INTERNATIONAL MONETARY

FUND

Fiscal Affairs Department

Indonesia

THE WORLD BANK

Budget Reform Strategy Priorities

Poverty Reduction and

Economic Management Unit East Asia and Pacific Region

June 2007

R. Allen, S. Eckardt, D. Jacobs, J. Kristensen, I. Lienert, S. Schiavo-Campo

For Official Use Only

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FOR OFFICIAL USE ONLY

INTERNATIONAL MONETARY FUND

WORLD BANK

INDONESIA

BUDGET REFORM STRATEGY PRIORITIES

R. Allen, S. Eckardt, D. Jacobs, J. Kristensen, I. Lienert, S. Schiavo-Campo

June 2007

The contents of this report constitute technical advice and recommendations given by the staff of the International Monetary Fund (IMF) to the authorities of a member country in response to their request for technical assistance. With the written authorization of the recipient country’s authorities, this report (in whole or in part) or summaries thereof may be disclosed to IMF Executive Directors and their staff, and to technical assistance providers and donors outside the IMF. Disclosure of this report (in whole or in part) or summaries thereof to parties outside the IMF other than technical assistance providers and donors shall require the written authorization of the recipient country’s authorities and the IMF’s Fiscal Affairs Department.

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Contents Page

Abbreviations and Acronyms ....................................................................................................5

Preface........................................................................................................................................6

Executive Summary ...................................................................................................................7

I. Background and Objectives..................................................................................................14

II. Macro-fiscal Analysis and Forecasting ...............................................................................17 A. Current Arrangements for Macro-Fiscal Analysis and Forecasting .......................17 B. Recommendations ...................................................................................................22

III. Annual Budget Preparation Process and Cycle .................................................................23 A. Analysis of the Present Situation ............................................................................23 B. Recommendations ...................................................................................................33

IV. Moving to a Medium-Term Performance-Related Budget Framework ............................35 A. Essential Features of a Multiyear Perspective ........................................................35 B. Present Strengths and Challenges for Developing an MTEF..................................36 C. Key Steps in Introducing an MTEF in Indonesia....................................................38 D. Implementing a Program- and Performance-based Budget System .......................43 E. Recommendations ...................................................................................................51

V. Budget Documentation .......................................................................................................53 A. Assessment of Existing Budget Documentation.....................................................53 B. Recommendations ...................................................................................................58

VI. Articulating the Reform Strategy.......................................................................................59 A. Formulating and Managing the Reform Agenda ....................................................59 B. Technical Assistance to Support Budget Reform ...................................................60

Appendix I: Indonesia’s Legal Framework for Budgeting ......................................................62

Appendix II: Samples of Budget Tables and Performance Information..................................67

Tables 1. Examples of Appropriation Structures for Performance-Based Budgets ............................28 2. Planning and Budget Documents Submitted to the DPR.....................................................55

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Figures 1. Possible Sequencing of Budget Reforms.............................................................................12 2. Illustration of a Four-Year MTEF........................................................................................36 3. Monthly Pattern of Disbursements of Capital Expenditure.................................................38 4. Proposed Committee Structure for Budget Reform.............................................................60 Boxes 1. Medium-term Macro-Fiscal Analysis ..................................................................................17 2. Technical Assumptions for Budget Projections—Practices in Selected Countries .............21 3. The Central Government Budget Preparation Process ........................................................23 4. Two-Stage Budget Review and Approval Processes by Parliament ...................................26 5. Legal Constraints on the Legislature’s Power to Amend the Budget..................................29 6. Adoption of Parliament’s Own Budget—International Experience ....................................32 7. Variants of Medium-Term Expenditure Planning ...............................................................35 8. Preparing Forward Estimates...............................................................................................39 9. Estimating the Recurrent Cost of Investment Projects ........................................................43 10. Issues Associated with Introducing a Performance-Oriented Budgeting System .............44 11. Definitions of Programs and Activities in Indonesia.........................................................45 12. France: Legal Requirements for Budget Information........................................................54 13. International Comparison of Budget Documentation........................................................56 14. Budget Documentation in South Africa.............................................................................57 15. Technical Assistance for Budget Reform ..........................................................................61 16. Constitutional Provisions on Public Finance and External Audit......................................62 17. Objectives, Content and Preparation of Annual Work Plans (WPs) .................................65

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ABBREVIATIONS AND ACRONYMS

ABPN Annual Budget Law (of central government) BAPPENAS National Development Planning Agency BI Bank Indonesia BPK Indonesia’s Supreme Audit Institution CBO Congressional Budget Office DAK Special Allocation Grants DAU Transfers of General Grants DG Directorate General DIPAs Budget Implementation Documents DPD Council of Representatives of the Regions DPR Parliament – the People's Representative Council EU European Union FAD Fiscal Affairs Department (of IMF) FPO Fiscal Policy Office GDP Gross Domestic Product GFMRAP Government Financial Management and Revenue Administration Project GFS Government Finance Statistics KBP Anti-Corruption Commission M&E Monitoring and Evaluation MOF Ministry of Finance MOHA Ministry of Home Affairs MTEF Medium-Term Expenditure Framework MTFF Medium-Term Fiscal Framework OMB Office of ManagementandBudget PER Public Expenditure Review (of the World Bank) RKA-KL Ministry’s Work Plan and Budget RKP Government Work Plan Rp Rupiah SPAN Computerized State Treasury and Budget System TA Technical Assistance TSA Treasury Single Account WP Work Plan

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PREFACE In response to a request from the Minister of Finance to advise the authorities on strengthening the budget process, a joint mission of the International Monetary Fund’s Fiscal Affairs Department (FAD) and the World Bank visited Jakarta during February 19 to March 2, 2007. The mission comprised Mr. R. Allen (head), Mr. I. Lienert and Ms. D. Jacobs (all FAD), Mr. S. Schiavo-Campo (member of FAD’s expert panel), and Messrs. J. Kristensen and S. Eckardt (World Bank). The mission met with the Minister of Finance, Mrs. Sri Mulyani Indrawati; the Minister of Planning, Mr. Paskah Suzetta; and the Chairman of the Supreme Audit Institution (BPK), Mr. Anwar Nasution. It also had fruitful discussions at the National Development Planning Agency (BAPPENAS), including with: Dr. Lukita Dinarsyah Tuwo, Deputy Minister for Development Funding Affairs; and Mr. Slamet Seno Adji, Deputy Minister for Economic Affairs. Within the Ministry of Finance (MOF), the mission met with the Secretary General, Mr. Mulia Nasution; the Director General of Budget, Mr. Achmad Rochjadi and his staff; the head of the Fiscal Policy Office (FPO), Dr. Anggito Abimanyu and his staff; the Inspector General, Dr. Permana Agung Dradjatturn and his staff; the Director of Accounting, Dr. Hekinus Manao; and the Director of Treasury Systems, Mr. Badarudin. In addition, the mission met with the Vice Chairman of the budget commission of Parliament (DPR), Mr. Hafiz Zawawi and other commission members; the Secretary to the Coordinating Ministry of Economic Affairs, Mr. Komara Djaja and other advisors to the Minister; the Planning Directors of the Ministry of National Education, Dr. Gatot Hari Priowirjanto, of the Ministry of Health, Mr. Madiono, and of the Ministry of Public Works, Mr. Bambang Guritno. Meetings were also held with representatives of the World Bank and the Australian government. The mission conducted a half-day workshop for government officials on the comparative experience of budget reform in various countries. The mission thanks Messrs. Stephen Schwartz (IMF senior resident representative) and Armando Morales (resident representative), who attended many of the mission’s meetings. The mission also expresses its appreciation to the staff of the IMF and World Bank Jakarta offices for their assistance in organizing the logistics of the mission. This report is the final version of the mission’s findings and recommendations, which has benefited from comments from the authorities, the FAD advisory committee and World Bank peer reviewers.

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EXECUTIVE SUMMARY

This report is designed to assist the authorities develop an overall road map for reforming budget preparation. A specific focus is on the steps to be taken to introduce a medium-term framework for the central government’s budget and a performance-based budget. These reforms require important preconditions to be in place, and a substantial change in the culture, incentives and behavior of the public service, and are likely to take several years to complete. Successive Indonesian governments have embarked on various reforms in the budget and public financial management system. New laws for governing budget and planning processes were adopted during 2003–04,1 which are gradually being implemented. The national development planning agency (BAPPENAS) and spending ministries have developed strategic government and ministerial plans that provide a basis for elaborating the framework for performance measurement and evaluation. Reforms are thus starting from a secure base and can also take advantage of the improved and stable macroeconomic and fiscal conditions, including a low fiscal deficit and a declining government debt ratio. The budget reform process is at an important stage of its evolution. The authorities have made a legal commitment to implement multiannual, performance-related budgeting. However, they have not yet identified concrete steps to realize these goals or the speed of progress they hope to achieve. The report makes recommendations designed to help move this agenda forward. It refers to the experience of other countries that have undertaken similar reforms. Although a few quick wins can be anticipated, the overall reform process is likely to be long, and should be managed prudently. In certain areas, the government has already started implementing the mission's recommendations. For example, the authorities intend to prepare a Medium-Term Fiscal Framework (MTFF) in the near future and include it in the “Financial Note” for FY2008. Macro-fiscal analysis and forecasting The capacity of the Ministry of Finance (MOF)’s Fiscal Policy Office (FPO) is being developed. Further capacity building efforts will be required to support the development of an MTFF and the related medium-term expenditure framework (MTEF), including improved revenue projections, and over the medium term, robust forward estimates of ministries’ expenditures and transfers to provinces and districts. The report recommends that the existing

1 Notably the State Finances Law 17/2003, the State Treasury Law 1/2004, and the National Development Planning Law 25/2004.

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technical committee, chaired by the FPO, meets regularly during the budget process, to update and finalize preparation of the MTFF. Streamlining the budget preparation process and timetable A sound basis for preparing the budget has been established by the new legal framework. The laws specify key dates for the budget preparation cycle, as well as the responsibilities of various actors involved in planning, budgeting and treasury management, which include the FPO, directorate general (DG) budget and DG treasury at the MOF, and BAPPENAS. The procedures defined by these laws and regulations, however, have certain features that are likely to constrain moving toward multiannual, performance-oriented budgeting. In particular the budget is characterized by: • A complex structure of budget appropriations.

• An input-driven structure that includes a very large number of budget entities (over 19,500 satkers) and a focus on the scrutiny of detailed line items.

• Frequent and detailed involvement of the parliament (DPR) in the budget examination and approval process. The DPR has unfettered rights to amend the budget though in practice it has used these powers conservatively.

• A complex process for approving the budget implementation documents (DIPAs) that, along with strictly annual appropriations and various administrative constraints, has distorted expenditure execution, especially for capital projects, whose spending during the fiscal year is back-loaded to the final months.

The report makes a number of recommendations that would streamline the budget preparation process. These include: • Simplifying the budget appropriation structure, notably by refining the existing

program structure in each ministry, and linking programs to outcomes and outputs. This is one of the most important and fundamental actions for implementing a medium term and performance-oriented budget system.

• Moving to a two-stage budget scrutiny and approval process by parliament: the first stage focusing on the government’s proposed medium-term fiscal policy strategy and the setting the budgetary envelopes at sector/program level; the second, approval of the detailed annual budget.

• Setting indicative amounts for total transfers to local governments in May–June and communicating these amounts to all 33 provinces and 434 districts.

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• Supporting the DPR in its efforts to simplify parliament’s internal arrangements for reviewing and approving the budget, including improving the efficiency of the reviews carried out by the budget committee and parliament’s sectoral commissions.

• Undertaking a thorough review of the budget calendar, to include an examination of ways to simplify DIPAs and finalize them without DPR approval.

• Liberalizing the virement rules for reallocating expenditures (with some limits, especially on salaries), to give line ministries greater flexibility during budget execution.

Moving to an MTEF and a performance-oriented budget process Developing an MTEF and a performance-oriented budgeting system are closely linked, and their development should proceed in step and be closely coordinated. Their implementation, moreover, should be gradual and requires other actions, including the proposed simplification of the appropriations structure and the development by ministries of “bottom-up” forward estimates of the cost of their programs over a three- or four-year period. The report indicates a sequence of measures, short term, medium term, and longer term, by which such a reform could be undertaken. The measures recommended by the mission comprise, for the short term: • Preparing and publishing a simple MTFF/MTEF with the 2008 budget, based on

“top-down” projections of expenditures and revenues, as part of its assessment of the overall fiscal position.

• Refining the current procedures for estimating revenue over the medium term so as to provide a reference point for programming affordable expenditure.

• Forming a joint working group of MOF and BAPPENAS to: (1) elaborate, in consultation with line ministries, a clear definition of “program,” “subprogram,” and “activity,” applicable to the entire government; (2) define the operational distinction between existing expenditure programs and activities (subprograms), and new expenditure programs or subprograms; and (3) develop a procedure for reliably preparing forward estimates and calculating the full cost of existing subprograms, including the allocation of salaries and other overhead expenses.

• Selecting a few initial pilot programs or subprograms for cabinet approval. For the pilots, there would be in-depth medium-term expenditure programming accompanied by key performance indicators by the selected ministries with a view to visible improvements in efficiency, as well as to gain experience.

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For the medium term (by 2011):

• Expanding the “bottom-up” expenditure programming exercise to additional subprograms, by including additional ministries each year.

• Adopting annual budgets based primarily on programs for each ministry/agency, which could be supplemented by appropriations for broad economic categories.

• Implementing a capacity-building program for line ministries and agencies in expenditure programming and cost accounting.

• Beginning the process of introducing medium-term expenditure projections in selected provinces or districts, provided that budgeting and accounting formats are the same as in central government and that an agreed procedure exists for regular reporting to central government.

• Encouraging the Indonesia’s Supreme Audit Institution (BPK) to develop its capacity for undertaking value-for-money audits of expenditure programs.

For the longer term (perhaps achievable by 2015): • For central government, completing the migration to a largely programmatic MTEF.

• Extending to general government the medium-term revenue and expenditure projections.

The quality of domestically-financed projects could be assured by establishing an “Investment Quality Assurance Office” within the MOF or BAPPENAS. This unit would formulate and disseminate standards and procedures for the preparation of large public investment projects; provide technical oversight of the preparation, appraisal and physical monitoring of domestically-financed projects; and guide and facilitate line ministries’ efforts to build capacity in this area. Budget documentation A streamlining and revamping of budget documentation will need to be made in step with the reforms of the budgeting process proposed in this report. Improvements could be made in the 2008 budget documents by including: (1) forward projections of expenditures, broken down by ministries in the first instance (by existing programs for the 2009 budget), revenues and other fiscal aggregates for a three-year period; (2) a fiscal risks statement; and (3) a citizens’ guide to the budget that provides easily understandable information on the fiscal outlook and budget proposals.

