mosley, L. (2003). Global Capital and National Governments. Cambridge: Cambridge University Press.

286  Research handbook on public financial management Osborne, D.,and Gaebler, T. (1992). Reinventing Government: How the Entrepreneurial Spirit is Transforming the Public Sector. New York: Plume. Ouyang, A. Y. and Li, R. (2020). Fiscal decentralization and the default risk of Chinese local government debts. Contemporary Economic Policy, 39(3), 641–667. Persson, T. and Tabellini, G. (2002). Political Economics. Cambridge, MA: MIT Press. Poterba, J. M. (1994). State responses to fiscal crises: The effect of budgetary institutions and politics. Journal of Political Economy, 104(4), 799–821. Revilla, E. (2013). Debt management in Mexico: A tale of two crises. In Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets, ed. L. Liu and O. Canuto. Washington, DC: World Bank. Rodden, J. (2002). The dilemma of fiscal federalism: Grants and fiscal performance around the world. American Journal of Political Science, 46(3), 670–687. Rodden, J. (2006). Hamilton’s Paradox: The Promise and Peril of Fiscal Federalism. New York: Cambridge University Press. Rodden, J., Eskeland, G., and Litvack, J. (2003). Fiscal Decentralization and the Challenge of Hard Budget Constraints. Cambridge, MA: MIT Press. Sadeh, T. and Rubinson, Y. (2017). Do the IMF and World Bank promote autonomous sovereign debt management? Working paper presented at the Political Economy of International Organizations Conference, Bern, Switzerland. Sakurai, S. and Menezes-Filho, N. (2008). Fiscal policy and reelection in Brazilian municipalities. Public Choice, 137(1), 301–314. Shi, M. and Svensson, J. (2006). Political budget cycles: Do they differ across countries and why? Journal of Public Economics, 90(8), 1367–1389. Smith, H. J. (2013). Explaining borrowing patterns of Mexican cities: The case of the state of Guanajuato. Economic Alternatives, 2, 75–87. Smith, H. J. and Benton, A. L. (2017). The role of metropolitan cooperation and administrative capacity in subnational debt dynamics: Evidence from municipal Mexico. Public Budgeting & Finance, 37, 58–82. Smith, H. J., Park, S., and Liu, L. (2019). Hardening budget constraints: A cross-national study of fiscal sustainability and subnational debt. International Journal of Public Administration, 42(12), 1055–1067. Smith, H. J. and Revell, K. (2016). Micro-incentives and municipal behaviour: Political decentralization and fiscal federalism in Argentina and Mexico. World Development, 77, 231–248. Ter-Minassian, T. (1997). Fiscal Federalism in Theory and Practice. Washington, DC: International Monetary Fund. Thau, A. (2011). The Bond Book, 3rd edition. New York: McGraw-Hill. Torres, G. and Zelter, J. (1998). Rating Securitizations Above the Sovereign Ceiling. Fitch Information Bulletin. Von Hagen, J. (1991). A note on the empirical effectiveness of formal fiscal restraints. Journal of Public Economics, 44, 199–210. Weingast, B. (2009). Second generation fiscal federalism: The implications of fiscal incentives. Journal of Urban Economics, 65(3), 279–293.

16. Emerging research issues in subnational government debt management Dario Cestau

INTRODUCTION The municipal bond market is the financial backbone of America’s infrastructure, and the effective functioning of this market is crucial for the provision of public services. With $4 trillion in par value outstanding in 2021, it is one of the largest capital markets in the US, and with about $400 billion issued every year, no less can be said about its primary market. For decades, this market has been a synonym of extraordinary credit stability and low default rates. However, it is evolving in fundamental ways. As rating volatility and cumulative default rates continue to increase, “municipal bankruptcy is no longer taboo” (Moody’s, 2020: 6). The sector is confronting unprecedented challenges that threaten the financial health of municipal issuers. In addition to a global health and economic crisis and the threat of climate change, municipal issuers are experiencing a substantial increase in pension burdens, declining economic bases (Abott and Singla, 2021), as well as pervasive demographic shifts. Since their inception, municipal bonds have been exempt from federal income tax. The tax exemption makes municipal bonds an unattractive investment for institutional investors but a very attractive one for retail investors. Compared to other large financial markets, households hold a disproportionately large share of the market. As of 2021, retail investors hold 44 percent of the total par value outstanding directly in their portfolio and another 27 percent indirectly in mutual funds.1 On the supply side, the municipal bond market also stands out from other capital markets by presenting a very large and very diverse number of issuers, ranging from the city of Los Angeles to small rural areas. There are more than 100,000 potential units authorized to issue municipal bonds. The financial intermediation industry of the municipal bond market does not lag behind (both sides of) its clientele, both in terms of the number and diversity of its members. There are over 2,000 broker-dealer firms registered with the MSRB, of which 700 actively trade municipal bonds in any given month (Li and Schürhoff, 2019). Trading takes place in a decentralized over-the-counter (OTC) market, where trades are negotiated bilaterally between investors and broker-dealer firms. The unique characteristics of this market contribute to its equally unique opacity and fragmentation. The frictions and inefficiencies that they create inevitably lead to abnormally high credit and liquidity premiums, which have direct negative consequences on borrowing costs. To begin with, the yield spreads of municipal bonds are too high for their historically low credit risk. Given that the risk premium explains about 80 percent of the yield spread (Schwert, 2017), this means that the price of risk is unusually high in this market. On the same hand, liquidity is exceedingly low. Harris and Piwowar (2006) and Green et al. (2007b) estimate that transaction costs are in the order of 1.3 to 2 percent of traded value, which is a large share of a bond’s yield. Green et al. (2007a) also show that municipal bonds are quite underpriced when issued and present high levels of price dispersion during the first days of trade. 287

288  Research handbook on public financial management We begin this chapter by briefly reviewing the most recent literature on the causes and consequences of the high credit risk and liquidity premiums in the municipal bond market. We then turn to focus on how the different legal structures that back municipal bonds affect credit risk. This topic has been off the radar until recently, but we believe it will become a new trend in academic literature in the coming years. We discuss emerging research and provide directions for future work on this subject.

LIQUIDITY AND CREDIT RISK Regarding liquidity, transaction costs depend on the cost of facilitating the trade and the market power of dealer firms. Due to the unique characteristics of this market and the fact that there is no centralized trading system, information about available bonds and suitable counterparties is sparse and asymmetric. Therefore, search and matching of bonds and counterparties are the main frictions when trading municipal bonds. To cope with them, dealers form trading networks with other dealers. Li and Schürhoff (2019) document the topology of the dealer network in the municipal bond market. They find a core–periphery structure with about 10 to 30 highly interconnected dealers at the core and more than 2,000 peripheral dealers. Several theory papers, such as Neklyudov (2019) and Hugonnier et al. (2022), obtain similar network structures in models of decentralized trade. However, none of this theoretical research on OTC markets incorporates many of the factors that correlate with dealer networks and market power in the municipal bond market. In fact, what these factors are is still largely unknown. This strand of literature is just beginning to emerge. Cestau (2019) finds that the share of competitive sales in primary markets of municipal bonds is highly correlated with different measures of underwriting competition. Cestau (2020) shows that political connections, distance to issuers, and distance to other underwriters are correlated with the decision to enter underwriting markets in new states and form dealer networks. Further empirical research on the factors that affect market power, dealer networks, and consequently, transaction costs, still needs to develop. Ultimately, it must be complemented by theoretical research that can reproduce the observed topology of dealer networks and market power from dynamic general equilibrium models that incorporate search and matching frictions and the factors determining the competitive advantages among broker-dealer firms. The critical role that information plays in determining transaction costs also means that the importance of pre-trade and post-trade transparency should not be underestimated. Regarding post-trade transparency, Schultz (2012) finds that, although transaction costs did not change much, price dispersion declined dramatically after the introduction of the 15-minute trade reporting by the MSRB in 2005. Pre-trade transparency has also increased significantly since the financial crisis with the development and popularization of new electronic trading platforms. The emergence of these platforms provides fertile ground for future research on the effects of pre-trade transparency and electronic trading on dealer competition and dealer networks. As for the high price of risk, Cestau (2019) documents that the municipal bond market is visibly fragmented along state lines, which limits arbitrage and risk diversification. This fragmentation is not only due to the existing information asymmetries and dealers’ market power, but also to tax asymmetries between states. Babina et al. (2021) find that these tax asymmetries make tax-exempt yields more sensitive to political uncertainty and supply shocks. Schultz

Emerging research issues in subnational government debt management  289 (2013) shows that they contribute to systematic yield differences between bonds from different states, and Li and Schürhoff (2019) argue that they create sub-markets that curb dealer competition. Similarly, the federal income tax exemption also limits arbitrage between municipal bonds and taxable bonds (Green, 1993), although it also creates price distortions beyond those caused by market segmentation (Cestau et al., 2013; Landoni, 2018). As for the credit risk, Cornaggia et al. (2018) and Adelino et al. (2017) show that investors rely on credit ratings beyond bond fundamentals, which means that issuers and investors are susceptible to potential flaws in the assessments made by rating agencies. This begs the questions: Do credit ratings provide correct assessments of municipal bond credit risk? Is the real credit risk embedded in bond yields? Not so long ago, rating agencies, regulators, and data services paid no attention to the different types of legal protections that state laws provide for bondholders. However, recent default and bankruptcy events unveiled how important they really are. Today, rating agencies consider several factors when determining the credit rating of a new issue. About 30 percent of the credit rating is determined by economic indicators of the strength of the local economy and the tax base, another 30 percent is determined by financial indicators of the fiscal and financial position of the issuer, financial leverage, based on debt and pension burdens, has about a 20 percent weight, operating history a 10 percent, and the remaining 10 percent measures the issuer’s legal and institutional ability to match general revenues with general expenditures.2 However, the specific legal structures that back municipal bonds still have marginal notching effects on credit ratings. In the next section, we document the different types of protections afforded to bondholders by state laws. We also review the emerging literature on the legal security of municipal bonds and discuss promising avenues for future research. But before we dive into these topics, we introduce and explain the appropriate framework to interpret legal texts and predict how courts will behave in each case; we delve into the subtleties and nuances of different legal languages.

THE LEGAL SECURITY OF MUNICIPAL BONDS General obligations (GO) provide the greatest protections to bondholders. However, GO bonds are not ironclad payment guarantees, and “not all general obligation bonds are created equal” (DeMarco et al., 2017; D’Imperio and Hackett, 2013). Until recently, it was believed that all local general obligation bonds were backed by a pledge of the “full faith and credit” and the taxing power of the issuer, and because of these pledges, they all enjoyed the same protections during defaults and bankruptcies. However, the unfoldings and settlements of recent bankruptcy events surprised many: of the two types of general obligations outstanding during the 2011 Jefferson County bankruptcy, only one of them defaulted (Moody’s, 2020).3 In the case of Detroit’s bankruptcy, despite all enjoying recourse against the general funds of the city, recovery rates for unlimited general obligations, limited general obligations, and lease bonds backed by the general funds of the city were substantially different: 73 percent, 42 percent and 12 percent, respectively (Cestau et al., 2018). Furthermore, in both cases, some GO bonds were treated as secured debt and some not (NFMA, 2017; Moody’s, 2020). In light of these events, it became clear that the general obligation moniker does not always mean the same. Moreover, differences matter. The term is often employed in the constitutions and statutes of every state. However, it acquires different meanings depending on the case. To begin with, the term entails different

290  Research handbook on public financial management protections to bondholders depending on the issuer type; GO bonds are usually supported by some degree of property taxing power at the local level, but not at the state level. The general obligation pledge even permits different degrees of security for the same issuer, as the Detroit case demonstrates. More importantly, the legal security implied by the general obligation pledge varies considerably across states. For example, a GO bond issued by a school district in California is secured solely by an exclusive and dedicated levy of ad valorem property taxes and no other revenues, while in New England, GO bonds are secured by all the general revenues of the issuer but the general obligation pledge does not create a separate property tax levy. The years ensuing the Detroit and Jefferson bankruptcies witnessed a growing interest in understanding the extent to which the legal security of a bond prevents defaults, and what protections they provide when defaults or bankruptcies materialize. Rating agencies changed the way they evaluate the credit risk (Chang and Thompson, 2016), and bond lawyers developed more comprehensive classifications of general obligation bonds (Doty, 2013; DeMarco et al., 2017; D’Imperio and Hackett, 2013). These new classifications concurred that two “opposite” classes of legal features affected the security of municipal bonds: the breadth of the pledge, and the degree of specificity of the pledge. The breadth of the pledge refers to the scope of resources legally available to pay bondholders. Broader pledges, encompassing all or most of a government’s resources provide more flexibility and range of action to the issuer to service debt. As long as the sources of funds are not perfectly correlated, they provide greater shielding from specific revenue shocks. However, broad pledges that use blanket language such as “the full faith and credit” or “all available resources” possibly provide little or no protection during events of default or bankruptcy. Court decisions on governmental matters are strongly restricted by the principle of “separation of powers.” Because of this principle, courts cannot directly impose taxes or seize funds for the benefit of bondholders. All they can do is issue a court order compelling a government official to execute a duty he or she is legally obligated to perform. Because judges are reluctant to meddle in government affairs, the more specific the law is about these duties, the more likely a judge is to compel performance of such duty. Also relevant are the force and effect of the language of the statute itself and the clarity with which it states that it is a non-discretionary duty (Artin et al., 2014). We refer to all these attributes as the specificity of the pledge, and the degree of specificity will directly determine the probability that a judge issues a court order compelling certain duties that increase recovery rates; this is our premise for evaluating the legal protections afforded to bondholders during defaults and bankruptcies. Let us illustrate this by looking at three very common examples of legal languages: ‘The issuer shall pledge its full faith and credit for the prompt payment of the bonds’; ‘the issuer shall pledge its full faith and credit and shall collect an annual property tax sufficient to pay the bonds unless paid from other sources’; ‘the issuer shall pledge its full faith and credit … [A superior third-party authority] is obligated to annually levy separate and dedicated ad valorem property taxes, in addition to all other taxes, in an amount sufficient to pay the bonds, without limitation as to rate or amount. Such taxes will be placed directly [by the third-party authority] in a segregated fund held by said authority, which is designated for the payment of the bonds and for no other purpose.’

All of the above legal securities possess the same broad pledge, which includes general revenues and the taxing power of the issuer. In theory, a judge could order to collect additional property taxes for the benefit of the bondholders based on this pledge. However, this is very unlikely in the first of the examples because, since there is not a specific pledge of property

Emerging research issues in subnational government debt management  291 taxes, it is not clear that it is a mandatory duty. Moreover, the law does not implicitly or explicitly prioritize debt service over other essential government services, and this will also result in a court being unwilling to issue a writ of mandamus. The second and third examples are quite different in the sense that the bonds are additionally secured by a specific pledge of property taxes. Because there is a clear mandatory duty, this specific pledge increases the chances that a judge compels collection of additional taxes. Not by much, however. Even if priorities have been established in favor of bondholders by legislation, the very reason a local government exists is to provide certain government functions. They are an inherent priority because if debt service prevents a government from performing them, it would cease to exist and the debt would be extinguished. Furthermore, it is difficult to determine the boundaries of what constitutes an essential service, the extent to which essential services and debt service compete for the same limited dollars, and whether an increase in the tax rate would further deteriorate the tax base and tax revenues. The judge will be reluctant to make these determinations and create a precedent. Nevertheless, the third legal language also calls for other specific duties that will positively and greatly affect the protections afforded to bondholders, as well as recovery rates. First, this legal protection explicitly prohibits the issuer from using the collected funds for any other purpose other than paying the bonds. Regardless of the level of financial distress, any court will be willing to issue an order restraining a government official from performing an act prohibited by law. As a general rule, explicit and specific prohibitions provide effective and strong protections to bondholders. This security feature was the prime reason behind the higher recovery rates for unlimited tax GO bonds during Detroit’s bankruptcy. Rather than claiming an increase in the tax rate over the constitutional limit, the plaintiff alleged that the city was unlawfully diverting voter-approved property taxes that were only to be collected and used for the sole purpose of paying the bonds (Cestau, 2018). Detroit’s limited tax GO bonds, on the other hand, while also backed by a specific pledge of property taxes, did not benefit from this particular security feature, and this led to much lower recovery rates. Second, the third example requires a third-party tax collector to transfer the collected funds directly to the bond’s trustee so that they never flow into the issuer’s general fund. Courts will have no qualms to compel performance of this duty. Moody’s calls the combination of these two features a “lock box,” and since 2016, it adjusts credit ratings a notch up when present. Moreover, the force and effect of the language in the third example probably creates a statutory lien on pledged revenues. In states where municipal issuers can file for bankruptcy protection, statutory liens are important risk and recovery rates determinants because they give bondholders a secured claim on pledged revenues that continues to attach to revenues collected after a bankruptcy filing. The law does not need to specifically state that there is a statutory lien (NFMA, 2017); a court would probably find that the force and effect in this example effectively creates one. It would not be without contention, however. It had always been believed that all GO bondholders were to be treated as secured creditors in bankruptcy, but during Detroit’s bankruptcy, the city’s Emergency Manager declared that limited and unlimited GO bonds should be treated as unsecured debt. He contended that there was no sufficiently explicit language in the state law to grant GO bonds a statutory lien on tax revenues (NFMA, 2017). While Detroit’s case, and recent similar cases, were solved in court-approved settlements and not by judgment, the sanctity of the full faith and credit pledge was surely undermined by these claims. To avoid controversy, recent legislation has included explicit statutory liens language

292  Research handbook on public financial management such as “bonds issued and sold pursuant to this chapter shall be secured by a statutory lien on all revenues received pursuant to the levy and collection of the tax.”4 The degree of specificity not only protects bondholders in bankruptcy or default, it also helps to prevent these events. First, a requirement to levy an additional property tax effectively creates an additional source of revenues for the issuer. Absent this requirement, this resource, and the flexibility it conveys, would not be available to the issuer since local governments can only collect those taxes that constitution or legislation expressly allows. Second, data shows that local governments are more reluctant to default when the security features of the bonds make it very likely that a court compels debt service. In other words, they will not default if they estimate it unfruitful to seek debt relief. For example, when Jefferson County defaulted on its general obligations, its school warrants were not impaired (Moody’s, 2020), probably due to the superior features of their legal security. Like this we find many other examples, generally involving a default on lease revenue bonds but not on general obligations. A Tested Classification The new classifications developed by bond lawyers were consistent in that the breadth and specificity of the pledge were determining risk factors; however, they were not tested taxonomies. They did not provide a measure of fit or the frequencies with which each legal characteristic was observed in the data. The only empirically tested classification was developed by economists in Cestau et al. (2018). Cestau et al. (2018) classify the legal security backing long-term obligations issued by independent school districts throughout the country. The classification is comprehensive and parsimonious, and although it was developed for school bonds, it is scalable to most local government bonds because applicable laws are either common to all municipal issuers in a state or drafted similarly. In the following sections, we will discuss and analyze in detail this classification and how the different legal structures affect the protections granted to bondholders. We will also discuss what risk factors are not captured by this classification. Regarding the breadth of the pledge, Cestau et al. (2018) state that every contract that creates a long-term financial obligation, bonded or not, has recourse against the general funds of the issuer. Statutory law may require the issuer to augment the recourse by pledging its “full faith and credit.” In Detroit’s case, the bonds with the lowest recovery rate lacked this additional pledge. Conversely, the law may also require to limit the recourse to different degrees. It may fully restrict it, or it may partially restrict it against certain funds or revenues, such as the capital fund. All in all, Cestau et al. (2018) recognize four types of broad pledges: full faith and credit, unrestricted (all available funds), restricted (capital fund), and no recourse whatsoever. Regarding the specificity of the pledge, they state that, in addition to or in lieu of the general pledge, the issuer may specifically pledge ad valorem property taxes. The specific pledge of property taxes can be limited or unlimited. If unlimited, the issuer may be compelled to raise property taxes to the extent necessary to pay its obligations in full without regard to constitutional tax limits. They also find that pledged property taxes may originate from tax levies with varying degrees of usage restrictions or prohibitions. They can come from dedicated debt levies solely for paying debt, special levies for “special” purposes, capital levies for capital expenses, or the general levy for general purposes. As mentioned earlier, the usage restriction was critical in determining recovery rates during Detroit’s bankruptcy. Sometimes, dedicated debt levies produce an offsetting reduction in the general levy. Finally, in addition to or in lieu

Emerging research issues in subnational government debt management  293 of the general pledge and the specific ad valorem pledge, the issuer may specifically pledge other special revenues such as: sales taxes, federal aid, state aid, special assessments, property tax abatements, incremental tax receipts, judgment settlements. Table 16.1, presented in Cestau et al. (2019b), provides the first and only measurement of the heterogeneity of the legal securities of municipal bonds. It lists all the observed types of legal securities, along with their frequencies, for the population of all long-term new-money “deals” issued between 1990 and 2014 by independent school districts reported in the SDC Platinum database. The table shows that, while a handful of legal structures accumulate the majority of the observations, this sample alone presents 34 different combinations of the various kinds of broad and specific pledges. The table probably underestimates the true heterogeneity of legal securities as it is based only on long-term bonds issued by independent schools. Table 16.1 reveals that the legal securities of municipal bonds are much more diverse and complex than originally thought. This classification helps us deal with this complexity. It is also a step forward in providing and disseminating better information about the credit quality of municipal bonds. Martell et al. (2021) demonstrate that this type of information plays an important role in the development of local capital markets. Table 16.1

Security structures

General Obligations:

GO

RV

Ultd Dadval FF Bd

17,082

35

Ultd Gadval FF Bd

7,931

9

Ultd Dadval RV Bd

3,676

16

Ultd Dadval GF Bd

3,647

21

Ltd Gadval FF Bd

1,982

39

Staid Ultd Dadval FF Bd

1,479

13

Ltd Dadval FF Bd

1,132

3

375

70

FF Bd Sales Ultd Dadval FF Bd

333

0

Ultd Cadval GF Bd

215

5

Ultd Dadval off FF Bd

169

0

Sales Ultd Dadval GF Bd

74

0

Staid Ltd Dadval GF Bd

64

1

GF Bd

22

25

Ltd Dadval GF Bd

43

0

Ltd Sadval FF Bd

59

4

CF GF Bd

19

2

Cadval Ultd Dadval FF Bd

18

0

Abat Ultd Dadval FF Bd

5

0

GF Cp

95

933

Ultd Dadval GF Cp

96

397

FF Cp

40

202 147

Ltd Dadval GF Cp

66

Ltd Gadval FF Cp

46

31

Ultd Dadval FF Cp

61

10

Ultd Gadval FF Cp Revenue Bonds: Ltd Sadval RV Bd

1

13

GO

RV

1,207

31

Sales RV Bd

153

502

Asmt RV Bd

32

407

294  Research handbook on public financial management Revenue Bonds:

GO

Ltd Cadval RV Bd

266

RV 13

Ltd Gadval RV Bd

7

15

Fedaid RV Bd

0

10

AP Cp

46

2,722

CF Cp

0

27

Note:  The table compares the security structures of long term financings of school districts in the US since 1985 to the SDC GO-RV classification. Types of obligations: bonds (Bd) and lease-backed obligations/certificates of participation (Cp). Types of recourse against general revenues: full faith and credit (FF), unrestricted (GF), restricted (CF), no recourse (RV), termination clause (AP). Limits to the ad valorem pledge: unlimited (Ultd) and limited (Ltd). Types of ad valorem levies: for debt service (Dadval), for special purposes (Sadval), for capital expenses (Cadval), for general expenses (Gadval). Other pledged revenues: sales taxes (Sales), federal aid (Fedaid), state aid (Staid), special assessments (Asmt), property tax abatements (Abat). Source:  Cestau et al. (2019b).

Sometimes it is not even clear how to classify a bond into the revenue and GO categories based on its legal security. Table 16.1 divides the observed legal securities into general obligations and revenue bonds, and compares this categorization to the GO-revenue classification reported in the SDC database. Previously we said that the statutory definitions of general obligations differ across laws and states, and the same is true for revenue bonds. The term is generally used in state constitutions and statutes in connection with obligations that do not have recourse against the general funds of a local government with broad taxing powers and that are secured solely by a special property tax or other special revenues. Based on the statutory uses of these terms, Cestau et al. (2018) define a general obligation as any obligation with recourse against the general funds of the issuer or backed by an unlimited pledge of property taxes, and revenue bonds the rest. Table 16.1 shows that for some security structures, this classification differs from that used by the SDC Platinum, as well as by other data services and rating agencies. One case of a legal security that is difficult to categorize is when the bond is paid exclusively from the levy of a special ad valorem property tax with a fixed tax rate. Special property taxes consist of separate and additional taxes that states occasionally authorize to provide funds for essential purposes, such as environmental cleanup, accessibility and life safety, when they are not adequately funded. Most times, the law authorizes to issue bonds to anticipate the proceeds of the special levy provided that they are solely paid from said taxes. In essence, these bonds have all the distinctive features of a revenue bond. However, data services and rating agencies generally classify them as general obligations simply because they are backed by property taxes. Another case of discrepancy is that of lease-backed obligations. Lease-backed obligations are a special case of securities that are issued by a separate legal entity that is created and controlled by a local government. They take the form of either lease revenue bonds or certificates of participation, and they are secured by the lease payments stipulated in a capital lease between the issuer and the local government. These types of securities have become a major source of funds for local governments. Detroit alone had $1.45 billion certificates of participation outstanding at the time it declared bankruptcy. While technically revenue bonds, the obligation of the governmental lessee can vary substantially. Generally, the lessee has the right to not appropriate funds for the lease payments (appropriation leases) or is not obligated to do so if leased property is not used (abatement leases). Although the issuer is not unconditionally obligated to draw from its general fund to pay, bonds with either termination clause are known as general fund securities. However, sometimes statutory law establishes recourse against

Emerging research issues in subnational government debt management  295 the lessee’s general or capital funds, or even stronger legal structures, comparable to those of general obligations. Nevertheless, data services always classify them as revenue bonds, regardless of the underlying security structure. Nonetheless, better and more precise classifications should emerge. A good classification ought to be: consistent, where the same value must represent the same security feature in all cases and vice versa; comprehensive, that captures the heterogeneity in the legal structures to a large extent; and parsimonious or dense, where each value and category includes a large number of cases from the largest possible number of states. Empirical Estimates Returning to the fact that recent literature has documented great heterogeneity in legal securities, questions arise such as to what extent this heterogeneity carries over to the protections granted to bondholders and what are the effects on offering yields. The answers to these questions will provide critical information for decision-making that reduce borrowing costs for local governments. While this topic has gained momentum in the municipal financial press, the academic literature still needs to develop. It is a promising field for exciting research and, given the size of the market and the pressing need for capital by local governments, its relevance is undeniable. Directly or through fiscal multipliers, borrowing costs are an important determinant of infrastructure and the quality of public services (Adelino et al., 2017; Dagostino, 2018). While the effects on credit spreads are still unknown, we know that they are not captured by the credit ratings. Credit rating agencies are yet to fully incorporate the legal security in their credit risk assessments. Moody’s adjusts the credit rating up by one notch when a “lock box” is used and may notch it down when taxing headroom is low. However, the bulk of the credit rating is determined by financial, social and economic factors. It is similar with the S&P rating. We do not know to what extent they have tested and ruled out the effects of different legal structures, but there is a clear recent trend to incorporate better and more precise information about them. And each time they incorporate a new legal feature, the effects on credit ratings are sizable (Chang and Thompson, 2016). Most likely, if legal security has not been fully incorporated, it is because they have not yet developed or tested a consistent, comprehensive and parsimonious classification. After all, the credit rating is based on the factors that they consider most important but also “universal and measurable” (Moody’s, 2021). In any case, it is a fact that legal security affects recovery rates. Even if the effects on yields are small on average, they certainly become significant when credit conditions worsen. Testing the different GO legal structures poses a real challenge, however. To begin with, default and bankruptcy events involving general obligation bonds are too limited in number to allow credible statistical inference of the effects on recovery rates. Furthermore, most cases are resolved by negotiated settlement rather than court judgment, and when it is not the case, judges are careful to avoid creating precedents with their sentences. Due to this lack of case law, it is impossible to accurately predict how judges will balance the rights of bondholders and taxpayers. Measuring the effects on yield spreads rather than on recovery rates or default events is not a panacea. Since legal security is determined by state law, cross-sectional variation within states is low. Therefore, state fixed effects are detrimental to identification, but if they are not included, legal security effects soak up those of unobserved state variables. Even a good estimation design spared from unobserved confounding variables would not be exempt

296  Research handbook on public financial management from problems. Until recently, investors and rating agencies paid no attention to legal security, so there is no guarantee that it is priced correctly and embedded in bond yields. Therefore, in what follows, we provide a qualitative analysis of the different security features, discuss the little evidence provided in the existing literature, and suggest different alternatives for testing them. Two papers provide novel empirical research on the legal security of municipal bonds, Moldogaziev et al. (2017) and Cestau et al. (2019a). Moldogaziev et al. (2017) study the effect of statutory liens on borrowing costs.5 They find that statutory liens have very modest effects, on the order of one digit in terms of basis points, on offering yields. However, their identification comes from comparing bond yields across states with and without statutory liens, and of course, they cannot include state fixed effects. Very likely, their estimates capture the effects of unobserved state variables. This does not mean it is not possible to obtain within-state variation in statutory liens. Some states authorize multiple types of GO bonds and revenue bonds, some with and some without statutory liens, which provide cross-sectional variation in those states. There have also been recent law changes in some states that have established or reaffirmed statutory liens, providing also time-series variation. Both cases allow estimating the effect of statutory liens while still controlling for unobserved state variables. Cestau et al. (2019a) estimate the residual effects on bond yields of six different legal securities after controlling for the credit rating. The legal security is a pure component of credit risk and, if properly incorporated into the credit rating, it should have a zero effect on bond yields. However, the paper finds significant residual effects, demonstrating that rating agencies do not process all relevant data on legal security. To begin with, they find that bonds only backed by the general or capital funds of the issuer – not to be confused with general fund securities, where there is no obligation to pay – offer significantly higher yields than bonds backed by the full faith and credit, or a specific pledge, or both, after controlling for the credit rating. Although rating agencies generally assigns the same rating to all bonds issued by the same entity on the grounds that, after all, it is the same issuer and issuers have historically shown to act in good faith, investors require a premium for holding the aforementioned bonds beyond that corresponding to their credit rating. This result is consistent with the fact these bonds typically have the lowest recovery rates and perhaps higher default rates. Cestau et al. (2019a) also find no significant differences between the different types of bonds backed by the full faith and credit of the issuer, whether they are enhanced by a limited or unlimited specific pledge, or not. This result is consistent with our analysis of the three examples of legal securities conducted above, where we concluded that a specific pledge should have small effects on credit risk because judges will be reluctant to compel the collection of additional taxes or determine priorities between bondholders and essential services. We also concluded that other specific duties have more decisive effects on credit risk, such as a “lock box.” Rating agencies take this legal structure into account when computing the credit rating, and this explains why there is no residual effect for unlimited GO bonds even though they often entail dedicated taxes. Finally, they find that revenue bonds backed by special revenues have no difference with revenue bonds backed by property taxes, have slightly higher yields than full faith and credit bonds, and have lower yields than bonds only backed by the general or capital funds of the issuer; all after controlling for credit rating. This begs the question: What does the full faith and credit pledge have that other pledges do not? Realistically, not much, bond lawyers say. The term makes many uneasy because it is often employed in constitutions and statutory laws but it is seldom defined by any of their

Emerging research issues in subnational government debt management  297 provisions, or in case law. In the context of local governments, based on the statements of the Supreme Court of Florida in State ex rel. Babson v. Sebring6 and the New York court of Appeals in Flushing National Bank v. Municipal Assistance Corp.,7 the pledge means that the issuer makes an express undertaking to use in good faith its full credit and resources to produce sufficient funds to pay the bonds. This basically means that a judge could compel collection of an additional tax or revenue, but, for the reasons stated above, this is unlikely to happen. Therefore, from a legal point of view, the pledge does not differ much from a simple recourse against the general funds. In the end, timely debt service really depends on the good faith and willingness of the issuer to do that which it cannot be realistically compelled to do. This is exactly Moody’s argument, but instead of being applicable to all bonds, data shows it should be applied to those bonds for which the issuer has expressly committed its honor and good faith by means of the “full faith and credit” symbolism, at least as seen by investors. Nevertheless, future research may improve the analysis carried out by Cestau et al. (2019a) in many respects. Identification may be expanded by also including lease-backed obligations and other types of issuers beyond school districts, which is the sample of issuers they use. The legal security comprising all revenue bonds backed by special revenues may be too broad to be representative of its components. Special revenues may be very different in nature and therefore have substantially different volatilities. Future research should test each of them individually. The term “limited pledge” may also be too broad, as it encompasses all types of legal limitations to property taxation, and these can vary to a great extent. There are ceiling limitations and growth limitations, these can be on the tax rate or on the levy dollar amount, and they may apply to issuers or geographic regions. Each variation may have a different effect on credit risk, and this should be the subject of future research. Future research should also expand the incipient literature on legal security along the following lines. To begin with, new literature should study the effects of the different usage restriction levels. The usage restrictions are effective legal structures from a legal point of view and there is strong evidence that they affect recovery rates. A usage restriction isolates the source of the pledged revenues from shocks to otherwise competing expenditures, protecting the resources available to pay bondholders. Investigating interaction effects between the different legal features also deserves further exploration, not to mention interactions with default probability. Also relevant is to classify and measure the effects of other legal structures not mentioned here, such as those related to reserve funds. Beyond all this, the challenge remains to determine the channels through which each legal security affects credit risk, whether it is by preventing defaults or by enabling higher recovery rates, and within the former, whether it is by affecting the willingness to pay or the resources available to pay. After all, evidence suggests that underlying all effects, legal structures affect credit risk through three channels: willingness to pay, resources available to pay, and enforceability in court. To succeed in these tasks, researchers must also work out the apparent mispricing of fundamental risks.

OTHER EMERGING RESEARCH Another strand of the literature that has gained momentum in recent years is that related to pension liabilities. The standardization provided by the new accounting rules for public pension plans introduced by GASB 67 and 68 in 2014 has opened the door to large-scale cross-sectional analysis. However, data is still very limited and most papers rely on

298  Research handbook on public financial management hand-collected data. We encourage data services to get up to speed in this regard. With the arrival of better and universal data, we expect this literature to flourish.

NOTES 1. SIFMA, US Municipal Bonds Statistics. 2. Nakhmurina (2020), Gao et al. (2019) and Mullins and Wallin (2004) find that fiscal oversight programs and overarching tax and expenditure limits (TELs) have significant effects on bond yields. 3. It had an 88 percent recovery rate. 4. Section 15251(b), Education Code, California Law. 5. In a related paper, Yang (2019) studies the impact of bankruptcy authorization laws on state borrowing costs. 6. 155 So. 669, 672 (Fla. 1934). 7. 358 N.E.2d 848 (N.Y. 1976).

REFERENCES Abott, C. and Singla, A. (2021). Helping or hurting? The efficacy of municipal bankruptcy. Public Administration Review, 81(3), 428–445. Adelino, M., Cunha, I., and Ferreira, M. A. (2017). The economic effects of public financing: Evidence from municipal bond ratings recalibration. The Review of Financial Studies, 30(9), 3223–3268. Artin, K. R., Beinfield, R. H., Fillingham, A. D., Harrington, G., Larson, J. S., Johnson, B. T., Crawshaw-Lewis, S., Manley, R. A., MacLennan, A. M., McNally, J. M., Rhodes, W. C., Roche, K. M., Smith, J. E., Unkovic, D., and Weber, F. A. (2014). General Obligation Bonds: State Law, Bankruptcy and Disclosure Considerations. White Paper. National Association of Bond Lawyers. Babina, T., Jotikasthira, C., Lundblad, C., and Ramadorai, T. (2021). Heterogeneous taxes and limited risk sharing: Evidence from municipal bonds. The Review of Financial Studies, 34(1), 509–568. Cestau, D. (2018). The political affiliation effect on state credit risk. Public Choice, 175(1), 135–154. Cestau, D. (2019). Competition and market concentration in the municipal bond market. http://​dx​.doi​ .org/​10​.2139/​ssrn​.3497599. Cestau, D. (2020). Specialization investments and market power in the underwriting market for municipal bonds. https://​www​.brookings​.edu/​wp​-content/​uploads/​2020/​06/​Cestau​-2020​.pdf. Cestau, D., Green, R. C., Hollifield, B., and Schürhoff, N. (2019a). Should state governments prohibit the negotiated sales of municipal bonds? http://​dx​.doi​.org/​10​.2139/​ssrn​.3508342. Cestau, D., Green, R. C., and Schürhoff, N. (2013). Tax-subsidized underpricing: The market for build America bonds. Journal of Monetary Economics, 60(5), 593–608. Cestau, D., Green, R. C., Hollifield, B., and Schürhoff, N. (2018). The Cost Burden of Negotiated Sales Restrictions: A Natural Experiment Using Heterogeneous State Laws. Working paper, Swiss Finance Institute. Cestau, D., Hollifield, B., Li, D., and Schürhoff, N. (2019b). Municipal bond markets. Annual Review of Financial Economics, 11, 65–84. Chang, H. and Thompson, G. (2016). US Local Government General Obligation Limited Tax Debt. Request for Comment. Moody’s Investors Service. Cornaggia, J., Cornaggia, K. J., and Israelsen, R. D. (2018). Credit ratings and the cost of municipal financing. The Review of Financial Studies, 31(6), 2038–2079. Dagostino, R. (2018). The Impact of Bank Financing on Municipalities’ Bond Issuance and the Real Economy. Working Paper. DeMarco, T., Perlovsky, I., and Sackler, D. (2017). Not All Local General Obligations Are Created Equal. White Paper. Fidelity Investments. D’Imperio, A. and Hackett, K. (2013). Not All G.O. Bonds Are Created Equal. Commentary. Kroll Bond Ratings.

Emerging research issues in subnational government debt management  299 Doty, R. (2013). Diversity and default risks of municipal bonds. Municipal Finance Journal, 34(2). Gao, P., Lee, C., and Murphy, D. (2019). Municipal borrowing costs and state policies for distressed municipalities. Journal of Financial Economics, 132(2), 404–426. Green, R. C. (1993). A simple model of the taxable and tax-exempt yield curves. The Review of Financial Studies, 6(2), 233–264. Green, R. C., Hollifield, B., and Schürhoff, N. (2007a). Dealer intermediation and price behavior in the aftermarket for new bond issues. Journal of Financial Economics, 86(3), 643–682. Green, R. C., Hollifield, B., and Schürhoff, N. (2007b). Financial intermediation and the costs of trading in an opaque market. The Review of Financial Studies, 20(2), 275–314. Harris, L. E. and Piwowar, M. S. (2006). Secondary trading costs in the municipal bond market. The Journal of Finance, 61(3), 1361–1397. Hugonnier, J., Benjamin Lester, B., and Weill, P.-O. (2022). Heterogeneity in decentralized asset markets. Theoretical Economics, 17(3), 1313–1356. Landoni, M. (2018). Tax distortions and bond issue pricing. Journal of Financial Economics, 129(2), 382–393. Li, D. and Schürhoff, N. (2019). Dealer networks. The Journal of Finance, 74(1), 91–144. Martell, C. R., Moldogaziev, T. T., and Espinosa, S. (2021). Information Resolution and Subnational Capital Markets. Oxford: Oxford University Press. Moldogaziev, T. T., Kioko, S. N., and Hildreth, W. B. (2017). Impact of bankruptcy eligibility requirements and statutory liens on borrowing costs. Public Budgeting & Finance, 37(4), 47–73. Moody’s (2020). US municipal bond defaults and recoveries, 1970–2019. Technical report. Moody’s Investors Service. Moody’s (2021). US Local Government General Obligation Limited Tax Debt. Methodology Report. Moody’s Investors Service. Mullins, D. R. and Wallin, B. A. (2004). Tax and expenditure limitations: Introduction and overview. Public Budgeting & Finance, 24(4), 2–15. Nakhmurina, A. (2020). Does fiscal monitoring make better governments? Evidence from US municipalities. http://​dx​.doi​.org/​10​.2139/​ssrn​.3293340. Neklyudov, A. (2019). Bid-ask spreads and the over-the-counter interdealer markets: Core and peripheral dealers. Review of Economic Dynamics, 33, 57–84. NFMA (2017). General Obligation Bond Payments: Statutory Liens and Related Disclosures. White Paper. National Federation of Municipal Analysts. Schultz, P. (2012). The market for new issues of municipal bonds: The roles of transparency and limited access to retail investors. Journal of Financial Economics, 106(3), 492–512. Schultz, P. (2013). State Taxes, Limits to Arbitrage, and Differences in Municipal Bond Yields Across States. Working Paper. Notre Dame University. Schwert, M. (2017). Municipal bond liquidity and default risk. The Journal of Finance, 72(4), 1683–1722. Yang, L. (2019). Not all state authorizations for municipal bankruptcy are equal: Impact on state borrowing costs. National Tax Journal, 72(2), 435–464.

17. Emerging research issues in sovereign debt management Teresa Ter-Minassian

INTRODUCTION Recent decades have witnessed a substantial rise in public debt worldwide, but especially in advanced economies. According to the International Monetary Fund (IMF, 2021), the average gross debt of the general government in these economies has risen from 75 percent of GDP in 2006 to nearly 122 percent of GDP in mid-2021. The increase has been driven primarily by fiscal responses to major crises, such as the 2008–2009 global financial crisis and the still-ongoing COVID-19 pandemic. The increase in the debt-to-GDP ratio has been less sharp, but still significant, in developing countries, which generally face tighter financing constraints. The ratio has increased from 39 percent to over 64 percent on average in emerging and middle-income economies, and from 34.5 percent to 50.2 percent in low-income ones. Such sharp increases in public debt worldwide raise important questions regarding fiscal sustainability, risks of debt crises, and the appropriate policies to minimize such risks. There is significant empirical evidence that large, sustained increases in the public debt increase the vulnerability to debt crises, especially in developing countries (Kose et al., 2021a). Issues of debt sustainability are all the more relevant because governments worldwide face further fiscal pressures related to aging populations, mitigation and adaptation needs for climate change, lingering effects of the pandemic, and the erosion of some tax bases by the digital revolution. It is therefore not surprising that a growing academic or policy-oriented literature is focusing on the issues of public debt sustainability and management. This chapter aims to provide a compact and reader-friendly overview of the main findings and conclusions of such literature. It focuses on three main sets of interrelated issues: ● Assessing public debt sustainability; ● Options to address significant risks of unsustainability; and ● Managing effectively a sustainable public debt. Specifically, the second begins with a brief discussion of some conceptual issues, such as: debt as part of the public balance sheet; the appropriate perimeter of the public debt concept; and the analytical framework to assess debt sustainability, focusing on the determinants of the debt dynamics. It concludes with a review of main current tools to assess debt sustainability under the inherent uncertainty of those determinants. The third section provides an overview of policy options to prevent or correct debt unsustainability. It begins with a brief discussion of fiscal consolidation and the considerations that should guide choices about its size, timing, and composition. It then discusses the role of higher GDP growth and of “heterodox” policies, namely inflating the debt away, and financial repression, as alternatives, or complements to fiscal adjustment. It concludes with a discussion of a range of issues relating to sovereign debt restructuring and default. 300

Emerging research issues in sovereign debt management  301 The fourth section begins by arguing that public debt management should be viewed as part of an integrated asset-liability management, and briefly reviews the progress made by various countries, and the still lengthy road ahead, in this area. It then discusses main issues in public debt management, including objectives; trade-offs between costs and risks; and the key ingredients for successful debt management. It concludes with an overview of issues in the development of local currency markets for sovereign debt, given the importance of such a development for minimizing the exchange-rate related risks for debt management and more generally for mobilizing domestic private savings. The final section presents some concluding reflections.

