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Ineffective Monetary Incentives

An examination of public sector pay in countries around the world reveals that civil servants generally are paid less than their private sector equivalents. However, the public-private sector wage differential varies greatly. While civil servants in OECD countries and some of the high-growth Asian economies such as Singapore and Hong Kong are compensated quite well in relation to similarly qualified private sector counterparts, African and Latin American public sector wage levels are well below those of the private sector. Moreover, while public sector wages in industrialized and high-growth developing countries have tended to match real increases in private sector wages, in lower growth regions of the world the decline of public sector wages since 1975 has been sharp and potentially very troubling. (Click here to access recent public sector pay data, arranged by country.)

Some research directly relates declining relative public sector wages in lower growth regions such as sub-Saharan Africa and Latin American to the demands of structural adjustment programs (see Colclough 1997). In Zambia, for example, the real value of public sector salaries in 1991 was less than one-quarter of their value in 1975. And due to greater salary compression, senior Zambian civil servants received salaries in 1991 equivalent to only 11-15 percent of those paid in 1975. In Argentina average real wages of civil servants fell by 50 percent between 1974 and 1980. Wage erosion and salary compression were also commonplace in Central and Eastern Europe, the Republics of the former Soviet Union, and some South and Southeast Asian countries over the same time period.

How did these civil services manage to retain their employees, in the face of such sharp declines in average real wages? And how can civil services around the world attempt to attract and retain the "best and brightest" for their administrative cadres if wages in the public sector are systematically lower than what individuals could earn in the private sector?

Base pay and other incentives                           

In the lower growth developing countries, although there has been some loss of the most skilled and experienced civil servants to more financially lucrative private sector careers, many have preferred to keep their public sector jobs rather than look for employment elsewhere. Certainly, in many countries, high unemployment has been an important factor in maintaining the appeal of public sector posts, even at much lower wage levels. Yet, there are several other factors also at work. Several components of public sector compensation should be taken into account when assessing the adequacy and incentives embedded within a pay system. These varied components can be illustrated schematically as follows:

contractually-provided

non-contractual/ intangible

monetary

in-kind

current rewards

base rewards

1. base wage/salary

2. health insurance

3. job security, prestige, social privileges

allowances

4. transportation, housing, meals, telephone, travel, cost-of-living

5. transportation, housing, meals, travel

6. trips abroad, training

future expectations

7. pension

8. housing, land, etc.

9.reputation,re-employment after retirement

In short, there are a variety of rewards other than base salaries. Other monetary components of compensation, such as cash allowances and pension entitlements, are the most obvious. While real public sector wages fell sharply in lower growth developing economies, the importance of allowances meant that real earnings declined far more slowly. Colclough points out, for example, that housing benefits for Zambian civil servants amounted to more than the value of their salaries by 1991/92. The maintenance of these allowances slowed the attrition of skilled and professional workers to the private sector.

In addition to monetary benefits, there are also many in-kind and intangible rewards that accrue to civil servants. The positive incentive effects of prestige, reputation, and expectations of job stability should not be underestimated. Indeed, the implicit value of these intangible benefits, particularly job security, is often cited as grounds for the seeming disparity between public and private sector wages. (For further discussion of this topic, see this site's page on non-monetary incentives.)

Pay flexibility         

In a number of settings, the principle that rewards for the same job should be standardized no longer applies. Pay systems in many countries now include variable, discretionary elements in addition to base pay. Pay differentials can result from decentralization of the pay determination process, as well as from structural variations between different organizations, groups of employees, locations, or sub-sectors. Individual or group-based variations in pay also may be awarded on the basis of skills, responsibilities, or performance (OECD 1993).

Experience in the OECD shows that governments have been able to increase compensation flexibility without damaging consequences. But there are compelling theoretical reasons to expect that, without careful management, reward differentials can encourage patronage and corruption (Marsden and Richardson 1994; Kessler 1999; Jensen and Murphy 1990; Murlis 1993; Perry 1991; Teel 1986). Clearly, the debate surrounding performance-related pay in the civil service is far from over.

Some key measures                

1. Vertical compression is the ratio between the top and bottom salaries in the civil service. It also may be used to refer to the ratio between the total salary package of an official in the highest echelon/rank and that of an official in the lowest echelon/rank within the same agency. There are different ways to calculate vertical compression. One is to divide the salary at the midpoint of the highest public employee pay category by the salary at the midpoint of the lowest category. Another, more rigorous approach, is to take the median of the ninth decile of disposable monetary compensation divided by the median of the first decile of disposable monetary compensation (cell 1 + cell 3 in the table above). In either case, this calculation is on a single year basis and excludes any net present value of future pension entitlements and any estimated value of in-kind benefits (Lindauer and Nunberg 1994; OECD 1993; OECD 1994; OECD 1998).

An important reason to look at vertical compression measures is that a highly compressed wage structure reduces civil servants' incentives to pursue a long and successful career in the civil service by reducing the appeal of promotions. Thus, incentives for productivity are less powerful. In some cases, wage compression may also encourage moonlighting.

