Public Policies towards Investment Technology and Efficiency

#### **Chapter 6**

## Perspective Chapter: The Impact of Human Capital Investment on Economic Growth – Arab Countries Evidence from 2001 to 2021

*Nemer Badwan*

#### **Abstract**

The study aimed to measure the impact of investment in human capital on economic growth in a group of Arab countries during the period (2001 to 2021) using static panel models. We used a set of independent variables to express the investment variable in human capital for Arab countries represented in the enrollment ratio in the primary stage, secondary school enrollment ratio, higher education enrollment ratio, life expectancy rate, and education expenditure. Also, we used per capita GDP as a variable representing economic growth. The study found a set of results, the most important of which is the absence of the impact of the enrollment rate in primary and secondary education on the per capita share of GDP. The study also found the presence of a significant and negative impact of the enrollment rate in higher education on the per capita share of GDP and in addition to a positive morale effect on spending on employment and education, life expectancy on per capita GDP.

**Keywords:** investment, human capital, economic growth, Arab countries, education, static panel models

#### **1. Introduction**

In recent economic literature, the importance of human capital in a country's economic development has been emphasized. Countries and international organizations who believe in such a role have lately rekindled their interest in supporting investment in human capital to raise living standards by increasing productivity, cutting unemployment, and alleviating poverty.

Over the last decade, the Arab region's exceptional economic expansion has not corresponded with similarly robust labor and human resource development, generating apparent worries about the region's ability to sustain and balance growth [1, 2]. According to the results of the survey, just 38% of Arab CEOs feel there is an adequate supply of skilled indigenous labor, implying a strong reliance on expatriate recruiting. The Gulf region is the most affected by the shortage of trained labor, with a 91% dependency on expatriates. Furthermore, as Gulf CEOs have pointed out, the quality

and productivity of expatriates are significantly better than that of the indigenous labor at all levels of management [3, 4].

The value of human capital may be seen in the total effects on individuals and macroeconomics. Individually, education and training, as one of the primary instruments for accumulating knowledge and practical experience, are among the most essential variables in increasing one's earnings [5, 6].

For example, using statistical surveys, the "Mincer" model [7] was used in various studies to measure the return on education in different nations. This research showed that there is a positive association between income and educational attainment.

At the macroeconomic level, research that used macroeconomic models revealed the relevance of human capital in fostering long-term growth. In this context, the notion of human accumulation of capital was viewed as a key driver of economic progress and gross national product [8, 9].

As a result, the World Bank created a human capital initiative in 2017 that brought together governments worldwide to boost human capital investment and close gaps in this field. Other organizations, such as the World Economic Forum and United Nations agencies, have also recognized the importance of human capital and are working to develop a methodology for measuring it [10–12].

Moreover, the link between human capital and economic development takes time to build [13, 14]. In this way, all theories and models emphasize the beneficial benefits of human capital on long-run income per capita growth, which is ensured, in part, by increasing economic productivity [15].

Productivity is not everything, as Krugman [16] said, but it is practically everything in the long term. The ability of a country to enhance its quality of life over time is nearly completely determined by its ability to increase production per worker.

As a result, productivity is seen to be the most essential component in long-term economic growth. Furthermore, one of the most contentious issues among economists is the direction of causation between several macroeconomic variables. Knowing which way causation runs between two economic variables aids policymakers in making accurate and efficient decisions about such economic aggregates. Similarly, the purpose of this research is to determine the direction of causation between human capital and economic growth.

Given the global economic transformations that affect all countries of the world and that have brought about radical changes in many economic aspects, many countries seek to adapt and adapt to global developments because of their repercussions on their economies and to find solutions and alternatives to that; as these countries seek to introduce new concepts to control their economic conditions and achieve economic stability, economic growth is one of the most important indicators that reflect the economic situation of countries, which is used to compare among themselves and on the basis of which they are classified into developing and developed countries, in addition to being a tool in the hands of economic decision-makers through which solutions are developed to address imbalances in a timely manner [17].

In addition, the world has witnessed great growth in terms of awareness of the value of the human being as a goal and a means in the system of economic development, and the path to positive integration in the system of advanced economies has become subject to what can be achieved and achieved. It plays an important and pivotal role in achieving it.

In light of the new world order and economic developments at the global, regional, and local levels, and their repercussions on the Arab region [18], it has become necessary for Arab countries to invest in the human element and give it great importance

*Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*

through education, training, and qualification to form a pillar of their economies, and this is what we will try to identify through our study, through which we seek to measure the impact of investment in human capital on the economic growth of a group of Arab countries during the period (2001–2021) and to know the importance of investment in human capital in achieving economic growth in Arab countries [19].

The data were collected from multiple sources such as the Arab Monetary Fund, the World Bank, the International Monetary Fund, and the World Economic Forum.

#### **1.1 Hypotheses of the study**

To answer the sub-questions, we formulated the following hypotheses:

**H1:** Expenditure on developing the capabilities and skills of the human element that can increase its productivity in later periods;

**H2:** The theory of endogenous growth is based on dividing capital into two categories: material and human.

**H3:** There is a significant and positive impact of the enrollment rate in the various educational stages on economic growth in Arab countries.

#### **1.2 The importance of the study**


#### **1.3 The objectives of the study**

Through this study, we try to know and explore:


#### **2. Literature reviews**

#### **2.1 Theoretical literature for investing in human capital and economic growth**

#### *2.1.1 A conceptual approach to investing in human capital*

There are many definitions of the concept of investment in the human element, as there are many definitions by the number of economists who were interested in this topic and dealt with research and analysis, because this topic has many economic and noneconomic dimensions in which there are many different points of view, as the United Nations defined investment as total capital formation the fixed expenditure on the acquisition of new capital goods in addition to the renewals and improvements that take place on capital goods only, but also on the acquisition of documents and financial assets [20].

Furthermore, the concept of human capital is characterized by strong interlinkages with many other important concepts such as knowledge capital, social capital, and human development, but it is distinguished from them in that it focuses on the human element [21, 22].

UNICEF defined it as the stock owned by the state of the healthy population efficient and productive learners, which is a key factor in estimating their potential in terms of economic growth and the promotion of human development.

Al-Hanawi defined investment in human capital as spending on a person to increase his production skills and knowledge and thus increase the income that they can obtain in the coming periods, as Abu Ragheef and al-Aqili define it as spending on developing human capabilities, skills, and talents in a way that enables them to increase their productivity [23–25].

#### **2.2 Three basic elements of the human capital**


#### **2.3 Theoretical framework for economic growth**

Definition of economic growth: Opinions differed and varied in defining a comprehensive definition of economic growth that includes all its aspects. The most important of these opinions are as follows:

John Revoir defines economic growth as the gradual transformation of the economy through an increase in production and welfare so that the situation that the economy reaches is in one direction, which is the increase in economic welfare.

Simon Kuznets defines economic growth as the rise in the share of the individual or the labor component's share of the volume of output, as the increase in the volume of output is often accompanied by a rise in the size of the population, on the per capita index of the volume of output.

Raymond Baran sees economic growth as "the increase in the available wealth and population," while François Perot sees growth as "the increase that occurs over a period of several long periods of time for a positive indicator in a country."

