Why Budget Institutions Cannot Control Government

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Why Budget Institutions Cannot Control GovernmentSpending: Evidence from Latin America

Jon Bischof

Harvard UniversityDraft: Please do not cite without permission.

March 13, 2008

Abstract

Studies of political institutions have consistently found that hierarchical budgetrules are positively correlated with higher fiscal surpluses. However, this paper showsthat budget rules only affect a small portion of overall fiscal expenditures and thatempirical studies that suggest otherwise misspecify the dependent variable and producemisleading results. I argue that off-budget expenditures and obligations established bystatute and constitutional mandate have largely sidelined the appropriations process.Although previous studies have found a positive relationship between budget rulesand overall fiscal surpluses, this variable is an interaction between two separate policydecisions, making it impossible to distinguish whether the empirical relationship is aproduct of lower expenditures, higher revenues, or some combination thereof. Usingcross-sectional and panel data from Latin America (1990-2005), I break down the fiscalsurplus into spending and revenues and show that budget rules have no relationshipwith either the level or rate of increase in spending. I conclude by arguing that mostimportant fiscal policy decisions are made via legislation and that public finance cannotbe separated from normal legislative politics.

Can the formal rules of the budget process explain variation in fiscal policy outcomes?

A growing number of scholars are using differences in budget institutionsthe rules that

govern the formulation, approval, and execution of the budgetto understand why some

Email: [email protected]. I would like to thank Jorge Domnguez, Steve Levitsky, Rich Nielsen,and David Andrew Singer for their invaluable and extensive comments on this paper, as well as FrancesHagopian and Carlos Gervasoni for assistance with earlier versions. This paper was presented at the annualconference of the Midwest Political Science Association in Chicago, April 6, 2008.

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Jon Bischof Why Budget Institutions Cannot Control Government Spending

countries run larger deficits than others (e.g., Alesina and Perotti 1999; Baldez and Carey

1999). Identifying the appropriations process as a common pool problem, this literature

predicts that more hierarchical decision rules that concentrate authority in the president

or finance minister should lead to lower deficits and a more rational allocation of resources

since a single actor will fully internalize the cost of additional spending. A large number of

supporting empirical studies have found a positive relationship between the centralization of

the budget process and primary surpluses in places as diverse as Western Europe (von Jagen

1992), Latin America (Alesina et al. 1999; IDB 1997; Filc and Scartascini 2007), Argentine

provinces (Jones et al. 1999), and Eastern Europe (Fabrizio and Mody 2006), as well as a

broad sample of developed and developing countries (Woo 2003).

This paper uses evidence from Latin America to argue that these findings are mislead-

ing. While it is true that a small portion of the budget (primarily public investment) can be

modified from year to year in the appropriations process, the vast majority of spending is

mandated by statutory or constitutional law and can only be modified by legislative majori-

ties or supermajorities. In the first section of my paper I show that the two biggest expenses

in many statessocial security programs and transfers to subnational governmentsare not

even part of the central government budget. I further demonstrate that, even excluding

interest payments, most of the items actually in the budget are specifically mandated by law

or protected by spending floors and revenue earmarks.

In the second section, I explain the robust empirical relationship between budget insti-

tutions and primary surpluses in the literature by arguing that the dependent variable has

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been incorrectly specified. After breaking the surplus into primary spending and revenues

for the budgetarycentral government, I show that hierarchical budget institutions have no

relationship with spending and a very robust positive effect on revenues. Interestingly, this

finding is even more pronounced for the consolidated central government.

In a third, concluding section I divide the policymaking arena between the budgetary

arena and the legislative arena (where most spending is determined). Given that broad

legislative coalitions are needed to make policy changes in the latter, I argue that research

on fiscal policy cannot ignore legislative politics and must consider variables such as the

partisan powers of the president, party and coalition politics, and the electoral incentives of

individual delegates.

1 Budget Institutions and Fiscal Outcomes

1.1 What Are Budget Institutions?

Budget institutions are the formal rules that govern the formulation, passage, and execution

of the budget. Interest in these rules arises from a conceptualization of fiscal indiscipline as

a special case of the common pool problem. For example, Weingast, Shepsle, and Johnsen

(1981) show that in a legislature with geographically based districts, delegates from each

of the N districts will request public projects long after the marginal social cost exceeds

the marginal social benefit since they internalize only 1N

of the costs. The Inter-American

Development Bank (IDB) (1997: 99) offers a succinct illustration: if splitting a restaurant bill

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evenly among nine friends, one is much more likely to order an expensive lobster dish over the

chicken than when eating alone. Thus, rules that concentrate decision-making power in the

hands of a single nationally-oriented official should produce more efficient policy outcomes

since he fully internalizes the entire social cost of marginal increases in spending.

Presidents can be granted a variety of tools with which to control budget outcomes. First

are restrictions on the legislatures ability to alter the presidents initial budget proposal. If

there are no restrictions on legislators ability to amend the budget, then there will be great

opportunity to add particularistic spending and earmarks to the proposal. However, if the

legislature is required to find sources of funding for all new spending (pay as you go), ask

the executive for permission first, or is only allowed to decrease and not to add spending,

then it is much less likely that they can burden the budget with particularistic amendments

without the complicity of the president. Another means of constraining the legislature is the

determined default outcome should it fail to pass a budget. If the presidents budget or

the previous years budget is enacted, then the president has little need to compromise with

the legislature. But if he has to submit a new budget or, at the extreme, if the government

is forced to shut down, then the costs of confrontation may be so great that the president

will offer significant concessions in anticipation of the legislatures demands.

