CAPITAL BUDGETING IN THE NEW ZEALAND GOVERNMENT
 
Testimony to the
Presidential Commission to Study Capital Budgeting
by
George Troup, Deputy Chief of Mission, Embassy of New Zealand
New York, 8 May 1998
 
 

Introduction

Thank you, Mr Chairman, for the opportunity to take part in this hearing. It is an honour for me to do so, and of course for New Zealand that you have expressed interest in our experience.

I must stress at the outset that I am a generalist diplomatic representative rather than an expert on capital budgeting. If I am unable to respond today to any questions you may have, I will undertake to seek answers and make them available to the Commission.

My testimony addresses in particular point (a) of the Commission's terms of reference: capital budgeting practices by other governments and their pertinence for the Federal Government. It also directly responds to point (c): the role of depreciation. I hope that it will shed some light on the other points.

To set our system of capital budgeting in a broader context, I should refer briefly to the comprehensive set of economic and public sector reforms that New Zealand undertook beginning in 1984. The imperative driving these reforms was that the New Zealand economy, as a consequence of over-regulation and unsustainable government spending, had performed poorly over several decades and was facing a crisis of overseas indebtedness. The reforms undertaken aimed at promoting efficiency through the use of market mechanisms. The public sector was restructured as far as possible in accordance with a private sector model.

In particular, this involved replacing detailed central controls on inputs by the delegation of authority to managers for the use of resources. For this to be effective, the increased freedom had to be accompanied by robust information systems which allowed managers to be held accountable, and a system of appropriate incentives to align the interests of managers with those of the Government and ultimately of taxpayers. An interlocking system of planning and accountability was implemented, with an unbroken chain reaching from the overriding socio-economic goals determined by the Government (for which it is accountable to voters); through the Strategic Result Areas that provide three-year targets for the public service as a whole; to the Key Result Areas determined annually for each Government department and agency and embodied in their corporate plans; then the Key Objectives for each operational unit as set out in its operational plan; and ultimately the job description of each individual staff member. Each document is specifically reconciled with those further up the hierarchy, and the subject of regular reporting on the achievement of targets.

It is within this context of devolution and accountability that the system of capital budgeting takes its place.

Overview of Public Sector Management Reform

Reform of the core departmental financial management system began in 1988. It was designed to redefine the nature of the accountability relationship between a government Minister and his or her department. It also sought to improve the incentives on departmental managers to respond to the government's policy priorities.

I should note here a fundamental difference between the US system of Government and that in New Zealand (based on the "Westminster" system). New Zealand makes a clear distinction between Ministers (elected Members of Parliament, who take political responsibility to decide Government policy collectively) and Departmental Secretaries or Chief Executive Officers, who are professionals appointed by an apolitical process to manage Departments delivering outputs under contract to Ministers. The New Zealand version of the Westminster system treats Departments essentially as businesses, operating to the extent possible in contestable markets. Ministers have two main roles: as purchaser of services from Departments; and as owner of Departments. Systems have been in put in place to mitigate potential conflicts between these two roles.

Under our new system, departmental Chief Executives are appointed on limited-term, performance-based contracts. They negotiate with their Minister annual agreements which specify the performance expected of the Chief Executive. These "performance agreements" are used as the basis for assessing the Chief Executive's performance at the end of the year.

The annual agreements define performance in terms of the things the Chief Executive can be held accountable to deliver: outputs (goods and services) rather than outcomes. The agreements recognise the Government's interest as owner as well as being a purchaser of a department's outputs, and that good "ownership performance" (such as investment to maintain the department as a going concern) is a second key dimension of Chief Executive performance.

The move to an output control system has allowed the near total delegation of input control to Chief Executives. These delegations include control over personnel levels, rates of remuneration, and the mix of labour, capital, and various operating items.

These reforms were accompanied by changes to the budgeting and accounting systems. A major change was the adoption of accrual accounting. Unlike cash accounting, which only reports cash flows, the accrual method also measures the full cost of a department's operations for the year, allocated to outputs to reflect the true cost of each government programme. A second advantage of the accrual basis is that it reports the assets and liabilities of the department.

The New Zealand Government now produces a full set of accounts according to Generally Accepted Accounting Principles (GAAP): operating statements, statements of financial position, and cash flow statements for each agency and for the Government as a whole.

Despite initial scepticism, accrual accounting is now widely considered to be an important element of our financial management reforms. I will outline four of the major consequential effects flowing from its adoption.

Separating Operating and Capital Flows

A Better Deficit/Surplus Measure

The adoption of accrual-based budgeting and accounting has changed the way expenditure is recognised and the way the deficit/surplus is calculated.

A key feature of the accrual method is that it distinguishes between operating and capital flows. Operating (non-capital) flows are reported in an operating statement while capital flows are reflected in a balance sheet. Operating and capital cash flows are separately reported in a statement of cash flows.