#### **2.4 Types of economic growth**

There are different types of economic growth such as:

• **Expanded economic growth:** This growth is represented by the fact that the increase in income takes place at the same rate as the increase in the population. *Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*


#### **2.5 Theoretical models of economic growth**

Many economic theories have been concerned with the study of economic growth, and the most important of which are as follows:


#### **2.6 Applied literature for investing in human capital on economic growth**

In the following, the most important previous studies that dealt with the subject of the study will be presented:

Human capital and economic development [29] in the Nigerian experience: this study aimed to measure the relationship between investment in human capital and economic growth in the state of Nigeria during the period 1982 to 2011, primary education enrollment rate, intermediate education enrollment rate, and higher education enrollment rate, in addition to the GDP variable to express economic growth.

After conducting the Johansson test and estimating the model, it was found that there is a long-term relationship between investment in human capital and economic growth, in addition to a positive significant effect on all study variables except for government spending on education and enrollment rates in primary education [30, 31].

Investment in human capital and its impact on economic growth [32] in the case of Algeria from 1970 to 2011: this study aimed to measure the impact of investment in human capital on economic growth in Algeria during the period 1970 to 2011 by measuring the contribution of a group of educational system indicators to express the investment variable in human capital represented by the number of people enrolled in different educational stages, public spending on national education [33], and outputs university education, as it was relied on the growth of real gross product to express the economic growth variable, where the model was estimated using the totally weighted least squares method (FM and OLS), and the study found a positive effect of the educational system indicators on the growth of the real gross product [29, 34].

The impact of investment in human capital on economic growth in the Syrian Republic from 2000 to 2010 [35]: the aim of the study is to measure the effect of capital investment on economic growth in Syria during the period 2000 to 2010, using the Cobb-Douglas model and the neoclassical growth models. A set of variables were used to express the investment variable in human capital represented in the growth of the labor force, the growth of the number of students registered in the different stages, the education budget percentage of the general budget in addition to the GDP, and variable to express the economic growth variable. The study found a statistically significant effect of the growth rate of the operating category and the proportion of the general budget on the growth rate of GDP, but there is no statistically significant effect of the growth rate of the number of students enrolled in the different educational stages on the rate of growth of local GDP in Syria.

The impact of education on economic growth in the case of India from 1975 to 2016 [29]: this study aimed to determine the relationship between education and economic growth in India during the period 1975 to 2016 using an autoregressive vector model.

Then, model estimation and procedures for the co-integration methodology and the Granger causality test have been reached in the study. The study indicates the absence of the effect of the enrollment rate in primary and intermediate education on economic growth, in addition to the presence of a strong impact of the enrollment rate in higher education on economic growth.

#### **2.7 Literature review on human capital and long-run economic growth**

Human capital has several meanings that change throughout time. The Organization for Economic Cooperation and Development's definition is one that most scholars, international organizations, and institutions use (OECD). Human capital, according to the OECD [29], is described as "individual knowledge, skills, abilities,

*Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*

and traits that promote the production of personal, societal, and economic well-being."

Similarly, the World Bank [36] uses a virtually identical definition of human capital: knowledge, skills, and health capacities that individuals acquire throughout their lifetimes, allowing them to reach their full potential as productive members of society1 . The World Bank definition differs from the OECD definition in that it considers the health factor and relates human capital attributes to potential productivity.

Furthermore, there is much study on technology diffusion in which human capital is a critical aspect. Many pioneering scholars, like Nelson and Phelps [37], Grossman and Helpman [38], and Barro and Sala-I-Martin [39] have produced theories of human capital.

The empirical research on human capital and its impacts on economic growth is broad and difficult to list, although there are a few notable publications that are frequently quoted, including Borensztein et al. [40] and Benhabib and Spiegel [41]. Human capital impacts are primarily taken into account in endogenous growth models, both theoretically and experimentally.

With this class of models, the pioneering contributions in this modeling domain grew, particularly by Romer [42] and Lucas [43]. These models were introduced as an alternative to Solow's and Swan's neoclassical growth models (Solow-Swan model).

The focus on the accumulation of information and its endogenization, whether this knowledge is reflected in the form of technical advancement, ideas, or human capital, is one of the main characteristics of such models.

As an alternative to the competing neoclassical (Solow-Swan model), endogenous growth theory models were designed to endogenize the role of externalities and their contribution to understanding the persistence of the long-run per capita growth rate [29, 44]<sup>2</sup> .

The latter regards such externalities, or what is supposed to be technological development, as exogenous. Indeed, in the Solow-Swan model, exogenous components dictate the steady-state growth rate, and the macroeconomic aggregates (capital, output, and consumption) expand at a constant exogenous rate of population growth, keeping the per capita corresponding numbers constant and therefore not growing [45].

As a result, the key substantive implications concerning the long term, according to Barro and Sala-I-Martin [39], are that steady-state growth rates are independent of the saving rate or the degree of technology, because of diminishing returns, a model without technological development, such as the Solow-Swan model, predicts that economies would converge to a stable state with zero per capita growth to scale.

The total factor productivity (TFP) metric assessed the percentage of increase explained by technical advancement to be higher than 50%, as reported by Jones and Romer [46], or range between 50 and 70%, as proposed by [47].

The model proved to be outmoded as well [44]. In comparison to the neoclassical Solow-Swan model, this is an "empirical" argument supporting the strength of endogenous growth models. The latter, with its conventional framework, was unable

<sup>1</sup> The measurement of the human capital is difficult as the knowledge, capabilities and skills embodied in people used in production to create personal and social well-being as stated in the previous definitions, cannot be separated from people compared to the financial and physical assets that can be separated.

<sup>2</sup> Solow and Swan published 1956 two distinct papers on the same issue, and their model is referred to as the Solow- Swan model or often as only the Solow model in Ref. to the more famous of the two economists.

to explain the ongoing nonzero per capita growth rates in many industrialized nations and was thus chastised for overlooking long-run growth factors.

As a result, one of the most important goals of the pioneers of endogenous growth theory is to include other long-run growth factors. This involves expanding the notion of capital to include additional factors as production inputs such as human capital [8, 43], creativity, ideas, and knowledge while avoiding the premise of declining return to scale [38, 48, 49].

As a result, according to Barro and Sala-I-Martin [39], having human capital as an explicit factor of production relaxes the assumption of diminishing returns to a broad concept of capital (as in classical models) and leads to long-term per capita growth in the absence of exogenous technology, thus playing the role of such technology<sup>3</sup> .

Since then, numerous sources of growth that are directly or indirectly connected to human skills, like creativity, ideas, human capital, and R&D expenditures, have been increasingly incorporated into the production function as inputs [46, 50].

The importance of human capital, which is heavily stressed in several types of endogenous growth theory, has numerous policy consequences [51–54]. Indeed, public spending policies cover a wide range of expenditures and transfers that have a direct influence on human capital, and these policies are crucial in the development and quality of human capital. These policies address a wide range of topics in health, education, and research (Research and Development, R&D).

Some of these expenditure items may have externalities that influence the productivity of other sectors that produce information, ideas, and human capital. Many economists used endogenous growth models to analyze the function of human capital in interacting with other forms of public expenditures (both flows and stocks) [55–57].

The direction of causation between various macroeconomic variables is another key question that has sparked debate among economists. Knowing which way causation runs between two economic variables aids policymakers in enacting precise and efficient policies on such aggregates. Similarly, the purpose of this research is to determine the direction of causation between human capital and economic growth. Indeed, the major study developed a consensus regarding the influence of human capital on countries' GDP, leading to the conclusion that human capital drives economic growth.

GDP, on the other hand, plays an essential role in increasing the quantity and quality of human capital. Higher GDP is more likely to devote resources to sectors that directly influence human capital, such as education<sup>4</sup> and health, as assessed by government spending in these areas [59]. Other expenditures and investments in capacity building and training, as well as research and development<sup>5</sup> , are expected to support human capital levels and quality. In conclusion, GDP is expected to have direct feedback effects on human capital, resulting in a reversal of causality.

