the growth penalty of high government pay rates

8/22/2019 The Growth Penalty of High Government Pay Rates

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Economics and REsEaRch dEpaRtmEnt

te Grw pely

f hg Gvere

py Re

Craig Sugden and Kiyoshi Taniguchi

June 2008

RD WoRking PaPER SERiES no. 118


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ERD Wrking Paper N. 118

The GrowTh PenalTyof hiGh GovernmenTPay raTes

CraiG suGdenand Kiyoshi TaniGuChi

June

2008Craig Sugden is Country Economist with the Pacifc Department; Kiyoshi Taniguchi is Country Economist with the

Uzbekistan Resident Mission, Asian Development Bank. The authors thank seminar participants rom the Central

and West Asia Department, Pacifc Department, and Economics and Research Department o the Asian DevelopmentBank; and C.Y. Choi, Ron Duncan, Rana Hasan, Bruce Knapman, and Fred Nixson or their advice. Views expressed

in this paper are not necessarily those o the Asian Development Bank, its executive directors, or the countries theyrepresent. Responsibility or any errors rests with the authors.


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Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippines

www.adb.org/economics

2008 by Asian Development BankJune 2008

ISSN 1655-5252

The views expressed in this paper

are those o the author(s) and do notnecessarily reect the views or policies

o the Asian Development Bank.


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FoREWoRD

The ERD Working Paper Series is a orum or ongoing and recently completedresearch and policy studies undertaken in the Asian Development Bank or onits behal. The Series is a quick-disseminating, inormal publication meant to

stimulate discussion and elicit eedback. Papers published under this Seriescould subsequently be revised or publication as articles in proessional journalsor chapters in books.


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CoNtENts

Abstract vii

I. Introduction 1

II. Studies o Government Size and Economic Growth 2

III. Stylized Facts 4

A. An Indirect Measure o Government Employment SharesA. An Indirect Measure o Government Employment Sharesand Relative Pay Rates 4

B. Government Employment Share, Pay Rate, and Income 7

IV. Theory 11

A. The Presence o Economic Rent 11 B. The Modifed Harris-Todaro Model 12 C. The Harris-Todaro Equilibrium and Economic Rent 15

V. Empirical Analysis 16

A. Introduction 16 B. Data 16 C. Simple Pooled Regression 18 D. The Endogenous Model 21 E. Interpretation o Empirical Analysis 23

VI. Conclusion 23

Appendix I 27 Appendix II 48 Reerences 51


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AbstRACt

This study examines the role o government pay rates in economic growth.A trend decline in government pay rates, expressed relative to what an economycan aord, is identifed in many developing countries. The decline is attributed to

the erosion o economic rents. Drawing on the theoretical insights o the Harris-Todaro two sector model, the study argues that static and dynamic benefts romthe erosion o rents would lead to a negative relationship between government pay

rates and economic growth. Utilizing the pooled regression models as well as the

easible two-stage generalized method o moments estimator, the study concludesthat relative government pay rates are negatively related with economic growthin developing countries; hence, high government pay rates penalize economic

growth. Countries that retain high government pay rates are identifed.


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I. INtRoDuCtIoN

Theory explains that government expenditure can contribute to economic growth throughthe provision o public goods and the correction o other market ailures. Government expenditure

that corrects market ailure can achieve a social return that exceeds private returns rom displacedprivate savings. But inefciency in production by government agencies and rent seeking can resultin adverse eects rom government expenditure. Furthermore, the deadweight costs borne in raisingtaxes to und expenditure, and the crowding out and inationary eects o government expenditure

can be signifcant. Theory alone cannot determine whether the positives outweigh the negativesand the optimal size o government. Empirical studies are needed to shed light on whether thebenefts o government expenditure outweigh the costs and whether the net benefts depend onthe size o government.

Early empirical studies o government size tended to identiy a negative relationship betweensize and economic growth in both a developed and developing context, where size is measured

by aggregates o government expenditure and revenue. The fnding o a negative relationship hassupported the view that the long-run expansion in government, observed in many countries, haspenalized economic growth. Such a view is important given the implications or public policy andassociated political overtones in many countries. More recent studies suggest caution in reaching

the view that larger governments penalize economic growth, citing the sensitivity o the earlierfndings to model specifcation and estimation technique. The debate on the relationship betweeneconomic growth and government size in developing countries is best seen as remaining open.

