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INTERNATIONAL ASSOCIATION OF SCHOOLS AND

INSTITUTES OF ADMINISTRATION

ASSOCIATION INTERNATIONALE DES ECOLES ET INSTITUTS D’ADMINISTRATION

GT-WG VI

Public Administration: Challenges of Inequality and Exclusion

Miami (USA), 14-18 September 2003

L’Administration publique Face aux défis de l’Inégalité et de l’Exclusion

Miami (Etats-Unis), 14-18 Septembre 2003

Fiscal Discipline as a Capacity Measure of

Financial Management by Sub national Governments

Yilin HOU

Department of Public Administration and Policy School of Public and International Affairs

University of Georgia USA

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Author’s Biographical Note Mr. Yilin Hou holds a master’s and a PhD degree in public administration from the Maxwell School of Syracuse University, USA and now teaches at the Rutgers University-Newark, USA. He worked through the Government Performance Project (1998-2002) first as a research associate and then as a faculty expert in financial management. His research interests are public finance and budgeting, and strategic management.

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Abstract Public management literature has not adequately covered specific

capacity measures of financial management in subnational governments.

Using data from four national surveys of American state, metropolitan and

county governments conducted by the Government Performance Project

(GPP) at Syracuse University from 1998 to 2001, this paper attempts to

fill in the niche by developing a conceptual framework that builds toward

future subnational financial governance.

Fiscal discipline is defined as the capacity of a government to

maintain smooth financial operation and long-term fiscal health. It

branches into (1) multi-year perspective on budgeting and (2)

mechanisms to maintain fiscal health and stability over business cycles.

The measure is a scale ranging from low to high. The paper holds that

strong fiscal discipline builds up financial management capacity which

contributes to sound governance at subnational levels. The paper’s

purpose is to develop a capacity measure of governmental financial

management that can be applied cross-countries.

Key words Fiscal discipline; financial management; management capacity; performance; subnational government

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Fiscal Discipline as a Capacity Measure of Financial Management in Subnational Governments Raising revenue through taxation and then spending tax dollars for public goods forms the very basis for the existence and functioning of all governments. It is no exaggeration to say that no government can last without public financial management. The significance of public financial management, however, has so far been only ‘explicitly implied’ —in fact it has long been taken for granted, for a review of public management literature would show little published academic mention to it. i Specific capacity measures of financial management in subnational governments have in particular been an inadequately covered area in public management research. Using data from four national surveys of American state, metropolitan and county governments conducted by the Government Performance Project (GPP) at Syracuse University from 1998 to 2002, this paper attempts to fill in this niche by developing a conceptual framework that helps build towards future subnational financial governance. This paper defines fiscal discipline as the capacity of a government to maintain smooth daily financial operation and long-term fiscal health. Thus defined, fiscal discipline necessarily branches into (1) multi-year perspective on budgeting and (2) mechanisms to maintain fiscal health and stability over business cycles. Fiscal discipline covers a wider territory than conventionally used; as a capacity measure it is an aggregate score for areas covered, ranging from low, moderate, to strong and high. The paper holds that strong to high degrees of fiscal discipline build up financial management capacity which contributes to sound governance at subnational levels, moderate fiscal discipline may not lead to high management capacity, and that low fiscal discipline reflects low capacity. Therefore, to build up its financial management capacity, a government needs to start with strengthening its fiscal discipline. Fiscal discipline is designed as a generic framework covering the core areas of financial management that are essential components of any financial management system. The paper’s purpose is to develop a capacity measure of governmental financial management that can be applied in not only developed but also developing/transitional countries that adopt different political and economic systems. The paper is organized as follows. Section one traces different usages of the term ‘fiscal discipline’ and redefines it for this research. The next section examines ‘fiscal discipline’ in the context of results from four national surveys of state, metropolitan and county governments in the United States under the framework defined in section one. The objective is to testify whether this framework can capture the management capacity of subnational governments. Section three refines the framework to a more visible and specific capacity measure. The last section concludes with limitations of this paper and suggestions for further research.

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1. Fiscal Discipline Defined The term ‘fiscal discipline’ in public finance literature has been used broadly without strict definition by academia as well as by professional organizations like the Government Finance Officers Association (GFOA), the National Association of State Budget Officers (NASBO) and the National Council of State Legislatures (NCSL). Researchers found the term so broad or vague that they did not care much about it. ii Practitioners, however, found it a very convenient tool for general reference, so they simply resort to it at their will. This might have been one of the reasons why this concept has not drawn proper and adequate attention. Academic usage of the term has so far been in three related meanings. The first is by public finance theorist Richard Musgrave to mean mainly deficit financing of current operations, i.e., a government should cover its current expenditures only with current revenues. Deficits can bring current benefits to residents and win political support for officials but add tax burden on future tax payers. (Musgrave 1959; Musgrave and Musgrave 1989, 101) Inferences are: One, such deficit financing indicates low or even absence of fiscal discipline; two, fiscal discipline involves not only elected officials but also voters/tax payers, both of whom pay more attention to immediately current needs than the future; three, it is up to professional finance managers (elected or appointed) to correct this erroneous inclination so as to maintain proper fiscal discipline. The second usage, by John Mikesell, upholds Musgrave’s point against deficit financing, ‘restraining expenditures to the limits of available finance,’ and elaborates on fiscal discipline as part of the budgetary control process, ‘insuring that enacted budgets are executed, and preserving the legality of agency expenditures’ in intent and amount. (Mikesell 1999, 44-45) Obviously, the ‘discipline’ here is intended for elected as well as appointed officials to abide by the will of the people expressed through their representatives, the legislators. That is, fiscal discipline is exercised if government agencies execute the appropriations bill faithfully by spending approved amounts of money on legislatively intended items or purposes. The third usage extends the coverage of fiscal discipline to legislators: The legislature should act to ‘meet its own deadlines…on resolutions, budget and appropriation bills.’ (Axelrod 1988, 146) iii Placing the words into their context, several inferences can be made. To begin with, legislators are also subject to the restraint of budgetary discipline though as representatives of voters, they may try pork barreling for their districts. Then, cooperation among legislators themselves and with the executive branch is necessary to maintain smooth budgetary processes. If their representation of the voters’ interests distorts the normal budgetary procedure, fiscal discipline is discounted. The interpretations of fiscal discipline from the above three aspects are in fact complimentary. Together they form a more complete picture: Fiscal discipline is meant for all players in governmental finance—legislators, elected officials, civil servants, and citizens as well. If any one group of these players goes astray, finance managers should uphold their