ASSESSING PUBLIC DEBT SUSTAINABILITY Debt as Part of the Public Sector’s Balance Sheet This chapter focuses primarily on the analysis and management of sovereign debt. This focus is common in both the academic literature and policymaking, mainly because of the seriousness and visibility of the risks of debt mismanagement and unsustainability. Nevertheless, it is useful to begin the discussion of sovereign debt by recognizing that it is only one component of the broader public sector’s balance sheet (PSBS), which also includes financial and non-financial assets and non-debt liabilities, including contingent liabilities and future liabilities related to pensions and to public-private partnerships (PPPs). A broader perspective on the entire PSBS allows policymakers to, among other things: ● Focus on a suite of useful indicators of the state of the public finances, including net worth (total assets minus total liabilities); net financial worth (total financial assets minus total financial liabilities); gross debt; and net debt (gross debt minus financial assets). ● Identify, through appropriate stress-tests, risks stemming from maturity and other mismatches of assets and liabilities of the government and of state-owned enterprises (SOEs). ● Take steps to mitigate such risks. ● Improve the management of assets, to increase their financial returns and/or the level and quality of the public services they provide.1 ● Compare the current net worth with the expected future streams of revenues and expenditures, to get a sense of the intertemporal solvency of the public sector on present policies, and to identify needs and scope for policy adjustments. However, analyses of the PSBS are frequently hampered by serious deficiencies in the relevant information. Few, mostly advanced, countries compile and regularly update reasonably comprehensive and detailed data on their non-financial assets and non-debt liabilities. The valuation of nonfinancial assets, especially heritage and natural resources, is quite complex, and the lack of international accounting standards in this area complicates inter-country comparability. In 2018, the IMF published in its October Fiscal Monitor estimates of the 2016 PSBS for 31 countries that account for about 61 percent of global GDP (IMF, 2018a). Their analysis yielded several interesting results:

302  Research handbook on public financial management ● Although financial markets mostly focus on gross debt as indicator of a government’s solvency, they also reward, through lower interest spreads, countries with higher stocks of assets. ● The combined net worth of the sample countries in 2016 was positive, but several countries, including most of the G7, had a negative net worth. Also, most countries’ net worth has been lastingly reduced by the global financial crisis, as a result not only of increases in fiscal deficits and debt, but also of declines in public investments and of a deterioration in the finances of public corporations. ● Stress tests showed that some countries’ balance sheets are especially vulnerable to risks, including shocks in output, commodity prices and natural disasters. In others, however, the composition of the balance sheet can help cushion the impact of some such shocks.2 ● Intertemporal balance sheet analysis pointed to the likelihood of severe deterioration in some countries’ net worth over the long term in the absence of relevant policy changes (for example, pension reforms). The 2018 analysis aimed at stimulating a broader range of countries to compile or improve their PSBS data and analysis. The IMF continues to devote a nonnegligible portion of its technical assistance and training to supporting such efforts. Some Issues in the Definition of Sovereign Debt The term sovereign debt is generally used to refer to the debt of the national government, which in most countries represents by far the largest share of the total public sector debt. However, there is growing consensus in the literature that debt sustainability assessments should focus on a broader perimeter of the concept. International organizations like the IMF and the World Bank (WB) have long recommended conducting such assessments for the entire General Government, and the European Union (EU) defines, and tests compliance with, its fiscal rules in terms of the same aggregate. This broader focus reflects the substantial decentralization of revenue and spending responsibilities to subnational governments (SNGs) and the recognition that in most countries the national government eventually has had to bail out these governments when they incurred serious financial difficulties. Still many (mostly developing countries) continue to focus on the debt of the national government, mainly because of limitations in the availability of timely and reliable data on the subnational finances.3 A more controversial issue is whether public debt sustainability assessments should also include SOEs. The most common approach is to include those non-financial SOEs that are substantially dependent on government financial support.4 For instance, the EU includes in the perimeter of the general government SOEs that receive more than half of their revenues from the national budget. It should be recognized, however, that even SOEs with lower degrees of financial dependence on the government can create significant fiscal risks, as a result of serious governance flaws, uncompensated quasi-fiscal operations, and a lack of clear rules limiting their access to borrowing in line with their capacity to service the resulting debt.5 This makes it all the more important to include in public debt sustainability assessments the contingent liabilities associated with such risks, as discussed below.

Emerging research issues in sovereign debt management  303 Another important issue in the definition of sovereign debt is the valuation of the debt. The debt can be valued at its face value (the amount to be repaid at maturity); its nominal value (its outstanding principal plus unpaid accrued interest); or its value in the secondary market. The first two concepts are the critical ones from the perspectives of the debtor government and of those holders of debt instruments that intend to hold them until maturity. The third matters mainly for investors interested in liquidity of the instruments. Market values are typically characterized by significant volatility over the life of debt instruments. The face value of sovereign debt (e.g. Treasury bills) issued at discount is initially higher than its nominal value. Focusing only on the latter would understate the debt burden of a government and create incentives for short-sighted politicians to use disproportionally this type of debt. Differences between the market and the face or nominal values provide insights into the evolution of market perceptions of a sovereign’s solvency, but can also be significantly affected by other factors, such as domestic and global liquidity conditions. For these reasons, in conducting debt sustainability assessments, it is critical to understand which valuation criteria are used to compile a country’s sovereign debt data. Analytical Framework for the Assessment of Sovereign Debt Sustainability In principle, a government can be considered solvent if it meets its intertemporal budget constraint, namely if its debt is equivalent to the cumulative value of its future non-interest (primary) balances over an infinite time horizon. It is apparent, however, that there is no operationally feasible way to assess solvency so defined,6 given the impossibility of predicting revenues and expenditures over such a horizon. Therefore, there is broad consensus in the literature that debt sustainability should be assessed on the basis of the expected dynamics of the debt over more or less long but finite time periods.7 Ex-post, changes in the debt-to-GDP ratio are given by the following equation: dt-dt-1 ​= ((rt-gt)/(1+gt))dt-1-pbt

(17.1)

where d stands for the debt-to-GDP ratio; r for the average real interest rate on the debt; g for the rate of growth of real GDP; and pb for the primary fiscal balance. It should be noted that Eq. (17.1) does not take into account off-budget debt-creating flows, such as valuation changes, and the realization of contingent liabilities. The next subsection discusses how to incorporate them in debt sustainability analyses. The debt is considered sustainable if it stabilizes at a given time horizon t*, i.e. if dt* -dt*-1=0. There are no hard and fast criteria to guide choice of the length of the time horizon for the debt stabilization. Factors likely to influence it are, on the one hand, financial markets’ perceptions of the credibility of a government’s commitment to fiscal sustainability; and, on the other hand, the balance of economic and political costs and benefits of the speed of the debt’s convergence to a stationary level. These factors vary across countries and over time. Generally speaking, advanced countries can afford slower paces of convergence than emerging and developing economies (EMDEs). It is apparent from Eq. (17.1) that the debt dynamics at any point in time are shaped by three determinants: the initial size of the debt ratio (dt-1); the difference between the real interest rate and the real growth rate; and the primary balance. Specifically, ceteris paribus, the public debt

304  Research handbook on public financial management is more likely to stabilize the lower are its initial stock, and the average real interest rate on it; and the higher are the real GDP growth rate and the primary fiscal surplus. Advanced economies have long enjoyed favorable differentials between the GDP growth rate and the average interest rate on their public debt, as documented by Blanchard (2019) and Furman and Summers (2020) for the United States, and by Blanchard et al. (2021) for the European Union. In the last decade, the unprecedented expansion of the balance sheets of the Central Banks of major advanced economies has certainly contributed to near-zero borrowing costs for the respective governments. Thus, the sustained increase in the public debt in these countries has been largely a reflection of the accumulation of significant fiscal deficits, including most recently to mitigate the impact of COVID-19. Although many EMDEs have also enjoyed favorable growth-interest rates differentials, these have tended to be smaller on average than for advanced economies, despite generally higher real GDP growth. Moreover, the differentials have been more volatile, reflecting the greater vulnerability of EMDEs to external shocks and changes in financial markets conditions. Also, for a number of EMDEs, especially those with histories of debt difficulties or defaults, the differentials have been negative, impacting adversely the debt dynamics (Kose et al., 2021b). The determinants of the debt dynamics are not independent of each other. There is some evidence that very high levels of debt affect adversely the GDP growth rate (Reinhart and Rogoff, 2009). Interest rates may also be affected by the sign and size of the primary balance, an important indicator of fiscal policy for financial markets, although other factors such as global and domestic liquidity conditions may play a more important role in this respect. Finally, policy-makers tend to react to changes in the debt and in the difference between interest rates and growth rates by adjusting the primary balance, but the intensity of such reactions varies widely across countries and over time. For example, Mendoza and Ostry (2008), using a large country panel over 25 years, found that the policy response to growing debt tended to be stronger in the emerging than in the advanced countries, likely reflecting tighter financing constraints. These considerations highlight the high degree of uncertainty that inevitably affects ex-ante debt sustainability assessments based on forecasts of the relevant variables. Recognition of such uncertainty has increasingly shaped the technology of debt sustainability analysis (DSA) over the last decade or so. The next subsection provides an overview of the main current tools for DSA. Main Tools for Debt Sustainability Analysis International financial institutions, such as the IMF and the World Bank (WB) and the European Commission (EC), have been at the forefront of the development of increasingly complex DSA frameworks, aiming to incorporate uncertainty, different time horizons, and off-budget debt-creating flows, while allowing for the differences in risk profiles between countries at different levels of development. Specifically, the IMF developed in the early 2000s, and has revised repeatedly since then, a DSA framework for 120 market-access countries (MAC), with some differences in parameters between advanced (AEs) and emerging and middle income (EMDEs) economies. For 70 low-income countries (LICs), a separate framework was jointly developed in 2005 by the

Emerging research issues in sovereign debt management  305 IMF and the WB. It has been refined repeatedly since then, with the last revision taking place in 2018. The IMF’s MAC-DSA, introduced in 2002, aimed to illustrate debt projections, the underlying assumptions regarding their drivers, and the sensitivity of the debt path to standardized stress scenarios (IMF, 2002). Its review in 2011 introduced important reforms, in response to shortcomings revealed by the Global Financial Crisis (GFC) and euro area sovereign debt crisis8 (IMF, 2011). The current framework, launched in 2013 in response to this review, includes the following key features: ● A risk-based approach, i.e. a distinction between high- and low-vulnerability countries, in analyzing risks of debt crisis across the IMF’s membership; and ● New elements in the DSA output including: (i) an analysis of the realism of baseline projections; (ii) a heat map based on thresholds for debt, gross financing needs (GFNs), and debt profile indicators, to summarize sustainability risks; and (iii) debt fan-charts to capture the full distribution of risks around the baseline (see IMF, 2013a for details). A new review of the framework in 2020 identified continuing shortcomings in it, including a mixed record in assessing risks of sovereign stress; still inadequate coverage of debt and non-debt liabilities; insufficient granularity in the characterization of risk profiles of different countries;9 and the fact that the methodology does not provide an adequate basis for probabilistic assessments of debt sustainability. Based on this review, the IMF will begin utilizing later in 2021 a new version of the MAC-DSA, now renamed the MAC Sovereign Risk and Debt Sustainability Framework (SRDSF), which utilizes additional state-of-the-art analytical tools, with the aim of increasing the predictive power of the framework with respect to both liquidity stress and debt unsustainability of sovereign borrowers (IMF, 2021). The main innovations included in the SRDSF include: ● Making general government the default option for coverage, and requiring greater granularity in information on its composition and profile.10 ● Distinguishing three time-horizons for the analysis, namely: ● A short-term one, in which the risk of debt stress will be predicted through a logit regression using as explanatory variables ten indicators grouped into five categories (the country’s quality of institutions, stress history, cyclical position, and debt burden; and global risk appetite). ● A medium-term (5-year) one, in which stress and unsustainability risks will assessed on the basis of: (a) probabilistic fan-charts of debt developments around a baseline scenario; (b) indicators of debt rollover risks; and (c) stress tests tailored to each country’s characteristics (e.g. exposure to natural disasters; dependence on revenues from commodities; high vulnerability of the financial system, etc.). ● An optional long-term (10-year) one, to analyze sustainability risks stemming from longer-term factors such as population aging, natural resources depletion, and climate change. ● Expanding the coverage of the tools for realism checks on the analysis.

306  Research handbook on public financial management The framework includes an error-minimizing methodology to combine the results of the various indicators for each time horizon into a composite index that maps into an overall risk assessment (low, medium, or high).11 The LIC-DSF provides guidance to national policymakers, as well as to potential lenders and to IMF and WB staff, in evaluating the risk of sovereign debt distress in low-income countries. It also represents an essential input into analyses of individual countries’ fiscal space available to accommodate additional spending (in particular, on public investments12) and/or tax cuts, without jeopardizing debt sustainability over the medium to long-term (see IMF, 2018b for details). The LIC-DSF utilizes the Country Policy and Institutional Assessment (CPIA, an index produced annually by the WB staff) to classify countries based on their debt-carrying capacity. It also uses a set of threshold levels for selected debt burden indicators linked to elevated risk of debt distress that are statistically estimated for varying levels of debt-carrying capacity. Baseline macroeconomic projections and stress test scenarios are evaluated relative to these thresholds, and are used, in conjunction with staff judgment, to assign to the country in question a risk rating of debt distress. Figure 17.1 depicts the architecture of the LIC-DSF in its current version, with an asterisk marking changes introduced in 2018.

Source: IMF (2018a).

Figure 17.1

The architecture of the LIC-DSF in its current version (with an asterisk marking changes introduced in 2018)

The IMF-WB DSA frameworks have represented useful models for other multilateral institutions and bilateral lenders in shaping their own tools of debt sustainability analysis. The EC framework is especially interesting because it explicitly incorporates long-term projections prepared by its Working Group on Ageing (see the EC’s Debt Sustainability Monitors and Ageing Reports for details). In 2019, the Chinese authorities unveiled a Debt Sustainability

Emerging research issues in sovereign debt management  307 Framework, modeled on the LIC-DSF, for countries participating in the Belt and Road Initiative.

PREVENTING OR CORRECTING PUBLIC DEBT UNSUSTAINABILITY13 This section provides a (necessarily summary) overview of policy options that a government has when facing significant risks of debt stress or even unsustainability, as identified through a DSA of the types discussed in the previous section. Policy options to prevent debt unsustainability seek to change the trajectory of the determinants of the debt dynamics, namely the primary fiscal balance; the real growth rate of GDP; and the average real cost of government borrowing, Accordingly, they include “orthodox” policies such as fiscal consolidation, structural policies to boost the growth of potential GDP, and improvements in public debt management; and “heterodox” ones, such as resort to the inflation tax, and financial repression. These are discussed in turn below. Since some of these policies may entail significant economic, social, and political costs, governments facing unsustainable debt dynamics may not be willing to pursue them to the extent required to stabilize the debt at a level acceptable to financial markets. In these circumstances, it may be necessary to secure a restructuring of the debt or an outright reduction of its value. However, a sovereign defaulting on its debt is not costless either. The section below discusses these costs and possible approaches to mitigating them. Options to Reduce Sovereign Debt, Other Than Through Restructuring and Default Fiscal consolidation It should be noted at the outset that fiscal consolidation (an increase in the primary surplus, or a reduction in the primary deficit) may be appropriate also in some circumstances when a government is not facing significant debt unsustainability risks. In an open economy with capital mobility facing overheated domestic demand and inflationary pressures, a fiscal tightening can avoid putting the whole stabilization burden on monetary policy, thereby moderating upward pressures on the exchange rate. Fiscal consolidation may also be required by existing fiscal rules. Numerical fiscal rules have become increasingly common worldwide (Figure 17.2).14 As of 2021, 85 countries include a debt limit in their fiscal rules’ framework. These limits are generally set at levels lower than those that would signal high risks of stress. Debt limits that are above the current value of the debt stock function mostly as medium-term fiscal anchors, with budget balance- or expenditure-based rules guiding the annual budget process. If the existing debt stock is above the limit, the fiscal framework typically includes rules regarding the path of convergence to it. Fiscal rules have become more flexible in the last decade, incorporating features such as reference to a cyclically-adjusted balance, escape clauses in the event of large and unforeseeable exogenous shocks, and in some cases periodic review clauses (Schaechter et al., 2012). Some countries exclude borrowing to finance public investments from the debt, budget balance, and expenditure limits (so-called golden rules). Such exclusions can, however, give rise to unsustainability risks, especially in countries where public debts are already high, and public investment management systems are fraught with significant flaws.

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Source: IMF Fiscal Rules dataset (Fiscal Rules (imf.org)).

Figure 17.2

The worldwide rise of numerical fiscal rules (number of countries with such rules)

A government wishing to reduce its debt-to-GDP ratio through fiscal adjustment typically faces choices and trade-offs in a number of dimensions, including the size and time profile of the adjustment, its composition, and related effects on efficiency and equity. A front-loaded adjustment generally has benefits in terms of market confidence and related reduction of risk premia on sovereign debt instruments. It may also be necessitated by very tight short-term financing constraints. On the other hand, large procyclical cuts in public spending or increases in taxes tend to have higher multiplier effects during economic downturns, thereby significantly aggravating them (Auerbach and Gorodnichenko, 2012). In some cases, the adverse impact on GDP may actually result in an initial increase in the debt-to-GDP ratio,15 with potentially adverse effects on market confidence. In such cases, if financing availability allows it, a more gradual adjustment, resulting in a slower convergence of the debt to its desired value, may be preferable. Political economy considerations also weigh on the choice of the adjustment path, and they vary in different countries. Frequently, there is a trade-off between the size of the adjustment and its durability. The empirical literature on this issue (e.g., IMF, 2013b; Escolano et al., 2014; and Zheng, 2014) suggests that large fiscal consolidations are typically not sustained over extended periods of time. On the other hand, a substantial up-front adjustment may create sufficient buffers (for example at the outset of a new government) to provide fiscal space for significant subsequent easing at a politically more difficult time (e.g. in the runup to new elections).

Emerging research issues in sovereign debt management  309 The composition of the fiscal adjustment also matters. It is impossible to do justice here to the vast literature on the macro and microeconomic effects of different types of spending cuts and revenue mobilization measures. A few main lessons from it can be summarized as follows: ● Within these broad categories, multipliers vary significantly depending on the specific measure. For example, cuts in public investments have stronger impact on growth than those in untargeted transfers to households (Abiad et al., 2016; Ardanaz et al., 2021). ● Increases in income taxes are more detrimental to growth than those in consumption or property taxes (Brys et al., 2016). ● Longer-term effects on the growth of potential output also reflect institutional characteristics (for example, the quality of public investment management systems (Gupta et al., 2014; Miyamoto et al., 2020); whether the spending cuts relate to especially distortionary items, such as energy subsidies (Clements et al., 2013); and whether revenue mobilization efforts take the form of base-broadening measures, or of tax rate increases.16 ● Different adjustment measures have also different impacts on income distribution,17 a fact that in turn affects both their social and political feasibility in the short term, and the likelihood of their durability over the longer run. In summary, there is no one-size-fits-all optimal strategy for fiscal consolidation. Choices regarding its overall size, time profile, and composition need to be carefully tailored to each country’s specific economic, institutional, and socio-political circumstances. Growing out of debt Ceteris paribus, an increase in the real rate of economic growth can reduce a debt-to-GDP ratio both by increasing the denominator of that ratio, and by improving the primary fiscal balance through the operation of the automatic stabilizers (unemployment benefits and taxes with high income elasticity). However, the latter tend to be small in developing economies. Moreover, relying primarily on higher growth to reduce the public debt can be problematic also for other reasons: ● Empirical evidence suggests that the governments of many EMDEs have used the fiscal dividends of economic booms to increase spending, rather than to reduce the public debt. ● A demand-driven increase in the GDP growth rate is frequently followed by an increase in real interest rates, which in turn affects adversely the public debt dynamics. ● The structural reform policies required to engineer a sustained supply-driven boost to GDP growth tend to be politically difficult and to act with long and difficult-to-predict lags. These policies include measures to increase the size and skills of the labor force; to facilitate efficient public and private investments; and to promote total factor productivity by reducing market rigidities, increasing external openness, and promoting the adoption of efficient new technologies. For these reasons, it is not surprising that the empirical literature finds that sustained debt reductions driven primarily by higher growth have been rare, especially among EMDEs (Reinhart et al., 2003). Going forward, long-term trends, such as the aging-related slowdown in the labor force, and continued sluggish growth of total factor productivity can be expected to impact negatively the growth potential of advanced economies as well.

310  Research handbook on public financial management Inflating the debt away Public debt denominated in domestic currency18 can be reduced through an unanticipated increase in the inflation rate that does not result in a contemporaneous increase in the average interest rate on the debt. The surprise increase in inflation acts as a tax on the government bondholders. Those who hold fixed-rate and longer-maturity instruments are obviously most exposed to such a tax. Governments whose domestic debt is of longer average maturity and with a higher proportion of fixed rate instruments may be more tempted to use the inflation tax to reduce the debt. However, over time investors in government securities adjust their inflation expectations and reflect them in the interest rates they require to rollover maturing debt or to acquire new one. Thus, to keep ahead in such a “repeated game,” governments need to keep using further surprise increases in inflation. Accelerating rates of inflation may eventually lead investors to require higher real interest rates, to compensate for perceived increased inflation risks. Higher real interest rates on the public debt tend to propagate to private debt as well, with likely adverse effects on economic growth, and ultimately on the public debt dynamics. Accelerating inflation also tends to lead to a significant shortening of the average maturity of the public debt, and a consequent increase in gross financing needs, a key indicator of sovereign stress risks. Moreover, accelerating inflation has substantial efficiency and welfare costs. It can lead to distortions in relative prices, when different goods and services have different degrees of price stickiness. It hurts disproportionately fixed-income income groups that tend to be in the lower part of the income distribution. And, as international experience amply demonstrates, it hinders the development of deep and efficient domestic capital markets. Recognition of the risks of resorting to the inflation tax as a means of reducing the public debt has been a primary motivation of the worldwide trend in recent decades to strengthen the independence of the monetary authorities from the government. Financial Repression Sovereign debt can also be reduced through financial repression. This term, initially coined by Shaw and McKinnon in the early 1970s, refers to measures, mostly of a regulatory nature, that keep market interest rates below the levels that would prevail in the absence of such measures. Such policies include restrictions on banks, such as ceilings on interest rates, directed lending, reserve and portfolio requirements; and capital controls that restrict investors’ ability to arbitrage across countries. Some of these measures may be adopted for prudential reasons, or to favor particular sectors of the economy, such as housing, or SOEs, or to prevent losses of international reserves, rather than to reduce borrowing costs for the government, but they still do have a favorable impact on such costs. Other measures, such as legal requirements or moral suasion for banks to hold a minimum portion of their portfolio in government securities, are more directly aimed at keeping down interest rates on the public debt. Financial repression has been especially common in developing economies, contributing to the underdevelopment of capital markets in many of them, but is no stranger to advanced economies as well. For example, Reinhart and Sbrancia (2015) estimated that financial repression was a key factor in the maintenance of negative real interest rates in several advanced economies in the aftermath of the Second World War and through the 1970s.19 This, in combination

Emerging research issues in sovereign debt management  311 with high rates of real GDP growth and significant inflation, was instrumental in reducing the public debt ratios in those countries during that period. In more recent years, in the aftermath of the GFC of 2008–2009, tightened liquidity and capital requirements for banks, and moral suasion in some countries, have encouraged increased bank holdings of sovereign bonds of advanced countries, which enjoy a zero risk weighting. Moreover, major central banks, including the US Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan, have embarked in unprecedented expansions of their portfolios of government securities, thereby allowing the maintenance of negative real interest rates on the sovereign debt of these countries in the face of sharply higher borrowing needs. Ensuring a non-disruptive exit from such policies through a smooth tapering of the bond purchases will pose a difficult challenge to policymakers and debt managers in those countries in the short to medium term. Sovereign Debt Restructuring and Default Restructuring their debt is another option for sovereigns facing a significant risk of debt distress or a clear diagnosis of unsustainability. In some cases, when the risks are mainly of a liquidity nature (i.e. related to current or prospective large gross financing needs) a preemptive, market-based reprofiling of debt maturities may be feasible at a reasonable cost. Such a restructuring would typically not involve a reduction in the net present value (NPV) of the debt and would be considered part of a prudent debt management. This section discusses various forms of changes in the terms of debt-related payments, including but not limited to reductions in the face value of the debt, which involve a reduction in its NPV. Although some of these operations may not fall under the contractual heading of default, they are classified as such by rating agencies (Ams et al., 2020). A government contemplating some form of debt default needs to carefully consider its costs, as well as lessons from international experiences about possible steps to mitigate such costs. The main costs of default involve: ● Loss of market access. This is sometimes overstated in the literature. In most cases, governments choosing to make a (more or less coercive) demand for a reduction in the NPV of their debt, are already experiencing severe constraints on their market borrowing. Also, some empirical studies (e.g., Panizza et al., 2009; Gelos et al., 2011) find that the adverse effect of a default on borrowing costs is relatively short-lived (say, a couple of years). However, other studies (e.g. Cruces and Trebesch, 2013; Catao and Mano, 2017) find larger and longer-lasting adverse impacts. These differences can be partly explained by the fact that restructuring episodes differ in terms of process, and of results in terms of restoring debt sustainability. Also, global liquidity conditions and the related search for yield are likely to play a role in the length of investors’ memory. ● Impact on the economy. There is an extensive literature suggesting that sovereign defaults tend to be accompanied by downturns in output, domestic and foreign investments, and external trade.20 These negative trends are exacerbated when the default is accompanied by a domestic banking crisis, a risk that is especially serious when banks have chosen, or have been coaxed into, holding large shares of the sovereign debt (the so-called doom loop; Gennaioli et al., 2014).

312  Research handbook on public financial management ● Creditor litigation. This is especially relevant for debt issued under foreign jurisdictions and may include the attachment of sovereign assets abroad. This risk has risen in recent decades, as a result of the rise of so-called vulture funds that specialize in buying distressed sovereign debt instruments at deep discounts, in the hope of forcing the issuing government through litigation to redeem them at their face value.21 Other choices facing a sovereign in debt distress relate to: ● The scope of the restructuring in terms of creditors involved: ● Official vs. private creditors. It is generally accepted that debt to the IMF, as the global lender of last resort, is not subject to restructuring.22 Debt to other multilateral institutions, like the World Bank and other multilateral development banks (MDBs), is also generally excluded from restructurings. ● Restructuring of sovereign debt to bilateral official lenders has traditionally taken place under the umbrella of the so-called Paris Club, which sets terms and procedures agreed among its members for such restructuring. The Paris Club conditions its debt relief to debtor countries’ agreements with the IMF, aimed at ensuring post-restructuring debt sustainability. These restructurings are not considered defaults by the rating agencies, a fact that is important to avoid downgrades and the related increase of borrowing costs. ● This well-established landscape for the restructuring of official debt has been changed substantially in recent years by the emergence of non-Paris Club creditors, notably China, which has undertaken extensive lending to emerging and low-income countries, in amounts and at terms that remain quite opaque. Efforts are ongoing by the IMF and the World Bank, under the umbrella of the Group of Twenty (G-20), to require countries that borrow from these institutions to substantially increase the transparency and granularity of their debt statistics (see IMF, 2020b for details). ● Foreign vs. domestic creditors. Restructuring domestic debt may appear easier because of the extensive legal and moral suasion powers that a government holds on its subjects. However, the levying of such an implicit tax has potentially high political and economic costs for the government, particularly when the main holders of the debt are financial institutions, for the reasons mentioned above.23 For this reason, governments often prefer to reduce their domestic debt through higher inflation or through financial repression, as discussed in the previous section, rather than through outright default. ● Default on foreign debtors may be politically more appealing because it shifts the immediate burden to investors outside the country, who do not vote in it. For example, domestic creditors were excluded from the 2015 debt restructuring by Ukraine. However, the reputational and economic costs of a default on external debt may tilt the balance in favor of a purely domestic one, as in the case of Jamaica in 2013. ● The timing and size of the proposed NPV reduction. Governments facing sizable risks of debt distress are generally loath to acknowledge such risks and act on them, because they recognize the substantial costs of a debt restructuring. The IMF (2014) found that 80 percent of countries that eventually undertook a debt restructuring had had high debt levels for at least the preceding three years. But delays in facing up to restructuring needs are also

Emerging research issues in sovereign debt management  313 costly, because they are frequently accompanied by a progressive erosion of investors’ confidence, shortened maturities, and increased cost of borrowing. Also, the uncertainty associated with a debt overhang tends to sap domestic business confidence, and sometimes leads to capital outflows, with adverse effects on the exchange rate and on economic activity more generally. Restructurings may be not only too late, but also too little, as governments may try to minimize their costs by asking for smaller NPV reductions than would be necessary to ensure sustainability of the restructured debt. Unfortunately, an inadequate restructuring generally ends up requiring subsequent further defaults. Objective analyses of impartial and technically qualified advisors (including the IMF) can help governments to avoid this pitfall. In advising on this delicate issue, it is essential that the advisors make a realistic assessment not only of the economic factors affecting future debt sustainability (such as interest rates and GDP growth rates) but also of the maximum socially acceptable level of the fiscal adjustment required for such sustainability. ● The restructuring process. The two main challenges to be faced in a sovereign debt restructuring process are asymmetries of information between the debtor and its creditors; and creditors’ coordination. Asymmetries of information arise because the sovereign is obviously better placed than its creditors to assess the scope to improve its primary balance through revenue and expenditure measures. Creditors therefore tend to believe that the sovereign’s proposal for debt reduction understates its true scope for fiscal adjustment, and respond by offering substantially lower relief. The above-mentioned impartial third party can play a useful role in bridging such information gap (Buchheit et al., 2020). Debt restructuring is viewed by creditors as a zero-sum game. Each would like to get a smaller share of the haircut than the others but, recognizing that this is unlikely to happen, focuses on ensuring that no one else does. This implies that a credible promise of fair distribution of the burden can significantly facilitate negotiation of a deal acceptable to all. Again, the involvement of an impartial third party can help provide assurances of such fairness. However, the process has been substantially complicated in recent decades by the rapid diversification of creditors (hundreds or thousands of bondholders, instead of a few major international banks as in the 1980s) and the emergence of new semi-official lenders, such as SOEs. Creditors’ committees are frequently created to facilitate the negotiation process.24 The problem of holdouts is being addressed through the use of increasingly comprehensive collective action clauses (CACs), which enable a qualified majority (typically 75 percent) of bondholders to accept a debtor’s offer, with binding effect on all bondholders of the debt covered by the clause. However, CACs have only become frequent in new debt issuances over the last decade, therefore they still do not cover a large share of outstanding sovereign debt.

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MANAGING A SUSTAINABLE PUBLIC DEBT EFFECTIVELY Sovereign Asset-Liability Management (SALM) An integrated asset-liability management (ALM) approach has long been used by financial institutions to reduce currency, maturity, indexing, and other mismatches between assets and liabilities, with the aim of enabling their balance sheets to better withstand shocks. In contrast, the objectives for managing sovereign assets and liabilities are usually distinct, and often uncoordinated. The main objective of government liability management is to ensure financing of the budget at the lowest possible cost, subject to an acceptable level of risk. On the asset side, the main objectives are to ensure that cash balances are adequate to meet upcoming payments, and to maximize the service potential and purchasing power of the long-term assets, with a moderate level of risk. An integrated SALM approach aims to identify the various types of assets and liabilities that a sovereign manages, and to explore whether the financial characteristics associated with those assets can provide insights for managing the cost and risks of the liabilities. Such an approach allows governments to evaluate risk exposures for their entire balance sheet, and to assess the feasibility of reducing net interest expenditure and various types of portfolio risks (Cangoz et al., 2018). Although the benefits of a SALM approach are potentially substantial, there are important hurdles for its adoption that explain why only very few advanced countries have implemented such an approach in full. However, a number of other advanced and emerging economies are implementing a SALM for some parts of their balance sheets. A first prerequisite for the adoption of a SALM is the compilation of a balance sheet for the sovereign. The challenges faced in this task have been discussed above. But even countries that are quite advanced in the compilation of balance sheets often use them more to monitor developments in their assets, liabilities, and net worth, than to manage them in an integrated fashion. For instance, a 2017 survey of 28 mostly advanced countries by the World Bank found that only a quarter of those countries use the balance sheet to analyze mismatches of various sorts between assets and liabilities (Cangoz et al., 2018). Only New Zealand prepares stress tests for the entire sovereign balance sheet.25 Other countries that have embraced a SALM approach focus on the analysis of the impact of specific risks (e.g. currency- or maturity-related ones) on some parts (typically only the financial components) of their balance sheets. A second important hurdle in the implementation of a SALM is the frequent fragmentation of institutional responsibilities in this area. Typically, cash management is the responsibility of an office (the Treasury) in the Ministry of Finance, while the management of the public debt may be delegated to a special Debt Office separate from the ministry. A Sovereign Wealth Fund may be in charge of longer-term public assets, a separate ministry (or ministries) may be responsible for managing sovereign equity in SOEs, and the Central Bank is generally in charge of the management of the country’s international reserves, and sometimes of its foreign debt. Ensuring adequate coordination of these various bodies can be quite a challenging task. The above-mentioned World Bank survey provides examples of strategies that have been adopted by different countries, like Canada, Chile, Denmark, and Uruguay,26 to ensure sufficient coordination among responsible agencies to enable an integrated management of some parts of the sovereign balance sheet. A number of other countries have instituted high-level coordinating

Emerging research issues in sovereign debt management  315 committees that include all or most of the institutions involved in SALM, to facilitate the exchange of relevant information and avoid conflicting strategies. Coordination is especially important between cash and public debt management. The development of the cash management function typically goes through three different stages: (a) the implementation of a Treasury Single Account (TSA), i.e. the integration of all or most government accounts into a single one, held at the Central Bank or at a major commercial bank;27 (b) building a capacity to reliably forecast inflows and outflows into the TSA; and (c) moving to an active cash management, with the Treasury borrowing and lending in the money market, with a view to smoothing cash flows, thereby reducing sovereign borrowing costs (Jonasson et al., 2020). Active cash management is usually conducted by the Treasury through the issuance of short-term instruments (T-bills) and repurchase agreements (repos) on such instruments. Active cash management is greatly facilitated by well-developed overnight and term money markets. It is obvious that the issuance of T-bills needs to be coordinated with that of other sovereign bonds by the debt manager, which may be the Treasury or a separate Debt Office, with a view to promoting the establishment of a smooth and not too volatile yield curve. In particular, information about the timing of prospective large cash inflows and outflows into the TSA, and of T-bill maturities, is important for debt managers to decide on the timing of bond issues. Key Issues in the Management of Sovereign Debt Objectives and risks Sound sovereign debt management is key for fiscal sustainability. A debt structure that is robust to interest rates, exchange rate, and other shocks can allow a country to sustain a higher debt level in times of difficulty. The main objective of sovereign debt management is to ensure that the government’s gross financing needs are met at the lowest possible cost over the medium to long term, consistent with a prudent degree of risk. It is therefore apparent that sound debt management involves trade-offs between costs and risks and requires well-informed judgments about them. A medium-term debt management strategy (MTDS) defines a government’s main objectives in deciding the targeted composition of its debt over a medium-term horizon (typically three to five years), taking into account its estimates of the trade-off between costs and risk during that period. Cost at Risk (CaR) techniques can be used to rank different issuance strategies and liability management operations on the basis of their performance under different shocks. Stochastic scenario simulations can be used to assess the robustness of different strategies by showing the probability of debt servicing costs exceeding the specified CaR value under each scenario. The main types of risks faced by debt managers are (Jonasson et al., 2020): ● Rollover risk. This risk refers to the fact that maturing debt may have to be refinanced at an unusually high interest cost or cannot be rolled over at all. The rollover risk is higher when the maturity profile is concentrated on or around a particular maturity and/or it is short, with large redemptions. ● Funding risk. This risk refers to the issuance of new debt to cover fiscal deficits. Although conceptually distinct from rollover risk, in practice it tends to be affected by the same

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● ●

● ● ●

factors that impact the latter, in particular market liquidity conditions and sovereign credit ratings. Interest rate risk. This risk stems from the impact of changes in market interest rates on the cost of servicing new or existing floating-rate debt. Exchange rate risk. The degree of such risk depends on both the volatility of the exchange rate and the share of the debt that is denominated in foreign currency. The debt manager can affect the exposure by varying the composition of his debt portfolio, but cannot affect the risk factor, namely the exchange rate. Counterparty credit risk. This risk relates to derivative contracts that debt managers enter into, and depends on the probability of the counterparty defaulting, the size of the future potential exposure, and the recovery value in the event of default. Various types of legal and operational risks. Risks related to the materialization of contingent liabilities, either explicit (guarantees) or implicit (e.g. bailouts of insolvent subnational governments, SOEs, or financial institutions).28

The brief taxonomy above highlights some of the main trade-offs faced by policymakers and debt managers. Typically, debt with shorter maturities is less expensive than debt with longer ones (the yield curve is generally upward-sloping), but it entails greater rollover risks. Floating rate debt may be cheaper than fixed-rate one in the short run but turn out to be more expensive over the longer term, if interest rates start rising. Debt denominated in foreign currency generally carries lower interest rates than debt denominated in the national currency, but it entails potentially large foreign exchange risks. However, it may be the only option for developing countries that do not have adequately developed domestic capital markets to borrow at other than very short-term maturities (the so-called original sin (Eichengreen et al., 2005)). Heavy reliance on foreign investors also increases rollover and funding risks, as they tend to be more sensitive to changes in sovereign credit ratings.29 Certain features (such as embedded put options, which involve the ability of the holder to require redemption of a bond before maturity; or early cancellation clauses in the event of trigger rating downgrades) and the use of complex derivative structures can also heighten debt portfolio risks. The management of contingent liabilities is quite challenging. The granting of government guarantees should be subject to careful scrutiny, and a ceiling on their stock should be included in the budget. The budget should also include in an annex on fiscal risks the face value and an estimate of, and a provision for, the expected value of realization of each (or at least each main category of) guarantees. Fees should also be levied on the guarantees, preferably related to the expected values of their realization. On the other hand, the management of implicit contingent liabilities goes well beyond a debt manager’s remit, as it involves the formulation and firm implementation of sound policies on fiscal decentralization, relations with SOEs, and financial system regulation and supervision. A growing approach to mitigating certain types of risk in sovereign debt management is the use of state-contingent debt instruments (SCDIs) ( Bredenkamp et al., 2020). These bonds link debt service to economic variables, such as GDP growth or commodity prices, or to exogenous shocks such as natural disasters, that affect a government’s debt servicing capacity. They have the advantage of increasing fiscal space during periods of difficulty. However, this potential

Emerging research issues in sovereign debt management  317 benefit has to be weighed against the higher interest rates that typically these types of instruments carry. Also, SCDIs, as any type of insurance, can give rise to moral hazard, allowing governments to choose riskier policies (e.g. less investments in adaptation to climate change, or laxer building codes in earthquake-prone areas) or to delay adjustment to structural changes in the indexing variable, because of the protection afforded by the bonds. Finally, some types of SCDIs may open scope for governments to manipulate the indexing variable.30 Institutional issues A sound institutional framework is essential for effective sovereign debt management. Such a framework should establish clear responsibilities and accountabilities for the various aspects of debt management. The laws and regulations specifying such responsibilities should be transparently disseminated, with a view to promoting investors’ confidence. International experience demonstrates that, to minimize risks of uncoordinated decisions and blurred accountabilities, the responsibilities should be concentrated in a single institution. Most countries (especially emerging and low-income ones) assign such responsibilities to the Ministry of Finance (specifically, to the Treasury or to a separate Public Debt Department). However, a growing number of advanced economies has embraced in recent years the creation of a Public Debt Office, separate from the Ministry of Finance, although often reporting to that Minister. The main rationale for such a move is the greater flexibility in terms of salaries and employment conditions that such an arrangement affords. This flexibility is seen as needed to acquire and retain staff with the specialized skills required for effective sovereign debt management. A separate Debt Office may make it, however, more challenging to ensure adequate coordination with other relevant agencies inside and outside the Ministry of Finance, including the Central Bank. The organizational structure of modern debt management offices is based on the separation of responsibilities among the front, middle, and back offices. This facilitates both specialization and effective operational risk management. The key functions are (Wheeler, 2004): ● Senior management (supported by internal audit and compliance). ● Front office: primary issuance and execution, internal and external, and all other funding operations, including secondary market transactions (debt and cash), portfolio management, and hedging transactions. ● Middle office: policy and portfolio strategy development and accountability reporting; policies, processes, and controls for internal risk management. ● Back office: transactions’ recording, reconciliation, confirmation, and settlement; maintenance of financial records, and database management. Developing local currency bond markets (LCBMs) The development of deep and well-functioning markets for sovereign debt issued in local currency is important not only to reduce currency and maturity risks, but also to foster the broader development of domestic capital markets that price risk appropriately and facilitate the financing of private investments. LCBMs have grown significantly over the last couple of decades, and in 2019 accounted for 95 percent of sovereign debt in advanced economies and for over 46 percent in emerging markets (IMF and World Bank, 2021). There is, however, significant scope for their further growth in both advanced and developing economies, especially in the wake of the worldwide COVID-19-induced growth in sovereign debt levels.

318  Research handbook on public financial management There is a substantial literature on the obstacles to the development of LCBMs and on best international practices in addressing them.31 The main impediments include macro or political instability; financial repression; low domestic savings; paucity of institutional investors; proliferation of government agencies issuing securities, fragmenting the market; unpredictable issuance policy; and the absence of the necessary market infrastructure. International institutions like the IMF, the World Bank, and regional MDBs have published policy guidelines to mitigate such impediments32 and provided extensive technical assistance to their members in implementing them. The most recent version of such guidance (IMF and World Bank, 2021) significantly increases its granularity and specificity. It includes: ● A framework to analyze the state of key enabling conditions for the development of LCBMs, namely the structure of the economy and general macroeconomic conditions; the state of the public finances (budget balance, debt stock, and gross financing needs); and monetary policy and financial stability. ● A detailed toolkit to diagnose the state of development of the main building blocks of LCBMs, namely the money market; the primary market for sovereign debt issues; the secondary market; the investor base; the legal and regulatory framework; and the technological infrastructure for these markets. The diagnostic toolkit includes a large number of relevant qualitative and quantitative policy and outcome indicators. The Guidance Note also includes a detailed list of policy and institutional reform options to address the weaknesses identified by the diagnostic toolkit for each building block. These options are based on lessons from experiences of a number of countries at different levels of development of their LCBMs.33 The Note emphasizes the importance of setting up an appropriate institutional structure, consisting of a high-level committee and various technical working groups of relevant government officials and private sector participants (e.g. financial institutions and technology firms), to prepare a blueprint of the reform strategy and support its implementation, once approved by the government and, if and as necessary, the parliament.

SOME CONCLUDING REFLECTIONS The massive increase in the ratios of sovereign debt to GDP in the last decade, especially in the wake of the COVID-19 pandemic, has brought the issue of debt sustainability to the forefront of academic and policy debates. To be sure, for many advanced countries, the unprecedented injection of liquidity by central banks and the consequent ultra-low rates of interest have bought fiscal space to accommodate in 2020–21 both the operation of the automatic fiscal stabilizers and large discretionary stimulus packages, to support domestic demand and cushion the impact on incomes of the pandemic-required restrictions to mobility and activity. But, as advanced economies reopen and inflationary pressures begin to emerge, the risk of monetary tightening by major central banks, and of a related rise in interest rates, is growing. In such a scenario, global risk appetite is likely to decline, making it more difficult especially for emerging markets to meet large financing needs. At the same time, sovereign debt dynamics are likely to turn more adverse, especially for countries with structurally weak growth rates. Against this background, the issues of how to assess public debt sustainability under conditions of high uncertainty; how to reduce a public debt that is clearly unsustainable or borders

Emerging research issues in sovereign debt management  319 on unsustainability; and how to manage prudently and efficiently one that is sustainable, have become all the more important for both policymakers and public finance scholars. This chapter has attempted to provide a compact and reader-friendly overview of the vast literature on these issues. Given space limitations, it was clearly impossible to do full justice to them, and therefore the reader interested in going in greater depth into any of them is encouraged to make use of the extensive references provided. The main conclusions that can be drawn from that overview can be briefly summarized as follows. Public debt is considered sustainable when it can be shown to converge to a stable or declining path under a set of deterministic or preferably stochastic scenarios, modeling a range of shocks that reflect the characteristics and history of each country. The technology of debt sustainability analysis has been substantially refined in recent years, but for several countries its application continues to be hampered by data limitations, in particular the opacity of the terms of loans received from some non-traditional bilateral lenders. It is increasingly recognized that debt is only a part of the sovereign balance sheet, and that an increase in the debt-to-GDP ratio can have different macroeconomic implications and entail different degrees of vulnerability, depending on whether it is incurred to finance consumption or asset accumulation. For these reasons, some scholars now advocate focusing on a sovereign’s net worth rather than debt, and targeting some concept of net, rather than gross, debt. Such netting out of assets against liabilities ignores, however, that there may be significant gaps between the return on assets and the cost of debt, and significant differences in the maturity structure of the two aggregates. Also, financial markets give clear preeminence to a sovereign’s gross debt, when deciding on its rating. Reforming debt- or budget balance-based fiscal rules, to make them more investment-friendly without putting debt sustainability at risk, remains a significant challenge for policymakers worldwide, including notably in the European Union. Fiscal adjustment remains the main approach to reducing a sovereign’s debt, when necessary to maintain or restore its sustainability, given the shortcomings of alternative “heterodox” approaches, such as resort to the inflation tax, or significant financial repression. But it is increasingly recognized that pro-cyclical fiscal adjustments can have substantial costs, at least in the short run, in terms of growth because multipliers tend to be higher during recessions and when fiscal consolidation is accompanied by monetary tightening. The growing use of cyclically adjusted fiscal rules reflects this recognition. Also, there is growing awareness of the fact that the composition, as well as the size, of the adjustment matters in terms of growth, equity, and social sustainability. Coercive debt restructuring and default are the least desirable options to deal with an unsustainable sovereign debt, because of their macroeconomic, reputational, and legal costs, which were discussed in the third section. International experiences provide, however, various lessons to mitigate to the extent possible such costs. The support of an independent, credible third party, like the IMF, can help reduce information asymmetries between the sovereign and its creditors, thereby facilitating the conclusion of an agreement on the terms of the restructuring. Sovereign debt management requires a skillful balancing of borrowing costs with a range of risks (discussed in the fourth section). Ideally, it should be conducted in the context of an integrated asset-liability management approach, which allows governments to evaluate net returns and risk exposures for their entire balance sheet. However, the challenges of compiling reasonably reliable sovereign balance sheets, and the fragmentation of institutional responsi-

320  Research handbook on public financial management bilities in this area have precluded so far a full-fledged SALM, except in New Zealand. But progress continues to be made in a number of countries towards (more or less comprehensive) partial SALM. Many countries coordinate closely at least debt and cash management. The chapter emphasizes the importance of a sound institutional framework for sovereign debt management, including a robust legal base, clear definition of responsibilities and accountabilities, and human resource policies that allow the acquisition and maintenance of specialized skills for the debt management office, to deal effectively with financial markets and bilateral lenders. The development of well-functioning local currency markets for sovereign debt is important to reduce currency and maturity risks, and to foster the growth of domestic capital markets more generally. The growing literature on the subject emphasizes the importance of a good diagnostic of the economic and institutional impediments to such development, and the formulation of an appropriately selective and sequenced strategy of reforms to address such impediments. High-level political buy-in, as well as technical soundness, are likely to be key to the success of the strategy.