Second, the president can be given a number of proactive powers. If during the execution

of the budget (in the next fiscal year) the president can modify the budget at his own

discretion, then it will be easier to balance the budget even if revenues are lower than

projected (or if any other contingency arises). But if he is unable to do so or needs the

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Table 1: Presidential Budgetary Powers

Country Proposalpower

Leg.amendpower

Reversionoutcome

Pres.impndpo

wer

Pres.modifypower

(duringexecution)

Index

Brazil Yes 3 2 2 3 10El Salvador Yes 3 1 3 2 9Chile Yes 2 2 2 2 8Ecuador Yes 2 2 1 3 8

Nicaragua Yes 3 3 1 2 8Peru Yes 3 2 0 3 8Paraguay Yes 0 2 3 2 7Costa Rica Yes 1 2 2 2 7Uruguay Yes 3 1 2 1 7Colombia Yes 2 2 1 2 7Dom. Republic Yes 3 1 1 2 7Venezuela Yes 3 1 1 2 7Panama Yes 2 2 0 2 6Argentina Yes 1 1 1 2 5Mexico Yes 0 0 1 3 4

Bolivia Yes 0 2 1 0 3Guatemala Yes 0 1 1 0 2

Source: UNDP (2004: 80). Higher values indicate greater cen-tralization in the decision-making process. See Appendix A foran explanation of the UNDPs coding rules.

approval of legislators (most likely unwilling to cut their own projects), then it will be easier

for deficits to get out of control. Finally, if the president can impound funds rather than

spending the amounts budgeted, he will also be better able to ensure a balanced budget.

In some countries, such as Ecuador, the president can do this by decree; in others he has

no ability to do this or can only do so for non-earmarked funds or if revenues are less than

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projected. The greater his discretion, the greater the level of presidential dominance over

the budget process.1 Table 1 presents an index of these powers for Latin American countries

(with higher values meaning greater centralization in the decision-making process).2

1.2 What Can Budget Institutions Explain? What Should They?

Previous studies which have found that hierarchical budget institutions can restrain fiscal

indiscipline have consistently used consolidated central government primary surplus data,

a measure which includes all spending executed by the central (as opposed to subnational)

government.3 One can immediately see several problems with this choice of dependent

variable. On one hand, it excludes spending by subnational governments, which can account

for as much as half of total public sector expenditures (such as in Brazil and Argentina).

On the other, it includes a number of items, such as social security funds or parafiscal

organizations, that are established outside the budget. Therefore, these studies are using1While the exclusive right to draft the budget proposal is also important, there is no variation in this

variable in Latin America and in presidential systems generally. Also, while this literature often highlightsthe transparency of the budget process as an important intervening variable, it does not fit neatly intothe common pool framework and never shows up as significant when indices of budget institutions aredisaggregated.

2Since this paper focuses on Latin America, I have chosen to restrict myself to presidential systems,which account for all countries excepting a few island nations in the Caribbean. Whether presidential andparliamentary systems can be compared directly in this respect is unclear. As Kraan (1996: 26) argues, whilebargaining in presidential systems is primarily between the president and the legislature, a vote on the budgetin a parliamentary system is often treated as a vote of confidence in the governmentmaking voting againstthe proposal far more costly. For this reason, studies of budget institutions in parliamentary contexts (e.g.,

von Hagen 1992) focus on the relative power of the finance minister vis-a-vis the other spending ministers,while studies of presidential systems (e.g., Alesina et al. 1999) focus on the the power of the presidentvis-a-vis the legislature. Since the finance minister has little independent power in a presidential systemand the legislature has little independent power in the parliamentary system, these studies must code fordifferent things or code for both (if using a mixed sample) and assume that they are substitutes. Futurestudies should be more explicit in how they handle this discrepancy.

3These studies include von Jagen (1992), Alesina et al. (1999), IDB (1997), Filc and Scartascini (2007),Jones et al. (1999), Fabrizio and Mody (2006), and Woo (2003).

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budget rules to explain spending that is not part of the budget.

In addition, there is significant evidence that most items in the budget are inflexible and

not subject to the appropriations process. Government payroll costs, pensions, health and

education spending, subsidies, and other social welfare programs are usually predetermined

by legislation or constitutional mandate even if they are nominally included in the budget.

Finally, these scholars are making claims about spending restraint while using surpluses

as a dependent variable, which is the interaction between spending and the amount of revenue

collected via tax legislation. Therefore it is not clear to what extent the difference between

countries with strong and weak budgetary institutions can be explained by spending

restraint or increased revenue extraction. I develop each of these points below.

1.2.1 What Is Actually Included in the Budget?

While the budget is an important piece of overall fiscal policy, a significant portion of spend-

ing executed by the central government in some countries never passes through it. The most

familiar example of this is social security transfers, which are collected as a special tax on

wages or corporate revenues and then sent out to individual citizens according a formula

established by law. Another source of off-budget spending is parafiscal organizations, which

are legitimate public sector institutions that have proprietary sources of revenues not part

of the central government budget. One example is Colombias National Learning Service

(SENA), which uses mandatory employer payroll contributions to provide worker education

programs.4 To make meaningful inferences about the effect of budget institutions, these

4See Echeverry et al. (2006: 59-60) and http://www.ilo.org/public/english/region/ampro/cinterfor/ifp/sena/index.htm for more information.

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expenses must be excluded from consideration.

Revenue sharing agreements with subnational governments are a separate component of

off-budget spending.5 Decentralized spending is not included in measures of consolidated

central government expenditures, but it still accounts for a set of allocation decisions that

budget institutions cannot influencedespite having a tremendous impact on the overall

fiscal health of some countries. These transfers are usually constitutional mandates and can

only be modified with large legislative majorities.

In Brazil, the 1988 constitution requires that 21.5% of revenues from the Income Tax

and Tax on Industrial Products be shared with the states and another 22.5% be transferred

directly to municipalities. More importantly, the constitution cedes the collection of the

most lucrative tax, the VAT on goods and services (ICMS), to the states, which accounts for

87% of their total revenues (OECD 2001: 76-77). In Argentina, tax collection is much more

centralized, producing a vertical imbalance of 64.5%. The Coparticipation scheme, written

into the constitution in 1994, requires that the federal government transfer 57% of shared

revenues to the provinces and leaves another 1% to be distributed to them discretionally

(Tommasi et al. 2001: 160-62). The 1998 Ecuadorian constitution requires that 15% of

central government revenues be earmarked for local governments. Similarly, the Colombian

revenue sharing system established in the 1991 constitution put all government revenues

into a shared pool and actually required the portion going to subnational governments to

increase from 21.3% in 1993 to nearly 50% by 2002, an adjustment that was carried out

5However, in Colombia and Ecuador it may be that these transfers actually are part of the budget; Ivebeen having trouble finding information on this. Either way, its totally non-discretionary.