<sup>3</sup> The only difference is that technology, in the form of ideas or knowledge, can be shared once discovered, making it a nonrival good; however, when thinking of human capital as skills and capabilities embedded in people, the use of such skills in one activity prevents them from being used in another, making human capital a rival good.

<sup>4</sup> In an OECD book, for example, the statement: Does education stimulate growth, or does growth push individuals to consume more education? highlights the causation in both directions between education and growth. In practice, causation is likely to work in both directions [58].

<sup>5</sup> The current health crisis of the covid-19 virus, in which health professionals and researchers in laboratories have found themselves on the front lines to save the human species, is a great example of the critical role of human capital in the health, education, and R&D sectors directly impacting human capital.

*Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*

#### **Figure 1.**

*The set of external factors affecting human capital. Source: Prepared and compiled by the author based on the outputs of [46].*

Reverse causality is a phenomenon that throws econometric calculations for a loop. Furthermore, GDP acts as a passthrough for the impacts of various economic and institutional policies on GDP.

Indeed, human capital is influenced by a variety of external elements (geography, institutions, and culture), as well as economic and institutional policies, as outlined by Chang-Tai and Klenow [47] in **Figure 1**.

#### **3. Methods and data sources**

#### **3.1 The method and tools used**

Relying on an econometric model in order to determine the impact of investment in human capital on economic growth in the Arab countries which is represented by the static panel model is the appropriate model for analyzing the study data.

#### **3.2 Study sample**

The study sample consists of 11 Arab countries, namely Algeria, Tunisia, Morocco, Mauritania, Bahrain, Egypt, Palestine, Jordan, Oman, Kuwait, and Qatar, where these Arab countries were selected according to the availability of data for the study variables during the period 2001 to 2021, as shown in **Table 1**.

#### **3.3 Study variables**

Based on previous studies and on the availability of data for countries, during the study period from 2001 to 2021, we used a set of variables, which can be defined as follows:

**Dependent variable (GDP-P):** Represented by the per capita GDP at current prices in US dollars to express economic growth.

**Independent variables:** A set of variables were relied upon to express the investment in human capital, which are as follows:

**PRM:** the percentage of enrollment in the primary stage (out of total education); **SEC:** the percentage of secondary school enrollment (out of total education); **TER:** the percentage of enrollment in higher education (out of total education);


#### **Table 1.**

*Samples of Arab countries.*

**LER:** total life expectancy at birth (total in years); **GEN:** spending on education (in current US dollars).

#### **4. Results and discussion**

We will first present the results of the study, based on the analysis description of the variable and the correlation of the variables through the correlation matrix that shows the extent of the correlation of the variables between them, and then we present the most important results of estimating the panel model and the differentiation tests.

**Descriptive analysis of variables:** The descriptive analysis of the variables represented in **Table 2** shows the following:

The per capita GDP in the Arab countries has reached its lowest levels during the period 2001 to 2021, and it reached a value of 496.7562 US dollars in Mauritania in 2002, while the highest level was recorded at 97068.11 in the State of Qatar in 2012.

The highest value of the enrollment rate at the primary level was recorded 126.3591 out of the total education in Algeria in 2013, which indicates the spread of awareness and desire for education, in addition to free education, which gave citizens an opportunity to enroll in education. Enrollment in the secondary stage of the total education was recorded in the State of Kuwait at 116.8016 in 2005, and the lowest value recorded was estimated at 15.07116 in Mauritania in 2002, while the highest value of the percentage of enrollment in higher education was recorded in the State of Kuwait at


#### **Table 2.**

*Descriptive statistics for the variables.*

*Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*


*Source: Prepared and compiled by the author based on the outputs of Eviews10 (matrix of correlations between variables).*

#### **Table 3.**

*Matrix of correlations between model variables.*

62.68352 in 2016, which indicates the development of its infrastructure and infrastructure. In addition to the value of the granted university degree and its compatibility with the labor market, the lowest value was recorded in Mauritania, where it reached 2.896840 in 2002.

Expenditure on education recorded its highest level in Egypt with a value of 1.87E +10 US dollars in 2016, while the lowest value was recorded in Mauritania with a value of 36,254,822 US dollars in 2008.

The highest value of life expectancy was recorded in Qatar in 2017, which reflects the good living conditions in this country, while the lowest value was recorded in Mauritania in 2001.

The lowest value for the standard deviation was for the life expectancy variable out of the total years, which amounted to 6.341174, which indicates that the values of the latter are more homogeneous from one country to another if compared to other study variables.

The matrix of correlations between the model variables represented in **Table 3** shows that there is a very weak correlation of per capita GDP with the enrollment rate in the primary stage of the total education amounted to 0.13252, and it has a medium direct correlation with the secondary school enrollment rate of the total education amounted to 0.481850, while A very weak direct correlation with the percentage of enrollment in higher education out of the total education, which amounted to 0.084883, and it has a medium direct correlation with the average life expectancy that reached 0.560323, and in the end, we find that it has a very weak correlation with the percentage of expenditure on education which amounted to 0.055834.

#### **5. Empirical models**

#### **5.1 Estimating panel models**

In order to measure the impact of investment in human capital on economic growth, the three models of static panel, namely aggregation regression model, stochastic regression model, and fixed-effects model, were estimated as shown in **Table 4**.

The model prepared as a basis for the estimate can be formulated as follows:


#### **Table 4.**

*Results of estimating panel models.*

$$GDP - P\_{it} = a\_0 + a\_1 \text{PRMit} + a\_2 \text{SECit} + a\_3 \text{TER} + a\_4 \text{GENit} + e\_{it} \tag{1}$$

where *α***:** the parameters of the models; *εit***:** random error limit; **29; t = 1:** the time period from 2001 to 2021;**11; I = 1:** the syllables that are represented by a group of 11 Arab countries;

Including the number of observations: 290 = 29 \* 11 = n = N \* T.

#### **5.2 Comparison between estimated models**

To compare the three models, we use the following tests:

**Fisher's test:** for differentiation between the cumulative regression models and the effects constant. Fisher's constrained test is used to compare the two models of cumulative regression and fixed effects and depends on the following two hypotheses:

**The null hypothesis:** a cumulative regression model is appropriate.

#### **Alternative hypothesis:** A fixed-effects model is appropriate.

Where the value of the constrained (Fisher) is calculated according to the following relationship:

$$\mathbf{F}(\mathbf{N}-1, \mathbf{NT}-\mathbf{N}-\mathbf{k}) = \frac{\frac{\left(\mathbf{R}\_{\text{FEM}}^2 - \mathbf{R}\_{\text{PAM}}^2\right)}{\left(\mathbf{N}-1\right)}}{\left(\mathbf{1} - \left(\mathbf{R}\_{\text{FEM}}^2\right)/\left(\mathbf{NT}-\mathbf{N}-\mathbf{k}\right)\right)}\tag{2}$$

where **R<sup>2</sup> FEM:** fixed-effects model parameter; **R2 PRM**: aggregate regression model coefficient of determination; **K:** estimated number of parameters; **N:** number of sample members; **NT:** the number of views.

Fisher scheduled value: (5–11-1290–11) F (9,275) = 1.75,5%) = Ft.

Fisher calculated value: 17.297 = ((275)/(0.761412–91)) /) /) (0.450127) (0.761412)) = Fc.

*Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*


**Table 5.** *Husman test results.*

#### **5.3 Comparison of the two values**

Since the calculated value of Fisher is greater than the tabulated value, we accept the alternative hypothesis, which states that the random-effects model is appropriate, as shown in **Table 5**.

#### **5.4 Comparison between fixed- and random-effects models**

To compare the two models of fixed effects and random effects, we use Husman test based on the following two hypotheses:

**The null hypothesis:** The random-effects model is appropriate.

**Alternative hypothesis:** A fixed-effects model is appropriate.

As per **Table 5**, the probability value reached 0.1938, which is greater than 5%, and we accept the null hypothesis, meaning that the random-effects model is appropriate.

#### **5.5 Discussion**

There is no doubt that human capital is important for development, and its beneficial impact on economic growth, which this study confirms, has been demonstrated in the empirical literature using many methodologies and variables to quantify human capital [60–63]. However, due to the disparities in methodologies and effects, it is impossible to compare such impacts in terms of size in the empirical literature.

Indeed, a researcher working on the same variable may not employ the same estimating method or model, and those working on the same approaches could have utilized various measures of human capital. As a result, there are usually comparisons of samples and nations within the same research rather than with other studies in many different studies covering similar issues, which we implemented in our work by using two benchmark samples of Asian and OECD countries. Nonetheless, certain uncommon studies might be studied to compare our findings with their conclusions, which appear to be in agreement with ours.

Furthermore, in terms of returns to scale, our findings are consistent with what is predicted and demonstrated in the theory of endogenous growth models, which shows that taking human capital into account leads to higher returns to scale see the literature section ([8, 43, 55]; and many others). Returns to scale are also shown to be impacted by a country's degree of affluence, with higher-income nations seeing stronger returns to scale in the presence of qualified and competent human resources.

Moreover, we should mention several issues with data creation that might affect the quality of any estimations in the literature, including ours. The first difficulty involves constructing the human capital variable. Thus, as described by the human capital definitions, evaluating human capital mostly entails measuring embedded soft skills and health capacities. Human capital has been measured using a variety of

approaches. We utilized the one we considered, which involved the quantity of human capital adjusted for quality with sufficient observations.

The World Bank's recent work to develop the human capital index [29] demonstrates an innovative methodology that links human capital to factors other than the rate of return on education, such as pupil health, which is considered the foundation of future human capital and expected labor productivity [64]. However, due to the small number of data (the research only began in 2017), we decided not to include this metric in our estimating technique.

As a result, in addition to investing in human capital, Arab nations are urged to contribute to improving human capital statistics by participating in international initiatives that specifically evaluate human capital quality.

Moreover, the physical capital stock is a computed variable that is commonly approached using the recurrent perpetual inventory equation, which is one of the most widely used approaches. The current stock is compared to the prior one, less the depreciated past stock, and the flow of current investments is added to the calculation. Some assumptions are required for such a recurring equation, notably for the initial point in the time series and the depreciation rate. The quality of the derived capital stock is determined by the correctness of these assumptions.

However, this is a universal issue and difficulty that all empirical literature faces, and it has the potential to change genuine elasticities values, necessitating greater caution in interpreting scientific works as well as increased attempts to improve the quality of the empirical literature.

By following the methodology of the static panel model, which corresponds to the nature of the study, three types of models were estimated, and after conducting comparison tests, it was found that the best model for the study is the random-effects model. The Arabic chosen during the study period is as follows:


#### **6. Conclusions and policy implications**

Through this study entitled "The impact of investment in human capital on economic growth a benchmarking study for a group of Arab countries during the period 2001 to 2021," we tried to measure the impact of investment in human capital on economic growth, and the study reached a set of results, the most important of which are given in the following sections.

#### *Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*

Investment in human capital contributes to improving its productivity, which increases the benefits and benefits resulting from its work. In addition, economic growth in the Arab countries under study is negatively and morally related to the rate of enrollment in higher education, which contradicts the economic theory and reflects the deteriorating state of the higher education situation in Arab countries, and also economic growth in Arab countries during the study period is positively and morally linked with spending on education and life expectancy at birth.

Human capital is frequently viewed as a source of long-term economic growth when it is included in the endogenous growth hypothesis. It is frequently cited as one of the most important drivers of long-run growth that explains development variations among countries. For a sample of 11 Arab nations, this article showed the significant positive impact of human capital on economic growth; nevertheless, the sample of Arab countries is not widely behind in terms of human capital contribution to GDP growth.

Furthermore, this study also looked at the direction of causation between GDP and human capital, determining that while the former causes the latter, the latter has feedback effects on the former. Obviously, this has significant policy consequences. The bidirectional causation between human capital and GDP produces a feedback loop.

As a result, enhancing human capital's contribution to long-term growth necessitates investments in critical areas that directly support human capital. Education, vocational training, health care, and research and development for creative ideas and innovations are among these areas, which have a greater impact on employees' longterm output.

As a result, governments should prioritize such industries in their spending programs, which is likely to sharpen workers' abilities and increase productivity, resulting in positive GDP feedback. Furthermore, technological advancements are fast-changing and modifying our reality, affecting our way of life in a worldwide competitive world.

As a result, in order to compete and succeed in such a changing environment, governments should invest in their people by improving their skills and potential knowledge, which will, in turn, lead to significant economic and societal advantages in the long term.

#### **7. Policy recommendations**

Through the results obtained, a set of recommendations was proposed which are represented as:


• Cooperation among Arab countries and the exchange of experiences to develop the human element, in addition to drawing on the experiences of the pioneering countries in the field.

#### **Acknowledgements**

The author extends their appreciation for their support for scientific research at the Palestine Economic Policy Research Institute (MAS) in Palestine to support this research and encourage the author in particular. The author also sends a special thanks and a great appreciation to the jury staff Reviewers and to the Editorial Board at IntechOpen.

### **Author's contribution**

The Sole Author Designed, Analyzed, Interpreted and Prepared the Chapter.

#### **Conflict of interest**

The author has declared that no competing interests exist.

### **Data availability statement**

The data and materials that support the findings of this study are available from the corresponding author upon request. Datasets are derived from public resources and made available to the authors. Data analyzed in this study were a reanalysis of existing data, which are openly available at locations cited in the reference section.

### **JEL classification codes**

G11, I2, I1, J3, J8, J24, N3, O47.

### **Author details**

Nemer Badwan Palestine Economic Policy Research Institute (MAS), Ramallah, Jerusalem, State of Palestine

\*Address all correspondence to: therock2031@gmail.com; nemer.badwan@mail.ru

© 2022 The Author(s). Licensee IntechOpen. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

*Perspective Chapter: The Impact of Human Capital Investment on Economic Growth… DOI: http://dx.doi.org/10.5772/intechopen.107100*

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#### **Chapter 7**

## Public Finance Management: Essence, Problems, and Development Prospects

*Liudmila Tkachenko*

#### **Abstract**

The chapter justifies the increased interest in public sector financial management (PFM) through its scaling up in the economy. The paper reveals the essence of the PFM system, through an analysis of the definitions of the PFM, the role of the public sector in the economy, the key elements of the PFM system, and a comparative analysis of financial management systems in the public and the private sectors of the economy. The problematic issues of the functioning of the PFM system, which include the issues of assessing the quality of the PFM, are analyzed. The quality of the PFM is understood as its effectiveness, efficiency, and achievement of the goals of the PFM, the main of which is the growth of the well-being of society. The statement proved that the amount of public spending is not evidence of the effectiveness of the PFM system. The factors influencing the efficiency of the PFM system functioning are revealed. The importance of financial information formed in the system of state accounting on an accrual basis on the basis of IPSAS for making government decisions is revealed. An alternative point of view on the formation of financial information is given.

