Occasional Papers are written by the Staff of the Directorate-General for Economic and Financial Affairs, or by experts working in association with them. The “Papers” are intended to increase awareness of the technical work being done by the staff and cover a wide spectrum of subjects. Views expressed do not necessarily reflect the official views of the European Commission. Comments and enquiries should be addressed to: European Commission Directorate-General for Economic and Financial Affairs Publications B-1049 Brussels Belgium E-mail: Ecfin-Info@ec.europa.eu This paper exists in English only and can be downloaded from the website http://ec.europa.eu/economy_finance/publications A great deal of additional information is available on the Internet. It can be accessed through the Europa server (http://europa.eu ) ISBN 978-92-79-08371-6 doi: 10.2765/25008 © European Communities, 2008

THE QUALITY OF PUBLIC FINANCES Findings of the Economic Policy Committee-Working Group (2004-2007)

Edited by:

Servaas Deroose

(Director, Directorate Macro economy of the euro area and the EU, Directorate-General Economic and Financial Affairs)

Dr. Christian Kastrop

(President of the Economic Policy Committee of the EU. Chairman of the EPC-Working Group "Quality of Public Finances" (2004-2008).

Deputy Director General "Public Finance and Economic Affairs", Federal Ministry of Finance, Germany)

March 2008

Abstract:

Improving the quality of public finances has become a key policy challenge for European policy makers. While maintaining sound budget positions remains the linchpin of the European Union's fiscal framework, rising pressures from globalisation and ageing populations are calling to improve also the qualitative aspects of fiscal policy with a view to supporting economic growth. This includes to better target public resources, raise the efficiency of public spending, modernise public finance institutions and budget administration, create supportive fiscal frameworks and establish efficient and growth-enhancing revenue systems. The need for such a comprehensive approach to strengthen public finances is laid out in this collection of papers prepared by the EPC Working Group on the Quality of Public Finances between 2004 and 2007. It also highlights the challenges that come along with policy implementation by drawing on a number of country case studies.

Key words: Public finances, fiscal policy, public spending, expenditure composition, fiscal governance, fiscal rules, public administration, expenditure efficiency, health expenditure, innovation policy, revenue systems, taxation, COFOG

JEL classification: E01, E62, H11, H20, H30, H50, H51, H61, H83

CONTENTS

Foreword ............................................................................................................................................................ 5

I. FRAMEWORK AND DATA ISSUES

1. Introductory Note ................................................................................................................................... 11

2. Restructuring Public Expenditure – Challenges and Achievements. Key Issues on the Quality of Public Finances Economic Policy Committee ................................................................................................................... 13

3. Report on Quality of Public Finances Issues – Work Accomplished and Way Forward Economic Policy Committee ................................................................................................................... 21

4. Quality of Public Finances and Growth António Afonso, Werner Ebert, Ludger Schuknecht and Michael Thöne .............................................. 39

5. Possible Ways to Implement a Dataset to Analyse the Quality of Public Expenditure Economic Policy Committee ................................................................................................................... 61

II. FISCAL GOVERNANCE

1. Introductory Note ................................................................................................................................... 89

2. National Numerical Fiscal Rules for Sound Public Finances European Commission ........................................................................................................................... 91

3. The Role for Fiscal Agencies Xavier Debrun, David Hauner and Manmohan S. Kumar (International Monetary Fund) ................. 129

4. Design Choices for Fiscal Policy Rules Barry Anderson and Joseph J. Minarik (OECD).................................................................................. 149

5. Improving Public Sector Efficiency: Challenges and Opportunities Teresa Curristine, Zsuzsanna Lonti and Isabelle Joumard (OECD).................................................... 179

6. Modernising Public Administration: Initiatives to Improve the Efficiency and Effectiveness of Public Spending European Commission.......................................................................................................................... 209

7. Expenditure Ceilings and Fiscal Policy – Swedish Experiences Urban Hansson Brusewitz and Yngve Lindh (Ministry of Finance Sweden)........................................ 223

8. Program Budgeting and Performance Management in France: The 2001 Reform of the Constitutional Bylaw Frédéric Bobay (Ministry of Economy, Finance and Industry France) ............................................... 235

III. COMPOSITION AND EFFICIENCY OF EXPENDITURE

1. Introductory Note.................................................................................................................................. 249

2. The Efficiency and Effectiveness of Public Spending Economic Policy Committee and European Commission..................................................................... 251

3. Impact of Public Expenditures to Boost Innovation Rikke Lilienthal (Ministry of Finance Denmark).................................................................................. 257

4. Public Sector Efficiency: Evidence for New EU Member States and Emerging Markets António Afonso, Ludger Schuknecht and Vito Tanzi............................................................................. 279

5. Relative Efficiency of Health Provision: A DEA Approach with Non-Discretionary Inputs António Afonso and Miguel St. Aubyn .................................................................................................. 309

6. Austrian Approach towards the Quality of Public Expenditures Ulrike Mandl (Federal Ministry of Finance Austria) ........................................................................... 327

7. Improving Innovation Policy: The Search for Knowledge about its Effectiveness Marco van Hengel and Niek Nahuis (Ministry of Finance The Netherlands) ...................................... 333

IV. COMPOSITION OF REVENUE AND EFFICIENCY OF TAX SYSTEMS

1. Introductory Note ................................................................................................................................. 347

2. Structure of Tax Revenue and the Quality of Public Finance Christian Valenduc (Federal Ministry of Finance Belgium) ................................................................ 349

3. Tax Revenues in the European Union: Developments and Economic Issues European Commission.......................................................................................................................... 363

V. CASE STUDIES ON IMPROVING THE QUALITY OF PUBLIC FINANCES: "REDIRECTING SPENDING AND IMPROVING FISCAL INSTITUTIONS

1. Introductory Note ................................................................................................................................. 393

2. Public Finance Reform in the Czech Republic Ministry of Finance of the Czech Republic........................................................................................... 395

3. Finnish Experiences on Redirecting Public Expenditures Ministry of Finance Finland ................................................................................................................. 403

4. German Experience on Redirecting Public Budgets Federal Ministry of Finance Germany ................................................................................................. 415

5. Redirecting Public Expenditure in Italy Danila Malvolti and Mauro Mare (Ministry of the Economy and Finance Italy) ................................ 431

6. Malta: Redirecting Public Expenditure Ministry of Finance Malta .................................................................................................................... 445

7. Public Finance Reform − Polish Experience Ministry of Finance Poland ................................................................................................................. 459

8. Redirecting Public Expenditure in Portugal Ministry of Finance and Public Administration Portugal .................................................................... 467

9. Spanish Experience in Redirecting National Public Budgets Ministry of Finance Spain .................................................................................................................... 475

10. Re-directing Public Expenditure − The UK Experience HM Treasury ........................................................................................................................................ 487

5

FOREWORD

The relevance of quality of public finances

Improving the quality of public finances has become a key policy challenge for European policy makers. While maintaining sound budget positions is the linchpin of the European Union's fiscal framework, rising pressures from globalisation and ageing populations have put additional demands on fiscal policy with a view to supporting economic growth. In particular, the upward pressures from age-related expenditure require public spending in other areas to become more efficient to free up resources so as to avoid a further increase of the already large public sectors and high tax burdens in many EU Member States. More generally, greater public spending efficiency is an objective that is independent of the size of government sectors and has therefore received much attention recently. Modernising public finance institutions and budget administration as well as creating supportive fiscal frameworks can help achieve this objective and have therefore been another focus of the work on quality of public finances (QPF). At the same time, public resources can be better targeted toward “growth-enhancing” areas, for example R&D and education. These challenges should be tackled hand in hand with creating revenue systems that are apt to the challenges of today's globalised markets. In particular, efficient tax structure should keep in check the disincentives for the provision of capital and labour and thereby potentially damaging growth prospects.

