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December 28, 2009

Efficiency Dividends: What is the Magic Number?

Posted by Richard Hughes 

What a difference a year makes. Last autumn, the fiscal policy debate in advanced countries was dominated by the need to shore up ailing financial systems, stimulate hesitant consumers, and bolster faltering economies. Twelve months later, the financial headlines are filled with talk of exit strategies and fiscal sustainability, and policy discussions are increasingly focused on the questions of when, where, and how to go about a fiscal consolidation.

Previous postings have discussed the lessons from successful consolidation episodes in the past, one of which was to favor cutting expenditure over raising taxes as a route to sustainability. However, concerns about protecting “priority” services during such expenditure-based consolidations have prompted a number of fiscally-challenged finance ministries to resuscitate the idea of an “efficiency dividend.”

What is an efficiency dividend?

An efficiency dividend is an amount of spending that can, in theory, be shaved-off each ministry or agency’s budget without harming “frontline” service delivery, i.e. without changing the outputs of government agencies that actually matter to the public. An efficiency dividend can therefore be thought of as a proxy measure for the annual increase in public sector productivity.

In most cases this dividend is extracted at the start of the budget process so that it can be reallocated (or pocketed) through the budgeting process – thus increasing the budgetary discretion available to policy-makers. In countries with less orderly budget processes, such a dividend is levied at the end of the budget process when it is discovered that the sum of individual allocations exceeds the desired spending totals.

While “across-the-board cuts” have gotten a bad name in this age of strategic, evidence-based, performance-oriented budgeting, efficiency dividends carry a number of enduring attractions for weary, crisis-battered finance ministries:

• First, they help to arrest the upward expenditure drift that is inherent to many budget processes. Efficiency dividends allow finance ministries to “dig into the baseline” before getting to a discussion of how to allocate any additional expenditure that might be available.

• Second, they help to circumvent the problems of asymmetric information and “gaming” that arise between finance ministries and line ministries in the search for efficiencies. By putting line ministries in charge of identifying where and how to realize efficiencies, efficiency dividends pre-empt the propensity for line ministries to offer up only politically sensitive areas or “bleeding stumps” when asked to identify savings opportunities.

• Third, by holding all line ministries to the same standard, they allow finance ministries to rely on peer pressure around the cabinet table to ensure savings are identified and delivered. If a recalcitrant departmental minister demands to know why he must find X% savings on his budget next year, the finance minister can simply reply “Because everyone else is.”

How big is the efficiency dividend?

How much efficiency can you squeeze out of the public sector in a given year? The answer to this question seems to depend on two things: (i) how broadly one defines the concept of public sector efficiency and (ii) how frequently these efficiency dividends are reaped from ministerial budgets.

A quick survey of the empirical literature suggests that long-run public sector productivity growth is usually estimated to be below that of the private sector; somewhere between 0.5 and 2 percent per year. This general finding is consistent with the routine efficiency dividends that countries like New Zealand (0.8 percent), Australia (1.25 percent), Sweden (2 percent) and the UK (2-2.5 percent) have built into their budget processes on a permanent basis.

However, such studies may underestimate the level of efficiency that can be squeezed out of the public sector in any given year for two reasons.

• First, these studies tend to focus solely on improvements in “productive” efficiency – i.e. the increase in output per unit input within a given service. This ignores the gains that can come from improvements in “allocative” efficiency – i.e. changes in the allocation of resources to better reflect the preferences of taxpayers and citizens between services.

• Second, these studies look at the long-run relationship between inputs and outputs over a decade or more which tends to iron out the inevitable peaks and troughs in public sector productivity that come when expenditure on a given sector is ramped up or slashed back.

So assuming that the “fat” has been left to accumulate for a number of years and one uses the broadest possible definition of “efficiency”, what is the maximum efficiency dividend a government might expect to reap from the public sector as a whole in a given year? 

Recent “big push” efficiency drives across a range of advanced countries reveals a remarkably consistent answer: about 3 percent per year. While different countries have expressed their efficiency dividends in different ways at different times, they all tend cluster around this cosmological constant. For example:

• In response to the financial crisis that hit the country in the mid 1990s, the Swedish government presented a comprehensive fiscal consolidation plan in 1994 which included an across-the-board reduction in government consumption of 3 percent in one year. This measure was instrumental to the success of the country's consolidation effort.

• In the UK’s most recent multiyear budgeting exercise, the 2007 Comprehensive Spending Review, Departmental Expenditure Limits were set on the assumption that all departments would make 3 percent “value for money” savings in each of the next three years.

• Both the Strategic Reviews launched by the Canadian government in 2007 and France’s Révision générale des politiques publiques (RGPP) started from the aim of identifying at least 10 percent savings over a three year period on the expenditure programs under examination. On an annualized basis this equates to just over 3 percent per year.

• Korea’s rolling Program Evaluations launched in 2006 aimed for a 10 percent annual cut in programs rated as “ineffective.” However, these evaluations tended to look at no more than one-third of expenditure programs at any one time, resulting in a reduction in total expenditure of about 3 percent per year.

• In Australia the first budget tabled by Kevin Rudd’s incoming Labor government for 2008 demanded a one-off additional 2 percent efficiency dividend of all ministries and agencies on top of the flat 1.25 percent that had been levied on administrative budgets since 1987. This took the total efficiency improvement expected of Australia’s public services in 2008 to 3.25 percent per year.

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Comments

Excellent piece Richard. It is timely to remind us that, even while doing our best to target cuts strategically, the use of an ongoing "efficiency dividend" helps to provide a bit more fiscal space to help consolidation or, in less unhappy times, to shift money to higher priority areas. Effiency dividends should, in my opinion, be seen as a key part of the process of setting expenditure envelopes in a top-down budget process.

Two thoughts:

(1) I think it's useful to distinguish between an ongoing efficiency dividend and one-off across-the-board cuts, with the former being maintained indefinitely, and the later applying for a defined period (which could be more than one year). From this perspective, I wonder a little about the indefinite sustainability of 3%. Of course, in terms of post-crisis consolidation measures many countries are clearly going to need cuts of more than 3%, and there could be considerable merit (politically and managerially) in front-loading such cuts rather than dragging them out over an extended period.

(2) Another interesting thing about the efficiency dividend -- at least as it applies in Australia -- is that it applies to specific categories of expenditure and not to others (e.g. transfer payments). So an x% efficiency dividend tends not yield significantly less than an x% reduction in aggregate expenditure.

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