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professional standards (and ethics) to restore proper discipline. Besides, fiscal discipline is applicable not only in the budgetary process to limit current expenditures within currently available means and to guarantee timely adoption of a reasonable budget to guide governmental operation in the coming fiscal year, but also in the implementation of approved budgets so that the fiscal discipline embedded in the budget document is faithfully executed and line managers do not go against legislated intents. The above interpretations, however, focus only on the current (upcoming) fiscal year, which according to more recent research is far from enough. For smooth financial operations, a multi-year perspective on budgeting is necessary (Schick 2000), because any focus on the current year falls short of planning which is an indispensable part of financial management that has become a trend. It is difficult if not impossible to maintain annual structural balance between current revenue and current expenditures without resorting to multi-year financial planning. (Hou 2002a) In fact multi-year budgeting has become an increasing trend even among developing and transitional countries. (Boex, Martinet-Vazquez and McNab 2000) The multi-year perspective requires governments to conduct and do well in two more areas: One is revenue and expenditure estimation for the coming years; the other is to gauge the future fiscal impacts of all major management decisions, because all decisions carry financial consequences. (Brigham 1982, 3) Furthermore, sound budgetary practices and well-planned budgets must come with mechanisms devised to maintain fiscal health and stability in cases of downturns of the economy and unexpected emergencies which are natural occurrences out of the control of subnational governments. In the more conventional economic wisdom, the stabilization function belongs only to the national governments (Musgrave 1959; Oats 1972). New theoretical exploration claims that subnational governments may play a role in stabilizing government expenditures during recessions (Gramlich 1987) and recent research provides evidence that counter-cyclical fiscal devices have been effective in this regard at the state level in the United States (Hou 2001a and b). Such devices include general fund surpluses and budget stabilization funds. Fiscal health and stability is not complete without sound mechanisms for debt management. Debts are necessary in infrastructure construction to form an adequate flow of resources (current year revenues are not enough) and to achieve inter-generational equity (the facilities benefit future residents longer than current tax payers). But since current residents enjoy full benefits from the facilities while paying only a fraction of the costs for each year of their residence, they may demand more such construction and their political representatives may simply follow the voters’ will. Thus, mechanisms that restrict the amount, type, and maturity of debts are necessary for long-term fiscal health and stability, so that financial operation in the coming years will not be strained of resources by too large a debt service burden. Thus defined, fiscal discipline is a broader concept than used in the past. It branches into (1) multi-year perspective on budgeting and (2)

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mechanisms to maintain fiscal health and stability over business cycles. The two branches cover three stages of the governmental finance process: (a) Medium- to long-term planning—revenue and expenditure estimation, gauging fiscal impacts of major management decisions, and debt management; (b) budget compilation and adoption—structural balance between current revenues and current expenditures, and adoption of budget prior to start of fiscal year; (c) budget execution/financial operation—achieving structural balance, and maintaining built-in counter-cyclical devices. --Insert Figure of Fiscal Discipline about here— Such a concept of fiscal discipline grasps the core of governmental financial operations. Applied well, it builds up financial management capacity that leads to sound governance at subnational levels. 2. Fiscal Discipline in US State and Local Governments To illustrate how the framework of fiscal discipline works in subnational governments, let’s take as example the financial management in US state and local governments. From 1997 to 2002 the Pew Charitable Trusts (Philadelphia, USA) funded a nationwide comprehensive study of the federal, state, metropolitan and county governments—the Government Performance Project (GPP). The GPP surveyed selected federal agencies, all 50 state governments, 35 metropolitan cities and 40 counties. The cities and counties sampled were the largest ones by government revenue. They are distributed all over the country. (For a list, see appendix 1.) The GPP surveys focused on the management capacity of governments instead of merely current performance because it is the management capacity that counts for performance. The GPP survey instrument was divided into five management areas: financial management, capital management, human resources management, information technology management, and managing for results. Data used in the following analyses were taken from the financial management section of the surveys, 1998 and 2000 for the 50 states, 1999 for the 35 metropolitans, and 2001 for the 40 counties. 2.1 Multi-Year Perspective on Budgeting Timely Budget Adoption Budgets are a financial plan and a guide for governments (Schick 1966). As such, adoption of budgets before the start of each fiscal year is a necessary condition for smooth operation. However, the budgeting process is highly politicized, involving multi-players and the coordination (even bargaining and compromises) between the executive and legislative branches. In this sense, whether a government can get its budget passed in a timely fashion for the new fiscal year is an indication of its operating environment. At the state level, budget adoption prior to start of fiscal year is not a big problem. Eighty-eight percent of states (44) adopted budgets in time for fiscal year 1999. The case with the big cities is similar—among the 83