NOTES 1. 2. 3. 4.

5. 6. 7. 8. 9. 10. 11. 12.

See Detter and Fölster (2015) for a discussion of the benefits from a sound management of commercial public assets. For example, in Kazakhstan (a country highly dependent on oil exports), use of the large, diversified, and liquid national wealth fund substantially mitigated the adverse impact of the oil price shock in the mid-2010s. Some countries, like the US, argue that this focus is more appropriate in their case because of the federal nature of the country and a prolonged history of no bailouts of SNGs by the federal government. Issues in subnational debt management are covered in another chapter of this book. The debt of financial SOEs, including the Central Banks, is generally excluded from the definition of sovereign debt. It is important to include in the latter, however, the portion owed to the Central Bank, as loans or, more commonly, bonds purchased by the Bank in the primary or secondary markets. These have increased exponentially in recent years, especially in advanced countries, in the wake of the global financial and COVID-19 crises. See Ter-Minassian (2017) for a comprehensive discussion of fiscal risks from SOEs. See also Baum et al. (2020), and Ch. 3 of the IMF Fiscal Monitor, April 2020 (IMF, 2020a). Wyplosz (2011) calls assessing government solvency a “mission impossible.” See Debrun et al. (2020) for a more extensive discussion of the links between solvency and sustainability. The shortcomings included optimistic growth projections in several crisis countries, partly reflecting underestimated fiscal multipliers; the lack of a bottom-line sustainability assessment; limited scope for country heterogeneity; and ineffective tools to illustrate uncertainty. Countries are currently put in two different baskets (Advanced Economies and Emerging Markets) with different thresholds for key parameters of the analysis, although the two groups are in fact quite heterogeneous. This is important since the last couple of decades have witnessed significant changes in the composition of creditors (e.g. a sharp increase of Chinese bilateral lending and of non-bank financing). The IMF staff will still be able use judgment to overrule or qualify the results of the SRDSF, but it will be required to explain in greater detail the reasons for doing so. The LIC-DSF is also complemented by the use of model-based analyses of the impact of public investments on the rate of GDP growth determinant of the public debt dynamics. Available tools for such analyses include the IMF’s Debt-Investment-Growth (DIG) model (see Buffie et al., 2012); its extension to account for natural resources (DIGNAR) (see Melina et al., 2016 for details); and the World Bank’s Long-Term Growth model (https://​www​.worldbank​.org/​en/​research/​brief/​LTGM).

Emerging research issues in sovereign debt management  321 13. This section draws significantly on Abbas et al. (2020). 14. For discussions of how to select, design and calibrate fiscal rules, see Eyraud et al. (2018a and 2018b). 15. Abbas et al. (2013) found that, in advanced economies since the 1980s, large fiscal contractions (as measured by the improvement in the cyclically adjusted primary balance) have typically been associated with rising ratios of the public debt to GDP. 16. The deadweight loss entailed by a tax is estimated to rise more than proportionally to the increase in its marginal rate. 17. Lustig (2018) presents a methodology to assess the distributional effects of different fiscal instruments. The Commitment to Equity (CEQ) website (commitmentoequity.org) includes a number of papers applying this methodology to different countries. 18. Debt denominated in foreign currency cannot be inflated away to the extent that the exchange rate depreciation, and hence the rise in the local-currency value of the debt, leads, rather than lagging, the inflation-induced rise in nominal GDP. 19. Reinhart and Sbrancia (2015) estimated the effect of financial repression on interest rates as the residual after purging changes in such rates of the impact of unanticipated changes in inflation. 20. The paper by Ams et al. (2020) includes many references to this literature. 21. An iconic example in this respect is the aftermath of Argentine default of 2001 (Hebert and Schreger, 2017). 22. Some countries have incurred arrears to the IMF for some years, but these have eventually been repaid through the so-called right accumulations procedure. Also, the Fund and the World Bank have provided debt relief to their poorest members under the HPIC-MDRI facilities. See IMF Factsheet – Debt Relief Under the Heavily Indebted Poor Countries (HIPC) Initiative (imf.org) for details. 23. In some debt exchanges (e.g. Jamaica in 2013) the Central Bank provided liquidity support to the banks, in order to minimize the disruptive effects of the sovereign debt restructuring. In contrast, the Russian government’s default on its Treasury bills (GKOs) in 1998 had devastating effects on the banking system. 24. See Buchheit (2009) and DeSieno (2016) for details on the benefits and costs of creditors’ committees. 25. See New Zealand Treasury’s 2018 Investment Statement. https://​treasury​.govt​.nz/​publications/​ investment​-statement/​2018​-investment​-statement. 26. On the case of Uruguay, see also Amante et al. (2019). 27. See Fainboim and Pattanayak (2011) for comprehensive discussions of the theory and practice of implementing a TSA. 28. There is a vast literature on contingent liabilities. See e.g. Brixi and Schick (2002); OECD (2005); Petrie (2013); Bova et al. (2016); and IMF (2016). 29. Arslanalp and Tsuda (2014) developed an investor base risk index which focuses on the stability of investor demand, with lower scores attributed to domestic investors than foreign ones. The index has significant predictive power of sudden stops in flows to sovereign debt. 30. There is a growing literature on why SCDIs have continually disappointed. For example, Roch and Roldan (2021) suggest that the premium on ambiguity is too high to make SCDIs operationally worthwhile. 31. See e.g. Arvai and Heenan (2008); Jonasson and Papaioannou (2018); and Jonasson et al. (2020). 32. See e.g. World Bank and IMF (2001); World Bank (2007 and 2014); and IMF and World Bank (2018 and 2020). 33. The Guidance Note includes 13 country case studies (mostly emerging markets in different regions of the world) selected to illustrate different specific challenges faced by the authorities in developing their LCBMs.

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Emerging research issues in sovereign debt management  323 Debrun, X., Ostry, J. D., Willems, T., and Wyplosz, C. (2020). Debt sustainability. In S. A. Abbas, A. Pienkowski, and K. Rogoff (eds.), Sovereign Debt: A Guide for Economists and Practitioners. Oxford: Oxford University Press, 151–191. DeSieno, T. B. (2016). Creditor committees in sovereign debt restructurings: Understanding the benefits and addressing concerns. In M. Guzman, J. A. Ocampo, and J. Stiglitz (eds.), Too Little, Too Late: The Quest to Resolve Sovereign Debt Crises. New York: Columbia University Press, 175–186. Detter, D. and Fölster, S. (2015). The Public Wealth of Nations. Basingstoke: Palgrave Macmillan. Eichengreen, B., Hausmann, R., and Panizza, U. (2005). The pain of original sin. In B. Eichengreen and R. Hausmann (eds.), Other People’s Money: Debt Denomination and Financial Instability in Emerging-Market Economies. Chicago: University of Chicago Press, 13–47. Escolano, J., Jaramillo, L., Mulas-Granados, C., and Terrier, G. (2014). How Much is A Lot? Historical Evidence on the Size of Fiscal Adjustments. IMF Working Paper 14/179. Eyraud, L., Baum, A., Hodge, A., Jarmuzek, M., Ture, H. E., Mbaye, S., and Kim, Y. (2018a). How to Calibrate Fiscal Rules: A Primer (No. 2018/002). Washington, DC: International Monetary Fund. Eyraud, L., Lledó, V. D., Dudine, P., and Peralta, A. (2018b). How to Select Fiscal Rules: A Primer. How-to Note no. 9. Washington, DC: International Monetary Fund. Fainboim, I. and Pattanayak, S. (2011). Treasury Single Account: An Essential Tool for Government Cash Management. IMF Technical Notes and Manuals. Furman, J. and Summers, L. (2020). A reconsideration of fiscal policy in the era of low interest rates. Draft for discussion. Gelos, R. G., Sahay, R., and Sandleris, G. (2011). Sovereign borrowing by developing Countries: What determines market access? Journal of International Economics, 83(2), 243–254. Gennaioli, N., Martin, A., and Rossi, S. (2014). Sovereign default, domestic banks, and financial institutions. Journal of Finance, 69(2), 819–866. Gupta, S., Kangur, A., Papageorgiou, C., and Wane, A. (2014). Efficiency-Adjusted Public Capital and Growth. World Development, 57(C), 164–178. Hebert, B. and Schreger, J. (2017). The costs of sovereign default: Evidence from Argentina. American Economic Review, 107(10), 3119–3145. IMF (2002). Assessing Sustainability. IMF Policy Paper. IMF (2011). Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis. IMF Policy Paper. IMF (2013a). Staff Guidance Note for Public Debt sustainability Analysis in Market-Access Countries. IMF Policy Paper. IMF (2013b). Fiscal adjustment in an uncertain world. Fiscal Monitor, April. IMF (2014). The Fund’s Lending Framework and Sovereign Debt – Annexes. IMF Policy Paper. IMF (2016). Analyzing and Managing Fiscal Risks: Best Practices. IMF Policy Paper. IMF (2018a). Managing public wealth. Fiscal Monitor, October. IMF (2018b). Guidance Note on the Bank-Fund Debt Sustainability Framework for Low-Income Countries. IMF Policy Paper. IMF (2020a). Policies for the recovery. Fiscal Monitor, October. IMF (2020b). Update on the Joint IMF-WB Multipronged Approach to Address Debt Vulnerabilities. IMF Policy Paper. IMF (2021). Review of the Debt Sustainability Framework for Market-Access Countries. IMF Policy Paper. International Monetary Fund and the World Bank (2018 and 2020). Staff Note for the G20 International Financial Architecture Working Group (IFAWG): Recent Developments on Local Currency Bond Markets in Emerging Economies. International Monetary Fund and the World Bank (2021). Guidance Note for Developing Government Local Currency Bond Markets. Jonasson, T. and Papaioannou, M. G. (2018). A Primer on Managing Sovereign Debt-Portfolio Risks. IMF Working Paper 18/74. Jonasson, T., Papaioannou, M. G., and Williams, M. (2020). Debt management. In S. A. Abbas, A. Pienkowski, and K. Rogoff (eds.), Sovereign Debt: A Guide for Economists and Practitioners. Oxford: Oxford University Press, 192–224.

324  Research handbook on public financial management Kose, M. A., Ohnsorge, F., and Sugawara, N. (2021a). A Mountain of Debt: Navigating the Legacy of the Pandemic. World Bank Policy Research Working Paper 9800. Kose, M. A., Ohnsorge, F., Reinhart, C., and Rogoff, K. (2021b). The Aftermath of Debt Surges. World Bank Policy Research Working Paper 9771. Lustig, N. (2018) Commitment to Equity Handbook. Available at: Methodology – CEQ Institute (commitmentoequity.org). Melina, G., Yang, S. C. S., and Zanna, L. F. (2016). Debt sustainability, public investment and natural resources in developing countries: The DIGNAR model. Economic Modelling, 52 (Part B), 630–649. Mendoza, E.G. and Ostry, J. D. (2008). International evidence on fiscal solvency: Is fiscal policy responsible? Journal of Monetary Economics, 55(6), 1081–1093. Miyamoto, H., Baum, A., Gueorguiev, N., Honda, J., and Walker, S. (2020). Growth impact of public investment and the role of infrastructure governance. In G. Schwartz, M. Fouad, T. Hansen, and G. Verdier (eds.), Well Spent: How Strong Infrastructure Governance Can End Waste in Public Investment. Washington, DC: International Monetary Fund, 15–29. Organisation for Economic Co-operation and Development (OECD) (2005). Explicit Contingent Liabilities in Debt Management. Paris: OECD Publishing. Panizza, U., Sturzenegger, F., and Zettelmeyer, J. (2009). The economics and law of sovereign debt and default. Journal of Economic Literature, 47(3), 651–698. Petrie, M. (2013). Managing fiscal risk. In R. Allen, R. Hemming, and B. Potter (eds.), The International Handbook of Public Financial Management. Basingstoke: Palgrave Macmillan, 590–618. Reinhart, C. M. and Rogoff, K. S. (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press. Reinhart, C. M., Rogoff, K. S., and Savastano, M. (2003). Debt intolerance. Brookings Papers on Economic Activity, 34(I). Reinhart, C. M. and Sbrancia, M. B. (2015) The liquidation of government debt. Economic Policy, 30(82), 291–333. Roch, M. F. and Roldan, F. (2021). Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt. IMF Working Paper 21/076. Schaechter, A., Kinda, M. T., Budina, M. N., and Weber, A. (2012). Fiscal Rules in Response to the Crisis: Toward the “Next-Generation” Rules. A New Dataset. IMF Working Paper 12/187. Ter-Minassian, T. (2017). Identifying and Mitigating Fiscal Risks from State-Owned Enterprises (SOEs). IDB Discussion Paper 546. Wheeler, G. (2004). Sound Practice in Government Debt Management. Washington, DC: World Bank. World Bank (2007). Developing the Domestic Government Debt Market: From Diagnostics to Reform Implementation. Washington, DC: World Bank. World Bank (2014). Guide to the Government Securities Market Development Toolkit for Low-Income Countries – Finance and Markets Global Practice (GFMDR). Washington, DC: World Bank. World Bank and IMF (2001). Developing Government Bond Markets: A Handbook. Washington, DC: World Bank. Wyplosz, C. (2011). Debt sustainability assessments: Mission impossible. Review of Economics and Institutions, 2(3). Zheng, L. (2014). Determinants of the primary fiscal balance: Evidence from a panel of countries. In C. Cottarelli, P. Gerson, and A. Senhadji (eds.), Post-Crisis Fiscal Policy. Cambridge, MA: MIT Press, 67–96.

PART VII GOVERNMENT PROCUREMENT AND CONTRACT MANAGEMENT

18. Foundations of public procurement Spencer T. Brien

As the COVID-19 pandemic progressed through 2020 and 2021, governments around the world struggled to provide masks to their citizens (Shields et al., 2020). Supply chain disruptions made it difficult to find adequate supplies of essential resources. Counterfeit N95 masks entered the market and introduced risk and uncertainty into medical purchasing (Woodward, 2021). Government capacity to purchase reliable and timely products is an essential element of the public response to the COVID crisis, but disruptions to government purchasing exacerbated the public health threat. One potential outcome of this pandemic is that it may serve as a focusing event for the problems associated with public procurement. Public procurement is a core function of public administration. The act of government purchasing ties directly to the basic social contract between the state and the public. The state employs resources obtained through taxation to purchase goods and services that are to be used in the public interest. The fiduciary responsibility to be good stewards of public resources while wielding this purchasing power is inherent to public service. The enormous magnitude of resources engaged in public procurement reflects the scale of this responsibility. For the 2019 fiscal year, the United States federal government conducted nearly 77 million unique contracting actions that added up to a total dollar amount of approximately $590 billion.1 Add in state and local government contracting and the total value of public sector contracting in the United States may be two to three times that amount.2 As new researchers approach questions relating to government purchasing, it is important to develop a familiarity with the foundations of inquiry in this area. This chapter is organized around five topics that provide context for many of the problems and questions in the fields of public procurement and contract management. In combination with the subsequent two chapters of this book, this is intended to provide a helpful start for research on procurement systems. The first section of this chapter introduces the basic premise of whether a government should purchase products from a supplier or produce them itself. The connection between the “make or buy” decision and the concepts of provision and production are illustrated. This decision is then examined through the framework of government coercion as a way to categorize the types of political discourse used to debate procurement decisions. The next section discusses principal-agent models and the distribution of risk between buyers and sellers. This section discusses how many features of procurement contracts are designed to reduce the risks that would otherwise prevent many contracts from being signed. The following section examines how contracts also include many other structures that promote policy goals relating to economic development and social advancement that go beyond simply purchasing products in an efficient and timely manner. The last two sections of this chapter examine challenges to public administration created by increased public outsourcing. The former discusses the concept of the “hollow state,” which refers to concerns about the way the fundamental tasks of administration change as governmental activities shift from direct production of programs to contract management. 326

Foundations of public procurement  327 The latter section examines the concept of contract complexity. This complexity extends the risks examined in principal-agent frameworks and examines factors that increase the cost and challenge of contract management.

MAKE OR BUY DECISIONS One of the central dilemmas in the practice of public procurement is determining which functions should be directly produced by the government and which can be purchased from external entities. Known as the “make or buy” decision, this is a universal question for both public and private entities.3 While the private sector approaches this question primarily from a profit-maximizing perspective, governmental entities must balance a variety of competing considerations. These include requirements for public transparency in contracting, internal political objectives, budgetary law, and procedural regulations (Telgen et al., 2007). Untangling the make or buy decision can give context for the various structures and procedures that exist in public procurement administration. The choice to make or buy a good or service is divided into two separate decisions: provision and production (Kolderie, 1986; Johnson and Watson, 1991). Provision describes the process of determining the quantity, quality, and scope of public programs. Production describes the work of manufacturing and delivering these programs. Both provision and production can be performed either internally, meaning within the organization, or externally, meaning by some other entity. These external entities can be private firms or non-profit organizations. Intergovernmental relationships even allow public entities to procure either the provision or the production of services from other governments. These intergovernmental procurement agreements may occur within or across tiers of government, such as city-to-city procurement, or city-to-province agreements. Table 18.1 provides several examples of different permutations of internal and external performance of the production and provision functions. Table 18.1

Foundations of public procurement

Internal

Production Internal

External

Quadrant 1

Quadrant 3

Purely internal government activities

Contracted production of government provisioned

● Public Schools

programs

● Municipal police

● Privatized trash collection

● Inspections conducted by the Food and Drug

● Charter Schools ● Private consultants delivering analytical support to

Provision

Administration

federal agencies Quadrant 4

External

Quadrant 2 Public production of functions for external organizations

Private production and control over social activity

● Cities charging concert venues for supplemental public

● Private businesses

safety services ● School districts conducting state mandated standardized tests

● Self-Regulation of social media content by tech firms ● Establishment of movie ratings by the Motion Picture Association of America

328  Research handbook on public financial management The four quadrants of Table 18.1 depict different permutations of internal and external provision and production. In practice, however, there are a multitude of incremental gradations between the categories. Internal production combined with internal provision applies to purely internal government activities. This is depicted in Quadrant 1 of Table 18.1. A single public organization both determines the character and quality of goods or services to be delivered and performs the actual work of producing them. Primary and secondary public education that is produced locally and whose curriculum is controlled by a local school board would fall into this category. Similarly, local police services that are produced and controlled by a municipal police department are characterized by both internal production and provision. Quadrant 2 of Table 18.1 depicts internal production accompanied by external provision. This represents a public organization producing programs that are controlled by external organizations. Elements of public education fit this description when a local school district must perform tasks such as standardized testing that is controlled and mandated by the national government. The control that national government has over the nature of the testing shifts some of the provision responsibility outside of the school district. Keeping provision internal, while employing external production frequently applies to many procurement contracts. These are depicted in Quadrant 3 of Table 18.1. One relatively simple example is privatized trash collection. Conceivably, the municipality gets input from the taxpayers on the preferred schedule and means of trash pickup and then comes to an agreement with a private firm on the price of delivering that service.4 This reflects an internal provision/external production approach to trash pickup services. The municipality may only receive proposals, however, from firms who have invested in trucks and other equipment that requires specific types of garbage cans. The use of these capital assets for trash collection in other cities in the region may also limit the days that are available in a new service contract. These constraints narrow the service configurations presented to public officials. This shifts some of the provision function from the municipality to the private firm. In the case of food safety regulation, industrial food processors may invest in technologies that allow inspections to occur in a relatively quick and low cost manner to reduce disruptions to their manufacturing activities. These investments shift some of the production of inspection activities to the regulated firm. Both parties in public–private relationships need to maintain awareness of any shifts in the distribution of production and provision responsibilities as these relationships develop over time. Quadrant 4 of Table 18.1 depicts areas of commerce that are left wholly to the market for self-regulation and determination. Shifts in policy, such as an expansion of regulatory control may move areas of the economy out of Quadrant 4 as elements of private provision and/or production are shifted to the public sector. Deliberations surrounding “make or buy” decisions often have the potential to become ideologically charged. Lowi’s (1998) typology of the political discourse that accompanies different types of government coercion can help give context to the argumentation used in these deliberations. Within Lowi’s terminology, most public programs are described as public facilities. These are goods and services that are not targeted towards specific groups based on income or other socioeconomic characteristics, but instead provide some benefit to society as a whole. Examples include infrastructure, public schools, or national defense. The provision of these public facilities is described in Lowi’s typology as a form of distributive coercion. This form of coercions describes the government’s use of its authority to collect taxes and then apply those resources to the delivery of public programs.

Foundations of public procurement  329 Lowi’s typology identifies two types of political discourse: “mainstream” and “radical.” Mainstream discourse refers to the politics of compromise, in which participants are able to share a single perception of the nature of the conflict, but may disagree on what the final outcome should be. In the context of distributive coercion, mainstream discourse centers on the concept of utility and is often expressed using different forms of cost-benefit analysis. For example, opposing parties to the construction of a new bridge may have competing estimates of the construction costs and the economic benefits that the bridge would impose on the region. Private sector “make or buy” decisions occur almost entirely in this mainstream because profit maximization and utility are the entire consideration. Radical discourse describes the politics of polarized ideological conflict. Opposing parties have fundamentally different views and values regarding the inherent morality of the topic at hand. In the context of distributive coercion, radical discourse expresses a conflict over the concept of civic virtue. The decision to provide or fail to provide a given public program has an inherent morality that reflects the character of that society. In this language, failure to provide an adequate public education is not just an inefficient underproduction of education, but it is a moral failing to withhold from children an essential asset needed to participate fully in society and the economy. One of the ways “make or buy” decisions are framed in radical discourse is with an ideological assumption that private sector production will be more efficient than public sector production. This perspective has played a role in generating support for the contract city model of governance, an approach to city management in which nearly all functions are produced by private sector contractors (Porter, 2006; Bradbury and Waechter, 2009; Ni, 2010; Brien and Hine, 2015). If government production is framed as inefficient and wasteful of taxpayers’ resources while private production is described as the antidote by introducing competition and efficiency, then there is a moral imperative to maximize privatization. The push to maximize privatization with the assumption that business and market-based practices are going to generate efficiencies sometimes arises as a crude application of the ideas associated with New Public Management (NPM). NPM, originally conceptualized by Hood (1991, 1995), consists of a collection of administrative reform doctrines that emphasize adopting private-sector business practices in government and increasing competition in public enterprise. Funck and Karlsson (2020) conducted a metanalysis of NPM research over the last 25 years and their article is an excellent starting place for researchers trying to understand the different ways NPM is interpreted and applied. One of the challenges with applying NPM concepts, however, is that it may be simplified into an assumption that privatization and competition will always improve over current public sector performance. This can flow into a form of “radical discourse,” as defined by Lowi (1998). The challenge of radical discourse is that it does not allow for compromise because it would violate the opposing parties’ core ideological beliefs. Mainstream evidence that questions the cost savings of particular cases of privatization does not engage with the ideological assumption that greater privatization improves the civic virtue of a society. Examining make or buy decisions within this ideological framework helps position procurement and acquisitions as an exercise of political power. US federal spending occurs under legislated Congressional authority. Returning to the starting questions of provision and production decisions and then examining the kinds of political discourse used to argue for different answers to those questions provides an important background for inquiry into procurement administration.

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RISK, UNCERTAINTY, AND PRINCIPAL-AGENT THEORY Entering into a contractual procurement agreement can create a variety of risks for both public officials and the external entities seeking to sell goods and services to the government. Many aspects of the contracting cycle are designed to help mitigate these risks.5 This section briefly defines several concepts used to help researchers and procurement professionals understand and categorize different types of contracting risks. These concepts are then used to introduce a conceptual tool called “principal-agent theory” that examines the behavioral incentives that motivate contract design. It is important to start this discussion of risk by defining two separate types of risk associated with contracting behavior: moral hazard and adverse selection. Moral hazard describes how an actor’s behavior and incentives might change after they have entered into a contractual agreement in a way that harms the other party to the contract. In contrast, adverse selection describes the risk that there is an information imbalance between the buyers and sellers in contracting agreements and that actors with an advantage would seek out contracts that they know they can abuse. Both types of risk are often initially described in the context of insurance contracts, though they also apply more generally. Consider the case of automotive liability insurance. Moral hazard refers to any change in the driver’s behavior after they have purchased insurance. Assume that the insurance company had already reviewed the driver’s history and overall characteristics and set the price of the insurance based on their prior behavior. If the driver, once insured, begins to behave more recklessly than they would before because they no longer bear the full cost of any damage they may cause, then they are exhibiting moral hazard. Adverse selection would occur if a driver knew they had a hidden condition that made them a greater traffic risk than the public information possessed by the insurer would suggest. The driver knowingly shifts a greater risk onto the insurer than the contract terms allow. Moral hazard can influence public procurement agreements in multiple ways. Government buyers may be concerned that a firm hired to construct a building may attempt to cut costs by using substandard materials. This would increase the firm’s profit at the government’s expense. Alternatively, external sellers can also be affected by moral hazard when buyers initiate costly change requests. Many firms hired to deliver services must make investments specific to their customer that can’t be easily transferred. Firms must consider whether to meet the change requests or be forced to abandon their costly investments in the initial service agreement. Williamson (1996) described this as the “lock-in” problem and it represents a significant vulnerability for firms considering doing business with public entities. Both the buyers and the sellers in procurement relationships can exhibit moral hazard if their behaviors and incentives change once a contract is signed. Transaction cost economics assumes that government officials and external service providers are ultimately self-interested. Contracts are signed because both parties expect that they will be better off by agreeing to the terms (Kim and Brown, 2012). However, this rational self-interest alone isn’t the cause of moral hazard. It arises because the design of the contract has changed the incentive structures for one or more of the actors and their behavior after signing is different than what it would have been before accepting the terms of the agreement. Economic analysis of procurement contract design has undergone a transformation in the last few decades that has resulted in two theoretical approaches. The earlier approach focused on the concept of information asymmetry between the buyer and the seller prior to the signing

Foundations of public procurement  331 of a procurement contract. An information asymmetry means that one of the parties to the contracting relationship has more information about the true costs of producing the good or service than the other party. This is especially a problem if the seller has more information than the buyer and uses this information to negotiate a contract for a higher price. If the buyer expects to be at a disadvantage in negotiations, the design of contracts must include some mechanism to force sellers to reveal their information. If the private information is not revealed, then some buyers will choose to leave the market and many mutually beneficial procurement transactions would not occur. Laffont and Tirole (1993) summarize the economic literature applying this approach. One of the key results from this earlier economic analysis of contract design is that it predicts that buyers would offer a broad range of contract designs and price points to induce sellers in a competitive market to reveal their information. Bajari and Tadelis (2001) review the construction management literature to demonstrate that buyers do not in fact offer a menu of contract options, as economic models would have predicted, and instead the authors find that contract design centers on two dominant structures: the Fixed Price (FP) contract and the Cost Plus (C+) contract. Bajari and Tadelis go on to show that pre-contract award information asymmetries are only a minor consideration in contracting, while risks and uncertainties that only develop for both buyers and sellers after the contract has been signed are a dominant concern for contract management. The authors identify “design failures, unanticipated site and environmental conditions, and changes in regulatory requirements” as the dominant risks practitioners and construction management researchers are concerned with (Bajari and Tadelis, 2001: 388). By focusing on the uncertainties that arise after the contract has been signed, Bajari and Tadelis (2001) develop a new perspective on contract design. This new approach applies Transaction Cost Economics (TCE). TCE examines how the resources needed to communicate, observe, and interact with people and organizations influences decision-making. Applying this to public procurement highlights the costs associated with completely describing the good or service within the terms of the contract. The actual features of the product may be uncertain at the time of contract award. For example, neither party to a contract for the construction of a new building would know what the weather will be like during the construction process and the impact that would have on the timeline and construction costs. Other uncertainties, such as the probability that an unknown fuel tank or other environmental hazard was buried beneath the construction site would similarly disrupt construction activities. At the time of contract design, the buyer and the seller must decide how much work and resources will be dedicated to specifying the product and any contingencies up front, or allowing the contract to incorporate new costs as they arise. Brown et al. (2010) frame this problem as “complex products” and the degree of complexity and the willingness of either buyer and seller to take on them these risks factors into the decision to adopt FP or C+ contract structures. The Contract Management Standard published by the National Contract Management Association (NCMA, 2019) identifies several activities that occur during the solicitation planning phase of the procurement lifecycle that make up the transaction costs associated with clearly defining a product. These include identifying the requirements and measurable outcomes, specifying a delivery schedule, and identifying any property, equipment or information furnished by the external contractor. Additionally, during the initial phase of requesting offers, government procurement professionals respond to information requests from potential offerors and publicize the criteria for evaluating future offers. These tasks help clarify expectations

332  Research handbook on public financial management and align incentives for the future agreement. The work required to obtain and specify this information is costly in terms of both money and time. The decision to switch to a C+ contract design make the overall contracting process easier to manage and reduces the likelihood of costly contract renegotiation later in the procurement lifecycle. Quantifying the financial relationship between incurring these transaction costs and choosing between a FP and C+ contract design is the key insight of Bajari and Tadelis (2001). Public procurement is affected by adverse selection when there is a significant information asymmetry between buyers and sellers. Often this involves potential suppliers that have more information than the buyers on the full costs of producing goods and services. Consider a city that seeks to procure park maintenance services at a particular price. If the government’s offered price is less than what informed firms expect the full cost to be then then will either pass on the contract or try to negotiate a higher price. The firms that would accept the initial contract either are less qualified at their work and will suffer unanticipated costs or will seek to renegotiate after the contract has been accepted. The information asymmetry can cause the city to systematically enter into contract with the lesser quality firms. Another source of adverse selection occurs when governments encounter “thin markets,” meaning that there are only a few firms that dominate product categories. This can enable the firms to exert monopolistic market power. It can become difficult for public procurement professionals to accurately estimate the true cost of service production, which enables firms to place upward pressure on the prices. Economies of scale may also enable firms to geographically dominate a market in a metropolitan area, such as a waste disposal firm that services multiple suburban communities. The risk of thin markets is especially common when governments seek complex products (Brown et al., 2010). Principal-agent (PA) theory seeks to formally model contracting arrangements within the context of imperfect information and the paired risks of moral hazard and adverse selection. This theory is applied to contract design to examine how risk is distributed across buyers and sellers by different contract structures.6 These structures help alleviate risk and enable contracting agreements that otherwise would have been rejected. One of the most relevant applications of principal-agent theory for the field of public procurement is the analysis of fixed-price and cost-plus contract designs. Fixed-price contracts specify a level of compensation for goods or services provided by the contractor. Cost-plus contracts instead set reimbursement to the total costs incurred by the seller. These two contract designs are the primary structures for procurement agreements. Bajari and Tadelis (2001) examine the distribution of risk between buyer and seller in these two types of contracts under different scenarios. They demonstrate that a key factor in the choice between the two contract types is the clarity and certainty in the cost of building and delivering the products. Goods that are clearly defined beforehand, such as the delivery of frequently ordered supplies, are more efficiently procured using a fixed cost contract. Less defined products that have uncertain costs that will only be revealed during the process of production and delivery are more optimally procured using cost-plus contracts. Bajari and Tadelis (2001) describe the cause for this difference as the friction created by change orders necessitated by newly discovered costs. Consider a construction project that is delayed by the weather. The delays will increase a variety of costs for the project. Prior to the signing of the contract neither party knows what the weather would be like. If the project were organized under a fixed-price contract then the construction firm would have to bear the costs. Potential sellers would reject contracts that place too much of the burden of that risk

Foundations of public procurement  333 on them. Alternatively, they could attempt to adjust the contract, but this renegotiation would create transaction costs that both parties would like to minimize. Instead, a cost-plus contract is designed that allows the firm to charge the full cost of construction to the buyer. The contract may also include incentives for speedy completion of the project.

PUBLIC PROCUREMENT AS A TOOL OF PUBLIC POLICY There are many features of public procurement systems that go beyond simply helping governments buy products efficiently. Public officials use regulations and law to use public procurement systems as a tool for achieving a broader set of policy goals. Consider that, for the 2019 fiscal year, the federal government spent nearly $590 billion dollars on procurement contracts.7 Who the government buys its products from is an important dimension to procurement policy. Redirecting where this money is spent can be a powerful mechanism for targeting economic development opportunities. Before discussing examples of the different ways governments direct procurement dollars to different groups, this section introduces a theoretical framework that helps explain the use of the government’s purchasing power for policy goals. Organizations are frequently classified as being either public or private as if there were a clean line separating them. Dimensional Publicness Theory rejects this simple divide and instead describes a spectrum of political and economic influences over all organizations (Bozeman, 1987, 2013; Bozeman and Bretschneider, 1994; Bozeman and Moulton, 2011). At one end of this spectrum is the private firm that is primarily motivated to maximize profits. Economic interests dominate the operation of these organizations. At the other end of the spectrum is the government agency funded wholly with tax dollars and whose activities are guided by political control. Between these two extremes are a whole range of organizational types that vary in balance of political and economic control over their operations. The different degrees of publicness can be understood using four dimensions of political and economic influence over organizations. These four features are ownership, funding, goal setting, and control (Bozeman, 1987; Goldstein and Naor, 2005). These four dimensions are depicted in Table 18.2. Ownership describes the legal definition of possession over the organization. Funding describes the source of revenues and primarily distinguishes between taxing authority and fees charged to customers in exchanges for products or services. Goal setting separates organizations oriented towards generating profits versus those that pursue public service objectives. Control refers to how closely the organization adheres to government rules and policies. Two studies by Fottler (1981) and Perry and Rainey (1988) categorize organizations based on these attributes. Table 18.2

Four dimensions of publicness

Publicness Attribute

Definition

Examples of variation within government entities

Ownership

Legal ownership of the organization

● Public libraries

Funding

Origin of resources through taxes or charges

● Public schools funded with property taxes

to customers

● Building permit offices funded with user fees

● State-owned enterprises

● Toll roads

334  Research handbook on public financial management Publicness Attribute

Definition

Examples of variation within government entities

Goal Setting

Guided by public service objectives

● Bureau of Land Management enforcing environmental restrictions on cattle grazing ● Procurement directed towards small businesses

Control

Adherence to government-established rules and laws

● Federal agencies found to have committed Anti-Deficiency Act Violations

Dimensional Publicness Theory can be applied to public procurement by examining the interaction of the goal setting and control dimensions in the design and administration of government procurement systems. First, with respect to publicness in goal setting, government acquisitions systems are motivated by a different set of objectives than private or corporate procurement activities. While private-sector procurement functions are oriented towards acquiring resources efficiently, public procurement incorporates additional goals designed to improve public welfare. Thai (2001) describes government officials’ need to balance between procurement goals and non-procurement goals: The procurement goals normally include quality, timeliness, cost (more than just the price), minimizing business, financial and technical risks, maximizing competition, and maintaining integrity. Non-procurement goals normally include economic goals (preferring domestic or local firms), environment protection or green procurement (promoting the use of recycled goods), social goals (assisting minority and woman-owned business concerns), and international relations goals. (Thai, 2001: 27)

Non-procurement goals originate through political influence and control over government acquisitions systems. Procurement officials in the Department of Defense are not creating policies to direct procurement to small businesses or minority-owned businesses on their own; these objectives are driven by Congress and its power to control acquisitions activities. They are a defining feature of the publicness in public procurement systems. One non-procurement goal that is supported with a variety of organizational structures and regulations is the support of procurement through small businesses. The Small Business Act of 1953 mandated that a “fair proportion” be directed to smaller businesses.8 At least since President Eisenhauer’s 1961 farewell address warning against the influence of the growing military-industrial complex, there has been concern regarding defense manufacturers influencing federal policy. Adams’ (1968) analysis of the military industrial complex highlighted the efforts of large corporations to lobby for policies that protect their economic interests in supplying military equipment and new technologies. These lobbying efforts mute the innovation and efficiencies created by economic competition. Adams points to a study by the US Senate Armed Services Committee that shows that the production of critical defense resources, such as tungsten, was concentrated in a handful of large suppliers (United States, 1962). Directing procurement activities towards smaller firms may help mitigate the consolidation of political power and economic activity in a few firms that would then be able to charge uncompetitive prices. Governments have created a variety of policies to promote contracting with small businesses. One such tools is the procurement “set aside.” The US government in most cases reserves contracts of value between $10,000 and $250,000 for small businesses, unless the agency is unable to find offers from at least two businesses (Dilger, 2021). Other programs include efforts to educate small businesses on federal contracting procedures and regulations

Foundations of public procurement  335 to enable them to make successful contract offers. Much of the work of the Small Business Administration is facilitating interactions between federal agencies and potential sellers. A growing academic literature examines the overall economic impact of this broad class of programs supporting small businesses. One finding is that, while many federal agencies have targets for procuring resources through small businesses, in most cases they actually fail to meet those goals (Hawkins et al., 2018). In many cases government officials fail to receive adequate offers from small businesses for contracts and this has led to questions on whether federal government efforts to procure resources through small businesses are actually in good faith (Grammich et al., 2011; Ivory, 2012). One potential concern is that small businesses may be associated with higher transaction costs because they are unable to take advantage of the economies of scale that enable larger firms to operate more efficiently. Hawkins et al. (2018) find evidence countering this argument, however, and find that federal procurement officials underestimate the operational capacity of small businesses. Additionally, the authors demonstrate that small-businesses set-asides have lower transaction costs per offering even after controlling for the relatively simpler products purchased within the set-aside threshold. Nicholas and Fruhmann (2014) note, however, that policymakers and academics should be cautious in assuming that increasing procurement through small businesses will create new jobs and economic growth. Their analysis of European small businesses set-asides reveals a need for additional tracking of employment growth and job losses within the small-business procurement sector. Another important way that public procurement systems are used to pursue political goals is through the promotion of contracting with minority and women owned businesses. The objective behind these initiatives is rooted in Representative Bureaucracy Theory (Smith and Fernandez, 2010; Fernandez et al., 2013; Brunjes and Kellough, 2018). At its core, Representative Bureaucracy Theory predicts that bureaucrats working in government make decisions based on their own background, perspectives and experiences. The views of minorities in the general public are more likely to be represented in government policy if the demographic profile of government officials aligns with the profile of society (Krislov, 2012; Meier, 1993; Mosher, 1982; Saltzstein, 1979). The papers by Smith and Fernandez (2010) and Fernandez et al. (2013) apply representative bureaucracy theory to examine whether representation of women and minorities in the federal acquisition workforce increases the proportion of contracts awarded to businesses owned by women and minorities. Brunjes and Kellough (2018) further this line of inquiry with more detailed interactions between identity, education, and job category. The application of Representative Bureaucracy Theory to the procurement workforce may help to identify whether organizations orient their goals toward public service objectives. The publicness of government organizations depends on the degree to which managerial decisions reflect the values and perspectives of the public at large. Examining how the characteristics of the procurement workforce impact the publicness of government organizations may help to provide more context for recruitment and the overall operation of procurement systems. The use of procurement systems to pursue policy objectives takes on a new context when considering whether the goals of the organization align with the policy preferences of the served public.

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HOLLOWING OUT OR CONTRACTING FOR LEADERSHIP The expanding scale of public outsourcing has raised concerns that governments are losing capacity to meet the public’s needs. If governments consistently choose “buy” when making the make-or-buy decision, does that make it harder for them to internally produce goods and services in the future? How long will it take to rebuild the skills and experiences needed to successfully deliver services? This section briefly introduces some of the primary concerns associated with increased government contracting. The terms “hollowing out” and the “hollow state” have been used for the last few decades to describe the problem of governments losing capacity as they increasingly rely on procurement contracts to deliver public programs. The terms were initially applied by Milward et al. (1993) and were subsequently explored in a large literature that evaluated government managerial capacity in a variety of service settings (Milward and Provan, 2000, 2003; Scott and Greer, 2019; Sementelli, 2020). One of the central themes of the hollow state literature is that many types of public policy are addressed with networks of actors inside and outside of government. As hollowing out progresses, the task of governance shifts from the production and oversight of public programs to the management of these networks and partnerships. As the administration of public programs shifts from direct production to contract and network management, the task of public management itself changes. The shift from operational control to coordinating and evaluating network performance requires different tasks and abilities. Part of the concern associated with the hollowing out of government is that the skills of public officials would lag behind their requirements as the task of governing changes. Brown and Potoski (2003) identified three types of contract management capacity that state and local governments can invest in to improve contracting outcomes. These are: (1) feasibility assessment capacity, which enables more accurate make or buy decisions, (2) implementation capacity, which describes the ability to bid and negotiate contracts and achieve a competitive offering, and (3) evaluation capacity, or the resources to measure contractor performance. Making these investments is costly, however, and Brown and Potoski caution that smaller governments may have less capacity to develop these resources and systematically experience worse contracting outcomes.

COMPLEX SERVICES/UNCERTAINTY A common problem in public procurement is that the government is not able to clearly express to the seller the exact characteristics of the thing it wants to buy. The Department of Defense may seek to procure a communications system that is able to solve a current problem, but the technology hasn’t been developed yet and so the contract will include research and development in addition to manufacturing and delivery. A city may contract out for a broad public works contract that includes contingency services for tree and/or snow removal that only occur during extreme weather events. The uncertainty associated with these types of products adds a new dimension contract management. Brown et al. (2010) proposed a typology of different dimensions of product and contract complexity that influence the principal-agent relationship. Their first dimension is the complexity of the product itself – the cost of producing it, the length of time until delivery, total payment, and the ultimate characteristics of the product. The second dimension is the degree

Foundations of public procurement  337 of formality in the relationship between the principal and the agent. How clear are the expectations for the behavior of each party, how is performance measured, and how much of the agreement is legally binding? The third dimension describes the degree of strategic behavior on the part of both principal and agent due to the existing uncertainties. What features of the relationship create incentives for one party to act at the expense of the other? Increased complexity across any of these dimensions raises the challenge of contract management. One form of complexity arises from the use of a single contractor to provide a variety of different goods and services. Comprehensive service agreements have the potential to create efficiencies for both the buyer and the seller. It can reduce the number of contract bids to oversee and it can create economies of scale for the provider as they are able to use personnel and equipment for multiple service functions. Multi-function contracts can create inefficiencies, however, in the form of diseconomies of scope. Diseconomies of scope refer to the increased governance costs associated with a single contractor providing multiple functions, above that if the functions had been contracted to separate external partners (Rawley and Simcoe, 2010; Brien and Hine, 2015). These can manifest if the comprehensive service provider is able to take actions that heighten its information advantage over government officials because of the range of functions that it performs. In a principal-agent setting the private firm expects to be able to charge prices that allow it a normal rate of return. Typical service contracts last for a fixed period and then the government may choose to renew the contract or rebid it out to the open market. With complex products, the government may initially overpay to compensate the firm for the risk of bearing uncertain costs of delivering the service, but over time, as the uncertainty is lessened that risk premium would be eliminated and the firm’s compensation would just reflect normal profits. In a comprehensive service agreement, however, the agent may be able to transfer funds across functions and this may make it more difficult for the government to fully assess the true cost of service production. Over time, single function contracts would return more of the risk premium back to the government than multi-function contracts. To mitigate this problem, the contract may include structures that require additional reporting and even audits to reveal how funds were spent. Including these structures would add to the burden of contract management, however. Many procurement contracts are for administrative functions that go beyond tangible services such as sanitation or health care delivery. One way for governments to increase contract management capacity is to contract for management services themselves. Cities have contracted for economic analysis, capital planning advice, and many of the technical tasks of budgeting. Another form of diseconomy of scope may arise when these soft administrative services are delivered by the same firm that is producing more tangible public works services (Brien and Hine, 2015). Imagine a firm providing guidance to a city council on the traffic load within the city and the expected wear on the transportation infrastructure. If that firm is also responsible for filling potholes and performing road resurfacing functions, there is the potential that the advice that they give the city would be adjusted to also serve the firm’s interest in producing that infrastructure. The city can conduct reviews and audits of the managerial services it purchases, but again, this creates additional tasks and contract management responsibilities due to the combination of multiple functions in a comprehensive contract. This chapter provides an introduction to several different approaches to thinking about public procurement systems. The legal and political contexts of government procurement are central to the difference between public and private acquisitions and contract management.

