The private Vs public sector debate in perspective

A dominant recurring theme in debates about development in India is about how the private sector can complement the government. In fact, there are a large number of influential voices who today feel that the private sector, if they are unshackled off their regulatory chains, can assume the dominant role in the development process.

In other words, they advocate that the government should put in place "the enabling framework" (translation - limited regulation and lower taxation) and should cede the space for the "markets to work its magic". At best, the government can continue to play a marginal role as service provider, if only to keep the markets competitive and honest.

Accordingly, it is suggested that governments should promulgate public policy that enables a dominant role for private sector in secondary and tertiary health care and education, urban infrastructure like water and sewerage, roads, electricity distribution and so on. In all these sectors, they argue, governments should step aside and free the private sector from regulatory restraints. They see government as having failed (and nonbody can dispute that) and therefore, as a corollary, the private sector should take over. So what gives?

There is no denying that over the past decade-and-half, the private sector in India has shown adequate capability to assume a greater role in this journey. However, this evidence cannot be stretched to conclude that the private sector is now capable of delivering the major share of the burden in delivering on these objectives. It is imperative that we place the role of private sector and governments in their proper perspective.

Let me illustrate this with the example of the provision of affordable urban housing. The mainstream debate on the issue is today focussed on putting in place an enabling framework that will help private developers bring more housing stock into the market, on unlocking the large chunks of government lands with various government agencies through public private partnerships (PPPs), and facilitating access to credit to home buyers. Supporters argue that these policies will help the private sector seize the initiative and meet the massive housing requirement for the economically weaker section (EWS).

This argument reveals a shocking level of disconnect with reality. The overwhelmingly major share of demand for affordable housing in cities comes from the EWS. Therefore, it is only appropriate that the priority for any policy that seeks to increase the supply of affordable housing should be on housing for EWS. This naturally means that LIG, MIG, and other categories of housing, while important, will be secondary priorities for public policy.

However, the aforementioned mainstream agenda is heavily skewed in the opposite direction. Private sector has an important, even dominant, role to play in the provision of housing for LIG, MIG, and other categories. But on purely commercial considerations, the burden of provision of EWS housing will have to vest with government.

Consider the commercials. The conservative cost of any decent 300 sqft multi-storied EWS house will be around Rs 2-2.5 lakhs. This is excluding the considerable cost of land and infrastructure. Assuming a tenor of 15 years and interest rate of 10%, a Rs 1 lakh loan will require an equated monthly instalment (EMI) of Rs 1100. This is about the maximum that an EWS household can pay. In fact, an EMI of Rs 800, which means a loan of Rs 75000 at the same terms, is a more realistic estimate. At the first estimate, assuming an upfront beneficiary payment of about Rs 20000, the subsidy will have to be Rs 0.8-1.3 lakh. Add in the land and infrastructure cost, the subsidy burden per unit will multiply a few times. Who is going to finance this construction subsidy? How many EWS beneficiaries can access banks for loan tie-up, especially given the massive NPAs banks have piled up in this category? Would it not be required for governments to use most of the available scarce pool of public lands for EWS housing?

Given this, governments will have to heavily subsidize any EWS housing schemes. Private participation will have to be confined to construction (on tenders), professional project management, and possibly outsourcing of rent collection and maintenance services. No PPP, innovative structuring of projects, or establishment of enabling policy framework can gloss over this reality.

In the circumstances, efforts to leverage private participation with allotment of government lands at concessional rates (or even free of cost) or provide generous fiscal concessions to developers, will merely constrain scarce public resources and detract from the more important and several times bigger challenge of building an adequate stock of EWS housing. In other words, by following the mainstream agenda, we will end up, at best, meeting the objectives with respect to a small part of the market, while overlooking the major portion of the market. None of this is to downplay the importance of LIG, MIG, and other parts of the market, but only to argue that its promotion should not come at the cost of the much larger market and public policy priority regarding EWS housing.

The choices that face public policy makers are stark. Should we allot scarce public lands to private developers or take up development on PPP so as to promote LIG/MIG housing or should we use them to develop stock of public EWS housing? Similarly, who should take precedence in the use of government's limited fiscal resources in the housing sector?

