Public Finance and Management

1
Public Finance and Management

• Microeconomics of the Budget
• M. Baher El-Hifnawi
• East Asia and the Pacific
• World Bank
• May 1, 2006

2
Public Expenditure Analysis

• Rationale for Government Intervention
• Instruments/Mechanisms for intervention
• A Framework for the Appraisal of Development
  Expenditures

3
When should governments intervene?

• Market failures (public goods, externalities)
• Redistribution

4
How should governments intervene?

• Subsidy
• Regulation
• Public provision

5
Mechanisms for intervention

• Regulation
• Grant/Subsidy
• Direct provision

6
Framework for Appraisal of Development
Expenditures

• Sector analysis
• Cost benefit analysis
• Cost effectiveness

7
Framework for Appraisal of Development
Expenditures

• Cost Benefit Analysis
• Economic analysis is the project worthwhile?
• Financial analysis what are the fiscal impacts?
  Is the project financially sustainable?
• Stakeholder analysis Who gains? Who loses? Any
  contributions to poverty reduction?
• Basic needs analysis any additional benefits
  attributed to addressing a basic need?
• Risk analysis how robust are the results?

8
Project Parameters
Project Parameters (Tables 1a, 1b, and 1c)
Price Levels and Exchange Rate (Table 2)
Financial Analysis
Unit Cost of Production (End of Table 5)
Loan Schedule (Table 7)
Investment and Depreciation Schedule (Table 9
and 10)
Production and Sales (Table 3a, 3b, 4 and
5) Working Capital (Table 6)
(Interest Expense)
(Depreciation Expense)
(Cost of Good Sold)
Income Tax Statement (Table 11)
(Taxes)
Total Investment Cash Flow (Nominal) (Table 12)
(Loan)
Equity Holders Cash Flow (Nominal) (Table 14)
Total Investment Cash Flow (Real) (Table 13)
Equity Holders Cash Flow (Real) (Table 15)
9
Economic Analysis

• Step One National Economic Parameters
• a. Economic Opportunity Cost of Capital
• b. Foreign Exchange Premium
• (Table 16 for FEP)

• Step Two Economic Conversion Factors for
• a. Project Output(s)
• b. Project Inputs, including
• Investments
• Operating Expenses
• Labor
• c. Working Capital
• d. Taxes, Tariffs, Subsidies, and Loans
• (Table 17a,17b, 17c, 17d and , 17e)

• Step Two Economic Conversion Factors for
• a. Project Output(s)
• b. Project Inputs, including
• Investments
• Operating Expenses
• Labor
• c. Working Capital
• d. Taxes, Tariffs, Subsidies, and Loans

(Applied to Real Financial Cash Flow
Statement)
Statement of Economic Costs and Benefits (Table
18)
10
Stakeholder Analysis

• A. Economic Real Net Resource Flow
• (Table 18 of MPR Case)

-
(Minus)
B. Financial Real Net Resource Flow (Table 13 of
MPR Case)
(Yields)
C. Net Resource Flow of Externalities (Table 19
of MPR Case)
D. Present Value (Table 20 of MPR Case)
E. Allocation of Externalities (Table 20 of MPR
Case)
11
Stakeholder Analysis (Continued)

• F. Summary of Stakeholders Net Benefits (Costs)
• (End of Table 21 of MPR Case)

G. Reconciliation of Economic and Financial
Analyses (Top of Table 21 of MPR Case) Economic
NPV Financial NPV PV Externalities
H. Basic Needs Analysis
12
Risk Analysis

• A. Sensitivity Analysis
• (Table 22 of MPR Case)

B. Risk Variables (Table 23 and 24 of MPR Case)
C. Results (Table 25 and 26 of MPR Case) (Figure
1, 2, and 3)
13
Economic AnalysisThree Basic Postulates
forApplied Welfare Economics

