The Fiscal Gains from Contracting Out: Transfers or Efficiency Improvements

Contracting out is a policy that yields unambiguous fiscal gains to the governments that practise it . However, the majority these gains represent transfers from employees through reduced wages or increased work intensity. Some of these transfer losses are passed on to central governments through increased tax evasion. In this paper, the social costs and benefits of reductions in public sector wages are examined. It is argued that exploitation of labour market monopsony power by governments may create social losses even when the aggregate real wage is above the equilbrium level. THE FISCAL GAINS FROM CONTRACTING OUT: TRANSFERS OR EFFICIENCY IMPROVEMENTS For the last fifteen years or so, governments have been urged to adopt measures such as privatisation and contracting out in order to improve their fiscal position, and to increase overall economic efficiency. Interestingly enough, although privatisation has an obvious impact on measured budget balances, there is no evidence that it actually increases the net worth of the public sector, and advocates of privatisation have not thought it necessary to look for such evidence. The limited evidence available suggests a strong case that privatisation actually reduces the net worth of the public sector. For example, the privatisation of British Telecom (arguably the pivotal event in the recent history of privatisation) involved the issue of 50 per cent of the shares in a secure and highly profitable enterprise for an amount approximately equal to one year‘s gross earnings (or about three years’ net profits). Partly paid shares sold at 50p were immediately traded for 93p. Mayer and Meadowcroft (1986) suggest that this privatisation represented a transfer of about 20 per cent of BT from the UK government to the share purchasers (a significant proportion of whom were not UK citizens). Further evidence suggesting a systematic loss of public sector net worth from privatisation is presented in Quiggin (1994). No such doubts arise in the case of contracting out. A large number of studies have found that the budgetary cost of providing services is reduced by contracting out. Domberger, Meadowcroft and Thompson (1986) and Cubbin, Domberger and Meadowcroft (1987, 1988) (hereafter Domberger et al) examine two such cases of contracting out and estimate average budgetary gains of 20 per cent. This figure has been very widely quoted, and appears to have some support from other studies. Although, there are may be some grounds for questioning the magnitude of the estimates, there appear to be no grounds for doubting that contracting out reduces budgetary costs. 2 Given the existence of these gains, it is important to determine their source. If the gains arise from increases in the efficiency with which tasks are performed, there is presumably a net social benefit from contracting out. On the other hand if the gains arise from reductions in wages or from other transfers, the issues are much more complex. Domberger et al attempt to partition budgetary savings into efficiency gains and transfers, but their techniques are open to a number of objections. The object of this paper is to argue that the majority of the budgetary gains from contracting out represent transfers either from employees, or, through tax evasion, from the Federal government. Given this result (and assuming that tax evasion is unambiguously undesirable), the question arises of whether there is a net social benefit arising from the use of contracting out to reduce wages and, if so, how this benefit should be assessed. Because of its influential role in the literature and because of the generally high quality of the data and of the analysis, attention will be confined to the work of Domberger et al. Domberger et al examine the contracting out of garbage collection and hospital cleaning services in Britain. In-house teams as well as outside firms were permitted to compete for contracts. Both when in-house teams were successful and when the contract went to outside firms total cost reductions are estimated to be of the order of 20 per cent. This was lower than initially estimated gains. In the first round of contracting out of hospital cleaning services, average savings of 40 to 50 per cent were achieved, but many contractors either failed to provide adequate service or lost money doing so. To counter the potential for failure, contractors were in some cases required to post performance bonds. Because of this and the losses on early contracts, savings on later contracts were smaller. If this adjustment process was not completed at the time the Domberger et al studies were undertaken, the total gain may have been overestimated. 3 1 The review presented in this section is based, in part, on work previously presented in Quiggin (1992). However, this issue will not be pursued here. Milne and McGee (1992) re-examine the question of contracting out of hospital cleaning and catering services, using data for 1985-86. They obtian higher estimates of cost savings, primarily because they treat changes in the prevailing level of wages as a source of benefits. Milne and McGee emphasise the role of wage reductions (and also losses incurred by over-optimistic contractors) as a source of cost savings for local authorities. They observe that in-house NHS staff partially or wholly forfeited bonuses (which could amount to one-third of total pay) and that similar reductions relative to pre-existing wage levels were imposed on contract staff. Domberger et al attempted to address the question of whether cost savings represented transfers using Farrell's (1957) notion of technical efficiency. Using linear programming to estimate a frontier cost function, the gains were partitioned between those attributable to differences in technical efficiency and those attributable to other sources including reductions in wages and fringe benefits. Domberger et al observe that the gains not accounted for by differences in technical efficiency may arise from a number of sources other than wage reductions most notably increases in the efficiency of the input mix. This issue deserves a little further attention. Measures of technical efficiency involving the fitting of a frontier typically have the property that extreme observations will lie on the frontier unless they are strictly dominated. As in example, suppose that there are two inputs, labor and capital, a given firm is the most capital-intensive in the entire sample. As long as there is no other firm which achieves higher labor productivity with lower capital input (implying a negative marginal product of capital) this firm will lie on the frontier, even if the implied marginal product of capital is very low. By contrast, if there are a large number of firms with fairly similar capital-labor ratios, the great majority must lie inside the frontier. It follows that frontier techniques will tend to identify efficiency gains whenever firms adopt input mixes that 4 differ from those of most existing firms. A more critical problem is that the measured technical efficiency gains could include a substantial transfer component. The first possible source of transfer is increased intensity of effort. Indeed, the main source of efficiency gains explicitly noted by Domberger et al is the replacement of fixed 'task and finish' payments (sometimes for tasks which have become less onerous since the time rates were set) with piecework rates. Productivity gains from such changes in payment schedules will arise primarily from increased effort. Furthermore, the observation that tasks have become less onerous since rates were initially set implies that the new piecework rates will embody an effective reduction in wages in the absence of increased effort. Ganley and Grahl (1988) cite a number of cases of increases in working hours or reductions in working conditions associated with contracting out of garbage collection. There is a tendency, criticised in Quiggin (1992), to regard output gains arising from increased effort as a free good. Such a view has no basis in neoclassical economic theory, although it may be supported by X-efficiency arguments (Liebenstein 1966). Such arguments require the existence of unexploited gains from trade, arising from distortions in the bargaining process (in addition to any element of union monopoly power). The implied claim is that the wage bargain embodies excess on-the-job leisure, in the sense that both workers and employers would prefer a bargain with higher wages and higher work intensity. There is no clear reason why bargains should be systematically biased in this way. The argument that apparent increases in technical efficiency are more likely to reflect increases in work intensity gains strength from consideration of the tasks contracted out. Cleaning is a job with very limited capacity for either technical or organisational innovation. Cleaners typically work alone or in pairs, using equipment which has not changed substantially for decades. Furthermore, cleaners are normally paid for completion 5 of a specified task, with no direct monitoring of time spent on the task, so that there is little scope for unions to impose restrictive work practices. The claim that there exist unexploited changes in cleaning methods permitting a twenty per cent increase in output with no increase in effort or reduction in service quality seems inherently implausible. In the case of garbage collection, there is more scope for technical innovation (for example through the use of large ‘wheelie’ bins). However, such changes would probably have been captured explicitly in the detailed data available to Domberger et al. The simplest source of increased labor productivity in tasks of this kind is speed-up — in this case, requiring collectors to run faster. Up to a certain point, speed-up yields efficiency gains as well as transfers, since the truck and driver are used more efficiently. However, speed-up can