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percent of the 35 cities (29) that responded to this question, 90 percent (26) adopted the budget for fiscal year 2000 before start of the year. iv At the county level, the rate of timely budget adoption (approval by the Council before start of the county’s fiscal year) is lower than at the state and city levels. From fiscal year 1997 to 2001, it was between 69 and 80 percent in a sample of thirty-five counties. v It is difficult to offer an even remotely ‘educated’ guess as to the attributes to the different timely adoption rates at the three levels. Though local politics may be a factor that had contributed to late adoption of the counties’ budgets, state politics is by no means any easier (many scholars would claim it is much messier). If we speculate that multi-intergovernmental revenues (from the federal and state governments) for counties may complicate the process, the cities had faced the same situation. A possible clue may be that local governments are subject to legal restrictions imposed by states, vi as the case is with New Jersey municipalities, vii but wouldn’t cities have encountered the same dilemma if counties had? No doubt, this is an area that cries for further research. But on the whole, relatively high rate of timely budget adoption is common among high performing governments. Budget Reflects Structural Balance Between Revenues and Expenditures Balancing the annual budget is a very strong legal requirement at the state and local levels. It is also of much significance in terms of fiscal discipline. However, balancing the budget is easier said than done. With such strong legal restrictions and high public scrutiny, many governments still cannot hit this target. (Hou 2002a) At the state level, a combined 72 percent (36 states) can balance, out of which 38 percent (19) can balance their current revenue for current expenditures, and 34 percent (17) balance their budget using carry-forward balances from the last fiscal year, which is a normal practice, especially for years of downturns. For the three fiscal years from 1996 through 1998, the 35 cities on average balanced their revenues against expenditures in both the general fund and the total operating fund, with a small positive margin for the former (average 1.57 percent and median 0.88 percent) and the margin is a little bit larger for the total operating fund (average 2.39 percent and median 1.81 percent). The counties on the whole came out with larger general fund surpluses than the cities. So balancing the budget is no problem for these local governments. The counties’ fiscal discipline is shown in the fact that when their general fund has a surplus, only 23 percent (8 counties) put the surpluses back into the general fund for the next year; instead, 77 percent (27 counties) use the surpluses for capital expenditure, reducing debt or unfunded pension liability or increasing their reserves. Though also common at the state and city levels, such practices are much more salient at the county level. Among these practices, using part of the general fund (or general fund surpluses) to partially fund capital investment that conventionally is

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done solely through debt financing is a relatively more recent revival of an old tradition. viii This way of financing infrastructure is ‘against’ the widely accepted theoretical principle of inter-generational equity, but it is a way to reduce future debt burdens with current extra resources, with many advantages—possibly higher credit rating from the financial market and thereby lower interest costs on debt issues, higher confidence among the residents and thus higher attractiveness to businesses and investors, shorter cycle of construction thus earlier receipt of benefits from the projects, to name just a few. During times of economic booms as the mid- and late 1990s in the United States, this is a technically wise and politically courageous endeavor. Revenue and Expenditure Estimation ix Adopting budgets in time and maintaining structural balance both need quality information—estimates—about the amount of revenues and expenditures for the coming years. Accurate estimates do not come easily. They are built by well trained, experienced professionals using advanced computing equipment working on data collected from many aspects of the society accumulated over time. It is a resource-intensive enterprise. Every percentage point increase of the accuracy is achieved with millions of investment. Expensive as it is, it is essential because it contributes substantively to sound financial management. Eighty-four percent of states (42) conduct future budget projections that are equal to or longer than two years. And 84 percent (42) update the estimates for the current year twice or more. Figures in Table 1 are calculated by subtracting the actual from the estimated amount then divided by the estimate. Positive ratios for revenue indicate actual revenue is larger than estimates (underestimation of revenue); negative ones mean the actual revenue is smaller than estimates. Negative ratios for expenditure indicate an actual expenditure that is smaller than estimated (overestimation of expenditure) and positive ones mean the actual expenditure exceeds. Smaller absolute values indicate higher accuracy (smaller error) rates. From Table 1 ‘state estimation accuracy’ we can make the following inferences. First, the four-year (fiscal years 1996 through 1999), 50-state average accuracy for both revenue and expenditure of the general fund and total operating fund is fairly high, all better than the five percent benchmark. Second, most of average and median rates for revenue are positive and those for expenditure are negative. These consistently different accuracy rates for revenue and expenditure estimates pinpoint the widely adopted practice of ‘fiscal conservatism’ or ‘protective’ estimates, i.e., underestimating revenues and overestimating expenditures so that annual financial operations would end in positive balances (surpluses). Besides, the error rate of general fund revenue is higher than that of total operating fund revenue, indicating that the conservatism in revenue estimation is more clustered in general fund than total operating fund. On the other hand, the error rate of general fund expenditure is smaller than that of total operating expenditure, implying that the total expenditure

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had been more over-estimated. Finally, the absolute value of the average in both revenue and expenditure estimates is consistently larger than that of the median, meaning that revenue estimation is positively skewed and expenditure estimation is negatively skewed. That is to say, some states exercised extreme fiscal conservatism. x --Insert Table 1 about here— The 35 large cities are more accurate than the states with their estimates: The error rates of revenue estimation range from 2.8 to 3.4 percent and the error rates of expenditure estimation flows only between negative 0.2 percent and 1.4 percent. Both ranges are much smaller than the five-percent benchmark. Such high accuracy leaves little room for intended fiscal conservatism. The 2.8 to 3.4 percent of revenue estimates may be by intention but not large in comparison with those of the states, for that small margin is barely enough for working capital needs. The positive sign on expenditure figures is more puzzling: It implies that the cities spent more than they planned, but that is against intuition and literature. xi Perhaps we can speculate that the cities are a little bit ‘conservative’ with revenue estimates but not with expenditure estimates. Finally, unlike the states, the cities do not present much difference between the estimates for their general fund and total operating fund. --Insert Table 2 about here— The percentage of counties that conduct and update their revenue and expenditure estimates exceeds that for the states and cities. Ninety-five percent (38) of the counties estimate at least for the coming year and one year into the future, with nearly 90 percent (35) forecast two years into the future. Besides, ninety percent update their estimates within the fiscal year: Ten percent (4) update estimates semi-annually and 80 percent (32) update at least quarterly. Among this combined 90 percent, half formally adopt the updated estimates. The accuracy of county estimation of their revenues and expenditures, however, displays features different from those of the states. First, estimation accuracy of the general fund revenue is much higher (error rate lower) than the states: the annual all-county averages as well as the four-year all-county averages fall below 2 percent, in the excellent range. This ‘excellent’ accuracy, however, is difficult to interpret as to its causes. A detailed discussion is beyond the scope here. xii On the other hand, the error rate of general fund expenditure estimation, both annual and four-year averages, goes above the 5 percent benchmark. This is not surprising considering the limited amount of expertise and resources available at the county level for this purpose. Second, when we take into account the practice of ‘fiscal conservatism’ in estimation, it is clear that one, revenue estimation leaves little room for this conservatism; and two, the off-the-mark accuracy of expenditure estimation is on the negative side only, i.e., it is the major means of the ‘protective’ device. Thus, the higher error rate is perhaps no longer an ‘error’ any more. It is intended. Third, in both revenue and expenditure estimation, the averages are lower than the median, i.e. the distribution of the statistics is negatively skewed. For revenue, this