Similar analysis can be done for many other sectors to expose the ignorance that masquerades as informed opinion and knowledge in advocating a dominant role for private sector and a marginal role for government in the development process in those sectors. I believe that if governments have been found to fall short in delivering its objectives, the solution is not to simply abdicate the responsibility and cede ground to private sector. This would be unwise, especially in areas where the inherent nature of the problem makes the private sector unsuitable and government participation imperative.

In the circumstances, while encouraging private participation, the main focus of the debates should be on policies that strengthen the government's ability to manage such initiatives and increase their likelihood of success. The scarce financial and administrative resources of public agencies should be channeled towards ensuring bang for the buck with its full range of objectives. Simplifying the problem by taking the easy way out will only exacerbate the problem. Further, public policy should not be captured to fuel the interests of certain categories of consumers and participants within each sector.

Public contracting Vs in-house service delivery?

Conventional wisdom would have it that private contracting is more cost-effective than government in-house activity in that they deliver services with greater quality aand at cheaper prices. I have sought to provide a more nuanced perspective on the issue here, here, and here.

In this context, a first of its kind comprehensive comparative study of the cost of in-house government delivery versus private contracting by the Project on Government Oversight (POGO) in the US reveals several interesting findings. It analyzed the total compensation paid to both federal and private sector employees, and annual billing rates for contractor employees across 35 occupational classifications covering over 550 service activities to assess the cost-effectiveness of federal service contracting. The study writes,

"The current debate over pay differentials largely relies on the theory that the government pays private sector compensation rates when it outsources services. This report proves otherwise: in fact, it shows that the government actually pays service contractors at rates far exceeding the cost of employing federal employees to perform comparable functions.

Our findings were shocking — POGO estimates the government pays billions more annually in taxpayer dollars to hire contractors than it would to hire federal employees to perform comparable services. Specifically, POGO’s study shows that the federal government approves service contract billing rates — deemed fair and reasonable — that pay contractors 1.83 times more than the government pays federal employees in total compensation, and more than 2 times the total compensation paid in the private sector for comparable services... Federal government employees were less expensive than contractors in 33 of the 35 occupational classifications POGO reviewed... Private sector compensation was lower than contractor billing rates in all 35 occupational classifications we reviewed...

We believe awarding government service contracts is nearly always more expensive than having such work performed by federal employees, even after accounting for the total cost to the government of federal employee fringe benefits and associated overhead costs."

In simple terms, this effectively negates the widespread perception that contracting out service delivery will result in considerable savings. The argument that outsourcing or contracting will automatically result in competition and resultant efficiency improvements and tax payer dollar savings is questionable, certainly the later. As the study finds out - using contractors to perform services may actually increase rather than decrease costs to the taxpayers.

And about the reasons for this failure of governments to wring out better deals from private contractors than even the private sector,

"POGO found several failures in government procurement, employment, and data systems that limit the government’s and the public’s abilities to assess and correct excessive costs resulting from insourcing or outsourcing federal services. Failures included the lack of standards for calculating cost estimates and justifying insourcing or outsourcing decisions; the lack of data related to negotiated service contract billing rates; not publishing government information about the number of actual contractor employees holding a specific occupational position under any given contract; and that there is no universal job classification system."

Cost-effectiveness consists of two parts - efficiency improvements and cost of service delivery. Though, as the study shows, contracting fails on the later, it does bring in efficiency improvements. This does mitigate the higher cost of service delivery to some extent. But even with this, the cost of contracting remains far higher, as seen from the comparative study, for similar service delivery in private sector (where the efficiency improvements are less substantial).

This cost of contracting becomes even greater in developing countries where the cost of transacting with the government is substantial and a premium gets priced into the contract cost. This apart, the inability or limitations inherent in public contracting systems comes in the way of governments getting the best possible deal. Finally, there is the issue of inherent problems of co-ordination and resultant transaction costs associated with scale that applies to contracting certain public services. All these three problems are greater in developing countries, and therefore the premiums are higher.

None of this is an endorsement of in-house serive delivery or a case against outsourcing or public contracting. My objective is two-fold. One, it is important that we rectify the skewed public perception that private service delivery is inherently more efficient and cheaper than in-house service delviery. Second, a proper recognition of these deficiencies is important to help us design and implement outsourcing contracts that are cost-effective.

Is the pendulum swinging on outsourcing civic services?

