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"Fiscal Headroom": A Flawed Approach to Expenditure Prioritization

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(Originally published in July 2009 on the IMF's PFM blog)
What is the best methodology for prioritizing expenditure in a medium-term context? One view is that the focus should be on the “fiscal headroom” – also referred to in francophone countries as the “marge de maneouvre”.  I’ve seen this approach up close in two countries recently. It is an approach which is not only flawed in principle, but particularly unsuited to the post-crisis fiscal circumstances of most countries.
Some background first. The core of medium-term budgeting is the idea that multi-year estimates of the affordable ceiling for aggregate expenditure (based on projections of revenue and macroeconomic conditions, as well as a clearly-specified fiscal policy) are compared with “forward estimates” for expenditure (which project expenditure on an unchanged policy basis). Any gap between trend aggregate expenditure and affordable aggregate expenditure will thereby become evident. Expenditure policy decisions can then be made with a clear understanding of their implications for fiscal sustainability.
The “fiscal headroom” approach says that expenditure prioritization should focus mainly on how to allocate the gap between the aggregate expenditure limit and the forward expenditure estimates. It is assumed that this gap will be positive, providing an amount which can be spent on new initiatives. Prioritization is then about how to spend the money available for new initiatives.
There are two things wrong with this approach. The first is the assumption that there will necessarily be any “fiscal headroom” to allocate. In post-crisis circumstances, with many governments facing major permanent reductions in revenue streams and increased expenditures associated with bailouts, this is clearly an unwarranted assumption. The second problem is that, even in good times, the “fiscal headroom” doctrine encourages a passive and uncritical acceptance of ongoing current expenditure.
The fiscal headroom doctrine reflects, in fact, the widely-condemned dual budgeting doctrine. This doctrine makes the mistake of viewing current expenditure as essentially “non-discretionary”. It regards capital (or “development”) expenditure as the only – and quite separate – domain in which expenditure policy choices can be made. These faulty assumptions lead to a view that expenditure prioritization is essentially a matter of determining the margin between aggregate medium-term capital expenditure commitments and the feasible medium-term aggregate capital expenditure, and then deciding what new development projects to initiate.
Contrary to this manner of thinking, the heart of good expenditure prioritization must be systematic processes for the critical examination of the mass of ongoing expenditure, in which current and capital expenditure are reviewed jointly. In short, good “expenditure review” processes. The fiscal headroom doctrine, together with any other approach to budgeting which explicitly or implicitly encourages unthinking incrementalism, should be firmly discouraged.
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