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indicates more cases of actual revenue lower than expected amounts; for expenditure, however, more counties spend less than they plan, saving a larger margin for unexpected incidents. Therefore, these county governments rely on the differential of estimated and actual expenditures to accumulate positive year-end surpluses as a fiscal ‘self-protective’ device. This is something not mentioned in previous literature. --Insert Table 3 about here— Gauging Future Fiscal Impact of Financial Decisions All management decisions bring financial impacts. (Brigham 1982, 3) Assessing the major decisions and preparing for their possible financial consequences is essential for higher estimation accuracy, smooth budgeting procedures. It is also a necessary step towards a multi-year perspective on budgeting. Like revenue and expenditure estimation, this is also a manpower-intensive activity; unlike making financial estimation that is done a few times a year, this is an on-going activity to track all important management decisions. To smaller governments, the strain on personnel might be too much. Almost all states assess impacts of state legislations. The methods used are mainly two: fiscal notes (90 percent, 45 states) and other methods (30 percent, 13 states, overlapping). The length of assessment extends to more than one year in 96 percent (48) of the states. The percentage of states that assess impacts of federal legislations drops to 70 (35 states) only. Eighty-eight percent (44) assess out-year impacts on pensions but only 54 percent (27) assess impacts on vacations (a combined 50 percent [25 states] assess both pension and vacations). Of these, about 80 percent are done on an annual basis, i.e., very few states do it more than once a year. The assessment rate lowers a lot at the local levels. Only 20 cities out of the 35 (57 percent) have a formalized process for assessing the impacts of all local legislations. xiii Of these cities, ten (29 percent) formally assess all potential legislations of the city and seven assess legislations when they are passed. At the county level, only about half assess local legislations; the percentage is even lower that assess pension and accrued vacation liabilities. Summary of Findings The rate of timely budget adoption is highest with the states, then goes down to cities and is the lowest with counties. On maintaining the structural balance between revenues and expenditures, however, counties and cities do better than states. Counties allocate their surpluses for one-time expenditures and pay-as-you-go financing of capital investments. On the whole, all surveyed governments achieved high accuracy rate on revenue and expenditure estimation. I prefer to interpret their high accuracy rates in terms of fiscal conservatism. For states, the conservatism is more displayed in general fund on revenue estimates and in total operating fund on expenditure estimates. Some states even go to extremes along this ‘self-protective’ line. The 35 cities achieved higher accuracy rates than states, leaving little room for fiscal conservatism

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which in relative terms is more obvious in revenue than expenditure estimation. The counties’ accuracy rate on revenue estimation also surpassed that of states. Their error rate on expenditure forecasts, however, is higher. Such ‘errors’ are the location of the counties fiscal conservatism. Although almost all states assess the financial impacts of state legislations, only 70 percent of them assess federal legislations. The rate of assessing legislations drops to 60 percent for the cities and 50 percent for the counties. This fact indicates that the surveyed governments still have lot of work to do towards fully embracing the multi-year perspective on budgeting. 2.2 Mechanisms for Fiscal Health and Stability As defined in Section One, counter-cyclical fiscal devices are necessary reserves to maintain service levels when revenue shortfall occurs and good debt management policies can guard against disproportionate debt burdens on future financial operations. Here we examine these two areas. Maintaining fiscal stability used to be taken as a federal function that subnational governments have no to play with (Musgrave 1959; Oats 1972). Theorists have forwarded contrasting propositions. Edward Gramlich for example believes that state and even local governments may have a role to play. (1987) Afterwards, researchers have come up with empirical evidence at the state and large city levels (Pollock and Suyderhood 1986; Sobel and Holcombe 1996; Wolkoff 1987; Wagner 1999). More recently, Hou (2002a) has provided evidence that subnational counter-cyclical fiscal policy exists and was effective at the state level in the past 20 years. Besides, debt management and investment management are vital areas for fiscal health at both state and local levels. Counter-Cyclical Fiscal Devices Though governments can have quite a few counter-cyclical fiscal devices in times of need, the two major ones are general fund surpluses and the budget stabilization fund. The former has historically been of such use while the latter became widespread only since the 1980s. Budget Stabilization Fund (BSF) xiv By the end of 1999, ninety percent of states (45) had had a legislation enabling a budget stabilization fund. The percentage might be higher if we consider the facts that Alabama was considering one, pending on legislative action and Illinois’s legislature had passed one, pending on governor’s signature. xv The percentage is much lower at the city and county levels. Only 17 cities (49 percent) report having a budget stabilization fund. Among the 40 counties, the percentage is a mere 40 percent (16) and among these, only six (15 percent) are legally required BSFs, i.e., with enabling legislations, with another eight (20 percent) having a general fund balance requirement.