The labor intensity o government means that government employment levels and pay rates arepotentially key actors in determining the eect o government on economic growth. Notably, anexpansion in government employment is likely to have a very dierent eect when public employeesare over-paid compared to when they receive a reasonable rate o pay. It is sae to argue that the

aordability o government employees is a signifcant inuence on whether governments providethe essential inputs needed or economic growth. This is likely to be a particularly importantconsideration during the early stages o economic development when extensive market ailures

impair the emergence o private sector service providers.

Existing studies o aggregate government expenditure and revenue obscure the potentialrole o government employment and government pay rates. This study complements past work

by investigating international patterns in government employment and pay rates. Our measure ogovernment pay rates is expressed relative to what is aordable or an economy. Indirect measureso government employment shares and relative pay rates are adopted to overcome data limitationsthat have curtailed past research in this area.

Drawing on a panel data set covering more than 150 countries, evidence is presented o anupward trend internationally in government employment shares and a downward trend in relativegovernment pay rates. Relative government pay rates are ound to be trending down to a level that

is apparent at high income levels, and to be inversely related with the government employmentshare. While the ocus o the study is on developing countries, it is noted that this broad depictionis relevant to both developing and developed countries. The downward trend in relative pay ratesis, however, more pronounced in a developing context.


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We argue that the decline in relative pay rates identifed in many economies as they develop

is attributable to the erosion o rents embedded in government pay rates. These rents are attributedto rent seeking behavior and scarcity in the supply o skilled labor. Drawing on insights rom theHarris-Todaro two sector model and plausible dynamic eects, it is hypothesized that the reduction

in relative government pay rates contributes to economic growth in developing countries. Notably,a decline in rents in government pay rates is seen to assist growth by making public services thatare important or the eective unctioning o an economy more aordable, and by supporting ashit in an economys resources out o low productivity activities.

Empirical investigation o the experience o a large sample o developing countries concludesthat relative government pay rates are negatively related to economic growth. In contrast, there isno apparent relationship between government employment share and economic growth in developing

countries in the sample. It is concluded that it is governments relative pay rates, rather than its sizeas measured by employment share, which matters or economic growth in developing countries.

The paper is structured as ollows. The next section presents the background to our study o

government employment and pay rates by reviewing empirical studies o the relationship between

government size and economic growth. Measures o government employment shares and relative payrates and trends in these measures are then presented. The paper then presents a theoretical rationale

or the relationship between these measures o government and economic growth in developingcountries. Regressions are presented or developing countries that explore the relationship betweenper capita gross domestic product (GDP) growth and either the measure o relative pay rates oremployment shares, controlled or policy, institutions, and initial endowments. A fnal section presents

the key implications o the study, including the identifcation o those countries that appear to bepaying a growth penalty by preserving their public servants as a well-paid elite.

II. stuDIEs oF GovERNmENt sIzE AND ECoNomIC GRoWth

The consequences or economic growth o government size have been explored widely through

the examination o government expenditure and taxation aggregates. On the basis that it is theproduction decisions o government that matter to economic growth and not the transer unction ogovernment, many o the early empirical studies avored the examination o government consumption.Such studies were spurred on by the development o national accounts at international prices.

Others examined the level o taxation in order to capture the deadweight costs and impacts on theeconomy o raising revenue.

As o the early 1990s, the weight o empirical evidence was tending toward the view that larger

governments penalized economic growth, in both a developed and developing context. Findings oa negative relationship between economic growth and size are presented in Smith (1975), Landau(1983), Marsden (1983), Landau (1985), Saunders (1985), Landau (1986), Marlow (1986), Grier andTullock (1989), Barth and Bradley (1988), Barro (1989), Grier and Tullock (1989), Alexander (1990),

Barro (1991), and Engen and Skinner (1992). Nonetheless, some studies ound a positive relationshipbetween the size o government and growth, or the absence o such relationship. Examples includedRubinson (1977), Katz et al. (1983), Kormendi and Meguire (1985), Ram (1986 and 1993), and

Conte and Darrat (1988). Grossman (1988) presents evidence o a nonlinear relationship or theUnited States and no net impact o government size.

