CHAPTER SEVEN

Budgeting and Expenditure

Management in Local Government
Nick Devas

Roles of financial planning and budgeting

There are three key roles for financial planning and budgeting in local government.
Firstly, policy-making involves setting expenditure priorities in line with policies and
plans, and then allocating the available resources in line with those priorities. The
policy-making role also involves choices about local tax rates, together with tariffs for
fees and charges, so as to generate sufficient resources to meet the planned expenditure.
Secondly, financial planning can be used as a management tool, to provide financial
information for the managers of services and programmes, to ensure that expenditure
programmes deliver value for money, and to monitor revenue and expenditure perform-
ance during the year. Thirdly, it can be a mechanism of control, through the authori-
sation of expenditures, prevention of abuse and fraud, and ensuring solvency by pre-
venting fiscal deficits.
Plans and budgets also serve as instruments for citizen participation and local govern-
ment accountability, enabling citizens and civil society to engage with local decision-
makers about the use of available resources, and subsequently to hold the local govern-
ment to account for their actual use.
Annual budgets should reflect longer-term development plans and policies, as well as
any medium-term financial and expenditure plans, such as a medium-term expenditure
framework (MTEF), which should provide the framework for the annual budget. The
longer the time scale, the broader the plan needs to be because of the degree of uncer-
tainty. Thus, long- and medium-term plans need to identify broad strategies, whereas
annual budgets need to be detailed for purposes of financial control.
Plans and budgets seek to identify:
• Objectives and targets for revenue and expenditure programmes
• Future expenditure needs
• Future resource availability
• Changes in circumstances which will affect needs and resources

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• Constraints and opportunities
• Strategies for achieving objectives within the constraints
• Priorities between alternative uses of resources.

Recurrent and capital budgets

It is normal to distinguish between recurrent and capital budgets (the former is some-
times referred to as the revenue budget). The recurrent budget covers all expenditures
for ongoing activities, including wages and salaries, operating costs, maintenance costs
and transfer payments (e.g. welfare payments and transfers to lower levels). It also
includes debt servicing (although the repayment of the principal element of debt serv-
icing may be treated separately in some budgeting systems).
Since the benefits of recurrent expenditure are used up during the course of the year, it
should be financed from current income: taxes, charges and recurrent grants, and not
from borrowing or asset sales.
Capital expenditure involves the creation or acquisition of new assets which last for
more than one year (‘lumpiness’), which can be financed from capital receipts (borrow-
ing, asset sales or capital grants), as well as from recurrent income. However, the dis-
tinction is not always clear: small items which last for more than one year (e.g. books)
are usually classified as recurrent.
Some countries adopt different definitions, e.g. plan and non-plan in India, routine and
development in Indonesia. These distinctions may have an economic justification
(consumption versus investment), but they may have distorting effects (failure to spend
money on maintenance means that ‘development’ expenditure has to be incurred to
rehabilitate the asset). It may also blur the distinction about the appropriate way to
finance the expenditure.
It is critically important that capital financing (borrowing or asset sales) is not used to
finance recurrent expenditure, since that is unsustainable. In some systems (e.g. in
some central and eastern European countries), the absence of separate capital budgets
has meant that when capital assets (e.g. local government-owned property) were sold,
the receipts were used up on current expenditure. However, too great a separation
between capital and recurrent budgets can create other problems. When planning the
financial requirements of a service, it is necessary to consider both recurrent and capi-
tal expenditures together, since effective and efficient provision of a service requires an
appropriate combination of capital and recurrent spending.

The sub-national government budget preparation process

The budget preparation process usually occupies most of the year preceding the budget.
It involves a number of stages.