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What has caused the delay of BSF legislation at the city and county levels is beyond our knowledge with currently available data. It is a mere guess that perhaps the local governments are going through a similar exploration process as states did before the 1980s. The current recession may become a trigger for governments of large cities and counties to adopt the BSF, as the case with the states. The states seem to have a fairly high BSF balance. Take fiscal year 1999 for example, the average BSF balance against general fund expenditure is 4.84 percent (median 3.26 percent). About 54 percent of states maintained a BSF balance ranging from 4 to 9 percent; another 18 percent of states had balances between 2 and 4 percent. xvi The cities maintain a much lower BSF balance: The balance of about 20 percent of cities was below 2 percent of general fund expenditure, 20 percent between 2 and 6 percent, none had a balance between 6 and 10 percent. The counties’ BSF balances do not form a comparison due to its small sample. General Fund Surplus (GFS) General fund surplus is here defined as the unreserved undesignated balance of the general fund at the end of fiscal year. xvii This surplus can be used to cover any unexpected expenses and as working capital. A review of the GFS of the state, city and county governments reveals different patterns at these levels. The following table provides summary statistics of GFS as a percent of general fund expenditure. xviii --Insert Table 4 about here— An examination of the summary statistics reveals that for both the annual and three-year average of the average and median GFS, the states rank the lowest, the cities higher than the states, and the counties the highest. For the minimum and maximum balances (marked as ‘low’ and ‘high’ in the table, respectively), the states are again the lowest, the cities higher than the states, and the counties the highest. This order goes in exact contrast to the adoption of the budget stabilization fund at the three levels. From the above data, a preliminary conclusion seems to be that the states rely mostly on BSF as a counter-cyclical fiscal device for self-protection against revenue downfalls. The counties depend almost solely on general fund surplus as a fiscal reserve for protection. The cities present the middle case—with fairly wide adoption of the budget stabilization fund, they maintain some BSF and also a relatively large amount of general fund surplus as reserves. The question then is: Why do the states and counties consult to different devices? A probable reason, when we take into account the politics of spending, is that at the state level, legislators often employ pork barreling to favor their electorates, thus forming the spending pressure that goes against fiscal reserves during good years. On the other hand, tax payers tend, since the late 1970s’ tax revolt movement, to restrict the taxing power of state governments, which is in a sense far away from their direct provider of vital services, thus forming the political pressure

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that fights against taxation for refunds during booms. The cities again present the middle case. The following table presents the distribution of general fund surplus in various ranges, from deficit to over 20 percent of general fund expenditure. This distribution makes clearer the difference between the three levels of government: --Insert Table 5 about here— The first striking difference is the percentage in general fund deficits: 22 percent of states in contrast to six percent of cities and merely three percent of counties. In contrast, only four percent of states and six percent of cities but 21 percent of counties fall in the category of very large surpluses (over 20 percent). The cities stand out in the middle ranges: They make up a higher percentage in the 5-10 percent and 10-20 percent ranges than the states or the counties. How should we interpret these results? Obviously, there is not just one perfect policy that fits all levels of government. Different devices better serve different levels. Thus, in assessing the performance of the state, city and county governments, we must apply appropriate measures. 2.3 Lessons from the American Case The example from American state and local governments illustrates the actual use of fiscal discipline in several aspects. First, fiscal discipline as defined in this paper is easily traceable in the daily operation of subnational governments, with its branched areas covering the core of financial management. Second, though the concept of fiscal discipline applies well to all subnational levels, each level of government, with a different management environment from other levels, may deserve different assessment standards in some of the areas. 3. Fiscal Discipline as a Capacity Measure Fiscal discipline as defined in this paper and illustrated in the previous section serves well as a measure of financial management capacity in subnational governments. Take for example the 40 American counties from the GPP survey, in which we first calculate a score for each of the areas covered under this term, then sum up the area scores for a fiscal discipline score (Table 6, Column 2). There exists a high correlation between the fiscal discipline score and the total calculated score of financial management (0.93), because fiscal discipline really covers the core of financial operations. The correlation between the fiscal discipline score and the final grade of financial management remains high (0.70). The final grade for financial management differs from the calculated score in that the latter takes data only from the survey response and published documents, i.e. source of hard data, whereas the final grade considers factors from sources other than hard data are considered. xix Surprisingly, even the correlation between fiscal discipline and the final overall grade (of all five sections) is considerable (0.59). What this tells us is that fiscal discipline is not only a good capacity measure of financial management but potentially an indicator of the overall management capacity.

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--Insert Tables 6 and 7 about here— As shown in Section 2, for each of the specific management areas covered under the concept of fiscal discipline, assessment standards may vary for different levels of government. A typical example is the accuracy of revenue and expenditure estimates: Governments at a higher level like the states in the US have more resources and expertise in financial management and therefore can achieve higher estimation accuracy. City and county governments, on the other hand, do not have as much expertise on forecasting nor as much resources to invest into estimation activities. Therefore, the results of assessment would be distorted if the same accuracy rate is taken as the benchmark. xx Besides, different tools may better fit different levels. The counter-cyclical devices are an example. While the budget stabilization fund has been the choice of most US state governments, more of the city and county governments in the GPP surveys prefer general fund surpluses. In this case, overemphasizing the importance of the budget stabilization fund and discounting general fund surpluses would downgrade the capacity of the city and county governments. Therefore, in using fiscal discipline as a capacity measure to assess the management capacity and actual performance of subnational governments, weights should and can be adjusted for different levels of government and for specific management areas. As long as the adjustments are systematically applied, the assessment results should be consistent and fair. Take again the example of the US counties. Had another set of weights been used in calculating the aggregate score of fiscal discipline, the results would have been consistent in relation to the total score. (See Table 6) Thus, scores from management areas sum to a final measure of fiscal discipline (Column 2 of Table 6) that is a scale ranging from 0 to a high number, which can be characterized into classes of low, moderate, strong and high (or more classes as necessary and fit). The dividing lines between every two neighboring classes vary from case to case, depending on the sample size. This paper holds that strong to high fiscal discipline builds up financial management capacity which contributes to sound governance at subnational levels. Moderate fiscal discipline is barely adequatem while low or poor fiscal discipline reflects poor management capacity. Thus, any government needs to first improve its fiscal discipline if it wants to improve its financial management capacity. In this sense, fiscal discipline is an essential component of good governance. Since fiscal discipline as defined here covers the core areas of financial management, its variation from country to country should not be very large despite the differences in the political system adopted in countries around the world. In this sense, fiscal discipline is a good candidate as a capacity measure of governmental financial management that can be applied worldwide.