338  Research handbook on public financial management For students starting to undertake research in this field it is important to intentionally engage with this difference.

NOTES 1. “Awards by Contractor Type” General Services Administration (2021). System for Award Management. Federal Contract Actions and Dollars. Standard Reports. beta.sam.gov. 2. Assuming that state and local total spending is composed of a similar share of procurement contracts as the federal government. 3. Coase (1937) first formally analyzed the question for private firms. He modeled the profit-maximizing conditions for firms to buy goods and services from the market rather than producing them internally. See Klein (2005) for a review of the private sector literature on make or buy decisions. 4. There is an extensive literature examining the provision and production of waste management services. See Bel and Warner (2008) for a review of studies examining the cost impacts of waste privatization. 5. For example, “The Contract Management Standard” published by the National Contract Management Association (2019) identifies several activities in the procurement lifecycle that are designed to improve clarity for both buyers and sellers in public procurement relationships. 6. Sappington (1991) provides an excellent review of the primary features of economic models of principal-agent interactions. The analysis by Stiglitz (1974) on risk-sharing in agricultural contracts is one of the early formal models of principal-agent interactions. 7. “Federal Contract Actions and Dollars,” General Services Administration (2021). System for Award Management. Federal Contract Actions and Dollars. Standard Reports. beta.sam.gov. 8. See Sakallaris (2007) for a more complete legal history of small business set-asides in federal procurement.

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340  Research handbook on public financial management Perry, J. L. and Rainey, H. G. (1988). The public–private distinction in organization theory: A critique and research strategy. Academy of Management Review, 13(2), 182–201. Porter, O. (2006). Creating the New City of Sandy Springs: The 21st Century Paradigm: Private Industry. Bloomington: AuthorHouse. Rawley, E. and Simcoe, T. S. (2010). Diversification, diseconomies of scope, and vertical contracting: Evidence from the taxicab industry. Management Science, 56(9), 1534–1550. Sakallaris, A. G. (2007). Questioning the sacred cow: Reexamining the justifications for small business set asides. Public Contract Law Journal, 36(4), 685–700. Saltzstein, G. (1979). Representative bureaucracy and bureaucratic responsibility: Problems and prospects. Administration & Society, 10(4), 465–475. Sappington, D. E. M. (1991). Incentives in principal-agent relationships. Journal of Economic Perspectives, 5(2), 45–66. Scott, T. A. and Greer, R. A. (2019). Polycentricity and the hollow state: Exploring shared personnel as a source of connectivity in fragmented urban systems. Policy Studies Journal, 47(1), 52–76. Sementelli, A. (2020). Fear responses: Intersubjectivity and the hollow state. Journal of Borderlands Studies, 35(1), 99–112. Shields, M., O’Donnell, C., Liu, R., and Deutch, A. (2020). As virus explodes, world races to mask up. Reuters, March 25. https://​www​.reuters​.com/​article/​us​-health​-coronavirus​-masks​-insight​ -idUSKBN21C2PE. Smith, C. R. and Fernandez, S. (2010). Equity in federal contracting: Examining the link between minority representation and federal procurement decisions. Public Administration Review, 70(1), 87–96. Stiglitz, J. E. (1974). Incentives and risk sharing in sharecropping. The Review of Economic Studies, 41(2), 219–255. Telgen, J., Harland, C., and Knight, L. (2007). Public procurement in perspective. Public Procurement: International Cases and Commentary, 16. Thai, K. V. (2001). Public procurement re-examined. Journal of Public Procurement, 1(1), 9–50. United States (1962). Inquiry into the Strategic and Critical Material Stockpiles of the United States. US Government Printing Office. Williamson, O. E. (1996). The Mechanisms of Governance. New York: Oxford University Press. Woodward, A. (2021). Washington state hospitals unknowingly bought 300,000 fake N95 masks for their healthcare workers. The Business Insider, February 9. https://​www​.businessinsider​.com/​ washington​-hospitals​-unknowingly​-bought​-used​-fake​-n95​-masks​-2021​-2​?r​=​US​&​IR​=​T.

19. Future directions for research in public procurement and contract management Benjamin M. Brunjes, Sawsan Abutabenjeh, Lachezar G. Anguelov, Ana-Maria Dimand and Evelyn Rodriguez-Plesa

INTRODUCTION Procurement and contract management are essential elements of twenty-first century governance. Recent exigencies, such as COVID-19, severe weather events, and wicked social problems (like homelessness and climate change) reinforce the importance of public procurement and contracting, highlighting the extent to which governments depend on contractors and private sector partners for critical resources and program support. Despite early qualms about the appropriateness of widespread contracting out (Moe, 1987; Gormley, 1994; Moe and Gilmour, 1995), modern public organizations are routinely engaged in the management of complex cross-sectoral networks, including contracts with other organizations tasked with supporting and implementing public programs. If anything, governments are becoming increasingly reliant on private-sector partners. In 2020, the US federal government for the first time spent more than $1 trillion on contracts, an increase of more than $400b (or 70 percent) in contract spending when compared to 2010, far outpacing inflation. As a result of continued fiscal pressures, regional and local governments are also spending more with contractors, with some adopting extreme forms of contracting out (Prager, 2008; Warner et al., 2021). Despite these trends, public procurement and government contracting remain understudied (Trammell et al., 2020; Sadiq and Kessa, 2020). Public procurement is a complex government function, as it links closely with budgeting, influences the creation and enactment of organizational strategy, and affects the implementation and performance of public programs (Brown et al., 2013; Schapper et al., 2006; Harland et al., 2021). Initial steps have been taken to describe the use of government contracts (e.g. Ferris and Graddy, 1986; Thai, 2001; Thai and Grimm, 2000), understand transaction costs in contracting (e.g. Brown and Potoski, 2003; Reeves, 2008; Petersen et al., 2019), and make sense of principal-agent relationships in contracting (e.g. Coats, 2002; Gordon et al., 2019; Romzek and Johnston, 2005). Building on these traditions of research, contracting and procurement offer fertile ground for future scholars interested in developing a better theoretical and practical understanding of modern governance. To help guide future research on contracting and procurement, in this chapter we outline the primary takeaways from existing scholarship and identify four important gaps in the literature. For each gap, we review existing studies and present a series of research questions that remain unanswered. The next section provides an overview of the literature on public procurement and contracting, introducing the diverse intellectual tradition of public procurement scholarship and identifying areas where more work is needed. Then we explore strategic procurement and contract design, solicitation and equity, contract management, and contractor performance in depth, offering insight into the frontiers of the study and practice of public procurement. We 341

342  Research handbook on public financial management conclude with an overall assessment of the state of the field and a summary of areas where new approaches and scholarship are needed.

PROCUREMENT AND CONTRACTING Scholarship on procurement and contracting is conducted across a range of academic fields, in different political contexts, using diverse data and methods, and applying many different theoretical perspectives (Caldwell et al., 2005; Flynn and Davis, 2014; McCue et al., 2015; Snider and Rendon, 2008). Basic terms and ideas are disputed across disciplines and few attempts have been made to systematically categorize and join literatures (Flynn and Davis, 2014; Snider and Rendon, 2008). For example, differentiating between procurement and contracting is difficult. In public-sector oriented literatures, such as public administration, public policy, and political science, the term procurement often refers to the acquisition of relatively simple resources, while contracting is used to describe the steps and processes required to reach and implement the terms of more complex agreements (Eckerd and Girth, 2017; Kim and Brown, 2017; Brown et al., 2016). Procurement describes the purchase of goods and services where “attributes are understood in advance of the exchange so that production costs, selling prices, and product capabilities are well known” (Brown et al., 2016: 296), while contracting covers “the governance system – the contractual architecture of rules and incentives established to align the behaviors” of parties to a contract (Kim and Brown, 2017: 44). Thus, contracting has drawn more interest from public-sector scholars as it connects easily to contemporary governance topics, such as strategic management, networked governance, and collaboration (Flynn and Davis, 2014; Trammell et al., 2020). Unfortunately, this also means public procurement studies have been provincialized and are rarely published in core journals (Trammell et al., 2020; Snider and Rendon, 2008). However, in business-related fields, such as supply chain management, procurement has been defined as “the management of external resources—goods, services, capabilities, and knowledge—that are necessary for running, maintaining, and managing the primary and support processes” of an organization (Van Weele and Van Raaij, 2014: 57). As a result, procurement is viewed as a critical and strategic organizational activity, occurring in the context of complex networks of suppliers and consumers (Bäckstrand et al., 2019; Van Weele and Van Raaij, 2014; Van Weele, 2010). Contracting, which has been characterized as part of both linear and cyclical procurement processes, simply refers to the “start of operational activities, which generate invoices” (Bäckstrand et al., 2019: 5). Contract management and other contracting challenges are mentioned, but they are largely seen as activities or tasks under the broader umbrella of procurement (Patrucco et al., 2017). Thus, the most fundamental terms (contracting and procurement) are defined differently depending on the field of study. In this chapter, we will use “procurement” as the umbrella term to describe the entire purchasing process, including its impact on overall organizational strategy and performance. Here “contracting” refers to the process used to manage individual purchases, including the decision to buy, the description of need, the processes used to solicit and evaluate proposals, and the management and evaluation of contractors (also referred to as vendors) as they perform their work. While there is disagreement over many key terms, scholars across fields tend to agree that public procurement is distinct (Amman et al., 2014; Thai, 2001; Snider and Rendon, 2008; Patrucco et al., 2017). The dominant rationale for public procurement is deeply rooted in

Future directions for research in public procurement and contract management  343 efficiency, as existing markets can substantially lower ex ante public investments and market competition can reduce the cost of needed goods and services (Boyne, 1998; Kelman, 2002; Williamson, 1981). Stemming from New Public Management reforms, contracts are designed to insert competition and business-like management processes into governments to lower costs and boost efficiency (Osborne and Gaebler, 1992; Boyne, 1998; Kettl, 2010). However, government rules complicate public procurement, prioritizing values that are not as important in private-sector procurement (Bretschneider, 1990; O’Flynn, 2007; Rainey, 2009; Rainey and Bozeman, 2000). In addition to the more “commercial” goals associated with the efficiency and effectiveness of procurement, government procurement rules are designed to ensure procurement process accountability and promote socio-economic goals, such as sustainability and equity objectives (Patrucco et al., 2017). As a result of these divergent goals, public procurement includes different process requirements, such as fair bidding, open competition, transparent evaluation of bids and proposals, and the unilateral right of governments to sever contracts without cause (Cooper, 2003; Curry, 2016). Rainey and Bozeman (2000: 456) identify procurement as one of the primary differences between public and private organizations, noting that “public managers experience longer delays [than private counterparts] in getting approval to purchase equipment and in the processing of those purchases.” Accordingly, public procurement blends elements of pure market efficiency with democratic values and specialized processes, resulting in a complex context for scholarship and analysis. Originating with New Public Management ideas about the benefits of privatization, early public procurement studies attempted to examine the extent to which purchasing goods and services from private firms affected government-incurred costs when compared to direct public provision (Lane, 2002; Nemec et al., 2005; Philip and Daganda, 2013; Prager, 1994; Savas, 1977). During this time, descriptive studies also summarized what types of services were contracted out and what types of vendors were hired (e.g. Ferris and Graddy, 1986). There was also pushback from scholars who worried about the extent to which market-oriented reforms would undermine important public values and processes, including accountability and transparency (Moe, 1987; Gormley, 1994; Gilmour and Jensen, 1998), equity (Erridge, 2007; Frederickson, 1996; Hoggett, 1996; McCrudden, 2004), the ability of civil service systems to deliver and monitor public programs (Peters and Savoie, 1994; Howlett, 2003; Terry, 2005; Milward and Provan, 2000), and the basic processes of democracy (Box, 1999; Morgan and England, 1988; Rosenbloom and Piotrowski, 2005). Responding to this normative discussion over the appropriateness of contracting out, scholars began to investigate the circumstances when public procurement might make sense. Adopting ideas from transaction cost economics, many studies focused on the “make or buy decision,” trying to ascertain what kinds of goods and services should be contracted out and which governments should produce internally (e.g. Brown and Potoski, 2003; Brown et al., 2019, O’Flynn and Alford, 2008; Tadelis, 2002; Williamson, 1981). After building evidence about the extent to which different types of transaction costs (particularly asset specificity, ease of measurement, and uncertainty) influence the potential success of government contracts, academic attention turned to how to better manage contracts. Adopting an agency theory perspective, many studies have investigated how to reduce information asymmetries between the state and its vendors to facilitate better management and spur performance (e.g. Amirkhanyan et al., 2014; Girth, 2017; Romzek and Johnston, 2002; Lambright, 2009; Van Slyke, 2007; Witesman and Fernandez, 2013). In addition to these lines of scholarship, there have been a range of studies on public procurement from other perspectives. In political science, procurement has been investigated as

344  Research handbook on public financial management a method to deliver benefits to favored constituents (Anderson and Potoski, 2016; Carpenter and Krause, 2015; Dahlström et al., 2021), while others have analyzed the extent to which centralization matters in different political contexts (e.g. Wang and Li, 2014; Karjalainen, 2009; Ferraresi et al., 2021). Still other studies have investigated equity in public procurement, analyzing the effectiveness of bureaucratic representation (Smith and Fernandez, 2010; Fernandez et al., 2013; Brunjes and Kellough, 2018), the attainment of equity (and sustainability) goals (Andrews and Van de Walle, 2013; Alkadry et al., 2019; Denes, 1997; Hafsa et al., 2021; McCrudden, 2004; Rice, 1992; Warner and Hefetz, 2002), and the social impact of public procurement, including the use of social impact bonds (Arena et al., 2016; Joy and Shields, 2013; Liebman, 2011; Warner, 2013). In addition, public procurement research has been conducted across the globe, with studies covering procurement in Asia (Jones, 2007; Hazarika and Jena, 2017), Africa (Kauppi et al.; Nyeck, 2016), Europe (Bovis, 2012; Edler and Georghiou, 2007), Australia (Aulich and O’Flynn, 2007; Raisbeck et al., 2010), North America (Cravero, 2017; Lawther and Martin, 2005), and South America (Ribeiro et al., 2018; Rullan et al., 2012; Schapper and Malta, 2011), covering topics such as ethics, corruption, contractor management, and innovation. While many themes from the findings of these studies are highlighted in previous chapters, here they exemplify the contextual and theoretical richness in public procurement scholarship. Taken together, it is clear the public procurement research is wide ranging. However, it is also evident that the field lacks a clear identity, as key terms remain disputed and theoretical perspectives unsettled. And, despite the large amount of scholarship, there are still substantial gaps in the literature (Flynn and Davis, 2014; Thai and Piga, 2007; Trammell et al., 2020). Some of these gaps are related to the overall conceptualization and role of procurement in public organizations. While business-oriented literatures have recognized the strategic importance of procurement, government-oriented literatures have not addressed the larger role of procurement in organizations carefully (Cooper, 1980; Thai, 2001; Snider and Rendon, 2008; Patrucco et al., 2017). More research into the role of strategic procurement and contract design may help reduce organizational uncertainties and increase procurement flexibility by leveraging relationships across different levels of government, investing in buyer–supplier relationships, and integrating supply chain management with other public management processes (Apte et al., 2011; Cousins and Spekman, 2003; Lawther and Martin, 2005). Other gaps are related to the need to move beyond normative discussions to more practical treatment of the challenges facing public managers today. Much attention in recent years has been devoted to the “make or buy” decision – when to contract out – while existing public procurement initiatives account for outsized proportions of GDP and require active management (Brunjes, 2020). Relatively few public procurement studies directly address pressing practical challenges, such as how to manage contractors and how to measure different aspects of performance (Brunjes, 2022; Patrucco et al., 2017; Petersen et al., 2019). More attention should be given to elements of human capital, contract management tools (e.g. financing, modifications, and incentives), discretion, and performance implications (Petersen et al., 2019). Finally, too few studies have investigated how to effectively interact with vendors, how to advance social equity in government contracting, and how to include firms that have been traditionally marginalized from public procurement opportunities (Alkadry et al., 2019; Fairchild et al., 2018). Accordingly, in this chapter, we advance four areas for future scholarship on public procurement and contracting: (1) strategic procurement and contract design, (2) vendor solicitation and equity, (3) contract management, and (4) contractor performance. As a result of the

Future directions for research in public procurement and contract management  345 ongoing use of contractors to design, support, and implement government programs, these topics are central to advancing knowledge of public procurement practice and theory, and are intimately related to other scholarship on the management of public organizations. For each section, we introduce the topic, review the state of the field, and identify implications for future research.

STRATEGIC PUBLIC PROCUREMENT In organizations, strategic management combines visionary and incremental elements to create a culture of progress towards shared goals and objectives (Poister and Streib, 1999). Evolving from clerical functions to become more value-based and intentional, contracting and procurement are increasingly recognized as contributing to the strategic management of public organizations (Abutabenjeh, 2021; Guarnieri and Gomes, 2019; McCue and Gianakis, 2001; Matthews, 2005). In addition to overseeing transactions with vendors and contractors, public procurement officials are expected to correlate, synchronize, interact, share information, and reinforce other functions within an organization. Bridging organizations, procurement works closely with finance, human resources, budget, information technology, legal, and issue/policy offices (Quayle, 1998; Abutabenjeh, 2021; McCue and Pitzer, 2005). Externally, procurement and contract managers regularly interact with potential partners and suppliers, political overseers, and service recipients (Abutabenjeh et al., 2023). According to Demel et al. (2015: 3) in government, “the strategic value of procurement flows from the creation of opportunities for advance planning, obtaining best value, reducing risk, and maintaining the integrity of the use of public funds.” As a result, in modern public agencies, procurement should be managed as a critical component of organizational strategy. Strategic procurement, also referred to as strategic sourcing, is “the process of designing and managing supply networks in line with operational and organizational performance objectives” (Narasimhan and Das, 1999: 687). Though related to contract design, which is concerned with developing requirements and creating proper structures to affect contract outcomes, strategic procurement is a more holistic approach that ties procurement and contracting activities to broader organizational objectives. Strategic sourcing requires analyzing an organization’s spending in collaborative and structured ways to make strategic decisions regarding the organization’s needs (OMB, 2005). Strategic procurement also calls for leveraging collaborative relationships across tiers of government, establishing relationships with critical contractors, and integrating supply chain management with other public processes (Apte et al., 2011; Cousins and Spekman, 2003; Lawther and Martin, 2005). Benefits of strategic sourcing include allowing public agencies to “optimize performance, minimize price, increase achievement of socio-economic acquisition goals, evaluate total life cycle management costs, improve vendor access to business opportunities, and otherwise increase the value of each dollar spent” (OMB, 2005: 1). State of the Field: Strategic Sourcing Scholars have constructed several models for strategic procurement, summarized in Figure 19.1. Building on Williamson’s (1981) foundational work, strategic procurement involves deciding to make or procure a good or service, assessing potential transaction costs through

346  Research handbook on public financial management requirements generation and market analysis, and then forming a strategy to manage the procurement using the results of the foregoing planning and analysis. Acknowledging the challenges of procuring a wide range of goods and services, Vitasek (2016) designed tailored procurement models for transactional, relational, and investment contracts. These models “operate along a continuum depending on the complexity of the marketplace and the strategic needs of buyers and suppliers” (Vitasek, 2016: 126). Strategic sourcing models are used to select suppliers/vendors, products, or services while maximizing benefits and minimizing costs to the organizations.

Source:

Adapted from Yagoob and Zuo (2015).

Figure 19.1

Strategic sourcing model

Research has examined several approaches to strategic sourcing in public and private organizations. The private sector has shown benefits from using strategic sourcing tools (Reed et al., 2005; Rendon, 2005). Companies such as IBM, United Technologies Corp (UTC), Koda, Southwest Airlines, and Deere & Co. have demonstrated improved process performance, reduced cost, increased collaboration, and enhanced productivity and profitability (Reed et al., 2005; Rendon, 2005). For example, assessing multiple factors to evaluate efficiency in a large multinational telecommunications company, Talluri and Narasimhan (2004) show that applying strategic data envelopment analysis (DEA) increases efficiencies of different suppliers. Though strategic procurement has been widely studied in business-oriented supply chain scholarship, it has not received similar attention in public-sector studies, especially in the United States (Patrucco et al., 2017). Yet, there is evidence that strategic sourcing is increasingly important in the public sector. In Europe, the supply chain literature has noted the need for more attention to strategy in public procurement (Kim et al., 2015). More recent studies have taken up this mantle, for example covering the extent to which “right-sourcing” models are appropriate and effective in the public sector (Jensen, 2017), the role of strategic sourcing in sustainability programs (Aldenius and Khan, 2017; Malolitneva and Dzhabrailov, 2019; Mélon, 2020), and the extent to which strategic procurement can improve the efficiency and cost-effectiveness of public service delivery (Milosavljević et al., 2019; von Deimling et al., 2016). In the United States, the National Association of State Procurement Officers (NASPO) has listed strategic sourcing and strategic procurement leadership as top priorities for state-level contracting, but the diffusion of strategic sourcing has been slow (NASPO, n.d.). At the federal level, defense agencies and the Department of Homeland Security (DHS) were early adopters (Rendon and Snider, 2019). Yet few studies have assessed the ways that procurement strategies affect agency goals, management processes, procurement costs, or outcomes for agencies or service recipients. Those that have are focused on federal agencies. Using qualitative data and spend analysis, Hawkins et al. (2014) showed how the United States Air Force uses the sourcing of knowledge-based services (KBS) to improve efficiency. They find that “public

Future directions for research in public procurement and contract management  347 policy governing the procurement of knowledge is needed” (Hawkins et al., 2014: 215), indicating that strategic procurement may be a critical component of effectively managing complex, relational contracts. Apte et al. (2011) employed an optimization model to the US Air Force’s strategic sourcing approach for services at military installations, showing that past performance and cost of services are critical to sourcing decisions. Thus, opportunities remain to ascertain the use and impact of strategic sourcing initiatives in the public sector. Implications for Future Research As more governments adopt strategic sourcing, additional research is needed into the diffusion of these tools, the effects of strategic sourcing approaches on procurement processes and outcomes, and the integration of procurement within broader organizational processes and systems. There are also barriers that hinder strategic public procurement from fulfilling its coordination and connector role. Non-competitive markets, conflicts between efficiency and equity goals, and pervasive red tape (primarily in the form of rules, guidelines and regulations) are challenges (Glas et al., 2017; Matthews, 2005; Apte et al., 2011). Managing differences in demand and expectations from manifold overseers, stakeholders, and service recipients is essential in the public sector. Cousins and Spekman (2003) emphasize that there may also be barriers throughout the supply chain such as failing to build long-term relationships with key players, not involving suppliers in the procurement process and design, and not accepting performance metrics. Recent studies indicate that the number, type, and depth of government– vendor relationships can influence procurement, especially credibility between partners (Bertelli and Smith, 2010), the attainment and prioritization of public values (Crosby et al., 2017; Page et al., 2015; Koliba et al., 2017), and contractor performance (Brunjes, 2022; Klijn and Koppenjan, 2016). Additional research is needed to better understand barriers to strategic sourcing, including how they arise and their impacts on procurement and organizational processes. In addition, studies are needed to identify tactics to overcome barriers in different geographic, institutional, and theoretical contexts, including how to initiate and manage relationships effectively. Adopting strategic procurement approaches will also challenge public organizations to rethink core processes, reassess the relative importance of public values, and balance the competing objectives of different stakeholders. Future researchers could investigate the relationship between procurement and strategy, including the ways that procurement affects organizational strategy, how strategic approaches influence organizational and vendor performance, and the extent to which strategic procurement contributes to (or detracts from) other policy and management objectives. As governments around the world continue to engage in networks of collaboration and contracting, a better understanding of procurement’s role and influence as a critical contributor to organizational strategy is needed.

SOLICITATION AND MARKET INTERACTION To take advantage of competitive forces, which lower costs and improve accountability, governments often solicit bids or proposals from markets of suppliers. Governments interact with the market through solicitations to collect and evaluate submissions before they make a contract award. NASPO identifies three broad source selection categories: formal competition

348  Research handbook on public financial management (e.g. invitation for bids, request for proposals), informal competition (e.g. small purchases, request for quotation, request for information), and non-competitive procurement (e.g. sole source procurement, emergency procurement). The European Union has a similar structure where formal competition follows open procedures (i.e. open to any vendor), restricted procedures (i.e. pre-selected vendors can participate), or competitive negotiated procedures (i.e. pre-selected vendors can submit the initial bids and negotiate) (Your Europe, n.d.). Alternative procurement procedures used when uncertainty exists in the need for a good and/or service or the market include competitive dialogue, innovation partnership, and design contest (Your Europe, n.d.). These procedures are comparable to requests for information which are used when a better understanding is needed about the market for goods and/or services. Many of the decisions about how to design contracts, solicit vendors, and interact with the marketplace remain opaque (Brunjes, 2020). Yet, these decisions are some of the most important in the procurement process, as they establish how potential contractors will interact with government, where government will allocate resources, and how bids and proposals will be evaluated (Curry, 2016). Accordingly, solicitation and market interaction offer another area where additional research is necessary. State of the Field: Markets and the Solicitation Process Competition is an important principle of public procurement. It fosters process transparency and promotes impartiality (Racca et al., 2011; Atkinson, 2020). A key assumption of New Public Management is that a competitive market regulates the supply and demand dynamic that makes contracting and procurement effective (Kettl, 1993; Kelly, 1998; Kim and Brown, 2012). Competition promotes efficiency and encourages bidders to minimize their prices and provide best quality services (Fernandez, 2007; Brunjes, 2020). Furthermore, open and fair competition offers broad opportunity for a range of suppliers to submit and be evaluated under the award criteria, democratizing contracting out (Racca et al., 2011). While competition cannot eliminate all risks or guarantee good performance, it establishes incentives that should motivate vendors to lower their costs, offer thorough assessments of task requirements, and perform as well as possible after selection (Brunjes, 2020; Lamothe and Lamothe, 2009; Malatesta and Smith, 2014). Though selection criteria vary depending on the objectives of the solicitation, competitive processes should result in awarding a contract to the most responsible and responsive bidder. Yet, despite early evidence that competition could lower costs, there is recent evidence that competition may not lead to improved contract outputs and outcomes (Brunjes, 2020, 2022; Lamothe and Lamothe, 2009). Sometimes selection criteria only assess cost, but studies show that other factors may also be important, such as quality, innovation, and equity objectives (Curry 2016; Lamothe and Lamothe, 2009). While competitive markets may be the ideal setting for solicitation, market imperfections on the supply and demand side are common. In some cases, governments are the only or primary buyers of certain goods and services (e.g. prisons, nuclear weapons, space related goods and services, etc.). On the supply side, there are also instances where only one or very few vendors can supply certain goods and services (e.g. utilities, emerging technology, highly specialized services). Market imperfections stemming from monopsony or monopoly can lead to information asymmetries, making it difficult for the “government to be an independent, knowledgeable buyer, capable of managing in the public interest” (Kelly, 1998: 206). In some instances,

Future directions for research in public procurement and contract management  349 governments can forgo competitive solicitations, though there are legal limitations to prevent “sole sourcing” except in cases where only one vendor exists or when there is a qualifying urgency (Federal Acquisition Regulation 18.102; Your Europe, n.d.), real estate purchases (Your Europe, n.d.), or if the contract value falls below a specified threshold (European Commission, n.d.). For instance, a single tender procedure applies for contracts valued under 20,000 euros under European Union directives (European Commission, n.d.). Despite its benefits, competitive solicitation has limitations and challenges. First, vendors may not be aware of or able to respond to opportunities, requiring contract managers to engage in outreach and advertising (Johnston and Girth, 2012). Even if potential contractors are aware of solicitations, administrative rules can be burdensome to firms without previous government contracting experience (Cooper 2003; Herd and Moynihan, 2019). To stimulate competition and promote access for disadvantaged businesses, governments take steps to “level the playing field, so that no vendor has an unfair advantage over any other” (Atkinson, 2020: 1170). In the US, small and disadvantaged businesses are the beneficiaries of set asides (which restrict competition to certain types of firms) and mandatory incentives during evaluation (Kidalov and Snider, 2011). The US federal government has spending goals for procurement with small firms, and most state and local governments have similar programs (Fairchild et al., 2018). In Europe, the European Commission advocates for procurement with small firms, offering size standards and setting aspirational goals, but implementation is voluntary and left up to member nations (Kidalov and Snider, 2011). Other nations around the world also engage in efforts to stimulate competition and invest in small businesses, with approaches varying depending on the objectives of the program (Thai, 2017). While these approaches can increase the number of firms interested (or able) to bid on government contracts, they also require active management and often force an uncomfortable balance between the equity and efficiency goals of public procurement programs. Second, market imperfections can lead to thin markets where there are no (or few) vendors of desired goods and services (Kelly, 1998; Fernandez, 2007). Procurement officials may be forced to sole source (limiting the benefits of competition) or opt not to purchase a good or service. Third, corruption and political influence may steer the solicitation and evaluation stages (Fernandez, 2007). Influence peddling, patronage, cronyism and other forms of corruption are risks in procurement, as both political and administrative actors have the ability to apply power and discretion (Burguet and Che, 2004). Finally, some organizations lack financial and technical capacity, which can result in poorly written solicitations or contribute to contract failure (Joaquin and Greitens, 2012; Yang et al., 2009). Though some work has investigated how to manage in less competitive markets (Girth et al., 2012; Warner and Hefetz, 2012; Johnston and Girth, 2012; Petersen et al., 2019), additional studies are needed on advertising opportunities to vendors, understanding pathways and responses to political influence, and building sufficient procurement and contract management capacity. Implications for Future Research: Discretion and Equity in Solicitation Many of the mechanics of solicitation are understudied. We know little about how requirements are generated, the approach to and effectiveness of market analyses, the design and effects of advertising solicitations, and how submissions are evaluated. Kinsey (2004: 161) notes that “the level of transparency within US procurement has fallen dramatically … driving much of the procurement system underground … as billions of dollars of government con-

350  Research handbook on public financial management tracts pass through a largely obscure process.” Similar opacity problems have been noted in other nations around the world (Thai, 2017). As a result, additional scholarship is needed on solicitation, particularly studies that link these process steps to managerial actions, administrative rules and regulations, public values, and vendor performance. While rules and regulations guide practitioners in most phases of the procurement process, aiming to uphold the integrity and transparency of public expenditures, contracting personnel have considerable discretion throughout the procurement process. Brunjes and Kellough (2018) note that contract managers use their discretion to set specifications, design contracts, identify and execute a marketing approach, establish and implement evaluation criteria, and select winning proposals. Kim and Brown (2012) find that discretion accounts for the variation in contract designs as well. There is considerable discretion in the advertisement and marketing of solicitations. In general, the goal of such outreach is to increase awareness of contracting opportunities and maximize accessibility and participation (Bryson et al., 2013). There are several ways to enhance vendor participation. Targeted advertising can be used to reach historically excluded businesses (La Noue and Sullivan, 1995). According to a 2007 report from the National Institute of Government Procurement (NIGP), other strategies that can help advertise solicitations include: ● ● ● ●

Vendor outreach sessions Conferences, teleconferences, tradeshows, etc. Listing contracting opportunities in searchable databases or listservs Unbundling large contracts into smaller contracts to increase access for smaller or disadvantaged firms ● Providing clear written materials on the contracting processes Much of the research on discretion in contracting centers on developing and implementing equity programs, designed to solicit contracts with small, minority-, women, and veteran-owned businesses (Terman, 2013). Equity-oriented contracting programs aim to provide access, limit discrimination, and afford opportunities to historically disadvantaged businesses and communities. Recent studies demonstrate that demographic representation in the public bureaucracy is correlated with more contracting activity with disadvantaged firms, though there are substantial differences based on representation by race, ethnicity, and gender (Fernandez et al., 2013; Brunjes and Kellough, 2018). Future studies should adopt new lenses (not just representation) to investigate inherent biases in the mechanics of contract design and solicitation. As relational contracting becomes more common, exclusionary procurement practices that preference established vendors may become more prevalent (Bartels and Turnbull, 2020; Bertelli and Smith 2020). How has the combination of institutional factors and administrative discretion protected or benefited certain classes or types of vendors? How do managerial behaviors and attributes affect the pool of bidders? And what steps can be taken to improve the performance of procurement equity programs?

CONTRACT MANAGEMENT The expansion of contracting over the last forty years was expected to lower the cost and improve the quality of government services (Cooper, 2003). Yet, there is not a preponderance

Future directions for research in public procurement and contract management  351 of evidence that these benefits have materialized (Alonso et al., 2017). One reason is the assumption that managing contracts would be relatively easier and cheaper than managing public programs directly (Boyne, 1998). Indeed, initial evidence shows that procurement processes and contract management are complex, requiring different skills sets than traditional program administration (Cordella and Wilcocks, 2010; Rehfuss, 1989). Hidden costs are prevalent throughout the contracting process, largely in the form of resources dedicated to contract design, solicitation, and management (Forrer and Key, 2004; Joaquin and Greitens, 2012). Though some initial work has been conducted on how to manage ex ante transaction costs around design and solicitation (Taponen and Kauppi, 2020), the study of contract management remains nascent (Petersen et al., 2019). In this section, we summarize previous studies on contract management and present a series of questions that future researchers might explore. State of the Field: Managing Agents Government contracts create a new layer of principal-agent relationships. Deciding to buy rather than make a good or service further removes the design and delivery of public services from democratically elected branches of government, creating information asymmetries and bringing organizations with different motivations into the policymaking process. As a result, agency theory tends to dominate the extant scholarly work on contract management, though other lenses like transaction cost economics and resource dependence have also been applied. Agency theory holds that principals cannot fully know the behavior of their agents, as agents are likely to possess expertise and information advantages. Principals can neither be sure that agents accurately represent their qualifications prior to a contract nor that agents are making progress toward contract objectives. As a result, principals must find ways to overcome ex ante adverse selection and ex post moral hazard. While solicitation procedures are used to limit adverse selection, it falls on contract managers to work to overcome moral hazard. Since contractors often know more about the details of the work provided and perform work at separate locations from government overseers, shirking, cost inflation, and other undesirable behaviors are possible. Contract managers have several different strategies they can use to overcome principal-agent problems. Some approaches might be described as contractual, or fulfilling the formal requirements of the exchange, while others are more relational, addressing or building on informal, interpersonal elements of the interaction (Bertelli and Smith, 2010; Högberg et al., 2018). One of the most common is the frequent exchange of information to limit asymmetries, which occurs through contractual (deliverables, reports, scheduled meetings, information requests) and relational (conversations, observation) means (Ter Bogt, 2018). Other mechanisms to motivate performance include working with established partners (Brunjes, 2020), applying penalties and rewards (Girth 2017; Lambright 2009), and matching management tactics to a vendor’s intrinsic motivation (Van Slyke, 2007; Witeseman and Fernandez, 2013). As Lambright (2009: 222) notes, “structuring contract penalties and rewards to reduce goal conflict between the principal and the agent helps minimize principal–agent problems.” The attributes of services and markets stipulate the types of risks governments are exposed to, as well as the mitigation strategies that might be available to them (Brown et al., 2006). Conditions which exacerbate information asymmetries worsen agency problems and are generally indicated by the presence of high levels of uncertainty, difficulty measuring progress and desired outcomes, and asset specificity both ex post and ex ante. Principal-agent problems

352  Research handbook on public financial management are arguably lower in exchanges where relational contracting and stewardship theory are more appropriate (Brown et al., 2006; Van Slyke, 2007; Lambright, 2009). An appealing feature of government contracting is the expectation that competitive markets will lower costs of service delivery (Van Slyke, 2003). In other words, contracting is viewed as a “way to reduce service costs through competitive efficiencies and economies of scale” (Brown et al., 2006: 323). Yet, competitive markets do not always materialize (Girth et al., 2012). As a result, emphasis on relationships can become an important strategy to overcome agency problems, as familiarity, trust, and credibility can reduce the likelihood of moral hazard or other performance problems (Girth et al., 2012; Kolpakov and Anguelov, 2018; Brunjes, 2020). It is also possible that over time or with goal congruence, principal-agent dynamics evolve into principal-steward exchanges (Van Slyke, 2007; Witeseman and Fernandez, 2013). Contract management decisions should not be reduced to studies of static binary choices by procurement officials tasked with vendor oversight. After all, in longer-term contracts management approaches can evolve from formal, arms-length arrangements to relationships “based on trust, reputation, collective goals, and involvement where alignment is an outcome that results from relational reciprocity” (Van Slyke, 2007: 162). Contract management dynamics are not static, and oversight strategies are likely to change over time and be context specific. Cross-national differences deserve more attention, as the objectives of contract management “relate to wider debates about accountability in democratic governance” (Blomqvist and Winblad, 2022: 236). In recent years, European scholars have studied the details of relational contract management, offering evidence that trust and control interactions can create problems. Högberg et al. (2018) offer evidence of mixed coevolution in a Swedish municipality where “both trust and distrust develop simultaneously as a result of control” (Högberg et al., 2018: 209). In the Netherlands, Ter Bogt (2018: 139) finds that “informal contact and trust played an important role in the control relationship.” These case-study findings are consistent with previous studies suggesting that the presence of formal control mechanisms can negatively influence the behavior of contractors and their relationship with government agencies (Anguelov, 2020; Girth, 2017; Romzek and Johnston, 2005). The challenge is how to balance elements of control and credibility (Bertelli and Smith, 2010). In Sweden, there is evidence that “socially-oriented control seems preferable from a trust perspective, as does a participatory approach to developing and implementing control systems” (Högberg et al., 2018: 209). Yet, more work is needed to understand how to balance control and credibility mechanisms, especially in the context of vendor motivations, complex work requirements, and the possibility of moral hazard. Implications for Future Research: Managing Contractors Contract management spans multiple capacities and their associated tools. While theoretical and empirical research has proliferated around reducing information asymmetries, more work is needed in the implementation and evaluation stages (Yang et al., 2009) and to account for managers’ decisions when faced with ex post transaction costs (Petersen et al., 2019). Monitoring and enforcement (ex post transaction costs) Oversight and accountability are essential for successful government contracting. Most studies in this research stream describe monitoring tasks throughout the contracting process and provide reasoning for who would be responsible for their implementation (e.g. Amirkhanyan,

Future directions for research in public procurement and contract management  353 2009; Anguelov, 2020; Brown and Potoski, 2006; Marvel and Marvel, 2007; Petersen et al., 2019; Yang et al., 2009). Yet, we still are not sure whether monitoring changes, or how oversight mechanisms are modified over the life of a contract. The contracting process is dynamic, where outsourcing, alteration, and insourcing are possible. Public managers regularly choose whether to retain the services of the incumbent vendor or replace them with another bidder (Albalate et al., 2020). For a variety of reasons, governments can also opt to bring a service back “in-house” for direct production when savings do not materialize or when monitoring or market challenges present themselves (Warner and Hefetz, 2012; Riles, 2014). Contracting back in, or “remunicipalizing,” government services that were previously contracted out can also be the result of political pressures (Campos-Alba et al., 2021). Incorporating tenets from Real Options Theory (ROT) can complement both agency and stewardship explanations in understanding how contracts change over time (Schepker et al., 2014). When public managers contract with a new vendor, ex post transaction costs might be higher, as there is more of a need to build communication pathways, validate the vendor’s performance, and build trust through shared experiences. New contractors also require more work ex ante, as managers spend more time gathering information, checking references, developing performance metrics, and planning deliverables (Petersen et al., 2019). However, as a credible relationship develops between parties to a contract (Bertelli and Smith, 2020), lower ex post expenditures are to be expected (Lamothe and Lamothe, 2012). Yet there are few studies about how relationships change over time and the ways that relationships affect decisions to insource or outsource. Options theory would posit that after the initial performance period, the purchasing entity will decide whether to exercise a renewal option. Working with the same vendor would reduce ex post expenditures, particularly in the presence of trust between contracting parties. In such cases, less active oversight and allowing vendors to self-report performance are likely. Some initial work has been done, demonstrating that relationships lower ex ante transaction costs (Petersen et al., 2019). Future research can extend these ideas into the management phase of the contract. For example, it would be important to assess how relationships and the presence of different options might affect both the decision to use experienced contractors and rely on contractor performance indicators. Analyzing contracts and archival performance data (specifically modifications and renewals) in addition to perceptions would allow scholars to make better claims about how relationships manifest in agreements over time. Addressing complexity of contracting networks Agency theory is commonly applied in contract management studies, yet we frequently ignore the complexity of the delivery networks used to produce government services. Arguably, a multiple-principal, multiple-agent approach is more appropriate (Waterman and Meier, 1998). At the very least, expanding the traditional principal-agent model to three participants is warranted (Patty and Penn, 2014). Given the acknowledged importance of political influence and service recipient satisfaction, considering contractors within the broader study of networks is necessary (Koliba et al., 2017). As networks increasingly rely on third parties for support in administration and implementation, studies of contractor centrality and relative influence are needed. To what extent is the management of contractors shared among networks participants? And how do contracts affect and experience pressures from political actors? Similarly, how do service recipients affect contract management? In this vein, scholars should also explore

354  Research handbook on public financial management questions that account for more than a simplistic dyad consisting of a contract manager and vendor. Such inquiries should aim to build on the growing body of literature on service triads and network management in public-private contexts (Kelleher and Yackee, 2009; Koliba et al., 2017; Bell and Scott, 2020). Aligning public values and contract management A key motivating factor for government contracting is cost savings (Ferris and Graddy, 1986; Osborne and Gaebler, 1992; Savas, 1977). However, this need not be the sole public value under consideration. Ultimately, contractors are responsible for promoting the priorities of their principals. Efficiency, effectiveness, responsiveness, accountability, transparency, benevolence, integrity, and equity are all important public values. Yet most contract management research has focused on accountability and efficiency. More research is needed into how governments use contracts to promote equity and integrity. To this point, studies of equity programs have stopped at the award phase: winning the contract is seen to be evidence of the attainment of equity goals (Resh and Marvel, 2012). As a result, we know little about how historically excluded vendors are managed. Are such vendors more or less likely to experience financial penalties, additional work modifications, or change orders than other contractors? To what extent are lasting relationships built with these firms? How do procurement rules influence relationship-building with historically excluded vendors? Is there evidence of systemic or implicit bias in the ways that minority- and women-owned ventures experience working as government contractors? And does winning government contracts have broader effects in disadvantaged communities – is procurement an effective agent of social change? Additional work is needed to answer all these questions. Contract management: behavioral approach The rapid increase of behavioral public administration research also creates an opportunity for contract management scholars. Early behavioral research on government contracting explores how recipients evaluate the performance of public services (Van den Bekerom et al., 2021), how willing citizens are to coproduce public services under various arrangements (James and Jilke, 2020), and how managers evaluate secondary policy objectives (Lerusse and Van de Walle, 2021). Building on this research, scholars should explore how contract managers evaluate competing goals (values), and what motivates their use of penalties, rewards, and other managerial tools. Similarly, experiments could be used to assess how different levels of discretion (and the biases contained therein) impact vendor selection, management and/or monitoring strategies.

CONTRACTOR PERFORMANCE Government contracts are used to promote many different public values and to achieve a wide range of outcomes. Of these, efficiency has been the dominant rationale for the use of contractors. Due to infrastructure, expertise, and nimbleness advantages, contractors are expected to be able to deliver goods and services to (or on behalf of) public organizations at a lower cost, resulting in efficiency gains (Savas, 1977). Contractors may also be better suited to the challenges of customer service, able to segment markets effectively and meet the needs of service recipients (Osborne and Gaebler, 1992). Despite potential efficiency and effectiveness

Future directions for research in public procurement and contract management  355 benefits, few studies on contracting in public administration have investigated performance. Instead, the field has largely focused on identifying conditions when it is appropriate to contract out different kinds of work (Brown et al., 2006; Kettl, 2015; Petersen et al., 2019; Tadelis, 2002). Yet, in a world where contracting is commonplace and often required, public managers need theory-driven, empirical evidence about how to manage vendors to ensure that public objectives and the value promises of contract are met. There is a rich literature on performance in public bureaucracies (Johansen et al., 2018; Moynihan, 2008), but the corresponding literature on defining, measuring, and overseeing performance when governing by contract is quite thin (Brunjes, 2022; Moynihan et al., 2011; Petersen et al., 2019). As a result, developing a better understanding of contractor performance, including how to measure and motivate performance, is among the most important areas for growth in the study of public sector contracting. In this section, we describe previous studies on performance in the contract state and develop research questions to guide future scholarship. State of the Field: Measuring Contractor Performance Performance has been a central topic in public administration scholarship over the last thirty years. Though much progress has been made, scholars have noted ongoing problems with conceptualizing and measuring performance. At the most basic level, performance is difficult to define. Despite a reputation as value-neutral and highly technical, elements of performance management establish which activities will be measured and reported (Moynihan, 2008). This means that performance is highly political and its definition quite fluid, as powerful actors inside and surrounding the bureaucracy work to influence the goals and objectives that guide much of government activity. Given the highly varied nature of government work and the competing values that guide program implementation, performance also takes on very different meanings in different contexts. As a result, “performance tools are not viewed as simple or neutral but rather as a necessary part of an evolving and inevitably imperfect system of governance” (Moynihan et al., 2011: i153).

