Quality of public finances: some illustrations

1. Quality of public finances: some illustrations António Afonso (European Central Bank; ISEG/UTL-Technical University of Lisbon; UECE-Research Unit on Complexity and Economics ) Política fiscal y coordinación de políticas San Sebastian, 24 July 2009 These slides reflect the views of the author and do not necessarily reflect those of the ECB or the Eurosystem.

2. Introduction and motivation • Measuring performance and efficiency • Methodology • Illustrative examples • Overall public sector • Education • Health • Social spending • Conclusions A. Afonso

3. “Public expenditure ratios have steadily increased in the euro area since the 1960s before peaking and, in some cases, declining in more recent years. Public expenditure is nevertheless much higher than in most other industrialised countries. According to many observers, it exceeds the levels required for the efficient provision of essential public services.” (ECB, Monthly Bulletin, April 2006, p. 73). Introduction and motivation “The need to improve competitiveness, concerns about fiscal sustainability and growing demands by taxpayers to get more value for public money as well as the need to reconsider the scope for state intervention in the economy has prompted efforts to increase the focus of budgets on more growth-enhancing activities and gear the tax mix and the allocation of resources within the public sector towards better efficiency and effectiveness.” (EC, 2007, p. 9) “The question we ask today is not whether our government is too big or too small, but whether it works (…). Where the answer is yes, we intend to move forward. Where the answer is no, programs will end. And those of us who manage the public's dollars will be held to account – to spend wisely, reform bad habits, and do our business in the light of day – because only then can we restore the vital trust between a people and their government.” (Barack Obama inaugural speech, 20 January 2009) A. Afonso

4. Public finances efficiency and economic growth Introduction and motivation A. Afonso

5. Public finance developments, notably the growth in the size of the government, have increasingly been in the focus of policy debates. • The existing fiscal framework in the EU has increased the awareness of the relevance of fiscal sound behaviour. • The EC, the Lisbon Reform Agenda and the Stability and Growth Pact argue for assessing fiscal policy developments also by taking into account the quality of public finances, especially the efficiency and effectiveness of public spending. • At the EU level the Working Group for the Quality of Public Finances was created in the Economic Policy Committee (in 2004). Introduction and motivation A. Afonso

6. Total General Government spending (% of GDP) • General government sector increased in the euro area and in the EU15 from 1980 to 1995 • In 2007, higher than US and Japan Introduction and motivation Source: EC Ameco database and EC spring 2008 economic forecasts. DE, ES, GR, IE, SE, EA, EU15: values for 1980 are from the Ameco autumn 2006 database (old definition). For 1995, values reflect the euro area 13 whereas for 1980 values reflect the euro area 12 and West Germany respectively. A. Afonso

7. Measuring public sector performance and efficiency Main questions: • Are “public” services satisfactory considering the amount of resources allocated to its activity? • Could one have better results using the same resources? • Could we have the same results with lower expenses? • Can we measure cross-country efficiency and determine benchmark countries? • Can we explain measured inefficiency? • systemic component, • environmental or non-discretionary component. Performance and efficiency A. Afonso

8. Measuring performance and efficiency • Public sector performance can be measured via output/outcome indicators: • Health, education, infrastructure, income distribution… => need for good indicators Performance and efficiency • Public sector efficiency relates outcomes to the resources used/inputs: • => need for homogenous and matching data (heterogeneity is a limit) Key issues:methods and (homogeneous and “right”) data to assess performance and efficiency. A. Afonso

9. Methodology (1) • The common “production function” relates inputs (xi) to output (y): y = F (x1,x2) • Alternatively: F (x1, x2) is a production possibilities frontier • Note that: • typically there are several outputs, (y1, y2, ...)=F (x1,x2, ...); • their joint production depends on several inputs • and on other “environment” variables. • Non-parametric methods commonly used in the literature: • FDH, DEA, both; • Non-discretionary inputs should be considered; • There are some examples of two-step (tobit/bootstrap) analysis. • Parametric methods: stochastic frontier analysis. A. Afonso

10. Examples of possible methods Cost efficiency Technical efficiency Productivity Methodology (2) Total Factor Productivity Partial Indicators Frontier Analysis Malmquist Indices Parametric Non-parametric Deterministic (COLS) Stochastic (SFA) DEA FDH Two-step analysis Tobit Extensions for Panel Data Bootstrap Fixed Effects GLS Random Effects A. Afonso

11. Methodology (3) One should be able to: • i) estimate output efficiency scores for EU/OECD countries, taking into account the resources employed; • ii) explain efficiency scores, controlling for environment factors (non-discretionary inputs). Most used methodologies: • “raw” efficiency scores: DEA (data envelopment analysis); • stochastic frontier; • explaining inefficiency: • tobit regression, • bootstrap technique A. Afonso