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gradually over the 1990s (Dillinger and Webb 1999: 9-10). Since the amount (and often use)

of these funds is non-discretionary, the central government is only responsible for a fraction

of spending in decentralized states.

To assess the magnitude of the discrepancy between on- and off-budget spending, I col-

lected data from the IMFs Government Finance Statistics, which differentiates between

three levels of government spending: (1) the budgetary central government, which includes

items executed by the central government as part of the budget, (2) the consolidated cen-

tral government, which includes all items executed by the central government, and (3) the

consolidated general government, which includes all items executed by both the central and

subnational governments.

Table 2 presents the figures from four selected countries in Latin America. In the third

column I list all of the spending items specified for each country at the different levels in the

IMFs codebook. In the fourth column I list the average magnitude of primary spending at

each level in the GFS database for all years available from 1997 to 2000. The results are

alarming: in Brazil and Uruguay less than half of the spending included in the measure used

by other studies (central government spending) is actually part of the budget. 6 Furthermore,

items actually included in the budget account only for about a third of total government

spending. This brings in question the accuracy of previous studies and the usefulness of

budget institutions in explaining overall fiscal policy outcomes.

The magnitude of this discrepancy varies widely between countries. The difference be-

6If, as they claim, Filc and Scartascini (2007) use general government surpluses as their dependentvariable, this error is compounded.

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Table 2: Primary Expenditures (%GDP) by level of government in IMF Government Finan-cial Statistics

Country Level of govt Entities included (cumulative) Expenditure

Brazil(1997-1998)

Budgetary CentralGovernment

Congress, judiciary, ministries, and presidency 10.06

Consolidated Cen-tral Government

Federal universities and federal university foundations;Government agencies, boards, and commissions; Nationaland regional development agencies; National Highway De-partment; Technical schools

23.29

Consolidated Gen-eral Government

Federal district and 27 state governments; 5,508 municipalgovernments

38.23

Uruguay(1997-2000)


Legislature, ministries, and presidency; Court of accounts,electoral court, judiciary, and tribunal for administrativedisputes; National Administration for Public Educationand University of the Republic

13.14


FLD (Fondos de Libre Disponibilidad); Social securityfunds; Social insurance fund

29.79

Consolidated Gen-

eral Government

19 departmental governments 34.72

Mexico(1997-2000)


Administrative agencies; Congress, electoral authorities,judiciary, presidency, secretariats, and tribunals; Govern-ment agencies

12.05


Social Security Institute for the Mexican Armed Forces;Institute of Security and Social Services for GovernmentWorkers; Mexican Social Security Institute

14.89

Consolidated Gen-eral Government

Federal district; 31 state governments; 2,430 municipal gov-ernments

21.28

Nicaragua(1997-2000)


Decentralized entities (7), electoral council, general con-troller office, judiciary, ministries (12), national assembly,and presidency

15.61


General Procurement of Human Rights; Public ProsecutorOffice; Public universities (8); Nicaraguan Social SecurityInstitute

18.20

Consolidated Gen-

eral Government

Regional government of North Atlantic; Regional govern-

ment of South Atlantic; 152 municipalities

19.20

Figures for local government spending in Uruguay and Nicaragua were not available from the IMF database;subnational spending estimated by using fiscal decentralization figures from IDB (1997: 157).

tween budgetary and consolidated central government spending is determined by the size of

a countrys social security program and the extent to which spending is executed by extra-

budgetary entities. The difference between the consolidated central and general governments

is determined by the depth of fiscal decentralization. In Table 2 I chose four countries that

roughly represent four distinct groups of Latin American countries, ordered by level of dis-

crepancy. The first group of Brazil and Argentina has both significant transfer programs

and fiscal decentralization. The second group of Uruguay, Costa Rica, and Panama has sig-

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nificant transfer programs but is mostly centralized. The third group of Mexico, Colombia,

Bolivia, and Venezuela has limited transfer programs but significant decentralization. Fi-

nally, the fourth group of Nicaragua, the Dominican Republic, Chile,7 Ecuador, El Salvador,

Guatemala, Paraguay, and Peru has neither extensive transfer programs nor decentralization;

central government spending is most reasonable as an approximation for budgetary spending

in these countries. Given the comparative data on social spending in Segura-Ubiergo (2007:

13-14), most Western and Eastern European countries likely fall in the first and second

groups.

1.2.2 How Flexible Is the Budget?

Country studies of fiscal policymaking consistently observe that most spending within the

budget is fairly rigid and not amenable to yearly modifications in the appropriations process.

According to a study of budget inflexibility in Latin America by Echeverry et al. (2006), the

only item commonly flexible across countries is public investment and the direct purchase

of goods and services, with overall levels of rigidity in the budget ranging from 84% to 92%

among Argentina, Colombia, Mexico, and Peru. Another report by Lisa Schineller (2006:

56-57) from Standard and Poors measures rigidity at 5055% for Chile, 75% for Costa Rica

and Ecuador, and 90% for Panama and Uruguay.8 These inflexibilities arise from compulsory

payments mandated by law, earmarked revenues that must be spent for a specific purpose,

7The inclusion of Chile in this group is counterintuitive but probably explained by the 1981 privatizationof the state pension program. This does not mean that the Chilean state does not engage in social spendingbut that what they do spend is mostly included in the budget.

8These papers include interest payments and have differing methodologies, but there are few sources thatmeasure inflexibility for more than one country at a time.

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or spending floors that mandate that the state spend a certain percentage of fiscal resources

in one area at the expense of others.

One of the biggest single expenditures in the budget is defined benefit pension systems for

the private sector and civil service. As Echeverry et al. (2006: 95) note, not only are outlays

determined by a legal formula, but the responsibilities of the state begin when employees

decide to retire and do not end until their rights expire, leaving future financing requirements

difficult to estimate. In 2003, pensions accounted for about 20% of the Argentine budget,9

17% of the Colombian budget, 9% of the Mexican budget, and 21% of the Peruvian budget.