**Keywords:** public finance management, public spending efficiency, PFM system, essence of the PFM, assessing the quality of PFM, accrual accounting

#### **1. Introduction**

Effective public financial management, known as public financial management (PFM), is fundamental to the development and growth of the economies of individual countries. As populations grow, resources shrink, or economies become more complex, the importance of PFM increases.

One of the reasons PFM is so important is that taxpaying citizens in any country expects their public finances to be well-managed. They expect them to be distributed efficiently, used to deliver quality services, and provide a safe and stable environment in which society can exist and thrive. They also expect finances to be collected and spent fairly and in accordance with the law, surpluses, deficits, and debt levels understandable and manageable.

In addition, the private and public sectors are largely interdependent and must trust each other if they are working together to develop cities and countries. Such confidence requires government accountability and transparency in both

decision-making and reporting. When such expectations are not met—when trust is lost—there can be serious consequences.

Governments have a responsibility to their citizens and taxpayers to put in place effective public financial management systems and to use those systems to protect and ultimately enhance the country's economic sovereignty [1].

The growth of the general public sector has been one of the key features of contemporary economic history. The scale of the general public sector is expounded on how a society's reliance on markets and private institutions has evolved, which successively may be driven by differences across economic philosophies concerning the role of the state.

Actually, measuring government size is complex as there is no single quantitative measure that conveniently summarizes the whole impact of the state on the economy. The government in the economy operates as a producer of products and a consumer of resources, further as an employer of labor and an investor of capital.

Governments also transfer resources *via* subsidies and entitlement payments. In addition, the government has an important impact on the economy *via* its regulatory activities in terms of both corporate and individual activity. The tax revenues raised to finance these activities even have an economic impact through incentives and distortions. The economic indicators of the size of the public sector are trying to be associated with the influence of the government and its control over economic resources.

A particular definition of state spending, such as government expenditures on goods and services, has the advantage of reflecting the policy choices of the state. However, such a measure omits transfers and only provides information about the role of the government as a consumer or spender within the economy. As a result, when studying the expansion of the public sector more general measures of total government revenues and expenditures are preferable. Since most measures of public sector growth have demonstrated an upward trend over time and try to account for changes within the scale of the general public sector need not be too preoccupied with which measure is utilized, provided it focuses on resource use.

Two of the foremost common measures are government spending as a share of national output (GDP) and government revenues as a share of GDP. Other measures may include government spending per capita, the number of public sector employees, or public sector employment as a share of total employment. Government spending as a share of GDP is a relatively simple view of the effect of government on the economy given the effects, not only of spending, but also of regulation, income redistribution, and indirect spending *via* tax expenditures [2].

This trend continues to the present, as shown in **Table 1**. To analyze the growth in the scale of the public sector, the top 20 countries in terms of public expenditures were selected as % of GDP in 2000 and compared with them similar indicators for 2020 (the duration of the analyzed period is 20 years).

The change in the scale of public spending over 20 years is presented in the form of a diagram in **Figure 1** below.

The concentration in one sector of the economy, managed by a relatively small group of persons with a significant amount of financial and other economic resources, will certainly be of interest. There are many actors involved in making financial decisions about the allocation of public resources. These include political parties, presidential administration, local governments, civil society, Ministry of Finance, central bank, and others. The goals pursued by the participants in this process may not coincide. For example, political parties pursue the goal of securing funding for an election campaign. Civil society will insist on increasing transparency and


*Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*

#### **Table 1.**

*Analysis of the dynamics of the public spending over 20 years, billion U.S. dollars. Data source: World Bank.*

accountability of the spending of budgetary funds in the form of taxes paid by them. Local governments are focused on achieving results in accordance with the approved budget. In short, a significant part of the economically active population is interested in the quality and effective functioning of the financial management system in the public sector.

The public sector of the economy, as a rule, occupies a leading position in the economy of developed countries. The efficiency of the functioning of this sector largely depends on the qualified management that makes management decisions in relation to such organizations.

It should be noted that the most modern management technologies have been developed and confirmed their success in practice in relation to commercial organizations. Commercial organizations have as their goal the extraction of profit and the growth of the welfare of their shareholders. These goals are quite easily measurable and formalized into a sufficient number of indicators, indicating that the commercial organization has achieved its goals.

Organizations in the public sector of the economy differ significantly from commercial organizations. The purpose of the creation of budgetary organizations is to

#### **Figure 1.**

*Change in scale of government spending over 20 years, billions of U.S. dollars. Data source: Table 1.*

provide public goods, such as services in the field of law enforcement, health care, education, and others, and not to increase the welfare of shareholders. It is quite difficult to assess the economic effect of the provision of such services. Measuring the impact of providing these services cannot be approached by relating costs to benefits because the benefits of providing such services are difficult or impossible to quantify in monetary terms. For example, the benefit of providing health care services is to increase the public health of the nation.

In all our societies, citizens expect higher standards of service from government and public services, just as they expect better services from the private sector. But, at the same time, the desire to increase taxes to pay for these services is absent to the same extent. The only way to resolve this dilemma is to ensure that whatever governments can afford to spend gives the highest possible return and meets the needs of citizens. In other words, the efficiency or productivity of public spending should increase over time.

As a result of this desire to meet societal expectations, governments are subject to increasing demands for accountability. But, at the same time, citizens, taxpayers, and users of public services—significantly overlapping groups—have a legitimate claim to accountability for the use of tax revenues that governments spend on the needs of their citizens' behalf. Has the money been put to good use to achieve the results that society wants, or, on the other hand, has the money been wasted?

#### **2. An essence of the public financial management**

Any scientific study requires clarity of the key definitions that are utilized in it. It should be noted that there is a dearth of an unambiguous approach to the definition of public financial management to date.

The essence of financial management in the public sector is expressed through its definition. At the same time, its essence is also revealed through the goals and objectives it solves.

#### **2.1 The PFM definitions**

The analysis of PFM definitions was in the following works [3–5]. Of course, this is not a complete list of works where one can find definitions of PFM. At the same time, it is necessary to emphasize the lack of a unified approach to the definition of PFM at the current moment, and hence the lack of a common understanding of its essence. As a rule, existing definitions contain information that PFM is a set of established rules, tools, and processes. Existing definitions of PFM do not contain the objectives of financial resource management and do not take into account the risks associated with this process. Therefore, based on the analysis of existing definitions of PFM, the author proposed his own definition, which eliminated the above disadvantages [6].

"PFM might be a system of principles and methods to improve and adopt management decisions by public authorities and non-profit organizations on the formation, distribution and efficient use of economic resources so as to enhance the welfare of the country's population, which involves systematic monitoring of these decisions, additionally because the identification of emerging risks and also the development of measures to prevent them."

Despite the analysis of the definitions of PFM, I would prefer to draw attention to one more of them.

"PFM deals with the laws, institutions, systems, and procedures available to governments seeking to protect and use resources effectively, efficiently, and transparently. While PFM encompasses taxes and other income, borrowing, and debt management, its main focus is expenditure management, especially in the context of public budgeting." [7].

This is done to emphasize and justify the essence of the PFM in the context of this chapter as public expenditure management.

