Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 6 7 There are, of course, a wide range of factors that create incentives for better — or worse — decisions. These include governance arrangements, transparency requirements, budget systems, processes and rules, assignment of authority for budget and spending decisions. These incentives may be formal or informal. For a fiscal management system, key incentives relate to how financial performance (flows) and financial position (stocks) are defined and measured. The goal is to align the interests of managers, investors, financial intermediaries, politicians and the general public. Key to this is the use of measures that reflect performance and position in a comprehensive and reliable manner — this is where proper accounting comes in. ‘Proper’ in this context means accounting that fully reflects all revenues and expenses, as well as the range of physical and financial assets and liabilities. Where key decisions are made on the basis of information only about cash flows and debt, there is an incentive to substitute future cash inflows for present ones given the political significance of reported current performance. Perhaps the worst example of this is where future pension benefits are substituted for current wages, which subsequently has the effect of building ever- increasing liabilities that can, ultimately, become unsustainable. Were the performance measures to recognize the incurrence of liabilities, rather than just the cash outlaid, the costs of pensions would be recognized in the year the work was done, rather than the year the pension was paid. The consequences of basing key financial decisions on cash flows can be seen in the pension problems faced by many governments. Accrual based-budgeting: The missing link The current status of accounting within the PFM systems of governments can be characterized as follows: • many governments budget, make appropriations and report on a cash basis; • some governments budget and appropriate on a cash basis, but then report on an accrual basis; • relatively few budget and report on an accrual basis, but appropriate on a cash basis; • virtually none budget, appropriate and report on an accrual basis. The decoupling that occurs with accrual reporting and cash-based budgeting largely defeats the purpose of moving to accruals. In order to achieve the right incentives and signals, it is necessary to align the concepts and metrics used in reporting (ex-post) on performance, and those used in stating the expectations (ex-ante) — budgets and appropriations. Budgets and appropriations cannot fully reflect the resources used by governments unless they are also on an accrual basis and capture all the assets and liabilities on the government’s balance sheet. In effect, a PFM system that is based only on cash flows and debt ignores critical assets (especially physical assets) and non-debt liabilities (such as public sector pensions) and is therefore inadequate for managing the complex financial operations of modern government. Those governments that have progressed to reporting on an accrual basis but still budget and/or make appropriations on a cash basis face two significant problems. First, their reporting does not align with their budgeting and appropriations, creating misaligned signals and incentives and, frequently, a sense that the move to accrual reporting was not worth the effort. Second, and more importantly, their budgets and hence their operational decision making continue to effectively ignore the management of assets and liabilities that are not cash or debt. In contrast when budgets are on an accrual basis, it is possible to get a clearer view of the real cost of providing services — which includes such non-cash elements as depreciation or asset impairment — and this in turn provides a more economically realistic picture of value for money, enabling comparison with the cost of providing similar services from an alternative supplier. Such comparisons provide an incentive to consider the value for money of the specific service, encouraging a greater focus on operational efficiency. Making major financial decisions and budgeting on the basis of accrual information enables decision makers to see the planned impact What is not measured does not count Cash accounting focuses on a few narrow and unrepresentative numbers; it has led to chronic under-investment in, and under-management of, valuable publicly owned assets. Accrual accounting is consistent with the IMF economic framework for fiscal policymaking; it is almost two decades since the IMF shifted its manual for Government Finance Statistics (GFS) from a cash to an accrual basis. Many countries are following suit, with the Chartered Institute of Public Finance and Accountancy (CIPFA) and the International Federation of Accountants (IFAC) predicting that almost two-thirds of governments around the world will have moved to accrual- based accounting within the next five years. 2 But even when countries make such a change to their accounting systems, they often do not go far enough to reap the full benefits. They fail to use the information those systems produce in their fiscal decision making. Why? In most cases, the political will required to manage public assets better — to provide full disclosure of these assets and to create the incentives to encourage policymakers to act — has been lacking, as the immediate gains were not obvious. In the current urgent circumstances, with so many lives and livelihoods at stake, the case for better stewardship of public assets could not be more pressing. Why incentives matter In any organization, including a public financial management (PFM) system, decision makers respond to a broad set of incentives. It is therefore critical that incentives are designed to encourage the right decisions and actions. Key decisions and actions within a PFM system include: • major financial and other policy decisions, such as privatizations; • resource allocation decisions, whether capital or operating; • revenue-raising decisions; • financial control decisions in an operating context; and • asset management decisions. Incentives should encourage decisions that are aligned both across an organization as well as vertically. For example, fiscally-responsible decisions at an aggregate level should be supported by efficient management of service delivery, including asset utilization, at the operational level. Capital Charge A perennial problem of financial management in the public sector is poor asset utilization, which can be most obviously seen in decaying infrastructure. An incentive for better management can be created through the use of a capital charge, which requires government organizations to meet the cost of the capital they employ. The charge rate reflects the opportunity cost to taxpayers of having resources invested in government assets. For example, the New Zealand Government levies a charge of 6% of the net worth (assets less liabilities) of their departments. This means the measured cost of services includes all costs, and so is better able to be compared with alternative external providers, and it also provides departments with an incentive to dispose of assets that are not productive and to better manage the structure of their balance sheets. How Smart Public Assets Management Can Drive the Post-COVID-19 Recovery