• A. The competitive demand price for a given unit
  of an item measures the value of that unit to the
  demander
• Willingness to pay
• B. The competitive supply price for a given unit
  of a good or service measures the value of that
  unit to the supplier
• Opportunity cost
• C. Costs and benefits accruing to different
  groups should be added up to determine overall
  economic benefits i.e. A dollar is a dollar no
  matter to whom it accrues

14
Illustration of Basic Postulates
Postulate A Willingness to Pay
Postulate B Opportunity Cost
Price
Price
Market Supply Curve
Market Demand Curve
d 0
P
s 0
P
Quantity per year
Quantity per year
Qo
Qo
15
Non-Tradable Commodities

• A good or service is considered non-tradable when
  its domestic price is determined by local demand
  and supply.
• An increase in demand (or supply) by a project
  could affect the amounts demanded by domestic
  consumers (or produced by other suppliers).

16
Non - Tradable Good
Price
Domestic Supply
S
Distorted World Supply Price
Em PCIF (1Tm) Fm
Pm
Distorted World Demand Price
Em PFOB (1-tx) - Fx
Domestic Demand
D
Quantity per year
17
Steps to Estimate the Economic Value of a
Non-Tradable Good or Service 1) Adjust for
distortions in the market for the item (whether
input to, or output of, the project). 2) Correct
for the foreign exchange premium if there is an
impact on the quantity supplied by other
suppliers in the market (ws). 3) Correct for
distortions in the markets for the inputs used to
produce the item. Correction is applied to the
proportion of the item produced by other
suppliers in the market (ws).
18
Non-Tradable Goods Economic Benefits of Project
Output (No Distortions)
Price
S0
A
S0 Project
C
P0
E
G
F
P1
B
D
D0
s1
Q
d1
Q0
QT
Q
Quantity
Value of Resources Saved
Value of Increased Consumption
19
Calculating the Economic Value of Non-Tradable
Goods
Economic Value W s P s W d P d
weighted average of supply (Ps) and demand
(Pd) price
Supply Elasticity
?

Where
W s
Supply Elasticity - Demand Elasticity
? - ?
Demand Elasticity -?
W d

Supply Elasticity - Demand Elasticity ? -
?
P s Supply Price
? (defined positively)own price elasticity of
supply
P d Demand Price
? (defined negatively) own price elasticity of
demand
20
Potable Water Supply ExpansionThe Manila
South Water Distribution ProjectThe Economic
Benefits of Water to Paying Customers
21
Non-Tradable Goods Economic Benefits of Project
Output (Tax on Output)
Step One Adjusting for Distortions in the Market
for Good or Service
Economic Benefits
W s P
m0
W d P
m0
(1 t s )
Example W s 1/3, W d2/3 Pm120, t s 0.15
Pe1/3(120)2/3(120)(10.15)132
Pe4080(1.15)132
22
Non-Tradable Goods Economic Benefits of Project
Output (Subsidized Output)
Price
S0
S
After subsidy 0
s0
m0
P
H
P

/ (1-k)
S
A
After Subsidy 0Project
m1
s1
F
/ (1-k)
P
P

E
d0
m0
I
P
P

J

m1
d1
P
P
G
B
C
D
D0
Quantity
Q
Q
Q
s1
d1
d/s0
Economic Benefits
m0
P
W s
W d P
m0
(1-k)
Value of Resources Saved
Value of Increased Consumption
Example W s 1/3, W d2/3 Pm90, k 0.40
Pe1/3(90/(1-0.4))2/3(90) Pe1/3(150)2/3(90)
110
23
Non-Tradable Goods Economic Costs of Project
Input (Subsidized Input)
Price
S0
H
s1
m1
P
P