In particular, continuing to penetrate into the essence of the PFM and in general, the public sector of any country, it should be noted that it is shaped by its current economic conditions, history, policies, resources, and the demands placed on it by its public. However, any government in any country faces some common problems. These include:


#### **2.2 The role of the public sector in the economy**

The essence of financial management in the public sector is also indicated by the role of this sector in the economy. There are several views on the role of the public sector in the economy. But, one way or another, they are all limited to two polar points of view, which can be described as minimalist and maximalist. Given the economic complexity of the modern world, one would expect most governments today to be somewhere between these two extremes, and also the direction within which they lean "inevitably depends on the prevailing intellectual winds."

The minimalist role of PFM, which is usually associated with the work of Adam Smith, "the responsibilities of the government or the state are limited because the

citizens themselves, through supposedly well-functioning markets and using their own efforts and incomes, must take care of their needs, both personal and social." As a result, the public sector provides the government's main legal mechanism and assumes the role of "night watchman." An alternative and polar opposite role, usually associated with the writings of Karl Marx, is that "most economic decisions are made primarily by the political representatives of the people or the working class, who supposedly act on behalf of the state" and economic decisions are made through central planning [8].

#### **2.3 PFM system: key elements**

Describing the essence of the PFM, one cannot avoid describing it as a system that is usually described in terms of an annual budget cycle, as shown below in **Figure 2**. This annual cycle is aimed at ensuring that public spending is well planned, executed, accounted for, and carefully checked.

The key elements of the annual budget cycle of the PFM system are:


#### **2.4 PFM system & FM system**

To a first approximation, the financial management system in the public sector is similar to that in the private sector. That is, the financial management system in the private sector also includes an element of planning (budgeting and approval), budget

**Figure 2.** *Typical key elements of a PFM system. Source: Ref. [9].*

#### *Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*

execution and monitoring, an accounting and reporting system, and an internal control and audit system.

However, the PFM system is much more complex, if only because of the larger number of participants involved in the process. So, among the participants in the financial management system in the corporate sector can be attributed—the company's management, shareholders, employees, accountants, and auditors. In the process of financial management in the public sector, the listed actors should include political parties, parliament, civil society represented by citizens, Ministry of Finance, local governments, and presidential administrations. And this is not a complete list. This greatly complicates the functioning of the PFM system at each stage. At the same time, each of the actors has its own interests in the results of the functioning of this system, which may differ. For example, residents of a small town are interested in the construction of a medical center, and the local government gives priority to the construction of roads in the region. Which solution is to be preferred? How much funding will be provided? These and other issues are resolved through lengthy coordination, approval, accounting, monitoring, and control systems.

Compared to the private sector, the functioning of public administration differs in several important respects. The main difference lies in the dichotomy of customer perception. For public administration, the client is both a citizen and a recipient of certain public services [10].

Therefore, the actions taken should be differentiated depending on whom they are addressed. The needs of a recipient of public service and citizen may differ. The former relies primarily on high-quality public services, while the latter relies mainly on the opportunity to participate in democratic decision-making processes, as well as on the implementation of public strategy and mission by the authorities.

It should be noted that it is the fundamental complexity of the concept of "client" that makes it difficult to implement unambiguous measures to study the results of the activities of government bodies. H. G. Rainey highlighted the distinctive features of community organizations [11].

An analysis of the characteristics of organizations related to the public sector made it possible to identify factors that affect the efficiency of the PFM system:


added value they create can be greater than that of the private sector, since it is not limited to the criterion of profit, and the public interest is crucial [12, 13].

All of the above differences between the public and private PFM systems have a practical aspect.

In theoretical terms, financial management in different sectors of the economy (public and corporate) is based on different basic concepts, as illustrated in **Figure 3**.

Each of the concepts presented in **Figure 3** deserves separate attention. However, presenting a detailed analysis of them in this chapter is beyond the scope of this publication. Nevertheless, brief conclusions from the results of such an analysis should be provided. This is important since it is the concepts that determine the principles of functioning of each of the financial management systems (private and public), determine their goals, and the mechanism for implementing the principles and achieving goals.

From this follows the need to improve and develop both the basic concepts of financial management in the public sector and, as a result, the methods arising from these concepts.

In addition to the above, the complexity of financial management in the public sector is due to the specifics of this sector of the economy, which consists of deferred economic benefits and benefits to society. These benefits, moreover, are difficult to measure or not to be measured at all.

#### **Figure 3.**

*Basic concepts in private and public finance management systems. Source: Compiled by the author.*

A detailed analysis of the concepts, presented in **Figure 3**, allowed us to briefly draw the following conclusions.

Management concepts in the private sector:


Management concepts in the public sector:


Completing the comparative analysis of financial management in various sectors of the economy (PFM systems and FM systems), it is obvious that the main differences that do not allow developing uniform approaches to management in various systems are:


It is worth noting that, of course, the financial management system is a kind of universal mechanism. Therefore, it is still possible to use common tools in financial management systems in various sectors of the economy.

For example, PFM uses the principle of program-targeted management and expenditure financing borrowed from the corporate sector. Performance budgeting is a tool that has come into the financial management system in the public sector as well as from the corporate sector.

The complication of the conditions for conducting financial activities due to the constantly changing economic environment, and the lack of financial resources due to increasing factors of uncertainty, make financial management the most difficult and

responsible function of the state, municipalities, and any economic entities, regardless of the form of ownership.

#### **3. PFM: problematic issues and prospects for their solution**

Strong and effective public financial management (PFM) is a vital component of good governance. The PFM strategy supports fiscal and macroeconomic stability, steers the allocation of public resources in line with national priorities, supports the efficient delivery of poverty reduction and economic development services, and ensures transparency and control of public funds.

Efficient and efficient public financial management is essential to address the challenges of the current global financial crisis and the fiscal adjustment process.

#### **3.1 The challenge of measuring the effectiveness and efficiency of a PFM system**

As already emphasized above, the goal of public sector financial management is to manage scarce resources to ensure the economy and efficiency in achieving the results necessary to achieve the desired results that will serve the needs of society. A sound public financial management system enables governments to make the best use of their resources to improve the quality of life in society.

In essence, this means that effective management of public finances should lead to an increase in the welfare of society. In other words, those public expenditures that the governments of various countries bear should lead to an increase in the quality of life and the welfare of society. Is it so? Various indicators are proposed to measure well-being in society, including the social progress index. The social progress index is a composite indicator of the international research project social progress imperative, which measures the achievements of the countries of the world in terms of social well-being and social progress. This index was created in 2013 under the direction of Michael E. Porter, Chairman of social progress imperative, Harvard University professor of strategic management and international competitiveness. The index's editorial board includes representatives from a number of leading universities and research centers, including Harvard Business School and the Massachusetts Institute of Technology.

The index [14] does not include indicators of the economic development of the countries of the world (such as the level of GDP and GNI) but is intended to assess public well-being in a particular country. It is worth noting that the GDP indicator is often used to measure the economic well-being of a society, for example, GDP per capita.

As has been repeatedly emphasized in the literature, the generally accepted definition of GDP differs in many ways from welfare. This distinction was well known to the economists who developed the modern concept of GDP. For example, GDP does not include important social characteristics, such as discrimination and crime. In addition, as a general economic concept, GDP does not provide information about the distribution of income, which is important for the well-being of individuals in the economy. For example, GDP excludes most household production and other "nonmarket" activities, such as recreation, even though most of these activities actually increase households' true consumption; thus, increase welfare. GDP also does not reflect environmental characteristics, such as climate change and the availability of natural resources.

*Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*

Despite these well-known differences, GDP is often used—by politicians, reporters, the general public, and even economists—as a measure of wealth, or at least economic well-being.

