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Bloated bureaucracies and over-staffed public enterprises are a frequent legacy of state-led development strategies. They may also reflect fundamental institutional weaknesses in establishment control and pay determination. The extent of labor redundancies may be such that any serious downsizing could be politically unfeasible, at least if it were to rely on involuntary dismissals. Hence the increasing popularity among developing country governments,multilateral organizations and donor countries of a voluntary approach to reductions in public sector employment. More specifically, the idea is to offer severance pay to encourage the redundant workers to quit, thus overcoming their resistance to downsizing, restructuring, and privatization. In many developing countries "buying out" redundant workers is in fact the only way to bypass the legal obstacles to the dismissal of public sector employees. [The page on government employment and wage concerns sets out more precisely how to define and measure government employment.]

While the efficiency gains from public sector downsizing are potentially large, the chances of mishandling it are also considerable. The frequently observed "revolving door" syndrome, whereby separated workers are subsequently re-hired, suggests that some downsizing operations lead to the departure of those who make the public sector work. Damaging the ability of the government to get things done will do little to spur economic development.

There are additional ways in which downsizing may be mishandled. Severance pay packages are usually set in an arbitrary way. Typically, a rule-of-thumb involving salary and perhaps seniority in the public sector is used. For instance, separated workers may receive two years of salary, or one month of salary per year of service, or some other combination of these two variables. Yet the resulting amount may bear little relation to the true loss these workers experience as a result of their separation. Some workers clearly suffer, whereas others become net winners. [The page on evaluating pay and establishment choices provides some guidance on the use of appropriate comparators to reduce the risk that some retrenched workers will become net winners while others suffer.] In addition to the cost of severance pay packages, considerable resources may be spent on re-training and redeployment programs that are ineffective, and therefore may not be valued by workers.

Assessing the returns to downsizing operations is also difficult. The typical evaluation compares the cost in terms of severance pay packages, re-training and redeployment programs to the savings in terms of public sector wages. But this comparison is misleading. Over-staffing is only one among several distortions common to the public sector. Consequently, financial returns are not a good measure of economic returns. Just to mention another distortion, public sector wages usually differ from private sector wages, and are therefore not a good indicator of the opportunity cost of labor. [The page on Non-monetary incentives provides guidance on the elements of the total compensation package that public officials receive, including the relationship between in-kind/intangible benefits and monetary compensation.] In addition, the externalities from mass retrenchment should be considered. The most obvious externalities arise in the context of one-company towns, which may easily become ghost towns after downsizing takes place. But public sector downsizing leads to fiscal externalities too, because it reduces the equilibrium level of government expenditures, hence the burden from distortionary taxes. Due to all of these distortions, economic returns to public sector downsizing can be either higher or lower than suggested by financial returns.

Additional information on this topic can be found at the Shrinking Smartly website.

World Bank policy                                                              

Until recently, one of main obstacles to the implementation of the voluntary approach to public sector downsizing was its cost. Sometimes, hundreds of thousands of workers need to be relocated to the private sector. With an average compensation, re-training and redeployment package amounting to several thousand dollars per worker, a single downsizing operation may cost hundreds of millions of dollars. However, some of the countries where public sector downsizing is most desperately needed are cash strapped. Recent changes in the attitude of multilateral organizations towards funding severance costs have softened this budget constraint.

The World Bank has two basic types of lending instruments: investment loans and adjustment loans. Investment loans have a long-term focus (5 to 10 years), and finance goods, works, and services in support of economic and social development projects in a broad range of sectors. Adjustment loans have a short-term focus (1 to 3 years), and provide quick-disbursing external financing to support policy and institutional reforms. All loans are governed by the World Bank’s Operational Policies, which aim to ensure that Bank-financed operations are economically, financially, socially, and environmentally sound. Fiduciary policies and procedures govern the use of project-related funds, particularly for the procurement of goods and services. Safeguard policies help to prevent unintended adverse effects on third parties and the environment.  Further details are available in the World Bank brochure "Lending Instruments: Resources for Development Impact."

In March 1996, the World Bank’s operational rules for investment lending were modified so as to allow financing of severance pay as a component of an operation to restructure an enterprise or sector. The severance pay component must be an integral part of the project aimed to make the enterprise or sector more productive. The project's design and justification must be based on the increased productivity of the activities remaining in the enterprise or sector after restructuring and on the related development activities. Budgetary savings and closures or inefficient enterprises alone are not sufficient justification for an investment project. While adjustment loans do not directly finance severance pay, the counterpart funds generated by the loan may be used by the borrower for financing severance pay.


This page was authored by Martin Rama of the World Bank, with assistance from Niki Dewitt, Gennady Pilch, and Mike Stevens. It was submitted on 9/12/00.

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