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Developing and articulating the strategy for reforming budget preparation A high-level budget reform committee could be established to lead, supervise and manage the budget reform process. The committee could be chaired jointly by the minister of finance and the minister of planning, and comprise senior officials from the MOF, BAPPENAS and the coordinating ministry on economic affairs. Several working groups could be established to support and manage key aspects of the reform process—program review; budget process reform; performance measurement; and outreach, socialization and capacity building. The committee might consider making a public statement of the proposed budget preparation reform strategy, summarizing the main actions taken in 2007 and those proposed for 2008 and later years, the expected benefits, short term and longer term; and the arrangements being set up to develop the budget reform strategy. The reform plan would spell out processes, responsibilities and milestones, and outline complementarities between various reform elements. Figure 1 suggests a possible sequencing of the reforms, together with suggested milestones and the requirements, if any, for changes in legislation. A detailed action plan would build on the recommendations in this report and reflect the government’s own priorities. Donors, including the World Bank and the Australian government, have pledged substantial for budget reform, including through resident or peripatetic experts. The government may wish to avail itself to these offers to assist in refining and implementing some of the report’s recommendations. Consideration should be given to issues that, while not technically part of the budget preparation process itself, will be critical to its reform. These include: (1) advancing reforms of the public service to introduce greater flexibility into arrangements for organizational restructuring, and strengthening the role of merit criteria in the hiring, advancement and development of civil servants; (2) strengthening internal control and audit within all ministries and government agencies, since budget program managers will have enhanced flexibility, as well as augmented accountability for ensuring integrity in performance-oriented budget management; and strengthening the capacity of the external audit agency (BPK); (3) ensuring that the development of the proposed treasury automation (the “SPAN” system) and other computerization efforts are synchronized with the needs of a new multiannual, performance-based budget system, and with administrative capacity; and (4) giving appropriate attention to change management aspects of the reform and the “socialization” of the strategy with the DPR, line ministries and other key players.

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Figure 1. Possible Sequencing of Budget Reforms

Legal Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Requirements

Coordinated Reform Process: Involvement of key stakeholders

Set up Steering Committee, Working Group and align Budget Reform Unit as secretariat

Milestone 1: Budget Reform Task Force Operational, MoU signed, full-time staff appointed

Joint ministerial decree

Formulate budget reform action plan

Milestone 2: Reform action plan launched

Adopt focused two stage budget approval process as envisaged by Law 17/2003

Reinstate, with DPR, a two-stage focused budget scrutiny and approval process

Review and adjust DPR internal operating procedures between various commissions to streamline decision-making process. Milestone 3: Plenary Session of DPR adopts annual budget for 2009 after focused two-stage process

Budget Documentation Prepare Citizen's Guide to 2008 Budget

Milestone 4: Citizens Guide Budget 2008 published and on MoF and Bappenas homepage available

Medium Term Fiscal Framework (MTFF) adopted with Budget 2008

Formalize FPO lead role in implementing MTFF

Extend MTFF forecasts for all major macro-economic assumptions, revenues and expenditures, for presentation in 2008

Milestone: 5:2008 Budget presents MTFF

Adopton of APBN on new basis

Introduce Flexibility in Budget Management

Liberalize virement rules to allow spending ministries to re-allocate between satkers, activities, and selected economic types,without MOF approvalMilestone 6: Enhanced Effectiveness in Budget Execution Budget 2008

Clarification of law amnd/or regulations

Pilot Program Based Bugdeting/MTEF

Set up working group of MOF, BAPPENAS and selected ministries to review program structure

Establish structural reform units in line ministries and in auditBegin refining programs and socializing the concept in audit and pilot institutions

Select Pilot Programs for Program Based Budget Appropriation in Budget 2009, set clear output targets, and estimate multi-year costs

Approve Program Budgets to Pilot Programs, in parallel with 2009 BudgetMilestone 7:Program based Budgeting Piloted in Budget 2009

New ministerial decree

2011Expected Reform Outcome Tasks 20102007 2008 2009

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Figure 1. Possible Sequencing of Reforms (continued)

Legal Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Requirements

Evaluate and Extend Program Based Budets/MTEF

Monitor and evaluate results in pilot programs and adjust program structure

Milestone 8:Results of Pilot Programs provide basis for expansion to other programsDevelop Capacity Building Program for Line Ministries on forward cost estimates and program based budgetingDeliver training Roll out program budgeting to whole of governmentMilestone 9:Adopt, by DPR, annual budget primarily on a program basis (all ministries) ?

Modifications to Law 2003/17

Enhance ex ante appraisal of large investments

Prepare and disseminate guidelines for preparation and appraisal of large investment projectsMilestone 10:Improved and standardized appraisal procedures for large scale investment projects

Audit Reform

Progressively establish performance orientation of ex post controls and money for value audits (external and internal audit systems)Mile Stone 11: Performance oriented audit systems

2007 2008 2009 2010 2011Expected Reform Outcome Tasks

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I. BACKGROUND AND OBJECTIVES

This report is designed to assist the authorities develop an overall strategy for reforming budget preparation and strengthening the budget process. A specific focus is on the steps to be taken to introduce a multiannual, performance-based budget. These reforms are planned against the background of improved macroeconomic and fiscal conditions, including a declining government debt ratio. Issues related to fiscal federalism are not substantively covered in the report. Successive governments have embarked on reforms in the budget and public financial management system, with support from donors. Progress in budget reform so far includes: • Adopting a new legal framework for planning, budgeting, treasury management,

and external audit. New laws were adopted by Parliament during 2003–04 and new government regulations for implementing the new laws have been approved.

• Restructuring the MOF. A first restructuring occurred in 2003, when the DG of treasury was established, separate from DG budget.2 A second restructuring occurred in 2006, when a FPO was established with a focus on macro-fiscal policies and projections, and a new DG debt was created by splitting off two debt directorates from DG treasury.

• Unifying the previous routine and development budgets. As from the 2005 budget, a new economic and functional classification was introduced for budget expenditures, based on the IMF’s Government Finance Statistics Manual (GFSM 2001) system.3

• Beginning a process of rationalizing government bank accounts and improving cash management.4 A principal objective is to establish a treasury single account (TSA) and to close government accounts outside the control of DG treasury.

• Issuing new government accounting standards. The State Finance Law 17/2003 requires the accrual-based recognition of revenues and expenditures within five years. Important steps include the issuance of Government Regulation 24/2005 on

2 The restructuring of the MOF was broadly in line with recommendations made by FAD missions, whose reports analyzed reform proposals. See Action Plans to Improve Public Expenditure Management, by J. Brumby, and others, April 2003, and PEM Reform: Next Steps, by J. Brumby, and others, June 2004.

3 See Indonesia: Treasury Modernization and Related Reforms, by J. Brumby, and others, April 2005, and Report on the Government Finance Statistics Mission, January 11–24, 2006, by R. Shepherd and B. Donaghue.

4 See Indonesia: Improving Cash and Debt Management, by I. Lienert and others, March 2007.

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government accounting standards and templates for accounting statements to be used by central and local governments.

• Finalizing plans to introduce an integrated financial management information system (the SPAN project). The World Bank’s Government Financial Management and Revenue Administration Project (GFMRAP) focuses particularly on computerization of treasury operations. The GFMRAP also includes support to change the budget system—within the MOF and BAPPENAS—as well as for improving parliamentary involvement in the budget approval processes.

• Committing to improve fiscal transparency. The government published a fiscal transparency report.5 The public availability of fiscal information is improving and the government intends to publish a fiscal risk statement with the 2008 budget.6

• Reviewing expenditure policies. To promote the discussion of possible reforms, the World Bank prepared a Public Expenditure Review (PER) in 2007.7

Despite these encouraging developments, the budget process remains complex and fragmented. Moreover, progress in improving strategic budget planning in DG budget and BAPPENAS has not received the same attention as the reforms implemented or planned for DG treasury or DG debt. This relative neglect is exacerbated by the ongoing focus on detailed annual projections conducted by parliamentary commissions. In addition, the DIPAs are excessively detailed, and will need revision if the government is to implement its ambitious budget reform agenda. There are also rigid civil service rules for recruitment, advancement and termination of staff. Changing administrative structures is a politically sensitive and time-consuming process, including the steps needed to appoint staff of the highest civil service grades (Echelon 1 and 2). The civil service salary-setting system is characterized by rigidities. In addition, there are remuneration supplements that are not fully transparent. All of these features may constrain the future pace of budget-related reforms. The introduction of a multiannual and performance-based budgeting system has been planned by the authorities for some time.8 However, the concrete steps to realize these

5 See Indonesia: Report on Observance of Standards and Codes—Fiscal Transparency Module, IMF Country Report No. 06/330, September 2006. 6 Technical assistance (TA) was provided by FAD for this purpose. See Indonesia: Statement of Fiscal Risks, by J. Davis, and others, March 2007.

7 See Spending for Development, Indonesia PER, Conference Edition, World Bank, February 2007.

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goals have not yet been identified. This report refers to the experiences of countries that have adopted similar budget reforms. One important lesson is that the overall reform process is likely to be a lengthy one. However, measures might be taken in 2007 and 2008 to achieve small but significant changes that could be built on in subsequent years. The remainder of this report is laid out as follows. Section II reviews the institutional arrangements for macro-fiscal analysis and forecasting. Section III assesses the organizational arrangements and procedures for preparing the annual budget. The introduction of a multiannual budgeting perspective and a program- and performance-based budget system, is examined in Section IV. Options for improving the budget documentation are described in Section V. The articulation and sequencing of reforms, and likely TA requirements, are discussed in the final Section VI. Appendix I summarizes the key provisions of Indonesia’s existing legal framework for the budget and national development planning systems. Appendix II provides an illustrative example of good practice in presenting budget documentation, based on the case of South Africa.

8 For example, in 2005, DG Budget and Fiscal Balance issued a “Medium-Term Expenditure Framework Guide,” prepared with the assistance of an advisor (S. MacLeod). However, the guide was not implemented.

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II. MACRO-FISCAL ANALYSIS AND FORECASTING

This section discusses the current arrangements for macro-fiscal analysis and forecasting. It also reviews the need for improvements in these arrangements and capacity building within the FPO of the MOF, and makes recommendations in this regard.

A. Current Arrangements for Macro-Fiscal Analysis and Forecasting

The responsibilities of the FPO have been defined. There are five units in the FPO—the macroeconomic unit, a global issues unit, a revenue unit, an expenditure unit, and a risk management unit. Box 1 summarizes the macro-fiscal analysis and other functions that are often located in a macro-fiscal unit of a MOF.

Box 1. Medium-term Macro-Fiscal Analysis

Medium-term macro-fiscal analysis is concerned with the links between fiscal policy, other financial policies, and medium-term macroeconomic objectives. Hence, it focuses primarily on:

• Macroeconomic developments and the appropriate fiscal policy targets in the short term;

• The sustainability of fiscal policy over the medium term;

• The forecasting of fiscal aggregates—and in particular, revenue, debt service, and expenditure—over the medium term, as an input to annual budget preparation;

• The monitoring and reporting of revenue, debt service, and expenditure developments, and determining the consequences for the fiscal deficit and its financing; and

• The analysis of fiscal policy issues as a basis for providing advice to the minister of finance and other senior government officials.

Fiscal monitoring and reporting. This involves monitoring and reporting fiscal developments as a basis for providing information on the implementation of fiscal policy and identifying the need for possible corrective measures when fiscal policy is inconsistent with original targets.

Fiscal policy analysis. This involves in-depth analysis of fiscal policy issues including the assessment of short-term and medium-term fiscal developments, as a basis for providing advice on the design of fiscal policy, possible corrective measures, and other policy questions.

The FPO’s capacity is developing, for example by the recent transfer of the macroeconomic unit in DG budget, and technical assistance is being received.9 The State Finance Law specifies that the Minister of Finance shall arrange fiscal policy and regulate the macroeconomic framework (Article 13). Based on this legal provision, the FPO has been

9 Assistance was received in November 2006 from FAD, when an economist provided guidance in developing a model for testing sensitivity of the annual budget to changes in key assumptions. Further TA is planned to be provided by the Australian government and the World Bank.

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confirmed as the lead agency for finalizing the medium-term macro-fiscal projections. Since BAPPENAS has sectoral knowledge and expertise, the FPO will continue to rely on its advice in making sectoral growth projections, just it depends on input from Bank Indonesia (BI) for price, interest rate, and exchange rate technical assumptions. However, the final responsibility for all technical assumptions to be used in preparing the draft annual budget rests with the FPO. This arrangement, though not yet fully effective,10 is developing quite well as each organization provides technical input in its area of expertise and can challenge the methods, assumptions and procedures used to generate the projections. Budget forecasts and underlying macroeconomic assumptions are clearly presented in the annual budget.11 The main macroeconomic assumptions, including real economic growth, inflation, interest rates, oil prices and volumes, are contained in the budget documents submitted to the DPR. Projections of these variables are prepared collaboratively, by a committee of technical staff from the FPO, DG budget, BAPPENAS, the national statistics office, the BI, the ministry of energy and mineral resources, and the coordinating ministry of the economy, chaired by the director-general of the FPO. The committee periodically reviews macroeconomic assumptions and revises them as appropriate. The parliamentary budget committee examines the macroeconomic framework and suggests modifications to assumptions. Spending and revenues may, as a consequence, be revised upwards by the DPR’s sectoral commissions and budget committee relative to the projections contained in the government’s draft annual budget.

Other aspects of the current arrangements for macro-fiscal analysis and forecasting could be improved. There is high variability in the quality of fiscal projections.12 Also, the budget documents submitted to parliament have not fully analyzed the sensitivity of the projections to changes in macroeconomic variables13 and the main fiscal risks have not been disclosed. The authorities are aware of these shortcomings and are taking steps to improve the situation. For example, it is planned to present a sensitivity analysis for macroeconomic indicators and their implications for budget policy in the MOF’s “Financial Note” for FY2008. This document will also include a fiscal risk analysis, for which capacity in the FPO is being strengthened.

10 Under current arrangements, several entities are involved with macroeconomic forecasting, including BI, DG budget (despite the transfer of a unit to the FPO), the FPO, and BAPPENAS.

11 See IMF Country Report, No. 06/330, September 2006.

12 See Indonesia: Statement on Fiscal Risks, op. cit., pages 16–17.

13 Since the 2006 budget, the sensitivity to changes in oil prices has been shown in budget documents.

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Improving the medium-term focus of budget projections

Although some medium-term macroeconomic and fiscal forecasts are prepared by the FPO, they are not yet used directly in the budget process. Many countries have developed, as a preliminary step in moving towards an MTEF, an MTFF comprising key macroeconomic assumptions and projections of the main fiscal aggregates (including fiscal deficit/surplus targets) over a three- to five-year period. The 2006 World Bank PER sets out a draft MTFF for the period up to 2010.14

An MTFF can assist policymakers in reviewing inter-temporal policy alternatives—such as the possibility to undertake sustainable expenditure in the future in exchange for fiscal adjustment in the present. Also, short-term fiscal policies often ignore the existence of “contingent” government liabilities—implicit and explicit—emerging, for example, from loan guarantees, weak financial institutions, or the financial and debt management policies of local authorities or public enterprises that are de facto underwritten by the central authorities. Under a medium-term perspective to policy design, such risks can be considered and policies formulated to address them.

The lack of medium-term fiscal orientation could be rectified by ensuring that clear documents and discussion agendas are prepared by the executive to guide parliamentary consideration. In general, it is prudent for the government to propose a budget with conservative revenue estimates, but not excessively so. Scenarios showing the consequences of alternative assumptions of key parameters on revenues, the proposed deficit, and spending should be shown to parliament, to highlight the risks involved in reducing debt more quickly or spending more when there are “excess” oil revenues. Since revenue projections for oil are inherently uncertain, and there is a need to develop a long-term strategy for using oil revenues, as well as macroeconomic considerations, major oil producing countries are encouraged to focus on the non-oil deficit as a key indicator of fiscal policy.

