PART I: What is public financial management?

Introduction
The first section of Part I explains the main public finance elements: expenditure,
revenues and the deficit/debt. The second section describes the concept of public
financial management and the third section elaborates the difference between
public financial management and public financial policy.


The main elements of public finance
Every government, regardless of its political orientation, needs resources
resources to pay the wages of civil servants, police officers and the army, and to
finance public utilities such as roads, for example. To finance these services,
every government needs to collect resources from the economy. If a government
spends more resources than it is able to collect, it has to borrow to finance its
deficit and it will build up debt. The focus of public finance is on a countrys
expenditure, revenues, deficit and debt and how these elements are linked (see
also text box 1).

Module 1: The budget General framework (Part I) 1

Text box 1: Expenditure, revenue, deficit and debt
Public expenditure, revenues, deficit and debt are linked aspects of public finance. If a country is
spending more than its revenues, it has a deficit. This excess spending has to be financed, so the
government has to borrow money to finance the deficit. Consequently, government debt rises. If the
government spends less than its revenues (which is less often the case), it has a surplus and it can
repay some of its outstanding debt. By doing this, the government can lower its interest payments,
creating more fiscal space for other spending.

Figure 1 presents the triangle of public finance with its main elements: expenditure, revenues and
debt. The arrows in the figure show the desirable direction and represent the usual preferences of a
government. Politicians in general prefer to have higher expenditure, lower taxes and a lower debt.
However, in practice it is impossible to achieve all three at the same time. An increase in expenditure
will lead to a higher deficit (and debt) unless revenues are increased. Therefore, public financial
management always has to deal with tensions between political wishes on the one hand and the public
finance reality on the other. Trade-offs need to be made.

Figure 1: Public finance triangle and political preferences

















Expenditure
Debt
Revenues Expenditure
Debt
Revenues



Note that the arrows in Figure 1 do not represent the technical relationship between expenditure,
revenues and debt. This would suggest that an increase in expenditure and a decrease in revenues will
lead to a lower debt. In reality, however, an increase in expenditure will lead to a higher deficit (and
debt) unless revenues are increased at the same time. Similarly, a decrease in revenues will result in
a higher deficit (and debt) unless expenditures are lowered at the same time. The only way to reduce
the public debt is either to lower government expenditure or to increase the revenues.
Module 1: The budget General framework (Part I) 2
What is public financial management?
The government has to extract resources from the economy to finance its
services. However, it should maintain control of the level of expenditures in
relation to the revenues that can be collected. Collecting tax should not harm the
national economy and should be done in an efficient and effective way.
Moreover, the government needs to use the resources in an efficient and
effective way, in line with the needs of the people. To do this, it needs a system
of institutions, rules, regulations, procedures and processes through which
decisions are made and implemented. This set of rules and processes is the
public financial management (PFM) system. Public financial management is
sometimes also called public expenditure management, because the focus is
often mainly on the expenditure side of the budget.

Public financial policy versus management
It is necessary to distinguish public financial management from public financial
policy. Public financial policy focuses on what is to be done. What should be the
level of government expenditure? What should be allocated to each sector? What
is the optimum level of taxation? What level of the fiscal deficit as percentage of
the Gross Domestic Product (GDP) is acceptable? Public financial management
focuses on how it is to be done. How to realise the desired level of government
expenditure? How to realise the desired reallocation of resources between
sectors? How to achieve the optimum level of taxation? How to control the fiscal
deficit?

Public financial management is instrumental in nature. PFM is the whole complex
of institutions, rules, regulations and processes that are in place to achieve policy
objectives. Public financial management and policy can be analysed separately,
although the objectives (policy) and the instruments (management) to achieve
these objectives can be seen as two sides of the same coin. Assessing public
financial management in a country can be done regardless of the countrys policy
choices, economic orientation or strategic priorities.


Objectives of PFM
Although PFM is instrumental in achieving public finance policy objectives, this
does not mean that PFM itself does not have objectives.

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The three main objectives of a public financial management system are to
achieve:

1. Aggregate fiscal discipline to control and achieve a sustainable balance
between revenues, expenditure and debt
2. Allocative efficiency to allocate resources to uses that reflect the
governments policy priorities
3. Operational efficiency to deliver public services efficiently and effectively.

Module 1: The budget General framework (Part I) 4