The role of the Working Group on Quality of Public Finances

Responding to the importance of quality of public finance, the Working Group on Quality of Public Finances was formed in 2004, as a sub-committee to the Economic Policy Committee (EPC). Its objective is to analyse the links between public finances and long-term potential growth. Since QPF comprises many dimensions, the Working Group decided to follow a step-by-step approach and over time focus on the various aspects of QPF, including by presenting and discussing country experiences.1

Members of the Working Group include expert staff of the Member States, the European Commission, Eurostat and the European Central Bank. Moreover, the OECD and the IMF participate as observers and have provided input. The Group has also regularly invited experts from academia and national and international administrations for an exchange of views.

The main issues discussed and the main findings

The key aspects of QPF, which the Working Group has discussed since 2004, are presented in this collection of papers. Unfortunately, only a subset of the large amount of work can be included here due to space constraints. It should also be noted that the papers reflect the state at the time when they were presented at the Working Group. That means, especially for the country case studies, policies and institutions may have changed since, which is not reflected in the papers.

The papers are structured into five sections broadly covering the key topics of the Working Group. The main issues and findings are as follows:

Framework and data: The first focus of the Working Group was to define a concept of quality of public finances and identify data needs to conduct cross-country studies. Quality of public finances

1 The original EPC mandate from May 2004 was accompanied by specific ECOFIN mandates of January 2006, October 2006 and June 2007.

6

has commonly been viewed as a concept with many facets. An EPC note (2007) defined QPF as “a broad concept which refers to the conduct and organisation of budgetary policy and its potential impact on long-term growth of the economy.” As summarised in the EPC notes from 2006 and 2007 and the paper by Afonso et al. (2005), presented in Section I, empirical evidence suggests that public finances can contribute to this objective by well-targeted expenditure and more efficient use of scarce public resource which also allows lowering the overall size of governments and the tax burden. Sound budget positions are key for these objectives and can be helped by fiscal rules and institutions.

Since meaningful and comparable data are key for the cross-country analysis of quality of public finances, the Working Group paid much attention to identifying and filling data gaps, in particular on public spending. The paper by the EPC from 2004 describes that the Classification of Functions of Government (COFOG) was agreed to be the most useful starting point in this respect as it allowed splitting up government expenditure by functions rather than by economic classification. The former lends itself better for studying the productivity and efficiency of expenditure. By now, these data are available for all EU Member Sates through the Commission services' AMECO database. However, since the aggregation level was still too high to assess, for example, the role of R&D spending for growth, the work was advanced on providing second-level data (COFOG-II). This work is ongoing and data are envisaged to be made publicly available soon.

Fiscal governance: Fiscal governance cuts through all dimensions of quality of public finances, but particularly helps ensure sound budgets and sustainability. A paper by the European Commission (2006) provides a comprehensive overview of the numerical fiscal rules in the European Union and documents their rising importance. Moreover, it finds empirical evidence that strong fiscal rules with a wide coverage of budgetary items are linked to better budgetary outcomes. A paper by Anderson and Minarik (2006) compares deficit and expenditure rules and clearly recommends the latter in terms of best accomplishing the multiple objectives of the budget. Another institutional option to lower the deficit bias are fiscal institutions (also called fiscal agencies) which provide independent analysis, forecasts or judgements as shown in the paper by Debrun, Hauner and Kumar (2007). The work by Curristine, Lonit and Joumard (2006) focuses on the role of budgetary procedures, in particular performance-based budgeting, in improving public efficiency. Country experiences in this area and modernising public administrations more generally are surveyed in the European Commission note (2007). Instructive are the country examples of fiscal governance frameworks. The paper by Hansson-Brusewitz and Lindh (2005) details the Swedish experience with medium-term expenditure rules, while the paper by Bobay (2005) describes the French budget reform from 2001 that introduced a new budget structure along with goals and performance indicators.

Composition and efficiency of expenditure: Initially the Working Group paid much attention on reviewing the composition of public expenditure given the links between some spending components and growth (see for example an overview of the literature in the 2004 Public Finance Report). Two country cases, Austria and the Netherlands, are presented in this section, describing the experiences with shifting expenditure in support of growth (more country examples can be found in Section V). The particular role that public expenditure can play in boosting innovation is assessed in the paper by Lilienthal (2004).

Given the pressures to reduce public spending, another focus has been on how to assess and improve the efficiency of public expenditure. The main challenges for such analysis, such as the measurement of inputs, outputs and outcomes to obtain efficiency indicators, and the main reform avenues, such as structural and institutional reforms, are summarised in a joint EPC/European Commission note (2007). Comparative estimates of efficiency of public expenditure and overall public sector performance for new Member States are provided in the paper by Afonso, Schuknecht and Tanzi (2005). This study builds on their earlier paper on efficiency, covering the old Member States. While the paper stirred some critical discussions on the methods used, it opened the door for further efficiency studies, which explicitly take into account the determinants of efficiency such as the one by Afonso and St. Aubyn (2006) on health provision.

7

Composition of revenue and tax systems: The structure of revenues can impact long-term growth, mostly by affecting the allocation of labour and capital. While there is some evidence that consumption taxes create fewer disincentives for growth than direct taxes, the detailed structure of such taxes need to be carefully considered. Valenduc (2005) explains these challenges for assessing the quality of tax revenue systems and focuses particularly on the choice of indicators which he applies in an analysis of the Belgian tax system. In addition to minimising distortions from tax systems for economic growth, the Member States of the European Union also face important challenges in maintaining robust tax bases. Firstly, aging will reduce the labour tax base. Secondly, the increased mobility for labour and capital that globalisation is bringing could complicate their reliability as tax basis. And thirdly, the desire to shift taxation away from labour “to make work pay” requires finding alternative tax basis. The paper by the European Commission (2007) reviews the recent trends in taxation in the European Union and discusses several ways in light of these rising challenges.

Case studies on improving the quality of public finances: The last section is devoted to detailed country studies. The examples of the Czech Republic, Finland, Germany, Italy, Malta, Poland, Portugal, Spain and the United Kingdom summarise expenditure trends and review reforms in the public sector with the aim of improving the efficiency of spending and strengthening fiscal institutions. The emphasis of policies reflects the country-specific circumstances, for example fiscal consolidation in the Czech Republic through an expenditure and revenue-based approach; the introduction of spending limits for a whole electoral period in Finland; a three-pronged approach (structural reforms, tax cuts and consolidation) to foster growth in Germany; budgetary institutional reforms in Italy to raise public sector productivity; the reduction of the government sector and public employment in Malta; rebalancing fiscal positions in Poland and Portugal largely from the expenditure side, while at the same time raising efficiency; in Spain shifting spending to those items with the largest impact on medium and long-term potential growth; and the implementation of a new public spending framework for improving the quality and cost-effectiveness of public services in the United Kingdom.

The way forward

The objective of raising the quality of public finances remains pertinent. The re-launched Lisbon Strategy from 2005 provides a foundation for future work,2 which was recently reiterated by the ECOFIN Council in its meeting on 9 October 2007. It specifically gave the Commission and the EPC a mandate to continue its work in this area as the Council conclusions included the following statement: “It invites the EPC and the Commission to step up their efforts to improve the analysis, methodology and measurement of the quality of public finances, including the efficiency and effectiveness of public expenditure and revenue structures, as well as of major public sector reforms. Ministers also re-iterated their June 2007 request for Member States to step up efforts in the provision and subsequent analysis of COFOG, level II data (…).” Following this mandate, the Working Group is aiming to make quality of public finances operational as part of the Lisbon strategy and against the background of strengthening the coordination and surveillance of fiscal and economic policies. Based on a comprehensive conceptual framework, work is envisaged to continue on the efficiency and effectiveness of specific expenditure categories, the efficiency of revenue systems and the role of fiscal governance. The Working Group will also continue, together with the Commission, to conduct cross-country studies and exchange country experiences in the various dimensions of quality of public finances and their macroeconomic links to growth.

2 Integrated Guideline No. 3 of the re-launched Lisbon Strategy states: "To promote a growth- and employment-orientated and efficient allocation of resources, Member States should, without prejudice to guidelines on economic stability and sustainability, re-direct the composition of public expenditure towards growth-enhancing categories in line with the Lisbon strategy, adapt tax structures to strengthen growth potential, ensure that mechanisms are in place to assess the relationship between public spending and the achievement of policy objectives, and ensure the overall coherence of reform packages."