These obligations can only be modified outside the budget process with the passage of a

new law or constitutional amendment. Moreover, shedding these liabilities is a lengthy and

expensive process that stretches over numerous fiscal years: even if the president can gather

a sufficient legislative coalition to privatize the pension system, the transition costs from

continuing to pay benefits to current retirees while losing contributions from employers and

employees that move to the new system can be enormous. For example, Guidotti (2006:

79-81) estimates that Argentinas 1993 pension reform cost the Treasury 2 2.5% GDP

annually from 1993-2000 and identifies it as one of the factors leading up to the countrys

2001 fiscal and economic meltdown.

In an extreme case, the Brazilian pension system (which accounted for 10 .5% of GDP

in 1999) can only be modified by amending the constitution, preventing the government

from reducing incredibly generous benefits to civil servants equal to 100% of their last basic

9Most other sources put this figure at 30%, but this depressed number may be due to approximately 45%of the budget spent paying down the countrys debt after the 2001 crisis. Abuelafia et al. (2005: 21) putpensions at 39% of primary expenditures and 34% of total expenditures for 2004.

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salary (OECD 2001: 97-103). Although the Brazilian presidency has the strongest budget

prerogatives in the region, they could not help President Cardoso to muster the two-thirds

of representatives required from both houses of Congress to amend the constitution. His

proposed reform package was only approved in 1998-99 after two of the most important

measuresthe capping of benefits at 70% of previous wages and the immediate application

of higher retirement ageswere removed.10

Pensions are the largest component of a hodgepodge of transfers that the state can be

legally obligated to send to various public and private entities. Recipients include house-

holds, enterprises, provinces (in addition to revenue sharing agreements), universities, and

international organizations. The World Bank (2003: 76) estimates these to account for 26%

of the Argentine budget. Echeverry et al. (2006: 62-3) find that transfers to the provinces

in Colombia (mostly for health and education) account for 37% of primary expense, while

other transfers (excluding pensions) accounted for another 12%.11

These are also mandated

by law and cannot be altered in the appropriations process.

Another major category of inflexible spending is the payroll for government employees.

While the Brazilian and Mexican governments (among others) were able to implement hiring

freezes and voluntary retirements to slow the growth of personnel expenses, there are signifi-

cant legal and constitutional hurdles to reducing the number and wages of current employees

in the short term. In Mexico, for example, article 75 of the constitution establishes a public

employment contract as an acquired right that cannot be rescinded. 12 As Echeverry et al.

10Meaningful changes were not made until 2003 during the Lula presidency. See OECD (2005: 54)11I had to do a bit of calculation on my own here, but all the necessary pieces are in the tables on pp.

62-63.12This only applies to workers represented by the monopoly Federacion de Sindicatos de los Trabajadores

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(2006: 104) note, the president would need a law passed to modify the current labor regime

if major changes are to be made.13 Brazils 1988 constitution also has strict limits on the

firing of public employees (OECD 2001: 46-47). Of course, de facto rigidity can also come

from more familiar sources such as labor union resistance, especially when civil servants are

protected by a single monopoly labor union or federation (Murillo 2000).

This is not to say that significant reductions cannot be achieved, but they require consul-

tation with the legislature and cannot be made at executive whim. In exchange for taking

over early from the failed Alfonsn administration in Argentina, Carlos Menem demanded

that the lame duck Radical-dominated congress grant him special powers and increased flex-

ibility in overhauling the state. The 1989 State Reform Law (Law 23,696) weakened existing

labor contracts and delegated to Menem sweeping decree powers allowing him to liquidate

a significant portion of public enterprises and adjust the wages and number of civil servants

in the National Public Administration (Ozlak 1997: 91-92). Oszlak (2001: 2-3) documents

a breathtaking reduction of federal employees and finds that 125,000 workers were forced

into early retirement and another 240,000 public enterprise employees were transferred to

the private sector via privatization. However, this delegation of powers is highly unusual

and the product of economic crisis; it was rescinded in the second Reforma del Estado law

after the necessary changes had been made (Rinne 2003: 44-47).

Payroll costs are a much greater part of the budgets of Central American countries, which

al Servicio del Estado (FSTSE), not the small group of semi-independent professionals known as empleadosde confianza(confidence employees). These workers are hired for their skills and experience and, althoughfairly well paid, do not have the right to organize. They usually leave when a minister resigns and must seekemployment in another agency. See Gault and Amparan (2003).

13In fact, Zedillo was unable to pass exactly this type of reform through the legislature in the 1990s. SeeHeredia (2002).

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have generally not established extensive social programs, than more developed countries.

Compensation of employees accounted for over 30% of the Nicaraguan and Guatemalan

budgets in 2003 and over 40% in Costa Rica, the Dominican Republic, and El Salvador. 14

In most other countries in the region this component was around 20% of the budget (World

Bank WDI).

Finally, significant portions of spending that should theoretically be flexible can be made

rigid by legal or constitutional spending floors and revenue earmarks. Some laws actually

require spending to increase to a certain level far above past outlays or to increase at a

certain rate. These restrictions force the government to allocate a certain portion of the

budget to a specific program or sector and remove a large portion of spending from the pool

of resources that can be modified during the budget process.

Health and education spending are the most common targets of this protection, and

examples are legion in Latin America. In Argentina, the Education Finance Law (Law

26,075) requires education, science, and technology spending to increase to 6% of GDP by

2010; in order to meet this goal, the government had to increase education spending by

17% between 2006 and 2007 (CIPPEC 2006: 14-15). In Ecuador, the constitution requires

that 30% of government expenditures be destined for education, while the rate of increase in

health care expenditure cannot fall below the rate of increase of overall expenditures (World

Bank 2005: 54). The Social Development Law in Mexico prohibits social spending by the

federal government from declining in real terms from year to year. In addition, the General

14Costa Ricas inclusion in this group is surprising, but their spending on payroll was one of the highestat 43%, a number that I have confirmed with other sources. It may be that much of their social spending isoff-budget.