The budget commission of the DPR has recently revised upward the government’s revenue projections, which has boosted spending. For example, during discussion of the assumptions underlying the draft 2007 budget, the indicative ceiling for aggregate spending was revised up significantly by parliament after the discussions in May–June, and further upward revisions were made to spending after the draft annual budget law (of central government) (ABPN) was submitted to parliament in mid-August 2006. There are risks in such an approach, although these have not been evident during the recent period of rising international prices for oil. However, in the event of a downturn in oil prices, budget spending could be built on revenue assumptions that do not materialize, creating the risk of problems during budget execution. 14 See Table 1.10 on page 18.

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Further steps are needed to improve revenue projections. In recent years, the volatility of production volumes and prices of natural resources has resulted in a low quality of revenue projections. Several countries have introduced mechanisms to ensure that revenue assumptions are prudent and scrutinized by an independent panel of experts or an independent agency (e.g., see Box 2). In Indonesia, while revenue assumptions have been prudent, the government has perhaps been excessively conservative in recent years, in part because this limits the transfers to local governments (since transfers are dependent on projected revenues).

Medium-term fiscal targets, such as the overall balance, are presently limited to the central government but could be extended. Government Regulation 23/2003 requires that the cumulative general government deficit does not exceed 3 percent of GDP and the cumulative debt does not exceed 60 percent of GDP. Currently this fiscal rule is not monitored, let alone enforced. There is a need to introduce mechanisms for allocating the cumulate deficits and debt between central, provincial and districts.

The annual budget presented to the DPR could be supplemented by presenting estimates of the main fiscal targets of general government. Although the budgetary importance of the subnational governments is quite large, the annual budget presented to the DPR currently includes only the transfers to local governments. Improvements in the availability and quality of data on subnational government finances are urgently needed. In the short term, it would be useful for the FPO to start incorporating data on the main general government budgetary aggregates (e.g., the overall fiscal balance, total spending, total revenues) in the MTFF. One approach could be to monitor changes in local government balances,15 initially by using information related to the financing of fiscal balances, and using the transfers to subnational governments as the main input to calculating revenues of subnational governments (locally-generated revenues are relatively small), thereby estimating subnational governments’ expenditures as a residual.

15 MOF have indicated that they intend to prepare budget deficit projections for FY2008, not only for central government transactions, but also for provincial budgets.

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Box 2. Technical Assumptions for Budget Projections—Practices in Selected Countries

It is unusual for legislatures, or their budget/finance committee, to alter the technical assumptions underlying medium-term budget projections. Selected practice is: Brazil. In June of each year (six months before the start of the new fiscal year), congress adopts an annual “Budget Guidelines Law,” which indicates fiscal targets, including revenues, expenditures and deficit, over a three-year period. This law also lays out the assumptions for variables such as GDP growth, inflation, the exchange rate, and interest rates, as well as the impact of changes in these variables on budget aggregates. The detailed annual budget, adopted by the congress in December, must be consistent with the guidelines law, but may be revised by congress if any assumption is considered inadequate or incorrect. Should congress revise the technical assumptions, resulting in upward revisions to revenues and expenditures which the executive considers unrealistic, the Presidential Decree (revised every two months) implementing the budget would be based on lower aggregate revenues and expenditures, and spending ministries would be forced to cut program spending according to the priorities of their ministry, in order to comply with the executive’s aggregate spending targets. Canada. Department of Finance (DoF) officials meet with the chief economists of major banks and private sector economic forecasting firms to agree on a set of economic assumptions projecting fiscal aggregates over a five-year period, based on existing policy assumptions. The DoF makes two adjustments to the private sector estimates of the budget balance: (1) an amount for “economic prudence,” based on analysis of the risk to the budgetary projections of variations in key economic assumptions, such as GDP growth and interest rates; and (2) an annual contingency reserve, to provide an extra measure of back-up against errors in the economic forecast. If not needed, this reserve is used to reduce the government’s stock of outstanding debt. United Kingdom. The Finance Act 1998 requires the National Audit Office to examine and report on conventions and assumptions underlying the treasury’s fiscal projections, to ensure that the assumptions used are “reasonable and prudent”. The examination includes a three-year rolling review of the assumptions previously audited. United States. The projections underlying the President's budget proposal are based on assumptionsof the Office of Management and Budget (OMB). Congress's budget projections are based on those of the Congressional Budget Office (CBO). The various committees of Congress almost always accept the technical assumptions proposed by CBO, which also prepares sensitivity analyses of how the projections could change should different assumptions by used. There is no obligation for OMB and CBO to align their technical assumptions since OMB and CBO are independent of each other. However, in practice, OMB and CBO confer with each other and, at times, use identical assumptions for key variables.

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B. Recommendations

For the short term, the government may wish to:

• Enhance the disclosures of budgetary information and analysis, especially concerning sensitivity analysis for macroeconomic indicators and fiscal risk analyses.

• Prepare and publish a simple MTFF/MTEF with the 2008 budget, based on “top-down” projections of expenditures and revenues, and presented as part of the government’s assessment of the overall fiscal position.

• Refine the current procedures for estimating revenue over the medium term so as to provide a reference point for programming affordable expenditure. Avoid unrealistic assumptions of world oil prices in budget projections.

For the medium term:

• Consider establishing fiscal and debt targets at the general government level, that is, for both central and subnational governments. This would require close coordination by the FPO, DG fiscal balance and the ministry of home affairs (MOHA).

• At an appropriate stage, include in the annual budget documentation scenarios for changed intergovernmental funding arrangements, based on indicative ceilings for transfers in years beyond the upcoming budget year.

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III. ANNUAL BUDGET PREPARATION PROCESS AND CYCLE

A. Analysis of the Present Situation

The new budget-related legal framework clarified the responsibilities of various actors involved in planning, budgeting and treasury management. The laws and regulations (see Appendix I) lay the basis for future reforms, notably the introduction of a medium-term, performance-oriented annual budget. Annual budget preparation begins 11 months before the new fiscal year begins and culminates with the adoption of the annual budget law on October 31 (Box 3). A large number of central government ministries and agencies, as well as various parliamentary commissions, are involved in this process.

Box 3. The Central Government Budget Preparation Process

Month 1/ Description of Stage

The fiscal year is January 1–December 31, in which all authorized cash expenditures must be made. There is no end-year carry-over of budget authorizations, nor any complementary accounting period.

February–March MOF and BAPPENAS issue a joint budget circular to line ministries. The circular provides guidelines on the preparation of ministries’ work plans (WPs) and includes indicative budget ceilings for each ministry, broken down by programs.

March Ministries prepare their initial WPs, in line with the government work plans and their own strategic plans prepared for a five-year period (currently 2005–09).

April–May 15 BAPPENAS, in coordination with MOF, reviews WPs.

MidMay (Art.13) Government submits to the DPR the Fiscal Policy and Government Work Plan (RKP) document, which includes description of the macroeconomic framework, fiscal policies and priorities for the upcoming budget year. Ministerial WPs as well as the RKP are submitted.

May 15–June 15 Discussions are held by MOF and parliamentary commissions on fiscal policy, ministries’ WPs and proposed expenditures, including transfers to local governments.

June 15 MOF issues a revised budget circular including a preliminary budget ceiling for ministries’ programs, taking into account the agreement reached with the DPR on budget policies and priorities.

June 15–July 15 Ministries, together with parliamentary sectoral commissions, discuss the WPs in line with the preliminary ceilings issued by the MOF. WPs are detailed by administrative units, programs, activities, and broad economic categories of expenditures. Ministries submit discussed WPs and budgets to the MOF and BAPPENAS for review.

July 15–Aug 15

MOF and BAPPENAS review the consistency of ministerial work plans and draft budgets (RKA-KL) with preliminary ceilings. MOF compiles the reviewed ministerial RKA-KLs, the draft State Budget and Financial Note, which defines budget priorities for the next budget year and which is discussed in cabinet.

August Art. 15 (1)

Government submits the draft State Budget and Financial Note including the reviewed ministerial WPs to the DPR. The President delivers the annual budget speech.

August 15–October 31 Sectoral Committees and the budget commission of the DPR review the macro-assumptions, revenues, expenditures and financing of the draft budget.

October 31 Art. 15 (4)

DPR in plenary session approves the annual budget as a State Budget Law (APBN). Appropriations are detailed by ministerial head agencies, functions, subfunctions, programs, and the economic classification.

November MOF, in coordination with parliamentary sectoral commissions, disaggregate the APBN into organizational units, functions/subfunctions, location, and types of expenditure.

December 1–31 Ministries prepare their documents on budget implementation (draft DIPAs) and submit them to MOF by December 15. Ratification by end-December by presidential decree of the ministries’ projections and issuance of the documents on budget implementation (DIPAs).

1/ Dates shown in bold are contained in specific articles of the State Finances Law 17/2003.

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The legal framework16 The legal framework mandates the preparation of government work plans. Besides requiring an overall statement of the government’s medium-term strategy and policy priorities, sectoral strategies and policy priority statements are also required. These provide a useful starting point for the budget reforms discussed in this report.

Whereas it is not unusual for a budget cycle to begin 10–12 months prior to a new fiscal year, it is unusual for parliament to adopt the budget as a law two months before the fiscal year begins. In most countries, the annual budget is adopted during the month preceding the new fiscal year. The early adoption of the annual budget by the DPR is designed to allow sufficient time prior to the beginning of the new fiscal year to: (1) notify regional and district authorities of the final amount of intergovernmental transfers from the central government budget; and (2) provide two months for the detailed budget implementation documents to be finalized. There are, however, alternative ways of providing assurances to subnational governments of the size of likely transfers (see below).

The laws are somewhat unclear on some specific issues, particularly: (1) the degree of detail for spending approval required by the DPR; and (2) the nature, type and duration of annual appropriations. These issues, which are discussed further below, may necessitate eventual changes in laws or regulations.

Parliamentary approval of the government’s fiscal strategy and budget

A striking feature of the budget preparation process is the extent and nature of interventions by the DPR. Box 3 indicates that parliament is involved four times in the preparation of the annual budget: first, to discuss the fiscal policy and budget priorities document, which results in reaching agreement with the MOF on preliminary budget ceilings and the macroeconomic framework; second, to discuss revised annual work plans of ministries and institutions, prior to submission of the draft budget to the DPR in August (discussions may take place on an informal basis, with direct communication between sectoral parliamentary commissions and their corresponding spending ministries); third, detailed discussions on the draft budgets of ministries (RKA-KLs) during September–October, prior to budget adoption by the DPR by October 31; and fourth, after end-October, when parliamentary commissions approve ministries’ budgets at the most detailed level. The process of reaching consensus within parliamentary committees has not been easy and there appears to an overemphasis on the scrutiny of the details of the budget. Many

16 See also Appendix I.

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political parties are represented in the DPR and several factions17 are represented on parliament’s 11 commissions. Sherlock (2003) notes that there are a large number of members (averaging over 60) on each commission.18 Moreover, it is difficult for commissions to reach quorums because of non-attendance; there are multiple agendas for members; unfocussed commission meetings; difficulties in reaching decisions; and low quality of discussion, debate, and questioning in commissions. For hearings, government officials may be subjected to long sessions with parliamentary sectoral commissions.

The DPR’s budget commission prepares an assumption on the indicative size of the fiscal deficit. For the 2006 budget, the budget commission worked on an assumption of a central government deficit target no greater than 1.2 percent of GDP. This compares favorably with the overall general government deficit of 3 percent of GDP specified in Government Regulation 23/2003 on the control of cumulative deficits. However, the budget commission’s deficit target could be changed should there be upward spending pressures. The indicative target is only for a single year, not for the medium term.

The intention of the State Finances Law was for one initial budget review by parliament, not two. The primary purpose of the initial review is to examine “the macroeconomic framework, and core fiscal policies and priorities.” It was intended that this be followed by only one examination of the draft detailed budget during mid-August to end-October. Such a two-stage parliamentary budget review and approval process is common (Box 4). In Indonesia, the two-stage intervention is stated both in law and in the DPR’s rules of procedure (see Appendix I). It appears that, since the government submits detailed information to the DPR, the parliamentary commissions have taken advantage of this to examine many details of the budget. This takes considerable time and is one reason why the number and length of parliamentary hearings and interventions have increased.

At what level of detail should parliament approve the annual budget?

The State Finances Law requires the DPR to adopt an excessively detailed budget. A simplification of the complex appropriation structure would be useful to replace the present budget, for which appropriations are by organizational units, functions, programs, activities and economic types of expenditure.19 One alternative would be for the DPR to approve broad

17 A faction is a grouping of members of parliament based on the configuration of political parties as the result of the general elections. Factions, rather than parties, are represented on parliamentary commissions. Further details are provided in the rules of procedure of the DPR.

18 See Sherlock, Stephen, 2003, in “Struggling to Change: The Indonesian Parliament in an Era of Reforms.”

19 There are currently 19,945 spending units (satker), each of which has a detailed budget: there are also about 160 programs that are supported by activities, 11 broad functions complemented by 79 subfunctions, five economic categories (salaries, goods and services, transfers, other current, and capital) of spending, two funding

(continued...)

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bands of expenditures, with further details being contained in budget implementation documents (see discussion below).

Box 4. Two-Stage Budget Review and Approval Processes by Parliament

Most parliaments or state legislatures intervene substantively only twice in the budget approval process. Key issues for parliament are: the focus and timing of its reviews and approvals, including the annual and medium-term budget and expenditure frameworks. Review and Approval of Medium-term Fiscal Strategies and Budget Framework Many countries’ parliaments consider the government’s annual budget proposal in the context of a well-justified medium-term fiscal strategy. Some parliaments (e.g., Brazil, New Zealand) have adopted a Fiscal Responsibility Law that requires the government to present medium-term projections of revenues, expenditures, fiscal surplus or deficit, and government debt. The medium-term expenditure projections are usually indicative, although in Sweden, the parliament can adopt the medium-term expenditure projections as legally-binding upper limits on spending. A fiscal strategy, jointly agreed by the executive and parliament, enhances its credibility and guidance for future fiscal policies. Annual Budget Review and Approval In many countries, the annual budget framework is reviewed by parliament as part of a pre-budget debate on the government’s proposals on budget proposals. This typically occurs 6–8 months prior to the start of the upcoming fiscal year. In some cases, at this stage, parliament adopts legally-binding expenditure or deficit limits for the annual budget.

Spending ministries need to have more flexibility in reallocating between spending items. In recent annual budget laws, authority has been provided by the DPR to the MOF to reallocate between satkers of the same ministry, and between activities under the same program (with some restrictions in each case). However, virement rules for ministries are very restrictive: currently they can only reallocate between subactivities. It would be more appropriate, especially if a performance-oriented budget system is introduced (see Section IV), for ministries to have the flexibility to reallocate between satkers and between activities provided total spending in the ministry for a given program is unaltered. For economic categories, there could, for example, be swapping between salaries, “other current,” and capital spending, but with a restriction of no reallocation into salaries (given the large size of such expenditures).

sources (domestic or external), and about 400 locations in geographical areas. The latter are of particular interest to individual elected members of the DPR.

21 Issues related to formulating programs spread over more than one ministry are discussed in Section IV.

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Simplifying the structure of budget appropriations.

In introducing a performance-oriented budget system, it will be important to first simplify the budget appropriation structure. A change in the State Finances Law would be needed for this. In countries with performance-oriented budget systems, parliament votes on a budget in which, for each ministry, there are a number of budget programs or outputs.21 In some countries, appropriations by major economic categories are embedded in programs (and/or subprograms).22 In Indonesia, a “program” budget structure already exists,23 with about 160 programs. However, the programs in ministries’ work plans are usually aligned to administrative structures within ministries, and there is less focus on achieving outputs or outcomes. With refinement, the present program/activity structure for ministries and other institutions could be used as the main basis for defining appropriations in the annual budget law adopted by the DPR.

