INTRODUCTION Chapter 1

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In what many characterize as the information age,1 it is to be expected that any book dealing with large organizations operating in the world economy would focus extensively on information. This book is about complex governmental insti- tutions that operate in a world economy and society, and its extensive focus on information is no surprise. This book is about budgets, budgeting systems, and budgeting processes; the nature of the decisions that are made; and the processes by which those decisions are made. As we discuss throughout the book, budget- ing has always been about information, and budget systems are about gathering the best information available, whether that information be primarily of a techni- cal nature or primarily of a political nature, and bringing that information to bear on decisions about allocating resources to purposes.

Public budgeting involves the selection of ends and the selection of means to reach those ends. It involves the division of society’s economic and financial resources between the public sector and the private sector as well as the allocation of such resources among competing public sector needs. Public budgeting sys- tems are systems for making choices of ends and means. These choices are guid- ed by theory, by hunch, by partisan politics, by narrow self-interest, by altruism, and by many other sources of value judgment including avarice and perceptions of the public interest.

Public budgeting systems work by channeling various types of information about societal conditions and about the private and public values that guide resource allocation decision-making. Complex channels for information exchange exist. Through these channels, people process information on what is desired, make assessments of what is or is not being achieved, and analyze what might or

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might not be achieved. Integral to budgeting systems are intricate processes that link both political and economic values. In making decisions that ultimately deter- mine how resources are allocated, the political process uses sometimes bewilder- ing and often conflicting information about values, about actual conditions, and about possible condition changes. This book is an analysis of procedures and methods—past, present, and prospective—used in the resource allocation process.

This chapter examines some basic features of decision-making and budgeting systems. First, some major characteristics of public budgeting are explained through comparison and contrast with private forms of budgeting. Second, the development of budgeting as a means of holding government accountable for its use of society’s resources is reviewed. Next, budgets and budgeting systems are defined. Finally, the role of information in budgetary decision-making is considered.

Distinctions Regarding Public Budgeting

Budgeting is a common phenomenon. To some extent, everybody does it. People budget time, dollars, food—almost everything. The family hardware store budg- ets, Wal-Mart budgets, and governments budget. Moreover, important similarities exist in the budgeting done by large public and private bureaucracies.2

Budgeting is intended as a mechanism for setting goals and objectives, for allocating the resources necessary to achieve those objectives, for measuring progress toward objectives, for identifying weaknesses or inadequacies in organ- izations, and for controlling and integrating the diverse activities carried out by numerous subunits within large bureaucracies, both public and private. Budgeting is the manifestation of an organization’s strategies, whether those strategies are the result of thoughtful strategic planning processes, the inertia of long years of doing approximately the same thing, or the competing political forces within the organization bargaining for shares of resources. Once resources are allocated through the budgetary process, the organization’s strategies become apparent even if they have not been articulated as strategies. Budgeting means examining how the organization’s resources have been used in the past, analyz- ing what has been accomplished and at what cost, and charting a course for the future by allocating resources for the coming budget period. Whether this process is done haphazardly or after exhaustive analyses, whether it is carried out by order of the chief executive officer or requires the extensive input of citizens, it is still budgeting.

Budgeting is also about assigning responsibility for accomplishing the results intended by the executive and legislative actors that ultimately set the public budget. Budgets are executed by individuals generally within large bureaucracies. Budget

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allocations identify not only the amounts to be spent and the intended purposes of those expenditures, but also the unit within the bureaucracy—and by implication, the individuals managing that unit—responsible for achieving the intended results. In the contemporary age in which much of the value in any process, whether producing a commercial good or producing a public service, is in the information or knowledge applied, responsibility for budget decisions and budget implementation is vastly more complicated. First, the information available to the decision makers, whether they choose to use it or not, is much more extensive. Second, decision-making process- es are more highly visible to citizens and other stakeholders. Thus, for practical rea- sons, and because strong central government controls are politically less feasible than in the past in most countries, budgetary decisions are more decentralized than ever.

