Stop Squeezing the Baseline!

This article is published in association with IMF.

Holger van Eden

Too much. Ok, dear ministry of finance official, a little squeeze is fine, but decreasing existing expenditure commitments to bare bones levels has serious drawbacks. One of the unintended consequences of squeezing too much is that the baseline, the path of expenditure under unchanged policies, actually starts growing faster over the medium-term. How can such a paradox happen, you might ask. Isn’t cutting the baseline a good thing? Shouldn’t it reduce the spending pressures that so many countries face?

Well, in many cases it, alas, doesn’t work like that. Restraining ongoing expenditure increases fiscal space during budget preparation, which means…. more, not less, new initiatives can be funded under the expenditure ceiling. Politicians will love you for that. Spending on new policies is what politicians are born to do. However, this year’s new initiatives will be added to next year’s baseline, possibly for perpetuity (if there is no regular weeding out of obsolete and low-priority spending). And this will be repeated every year! Meaning the more you squeeze the baseline now, the more expenditure pressures are likely to rise in the future. Strange, right?

There may be other, more serious consequences for the effectiveness of government, however. Let’s dive a bit deeper.

Many countries calculate the baseline by simple multiplication with an inflation metric. Line ministries receive last year’s budget plus inflation for their program expenditure. That should be plenty, say many budget offices. However, what if in the health sector the number of elderly is increasing? More than 50 percent of lifetime healthcare spending is spent on those aged 65 or older. If the share of the elderly in the population increases rapidly, as it has in many OECD countries, then obviously increasing the baseline in line with inflation will not suffice to ensure the same level of health care.

In other countries, these issues might appear in different ways and in different sectors. Many emerging market countries are still in a stage of rapidly improving their transport infrastructure. China invested around 4.8 percent of GDP in transport infrastructure in 2022 (ten times the amount invested by the US in GDP terms). But more roads and increased traffic means more maintenance expenditure. If new roads are not maintained adequately their economic life can be drastically shortened from say 20 years to perhaps only six or seven years, and the high levels of capital investment that the government is so proud of will be used very inefficiently.

Infrastructure maintenance is not cheap, however. Developing and emerging market countries will need to spend anywhere between 1 and 3 percent of GDP to reach their SDG goals for the maintenance of their key infrastructure sectors. With the furious expansion of infrastructure in regions such as East and South-East Asia, baseline maintenance expenditure will need to keep up.

These are obvious examples of where baselines need to grow faster than inflation. However, often finance ministries do not allow baselines to reflect these “cost drivers”. The money is just not there according to finance officials, or, perhaps more truthfully, new investment and new policy initiatives are seen as more important. A more realistic definition of baselines could help redress this imbalance to some extent. Baselines should reflect the amount of spending needed to keep the “policy effort” the same, with policy effort defined as keeping the inputs per policy recipient the same. For example, if your student population is growing or the number of citizens eligible for government healthcare, such a definition would ensure that spending on education per pupil, or healthcare per citizen, remains constant in real terms.

This is still an input-based calculation. Even, better, but more complicated, is to define “policy effort” in output or even outcome terms. Maintenance expenditure is a good example where that is needed. Road maintenance baselines should aim to keep road quality at an agreed minimum level, and take into account not only the growth of the road network but also the number of road users. It would be strange to reduce your maintenance standards as road usage increases. So different baseline definitions may be needed for different expenditures.

While the case for incorporating obvious cost drivers, especially legal ones – think social benefits – is gradually resonating with finance officials in emerging market countries, more mundane expenditure is often not so lucky. Squeezing the baseline, even below the inflation rate, is considered a very good thing because, as I often hear, “there really is a lot of waste and inefficient expenditure” in the public administration caused by overstaffing, weak performance, unnecessary training and travel, too many meetings and official lunches, and so on.

That may be all well and good. And finance officials do often consider themselves as a small island of competency in a sea of inefficient and ineffective civil servants. But the question is: will reducing baseline expenditure really improve government performance? In the literature the possible “efficiency dividend” that can be reaped from a representative line ministry is often estimated at a maximum of 1 to 2 percent per year. But this is a rule of thumb from advanced economies where expenditure programs are often (initially) well-funded. Will such efficiency cuts improve efficiency and effectiveness of line ministry spending in the developing world?

Often there is not really much evidence for sizeable inefficiencies. Yes, some rather modest perks can be cut, but do these really amount to so much? Rather there is often evidence of low performance. And low performance is more often than not caused by a combination of underfunding, low institutional and human capacity, and weak management. Sometimes, development partner support has run out and the budget has been unable to compensate, sometimes trained people leave for the private sector.

Turning weak line ministries into centers of excellence is a long and arduous process. Squeezing operational expenditure is usually not the answer and often results in systematic underfunding and continued underperformance. Rather capacity building, leadership, change management, modernized business processes, accountability, and clarity on objectives and priorities are elements for government transformation, as well as adequate resources for the line ministries to do their job. So, please, don’t squeeze the baseline too hard!