Efficient Public Sector Downsizing - Finance & Development - September 1997 - Martin Rama

UBLIC sector downsizing is becoming an increasingly important ingredient of economic reform in developing countries. Among the unfortunate legacies of state-led development, bloated bureaucracies and overstaffed public enterprises are especially problematic. Labor redundancies are particularly severe in the transition economies of Central Europe and the former Soviet Union, where the shift from central planning to market orientation requires millions of workers to leave the public sector. But retrenchment is needed in other regions, too. In Latin America and South Asia, decades of protective policies have led to the proliferation of white elephants and “sick” industries, some of which cannot be salvaged. All over the world, technological progress is making natural monopolies disappear, exposing formerly somnolent public utilities to harsh competition. As traditional and authoritarian ways are replaced by more modern and democratic ones, countries’ governments and business leaders are showing a greater willingness to correct the employment excesses that have resulted from past patronage and cronyism. In many developing countries, the extent of labor redundancies is so vast that any serious downsizing may actually be politically infeasible, at least if it is to rely on involuntary dismissals. Consequently, a voluntary approach to reducing public sector employment has been popular with developing country governments and the multilateral organizations and donor countries that assist them. More specifically, severance pay is offered to encourage redundant workers to quit and thus overcome their resistance to downsizing, restructuring, and privatization. Until recently, one of the main obstacles to implementing the voluntary approach to public sector downsizing was its extremely high cost. In a typical national public sector downsizing operation, hundreds of thousands of workers need to be relocated to the private sector, with the average compensation and retraining package amounting to several thousand dollars per worker. A single operation may therefore cost hundreds of millions of dollars. Unfortunately, the countries where such operations are most needed are usually cash strapped. Recent changes in the attitude of some multilateral organizations toward mass retrenchment, however, have significantly eased these constraints. For instance, in February 1996, the World Bank’s operational rules were modified to allow lending to fund severance pay, provided that it is being offered as part of a plan to restructure the public sector. And other multilateral organizations have also demonstrated that they favor the voluntary approach to public sector downsizing. As a result, many developing countries are either planning or already undertaking public sector downsizing operations. While the efficiency gains from public sector downsizing operations are potentially large, there is also considerable risk of mishandling them. It is painfully clear that the public sectors of many developing countries are plagued with large numbers of workers who contribute little or nothing to output or welfare. The issue is whether the use of severance pay packages will encourage low-productivity workers to depart or rather induce their more productive peers to do so.