Figure 19.2

Performance management tasks

Contracting scholars face many of the same challenges as traditional public administration scholars when attempting to define and measure performance, and many of the same basic questions persist. There are elements of performance management across the procurement process and contracting cycle. And, as shown in Figure 19.2, ex ante elements might affect vendor performance ex post (Brown et al., 2006; Brunjes, 2020; Petersen et al., 2019). Ex

356  Research handbook on public financial management ante, little is known about how governments use procurement strategies to generate requirements and performance metrics for contractors during solicitation. Even less is known about how negotiations over performance expectations occur during contractor selection. Ex post, governments implement performance management tasks, including incentivizing, monitoring, and enforcing performance targets, but little is known about the extent to which these tasks affect actual performance. Here, performance is closely tied to contract management, but to fully understand what constitutes good management, performance-related output and outcome assessments are likely needed. As contractor performance information may relate to a contractor’s ability to compete for future contracts, many of the details of contractor performance are not made publicly available. In the US, at the federal level, FAR 42.1503(4)(d) holds all past performance data as “source selection sensitive,” meaning that performance information is closely held, and many other nations and subnational governments have similar rules (Kidalov and Snider, 2011; Kinsey, 2004). As a result, contracting scholars do not have access to official contractor performance reports, meaning that the development of performance measures is comparatively challenging and often controversial. Making matters worse, contractors provide a wide range of goods and services across governments, from simple commodities to advanced weapons systems and complex human and management services. Developing comparable measures that facilitate the investigation of underlying truths across this diverse groups of contracts presents a sticky problem for scholars. Previous measures used to assess contractor performance have included cost, perceptual measures, and contract modifications. Motivated to investigate potential efficiency gains, early contractor performance studies tended to focus on cost (Boyne, 1998; Prager, 1994; Savas, 1977). While these studies present evidence that vendors may be able to complete relatively simple tasks (such as trash collection) at a lower cost than public agencies, other scholars have noted that these studies ignore the management costs associated with overseeing and implementing the contract, which may outweigh the cost savings (Box, 1999; Boyne, 1998; Milward and Provan, 2000). Cost may have different meanings across different types of contracts, even if proportional measures are used, as the size of contracts can vary from thousands to billions of dollars. Recent studies in Europe have wrestled with this problem (e.g. Flynn, 2018; Plaček et al., 2020), ultimately noting that distinguishing value for money from raw costs is difficult, while acknowledging that cost serves as a useful starting point in nations attempting to develop accountable and efficient procurement systems. It is also clear that the resources expended during a contract are an input to the contracting process and not necessarily evidence of any particular performance output or outcome, meaning that cost measures may ignore both quantity and quality elements of the good or service provided. Other scholars have adopted perceptual measures, surveying public managers ex post about contractor performance (e.g. Yang et al., 2009; Johnston and Girth, 2012). Though this increases comparability, perceptual measures may also be an unreliable method of assessing performance, as it is widely recognized that people suffer from memory problems and cognition biases (Ketokivi and Schroeder, 2004). In the case of vendor performance, it is likely that public officials have incentives to inflate or obscure performance information. More recently, answering the call to develop both cross-cutting and impact-related measures, scholars have looked to different types of modifications as indicators of performance. Modifications are generally viewed as evidence of performance problems, as they signal the need to redirect a vendor. Scholars have looked at the number of change orders and the

Future directions for research in public procurement and contract management  357 number of total modifications as measures of both complexity and performance, suggesting that increased modifications may indicate managerial difficulty (e.g. Kim and Brown, 2012; Girth and Lopez, 2019; Brunjes, 2019). Others have used the final modification of the contract to assess performance, focusing on termination as evidence of poor performance (e.g. Reis and Cabral, 2015; Brunjes, 2019, 2020). These approaches are promising, yet the meanings and interpretation of these variables are also disputed. Additional modifications can be made to add resources if a vendor is doing well. And termination provides little insight into what influences good performance. Implications for Future Research Currently, there is little agreement in the public-sector scholarship over how to define or measure contractor performance. At the most basic level, future scholars need to investigate performance across the procurement process and generate measures that are meaningful across the diverse range of contracts that governments manage. Yet, as Hodge establishes, there are many other possible measures of performance, including the social, political, and legal impacts of the contract which have been long neglected (Hodge, 1998). This includes attempting to link inputs to outputs and outcomes, and assessing the effects of design elements (the plan for a contract) on contract implementation and results. That is, understanding contract performance in the complex context of modern governance requires considering all of the previous elements mentioned in this chapter (strategy, solicitation and design, and management) in context to develop an array of measures that are detailed enough to be meaningful but also applicable across a range of operational activities. Future scholars will need to catalog and classify previous measures and develop and test new approaches. In addition, studies are needed to understand how public organizations evaluate contractor performance and assess how performance information contributes to organizational learning about future contracting initiatives. What processes and data are used inside government to assess contractor performance? To what extent do existing contractor performance assessment approaches affect the procurement process, including strategies, solicitations, and management during the period of performance? And, how have pay-for-performance initiatives in contracting influenced vendor performance and public procurement processes? Finally, future studies should also investigate the role of politics in vendor performance, including the power of vendors in more relational contracts and the role of political institutions across the contracting cycle (from establishing performance criteria to influencing negotiations and the use of sanctions). While there is evidence that fiscal rules lead to spending down budgets via contracts (Liebman and Mahoney, 2017), other political elements doubtless affect contractor performance and performance assessment. As discussed, relational contracts have the potential to reduce management costs and may lead to fewer performance problems (Bertelli and Smith, 2020; Brunjes, 2020, 2022), yet they also may limit future competition by creating knowledge-based asset specificity that will scare off other vendors or create connections that justify sole souring. How do political influence and relationships affect vendor performance?

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CONCLUSION Public procurement and contracting are important functions in government agencies. Private-sector partners are now engaged in nearly every aspect of public management and public finance, providing subject matter expertise, consulting services, program implementation, and key supplies and support. The US federal government spends approximately 40 percent of its annual discretionary budget on contracts, and across all tiers of government in the US, contractors receive more than $2 trillion in public spending, approximately 10 percent of the total GDP (FPDS-NG, 2020). Contracting out is not only big business but an essential part of modern governance. Over the past four decades, public-sector scholars have built a strong foundation of studies on public procurement and government contracts. In a variety of settings, these scholars have explored both descriptive and normative research about what is and should be purchased from private partners. Along the way, transaction cost economics and agency theory have provided most of the undergirding theory. We have summarized many of their findings and identified four areas where additional research is necessary: ● Strategic procurement and contract design: the linkage between procurement planning and outcomes for both the organization and the individual contract. ● Solicitation and discretion: the mechanics of translating the strategy and requirements into a signed contract, including design and the application of administrative expertise. ● Contract management: overseeing the contractor during the period of performance, including motivating work and applying rules, incentives, sanctions, and options. ● Performance measurement: assessing the outputs and outcomes of associated contracts as well as the effect of contracting on public organizations and their procurement processes. For each of these areas of research, we have posed a series of research questions to help guide future scholarship. After nearly four decades of studying public sector contracting, it is clear that much work remains to be done to understand how to manage contractors and their effects on government performance. As the field moves from attempting to understand when it is appropriate to contract out to how to effectively manage vendors, improving our understanding of strategy, market interaction, management, and performance is critical. Future scholars confront a subfield that needs rigorous, empirical study grounded in leading theories, but that also continues to pursue practically relevant topics. Here, we have attempted to bridge that gap, offering practically oriented questions rooted in prominent procurement and contracting theories. Each of these areas is fertile ground that will likely be the focal point of contracting scholarship over the next decade or more, generating findings that will be critical for our understanding of modern governance and the management of cross-sectoral partnerships in the twenty-first century.

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Future directions for research in public procurement and contract management  365 Rainey, H. G. (2009). Understanding and Managing Public Organizations. Hoboken, NJ: John Wiley & Sons. Rainey, H. G. and Bozeman, B. (2000). Comparing public and private organizations: Empirical research and the power of the a priori. Journal of Public Administration Research and Theory, 10(2), 447–470. Raisbeck, P., Duffield, C., and Xu, M. (2010). Comparative performance of PPPs and traditional procurement in Australia. Construction Management and Economics, 28(4), 345–359. Reed, T. S., Bowman, D. E., and Knipper, M. E. (2005). The challenge of bringing industry best practices to public procurement: Strategic sourcing and commodity councils. In K. V. Thai (ed.), Challenges in Public Procurement: An International Perspective (pp. 271–289). Boca Raton, FL: PrAcademics Press. Reeves, E. (2008). The practice of contracting in public private partnerships: Transaction costs and relational contracting in the Irish schools sector. Public Administration, 86(4), 969–986. Rehfuss, J. (1989). Contracting Out in Government: A Guide to Working with Outside Contractors to Supply Public Services. San Francisco: Jossey-Bass. Reis, P. R. and Cabral, S. (2015). Public procurement strategy: The impacts of a preference programme for small and micro businesses. Public Money & Management, 35(2), 103–110. Rendon, R. G. (2005). Commodity sourcing strategies: Processes, best practices, and defense initiatives. Journal of Contract Management, 3(1), 7–20 Rendon, R. G. and Snider, K. F. (2019). Management of Defense Acquisition Projects. Reston, VA: American Institute of Aeronautics and Astronautics. Resh, W. G. and Marvel, J. D. (2012). Loopholes to load-shed: Contract management capacity, representative bureaucracy, and goal displacement in federal procurement decisions. International Public Management Journal, 15(4), 525–547. Ribeiro, C. G., Inácio, E., Raun, A. T., and Li, Y. (2018). Unveiling the public procurement market in Brazil: A methodological tool to measure its size and potential. Development Policy Review, 36, O360–O377. Rice, M. F. (1992). Justifying state and local government set-aside programs through disparity studies in the post-Croson era. Public Administration Review, 52(5), 482–490. Riles, S. (2014). Understanding reverse privatization in US local governments. PhD dissertation, University of Georgia. Romzek, B. S. and Johnston, J. M. (2002). Effective contract implementation and management: A preliminary model. Journal of Public Administration Research and Theory, 12(3), 423–453. Romzek, B. S. and Johnston, J. M. (2005). State social services contracting: Exploring the determinants of effective contract accountability. Public Administration Review, 65(4), 436–449. Rosenbloom, D. H. and Piotrowski, S. J. (2005). Outsourcing the constitution and administrative law norms. The American Review of Public Administration, 35(2), 103–121. Rullan, S., Saucedo, E., and Bacaria, J. (2012). Public procurement for innovation: Challenges and prospects for Latin America. 2012 International Symposium on Management of Technology (ISMOT) (pp. 599–601). IEEE. Sadiq, A. A. and Kessa, R. (2020). US procurement in the age of COVID-19: Challenges, intergovernmental collaboration, and recommendations for improvement. The American Review of Public Administration, 50(6–7), 635–641. Savas, E. S. (1977). An empirical study of competition in municipal service delivery. Public Administration Review, 37(6), 717–724. Schapper, P. R. and Malta, J. N. V. (2011). Public Procurement Reform in Latin America and the Caribbean. Washington, DC: World Bank. Schapper, P. R., Malta, J. N. V., and Gilbert, D. L. (2006). An analytical framework for the management and reform of public procurement. Journal of Public Procurement, 6(1). Schepker, D. J., Oh, W. Y., Martynov, A., and Poppo, L. (2014). The many futures of contracts: Moving beyond structure and safeguarding to coordination and adaptation. Journal of Management, 40(1), 193–225. Smith, C. R. and Fernandez, S. (2010). Equity in federal contracting: Examining the link between minority representation and federal procurement decisions. Public Administration Review, 70(1), 87–96. Snider, K. F. and Rendon, R. G. (2008). Public procurement policy: Implications for theory and practice. Journal of Public Procurement, 8(3), 310–333.

366  Research handbook on public financial management Tadelis, S. (2002). Complexity, flexibility, and the make-or-buy decision. American Economic Review, 92(2), 433–437. Talluri, S. and Narasimhan, R. (2004). A methodology for strategic sourcing. European Journal of Operational Research, 154(1), 236–250. Taponen, S. and Kauppi, K. (2020). Service outsourcing decisions: A process framework. Journal of Global Operations and Strategic Sourcing, 13(2), 171–194. Ter Bogt, H. (2018). NPM’s “ideals” about the accountability and control of outsourced activities: Tough, but realizable, or a utopian dream? European Policy Analysis, 4(1), 118–145. Terman, J. (2013). Evaluating political signals: The nature of bureaucratic response in minority preference purchasing. American Review of Public Administration, 44(5), 522–549. Terry, L. D. (2005). The thinning of administrative institutions in the hollow state. Administration & Society, 37(4), 426–444. Thai, K. V. (2017). International public procurement: Concepts and practices. In K. V. Thai (ed.), International Handbook of Public Procurement (pp. 1–24). New York: Routledge. Thai, K. V. (2001). Public procurement re-examined. Journal of Public Procurement, 1(1), 9–50. Thai, K. V. and Grimm, R. (2000). Government procurement: Past and current developments. Journal of Public Budgeting, Accounting & Financial Management, 12(2), 231–247. Thai, K. V. and Piga, G. (2007). Advancing Public Procurement: Practices, Innovation and Knowledge Sharing. Boca Raton, FL: PrAcademics Press. Trammell, E., Abutabenjeh, S., and Dimand, A. M. (2020). A review of public administration research: Where does public procurement fit in? International Journal of Public Administration, 43(8), 655–667. van den Bekerom, P., van der Voet, J., and Christensen, J. (2021). Are citizens more negative about failing service delivery by public than private organizations? Evidence from a large-scale survey experiment. Journal of Public Administration Research and Theory, 31(1), 128–149. Van Slyke, D. M. (2003). The mythology of privatization in contracting for social services. Public Administration Review, 63(3), 296–315. Van Slyke, D. M. (2007). Agents or stewards: Using theory to understand the government-nonprofit social service contracting relationship. Journal of Public Administration Research and Theory, 17(2), 157–187. Van Weele, A. J. (2010). Value creation and purchasing strategy. International Trade Forum, no. 4. International Trade Centre. Van Weele, A. J. and Van Raaij, E. M. (2014). The future of purchasing and supply management research: About relevance and rigor. Journal of Supply Chain Management, 50(1), 56–72. Vitasek, K. (2016). Strategic sourcing business models. Strategic Outsourcing: An International Journal, 9(2), 126–138. Von Deimling, C., Essig, M., Schaupp, M., Amann, M., and Vafai, S. (2016). Life-cycle cost-management as an instrument for strategic public procurement: State of the art and perspectives. 25th Annual IPSERA Conference, Dortmund. Germany (vol. 2, no. 2964.3922). Wang, C. and Li, X. (2014). Centralizing public procurement in China: Task environment and organizational structure. Public Management Review, 16(6), 900–921. Warner, M. E. (2013). Private finance for public goods: Social impact bonds. Journal of Economic Policy Reform, 16(4), 303–319. Warner, M. E., Aldag, A. M., and Kim, Y. (2021). Privatization and intermunicipal cooperation in US local government services: Balancing fiscal stress, need and political interests. Public Management Review, 23(9), 1359–1376. Warner, M. E. and Hefetz, A. (2002). Applying market solutions to public services: An assessment of efficiency, equity, and voice. Urban Affairs Review, 38(1), 70–89. Warner, M. E. and Hefetz, A. (2012). Insourcing and outsourcing: The dynamics of privatization among US municipalities 2002–2007. Journal of the American Planning Association, 78(3), 313–327. Waterman, R. W. and Meier, K. J. (1998). Principal-agent models: An expansion? Journal of Public Administration Research and Theory, 8(2), 173–202. Williamson, O. E. (1981). The economics of organization: The transaction cost approach. American Journal of Sociology, 87(3), 548–577.

Future directions for research in public procurement and contract management  367 Witesman, E. M. and Fernandez, S. (2013). Government contracts with private organizations: Are there differences between nonprofits and for-profits? Nonprofit and Voluntary Sector Quarterly, 42(4), 689–715. Yagoob, A. and Zuo, T. (2015). Application of strategic sourcing practice in public and private sectors: Literature review. European Journal of Business and Management, 7(24), 40–51. Yang, K., Hsieh, J. Y., and Li, T. S. (2009). Contracting capacity and perceived contracting performance: Nonlinear effects and the role of time. Public Administration Review, 69(4), 681–696. Your Europe (n.d.). Public Tendering Rules. https://​europa​.eu/​youreurope/​business/​selling​-in​-eu/​public​ -contracts/​public​-tendering​-rules/​index​_en​.htm​#shortcut​-0.

PART VIII A PATHWAY FOR MANAGING PUBLIC FINANCES IN THE YEARS AHEAD

20. Great ideas in behavioral public financial management Kenneth A. Kriz

BACKGROUND One might be excused for looking at the title of this chapter and wondering why anyone would focus on behavioral public finance. Part of the question would likely come down to the impression that all public finance research is behavioral. And there is certainly evidence that would support this thought. As a large portion of public finance research examines decisions in budgets, taxes, debt, and other domains, one could reasonably argue that public finance is inherently behavioral. But that is somewhat beside the point. The modern study of behavioral public finance is explicitly behavioral, analyzing behaviors of individuals and groups. Prior study in public finance was implicitly behavioral, with an underlying framework that forms the basis of the research. Once results were obtained in the earlier form of research, typically from aggregated data, the behavioral implications were assumed. However, the “new wave” of behavioral research has more explicitly modeled and tested for individual-level behaviors. An important point of departure for any behavioral study is its definition of behavioral. There is a literature in behavioral public administration that defines a behavioral study as one that involves micro-level analysis of individual level behavior and attitudes (Grimmelikhuijsen et al., 2017). Recently, Espinosa et al. (2021) applied a similar definition to define behavioral studies in public finance. While there are other definitions that focus more on experimental studies (see, e.g., Mohr and Kearney, 2021), we choose to use the broader definition in this chapter. Behavioral research in public finance started as an outgrowth in research on behavioral economics and finance, popularized by the work of scholars who questioned the assumptions underlying traditional economic and financial models. As popularized in the aptly titled The Undoing Project (Lewis, 2017), the scholars – who borrowed and adapted theories from psychology and social psychology – sought to better understand the behavioral underpinnings of economic theories. But in doing so, they created newer and more well-grounded behavioral theories and models. Our goal in this chapter is to trace the intellectual development of the field of Behavioral Public Finance and to give concrete examples of its application to select research questions. The intent is not to give a comprehensive listing of behavioral public finance papers, as we will see later this would be an immense task. And there are other papers that have examined the current literature at the time that this chapter was written (see, e.g., Mohr and Kearney, 2021; Alm and Bordeaux, 2013).

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TRADITIONAL MODELS IN ECONOMICS, FINANCE, AND PUBLIC FINANCE Traditional models in economics and finance developed out of the classical school of economics. The classical school, developed in part by economists and moral philosophers such as Adam Smith, Jeremy Bentham, David Ricardo, John Stuart Mill, and Jean-Baptiste Say, was one of the most fundamental pieces of human philosophy ever developed. Up to Smith’s time, governments were mostly monarchic, and individuals were seen as vassals of an all-powerful and encompassing state. The classical economists developed models and philosophies that put individuals at the center of social life. They did so by emphasizing economic decisions that actors such as consumers and producers made in daily life. Adam Smith’s “pin factory” as a model demonstrated how individuals and organizations, acting in their own best interests, could produce output that served customers and provided jobs for workers and profits for business owners. Through emphasizing the pre-eminent role that individuals play in market economies, the development of classical economics allowed for nations to move away from feudalism and toward capitalist market economies. The models of the classical economists were almost always based on a mechanistic kind of rational behavior. Consider one of Ricardo’s most famous models, Ricardian equivalence. The model is built to answer a question appropriate to the study of public finance, namely whether tax increases or debt issuance would be preferable as a way to finance spending increases (the particular issue Ricardo analyzed was the financing of a war – McCulloch, 1946: 539–540). Ricardo pointed out that taxpayers should be indifferent between tax increases or debt issuance (as long as the interest rate paid on the debt was fixed). They would just adjust their savings upward and consumption downward in response to debt issuance, essentially taxing themselves by the amount of projected future debt payments. The implicit model of human behavior that Ricardo employs is mechanistically rational, with taxpayers using proper intertemporal optimization to assess the future cost of debt service. Perhaps interestingly, Ricardo himself did not necessarily believe in this; he adds a little noticed caveat at the end of his example: “but the people who pay the taxes never so estimate them, and therefore do not manage their private affairs accordingly” (McCulloch, 1946: 540). The classical economists concerned themselves with the “Theory of Value,” in other words how a good or service obtained its value in the marketplace. Some theories sought to place emphasis on value coming from costs of production or from the value of labor used to produce it (Karl Marx’s theories derived from this school of thought). But in the latter half of the nineteenth century, a new school of thought on value emerged. The “Neoclassical” school of economics sought to model value as the sum of economic decisions made by individuals regarding the value of products. The “Marginalist Revolution” started by William Stanley Jevons, Leon Walras, and F. Y. Edgeworth, emphasized the subjective notion of utility in individual decision-making. Jevons’ equimarginal principle led the way, modeling consumption decisions made by individuals equating the marginal utility of consumption for two different goods to their relative prices (Jevons, 1888: 60). Once again, the notion of individual decision-making is based implicitly on an individual acting with perfect knowledge, and exercising deliberative rational thought over her decisions. The sum of work in the classical and neoclassical tradition produced the concept of “homo economicus” – economic man – an individual acting rationally in the pursuit of acquisition of wealth (the phrase actually was coined by a critic of one of classical economics’ leading lights – John Stuart Mill).

Great ideas in behavioral public financial management  371 Importantly for the evolution of economic thought were the models of how individuals dealt with uncertain aspects of consumption and production decisions. Not surprisingly, the models in the early literature relied heavily on assumptions of perfect information and mechanistic rationality. An example of this is in Jevons (1888: 35–36) where he lays out the notion that the effect of uncertainty on utility should be to weight outcomes and associated utility according to the probabilities of outcomes. This formulation was eventually taken to its completion by Von Neumann and Morgenstern (1953: 17–20), who as part of their development of utility axioms set forth that rational individuals should use objective probabilities in determining utilities likely to be achieved from certain negotiations or decisions in economic games.

CHALLENGES TO TRADITIONAL THEORY: THE ROOTS OF BEHAVIORAL ECONOMICS AND FINANCE Paradoxes Even as traditional theories of utility, individual economic and financial behavior, and the implications of these theories were being built, researchers were aware that the theory posed challenges in application. In his seminal piece that laid out the concept of utility as the basis for economic decisions, Bernoulli (1954) also presented what has come to be known as the “St. Petersburg Paradox.” In setting forth the fundamental tenets of utility, Bernoulli presaged Jevons and others by over 100 years in stating that individuals make decisions about the desirability of a good or service in a situation of uncertainty in relation to their beliefs of the probability of outcomes from the good or service. However, he points out a situation, suggested to him by his cousin Nicholas Bernoulli. Let us say that one person, Peter, tosses a (fair) coin and does so until it lands heads up. He agrees to give another person, Paul, one dollar if the coin lands heads up on the first throw, two dollars if on the second, four if on the third toss, eight if on the fourth, and so forth. The question is how much should Paul be willing to pay to play this game? Mathematically, the answer is an infinite amount, as the probability of the game surviving until the next flip falls by one half with each flip of the die and approaches but never becomes zero while the payoff for the next consecutive flip rises exponentially. However, as Bernoulli notes, very few even hard-core gamblers would wager $20 on this game.1 The reason for this is that Bernoulli understood that humans do not act as automatons, calculating strictly the odds and applying them without emotion to outcomes. Instead, we as humans tend to assign a probability of zero to outcomes with very low probabilities. Since humans edit the odds of low probability outcomes to zero, this induces a type of bias against taking risks with very high payoffs but low probabilities, inducing behavior in contrast to what Jevons or Von-Neumann Morgenstern would predict. This also explains why many weather forecasters report angry messages from viewers after forecasting a low probability of rain (say 10 percent) only to see that outcome happen. Another paradox, discovered much later, is due to Allais (1953). His paradox centers on one of the tenets of Von Neumann-Morgenstern (VNM) utility theory (Von Neumann and Morgenstern, 1953), the concept of the continuity of preferences over lotteries. What this means is that under VNM and other traditional expositions of utility, the structure of the choices that one faces should not influence the decisions that they make. This is sometimes

372  Research handbook on public financial management also called the independence property of utility under uncertainty. What Allais discovered was that in fact the structure of choices did influence what individuals preferred. He did this through offering sets of choices that differed in their presentation but when analyzed thoroughly had common elements. He asked people to first evaluate and choose from two uncertain choices: (a) a 100 percent chance of 100 million francs; or (b) an 89 percent chance of 100 million francs, a 1 percent chance of nothing, and a 10 percent chance of 500 million francs. He then presented them with two more uncertain choices and asked them to evaluate and choose: (c) an 89 percent chance of nothing and an 11 percent chance of 100 million francs; or (d) a 90 percent chance of nothing and a 10 percent chance of 500 million francs. Overwhelmingly, people presented with these two sets of choices preferred (a) and (d). But that is inconsistent. Choosing option (a) over (b) implies that an individual is risk-averse, choosing the 100 million francs with certainty over a gamble with an expected payoff of 139 million francs. But choosing option (d) over (c) implies that an individual is risk-seeking in that they choose a gamble with a higher expected payoff even with (slightly) greater uncertainty. The implication of the Allais paradox is that the framing of choices has an effect on what individuals choose. We will return to this point shortly. Studies of Individual Behavior Until the post-Second World War era, much of economics was consumed with either the development of theories of economic behavior or with studies of aggregate economic behavior. Studies of average outcomes or trends in decisions and outcomes were the predominant form of economic inquiry. This started to change in the immediate aftermath of the war as researchers began to unpack decisions made during the run-up to the Great Depression and Second World War and decisions made during those periods. At research institutions such as the Carnegie Institute of Technology (now Carnegie-Mellon University), Oxford University, and the University of Michigan, the focus began to turn to the intersection of psychology and economics. At Carnegie-Mellon, the charge was led by Herbert Simon. A polyglot with interests in public administration, economics, and decision theory, Simon unpacked administrative theory to examine individual behaviors and decision-making. In his seminal book Administrative Behavior, he lays out the model of rational decision-making that was seen to govern decisions made in administrative organizations, then breaks apart the assumptions underpinning the theory. He lays out three main points of departure with the rational model in citing how actual observed behavior differs from the mechanistically rational standard: (1) Rationality requires a complete knowledge and anticipation of the consequences that will follow on each choice. In fact, knowledge of consequences is always fragmentary. (2) Since these consequences lie in the future, imagination must supply the lack of experienced feeling in attaching value to them. But values can be only imperfectly anticipated. (3) Rationality requires a choice among all possible behaviors. In actual behavior, only a very few of all these possible alternatives come to mind. (Simon, 1997: 93–94)

Many writers summarize Simon’s contribution in the familiar term “bounded rationality” and focus on the third observation. But for economic and financial theory the first two are as powerful. Referencing the Jevons-VNM formulation of decision-making under uncertainty, weighing the probabilities and outcomes, Simon’s first limitation implies that probabilities are

Great ideas in behavioral public financial management  373 difficult to arrive at, his second limitation implies that outcomes only known imperfectly, and the third limitation implies that not all outcomes are considered because they are difficult to see. So beyond a simple notion that individuals are limited in their ability to see options, Simon’s work represents a complete repudiation of Jevons-VNM utility determination. Instead, Simon goes on to talk about the role of social psychological and cognitive factors in decision-making, things like docility, memory, habit, positive stimuli, and behavior persistence. Simon’s work can be juxtaposed with the growth of the “Chicago School” of economics that was also developing during the post-Second World War period. The Chicago School economists included Milton Friedman, Friedrich von Hayek, and especially Gary Becker. Though the writings of the Chicago School economists addressed individual behavior, they were almost exclusively neoclassical, rooted in Jevons-VNM formulations of utility. The “behavior” portrayed in their writings is almost entirely mechanistic, even while giving lip service to other motivations. Less well-known than Simon, George Katona’s work at the University of Michigan nonetheless had significant influence on the development of behavioral economics (or as he called it psychological economics). Katona also pleaded for the study of individual behavior more than economic aggregates because while those aggregates could reveal aggregate outcomes, they could not reveal how the outcomes were attained. For example, if an economic aggregate revealed that the national savings rate decreased in a given year, it was not clear whether that resulted from the decisions of many households to decrease their savings a little or from a few households saving much less (Katona, 1947: 450). Katona goes on to describe the economics that has come before as “economics without psychology,” in other words without explicitly modeling and testing the behavioral element of economic explanations for an observed phenomenon. He attributes this lack of strong behavioral elements as coming both from a lack of interest among economists but also from a limited view of psychology that had prevailed prior to his era. Katona advocated strongly for the application of psychological theories and methods in studying economic phenomena. He cited many ways this could be done, including: 1. Use of theories of human behavior imported from areas of psychological research. 2. Use of case studies of individual behavior. 3. The use of survey research methods in economic analysis. In a later study that illustrated the use of the psychological method in economics, Katona and his colleagues asked individuals that had seen their incomes increase during periods of high inflation whether they felt better off and more accomplished, and whether they thought that their future expectations for income growth were high. Sixty percent of respondents answered yes to these questions, showing a profound confusion between money income and real income. People were failing to see through the veil of inflation, as traditional economic theory would propose (Katona, 1974). Heuristics and Biases The next big development in behavioral economics was due to a pair of psychologists. In a pair of papers separated by five years, Daniel Kahneman and Amos Tversky sketched out a theory based on a decade of research into cognitive biases that people show in their decision-making (Kahneman and Tversky, 1979; Tversky and Kahneman, 1974). They called this theory

374  Research handbook on public financial management “Prospect Theory,” perhaps because much of their work was about how people evaluate risky prospects (in an interview one of the authors is purported to have said that the term was meaningless but sounded good). Prior to this, the two researchers had carried out several studies of individual behavior, testing hypotheses of behaviors that were predicted by models based on “rational” decision-making principles. They found systematic deviations from their hypothesized behaviors. For example, in one of their first studies together they tested whether individuals demonstrated “representativeness bias” by asking a group of students the following question: There are two programs in a high school. Boys are a majority (65%) in program A, and a minority (45%) in program B. There is an equal number of classes in each of the two programs. You enter a class at random, and observe that 55% of the students are boys. What is your best guess – does the class belong to program A or to program B? (Kahneman and Tversky, 1972)

The correct answer is program B, because while the point estimate of each class’s gender composition is equidistant from the observed value, the variance for program B is slightly greater than that of program A, making it more likely that the observed value falls into the confidence interval for the program’s gender composition. However, by an overwhelming margin, the students chose program A. Kahneman and Tversky reasoned that the students were acting on their representative bias in choosing A because in both program A and the random classroom, the majority of students were boys. This violates a fundamental assumption of rational decision-making, namely that only relevant information should be used to make a decision and it should be made without reference to a particular piece of information. In their theoretical works, Kahneman and Tversky postulated that biases were built out of a two-stage process of cognition. In previous models, individuals were seen to perceive a situation or proposition and immediately solve it. This may work with very simple problems, but with more difficult ones, where there were significant uncertainties with outcomes or probabilities, or there was little time for reasoning, individuals were theorized to approach a decision in two steps. In the first, editing of the situation or prospect takes place. The purpose of this step is to simplify the decision by editing out non-essential information or by focusing on the most pertinent facts. Then in the second stage, evaluation, the edited situation or prospects are evaluated, and a decision is reached (Kahneman and Tversky, 1979: 274). We note here how this formulation mirrors Simon’s bounded rationality concepts. Individuals faced a high cognitive load in making some decisions, and they engage in editing to simplify them. Some of the editing tools Kahneman and Tversky discussed were: 1. Coding of each outcome’s gains or losses to a specific reference point, as opposed to the prediction of rational models that the evaluation of outcomes is done with respect to the gain or loss in overall utility. 2. Combination of probabilities associated with identical or similar outcomes, so a prospect of a $200 gain with 0.25 probability (($200, 0.25) using the usual notation) and a $200 gain with 0.25 probability ($200, 0.25) will be combined to a $200 gain with 0.5 probability ($200, 0.5). 3. Segregation of riskless or certain components, so a ($500, 0.2) prospect and a ($700, 0.8) prospect can be simplified into a certain gain of $500 and a ($200, 0.8) prospect. 4. Cancellation, where decisions are isolated if part of a multi-stage decision process and common outcome-probability pairs are discarded (a (300, .20; 200, .50; -50, .30) and (300,

Great ideas in behavioral public financial management  375 .20; 250, .50; -100, .30) can be reduced by cancellation to a choice between (200, .50; -50, .30) and (250, .50; -100, .30). 5. Simplification, which involves rounding outcomes or probabilities to more familiar values, so a ($127, 0.47) prospect would be evaluated as ($125, 0.5). An important corollary of this is reflected in the St. Petersburg paradox, the rounding of very low probabilities to 0; and 6. The scanning of prospects to detect dominated alternatives. These are then rejected without further evaluation. Kahneman and Tversky go on to say that many cognitive biases are developed because of improper uses of editing. They offer some examples such as the simplification edit eliminating some real differences, which creates intransitivity of preferences (A is preferred to B in one setting but B is preferred to A in others). They then go on to build a model for the evaluation phase of decision-making where the perception of probabilities and outcomes is used in lieu of actual probabilities and outcomes. This suggests that the perception of probabilities and outcomes can be too high or too low compared to a rational assessment of the real values. The combination of editing errors and misperceptions of probabilities or outcome utilities renders expected utility theory (as in VNM utility) only a specific case of a more general class of utility functions. This is what leads to the disconnect between theorized and observed behavior.

EMERGENCE OF BEHAVIORAL ECONOMICS AND FINANCE Behavioral economics took off as a field in the wake of the Kahneman and Tversky formulation of prospect theory. Prospect theory and related psychological principles began to be applied to many domains, from consumer behavior (see, e.g., Thaler and Shefrin, 1981) to business investment decisions (Statman and Caldwell, 1987). The academic study of Business Finance saw a similar growth in behavioral topics. Early work on investor preferences in the 1980s (see, e.g., Shefrin and Statman, 1984) gave way to increasingly sophisticated testing of corporate and investor behavior. Figure 20.1 shows the growth of publications on the topics of behavioral economics and behavioral finance. From a handful of publications during the 1970s and 1980s, the number of papers using behavioral methods and models grew exponentially during the 1990s and 2000s. Over 800 articles were published in 2020 that had keywords of behavioral economics or behavioral finance. The other aspect of the growth of behavioral approaches to economic and financial research is the breadth of topics that have been addressed. The “behavioral revolution” has touched many areas of academic study, changing the theories underpinning them along with the approaches to research design and analysis. Experimental and quasi-experimental methods have been used much more frequently in fields ranging from political science to gerontology and even linguistics and English.

DEVELOPMENT OF BEHAVIORAL PUBLIC FINANCE During the past decade, explicit behavioral approaches and theories have begun to be used more in the field of public finance. As we discussed earlier in the chapter, public finance has

376  Research handbook on public financial management

Source:

Scopus search for articles with keywords “behavioral finance” and “behavioral economics.”

Figure 20.1

Publications on the topics of behavioral economics and behavioral finance, 1972–2020

always been implicitly behavioral. But the approaches have generally been based in traditional rational choice models (VNM) and the research has been done using aggregate data and not explicitly examined individual behavior. Examples of this have been seen in many subfields of public finance, including public budgeting and financial management. Early Strains The earliest work in public finance, public budgeting, and public financial management had a distinctly implicit behavioral flavor. As stated above, Ricardo (McCulloch, 1946) used a distinct model of rational choice, and applied it to questions of public finance. He was but one of a long line of researchers from Adam Smith and David Hume to James Mill and John Stuart Mill who thought about public finances in the context of rational utility maximization. One of the earliest textbooks of public finance contains an implicit model of public budgeting behavior. Bastable (1903), writing about governments as organizations, opens with a discussion of organizational incentives in private enterprise. Then he says: “The state organisation is differently placed. ‘Sinister interests’ exercise a good deal of control on its actions. There are large classes whose aim is to increase, not to reduce, the public expenses. More particularly is this true of those connected with the great spending departments of the state” (Bastable, 1903: 30).

Great ideas in behavioral public financial management  377 The expected-utility framework was a part of many of the models featured in the traditional literature on public finance. Ramsey (1928) used general utility functions to arrive at his principles of optimal taxation. Key (1940) and Lewis (1952), among many others, viewed the budget as essentially an exercise in applied economics, with attendant utility functions. Key did not feel that a social utility function could be determined from individual decisions, but Lewis was more sanguine. Even going all the way back to Willoughby (1918), behavior of public officials was implicitly modeled and used for recommendations about budget structure and presentation. Wildavsky (1964, 1988) was one of the first authors to explicitly examine budgetary behavior within a theoretical lens. His notions of “satisficing” and “incrementalism” reflected his reliance on Simon’s notions of bounded rationality. Budget actors, facing a nearly impossible level of uncertainty and placed in a position where the utility functions of citizens and other stakeholders are only partially observable, were observed to focus on incremental changes from previous budget levels. This was not an optimal decision-making strategy in a VNM sense of the word, but for those caught in the undesirable position of being a budget decision-maker, this was a natural way to reduce informational uncertainty. While other methods of budgetary decision-making were proposed, incrementalism remains to this day one of the best working models of budgetary decision-making. After the work of Wildavsky, studies into budgetary decision-making using behavioral models have languished. While some have sought to explain deviations from incremental behaviors, they have generally used “models” which were neither behavioral nor predictive of individual behavior (see, e.g., Jones et al., 1998). Other studies sought to understand the motivations of budget actors but were not based in a solid theory of behavior (Willoughby and Finn, 1996). However, many other areas of public finance study have seen strong growth in the use of behavioral finance-based models. Public Goods The area that saw the earliest development of behavioral models and adoption of behavioral experiments was in testing the theories of public goods. In one early paper, Marwell and Ames (1979) used experiments to determine whether individuals would “free-ride” as predicted by prevailing theories of public goods. Using high school students as subjects, the authors randomly assigned subjects into large groups or small groups. Each individual made a decision to invest tokens in either an “individual” account or a “group” account. Individual accounts got a set rate of return (a private good). Group accounts split the total amount contributed if above some given threshold, otherwise got 0 (public good). A random selection procedure determined individuals within groups to get a disproportionate return on the public good account. The results showed little support for “free-riding”; a high level of public good participation was observed throughout multiple iterations and manipulations. Overall, the results showed support for Olson’s (1971) hypothesis that public goods are provided when the interest of one group member exceeds the cost of the good. Over the years, the study of public goods behaviors has featured prominently in the academic literature on public finance. Many years after the Marwell and Ames piece, Fischbacher, Gächter and Fehr (2001, FGF) studied the effects of public knowledge in determining public goods behaviors. They used a sample of 44 undergraduate students in Switzerland, separated into four groups. They employed a similar setup as Marwell and Ames in terms of individual

378  Research handbook on public financial management accounts and group accounts, but with the addition of a “contribution table” where participants set their proposed contribution based on the average contribution of others. Then a random selection mechanism was used to determine whether the conditional contribution would hold, and which contribution table would be the payoff. FGF observed mixed results in terms of public goods behaviors. Half of subjects demonstrated “conditional cooperation,” while 30 percent were strictly free-riding, and 14 percent had “hump-shaped” conditional contributions where they appeared to be trying to play the odds with respect to the conditional contribution being selected. One phenomenon that was observed in many papers, including Marwell and Ames and FGF, was that in multiple round experiments participants became less willing to cooperate (pay for the public good) in later rounds. This indicates that as individuals consume public goods, they may learn that they don’t have to pay. One strong mitigating factor in this is the potential role of punishment for non-cooperative behavior such as free-riding. This was examined in a series of papers starting with Fehr and Gächter (2000). They used 240 Swiss undergraduate students randomly selected into groups of four and a similar contribution scheme as FGF. However, they added an opportunity for group members to punish others after it was revealed how much they contributed to the public good. The game was repeated six times but with participants sorted into new groups. The results showed strong levels of punishment for non-cooperative behavior parentheses (what Fehr and Gächter called “altruistic punishment”), correlated with past contribution levels. Further, cooperation increased with prior punishment and expected future punishment. This indicates that punishment can be a strong deterrent for non-cooperative behavior like free-riding. Numerous studies of the role of punishment in securing prosocial behaviors with regard to public goods provision followed. In one particularly interesting study, Herrmann et al. (2008) examined relative levels of altruistic punishment and antisocial punishment (where participants punished those who contributed more to the public good) across different cultures through carrying out the same experiment as Fehr and Gächter in multiple locations throughout the world. They found that in most cultures, prosocial punishment rates greatly exceeded antisocial punishment rates, for example in places like Boston, USA, Melbourne, Australia, and Nottingham, England. However, in some locations such as Minsk, Belarus, Samara, Russia, and Riyadh, Saudi Arabia, rates were more equal. And in two locations, Muscat, Oman and Athens, Greece, rates of antisocial punishment exceeded rates of prosocial punishment. The researchers then regressed the average “expenditure” on prosocial and antisocial behaviors in different locations with answers to questions from the World Values Survey. They found significant effects for many variables, confirming that the effects were likely results of underlying cultural phenomena and differences in the way different cultures approach social versus individual values. Tax Compliance Compliance with paying taxes is another area that received relatively early attention to behavioral elements. Traditional economic models use a basic model where individuals approach a decision whether or not to pay the full amount of tax that they owe as essentially a benefit cost decision. If the benefit of resources “saved” from tax authorities is greater than the potential cost of being audited, convicted of tax evasion, and penalized, then individuals may be more likely to evade taxes.

Great ideas in behavioral public financial management  379 In an early study of this model, Alm et al. (1993) used a sample of undergraduate students in an experimental design. They received an initial endowment of a small amount of money. They were also given information on fixed tax rates, fines and audit probabilities (and in one round information on a public good). Then they were given a randomly assigned “income” and chose how much to disclose in taxes. A randomly assigned audit determination was then made. The results suggested that the basic economic model held in many respects, compliance increased with income and with audit probability. However, two effects were not predicted by the standard model. First compliance increased when the public good was revealed. Second, tax compliance decreased with the tax rate, which is not predicted by the traditional model. In a later study, Alm et al. (1999) used a similar setup, once again working with undergraduate students. However, this time they added rounds where participants could vote on tax rates, fines and audit probabilities. Also, subjects now would share in the pool of taxes being paid, similar to a public goods experiment. The results of this study suggested that compliance decreased when participants first voted to reject a higher audit probability and compliance increased when a stricter audit probability was passed. These results suggest that culture can send a signal regarding the acceptability of tax compliance or evasion that makes it more or less likely. These results, along with numerous others, suggest a role for information in encouraging tax compliance. As with most traditional economic models, the models underpinning tax compliance often take the role of information for granted. But individuals can respond as much to information as they can to incentives. This was the premise for a book that likely took the study of behavioral economics to a new level. The book Nudge, published a few years after the Alm et al. results were obtained, gave examples of how a simple reframing of information could change individual behaviors (Thaler and Sunstein, 2008). Based on the work of two scholars with several years of behavioral research to their credit, the book became a bestseller and even the title itself became a bit of a phenomenon. The concept of a “nudge’’ is the concept of reframing and hopefully altering (for society’s best) a decision through providing an extra piece of information that doesn’t require any new rules or regulations. An example given by the authors concerns a particularly treacherous stretch of Lake Shore Drive in Chicago, where drivers encounter a sharp turn after a long, straight bit of road. In order to turn the corner safely, drivers must slow down dramatically. In the past, many drivers overestimated their ability to maneuver their vehicle through the turn, tried to take it too fast, and ended up crashing. The city of Chicago had tried many different methods to make people slow down, including posting signs for speed, flashing lights, etc. They finally found a very simple but effective solution by adding bright white stripes across the road that were at first widely spaced but then narrowed in their spacing dramatically as the apex of the curve was near. This visual clue, a nudge in the book’s parlance, was enough to help drivers accurately assess the risk of going too fast through the curve. In a similar way, the Behavioral Insights Team, formed in the UK after publication of the Thaler and Sunstein book, found that tax compliance increased for members of various occupations when letters were sent to them indicating that their occupation was being focused on for examinations (audits – Service et al., 2014). The subtle piece of information, which corrected potential underestimation of the likelihood of being audited, led to better tax compliance at a minimal cost.