8

Words of appreciation

The work on quality of public finances that is summarised in this collection of papers reflects the joint efforts by all members of the Working Group. Even if only an excerpt of papers can be shown here, we are most grateful to all contributors to the Working Group since 2004. While we cannot name all people individually, let us nevertheless point out some who have been instrumental in setting up the Working Group and advancing its work. From the European Commission, we are particularly grateful to Elena Flores Gual, Fabienne Ilzkowitz, Joaquim Ayoso Casals, Giuseppe Carone, Adriaan Dierx, Ulrike Mandl, Laurent Moulin, Gaëtan Nicodème, Jan-Host Schmidt and Peter Wierts, who have been key contributors by providing numerous important issues notes and advancing the discussions over time. From the EPC, we would like to thank Heinz Scherrer and Olaf Prüßmann for their excellent support to help keep the Working Group stay on track. We also greatly appreciate the ongoing support from the European Central Bank and particularly from António Afonso whose conceptual work has given indispensable stimulus to the Working Group. From Eurostat, our thanks go to Eduardo Barredo Capelot and his team for the instrumental work on COFOG data. In that respect, our special thanks also go to Raffaele Malizia (Italian participant in the Working Group) for the comprehensive work on indicator developments based on COFOG and Werner Ebert and Tanja Burckardt (Ministry of Finance, Germany) who played an important role in developing the conceptual and strategic work of the Working Group.

Last but not least, we would like to thank the team that has made the publication of this collection of papers possible. We are greatly indebted to Werner Ebert and Andrea Schaechter as the project leaders who have assembled this book in a very short period of time. They received excellent editorial assistance by Anna Rauch, help by Olaf Prüßmann and support in the production process by Dominique Marchalant.

Brussels, 5 February 2008 Servaas Deroose

Christian Kastrop

I. FRAMEWORK AND DATA ISSUES

11

INTRODUCTION: I. FRAMEWORK AND DATA ISSUES

The ‘quality of public finances’ (QPF) is a manifold concept. Originally, the idea to explore qualitative aspects of fiscal policy stemmed from the notion that concentrating solely on quantitative aspects, in particular the Maastricht criteria, is not comprehensive enough and could possibly result in suboptimal outcomes including unwanted side-effects. Therefore, right from the beginning, the task of the Economic Policy Committee’s QPF-Working Group has been to explore the links between the qualitative and the quantitative sides of fiscal policies. This first section on methodology and data issues prepares the ground for this analysis. Here, also the fundamental question of defining the concept is addressed.

The first paper by the Economic Policy Committee (2006) reflects the first two years of the Working Group on QPF. During that time, the Working Group concentrated mainly on the expenditure side of the budget. In that respect, the work on quality covered three elements: investigating the role of budgetary institutions in identifying and implementing expenditure priorities; analysing and monitoring trends in the composition of public expenditure; and measuring the efficiency of public expenditure. In the meantime, as the second paper by the Economic Policy Committee (2007) on "Work accomplished and the way forward" points out, also the composition and qualities of tax revenues have become an important issue of QPF-analysis – yet, this is a nascent branch at the moment.

Thus, the paper on the quality of public finances and growth by Afonso, Ebert, Schuknecht and Thöne (2005) concentrates on the linkages between the level and composition of public expenditure and its financing via revenue and deficits on the one hand, and economic growth on the other hand. In general, the authors find that fiscal policies are of high quality and support growth if they fulfil five requirements: They (1) provide for an institutional environment supportive to growth and sound public finances, (2) limit commitments to the essential role of government in providing goods and services, (3) set growth promoting incentives for the private sector and make efficient use of public resources, (4) finance government activities and where appropriate private sector activities with an efficient and stable tax system, and (5) support macroeconomic stability through stable and sustainable public accounts.

In their paper, Afonso and colleagues also provide a survey of different empirical studies which shows that an objective and unambiguous overall catalogue of “high quality”-expenditure items cannot be established. Yet, as the Working Group on the quality of public finances learned, there is also very limited comparable data on the composition of public finances. When the Working Group started, the composition of government expenditure could only be examined with first level data from the ‘Classification of Functions of Government’ (COFOG), i.e. in no more than ten different categories. To overcome this knowledge gap, the Working Group outlined ‘possible ways to implement a dataset to analyse the quality of public expenditure’ and conducted a survey among its members on the feasibility of an improved dataset as outlined in the EPC not from 2004.

At the center of this improved set stand expenditure data broken down at a second level (COFOG-II), i.e. differentiated into seventy different groups. Meanwhile, Eurostat and the Member States have established a specialised COFOG-task force on this matter. On the basis of voluntary submissions, this work is ongoing, COFOG-II-data for most Member States are being produced, and they are envisaged to be made publicly available soon, as the above mentioned EPC-note of 2007 reports.

13

RESTRUCTURING PUBLIC EXPENDITURE: CHALLENGES AND ACHIEVEMENTS

KEY ISSUES ON THE QUALITY OF PUBLIC FINANCES

Economic Policy Committee

Paper completed: January 2006

1. Background

The current EU economic policy framework considers budgetary discipline and fiscal sustainability to be key elements in achieving a sound and growth-supportive economic environment. In recent years, in support of these priorities, the concept of “Quality of Public Finances” has gradually been acquiring greater relevance in the economic-policy making debate at the national and EU levels on how fiscal policy can contribute to more growth and employment1.

The focus on quality supports the quantitative criteria of the current EU fiscal surveillance framework. In the new Broad Economic Policy Guidelines 2005-2008 (BEPGs), Member States are asked to direct the composition of public spending towards growth-enhancing items, adapt tax structures to strengthen growth potential and assess properly the relationship between public spending and the achievement of policy objectives. Notably, the ECOFIN report to the March 2005 European Council on “Improving the implementation of the Stability and Growth Pact (SGP)” includes specific references to the overall quality of public finances and the implementation of policies in the context of the “Lisbon Agenda”, as elements to be taken into account when assessing budgetary developments in the EU. The reform of the Pact stresses the role of national institutions and fiscal rules in reinforcing the fulfilment of the fiscal objectives considered in the SGP and strengthening the quality of public finances.

Against this backdrop, the Economic Policy Committee (EPC) has analysed the links between public finances and long-term growth. This note deals with three elements: (1) investigating the role of budgetary institutions in identifying and implementing expenditure priorities; (2) analysing and monitoring trends in the composition of public expenditure; and (3) measuring the efficiency of public expenditure. The analysis at this stage has focused on the expenditure side of the budget.

1 The concept of quality encompasses those elements of public finances that ensure the most effective and efficient use of

public resources with a view to raising the long-term growth potential of the economy.

14

2. First results2

The composition of public finances, budgetary laws, fiscal frameworks and institutions are issues of national responsibility. Therefore, analysing Member States’ quality of public finances requires due consideration of their heterogeneity in terms of national preferences and specific institutional and behavioural context (concerning, for example, the level of development and the quality of the infrastructure or their education systems).

(1) Defining and implementing priorities: the role of budgetary institutions and fiscal rules

One approach to evaluate budgetary quality is to assess the degree to which Member States’ spending reflects their ex-ante identified economic policy priorities. In general, countries that have maintained fiscal discipline have been able to put a stronger focus on efficient resource allocation. National case studies carried out by the EPC confirm that most Member States have established expenditures priorities in key areas of R&D, education and investment (Table 1). In practice, however, these priorities are easily crowded-out by upward pressures in other categories during the budgetary decision-making process and in the course of budgetary implementation (e.g. structural spending items such as ageing). This can largely be explained by the soft nature of the announced priorities and in several countries an inappropriate institutional setting through which they should be implemented.

The case studies provide first indications that those countries that have been at the forefront of institutional reform, by introducing national expenditure rules and performance budgeting schemes within a medium-term framework, manage better to redirect public spending towards their national expenditure priorities and to protect these targeted items during periods of fiscal consolidation.3

Therefore, effective and appropriate budgetary institutions appear to be a key factor in facilitating the implementation of medium-term policy objectives, which are relevant not only for raising the quality of public budgets but also for helping maintain fiscal discipline and budgetary consolidation.

