Ending the Confusion on Medium-Term Expenditure Ceilings

Expenditure ceilings are a key instrument for achieving the objectives of medium-term budgeting. This is why the question of how to set appropriate and workable expenditure ceilings has been a major focus of public financial management over the past two decades. Erroneous notions as to what constitutes best practice in ceiling-setting have, however, been a major problem. Discussion of the topic has been further confused by the use of the term ceiling in several different senses which are often not clearly distinguished. What follows aims to help dispel this confusion.

What I and many other people have in mind when we talk about expenditure ceilings as a key instrument of medium-term budgeting is the use of multi-year aggregate expenditure ceilings to constrain spending decisions during the preparation of the budget. The multi-year aggregate ceilings are, approximately speaking, estimates of the total amount the government can spend in the coming fiscal year and each of the later (“outer”) years of the medium-term timeframe while meeting its aggregate fiscal policy objectives (such as keeping debt at targeted levels). During budget preparation, the government ensures that the decisions it takes do not push total spending above these aggregate ceilings. The ceilings constrain the entire process of putting the budget together, and can be changed during that process only under very limited circumstances (n1).

This “top-down” approach to budgeting is an effective way of achieving the central objective of medium-term budgeting, which is to ensure that all expenditure and revenue decisions are consistent with aggregate fiscal policy objectives. This helps the government stick to its fiscal policy objectives. It also improves expenditure quality by helping to avoid the situation where governments make major decisions about new spending measures and capital projects only to find themselves forced at some later point to cancel them or slow down project execution because of a lack of sufficient funds. The medium-term framework thus reduces spending ministry uncertainty about their future budgets.

The two points to note about this conception of the core role of ceilings in medium-term budgeting are that:

  • It assigns a central role to aggregate expenditure ceilings and
  • These expenditure ceilings apply only during the budget preparation process. They are what I have elsewhere called “planning” ceilings.

In what follows, I will refer to this as the “core” concept of the role of expenditure ceilings in medium-term budgeting.

The key point is that, beyond this core concept, most other ideas of what constitutes “best” or “advanced” practice in ceiling-setting are wrong. I critiqued one such idea — the proposition that medium-term budgeting requires the setting of hard ministry budget ceilings at the start of the budget preparation process — in an earlier blog piece. There are, however, three other similarly misguided propositions that are often put forward, namely:

  1. That fixed outer-year aggregate expenditure ceilings represent advanced practice, whereas indicative aggregate ceilings are a less advanced and inferior form of medium-term budgeting.
  2. That setting fixed outer-year budget ceilings for ministries constitutes advanced practice in the same sense.
  3. The expenditure ceilings used during budget preparation should also be applied during budget execution.

In what follows, I examine the first of these propositions. I will return to the others at a later stage.

Fixed Multi-Year Ceilings?

The proposition that setting fixed aggregate expenditure ceilings for the outer years of the medium-term framework constitutes best practice is an example of the phenomenon — unfortunately quite common — in which the approach taken by certain advanced countries is deemed to be best practice notwithstanding that other advanced countries take different and equally effective approaches.

The fixed outer-year ceilings doctrine is perhaps less dominant than it was, say, a decade ago (n2). Nevertheless, it continues to command the loyalty of people in surprising places. An example can be seen in a recent IMF paper which identifies what it sees as four phases in the development of medium-term budgeting systems, and asserts that fixed multi-year ceilings (n3) are one of the defining features of phase IV (the “Advanced MTBF”). Indicative (non-fixed) outer-year ceilings are, by contrast, deemed in this paper to be a feature of the less developed (and inferior) phase of medium-term budget development (phase III – “Maturing MTBF”).

To understand what is at stake here, consider the practical application of the “core” concept outlined above of how ceilings should be used in a medium-term budgeting framework. Concretely, it means that in preparing the budget for 2023-24, the government will be guided by aggregate ceilings not only for that year, but also by the ceilings for 2024-25 and 2025-26 (the two outer years). Spending decisions taken at that time must not, when taken in conjunction with pre-existing “baseline” expenditure, result in projected expenditure exceeding the aggregate ceilings in any of these three years.