90 Financing Local Government

a) Reviewing the context and planning framework
This should take account of:
• National, regional and local long- and medium-term development plans, policies and
priorities; the annual budget should be seen as the mechanism for implementing
such plans and strategies by allocating resources to them;
• The medium-term expenditure framework, which determines the parameters for the
annual budget – as such, the budget represents the first year of a three-year rolling
plan and the annual budgeting process will be largely about fleshing out the details;
• A review of actual performance of revenues and expenditures during the current and
previous years, against the budgets for those years;
• The opportunities for citizens to participate in identifying the needs and priorities of
the locality, and whether that process takes account of different interests, for example
those of poor and marginalised groups, rather than reflecting only the views of the
vociferous and well connected.
b) Revenue forecasting
This should not be just trend extrapolation, but should be a realistic assessment of the
previous year’s actual revenue performance and the factors that may affect revenues in
the coming year, including exogenous factors which may affect revenue (e.g. changes
in the local or national economy and changes in government policy which may affect
local revenues). It should also take account of the scope for increasing revenue collec-
tion performance (increased effectiveness – but this needs to be realistic, so as to avoid
revenue shortfalls during the year), and for revising tax and charge rates (especially
those fixed in money terms) in line with inflation, and projecting the impact on the
revenues of higher tax rates.
c) Estimating expenditure requirements
Recurrent expenditure estimates should:
• Be based on current commitments (i.e. the continuing costs of current services);
• Adjusted for inflation (this is usually best handled centrally by the finance depart-
ment on a consistent basis for the whole budget, with spending departments prepar-
ing proposals at constant prices);
• Identify potential cost savings from greater efficiency or alternative ways of deliver-
ing services;
• Incorporate new commitments (recurrent cost implications of new commitments,
e.g. operations and maintenance, and the debt-servicing implications of capital
developments; effects of changes in national legislation or requirements; effects of
approved changes in policy);

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• Add in costs of proposed improvements to service provision.
It is important that estimates prepared by departments within the local government
should be based on adequate guidance in advance from the municipal finance depart-
ment about resource limits and policy priorities. This enables those managing the serv-
ices to plan realistically within the resources available. In the absence of such guidance,
spending departments are likely to bid high (‘pad their bids’) in the expectations of
cuts, obliging the central finance department to make arbitrary decisions about cuts in
budget proposals later in the process. However, this does require an appropriate mech-
anism for making broad resource allocations between departments or sectors. These are
strategic choices which need to be made by elected representatives through a proper
policy process based on agreed objectives and strategies.
Capital expenditure requirements will include previously agreed projects and proposed
additional projects. Ideally, all projects should be subject to proper project (cost bene-
fit) appraisal as part of the planning process, and future recurrent cost implications
should be identified.
d) Balancing the budget
Invariably, expenditure needs exceed available revenue. Difficult choices have to be
made. The options are:
• Increasing revenue, by raising tax or charge rates (but forecasted revenues need to
be realistic, since unrealistic forecasts can lead to unplanned budget deficits or
unplanned expenditure cuts during the year);
• Cutting expenditures;
• Drawing down reserves – if they are available;
• Budgeting for a deficit – something which no system of decentralised government
finance allows.
Balancing the budget is essentially a political process. Although the municipal finance
department may manage the process, ultimately decisions need to be taken by elected
representatives, since these are strategic choices. The process needs to be as open and
transparent as possible, and it must be guided by agreed policies and strategies of the
elected council.
e) Formal approval of the budget
Approval must be given before the beginning of the financial year if budgetary control
is to be effective. As well as approval by the elected council of the local government,
the central (or state/provincial) government may have to give its approval. Delays in
approval undermine the budget as a tool of expenditure management.

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Some issues in local government budgeting
Input versus output budgets
Most conventional budgets are prepared in input terms: line items for wages/salaries,
materials, transport, etc. Such budgets are useful for controlling expenditure, but give
no indication of output, and nothing against which performance can be judged.
Ideally, budgets should be based around expenditure programmes with clear objectives,
service standards, outputs and performance targets. Programme outputs can then be
linked to the input costs in line-item terms needed to achieve the outputs. However,
outputs and performance targets may be difficult both to specify and to measure. PPBS
(programme performance budgeting system) is the classic form of programme budgeting,
but is generally regarded as too complex and elaborate. Nevertheless, some attempt to
specify outputs and performance targets, and to relate inputs to outputs, is essential if
resources are to be better used. Without an indication of outputs, the only measure of
performance is whether the money is spent, rather than what has been achieved.