To test the hypothesis about the correspondence of the level of public spending to the level of public welfare, the ratings of the top 10 countries according to the social progress index for 2020 and the corresponding public expenditures for the same period were analyzed. The results of the analysis are presented in **Table 2**. It should be emphasized that at the time of writing this chapter, the ranking of countries on the social progress index for 2021 had already been published. However, data on the level of government spending as a percentage of GDP for the same period has not yet been found. Therefore, the ratings were compared for 2020. According to the author, the trend will continue in 2021 and over the next few years.

Without deep analysis, a simple visual comparison of the various rankings shows that the level of public spending does not correspond to the achievement of a high level of the social progress index. For example, Switzerland deserves attention, which when compared with other countries, has one of the lowest scores in terms of public spending (122 points). At the same time, this fact is not decisive for achieving a high value of the social progress index (6 points). Small gaps in the ratings are shown by the Netherlands, Iceland, and Sweden, which may indicate the prudent use of public resources and the achievement of government goals in the field of public financial management. Although, it is obvious that this indicator is not the only measure of the success of the PFM system.

Another and most popular indicator that measures the level of well-being of a society is GDP per capita. This indicator has also been tested against the level of government spending. The top 15 countries in terms of GDP per capita were taken for analysis. The analysis was carried out for 2020. The results of the analysis are presented in **Figure 4**.


#### **Table 2.**

*Comparative analysis of the ratings of the top 10 countries on the social Progress index and their corresponding ratings on the level of public spending, as a percentage of GDP, 2020. Data source: Social progress index, 2020- h ttps://www.socialprogress.org/search/?q=Social%20Progress%20Index%202020. Government spending as a percentage of GDP, 2020 - https://ru.theglobaleconomy.com/rankings/government\_size/MENA/.*

**Figure 4.**

*Top 15 countries by GDP per capita, PPP, 2020.Data source: International Monetary Fund https://data.imf.org/, https://our\_worldindata.org/government-spending#total-government-spending.*

**Figure 4** shows the discrepancy between GDP per capita and government spending in the top 15 countries in the ranking. This fact can be interpreted as follows. The amount of public spending directly does not allow achieving the goal of the PFM—the growth of the welfare of society. Again, this statement is not true for all countries, as can be seen from the analysis. For example, the United Arab Emirates (UAE) and Norway show significantly different levels of government spending, 4.27% and 26.55%, respectively (Appendix 1.) However, GDP per capita in these countries in 2020 was almost at the same level as 63299.42 U.S. dollars in the UAE and 63,548 U.S. dollars in Norway.

Of course, one should not draw unambiguous conclusions from the results of such a simple analysis. But the findings lead to the following reflections: "Is it that the financial management system in some countries functions so inefficiently? What is the measure of the effectiveness of the functioning of the PFM system?"

There is one more conclusion. The amount of money that governments in various countries spend on public services is not a measure of the effectiveness of government spending.

A significant number of works have been devoted to the problem of measuring the effectiveness and efficiency of the PFM [15–24].

It is preferable to measure performance in terms of outputs, outcomes, or the impact of the policy objectives. Thus, performance can be measured by various indicators, including corruption, red tape, or wastage; the size of any shadow economy (i.e., untaxed income); the strength of the rule of law; the health and life expectancy of its population; the educational achievement of its population; and the quality of its communications and transport infrastructure. Such "macro" indicators can help chart the effectiveness of public sector reforms in different countries. In addition, there are several global frameworks that specifically assess countries' public sectors on various measures, such as service delivery, strength of financial systems, accountability, and quality of the regulatory environment.

#### *Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*

At the end of the analysis of approaches to measuring the effectiveness of the PFM system, it is necessary to draw the reader's attention to the fact that the criteria for measuring efficiency (quality PFM system) are classified in accordance with the models (concepts) of government management.

**Figure 5** presents three main models (concepts) and indicators that are consistent with these models (concepts).

So, by the model of the service state, an indicator of the success of PFM is an indicator of the satisfaction of citizens with public services. The measurement of this indicator relates more to the field of sociology since it involves a survey of citizens in the format (satisfied/not satisfied/find it difficult to answer).

By the model of an effective state and the concept of sustainable development, the main indicators are indicators of the effectiveness and stability of public finances. The performance category is key to financial management.

The most difficult thing in managing finances in the public sector is measuring the effectiveness of their use, and hence the quality of financial management, as a result of the efforts of all entities involved in the management cycle of public financial resources.

A significant role in providing significant support in measuring the quality of financial management to governments of all countries of the world and organizations belonging to the public sector of the economy is assigned to the public expenditures and financial accountability (PEFA) program.

The PEFA framework has become the "gold standard" when it comes to measuring the performance of PFM systems.

This program has been implemented since 2001 within the framework of the activities of a number of international organizations, such as World Bank, European Commission, International Monetary Fund, and representatives of the strategic partnership with Africa, and is also used by the governments of countries, such as Norway, Switzerland, France, and the United Kingdom.

The purpose of the functioning of this program is to strengthen the capacity to assess the state of national public financial management systems and develop the necessary management decisions. This methodology includes the best practices for assessing the quality of public sector financial management.

#### **Figure 5.**

*The main models of public administration and indicators correspond to these models. Source: Compiled by the author.*

The program "public expenditure and financial accountability" (PEFA—public expenditure and financial accountability) defines 31 performance indicators, grouped into seven groups, which are key elements of the public financial management system. The seven groups of performance indicators under the PEFA program are presented in **Table 3**.

A feature of this system for assessing the quality of financial management is that each indicator changes on a scale from A to D, where A is the highest, that is, this indicator meets all criteria, and D is the worst. At the same time, the assessment of indicators on a scale from A to D is carried out by two developed methods: M1 and M2. The PEFA guidelines indicate which method should be used for each indicator.

The main advantage of using this method of assessing the quality of financial management is the availability of a convenient assessment system that allows you to use various methods of assessing M1 or M2, depending on the significance of the indicator and its impact on the final result. This technique allows them to achieve more accurate and correct evaluation results, while it is also worth noting the simplicity of its application.

To date, there are other generally recognized tools for measuring the effectiveness of the PFM system. These include:


#### **Table 3.**

*The groups of performance indicators under the PEFA program [25].*

*Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*


#### **3.2 Why do we need to measure the effectiveness of the PFM system?**

Effective performance management demonstrates that timely and accurate information significantly improves decision-making and that the right measures encourage the desired behavior. Out-of-date or irrelevant information leads to poor decisionmaking and measuring the wrong things may lead to unplanned consequences.

The results of the PFM quality assessment are used to solve the following tasks, which are presented below in **Figure 6**.

Public financial management is totally critical to improve the standard of public service outcomes. It affects how funding is employed to deal with national and regional priorities, the provision of resources for investment, and also the costeffectiveness of public services. Also, it is quite likely that the general public will have greater trust in public organizations if there is strong financial stewardship, accountability, and transparency in the use of public funds [26].

It is important for governments to get it right because it impacts a broad range of areas, including aggregate financial management (fiscal sustainability, resource mobilization, and allocation), operational management (performance, value-formoney, and budget management), governance (transparency and accountability) and fiduciary risk management (controls, compliance, and oversight) [27]. In addition, effective public financial management is important for decision-making.