2. Horizontal compression refers to the degree to which earnings may differ for officials at the same grade or level, with the same seniority. This measure may be calculated for those in the same or in different agencies. It is arrived at by dividing total permissible monetary compensation (including all discretionary allowances) by base compensation alone (i.e., without any discretionary allowances) (OECD 1994).

As employers, governments often wish to create incentives for new ways of working or for the introduction of new policies. However, a pay progression system that is based only on length of service creates rigidity, reducing incentives for increased productivity. Remuneration structures have to be studied thoroughly on a case by case basis (OECD 1996). In cases of individualization of pay, peer pressure as well as unions' views of equity can prevent significant pay dispersion.

3. Public/private wage comparisons can be extremely useful; but it is frequently unclear who or what those comparators should be. In industrial countries, the usual comparators are clerical jobs in private companies. But this comparison may not be relevant in many developing countries, where the true employment alternatives of many public sector workers are in the informal sector of the economy. Public sector jobs may be under-compensated with respect to jobs in the top formal sector companies of a developing country, but still be over-compensated with respect to the "average" job. Similarly, public sector jobs may pay a low salary, but offer health coverage, annual leave, old-age pension, and other benefits.

Choosing elite private sector companies as comparators has led to serious fiscal problems in some countries. These comparisons have convinced government officials, trade unions, and public opinion that public sector workers are dramatically under-paid. Through policy choices, strikes, or arbitration awards, their salaries often have been increased dramatically across the board, making the wage bill unsustainable. It is thus important to supplement any comparator study with a careful analysis of earnings in and out of the public sector, using individual (or household) surveys. (For further information on this topic, see this site's page on evaluating pay and establishment choices.)

Varieties of dysfunction                                    

Real wage erosion within the public sector has resulted in pay levels in some countries that are well below what would seem to be the reservation wage of the individuals employed. Allowances, in-kind benefits, and intangible incentives such as job security have contributed to lower than expected attrition rates (Colclough 1997). In many instances, however, employees have retained their public sector jobs while resorting to other income-generating activities. Outright corruption is perhaps the most pernicious effect. Absenteeism and day-lighting also undermine public sector efficiency.

Over-compensation can create excessive pressure for public sector employment and strain government finances. Conversely, low public sector pay relative to the private sector can be associated with skill shortages, and with corruption.

The empirical evidence as to whether low civil service wages foster corruption is mixed. Findings from cross-country data vary depending on the wage data and corruption data used, the countries that are included in the analysis, and the research design. Rauch and Evans (2000) create a wage measure for 35 developing countries based on country experts' judgements of how salaries of higher officials compared to those for private sector managers with similar training and responsibility. They find no relationship between this measure and subjective assessments of corruption in government as provided by the International Country Risk Guide (ICRG) and other firms. Van Rijckeghem and Weder (2000) collected pay data from the ILO, IMF, and country sources for 28 developing and low-income OECD nations for the period 1982-94. In cross-sectional tests they find that higher pay relative to manufacturing wages is associated with less severe corruption, as measured by the ICRG. However, in other tests that rely only on time-series variation in the data, they find no evidence that changes in pay are associated with changes in corruption. In their sample of 63 countries (including developing and developed nations) Swamy et al. (2001) find no relation between pay (relative to per capita income) and corruption, as measured by a Graft index constructed by Kaufmann et al. (1999). La Porta et al. (1999) find that the simple correlation between pay (relative to per capita income) and the ICRG corruption rating is -.50 for a sample of developing and developed nations, i.e. higher pay is associated with a lower rating, indicating more severe corruption where pay is higher. They also report that pay is significantly higher in countries with primarily Catholic or Muslim populations, compared to Protestant nations.

There are numerous difficulties in cross-country analyses of pay and corruption, which suggest caution is needed in interpreting any results. First, there is likely to be measurement error in the corruption ratings (see Kaufmann et al. 1999) as well as in the pay data. Corruption ratings do not assess the civil service only, but rather governmental corruption more broadly, including legislative and judicial corruption. Schiavo-Campo et al. (1997) and van Rijckeghem and Weder (2000) discuss various limitations of data on public employee compensation (e.g. omission of in-kind benefits and allowances, deferred benefits such as pensions, job security) that make it less than strictly comparable across nations. These measurement problems make it more difficult to detect empirically a link between pay and corruption, were such a relationship to exist.

Second, the appropriate benchmark for comparison is unclear. Per capita income and manufacturing wages are commonly used because of data availability. But public sector pay in neighboring nations, or even pay offered by international organizations may also affect the incentives of public officials.

Third, even if a consensus were to emerge that pay did (or did not) influence corruption, the direction of causality would be difficult to establish. If corruption takes the form of waiving fees or taxes, or increasing procurement costs, there will be fewer public resources available to compensate public officials. Corruption could lead to lower pay, rather than the reverse. (There is even reason to expect that under certain circumstances higher pay might actually worsen corruption. At a given employment level, higher pay may crowd out other funding necessary for provision of services, increasing bribe-seeking opportunities by lengthening queues.)