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Education Law compels the state to spend the equivalent of 8% GDP on education, 1% of

which must be destined toward scientific research and technological development (Echeverry

et al. 2006: 85-87). Brazil is one of the most notorious cases of earmarking since the aggregate

value of restrictions is enormous and written directly into the constitution. An amendment

approved in 2000 required aggregate federal health spending to grow by 5% in real terms

from its 1999 level in fiscal year 2000 and for further yearly increases in line with GDP

growth thereafter. The constitution also establishes a minimum per pupil spending floor for

the first to eighth grades and requires that minimum pension payments to be adjusted by

the same rate as any minimum wage increase (OECD 2005: 28; Alston et al. 2005: 52-54).

The same inflexibility can also be imposed by earmarking specific sources of revenue to-

ward a program or sector. In Ecuador, 15% of oil revenuesthe main source of income for

the governmentare earmarked for various sectoral organizations as well as health, educa-

tion, and road maintenance. The same can be said for about 21% of tax revenues (Meja

Acosta et al. 2006: 53-56). In Brazil, 18% of taxes are automatically set aside for education

spending, in addition to a special financial transactions tax (CPMF) earmarked for health

care and a contribution from fuels (CIDE) reserved for transportation infrastructure and

subsidies for the energy sector (Alston et al. 2005: 51-54).15 Of course, one cannot forget

the sometimes massive earmarks for transfers to subnational governments that consume a

large portion of revenues in decentralized countries, but this is usually not incorporated into

central government spending figures. Table 3 presents cross-sectional data on the magnitude

15However, the Brazilian Congress failed to reapprove the CPMF in December 2007, so the provisionalpart of its name may finally have kicked in after 13 years.

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Table 3: Earmarked Spending (as a percentage of primary spending) in Selected LatinAmerican Countries

Country Earmarked SpendingColombia 81Brazil 80Argentina 60Guatemala 55Costa Rica 45El Salvador 12Honduras 11Peru 1Source: Singh et al. (2005: 34)

of this inflexibility, but these figures include all transfers to subnational governments. 16

The consequence of this inflexibility in the budget is highly pertinent to the study of

fiscal rules: by predetermining most of the expenditures according to legal formulas and

earmarks, rigidity undermines the entire logic of the appropriations process. As Wildavsky

(1992: 273) writes in his classic study of the American budget:

Budgeting and entitlement are incompatible concepts. Budgeting refers...to the al-location of limited resources for financing competing purposes. But if budgeting issupposed to be resource allocation, then entitlement is mandatory resource segrega-tion...Basically, entitlements are about budgeting by additioneach sum for every pro-gram added to othersnot budgeting by subtraction, in which programs are eliminatedor reduced, or where more for one means less for another.

Given these rigidities, the prerogatives of the president within the budget process seem

disconnected from most spending decisions. These reservations bring into question the use-

fulness of the common pool framework in conceptualizing fiscal policymaking, requiring

reconsideration of how fiscal policy is negotiated and how fiscal outcomes can be improved.

16Earmarked transfers in Peru are larger than what is presented in the table but small overall and off-budget. Echeverry et al. (2006: 121-22) document that 2.4% of revenues collected by the central governmentare transferred to the tax administration office (SUNAT) and central bank and another 5% is sent to themunicipalities. The rest of municipal resources are own revenues.

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1.2.3 Should the Dependent Variable Be Surpluses or Spending?

The third major concern with existing studies is the use of fiscal surpluses as a dependent

variable while drawing conclusions about how the rules of the budget process can restrain

excessive spending. Since the surplus is the interaction between two separate (both in time

and in decision-making authority) policy decisions, one cannot distinguish whether the pos-

itive coefficient estimated for these rules represents a decrease in expenditures, an increase

in revenues, or some combination thereof. While it could be argued that deficits are an

interesting variable in themselves given their relation to a countrys debt burden, common

pool models attempt to explain levels of spending, not deficits.17

Retrenchment achieved through tax increases would not fit into this framework. For

example, when Brazil under President Cardoso turned around chronic public sector deficits

by increasing the tax burden about 7% GDP over his mandate rather than cutting spending,

OECD analysts (2005: 26-32) worried that this would depress growth and push more workers

into the informal sector, arguing that retrenchment without expenditure reductions was

short-sighted and unsustainable. Furthermore, tax bills are not part of the budget process

and often subject to different requirements for approval. For instance, in Mexico the revenue

law must be passed by both houses of Congress and is subject to presidential veto. The

budget law, however, is considered at a later date by only the Chamber of Deputies. Because

it is not approved by both houses, the president technically does not have the ability to veto

under the 1917 constitution (Weldon 1997: 238-39). Therefore one would have to code an

17For instance, Weingast, Shepsle, and Johnsen (1981: 645) assume away the deficit implications of spend-ing with a tax system that covers all expenditures.

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entirely new variable to measure the effect of institutional rules on tax law and, by extension,

the surplus. The magnitude of this problem will be tested in the next section when I reanalyze

the empirical relationship between budget institutions and fiscal policy.

2 Remeasuring the Effect of Budget Institutions

Why does the empirical literature on budget institutions consistently find a positive impact

on overall fiscal outcomes if most spending is not affected by these rules? In this section

I attempt to improve the estimate of the effect of budget institutions by modifying the

dependent variable to reflect the realities of the budget process and the exact claims of

the common pool literature. While it would be difficult to find detailed expenditure data

for all countries and classify each item by level of flexibility, it is fairly straightforward to

address the other concerns laid out in the previous section by using the expenditures of the

budgetary central government as a dependent variable. After respecifying the dependent

variable, I use bivariate correlation plots and time-series cross-sectional data to show that

budget institutions have no effect on spending at any level of government.

The methodology employed in this section has limitations. While the IMFs Government

Financial Statisticsis the only source that breaks down fiscal data thoroughly enough to

allow accurate comparisons between countries and across different levels of government,

missing data is a significant problem.18 Given that this study focuses on presidential systems

18ECLACs (2006) Statistical Yearbook of Latin America, in contrast, has little missing data but usesdifferent levels of government for each country and only has consolidated central government or consolidatedpublic sector figures.