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seCTion ii

sTudiesofGovernmenTsizeand eConomiCGrowTh

These earlier studies were conducted against a background o predictions rom the prevailing

growth models that government expenditure would not aect the steady-state growth rate, althoughit would potentially having important transition eects. Ram (1986 and 1993) presented one othe more developed, earlier theoretical rameworks. Rather than testing or a partial correlation

between expenditure or revenue and economic growth, Ram (1986) tested or the presence o anexternality eect o government activities on private production. This approach was criticized byCarr (1989) and Rao (1989), as it rested on restraints on relative productivity that were set on apriori grounds and cannot be inerred rom the data.1

The development o endogenous growth models has provided new directions by arguing howgovernment activities could aect the steady-state growth rate. Barro (1990) distinguished betweenproductive and nonproductive expenditure and distortionary and nondistortionary taxation, arguing

that tests should ocus on the relationship between growth and productive expenditure. Dowrick (1996)extended Barros (1990) ramework to identiy the importance o the nominal level o governmentexpenditure, on the basis that the deadweight losses rom taxation arise rom the nominal level and

not the real level. Other contributions rom endogenous growth perspectives include Lucas (1988),Easterly (1989), Rebelo (1991), Barro and Sala-i-Martin (1992), and Mendoza et al. (1997).

More recent empirical studies drawing on both the insights rom endogenous growth theory

and improved econometric methods have tended to fnd more support or a positive relationshipbetween government size and growth. Studies fnding a positive relationship include Romer (1989and 1990), Devarajan et al. (1996), Caselli et al. (1996), Kneller et al. (1999), and Romero-Avila(2006). But some studies, such as De La Fuente (1997), Folster and Henrekson (1999 and 2001)

and Durlau et al. (2008) have repeated earlier fndings o a negative relationship. Easterly andRebelo (1993) conclude that the view that tax rates matter or economic growth is ragile, andMiller and Russek (1997) report that tax-fnanced increases in expenditure raise economic growthin developing countries while debt-fnanced increases retard economic growth. Karras (1993 and

1996), Dowrick (1996), and Aly and Strazicich (2000) fnd support or the view that the costs ogovernment do outweigh the benefts as governments get too large (relative to a hypotheticalsocially optimal level), at least or higher income countries, yet governments are not necessarily

at the point o being too large.

Notably, the more recent fndings o a positive relationship have tended to concentrate ondeveloped countries; an emphasis that appears to arise rom the greater demands placed on data

by new theoretical rameworks and estimation techniques. Hence it is unclear how well the morerecent support or a positive relationship carries to a development context.

Kneller et al. (1999) and Bleaney et al. (2001) argue that insufcient attention has been

paid by empirical studies to the implications o the government budget constraint. This requiresthat a change in one fscal variable must be fnanced by a change in another or in a range o fscalvariables. They highlight that the fscal variables included in growth equations are defned relative

to the omitted fscal variables, which can be on the revenue or expenditure side o the budget, orbe fnancing items. This makes it difcult to isolate the actors behind empirical fndings on therelationship between a measure o government size and economic growth.2 Others to raise thisissue include Helms (1985), Mofdi and Stone (1990), and Miller and Russek (1997).

1 Rao (1989) also criticized Ram (1986) on econometric grounds.2 Only when the omitted fscal variable is uncorrelated to economic growth would the estimated coefcient describe the

eect o the included fscal variable on economic growth. Otherwise the estimated coefcient includes the relationship

with growth o both the identifed fscal variable and the omitted variable.

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Some have argued that a micro approach is necessary to add up the impact o the components

o government expenditure and revenue in order to understand the impact o government size.Disaggregated studies have tended to fnd a negative relationship between transers and economicgrowth and a positive relationship between government investment and growth.3 The International

Monetary Fund (1995) highlighted evidence o the productivity o primary education and communityhealth services, particularly in developing countries, as well as health education and preventative healthcare expenditures. Gerson (1998) highlighted the potential or expenditure on health, education, andinrastructure to contribute to growth, while arguing that spending on deense and social services

could also contribute by maintaining the social abric and supporting political stability. Miller andRussek (1997) also report dierent growth eects or dierent sectors o expenditure.

