Public Sector Downsizing

This note provides an economic analysis of public sector downsizing operations and illustrates the analysis with examples of reforms during the 1980s and 1990s. Juan Jose Diaz presents the most common types of reforms: voluntary departure schemes, involuntary retrenchment schemes, contracting-out schemes, employee ownership, and privatization. The rationale for this sort of reform is to address the problem of a public sector characterized by public agencies and state-owned enterprises that are overstaffed, bureaucracies that are bloated, and public services that are inefficient.
 
One of the most recurrent challenges linked to this type of reform is the problem of adverse selection in voluntary separation schemes, which leads to the rehiring of essential staff, overcompensation, externalities of downsizing, and difficulties in the appraisal of financial and economic returns.

The author identifies key stakeholders in these reforms, their likely responses, and the dissemination channels of the impacts of the reforms. The financial costs of separation packages designed to compensate displaced workers may be substantial, and mass layoffs may generate significant social and political costs. Downsizing operations directly affect stakeholders other than separated workers, such as entire communities in the case of one-company towns, caterers and providers of services to state-owned enterprises, and final consumers and taxpayers.

The author concentrates on assessing the welfare losses among dismissed workers. These consist of the present value of the resulting change in earnings, the present value of the losses in nonwage benefits, and other intangible losses from separation. Downsizing may generate differential distributional impacts. Traditional rules of thumb used to compute severance compensations take into account only current wages and years of tenure in the public sector. Changes in welfare after dismissal are related to other observable characteristics that may serve as the basis for the design of a “just right” compensation package. In particular, the author suggests that a well-tailored downsizing operation may consider the education, geographic location, and gender of workers. Various studies also show that the just right severance compensation package outperforms more traditional rules of thumb on the grounds of both costs and fairness.

To help assess the consequences of various downsizing strategies on the computation of severance packages, the author refers to a computer application called the Downsizing Options Simulation Exercise that has been developed by the World Bank.

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