Adopting a budget by program does not mean abandoning other classifications. More detailed classifications, notably those by satker, function/subfunction, economic type, location, and funding source, are necessary for budget execution and expenditure control, including for deconcentrated expenditures in provinces and districts. However, if the State Finances Law were to be changed, so that annual budget appropriations were only defined by programs (possibly augmented by a broad economic classification), such a simplification would provide parliament with greater clarity on the objectives of the annual budget and allow a focus on the outcomes important for politicians.

Program-based appropriations would not apply to transfers to subnational governments. Such transfers have increased significantly since the government’s decentralization reform program began in 1999. It is especially at the level of the 434 districts—the tier of government immediately below the 33 provinces—that reliance on central government transfers is high. Total spending at provincial and district levels now represents about 36 percent of total general government spending. Of this, nearly 60 percent is financed by central government transfers, which would continue to be shown separately in the budget appropriations.

Adoption of a meaningful program-based budget should not be envisaged until 2010 at the earliest. The timing of adopting program-based budget appropriations depends on how

22 For example, for each program in France’s budget, the government presents to parliament indicative targets for seven broad economic categories of expenditures (including salaries, operating expenditures, transfers, subsidies, capital, and debt servicing). However, the only binding ceiling is that for salaries; for all other categories, budget managers are permitted to increase or decrease indicative ceilings.

23 Annex III of the annual budget includes these “programs,” which are broadly in line with the program structure of annual work plans (RKP). Box 11 in section IV defines programs and activities.

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quickly all main players in the legislature and the executive reach a consensus.24 One step in this process would be an amendment to the State Finances Law. Irrespective of the timing of the change in law, it could be expected that refinements to ministries’ existing programs would take considerable time. In addition, a “socialization” effort for the new system’s introduction would be necessary, to prepare for the change.

Budget amendment powers

Currently the DPR has unlimited budget amendment powers, which could pose a threat to medium-term fiscal sustainability. Law 17/2003 provides that “the DPR may table amendments regarding the amount of the receipts and spending specified in the budget bill” (Article 15). Although central and provincial fiscal deficits are currently presently well controlled, this may not always be the case.

To protect overall fiscal discipline, it would be useful to examine the advantages of placing legal constraints on parliament’s budget amendment powers. In many countries, laws restrict budget amendments by parliament (Box 5). Even in countries where there are no legal constraints, there are often voluntary constraints on the legislature’s budget-amendment powers.25 For example, some European countries (e.g., Netherlands, Germany) adopt “Coalition Agreements,” which specify fiscal policy objectives for the term of the parliament. In Finland, the Constitution requires the political parties forming the government to agree on an economic program prior to the formation of the government, in order to ensure that a parliamentary majority supports the government’s fiscal policy objectives.

24 France adopted a new law in 2001 for the purpose of changing the input-based annual budget to one based on missions and programs. To ensure that the new system was well-prepared and to avoid difficulties in implementation, a five-year period was planned for introduction of the new program-based budget, which began in 2006. Prior to that date, pilot ministries were selected to run program-based budgets on an experimental basis. For these ministries, both the old and new budget systems were run in parallel.

25 The United States Congress has unrestricted budget amendment powers. However, under the 1974 Congressional Budget Act, a Budget Resolution, laying out the main fiscal aggregates, is adopted by congressional budget committees prior to adoption of the annual federal Appropriation Acts by Congress.

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Box 5. Legal Constraints on the Legislature’s Power to Amend the Budget About half of the OECD countries have strong legal restrictions on the legislature’s authority to amend the budget. These are specified in laws, regulations, or even the Constitution, as follows:

• Constitution, e.g., France, Germany, and Spain. Korea also has strong constitutional restrictions on the National Assembly, which is neither allowed to increase the amount of any expenditure item, nor create a new expenditure item without the prior consent of the executive.

• Law, e.g., France’s Organic Budget Law elaborates on a constitutional restriction, which does not allow parliament to increase expenditures unless either revenues are increased by the same amount, or other expenditures are reduced.

• Parliamentary regulations, e.g., New Zealand, United Kingdom, under which parliament has restricted itself from not increasing spending proposed by the government.

The extent of the restrictions on amendment powers of the legislature varies: • Very strong: Parliament must adopt the proposed budget as a whole unless changes are very

minor or total expenditures are reduced (e.g., Australia, Canada, India, and New Zealand).

• Moderate. Total expenditures may only be increased (or total revenues reduced) if there are offsetting measures which leave the budget deficit unchanged (e.g., France and Germany).

• Unrestricted. For example, the four Nordic countries. In the case of Finland, the Constitution provides Parliament with the authority to make amendments. However, for the European Union (EU) members with no domestic legal restrictions, the EU’s limits on general government deficits and debt constrains the extent of parliamentary amendments. In Sweden, parliament’s amendment power at the budget approval stage is limited by the aggregate expenditure ceilings that parliament adopts. Similarly, in Brazil, parliament adopts a budget deficit target in midyear, as the first step of its two-part budget approval process, prior to adopting the detailed budget by end-year (see Box 3).

_______________________ Sources: OECD, 2003 Budget Practices Survey; Lienert and Jung, 2004, The Legal Framework for Budget Systems: An International Comparison, OECD Journal of Budgeting, Volume 4, Number 3.

Parliament’s budget amendment powers would need to be revisited once the appropriation structure is changed. As discussed above, the DPR can introduce amendments to the president’s draft budget at any level of detail. However, if program-based appropriations are introduced and spending ministries are to be provided with flexibility in managing inputs for achieving the objectives of budget programs, budget managers should not be constrained by parliament (or possibly not by the MOF either) at the detailed level, as at present. In most countries, the law authorizes the parliament to reallocate at Level 2 or 3 of Table 1.

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Table 1. Examples of Appropriation Structures for Performance-Based Budgets

A. France 1/ B: Netherlands C: Sweden D. (possibly

Indonesia) Level 1

Mission

Administrative unit (ministry etc.)

27 Expenditure Areas

Administrative unit

Level 2 Program, with salaries for each

Program Mixed: economic & administrative unit

Program, possibly including subprograms

Level 3 Activity Subprogram with main economic classification

Activity Activity (possibly under subprograms)

Level 4 Activity 1/ See http://www.performance-publique.gouv.fr. If budget amendment powers were to be restricted by law, the DPR would not be prevented from being able to critically examine the executive’s proposed budget. Parliamentary committees’ current strong incentive to review the draft detailed budget stems from their desire to ensure that some detailed line items are included in the annual budget. When a performance-based budget is introduced, parliament would need to focus on what results (outcomes and outputs) government spending programs are trying to achieve. Should parliament be dissatisfied with results, it would be able to intervene forcefully in subsequent years.

Arrangements within parliament for budget approval

Preliminary work for adopting the budget in parliament is done in various commissions. The key committee is the budget commission, which is composed of over 80 members of parliament drawn from all other sectoral commissions. The budget commission’s main roles are to scrutinize draft budgets and approve annual budgets and budget accountability reports. Whereas the MOF reaches agreement with the budget commission (its main counterpart) on the overall budget, spending ministries may reach separate budget-related agreements with sectoral commissions which need to be reconciled with the budget committee. Final budgets for each ministry—detailed down to the level of 19,945 satkers—must presently be approved by the sectoral commission responsible for oversight of that ministry. Sectoral commissions do not always complete their examinations of detailed

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budgets prior to the adoption by the DPR of the overall budget by end-October. When this happens, the DIPAs are asterisked and the budget of the ministry in question cannot be implemented—that is, spending cannot take place—until the relevant parliamentary commission approves it. For example, for the 2007 budget, the Commission responsible for agriculture had not approved the detailed budget for the ministry of agriculture by mid-February 2007. The budget commission is reviewing internal budget scrutiny arrangements with a view to ensuring that all parliamentary commissions complete their work in a timely manner. Proposals for a revised timetable for parliamentary scrutiny and approval were being prepared in February 2007, in order to streamline the budget commission’s procedures for examining and approving the draft annual budget law. Consideration could be given to establishing a nonpartisan budget office to assist parliament in preparing budget scenarios.26 Although the budget commission has recruited a few technical staff to assist in its analytical work, compared with some other countries with presidential systems of government, the current technical support to the DPR is limited. Parliament is contemplating changing the State Finances Law so that is has more autonomy for its own budget. In many countries, the formulation and adoption of parliament’s budget follows that of other constitutional bodies that are independent (or partly independent) of the executive (Box 6). For Indonesia, these include: the Constitutional Court; the Supreme Audit Institution, BPK; the Anti-Corruption Commission (KPK) and the Electoral Commission. The draft budgets of constitutional bodies come under less scrutiny by the MOF (or BAPPENAS) than required for spending ministries. Nonetheless, a senior official or head of the constitutional body concerned (e.g., the Secretary General of the DPR) is assigned to be responsible for preparing a budget that follows the same broad classification and accounting structure as for government ministries.

26 For example, in the United States, the Congressional Budget Office (CBO) assists the Congress, especially the House and Senate Budget Committees, by preparing reports and analyses. In accordance with the CBO’s mandate to provide objective and impartial analysis, CBO’s reports contain no policy recommendations.

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Agreement with the executive on the preparation of DPR’s own budget and the format of its budget execution reports is needed. Some compromise on the amount of detail to be included in the budget execution reports might be necessary, but the DPR should be held accountable for responsible financial management of its own budget, and its final accounts should be audited by the BPK, in line with international good practice. Unallocated expenditures

Under present budget preparation procedures, the detailed budget is partly compromised by including a sizeable amount of unallocated spending in the adopted budget. In the 2006 budget, such unallocated expenditures (lain lain) amounted to around 6 percent of total central government expenditures (somewhat higher than normal). When it is not specified how this money is to be spent, budget transparency is reduced.

Clear rules for the level and use of unallocated expenditures appear to be needed. Efforts should be made to reduce the size of the contingency reserve to perhaps 1–2 percent of total spending. It would be used for well-defined emergency or unexpected spending (in some countries, a contingency also acts as a buffer against errors in revenue forecasting or other fiscal risks). Typically, the government (or the minister of finance) issues instructions that explain the types of spending for which the contingency reserve can be used, the procedures for making requests, and the ex post reporting requirements to parliament.

Box 6. Adoption of Parliament’s Own Budget—International Experience

• Each constitutional body, such as the two chambers of parliament, the Constitutional Court, the

external audit agency, etc. have their own budgets, which are shown separately in the annual budget law.

• Each constitutional body is responsible for preparing and executing their own budget. However, they all follow government accounting standards for budget reporting and prepare an annual report on their own financial performance.

• Parliament’s budget is reviewed ex post by the external audit agency.

• The budget of constitutional bodies is decided in collaboration with the executive. Although technical agreements may be reached with the MOF, some items in the budgets of constitutional bodies require high-level political decision.

• The salaries of constitutional positions, for example, parliamentarians, may be determined by an independent higher salaries commission or by political decision. The salaries of secretariats serving parliament may be independently determined or may follow civil service arrangements, for example, when government officials serve parliamentary bodies for specific contractual periods.

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Timing of budget approval and amounts of regional transfers In principle, adoption of the central government budget by end-October enables local governments to adopt their budgets prior to the beginning of the fiscal year (which, like the central government, also approves their annual budgets on a calendar year basis). In practice, however, many local governments do not adopt their annual budgets until after the beginning of the new fiscal year (in some cases, midway through the fiscal year). It would be possible for the DPR to take earlier decisions on the indicative amount of total transfers to local governments. In particular, when it reviews the macro-fiscal framework after mid-May, there is an opportunity for deciding the preliminary level of transfers to local governments for the following year. Since the amount of general transfers (DAU) is based on revenues, it would be quite easy to make projections for DAU grants to local government. In completing its deliberations on the macro-fiscal framework in June, the DPR could decide on a guaranteed minimum amount of general and specific grants. This would allow subnational governments to plan for their core expenditure programs, and add other programs when the final transfers are know. A midyear decision of the DPR would be made easier once an MTEF is adopted. The MTEF would include indicative amounts for the annual DAU and special allocations grants (DAK) transfers to subnational governments, not only for year (+1), but also indicative ceilings for year (+2) and year (+3). These amounts would provide provincial and district governments with greater predictability of transfers likely beyond the immediate 12-month period ahead.

B. Recommendations

For the short term, the government may wish to:

• Make proposals to simplify the budget appropriation structure, which could be based mainly on a program/subprogram structure in each ministry, possibly augmented by a few broad economic classifications such as salaries, nonsalaries, and capital spending.

• Review the amendment powers of parliament, with a view to proposing amendments to the State Finances Law in line with a simplified budget appropriation structure.

• Liberalize virement rules so that spending ministries can reallocate spending between satkers, activities, some economic categories (with the exception of transfers into salaries which should continue to be strictly controlled by the MOF) and location within a given program, without seeking prior MOF approval. For reallocating between programs, DPR approval must be sought, since programs would become the key basis for annual budgetary appropriations.

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• Undertake a thorough review of the budget calendar, to include an examination of ways to simplify DIPAs and finalize them without requiring the approval of DPR.

• Support the review by the DPR of its own internal operating arrangements for budget review, decision-making and approval, with a view to ensuring that all parliamentary commissions have focused discussions on the draft annual budget law.

• In particular, encourage parliament’s commissions to reduce the extent of their detailed interventions and to implement a two-stage budget scrutiny and approval process: first, during May–June, when the DPR reviews the government’s proposed medium-term fiscal policy strategy and approves the key aggregates for preparing the detailed annual budget; and second, during mid-August to end-October, when the DPR scrutinizes and approves the detailed annual budget.

• Provide to the provinces and districts, in June, the indicative minimum amounts of total transfers from the budget in the following year.

For the medium term:

• Implement a budget program structure, possibly supplemented by appropriations for broad economic categories in the program budget appropriations of each ministry.

• Strengthen technical support to the DPR—perhaps by setting up a nonpartisan parliamentary budget office to prepare scenarios of budgetary developments based on variations in key macro-fiscal parameters.

• Establish clear rules to streamline the use of unallocated reserves, and reduce their level in line with international good practice.

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IV. MOVING TO A MEDIUM-TERM PERFORMANCE-RELATED BUDGET FRAMEWORK

A medium-term expenditure framework and a performance-oriented budgeting system are closely linked, conceptually and practically, and their development should proceed in step and be closely coordinated. This section reviews the current situation, the lessons of international experience, the possible elements of a reform approach suitable to Indonesia, and makes recommendations for consideration by the authorities.

A. Essential Features of a Multiyear Perspective

As recognized by the authorities, a medium-term perspective is a fundamental requirement for a good budget system.27 Although the budget, which provides the legal basis for effecting expenditure, will remain annual, its effectiveness is enhanced by being framed in a perspective longer than one single year. In practice, multiyear means medium term—that is, a perspective covering from two to four years beyond the coming budget year. In Indonesia, given the fluid fiscal prospects, which are vulnerable to fluctuations in the world oil price, a perspective covering two years beyond the coming budget year seems appropriate.

Extensive international experience demonstrates the difficulties and substantial time required to achieve a meaningful MTEF process, which should include a judicious combination of the three main variants of medium-term expenditure planning summarized in Box 7, taking into account the specific country circumstances and choices.

Box 7. Variants of Medium-Term Expenditure Planning

The following three main variants are not necessarily mutually exclusive:

• Traditional planning, which identifies all major programs and their funding over a fixed multi-year period. These plans provide the development vision and policy direction, but changing circumstances affect the realism of many projections. Also, because expenditure plans are normally not prepared under a revenue constraint, there is a risk of overloaded programs, harming the credibility of both the plan and the annual budget.

