Cutting budget expenditure: ‘Mission Impossible’?

27. maijs, 2009


Vjačeslavs Dombrovskis

How about this? It appears that Latvia's State Revenue Service (VID) will only work four days a week, including its boss, Mr. Jakans. This follows 31% decrease in VID's budget, as compared with 2008. Naturally, the officials are unanimous in saying this will not affect the effectiveness of VID in collecting taxes…

Given such measures, how can anyone still harbor doubts that the government will achieve the budget deficit target of 7 percent of GDP??!

But my main objective in this post is not to mock the Latvian government. That would be too easy. About a month ago Danske Bank’s Lars Christensen wrote Repše’s plan to cut by 40% is “Mission Impossible”. Is it? After all, we do see private firms implementing sometimes savage cuts in their operating costs and then moving on. However, the public sector is fundamentally different from the private sector because the bureacrats have what I would call a ‘monopoly of technical expertise’.

Let me explain using a simple example. Suppose you want to renovate your apartment but you’re really no expert in construction. So you contract the renovation to a construction brigade. Clearly, your interests (pay less) are in conflict with the interests of the workers (earn more). Not being an expert yourself, you don’t know what the ‘true’ cost of renovation is, but you understand that construction workers have every reason (and opportunity) to overcharge. A familiar setting, isn’t it? What should you do? It makes sense to get a second opinion. It’s easy to call another brigade and ask them to name their price. And maybe a third one, and so on. Naturally, the construction people are fully aware of your options, and this knowledge disciplines them. If this is the buyers’ market, you will expect to pay the price that is reasonably close to the ‘true’ one, even if you know nothing about construction. The reason is that competing suppliers of services do not have a monopoly on technical expertise.

This is not the case in the public sector. There is no competition among the independent providers of services. The public sector is best thought of as a set of monopoly agencies, providing various services. As a result, the bureacrats often possess a ‘monopoly on technical expertise’. How many managers specialize in running the police, the armed forces, hospitals, or collecting taxes? Thus, public sector managers have a natural advantage in over-charging their ‘customers’ – taxpayers and their political representatives. It’s just very hard to get a ‘second opinion’ on how much it really costs to run the tax colleciton agency.

What are the implications for trying to reduce public sector expenditure? A naive approach would start with assuming that the bureacrats are benevolent servants of the public good and all you have to do is to ask. A more prudent approach, however, would recognize that the world is a brutal place and bureacrats are as self-interested as anyone else. They, too, want to earn more while working less. And their ‘monopoly on expertise’ makes it easier for them to achieve this. Unfortunately, it seems that the government of Dombrovskis has taken the naive approach. I think they made two big mistakes.

The first mistake was that the government asked the ministries to come up with cost-cutting plans, without really setting any clear performance standards. Given the ‘monopoly on expertise’, this makes it too easy to reduce the costs by decreasing provision of public services. VID saves by working 4 days a week. Hospitals save by shutting down whole departments and sending doctors on unpaid leave. It also makes it possible for the senior bureacrats to save by laying off large numbers of lower rank employees, while keeping high salaries for the ‘inner circle’. Witness the thousands of teachers who will soon be sacked. Given the context, it is not clear what is the wisdom of ‘economizing’ on the salaries of people who then need to be paid unemployment benefits.

The second, and most serious mistake of Dombrovskis government is to make exceptions. Some ministries must cut the costs by 40%, others – by less. Some areas are not touched at all. Seeing that exceptions are made, bureacrats have incentives to invest in becoming an exception. What exactly they will do depends on their perceptions of what will grant them exceptional status. For example, if they think exceptions are granted to areas where reductions have socially disruptive effects, they will try to reduce spending in a disruptive way. Managers of hospitals will want to shut down hospital wards and visibly decline healthcare to those who seek it. VID will declare it will work less. Etcetera, etcetera, etcetera. The result would be the chaotic reduction in public spending AND in provision of vital public services, with potentially disastrous effects on the economy and society. And precious time will be wasted as bureacrats will be preoccupied with trying to be an exception, rather than running more efficient units.

I think any program of cutting fiscal spending must begin with a proper awe of the ‘monopoly on expertise’ that managers of public agencies have. First, whenever possible, reformers should seek independent expert opinions of the operating costs. Perhaps within the ranks of the middle management of the ministries, making discreet promises of promotion. Second, given the economic context, and the ‘monopoly on expertise’ , the reformers should strive for a clear plan based on uniform reductions in wages in all of the public sector. No negotiations, no exceptions. Third, there should be clear rules regarding uninterrupted provision of public services and provisions for monitoring this. The main aim of this short-run reform should be a nominal reduction in operating costs, while minimizing the impact on provision of services to the economy.

Sounds like a ‘mission impossible’, doesn’t it?

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