Public sector downsizing :Public sector downsizing Martin Rama The World Bank


Contents of the presentation :Contents of the presentation The context A mixed record Adverse selection Losses from separation Compensation packages Training and assistance programs Returns to downsizing


The context :The context Labor retrenchment is increasingly used as an ingredient of economic reform It is seen as the only durable fix for recalcitrant budget deficits Since 1996 the World Bank can lend for severance pay in state-owned enterprises Since 2002 it can lend for severance pay in the civil service If the World Bank does not lend, other donors and multilateral agencies will


Usual problems :Usual problems Downsizing operations are often implemented in a rush (especially when facing large budget deficits) Separation packages are often copied from other operations, and their formulas are ad hoc Some separated workers are under compensated, others get “golden handshakes” The composition of “stayers” and “leavers” is often discovered after the operation is carried out The liabilities created by early retirement programs are seldom evaluated While financial returns to the operation may be known, economic returns are seldom assessed


A mixed record :A mixed record A survey of 41 downsizing operations supported by the World Bank in the early 1990s shows that: Most operations display high financial returns (the average payback period is about two years) But 40 percent of the operations display some re-hiring (substantial in 20 percent of the cases) For each dollar spent on workers compensation, two dollars were spent on enhancing safety nets


Adverse selection :Adverse selection Voluntary separation packages are more attractive to productive workers In some cases, no downsizing can be preferable to a “wrong” downsizing The optimal mechanism is a “menu” of offers, but how to implement this in practice? Some kind of targeting is needed before offering voluntary separation packages


Losses from separation :Losses from separation They include loss in earnings, in tangible benefits (housing, pension, etc.) and in intangible benefits (job security, lower effort, etc.) Three approaches to estimate the loss: before-versus-after, in-versus-out and stayers-versus-leavers These approaches show that the “size” of the loss varies considerably across countries, and with the characteristics of public sector workers


Some frequent patterns :Some frequent patterns Those with more education tend to lose less, in relative terms Those who have spent more time in the public sector lose more on an annual basis But they may lose less in a long-term perspective, because they are denied fewer years of service Women tend to experience a larger drop in earnings and benefits, but not in well-being


A practical strategy to predict losses :A practical strategy to predict losses Use household survey data to estimate potential earnings and tangible benefits out of the public sector Focus on those who could gain by leaving to estimate the value of intangible benefits Adjust observed earnings and tangible benefits by the estimated value of intangible benefits Subtract potential earnings out of the public sector to assess the annual loss from separation Compute the present value of this loss for all the years until retirement age


Designing a compensation package :Designing a compensation package Each severance pay formula leads to a specific amount of compensation per public sector worker This compensation can be compared to the losses computed using household survey data If compensation is higher than the loss, the public sector worker would not feel penalized to leave Some packages are better than others in terms of their cost, fraction of workers satisfied, or the composition of stayers and leavers


The severance pay formula :The severance pay formula The “best” formula may not look too different from formulas used elsewhere For instance, it may pay A years of salary, or B months of salary per year of service But the choice of A and B is not arbitrary Small changes to A and B can actually modify the downsizing outcomes quite radically


Political considerations :Political considerations In the end, the choice of a compensation package is a political decision But technical work on the “best” compensation package can provide a useful benchmark A related issue is whether separated public sector workers should be “fully” compensated As they are seldom poor, even after retrenchment, full compensation is hard to justify But it might be necessary for political reasons


Re-training and assistance programs :Re-training and assistance programs Government resources can be used to offset the loss from separation (as in severance pay) Or they can be used to reduce the magnitude of the loss (as in re-training or placement programs) The effectiveness of re-training and placement programs appears to be quite limited Separated workers should be allowed to choose their own mix of compensation and re-training


A practical approach to re-training :A practical approach to re-training Before downsizing: Tender for re-training services, open to all Chosen providers present their services Workers learn the assistance they are entitled to At downsizing: Workers choose their re-training providers (if any) The cost is deducted from the assistance


Returns to downsizing :Returns to downsizing Downsizing and investment operations are similar: large upfront costs with potential long-term benefits Therefore, the ex-ante assessment of these operations should be similar too. The ex-ante assessment involves a comparison of costs and long-term benefits But benefits from the perspective of the downsized unit, or of society as a whole?


Financial versus economic returns :Financial versus economic returns Public sector over-staffing is only one among several distortions: “Wrong” pay schedules in the public sector Transfers to or from the budget Relocation costs and externalities Correcting only one distortion does not necessarily increase efficiency Financial returns do not take these other distortions into account; economic returns do


Financial returns :Financial returns Costs: Severance pay packages Re-training and assistance programs Liabilities from early retirement Benefits: Savings in terms of salaries Typically benefits largely exceed costs


Economic returns :Economic returns Labor reallocation Are separated workers more or less productive out of the public sector? Depends on extent of adverse selection and on labor market conditions Reduced taxation If taxes did were not distortionary, financial returns would only entail redistribution. The output effect of reduced taxation depends on the marginal tax burden