• A medium-term set of budget projections, based on bottom-up estimates for various taxes and other revenues sources, and an estimate of aggregate expenditure for each central ministry and agency.

• An expenditure programming approach, which entails: (1) a clear distinction between ongoing and new programs; (2) producing savings in low-priority programs in order to create fiscal space for new higher-priority programs; and (3) including in addition to ongoing programs, new spending policies and programs—these are included in the draft annual budget only if financing is reasonably assured, for example, foreign-financed projects.

27 Such a perspective has been referred to as multiyear programming, medium-term budget framework, MTFF, MTEF and forward estimates.

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The lynchpin of the MTEF process is a robust set of revenue projections. As illustrated in Figure 2, projected expenditure under existing programs is assumed to decrease through time, both because a number of projects come to an end and from programmed savings in ongoing low-priority projects. The difference between estimated revenue and expenditure projected under existing programs is available—not earmarked—to finance expenditure under new programs. The resulting fiscal space for new spending may be disaggregated by programs, thereby giving ministries a measure of predictability. However, these are indicative levels of spending, not entitlements. Note that, although not shown in Figure 2, a contingency reserve may be included for the out-years, depending on the reliability of revenue projections and the strength of the entitlement culture. Also, the available resources for the out-years may be partly dedicated to improving the fiscal balance, or, if fiscal prospects permit, be augmented.

Figure 2. Illustration of a Four-Year MTEF 1/ 1/ In year t, for simplicity, revenue is assumed to incorporate the target fiscal balance. In the out-years t+1 through t+3 the “available resources for new programs” may be partly allocated to deficit reduction or augmented by a programmed budget surplus, depending on the initial situation and on the medium-term macroeconomic and fiscal targets.

B. Present Strengths and Challenges for Developing an MTEF

The State Finances Law 17/2003 provides for an MTEF and first steps are being taken to implement this requirement. The 2007 budget included indicative funding levels for 2008. The funding level is generally derived through an extrapolation of the 2007 appropriation. The MOF has indicated that the 2008 budget will include forward spending estimates covering 2008, 2009, and 2010. As in the 2007 budget, the forward estimates are planned to be aligned with the classification of appropriations in the binding part of the

Revenue = Expenditure

t t+1 t+2 t+3

Expenditure on existing programs

Projected revenue

Available resources for new programs

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budget and is accordingly envisioned to be very detailed. These projections are largely mechanical. They are not examined by the MOF and little effort goes into preparing them in the line ministries.

As noted, macro-fiscal forecasting capability within the executive is being strengthened, and other steps have been taken to facilitate the development of an MTEF. An FPO has been established; multiyear macroeconomic analysis is carried out; and the strategic five-year national development plan guides the formulation of detailed annual work plans for central government. Initial steps have also been taken to require ministries to indicate the outputs expected for the expenditures allocated to various programs. Moreover, as explained earlier, the government has implemented a new functional classification, as well as a “program” classification, and is also working on refining its standard input costs. However, further work is needed to refine the classification and costing systems, with a view to applying them uniformly across all ministries and agencies.

Fiscal targets are agreed in cabinet and discussed by the parliament for the budget year in question but there are no targets for forward years (see Section II). The impact of new policy proposals on the fiscal targets is not systematically evaluated nor discussed by ministers during budget preparation. However, as revenue has exceeded forecasts in recent years, there has not been pressure to introduce such factors into the budget deliberations. Performance against the fiscal targets is monitored as regards central government transactions and reported to parliament midyear as well as after the budget year.

Typically, there has been a spending rush at the end of the fiscal year. In recent experience, around 60 percent of the annual disbursement of nonrecurrent expenditures has taken place in the last three months of the year (Figure 3). In addition to inducing wasteful and inefficient spending, the end-year rush distracts ministries’ attention from preparing for the following year’s budget, which has contributed to delays in budget execution in the coming fiscal year. Prior to the 2007 budget, this problem was partly due to the late issuance of DIPAs, leading to a late start in budget execution. The problem was exacerbated by substantial midyear upward revisions to budget expenditures, related mainly to the spending of windfall oil revenues. The upward revisions are allocated to ministries in late August leaving only a few months to execute the significantly increased budget. End-year spending rushes are especially problematic for the implementation of large investment projects, which requires predictability of resources. One solution, used in some countries, would be to introduce a legislative provision for multiyear authorizations of commitments for investment projects, which would also be subject to the (cash) limit of the annual appropriation.

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Figure 3. Monthly Pattern of Disbursements of Capital Expenditure

0%10%20%30%40%50%60%70%80%90%

100%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Monthly 06 Monthly 05 Monthly 01-04Cumulative 06 Cumulative 05 Cumulative 01-04

Source: World Bank PER, 2007, op. cit. Each ministry is solely responsible for the preparation and appraisal of domestically-financed investment projects. There is no assurance of uniformity of procedures for their preparation and appraisal, nor any mechanism to verify that sound procedures were followed, including accurate estimation of the cost of projects in the out-years and their recurrent costs after completion. Thus, the desired integration of capital and recurrent expenditure has been obtained only at a formal level, ministry by ministry. Without interfering with ministries’ responsibility to decide on investment choices, the application of sound procedures would assure that projects are well prepared for successful implementation.

C. Key Steps in Introducing an MTEF in Indonesia

“Projection-based” and “programmatic” MTEFs

A “projections-based” three-year expenditure framework is planned to be introduced in the 2008 budget. The FPO has improved its capacity to prepare medium-term projections of revenue and aggregate expenditure. Revenue estimates are based on bottom-up projections of tax and nontax revenues, and expenditure projections are to be based on indicative aggregates for each central ministry and major agency. Thereafter, this “projections-based MTEF” would be updated (“rolled over”), prior to the preparation of each annual or midterm revised (or supplementary) budget.

Extending a “projection-based MTEF” to subnational governments is not feasible nor desirable in the foreseeable future. Given that fiscal decentralization is still ongoing and that full data are not available at subnational level, this extension is only possible in the long term.

Beginning in 2008, multiyear expenditure programming could be gradually introduced for selected programs in central government. The process of moving beyond a “projections-

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based MTEF” to medium-term expenditure programming would entail progressively “filling-in” the aggregate expenditure projections for ministries and agencies by bottom-up estimates of the medium-term costs of selected programs and subprograms, derived from in-depth analysis (in terms of Figure 2, the shaded area would be gradually disaggregated and its definition improved). This would allow the authorities to learn from experience and progressively extend the framework to cover other expenditure subprograms. The eventual outcome would be a set of medium-term estimates of expenditure for each ministry. These would be largely grounded on subprograms that are designed in depth and reviewed regularly, and would include a clear distinction between “existing” and “new” activities, a systematic focus on the cost-effectiveness of new expenditure proposals, and robust accountabilities against a mix of performance indicators appropriate to the activities in question.

The evolution of a full program-based MTEF will require technical advances in the methods of making forward estimates and the costing of program activities. A system of rolling forward estimates permits greater understanding of the medium term fiscal implications of decision making, thus leading to better resource allocation. Medium-term estimates also facilitates analysis of expenditure against a medium-term macroeconomic outlook. Box 8 summarizes the forward estimates process used in several advanced economies.

Box 8. Preparing Forward Estimates

Under a system of rolling forward estimates, the starting point for specifying indicative ceilings for each ministry during the budget preparation process for year x is a calculation of what levels of funding would be required for each ministry if it were simply to continue current programs, with no changes in policy. To make this calculation, the MOF takes the forward estimate for year x expenditure which it made during the preparation of the year (x-1) budget. It then adjusts that estimate to take account of any parameter changes such as changes in the client population (e.g., number of school pupils) that have changed the costs of maintaining existing expenditure policies, thus producing an updated estimate of funding requirements for the maintenance of existing spending policies. To derive the indicative expenditure ceilings, the estimates of the costs of existing policy need to be adjusted to take into account two key considerations: • Whether there are major new policy initiatives which it wishes to find room for in the budget under

preparation; and

• Macro-fiscal policy constraints on aggregate expenditure.

The indicative ceiling for each ministry will therefore not necessarily be the same as the previous year’s forward estimate. However, it will be derived from the previous year’s forward estimate by a clearly-defined process. Against this background, if the ministry concerned wishes to argue for increased funding, it may do so only on a narrow range of grounds—particularly by winning support for a new policy initiative. This greatly simplifies interaction between the line ministry and finance ministry in determining the line ministry’s prospective budget allocation.

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The mixed experience with MTEFs in many countries has shown that the following criteria are essential for eventual success: • “Buy-in” by the key interested parties. In particular, without active cooperation by

the spending agencies, the exercise may only formally meet central guidelines, without impacting on service quality or spending efficiency. In Indonesia, under current institutional arrangements, there is the additional challenge to ensure effective coordination between MOF and BAPPENAS (see discussion below).

• Respect for the principle of diminishing returns. Beyond a certain point, the costs of extending the exercise to smaller and smaller subprograms and specifying and monitoring large numbers of outcomes and outputs, outweigh the potential benefits.

• Tailoring the reform to available capacities. Development of an MTEF should not get too far ahead of administrative capacity and reform tolerance, and thus should be carefully monitored with feedback from the main stakeholders.

The relationship between budgeting and planning The laws adopted in 2003-04 attempted to clarify accountability for decision-making and to allocate specific responsibilities to BAPPENAS, MOF and spending ministries. Planning Law 25/2004 clarified BAPPENAS’ role, as the agency that assists the government in national development planning by preparing draft long term (20-year) and medium-term (5-year) plans. The planning agency also coordinates the preparation of the draft annual government work plan, which elaborates on the national priorities specified in the five-year plan. BAPPENAS and MOF jointly provide guidance to spending ministries to develop their annual work plans—trilateral meetings are held in April to discuss ministries’ policy priorities. In these discussions, some ministries refer to their own internal planning and budget documents, which may have a time frame of more than one year.

Despite the clarification of the respective roles of BAPPENAS and the MOF, some remaining areas of overlap need to be addressed. Specific areas where clarity is needed include assignment of primary responsibility for the preparation of the:

• Spending ceilings—in total and for each ministry/institution. The Planning Law refers to indicative ceilings, as does Government Regulation 21/2004. The latter states that the indicative ceilings are stipulated in a joint circular of the planning minister and the finance minister (Article 9). Given that the MOF takes the lead in developing the MTFF, it is appropriate for the MOF to take the lead role in establishing spending ceilings for ministries at all stages of the budget cycle. As for the indicative spending ceilings for each line ministry/institution which are exercised in February/March, maintaining the present very close coordination with BAPPENAS is essential, as the latter agency can advise on sectoral and ministerial priorities.

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• Funding of annual work plans. The government’s annual work plan includes references to the estimated cost of programs and likely funding sources. Such costing exercises are useful when they guide budget priorities and help rank new spending proposals. In Indonesia, such costings are not necessarily consistent with the annual budget prepared by the MOF, which fully takes into account the availability of revenues, consistent with projected annual deficit targets.

No major restructuring of MOF and BAPPENAS, or within either of these ministries, appears warranted at the present time. However, with the evolution of the budget reforms a reorganization of functions and activities might need to be considered in the longer term, especially given that the need for maintaining the planning function diminishes when MTEFs are updated frequently.28 The choice to retain two ministries with responsibility for planning and budgeting was reinforced by the adoption of the State Planning Law. Also, given that there have been two restructurings in MOF in recent years, there is need for a period of consolidation to permit efficient procedures to develop and the staff to adjust. Particularly at a time of major institutional challenges such as the move to an MTEF and performance-based budgeting, stability and predictability of institutional assignments and responsibilities are necessary for progress to be achieved and sustained. The existing division of responsibility between the MOF and BAPPENAS demands the highest level of cooperation between the two institutions. The assignment of roles should not be allowed to become a firewall. While preparation of the MTEF is a primary responsibility of the MOF, and program development and evaluation a responsibility of BAPPENAS, continuing close collaboration is essential for implementing this report’s recommendations. The rolling MTEF can be complementary to the five-year planning framework in the initial stages of development. These plans provide a solid basis for preparing performance-related programs and are reviewed midway through the plan period, as evidenced by the recent completion by BAPPENAS of a critical appraisal of the current plan for 2004–09. However, in the longer term, five-year plans may no longer be needed. Role of parliament From a technical viewpoint, establishing medium-term expenditure programming requires a drastic simplification of the excessively detailed budget allotment process discussed in Section III. This means that parliament should concentrate its scrutiny on 28 The elucidation to the State Finances Law states that “the setting out of development targets in a five-year plan is widely considered to be an unrealistic endeavor and increasingly out of line with the needs of government.” With the unification of the previous routine and development budgets, BAPPENAS lost its role in “development planning” and appraising capital projects of each ministry (see discussion later in Section IV).

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approving the broad priorities and expenditure policies, prior to detailed budget preparation, and then review the draft budget, on a program basis.29 Doing so would permit the DPR to substantially strengthen its ex ante control over the critical policy, revenue and expenditure issues, and its ex post oversight role, while allowing it to relinquish its current involvement in the details of expenditure allocation. Public investment A difficult challenge when moving to an MTEF is to project accurately the medium-term cost of public investment projects and programs. For other expenditures that may have multiyear implications, notably transfers to provinces and districts, entitlements, subsidies, and debt service, the medium-term costs can be projected relatively easily, with scenarios prepared by the FPO for changes in the parameters underlying the policies. For investment spending, the following are key requirements: • Sound preparation and appraisal of large projects.

• A realistic procedure for estimating the total cost of investment projects and their eventual recurrent costs (see Box 9). This is critical for both the integrity of public investment expenditure and the broader medium-term expenditure framework, particularly if government-financed projects are significant (in addition, the fiscal risks of planned public-private partnerships need to be examined).

• Predictability of resources for project completion—with a procedure for multiyear authorization of expenditures for implementation of approved capital projects.

• Close financial and physical monitoring of project implementation and completion, including through direct feedback from local bodies and individuals.

The quality of preparation of large projects of national interest would benefit from independent technical advice and scrutiny. At present, the preparation of investment projects and programs is left entirely with each line ministry. For most projects and programs this is acceptable, and is in keeping with the reform objective of integrating recurrent and capital expenditure associated with each program. However, large “strategic” projects and programs demand external contestability, which would improve their quality at entry and help alleviate the delays experienced in investment project execution, as well as strengthen this building block of the MTEF process.

29 In France, for example, there are only about 150 major programs subject to parliamentary approval. They are subdivided into about 500 subprograms, as operational guides. The executive is given by parliament the flexibility to allocate resources (except for salaries) within each approved program—and is held accountable to parliament for the results achieved, evaluated against various performance criteria and targets.

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D. Implementing a Program- and Performance-based Budget System

The authorities have already developed a sound understanding of the principles of performance-based budgeting. However, when it comes to moving ahead, most progress in developing elements of a performance framework has been made in the context of the national development plan and the annual work programs. Performance indicators have been prepared by a number of ministries, with BAPPENAS provided oversight. There is now a need to build on this foundation, and enhance the usefulness of the performance measures that have already been developed, especially with a view to linking them to outputs and outcomes.