12. DEA y - column vector of outputs, x - column vector of inputs, X - input matrix, Y - output matrix. q - efficiency score (q<=1). Methodology – DEA q < 1, inefficiency q = 1, efficiency Note:  is the measure of efficiency, given by the ratio between the weighted average of the outputs (y) produced and the weighted average of the inputs (x) used. See Coelli et al. (1998) for more details. A. Afonso

13. DEA and FDH illustration Methodology – DEA D’s output inefficiency A, C – efficient; B, D – less efficient. D’s input inefficiency A. Afonso

14. Non-discretionary inputs and two-step procedure (1) D’s environment corrected output score= d1c/(d1c+d2c) Methodology – exogenous factors D’s output score= d1/(d1+d2) 1 > d1c/(d1c +d2c)> d1/(d1+d2), the environment corrected score is closer to the frontier. A. Afonso

15. Non-discretionary inputs and tobit two-step procedure (2) Methodology – exogenous factors Non-discretionary inputs: Socio-economic differences play a role in determining heterogeneity and influence outcomes (for either schools, hospitals, local governments or countries’ achievements in an international comparison). • Two-step approach: • Efficiency scores (d) are regressed on non-discretionary factor (z): The efficiency scores are not higher than 1 (or always lower than one according to the setup), which allows using a tobit regression approach. A. Afonso

16. Malmquist Productivity Index – MPI (constant returns to scale) output • The DMU produces less than feasible under each period’s production frontier. • The MPI indicates the potential rise in productivity as the frontier shifts from period t to t+1. • The DMU at time t could produce output yp for input xt; • With the same input xt it could produce output yq at period t+1. Methodology – MPI Efficiency change index Technology change index input A. Afonso

17. Coelli et al. (2005). Stochastic frontier analysis • i – country, t – time period; • yit– output, GDP per worker; • Xit – vector of inputs, private and public capital per worker and human capital; • β – set of production function parameters to be estimated; • eit – normally distributed random error; • hit – non-negative efficiency effect, assumed to have a truncated normal distribution; • zit – non-discretionary factors (the governance indicators) that explain inefficiency; • – set of efficiency parameters to be estimated; A translog functional form for F(·) seems a sensible option. It is possible to produce a likelihood ratio statistic to test g=0 If g=0, there are no random inefficiency effects.

18. SFA production possibility frontier Stochastic frontier A. Afonso

19. Some literature • Van den Eeckhaut, Tulkens and Jamar (1993), efficiency in Belgian municipalities. • De Borger and Kerstens (1996), efficiency of Belgian local governments. • Evans, Tandon, Murray and Lauer (2000), efficiency of national health systems. • Gupta and Verhoeven (2001), education and health in Africa. • Clements (2002), education in Europe. • St. Aubyn (2003), education in the OECD. • Afonso, Schuknecht and Tanzi (2005, 2006), public sector in the OECD and in emerging markets. • Afonso and St. Aubyn (2005a, b), health and education in OECD. • Afonso and St. Aubyn (2006, 2007), health and education in OECD using bootstrap methods. • Afonso and Fernandes (2006, 2008), Portuguese municipalities. • Afonso and Scaglioni (2007), Italian regions. • Sutherland et al. (2007), education in OECD. • Eugene (2007), health, education, public order and safety and general public services in EU15. • Afonso, Schuknecht and Tanzi (2008), social spending and income distribution in the OECD. • St. Aubyn (2008), law and order efficiency measurement. • Geys, Heinemann, and Kalb (2008), German municipalities. • Afonso and St. Aubyn (2009), public and private inputs in aggregate production in OECD. • Another strand: for instance, study of the determinants of (education) quality using cross-country regressions, Barro and Lee (2001), Hanushek and Luque (2003). A. Afonso

20. Illustrative examples of public sector cross-country efficiency analysis • Overall public sector • Education • Health • Social spending A. Afonso

21. Conclusions • Public spending policies are more useful when they • are limited to core/productive spending (including basic safety nets); • provide services in an efficient manner; • Cross-country, sector level analysis is important to highlight best practices; • Social protection, health, and education accounted for 64-65% of total spending in the euro area/EU in 2006 (focus on these items); • DEA/tobit/bootstrap/stochastic frontier procedures have been recently used in the context of cross-country efficiency analysis; • Non-parametric analysis has the advantage that a priori conceptions about the shape of the production frontier are kept to a minimum; • Parametric analysis has the advantage of allowing for hypothesis testing; • Care is needed in selecting as homogeneous as possible data as well as the “right” data (physical vs. financial resources, etc.); • Countries far from the efficiency frontier: not necessarily inefficient (non-discretionary factors); • QPF indicators and efficiency assessments can help EU fiscal surveillance. SPs/CPs include a section on the quality of public finances; • An indirect cost of public sector provision inefficiency is the increase in the excess burden of taxation, (Afonso and Gaspar, 2007). A. Afonso