380  Research handbook on public financial management Tax Salience Whether the salience of taxes affects citizen behavior with regard to taxes is another area that has received much attention to behavioral implications. In an early study of this topic, Simonsen and Robbins (2000) surveyed a random sample of registered voters in Eugene, Oregon. They presented them with different survey questions asking about support for public services, one with tax information and one without. Voters were randomly assigned to receive the different questions. The results suggested that the more salient presentation of tax information greatly reduced support for public services. A larger study of the tax salience is due to Chetty et al. (2009). They performed a field experiment by posting tax-inclusive prices for some personal care products in a supermarket. This is opposed to the normal practice of posting tax-exclusive prices. Statistical comparison with similar goods in the same aisles and similar goods at other stores showed reduced sales for the products with the tax-inclusive price. Another study that showed a large effect of tax price information, though on a different tax, was conducted by Hayashi et al. (2013). They used a sample of 600 University of California–Berkeley students, staff, and alumni. The participants were randomly assigned to receive wage offers for doing a small task. They also received varying information on tax type (flat, progressive, etc. – Experiment 1), tax presentation (wage and tax versus net wage only) and net wage (Experiment 2). They found that tax presentation has a large effect. They also found evidence of “complexity aversion” – where individuals are willing to pay more in taxes to avoid dealing with a complex tax system. Most recently, Nguyen-Hoang and Yinger (2021) extended the concept of tax salience to the property tax (which had until that point not received as much attention in the salience literature). They compare the administrative implementation of different property tax exemption programs in New York state. Taking advantage of a natural experiment where exemption programs were implemented in ways that publicized the tax relief or not (hence effecting the salience for homeowners) and the framing of the relief as a tax reduction or as ordinary income, they find a strong salience effect. Voters demonstrated a higher price-elasticity of demand for high-quality education when they were more aware of the tax relief. The implications of the Nguyen-Hoang and Yinger results are that the design and presentation of tax relief programs were at least as important as the amount in affecting demand for education. Willingness to Pay/Willingness to Accept The willingness to pay for public goods and willingness to accept losing them is an area of rich interest. In some ways this strikes at the heart of the demand for public goods and services. This literature started in the late 1970s with the work of Banford et al. (1980). They used a sample of 80 residents in a community in British Columbia, asking them questions on their support for two services: a pier and postal services. The researchers varied the questions posed to citizens, with one form gauging the citizens willingness to pay for the public service and the other asking about the amount that citizens would have to be compensated to have the public service taken away (willingness to accept). Traditional economic theory suggests that the amount that individuals would be willing to pay to acquire a public good or service should be equal to the amount that they would be willing to accept if they had an existing good or service taken away (the Law of One Price). The researchers found, however, that the required compensation amount was much higher for both services.

Great ideas in behavioral public financial management  381 Later, Kahneman et al. (1990) formalized studies of what they termed the endowment effect – when the marginal rate of substitution between goods changes according to which good an individual perceives is owned by them, meaning that people who hold a good demand more to sell it compared to what they would pay to buy it in the first place – when they studied bargaining in an attempt to test one of the principles of the Coase theorem (Coase, 1960). The Coase theorem predicts that the outcome of a bargaining solution to externalities will be the same no matter who is assigned property rights initially. The authors developed a simple bargaining experiment with students at one of their universities. They found that bargaining failed in the majority of cases, casting doubt on the applicability of Coasian solutions in the real world. Another line of research in the general area willingness to pay/willingness to accept is the effect of different ways of portraying information and how that affects participants’ values. VNM utility functions implicitly assume that individuals process information as a perfectly rational individual would always perceive them. This predicts that there should be little deviation in individuals’ willingness to pay or willingness to accept based upon how the information is presented. However, Prospect Theory reminds us that individuals may edit information in order to reduce the cognitive load of calculating costs and benefits. An early paper in this stream of work is due to Arrington and Jordan (1982). They use a sample of 300 registered voters in the state of North Carolina. The researchers asked questions about support for various public services. The information in the questions was varied randomly for participants, with one group receiving information about the public service and a simple question of support, and the other group receiving information about the public service and a question about whether individuals were willing to pay a certain cost for the service (in per capita terms). The results showed a very low correlation between preference ordering based on the two forms of questions. Cost also had a small but statistically significant effect on support for the public good. The results of these first three studies strongly support the notion that how a question of willingness to pay for public goods or willingness to accept is “framed” can have a significant effect on the outcome of individuals’ actions. Later, researchers focused on whether framing information in various forms could have an effect on individuals’ perceptions. One vein of research looks at whether labeling the financing of public goods as “taxes” or something else can have an effect on willingness to pay. In a series of three studies, Hardisty et al. (2010) examined support for a carbon fee labeled either as an offset or as a tax. They found that respondents (especially those who were Democrats) were more supportive when the cost of regulation was labeled a carbon offset rather than a tax. They also found that the framing of the fee and the order of information presentation affected relative support for the fee. Recently Brunner et al. (2020) added to this literature by conducting a large-scale study that manipulated the framing of questions on a hypothetical property tax referendum (earlier the same authors had found support for tax framing effects in a quasi-experimental research project examining differences in referenda wording between Minnesota and Wisconsin municipalities (Brunner et al., 2018)). They found that the inclusion of tax information reduced support for property tax referenda. They also found that more explicit language about taxes reduced support for referenda even further. Another way that presentation of information may affect willingness to pay for public services is through the unintentional biasing of individuals perception of cost. This was investigated by Kriz (2014), who conducted experiments on two groups, the first being students in master’s degree programs and the second being a national sample of individuals. He manipu-

382  Research handbook on public financial management lated information on the cost of a public program, presenting the total cost of the program, the per capita cost, and the cost broken down into a monthly cost. He then asked participants their perception of the cost they would have to pay for provision of the public good. The results suggest that presenting information as the total cost of the service (and in one study the per capita cost) biased upward the respondents’ perceptions of the cost they would have to bear. This is in keeping with the literature on “anchoring and adjustment” biases, which states that individuals anchor their estimates of difficult to understand quantities to some known piece of information.

CONCLUSION: THE FUTURE OF BEHAVIORAL PUBLIC FINANCE In this chapter we have charted the birth and growth of behavioral public finance as an area of research inquiry within the field of public finance research. We traced its roots from a discontent with the models and predictions of traditional public finance and economics research. We examined several areas where behavioral public finance has had more of an impact. There are numerous other areas that we could have discussed, but we focused on areas with a substantial history of thought. Understanding the behavioral roots of public finance behaviors is essential not only for developing a deeper academic understanding of a substantial area of economic life, but also for developing models of public finance behavior that can guide fiscal policy. To take one area as an example, traditional economic theory would not predict the behavior of municipal bondholders in respect to changes in the fiscal environment such as the financial crisis or COVID pandemic. However, as developed in Kriz and Wang (2016), models of overconfidence and attribution bias (with investors mistaking early signs of financial crisis for something isolated and then facing a cascade of information showing the errors of their judgment) leads to selloffs in municipal securities that over the short-term send interest rates soaring to levels not suggested prior to the moment when the information cascade occurred. If our field is to give policy prescriptions, we need accurate models of behavior. This is the promise of behavioral finance. The future of behavioral public finance is indeed bright. There is ongoing work in a number of areas such as municipal bonds, municipal fiscal health, and tax behaviors. Recent conferences and journals in public administration have featured symposia on behavioral topics and experimental designs. And research laboratories are being developed to look at a logical extension of behavioral work – the neuroscience of public finance (see, e.g., Fennimore and McCue, 2021). Hopefully this area will continue to develop and provide more realistic models of the public finance domain.

NOTE 1.

When I demonstrate this in my classes, the median answer for my students is usually around $5 and surprisingly many students would not pay anything to play.

Great ideas in behavioral public financial management  383

REFERENCES Allais, M. (1953). Le comportement de l’homme rationnel devant le risque: Critique des postulats et axiomes de l’Ecole Americaine. Econometrica, 21(4), 503–546. Alm, J. and Bourdeaux, C. J. (2013). Applying behavioral economics to the public sector. Hacienda Publica Espanola, 206(3), 91–134. Alm, J., Jackson, B. R., and McKee, M. (1993). Fiscal exchange, collective decision institutions, and tax compliance. Journal of Economic Behavior & Organization, 22(3), 285–303. Alm, J., McClelland, G. H., and Schulze, W. D. (1999). Changing the social norm of tax compliance by voting. Kyklos, 52(2), 141–171. Arrington, T. S. and Jordan, D. D. (1982). Willingness to pay per capita costs as a measure of support for urban services. Public Administration Review, 42(2), 168–170. Banford, N. D., Knetsch, J. L., and Mauser, G. A. (1980). Feasibility judgements and alternative measures of benefits and costs. In P. N. Nemetz (ed.), Resource Policy: International Perspectives. The Institute for Research on Public Policy. Bastable, C. F. (1903). Public Finance. London: Macmillan. Bernoulli, D. (1954). Exposition of a new theory on the measurement of risk. Econometrica, 22(1), 23–36. Brunner, E. J., Robbins, M. D., and Simonsen, B. (2018). Information, tax salience, and support for school bond referenda. Public Budgeting & Finance, 38(4), 52–73. Brunner, E. J., Robbins, M. D., and Simonsen, B. (2020). Property tax information and support for school bond referenda: Experimental evidence. Public Administration Review, 81(4). Chetty, R., Looney, A., and Kroft, K. (2009). Salience and taxation: Theory and evidence. The American Economic Review, 99(4), 1145–1177. Coase, R. H. (1960). The problem of social cost. The Journal of Law & Economics, 3, 1–44. Espinosa, S., Kriz, K. A., and Yusuf, W. (2021). Behavioral public finance and budgeting: New approaches to old questions? Public Finance and Management, 20(1), 1–10. Fehr, E. and Gächter, S. (2000). Cooperation and punishment in public goods experiments. The American Economic Review, 90(4), 980–994. Fennimore, A. and McCue, C. (2021). Are public managers wired for risk aversion? Public Finance and Management, 20(1), 88–111. Fischbacher, U., Gächter, S., and Fehr, E. (2001). Are people conditionally cooperative? Evidence from a public goods experiment. Economics Letters, 71(3), 397–404. Grimmelikhuijsen, S., Jilke, S., Olsen, A. L. and Tummers, L. (2017), Behavioral public administration: Combining insights from public administration and psychology. Public Administration Review, 77, 45–56. Hardisty, D. J., Johnson, E. J., and Weber, E. U. (2010). A dirty word or a dirty world? Attribute framing, political affiliation, and query theory. Psychological Science, 21(1), 86–92. Hayashi, A. T., Nakamura, B. K., and Gamage, D. (2013). Experimental evidence of tax salience and the labor–leisure decision: Anchoring, tax aversion, or complexity? Public Finance Review, 41(2), 203–226. Herrmann, B., Thöni, C., and Gächter, S. (2008). Antisocial punishment across societies. Science, 319(5868), 1362–1367. Jevons, W. S. (1888). The Theory of Political Economy (3rd ed.). London: Macmillan and Co. Jones, B. D., Baumgartner, F. R., and True, J. L. (1998). Policy punctuations: U.S. budget authority, 1947–1995. The Journal of Politics, 60(1), 1–33. Kahneman, D., Knetsch, J. L., and Thaler, R. H. (1990). Experimental tests of the endowment effect and the Coase theorem. The Journal of Political Economy, 98(6), 1325–1348. Kahneman, D. and Tversky, A. (1972). Subjective probability: A judgment of representativeness. Cognitive Psychology, 3(3), 430–454. Kahneman, D. and Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263–291. Katona, G. (1947). Contribution of psychological data to economic analysis. Journal of the American Statistical Association, 42(239), 449–459. Katona, G. (1974). Psychology and consumer economics. Journal of Consumer Research, 1(1), 1–8.

384  Research handbook on public financial management Key, V. O. (1940). The lack of a budgetary theory. The American Political Science Review, 34(6), 1137–1144. Kriz, K. A. (2014). Anchoring and adjustment biases and local government referenda language. 107th Annual Conference Proceedings. National Tax Association Annual Conference, Santa Fe, NM. https://​ntanet​.org/​2014/​11/​107th​-annual​-conference​-proceedings​-2014/​. Kriz, K. A. and Wang, Q. (2016). Municipal bond risk premia during the financial crisis: Model and implications. Municipal Finance Journal, 37(2), 29–49. Lewis, M. (2017). The Undoing Project: A Friendship that Changed the World. New York: Allen Lane. Lewis, V. B. (1952). Toward a theory of budgeting. Public Administration Review, 12(1), 42–54. Marwell, G. and Ames, R. E. (1979). Experiments on the provision of public goods. I. Resources, interest, group size, and the free-rider problem. The American Journal of Sociology, 84(6), 1335–1360. McCulloch, J. R. (1946). The Works of David Ricardo, Esq., M.P.: With a Notice of the Life and Writings of the Author. London: John Murray. Mohr, Z. and Kearney, L. (2021). Behavioral-experimental public budgeting and financial management: A review of experimental studies in the field. Public Finance and Management, 20(1), 11–44. Nguyen-Hoang, P. and Yinger, J. (2021). How salience and framing alter the behavioral impacts of property tax relief. Public Finance and Management, 20(2), 112–149. Olson, M. (1971). The Logic of Collective Action; Public Goods and the Theory of Groups. Cambridge, MA: Harvard University Press. Ramsey, F. P. (1928). A mathematical theory of saving. The Economic Journal, 38(152), 543–559. Service, O., Hallsworth, M., Halpern, D., Algate, F., Gallagher, R., Nguyen, S., Ruda, S., and Sanders, M. (2014). EAST: Four Simple Ways to Apply Behavioural Insights. Behavioural Insights Team. https://​www​.bi​.team/​publications/​east​-four​-simple​-ways​-to​-apply​-behavioural​-insights/​. Shefrin, H. M. and Statman, M. (1984). Explaining investor preference for cash dividends. Journal of Financial Economics, 13(2), 253–282. Simon, H. A. (1997). Administrative Behavior: A Study of Decision-Making Processes in Administrative Organizations (4th edition.). New York: Free Press. Simonsen, W. and Robbins, M. D. (2000). The influence of fiscal information on preferences for city services. The Social Science Journal, 37(2), 195–214. Statman, M. and Caldwell, D. (1987). Applying behavioral finance to capital budgeting: Project terminations. Financial Management, 16(4), 7–15. Thaler, R. H. and Shefrin, H. M. (1981). An economic theory of self-control. The Journal of Political Economy, 89(2), 392–406. Thaler, R. H. and Sunstein, C. R. (2008). Nudge: Improving Decisions about Health, Wealth, and Happiness. New Haven: Yale University Press. Tversky, A. and Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131. Von Neumann, J. and Morgenstern, O. (1953). Theory of Games and Economic Behavior. Princeton: Princeton University Press. Wildavsky, A. B. (1964). The Politics of the Budgetary Process. Boston: Little, Brown. Wildavsky, A. B. (1988). The New Politics of the Budgetary Process. Glenview, IL: Scott, Foresman. Willoughby, K. G. and Finn, M. A. (1996). Decision strategies of the legislative budget analyst: Economist or politician? Journal of Public Administration Research & Theory, 6(4), 523–546. Willoughby, W. F. (1918). The budget as an instrument of political reform. Proceedings of the Academy of Political Science in the City of New York, 8(1), 56–63.

21. New insights for managing the public finance aspects of climate-resilient infrastructure systems Can Chen

INTRODUCTION: A CHANGING CLIMATE Climate change is one of the greatest global challenges facing our society. It is defined as “a change of climate which is attributed directly or indirectly to human activity that alters the composition of the global atmosphere and which is in addition to natural climate variability observed over comparable time periods” (United Nations, 1992: 7). Due to the dramatic climate change, natural disasters are becoming more frequent and costly. In the latest sixth global assessment, the Intergovernmental Panel on Climate Change (IPCC) concludes that global temperatures will rise beyond 1.5°C and 2.0°C during the twenty-first century. Moreover, the increased global warming will escalate the frequency and intensity of heat extremes, marine heatwaves, heavy precipitation events, tropical cyclones, agricultural and ecological droughts (IPCC, 2021). In the US, the Fourth National Climate Assessment (2018) contends that “climate change creates new risks and exacerbates existing vulnerabilities in communities across the United States, presenting growing challenges to human health and safety, quality of life, and the rate of economic growth” (US Global Change Research Program, 2018: 25). According to the National Oceanic and Atmospheric Administration (2021), the US has experienced $285 billion weather and climate disasters that have exceeded $1.875 trillion in total damages since 1980 (NOAA, 2021). In 2020, the US had a record-smashing 22 weather and climate disasters that killed at least 262 people and totaled approximately $95 billion damage (NOAA, 2021). Climate change also poses growing challenges for all infrastructure sectors such as transport, water, energy, and telecommunication. For instance, the 2012 Hurricane Sandy-induced flooding restricted travel for over 5 million weekday passengers in the City of New York. As climate change continues to worsen, it is crucial to make local communities more resilient to the changing conditions. Infrastructure is the backbone of building climate resilience. On one side, infrastructure will be affected by the impacts of climate change. On the other side, infrastructure will also play an essential role in building resilience against climate effects. In 2019, the Global Commission on Adaptation highlighted that climate-resilient infrastructure systems are one of the top six areas of investment required to adapt to a climate-uncertain future (The Global Commission on Adaptation, 2019). In November 2021, the US Congress passed the $1.2 trillion bipartisan infrastructure bill – the Infrastructure Investment and Job Act (IIJA). The bill includes a $47 billion investment in climate resilience and aims at helping communities become more resilient to the impact of floods, storms, droughts, wildfires, and hurricanes. The following section defines and categorizes climate-resilient infrastructure projects. 385

386  Research handbook on public financial management

DEFINING CLIMATE-RESILIENT INFRASTRUCTURE SYSTEMS What is a climate-resilient infrastructure system? It is important to define the concepts in the term of climate-resilient infrastructure systems. The Governmental Accounting Standards Board (GASB) views infrastructure assets as “long-lived capital assets that normally are stationary in nature and normally can be preserved for a significantly greater number of years than most capital assets” (GASB, 1999). Examples of infrastructure assets include roads, bridges, tunnels, drainage systems, water and sewer systems, dams, and lighting systems (GASB, 1999). It is worth noting that infrastructure such as transportation, drinking water supply, wastewater treatment, stormwater, and electricity and power infrastructure are all recognized as vulnerable to rising sea levels and climate change (Hines et al., 2022). There are no standard or agreed-upon definitions of resilience. The resilience concept has been applied in a wide range of empirical contexts. Presidential Policy Directive 8 (2011: 6) defines resilience as “the ability to adapt to changing conditions and withstand and rapidly recover from disruption due to emergencies.” The United Nations International Strategy for Disaster Reduction (UNISDR) (2009: 24) refers to resilience as “the ability of a system, community or society exposed to hazards to resist, absorb, accommodate to and recover from the effects of a hazard in a timely and efficient manner, including through the preservation and restoration of its essential basic structures and functions.” Willoughby et al. (2020: 6) define resilience as “the ability of a locality to weather a natural disaster with the least losses in terms of human life, public and private property, and finances.” In sum, resilience generally means the capacity to anticipate, prepare for, withstand, absorb, accommodate to, and recover from disruptions due to emergencies and natural hazards. According to Organisation for Economic Co-operation and Development (OECD), a climate-resilient infrastructure system is planned, designed, constructed, operated, and maintained in a way that anticipates, prepares for, and adapts to changing climate conditions (OECD, 2018: 4). Climate-resilient infrastructure projects differ from traditional infrastructure projects in two key aspects. On one side, they are less affected by the various impacts of climate change. On the other side, they facilitate the rapid recovery from future climate-exacerbated extreme events and rising sea levels (Meyer and Schwarze, 2019).1 In general, there are two types of climate-resilient infrastructure projects (O’Connell and Connors, 2019). The first type is grey infrastructure projects. They are traditionally engineered systems that provide benefits to water, drainage, or transportation systems through built structures (e.g., seawalls, elevated roads, stormwater pipes, shoreline levees, pump stations, tidal gates, and wave attenuation devices). The second type is green (or nature-based) infrastructure projects. They are based on ecological solutions and usually refer to natural or engineered infrastructure projects that mimic natural water cycles to manage stormwater and mitigate flood risk and extreme heat. Green infrastructure projects contain open space preservation, wetland restoration, living shorelines, and green roofs, which provide effective complements or substitutes for traditional built (or grey) infrastructure projects. Table 21.1 illustrates the impacts of climate change on electric power infrastructure and the resilience efforts for electric power infrastructure.

New insights for managing climate-resilient infrastructure systems  387 Table 21.1

Example of electric power infrastructure resilience efforts

Electric power system Generation

Climate impacts on electric power

Resilience efforts for electric power

infrastructure

infrastructure

Inundation of coastal infrastructure such as

Fortify coastal, off-shore and flood-prone

generation plants

infrastructure against flooding

Reduced efficiency of solar energy

Increase cooling system capacity for solar energy

Insufficient cooling water

Locate new facilities outside high-risk zones

Reduced output from hydropower generation Transmission and distribution

Flooding of electricity substations

Adjust design criteria for transmission lines

Damage to transmission lines from climate

Bury distribution lines

extreme

Use stainless steel material to reduce corrosion from water damage

Consumption

Change in energy demand patterns (e.g.,

Improve building and industrial energy

increased demand for cooling and reduced

efficiency

demand for energy for heating)

Source:

OECD (2018: 12).

There are different estimates of the investment needs of climate-resilient infrastructure. The Global Commission on Economy and Climate predicts that under a low-carbon scenario, over $90 trillion needs to be invested worldwide in climate-resilient infrastructure projects by 2030, and 70 percent of this estimate relates to urban areas (Birch and Rodas, 2020). According to the UN Environment Programme (UNEP), the true annual cost of adapting to climate change in developing countries could range between $140 and $300 billion in 2030 and rise to between $280 and $500 billion per year in 2050 (UNEP, 2016).

CLIMATE-RESILIENT INFRASTRUCTURE SYSTEMS: IMPORTANCE AND CHALLENGES The Benefits of Climate-Resilient Infrastructure Systems Infrastructure resilience projects make sound economic sense. The Global Commission on Adaptation (2019) and the World Bank Lifelines report (Hallegatte et al., 2019) both show that the benefits of making existing and new infrastructure more resilient outweigh its costs by a ratio of 4 to 1. A climate-resilient infrastructure system has the following benefits: First, it reduces greenhouse gas emissions, increases resilience to the changing climate, and supports low-carbon and sustainable development. Second, it facilitates rapid recovery from extreme weather events and mitigates the economic and social losses from natural hazards. Based on over 3,000 simulated scenarios, Hallegatte et al. (2019) point out an estimated value of $1.0 trillion in potential losses from climate change will be incurred if the world delays global action on resilience to 2030. Third, it reduces the risk exposure of the infrastructure assets, increases the life of infrastructure assets, and decreases the costs of infrastructure operation, repair, and maintenance. Fourth, it reduces the frequency and severity of disruption and improves the reliability and efficiency of infrastructure service provision. Fifth, a climate-resilient infrastructure system can raise property values (Kiel, 2021). Climate-resilient infrastructure projects protect residential and commercial properties, which

388  Research handbook on public financial management are perceived as safer and have diminished levels of risk exposure to property damage. Davlasheridze and Fan (2019) examine the impact of a large seawall on property values in the wake of Hurricane Ike. Based on residential housing transactions in the City of Galveston, Texas from 2000 to 2014, they find a positive price premium of up to 22 percent for seawall protected homes. Walsh et al. (2019) explore the property price impact of shoreline adaptation structures (e.g., bulkheads, ripraps) in the Chesapeake Bay region (Maryland and Virginia). Their findings reveal that adaptation structures have a significant positive impact on waterfront home prices. Kim (2020) examines the economic benefits of climate change adaptation measures on the housing markets of two representative coastal cities in the US located along the Atlantic Ocean – New York City (NYC) and Miami-Dade County (MDC). Based on a panel data hedonic pricing model and a difference-in-difference model (DID), Kim (2020) finds that single-family home properties in areas proximate to climate-resilient infrastructure projects experienced a housing price appreciation in both NYC and MDC. Finally, credit rating agencies (e.g., Standard & Poor’s and Moody’s) have announced that they will take climate change into account when assessing the credit worthiness of local government entities. A climate-resilient infrastructure system reduces the climate risks of local communities and lowers the interest rates and insurance costs paid by localities. The Challenges of Investing in Climate-Resilient Infrastructure Systems Despite the potential benefits from enhancing infrastructure resilience, there are challenges in investing in climate-resilient infrastructure systems (e.g., Plastrik et al., 2019; Connecticut Governor’s Council on Climate Change, 2021; OECD, 2018). First, climate-resilient infrastructure projects require substantial up-front costs. In the US, state and local governments are getting into trouble managing and maintaining their existing and aging infrastructure assets. They face the challenge of growing fiscal constraints to pursue new climate-resilient infrastructure projects.2 Second, climate change is evolving and complex. The inherent uncertainties in climate change make capital planning and financing for climate-resilient projects more complicated. Third, climate-resilient infrastructure projects often require inter- and intra-jurisdictional coordination across government units. They also involve a variety of actors and stakeholders such as policymakers, planners, investors and the financial sector, industry representatives, designers, engineers, researchers, disaster response professionals, standards developers, beneficiaries, and community members. The collective action challenges and conflicts often arise regarding environmental impact evaluation, funding priorities, and financing mechanisms.

FINANCING CLIMATE-RESILIENT INFRASTRUCTURE SYSTEMS Pay-Go Versus Pay-Use In the US, state and local governments utilize two methods of financing infrastructure (Marlowe et al., 2009; Chen and Bartle, 2022): pay-as-you-go (pay-go) and pay-as-you-use (pay-use). Pay-go financing relies on current revenues (cash or saving) to pay for infrastructure projects. The key strengths of pay-go financing are simple and less expensive. The primary disadvantages of pay-go financing include the need to accumulate sufficient funds,

New insights for managing climate-resilient infrastructure systems  389 placing an excessive burden on current taxpayers, and being unable to finance large-scale infrastructure projects. By contrast, pay-use financing (or debt financing) borrows the money (issuing long-term debt) to pay for infrastructure projects and makes repayments over time. The primary advantage of pay-use financing is the improvement of intergenerational equity by sharing the cost of infrastructure project development with future generations. The main disadvantages of pay-use financing are: (1) the complicated process involving multiple actors, (2) the involvement of transaction costs and interest costs, and (3) the constraints of legal borrowing limits and the need for voter approval. Traditional Financing In the US, traditional financing methods are used by state and local governments to pay for climate-resilient infrastructure projects (Table 21.2). They include general taxes, fees, user charges, intergovernmental grants, and debt financing (general obligation bonds and special revenue bonds). The following section discusses the advantages and limitations of these traditional financing mechanisms. Table 21.2

Traditional methods of financing climate-resilient infrastructure systems

Pay-as-you-go financing

Pay-as-you-use financing

Taxation

Bond financing

General Taxes

General Obligation Bonds

Special Dedicated Taxes

Revenue Bonds

Fees and User Charges

Private Activities Bonds

Intergovernmental Grants and Aid

Leasing-Revenue Bonds

Source: Author.

Taxes Tax revenues are the common funding sources used for funding infrastructure projects by state and local governments. There are two types of taxes. The first type is general taxes. General taxes are broad-based taxes on residents and businesses. General tax revenues, including property taxes, sales taxes, and income taxes, are often used to fund climate-resilient infrastructure projects that yield community-wide benefits. The advantages of using general tax revenues are large tax bases and relatively stable and predictable tax revenues. However, increases in general taxes may be subject to voter approval and may face public resistance. The City of Norfolk, Virginia began its resilience planning in 2013 when it joined the 100 Resilient Cities initiative. This city adopted a real estate tax increase of $.01 per $100 assessed value. This tax (the resilience penny) was dedicated for city resilience efforts. The second type is special taxes, which are more narrowly based taxes. Special tax revenues, including local utility taxes, telecommunication taxes, hotel taxes, and other occupancy taxes, are deposited into a special revenue fund and earmarked for building climate-resilient infrastructure projects. The primary strength of earmarking special tax revenues is protecting infrastructure funding from competition from other uses of these funds. In addition, several special taxes (e.g., local option gas tax, hotel/motel taxes) charge non-residents for the use of local infrastructure. However, the weaknesses of earmarking special tax revenues include the

390  Research handbook on public financial management volatility of special revenue sources (hotel /motel taxes), and the restriction of the flexibility and discretion of fiscal policymakers. User charges and fees User charges refer to the fees paid by residents and businesses for their uses of utilities and other public enterprises such as drinking water, wastewater, solid waste disposal, transit, airport, parking facilities, and others. Infrastructure projects such as stormwater, drinking water, and wastewater are often funded by user charges through an enterprise fund. User-charge financing can recover partial or full costs of the infrastructure development and operation and offer price signals to influence the consumption of infrastructure services. It is politically easier to use user charges to fund revenue-generating infrastructure projects rather than relying on general taxes. However, the disadvantages of user charges are the cost of revenue collection and placing an excessive burden on low-income households and individuals. Here is an example of using user charges to finance infrastructure resilience efforts. Since 2009, the City of Miami Beach, Florida has tripled stormwater fees. In 2014, the stormwater fees were raised 84 percent to cover a $100 million revenue bond to finance climate-resilience infrastructure projects (installation of pumps and elevated roads). Again, in 2016, the stormwater fees were raised 34 percent to cover the second $100 million revenue bond. Currently, the city’s monthly stormwater fees are $22.67. Besides user charges, other possible funding sources for climate-resilient infrastructure projects include exactions, land value capture, land dedications, special assessment, impact fees, and tax incremental financing. Like user charges, these funding sources rely on the benefit principle: those who receive benefits from climate-resilient infrastructure projects should pay for or share the costs of infrastructure resilience efforts. Intergovernmental grants Intergovernmental grants represent a major funding source for state and local infrastructure projects. The federal government administers a wide variety of grants that can be used for funding and financing state and local-sponsored climate-resilient infrastructure projects. For example, the Federal Emergency Management Authority (FEMA) has invested billions of dollars in flood-resilient infrastructure projects through its Hazard Mitigation Assistance (HMA) programs since 2000. The HMA grant funding usually distributes to local areas with the greatest risks of sea-level rise, flooding, and storm surge. Local governments must compete for the HMA grants by demonstrating a need and plan for mitigating the natural hazards. As of 2020, FEMA has awarded over 600 local infrastructure projects for more than $2.5 billion. The National Oceanic and Atmospheric Administration (NOAA) provides the regional coastal resilience grants for coastal infrastructure and ecosystem adaptation. The US Department of Housing and Urban Development (HUD)’s Community Development Block Grant (CDBG) program is also a significant grant funding source for local flood resilient infrastructure. Similar to federal grants, state grants allow local governments to tap into state funding sources to pay for infrastructure projects that improve climate resilience. For instance, the state of Florida provides grants to support local infrastructure resilience efforts to address the impacts of flooding and sea level rise such as the Resilient Florida Grant. Florida counties, municipalities, water management districts, flood control districts and regional resilience entities are eligible to receive this grant to fund projects that are not competitive at the national grant level.

New insights for managing climate-resilient infrastructure systems  391 Federal and state grants have the advantages of sharing the cost of infrastructure projects and enabling state and local governments to fund needed climate-resilient infrastructure projects. However, the disadvantages of intergovernmental grants contain hard restrictions on the use of intergovernmental grants for certain types of infrastructure resilience projects, significant staffing resources, administrative paperwork to apply to federal and state grants, as well as competing for limited grant funding sources. Bond financing In the US, the municipal bond market plays a crucial role in state and local capital financing. State and local governments rely on two general types of bond financing to finance infrastructure projects – General Obligation Bonds (GO Bonds) and Revenue Bonds. GO bonds are the long-term obligations of state and local governments backed by the bond issuer’s full faith and credit. Governments are fully obligated to repay GO bonds from their general tax revenues. GO bonds have a better credit rating and therefore are less costly to bond issuers. Traditionally, GO bonds are issued to finance infrastructure projects that do not yield substantial revenues, such as city halls and buildings, libraries, public safety equipment, fire stations, and jails. GO bonds have been used to finance climate-resilient infrastructure projects. Direct democracy mechanisms (voter initiatives and government referendums) play an important role in approving GO bonds for financing climate-resilient infrastructure projects. For example, in 2017, voters in the City of Miami approved a $400 million general obligation bond (the Miami Forever bond). About half of the bond proceeds were planned to build climate-resilient infrastructure projects that reduce flooding. In 2018, San Francisco voters endorsed a $425 million GO bond to finance its new seawalls for mitigating climate change and seismic risks. In 2021, Rhode Island voters overwhelmingly approved borrowing $74 million for environmental and recreation projects in state government referendum. Among the borrowed money, $7 million is used for municipal resiliency initiatives with the aim of helping cities and towns deal with rising seas and climate change. Revenue bonds are bonds that are typically issued to finance public facilities that have definable users with specific revenue streams (e.g., utilities, toll roads, toll bridges, parking facilities). Different from GO bonds, revenue bonds are not backed by general tax revenues. Instead, they are secured by the pledge of defined revenue sources generated from the bond-funded projects (e.g., user fees, tolls, facility rent). Therefore, revenue bonds have a higher risk than GO bonds due to the uncertainty of project-related revenues. The interest rates for revenue bonds are higher than GO bonds. However, the key advantage of revenue bonds is not subject to constitutional debt limits and may not require a public vote. The following is an example. In 2021, the City of Arlington, Texas issued an $ 8.3 million revenue bond to pay for the infrastructure improvement to enhance the resilience of the city’s municipal drainage systems. Innovative Financing To supplement traditional infrastructure financing approaches, state and local governments are turning to creative ways of financing climate-resilient infrastructure projects. Chen (2016) and Chen and Bartle (2022) define innovative infrastructure finance as an umbrella concept that supplements traditional infrastructure funding sources and financing methods and embraces

392  Research handbook on public financial management any strategy involving new funding sources, new financing mechanisms, and new financial arrangements in the provision of public infrastructure (Table 21.3). Table 21.3

Innovative financing for climate-resilient infrastructure systems

Types of innovative financing

Examples

New funding sources

New taxes: Regional Climate Adaptation Tax New fees: Resilience Fees

New financing mechanisms

New credit assistance tools (TIFIA Loans) New debt financing tools (Green Bonds, Environmental Impact Bonds, Resilience Bonds)

New financial arrangements

Public–Private Partnerships (PPPs) Private and Nonprofit Philanthropic Partners

Source: Author.

New funding sources New funding sources are any new measure that generates additional revenues (new taxes or fees) to pay for climate-resilient infrastructure projects. In response to the growing need for financing climate-resilient infrastructure projects, governments are searching for new revenue sources to fund their infrastructure needs. New taxes can be levied and designated for infrastructure resilience such as a climate adaption tax upon the approval of local voters. For instance, in 2016, San Francisco Bay Area voters approved a unique regional climate adaptation tax (a $12 regionwide parcel tax) for the San Francisco Bay Area. This new tax was expected to generate $500 million over 20 years for funding the infrastructure resilience efforts in this region. Besides new taxes, new fees such as resilience fees are levied to pay for resilient infrastructure updates and initiatives. Resilience fees refer to surcharges imposed on water and sewer usage or tax levies or surcharges on local property owners (Connecticut Governor’s Council on Climate Change, 2021). They are designed based on the degree of protection afforded, for example, by estimating the reduced climate risk of property damage. Resilience fees are used to “recapture” the private benefits of reduced risk and lower insurance costs that flow from infrastructure resilience investment (Connecticut Governor’s Council on Climate Change, 2021). For example, in 2014, the City of Northampton in Massachusetts established a new Stormwater and Flood Control Utility to support stormwater infrastructure resilience. The new utility is supported by a resilience fee, which is a surcharge based on water and sewer usage. There are two main advantages of new funding sources for climate-resilient infrastructure systems: providing a stable revenue source for infrastructure resilience funding and reducing the need and level of borrowing. However, the primary disadvantages are the political opposition to new taxes or fees, the equity concerns for high-risk, low-income neighborhoods, and they may be complex and costly to administer. New financing mechanisms New financing mechanisms refer to new methods of borrowing money in flexible and cost-effective ways to pay for climate-resilient infrastructure projects. They include new credit assistance tools (loans, loan guarantees, and lines of credit) offered by governments and new debt financing tools (green bonds, environmental impact bonds, resilience bonds). The Water

New insights for managing climate-resilient infrastructure systems  393 Infrastructure Finance and Innovation Act of 2014 created a federal credit program administered by US Environmental Protection Agency (EPA). The WIFIA provides federal credit assistance in the forms of direct loans, loan guarantees, and standby lines of credit to finance eligible water and wastewater infrastructure projects. The interest rate is lower compared with the market rate. In addition, total federal assistance may not exceed 80 percent of a project’s eligible costs. In 2021, the US EPA announced a $477 million low-interest WIFIA loan to the Hampton Roads Sanitation District (HRSD). This loan will help build the infrastructure necessary to allow HRSD to close an 80-year-old wastewater treatment plant and replenish groundwater supplies that are threatened by sea-level rise. In the last decade, new types of municipal bonds are tailored specifically to finance infrastructure resilience projects. The first one is green bonds. They are issued to exclusively finance or refinance new or existing eligible “green” projects that have significant environmental benefits such as renewable energy, energy efficiency, sustainable waste management, sustainable forestry and land use, and other projects that mitigate climate change (ICMA, 2021). In 2007, the European Investment Bank issued the first Climate Awareness green bonds. Since then, the green bond market has been expanding rapidly. In the US, Massachusetts issued the first tax-exempt municipal green bond of $99 million in 2017 for environmental infrastructure resilience projects. The main advantages of green bonds include: (1) attracting new capital market investors interested in environmental projects, (2) improving bond issuers’ environmental performance, and (3) enhancing bond issuers’ reputation for environmental sustainability. The main disadvantages of green bonds include (1) additional monitoring and reporting of green projects and (2) a less developed market than traditional municipal bonds. The second type is environmental impact bonds (EIBs). EIBs are an innovative performance-based financing tool that provides up-front capital from private investors for environmental protection projects (Quantified Ventures, 2018). Distinct from municipal bonds, EIBs use a pay-for-success approach that conditions payback to investors based on the performance of environmental projects (see Figure 21.1). In 2016, the Washington DC Water and Sewer Authority issued the first EIB in the US. This EIB was used to finance the construction of green infrastructure to manage stormwater runoff. The main advantages of EIBs include: (1) transferring risk from public sectors to private and nonprofit sectors, (2) harnessing capital, expertise, and reputation from private and nonprofit organizations, and (3) leveraging philanthropic and pro-social motivations among investors. The main disadvantages of EIBs are: (1) the complexity of bond structure, (2) high transaction costs, and (3) hard to measure the long-term environmental outcomes. The third type is resilience bonds. Resilience bonds are a variant of catastrophe bonds that link insurance premiums to resilience projects to monetize avoided losses (e.g., reduction of hurricane insurance costs and claim) via a rebate structure (Vajjhala and Rhodes, 2018). Resilience bonds explicitly incorporate the risk reduction value of a specific resilience project on the expected loss to investors. The construction of a resilient infrastructure project is expected to reduce the risk to investors (risk of losing their invested principal). This will lead to lower premium payments for public sector sponsors. In resilience bonds, the residence rebate (the cost savings from the reduced coupon payments to investors) is distributed to public sector sponsors (Figure 21.2). The main advantages of resilience bonds include (1) attractive to private investors, (2) risk transfer from the public sector to private capital markets, (3) levering private investment in resilient infrastructure, and (4) more affordable than insurance for public sector sponsors. The

394  Research handbook on public financial management main disadvantages of catastrophe bonds and resilience bonds are (1) the complexity of the bond structure, and (2) the high transaction costs.

Source:

Chen and Bartle (2022).

Figure 21.1

Source:

The financial model of Environmental Impact Bonds (EIBs)

Refocuspartners.com (2017).

Figure 21.2

Resilience bond model

New insights for managing climate-resilient infrastructure systems  395 New financial arrangements New financial arrangements involve new partners (the private sector, the nonprofit sector, or the public) in infrastructure financing and project delivery. Public–private partnerships (PPPs) are one salient example of new financial arrangements for financing climate-resilient infrastructure projects. PPPs are contractual arrangements in which governments form partnerships with the private sector to design, finance, build, operate, and maintain infrastructures such as toll roads, water supply facilities, and wastewater treatment plants (US Department of Transportation, 2012). Various types of PPPs exist because each of the five elements of PPPs (design, finance, build, operate, and maintain) can be combined (see Table 21.4). Table 21.4

Types of public–private partnerships (PPPs)

P3 Type

Characteristics

Design-Build (DB)

Design (D) and construction (B) are bundled into one procurement and contract.

Design-Build-Finance (DBF)

Design (D) and construction (B) are bundled into one procurement and contract with financing (F) provided by the contractor.

Design-Build-Maintain (DBM)

Design (D), construction (B), and maintenance (M) are bundled into one procurement and contract.

Design-Build-Finance- Maintain

Design (D), construction (B), and maintenance (M) are bundled into one procurement and

(DBFM)

contract with financing (F) provided by the contractor.

Design-Build-Finance- Operate

Design (D), construction (B), and operations (O) are bundled into one procurement and

(DBFO)

contract with financing provided by the contract.

Design-Build-Finance-

Design (D), construction (B), maintenance (M), and operations (O) are bundled into one

Operate-Maintain (DBFOM)

procurement and contract with financing (F) provided by the contractor. This P3 type is also called a concession.

Source:

Martin (2016).

In 2016, Prince George’s County, Maryland led the nation in the first-ever stormwater community-based PPP. Prince George’s County and the private partner (Corvias) have entered into a 30-year partnership to implement an urban stormwater green infrastructure retrofit program. Under this public-private partnership, Corvias will fund about 30–40 percent of the program costs upfront, construct the projects, and maintain green stormwater infrastructure assets. Under the PPP arrangement, both the short- and long-term risks associated with construction and maintenance are effectively transferred from the county government to the private partner. The White House and US EPA recognize the Prince George’s County stormwater retrofit PPP as among the most innovative in the nation. The main advantages of PPPs include (1) shifting project finance risks and long-term operations and maintenance responsibilities to the private sector, (2) leveraging private capital and tapping private sector expertise, and (3) avoiding more debt issuance and preserving bond capacity. However, the significant disadvantages of PPPs: (1) complicated contracts and complex negotiations, (2) demanding efforts of enforcement and monitoring contracts, and (3) loss of public control and flexibility due to the long-term nature of contracts.