The development of program budgeting is resource-intensive and the move should be gradual. Practical experience needs to be gained in implementing the key components of a performance-based budgeting system (see Box 10). The recommendations below comprise a series of measures—immediate, short term and longer term—consistent with the approach of

Box 9. Estimating the Recurrent Cost of Investment Projects

The objective of estimating the recurrent costs of investment projects is to quantify the overall implications of public investment on future years’ recurrent budgets. The reasons for doing so are primarily to underpin long-range economic planning, assess fiscal sustainability and future fiscal policy options, and reduce the risk of wastage of valuable assets for lack of sufficient operations and maintenance expenditure. Key principles of estimating recurrent costs of investment projects include:

• Collecting standard costs from national and international experience, and technical manuals. Although the requisite information is generally available, this is a substantial exercise, which requires structuring the information clearly, and arrangements for updating it at least annually;

• Deciding on the time period over which the recurrent costs are to be estimated (a minimum of five years after project completion);

• Deciding on the cost elements to be considered—primarily for labor (especially the higher-level skills required, e.g., surgeons in hospitals); durable goods (especially expensive equipment, e.g., x-ray machines) and materials; fuel and power supplies; and maintenance of buildings and other physical facilities;

• Deciding on a standard simple format for preparing the estimates, and aggregating them by sector and nationally;

• Including in the terms of references for the feasibility studies of projects, the requirement to estimate future recurrent costs, on a standard format;

• Limiting detailed recurrent cost estimation to large projects; for smaller projects, approximate calculations should be sufficient;

• For large projects, examining alternative variants of project design that have different combinations of initial investment and future recurrent costs;

• Because the MTEF is updated annually, before the start of budget preparation, the estimates of future recurrent costs of investment projects would also be rolled out annually, and adjusted according to changes in projections of domestic inflation, interest rates, import prices, etc.

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piloting a few programs initially, and progressively expanding the coverage to include other programs or subprograms.

Box 10. Issues Associated with Introducing a Performance-Oriented Budgeting System

• Program design. Common to most approaches to performance based budgeting is that the budget is structured around a number of programs responding to specified policy objectives. Key design questions involve the definition and number of programs and how to deal with programs that are cross-cutting, that is, for which more than one ministry/agency are responsible.

• Programs and activities. Policy objectives are delivered through programs and activities (or subprograms) for which operational objectives are formulated. Key design options involve how to define programs and activities and the level of detail on activities to be presented in the budget.

• Linkage. The relationship between the costs, inputs, outputs and outcomes of each program and activity (or subprogram) should be clarified and measures of economy, efficiency and effectiveness established. A key issue is how the outputs are related to the outcomes. In some approaches, information on outputs and outcomes is included in the budget documentation for each program but is not costed. In other approaches, the cost of each output is carefully estimated.

• Accountability. Performance objectives or targets should be set in regard to outputs and/or outcomes, subject to constraints regarding due process and input use. A key issue is who should be held accountable for achieving the stated targets (managers, ministers, government), for what aspects of performance (costs, inputs, outputs, outcomes, efficiency, etc.), by whom (other managers, ministers, parliament, the public), and by what means (e.g., through external audit, inter-agency dialogue within the executive, etc.). None of these choices are mutually exclusive.

• Basis for appropriations. Appropriations should be adopted by parliament also by programs. Within the executive, adequate control must be retained over inputs, and decisions are needed on the degree of central control by MOF over other dimensions of the budget classification structure (salaries, nonsalary expenditures, etc.; administrative units; location) and the type of information needed for in-year monitoring, especially for the preparation of a midyear budget performance report.

• Measurement and reporting. Key issues involve the frequency, quality and cost of establishing and maintaining the measurement and reporting systems; and which agencies or individuals are responsible for undertaking the measurement and reporting activities, which should be conducted with accuracy, impartiality and timeliness.

• Managerial flexibility. When introducing program/performance budgeting, program managers are given increased managerial freedom over the use and control of inputs, in exchange for increased accountability for results. Key decisions involve the extent to which such controls should be relaxed, over what time period, and the definition of transitional arrangements.

The current situation: progress achieved and future challenges

Although programs and priorities in the five-year plan and the annual plans have been defined, these are mainly in broad terms, and there is a need to more closely link ministries’ strategic plans with budget allocations. The largest programs typically cut across several ministries, thus complicating the task of assigning responsibility and accountability for program delivery and performance to individual ministers or program

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managers. Various terms are used to describe the current grouping of programs and activities (see Box 11). Moving to effective results-orientation would include the articulation of these general concepts and definitions into a language that applies uniformly across all government ministries and agencies.

Box 11. Definitions of Programs and Activities in Indonesia Program: “A program is an elaboration of policies of state ministries/ institutions containing a set of activities that are implemented to achieve measurable outcomes in accordance with missions of the state ministries/institutions.” (PP21/2004). The current five-year plan contains about 160 programs, varying substantially in scope and size—from the largest (excluding subsidies) of about IDR 19 trillion for nine-year basic education, and the smallest of only IDR 500 million for economic recovery for areas affected by natural disasters. Programs are not necessarily aligned to organizational structures, and about 30 of them are cross-ministerial programs. Activity: “An activity is part of a program implemented by one or several working units consisting of a group of actions utilizing resources in the form of personnel, capital goods including equipment and technology, funds or a combination of several kinds of resources as inputs to produce outputs in the form of goods and services.” (PP21/2004) The activities are stipulated in the ministerial work plans (Renja-KL) and work plans and budgets (RKA-KL) and priority activities for the government as a whole are included in the government work plan (RKP). There are currently about 1,300 “activities” under the 160 programs, although there are inconsistencies between the “activities” in work plans (for which BAPPENAS has oversight) and the activities of the programs shown in the annual budget (for which DG budget has responsibility). Activities under the nine-year education program include for example “provision of educational infrastructure for early childhood education.” This illustrates that the Indonesian definition of an “activity” corresponds approximately to what is generally termed a “subprogram”—which subsumes a number of activities for the common objective, none of which is used as a basis for accountability.

As noted, the planning framework already includes several performance targets and indicators, and such data are planned to be included in the 2008 budget. The midyear and annual budget realization reports are expected to eventually include reporting on performance against the targets included in the RKP and the budget. However, the existing process of defining performance targets and indicators does not follow a common approach, and they are not always the most relevant for the specific activities concerned. It does not appear that in-depth discussions take place on the relationship between performance targets and government policy priorities, or on the probable impact of program activities on outputs and outcomes. Moreover, the process of identifying performance targets and indicators does not yet involve the staff of agencies directly involved in service delivery, nor the users of these services. Reforms in these areas over the medium term are desirable.

Standard unit costs of inputs are disseminated by the MOF. Reliable and verifiable costing procedures are a prerequisite for both medium-term expenditure programming and a

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results-oriented budget system. Currently, the MOF issues an annual update of selected unit costs of inputs before the preparation of the annual RKA-KL by the line ministries. The MOF only prepares unit costs for salary supplements (honoraria), overtime payments, and travel allowances. Other input costs are provided to the MOF by line ministries and agencies. A critical item for future development is the costing of outputs. While annual budget implementation reports are prepared, and execution is subject to internal and external audit, there is a need to adopt simple but systematic reporting on the extent to which the stated performance indicators have been met. BAPPENAS is currently drafting a government regulation on the monitoring and evaluation (M&E) of performance. Each spending ministry is expected to set up its own performance reporting system. Good progress is being made in the ministries visited by the mission, including health and education. However, most of the work required to formulate, supervise and maintain good performance indicators, and to develop an effective M&E system, lies ahead. On the positive side, BAPPENAS retains skilled staff with substantial experience of working with the sectors that could interact with the MOF and line ministries to develop a coherent system. The budget system needs to be redesigned to provide incentives to ministries or program managers to improve the sectoral allocation of resources and technical efficiency. Notwithstanding that the concepts of programs, activities and outputs is incorporated in the five-year development plan, the budget system is grounded on managing and controlling highly detailed inputs. This limits flexibility of financial resource utilization in budget execution, and focuses internal and external scrutiny only on compliance rather than improving the efficiency and effectiveness of government spending.

More flexible civil services rules are needed if budget managers are to become more accountable for program results. Civil service employment rules are complex and civil servant compensation system, which comprises a base salary and a large range of other forms of remuneration, is opaque. Although the base salary may be low, overall compensation of government employees compares relatively well with equivalent private sector jobs. In the area of personnel management, there are few formal sanctions and rewards for performance; recruitment and training are generally centralized; and line managers have limited influence on the selection, number, training and management of their staff. unless reformed, will constitute a major challenge to the development of performance-oriented budgeting. Developing an effective strategy for reform

International experience demonstrates that the process of implementing performance budgeting is both gradual and lengthy and attempts to short-circuit it have proven to be counterproductive. However, this in no way entails that no improvement can be expected except in the long run. On the contrary, as progress is made toward a fully operational

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performance-based budgeting system, visible achievements in specific programs should be obtained, leading to concrete improvements in certain public services and maintaining a positive momentum for further progress. Concurrently, public participation can progressively be expanded in appropriate ways—enhancing ownership of the reform process and augmenting the efforts of government itself.30

International experience also suggests certain practical criteria for introducing performance measurement and monitoring:

• Start by identifying a few key indicators based on the specific nature of the program and activity and after careful analysis—avoiding reliance on either any one single indicator to measure performance, or an excessive number of indicators, which makes effective monitoring and accountability very difficult.

• Avoid mechanistic formulas, and use the indicators only as the necessary starting point of a robust dialogue on performance.

• Because the data collection and transaction costs of introducing performance indicators are high, reporting and monitoring can be difficult. It is therefore necessary to weigh costs against the benefits expected in terms of better results.

• Finally, effective performance measurement and monitoring requires broad “buy-in.” In a country as large and diverse as Indonesia, the process of defining the right performance measures is important. It should not be only top-down, but also involve “frontline” civil servants as well as the users of the public services, to the extent practicable.

Strengthening accountability for performance Defining and measuring results is only a mean to improve performance, by making those in charge more accountable for the results of the financial resources entrusted to them. Accountability requires clear individual assignment of responsibility and authority. When a program or subprogram is located entirely within a ministry or spending agency, the appropriate locus of responsibility is the budget program manager, under the authority of his/her minister, who is concerned primarily for budget policy “outcomes.” In Indonesia, most budget program managers can be expected to be Echelon 1 staff, but this may not necessarily be desirable, as it would simply align programs and/or subprograms to present internal organizational and administrative structures. Once program managers are appointed, it will be necessary to clarify the responsibilities of secretary-generals of ministries, and other

30 One of many examples of the utility of public participation for improving service performance is the “report card” system first introduced in Bangalore and then extended to much of India and several other countries.

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Echelon 1 officials in the delivery of program outputs, and the nature of their accountability relationship with the program manager, their respective minister, as well as to relevant parliamentary commissions.

Certain programs of national importance need the coordinated interventions of several ministries (e.g., for poverty alleviation). Cross-ministry programs complicate accountability arrangements and need to be kept to a minimum, especially in the early stages of introducing a performance-based budget system. Realistic arrangements are needed to couple the assignment of responsibility with the authority to coordinate efforts. The pragmatic solution might be for the cabinet to designate a “lead ministry,” with the authority to coordinate the complementary activities of the other concerned ministries, and with high-level support to resolve disagreements and escalate major issues.31

The complexity of performance measurement increases as one proceeds from narrow input measures through outputs and outcomes. Although the quality issue is ever present, there is no major methodological difficulty in defining and measuring outputs: the issue with output indicators is their relevance. Similarly, the relevance of outcomes is rarely in doubt: the issue with outcome indicators is their feasibility as a motivator of performance. Outcome indicators are almost always more meaningful, and output indicators almost always more feasible.32 In any event, abandoning input and quality controls in favor of exclusive reliance on output measures carries substantial practical risks. Examples of medium-term outputs and performance targets for South Africa are shown in Appendix II.

Improving program design and costing Work on reviewing the appropriateness of the present 160 or so “programs” and revising or replacing them should start soon. The current five-year development plan covers the period until 2009 and will be replaced in 2010, which will provide an opportunity to make the required adjustments to the definition and structure of programs. While the five-year work plans is under the purview of BAPPENAS, close coordination with the MOF is essential to ensure that the program classification is identical to that used in the budget—at

31 For example, child vaccination programs involve health, education, information, and cooperation with local government, among other things. Thus, the ministry of health could be designated as the lead ministry, responsible, among other things, for elaborating a process of systematic coordination and exchange with the ministries of education, information, and home affairs.

32 Using the above example, it is easy to hold a nurse strictly accountable for the output of the number of vaccinations, but it is difficult to hold her/him responsible for the outcome of improving the health of village children. Yet, her/his active involvement in household hygiene may have more impact on improving children’s health than increasing the number of vaccinations, but will not be motivated by an incentive system that focuses only on the outputs. Moreover, in the absence of close oversight, it is difficult to prevent immunizations from being performed with less than the recommended quantity of vaccine (with the remaining vaccine leaking out of the health delivery system) or to falsify the records.

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the moment there are disparities, which are particularly pronounced at the “activity” level. The MOF, BAPPENAS, and spending ministries will need to collaborate closely when proposing a new program structure to the government (and parliament) for approval. As discussed in Table 1 of section III, the program/subprogram/activity classifications are varied in other countries and strategic decisions are needed. Program design could be further standardized through program preparation templates that could enforce a consistent government wide approach. Templates should request line ministries to provide specific result frameworks for each program that provide objectives, baselines, a break down of medium-term targets into annual targets and an outline of program strategies, as well as indicative funding requirements. Result frameworks should be aggregated at the ministerial level to provide for statements of objectives and a basis for ministerial performance reporting. An improvement in the quality of performance information related to activities is desirable, although this will take time. Currently, about 1300 activities support the achievement of program objectives. These include a number of minor and routine activities that deliver intermediate outputs in the overall result chain. The present system requires budget users to provide output targets for each activity. Little indication is given on how activity outputs relate to the achievement of overall objectives. A careful review of both the quantity and quality of performance information is warranted. Improvements are required in order to reflect full program costs more accurately. Substantial attributable costs are currently included in a separate program that covers civil service salaries, benefits, allowances, and honoraria; operational and maintenance costs; and administrative support services. Sophisticated cost allocation techniques, such as the activity-based costing methods used in advanced countries, are beyond the capacity of Indonesia at this stage, given the existing state of accounting methods and financial management information. However, it will be important to develop activity-based costing over the medium term. In the short term, improved program costing techniques could be integrated into pilot program (or subprogram) budgets, which would be run in parallel with the existing “conventional” budget of the pilot ministries or agencies. Such costings would initially exclude indirect costs (see next paragraph). At the initial stages of introducing budget programs, a separate item for nonsalary overhead/administration would be useful. It is costly to attribute overhead costs among the activities carried out by a given government office—e.g., “allocating” ordinary office supplies among the variety of “programs” for which they are used. However, at a later stage—when program costing is being refined—consideration could be given to apportioning overhead costs to individual programs.

Program monitoring and evaluation (M&E)

Effective program evaluation can be based on relatively simple techniques. The more sophisticated forms of “impact evaluation” involve collection and analysis of large volumes of

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data to isolate the effects of the program from the other factors that might have caused the outcomes. These large exercises have produced insights into the dynamics of the program, but have rarely been cost-effective. In Indonesia, methods to evaluate the cost-effectiveness of expenditure programs need to be cost-effective in relation to the improvements identified or the progress expected. With capacity limitations, program evaluation techniques should be simple and low-cost, rely on informed judgment, have meaningful consequences, and make public program evaluation results.33

Technical integrity and absence of politicization of the process are a key requirement for effective evaluation. The results of evaluations stand or fall largely on the credibility of the officials or experts undertaking the evaluations, and this credibility can only flow from their competence and independence. As Indonesian civil society learns to use the program information made public, it can add its voice to the results, and help foster continuing improvements in the efficiency and effectiveness of government expenditure programs.