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Latin America, the GFS database had complete data for only 15 countries for any extended

time period19 after 1990 (in this case I chose 1997-2000):20 Argentina, Bolivia, Brazil, Chile,

Colombia, Costa Rica, Dominican Republic, El Salvador, Guatemala, Mexico, Nicaragua,

Panama, Paraguay, Peru, Uruguay, and Venezuela. Thus we are left with insufficient degrees

of freedom for cross-sectional analysis.

Therefore, I primarily restrict myself to the simple bivariate correlation plots presented

in the other empirical studies without the accompanying cross-sectional regression. While I

also present panel regressions with robust controls, the fact that budget rules rarely change

over time means that this technique will depress the standard errors and overestimate the

statistical significance of my results. Although both methods produce identical results, future

work will have to employ a cross-regional analysis in order to fully exploit the GFS database.

The results from these simple plots, however, cast doubt on findings that hierarchical

budget rules can restrain spending. Figure 1 presents a bivariate plot between the UNDPs

index of presidential budgetary powers and primary balances for the budgetary central gov-

ernment of the 15 included countries. It appears that, even when restricting the dependent

variable to this narrower definition of government, the relationship between budget rules and

primary surpluses remains strong, with a correlation coefficient of 0.42. However, when the

dependent variable is broken down into primary spending and revenues in Figure 2, there

appears to be a slight positivecorrelation with primary spending (0.08) and a strong pos-

itive correlation with revenues (0.31). This implies that whatever relationship hierarchical

19An average of several years is necessary to smooth out differences in political budget cycles across thecountries.

20Although they began data collection in 1973, the IMF changed its coding scheme in 2001 and onlyrecoded data back to 1990.

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Figure 1: Scatterplot of Presidential Budgetary Powers and Average Primary Balance forBudgetary Central Government, 1997-2000 (correlation=0.42)

2 4 6 8 10

0

2

4

6

8

Presidential Budgetary Powers

Pr

imaryBalance1997

2000

ARG

BOL

BRA

CHL

COL

CRI

DOM

GUA

MEX

NIC

PAN

PAR

PER

SLV

URU

VEN

Figure 2: Scatterplot of Presidential Budgetary Powers and Average Primary Spending (left,correlation=0.08) and Average Revenues (right, correlation=0.31) for Budgetary CentralGovernment, 1997-2000

2 4 6 8 10

6

8

10

12

14

16

18


PrimarySpending1997

2000

ARG

BOL

BRA

CHL

COL

CRI

DOM

GUA

MEX

NIC

PAN

PAR

PER

SLV

URU

VEN

2 4 6 8 10

8

10

12

14

16

18

20


GovernmentRevenues19972000

ARG

BOL

BRA

CHL

COL

CRI

DOM

GUA

MEX

NIC

PAN

PAR

PER

SLV

URU

VEN

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Figure 3: Scatterplot of Presidential Budgetary Powers and Average Primary Balance forConsolidated Central Government, 1997-2000 (correlation=0.45)

3 4 5 6 7 8 9 10

1

2

3

4

5


Pr

imaryBalance1997

2000

ARGBOL

BRA

CHL

COL

CRI

DOM

MEX

NICPAN

PER

SLV

URU

VEN

Figure 4: Scatterplot of Presidential Budgetary Powers and Average Primary Spending (left,correlation=0.12) and Average Revenues (right, correlation=0.30) for Consolidated CentralGovernment, 1997-2000

3 4 5 6 7 8 9 10

15

20

25


PrimarySpending1997

2000

ARG

BOL

BRA

CHL

COL

CRI

DOM

MEX

NIC

PAN

PER

SLV

URU

VEN

3 4 5 6 7 8 9 10

15

20

25


GovernmentRevenues19972000

ARG

BOL

BRA

CHL

COL

CRI

DOM

MEX

NIC

PAN

PER

SLV

URU

VEN

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budgetary institutions has with primary surpluses, there is no evidence they are associated

with lower spending.

Despite large discrepancies between the two measures, Figures 3 and 4 show almost iden-

tical results for the consolidated central government,21 with budget institutions having a

strong positive association with primary surpluses and revenues and a weak positive rela-

tionship with primary spending. While I have already discussed why this more expansive

measure is problematic for the study of budget institutions, there does not seem to be any

room for confusion as concerns the relationship of these rules with government spending.

While these contrary findings appear persuasive, unfortunately I have insufficient degrees

of freedom to draw conclusive inferences. Moreover, I have not added any controls to factor

out other economic and demographic explanations of fiscal policy outcomes, creating danger

of omitted variable bias. One alternative is to add a time-series component to the data to

increase the number of available observations. While not unprecedented in this areaone

prominent example being Hallerberg and Mariers (2004) paper on budget institutionsthis

estimation technique is also imperfect. Since budget rules rarely vary over time, it is unclear

whether I am truly gaining more information by estimating how the same rules affect fiscal

outcomes year after year or whether this artificially increases the degrees of freedom and

thus deflates the standard errors. However, because this method will be biased toward type

I error (false positives) and I am only positing a negative result (that budget rules do not

depress spending), this estimation problem is actually working against me. If it is possible to

replicate the negative result from the bivariate plots in this unfavorable situation, it would

21Guatemala had to be dropped from these plots due to missing data.

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provide strong reinforcement for my finding.

To estimate these models, I use time-series cross-sectional data for the same fifteen Latin

American presidential democracies from 1990 to 2005.22 Using TSCS data involves numerous

estimation problems, which data limitations allow me to address with varying degrees of

success. To correct for differences in heteroscedasticity across panels and contemporaneous

correlation of the error terms, I estimate the coefficients with pooled ordinary least squares

(OLS) and the standard errors with panel-corrected standard errors as recommended by

Beck and Katz (1995).23 Because the panels are unbalanced, I use pairwise rather than

casewise estimation of the interpanel covariances.24 Given that serial correlation of the

errors is a common problem with time-series data, I used Woolridges (2002) test for first-

order autocorrelation in the panels; I had to reject the null hypothesis that there was no first-

order autocorrelation for all three of my initial regressions.25 I correct for this by assuming

common AR(1) correlation within all panels.26

Finally, given the additional degrees of

freedom offered by panel regression, I include an extensive battery of controls from other

papers that use fiscal outcomes as a dependent variable.27

The results from models (1) to (3) exactly match the findings from the bivariate plots.