396  Research handbook on public financial management

PUBLIC FINANCIAL MANAGEMENT OF CLIMATE-RESILIENT INFRASTRUCTURE SYSTEMS Public financial management is the core subset of public management that “focuses on generating financial information that can be used to improve decision-making” (Finkler et al., 2020: 2; Kioko et al., 2011). Sound financial management is vital for improving infrastructure resilience for four primary reasons. First, it helps public organizations obtain the financial resources needed to design and build climate-resilient infrastructure projects. Second, it helps public organizations increase the efficiency of operating and managing infrastructure assets. Third, it helps public organizations comply with the regulations and rules of disclosure. Fourth, it assists public organizations in lowering the risk of infrastructure investment. In general, public financial management involves multiple aspects of financial management: capital planning, asset management, debt management, procurement, and financial accounting and reporting. The following section discusses the crucial elements of public financial management of climate-resilient infrastructure systems. Capital Planning Infrastructure projects are lumpy and long-term investments. It is prudent to use the existing long-term capital planning and budgeting to identify and prioritize climate-resilient infrastructure needs, establish project scope and costs, estimate funding and financing sources, and forecast future operating and maintenance costs. In the US, government long-term capital planning is typically conducted by a multi-year Capital Improvement Plan (CIP). A CIP is a blueprint for planning a community’s public capital projects over a multi-year period (five or six years). The CIP is a natural tool for state and local governments to develop a plan to build a climate-resilient infrastructure system. The development of a CIP and capital budget needs to be prepared within a broader context of state and local governments’ visions and strategies of climate resilience and sustainable development. First, state and local governments officials can incorporate the climate risk and environmental resilience from hazard mitigation and environmental protection plans into the CIPs. It is recommended to incorporate climate resilience into the policy framework of CIPs and use the criterion of climate resilience to prioritize and rank new infrastructure projects (Chen and Bartle, 2022). Second, vulnerability assessments in hazard mitigation planning can be included in the feasibility study for capital project analysis. State and local governments can employ scenario planning exercises to evaluate vulnerabilities of infrastructure assets under different climate change scenarios (DeAngelis et al., 2011). Third, climate risk information needs to be regularly updated by government planning authorities to facilitate resilience planning efforts for infrastructure project development. Asset Management Climate-resilient infrastructure assets deliver significant environmental benefits of adapting to the future impact of climate change. Asset management is a critical but often neglected area for state and local governments. In essence, infrastructure asset management is the tool of managing infrastructure assets to minimize the total life-cycle costs of owning and operating these assets while delivering the desired service level (US EPA, 2008). The life cycle of an

New insights for managing climate-resilient infrastructure systems  397 infrastructure asset involves four phases: planning, acquisition, use, and disposal. The life cycle cost of an infrastructure asset is the total of all costs incurred throughout the life cycle. Effective asset management can help state and local governments optimize climate resilience capital investment, achieve efficient and effective management of public infrastructure assets, and ensure future financial sustainability. The core elements of asset management for climate-resilient infrastructure projects consist of making a comprehensive inventory of climate-resilient infrastructure assets, evaluating the condition and performance of climate-resilient infrastructure project portfolios, and developing asset management plans to guide strategic infrastructure investment and maintenance decisions on climate-resilient infrastructure projects (US EPA, 2008; Willoughby et al., 2020). Debt Management State and local governments often borrow money for financing large-scale climate-resilient infrastructure projects. However, given the growing fiscal constraint, gauging whether a government agency can afford to take on new debt – and how much – is a critical element in the financial management of climate-resilient infrastructure systems. As debt financing continues to be an attractive financing option (e.g., green bonds), it has become ever more important for policymakers and public financial managers to evaluate, manage, and monitor climate-resilient infrastructure-related debt. In essence, financing climate-resilient infrastructure projects demands sound debt management practices. First, before the bond issuance, a rigorous policy framework is critical to evaluate the performance of infrastructure projects for the purpose of improving climate resilience (National Academies of Sciences, Engineering, and Medicine, 2021). For instance, before issuing a green bond, the environmental benefits of proposed infrastructure projects should meet the standard principles proposed by the International Capital Market Association (ICMA) – the Green Bond Principles (GBP), the Social Bond Principles, and the Sustainability Bond Principles. Second, it is important to ensure bond proceeds are used exclusively for climate-resilient infrastructure projects. Demonstrating the significant benefits of infrastructure resilience is vital when meeting eligibility requirements. According to the GBP, Green, social, or sustainability bonds must have 100 percent of proceeds dedicated towards green and social projects (ICMA, 2021). Third, developing a bond program for climate-resilient infrastructure projects is helpful to manage refinancing and market risks and lowering debt burdens. Last, it is valuable to incorporate climate risk into the debt affordability analysis and develop sound debt management policies for reducing climate-related financial risk. Procurement Management Public procurement is a critical component of public financial management. It focuses on how public money is spent to purchase goods, services, and capital items (Coe, 2012). Climate resilience should be incorporated into public procurement procedures and approaches. The following section synthesizes good public procurement practices for climate-resilient infrastructure projects. First, integrating climate resilience generally incurs an additional cost for potential bidders to develop their proposals (Vajjhala and Monks, 2018). Government procurement agencies should consider the benefits and values of climate resilience when comparing and evaluating competing bids for infrastructure projects. Second, state and local governments

398  Research handbook on public financial management may adopt a green procurement policy and allow government agencies to consider the impact of environmental and climate change when awarding public contracts and concessions for infrastructure projects. In 2021, the Federal Acquisition Regulatory (FAR) Council amended federal procurement regulations. The new rule requires all federal government agencies to consider a supplier’s greenhouse gas emissions when making procurement decisions and gives preference to bids with a low-carbon component. Third, for infrastructure PPPs, it is important to clarify the allocation of responsibilities regarding climate-related risks during the different phrases of infrastructure project (e.g., planning, construction, operation, and maintenance). Risks should be allocated to the parties which are best able to manage climate-related risks. Last, state and local governments could turn to new types of procurement tools such as Requests for Ideas (RFIs), Challenge-based Procurement, and Performance Contracts to improve infrastructure resilience (Vajjhala and Monks, 2018). All three of these new procurement tools are more open-ended and outcome-oriented than conventional procurement tools such as Requests for Quotations (RFQ) and Requests for Proposals (RFP). Financial Accounting and Reporting Access to good financial information is essential to success in public financial management. Climate change will have significant influences on the standards and requirements of public financial accounting and reporting. First, private investors and lenders will increasingly require information about climate-related investment risks. Financial disclosures provide private investors with vital information on how the reporting government organizations cope with climate-related risks and opportunities. By contrast, inadequate financial disclosures will result in a mispricing of assets and noncompliance with transparency (OECD, 2018). Second, government officials will demand information on the vulnerability of infrastructure assets and the mitigation strategies of infrastructure vulnerability (DeAngelis et al., 2011). Third, infrastructure professionals will require information to manage the risks of climate change and support decisions to strengthen infrastructure resilience. In sum, climate-related risks need to be incorporated into government financial accounting and reporting standards, procedures, and documents. The research points to three suggestions. First, it is valuable to develop a comprehensive financial risk assessment of climate change, including frameworks for assessing organizational vulnerability and adaptive capacity. Second, it is crucial to account for the distribution of costs and benefits across different climate-resilient infrastructure projects. Third, government agencies should incorporate climate-related financial risk into public financial documents (e.g., budgets, financial statements, strategic fiscal planning) to increase transparency and promote accountability on infrastructure adaptation outcomes. State and local governments should follow the Green Bond Principles by the International Capital Markets Association (ICMA) and comply with the market best practices of transparency and disclosure in Green Bond issuances.

New insights for managing climate-resilient infrastructure systems  399

CONCLUSION AND DISCUSSION Infrastructure is the foundation of modern economies and societies. It provides not only critical infrastructure services such as transportation, water, electricity, and communications, but also the means for economic prosperity, health, and public safety. Given the vital importance of infrastructure to our social and economic well-being, it is crucial to make our infrastructure more resilient to the changing climate. Climate-resilient infrastructure systems are planned, designed, constructed, operated, and maintained in a way that anticipates, prepares for, and adapts to changing climate conditions. Investing in resilient infrastructure makes good economic sense as it improves efficiencies and reduces community vulnerabilities. The benefits of investing in climate-resilient infrastructure are substantial. To improve infrastructure resilience, this research concludes with the following strategies. First, it is essential to adopt a systems-approach for infrastructure resilience. Infrastructure is an interconnected system of transportation, communication networks, sewage, water, and electric power. Considering the climate impacts for individual infrastructure asset is necessary but insufficient to ensure that the infrastructure system functions reliably in a changing climate environment. For this reason, a systems-approach for infrastructure resilience requires infrastructure resilience at the project level to be embedded in a climate-resilient infrastructure network system that accounts for the direct and indirect effects of climate change. Second, financing is key to implementing climate infrastructure resilience projects because these investments require substantial up-front costs and generate long-term benefits. Currently, the public funding sources for climate-resilient infrastructure development are constrained. There is a dire need to promote innovative financing instruments that incentivize the efforts of building resilient infrastructure projects and provide efficient risk transfer mechanisms. In addition, developing climate-resilient infrastructure systems involves multiple jurisdictions and stakeholders. A coordinated governance structure and inter-agency coordination are necessary for effective and efficient financing and funding of climate-resilient infrastructure projects. Third, managing the public finance aspects of climate-resilient infrastructure systems is critical to improving infrastructure resilience. Sound financial management practices in capital planning, asset management, debt management, procurement, and financial accounting and reporting are necessary for building climate-resilient infrastructure systems.

NOTES 1. Emerging technological innovations have the potential of improving infrastructure resilience. For instance, smart cities can integrate the latest digital technologies (e.g., artificial intelligence, the Internet of Things, and blockchain) with traditional infrastructure sectors and create smart and sustainable infrastructure systems to support resilient cities (Mody, 2021). 2. There are no academic studies that explore the role of budget constraints such as debt limitations as well as tax and expenditure limitations on funding and financing climate-resilient infrastructure systems. However, there is some empirical evidence to suggest that restrictive fiscal institutions harm the capacity of investing in public infrastructure. For instance, Deller et al. (2013) find that restrictive TELs lead to greater deterioration of state-owned bridge condition. Chen et al. (2019) reveal that fiscal institutions of debt limit and TELs constrain city governments’ capacities to invest in capital assets, particularly for city roads. These studies may imply that state and local governments are fiscally constrained by the imposition of debt limit and TELs. Therefore, the fiscal

400  Research handbook on public financial management rules of TELs and debt limit may limit state and local governments’ fiscal capacity in funding and financing climate-resilient infrastructure projects.

REFERENCES Birch, E. and Rodas, M. (2020). The city climate-resilient infrastructure financing initiative. https://​ penniur​.upenn​.edu/​uploads/​media/​C2IFI​_Brief​.pdf. Chen, C. (2016). Banking on infrastructure: Exploring the fiscal impacts of state infrastructure bank (SIB) loans on leveraging state and local transportation investment. Public Budgeting & Finance, 36(3), 94–113. Chen, C. and Bartle, J. R. (2022). Innovative Infrastructure Finance: A Guide for State and Local Governments. Cham: Palgrave Macmillan. Chen, C., Han, Y., and Frank, H. A. (2019). What drives municipal capital investment? A long-panel data analysis of US central cities. State and Local Government Review, 51(3), 168–178. Coe, C. K. (2012). Procurement. In J. R. Bartle, W. B. Hildreth, and J. Marlowe (eds.), Management Policies in Local Government Finance (pp. 342–360). Washington, DC: International City/County Management Association Press. Connecticut Governor’s Council on Climate Change (2021). Taking action on climate change and building a more resilient Connecticut for all. https://​portal​.ct​.gov/​DEEP/​Climate​-Change/​GC3/​Governors​ -Council​-on​-Climate​-Change. Davlasheridze, M. and Fan, Q. (2019). Valuing seawall protection in the wake of Hurricane Ike. Economics of Disasters and Climate Change, 3(3), 257–279. DeAngelis, J., Briel, H., and Lauer, M. (2011). Planning for infrastructure resilience. American Planning Association. http://​planning​-org​-uploaded​-media​.s3​.amazonaws​.com/​publication/​download​_pdf/​ PAS​-Report​-596​-rev​.pdf. Deller, S. C., Amiel, L. N., Stallmann, J. I., and Maher, C. S. (2013). Do tax and expenditure limits hinder the condition of public infrastructure? The case of the Nation’s system of bridges. Public Works Management & Policy, 18(4), 379–397. Finkler, S. A., Smith, D. L., and Calabrese, T. D. (2020). Financial Management for Public, Health, and Not-for-Profit Organizations. Washington, DC: CQ Press. Governmental Accounting Standards Board (GASB) (1999). Statement No. 34: Basic financial statements and management’s discussion and analysis for state and local governments. Norwalk, CT: GASB. Hallegatte, S., Jun, R., and Rozenberg, J. (2019). Lifelines: The Resilient Infrastructure Opportunity. Washington, DC: World Bank. https://​openknowledge​.worldbank​.org/​handle/​10986/​31805. Hines, R. E., Grandage, A. J., and Willoughby, K. G. (2022). Staying afloat: Planning and managing climate change and sea level rise risk in Florida’s coastal counties. Urban Affairs Review, 58(2), 493–525. Kiel, K. A. (2021). Climate Change Adaptation and Property Values: A Survey of the Literature. Lincoln Institute of Land Policy Working Paper. https://​www​.lincolninst​.edu/​publications/​working​-papers/​ climate​-change​-adaptation​-property​-values. Kim, S. K. (2020). The economic effects of climate change adaptation measures: Evidence from Miami-Dade County and New York City. Sustainability, 12(3), 1097–1116. Kioko, S. N., Marlowe, J., Matkin, D. S., Moody, M., Smith, D. L., and Zhao, Z. J. (2011). Why public financial management matters. Journal of Public Administration Research and Theory, 21(suppl_1): i113–i124. Intergovernmental Panel on Climate Change (IPCC) (2021). The Sixth Assessment Report. https://​www​ .ipcc​.ch/​assessment​-report/​ar6/​. International Capital Market Association (2021). Green bond principles: Voluntary process guidelines for issuing green bonds. https://​www​.icmagroup​.org/​assets/​documents/​Sustainable​-finance/​2021​ -updates/​Green​-Bond​-Principles​-June​-2021–140621​.pdf. Marlowe, J., Rivenbark, W. C., and Vogt, A. J. (2009). Capital Budgeting and Finance: A Guide for Local Governments. Washington, DC: International City/County Management Association Press.

New insights for managing climate-resilient infrastructure systems  401 Martin, L. (2016). Public-private partnerships (P3s): What local government managers need to know. https://​icma​.org/​sites/​default/​files/​18–109​%20Public​-Private​%20Partnerships​-P3s​%20White​ %20Paper​_web​%20FINAL​.pdf. Meyer, P. B. and Schwarze, R. (2019). Financing climate-resilient infrastructure: A political-economy framework. https://​www​.ufz​.de/​export/​data/​global/​221987​_DP​_2019​_1​_Meyer​-Schwarze​.pdf. Mody, R. (2021). How smart city technology improves resilience and sustainability. https://​www​.cio​ .com/​article/​191737/​how​-smart​-city​-technology​-improves​-resilience​-and​-sustainability​.html. National Academies of Sciences, Engineering, and Medicine (2021). Analysis of Green Bond Financing in the Public Transportation Industry. Washington, DC: The National Academies Press. https://​doi​ .org/​10​.17226/​26066. National Oceanic and Atmospheric Administration (2021). 2020 U.S. billion-dollar weather and climate disasters in historical context. https://​www​.climate​.gov/​news​-features/​blogs/​beyond​-data/​2020​-us​ -billion​-dollar​-weather​-and​-climate​-disasters​-historical. O’Connell, L. and Connors, K. (2019). Financing climate resilience: Funding and financing models for building green and resilient infrastructure in Florida. https://​www​.hks​.harvard​.edu/​sites/​default/​files/​ centers/​research​-initiatives/​crisisleadership/​files/​financing​_climate​_resilience​_final​_report​.pdf. OECD (2018). Climate-resilient infrastructure. https://​www​.oecd​.org/​environment/​cc/​policy​ -perspectives​-climate​-resilient​-infrastructure​.pdf. Plastrik, P., Coffee, J., and Cleveland, J. (2019). Playbook 1.0: How cities are paying for climate resilience. https://​abag​.ca​.gov/​sites/​default/​files/​playbook1​.0howcit​iesarepayi​ngforclima​teresilien​ cejuly2019​.pdf. Presidential Policy Directive 8 (2011). National preparedness (PPD-8). https://​www​.fema​.gov/​emergency​ -managers/​national​-preparedness. Quantified Ventures (2018). Sharing risk, rewarding outcomes: The environmental impact bond. https://​ www​.quantifiedventures​.com/​blog/​what​-is​-an​-environmental​-impact​-bond. www​ Refocuspartners.com (2017). A guide for public sector resilience bond sponsorship. https://​ .refocuspartners​.com/​wp​-content/​uploads/​pdf/​RE​.bound​-Program​-Report​-September​-2017​.pdf. The Global Commission on Adaptation (2019). Adapt now: A global call for leadership on climate resilience. https://​gca​.org/​wp​-content/​uploads/​2019/​09/​GlobalCommission​_Report​_FINAL​.pdf. The United Nations International Strategy for Disaster Reduction (UNISDR) (2009). UNISDR terminology on disaster risk reduction. https://​www​.unisdr​.org/​files/​7817​_UNIS​DRTerminol​ogyEnglish​.pdf. United Nations (1992). The United Nations Framework Convention on Climate Change. https://​unfccc​ .int/​files/​essential​_background/​background​_publications​_htmlpdf/​application/​pdf/​conveng​.pdf. United Nations Environment Programme (UNEP) (2016). The Adaption Finance Gap Report. https://​ unepdtu​.org/​wp​-content/​uploads/​2018/​10/​unep​-gap​-report​-2016​-web​-6–6​-2016​.pdf. US Department of Transportation (2012). Risk assessment for public-private partnerships: A primer. https://​www​.fhwa​.dot​.gov/​ipd/​pdfs/​p3/​p3​_risk​_assessment​_primer​_122612​.PDF. US Environmental Protection Agency (2008). Asset management: A best practices guide. https://​nepis​ .epa​.gov/​Exe/​ZyPDF​.cgi/​P1000LP0​.PDF​?Dockey​=​P1000LP0​.PDF. US Global Change Research Program (2018). Impacts, risks, and adaptation in the United States: Fourth National Climate Assessment. https://​nca2018​.globalchange​.gov/​downloads/​NCA4​_2018​ _FullReport​.pdf. Vajjhala, S. and Monks, E. (2018). Better procurement tools can improve urban resilience. https://​www​ .brookings​.edu/​blog/​the​-avenue/​2018/​12/​03/​better​-procurement​-tools​-can​-improve​-urban​-resilience/​. Vajjhala, S. and Rhodes, J. (2018). Resilience bonds: A business-model for resilient infrastructure. Field Actions Science Reports, 18, 58–63. Walsh, P., Griffiths, C., Guignet, D., and Klemick, H. (2019). Adaptation, sea level rise, and property prices in the Chesapeake Bay watershed. Land Economics, 95(1), 19–34. Willoughby, K., Dzigbede, K. D., and Gehl, S. B. (2020). How localities continually adapt enterprise strategies to manage natural disasters. IBM Center for The Business of Government. https://​www​ .​businessof​government​.org/​report/​how​-localities​-continually​-adapt​-enterprise​-strategies​-manage​ -natural​-disasters.

22. Teaching public budgeting and finance to the next generation of scholars Bruce D. McDonald, III

INTRODUCTION The public administration subfield of public budgeting and finance is a broad arena of research that encompasses a variety of focus. This includes research into a government or nonprofit organization’s budget processes (see Calabrese, 2011; Decker, 2021), their accounting practices (Barbera et al., 2020; Coe and Ellis, 1991), and their economic impacts and organizational performance (Bel et al., 2022; Dzigbede and Pathak, 2020; Flink and Molina, 2020). From the researcher’s standpoint, the distinctions between these areas can easily blur as the reality behind the research questions we investigate touch on components from more than one area (Vogel and Hattke, 2022). Research into fiscal health, for instance, can cross from budgeting to accounting as we seek to explain how a government got into a position of fiscal stress and how that position is recorded in the books (see Foged, 2022; McDonald and Maher, 2019). It may also cross into public economics as we seek to understand the impact of the stress. However, when it comes to teaching, the ambiguity of the dimensions of public budgeting and finance can lead to challenges in the classroom. What one MPA1 program refers to as financial management may be classified as budgeting to another. As will be discussed later in this chapter, such variation exists within the field and is more common than expected. The challenge that this presents is complicated. The lack of consistent terminology can cause miscommunication in research, but more importantly, it can lead to a miscommunication in teaching. After all, a graduate of an MPA program who has taken a course in financial management from a program accredited by the Network of Schools of Public Policy, Affairs, and Administration (NASPAA) may have had a course focused on budgeting or governmental accounting. Still, it might have also focused on revenue, public debt, or even public economics more broadly. Ultimately, the burden of the challenges is borne by our students and their employers who must navigate the uncertainty about the student’s skills during their graduate studies. This chapter is an exploration of what we teach when we teach about public budgeting and finance. To address this issue, the remainder of this chapter is structured as follows: First, I will introduce the notion of public budgeting and finance and its dimensions to build a common language for talking about our courses. This language is then applied to NASPAA accredited programs to understand what we are a discipline require. Next, our courses’ nature is explored to better understand what learning outcomes our students are expected to achieve from their public budgeting and finance courses. Finally, a discussion of the teaching and educational resources that pertain to public budgeting and finance courses is provided.

402

Teaching public budgeting and finance to the next generation of scholars  403

STATUS OF PUBLIC BUDGETING AND FINANCE COURSES One of the challenges we face in teaching public budgeting and finance courses is that we lack clarity and consistency in the titling and content of our courses. A two-step process was undertaken to understand the state of teaching public budgeting and finance in the field. First, the curriculum of all 175 NASPAA accredited programs was reviewed to establish what public budgeting and finance-related courses were being taught, how often they were taught, and whether they were a required or an elective course.2 Course descriptions from the relevant courses were also collected to clarify what subject matter students would engage with and master. Second, all of the programs were contacted with a request for a copy of their syllabi from the courses’ most recent offering. In total, 171 syllabi were collected for public budgeting and finance-related courses from 87 programs, accounting for about 50 percent of all NASPAA accredited programs. Upon reviewing course descriptions and syllabi, I found that we have less agreement in the field about course terminology than we would expect. The content covered in financial management courses for many programs more closely aligned with the content of the budgeting courses from others. Similarly, public finance and financial administration were frequently used interchangeably and were used to describe courses across the spectrum of the field. Perhaps the most significant uncertainty came from the term “fiscal health,” which some programs used as a synonym for budgeting, used by others as a synonym for financial management, and still others as a more generic term for public finance. In total, nearly a quarter of all public budgeting and finance courses had characteristics that more closely resembled a different course than what they were labeled.3 This begs the question: What do we mean when we talk about public budgeting and finance education?

Figure 22.1

Dimensions of public budgeting and finance

Using the course descriptions and syllabi collected, and supplemented with a review of the literature and a series of structured interviews with local budget and finance practitioners, it is possible to establish a centralized definition for our courses and how they work together within the discipline. Based on the analysis, public budgeting and finance revolves around three primary dimensions. These are public budgeting, financial management, and public

404  Research handbook on public financial management finance (see Figure 22.1), which take on budgeting, accounting, and economic perspectives, respectively. While all three courses cover related material, they each provide their own unique perspective. Courses on public budgeting focus on the development of a public service organization’s budget. In the early days of budgeting research, the New York Bureau of Municipal Research viewed budgets as a communication device that communicated between the electorate, the staff, and the public as to what the government wanted to do and how it would accomplish those goals (Dahlberg, 1966). This perspective has carried forward as practitioners and researchers alike work to improve that communication process, and it is this effort that creates the structure of our courses on public budgeting. This includes discussions of the budget process and policies for an organization, general planning for the organization, and budget monitoring and performance measurement. Included in the dimension is a particular focus on budget format, budget cycle, and consideration of available revenue, all of which return to the theme of communication between concerned parties. Perhaps Irene Rubin said it best that, at its roots, budgeting is about guiding organizational behavior and organization management (Rubin, 2019). This perspective also aligns with the Government Finance Officers Association’s (GFOA) approach in their Certified Public Finance Officer program, where the module on budgeting includes a heavy focus on organizational planning. In reviewing the material, courses on financial management included a range of focus, including everything from government and nonprofit accounting to debt management, and in some cases included budgeting as the critical outcome. However, their general underlying theme has been an introductory perspective of governmental and nonprofit accounting and how to use the information that the perspective produces. Finkler et al. (2020: 2), whose textbook is the most frequently used book in financial management courses, define financial management as “the subset of management that focuses on generating financial information that can be used to improve decision making.” While they note that this includes managerial and financial accounting, accounting differs from financial management. Managerial accounting is the study of recording financial information to users who are internal to the organization, and financial accounting is the reporting to external users. In both instances, the focus is on the task of reporting (Wild and Shaw, 2021). Financial management takes the accounting process a step further to focus on how the information reported can improve decision-making within the organization and better manage the organization’s resources (Brooks, 2019). In perspective, a course in budgeting is about the planning and financial communication of a government’s resources, whereas a course in financial management is about how to use those resources effectively during the implementation stage. The distinction between planning and implementing allows for the introduction of topics into a financial management course pertinent to the day. The course’s fundamentals remain in governmental and nonprofit accounting, with students learning core concepts such as GASB standards, cost accounting, and assessing the financial position. The breadth of material covered allows for class discussions to be centered around how to use the accounting skills students are developing to address issues such as pension and debt management. Regardless of the inclusion of such issues, however, the premise of the course is on teaching students how to use the financial information of an organization in the decision-making process. The final dimension of public budgeting and finance is a course in public finance. Such classes are frequently used as a catch-all for MPA programs that want to introduce students to public budgeting and financial management. MPA courses in public finance typically

Teaching public budgeting and finance to the next generation of scholars  405 take a public policy and policy analysis view of the public budgeting and finance subfield to explore the policy dynamics inherent in budget development and the management of resources. An economic perspective is frequently added to the course, providing students the opportunity to consider the economic implications of budget and tax decisions. Whether the course takes a public policy or economic viewpoint, it tends to have a more interdisciplinary feel than the strict management focus seen in the other two dimensions. If public budgeting and financial management are courses about planning for the financial resources and using the resources appropriately and effectively, respectively, public finance will close the loop by providing an understanding of the impact of financial decision-making and the politics of the broader finance process. Which course, if any, an MPA program includes as part of the core curriculum is up to the faculty of the program. NASPAA establishes the core competencies that accredited programs must follow, but programs are allowed to interpret the competencies for themselves (Holmes, 2020). An overview of course offerings and program requirements are provided in Table 22.1. The analysis results show that the prominence of public budgeting and finance within MPA programs in the United States is less prominent than many imagine. Upon review, many, but not all, programs have adopted a requirement of at least one of the three courses. Of the 175 programs reviewed, 147 (84 percent) listed some version of a public budgeting and finance course as a core course. Most of the traditional MPA programs required a core course in public budgeting and finance, though the frequency of the requirement began to dwindle across the other program variants that NASPAA accredits. The majority of Master of Public Affairs programs, for example, required a public budgeting and finance course, though executive MPA courses and Master of Public Policy courses rarely did. Table 22.1

Public budgeting and finance course offerings by program

Course

Required

Elective

Number

Percent

Number

Percent

Public budgeting

91

52.0

37

21.1

Financial management

33

18.9

40

22.8

Public finance

34

19.4

21

12.0

Choice of course*

6

3.4

–

–

More than one course**

9

5.1

51

29.1

Nonprofit financial management

–

–

47

26.8

Government and nonprofit accounting

–

–

16

9.1

Other specialized courses

–

–

57

32.4

Notes: * “Choice of course” refers to more than one public budgeting and finance course being offered as part of the MPA program and students could choose which course they wanted to take. ** “More than one course” refers to a program having more than one course in public budgeting and finance as part of their required courses.

When considering what courses are part of MPA curricula, a core course in public budgeting was the most frequent requirement. A total of 91 programs (52 percent) required the course for all students in the program. Public finance was the second most common course, with 34 programs (about 20 percent) requiring students to complete the course. Financial management was required only slightly less frequently, with 33 programs (about 19 percent) requiring its completion. Six programs (about 3 percent) required a public budgeting and finance course but gave students a choice on what course they selected. When giving an option, students typically

406  Research handbook on public financial management were allowed to choose between a standard public budgeting and finance course and a nonprofit financial management course based on the focus of the student’s studies. Finally, a small selection of programs stood out from the rest in terms of their course requirements. Nine of the programs (about 5 percent) listed more than one public budgeting and finance course as a core course in the MPA curriculum. Perhaps the most interesting finding of the exploration into MPA courses is the wide variation in course offerings for program electives. While 91 of the 175 programs required a public budgeting course, another 37 (about 21 percent) offered public budgeting as an elective. In total, only 128 MPA programs (about 73 percent) have a public budgeting course on the books for their students to take. The number of offerings drops among financial management and public finance courses. Only 40 (about 23 percent) of MPA programs have a financial management elective for their students. Forty-seven programs (about 27 percent) offered a course in nonprofit financial management, 12 (about 7 percent) of whom offered both general financial management and a nonprofit financial management course. Between being offered as a core course and as an elective course, both in general public management and in nonprofit management form, only 108 programs (about 62 percent) of programs reviewed offered students a financial management course. Lastly, public finance was the apparent minority of course offerings, with only 55 programs (about 31 percent) offering it as either a core or elective course. Nearly all of the programs included in the study offered a course in public budgeting and finance as either a core or elective. A course option was offered somewhere in the curriculum by 159 programs (about 91 percent). While a public budgeting and finance course is required for 84 percent of MPA programs, only slightly more than half of MPA programs offer electives related to the subfield. In total, 96 programs from the study, about 55 percent of the programs, offered an elective course. As Table 22.1 outlines, the most frequently offered elective is a nonprofit financial management course, which was offered by 47 (about 29 percent) of programs. Only 16 programs offered a course in governmental and nonprofit accounting. The true distinction between MPA programs, however, is in the detail of the specialized elective offerings. Throughout all of the programs reviewed, a total of 57 specialized courses were found. These courses focused on topics such as capital budgeting, debt management, and revenue policy. The specialized courses accounted for about 32 percent of all electives offered in MPA programs; however, the offerings were condensed to a small number of programs. Only 27 programs (about 15 percent) of all programs reviewed offered specialized courses in public budgeting and finance to their students.

LEARNING OUTCOMES In the previous section of this chapter, attention was given to understanding what public budgeting and finance courses were being offered within NASPAA accredited graduate programs in the United States. This discussion involved clarifying what we mean when we talk about public budgeting and finance courses. Specifically, it involved defining the predominant courses that cover the three dimensions of the subfield. These are public budgeting, financial management, and public finance. In a discussion of teaching, it is not enough to describe the course being taught. Rather, student learning outcomes much also be considered. Learning outcomes are statements

Teaching public budgeting and finance to the next generation of scholars  407 about the knowledge, skills, and abilities that a student should acquire when taking a class (Goodman, 2020; Jordan and McDonald, 2022). In designing a course and its assignments, how students will engage and utilize the learned material should always be the primary concern (Goodman, 2020). One way to understand this is Bloom’s “Taxonomy of Learning.” According to the taxonomy, there are six different levels of learning by which students can gain knowledge (Armstrong, 2016). At the lowest level, students gain knowledge based on their ability to remember a set of information. As a student is taught material in the classroom, assignments are used to help elevate the level of learning. For example, a student may be able to define the budget process at the lowest level, but an assignment can be used that requires the student to explain the budget process to new city council members. As the student moves from defining to explaining, their level of knowledge increases. An overview of the levels, along with the expected level of achievement, is provided in Figure 22.2.

Source:

Armstrong (2016).

Figure 22.2

Bloom’s taxonomy of learning

In practice, Bloom’s taxonomy helps us translate the subject of a course into teachable goals. Some years back, NASPAA requested that its sections develop learning outcomes for their respective areas of teaching. While NASPAA gave up the idea of establishing outcomes for the subfields, the effort was not abandoned before the Budget and Financial Management Section created an outline of outcomes for public budgeting and finance courses. The process to create the outcomes followed a review of program syllabi, discussions with senior faculty, and relevant organizations, such as the GFOA, to determine the general expectations for budgeting and finance students. Sadly, the outcomes they established seem to have been lost to the ages, but informally, many of those who were involved in the process noted that the learning outcomes closely reflect a blending of the standard skills that were already being covered in our courses with the skills that are covered in the GFOA’s Certified Public Finance Officer program. It may not be possible to recreate those outcomes perfectly, but it does provide a basis for establishing core outcomes. Using the syllabi collected for this project and the information provided by the GFOA on the knowledge expected of Certified Public Finance Officers, I sought to clarify what the student

408  Research handbook on public financial management learning outcomes for each of our dominant courses should be. The syllabi showed variation in terms of approach to the subject matter; however, once the courses were categorized according to the consistent definition established in the previous section, several consistent outcomes began to emerge. The top five outcomes for each of the three types of courses are provided in Table 22.2. While the learning outcomes are by no means exhaustive, they provide a sufficient starting ground for faculty new to the course or who are looking to update their course material. Table 22.2

Key learning outcomes of public budgeting and finance courses

Course

Learning outcome

Public Budgeting

● Understand the fiscal structure of governments in the United States; ● Explain the public budgeting process and discuss the role of the budget in each stage of the budget cycle; ● Assess the characteristics of major tax instruments; ● Read, evaluate, and draft an organizational budget; ● Discuss the role of the budget in the planning process; ● Discuss the role of politics and policy in the budget process.

Financial Management

● Apply analytic techniques to financial information for use in decision-making; ● Interpret and evaluate the fiscal health of a public service organization; ● Analyze financial control strategies including the role of accounting, reporting, and auditing functions of the public sector; ● Create and interpret the key financial statements of an organization; ● Make resource allocation and pricing decisions using accounting techniques.

Public Finance

● Understand the fiscal structure of governments in the United States; ● Discuss the role of politics and policy in the budget process; ● Understand the impact of laws and public policies on government finance; ● Analyze fiscal problems and fiscal policy questions; ● Apply economic principles to financial decision-making; ● Read and evaluate an organizational budget; ● Discuss the roles of fiscal policies and their impact on socioeconomic outcomes.

One point of note from the establishment of the list and the broader review of the syllabi is how the learning outcomes connect across the courses. They also reflect a progression of learning from one course to the next as students engage with all three dimensions of public budgeting and finance. This can be seen, for example, in the outcome of a public budgeting course where students are expected to be able to read, evaluate, and draft an organizational budget. As students move from a public budgeting course into a financial management course, this skillset progress as they learn to make resource allocation and pricing decisions using accounting techniques that fall within the framework of the budget they created in their previous course. The progression continues into public finance as students learn to apply economic principles to the financial process to understand the implications and policy associated with the previous budget and management decisions.

RESOURCES FOR TEACHING While many of the textbooks for classes in public budgeting and finance do not include teaching resources, there are resources available that can help improve your capacity as a teacher and improve the learning experience of your students. NASPAA plays a crucial role

Teaching public budgeting and finance to the next generation of scholars  409 in teacher preparedness within the field, offering a number of panels on pedagogy and classroom management at its conference each fall. Included in the panels are topics curated by the association’s Budget and Finance Management Section. Topics covered at recent conferences have included incorporating social equity perspectives, using service-learning projects, and innovative teaching strategies for public budgeting and finance courses. The Association for Budgeting and Financial Management (ABFM) also provides teaching resources for its membership. As with NASPAA, ABFM has begun including more panels on teaching at its conference each fall. Examples of panel topics have included topical updates to GASB for the classroom and addressing challenges for teaching public budgeting and the doctoral level. The association website also includes a trove of syllabi for new instructors in the field. Syllabi are from a variety of programs and reflect the spectrum of public budgeting and finance courses from the field. Unlike NASPAA, which has a section focused on public budgeting and finance, the involvement of ABFM in updating its current resources or expanding its resource offering is limited. My graduate research assistant collected most of the syllabi some years back, and they have not been updated since. Although the syllabi may now be dated, the general content and pedagogical approaches outlined in the syllabi remain relevant to the discipline. Recently, Meagan Jordan and I have worked on an edited volume on how to successfully teach public budgeting and finance to MPA students (see McDonald and Jordan, 2022). The book brings experienced faculty from across the spectrum of public budgeting and finance to talk about what they teach and how the material can be taught effectively. As an example, Hildreth’s (2022) chapter addresses what students need to know about capital budgeting and debt financing. The chapter provides a crash course on what learning outcomes students should master, the background on what instructors need to know to relay these outcomes, and examples of assignments, such as requiring students to review a government’s debt affordability study and present the findings to the class. Another example of the book’s utility to teaching public budgeting and finance is the work of McDonald and McCandless (2022) regarding the incorporation of social equity perspectives into a public budgeting course. The book covers teaching strategy for a variety of topics, including financial management, budgeting, fiscal health, government auditing, pensions, and how to use case studies and service-learning projects. Academic Journals There are also several academic journals that publish articles related to teaching in the field. The primary source of published information comes from the pages of the Journal of Public Affairs Education (JPAE). Established in 1995 and published quarterly, JPAE is the official journal of NASPAA and is dedicated to the advancement of the scholarship of teaching and learning in public affairs (McDonald and Hatcher, 2018; Perry, 2019; Perry and Mee, 2022). The journal covers a variety of topics related to public administration education, including the internationalization of public administration education (Sun et al., 2021), challenges of work-life balance (Pautz and Vogel, 2020; Yusuf et al., 2020), approaches to teaching diversity (Witkowski et al., 2021), and ethics education (El Baradei, 2020; Meyer, 2021). It also provides research on improving student experiences, such as Perry’s (2021) discussion on improving our students’ public service motivation in the classroom and Ni et al.’s (2021) on improving MPA students’ experience in online courses.

410  Research handbook on public financial management While the journal’s breadth of topics helps guide our general approaches to pedagogy and classroom management, they cover topics that directly reflect on teaching public budgeting and finance courses. Maher et al. (2020), for example, provide a pathway to teaching about financial condition analysis in a budgeting course, complete with recommendations on implementing a financial condition analysis assignment to the course and how to adjust the assignment based on the time available in the course. Denison and Kim’s (2019) piece in the journal, which received the journal’s 2020 award for best paper, focused on connecting practice with the classroom in nonprofit financial management courses. More recently, the journal published Sun’s (2022) reflection on the essential skills for public budgeting and financial management. Finally, the journal publishes case studies, some of which can be used in a budgeting or finance classroom to add an application to the course material. Two additional academic journals publish research on topics related to public budgeting and finance education. The first of these, Teaching Public Administration (TPA), is the European equivalent to JPAE (Farrell et al., 2022). Published three times a year by the Joint University Council of the Applied Social Sciences in the United Kingdom, TPA takes a broader perspective for its focus by publishing a range of scholarship of teaching and learning as it applies to public organizations. Although only the occasional piece is focused on issues related to public budgeting and finance, TPA publishes a range of research that addresses the public administration classroom across a variety of cultural and governmental situations. The second journal is Issues in Accounting Education, which is published by the American Accounting Association. The journal focuses on publishing research and instructional resources for accounting faculty. Although much of what the journal publishes takes a corporate accounting perspective, the occasional publication does relate to our classes. Their most recent issue, for example, includes an article on using data analytics to calculate the effective tax rate in the classroom (Cheng et al., 2021) and an article on connecting policymakers with financial research (Burton et al., 2021). Other journals that publish research on public budgeting and finance do, on occasion, publish research on topics of teaching. These occasions, however, are more infrequent than they are common. Professional Associations In addition to the academic resources mentioned above, two professional associations also produce resources that may be useful in the classroom. The GFOA produces three types of resources that you might find helpful. The first is their archive of best practices, which guide practitioners on how issues or challenges can be addressed based on others’ learned experience engaged in government finance. Published online in short, easy-to-read discussions, the best practices are a valuable tool for helping students connect the theory of what they learn in the classroom with the reality of serving as a budget officer for a local government. The second are the publications produced by the GFOA. The GFOA publishes a magazine, Government Finance Review (GFR), which provides articles with practical advice, and a series of books and reports on government finance topics that are important to their membership. As a matter of practice, I frequently utilize a combination of the best practices, GFR articles, and excerpts from longer publications that align with the week’s topic to provide a practical application for the class. The GFOA also offers a Certified Public Finance Officer program. Although the program may be of interest to students after completing their MPA degree, the resources available to those studying towards certification may be of interest to a faculty member teach-

Teaching public budgeting and finance to the next generation of scholars  411 ing public budgeting and finances courses. These resources include outlines of core skills that a finance officer should know and recommended readings for studying those skills. The Association of Government Accountants (AGA) also offers a training program for government finance staff, whose graduates gain the title of Certified Government Financial Manager. Similar to the resources provided by the GFOA for its certification program, the AGA provides guidance for members seeking its certification. Included in these resources are competencies for a successful financial manager and study guides that students can use to help prepare to meet those competencies. For the public budgeting and finance faculty, both the competencies and study guides provide a valuable framework for designing a class that best prepares students to move into the field as leaders.

CONCLUSION Many universities throughout the United States offer MPA and other public affairs degrees, each of which includes at least one course in public budgeting or public financial management. These courses are important to the MPA curriculum as they provide the necessary grounding for leadership positions in public organizations. Unfortunately, many MPA programs face significant challenges with these courses. For programs large enough to have faculty training in public budgeting and finance, the faculty are often highly specialized, focusing on areas such as capital debt or state sales tax policy. For most programs, however, the faculty who teach these courses are often generalists who teach a variety of courses. In both cases, they often lack the expertise needed in all areas of public budgeting and finance. This chapter has sought to address public budgeting and finance education by providing a state of the field, as it were. After analyzing the course requirements and course offerings from 175 MPA programs in the United States, I found wide variation in terms of what courses were offered and an array of topics taught within these courses. The findings of the course analysis present some concern for the state of the field. Although some version of a public budgeting and finance course is being offered by most MPA programs in the United States, what that course is and what additional electives students have at their disposal is quite varied. Ultimately, this presents a challenge for public service organizations seeking to employ MPA students for their budgeting and finance needs. While employers can reasonably expect that the student has been exposed to public budgeting and finance during their graduate studies, there is little for them to go on to understand what that exposure looked like. The opportunity for students to engage in internships becomes even more important. To provide guidance for the public administration faculty member assigned to teach or develop a public budgeting and finance course, I provided a framework for understanding the three dimensions of the subfield (public budgeting, financial management, and public finance). This framework focused on establishing the focus of each course and then providing key student learning outcomes for the courses. Ultimately, this framework shows that the three courses work in tandem to provide students with a complete understanding of the financial processes of governments and nonprofit organizations. It is worth noting, however, that this chapter is not all-encompassing. Rather, there are many questions about the mechanics and pedagogical strategies for teaching that have not been discussed here (though a discussion of the teaching resources available does try and points interested readers to tools they might have been unaware of). Scholars from many of the subfields of public administration have begun

412  Research handbook on public financial management engaging in research to improve teaching quality in their area. Unfortunately, research into teaching public budgeting and finance has been few and far between, though the two educational journals of the field have expressed an interest in seeing more of this research. As more discussions regarding our pedagogy emerge, the hope is that new research will also take place, allowing the overall quality of our teaching and our students’ experience to grow. One challenge to teaching public budgeting and finance that must be considered is the internationalization of the material. Although much of public administration is explored through the eyes of a single government or bureaucratic system, comparative perspectives allow us to address old challenges in new ways (Langella et al., 2021; McDonald et al., 2022). Recent work into public budgeting techniques, for example, has noted how international experiences can be incorporated into an American context as a means of addressing social equity and gender imbalance issues (Rubin and Bartle, 2021). While there is benefit to adding international perspectives, this must always be done with caution as political and governmental context is important to the development of a budget. Countries have their own bureaucratic processes and accounting rules and guidelines. These variations can change the interpretation of budget data. While this limits the ability of a single class to fully incorporate such variation, acknowledging that differences exist can be beneficial to students seeking careers on an international stage.

NOTES 1.

Throughout this chapter, I follow Barth and Hammel (2020) and use the term MPA to reflect Master of Public Administration programs, but also any other program that would be eligible for NASPAA accreditation, including Master of Nonprofit Management, Master of Public Policy, and Master of Public Affairs. 2. There are 387 NASPAA member programs; however, only 175 of these programs are accredited by NASPAA. For an overview of the member programs and accredited programs, see NASPAA (2022). 3. The intention of this chapter is not to criticize or shame any program, but to talk about the state of the field. Accordingly, specifics as to which programs and which courses had alternative classifications will not be discussed.