22. PSP Source: Afonso, Schuknecht and Tanzi (2005). A. Afonso

23. Public sector overall efficiency, 2000 Source: Afonso, Schuknecht and Tanzi (2005). A. Afonso

24. Illustrative evidence on public sector performance and efficiency (considering general government spending) Good performance (two right-hand side quadrants), include lower efficiency/higher spending (Finland, Sweden, and Denmark) and higher efficiency/lower spending (Austria, Japan, Ireland, US). Source: Adapted from Afonso, Schuknecht and Tanzi (2005). A. Afonso

25. General Government functional spending (% of GDP) Source: OECD. A. Afonso

26. Source: OECD. A. Afonso

27. DEA results Note: in this example inefficient values are higher than unity. With the same inputs, it would be possible to increase the output. A. Afonso Source: Afonso and St. Aubyn (2006).

28. Results from education tobit: Note: in this example inefficient scores (d) are higher than unity. A. Afonso Source: Afonso and St. Aubyn (2006).

29. Health expenditure • OECD, 2003: • 8.7 % of GDP, of which 72.5% is public spending. Source: Afonso and St. Aubyn (2007). A. Afonso

30. Health inputs and outputs summary Outputs Inputs Source: OECD. • Infant survival rate (ISR) = [1000-infant mortality rate]/[infant mortality rate] A. Afonso

31. Principal component analysis (PCA) for health analysis • PCA reduces the dimensionality of multivariate data • Afonso and St. Aubyn (2007) in the case of health in OECD • apply PCA to the 4 input variables; • use the first 3 principal components as the 3 input measures (they explain around 88% of the variation); • applied PCA to the three output variables; • selected the 1st principal component (it accounts for around 84% of the variation); • This reduces the problem to 1 output – 3 inputs (helpful since, as as a general rule of thumb, there should be at least 3 units for each input and output) A. Afonso

32. Health output efficiency results – DEA Note: in this example inefficient values are higher than unity. With the same inputs, on average, output could increase. Source: Afonso and St. Aubyn (2007). A. Afonso

33. Results from 2nd step health Tobit Source: Afonso and St. Aubyn (2007). Note: in this example inefficient scores (d) are higher than unity. A. Afonso

34. Income distribution efficiency:Production possibility frontier (1 input, 1 output) Source: Afonso et al. (2008). A. Afonso

35. DEA income distribution efficiency (1 input, public social expenditure; 2 outputs, Gini coefficient, income share of poorest 40%) Source: Afonso et al. (2008). A. Afonso

36. Production possibility frontier, CRS, 1 input (social spending-to-GDP), 2 outputs (income share of poorest 40%, Gini) Source: Afonso et al. (2008). A. Afonso

37. Afonso, A. and Fernandes, S. (2006).“Measuring local government spending efficiency: Evidence for the Lisbon Region”, Regional Studies, 2006, 40 (1), 39-53. • Afonso, A. and Fernandes, S. (2008). “Assessing and Explaining the Relative efficiency of Local Government”, Journal of Socio-Economics, 37 (5), 1946-1979. • Afonso, A. and Gaspar, V. (2007). “Dupuit, Pigou and cost of inefficiency in public services provision”, Public Choice, 132 (3-4), 485-502. • Afonso, A. and St. Aubyn, M. (2005a). “Non-parametric Approaches to Education and Health Efficiency in OECD Countries”, Journal of Applied Economics, 8 (2), 227-246. • Afonso, A. and St. Aubyn, M. (2005b). “Assessing Education and Health Efficiency in OECD Countries using alternative Input Measures,” in Public Expenditure, 361-388. Banca d’ Itália. • Afonso, A. and St. Aubyn, M. (2006). "Cross-country Efficiency of Secondary Education Provision: a Semi-parametric Analysis with Non-discretionary Inputs", Economic Modelling, 23 (3), 476-491. [ECB WP 494, 2005] • Afonso, A. and St. Aubyn, M. (2007). “Assessing health efficiency across countries with a two-step and bootstrap analysis”, ISEG/UTL WP 33/2006/DE/UECE. • Afonso, A. and St. Aubyn, M. (2009). “Public and Private Inputs in Aggregate Production and Growth: A Cross-country Efficiency Approach”, mimeo. • Afonso, A. and Scaglioni, C. (2007). “Efficiency in italian regional public utilities’ provision”, in Servizi Publici: Nuove tendenze nella regolamentazione, nella produzione e nel finanziamento, pp. 397-418, eds. M. Marrelli, F. Padovano and I. Rizzo, 2007, FrancoAngeli, Milano, Italy. ISBN 978-88-464-8786-5. • Afonso, A., Schuknecht. L. and Tanzi, V. (2005). "Public sector efficiency: An international comparison," Public Choice, 123 (3), 321-347. [ECB WP 242, 2003] References (1) A. Afonso