/ (1-k)
C
After Subsidy 0
S
G
m0
s0
B
/ (1-k)
P
P

D
I
E
d1
m1
P
P

F
J

m0
d0
P
P
A
D0Project
D0
Quantity
d1
s 1
d/s0
Q
Q
Q
Economic Costs
m0
P
W s
W d P
m0
(1-k)
Value of Postponed Consumption
Value of Additional Resources
Example W s 1/3, W d2/3 Pm90, k 0.40
Pe1/3(90/(1-0.4))2/3(90) Pe1/3(150)2/3(90)
110
24
Example 1 Project Uses Electricity(Sales Tax,
Subsidy on Cost of Electricity Production, No
Other Distortions)
m0
Financial Market Price (P )Net of Tax .100
pesos/kWh
m0
Financial Demand Price (P P Tax) .120
pesos/kWh
d0
s0
m0
Financial Supply Price, (P P Subsidy)
.167pesos/kWh
Economic Price (Pe) Wd Pd WsPs. If
Wd 2/3, and Ws 1/3, then
Pe 2/3(.120) 1/3(.167) .136
pesos/kWh
25
Tradable Commodities Classification of a
Projects Inputs and Outputs

• A good or service is considered tradable when an
  increase in demand (or supply) by a project does
  not affect the amount demanded by domestic
  consumers
• An increase in demand for an IMPORTABLE commodity
  results in an increase in demand for imports
• An increase in demand for an EXPORTABLE commodity
  results in a reduction in exports
• When a project produces a tradable commodity,
  there will be either a reduction in imports or an
  increase in exports.
• An Importable commodity includes imported goods
  and domestically produced goods that are close
  substitutes for imported goods
• An Exportable commodity includes exported goods
  and close substitutes for exported goods

26
Importable Good
Price
Domestic Supply
S
Distorted World Supply Price
Pm
Em PCIF (1Tm) Fm
Domestic Demand
D
Quantity per year
do
so
Q
Q
so
do
Imports Q - Q
Em Market Exchange Rate
FM Domestic Freight to Market
Tm Rate of Import Tariff
PCIFPrice of imports at entry point to country,
including international freight and insurance
changes expressed in units of foreign currency
27
Project Supplies More of an Importable Good
Price
S domestic
S w/ project
S world
Em PCIF (1Tm) Fm
D domestic
Q1 Q2
Q3
Quantity
Project reduces quantity imported. No change in
domestic consumption.
28
Project Demands More of an Importable Good
Price
S domestic
Em PCIF (1Tm) Fm
S world
D w/ project
D domestic
Q1 Q2
Q3
Quantity
Project requirements will be met by additional
imports (world supply). Domestic consumption is
not affected.
29
Exportable Good
Price
Domestic Supply
S
Em PFOB (1-tx) - Fx
Distorted World Demand Price
Pm
Domestic Demand
D
Quantity per year
do
so
Q
Q
do
so
Exports Q - Q
Em Market Exchange Rate
tx Export Tax
Fx Freight and Trading Costs to Port
PFOBPrice of exports at point of export from
country in units of foreign currency
30
Project Supplies More of an Exportable Good
Price
S domestic
S w/ Project
Em PFOB (1-tx) - Fx
D world
D domestic
Q1
Q2 Q3
Quantity
Project increases exports. Domestic consumption
remains unchanged.
31
Project Demands More of an Exportable Good
Price
S domestic
D world
Em PFOB (1-tx) - Fx
D w/ Project
D domestic
Q1 Q2
Q3
Quantity
Project requirements will reduce quantity
exported. Consumption of previous consumers
remains unchanged.
32
Estimating The Economic Prices of Tradable Goods

• 1. Adjust for commodity - specific trade
  distortions
• Financial prices for the commodities demanded (or
  supplied) by a project must be adjusted for
  commodity-specific distortions and costs that
  drive a wedge between their international prices
  and their domestic market prices
• Taxes and Subsidies are transfers between
  consumers, producers, and the government.
  Therefore, they are not part of the real
  resources consumed or produced by a project.
• 2. Value the foreign exchange at the economic
  (shadow) exchange rate (Ee)
• Multiply the CIF and FOB prices at the border by
  the economic price of foreign exchange (Ee)
• Alternatively, add a foreign exchange premium
  (Ee/Em) - 1, or (Ee/OER) - 1, per unit of
  foreign exchange demanded (or supplied) by a
  project.
• 3. Adjust for handling and transportation costs
• The economic costs of handling and transportation
  that are necessary to move trade commodities to
  or from the point of entry must be included
• In the case of imported commodities, these costs
  should be added to the CIF price.
• In the case of exported commodities, these costs
  should be subtracted from the FOB price.