Incremental budgeting
Most conventional budgets are incremental: planned expenditures are based on the
previous year’s expenditures plus an allowance for inflation or service improvements.
Such budgeting is easy to do and offers relatively stability. However, it never challenges
whether the activity is really necessary, or whether it could be carried out in other more
efficient ways.
Bean and Hussey (1998) have summarised the advantages and disadvantages of incre-
mental budgeting:

Advantages Disadvantages
• Simple • Historic
• Quick • No account taken of necessary future
• Accurate if little change in activity changes
• Assumes the base is accurate
• Compounds historic errors

Zero-based budgeting
Zero-based budgeting (ZBB) is one alternative to incremental budgeting, but is gener-
ally regarded as over-elaborate and unrealistic in most situations. However, selective
use of ZBB can be valuable, for example, taking a particular service where there may be
large inefficiencies and specifying from scratch what is required to achieve the out-

Financing Local Government 93

put objectives and the costs of achieving these outputs. Contract specification for
contracted-out (or out-sourced) services is a comparable process to ZBB, since it requires
outputs and performance to be clearly specified in advance.
Some of the advantages and disadvantages of ZBB are shown in the box below (Bean and
Hussey, 1998).

Advantages Disadvantages
• Proactive • Time-consuming
• Realistic and accurate • Requires clear objectives
• Links into business plans • Many organisations do not have a
zero base, as they have to work with
the staff, buildings and resources they
inherit from year to year

Realistic revenue forecasts

The tendency of municipal governments in some countries is to inflate revenue fore-
casts to fit the projected level of expenditure, thereby pretending to show a balanced
budget. This can be highly damaging, since actual revenue collection will fall well short
of the forecast, with the result that the local government will run out of money during
the year and arbitrary cuts will have to be made. This undermines the legitimacy and
accountability of the budget process, and puts power into the hands of a few people
(e.g. the mayor or the finance director) to make arbitrary allocation decisions during
the year (Devas, 2003).

Unintended commitments
It is important to avoid unintended commitments. These can arise where approval is
given to make a start on a major capital project without taking adequate account of the
capital and recurrent cost implications in future years. Once the full costs become
apparent, it may be politically difficult to abandon the project. This strategy is often
used by project managers to establish incremental commitments to projects.

Consolidated budgets
Proper choices about resource use and transparency of decision-making require that all
resources are treated together in one budget. While there may be separate accounts for
specific services, these should all be brought together in one consolidated budget. The
non-transparent nature of ‘extra-budgetary’ accounts and special funds provides scope
for corruption and clientelistic decision-making.

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Participatory budgeting
In Brazil, municipal governments have experimented with participatory budgeting
(PB). Under PB, local communities are able to consider expenditure priorities affect-
ing their neighbourhood (Souza, 2001). These are fed through into the municipal
budget. Although the range of choice is often quite limited (city governments still
exert tight control over the process), it has resulted in some redirection of expenditure
towards the poor, wider participation of previously excluded groups and greater trans-
parency over budgetary decisions.
The model has been emulated by local governments in a number of countries. There are
also other ways in which greater participation in budgetary choices can occur:
• Giving local elected councillors a small budget for local priorities identified through
a participatory process (although this tends to reinforce the clientelistic relationship
of councillors with their electorate, as well as potentially giving an unfair electoral
advantage to the incumbent);
• Giving ‘area committees’ of the elected council some spending powers in relation to
their area;
• Establishing lower levels of elected local governance below the municipality, each
with their own resources and budgets (Devas, 2003).

Expenditure management
a) Financial procedures
Expenditure management procedures need to define rules about authorising orders and
payments, checking bills and recording payments. They must also include a method for
approving virements, also known as re-appropriations (that is, the ability to move
resources between budget heads).
Virements allow a degree of flexibility to deal with unforeseen or changed circum-
stances. A balance is required between the need for flexibility and the need for control
– if there is too much flexibility, the budget does not serve the purpose of determining
what happens.
b) Revised or supplementary budgets
Unforeseen or changed circumstances can also be handled by revised or supplementary
budgets during the course of the year, but these undermine the credibility of the origi-
nal budget. Frequent revisions make nonsense of the budgeting process, and revised
budgets may be subject to less rigorous scrutiny than the original budget, raising issues
about political choices and transparency. There is also the problem of where additional
resources come from, if they are needed. If budgets are revised so that they can allocate