The new deficit/surplus measure comes from the bottom line of the operating statement. Important aspects of this measure are:

The advantage of the operating/capital distinction is that the resulting surplus/deficit measure is not masked by large, often one-off capital flows. For this reason, even under the previous cash-based budgeting system we had removed all financial capital transactions from our deficit measure. However, this was only a rough operating/capital proxy and the accrual-based system is now providing us with a much better measure of the underlying fiscal position.

Notwithstanding the better deficit/surplus measure, all expenditures, be they operating or capital in nature, need to be financed. The cash flow statement provides financiers and financial markets with this information. In this way we have separate measures of the true cost of running the government for the year (the surplus/deficit from the operating statements) and the financing implications of this (from the cash flow statement). As in the business world, these two measures provide different information for different purposes.

Thus, just as economists use more than one indicator to monitor economic performance (for example, growth, inflation, unemployment), we now have a series of indicators to measure the Government's financial performance, providing greater transparency as to the fiscal position and medium-term trends.

Defining Capital

An operating/capital split makes it important to define clearly what is to be included in "capital". We use the definition provided by Generally Accepted Accounting Practice, which is essentially all assets and liabilities of the Government.

On the asset side this means:

We do not consider expenditure on human capital, education, or private sector research and development to be capital expenditure. While it can be argued that these expenditures are an investment, they do not generate an asset for Government. If we were doing a budget or set of national accounts for the country as a whole then we might consider treating these items as capital expenditure because it could be argued that they create an asset for the country. However, no asset is created for the Government and hence we regard them as operating expenses.

Similarly grants (in cash or kind) to private individuals, organisations, or institutions are accounted for as an operating expense unless the Government obtains some ownership rights in return. In most situations this is not the case.

Delegation of Capital Decisions to Departments

Delegation within a Capital Base

A second feature of the New Zealand system is the delegation of most capital expenditure decisions to departments.

As we implemented the new system in the early 1990s, each department identified and valued all of its assets and liabilities, thereby establishing its opening balance sheet position. This in turn determined the capital base for the department. Under our system, departments do not require an appropriation or even Ministerial approval to buy and sell assets within that capital base.

This freedom is quite extensive. For example, a department can sell a car and use the proceeds to buy another car, or a computer or land or furniture. Alternatively they can reduce their working capital and use the proceeds to buy a physical asset, or vice versa.

In making these capital decisions departments are restricted by:

The later restriction ensures that a department does not dispose of an asset that it requires to produce its outputs.

In this way we have delegated input control and replaced it with controls over what outputs are produced and the size of the capital base. Initially there were fears in some quarters that departments might abuse the new found freedom by investing unwisely. This has not proved to be so. By trusting managers while at the same time monitoring overall asset levels (something we were unable to do previously) we have found that managers have rationalised sensibly - selling surplus assets to upgrade computer equipment, for instance.

Capital Injections into Departments: A Sound Business Case

If a department runs short of working capital or is unable to finance asset purchases from within its existing balance sheet, it must seek a capital injection from the Government. To be successful it must justify its bid on the basis of "a sound business case".

As part of this business case the department must (among other things) identify:

This business case must be presented in the context of a medium-term strategic business plan which focuses on the demand for the department's outputs and the efficiency of the department's operations in their entirety. This is not simply an accounting exercise; it is a means of matching long-term strategy with operational planning. It does this by treating assets as future productive capacity, not a sunk cost.

The "sound business case" approach provides a discipline on departments to justify their requests. Frequently it encourages departments to withdraw bids they otherwise would have made.

The approach also provides Ministers with analytical information on which to base capital injection decisions.

Operating Impacts

A third feature of the New Zealand system is that we recognise the cost and consumption of capital in the budget and accounting systems.

The Cost of Capital: The Capital Charge

Capital, even that raised by a Government through taxes or borrowing, has a cost. As a means of encouraging departments to recognise this opportunity cost, each department is levied a "capital charge" which it is required to pay to the Treasury twice a year.

The charge is calculated as a percentage of a department's capital base (taxpayers' funds as per audited financial statements: modified historical cost, according to GAAP). The larger the base, the higher the payment required. Conversely, the lower the base the lower the charge. This creates an incentive for departments to minimise their existing capital base (and offset the frequently observed tendency to hoard capital).

As with all other expenses, department are required to allocate the capital charge across their outputs. It is thus reflected in the cost of each output purchased by the government and appropriated by Parliament.

At the whole of Government level, the charge (which represents an internal transfer) is eliminated from financial reports, and only the (accrual) cost of external financing is reflected in the deficit/surplus.

When the capital charge was introduced in 1991 at a rate of 13%, departments received funding to cover the cost at their existing capital base.