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Index

Aadhaar in India 53 Abbas, Y. 101, 102, 105, 106, 109, 110 ability-to-pay principle 188 academic journals 409–10 accountability, financial and political 156 accounting reforms 80, 82 government 83–85, 88–90 accounting standard adoption 103–4 accrual basis accounting 78, 79 vs. cash accounting 62–64, 99–100 reporting of 107 accrual budgeting 263 accurate costing 64–65 activity based costing (ABC) 64 Adams, W. 334 Adelino, M. 289 adequacy, examining revenues 190–92 Administrative Behavior (Simon) 372 adverse selection 330 agencies in budgeting, role 161, 162–63 agency theory 69, 351, 353 agents, managing 351–52 aging public sector workforce 167 Airbnb 36 alcohol products, excise taxes on 183, 184 “Alex” 206 Alibaba 36 AliPay 36 Allais, M. 371–72 allocations 61, 268 budgetary 118–19, 249–51 expenditure 240 Special Drawing Rights 28 Alm, J. 379 Amazon 36, 185 American State Administrators Project (ASAP) 159 Ames, R. E. 377–78 Annual Comprehensive Financial Report (ACFR) 97 Anthony, R. 117 anti-money laundering/countering the financing of terrorism (AML/CFT) regulations 33, 35, 39 appeals, disputes and 211–12 Appropriation Acts 61 Apte, A. U. 347 Arapis, T. 159, 162 Arrington, T. S. 381

artificial intelligence (AI) developments 210 use 206, 209 assessment, tax 206–8 collecting information 206–7 filing of tax returns 207 payment 207–8, 220 asset-liability management (ALM) approach 314 asset management 396–97 audits, tax 208–10 Australia consolidated financial statements (CFS) in 81 COVID-19 spending in 85 historic development of public budgeting 138 Outcomes and Outputs Framework (OOF) in 65 authority tools 22 automated attachment procedure 209–10 Baber, W. R. 103 Babina, T. 288 Bahiigwa, G. 217 Bailey, S. K. 157 Bails, D. 277–78 Baiocchi, G. 161 Bajari, P. 331–32 Bakong, Cambodia 38 balanced budget 240, 263 Balanced Budget and Emergency Deficit Control Act 127 balanced scorecard (BSC) 67–68 balance of payments (BPM) 78–79 balance sheet lending 53 Banford, N. D. 380 Banking Act 279 bankruptcy laws 282–83 bankruptcy 11, 289, 290–91, 292 BANOBRAS 281 Bartle, J. R. 391–92 Basel Accords 274, 284 Bastable, C. F. 376 Beck, A. W. 108 Becker, G. 373 behavioral approach, contract management 354 Bélanger, G. 159 Bendor, J. 160 benefit principle 187–88 Benson, E. D. 103 Bentham, J. 370

415

416  Research handbook on public financial management Bernoulli, N. 371 beverages taxes 184, 186–87, 196 Bifulco, R. 161 BigTechs 36, 38, 40 Black, F. 9, 10 black box model 248, 249 Blanchard, O. 304 blockchain technology 210, 220 blood transfusions 183 Bloom, B. 407 Bollinger, B. 186–87 bond(s) see also municipal bonds currency 317 environmental impact bonds (EIBs) 393 financing 391 general obligations (GO) 280, 289–91, 294, 391 green 393, 397 income 280 industrial development 280 issuer information 106 legal security of 289–95 rating 110 resilience 393–94 revenue 280, 294, 391 borrowing capacity 7 of private sector practices 62 bounded rationality concepts 372–73, 374 Bowling, C. 159, 162 Brazil direct cash transfers in 42 fintech applications for tax collections in 46–47 participatory budgeting in 67 breadth of the pledge 290–92 Brown, T. L. 331, 332, 336, 350 Brunjes, B. M. 335, 350 Brunner, E. J. 381 Buchanan, J. 125 budget 239, 240, 248, 251, 254 budgetary allocation 118–19, 249–51 budgetary incrementalism 155, 157, 166, 251 budget-maximizing bureaucrats 159–60 cash-based 252 constraints 2, 7–9, 228, 274, 275, 278 documents 259 managers, role 161, 162–63 maximizer hypothesis 159 outcomes 146, 260 planning and execution 49–51 spillovers 259 transparency 145–48, 259 Budget and Accounting Act 86, 122, 156 Budgetary Comparison Schedule (BCS) 109

Budget Control Act (BCA) 262 Budget Enforcement Act 262 budgeting 240, 241, 251 agencies, role 161, 162–63 contemporary 240 incremental 240, 250, 251 line-item 240 methodology 239, 241 outcome-based 240, 241 public 238, 239 zero-based 251 budgeting for outcomes (BFO) 129–30 budgeting in developed and developing countries budget transparency comparison 146–48 contemporary innovations 144–45 early innovations 140–44 factors influencing 145–46 historical development 137–40 introduction 136–37 budgeting research, national and subnational government emerging topics 160–64 agencies and managers 162–63 environmental shocks 163–64, 166–67 equity 161–62 fiscal sustainability 164 future directions for 165–70 causal inference in research design 168–70 forward-looking perspective 166–67 interdisciplinary perspective, maintaining 165 international and comparative perspective 167–68 multidisciplinary perspective 155–60, 165 in political science 155–56, 165 in public administration 156–58, 165 in public economics 159–60, 165 overview 154–55 budget innovations budgets, allocation and production functions 118–19 budgets, purposes of 117–18 client era 122, 124 constituent era 125–26 consumer era 126–28 customer era 129–30 public’s role in the governance process 119–22 subscriber era 131–33 bureaucrats, budget-maximizing 159–60 Caiden, N. 140–41 Callahan, C. M. 109 Canada Revenue Agency (CRA) 207

Index  417 cannabis taxes 184, 186–87, 195–96 capacity constraints 239 tools 22 capital charge system 64–65 gains 189 levies 292 markets 8–9 planning 396 capital improvement plan (CIP) 396 capitalism 5 Capital Market Regulation Legislation 279 carbon tax 186 Carter, J. 158 cash management 51, 315 reserve ratio 25 transfer social programs 48–51 cash-based budget 252 cash basis accounting 60–61 vs. accrual-based accounting 62–64, 81–82, 99–100 “catch and punish” paradigm 212 causal inference methods 168–70 Central Bank Digital Currency (CBDC) 38–39, 50–51 certificates of deposit participation (COPs) 11 Cestau, D. 288, 292, 293, 294, 296, 297 Ceteris paribus 309 challenge-based procurement 398 Charter of Budget Honesty Act 138 chatbots 206 Chen, C. 391–92 Chetty, R., 380 Chief Financial Officers (CFO) Act 86 China accounting reforms 89–90 debt management strategies 280–81 growth projections post COVID-19 pandemic 27 marketplace lending activity and 40 public accounting practices 89–90 public enterprises in 62 Cho, C. L. 159 cigarette packs, excise tax on 183 citizen participation in public budgeting 144–46 citizen welfare 226–27, 228, 229 Clark, C. 249, 250 Clear Line of Sight Alignment Projects (CLOS) 88 Cleveland, F. A. 141 client era 122, 124 climate change on budgeting 163–64, 166

defined 385 expenditures 266 climate-resilient infrastructure systems benefits of 387–88 challenges of 388 defined 386–87 financing bond financing 391 innovative financing 391–92 intergovernmental grants 390–91 new financial arrangements 395 new financing mechanisms 392–94 new funding sources 392 pay-go versus pay-use 388–89 tax revenues 389–90 traditional financing methods 389 user charges and fees 390 public financial management of asset management 396–97 capital planning 396 debt management 397 financial accounting and reporting 398 procurement management 397–98 Clinton, B. 127 “cloud computing” 209, 220 Coase theorem 381 Code of Good Practices for Fiscal Transparency 158 co-integration analysis 242 collection ratio 193 collective action clauses (CACs) 313 collective ownership 69 common reporting standard (CRS) 206 Community Development Block Grant (CDBG) program 390 competitive solicitation 348–49 completeness of good financial reporting 100, 108 complex products 331 compliance costs 193, 197 tax morale and 212, 213 concentration effect 244 Congleton, R. D. 226 Congressional Budget and Impoundment Control Act 125, 126 consolidated financial statements (CFS) 81, 82–83 constituent era 125–26 consumer era 126–28 consumer surplus 181 consumption taxes 190, 191, 197 continuing resolution (CR) 154 contract design 331, 332 see also public procurement and contracting

418  Research handbook on public financial management contracting, defined 342 see also contract management contract management see also public procurement and contracting agents, managing 351–52 aligning public values and 354 behavioral approach 354 capacity 336 contracting networks, complexity of 353–54 contractor performance 354–57 managing contractors 352 monitoring and enforcement (ex post transaction costs) 352–53 contractor performance future research, implications for 357 measuring 355–57 control and audit function 208–10 publicness and 333, 334 Copley, P. A. 107, 111 Cornaggia, J. 289 corporate income tax (CIT) 185, 220 corruption 204, 213, 214, 217, 220 Costa Rica, payment system for cash social programs in 43 Cost at Risk (CaR) techniques 315 cost-benefit analysis 329 Cost Plus (C+) contract 331, 332 cost(s) administering gaming taxes 192 carbon emissions 186 compliance 193, 197 income tax 192, 193 negative externality 186 of taxation 186 counterparty credit risk 316 Country Policy and Institutional Assessment (CPIA) 306 COVID-19 pandemic 11 credit markets and 273 debt sustainability and 300, 304, 318 economic shocks from 163–64, 166–67 global policy responses and 19–22 effects of major crises linger 27–28 tools of crisis response 22–23, 25 governments’ financial management and 85–86 local currency bond markets and 317 tax administration systems and 203 Coyne, D. 164 credit 5 assistance tools 392 cards, extensive use of 209 gaps 39–40 ratings 110, 282, 295

risk 288–89 creditors 312 crisis management see COVID-19 pandemic crowdfunding 34, 36, 40, 47 cryptoassets/cryptocurrency 37–38 Cuny, C. 102, 105–6, 109, 110 customer due diligence (CDD) 35 customer era 129–30 customer relationship management (CRM) 207 customs and tax administration, merger of 216 cyber risks in fintech solutions 50 data envelopment analysis (DEA) 346 “data processing centers” (DPCs) 216 data science and artificial intelligence 209 Davlasheridze, M. 388 deadweight loss 180–87 DeAngelo, L. E. 106 debt see also public debt management; sovereign debt debt-to-GDP ratio 300, 303, 308, 309, 319 default and restructuring 311–13 financing tools 392 management 397 settlement 10–12 sustainability framework 306–7 Debt Service Suspension Initiative (DSSI) 28 debt sustainability analysis (DSA) 304–7 (de)centralization of taxation 186–87 decentralized economy 251 decentralized governments 266 dedicated debt levies 292 Deis, D. 106 DeJong, D. V. 98–99 Demel, S. M. 345 democracy premium 277–78 Denison, D. V. 410 Denmark, consumption-tax revenue 190 developed countries 208 developing countries 208, 212–14, 275 see also tax administration systems digital channels 219 digital credit 39–40 digital identity 51, 53 digital investment 39, 40–41 digitalization 31–32 in global banking 37 of government payments 42–43, 47–48 of tax services 203, 205, 219 digital money 37–38, 43–45 digital wallet 33, 36 digitization 31 DiMaggio, P. J. 168 dimensional publicness theory 333–34 direct administrative control 276

Index  419 direct transfers 21 disclosure timeliness signals 105 discretion in contracting 349–50 diseconomies of scope 337 displacement effect 244 disputes and appeals 211–12 distributed ledger technology (DLT) 37–38 diversification, revenue 234 domestic vs. foreign creditors 312 Dominican Republic, non-tax revenue portal in 46 double-log regression approach 232 Douthett, E. B. 111 Downs, A. 159, 248 earnings management 107–8 Easton, D. 248, 249 EasyPaisa, Pakistan 35 Ebdon, C. 103, 111 e-commerce 221 economic efficiency, examining revenues 180–87 economic incidence 184–85 Economic Opportunity Act 126 economic recovery 18, 19, 23, 27–29 economic theory 125 Edgeworth, F. Y. 370 Edmonds, C. T. 101 effective tax rate, marginal tax rate vs. 188, 196 efficacy in revenue collection 204 efficiency in revenue collection 204 of tax administration services 215 e-identity in Estonia 53 elastic demand 183, 196 elasticity, tax 191, 192, 230, 231–32 electric power infrastructure resilience efforts 387 Electronic Identification Authentication and Trust Services (EIDAS) agreement 206 electronic invoicing system 219 Ellis, F. 217 emerging markets and developing economies (EMDEs) 21, 35, 303, 304 Emerging Science Citation Index (ESCI) 96 EMMA (Electronic Municipal Market Access) 95, 102, 105, 108–9, 110 e-money 33, 35, 37 endogenous preference formation 72 enforcement performance 204 entrepreneurial budgeting 143–44 see also budget innovations environmental impact bonds (EIBs) 393 environmental shocks, budgeting and 163–64, 166–67 e-payments 35–36 equity 23 budgeting and 161–62

examining revenues 187–90 ability-to-pay principle 188 benefit principle 187–88 horizontal 188–89 vertical 189–90 equity-oriented contracting 350 Espinosa, S. 369 Estonia, performance budgeting in 142 Eswatini 42 E-Tax 46 “eTrading” platforms 40–41 Euro area, growth projections post COVID-19 pandemic 27 European System of Accounts (ESA 95) 79–80 Eurozone 13 evaluation capacity, in contract management 336 excess burden see deadweight loss exchange rate risk 316 excise taxes 183–84, 186–87, 196 expenditure allocation 240 need 252 Experiments in Public Management Research 169 ex post transaction costs 352–53 Facebook 36 face value, debt 303 Fan, Q. 388 feasibility assessment capacity, in contract management 336 examining revenues 192–94 Federal Accounting Standards Advisory Board (FASAB) 86–87 Federal Emergency Management Authority (FEMA) 390 federal regulation, banking and financial sector 279 Fehr, E. 377, 378 Feldstein, M., 230 Fernandez, S. 335 filing delay 101 of tax returns 207 finance commodification of 10–12 and the theory of budget constraints 7–9 financial accounting and reporting 398 Financial Accounting Standards Board (FASB) 3–4 financial commodification 10–12 financial inclusion 32–33, 38, 42, 43 financial information quality 105–6 financialization 10

420  Research handbook on public financial management financial management information systems (FMIS) 31–32, 48, 49 Financial Management Initiative 88 financial regulation, debt management 274–76 financial reporting adoption and practices 107–9 implementation of good 100–102 relevance of 109 financial repression 310–11 financial technology (fintech) applications for public finance 34, 41 non-tax revenue collection 45–47 public debt management 47 public investment 47 treasury payments 42–45 applications for public finance, benefits of enhancing macro-fiscal forecasting 48–49 improving budget planning and execution 49–51 strengthening fiscal transparency 47–48 upgrading cash management 51 definition and concept 31–32 developments in the private sector 32 digital credit 39–40 digital investment 40–41 digital money 37–38 fintech payments 33 internet-based and app-based payment providers 35–36 mobile and online banking 36–37 mobile money 33, 35 payments 33 solutions, fraud in 50 fine-grained spatial information 260 Finkler, S. A. 404 Finland, consumption-tax revenue 190 fiscal analysis indicators 78 fiscal and monetary tools 23, 29 fiscal capacity 190–91, 197 fiscal consolidation 307–9 fiscal constraints, escape from 9–10 fiscal contagion 259 fiscal-illusion hypothesis 193–94, 197 fiscal institutions 262 Fiscal Monitor 301–2 Fiscal Monitor Database 19–20 fiscal policy 24–26, 243 fiscal prudence 12 fiscal rules 262–63, 275, 276, 277 fiscal space 21, 27–29, 283, 306, 308, 316–17 fiscal sustainability, budgeting and 164 fiscal tools 23, 29 fiscal transparency 47–48 Fischbacher, U. 377

Fitch Ratings 282 Fixed Price (FP) contract 331, 332 Fjeldstad, O.-H. 217 Flushing National Bank v. Municipal Assistance Corp 297 foreign vs. domestic creditors 312 formal competition 347–48 forward-looking perspective, budgeting research 166–67 Fottler, M. D. 333 France COVID-19 spending in 85 historic development of public budgeting 137–38 free market ideology 5 Friedman, M. 59, 373 Fruhmann, M. 335 fuel tax 187–88, 191, 196 “full faith and credit” pledge 296–97 Funck, E. K. 329 functional finance 6–7 funding mechanisms 264 publicness and 333 risk 315–16 Fung, A. 161 Gächter, S. 377, 378 Gaebler, T. 240 Gamage, D. 185 GCash in the Philippines by Globe Telecom 35 G20 countries 28 gender budgeting (GB) 161–62, 167 gender inequality 162 generally accepted accounting principles (GAAP) 82, 84, 87, 89, 98–99, 109 general obligations (GO) bonds 280, 289–91, 294, 391 Germany, historic development of public budgeting 138 Ghana historic development of public budgeting 139 system of performance contracting in 65 Giroux, G. 106 Glass–Steagall legislation 279 global economic growth and Covid-19 crises 19–22 global financial crisis (GFC) 9–10, 18, 300, 305 globalization 202–3, 205, 262, 268, 273 global resource allocation 268 Global Stablecoins (GSCs) 38 global warming, effect on budgeting 163, 166 goal setting, publicness and 333–34 gold standard 8, 14 good financial reporting practices 104

Index  421 Good Government Movement 119, 122 Goodnow, F. J. 141 Gore, A. K. 99, 103, 127 The Governance of Britain 88 governmental accounting, auditing, and financial reporting, research in see also public accounting practices financial reporting, value relevance of 102 accounting standard adoption 103–4 financial information quality 105–6 good financial reporting practices 104 information content of financial reporting 104–5 municipal audit 106–7 financial reporting adoption and practices adoption and implementation of GASB Standard 98–100 implementation of good financial reporting 100–102 future research directions financial reporting adoption and practices 107–9 measuring value relevance 110 other research avenues 111 other users of accounting information 110–11 relevance of financial reporting 109 type of relevant accounting information 109–10 past trends 96–98 Governmental Accounting Standards Board (GASB) 63–64, 86–87, 95, 96–97, 108, 404, 409 adoption and implementation of 98–100 Concept Statement No. 1 110–11 GASB 34 98–100, 103–4, 107 standards for US state and local governments 96–97 government budgeting 240, 251, 266 government debt 21, 39 government expenditures 259 government failure, in debt management 274–75 government finance 258 Government Finance Officers Association (GFOA) 129–30, 158, 407–8, 410–11 Government Finance Review (GFR) 410 Government Finance Statistics Manual (GFSM 2001 and GFSM 2014) 78–79 government financial data 258 Government Performance and Results Act 158 government solvency 303, 320 government spending 241, 242 government-to-person (G2P) payments 42 GovTech solutions 32, 46 Gramm-Rudman-Hollings Act 127

Granger causality test 243 grants 7 Great Depression 144, 279 Great Recession (2007–2009) see global financial crisis (GFC) Greece, Great Recession (2007–2009), 18 Green, R. C. 287 green bond principles (GBP) 397, 398 green bonds 393, 397 Greenspan, A. 9 gross domestic product (GDP) 136 gross national income (GNI) 136 Gulick, L. 119, 165 Gupta, S. 203 hackathon 43, 46, 53 Hallegatte, S. 387 Hallman, N. 103 hard budgets 7–8, 14 Hardisty, D. J. 381 Harris, L. E. 287 Harvard Dataverse 168 Hayashi, A. T. 185, 380 Hazard Mitigation Assistance (HMA) programs 390 healthcare costs, rising 167 Henke, T. S. 105 Her Majesty’s Treasury (HMT) 88 Hernández-Trillo, F. 282 Herrmann, B. 378 “heterodox” policies, debt unsustainability and 307 Hildreth, W. B. 409 Hirschman-Herfindahl Index 192, 234 Ho, A. T.-K. 160 Högberg, L. 352 Holland, P. W. 169 “hollowing out” 336 homeowners’ associations (HOAs) 129, 130 “homo economicus” 370 Hoover Commission 157, 240 horizontal equity 188–89 Hou, Y. 160, 164 household metaphor 5–6 Hugonnier, J. 288 Hume, D. 376 identification revolution 260 identification system, high-quality taxpayer 204–6 IMF-WB DSA frameworks 306 implementation capacity, in contract management 336 incentive tools 22 income bonds 280

422  Research handbook on public financial management income effect 185 income inequality 266, 267 income tax(es) 228 corporate 185 costs 192, 193 personal 188–89, 195, 197 progressive personal 188 incremental budgeting 155, 157, 166, 240, 250, 251 India direct cash transfers in 42 mobile money payments in 42 non-tax revenue portal in 45–46 system of performance contracting in 65 individual-level insurance claims 265 industrial development bonds 280 inelastic-demand curve 184 inelastic taxes 191, 192 inflation and interest rates 310 informal competition 348 information, collection of 206–7 information and communication technology (ICT) 131–32 information content of financial reporting 104–5 information resolution, debt markets and 273 Infrastructure Investment and Job Act (IIJA) 385 Ingram 98–99 InnoCentive 36 innovative financing 391–92 inspection effect 244 Integrated Financial Management Information System (IFMIS) 85 interdisciplinary perspective, budgeting research 165 interest rates 304, 316 intergovernmental competition and budget constraints 7 intergovernmental grants 390–91 intergovernmental transfers 251 international and comparative perspective, budgeting research 167–68 International Budget Partnership (IBP) 146–47, 149, 158 “International Exchange of Information” 208 International Federation of Accountants (IFAC) 80 International financial institutions (IFIs) 275 International Financial Reporting Standards (IFRS) 80, 82, 88 International Public Sector Accounting Standards Board (IPSASB) 64, 80 International Survey on Revenue Administration (ISORA) 205, 210, 219, 220 “international tax units” (ITUs) 216

internet-based and app-based payment providers 35–36 IremboGov, Rwanda 46 Issues in Accounting Education 410 Iversen, V. 217 Ivonchyk, M. 162 James, R. 217 Jefferson County bankruptcy 289, 290, 292 Jevons, W. S. 370 Jevons-VNM utility determination 372–73 Johnson, C. L. 102, 104, 109, 142 Jones, K. A. 160 Jones, S. 99 Jordan, M. M. 109, 381, 409 Journal of Behavioral Public Administration. 169 Journal of Public Administration Research and Theory 169 Journal of Public Affairs Education (JPAE) 409 Journal of Public Budgeting, Accounting & Financial Management 163 Kahneman, D. 373–75, 381 Karlsson, T. S. 329 Kasdan, A. 161 Katona, G. 373 Keen, M. 203 Kelemen, R. D. 283 Kellough, J. E. 335, 350 Kenya 206–7 historic development of public budgeting in 139 performance contracting in 66 system of performance contracting in 65 Key, V. O. 118, 124, 125, 155, 156, 377 Keynes, J. M. 182 Khan, A. K. 217 Khurana, I. K. 103 Khwaja, A. I. 217, 220 Kickstarter 36 Kido, N. 107–8 Kim, J. 103, 111, 388, 410 Kim, Y. W. 350 Kinsey, M. A. 349 Kioko, S. N. 109 knowledge-based services (KBS) 346 know-your-customer (KYC) rules 33 Kornai, J. 7 Koumpias, A. 213 Kriz, K. A. 381 Kurunmaki, L. 62 labor-leisure trade-off 185, 186, 228 Laffer curve 181–82, 191, 230, 231 Laffont, J.-J. 331

Index  423 large taxpayers units (LTUs) 216 later the long term council community plan (LTCCP) 67 leakage problem 49 lease-backed obligations 294, 297 legacy costs 264 legal language, in defaults and bankruptcies 290–91 legal security of bonds 289–95 LeLoup, L. T. 157 Leonardo, G. 213 Levitin, A. 283 Lewis, V. B. 377 Li, D. 288, 289 Liability Insurance Act 89 LIC-DSF 306–7 life-or-death necessities 183 limited pledge 297 Lindblom, C. 249 Linders, D. 121 line-item budget 141, 240 LinkedIn 36 liquidity risk 288–89 loans, extension of 39 local currency bond markets (LCBMs) 317–18 Local Government Amendment Act, New Zealand 67 local government financing vehicles (LGFVs) 281 “lock-in” problem 330 Lofton, M. L. 109, 162 long term financial strategy (LTFS) 67 Lowensohn, S. 106 Lowi, T. J. 329 low-income economies 21, 304 Lunsford, R. S. 160 machine learning based credit scoring 40 models 210, 220 macro-fiscal forecasting 48–49 MAC Sovereign Risk and Debt Sustainability Framework (SRDSF) 305 Mahdavi, S. 164 Maher, J. J. 105 “make or buy” decision 327–29, 343, 344 see also public procurement and contracting M-Akiba, Kenya 41 management by objective (MBO) 143 management discussion and analysis (MD&A) 99, 103, 109 “management risk analysis units” (MRAUs) 216 managers in budgeting, role of 162–63 “Marginalist Revolution” 370 marginal tax rate vs. effective tax rate 188, 196

marijuana, medical 195 market failure defined 180 negative externalities 186 imperfections 348, 349 marketplace lending 39 market-access countries (MAC) 304 Markman, E. 161 Marshallian measures of excess burden 196 Martínez-Vázquez, J. 213 Marwell, G. 377–78 Master of Public Administration (MPA) programs 402, 404–6 McCandless, S. 409 McDonald, B. D. 409 McKinnon, R. I. 7 McNamara, R. 125 medicaid 265 medical marijuana 195 medicare 265 medium-term debt management strategy (MTDS) 315 medium-term expenditure framework (MTEF) 240 merger of customs and tax administration 216 Metz, H. 124 Mexico debt management strategies 281 direct cash transfer in 42–43 historic development of public budgeting 139 tax burden in, case study 194 Migué, J.-L. 159 Mikesell, J. 187, 190, 191 Mill, J. S. 370, 376 Miller, P. 62 Minsky, H. 5 mobile banking 36–37 mobile money 33, 35 mobile network operator (MNO) 33, 35 Mocan, N. 185 Moldogaziev, T. T. 296 monetarily-sovereign governments 6–8, 13, 14 Monetary and Financial Statistics Manual (MFSM) 78, 79 monetary policy for crisis response 24 Moody’s 282, 291, 295 Moore, M. 214 moral hazard 274, 276, 317, 330, 332, 351, 352 Moreland, W. B. 157 Morgenstern, O. 371 M-Pesa in Kenya by Safaricom 35 M-Tax 46 multidisciplinary perspective, budgeting research from 155–60, 165

424  Research handbook on public financial management political science 155–56, 165 public administration 156–58, 165 public economics 159–60, 165 multi-function contracts 337 municipal audit 106–7 municipal bonds 280 breadth of the pledge 290 legal security of 289–95 liquidity and credit risk 288–89 market 287 tax exemption and 287 municipal default 11 Municipalities Continuing Disclosure Cooperation (MCDC) Initiative 102, 109 Municipal Securities Rulemaking Board (MSRB) 279 Musgrave, R. 247 MyInfo, Singapore 53 Nakamura, B. K. 185 Narasimhan, R. 346 national and subnational government budgeting see budgeting research, national and subnational government National Association of State Budget Officers 258–59 National Association of State Procurement Officers (NASPO) 346 National Contract Management Association (NCMA) 331 National Credit Union Administration 279 Nationally Recognized Municipal Securities Information Repositories (NRMSIRs) 106 National Oceanic and Atmospheric Administration (NOAA) 390 National Payments Corporation of India (NPCI) 53 National Performance Review (NPR) 127 natural disasters, on budgeting 163–64, 166 natural language processing technology 209 Naughton, J. 108 negative externalities 186 Nejadmalayeri, A. 103 Neklyudov, A. 288 neo-liberalism theory 68 Netherlands, COVID-19 spending in 85 net present value (NPV) 311, 312 Network of Schools of Public Policy, Affairs, and Administration (NASPAA) 402–3, 405, 406–7, 408–9 new public management (NPM) 58, 61, 138, 240, 329, 343, 348 future directions 72–73 influence of TCE in 71–72 public sector and 61–62

strategic planning and management and 66–68 New Zealand accounting reforms 89 consolidated financial statements (CFS) in 81 COVID-19 spending in 85 public accounting practices 89 strategic planning in 67 system of performance contracting in 65 Next Steps Initiative 88 Nguyen-Hoang, P. 380 Ni, A. Y. 409 Nicholas, C. 335 Niger, direct cash transfer in 42 Nigeria COVID-19 crisis and 21 historic development of public budgeting 139 Mobile Money Services in 51 Niskanen, W. A. 159, 162 Nixon, R. 8, 142 Nolte, I. M. 162 nominal value, debt 303 non-competitive procurement 348 non-procurement goal 334 non-take-up problems 49, 51 non-tax revenue collection 45–47 Norwegian Tax Administration (NTA) 206 Novick, D. 142 Novissi program, Togo 49–50 nowcashing 53 Nudge 379 numerical fiscal rules 307–8 Nylen, W. R. 161 Obama, B. 85 official vs. private creditors 312 Olken, B. A. 217 Olson, M. 377 Ombudsman 59 online banking 36–37 OPEB (Other Post-Employment Benefits) 95, 99–100, 103, 107, 108, 111, 264 open borders and budget constraints 7 Open Budget Index (OBI) 158 open budget survey 259 open government data (OGD) movement 85 operational risk management 317 optimal commodity tax paper 226 optimal organizational structure for tax administrations 215–16 Organisation for Economic Co-operation and Development (OECD) 19, 158, 179, 189, 190, 194, 196, 219, 220 organizational choice and revenue indicators 229–34

Index  425 revenue diversification 234 revenue volatility 232–34 tax base elasticities, tax buoyancy, and tax elasticity 229–32 “orthodox” policies, debt unsustainability and 307 Osborne, D. 240 outcome-based budgeting 240, 241 outsourcing 121, 125, 127 over-the-counter (OTC) market 287 ownership, publicness and 333 PagTesouro, Brazil 46–47 Pantaleoni, M. 251 Pareto optimality 246 Paris Club 312 participatory budgeting (PB) 161, 165, 171, 267–68 pay-go versus pay-use 388–89 payment, tax 207–8, 217, 220, 229 “payment gateway” 35–36 PayPal 36, 53 Peacock and Weisman’s theories 241, 243, 244 peer-to-peer (P2P) lenders 39 pension 95, 99–100, 103, 108, 111, 167, 404 liabilities 100, 264, 283, 289, 297 performance-based budgeting systems (PBBS) 65–66 performance budgeting 141–43, 157, 165, 259, 263 performance contracts 398 performance improvements, tax administration 210 Perry, J. L. 333, 409 personal income tax (PIT) 188–89, 195, 197, 220 Pigou, A. C. 186, 245 Pistor, K. 10–11 Piwowar, M. S. 287 planning, programming, budgeting systems (PPBS) 119, 125, 126, 129, 143, 157–58, 165, 240 platform lenders 39 Plummer, E. 104 point-of-sale terminal 35–36 Poland, performance budgeting in 142 policy options, for debt unsustainability 307–13 policy tools of crisis response 22–25 political feasibility, defined 193 political science, budgeting research in 155–56, 165 politics and economics 4–5, 162 public expenditure theories based on 248–49 Polzer, T. 162 population aging, consequences of 167

POSDCORB 165 positive externalities 196 Poterba, J. M. 277 Potoski, M. 336 price elasticity 183 Prichard, W. 214 Pridgen, A. K. 104 principal-agent (PA) theory 330–33, 337 principal-agent problems 351–52 principal-agent relationship 106 principal-agent theories 160 priority-based budgeting (PBB) 129–30 private sector borrowing practices 62 financial technology (fintech) developments in 32 digital credit 39–40 digital credit and investment 39 digital investment 40–41 digital money 37–38 fintech payments 33 internet-based and app-based payment providers 35–36 mobile and online banking 36–37 mobile money 33, 35 objectives 4 and public sectors, distinction 3–5, 58–61 private tax collection scheme 217 private vs. official creditors 312 privatization and tax farming 217 procurement see also public procurement and contracting defined 342 goals 334 management 397–98 tools 398 producer surplus 181 professional associations 410–11 program assessment rating tool (PART) 158 program budgeting 240 progressive era administration (PPA) 60 progressive taxes 188, 189 progressivity of tax structures in OECD nations 190 property rights theory 69–70 property taxes 184, 186, 191, 193, 196, 228 proportional taxes 189, 190 prospect theory 373–74, 375, 381 provincial sales taxes 195 public accounting practices changes in external environment 84–86 international experiences China 89–90 New Zealand 89 United Kingdom 88–89

426  Research handbook on public financial management United States 86–87 international government accounting standards European System of Accounts (ESA 95) 79–80 Government Finance Statistics Manual (GFSM 2001 and GFSM 2014) 78–79 International Public Sector Accounting Standards (IPSAS) 80 reforms and trends 80 cash-based to accrual-based accounting 81–82 consolidated financial statements (CFS) 82–83 whole of government accounts (WGA) 83–84 public administration, budgeting research in 156–58, 165 Public Administration Review 168, 169 public and private finance 5–7 public budgeting 238, 239 public budgeting and finance, teaching learning outcomes 406–8 resources for teaching 408 academic journals 409–10 professional associations 410–11 status of courses 403–6 Public Budgeting & Finance 168, 169 public budgeting systems administration/management side 156–58 causality in research methods 168–70 environmental shock to 163–64, 166–67 principal-agent theories regarding 160 public choice theory on 159–60 societal changes on 167 public choice theory 70–71, 159–60, 243 public debt 6 public debt management 47 see also sovereign debt subnational debt management strategies 278–83 democracy premium 277–78 emerging research issues in 287–98 globalization, problem with 273 governmental response 275–77 government failure 274–75 legal security, of municipal bonds 289–95 overview 273–74 sustainability, assessment 301–7 unsustainability 307–13 public debt management strategies 278–83 bankruptcy laws 282–83 in China 280–81

credit ratings 282 federal regulation 279 financial instruments 280 in Mexico 281 municipal bonds 280 in United States 280 public economics, budgeting research in 159–60, 165 public expenditure 238, 254 challenges of estimations 251–52 of implementations 252–53 future directions, for research climate change 266 data 258–60 equity and expenditure distribution 266–67 globalization 268 healthcare 265 infrastructure 265 methods 260–61 pensions and old age benefits 263–64 theories 261–62 impacts of, increasing 244 plans and government budgets 239–41 theories on budgetary allocations 249–51 on macroeconomic performances 241–45 on political processes 248–49 on public economics 245–47 public financial management 260 conceptualizing 2–3 effectiveness of 13 public financial management systems, changes to greater emphasis on accurate costing 64–65 greater emphasis on strategic planning and management 66–68 public and private sectors, distinction between 58–61 public sectors, changing organizational structure of 61–62 shift from cash to accrual accounting 62–64 shift from input and process to results-based management systems 65–66 public hearings 126 public investment 47 public management 260 public managers 106 publicness, dimensions of 333–34 public–private–nonprofit partnerships (PPNPs) 131 public-private partnerships (PPPs) 62, 69, 130, 253, 265, 301, 395–96

Index  427 public procurement and contracting see also contract management competitive solicitation 348–49 complexity/uncertainty 336–37 contract management 350–57 foundations of 327 future research on 341–58 “hollowing out” 336 make or buy decisions 327–29 overview 336, 341 principal-agent theory 330–33 scholarship on 342–45 solicitation and market interaction 347–50 strategic public procurement 345–47 supporting small businesses and 334–35 as a tool of public policy 333–35 public–public partnerships (or government-to-government partnerships) 62 public revenue, instruments and management of organizational choice and revenue indicators 229–34 revenue diversification 234 revenue volatility 232–34 tax base elasticities, tax buoyancy, and tax elasticity 229–32 overview 226 revenue policy and management 226–29 simple economic model 227–29 public sector changing organizational structure of 61–62 managers 101–2 new public management (NPM) and 61–62 private sector and, distinction 3–5, 58–61 public sector accounting and financial management future directions in 72–73 theories of agency theory 69 neo-liberalism 68 property rights theory 69–70 public choice theory 70–71 transaction cost economics (TCE) 71–72 public sector’s balance sheet (PSBS) 301–2 public value governance (PVG) 72–73 public values, contract management and 354 punctuated equilibrium model (PEM) of budgeting 155 pure theory of public expenditures 245 qualitative research 261 quality control review (QCR) 106 quantitative empirical methods 260 quick response (QR) codes 207

racial disparities 267 racial justice 267 radical discourse 329 Rainey, H. G. 333 rainy-day funds 163 Ramsey, F. P. 226, 377 rational budgeting 240 “rational ignorance” 195 real options theory (ROT) 353 reform, tax administration 204–12 assessment 206–8 collecting information 206–7 filing of tax returns 207 payment 207–8, 220 collections 210–11 disputes and appeals 211–12 enforcement and facilitation or service paradigms 204 registration and identification 204–6 trust and further challenges for reformers 212–14 verification, control and audit 208–10 performance improvements 210 taxpayer monitoring improvements 209–10 registration system, high-quality taxpayer 204–6 regressive taxes 189 regulation for crisis response 24 debt management 274–76 Reinhart, C. M. 310 repetitive budgeting 140 representative bureaucracy theory 335 “representativeness bias” 374 repurchase agreements (repos) 315 requests for ideas (RFIs) 398 requests for proposals (RFP) 398 requests for quotations (RFQ) 398 requests for results (RFRs) 130 required supplementary information (RSI) 99, 109 resident-subscribers 132–33 resilience bonds 393–94 defined 386 fees 392 resource accounting and budgeting (RAB) 88 resource allocations (or appropriations) 61, 129, 252 resource dependence theory 102 responsibility-centered management (RCM) 129 result-based management systems (RBMS) 65–66 retail investors 40–41 revenue 240 see also tax administration systems bonds 280, 294, 391

428  Research handbook on public financial management capacity 251 collection, efficacy and efficiency in 204 diversification 192, 197, 234 forecasting 124 indicators, organizational choice and 229–34 policy and management 226–29 projections 48–49 volatility 232–34 revenue-raising capacity 190–91, 197 Ricardian equivalence (Ricardo) 370 Ricardo, D. 6, 13, 370, 376 Rich, K. T. 103, 108, 109 Robbins, M. D. 380 Robinson, M. 66 rollover risk 315 Romer, C. D. 27 Romer, D. H. 27 Roosevelt, F. D. 8, 14 Rubin, D. 260 Rubin, I. 157, 404 rule-based system 276, 284 Russia-Ukraine war and global macroeconomy 28 Rwanda, fintech applications for tax collections in 46 Ryu, J. E. 159 Sahay, R. 33 Samuelson, P. 245–47 Sand Dollar, Bahamas 38 SARAs (“Semi-Autonomous Revenue Authorities”) 216–17, 220 Savage, J. D. 8 Say, J.-B. 370 Sbrancia, M. B. 310 Schick, A. 117, 118–19, 122, 124, 157 Schultz, P. 288–89 Schürhoff, N. 288, 289 scientific budgeting methods 241 secured debt 289 SEC (US Securities and Exchange Commission) 109, 279 Seiwald, J. 162 self-certification mechanism 105 self-funded capital 14 Senegal, fintech applications in 46 sensors, implementation of 209 Sexton, S. 186–87 Shah, A. 203 Shybalkina, I. 161 Sides, K. C. 160 Simon, H. 372–73, 374 Simonsen, B. 380 single payer system 265 “sin taxes” 184 Skype 36

Slemrod, J. 185 small and medium enterprises (SMEs) 212 Small Business Act 334 small businesses, procurement through 334–35 smart cities 132, 399 smartphone applications, extensive use of 209 Smith, A. 370, 376 Smith, C. R. 335 1993 SNA 78–79 social-economic shocks to budgeting systems 166–67 social equity problem 161 social safety net programs 164 Social Science Citation Index (SSCI) 96 social transfer programs 42–43 societal changes, on public budgeting systems 167 socio-economic information database initiatives 51 “soda tax” 186–87 soft budget 7–8 solicitation and market interaction 347–50 advertisement and marketing 350 competitive solicitation 348–49 discretion and equity in 349–50 South Korea, COVID-19 crisis in 21–22 sovereign asset-liability management (SALM) 314–15, 320 sovereign debt definition of, issues in 302–3 emerging research issues in 300–320 management, key issues in institutional issues 317 objectives and risks 315–17 restructuring and default 311–13 sustainability assessment, analytical framework for 303–4 DSA, tools for analysis 304–7 overview 300–301 public sector’s balance sheet (PSBS) 301–2 unsustainability 307–13 spatial data 259 Special Drawing Rights allocation 28 specialized units, creation of 216 special levies 292 special revenues 293 specific pledge 290, 291, 292, 296–97 “St. Petersburg Paradox” 371 Stablecoins 38 stable revenues 191 Standard & Poor’s 282, 295 state and local governments see also public budgeting

Index  429 capital markets for 8–9 climate-resilient infrastructure systems 388–95 financial reporting 96–98 NPM ideology and 86–88 state-contingent debt instruments (SCDIs) 316–17 State ex rel. Babson v. Sebring 297 state-owned enterprises (SOEs) 47, 59, 60, 73, 302, 313, 314 statutory incidence 184–85 Staw, B. M. 168 Steiss, A. W. 5 strategic planning and management 66–68 strategic public procurement 345–47 strategic sourcing 345–47 structural reform for crisis response 24 sub-central government expenditures 243 subnational governments (SNGs) 302 subnational public debt management credit risk 288–89 debt management strategies 278–83 democracy premium 277–78 emerging research issues in 287–98 empirical estimates 295–97 governmental response 275–77 government failure 274–75 legal security, of municipal bonds 289–95 liquidity risk 288–89 overview 273–74 subscriber era 131–33 substitution effect 185 sugary beverages tax 184, 186–87 Sunstein, C. R. 379 supply-and-demand curves with taxes 180–83 SUPRES 43 survival constraint 5–6 Sutton, R. I. 168 symbolic tools 22 synthetic asset creation 11 synthetic finance 9–10 Tadelis, S. 331–32 Taft, W. H. 156 Talluri, S. 346 targeted advertising 350 tax(es) 196 see also income tax(es); specific entries administration performance improvements 210 asymmetries 288–89 audits 208–10 base elasticities 230 beverages 184, 186–87, 196 buoyancy 230–31 cannabis 184, 186–87, 195–96

carbon 186 consumption 190, 191 elasticity 191, 192, 231–32 excise 183–84, 186–87 farming, privatization and 217 fuel 187–88, 191, 196 horizontal inequities 213, 220 incidence 184–85 inelastic 191, 192 morale compliance and 212, 213 voluntary compliance and 214 payment 207–8, 217, 220, 229 Pigouvian 186 progressive 189 property 184, 186, 191, 193, 196, 228 proportional 189, 190 rate, marginal vs. effective 188, 196 regressive 189 reliefs 21 returns, filing of 207 revenues 389–90 sin 184 soda 186–87 structures in OECD nations 190 supply-and-demand curves with 180–83 tobacco 183, 184, 191, 196 transparency of 194–95, 197 VAT 195, 197, 207, 220 withholding 205 tax administration systems challenges 205 institutional design 215–17 overview 202–4 performance, future assessments of 203 reformers, trust and further challenges for 212–14 reform in twenty-first century 204–12 assessment 206–8 collections 210–11 disputes and appeals 211–12 enforcement and facilitation or service paradigms 204 registration and identification 204–6 verification, control and audit 208–10 reforms creation of specialized units 216 human resources 217 merger of customs and tax administration 216 privatization and tax farming 217 SARAs 216–17 tax and expenditure limitations (TEL) 263, 399–400 taxation 13

430  Research handbook on public financial management taxation and revenue management adequacy 190–92 deadweight loss 180–81 (de)centralization of 186–87 economic efficiency 180–87 equity 187–90 ability-to-pay principle 188 benefit principle 187–88 horizontal 188–89 vertical 189–90 feasibility 192–94 overview 179–80 transparency 194–95, 197 taxonomy of learning, Bloom 407 taxpayer identification number (TIN) 205 taxpayer monitoring improvements 209–10 taxpayer’s bill of rights (TABOR) 127, 260 Taylor, F. W. 157 Taylor, S. 160 T-bills 315 Teaching Public Administration (TPA) 410 teaching public budgeting and finance see public budgeting and finance, teaching Teo, T. 283 Ter-Minassian, T. 277 Thai, K. V. 334 Thaler, R. H. 379 Thatcher, M. 88 theory of budget constraints 7–9 Thurmaier, K. 162 Tiebout, C. 245, 247, 253 Tieslau, M. A. 277–78 timeliness of good financial reporting 101, 108 Tirole, J. 331 tobacco tax 183, 184, 191, 196 toe hold approach 252 Togo, Novissi program in 49–50 transaction cost economics (TCE) 71–72, 331 transparency of taxes 194–95, 197 treasury payments 42–45 treasury single account (TSA) 45, 46–47, 48, 51, 315 trust, tax administrations’ reformers 212–14 Tullock, G. 125 Tunisia, system of performance contracting in 65 Tversky, A. 373–75 Twitter 36 Tymoigne, E. 6 Uber 36 Una, G. 50 uncertainty 11 The Undoing Project 369 unemployment insurance 164 UN Environment Programme (UNEP) 387

unfunded post-employment liabilities 264 United Kingdom accounting reforms 88–89 historic development of public budgeting 137–38 public accounting practices 88–89 public choice theory and reforms in 71 WGA in 81 United States accounting reforms 86–87 citizen participation in public budgeting 145 debt management strategies 280 growth projections post COVID-19 pandemic 27 historic development of public budgeting 138, 139 monetary sovereignty of 13, 14 public accounting practices 86–87 US dollar 8 unstructured supplementary service data (USSD) 46 unsystematic factors 11 user charges and fees 196, 390 value-added taxes (VAT) 195, 197, 207, 220 value relevance of financial reporting 102 accounting standard adoption 103–4 financial information quality 105–6 good financial reporting practices 104 information content of financial reporting 104–5 municipal audit 106–7 measuring 110 Van de Ven, A. H. 168–69 Van Gaalen, R. 160 vendor participation 350 Verdier, G. 203 verification and control function 208–10 Vermeer, T. E. 99 vertical equity 189–90 Vickrey, W. 7 virtual assistant automatic response systems 206 Visa 36 Vitasek, K. 346 volatility, revenue 232–34 Von Hagen, J. 277 von Hayek, F. 373 Von Neumann, J. 371 Von Neumann-Morgenstern (VNM) utility theory 371–72 "voting with the feet" model 245 Wagner, A. 241–43 Wallace, W. A. 104, 107

Index  431 Walras, L. 370 Walsh, P. 388 Wang, X. 104 Washington Consensus 274, 275 Water Infrastructure Finance and Innovation Act 392–93 “watertight” finances and budget constraints 7 Waymire, T. R. 109 web banking 36–37 Weber, M. 60 Web of Science (WoS) 96 WeChat 36 Weick, K. E. 168 Weingast, B. R. 7 Westerlund, J. 164 Westminster system 61 WhatsApp 36 White, J. 8 whole of government accounts (WGA) 81, 83–84, 88

Wildavsky, A. 8, 126, 155, 157, 162, 169, 249, 377 Wilder, W. M. 104 Williamson, O. E. 71–72, 330, 345 Willoughby, K. G. 162 Willoughby, W. F. 141, 157, 377, 386 Wilson, J. Q. 159 Wray, R. 8 Wright, D. S. 159 Wright, E. O. 161 Wyckoff, P. G. 159–60 Yinger, J. 380 zero-base budgeting (ZBB) 130, 143, 158, 240, 251 Zhang, F. 108 Zhao, B. 164 Zimmerman, J. L. 101