An alternative perspective on the economic growth and government size debate is that the

marginal government expenditure and revenue is o most concern as these determine the impacto cutting back or expanding government size. Easterly and Rebelo (1993) present some evidenceo a negative relationship between growth and marginal tax rates, while citing the difculty o

measuring marginal tax rates. Gupta et al. (2002) argue that fscal adjustments achieved by cutsto government wages, salaries, and transers, rather than increasing revenues and cuts to publicinvestment, can oster growth and are more likely to be sustainable. Evidence or this view ina developed country context is presented in Alesina and Ardagna (1998), Alesina et al. (1998),

Alesina and Perotti (1997), McDermott and Wescott (1996), and Von Hagen and Strauch (2001).In a developing country context, Gupta et. al. (2002) ound that fscal consolidations tended tohave the most positive eects or economic growth when they lead to a reduction in the domesticborrowing requirement and when public investment is protected.

The data limitations acing a study o government size have also received attention. Bergstrom(1997), Bairam (1990), and Gould (1983), among others, point out that the inclusion o governmentconsumption and investment in GDP biases analysis o total government expenditure or government

consumption toward fnding a positive relationship between government size and economic growth.Carr (1989) also points to the bias toward a positive relationship that arises rom the standardpractice o measuring government consumption at cost, rather than the unobservable value o

output. Carr (1989) points out that as government consumption is a combination o fnal demandsand intermediate usage, inclusion o the later biases upward measurement o GDP where this biasis likely to grow with the level o government expenditure.

III. stylIzED FACts

A. An Indirec meare Gernen Epen sareand Reaie Pa Rae

There are considerable difculties aced in preparing measures o government pay rates that

are consistent across countries and time. One approach is to obtain inormation rom governmentbudgets or payrolls on ofcial pay scales. But such inormation are oten confdential and, when theyare publicly released, it can be difcult to amass a collection sufcient or research. Some orm oaverage pay rate or measure o pay compression needs to be derived rom such data based on the

level o employment at dierent or representative pay grades. But inormation on employment by pay

3 See Easterly and Rebelo (1993) and the overview in Kneller et al. (1998). Devarajan et al. (1997) contest the fndingo a positive relationship between capital expenditure and economic growth in developing countries.

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seCTion iii

sTylized faCTs

grade is typically even harder to obtain than inormation on pay scales. And then when available,

inormation on employment by pay grade oten only covers permanently engaged employees andexcludes temporary or casual employees. It may also be impractical to convert the inormation toa usable orm, as it is oten contained in detailed records only. The approach o analyzing ofcial

pay scales is also vulnerable to variations across countries in administrative arrangements, notablywhether agencies under government control are on-budget or o-budget and whether budgets recordemployment unded by the activities o international donors or only by internally unded expenditure.A urther conceptual issue to be aced is whether the size o government should be measured by

direct government employment, or whether it should also include those private sector employeesthat are unded via government revenue (such as those in education and health).4

These difculties have created a barrier to research into government pay rates and employment

size.5 We seek to overcome this barrier by adopting an industry defned in the national accountsas a proxy o general government. This orms a unit o measure or the study that is standardizedacross countries and time. The community, social, and personal services industry has been used in

some studies as a proxy o the nonmarket sector, or example by Gemmell (1986). The community,social, and personal services industry is industry nine o the one-digit industrial classifcation andby international practice includes: public administration, deense and compulsory social security;education; health and social work; other community, social, and personal services; private households

with employed persons; and extra-territorial organizations and bodies.6 For the purposes o thisstudy, it would be preerable to base analysis on the government component o this industry, or atleast to separate personal rom community and social services. However such disaggregated data aretypically unavailable or difcult to obtain or a sufcient time period or developing countries.

Given the data limitation, and on the basis that it is typical or the output o the community,social, and personal services to be provided or at least largely unded by government, the studyadopts the community, social, and personal services industry as a proxy or general government.

That is, employment by general government is proxied by employment in the community, social,and personal services industry.