38. Afonso, A.; Schuknecht, L. and Tanzi, V. (2006). “Public Sector Efficiency: Evidence for New EU Member States and Emerging Markets”, ECB Working Paper n. 581, Applied Economics, forthcoming. • Afonso, A., Schuknecht, L. and Tanzi, V. (2008). “Income Distribution Determinants and Public Spending Efficiency ”, ECB Working Paper n. 861. • Barrios, S., Pench, L. and Schaechter, A. (2009, eds.). “The quality of public finances and economic growth: Proceedings to the annual Workshop on public finance”, European Economy - Occasional Papers n. 45. • Barro, R. and Lee, J-W. (2001). “Schooling Quality in a Cross-Section of Countries.” Economica, 68, 465-488. • De Borger, B. and Kerstens, K. (1996). “Cost efficiency of Belgian local governments: A comparative analysis of FDH, DEA, and econometric approaches”. Regional Science and Urban Economics 26, 145-170. • Clements, B. (2002). “How Efficient is Education Spending in Europe?” European Review of Economics and Finance, 1 (1), 3–26. • Coelli, T.; Rao, P. and Battese, G. (2005). An Introduction to Efficiency and Productivity Analysis. 2nd ed., Kluwer, Boston. • EC (2007). The EU economy: 2007 review, Moving Europe's productivity frontier. November • EC (2008a). “Public Finances in EMU 2008”. • EC (2008b). “The quality of public finances: Findings of the Economic Policy Committee-Working Group (2004-2007), Deroose, S. and Kastrop, C. (eds.). Occasional Papers 37, March. References (2) A. Afonso

39. ECB (2006). “The importance of public expenditure reform for economic growth and stability”, ECB Monthly Bulletin, April, pp. 61-73. • Eugène, B. (2007). “The efficiency of the Belgian general government in an international perspective”, mimeo, National Bank of Belgium. • Evans, D.; Tandon, A.; Murray, C. and Lauer, J. (2000). “The Comparative Efficiency of National Health Systems in Producing Health: an Analysis of 191 Countries”, GPE Discussion Paper Series 29, Geneva, World Health Organisation. • Geys, B., Heinemann, F. and Kalb, A. (2008). “Voter Involvement, Fiscal Autonomy and Public Sector Efficiency: Evidence from German Municipalities”, ZEW Discussion Paper 08-024. • Hanushek, E. and Luque, J. (2003). “Efficiency and equity in schools around the world”, Economics of Education Review, 22, 481-502. • Simar, L. and Wilson, P. (2007). “Estimation and Inference in Two-Stage, Semi-Parametric Models of Production Processes”, Journal of Econometrics, 136 (1), 31-64. • St. Aubyn, M. (2003). “Evaluating Efficiency in the Portuguese Education Sector”, Economia, 26, 25-51.” • St. Aubyn, M. (2008). “Law and Order Efficiency Measurement – A Literature Review”, ISEG/UTL WP 19/2008/DE/UECE. • Sutherland, D.; Price, R.; Joumard, I. and Nicq, C. (2007). “Performance indicators for public spending efficiency in primary and secondary education”, OECD Economics Department WP 546. • Van den Eeckhaut, P., Tulkens, H., and Jamar, M.-A. (1993). “Cost-efficiency in Belgian municipalities,” in Fried, H.; Lovell, C. and Schmidt, S. (eds.), The Measurement of Productive Efficiency: Techniques and Applications. New York: Oxford Univ. Press. References (3) A. Afonso

40. Corrective arm of the SGP * Mentions that the Commission and the Council, when assessing and deciding upon the existence of an excessive deficit, shall take into account “developments in the medium-term budgetary position (in particular, fiscal consolidation efforts in ‘good times’, debt sustainability, public investment and the overall quality of public finances)”. (see also EC, 2008a) Quality and efficiency in the SGP * Regulation of the European Council, N.º 1467/97 of 7 July 1997, modified by Regulation N.º 1056/2005 of 27 June 2005, on speeding up and clarifying the implementation of the excessive deficit procedure. A. Afonso

41. Non-discretionary inputs and tobit two-step procedure (3) • Problems with tobit traditional procedure: • - Each efficiency score estimate depends on all observed inputs and outputs: εi is serially correlated. • - The environmental variables are correlated with both inputs and outputs: εiis not independent from zi. Methodology – exogenous factors Simar and Wilson (2007) propose alternative estimation and inference procedures based on bootstrap methods. They assume: where εi is a left truncated normal random variable. A. Afonso

42. Data for education analysis Source: OECD.

43. Health analysis – 2nd step (bootstrap) Source: Afonso and St. Aubyn (2007). A. Afonso

44. PSP Overall public sector Source: Afonso, Schuknecht and Tanzi (2005). A. Afonso