33
Visayas Communal Irrigation Project

• Basic Facts
• The National Irrigation Administration
  (Philippine National Agency) proposes to
  rehabilitate 55 damaged communal irrigation
  systems and to build 25 new systems in Visayas.
• The projects additional components include water
  protection and erosion control, the strengthening
  of irrigation association, and the development of
  agricultural extension services.
• The goal of the project is to alleviate poverty,
  while improving environmental sustainability of
  the region.
• The life of project is 20 years.
• The economic benefits arise from the increased
  production of rice and corn, which must otherwise
  be imported.
• The foreign exchange premium is 24.6.
• The project is expected to cost approximately
  480.910 million pesos (US19.78 million).
• The project will be financed with US15.1 million
  loan from the International Fund for Agricultural
  Development, and remaining funding would be
  provided by the Philippine government.

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Summary for Tradable Goods
Economic Cost of Imported Input CIF (adj. For
Economic Exchange Rate) Economic Cost of
Freight to Project Economic Value of Import
Substitute Production CIF (adj. For Economic
Exchange Rate) Economic Cost of Local Freight
from Port to Market - Economic Cost of Local
Freight from Project to Market Economic Cost of
Exportable Input FOB (adj. For Economic Exchange
Rate) Economic Cost of Local Freight from
Export Producer to Project - Economic Cost of
Local Freight from Export Producer to
Port Economic Value of Export Production FOB
(adj. For Economic Exchange Rate) - Economic Cost
of Local Freight from Project to Port
39

• Stakeholder Analysis

40
DISTRIBUTIONAL/STAKEHOLDER IMPACTS

• FOR ALL INPUT AND OUTPUT VARIABLES
• NPV economic NPV financial S Stakeholder
  Impacts
• Stakeholder Impacts are often called
  externalities of project
• Example of a non-traded good with a sales tax
• Economic Value Financial Value Change in
  Government Tax Revenues Increase
  in Consumer Benefits - Loss in Profits
  to other producers

41
Financial, Economic and Distributive Effects of
Project to Supply Non-Traded Goods with no
Distortions
S
P
S Project
A
P0
B
C
P1
D
Q
Qd
Q0
QS
Financial Value of Output QsCBQd or P1 (Qd
-Qs) Economic Value of Output
QsCABQd Difference (Economic - Financial)
CAB CAB P1P0AB -P1P0AC Gain in Consumer
Surplus - Loss in Producer Surplus Economic Value
Financial Value Gain in Consumer Surplus -
Loss in Producer Surplus Financial Value
Distributive Impacts
42
Financial, Economic and Distributive Effects of
Project to Supply Non-Traded Goods with Unit Tax
P
S
E
P
S Project
F
A
C
B
D
Dn
Q
Qd
Q0
QS
Financial Value of Output QsCBQd Economic
Value of Output QsCAQ0 Q0ABQd AEFB AEFB
Increase in Government Revenue CAB P P
AB - P P AC Since P P AB P
P EF Therefore, CAB P P EF - P
P AC Gain in Consumer Surplus - Loss in
Producer Surplus Economic Value of Output
Financial Value of Output Change in Government
Tax Revenues Increases in Consumer Surplus -
Loss in Producer Surplus
43
Measuring Distributive Impact from Financial and
Economic Values of Inputs with Tariffs
P
S
C
B
F
PW(1t)
A
Pw
E
H
G
D Project
D
Q
Q
d2
s0
Q
s1
d1
d0
Q
Q
Q
d1
d2
Financial Cost of Importable Goods Q
CFQ Economic Cost of Importable Goods Q GHQ
(Ee / Em) Where (Ee / Em - 1) Foreign
Exchange Premium (FEP) Difference (Financial Cost
- Economic Cost) GCFH - Q GHQ (Ee / Em -
1) Gain in Tariff Revenues to Government -
Loss in Government Revenues from Additional Use
of Foreign Exchange in Importing This Input
d2
d1
d2
d1
44
Port Rehabilitation and Expansion The Makar
Project