The national accounts adopt a simplifcation in incorporating general government that can be

used to advantage in deriving a measure o government pay rates. For a normal industry, value-added is reected in the prices o the industrys output, and labor productivity can be ound asvalue-added per employee. As there is no price or public administration and most other activities

o general government, the value-added and hence productivity o general government is difcultto measure. The international standard is to measure value-added o general government as the

4 The measurement o government pay and employment rom such data is discussed in Kray and Rijckeghem (1995),

Schiavo-Campo et al. (1997), Schiavo-Campo (1998). and World Bank (2001).5 See or example Helller and Tait (1983) and Schiavo-Campo (1998).6 This defnition is the International Standard Industrial Classifcation o all Economic Activities (ISIC-Rev. 3 1993).

Under the International Standard Industrial Classifcation o all Economic Activities (ISIC-Rev. 2 1968), the industry

is defned to include: Public Administration and Deence; Sanitary and Similar Services; Social and Related Community

Services (Education services, Research and scientifc institutes, Medical, dental, other health and veterinary services,Welare institutions, Business, proessional and labour associations, and Other social and related community services);

Recreational and Cultural Services (Motion picture and other entertainment services, Libraries, museums, botanical andzoological gardens, and other cultural services not elsewhere classifed and Amusement and recreational services not

elsewhere classifed); Personal and Household Services (Repair services not elsewhere classifed and Laundries, laundry

services, and cleaning and dyeing plants, Domestic services and Miscellaneous personal services); and Internationaland Other Extra-Territorial Bodies.

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addition o the government wage bill and an estimate o the capital consumed. Hence what is

reported as value-added in general government is more accurately described as a measure o cost.As the sector is labor-intensive, value-added o general government is close to the total cost olabor. By implication, value-added in general government divided by the number o persons employed

can be used an estimate o the average pay rate in general government.International comparisons o the size o government have drawn on measures o government

consumption estimated at constant international prices (i.e., purchasing power parity adjusted

terms). The underlying international price deators could be applied to this studys estimate oaverage, nominal pay rates in government to derive an estimate o the real pay rate. However itis unclear whether these deators would provide a sufciently reliable representation o changesin the nominal price o labor. The study instead derives a measure o relative pay ratesthe ratio

o the average wage in the community, social and personal services industry to value-added peremployed person. That is:

Relative government pay rate

in general government=

Value-added in community, social, and personal servicesEmployment in community, social, and personal services

Total value-addedTotal employment

This measure has the intuitive interpretation o providing an indicator o the aordability ogovernment wage rates. For example, a relative pay rate o 400% would point to a less aordable

government than a relative pay rate o 100%.

One o the potential limitations o our indirect measure o relative government pay rates is thepresence o the private services component in community, social, and personal services. Inaccuracy

may arise i: (i) the private services share o community, social, and personal services changesmarkedly over time and the private and government relative wage is markedly dierent; or (ii) thereis a change in the wage o the private component relative to the government component. Data onthe government versus private component o community, social, and personal services are not readily

available. But data are available on the public administration, education, and health component othe community, social, and personal services industry. An evaluation o this data ails to fnd anobvious problem rom the mix o activities in the community, social, and personal services industry.Public administration, education, and health are ound to average approximately 75% o employment

in community, social, and personal services in 53 non-OECD countries; it averages approximately80% in the Organization or Economic Cooperation and Development (OECD) countries. The shareis ound to decline over time on average, but at a slow rate. For 53 non-OECD countries, the share

is ound to have declined by 0.3% per annum on average, while the rate o decline is ound to belower in OECD countries on average (Table 1).

Comparisons o our indirect measure o relative government pay rates and employment shares

and direct measures prepared by the World Bank are presented at Table 2. The indirect and direct

measures are ound to be positively correlated or periods where sufcient observations are availableor meaningul comparisons. The direct and indirect measures present a similar pattern across regions.Notably, relative government pay rates are ound to be lowest in the OECD countries and the Central

and Eastern Europe and Commonwealth o Independent States, and highest in Sub-Saharan Arica,the Pacifc Islands, and South Asia in the 1990s (see Appendix Table A1.1). A similar regionalpattern is also evident in earlier periods or our indirect measures and the direct measures preparedby Heller and Tait (1983) and Kray and Van Rijckeghem (1995).