Theory does not predict that higher pay will always reduce corruption, and this may account for the weak cross-country links between them. The basic theory is that wage premiums make corruption potentially more costly, as detection and punishment would entail losing a high-paying job instead of a low-paying one. However, the impact of pay is predicted to vary with monitoring and enforcement levels: where the risks of punishment and detection are minimal, the prospect of losing one's job – whatever the pay level – has no influence on bribe seeking. Where the risks are sufficiently high, no one will solicit bribes, whatever the pay rate. Thus, for countries with sufficiently high or low monitoring and enforcement of officials, one would not expect any relation between pay and corruption. Because cross-country studies are unable to identify and exclude those countries from the analysis (or test whether the impact of pay is conditional on monitoring), there is a bias toward finding no relation between pay and corruption.

Most of the difficulties plaguing cross-country analyses can be avoided in well-designed micro-level studies. Di Tella and Schargrodsky (2000) find that higher pay reduces corruption in procurement in public hospitals in Buenos Aires, but only when monitoring appears to be at intermediate levels, as the basic theory predicts. Corrupt behavior – as measured by excessive prices paid for inputs – is measured only for those officials whose wages also are being measured. Inputs and wages are paid from separate budgets, eliminating the possibility that a correlation is the spurious result of corruption leading to lower wages, or higher pay increasing corruption by lengthening queues.

Recommended readings                                     

Blinder, Alan S. ed. 1990. Paying for Productivity: A Look at the Evidence. Washington, D.C.: Brookings Institution.

Colclough, C. 1997. "Theories, Policies and Outcomes." In C. Colclough, ed., Public-Sector Pay and Adjustment: Lessons from Five Countries. London: Routledge.

Di Tella, rafael, and Ernesto Schargrodsky. 2000. "The Role of Wages and Auditing during a Crackdown on Corruption in the City of Buenos Aires."

Jensen, Michael C., and Kevin J. Murphy. 1990. "Performance Pay and Top-Management Incentives." Journal of Political Economy 98(2): 225-64.

Kaufman, Daniel, Aart Kraay, and Pablo Zoido-Lobaton. 1999. "Aggregating Governance Indicators." World Bank Policy Research Working Paper No. 2195. World Bank, Washington, D.C.

Kessler, Ian. 1999. "Report from Workshop 2: The public sector" from the Conference on employee financial participation, Dublin, 22 October.

La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny. 1999. "The Quality of Government." Journal of Law, Economics and Organization 15(1): 222-279.

Marsden, D., and R. Richardson. 1994. "Performing for pay? The effects of 'merit pay' on motivation in a public service." British Journal of Industrial Relations 32: 243-261.

Murlis, Helen. 1993. "Reward Management Strategies." In Pay Flexibility in the Public Sector. Paris: OECD/PUMA.

OECD (Organisation for Economic Cooperation and Development). 1998. "Performance Pay Schemes for Public Sector Managers: An Evaluation of the Impacts."

OECD (Organisation for Economic Cooperation and Development). 1997. "Trends in Public Sector Pay: A Study of Nine OECD Countries 1985-1990." Occasional Papers on Public Management No.1. Paris: OECD/PUMA.

OECD (Organisation for Economic Cooperation and Development). 1996. "Pay Reform in the Public Sector." Paris: OECD/PUMA.

OECD (Organisation for Economic Cooperation and Development). 1994. "Senior Civil Service Pay: A Study of Eleven OECD Countries 1980-1991." Occasional Papers on Public Management No. 4. Paris: OECD/PUMA.

Perry, James L. 1991. "Linking Pay to Performance: The Controversy Continues." In Carolyn Ban and Norma M. Riccucci, eds., Public Personnel Management: Current Concerns, Future Challenges. New York: Longman.

Swamy, Anand, et al. 2001. "Gender and Corruption." Journal of Development Economics 64(1): 25-55.

Teel, Kenneth S. 1986. "Compensation: Are Merit Raises Really Based on Merit?" Personnel Journal 65(March): 88-95.

Van Rijckeghem, Caroline and Beatrice Weder. 2000. "Bureaucratic Corruption and the Rate of Temptation: Do Wages in the Civil Service Affect Corruption, and By How Much?" (A condensed version of IMF Working Paper WP/97/73.)

Van Rijckeghem, Caroline and Beatrice Weder. 1997. "Corruption and the Rate of Temptation - Do Low Wages in the Civil Service Cause Corruption?" Washington D.C.: International Monetary Fund, Working Paper WP/97/73, June.

This page was developed by Elsa Pilichowski, with Jens Kristensen, Hélène Perrin, Mike Ruffner, and Deok Seob Shim at the Public Management Service of the OECD, and by Naazneen Barma, with Steve Knack and Nick Manning of the World Bank.  The page was submitted on 11/04/00.




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