Contracting out as a vehicle for privatization: half speed ahead.

• Author: Prager, Jonas
• Position: Privatization: Political and Economic Challenges

Privatization in its broadest sense entails a simultaneous retrenchment of the government sector and an expansion of the private sector. Although privatization is often thought of as synonymous with government sales of state-owned enterprises (SOEs), divestiture is far from the only privatization option. In the former Soviet bloc countries, for example, the rapid growth of newly-formed private businesses has reduced the public to private sector ratio, even though the sale of the many state-owned industrial behemoths has proceeded at a snail's pace. Liquidation of obsolete and uncompetitive government production units also has reduced the relative importance of the public sector. Similarly, the government's reach can be cut back by contracting out its functions to the private sector, replacing public production facilities and employees--though not ultimate responsibility--with private sector counterparts.

This article contends that while contracting out or outsourcing can be an invaluable component of a privatization program, it needs to be implemented judiciously. The pragmatic case for turning over government activities to private organizations rests primarily on the consequent savings; the public sector benefits by capitalizing on the private sector's presumed greater efficiency. The government sector, however, is not always less efficient. Moreover, even when the superiority of private enterprise is evident, contracting out is not always the less expensive alternative when all costs are fully allocated. Hence, a case-by-case analysis must replace crude generalizations of questionable merit.

The first section of this article examines the overall appropriateness of government contracting out: what types of government activities are good candidates? It also explores some noneconomic motives used to legitimize outsourcing services that were long thought to lie solely within the realm of government. The second section considers issues that ought to be raised by government authorities contemplating contracting out. This article then examines the growing practice of outsourcing infrastructure projects known as Build-Operate-Transfer (BOT), which resolves many of the questions that arise in the contracting context, but which raises some of its own. The penultimate section examines open competition, whereby in-house suppliers are permitted to compete with external contractors. The final section concludes with a few observations generated by the concepts and examples embedded in the article.

Candidates for Contracting Out

Downsizing is hardly a welcome activity either for the political authorities, especially ministers whose fiefdoms are shrunk, or the civil service whose members lose influence if not employment. Yet even though the case for reducing government intervention in the economy is often warranted, the implication that this be accomplished through divestiture is not always compelling. Thus, while it is not difficult to justify the sale of an SOE that survives only through subsidies or special regulatory advantages, such arguments would not apply to divesting a government company that holds its own in the marketplace. Similarly, the rationale for converting a monopoly SOE into a private monopoly is far from obvious, especially when the regulatory apparatus is itself undeveloped or underdeveloped.(1)

Furthermore, selling SOEs is not always possible; their potential profitability may be so uncertain as to induce apathy among prospective private owners. Although the government might just eliminate such operations, non-economic goals often overrule the adverse budgetary impact, at least for a while. Finally, some governmental activities, such as formulating laws or appointing judges, are by nature non-commercial and are obviously dubious candidates for removal from the government ownership rolls. Yet, the efficiency of SOEs and non-commercial public activities can be improved even when divestiture is either ruled out or delayed.

It is useful to distinguish among two types of outsourcing: macro-contracting and micro-contracting. In macro-contracting, an entire public activity is contracted out. Government-owned hotels can be operated by private hotel management companies as they are in Egypt and Jamaica.(2) Productive facilities, such as a steel mill or a port authority, can be leased to a private firm as happened respectively in Togo and Malaysia. Most of the administrative functions of the internal revenue or customs service--design and distribution, collection, even adjudication of conflicts--could be handled by private agents, thereby reverting to a more sophisticated version of the tax farming that was common in ancient times and medieval Europe.(3) Similarly, the educational system's operation could be removed from government hands (except for the setting of guidelines and standards), a less radical step than tax farming given that private educational establishments are common in much of the world.(4) In fact, most public sector functions could be contracted out to the private sector in principle, leaving to the government only those activities that are "inherently governmental functions"--which, in the words of the United States Office of Management and Budget, require either the exercise of discretion in applying government authority or the making of value judgments in making government decisions. Government functions normally fall into two categories: (1) The act of governing, i.e., the discretionary exercise of government authority, and (2) monetary transactions and entitlements.(5)

Clearly, one would be uncomfortable leaving the nation's defense in the hands of a mercenary army or local safety to a police force that the government had acquired from the lowest bidder. One might balk at a criminal justice system wherein contracted out judges were empowered to impose capital punishment or even significant losses of personal freedom. Would the public feel comfortable with privately-operated maximum security prisons and their population of dangerous criminals?(6)

In contrast, micro-contracting can be employed even in inherently government functions, for micro-contracting applies to only specific activities rather than entire functions. Thus, even a government-owned and operated criminal justice system in which judges are state employees could contract out court facilities maintenance.(7) Micro-contracts can be small and of brief duration such as the British local authority catering contracts, with an average annual value slightly exceeding 161,000 [pounds sterling] and an average duration of four and a half years.(8) Or they can entail substantial outlays over very long time periods as in the case of Britain's Inland Revenue Service 1 billion [pounds sterling], 10-year contract in 1994 with EDS, a global information services company, to design advanced tax collection programs as well as to maintain and operate the national tax authority's information systems.

Both macro- and micro-contracting reduce government power and often the potency of public employee unions as private employees replace civil servants. There is little doubt that the Thatcherite privatizations in Great Britain during the 1980s were not only ideologically based, but were also aimed at organized labor,. and, through the labor unions, at the Labour Party itself. Indeed, revenue maximization and cost effectiveness were not primary objectives. Shares in the initial public offerings of the companies to be privatized were underpriced, thus limiting the government's income from the sales. At the same time, the undervalued stock prices induced millions of Britons to become shareholders, anticipating virtually certain profits. As their expectations materialized, they either realized their gains or conserved their paper profits. In either case, they would be expected to be grateful to their Conservative benefactors.(9)

Yet privatization in its various manifestations is not always attributable to conservative parties. In New Zealand, for example, the major liberalizing reforms occurred between 1984 and 1992, years when the Labour government reigned supreme. It is quite clear that the motivations underlying privatization differ. Ideology energizes the right, while pragmatism reluctantly drives the left. Market-oriented ideologues advocate a minimal government presence, an attitude strongly rejected in principle by left-of-center thinkers. Nevertheless, even socialist-oriented governments have been forced to cope with fiscal crises that are the inevitable outcome of rising expenditures and the increasing reluctance of taxpayers to finance government activities. For the left, as well as for the right, a rethinking of the role of government has perforce implied greater use of contracting out. E.S. Savas, author of the seminal Privatization: The Key to Better Government,(10) states it succinctly:

The job of government is to steer, not to row the

boat. Delivering services is rowing, and the

government is not very good at rowing.(11)

In other words, the government can provide the services without having to produce them. Contracting out, more than other privatization options, epitomizes this attitude. The government sets the overall framework and specifies the objectives, while the contractor is responsible for service delivery.

Contracting out is hardly a new idea. It is common in less-developed countries characterized by deficiencies in certain technical specialties such as the design, construction, and even the operation of hydroelectric power systems and communication networks. Transfer of technology normally is accompanied by employment contracts to expatriate managerial personnel, at least until a core of local professionals can be trained to replace them.

Outsourcing is no less common in the industrialized world, although the reasons for it differ. In the developed world, governments choose contracting out not for lack of skilled...