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seCTion iii

PoverTyandinequaliTyin india: 19832004

Table 1PubliCadminisTraTion, eduCaTionand healTh emPloymenT

PERCENt oF sECtoREmPloymENta

ChANGE IN thE shARE oF

sECtoR EmPloymENt(PERCENt PER ANNum)a NumbER oFCouNtRIEs

All countries 76.7 0.21 78OECD countriesb 80.8 0.02 25Non-OECD countries 74.8 0.31 53

OECD = Organization or Economic Cooperation and Development.

a Sector is defned as community, social, and personal services.b The estimate derived rom the OECDs STAN Database (OECD 2005), excluding Japan (which appears to have an error

in the data), is 0.05.

Source: International Labour Organizations Key Indicators o the Labour Market.

Table 2CorrelaTionsforindireCTanddireCTmeasures

INDIRECt mEAsuREa

DIRECt mEAsuREPAy RAtEs FoR

1991997PAy RAtEs FoR

1998001

EmPloymENtshARE FoR1991998

EmPloymENtshARE FoR1998001

Pay rates or the mid-1990s 0.2715**

n=59Pay rates or the mid-1990s 0.3851***

n=56Employment share or the mid-1990s 0.6673***

n=64Employment share or the late 1990s 0.3609

n=20*** signifcant at 1% level; ** signifcant at 5% level.a Pay rate is defned as the ratio o value-added per employed person in community, social, and personal services to the

average or all industries. Employment share is the community, social, and personal services share o total employment.Data are derived as unweighted our-year averages o the available data or 19502006.

b Pay rate is defned as the average wage o the total general civilian government as a multiple o per capita grossdomestic product. Employment share is employment in total general civilian government as a percentage o the

population. Estimates are rom Schiavo-Campo (1998) or 1993 to 1996, or when unavailable, the latest available yearor 19911995 rom World Bank (2001).

Sources: Authors estimates derived rom OECD (2005); Timmer and de Vries (2007); census releases and statistical

compendiums o the Secretariat o the Pacifc Community (2007) supplemented by the statistics authorities inthe Pacifc; United Nations Statistical Divisions National Accounts Database, International Labour Organizations

Key Indicators o the Labour Market and LABORSTA; Schiavo-Campo (1998); and World Bank (2001).

b. Gernen Epen sare, Pa Rae, and Ince

Wagners Law hypothesizes that the demand or government services rises with income levels.

The relationship is evident in our data on the government employment share in developing anddeveloped countries. Higher government employment shares, i.e., larger governments, are evident

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at higher income levels (see Figure 1).7,,8 The potential contributors to the widespread growth in

the size o government include an elastic demand or public services with respect to income and thepublic choice rationale that emphasizes the sel-interest o politicians and bureaucrats in expandingsize in the ace o weak constraints on the use o revenue-raising powers.9

FIGURE 1GOVERNMENTEMPLOYMENT AND INCOME LEVELS

70

60

50

40

30

20

10

0

Gove

rnmentemploymentshare

10,000 20,000

Income per head (2,000 international dollar)

30,000 40,000 50,0000

Note: Data are 4-year averages o the available data or 1950 to

2006; N = 809; n = 155 (high- and low-income countries).Sources: Authors estimates derived rom OECD (2005); Timmer and

de Vries (2007); Secretariat o the Pacifc Community (2007)

supplemented by the statistics authorities in the Pacifc; United

Nations Statistical Divisions National Accounts Database;International Labour Organizations Key Indicators o theLabour Market and LABORSTA; and Heston et al. (2006).

Our fnding o a positive relationship between the government employment share and incomelevel is not surprising given the existing support or Wagners Law. However what has been paidlittle attention is the apparent relationship between income level and government pay rates. Relativegovernment pay rates tend to be highest at lower income levels and vice versa (see Figure 2). The

relationship is not as apparent as between employment shares and growth, because relative payrates have increased in some countries as incomes have risen. Countries that have moved againstthe international trend and increased relative government pay rates as incomes have risen include

Bolivia; Colombia; Costa Rica; India; Taipei,China; and Venezuela.