(2) Recent trends in the composition of public expenditure

Figure 1 summarises key trends in public expenditure in terms of its composition, over the past decade and for a broad sample of Member States4. Overall, they point on average to a long-term trend of increases in expenditure on transfers/social protection and decreases in public investment.5 Recent changes in the composition of public expenditure in the Member States show that many of those countries benefiting from large decreases in interest payments since the late 1990s used this room for manoeuvre for increasing expenditure on government consumption6 and on current transfers (Table 2). As decreases in interest payments fade out, room for manoeuvre in line with national priorities necessarily needs to be found in other categories of public expenditure, for which those of transfers and consumption are by far the largest. However, these are the categories in which pressures for expenditure increases will remain very high in the absence of reforms, in a context of expenditure pressures rising further due to ageing populations.

2 A fuller analysis of the preliminary findings of the EPC is included in the progress report of the EPC on the Quality of

Public Finances adopted by the Committee on 27 September 2005 (ECFIN/EPC(2005)REP/53776). 3 Performance budgeting in a strict sense is defined as the allocation of resources based on the achievement of specific,

measurable outcomes. 4 The sample depended on the availability of full time-series of data. 5 It should be noted that the picture for social protection expenditure is mixed, with substantive relative decreases in IE,

UK, FR and NL and substantive increases in SE, EL and PT. As regards the trends in public investment, one should note the changing boundaries between public and private investment, which are in part linked to privatisation.

6 This also includes the bulk of health care and education expenditure.

15

Figure 1 – Change in percentage points over total public expenditure over the period 1991-2003

-6,0

-4,0

-2,0

0,0

2,0

4,0

,

Interest payments Public Investment Social Protection Source: Commission Services.

Note: (1) This presentation does not reflect a normative choice in the sense of a classification of expenditure items into “growth-enhancing” items and “non growth-enhancing items”. It should also be noted that accounting conventions have an impact on these spending trends. This supports the case for the need for more precise data. (2) Countries included are BE, DK, DE, EL, IT, LU, PT, FI, UK. (3) Interest payments and public investment belong to the economic classification of public expenditure; social protection to the functional classification.

Ideally, the analysis on the composition of public expenditure would allow for detailed monitoring of the implementation of expenditure priorities as set by Member States themselves and the exchange of best practices. However, a broader and more detailed data set with longer time series is a necessary precondition for better ex-post evaluation of trends as well as monitoring of public expenditure composition. In practice the analysis on the composition of public expenditure is hampered by a lack of sufficiently detailed data. 7

In cooperation with Eurostat, concrete steps for moving towards more detailed data availability on the functional classification of public expenditure have been developed. Further efforts in broadening the data base are needed.

(3) Measuring the efficiency and effectiveness of public spending

The analysis of the quality of public finances is incomplete without addressing the efficiency and effectiveness of public expenditure, i.e. the achievement of priorities at minimum costs. This allows for analysing how specific inputs (e.g. expenditure on R&D) affect outputs (e.g. number of patents per million population) and final outcomes (i.e. increasing sectoral and overall productivity). Available empirical evidence on specific spending categories (in particular, impact assessments in the case of innovation and human capital formation) shows that spending inefficiencies can be high, thus suggesting room for improvement in the use of scarce public resources. This kind of assessment requires suitable evaluation methods and tools to provide policy-makers with a better understanding of the impact of their policies.

3. Further work

Efforts to improve the composition of public finances appear of utmost importance for the achievement of the goals incorporated in the Lisbon strategy. In the light of the first results and the priorities and

7 The reference data set to be improved is the so-called COFOG classification (General Government expenditure by

function and economic category) collected by Eurostat under the ESA95 transmission programme.

16

needs outlined above, the ECOFIN Council may wish to mandate the EPC to develop further the framework for assessing and promoting the quality side of budgets amongst Member States:

(1) The role of fiscal rules and institutions

In line with the literature on this topic, the first conclusions of the EPC point to the relevance of the design and nature of fiscal rules and institutions (e.g. medium-term budget frameworks, appropriate design of fiscal rules, budgetary transparency etc) to final budgetary outcomes. While it is clear that these issues fall under national competence and that there are no one-size fits all solutions, learning from best practices would be most useful. In addition, given the prominence of national budgetary rules and institutions to comply with common EU fiscal targets underlined in the context of the reform of the SGP, the analysis on this topic should be both broadened and deepened. This implies looking at a larger range of budgetary rules and institutions and their impact on key budgetary objectives (fiscal sustainability, the composition of the budget and the efficiency of public expenditure) and thus on long-term growth.

Against this background, the EPC could be mandated by the Ecofin to conduct jointly with the Commission a comprehensive analysis of the institutional aspects and budgetary rules in the EU.

(2) Analysing and monitoring expenditure composition

The BEPGs include a specific guideline on the quality of public finances (guideline No. 3). The Commission is monitoring the implementation of this guideline as part of its regular yearly assessments, but methodologies can be improved. A precondition to improve the analysis of public finances and to draw a clearer picture on the composition of public expenditure is the availability of more detailed, timely and comparable statistics. Specifically, three aspects of the data presently available should be improved: i) a broadening and extension of available COFOG data to the second level of the functional classification to facilitate cross-country analysis (at present such data is available for only 7 Member States); ii) longer national time-series should be available in order to carry out comparison across Member States and backwards analysis; and iii) other relevant data, for instance for public-private partnerships (PPPs) in infrastructure investment (including concessions and other types of public procurement), and tax expenditures, should also be considered in the analyses.

A clear mandate to the EPC in order to make, jointly with EUROSTAT and the National Statistical Offices, further progress on these statistical issues through the existing EUROSTAT COFOG taskforce or by other means as appropriate, would be an effective way to make progress.

(3) Measuring efficiency and effectiveness of public expenditure

Further work could focus on exchanging best practices on national experiences with systems of appraisal and evaluation, or continued work on performance-based approaches in budgeting. This might include, inter alia, the formulation of appropriate indicators of policy outcomes, the improvement of the information content of performance budgets, and the exchange of best practices in the use of evaluation techniques. Some work could also be undertaken on evaluating the efficiency and effectiveness of state aid.

The EPC stands ready to continue work on these issues in order better to assess the efficiency and effectiveness of public expenditure in achieving desired ends.

17

Annex:

Table 1 - Expenditure priorities in EU Member States

Member State Prioritised items How to create room for manoeuvre? AT Expand future-related spending (public

infrastructure, R&D, education) Contain past-related expenditure (that typically relate to income distribution); pension reform; public sector administration reform

BE R&D, education, transport infrastructure, health, justice and public security

Falling interest payments, containment of overall expenditures except priorities

CY R&D; physical infrastructure, human capital and knowledge

Defence, agricultural subsidies, grants to semi-governmental organisations

CZ R&D, education, transport infrastructure, programmes co-financed from the EU budget

Spending reforms in area of sickness benefits; pensions; state social support; assistance and central government employment (i.e. cuts in consumption and social transfers)

DE Education and training, research and innovation, measures to making it easier to reconcile work and family life

Labour market reforms, reforms in the pension and health care systems to limit social security expenditures, cutting down subsidies and tax expenditures

DK Education, human capital and knowledge Expenditure on economic affairs has declined EL Full priority given to fiscal consolidation Cutting down operating expenditure, consumption

expenditure ES Technological investment, development

and innovation, infrastructure, education Strict commitment to fiscal discipline

FIN Education, research and development Pension and health insurance reform and lowered unemployment security costs to curb social security expenditure, municipal sector

FR Employment, R&D, innovation, higher education, security

Reduction of state expenditure in real terms, enhancing efficiency, containment of social expenditure, promoting moderation in local spending

HU EU projects, certain infrastructural expenditure

Expenditures without priority, falling interest payments

IT Investment in infrastructures, capital formation in less developed areas of the country

Reduce the rate of growth in pension expenditure, falling interest payments, contain expenditure on goods and services, improve administrative procedures

LIT Knowledge society, public security and competitive economy

Pension and tax reform, improve public administration

LV Macroeconomic stability, knowledge and innovation, R&D, education, public services

Introduce medium-term strategic planning, improve cost efficiency

MT Education, environment Fiscal consolidation, public sector reform, reduce the size of the public sector, privatisation

NL Education and knowledge, health care, and public security

Strong fiscal consolidation aimed at increasing labour participation and improving long-term growth potential (for instance through social security reform)

PL Public investment, development of technical infrastructure

Adjustment in spending in a static way (elimination of unproductive social expenditures), and a dynamic way (elimination of indexation mechanisms)

SE Environmental protection, education, social security, health and medical care

Top-down budget process, general public administration, falling interest rates, provision of housing and social planning

SI Investment in science and technological development; education and training.