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4. Concluding Remarks The purpose of this paper is to fill in a niche in public management literature by developing a capacity measure of governmental financial management by subnational governments. The measure chosen is fiscal discipline that is based on the conventional usages of the term but broadened to cover the core areas of financial management—not only timely adoption of budget, structural balance between current revenue and current expenditures, but also accurate estimation of revenue and expenditure, gauging fiscal impacts of major management decisions, as well as mechanisms to maintain long-term fiscal health and stability. An aggregate score of fiscal discipline can be obtained by adding together scores for all areas covered under this concept according to a set of weights. Data from four national surveys by the Government Performance Project of state, metropolitan and county governments in the United States illustrate that fiscal discipline thus defined cover the major areas, and that a high correlation exists between the aggregate score of fiscal discipline and the total score of financial management, the final grade for financial management that considers more of broad management issues, and even the average final overall grade of all five subsystems of governmental management. This concept and usage of fiscal discipline is intended to be a capacity measure that can be applied to different countries; however, what this paper has done is only one step. Application of the measure into other countries is to be done and further details in application are to be explored.

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References Axelrod, D. (1988) Budgeting for Modern Government, New York: St. Martin’s Press, Inc. Boex, L.F. J., Martinez-Vazquez, J. and McNab, R. M. (2000) Multi-Year Budgeting: A Review of International Practices. Public Budgeting and Finance, 20:2 pp91-112. Brigham, E. F. (1982) Financial Management: Theory and Practice, third edition, New York: CBS College Publishing. Esser, J. L. (1991) Forward in Peterson and Strachota (eds) 19911, vii. Fisher, R. C. (1996) State and Local Public Finance, Irwin, second edition. Gauthier, S. J. (1991) Auditing in Peterson and Strachota 1991. Gramlich, E. M. (1987) Subnational Fiscal Policy in J. M. Quigley (ed) Perspectives on Local Public Finance and Public Policy, Vol. 3 pp3-27. Greenwich: Connecticut, JAI Press Inc. Hou, Y. (2001a) Effects of Budget Stabilization Funds on State General Expenditure, 1979-1999, working paper of the Campbell Institute of Public Affairs, Maxwell School, Syracuse University, October 2001. Hou, Y. (2001b) Testing the Effects of Sub-National Counter-Cyclical Fiscal Policies: Budget Stabilization Funds, General Fund Surpluses, and State Own-Source Expenditure, working paper number 6, the Campbell Institute of Public Affairs, Maxwell School, Syracuse University, November 2001. Hou, Y. (2002a) Subnational Counter-Cyclical Fiscal Policy: Testing the Effects of Budget Stabilization Funds and General Fund Surpluses, PhD dissertation, the Maxwell School, Syracuse University. Hou, Y. (2002b) Measuring the Capacity and Performance of State and Local Government Financial Management—Clues and Cues from the GPP in P. W. Ingrham (ed), Final Report of the Government Performance Project, Syracuse: the Maxwell School of Syracuse University. Mikesell, J. (1999) Fiscal Administration, New York: Harcourt Brace College Publishers. Miller, G. (with M. Corinne Larson and W. Paul Zorn) (1998) Investing Public Funds, second edition, Chicago: Government Finance Officers Association. Musgrave, R. A. (1959) The Theory of Public Finance, New York: McGraw-Hill. Musgrave, R. A. and Musgrave, P. B. (1989) Public Finance in Theory and Practice, fifth edition, New York: McGraw-Hill. New Jersey Initiative Final Report (2002) The New Jersey Initiative: Building Management Capacity in New Jersey Municipalities, The Maxwell School of Syracuse University.

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Peterson, J. E. and Strachota, D. R. (eds) (1991) Local Government Finance: Concepts and Practices, Chicago: Government Finance Officers Association. Peterson, J. E. and McLauphlin, T. (1991) Debt Policies and Procedures in Peterson and Strachota (eds) 1991. Schiavo-Campo, S. and Tommasi, D. (1999) Managing Government Expenditure, Manila: Asia Development Bank. Schick, A. (1966) The Road to PPB: The Stages of Budget Reform in Public Administration Review. Schick, A. (2001) Does Budgeting Have a Future? Paper presented at the 22nd annual meeting of senior budget officials, PUMA/SBO (2001)4, Paris: Organization of Economic Cooperation and Development. Simonsen, W. and Robbins, M. D. (1996) Does It Make a Difference Anymore: Competitive versus Negotiated Bond Issuance in Public Administration Review, 56:1 pp57-64. Oats, W. (1982) Fiscal Federalism, New York: Harcourt Brace Jovanovich. Strachota, D. R. and Peterson, J. E. (1991) Introduction in Peterson and Strachota 1991. Pollock, R. and Suyderhoud, J.P. (1986) The Role of Rainy Day Funds in Achieving Fiscal Stability in National Tax Journal 43:4 pp485-497. Sobel, R.S. and Holcombe, R.G. (1996) The Impact of State Rainy Day Funds in Easing State Fiscal Crises During the 1990-1991 Recession in Public Budgeting and Finance, 16:3, pp28-48. Wolkoff, M. (1987) An Evaluation of Municipal Rainy Day Funds in Public Budgeting and Finance, 7:2 pp52-63. Wagner, G. A. (1999) Essays on the Political Economy of State Government Saving and the Role of Budget Stabilization Funds, PhD dissertation, University of West Virginia.