7 A similar fnding is presented, albeit rom a smaller dataset, in Heller and Tait (1983), Kray and Van Rijckeghem (1995),

Schiavo-Campo et al. (1997), and Schiavo-Campo (1998).8 For the sake o comparison, data in Figures 13 include developing as well as developed countries.9 Cullis and Jones (1998, 35771) provide an overview o the literature on Wagers Law. Diamond (1977), Ram (1987),

and Easterly and Rebelo (1993) present supporting data. Rodrik (2000) also advances the argument that countries usesae government jobs as insurance against nondiversifable external risk.

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seCTion iv

aCCounTinGfor inequaliTybeTween1993 and 2004

FIGURE 2

GOVERNMENTPAY RATES AND INCOME LEVELS

400

350

300

250

200

150

100

50

0

Relativegovernmentpayrate

10,000 20,000

Income per head (2,000 international dollar)

30,000 40,000 50,0000

Note: Data are 4-year averages o the available data or 1950 to2006; N = 656; n = 131 (high- and low-income countries).

Sources: Authors estimates derived rom OECD (2005); Timmer and

de Vries (2007); Secretariat o the Pacifc Community (2007)supplemented by the statistics authorities in the Pacifc; United

Nations Statistical Divisions National Accounts Database;International Labour Organizations Key Indicators o the

Labour Market and LABORSTA; and Heston et al. (2006).

A oor is apparent in relative government pay rates in the order o 50%. This oor is most

pronounced in developed countries, but is also evident in some developing countries. Very ew countrieshave relative pay rates below this level, and once the oor is reached, government employmentappears to grow as incomes rise. A likely explanation or such a oor is that governments would

fnd it difcult to attract and retain sta i, on average, pay rates were too much below this level.Attempts to lower government pay rates below the oor are likely to see labor avor employmentin the private sector, reducing the labor supply and liting pay rates in government back to theoor level.

These data are suggestive o a negative relationship between the government employmentshare and relative government pay rates. This negative relationship is indeed evident visually(see Figure 3). That is, a decline in relative government pay rates is associated with a rise in the

government employment share. This relationship is evident across regions and over time, whether

developed or developing (see Appendix Table A1.1). But the strength o the relationship in developingcountries suggests that a decline in relative government pay rates is a eature o the economic

development process.



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FIGURE 3

GOVERNMENTPAY RATES AND EMPLOYMENT

450

400

350

300

250

200

150

100

50

0

Relativegovernmentpayrate(percent

)

10 20

Government employment share (percent)

30 40 50 500

Note: Data are 4-year averages o the available data or 1950 to2006; N = 725; n = 154 (high- and low-income countries)

Sources: Authors estimates derived rom OECD (2005); Timmer andde Vries (2007); Secretariat o the Pacifc Community (2007)

supplemented by the statistics authorities in the Pacifc; United

Nations Statistical Divisions National Accounts Database;International Labour Organizations Key Indicators o the

Labour Market.

Turning to the experience o developing countries, the ocus o this study, correlation coefcients

or developing countries are consistent with the visual relationships (Table 3). The governmentvalue-added share derived at current prices is ound to be positively correlated with relativegovernment pay rates, the government employment share and income levels. In contrast there isno apparent relationship between relative government pay rates and government employment share

with a commonly used measure o government size, the ratio o government consumption to GDPmeasured at international prices.

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seCTion iv

Theory

Table 3CorrelaTionsfor develoPinG CounTries

RElAtIvEGovERNmENtPAy RAtE

GovERNmENtEmPloymENtshARE

GovERNmENt

vAluE-ADDED(PERCENt oF GDPAt CuRRENt PRICEs)

GovERNmENt

CoNsumPtIoN(PERCENt oF GDP AtINtERNAtIoNAl PRICEs)

Government employmentshare

0.5989***N = 444

1.0000

Government value-added

(percent o GDP at currentprices)

0.3085***N = 444

0.3673***N = 444

1.0000

Government consumption(percent o GDP at

international prices)

0.0174

N = 417

0.0525

N = 538

0.1126**

N = 417

1.000

GDP per head

(at international prices)

0.2917***

N = 417

0.5206***

N = 538

0.1696***

N = 417

0.1366***

N = 1414

*** signifcant at 1% level; ** signifcant at 5% level.

GDP = gross domestic product.Sources: Authors estimates derived rom OECD (2005); Timmer and de Vries (2007); Secretariat o the Pacifc Community

(2007) supplemented by the statistics authorities in the Pacifc; United Nations Statistical Divisions NationalAccounts Database; International Labour Organizations Key Indicators o the Labour Market and LABORSTA;

and Heston et al. (2006).