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surplus revenue, it might be better to retain the surpluses and allocate them through
the proper budgeting process in the following year.
c) Financial information system to monitor budget implementation
There is a need for an effective financial information system to provide programme
managers with timely financial information and to provide finance staff with informa-
tion on the progress of the budget, including providing early warning of problems such
as over- or under-expenditure or of shortfalls in revenue. Such information needs to be
provided in a timely manner and in a format which makes identification of problems
easy. Computerisation can help, providing systems are properly designed.
d) Final accounts, auditing and accountability
Final accounts need to be produced on time, say within six months of the end of the
financial year, and submitted to the elected council. They should be audited by an
independent external auditor (usually appointed by central government), and the audi-
tor’s report should be submitted to the elected council. In addition, there should be
systems of internal audit, concerned with ensuring that systems are secure and prevent
fraud. Both internal and external audit should be concerned not just with probity but
also with effectiveness (achieving objectives or targets), efficiency (costs of services)
and value for money. Information on budgets, accounts and audit reports should be
made available to the public in ways that can be easily understood, as a means of hold-
ing the local government to account. (See chapter 8 for more detail on accounting and
auditing.)
e) Decentralised financial management to cost or budget centres
These days, it is common for at least some financial management responsibilities to be
decentralised to service managers within the local government – whether departmental
heads or lower level managers who are responsible for particular services. The units to
which financial management responsibility is decentralised are usually called cost
centres or budget centres (or profit centres if they are net revenue generators). In the
UK, a prime example is the decentralisation of financial management to school
governors. Heads of local government contractor units also have to have a high degree
of decentralised financial responsibility if they are to compete with private sector con-
tractors in competitive tenders.
Decentralised financial management requires the manager to deliver specified service
levels and performance within an approved budget. It has the advantages of encourag-
ing service managers to:
• Plan so as to make the best use of available resources, rather than ‘padding’ their
budget submissions for others (e.g. the central finance office) to cut;
• Use available resources most efficiently – efficiency improvements are rewarded by

96 Financing Local Government

being allowed to retain some or all of the savings within the budget centre to use to
improve the service or reward staff, rather than being penalised by having to return any
efficiency savings to the Treasury at year end;
• Collect all the revenue due for the service, since increased revenue means more
resources available for the service.
However, decentralised financial management requires a proper system for deciding on
the initial allocation of resources to each service, and proper specification of output or
service levels and performance targets. There must also be systems of monitoring
performance against targets, so as to hold service managers accountable, and financial
controls to prevent misuse of resources. Service managers need skills in financial man-
agement, although they can be assisted by specialist finance people. The success of
decentralised management also depends on an ‘internal market’, so that cost centres can
trade with each other, e.g. buy services from one another (and perhaps from an exter-
nal agency).
f) Cash-limited financial management
Where financial pressures are severe, and/or revenues are difficult to forecast, a system
of cash-limited budgeting may be introduced. Under such a system, the finance depart-
ment releases only the money that is received in the previous month, even if it is less
than what is in the budget. This ensures that a deficit is not incurred.
While, under certain circumstances, cash-limited budgeting may be necessary, it tends
to negate the purposes of the budget process as a means of managing expenditures in a
stable and consistent manner, and can prevent the achievement of other strategic
objectives. A better approach is to base budgets on more conservative and realistic
revenue forecasts, and then adhere to those budgets. If actual revenues prove to be
better than forecast, the surpluses can be added to reserves for use in subsequent years.
However, such prudence is often difficult to achieve when both local politicians and
officials demand greatly increased expenditure.

Financial management and the control of corruption

Decentralisation potentially puts more public resources at risk, in the sense that more
resources are handled at locations remote from direct central controls, with more people
having an influence on how the resources are used. Therefore, decentralisation may
disperse corruption more widely, although it may not increase the overall level of
corruption – indeed, it may help to curb it through greater accountability. Empirical
evidence on the relationship between decentralisation and corruption is very mixed:
for a review of the evidence from the various studies (Fjeldstad, 2004).
Nevertheless, achievement of the Millennium Development Goals requires services to
be delivered throughout the country, and this requires finances to be managed in a

Financing Local Government 97

decentralised manner, whether through local agencies of the central state or through
devolved local governments. Therefore, whatever the particular mechanisms of service
delivery at the local level, attention needs to be paid to financial management systems
at the local level, and the capacity of both local citizens and central government to
monitor resource use locally. This will involve developing secure revenue collection
arrangements to prevent loss, collusion and fraud; record-keeping and accounting
systems that inhibit fraud and provide automatic cross-checks; and public access to
information about resource availability and use, to promote greater accountability to
citizens. It will also require effective and transparent procurement and tendering
arrangements, and effective auditing systems, including the development of national
level, external audit capability, and systems that ensure that local governments act
upon the results of external audits.
Given limited financial management capacity at the local level, this is quite a tall
order, and there is no doubt that the lack of financial management capacity at the local
level is one of the main obstacles to effective decentralisation. Central support in terms
of skills training, development of appropriate financial management systems and cen-
tral monitoring systems are all needed. However, this is also constrained by the limited
capacity at the centre in many countries: capacity to know what is going on at the local
level, and to take action to rectify failure. Rent-seeking behaviour by central officials
and political disputes further weaken the ability of the centre to oversee local govern-
ment finances. However, it is important to stress again that these are problems inher-
ent in any system that seeks to deliver services, and therefore finance, across the coun-
try: they are not unique to decentralised (devolved) systems of government.