Public and Private Sector Differences in Objectives

Resource Availability. Important differences exist between the private and public spheres. In the first place, the amount of resources available for allocation in the budget process varies greatly. Both family and corporate budgeting are constrained by a relatively fixed set of available resources, even if vastly different in size. Income is comparatively fixed, at least in the short run, and therefore outgo must be equal to or less than income. Of course, income can be expanded by increasing the level of production and work such as a member of the family taking a second job, or tem- porarily by borrowing, but the opportunities for increasing income are limited.

Governments, on the other hand, are bound by much higher limits. In the United States at least, government does not use nearly all of the possible resources available. Only in times of major crises, such as World War II, has the government of the United States begun to approach the limits of its resources. Then the federal government borrowed an amount that eventually came close to equaling the total production of the economy in a year. Rationing, price controls, and other measures were imposed so as to limit severely private sector consumption and instead allo- cate most of society’s resources to the government. During other times, much is left to the private sector with government using only a fraction of society’s work force, goods, and services. In 2005, combined federal, state, and local government receipts amounted to just over 31% of total gross domestic product (GDP), with about three-fifths of that being the federal government. That percentage has varied little, from about 25% to about 30% since 1960.3 Government has the power to determine how much of the society’s total resources will be taken for public pur- poses. Private parties operate within the limits of their ability to acquire resources through their market activities: selling their labor, selling goods, and so forth.

Profit Motive. Another major distinction between private and public budgeting is the motivation behind budget decisions. The private sector is characterized

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by the profit motive, whereas government undertakes many things that are financially unprofitable. In the private sector, profit serves as a ready standard for evaluating previous decisions. Successful decisions are those that produce profits (as measured in dollars). Some companies of course may focus on short-term profits, and others may take a longer-term view, but in the end, failure to achieve a profit or at least break-even means the company goes out of business.

The concept of profit, however, can lead to gross oversimplifications about corporate decision-making. Not every budget decision in a private firm is deter- mined by the criterion of making an immediate profit. Sometimes corporations forgo profits in the short run. In the case of price wars, they attempt to increase their share of a given market even if it means selling temporarily at a loss. At other times, they incur large debts and take other apparently unprofitable actions to combat a hostile takeover, an attempt by an outsider to purchase enough stock to exercise control over a corporation’s assets. Sometimes their major objectives are to produce a good product and to build public confidence. They have enough con- fidence in their pursuit of customer service that the result will be sustained, long run profits. At other times they undertake actions for mainly social motives, wish- ing to make a contribution to the society that sustains their corporate existence, a concept known as corporate social responsibility or CSR.4 Still in private sector firms, revenues must exceed costs over the long run.

Large firms also budget significant resources for research and development (R & D) activities, only a few of which eventually will lead to a product that gener- ates large sales and profits. An R & D division can be evaluated over the long term by how many of its developments contribute to profits, but this kind of evaluation is difficult. Often, the results of R & D are subtle improvements in existing prod- ucts and measuring the amount of investment relative to the incremental profit gain is impossible. In this regard, private budgeting for R & D is no less difficult than the federal government’s support of R & D.

Overall, the evidence is that investing in R & D yields positive returns on that investment.5 A Congressional Budget Office review of studies estimating the value generated by R & D expenditures noted that although precise achievements are difficult to estimate, R & D spending does yield positive returns.6 A National Academy of Sciences panel studied five federal agencies’ implementation of the Government Performance and Results Act of 1993 to measure the results of their research and development activities. The study noted that the benefits of research are difficult to assess, concluding that “the most effective technique for evaluating research programs is review by panels of experts using the criteria of quality, rel- evance, and, when appropriate, leadership.” 7

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Regardless of the role profit plays in the private sector, government decision making in general lacks even this standard for measuring activities. Exceptions to this generalization are government activities that yield revenues. State control and sale of alcoholic beverages, whether undertaken for profit or for regulation of pub- lic morals, can be evaluated, like any other business, in terms of profit and loss. Similarly, the operation of a water system, a public transit authority, or a public swimming pool can be evaluated in business profit-and-loss terms. This does not mean that each of these should turn a profit. After all, operating a public swim- ming pool may be the result of a decision to provide subsidized recreation to a low-income neighborhood whose residents cannot afford other private recre- ational alternatives. The budgeting process, however, can be used to assess the operation as a business to clarify the subsidy level and to aid decision makers in comparing costs with those for other public services provided free of direct charge (see Chapter 12).