Raise cost efficiency of public administration; contain wage growth; change revaluation mechanism for social transfers

18

Member State Prioritised items How to create room for manoeuvre? UK Health, Education, Transport, R&D Better public services (stretching efficiency targets);

falling unemployment and rising economic participation have allowed savings to be made in welfare spending.

Source: National case studies

Table 2 - Redirecting Public expenditure: the Lisbon experience

Relative changes in composition of public expenditure in percentage points: averages 2003/4 versus 1998/99 (economic classification) and 2002/3 versus 1998/99 (functional classification)

Economic classification:

-10.0 -5.0 -2.0 -1.5 -1.0 -0.5 +0.5 +1.0 +1.5 +2.0 +5.0 +10.0

Subsidies DE SE, IE

FI, NL, IT, LU, DK, ES, FR, EL

PT, AT, BE, UK

Interest payments

EL, IE, SE, IT, BE, NL, ES, UK, DK, FI

PT DE, FR, AT

LU

Public investment

PT AT, DE

BE, SE

DK, LU, FI, IT

FR, UK, EL, ES

NL IE

Consumption LU AT, DE, FR

DK, PT

EL, ES, FI, UK, SE, IT, BE, NL

IE

Transfers UK, NL

FI ES, FR

IE, LU, DK

BE, IT, SE

DE, AT, EL, PT

Functional classification:

Economic affairs

PT DK, FR

DE, IT, FI

ES, BE

SE, LU

NL, UK, AT

EL, IE

Education DE, FR, LU, PT

BE, ES, EL, SE, AT, NL, IT

IE, FI, DK, UK

Health EL, AT

ES LU, DE

PT, DK

NL, BE, FR,

UK, IT, SE,

19

Economic classification:

-10.0 -5.0 -2.0 -1.5 -1.0 -0.5 +0.5 +1.0 +1.5 +2.0 +5.0 +10.0

FI IE General Public Services

EL IE, SE, IT, NL, UK, DK

BE, AT

ES FI, DE

LU PT FR

Social Protection

IE UK, FR, NL

FI ES, BE, LU

IT, DK, DE

AT EL, SE, PT

Source: Commission services. Notes: changes are measured in percentage points of total public expenditure. ” Economic affairs” includes expenditure for general economic, commercial and labour affairs, for agriculture and forestry, for fuel and energy, for mining, manufacturing and construction, for transport and for other industries. “Social protection” mainly covers benefits for subcategories such as sickness and disability, old age, family and children, unemployment and other forms of social benefits. “General public services” includes expenses related to executive and legislative organs, financial and fiscal affairs, external affaires, foreign economic aid, general services, interest payments and other expenses related to debt and part of research and development spending.

21

REPORT ON "QUALITY OF PUBLIC FINANCES" ISSUES

─ WORK ACCOMPLISHED AND WAY FORWARD ─

Economic Policy Committee

Paper completed: May 2007

Executive Summary

The "Quality of Public Finances" is a broad concept which refers to the conduct and organisation of budgetary policy and its potential positive impact on the long-term growth of the economy. Increasing the efficiency of public spending is in this context one of the most pressing challenges facing the EU Member States. Good value for money, i.e. maximising output with the input available, is essential because of the increased challenges on public finances stemming from globalisation and ageing.

In January 2006 the ECOFIN Council invited the Economic Policy Committee (EPC) and the Commission to analyse the following aspects linked to the quality of public finances: (i) national fiscal rules and institutions in the EU, (ii) data availability to better monitor the composition of public expenditures, and (iii) the measurement of public expenditure efficiency. This report describes the progress achieved so far in relation to these Council requests as well as in the analysis of the revenue side of public finances and suggests a possible way forward.

Cross-country comparison of public spending efficiency revealed significant differences across Member States and showed that efficiency gains are possible. Structural reforms and institutional features such as fiscal rules can help to improve the efficiency performance of public spending. For example, structural reforms contribute to a more business friendly environment and institutional arrangements, such as fiscal rules and institutions, could improve the conduct of fiscal policy.

Approaches on the institutional side concentrate primarily on changing budget procedures, and introducing results oriented approaches to budgeting. The use of performance information in the budget process is an important tool for decision-making. Performance information delivers a better picture of the governments´ goals and priorities and acts as a signalling device showing which measures are working, and which are not. More systematic and independent evaluation of existing policies could help to strengthen the efficiency of public spending, and there is a strong need for making better use of reliable methodological approaches towards assessing the success or failure of government programmes.

Further work in these areas should include exchange of information and best practices among Member States in order to be able to better identify the key drivers of efficiency. To measure the efficiency of public spending, better data on governments' inputs and outputs are essential. A more robust methodology and measurement framework should be established. Member States and the Commission could include analyses on effectiveness and efficiency in the Lisbon National Reform Programmes and the Community Lisbon Programme.

Progress has been made to improve the methodology and to increase the availability of data on the

22

composition of public expenditures. It is expected that data availability will improve significantly in the course of 2007, provided countries stick to their commitments and countries that deliver data agree to publication. However, some large Member States have not yet transmitted any COFOG second level data to Eurostat. As these countries account for a large proportion of government expenditures in the EU, it would be welcome if these Member States stepped up their efforts. Only a strong commitment by the national authorities to effectively deliver these statistics would allow for further progress in the assessment of changes in the composition of public expenditure in line with the Integrated Guidelines for jobs and growth and the Lisbon National Reform Programmes.

The stocktaking of the prevailing national fiscal rules and institutions showed that a lot of initiatives have been taken by Member States to strengthen their national fiscal framework. National fiscal frameworks have a positive impact on budgetary outcomes and have proved to help Member States in achieving their budgetary targets. The recently introduced or planned reforms go in the direction of an improved quality of the fiscal framework. A strengthening of national fiscal institutions and budgetary procedures has -to a lesser extent- also been implemented or at least announced. However, further efforts are still needed to reinforce domestic fiscal governance, which in turn will support the respect of the SGP provisions. Further work should address in particular the interaction of fiscal rules with other elements of the budgetary policy making as well as their influence on expenditure composition.

The quality of public finances is not just a question of the expenditure side but also of the revenue side. Discussions at the Informal ECOFIN in Berlin have welcomed the analysis made on the revenue side within the context of "Financing the Future". Work could continue to present a quantification of the effects of shifting taxes across tax bases in the context of the quality of public finances and to assess the relative merits of alternative revenue bases (profit versus. non-profit, green taxes, Public-Private-Partnership).

1. Introduction and background

The "Quality of Public Finances" is a broad concept which refers to the conduct and organisation of budgetary policy and its potential positive impact on the long-term growth of the economy. A comprehensive analysis should examine both the expenditure and the revenue side of the budget, while considering those institutional aspects of national fiscal frameworks that influence the developments in the budgetary aggregates (i.e. national fiscal rules and institutions and budgetary procedures) as well as the organisation of public administration.

This concept is acquiring a growing importance in the fiscal policy debate in the EU. The pursuit of fiscal stability oriented policies within the EU fiscal framework calls for an efficient and effective use of public resources. Similarly, the upward pressure on public spending resulting from age-related expenditure, which affects not only the overall size of public budgets but also their composition, requires due attention in order to avoid the crowding out of possible growth-enhancing budgetary items, such as education or R&D. Against this background, efficiency and effectiveness has to be measured and assessed and the availability of sufficiently detailed data is important to draw conclusions on the composition of overall spending. Demographic changes and globalisation pose new challenges to the revenue side of the budget as well. These new phenomena make it increasingly important to have growth-supportive revenue systems and to ensure an adequate and stable level of resources in order to finance public expenditure. Optimal framework conditions have to be in place to improve the quality of public finances: well designed fiscal rules and institutions but also structural reforms can support the quality agenda.