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Table 1: Accuracy of State Estimates of Revenues and Expenditures

(Federal funds included)

Item Fiscal Year 4-yr Avg

1996 1997 1998 1999 50

states General fund Average 4.20% 3.83% 4.75% 3.07% 3.59% Revenue Median 1.14% 2.77% 3.41% 1.60% 2.49%

Low -8.10% -7.62% -

12.61% -

12.39% -

11.03% High 65.63% 67.68% 64.95% 65.67% 65.70% Total operating Average 1.75% 3.35% 3.94% 1.64% 2.79% fund revenue Median 1.90% 1.02% 1.04% 0.97% 0.83%

Low -

11.43% -

15.73% -

12.77% -

12.91% -

10.20% High 29.46% 77.64% 80.24% 41.73% 47.23% General fund Average -2.03% -1.27% -2.09% -1.33% -1.67% expenditure Median -1.35% -0.97% -1.52% -0.47% -1.17%

Low -

23.02% -

28.38% -

28.61% -

29.14% -

27.25% High 14.50% 26.30% 15.35% 13.42% 16.62% Total operating Average -4.12% -2.63% -3.56% -4.33% -3.60% fund exp’dture Median -2.05% -1.58% -2.61% -1.64% -2.20%

Low -

41.89% -

43.27% -

43.90% -

40.80% -

42.23% High 26.40% 29.31% 32.70% 15.58% 24.22% Revenue estimation accuracy = (actual revenue - estimated revenue)/estimated revenue Expenditure estimation accuracy = (actual expenditure - estimated expenditure)/estimated expenditure

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Table 2: Accuracy of City Estimates of Revenue and Expenditure (Federal and state funds included)

Category 4 yr Avg

1996 1997 1998 1999 35 cities

General Fund Average 2.75% 2.32% 2.63% 3.77% 2.87% Revenue Median 2.15% 1.57% 2.81% 5.98% 3.13%

Low -3.87% -1.48% -38.79% -7.19%

-12.83%

High 15.35% 7.20% 19.41% 9.33% 12.82% Total Operating Average 3.33% 1.97% 5.07% 2.99% 3.34% Fund Revenue Median 2.71% 3.05% 3.33% 3.97% 3.26%

Low -10.87%

-20.25%

-12.18%

-14.84%

-14.53%

High 20.20% 12.27% 25.79% 18.65% 19.23% General Fund Average 0.54% 0.24% 0.17% 0.77% 0.43% Expenditure Median 0.38% 0.02% -0.09% -1.00% -0.17%

Low -13.99% -3.65% -5.93% -5.98% -7.38%

High 14.61% 5.86% 6.24% 11.85% 9.64% Total Operating Average 1.89% 2.31% 1.96% -0.83% 1.33% Fund Median 2.07% 0.56% 0.73% 1.85% 1.30%

Expenditure Low -20.43% -7.14%

-12.81%

-30.12%

-17.62%

High 23.49% 23.12% 25.81% 15.76% 22.05%

Able 3: Accuracy of County Estimates of Revenue and Expenditure (Federal and state funds included)

1996 1997 1998 1999 4-Yr Avg

General Average -0.65% 0.39% 0.22% 1.35% 0.33% Fund Median 0.46% 1.63% 1.13% 1.71% 1.23%

Revenue Low -

28.46% -

26.26% -

26.78% -

12.09% -

23.40% High 11.17% 9.64% 9.44% 11.97% 10.55% General Average -6.52% -7.78% -7.22% -6.76% -7.07% Fund Median -4.62% -6.93% -4.96% -5.19% -5.42%

Expenditure Low -

32.61% -

31.71% -

31.50% -

24.24% -

30.02% High 6.07% 7.04% 16.35% 3.48% 8.23%

Notes: 1. Data taken from county Comprehensive Annual Financial Reports.

2. Accuracy = (actual expenditure – estimated exp)/estimated expenditure

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Table 4: General Fund Surplus as a Percent of General Fund Expenditure

1996 1997 1998 96-98 Avg

States Average 2.33% 2.57% 4.23% 3.04% (50) Median 2.61% 2.64% 3.58% 2.94%

Low -

55.74% -

56.55% -

69.58% -60.62% High 25.10% 23.85% 26.52% 25.15%

Cities Average 7.00% 6.81% 8.28% 7.36% (35) Median 5.19% 4.84% 7.12% 5.72%

Low -

11.03% -8.17% 0.00% -6.40% High 28.87% 28.16% 29.27% 28.77%

Counties Average 10.82% 11.56% 13.41% 11.93% (39) Median 5.89% 6.78% 8.08% 6.92%

Low -1.23% 0.00% -5.35% -2.19% High 48.19% 55.02% 49.74% 50.98%

Notes:

1. Data are taken from Comprehensive Annual Financial Reports of these governments.

2. Figures are actual amounts at the end of each fiscal year.

3. Positive figures represent general fund surplus and negative ones denote general fund deficit.

Table 5: Distribution of 1996-1998 Average General Fund Surpluses States (50) Cities (35) Counties (39) Number Percent Number Percent Number Percent

Deficit 11 22% 2 6% 1 3% 0 -- 2% 10 20% 8 23% 7 18% 2 -- 5% 10 20% 5 14% 8 21% 5 -- 7% 2 4% 4 11% 5 13%

7 -- 10% 6 12% 6 17% 3 8% 10 -- 15% 4 8% 6 17% 5 13% 15 --20% 5 10% 2 6% 2 5%

> 20 % 2 4% 2 6% 8 21%

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Table 6: Fiscal Discipline Score for GPP County Assessment (2001)

Fiscal

Discipline Calculated

FM Final Final Full 56 Full 100 FM Overall Alameda 28.74 57.94 7 7 Allegheny 29.54 51.98 5 4 Anne Arundel 33.01 51.69 7 6 Baltimore 41.88 73.43 11 10 Broward 38.07 67.00 10 8 Clark 41.12 70.03 10 7 Contra Costa 34.41 64.47 8 8 Cook 13.51 23.64 8 7 Cuyahoga 35.36 69.35 9 6 Dallas 32.75 67.20 10 9 Erie 14.24 30.66 8 7 Fairfax 48.37 80.61 11 11 Franklin 36.27 66.12 9 9 Fulton 38.40 67.51 8 6 Hamilton 38.16 73.98 9 9 Harris 36.62 59.01 8 7 Hennepin 41.68 75.28 10 9 Hillsborough 43.25 74.57 9 6 King 34.56 66.10 8 6 Los Angeles 32.25 65.82 8 6 Maricopa 45.56 76.73 11 11 Mecklenburg 30.46 53.85 8 9 Miami-Dade 26.74 60.47 8 7 Milwaukee 29.26 59.40 7 8 Monroe 34.52 60.11 6 6 Montgomery 48.20 78.64 10 9 Nassau 13.30 26.23 1 3 Oakland 35.90 62.54 9 9 Orange 35.98 68.08 9 9 Palm Beach 28.76 62.45 9 7 Prince Georges 41.40 73.14 10 8 Riverside 29.66 54.36 8 7 Sacremento 33.38 58.23 8 7 San Bernandino 24.83 35.34 6 5 San Diego 40.25 70.85 11 10 Santa Clara 32.27 65.54 9 7 Shelby 39.89 66.45 9 9 Suffolk 29.21 47.26 8 5 Wayne 38.57 70.12 8 8 Westchester 37.41 61.36 9 7 1. The score for fiscal discipline is the sum of the scores for items defined in this paper, totaling 56. 2. Calculated financial management score is the total score of each county out of 100. 3. The final financial management score and the final overall score are converted from the published grades, ranging from A down to F. A is equal to 12 and F is 1.