Nevertheless, the majority of private sector budget decisions pertain to at least long-term profits, and most public sector budget decisions do not. Governments undertake some functions deliberately instead of leaving them to the private sector. Public budgetary decisions, for example, frequently involve allocation of resources among competing programs that are not readily suscepti- ble to measurement in dollar costs and dollar returns. For example, there are no easy means of measuring the costs and benefits of a life saved through cancer research, although the value of future earnings sometimes is used as a surrogate measure of the value of life. The U.S. government undertakes large programs to control or eradicate malaria and other tropical diseases, not based on economic or financial returns, but on a broad concept of the public interest in eradicating dis- eases that affect low-income populations in developing countries. Nor is there a ready means of clearly separating private incentives from public incentives. For example, although the National Cancer Institute spends millions of public dollars annually on cancer research, the amount is minuscule compared with the amount spent by private companies on research for cancer prevention and treatment.

Just because most public sector activities are not intended to be profitable, it does not mean that business-like measurement of results in relation to costs is use- less. Although not susceptible to bottom-line or profit-and-loss measurement, many government programs are able to measure their results in terms of output (efficien- cy) and outcome (effectiveness). The tropical diseases eradication programs under- taken by the U.S. government for reasons of the public interest, for example, can and are measured by the efficiency and effectiveness with which the programs are imple- mented.8 Legislation passed in 1993 mandated the use of performance measures to improve the federal government’s accountability for the results of its expenditures.9

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Public and Private Sector Differences in Services Provided

Public Goods. Some government services yield public or collective benefits that are of value to society as a whole, whereas, corporate products are almost always con- sumed by individuals and specific organizations. When Ford Motor Company produces automobiles, persons buying the automobiles use them to meet their own personal needs. When the Departments of Defense and Homeland Security produce a network for preventing nuclear devices from entering the nation’s ports, that network benefits the public in general. Economists call these kinds of products and services public goods. They have two properties. The first is nonex- cludability. Once the network is in place, no one can be excluded from its benefits.10

The second is nonrivalness. One person’s use of the good or service does not dimin- ish another person’s use. For example, a second person can “consume” national defense without lessening the benefits that the first person gets from that public good. Of course, few public products and services qualify as pure public goods, and many goods and services produced by governments are also produced by the private sector. Police protection is a public service, but communities, companies and even individuals also purchase from private security companies various forms of protection against crime.

Externalities. Another class of government services consists of those from which individuals can be excluded but for which the benefits, or costs, extend beyond those who are the immediate targets of the service. When Ford Motor Company sells a car, its stockholders enjoy the benefits of the profits, but those profits do not spill over to society at large. However, when a child is educated through a school system, not only does the child benefit, but society’s productive capacity is also enhanced. Many private schools educate children for a profit, and the owners of the school enjoy the benefits of the profits along with the child and society. However, it seems unlikely that these same for-profit schools would willingly pro- vide equivalent education to all children who cannot make tuition payments. Economists label the benefits that spill over to the rest of society externalities. Governments provide at least some services that produce significant externalities because the private sector would provide these only to the extent that profit could be made. Education, if left entirely to the private sector, presumably would be available only to those who could pay, or would be provided in insufficient quan- tity and quality for the needs of society.

Pricing Public Services. Defining just what is clearly public in nature and deter- mining what the private sector presumably cannot or will not provide is contro- versial. During the 1980s and 1990s, the federal government cut back on transfers to state and local governments, which also faced more stringent tax and spending

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limitations inspired by their voters (see Chapter 5). As a consequence, many serv- ices once thought to be exclusively public were converted into private services or to public services provided by private firms on a contract basis.11 That trend con- tinued when state and local budgets shrank dramatically with the recession that started in 2001–2002, though there is some evidence that smaller jurisdictions or smaller private contracting for public services has waned somewhat, while large contracts seem to be increasing.12

This trend advanced throughout many developing countries with public sec- tors even larger than in the United States. The Margaret Thatcher government, in privatizing many formerly public services such as the water utilities throughout the United Kingdom, served as a model for the early 1980s movement in the United States and around the world.