The importance of budgetary quality has been taken up in the main instruments for economic policy coordination in the EU, such as the Integrated Guidelines for Growth and Jobs1 and the National Reform

1 In particular, the Integrated Guideline no. 3 specifies that to promote a growth- and employment-orientated and efficient

23

Programmes. In the same vein, the ECOFIN report to the March 2005 European Council on "Improving the implementation of the Stability and Growth Pact (SGP)" includes specific references to the overall quality of public finances and the implementation of policies in the context of the Lisbon Strategy for Growth and Jobs as elements to be taken into account when assessing budgetary developments.

Therefore, in January 2006 the ECOFIN Council invited the Economic Policy Committee (EPC) and the Commission to analyse the following aspects linked to the quality of public finances:

1. The Council invited the Commission in joint co-operation with the EPC to conduct a comprehensive analysis of the existing national fiscal rules and institutions in the EU.2

2. The Council invited Eurostat and the National Statistical Offices, in co-operation with the EPC, to step up efforts on data availability to better monitor the composition of public expenditures.

3. Finally, the Council invited the EPC to further develop the measurement of public expenditure efficiency, by improving the information content of budgets and the exchange of best practices in the evaluation of public spending

This report summarises the progress achieved so far in relation to these Council requests and suggests a possible way forward.

2. Improving public expenditure efficiency

In response to the January 2006 Council request, the Commission submitted a background paper3 to the informal ECOFIN in April 2007 on the efficiency and effectiveness of public spending. A joint Commission/ EPC Issues paper served as a basis for Ministers' discussion. The main messages could be summarized as follow:

• Public spending represents a large share of GDP and therefore has a major impact on the productivity of the whole economy. Improved efficiency and effectiveness of public spending could alleviate budget constraints as it allows achieving the same results at lower levels of spending or increases value for money by achieving better outcomes at the same level of spending. Even though EU Member States' budgets show large country differences in both the level and the composition of public expenditures, cross-country comparisons can provide important insights into the policy challenges that countries face.

allocation of resources Member States should, without prejudice to guidelines on economic stability and sustainability, re-direct the composition of public expenditure towards growth-enhancing categories in line with the Lisbon strategy, adapt tax structures to strengthen growth potential, ensure that mechanisms are in place to assess the relationship between public spending and the achievement of policy objectives and ensure the overall coherence of reform packages.

2 This request is line with the statements included in the report on the SGP reform endorsed by the European Council in March 2005, which says that national budgetary rules should be complementary to the Member States’ commitments under the Stability and Growth Pact. It also says that national institutions could play a more prominent role in budgetary surveillance to strengthen national ownership, enhance enforcement through national public opinion and complement the economic and policy analysis at EU level.

3 Developed further in Mandl, U. A. Dierx and F. Ilzkovitz (2008), "The efficiency and effectivness of public spending," European Economy. Economic Paper No. 301 (Brussels).

24

Figure 1 - The concepts of efficiency and effectiveness

Monetary and non-monetary resources

Input Output OutcomeAllocative Efficiency Effectiveness

Environment factorse.g. Regulatory- competitive framework, socio-economic background,

climate, economic development

Technical Efficiency

Monetary and non-monetary resources

Input Output OutcomeAllocative Efficiency Effectiveness

Environment factorse.g. Regulatory- competitive framework, socio-economic background,

climate, economic development

Technical EfficiencyInput Output Outcome

Allocative Efficiency Effectiveness

Environment factorse.g. Regulatory- competitive framework, socio-economic background,

climate, economic development

Technical Efficiency

• The measurement of efficiency and effectiveness is complex. There are various ways to measure

public sector efficiency and effectiveness. Conceptually, efficiency is described by the relation between input and output (see Figure 1), with the objective of maximising output for a given amount of inputs; or of minimising inputs for a given output. Effectiveness relates the input to the final policy objective (the outcome). For instance in the area of education, money spent or the number of civil servants deployed for this public activity are often used as input. Output tends to be measured by performance indicators, such as the number of pupils finishing secondary school level. Since the outcome reflects the final policy objectives there can be different outcomes between countries, such as low youth unemployment or high welfare levels. As there are several limitations in covering the whole diversity of objectives, analytical work carried out so far has focused on the measurement and assessment of efficiency.

• Policy makers should be well aware that data limitations and the methodology applied can significantly affect the results. Moreover, cross-country differences can often be explained by factors beyond the control of decision makers. The choice of appropriate indicators is often constrained by data availability and comparability across countries. Moreover, quality aspects have to be taken into account. Not taking account of the quality of the teachers, for instance, could lead to under- or overestimation of efficiency. Adjusting for such considerations is not easy and moreover, it is not straightforward to measure governments' output or outcome when it comes to non-market outputs. Against this background the development of comprehensive and comparable data on input, output and outcome should be a priority for EU Member States. For example, as a basic requirement for the efficiency analysis COFOG 2nd level data availability would facilitate the data on monetary inputs. Experience has shown that focussing on individual spending areas is more promising in order to derive concrete policy recommendations. The analyses so far have focused on R&D and education but the efficiency of other important categories of public spending such as social protection, and health care could also be investigated. Bearing in mind the limitations and data constraints, first investigations in the spending areas of education and R&D, however, show that efficiency gains are possible.

• Public spending on education varies greatly in EU-countries and so do education outputs. Recent work suggests that, in a number of countries, reforms could visibly enhance performance of pupils while maintaining the education spending levels4. Recent investigations on efficiency of education

4 Afonso A., St. Aubyn M. (2006), "Cross-country efficiency of secondary education provision: A semi-parametric

analysis with non-discretionary inputs", Economic Modelling 23 (3), 476-491.; Afonso A., St. Aubyn M. (2005), “Non-parametric Approaches to Public Education and Health Efficiency in OECD Countries,” Journal of Applied Economics 8 (2), 227-246.; Sutherland D., Price R, Joumard I. and Nicq C. (2007), "Performance Indicators for public spending

25

spending suggest that factors such as parents' education or greater decision making autonomy at school-level (more competition between schools) affect the efficiency of money spent on education5. In addition, studies indicate that the social return on investment in education is highest when spending is on pre-school education6, which would suggest redirecting public spending on education to this specific area. On the other hand, more technologically advanced countries appear to get a higher value for money from tertiary education7. Regarding R&D spending, some studies investigate the leverage effect of public R&D spending on private R&D8. High levels of government funding for R&D may go hand in hand with a good innovative performance. First preliminary results of the study commissioned by the Commission on efficiency and effectiveness of public R&D spending suggest that efficiency gains are possible. Moreover, it seems that the most efficient countries maintain their high efficiency performance over time. The study will be available by the beginning of 2008.

• Structural reforms and institutional changes as policy tools help improve the performance of public spending. Structural reforms can play a role. For example, the leverage effect of public R&D on private investment in R&D and innovation could be amplified in a more competitive and business friendly environment. Most Member States have already taken steps in this direction. Besides opening up new areas of the economy to competition, reforming organisational aspects of public administration (e.g. the degree of outsourcing) also offers the potential for an improved public sector efficiency performance. Diverse approaches have been adopted by Member States to reforming institutional arrangements. These approaches concentrate primarily on changing budget procedures, and introducing results (output) oriented approaches to budgeting. Countries are at different stages of using or introducing performance information (i.e. performance measures and evaluations) into their budget processes. While shifting the budgetary focus from money spent (input) to output and outcome achieved, some Member States, like the UK and the NL, have gained experience in output-measurement. Experiences show that criteria like simplicity, transparency and focus have to be fulfilled in order to make optimal use of performance information and efficiency measurement.

Against this background, the importance of a more in-depth exchange of national experiences in increasing the efficiency of public spending has been stressed at the Informal Ecofin. A better identification of structural and institutional determinants of efficiency and a better understanding of their interactions could help to shape a more consistent policy agenda. Therefore, the EPC and Commission launched a questionnaire to gather more information in these areas (see also Annex 1).

