PFM Innovation in Estonia: Combining Performance Budgeting with Activity-Based Costing

Performance budgeting has been arguably around since the 1950-s. Its biggest promise has always been in a simple argument: we do not want to know only what the government spends on (especially if that information would be about inputs), but what it accomplishes with the money spent. It is a perfectly rationalist thinking behind it to say that at every level of decision-making, such as an agency, ministry, the Government and the Parliament this question should be at the forefront when considering alternatives for spending a euro or whatever other currency is in use. Unfortunately, we know that politics is messy and unfortunately results in less than full attention to such details. Parliaments, the highest authority to grant the executive the right to use the budget in a certain way, do not care - or aren’t capable of - making sense of neither all these performance objectives, nor performance reports to guide them in their decision-making. 

Also, activity-based costing (ABC) has been around long enough to have seen its rise and relative fall. Its promises once were considered great, mostly related to more accurate information about services and hence better management decision modelling. Also, this information on costs being driven by volume-related variables, allows in principle to make better budgeting decisions. However, its relative difficulty to implement properly and the waning interest in the information without a proper institutional system conducive to making use of that information beyond an individual agency level have been detrimental to its successful application throughout government (side note: I would be interested in hearing about stories contrary to that argument).

Despite of all the failed attempts and vanished zeal around the world, the Estonian Ministry of Finance declared that from this year, 2020, all the ministries have adopted the activity-based budgeting model, combining strategic planning with financial management and cost accounting moving towards ABC. Is it possible that the country has arrived in the final destination that is beyond the reach of any other country in the world?

The State Auditor has already called the gradual shift of power over the budget from the Parliament to the Government a move where the Parliament has played itself out - both in terms of deciding over spending, as well as requesting proper information from the executive about its spending plans. Not least has played a role an earlier reform from 2017 which required the budget to be decided based on the accruals basis - yet again voted by the majority of the Parliament through the Organic Budget Law. He also presents a compelling argument: even if the Explanatory Note of the Draft State Budget would be crystal clear (which it is clearly not) , it is not a legal act as such that the Government would have to follow, so it is free to do whatever it deems necessary within the limits of the approved budget.

Coming back to 2019, the MOF piloted the activity-based budgeting approach with two ministries, the Ministry of Social Affairs and the Ministry of Education and Science by presenting their budget based on programmes, programme measures and services, but for 2020 the new structure was still uncomfortable for most of the ministries so that the information about services was left out from the budget documentation completely. In other words, big junks of money called the programmes is decided by the Parliament based on relatively general promises called objectives.

So what is the expectation for future even if we consider 2020 as just a poor start? The biggest challenge seems to be service-based management of agencies that relies on the ‘most granular’ building blocks (i.e. the services) connected with budgeting and cost accounting. Managers have to figure out first what outputs their agency provides and then structure these into bundles of services that make sense to the public, but also represent what the agency does at the right level of detail - not too narrow, not too broad. Then they have to construct a cost management model which essentially uses algorithms to assign costs (both direct and indirect) to services. When I interviewed about 5-6 finance managers from various Estonian agencies, it became clear that both exercises are still underway: to come up with a solid list of services and construct a meaningful cost management model - traditional or ABC both being an option at this stage. What was more striking perhaps is that they all seemed to be in this ‘costing business’ for quite some years already and nevertheless had not nailed the two targets yet. 

And here comes my greatest concern. Services is the most understandable and down-to-earth level of budgeting that connected with programmes and their activities should give a good picture about what is going to be accomplished in a policy area and what it is going to cost. In order to make meaningful comparisons, this structure would have to stay intact for most of the time. However, since services are the business of the agencies it is likely that fixing them at a higher level than ministry would not be practical. Now that another key decision about the costing model also relies with the agency and virtually leaves everybody at the mercy of the agency management to present the costs of services as they deem necessary due to ‘black box’ of costing algorithms guiding the presentation of these figures, the overall presentation of the budget, as well as the budget performance reports will be on shaky ground.

So perhaps two measures would have to be added to the current budget practices if we hope that both the parliamentarians, as well as the general public could make better sense of the information. First, there is a need for the National Audit Office to audit the costing models to assure to the public that they ‘function properly’, the standard of which will have to be prepared by the MOF. Second, there has to be an agreement between the Government and the Parliament (perhaps facilitated by the NAO) on the structure and presentation of the right amount of detail in terms of explanations in the Explanatory Letter accompanying the draft budget to the Parliament. It may even have to be decided that the Explanatory Letter itself becomes - or is accompanied by - an analytical toolbox that can be played with to make cross-year, cross-agency comparisons and other analytical reports during the budget discussions. This could become a role for the NAO to help the Parliament to make better sense of the draft budget, the role not unheard of in other countries. 

A small country, such as Estonia, can make PFM innovation in government happen relatively easy. Often it may not take much more than a compelling vision, a dedicated team of enthusiasts in government and access to resources (in our case to EU funds) to push forward the relatively technical reforms. It nevertheless remains to be seen if the reform can deliver the results that would live up to its promises, and increase in transparency is on top of the list. Next year’s budget process is off the ground...