Program evaluation could rely partly on expertise external to the government.34 Even if simplified, program evaluations require a substantial input by economists, engineers, auditors and other professionals. These skills are in limited supply in government but are important in designing and running sound programs, not in evaluating them. However, a strong in-house capacity is essential to design, guide, contract, and monitor the external evaluators—in close consultation with the MOF and the line ministry concerned. Possibilities for obtaining feedback and contestability from the users of services themselves must also be considered, as appropriate participation by civil society can augment government efforts.

A robust dialogue on performance between knowledgeable civil servants familiar with the evasion and avoidance tactics in the bureaucracy will be far more effective than the mechanical and uncritical use of performance data. 35 There is little point to monitoring and evaluating the impact of government programs unless the evaluation results are 33 These are the principles that underlie the U.S. Office of Management and Budget’s Program Assessment Rating Tool (PART). After fruitless attempts to introduce complex methodologies for program evaluation, PART was introduced in 2002. It is based on a simple 30-item questionnaire to evaluate four dimensions of any program: objectives, planning, management and results, where the results dimension is given by far the highest weight. The expenditure program is then ranked along a four-point scale, from ineffective to adequate, moderately effective, and effective (www.whitehouse.gov/omb, keyword PART).

34 Chile is a country where almost all program evaluations are outsourced, but the government has established strong oversight procedures, including setting the terms-of-reference of the evaluations, monitoring the process, and assuring peer reviews.

35 This report cautions against the use of formal, detailed contracting within the public administration. While a few highly-developed countries have gone in that direction, with mixed success, diminishing returns have set in quickly. In brief, while an explicit written understanding of the key results expected is useful for the proposed dialogue on performance, it must not be allowed to expand into detailed "contracts," which can dilute accountability and lead to a time-consuming paper chase.

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systematically used to strengthen accountability and improve future performance. Mechanistic links between the evaluation findings and budgetary appropriations should be avoided. However, the evaluation findings must be taken into explicit and systematic consideration at an early stage in the budget process.

Although controls over the effective use of public resources cannot be relaxed, the development of performance-based budgeting calls for a gradual evolution of the audit system toward a focus on value-for-money aspects. Currently, the development of internal audit is still in the initial phase, and the external audit work of the BPK is largely focused on compliance and financial audit rather than on results. Although an early change in the audit mandate of the BPK is not recommended, BPK’s capacity to undertake performance-based audits should be gradually expanded, and applied to the proposed pilot budget programs.

E. Recommendations

For the short term, the government may wish to:

• Prepare a MTFF, based on “top-down” projections of revenues and expenditures, for the 2008. In this context, affirm that the MOF takes the lead role in establishing spending ceilings for ministries at all stages of the budget cycle.

• Form a joint working group of MOF and BAPPENAS to: (1) elaborate, in consultation with line ministries, a clear definition of “program,” “subprogram,” and “activity,” applicable to the entire government; (2) reconcile existing differences between “activities” in work plans and those in the annual budget; (3) define the operational distinction between existing expenditure programs, subprograms and “activities,” and new expenditure programs or subprograms (under new policies); and (4) develop a procedure for preparing forward estimates and calculating the full cost of subprograms, including the allocation of salaries and overhead expenses.

• Select some initial budget programs or subprograms for cabinet to approve as pilots. For the pilots, there would be in-depth medium-term expenditure programming, accompanied by key performance indicators, by selected ministries with a view to visible improvements in efficiency, as well as to gain experience.

• Establish criteria for choosing budget program managers and specify their responsibilities in delivering services in budget programs.

• Initiate, in consultation with the DPR, a series of outreach events to explain to legislators the concepts of a multiannual, performance-related budgeting framework.

For the medium term (by 2011):

• Gradually expand every year the “bottom-up” expenditure programming exercise to other programs and subprograms, and include additional ministries.

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• Implement a program classification for all budget appropriations.

• Implement a capacity-building program for line ministries and agencies in expenditure programming and costing techniques.

• Begin to introduce a process of medium-term expenditure projections in selected provinces or districts, provided that budgeting and accounting formats are the same as in central government and that an agreed procedure exists for regular reporting to central government.

• Encourage the BPK to develop its capacity for undertaking value-for-money audits of expenditure programs.

For the longer term (perhaps achievable by 2015): • For central government, complete the migration to a largely programmatic MTEF.

• Extend to general government the medium-term revenue and expenditure projections.

Consideration could also be given to establishing an “Investment Quality Assurance Office” within BAPPENAS or the MOF, to: • Formulate and disseminate standards and procedures for the preparation and appraisal

of large public investment projects, based on good international practice.

• Provide technical validation of the preparation, appraisal and physical monitoring of such large projects, based on these standards and procedures.

• Guide and facilitate line ministries’ efforts to build capacity in this area.36

36 Such an office would have no role in project selection, but only in facilitating the use of good procedures and standards in project preparation, and validating that they have been fully appraised and are ready for efficient implementation of the schedule envisaged for the project. Combined with the earlier recommendation to put in place a provision for parliamentary multiyear authorization of investment project expenditure, this function could substantially improve the efficiency of project implementation.

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V. BUDGET DOCUMENTATION

Adequate budget documentation is necessary to facilitate information flows between the executive, the legislative, and the general public, and to allow for informed budget choices. The availability of clearly laid-out and sufficient documents is also essential for fiscal transparency. This section assesses the existing budget documentation, reviews other countries’ experiences, and makes recommendations for improving the documentation, in pace with the overall budget reforms.

A. Assessment of Existing Budget Documentation

International experience suggests that the key budget documents are those that specify fiscal policy strategy and objectives, and those that show estimated revenues, planned expenditures, and fiscal risks, all within a clearly formulated medium-term macroeconomic context. These documents are supplemented by in-year budget reporting and specialized reports such as periodic long-term fiscal policy scenarios, reports on the government’s debt strategy and public debt developments. Such budget documents are typically submitted to the parliament and available to the general public.

Budget reforms in other countries have required substantial changes in the way budget information is organized and presented (see Box 12 for the case of France). Changes in the form of the presentation of the budget are interlinked with changes in the underlying budget process and procedures. At the same time, changes in budget documents can underpin changes in related business processes, information and work flows. In Indonesia, a key challenge will be to align budget documentation to the requirements of the future budget reforms such as the development of an MTEF and performance-oriented budgeting.

There has been recent improvement in the way the Indonesian budget is documented and presented. As from 2005, the government introduced a unified budget, integrating recurrent and development spending, and using new spending classifications. Expenditures in line ministries are presented by function and program. The budget documents include a description of the macroeconomic framework, its underlying assumptions, aggregate revenues and expenditures and the expected deficit for the budget year. The financial notes provide an extensive narrative on how stated policy objectives relate to spending proposals. The key publicly-available budget-related documents in Indonesia are shown in Table 2.

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Box 12. France: Legal Requirements for Budget Information

The 2001 Organic Budget Law requires the following documentation for the State budget:

• A prebudget report on the orientation of fiscal policy. This report, which is presented to parliament in May–June of each year, provides an early view of the government’s fiscal policy plans. It describes overall economic, social and financial developments and the medium-term development of state budget revenues and expenditures disaggregated by broad functions.

• A report on the economic, social and financial situation. This report is formally attached to the draft budget; it updates the prebudget report, and is required to contain the main hypotheses and projection methods of the variables underlying the budget projections, and the economic and fiscal outlook for at least four years following the budget year, including the revenues, expenditures and fiscal balance of general government.

• A detailed account of the previous year’s budget execution. As from 2006, when the budget was adopted on the basis of missions and programs, outcomes have been assessed on the basis of performance indicators associated with each program.

• Annual performance reports of each of the 150 or so programs are annexed to the budget execution report.

• Other explanatory annexes include: (1) a detailed evaluation of the fiscal impact of all taxes, by category of tax; (2) an analysis of the impact on revenues, expenditure and the fiscal balance of changes in budget presentation from that of the previous year; (3) details of revenues, current expenditure and capital expenditure; (4) estimates of revenues foregone by tax exemptions; and (5) details on special accounts that are permitted by law.

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Table 2. Planning and Budget Documents Submitted to the DPR

Document Content

Government Work Plan (RKP) and Macro-Fiscal Framework

Contains information on annual policy priorities and key program activities. The RKP is based on the program structure of the government five year plan. The RKP does not include expenditure aggregates or allocations. The macro-fiscal framework lays out the revenue projections.

Work plan and Budget of Ministries or Agencies (RKA-KL)

Annual budget requests prepared by line ministries providing details on output/volume targets, forward cost estimates (FY+1), output costs, revenue information at the activity level. Reviewed by BAPPENAS for conformity with RKP, and by DG budget for compliance with unit costs and classification. The RKA-KL is submitted to DPR as an appendix to the budget law.

Budget Bill (APBN) Contains the estimated revenue envelope (sources of revenue are identified individually), aggregate expenditure estimates, appropriations and general provisions applicable to the appropriations.

Financial Notes Contain details on expenditure allocations by economic, functional, organizational (ministry/agency) and program classification.

Budget Speech Contains the budget message of the President and information on the President’s budget and management priorities, as well as proposed spending priorities.

Medium-term projections of fiscal aggregates are not presently included in the budget documentation. Current budget documents focus largely on inputs and do not yet report much information on the outcomes and outputs of government ministries or programs. The ministerial work plans and budgets (RKA-KL) contain information on quantified physical outputs alongside the detailed line items. However, performance information is not systematically integrated into the key budget documents. Nor is there a systematic summary statement in the budget documents of the estimated fiscal effects of new policies (both for revenues and expenditures). In view of these factors, it is perhaps not surprising that budget documentation has not yet reached the standard of comprehensiveness and transparency achieved in some countries. In the Open Budget Index 2006 shown in Box 13, Indonesia’s relatively low score is a result of inadequate budget coverage, and a lack of medium-term perspective and performance orientation.37

37 However, these calculations take no account of the cost of preparing and publishing budget documents, and a cost-benefit analysis has not been carried out.

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Box 13. International Comparison of Budget Documentation The Open Budget Index 2006 was calculated from responses to a questionnaire that assessed the coverage, performance and multiyear orientation of publicly-available budget documents.

3 9

4 0

4 1

5 0

5 1

5 1

5 2

7 3

8 5

8 6

8 9

0 2 0 4 0 6 0 8 0 1 0 0

A rg e n t in a

B a n g la d e s h

In d o n e s ia

M e x ic o

P h ilip p in e s

P a k is ta n

In d ia

B ra z il

S o u th A fr ic a

N e w Z e a la n d

F ra n c e

C u m u la t iv e S c o r e O p e n B u d g e t In d e x

Source: www.openbudgetindex.org

Some countries have specified the form and content of budget documentation in their budget systems law (e.g., France). In Indonesia, it is probably not necessary for the State Finances Law 17/2003 to be amended in order for changes to be made in budget documentation; a government regulation or an MOF decree may be adequate. South Africa provides an example of good practice, with simple and transparent presentation of budgetary data, including information on performance by program (see Box 14 and Appendix II).

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Box 14. Budget Documentation in South Africa

Starting in 1994, the government of South Africa introduced an MTEF, changed the budget classification in line with GFSM 2001 and moved towards performance-based budgeting. As part of these reforms, budget documentation changed, including:

• Estimates for three forward years in addition to the budget year itself.

• The introduction of revised “Estimates of Expenditure and Revenue” tables, with a changed reporting structure that shows: the goal and purpose of expenditures; a strategic overview of key fiscal information and policy developments; a summary of expenditure estimates by program classification; and departmental receipts. Each program is subdivided into expenditure by subprogram, economic classification - current, capital, transfers and subsidies; recent outputs; and tables of outputs and performance measures by subprogram.

• Inclusion of service delivery and performance information.

• Definition of subprogram outputs and performance measures.

• Introduction of measurable objectives for each program.

• Supplementary budget documents including the Budget Review which provides a detailed explanation of the underlying policies behind the budget.

• Introduction of a “People’s Guide to the Budget,” published in five official languages, to provide a summary of the main budget proposals and data.

The main budget documents are: the Budget Review, Estimates of National Expenditure, the Budget Speech, Estimates of National Revenue, and the People’s Guide to the Budget. ________________________________ Source: http://www.treasury.gov.za/documents/budget/2007/default.htm

With the enhanced focus on results, reporting provisions should be amended to provide budget achievement reports to parliament, which can be used to hold sector ministries accountable for their performance. Law 17/2003 requires the president to submit an accountability report and budget realization report within six months after year-end. This is typically done in conjunction with the midyear budget revisions. In many performance-based budget systems, annual performance reports by line ministries are a key accountability mechanism, and frequently used in the budget negotiations with the MOF. In Indonesia, a number of line ministries—for example, education—have produced detailed sectoral performance reports, but these are not systematically included in legislative oversight documentation and not updated on a regular basis.

The authorities currently do not prepare reports on compliance with their fiscal rules, mainly due to the lack of timely reporting by local governments to the central government. Efforts are needed to improve the reporting of past and projected fiscal developments of provincial and district governments, which currently are running fiscal surpluses although this information is are not shown in budget documents.

A succinct citizen’s guide to the budget, aimed at the nonspecialist reader, would be a very useful complement to existing budget information. Many countries prepare easily understandable budget documents to inform citizens and other stakeholders on key fiscal

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policies. Such guides highlight specified subject areas or provide other significant presentations of budget data to place the budget in perspective.38 Similar guides could also provide an update on implementation of the government’s fiscal policy agenda.

B. Recommendations

For the short term, the government may wish to: • Prepare a citizens’ guide to the budget, starting with the 2008 budget.

For the medium to long term: • Integrate regular ministerial performance reports into the budget evaluation process and

legislative oversight.

• Overhaul the budget documents presented to parliament so as to include both medium term and performance-related information (countries such as France or South Africa—see Boxes 12 and 14, and Appendix II—could be used as guides).

• Publish, for each ministry, annual performance reports, which would highlight results of expenditures of programs and subprograms, and associated performance target outcomes relative to ex ante projections.

38 See for example A People’s Guide to the Budget issued by the South African Treasury, referred to in Box 14. This is available on http://www.treasury.gov.za/documents/budget/2007/default.htm.

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VI. ARTICULATING THE REFORM STRATEGY

Further work is needed to flesh out a comprehensive budget reform strategy, taking into account the recommendations of this report. As shown in Figure 1 of the Executive Summary, the authorities could take a number of useful measures in 2008 and 2009 to move forward the reform process. The elaboration of an even more comprehensive budget reform strategy would have the advantage of creating a platform for communicating to the wider community of stakeholders the objectives and challenges of budget reform, building understanding, visibility and support for the proposed strategy and action plan.

A. Formulating and Managing the Reform Agenda

A number of issues should be addressed in developing the reform agenda:

• Communicating and generating support for reform from staff, management and external stakeholders in the process.

• Identifying capacity-building requirements in the MOF, BAPPENAS, line ministries, the internal and external audit institutions, and the DPR.

• Prioritizing and sequencing the reform elements, and identifying key milestones.

• Preparing a timetable for activities and contingencies.

• Piloting, monitoring and evaluating the progress of the reforms.