Budget institutions have a significant positive effect on budget surpluses even after specifying

an extensive set of controls. But when the surplus is broken into primary spending and

22The exact country years included in these regressions can be found in Appendix B.23For replication purposes, this technique can be performed with the Stata command xtpcse.24This is the pairwise option in Stata for xtpcse.25This was performed with the Stata command xtserial. (This command does not come with Stata.

Type findit xtserial to download this command into the program.)26This is the corr(AR1) option in Stata for xtpcse.27Summary statistics and definitions for all variables can be found in Appendix B.

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Table 4: Panel Regressions for Budgetary Central Government, 1990-2005

Primary Surplus Primary Spending Revenues Spending First Diff.(1) (2) (3) (4)

Presidential 0.50*** 0.13 0.53** 0.16Budgetary Powers (0.14) (0.23) (0.20) (0.10)Inflation 0.00*** 0.00*** 0.00 0.01***

(0.00) (0.00) (0.00) (0.00)Financial Market 0.09* 0.14** 0.02 0.08*Development (0.04) (0.05) (0.02) (0.03)Trade Openness 0.04* 0.00 0.03** 0.03**

(0.01) (0.02) (0.01) (0.01)GDP Growth 0.02 0.10 0.09** 0.01

(0.05) (0.05) (0.03) (0.04)Per Capita 0.00 0.00* 0.00 0.00GDP (0.00) (0.00) (0.00) (0.00)% Population 0.33 0.09 0.32*Over 65 (0.20) (0.29) (0.16)% Change in 0.01 0.00 0.01 0.02

Terms of Trade (0.02) (0.03) (0.02) (0.02)Grants 0.00 0.00**

(0.00) (0.00)Unemployment 0.04 0.03 0.12 0.05

(0.09) (0.13) (0.07) (0.05)Agriculture 0.19(%GDP) (0.10)constant 1.22 8.81* 13.02** 2.31

(2.50) (3.93) (3.16) (2.60)R2 0.24 0.33 0.48 0.46Obs. 239 241 233 223

*p


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revenues, it once again appears that these rules actually have a negligible effect on spending

and a significant positive effect on revenuesthe 0.50% estimated increase on surpluses for

an additional rank of hierarchy is replicated not on the spending side (which has an estimate

indistinguishable from zero) but entirely on the revenue side.

However, before placing too much confidence in the estimates in regression (2), one must

ask to what extent surpluses are comparable to spending levels in time-series cross-sectional

data. A surplus is a flow variable (the amount of debt a country cancels each year), and

it is easy to imagine a country moving from the bottom quartile to the top quartile of the

distribution from year to year. The level of spending as a percentage of the economy, however,

is closer to a stock variable with a large inertial component: it is difficult to imagine

Guatemala (at 10% GDP) and Brazil (at 40% GDP) switching places in the distribution

within any time frame. Therefore, serial correlation of the errors within the panels should

be more severe in regression (2) and make our estimated coefficients less reliable.

To correct for this, I used the first differences in spending (P SP ENDi,tP SP ENDi,t1)

as a dependent variable in regression (4), which is the increase in spending from year to year.

This variable is closer to a budget surplus analytically and suffers from much less serial

correlation.28 Given the common pool problem identified in the literature, it should be the

case that countries with more hierarchical rules have smaller spending increases from year

to year since logrolling is controlled. However, from regression (4) we can see that countries

with stronger rules actually increase their spending at a faster rate, although this difference

28Indeed, the Woolridge test failed to reject the null hypothesis that there was no autocorrelation withinthe panels (p= 0.38).

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is not statistically different than zero.

Overall, there does not seem to be any evidence that budget institutions are a constraint

on spending. The empirical work in this section, though imperfect, shows that estimates

in previous studies that suggested otherwise were misleading since the dependent variable

did not measure what the budget institutions theory claimed to explain. Why budget rules

would be correlated with higher revenue extraction at all is an interesting question, but

speculation to this regard is beyond the scope of this paper.

3 Conclusion: From the Budget Arena to the Legisla-

tive Arena

In 1980, the Chilean military junta under Augusto Pinochet dismantled the countrys public

pension system and introduced a new, mandatory private sector system with competing

joint stock companies. There had been almost no public debate beforehand, although many

academic experts and officials in the social security administration opposed the reform, in

addition to traditional right wing parties. Those already in the old system were allowed to

remain, but the lower contributions required in the new plan triggered a massive transfer

of individuals to the private system. The new program remains in place today and covers

almost all of Chiles insured (Mesa-Lago and Muller 2002: 690-91). This initiative came

after the military had already dismissed one-third of the countrys civil servants in 1974 and

dramatically decreased the size of government (Larran 1991).

The speed and decisiveness of fiscal reforms under Pinochet is remarkable, but Chile was

not a democracy in the 1980s. Although many democratic constitutions try to streamline

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decision-making authority over government spending by creating a separate, more centralized

budget arena, the introduction of entitlement legislation, automatic revenue transfers, and

spending floors from the congress has pushed the vast majority of fiscal policy back into the

legislative arena. To succeed in this arena, aspiring reformers need more traditional assets

such as popular mandates and strong, disciplined legislative coalitions. When presidents in

democratic countries pursued sweeping reforms, they were forced to rally large legislative

coalitions to draft new laws, pass constitutional amendments, and to delegate decree powers

to them. Some, like Carlos Menem in Argentina, succeeded; others, like Fernando Collor

de Mello in Brazil and Carlos Perez in Venezuela, failed miserably. In order to centralize

decision-making power over welfare programs and subnational transfers in the same way that

some presidents are budget dictators, one would need to create a real dictator. It should

not be surprising, then, that Mesa-Lago and Muller find that the depth of pension system

reform and the strength of democratic institutions are inversely related.

