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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] V. Solutions to Recurrent Cost Problems
As noted in Section III, recurrent cost problems exist either because of host government policies or donor policies. Solutions to recurrent cost problems require either increasing the share of revenues going to the recurrent cost budget, reducing the level of investment, reducing the recurrent costs attached to each new investment, or increasing general government revenues (only after careful review of the potential negative effects on productivity and capital formation). 1
A. Re-examining the Recurrent Cost Coefficient
Where there is a serious recurrent cost problem, one solution is to re-examine the recurrent cost burdens of the project portfolio. The project mix might be changed in the direction of projects with a lower level of recurrent costs relative to investment costs than others. However, if projects have been chosen rationally, such that the current project mix represents the "optimal" allocation of investments, any restructuring will reduce the expected long-run rate of growth. What is the appropriate trade-off between overall project productivity and recurrent cost economizing?
The cost-benefit technique for analyzing projects is readily adaptable to answering this question. Any project will affect the government's budget in two ways through increased costs and increased revenues. The "r" coefficient is defined so as to measure the stream of recurrent expenditures related to a given project. There is, similarly, what we might call a "c" coefficient, or a cost recovery coefficient, which represents the increases in government revenues attributable to the project. While the cost data should be readily available from the project documents, the revenues are more elusive.
User charges make up one element of cost recovery. The second element is the increase in tax revenues, both direct and indirect generated by the project. For example, if the project increases farmer incomes, then part of that income will be taxed directly, through income taxes or export levies. Another part will be spent on inputs and therefore custom duties or goods which have excise taxes on them. Finally, part of the income is used to purchase locally-produced goods thus multiplying the income, as well as income, excise, and customs taxes. In most LDC's, because of substantial foreign trade leakages, this multiplier is not likely to be very large.
Thus, any project may be expected to generate a stream of economic costs and benefits, a part of which are, respectively, recurrent government expenditures and revenues. If the country has a recurrent cost problem, then government finances are a constraint to profitable investment. The appropriate procedure then, is to perform an economic analysis using a shadow price for government revenues, just as one uses shadow2 prices for labor and for foreign exchange. Sensitivity analysis might be used to examine a range of shadow prices,and determine under which set of assumptions a project design is acceptable. An example of this procedure can be found in Appendix II.
B. Increasing Donor Resources Going to Recurrent Budgets of Development Projects
Clearly, the most direct method for alleviating recurrent cost problems is financing recurrent costs explicitly. An earlier section of this paper argued that one of the causes of the recurrent cost problem is the limitations of fungibility caused by donor policies. Donors have open to them the option of increasing that fungibility by increasing the degree to which they are willing to finance recurrent costs.
In general, outside of counterpart requirements, USAID has been willing to finance certain recurrent expenditures only during project development. The recent decision to extend life-of-project funding to ten years makes more realistic the length of time needed for a project to move from the development phase to an ongoing, revenue generating project which will generate as much recurrent finance as it will recurrent expenditures. At this point, the LDC government would be more able and more willing to take over the financing. Any arrangements of this type will need a careful stipulation of the way in which USAID resources can be phased out and host country resources phased in. Before USAID becomes willing to increase its funding of the recurrent costs of a development activity, in fact, before the Agency makes an investment decision, it should be reasonably certain that policies affecting that activity are not likely to lead to the project's failure. Otherwise countries will be just as ill-prepared to assume the total funding of recurrent costs at the end of year ten as they often are now at the end of year five.
C. Donor Support of Government Sectoral Budgets
Since overall recurrent cost problems are due to either donor or LDC policies, it is first necessary to analyze the problem and determine its causes. Where LDC policies are not the main causes, or where policy reform is possible, USAID should be willing to consider providing general support to the recurrent budget. Among the instruments available for providing such support are cash transfers, CIP's, and PL 480 local currency generations. Such program support can be directed at a particular sector or at the macro level.
The first step in such a program is a macro-level analysis of the recurrent cost problem. At the least one would need time series on government outlays and revenues; an analysis of the government salary and cost structure vis-a-vis the private sector's costs; a discussion of the extent of reliance on user charges, and a discussion of the government's pricing policy for inputs and outputs in the productive sectors where USAID is active. Any project paper designed to provide recurrent cost budget relief must be justified in these terms.
Once the causes of the problem have been identified, a recurrent cost budget support program should include a blueprint for policy reform. These policy changes might include a greater reliance on user changes, a reduction in the subsidy level, a shift of government budget resources between sectors, improvement in tax administration,3 shifting certain activities from the public sector to the private sector, or a change in technologies (For example where government salaries are out of line, it may be appropriate to introduce new personnel categories with training and salaries more in line with the task. Thus, relatively less trained teachers could be used in certain settings, reducing the cost of delivery of education services.)
Lastly, general recurrent cost budget support programs should be, when possible, developed in concert with other donors. The recurrent cost problem is a result of the activities of all donors. Its resolution should involve the concerted action of all donors. Moreover, USAID activities in financially strapped LDC's must be planned in concert with other donor activities, since the recurrent cost problem only becomes manifest through the total development program, and not any single portion of it.
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 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.
D. Reducing the Level of Donor Support
Where recurrent cost problems are due to LDC government policy, and where that policy is not likely to change, USAID should seriously consider reducing the level of activity in the affected sector, or, if necessary, in the general development program. It makes little sense to invest in programs that are predicated on a given level of recurrent financial support, if that support is unlikely to be forthcoming. USAID activities, in such an environment, should be, wherever possible, designed so as to be insulated from government budget problems. Moreover, even small pilot projects are of limited value, if the financial resources are not available to broaden their reach, if they are successful.
1Assume, for example, that government revenues (GR) are 15% of GDP, that the current capital stock in development projects (KD) is 25% of GDP, that the share of government revenues going to the recurrent budget of the development sectors (RD) is a reasonable 30% of government expenditures, and that, due to the government's concern with directly addressing basic needs, the "r" coefficient, the annual value of recurrent expenditures associated with a dollar's investment, is 0.2. Then under current circumstances, government recurrent resources available for development projects are equal to RD x GR, or 4.5% of GDP. On the other hand demand is greater than the supply and a recurrent cost problem exists if these resources are more productive than new investments. Moreover, if new projects will generate greater recurrent costs then they will tax revenues, such a problem will persist.
[return to text]2There is a simple relationship here. The demand for resources equals RD x GR x GDP. If there is a recurrent cost problem then:
GDP x KD x r> RD x GR x GDP or KD x r> Rd x GR The solution then is to either reduce demand by reducing KD or r, or increase supply by increasing RD or GR. In other words, the available options include reducing the level of investment, reducing the recurrent cost coefficient, increasing the share of revenues going into the recurrent budgets of development projects or increasing general government revenues.
[return to text]3USAID should be willing, where feasible, to support institutional development in tax administration. Better administration can both alleviate budget pressure and reduce the marginal rate of taxation, thus providing greater incentives for entreprenuerial activity, both domestic and foreign.
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Last Updated on: July 11, 2001 |