This type of conversion is not a new idea, but public sector budget pressures have changed the landscape to require those who benefit directly from a govern- ment service to pay for its cost (see Chapter 5). For example, in the 1990s the U.S. Coast Guard stopped providing towing services to disabled boats unless a genuine emergency exists; it instead notifies private operators, who charge the cost to the disabled boat captain. That practice has cut back significantly on calls for towing in general, with prices providing a rationing mechanism. What is private and what is public varies over time, and public budgeting is affected by those variations.13

Other Public and Private Sector Differences. Whatever objectives other than profit private corporations may have, to stay in business they must seek economic effi- ciency and obtain the greatest possible dollar return on investments. In contrast, governments may be intentionally inefficient in resource allocations, undertaking services that the private sector would be reluctant to provide at all. For example, government-financed medical care for the elderly may be inefficient in the sense that other government programs provide greater economic returns to society, but it has been agreed that at least some support should be provided to the elderly. Governments are also charged with other unique responsibilities such as inter- vention in the economy (see Chapter 15).

Another difference between private and public organizations lies in the clien- tele and the owners of the means of production. In theory, at least, both corpora- tions and governments are answerable to their stockholders and clients. In the pri- vate sector, these individuals can disassociate themselves from firms. Their coun- terparts in the public sector are denied this choice except through the extreme act of emigration. Private stockholders expect dollar returns on their investments, and if they are not satisfied, they sell their shares. Because government costs and returns are not so easily evaluated, the electorate has no simple measure for assessing the returns on the taxes they pay, and they have no means to sell their

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shares, other than to move to another country. Even so, many state and local gov- ernments provide annual reports to citizens that are similar in purpose to stock- holder reports. These reports emphasize the investments government is making and the benefits citizens are receiving in lieu of profits. Of course the stockholders of corporations and of governments from time to time change management, the latter through regular elections.

Corporate budgetary decision-making is usually more centralized than gov- ernment decision-making. Corporations can stop production of economically unprofitable goods such as Oldsmobiles. Given the nature of the public decision- making process, however, governments encounter more difficulty in making deci- sions both to inaugurate programs and to eliminate them. For example, though there was an apparent large majority consensus for over two decades that the Medicare program that assists the elderly in financing health care, should include some form of prescription drug coverage, it was not until 2006 that a program finally was implemented.

Responsible Government and Budgeting

The emergence and reform of formal government budgeting can be traced to a concern for holding public officials accountable for their actions.14 The “reinvent- ing government” movement represents the most recent manifestation of a rather ancient concern that public officials be held accountable for their actions, though some critics have held that the precepts of reinvention are not new and not neces- sarily internally consistent.15 No matter the particular reform terminology in vogue, in a democracy, budgeting is a device for limiting the powers of govern- ment. Two issues recur in the evolution of modern public budgeting as an instru- ment of accountability—responsibility to whom and for what purposes.

Responsible to Whom?

Responsibility to Constituency. Basically, responsibility in a democratic society entails constituents holding their officials answerable, usually through elections. Elected executives and legislative representatives at all levels of government are, at least in theory, held accountable through the electoral process for their decisions on programs and budgets. In actuality, budget documents are not the main source of information for decisions by the electorate. Obviously, most voters do not dili- gently study the U.S. budget before casting their votes in presidential and con- gressional elections. However, when the government’s share of the total economy grows, it is increasingly clear that voters do hold elected representatives respon- sible for the overall budget, the budget deficit, and the general performance of the

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economy. That the electorate holds presidents responsible for the economy was evidenced in 1992 by President George H. W. Bush’s defeat in his bid for re-elec- tion. Eight years later, the 2000 election showed that even in the midst of a boom- ing economy, many voters were more concerned about apparent ethical and moral lapses in the White House than their happiness with the economy. In 2006, voters indicated great unhappiness with the wars in Afghanistan and Iraq and the over- all performance of the presidency by changing the party control in both the House and the Senate. Huge budget deficits seemed to play only a minor role in voter decisions in that election.