#### **Figure 6.**

*Tasks for which the results of financial management quality assessment are used. Source: Compiled by the author.*

#### **3.3 Accurate and reliable financial information generated in the accounting system is the basis for making informed decisions in the PFM system**

Accurate financial information is typically used as a decision-support mechanism and to ensure efficient resource allocation. Public financial management is a complex area with many new initiatives and relatively little success to date. Implementing public financial management reform is a challenging task for all countries. Therefore, for the successful deployment and implementation of public financial management projects, the applied methods of public financial management must be effective and efficient.

Better financial information in the public sector is being encouraged by the global drive to encourage the adoption of (IPSAS) international public sector financial reporting standards.

This drive to improve external reporting and will also improve the quality of internal management information, as it should be the same information used for setting budgets, monitoring, and forecasting throughout the year that will be used for the statutory financial reporting.

These standards are developed and issued by the IFAC international public sector accounting standards board (IPSASB). The council encourages the adoption of accrual accounting, although it recognizes that only a minority of countries currently use it.

The IFAC promotes quality information that contributes to the development of public financial management.

The IFAC prefers accrual accounting because cash accounting does not account for long-term issues, such as pension liabilities and large infrastructure investments. However, with regard to the application of accrual accounting in the public sector, as well as the application of IFRS, which implements the idea of corporate accounting and reporting, there is a special point of view.

Thus, despite claims that the introduction of business-style accounting based on IFRS will improve governance in the public sector, these standards were developed for companies with financial liabilities that limit shareholder risk and encourage

#### *Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*

management to take risks with shareholder funds in order to obtain more high profits. These standards were not designed to take into account the unlimited liability of taxpayers and citizens for public debt. This unlimited liability makes it necessary to maintain constitutional control over the main government and its access to public money. Controlling cash expenditures is not a feature of business-style accounting. In addition, this unlimited liability makes the accountability requirements associated with integrity particularly important. As New Zealand examples show, business-style financial statements involve business logic that is inconsistent with, and apparently inappropriate for, the overall public purpose and context of government finance. The transition to business-style financial management and reporting meant cutting off and removing key parliamentary guarantees and thus reducing the power of parliament to scrutinize and exercise financial control over the current government. Obviously, these changes transfer power to the executive branch [28].

A well-functioning accounting and financial management system are fundamental to a government's ability to allocate and use resources efficiently and effectively. In the absence of automation, countries rely on manual systems to process, record, manage, and report government financial transactions. Manual processes and systems can work well if they are supported by trained and disciplined staff. In the 1860s, long before automation, the German states were able to keep timely and accurate accounting records and reconcile cash balances on a daily basis, backed by a disciplined, skilled bureaucracy and clear procedures. Automation promises to improve the accounting, reporting, and management of public finances, but it does not in itself guarantee more inclusive, transparent, accountable, and legitimate public finances. Automation is a means to an end, not an end in itself [29].

Effective performance management demonstrates that timely and accurate information significantly improves decision-making and that the right actions stimulate desired behavior. Outdated or irrelevant information leads to bad decisions, and wrong measurements can lead to unintended consequences.

An assessment of the financial condition of organizations belonging to the public sector is also necessary, as is done in the corporate (commercial) sector. It is essential to monitor the activities that contribute to the achievement of strategic goals and the results that demonstrate the achievement of these goals. It is important to keep track of a reasonable number of things—the more measures users require, the less attention they pay to each and the less they understand the big picture.

Focusing on a limited number of key indicators gives more weight to individual performance.

Public sector workers are often motivated by different values than private sector workers. Performance management systems can be designed to take advantage of the higher level of innate motivation that exists in many public sector workers.

#### **4. Conclusion**

Summing up the study, it is necessary to state the fact that the growth of public spending, which has been observed in recent decades, entails an increase in the accountability of the governments of all states without exception, an increase in their responsibility to citizens who pay taxes, and an increase in the efficiency of the use of public financial resources.

Specialists in the field of public finance management are looking for tools to improve the efficiency of their use. These searches have led to the necessity and possibility of using approaches and methods that have proven themselves in the corporate sector (e.g., program-based management and performance-based budgeting).

However, the public sector financial management system is a much more complex system, which involves more actors than in the private sector. Measuring the performance of such a complex system is a challenge for virtually all governments.

Of course, the complexity of financial management in the public sector is predetermined by its essence. The essence of the PFM can be briefly expressed through its definition, which includes the principles, methods, and main elements of the public financial management system, the effective formation and use of public finances in order to improve the well-being of society and the mandatory identification and reduction of risks that impede the achievement of the goal.

Any process and public financial management is a process that requires measuring its quality and achieving the goal of its functioning. Most economists agree that the quality of financial management in the public sector can be measured by indicators, such as efficiency, effectiveness, and the welfare of society. The big challenge at the moment is to measure these indicators.

Thus, the most common and widely used indicators of the growth of the welfare of society; hence, the effectiveness of financial management in this society are gross domestic income (GDP) and GDP per capita, which show the amount of government spending per capita in the country. However, some indicators that measure the wellbeing of society are in conflict with traditional indicators, which is an occasion to think about what and how we measure.

To date, a sufficient number of systems for measuring the effectiveness of financial management in the public sector have been developed, including the PEFA system, which is also being improved from year to year.

Any performance measurement system is based on indicators that are extracted from the accounting and reporting system. A reliable, transparent public sector accounting system is the basis for obtaining truthful and correct indicators for measuring the effectiveness and efficiency of the public financial management system, on the basis of which reasonable and balanced decisions are made in the field of public financial management.


### **A. Data and sources for Figure 4**

*Public Finance Management: Essence, Problems, and Development Prospects DOI: http://dx.doi.org/10.5772/intechopen.109195*


#### **Author details**

Liudmila Tkachenko National Research Tomsk State University, Tomsk, Russia

\*Address all correspondence to: ludmila.i.tkachenko@gmail.com

© 2022 The Author(s). Licensee IntechOpen. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

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### *Edited by Habtamu Alem*

In the face of unprecedented challenges posed by the global COVID-19 pandemic, *Resilience and Realities - Exploring Pandemic Effects, Governance Challenges, and Economic Insights* offers a comprehensive exploration of the intricate interplay between public policies and uncertain times. This enlightening volume presents a thought-provoking collection of chapters that dissect the illusions, opportunities, and complexities surrounding public policies during crises. Spanning two captivating sections, this book embarks on a journey through the labyrinth of pandemic-related public policies, offering fresh insights into the ever-evolving landscape of economic responses and the resilient spirit of entrepreneurship. In the first section, "Illusions of Public Policies Amidst a Pandemic", readers are invited to dissect the enigma of navigating uncertainties in crisis management. Delve into the gendered impact of the pandemic on academic women, explore the untapped opportunities within the pandemic's wake, and scrutinize the efficacy of governmental economic strategies. The second section, "Public Policies towards Investment, Technology, and Efficiency", provides an insightful investigation into the impact of investment in human capital on economic growth. Review the intricacies of financial management within the public sector and gain an understanding of the multifaceted dimensions of technology, investment, and efficiency in public policies.With each chapter, esteemed authors contribute their expertise to illuminate the complexities of these critical topics. *Resilience and Realities - Exploring Pandemic Effects, Governance Challenges, and Economic Insights* is a vital resource for policymakers, economists, academics, and curious minds seeking a deeper understanding of the intricate nexus between public policies and uncertain times. Explore the wealth of knowledge and insights within these pages and embark on a journey toward a more informed and resilient future. Discover illuminating perspectives, engage in thought-provoking analyses, and embrace the ever-changing landscape of public economics. This book stands as a beacon of knowledge and enlightenment in an era of unprecedented challenges.

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