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Table 7: Correlation Between Fiscal Discipline and Maxwell FM Final FM Final Overall

0.93 0.70 0.59

Appendix

A. List of the 35 metropolitans covered in the GPP 1999 City Survey

Anchorage Honolulu New York City Atlanta Houston Philadelphia Austin Indianapolis Phoenix Baltimore Jacksonville Richmond Boston Kansas City San Antonio Buffalo Long Beach San Diego Chicago Los Angeles San Francisco Cleveland Memphis San Jose Columbus Milwaukee Seattle Dallas Minneapolis Virginia Beach Denver Nashville Washington Detroit New Orleans

B. List of the 40 counties covered in the GPP 2001 County Survey

Alameda, CA Erie, NY Maricopa, AZ Prince George's, MD

Allegheny, PA Fairfax, VA Mecklenburg, NC Riverside, CA Anne Arundel, MD Franklin, OH Miami-Dade, FL Sacramento, CA

Baltimore, MD Fulton, GA Milwaukee, WI San Bernardino, CA

Broward, FL Hamilton, OH Monroe, NY San Diego, CA Clark, NV Harris, TX Montgomery, AL Santa Clara, CA Contra Costa, CA Hennepin, MN Nassau, NY Shelby, TN Cook, IL Hillsborough, FL Oakland, MI Suffolk, NY Cuyahoga, OH King, WA Orange, CA Wayne, MI Dallas, TX Los Angeles, CA Palm Beach, FL Westchester, NY

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Figure: FISCAL DISCIPLINE

PLANNING BUDGETING OPERATING

Revenue & ExpenditureEstimation

Gauging Fiscal Impacts of Mgmt Decisions

Debt Management

Timely Adoption of Budgets

Structural Balance—current revenue & expenditure

Adopting Counter Cyclical Fiscal Devices

Maintaining Structural Balance

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Endnotes

i Recently, Hou (2002b) elaborates on the significance of financial management in government management

systems in terms of prominence of the finance management office, education and qualifications of finance

managers, public oversight and professional standards on government financial operations, employment of new

technology in financial management, the learning inclination, and recent focus on planning and control in

governmental finance.

ii I have found very little literature that elaborates on this concept.

iii The context of the comment by Axelrod is in regard to the United State Congress’s delay in coming up with

budget resolutions in the early 1980s.

iv I would be cautious about this percentage because the 35 cities are not a complete set of any category and then

only 90 percent of the 35 responded to this question.

v Five counties did not provide response to this question. The timely adoption rates for these five years are 69%

for 1997, 71% for 1998, 77% for 1999, 80% for 2000, and 74% for 2001 respectively.

vi In the American federal system, local governments are creatures of state governments. This is the ‘Dillon’s

Rule.’

vii The author’s first-hand data from the New Jersey Initiative project (Maxwell School, 2001-2002) is that many

municipalities in New Jersey cannot have their budgets adopted before the start of their fiscal year because of

some unique stipulations in the New Jersey local finance law. For details, see the financial management chapter

drafted by the same author in the NJI report (2002).

viii In the 1950s, near 50 percent of capital financing was from state and local own-source current

revenues. This source shrank steadily over the decades. (Peterson and McLoughlin 1991, 266)

ix In the GPP financial management survey, the term ‘ estimation’ refers to predictions for the coming fiscal

year, and ‘ forecasts’ for futures years. The word ‘ projection’ is used more generally. Since even the forecasts

are but a few years into the immediate future, this paper uses the three terms interchangeably for convenience of

narration.

x The true story would have been much more sophisticated than just fiscal conservatism because financial

managers are more oriented towards higher accuracy to raise their professional reputation; elected officials may

face political pressure from large surpluses. Reasons for such high ‘ error rates’ deserve separate treatment.

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xi Whether this is, at least partly, due to the urban nature of the cities in contrast to the states and counties is

beyond what the author can offer a reasonable interpretation with the current amount of information, but it is an

open clue for further investigation.

xii Obviously the methods used for estimation at the county level are not as advanced as those adopted at the state

level and the qualifications of county staff are not as good as the state level either; and we have data to support

this claim. On the other hand, revenue sources at the two levels are different, which may add some punch to this

difference in accuracy. Another important factor is the 50 states are a complete set while the 40 counties we have

examined form merely a small subset of the counties, lacking representativeness. The author will elaborate on

the accuracy attributes in a separate paper.

xiii Only 21 cities provided useable response to this question, making the percentages distorted. But we may

argue that most likely those that did not provide clear responses did not have a formalized procedure for the

assessment.

xiv Budget stabilization fund is popularly called ‘rainy day fund.’

xv Having a BSF legislation is not equal to having a real budget stabilization fund. For example, a state may have

no BSF balance at all for some (even many) years; some states may have merely a with-the-fiscal year device

that is strictly speaking not a BSF.

xvi Alaska as an extreme outlier keeps a very large BSF.

xvii For rationale of this definition, see Hou 2002, Chapter 3.

xviii Expenditure figures are in conformity with the generally accepted accounting principles (GAAP).

xix These are mainly interviews by participating journalists from the Governing magazine with county officials,

residents, consultants and so on.

xx The ‘ distortion’ would be consistent in extent for all assessed governments.