A first screening of the responses showed that Member States have adopted various approaches to enhance the efficiency of their public spending. Generally, reforms of institutional arrangements, e.g. decentralisation of political power, changing budget practices and procedures, are used to enhance efficiency. Very often these reforms go hand in hand with enhancing transparency and a clearer division of responsibilities and accountability. Structural changes, like increasing the scale of operations, are used in specific areas like education and health care (see Annex 1 for more details).

However, a more systematic screening of the information is necessary to draw more concrete conclusions. In addition, little information is available about the impact of reform initiatives so far.

efficiency in primary and secondary education", OECD Economics Department Working Paper No. 546

5 OECD (2007), "Linkage between performance and institutions in the primary and secondary education sector" 6 Heckman J.A. (1999), "Policies to foster human capital" (NBER 7288) 7 Vandenbussche J., Aghion P. and Meghir C. (2006), "Growth, distance to frontier and composition of human capital", J

Econ Growth 11, pp. 97-127. 8 For a comprehensive review of empirical evidence, please see David P. A., Hall B. H. and Toole A. A. (2000), "Is public

R&D a complement or substitute for private R&D? A review of the econometric evidence," Research Policy, Elsevier, vol. 29(4-5), pp. 497-529, April; and García-Quevedo J. (2004), "Do Public Subsidies Complement Business R&D? A Meta-Analysis of the Econometric Evidence", Kyklos, 57(1), pp. 87-107

26

The information available reflects that the use of performance information (PI) in the budget process is becoming an important tool for decision-making in order to move the focus away from spending towards actual achievements. In the decision-making process it could act as a signalling device showing which measures are working, and which are not. Overall, it improves transparency by providing more information on public sector performance. Country experiences so far also showed that the shift to output-oriented policy making is also a learning-by-doing process. The OECD9 has developed general guidelines for countries highlighting that there is no "one size fits all" model of performance budgeting and countries need to adapt their approach to their political and institutional context.

2.1. Possible way forward

Good value for money is essential because of the increased pressure on public expenditures. Moreover, government output is an important share of GDP and therefore, improvements in public spending efficiency with the objective to maximise the output for a given amount of inputs should be high on our policy agendas.

A continued exchange of views should allow identifying key drivers of efficiency and effectiveness. An exchange of information and case studies based on countries' experiences could help to agree on indicators that build the basis to draw reasonable conclusions on efficiency levels. Moreover it could lead to a common understanding of sound principles and methods for efficiency measurements on a cross-country basis.

Concerning specific spending items the work on data collection and availability should be improved. This should be based on efforts by Eurostat, National Statistics Institutes and the OECD to implement output measures in the national accounts. Progress is underway in the context of the "Handbook on measuring Education and Health Volume Output". However, a greater effort is required to get better input data (COFOG 2nd level). Finally, the shift from input- to output measurement in the budgetary process can be considered as a first step towards increasing the efficiency and effectiveness of public spending. In addition, following efforts should be taken in specific areas:

• R&D spending: the Commission services should continue to work towards identifying more appropriate methodologies that can be used to measure and assess cross country efficiency and effectiveness. Quantitative indicators of efficiency and its determinants could be discussed on the basis of the results of ongoing work.

• Education spending: There are already very valuable data available thanks to OECD efforts in the context of PISA. A new dataset on PISA will be available by the end of this year.

• Health spending: A better common understanding of the efficiency concept could help to facilitate the definition of appropriate indicators.

Once a more robust methodological framework and better data have been established, an overall assessment of the efficiency and effectiveness of public spending could be envisaged, possibly as part of the evaluation of the Lisbon National Reform Programmes. Such considerations could also be introduced in the evaluation of the budgetary situation in the Member States.

3. Data availability and knowledge about the composition of public expenditures

The composition of public expenditures reflects governments' input for policy objectives, like the Lisbon goals. However, in order to assess the achievements, more detailed and comparable data are needed.

9 OECD (2007)

27

Eurostat and Member States, with the support of the EPC, have created a taskforce whose objective it is to provide data for individual government expenditure items (based on the Classification of the Functions of Government – COFOG) with a sufficient level of detail (COFOG second level) and comparability. The detailed data requirements were defined by the EPC in May 2006 with a view to facilitating the monitoring and analysis of the quality of public finances within the context of the Lisbon strategy and the Integrated Guidelines.

The work developed along several lines: making progress on the methodology, increasing data availability, analysing possible synergies with other existing international data sets, and sharing best practices for the collection of COFOG data. The legal basis for the delivery of COFOG is the ESA 95 transmission programme. The transmission of the first level of COFOG (10 functions) is mandatory, while the transmission of second level COFOG (69 functions) is voluntary.10

3.1. Availability of COFOG first level data and possible conclusions on the composition of public spending

The transmission of COFOG first level data is well established in all Member States and timeliness and coverage of these data have recently improved considerably. This data, which is available on Eurostat's website, provides basic information, albeit at an aggregated level, for the analysis of the breakdown by function and the changes in the composition of public expenditure. Eurostat is working in close co-operation with Member States to overcome remaining quality issues.

Graph 1 is an illustration of the possible use of this data. It shows that three functions accounted for the largest share of government expenditure (not taking into account expenditure on interest) in the euro-zone both in 2000 and in 2005 (see Graph 1): social protection (19.4% of GDP in 2005), health (6.4% of GDP) and education (5.0%).

Figure 2 - Aggregated government expenditure of the euro-zone by function in 2000 and 2005 as % of GPD

0

5

10

15

20

25

Gen

eral

publ

ic

Def

ence

Publ

ic o

rder

and

safe

ty

Econ

omic

affa

irs

Envi

ronm

ent

prot

ectio

n

Hou

sing

and

com

mun

ity

Hea

lth

Rec

reat

ion,

cultu

re a

nd

Educ

atio

n

Soci

alpr

otec

tion

Economic functions

% o

f GD

P

20002005

Source: Eurostat

Some significant differences in the composition of expenditures across Member States can be observed:

• As for expenditure on social protection, the Nordic Member States plus France, Germany, Austria and Greece register figures well above the EU25 average (18.8%), whereas the Baltic countries, Ireland, Romania, Slovakia, Cyprus, Czech Republic, Spain, United Kingdom, Portugal and Malta stand significantly below this average.

10 Data are due at t+12 months after the end of the reference year.

28

• Regarding health expenditure, Member States are more evenly distributed around the EU25 average (6.5%). Ireland ranks in the first position in health expenditure, while a group of countries formed by Cyprus, the Baltic States, the Netherlands, Poland and Greece spend on public health between 2 and 3.5 percentage points of GDP less than the EU25 average.

3.2. Demand for more detailed information - Availability of COFOG second level

Although the first level of COFOG data provides an overall picture of the composition of public expenditures and the possibility for cross-country comparisons, there is clearly a need for more detailed data. For example, while a better knowledge of R&D expenditures is particular relevant in the context of the Lisbon Strategy, it is not possible to isolate these expenditures, except on the basis of COFOG second level data.

Longer time series and disaggregated data also allow the explanation of trends in some categories. For example, the overall growth in general government expenditure as a percentage of GDP between 2000 and 2005 has been concentrated in health (from 5.9% of GDP to 6.4%) and social protection (from 19.0% of GDP to 19.4%).

• Concerning health expenditures, a more disaggregated analysis shows that, in the case of Denmark, the increase in health expenditures (1.6%) between 1990 and 2007 resulted from an average real growth of 4.3% for medical products, compared to 1.3% for hospital services.

• Concerning social protection, the support for the elderly is dominant in nearly all countries which reported second level COFOG data for 2005, followed by expenditure on sickness and disability (relatively significant for Denmark, Sweden, Finland and Hungary).

Following the ECOFIN request for COFOG second level data, Member States, in co-operation with Eurostat, continued to work on the extension of the data set, on a voluntary basis, and on the improvement of the relevant quality aspects.

