Incentive problems may also arise in the appropriation of funds. The standard appropriation is on a gross basis, with a specified amount provided for each output class. However, the Public Finance Act 1989 authorizes net appropriations for output classes that earn trading revenue. These Mode B net appropriations authorise departments to spend up to the forecast trading revenue as long as this does not exceed the actual revenue earned. The Minister of Finance may direct the departments to spend a lesser amount. The more trading revenue the department earns, the more it can spend. The rationale of these appropriations is that departments should be permitted to cover the costs of producing outputs sold on a commercial basis.
The Act's definition of trading revenue excludes situations where the department has a legal monopoly in supplying the goods or services or where there are no competing sources of supply. As enforced by Treasury, Mode B net appropriations are made only when the outputs are contestable (inside or outside government) and when the costing system demonstrates that there is no cross-subsidization. In other words, the sales price of some outputs is not lowered by shifting part of their cost to other outputs. Treasury must approve all Mode B net appropriations, and it has done so sparingly. During the 1996/97 financial year, only eight output classes were on this basis. About 15% of the third-party revenue generated by departments is appropriated Mode B net. A large number of former Mode B net classes are no longer supplied by departments, having become the domain of more commercial organisations like Crown Research Institutes (CRIs).
Some departmental executives complain that the rules are too restrictive, that when they generate trading revenues, the amount available for expenditure still is limited by the amount appropriated. Appropriating on a gross basis discourages departments from generating trading revenue and thus diminishes contestability in the provision of outputs. It may also discourage them from seeking to recover full costs from purchasers of their outputs. The other side of the argument is that if the sale of outputs is not contested, the price will be set arbitrarily by the department rather than by market competition. In these circumstances, if the department were budgeted on a net basis, it could set prices well above cost and use the additional revenue as it saw fit.
It would be appropriate, I believe, to relax the rules slightly without opening the floodgates to abuse. Wider use of Mode B net would spur entrepreneurial behaviour by managers to develop markets for their outputs, recover costs, and increase the use of internal contracting and pricing within government. The change to Mode B net would be supervised by Treasury and subject to its approval, as is presently the case. Before authorising net appropriations, Treasury would have to be satisfied that the costing systems were sufficiently robust to guard against cross subsidies. In some cases, Treasury might establish hybrid modes, with only a portion of the trading revenue netted against the appropriation.