This paper found that off-budget expenditures and obligations created by statute and

constitutional mandate have mostly sidelined the appropriations process in determining fiscal

outcomes. Meaningful fiscal policy overhaul has not been accomplished by tinkering with

individual appropriations demanded by particularistic legislators but by tackling the massive

legal obligations accumulated in the construction of the modern welfare state. As the World

Bank (2003: 76) observed in its study of fiscal policy in Argentina:

Major policy initiatives tend to be taken outside the confines of the budget process...Infact, Congress main influence on spending is through substantive legislation, notthrough the annual budget law...[it does this] by passing laws dealing with pensions,health care, taxation, and other issues. In both the Government and Congress, budget-ing is regarded more as a means of financing ongoing activities than as an opportunity

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to define national priorities and policies.

In conclusion, scholars who want to explain fiscal policymaking cannot ignore normal

legislative politics, which, apart from structural conditions, is one of the most important

factors in explaining variation in policy outcomes. There is already evidence that the process

of pulling policy back into the legislative arena described in this paper is a product of power

struggles between the executive and congress: Huber et al. (2001) find that U.S. state

legislatures are most likely to exercise statutory control over the bureaucracy when there is

divided government. While the president has clear incentives to assert control over policy,

he is likely to face resistance in a democratic system. Furthermore, the very nature of

entitlement spending, which implies enduring social contracts between the government and

various consistencies, has lead most democracies to protect these outlays from the pressures

of the appropriations process. Although the formal rules of the budget process impact some

types of spending, this paper has argued that their ability to explain overall policy outcomes

is minimal.

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Appendices

Appendix A: Coding of the UNDP Index of Budgetary Powers

The UNDP index of the presidential budgetary powers is composed of four separate measures ofexecutive control:

The first measures on a scale of zero to three the legislatures ability to amend the presidentsproposal. If zero, the legislature can increase or decrease spending without restriction; if one,it cannot increase spending without finding new sources of revenue; if two, it needs thepresidents approval to do so; if three, it is categorically prohibited from increasing spending.

The second measures how favorable the reversion outcome is to the president if the legislaturefails to pass the budget. If zero, the government shuts down; if one, the previous years versionif enacted; if two, the presidents version is enacted.

The third measures the ability of the president to unilaterally impound spending after thebudget is approved. If zero, he cannot impound funds; if one or two, he can only impoundfunds if revenues are less than projected or only for non-earmarked expenditures, respectively;

if three, he can impound funds by decree (without restriction). Finally, the fourth measures the presidents ability to modify the budget after it is approved

by the legislature. If zero or one, he cannot (but in the former case the legislature can); iftwo he can do so with legislative approval; if three, he can do so by decree.

The resulting variable, PRES, has a range from zero to eleven, with higher scores meaning higherpresidential dominance over the budget process.

Appendix B: Variable Summary Information

Country Years included in Panel Regressions: Argentina (1990-2004), Bolivia (1990-2005),Brazil (1990-1994, 1997-1998), Chile (1990-2005), Colombia (1990-2005), Costa Rica (1990-2005),Dominican Republic (1990-2005), Ecuador (1990-1994), El Salvador (1990-2005), Guatemala (1990-2005), Mexico (1990-2000), Nicaragua (1990-2005), Panama (1990-2001), Paraguay (1990-2005),Peru (1990-2005), Uruguay (1990-2005), Venezuela (1990-2005).

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Table 5: Variable Summary Statistics

Variable Obs. Mean Std. Dev. Min Max

PRES 272 6.65 2.03 2.00 10.00PBAL 241 3.42 3.58 -32.26 11.29SPEND 241 14.71 5.83 4.08 65.23PSPEND 241 12.13 5.58 1.74 65.22DPSPEND 223 0.17 3.39 -42.66 9.07

REV 241 15.55 4.82 4.06 32.97INTEREST 241 2.57 2.59 0.01 25.33GRANT 239 0.55 1.33 0.00 11.92INFL 272 122.18 719.08 -1.17 7485.49FINMKT 272 35.97 14.16 10.62 93.66

OPEN 272 60.68 33.88 13.75 198.77GDPG 272 3.50 3.75 -11.03 18.29PCGDP 272 5889.05 2421.65 2056.75 12895.70POP65 272 5.35 2.36 2.73 13.23TRADE 272 4.61 0.15 3.93 5.24

UNEMP 272 9.96 4.43 1.60 22.00AGR 266 11.67 5.83 3.83 27.78

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Table 6: Variable Definitions

Variable Source Definition

PRES UNDP (2004) An index of the legislatures ability to amend the presidentsbudget, the reversion or default outcomes in the event of

legislative rejection, the presidents ability to unilaterallyimpound spending after approval, and the presidents abilityto modify the budget after the legislatures approval

PBAL IMF GFS (2007) Revenues less expenditures less interest payments on gov-ernment debt for the budgetary central government

PSPEND IMF GFS (2007) Expenditures less interest payments on government debt forthe budgetary central government

DSPEND IMF GFS (2007) First differences of PRISPEND variableREV IMF GFS (2007) Revenues for the budgetary central governmentINTEREST IMF GFS (2007) Interest payments on government debt (% GDP)GRANT IMF GFS (2007) Noncompulsory transfers received by government units from

foreign government units or international organizationsINFL World Bank WDI Inflation, consumer prices (annual %)FINMKT World Bank WDI Liquid liabilities (M3) as % of GDPAGR World Bank WDI Agriculture, value added (% of GDP)OPEN World Bank WDI Imports plus exports (% of GDP)GDPG World Bank WDI GDP growth (annual %)PCGDP World Bank WDI GDP per capita, PPP (constant 2000 international dollars)POP65 World Bank WDI Population ages 65 and above (% of total)UNEMP Political Risk Services

(various years)Open unemployment in urban areas (% of total labor force)

TRADE World Bank WDI Change in net barter terms of trade (2000=100)

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