State and local governments have specific creditors: the purchasers of bonds issued to finance long-term capital improvements. The interest rates that state and local governments have to pay on their bonds are affected by their ability to pro- vide creditors with convincing evidence of their creditworthiness (see Chapter 13). Hence, financial institutions that purchase bonds and ratings institutions that rate state and local bonds are important constituents to whom these governments are accountable.

Because the public in a large society cannot be fully informed about the oper- ations of government, the United States has used the concepts of separation of pow- ers and checks and balances as means of providing for responsible government. Power is divided among the executive, legislative, and judicial branches, and each provides some checks on the others. Although the president is held responsible to Congress for preparation and submission of an executive budget, only Congress can pass the budget. Specifically, the U.S. Constitution in Article 1, Section 9 states that “no money shall be drawn from the Treasury, but in consequence of appro- priations made by law. . . .” In most states and many localities, the chief executive has a similar responsibility to recommend a plan for taxes and expenditures. The legislative body passes judgment on these recommendations and subsequently holds the executive branch responsible for carrying out the decisions. Local gov- ernment practice varies more since some local governments do not have an elect- ed chief executive.

Development of the Executive Budget System. The development of an executive budget system for holding government accountable was a long process that can be traced as far back as the Magna Charta in 1215. The main issue that resulted in this landmark document was the Crown’s taxing powers. The Magna Charta did not produce a complete budget but concentrated only upon holding the Crown accountable to the nobility for its revenue actions.16 At the time, the magnitude of public expenditures and the use of these funds for public services were of less con- cern than the power to levy and collect taxes. It was not until the English Consolidated Fund Act of 1787 that the rudiments of a complete system were

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established, and a complete account of revenues and expenditures was presented to Parliament for the first time in 1822.17

The same concern in eighteenth-century England for executive accountability was exhibited in other countries. It was carried over to the American experience even prior to the ratification of the Constitution in 1789. Fear of a strong executive branch was evidenced by the failure to provide for such a branch in the Articles of Confederation in 1781. Fear of “taxation without representation” probably explains why the Constitution is more explicit about taxing powers than the pro- cedures to be followed in government spending.

The first decade under the Constitution saw important developments that could have resulted in an executive budget system, but the trend was reversed in subsequent years. The Treasury Act of 1789, establishing the Treasury Department, granted to the secretary the power “to digest and prepare plans for the improvement of the revenue . . . [and] to prepare and report estimates of the public revenue and expenditures.” 18 Alexander Hamilton, secretary of the treas- ury, in interpreting his mandate broadly, asserted strong leadership in financial affairs. Although the act did not grant the secretary power to prepare a budget by recommending which programs should and should not be funded, such a devel- opment might have subsequently occurred.

Instead, Hamilton’s apparent lack of deference to Congress strengthened that body’s support for greater legislative control over financial matters. To curtail the discretion of the executive branch, Congress resorted to the use of increasing num- bers of line items, specifying in narrow detail for what purposes money could be spent.19 The pattern emerged that each executive department would deal directly with Congress, thereby curtailing the responsibilities of the secretary of the treas- ury. The budgetary function of the Treasury Department became primarily minis- terial. The Book of Estimates, prepared by the secretary and delivered to Congress, could have become the instrument for a coordinated set of budgetary recommen- dations. Instead, it was simply a compilation of departmental requests for funds. A. E. Buck wrote, “Thus budget making became an exclusively legislative function in the national government, and as such it continued for more than a century.” 20

Modern Executive Budgeting. By the beginning of the twentieth century, changing economic conditions stimulated the demand for more centralized and controlled forms of budgeting. E. E. Naylor wrote that before this time there was little “enthusiasm for action . . . since federal taxes were usually indirect and …

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