Up to now there have been three voluntary transmissions of COFOG second level data to Eurostat, the last one in December 2006. Several Member States made considerable efforts and delivered second level COFOG statistics covering different periods. While at the end of December 2005, only 7 countries reported data to Eurostat, the current availability of COFOG second level data is up to 16 Member States' sets of data for the most recent years: Bulgaria, Belgium, Denmark, Germany (estimates for 2003), Estonia, Greece, Spain, Italy, Cyprus, Lithuania, Hungary, Poland, Portugal, Slovak Republic, Finland and Sweden. In addition, Ireland and France have delivered partial II level COFOG breakdowns (Ireland for the function environmental protection and France for sub-sector social security funds for years 1995-2003). However, Eurostat can only disseminate these figures when Member States do not object, and large Member States such as Germany11, France and the United Kingdom are still working to compile or complete their datasets Eurostat has started to publish COFOG second level data for some Member States on its website, and plans to enlarge the number of countries published.

In several cases data were transmitted only from 2000 or 2001 onwards, limiting the possibility to conduct a detailed structural analysis further back in time and to produce European aggregates12. Eurostat plans to investigate suitable methods with Member States to extend the time series available.

Concerning methodological developments, some Member States encountered serious theoretical and practical difficulties for the compilation of these figures, notably the lack of detailed source data for back years (especially the new Member States, and local government data) and scarcity of resources in some National Statistical Offices. The collection of second level COFOG statistics is not an easy task, partly

11 Preliminary data for 2003 are expected by the end of May. 12 Some countries only provided one year of data.

29

due to the fact that many of the expenditure-related activities conducted by a government at a detailed level fall under several possible headings.

There is accordingly a need to harmonise concepts and definitions in a consistent way across countries. Moreover, there is also a need to encourage synergies and further consistency with other international data sets, such as educational, social protection, health, or environmental accounts. Although it only meets once per year, all these issues are being tackled by the previously mentioned task force. Eurostat will publish a manual for the compilation of COFOG statistics in 2007.

3.2.1. Some common patterns

Notwithstanding all these drawbacks, and considering that work is still in progress and the data subject to improvement, some common patterns can be identified in the data transmitted so far, which show their usefulness for addressing user' needs. More light can be shed on the composition of public expenditures.

Expenditure under the COFOG 2nd level category "old age" (under social protection) appears for most countries to be the most relevant, ranging from around 15% of total government expenditure in 2005 in Belgium, Denmark, Slovak Republic, Lithuania, Finland, Hungary, Spain, and Estonia, to over 25% in Poland, Italy, Bulgaria and Greece. Some other very significant categories reported by most countries are sickness and disability, executive and legislative organs, and hospital services.

Moreover, the COFOG 2nd level data reported allow for an analysis of the different compositions across countries, for each of the first level categories. For example, the proportion of expenditure on pre-primary and primary education is relatively significant in countries like Sweden and Denmark, while Portugal devotes a very high share of educational expenditure to secondary education. Finland devotes a significant share to tertiary education, compared to the other countries which reported data.

When longer time series are available, there is also the possibility to analyse changes in the composition of public expenditure, both within each category through time and also across countries, as we have shown in the case of Denmark.

3.3. Future developments and way forward

Member States have been asked to step up their efforts to compile and disseminate COFOG second level data in order to comply with the requests of the Council. Given that the transmission of these data is voluntary, only a strong commitment by the national authorities to effectively deliver these statistics would allow the assessment of the degree of achievement of the Lisbon Agenda and the related Integrated Guidelines.

4. National fiscal rules and institutions

The Commission together with the EPC launched two comprehensive surveys among EU countries to take stock of the prevailing national fiscal rules and institutions over the period 1990-2005.13 Overall, the surveys provided substantial information on sixty national numerical fiscal rules and twenty three national independent institutions in the field of fiscal policy, and yielded interesting results in terms of

13 The survey on rules covered all types of numerical fiscal rules (i.e. budget balance, debt, expenditure and revenue rules).

Therefore, other types of rules such as budgetary legal procedures were not considered. As for the questionnaire on institutions, its coverage concerned the existing national institutions, others than the government, the Central Banks and the Parliament, which may have a direct or indirect influence on the conduct of fiscal policy and are primarily financed by public funds (i.e. private think-tanks or banks' research departments were not covered). These independent institutions generally provide inputs for budget preparation (e.g. forecasts), analyses on fiscal developments and/or recommendations on fiscal policy issues.

30

fiscal policy making:

Firstly, Member States have been increasingly relying on fiscal rules over the past twenty years, and point to the existence of a link between these fiscal arrangements and budgetary outcomes.

• Budgetary positions tend to improve in the years following the introduction of fiscal rules and primary government expenditures tend to grow less in the years following the introduction of expenditure rules.

• The characteristics of rules may influence fiscal developments. Rules enshrined in law or constitution and foreseeing automatic enforcement mechanisms seem to have a larger influence on budgetary outcomes.

• However, this does not prevent other "softer" arrangements based on political agreements or commitments from being effective in improving the conduct of fiscal policy (e.g. fiscal rules applied to central government in Finland).

• It also follows from the analysis that expenditure rules capping spending growth over the medium term and revenue rules determining ex ante the allocation of revenue windfalls may contribute to governments' commitment to avoid pro-cyclical policies in good times (e.g. fiscal rules in the Netherlands). In this respect, only a few rules currently in force are defined in cyclically-adjusted terms (e.g. budget balance rule for the general government in Sweden).

• However, there are other instruments that help address pro-cyclicality such as medium-term frameworks for budgetary planning. For instance, rules incorporated into medium- term budgetary frameworks, as a part of a comprehensive fiscal strategy, may be better adapted to economic and country specific circumstances while making stabilisation and sustainability objectives more compatible (e.g. Denmark).

• In addition, a multi annual rule could be considered superior to a rule that only sets a target for one year. Rules covering a medium term horizon could make circumvention more difficult and, therefore, reinforce credibility and prospects of fulfilment. In this respect, the coverage and escape clauses of the rule must be clearly defined in order to avoid arbitrary circumventions.

• Finally, in a number of Member States fiscal rules prove to be instrumental in promoting an appropriate budgetary coordination among general government tiers to maintain sound fiscal positions (e.g. Spain).

Secondly, a number of interesting facts emerges from the Commission analysis of fiscal institutions.

• The involvement of such independent institutions in the budget process appears to be an important element determining its influence on the fiscal decision-making. Different arrangements currently in place in some EU countries have proved to be effective in conveying the policy messages issued by these independent bodies.

• The most widespread options consist of regular hearings by the Parliament, consultation by the government in the course of the budgetary process, or the obligation of the fiscal authorities to justify departures from the forecasts or recommendations released by the institution (e.g. the Institute of Economic Research (WIFO) in Austria).

• According to some Member States' experiences, delegation of forecasting tasks for the preparation of the budget seems to help address possible optimistic biases in macroeconomic projections (e.g. the National Accounts Institute in Belgium). The existence of independent national advisory bodies and research institutes, through a higher degree of competition, may also contribute to eliminate biases in macroeconomic projections of national governments.

• Next, the institutions in place seem to have a considerable impact on the public debate as most of them enjoy a considerable reputation, which appears to be essential for exerting real influence on policy decisions.

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• Finally, fiscal institutions need to enjoy high credibility and a strong political support, which in turn should be reflected in a large degree of autonomy and functional independence.

• However, it must be stressed that special status is not always a pre-requisite for ensuring independence, which can also be achieved by government ownership and commitment to the duties assigned to the institution (e.g. the Central Planning Bureau in the Netherlands).

Country policy experiences show that numerical fiscal rules and institutions should not be seen as mutually exclusive but rather as complements.

• The existence of fiscal rules reflecting the main fiscal policy objectives of a country can help in specifying the mandate and facilitate the work of independent institutions. Fiscal institutions, on their side, can effectively contribute to monitoring compliance with the existing numerical fiscal rules, thereby increasing the chances that rules are respected. In turn, rules and institutions can complement each other since they potentially focus on different aspects of government finances.

• Numerical fiscal rules often apply to one sub-sector of the general government and generally have a short to medium-term orientation. In contrast, independent fiscal institutions potentially conduct analysis coverin