• Basic Facts
• Makar Port, located in General Santos City at the
  northern side of Sarangani Bay, a well-protected
  bay in Mindanao, lies along the main north-south
  trading axis which skirts Mindanao on its western
  shore.
• The objectives of the project are to increase the
  capacity and improve the efficiency of cargo
  handling facilities at the port to accommodate
  future flows
• The project will cost approximately 635 million
  pesos1
• Seventy-five percent of the total project cost
  will be provided as a grant by the US Agency for
  International Development (USAID) and the other
  25 will be provided from counterpart
  contribution by the Philippine government

45
Port Rehabilitation and Expansion The Makar
Project

• Project Outcome
• Deterministic case appeared good with
  partial financial analysis NPV Financial
  (with Project)10,760,000 million pesos
• Full analysis shows project provide a
  negative economic performance
• Project was implemented

46
Port Rehabilitation and Expansion The Makar
Project Incremental Financial-Economic Analysis
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Economic Benefits Makar Port Project

• Additional port revenue from expansion in
  traffic including foreign exchange premium.
• Additional rental income from containers yards.
• Reduction in waiting time of ships.
• Reduction in animal weight loss from waiting on
  ship.

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Potable Water Supply ExpansionThe Manila
South Water Distribution Project Economic
Benefits

• Economic benefits will be generated as a result
  of additional consumption by new connections
  (paying customers).
• Additional benefits will be generated by
  increased consumption of water by non-paying
  customers.
• Saving in the resources. The resources that are
  released by reduction of water supplied from
  water vendors and wells are an economic benefit
  to economy.

52
Stakeholder Impact Manila South Water
Distribution Project
(A)
(B)
(B-A)
PV Financial
PV Economic
at Economic
at Economic
PV of
Government
Non-Paying
Paying
Engineering
Water
Discount Rate
Discount Rate
Externalities
Users
Users
Services
Vendors
of 10.30
of 10.30
BENEFITS
Revenue Generated Water
2,148.23
4,515.02
2,366.79
2,570.50
(203.71)
Change in accts. Receivables
(86.22)
(181.21)
(94.99)
(103.17)
8.18
Benefits from
non-revenue water
939.92
939.92
939.92
TOTAL BENEFITS
2,062.01
5,273.74
3,211.73
COSTS
Investments
Civil works
510.32
500.11
(10.21)
10.21
Equipment and materials
624.87
778.59
153.72
(153.72)
Office buildings
7.11
7.25
0.14
(0.14)
Consulting services
3.39
3.39
0.00
Land
28.00
28.00
0.00
In-house eng. services
81.26
54.72
(26.53)
26.53
Taxes and duties
162.32
0.00
(162.32)
162.32
Operating and maintenance
Wages
710.43
710.43
0.00
Chemicals
102.19
98.10
(4.09)
4.09
Power
130.22
139.34
9.12
(9.12)
Maintenance
89.50
85.92
(3.58)
3.58
Income tax
Change in accts. payable
(11.54)
(11.54)
0.00
Change in cash balance
1.87
1.87
0.00
TOTAL COSTS
2,439.94
2,396.19
(43.75)
NET BENEFITS
(377.93)
2,877.55
3,255.48
17
940
2,467
27
(196)
As these are the net benefits of the
externalities, this includes the the benefits
of the consumer surplus on drinking and wash
water, minus the loss in well owner's
producer surplus, due to the fact that the well
owners are the consumers.