Reforms in financial management

Specific reforms to financial management that have been adopted in various places in
recent years include:
a) Simplifying accounting systems and making them more transparent; this may include
the use of accruals accounting for expenditure, to ensure that expenditure obliga-
tions incurred appear in the accounts, even if bills have not been paid;1
b) Computerisation of revenue collection and accounting systems, with appropriate
safeguards, to facilitate cross-checking and reduce opportunities for individual dis-
cretion and manipulation;
c) Paying grants directly from the Ministry of Finance to the bank account of the sub-
national government or institution for which it is intended, to prevent money being
sliced at intermediate stages;
d) Simplifying grant systems to increase transparency and public understanding, and
publicising information about formulae and allocations, including requiring public

98 Financing Local Government

 display of information about resources for particular facilities, services or projects,
as in Uganda;
e) Avoiding multiple funding sources for the same activity, which can be used to dis-
guise how the funds are used;
f) Requiring the submission of photographic records of project implementation;
g) Selective use of independent expenditure tracking studies to trace the use of funds
(Ablo and Reinikka, 1998; Dehn et al., 2002);
h) Clear rules about public procurement, specification of codes of conduct for local
officials and elected representatives, and arrangements for asset declarations by
elected representatives and senior officials;
i) Systems of monitoring local government performance that feed into the grant
system, as used in Kenya and Uganda;
j) Building local accountability through citizen report cards (India), citizen charters,
participatory budgeting (Brazil) and access to information.
All this requires a change of culture and practice within central government.
Decentralisation involves a shift from a direct role in service delivery to one of enab-
ling and monitoring the work of local governments and other agencies at the local
level. This requires the building up of capacity to monitor and verify effectively, and
systems that minimise the scope for monitoring to be undermined by rent-seeking
behaviour. It also requires central government to play its role within the system
properly: dealing promptly with requirements for approval, paying agreed grants and
revenue shares on time, and seeking to reinforce good practice at the local level.

Note
1 Under a cash accounting system, it is possible for unpaid debts to accumulate without these
being apparent from the accounts. This has resulted in huge problems of inter-agency arrears
in many countries, including Kenya, and has disguised the fact that many local authorities
are effectively insolvent. On the other hand, use of accruals accounting on the revenue side
can present a dangerously misleading picture where revenue collection performance is poor,
since unless the debtors position is examined, what the accounts show is the revenue due
rather than what has actually been received.

Financing Local Government 99

References and further reading
Ablo, E. and Reinikka, R. (1998). Do Budgets Really Matter: Evidence from Public
Spending on Education and Health in Uganda (World Bank) (available on World
Bank website)
Bean, J. and Hussey, L. (1998). Managing the Devolved Budget. London: HP
Publications.
Blore, I., Devas, N. and Slater, R. (2004). Municipalities and Finance: A Sourcebook for
Capacity Building. London: Earthscan. Chapters 6, 7 and 8 provide examples of improved
budgeting and financial management.
Dehn J., Reinikka, R. and Svensson J, (2002). Survey Tools for Assessing Service Delivery.
Washington, DC: World Bank.
Devas, N. (2003). ‘Can City Governments in the South Deliver for the Poor: A
Municipal Finance Perspective’, International Development Planning Review, 25 (1):
pp. 1–29.
Fjeldstad O.-H. (2004). Decentralisation and Corruption: A Review of the Literature.
Bergen, Norway: Chr. Michelson Institute.
Premchand, A. (2005). Controlling Government Spending: The Ethos, Ethics and
Economic of Expenditure Management. New Delhi: Oxford University Press.
Souza, C. (2001). ‘Participatory Budgeting in Brazilian Cities: Limits and Possibilities
in Building Democratic Institutions’, Environment and Urbanization, 13(1): 159–84.

100 Financing Local Government