Conventional wisdom on the delivery of civic services holds that service quality can be improved only if urban local bodies (ULBs) outsource or contract out or even privatize their services. In-house service delivery is perceived as fundamentally inefficient and inherently poor in quality. Accordingly, in recent years, there has been a clearly pronounced trend towards outsourcing civic utility services - water, sewerage, solid waste management, IT operations, customer care centers, etc - in many Indian cities.

In this context, Stephen Goldsmith, the deputy mayor of New York, and an one-time Republican Party star for privatizing government services when he was mayor of Indianapolis, has triggered off a debate on the merits of privatization of civic services with this very interesting op-ed column,

"Usually, when government officials talk about spending less money, they talk about outsourcing services to the private sector. And in many cases, that can be very effective. But union leaders often argue that it would be more cost-effective to give the work to city employees - and sometimes, they are right...

Mayor Bloomberg requested that I review all information technology, or IT, contracting. After conducting a thorough review, I have concluded that much of the solution lies not in more outsourcing to the private sector, but rather in employing city workers to perform more of our IT work. So in the weeks and months ahead, we will decisively shift more work from consultants outside government to our talented public employees. This will save taxpayers millions of dollars a year."

As part of this review, the Bloomberg administration has sought to consolidate the city's 40 separate data server rooms into a handful of centralized data centers. This project, expected to yield taxpayer savings of atleast $100 mn over the next five years, is being executed using public employees,

"To build our new data center, instead of hiring an outside vendor for project management and quality assurance as we would have done in the past, we insourced the work to the Department of Information Technology and Telecommunications' project management team... Using the know-how of city staff to oversee these projects will save an additional $25 million over and above the $100 million we will save from having fewer server rooms and other efficiencies. That center where the mayor stood was built in record time, from start to finish in only six months."

He also wrote about other successes with in-sourcing,

"Our Business Express tool - which helps businesses get permits faster - and our expanded 311 online program are both now led by insourced city employees, not consultants. The Finance Department is hiring 45 city employees to replace outside consultants, almost entirely in its technology department. That will save millions more."

And about the way forward,

"At the same time as we intelligently insource, we need to tighten our oversight over outside contractors. Competent and honest vendors respond best when they are well-managed by able city officials. We are proposing, therefore, to expand a high-level city vendor management office - and in the process, reduce the cost of outside projects and test whether certain projects are even necessary.

And we are going to start challenging all components of technology contracts, and ensure that the city does not pay a markup to a consultant for work we could just as well do internally. We must also focus on subcontractors - companies hired by our own vendors to help them complete their assignments... Insourcing the management of projects and important decisions about scope and cost will allow us to save taxpayer dollars, enhance service delivery and ensure that IT vendor resources throughout the city are delivering on time and on-budget for New Yorkers."

Predictably, this has re-ignited the debate about the merits of in-house service delivery and outsourcing of municipal services. Here are a few observations

1. As Mildred Warner writes, "Contracting out only saves money if there are technological innovations or economies of scale that come from moving functions out." It therefore becomes critical to objectively and accurately assess the costs and benefits of any such initiative. However, as we have seen with the numerous examples of high-profile failures with mergers and acquisitions with big private firms, such decisions are difficult to make.

It is no surprise that in recent years there have been a large number of cases of reverse contracting - bringing previously privatized services back in house - from cities across the world. A study for the International City Managers Association (ICMA) by Mildred Warner and Amir Hefetz finds that the reasons for reverse contracting are problems with service quality (61%), lack of cost savings (52%), improvements in public delivery (34%), problems with monitoring (17%) and political support to bring the work back in house (17%). As can be seen, the "reversals reflect problems with service quality and lack of cost savings in contracted services" instead of the usual suspect of political opposition.

2. There is a fundamental incentive challenge - private firms have incentives to reduce quality to enhance profits and governments have the incentive to reduce costs. This means that the city managers have to effectively police and re-align the incentives of the contractors. At the same time, they have to bear in mind the need to ensure that life-cycle costs of delivering the service is optimized.

However, this requires that the city managers have the requisite professional competence and integrity to effectively carry out this responsibility. Unfortunately, there are very few cities which have the required numbers of professionally competent (upto speed with the latest technologies and processes) and honest managers.

