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Recurrent Cost Problems in Less Developed Countries
May 1982
>> This Is USAID >> USAID Policy Papers >> Recurrent Cost Problems in Less Developed Countries
Executive Summary III. Causes of Recurrent Cost Problems
V. Solutions to Recurrent Cost Problems
VI. Conclusions and Recommendations
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[Download original document] Executive Summary
Introduction
There is a growing awareness that many of the poorest countries in the world, particularly those located in sub-Saharan Africa, are not allocating adequate budgetary resources to finance the recurrent costs of their present portfolio of development investments. Existing investments are, therefore, becoming unproductive, and future investments are likely to suffer from the same problem. In light of this situation, donors need to review their current policies to determine how to deal with this "recurrent cost problem." This paper analyzes the nature and causes of LDC recurrent cost problems and suggests a set of responses that Missions should consider in order to improve the effectiveness of USAID programs and projects.
Definition
Recurrent, or variable, costs are defined simply as those costs that recur, as opposed to capital, or fixed, costs, which are concentrated at the beginning of a project's life. Thus, in an agricultural research project, the costs of providing the buildings and equipment, as well as the costs of initial training and expatriate expertise are fixed costs, which occur only in the start-up phase of the project. The annual cost of salaries, utilities, maintenance, materials, and replacement of worn-out capital are recurrent costs which continue as long as agricultural research continues to be carried out.
An LDC government may be unable or unwilling to finance recurrent costs. There is a recurrent cost problem when finance is lacking for variable inputs even when they are more economically profitable than new capital inputs, either private or public. For instance, suppose a dollar spent on repairing a road increases the present value of total output by two dollars, while a dollar spent on a new road or a new factory increases the present value of total output by only $1.50. Then available resources should be spent repairing the road. 1 If this is not happening, if road repairs are underfinanced even though they are more valuable to the economy than new projects which are being financed, then there is a "recurrent cost" problem.
Why does such a situation occur? Why do governments misallocate resources? The major reasons are poor policy choices, both by the LDC's and, to some extent, by donors.
LDC Policy Failures
LDC policy failures can be grouped into three broad categories:
- Inability to raise adequate revenues;
- Misallocating public resources between capital and recurrent budgets or among expenditure sectors within the recurrent budget, including the over-staffing of central bureaucracies which have a vested interest in the continuation of subsidized programs;
- Project design failures or public policy failures which reduce the likelihood of a project achieving success.
Inability to Raise Revenues.
Sometimes, an LDC government's inability to finance recurrent expenditures is a result of its inability to raise sufficient resources, because of, for example, an institutional weakness in its tax system. More often, however, the problem arises from a failure to charge users for government services such as health, education, veterinary services, agricultural extension, transport, and water and sanitation. The failure to charge users for services (and thus the subsidization of those services) is frequently justified on equity grounds. In fact, subsidies, in practice, often tend to be inequitably distributed. For most poor countries, resources are inadeqaute to provide, for example, free universal extension services, while also pursuing other development objectives. Consequently, these services are provided to a chosen few. If however, charges were imposed for the use of the services, the increase in financial resources would enable the government to distribute these and other services more broadly. Subsidies as a "safety net" may be justifiable if they are carefully targetted at the poor. However, the majority of subsidies are imprudent and ineffective.
Misallocating Public Resources.
Even when governments have adequate revenues, they are often allocated badly. At times, certain sectors (e.g., agriculture) are underfinanced because of political pressures to provide revenues to other sectors which are more important politically, though less profitable economically. At times, the cost of government provision of services is too high,either because of excessive salaries for government employees or because of inappropriate technologies. Sometimes, government involvement in activities best left to the private sector (particularly marketing and manufacturing) results in substantial operating losses and consequent drains on the treasury.
Project Design and Public Policy Failures.
Projects may be underfinanced because the cost of variable inputs is greater than the returns to these inputs. There are three reasons for this situation occurring. First, the project may have been poorly designed. Second, changes in the external environment may have been poorly anticipated at the design stage and consequently, during implementation, the project becomes unprofitable. Third, government policies, both macroeconomic and sectoral, may inhibit the project's success. Whatever the reasons, failure to provide variable inputs to a project when they have a more profitable use elsewhere is a rational response. The problem being faced in this case is not a recurrent cost problem, but a project design or public policy problem, and the solution is project redesign or policy reform.
Donor Policies
Even where LDC policies are appropriate, donor policies may lead to an overinvestment in new projects and an underfinancing of the recurrent costs of existing projects. This is because donors tend to limit their financing to new investments. For many poor countries, the funds available for new capital projects, because they come largely from concessional assistance, are more plentiful than the funds available for financing the recurrent costs of existing projects, which come largely from domestic resources. Thus new roads are built while old ones are not maintained.
This analysis points to four basic responses available to USAID, depending on the causes of the recurrent cost problem:
- Project design
If design is the cause of the problem, USAID Missions and LDC governments should work to design projects so as to assure that their recurrent cost components are consistent with economic feasibility.
- In countries suffering from a recurrent cost problem, the economic analysis of projects should use prices for government expenditures and revenues that reflect the scarcity value of government resources;
- Projects should be designed, to the extent possible, to maximize the revenues from service charges (and/or contributions in labor and kind) consistent with the capacity of the beneficiaries to pay; and
- Where possible, government activities should be turned over to the market economy. This is generally desirable in all agricultural and industrial productive activities as well as marketing, distribution, trade and many services.
- Policy Reform
In countries where recurrent cost problems are important, recurrent cost issues should constitute a major part of the policy dialogue because of their integral relationship with macroeconomic concerns and the allocation of resources. If LDC policies are the cause of the problem, then Missions should
- attempt to persuade governments to make necessary reforms;
- enlist the support of the donor community for policy reform; and
- provide technical assistance in the form of expertise and training to support reforms, including such areas as fiscal policies and tax administration.
- Recurrent Cost Support
If recurrent costs constitute a serious problem and LDC government policies are appropriate and projects designed correctly, or requisite steps are taken to move toward appropriate policies and designs, then Missions should consider funding a portion of recurrent costs of host country projects through a variety of mechanisms at the project, sectoral and macro levels for a period up to ten years, providing the country agrees to shoulder an increasing share of total costs over this period. Policy performance should be monitored closely and periodically to determine whether such assistance should be continued.It is important to note that direct funding of recurrent costs, either at the project or budget level, is only justifiable under fairly narrow conditions. These conditions, which have been spelled out in this paper include:
- An acceptable policy framework or clear movement toward such a policy framework;
- An assurance that recurrent cost support has higher development impact than new investments;
- An inability of the host country to undertake recurrent cost financing;
- A carefully phased plan exists for shifting the entire burden to the host government.
- Reallocation of Assistance If the host government refuses to take sufficient action on project design and/or policy reform, USAID should seriously consider reducing the level of assistance to the affected sector or country.
1Economic logic requires that resources be allocated so that the "marginal revenue product" of each activity or use is the same. Streams of revenues and costs over time are measured in "present values," i.e., discounted by a rate which reflects the opportunity costs of capital and the society's rate of time preference.
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