The issue of fixed versus indicative ceilings pertains to the status of the outer-year aggregate expenditure ceilings when those years arrive. In the context of our example, this refers to what happens to the aggregate ceilings for the outer years (2024-25 and 2025-26) when, twelve months later, it is time to prepare the 2024-25 budget or, twenty-four months later, it is time to prepare the 2025-26 budget.

In a system of fixed outer-year ceilings, the aggregate ceilings for these years which were used during the preparation of the 2023-24 budget will remain unchanged (n4). In other words, if at the time of the preparation of the 2023-24 budget it was envisaged that aggregate expenditure in 2024-25 should not exceed $X trillion, then this same $X trillion limit will be applied when it comes to preparing the budget for 2024-25. The ceiling set previously for the other outer year (2025-26) will also remain unchanged. 

The most prominent example of this approach is Sweden.

By contrast, in a system of “indicative” outer-year ceilings, the aggregate expenditure ceilings are reset each year, taking into account current circumstances (such as any relevant changes in the macroeconomic environment and revenue forecasts). This means that the aggregate ceiling for 2024-25 which is applied during the preparation of the 2024-25 budget may —and probably will — differ to some extent from the aggregate ceiling for that year which was applied during the preparation of the 2023-24 budget.

The IMF paper justifies its claim about advanced practice with the assertion that “many advanced countries make use of binding multi-annual ceilings on spending.” It would, however, be more accurate to say that some advanced countries take this approach. Many advanced countries with well-developed and effective medium-term budgeting systems do not set fixed outer-year ceilings.

Germany is a notable example of such a country. Its medium-term budgeting system is long-established and highly effective. Budget preparation is constrained by multi-year ceilings (“benchmark decisions”), but these ceilings are revised during every budget cycle.

It is in no way clear that fixed outer-year ceilings are superior to indicative ones. Experience shows that whatever the advantages of fixed outer-year ceilings are, there are also disadvantages. Setting an aggregate ceiling this year for the financial year three years in the future, and insisting that it must remain unchanged when that year arrives, creates an increased risk of departure from the government’s fiscal policy objectives due to changed macroeconomic or other circumstances. Refusing to update the aggregate ceiling may result in a deficit higher than acceptable levels if trend revenue has fallen. Treating the outer-year ceilings as fixed substantially increases the potential cost of forecasting errors incorporated into the outer-year ceilings.

Underlying this is a fundamental point. This is that, although medium-term aims both to improve adherence to aggregate fiscal policy objectives and to reduce spending ministry uncertainty about their future budgets, there is a tension between these two aims. The design of the medium-term budgeting system necessarily involves making a trade-off between them. A system of fixed outer-year ceilings sacrifices some of the former for more of the latter. A system of indicative outer-year ceilings does the reverse.

The best way of viewing fixed outer-year ceilings is as one of a number of design options for a medium-term budgeting system, the appropriateness of which depends, amongst other things, upon specific country characteristics.

The above discussion has focused on design choices for advanced countries. However, it should also be noted that characterizing fixed ceilings as advanced practice runs the risk of encouraging some developing countries to “go for gold” by attempting to implement fixed multi-year ceilings. Yet fixed outer-year ceilings are particularly inappropriate in the circumstances of most developing countries.

Finally, let me mention that Australia — my country of origin — has operated a highly effective medium-term budgeting system for approximately four decades. There is no obvious way in which this system is inferior to that of, say, Sweden or the Netherlands. Yet there are no fixed outer-year ceilings in Australia (n5). Clearly, we need to be extremely cautious in making assertions about what constitutes best — or “advanced” — practice.

1 The most important of which is usually that the government makes tax policy changes which significantly raise or lower revenues, and which thereby affect how much can be spent while respecting aggregate fiscal policy objectives.

2 When, for example, the European Commission was advocating them (see Public Finances in the EMU 2010, p. 107).

3 ”Binding” in the paper’s terminology.

4 Apart from possible limited technical changes, such as for inflation.

5 In fact, the Australian approach does not even rely on expenditure ceilings at all. But that is another story, and does not weaken the general case for the “core” concept of the role of ceilings in medium- term budgeting.

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