3. It is no surprise that there are massive delays in all types of projects being executed in our cities. Monitoring and supervision, even of internally executed projects, have never been a strength of public systems. It is therefore unreasonable to expect municipal governments to do an effective job of external contract management, especially those involving complex and difficult to quantify outcomes.

Monitoring the adherence with service levels involves rigorous data collection and supervisory over-sight which is often beyond the competence of public officials and their bureaucratic systems. As can be expected, project management is one of the weakest areas of urban governance.

4. The most critical determinant of the success of any contracting agreement is the ability to monitor with reasonable degree of accuracy the achievement of outcomes. However, it is difficult to quantify the outcomes, leave alone the quality, of many civic services. Sometimes, it is difficult to even define and monitor certain outcomes. Performance-based contracts, which are successfully implemented across the private sector, is therefore difficult to structure for civic service delivery.

Further, even when it is possible to quantify outcomes and their quality, the process of data collection is a source of concern. It is either gamed by the contractor, in collusion with the supervising public officials, or its reliability suspect due to the sheer inefficiencies within public bureaucracies.

5. Compounding the problem is the absence of adequate competition and depth in the market for service providers. In the US itself, for most local government services the average number of alternative providers is less than two. Only one third of the 67 most common local government services have two or more alternative providers in the market. Reflecting the virtual absence of choice, fully 75% of contracts are given to the incumbent without re-bidding. The situation is far worse in developing countries like India. In other words, "all privatization does is substitute a private monopoly for a public one".

6. Cronyism and corruption is rampant in all our urban local governments. However it is not the exclusive preserve of our local bodies. Chicago's parking meter privatization is the most high-profile example of incompetence, short-sightedness, and corruption that characterises contracting of civic services.

Contracting out civic services, especially in the larger cities, require a highly professional bid process management. It should be free from external interference and decisions should be taken on purely professional and objective considerations. It is difficult to replicate such environments in most Indian cities.

The net result is a completely compromised bid process, in which extraneous considerations prevail over professional qualifications. The willingness of most service providers to play this game only makes the process even murkier. The result is a badly designed/structured contract (often done to favor certain parties) awarded to a contractor with neither the expertise nor the intent to execute the project effectively. Failure, criticism and controversy is therefore inevitable.

None of this is to oppose outsourcing and privatization and advocate in-house civic service delivery. As Nicole Gelinas writes, "Privatization of government services can be a tool for competent governments but it's not a cure for incompetence... privatization doesn't obviate the need for government competence and honesty, as well as for the democratic checks and balances that encourage these traits". Governments should decide to use outsourcing and privatization based on the specific project and the local market conditions and not on ideological considerations. Elliott Scalar has this standard for making privatization decisions,

"Three factors drive the decision: the number of interactions required between the service supplier and the purchasing organization; the ability of the purchasing organization to judge the quality of the product; and the nature of control over the physical assets and people involved in delivering the goods. The general rule of thumb is that when the number of interactions is high, quality is not easily determined and control over assets is required, you should keep the function in-house. If the reverse is true, you can outsource."

John Donahue prescribes this standard,

"Tasks that are well-defined, easy to monitor and available from competitive suppliers — call them 'commodity tasks' — are prime candidates for privatization. Tasks that are complex and mutable, lack clear benchmarks or are immune from competition — 'custom tasks' — should be kept in-house."

All this ultimately boils down to the original Coasean theory about firms and transaction costs - firms exist because the transaction costs associated with doing ancillary activities externally are simply too large. In this case, certain services, instead of being outsourced, are more effective if done internally within the civic utility.

The final word should go to an excellent meta-study of privatization across the world of water distribution and garbage collection by Germà Bel, Xavier Fageda, and Mildred E. Warner, which finds,

"Privatization of local government services is assumed to deliver cost savings but empirical evidence for this from around the world is mixed. We conduct a meta-regression analysis of all econometric studies examining privatization for water distribution and solid waste collection services and find no systematic support for lower costs with private production. Differences in study results are explained by differences in time-period of the analyses, service characteristics, and policy environment. We do not find a genuine empirical effect of cost savings resulting from private production. The results suggest that to ensure cost savings, more attention be given to the cost characteristics of the service, the transaction costs involved, and the policy environment stimulating competition, rather than to the debate over public versus private delivery of these services."