Iv. thEoRy

A. te Preence Ecnic Ren

The observed behavior points to economic rents being embedded in relative government pay

rates early in the economic development o many countries. Governments are commonly able toexpand employment even as they reduce their pay rates relative to average value-added in theeconomy as-a-whole. This suggests that the initial payment to labor was above the competitive orsupply price, and hence embodied rents.

Potential causes o such rents in developing countries include the scarcity o skilled laboremployed by government and rent seeking behavior. There are a number o ways in which rent seekingbehavior may maniest, including minimum wages set above the competitive wage or an established

practice o regular cost o living adjustments in excess o productivity growth. The civil servicewould avor high pays or obvious reasons and may orm unions to strengthen their negotiatingposition and secure market power. Politicians and rulers may avor high pays in a misguided attemptto raise incomes, in order to secure the support o the civil service or in the expectation that

high civil service pays would orm a benchmark that also provides them a high remuneration.10High government pay rates may also be avored as a means o redistributing wealth acquired bygovernments (e.g., rom natural resources or oreign aid) in the absence o ormal mechanisms or

10 For example, in commenting on the experience o Arica over the 1950s and 1960s, Todaro (1971, 396) argues that in

their natural and understandable desire to raise the standard o living o their working populations, Arican governments

acquiesced to pressure rom both trade unions and rom civil servants in setting urban wages at levels considerably inexcess o rural average incomes and the over-all opportunity cost o urban labour.



22/65

doing so. It appears that as development proceeds pressures build to erode these rents while at

the same time encouraging government to expand employment. The apparent result is that relativegovernment pay rates decline and the extra unds made available are at least in part allocated toincrease public employment, presumably so as to provide more services to the public.

b. te mdifed harri-tdar mde

We will build a theoretical model o the dual economy or developing economies. This sectionis largely adopted rom Harris and Todaro (1970), Gelb et al. (1991), and Basu (2000).

In the economy o our interest, there are only two sectors: the inormal (I) and the ormal

(F). At the early stage o growth, the inormal sector consists o subsistence agriculture, whilethe ormal sector is assumed to be dominated by general government. In order to produce XI and

XF units o output, each sector employs LI and LF units o labor, respectively. LI and LF are non-negative. Available total labor units, L, are fxed.

LI+ LF L

Let wbe the ormal sector wage, hence the public sector pay rate due to the general governmentdomination o the sector, in real terms. The inormal sector wage, which is assumed to be equalto marginal productivity o labor in the inormal sector, is denoted as wI. Due to the governmentsbudget constraint as well as the limited number o skilled labor eligible to work or the ormal sector,the employment capacity o the government is fxed at any given wage. That is, the number o

ormal sector jobs is exogenously fxed, while the inormal sector has a airly large labor absorptivecapacity. The number o the unemployed in the ormal sector can be denoted as (L LI) LF, whilethere is no unemployment in the inormal sector. Under this setting, the expected income (wage)

in the ormal sector can be denoted asw

L

L LF

I . Assuming that there are no rigidities on labormobility between two sectors, people transer rom inormal to ormal as ar as the strict inequality,

w LL L

wF

I

I>

holds, while migration will cease once the equalityw L

L LwF

I

I=

is obtained.

Assuming fxed capital endowment in the short run, output is produced by the labor inputs

according to the ollowing production unction:

X LI I I= ( )

X LF F F= ( )

The production unction is assumed to be twice dierentiable, and > 0 and


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seCTion iv

Theory

Further, we assume that the wage in the ormal sector has a political or institutional lower

bound o the wage range, w. Hence, the ollowing condition will hold:

w w

In equilibrium, the cost minimization (or proft maximization) will ensure to hold: ( ) = L wF F

As mentioned above, the inormal sector wage is determined at its marginal productivity olabor:

( ) = L wI I I

We revisit the sectoral transer condition. Workers will transer rom the inormal to the ormal

sector as ar as the ollowing condition holds: ( )

the growth penalty of high government pay rates

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