The "default" rate for the capital charge is currently set at 11%, though some departments have negotiated lower rates. The rate is determined on the basis of the Weighted Average Cost of Capital appropriate to a department, with both debt and equity components. Notionally the debt component reflects the cost of funds to the Government (the Government stock rate of interest) plus a risk premium. The cost of equity notionally reflects the return on capital expected by investors, as determined by the Capital Asset Pricing Model. Thus, the charge simulates the decision-making environment facing a private sector manager.

In practice, the high level at which the capital charge is set, compared with rental rates applying in the marketplace which typically represent an annual rate of return well under 10 percent, means that there is an increasing tendency to use rented accommodation rather than owning property.

Capital Consumption: Depreciation

The operating statement of each department is required to include the depreciation cost associated with its assets. This has a number of advantages, among them the fact that departments can no longer run down their assets by not maintaining or replacing them. If they do so, the immediate reduction in value is obvious from the balance sheet.

Depreciation is aggregated into the various categories of expenditure reported in the operating statement of the Government as a whole. The deficit/surplus thus includes the consumption of capital for the year (along with all other non-cash expenses).

While departments and the Government as a whole record depreciation as a separate line item in financial statements, for budgetary purposes departments are required to allocate all their costs across their outputs. This includes depreciation and other non-cash costs.

Appropriations are made on an output basis (the maximum accrual amount to be spent in producing each output) rather than on the basis of input line items. As a result, depreciation is not explicitly appropriated. Its inclusion in the cost of outputs means that it is implicitly appropriated, however.

Crown Assets

A fourth feature of our treatment of capital in budgeting relates to what we call "Crown assets". These are assets over which departments do not have full purchase/disposal control. Examples include national parks and historic buildings.

Crown assets are separated from departmental assets and recorded on the Crown (or Government) balance sheet rather than on a departmental balance sheet. Departments act as agents for the Government in the management of these assets, but have no authority to buy or sell them. Those decisions are made directly by Ministers on the basis of cost-benefit analyses.

Capital Decisions in the Non-Departmental Sectors

In addition to departments there are also a large number of Government-owned companies and semi-autonomous Government agencies in New Zealand. These typically operate under the same type of system as Government departments:

Unlike departments, Government-owned companies and some of the other agencies also have the power to borrow in their own name from the financial markets. This generally occurs only when they are operating in a competitive environment and are therefore subject to the efficiency disciplines of the private sector. The Government does not guarantee this debt and this helps ensure that financial markets keep an oversight on their performance.

Capital and the Budget Process

Implicit Capital Budget

At the beginning of each budget cycle, the New Zealand Government is required under the Fiscal Responsibility Act to publish a Budget Policy Statement setting out the fiscal parameters and broad policy priorities for the forthcoming budget. While similar in nature to a US Budget Resolution, the Budget Policy Statement is required to establish fiscal parameters for the following variables over a three-year period:

While there is no explicit requirement to establish a capital budget (an amount to be spent on capital investment), such a limit is therefore implicit in these variables.

The operating/capital distinction means that all capital expenditure has to be financed from within the balance sheet. This means new capital can only be funded by either running down cash reserves or increasing debt. Thus in order to set debt and net worth parameters the Government has to decide how much new capital investment it will undertake and how it will finance that investment.

Capital Investment Decisions

At the detailed level the decision-making process is relatively simple. In the course of the budget process Ministers decide which individual capital investment decisions to support in the light of their capital constraint.

Because detailed capital decisions are mostly delegated to departments and other agencies, Ministerial capital budgetary decisions concern:

The first two categories have "sound business case" information to support them and this provides an analytical basis for decision. The latter usually are supported by cost-benefit analyses.

Summary

The New Zealand budgeting and accounting systems use accrual rather than cash accounting. In this system capital flows are distinguished from operating flows and excluded from the measure of the Government's deficit or surplus.

A capital transaction is defined as one that generates an asset for the Government, as distinct from the country as a whole. All other transactions are treated as operating expenditure and included in the deficit/surplus calculation.

Detailed capital expenditure decisions are mostly delegated to departments, which are free to buy and sell assets within their capital base. If they need additional capital they must seek a capital injection from the Government. To be successful they must present a sound business case.

Ministerial capital decision-making consists of determining the level of capital injections into departments, Government-owned companies, or semi-autonomous Government agencies. They also make decisions about the purchase or development of Crown assets - assets of the Government which are not controlled by agencies.

The cost and consumption of capital is included in the cost of outputs and departmental operations but not explicitly appropriated.

The overall aim of these financial management reforms, consistent with the wider economic and government reforms, has been to introduce market disciplines similar to those applying in the private sector. As a personal observation, I would add that our experience has been that managers in general adapt surprisingly quickly to changes in the incentives that they face.

In conclusion, I am tabling for the information of the Commission:

This ends my prepared testimony. I would be happy to receive questions.


President's Commission to Study Capital Budgeting