It is important that the reform be anchored solidly within the organizational structure of the MOF and BAPPENAS, with the MOF being the lead agency. Given Indonesian civil service requirements, it is necessary that the structure be formalized and that staff be assigned full-time in structural positions to define and implement the reform program. Fixed-term local contractual staff could also be hired in support roles. The government might want to consider establishing a steering committee for budget reform. This would help elevate the profile of the reform effort. The mandate of the committee would be to draft a reform agenda and an implementation plan, to oversee and monitor progress and present proposals for the cabinet’s decision. The secretary general of the MOF, the directors general of DG budget, DG treasury, the FPO and BAPPENAS might be nominated as members of the steering committee, which could be chaired by the minister of finance. A structural unit in DG budget could serve as a secretariat for the steering committee, providing analysis, making recommendations, liaising with donors, procuring and managing consultants, monitoring progress and making reports. The Directorate for Budget Systems of DG budget could be developed to take on such a role. If possible under

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civil service rules, it would beneficial if BAPPENAS could second staff to the unit for 2–3 years, thereby making it a joint secretariat. A possible structure of working groups in some key areas is summarized in Figure 4. An existing committee, comprising directors from DG budget, DG treasury and BAPPENAS, established to support GFMRAP could be adapted to handle the wider budget reform agenda as well as GFMRAP-funded activities, coordination of technical assistance, and contributions from donors. Reforms in the budget area would need to be monitored and coordinated with other reforms in the MOF, including civil service reforms and organizational restructuring, by the Minister’s Delivery Unit, PUSAKA.

Figure 4. Proposed Committee Structure for Budget Reform The formulation and dissemination of a coherent reform agenda and reporting on progress will provide a basis and tool for communicating to staff, managers and external stakeholders. Reform of the nature and scale envisioned by the MOF and BAPPENAS will inevitably meet some resistance. It is therefore important to prepare staff, managers and stakeholders (including parliament, audit and the general public), for change by disseminating an overview of the planned reforms, including their goals, means, and timing. A structured program of training sessions, conferences, events, web-pages and other communication tools would complement and contribute to socializing the agenda. One of the working groups proposed in Figure 4 could focus on outreach activities. Capacity for reform is high at senior management level in the MOF and BAPPENAS but is perceived to be lower elsewhere, including in line ministries. It is proposed that a needs assessment in the MOF, BAPPENAS, and selected pilot ministries be undertaken as part of the process of formulating the reform agenda. The recommendations of the needs assessment could be included in the reform plan as a training component.

B. Technical Assistance to Support Budget Reform

Several donors, including the World Bank and the Australian government have pledged substantial technical and financial support for budget reform, through resident and peripatetic experts. Indeed, implementation of some of the report’s recommendations—for example strengthening of forecasting capabilities within the FPO, and the development of a revised program structure—have already been started.

Steering Committee

Working group on budget reform

Working Group on Program Review

Secretariat (Structural Budget reform unit)

Working group on per-formance measurement

Working group Capacity building

Working group on outreach and Socialization

Steering Committee

Working group on budget reform

Working Group on Program Review

Secretariat (Structural Budget reform unit)

Working group on per-formance measurement

Working group Capacity building

Working group on outreach and Socialization

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The authorities might want to engage expert(s) to help prepare a detailed action plan for reforming the budget preparation process, building on the recommendations in this report and the authorities’ perception of needs and priorities. Box 15 sets out an illustrative scenario of donor-financed TA and advisory services in key areas.

The introduction of an MTEF and performance based budgeting will necessitate reforms in a number of related areas, particularly: • Greater managerial flexibility. Performance management and budgeting requires

increased managerial flexibility by relaxing ex ante input controls in exchange for strengthened ex post controls over performance and results. The present environment for performance evaluation, and for internal and external audit, will need to be strengthened, in step with the progress of the budget reform program.

• Civil service rules and practices, which currently give little flexibility for budget managers to better align organizational structures, inputs and processes to achieve improved outputs and results. Reforms in regard to program management, performance incentives for public servants, recruitment, sanctions, and training would be needed to take full benefit of increased managerial flexibility.

Box 15. Technical Assistance for Budget Reform

The comprehensive budget reform agenda would identify when and where technical assistance and advisory services would be needed. An initial needs assessment would greatly facilitate informed management of assistance. As a point of departure, the following assistance could be considered: • One or more long-term resident advisors to assist in formulating, coordinating and implementing the

reform agenda.

• A peripatetic adviser in the area of macro modeling and/or revenue forecasting.

• A peripatetic adviser to advise the DPR on strengthening its processes for reviewing/approving the budget.

• A long-term resident advisor to assist in rationalizing the existing structure of 160 expenditure programs and developing the MTEF.

• Short-term consultants to rationalize the DIPA process and revise virement rules.

GMFRAP provides for one national and one international budget reform advisor to BAPPENAS and one national and one international budget reform advisor to DG budget. In addition, GFMRAP provides support to parliament to develop its role in oversight of the budget and to the FPO. The EC-Dutch-World Bank Multi-Donor Trust Fund provides USD 18 million in flexible support for public financial management reform over the next six years. The Department of Finance in Australia is discussing the possible provision of resident and peripatetic advisors and a comprehensive training program.

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APPENDIX I: INDONESIA’S LEGAL FRAMEWORK FOR BUDGETING

This appendix lists the main laws, government regulations and presidential regulations that pertain to the budget and planning system. It excludes regulations issued by the MOF. Key constitutional and legal provisions for budgeting are cited.

The Constitution

• The 1945 Constitution, including the four amendments enacted during 1999–2002, contains a chapter on public finance, a chapter on external audit (Box 16).

Box 16. Constitutional Provisions on Public Finance and External Audit

Chapter VIII: Public Finances (main Articles)

• The State Budget as the basis of the management of state funds shall be determined annually by law and shall be implemented in an open and accountable manner...

• The Bill on the State Budget shall be submitted by the President for joint consideration with the DPR, which consideration shall take into account the opinions of the Council of Representatives of the Regions (DPD).

• In the event that the DPR fails to approve the proposed Bill on the State Budget submitted by the President, the Government shall implement the State Budget of the preceding year.

• All taxes and other levies for the needs of the state of a compulsory nature shall be regulated by law.

Chapter VIIIA: Supreme Audit Board (Badan Pemeriksa Keuangan or BPK)

• To investigate the accountability of state finances, there shall be a single Supreme Audit Board which shall be independent. The result of any investigation of state finances shall be submitted to the DPR. Action following the result of investigation will be taken by representative institutions and/or bodies according to law.

• The members of the BPK shall be chosen by the DPR and will be formally appointed by the President.

• The BPK shall have representation in every province.

Additionally, the Constitution includes the following budget-related Articles:

• The President may issue Government regulations as required to implement laws (Article 5).

• The formation, change, and dissolution of ministries of state shall be regulated by law (Article 17 (4)).

• The relations between the central government and regional authorities in finances, public services shall be regulated and administered by law (Article 18A (2)).

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• The DPR shall hold the authority to establish laws (Article 20 (1) and shall hold legislative, budgeting and oversight functions (Article 20A (1)).

• The DPD shall participate in the discussion of Bills related to the relationship of central and local government; the financial balance between the centre and the regions; and shall provide consideration to the DPR over Bills on the State Budget (Article 22D (2)).

• The State shall prioritize the budget for education to a minimum of 20 percent of the State Budget and of the Regional Budgets to fulfill the needs of implementation of national education (Article 31 (4)).

Laws

New laws relating to the budget, treasury, planning and audit systems, and intergovernmental relations were adopted in 2003–05. These are: State Finances Law No. 17/2003 elaborates on Constitutional provisions for the budget system and contains various chapters, relating to: • General Principles including results-orientated accountability and transparency in

State financial management.

• Authority to Manage the State Finances. To assist the President to manage state finances, some powers are delegated to the Minister of Finance as the fiscal manager, and to other state ministers or institution heads as budget users. The Minister of Finance’s responsibilities include arranging fiscal policy and regulating the macroeconomic framework; preparing the draft budget; approving budget implementation documents; and preparing financial reports on accountability of budget implementation (Article 8).

• Preparation and Adoption of the State Budget. The central government shall submit its core fiscal policies and its macroeconomic framework for the subsequent year to the House of Representatives by not later than mid-May. The government and the House of Representatives shall discuss the core fiscal policies and the macroeconomic framework as part of the preliminary discussions on the subsequent year's budget (Article 13). The central government shall submit the Budget Bill, the financial notes and other supporting documents to the House of Representatives in the month of August. The budget approved by the House of Representatives shall give details of organizational units, functions, programs, activities and types of expenditure (Article 15).

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• Financial Relationship between the Central Government and Other Institutions, including with the Central Bank, local governments, and State enterprises.

• Implementation of National and Local Government Budgets. Detailed budget implementation to be provided for by Presidential Decree, including for allocations to budget units.

• Accountability for management of State finances. The law requires that the President shall submit bills on accountability for the implementation of the National Budget to the House of Representatives not later than six months after the end of the fiscal year. These consist of financial reports that have been audited by BPK. The financial reports shall contain the National Budget Realization Report, balance sheet, cash flow statement, and notes on the financial statements, to which shall be attached the financial statements of state enterprises (Article 30).

State Planning Law 25/2004 outlines the role of BAPPENAS in formulating economic development plans for one, five and 10-year periods. Provisions relating to government and ministries’ annual work plans are based on the State Finance Act and this law (Box 17).

State Treasury Law 1/2004 outlines the role of State/Regional Treasurers in executing budget revenues and expenditures, management public money, and accountability (reporting) of annual State/regional budgets.

Audit of State Financial Management and Responsibility Law 15/2004.

Decentralization laws. The 1999 decentralization was were revised in 2004: Law 32/2004 on Regional Governance, Law 33/2004 concerning Fiscal Balance between Central and Regional Governments, and Law 34/2004 on Regional Taxation.

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Government and Parliamentary Regulations Government Regulation 23/2003 on Controlling the Cumulative National Budget Deficit and Local Government Budget Deficits and Borrowings. This regulation includes requires the cumulative general government deficit not to exceed 3 percent of GDP and the cumulative debt not to exceed 60 percent of GDP. Government Regulation 20/2004 on the Formulation of Working Plans of Government. Lays out the requirement and responsibilities for preparing annual government working plans.

Box 17. Objectives, Content and Preparation of Annual Work Plans (WPs)

The following are direct excerpts from Law 25/2004 and Regulation 20/2004. Annual government work plans (RKPs) • Elaborate the medium-term work plan.

• Contain priorities for the development and design of the macroeconomic framework.

• Include directions for fiscal policies as well as programs of ministries/institutions, inter-ministerial and territorial programs.

• Include a funding framework.

• Are prepared by Planning Minister with the input of all ministers (and chairperson of agencies) through their respective work plans (Renja-K/L).

• Become the guideline for formulating the draft State Budget.

• Are discussed at draft stage in cabinet, after which the RKPs are issued by presidential decree, not later than mid-May.

Ministry and agency annual work plans (Renja-KLs) • Refer to priorities for national development, consistent with ministries’ medium-term plans,

which include the strategic vision, missions, objectives, strategies, policies and programs.

• Include indicative ceilings, policies, programs and activities executed directly by the government or by encouraging public participation.

• Are prepared by heads of ministries/agencies.

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Government Regulation 21/2004 on the Formulation of Working Plans and Budgets of State Ministries Institutions. Lays out the requirements and responsibilities for preparing annual working plans and budgets (draft RKA-KLs) of spending ministries. Government Regulation 23/2005 on Financial Management of Public Service Agencies. Government Regulation 73/2005 concerning the Central Government’s Budget Specification. Government Decentralization Regulations 55/2005, 56/2005, 57/2005, 58/2005 concerning Fund Balance (mainly tax sharing of central government with regions), Grants for Regions, Regional Financial Management. Rules of Procedure of the DPR (House of People’s Representatives) These rules include provisions for the internal organization of parliament, including the establishment of Commissions, one of which is the budget commission. They also include a chapter relating to adoption of the annual budget. Key provisions are: • The Budget Committee is assigned to conduct the discussion regarding on the

National Budget, as stipulated in Chapter XVIII.

• The Budget Committee is permanent. The DPR determines the structure of the members of the Budget Committee, which is composed of all the members of the other Commissions, with equal number of members of the Fractions. The Budget Committee is assisted by a Secretariat.

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APPENDIX II: SAMPLES OF BUDGET TABLES AND PERFORMANCE INFORMATION39

A. Budget Tables

The following sample tables S1 to S4, taken from the case of South Africa, show how key budgetary information can be presented.

Table S1. Macroeconomic Projections, 2005–09 2005 2006

Estimate 2007

Forecast 2008

Forecast 2009

Forecast Percentage change unless otherwise indicated Final household consumption Final government consumption Gross fixed capital formation Gross domestic expenditure Exports Imports Real GDP growth GDP deflator GDP at current prices (R billion) Consumer price inflation (CPIX) Current account balance (percent of GDP)

Table S2. Main Budget Framework, 2005/06–2009/10

2005/06 2006/07 2007/08 2008/09 2009/10 (R billion) Outcome Estimate Medium-term estimates Total revenue Percentage of GDP Total expenditure Percentage of GDP Debt service cost Percentage of GDP Noninterest expenditure Percentage of GDP Budget balance Percentage of GDP

Gross domestic product 39 From the South African National Treasury’s website at www.treasury.gov.za.

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Table S3. Medium-Term Expenditure Framework and Division of Revenue, 2006/07–2009/10

2006/07 2007/08 2008/09 2009/10 (R billion) Estimate Medium-term estimates National Provincial Local

Total expenditure Changes from baseline 1/ National Provincial Local

1/ Baseline allocations comprise the medium-term estimates published in the 2006 Budget, together with an inflation projection and growth assumption in 2009/10 over the 2008/09 allocations.

Table S4. National Budget Revenue, 2005/06–2009/10

2005/06 2006/07 2007/08 2008/09 2009/10 (R billion) Outcome Estimate Medium-term estimates Taxes on income and profits Persons and individuals Companies Secondary tax on companies Other Taxes on property Domestic taxes on goods and services Value-added tax Specific excise duties Levies on fuel Other Taxes on international trade and transactions Stamp duties and fees

Total tax revenue Nontax revenue and repayments

Main budget revenue Percentage of GDP Changes from 2006 Budget Total tax revenue Main budget revenue

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Table S5. Consolidated Government Expenditure by Type of Service, 2005/06–2009/10

2005/06 2006/07 2007/08 2008/09 2009/10 (R billion) Outcome Estimate Medium-term estimates Social services Education Health Welfare and social security Housing and community dev. Protection services Defense and intelligence Justice, police and prisons Economic services and infrastructure Water and related services Agriculture, forestry and fishing Transport and communication Other economic services Administration of which: Local government equitable share

Total Interest Contingency reserve

Consolidated expenditure

B. Performance Information: General Education

The General Education program in South Africa (Program 3) manages national policy, programs and systems for general education, and quality assurance. There are three subprograms: • General Education and Training Curriculum and Assessment develops and implements

the curriculum and related programs and systems for general education and for evaluating and maintaining policy initiatives.

• Institutional and Human Resources Development develops policies and programs to promote the development of educators and management and governance capacity, and evaluates qualifications for employment in education.

• Quality Promotion and Assurance strengthens the education system’s understanding of the performance of learners and institutions, and increases the levels of accountability for educational outcomes at all levels of the system.

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Illustrative medium-term outputs and targets are as follows:

Subprogram Output Measure/indicator Target

General Education and Training Curriculum and Assessment

National curriculum statement implemented in the senior phase Monitoring and evaluation system

Number of teachers provided with assessment guidelines Monitoring and evaluation system established Percentage of schools monitored and evaluated for curriculum-related programs

All teachers in the senior phase by January 2007 By March 2007 5 percent of senior phase schools, Grade R and special schools