A Proposal for Using Incentive Pre-Commitments in Public Enterprise Funding

Abstract

Among the central problems of LDCs is the poor performance of their public enterprises (PEs), and the limited ability of governments and other agencies to improve this performance. In practice, a typical funding agency possesses extremely few levers to improve the performance of an ongoing PE, with perhaps the most potent lever being negotiation over the conditionality for original funding. The present paper suggests a more effective use of such limited levers.

We propose that project authorities should be asked and induced to undertake two kinds of pre-commitments at the time of funds approval; a pre-commitment to: (i) link a non-negligible part of the project's employees' compensation to the actual PE performance (we call this the "profit-sharing pre-commitment"), and (ii) liquidate the project if its ex-post performance falls below some threshold level (we call this the "liquidation pre-commitment"). Inducements might include making the availability and softness of funding contingent upon such pre-commitments.

We discuss three primary sources of PE losses (namely, conventional allocational inefficiencies, X-inefficiencies, and project irreversibility due to "soft budget constraints"), compare the likely relative magnitudes of associated losses, and argue how incentive pre-commitments would help ameliorate these losses. A simple illustration of the likely large order of magnitude of the "option" value of gains from reversibility is also presented.

This paper places a central emphasis on pre-commitments because, given the political-economic environment of an LDC, the feasibility of remedial actions is greatly reduced if provisions for such actions have not already been agreed upon in advance--and understood by the parties involved--at the project approval stage. Also, the basic idea of pre-commitments is not in conflict with other approaches for improving PE performance.

This paper does not take a position on whether PEs are or are not desirable. Under the premise that PEs are likely to remain important in LDCs in the foreseeable future, our objective is to develop some constructive steps towards improving PE performance. The proposed pre-commitments represent such a step because even though these pre-commitments will not solve all or most of the problems of PEs, and even though the magnitude of the resulting overall benefit would vary across situations, it is difficult to imagine scenarios where such pre-commitments could actually harm PE performance. By contrast, many scenarios can be envisioned where incentive pre-commitments and accountability will improve PE performance.