Saíd El-Naggar
Published Date:
June 1989
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Faik Ali Abdul Rasool

It is not my intention to present a summary of the ideas contained in the paper presented by Peter S. Heller and Christian Schiller. I shall attempt to stress other aspects of the fiscal implications of privatization in developing countries while briefly reviewing the privatization of the socialist sector in Iraq, which received little attention in the paper. By so doing, I believe I will have provided a supplement to the paper, which I thoroughly enjoyed.

In the first part of the paper the authors argue that privatization will achieve economic efficiency gains through reductions in costs and improvements in allocative efficiency. They emphasize that the resulting efficiency gains should not be attributed so much to the change from public to private ownership as to the change in structure of the market in which the enterprise is operating and the creation of an atmosphere of competition.

I differ with the authors in considering market competition as one basic factor without making any distinction between political sytems and the level of economic development of the countries in question. Their analysis might be valid for industrial countries which possess the physical and human resources as well as the institutional and juridical structures that are necessary for the creation of market competition, even though rapid technology changes and the availability of physical resources may limit effective competition among producers in these countries. In the developing countries, however, competition among producers is an economic luxury, as most enterprises constitute monopolies, not only as a result of state protection but also because of purely economic considerations: namely, that these enterprises were originally designed with enough capacity to cater for total domestic demand and benefited from the advantages of economies of scale. On the other hand, the economies of many developing countries were not large enough to allow for the establishment of more than one economically viable project, either because of their small populations or their low per capita incomes. Moreover, the shortage of foreign exchange might make it impossible to establish competitive enterprises, and if it did, it might not be sufficient to allow these enterprises to operate at full capacity or enable them to meet demand, thus benefiting from the advantage of competition and from reduced costs.

Therefore, the competition factor might be valid only for the industrial countries. The developing countries, on the other hand, will be unable to provide for competitive conditions for the reasons stated above.

Unlike the authors, I would therefore contend that change from public to private ownership, removal of external interference in production and marketing, along with administrative restructuring and changes in enterprise management, replacement of government supervision with supervision by equity holders, and the cutting of administrative fat have a considerable impact on increasing productivity and reducing costs. Changing market structure toward the creation of competitive conditions for privatized corporations could be regarded as surpassing the resources or economic capacity of most developing countries, at least in the short and medium terms, although this can be a successful recipe for the industrial countries.

While agreeing with the authors that privatization is not confined to a change from public to private ownership but includes many other options such as lease or management agreements between the government and the private sector, I did not find in the paper any analysis of the fiscal implications of such forms of privatization. The fiscal implications of lease or management agreements will no doubt differ from those of ownership transfer. While averting the risks of inflation and income distortions that normally accompany privatization in the developing countries, lease and management agreements ensure the creation of a competitive environment and, consequently, efficiency in areas such as the hotel and tourist industries. In Iraq, large hotels, tourist sites, and many industrial enterprises have been managed by local and foreign concerns on conditions and at prices determined by the Government.

Leaving aside the issues of privatization, competition, and efficiency, I shall now turn to the authors analysis of the factors determining the sales price of public enterprises. In addition to the traditional factors cited by the authors in their paper, I believe that there are other significant determinants of the sales price, including the following:

  • The technological content of the enterprise’s operations: whether production is capital or labor intensive, and the extent of capital and labor availability in the country.

  • Whether the enterprise enjoys specific allocations in imports and foreign exchange, and the extent of reliance on domestic raw materials vis-à-vis imports of such materials.

  • Potential marketing of the enterprise’s production at competitive prices in foreign markets, especially those of neighboring countries. This will naturally provide the foreign exchange requirements for financing imports of raw materials and other inputs.

  • The size of the financial market, the availability of capital, and the degree of liquidity in the economy, as well as the restructuring of the public enterprises to be privatized.

  • The level of economic development, the inflation rate, and the rate of interest. These factors, in my view, are of special importance in determining the sales price of public enterprises in the Arab and other developing countries, regardless of the method of selling the public assets (offers for sale or tender offers).

The financial status of the enterprise is an important determinant in the sales price. That an enterprise is unprofitable does not necessarily mean that it is inefficient. Unprofitability might be the result of administered pricing of the enterprise’s production. Privatizing might improve the financial status of the enterprise—not because of improved efficiency but because of higher prices for its products. Selling such enterprises at below market prices will be a form of subsidy by the taxpayers and the government to a limited number of interested buyers or shareholders.

If the governments concerned are willing to abandon public enterprises, privatization should take the form of a transfer of ownership free of charge and on an equal basis to the public at large, either as individuals or families or as employees of the enterprises themselves. Such an action would undermine any opposition to privatization and for the first time afford the public an opportunity to own equity that yields significant dividends, especially for the low-income groups. Providing the population with equity is not without its price, however, since depriving the government of a financial resource resulting from the sale of its assets will reduce its ability to pay off its debts and debt servicing, which in turn will prevent it from reducing tax rates, in spite of reducing the size of the public sector.

Thus, instead of the expected lower tax rates resulting from reducing the size of the public sector, individuals will earn profits from privatized corporations, while tax rates remain unchanged. These profits, compared with a tax reduction, have the following advantages for the individual:

  • Tax reduction would benefit only taxpayers, whereas profit distribution would benefit society as a whole.

  • A shareholder can sell or mortgage his shares to get his price on the market, while there is no guarantee that the government will reduce taxes as a result of selling its assets to the private sector.

  • A public share issue would help to create a popular financial market that could provide an important incentive in promoting a financial and savings awareness among the population in general, while affirming a national sense of belonging and responsibility to control public sector activity, since ownership would eventually be in the hands of the population.

In appraising the impact of privatization on government subsidies the authors discuss certain alternatives that prevent the government from abandoning certain social objectives, and thus continue subsidies in one form or another. The authors should have paused a little here to reconsider the objectives of privatization. The most important objective (as well as introducing the element of competition) is reduction of the government’s budget deficit (which results mainly from subsidies to public enterprises to maintain the price level of their products). Consequently, abandoning these enterprises would sooner or later lead the government to abandon these social objectives to reduce its budget deficit; otherwise its financial position would deteriorate because the deficit would remain in spite of cutting down the size of the public sector.

It is not unrealistic to assume that in most of the countries in which privatization has been applied the governments have had to abandon their social objectives. Consequently, the prices of products of privatized enterprises were increased to a level that covered both the subsidies given by governments before privatization and the profit margins for the private sector to promote production and ensure the success of privatization.

Having discussed the theoretical analysis of privatization with emphasis on its financial implications for developing countries—where economic conditions are totally different from those of industrial countries—I would like briefly to review privatization in Iraq, to which some reference was made by the authors. Since the beginning of 1987, Iraq has pursued a daring privatization policy designed to give the private sector a greater influence in the economy. While the details of these reforms have not yet been announced, it is not expected that this policy will include all the strategic industries such as petrochemicals, oil refineries, steel and potash, as well as a number of public enterprises, such as railways, electricity, water, banks, and insurance companies. All other industries are liable to be privatized depending on the availability of buyers.

The public sector is considered large in Iraq, with production representing 69 percent of GDP in 1986 (excluding the oil sector). The socialist sector accounts for 63 percent of the value added in agriculture, 78 percent in manufacturing, 48 percent in wholesale and retail trade, 95 percent in social and private services, and 100 percent in banks, insurance, power, and water sectors. With the exception of agricultural enterprises, most public enterprises are profitable. Losses in the agricultural sector may be attributed to government price controls, especially on foodstuffs and other essential commodities. The socialist sector enterprises have registered high profits, contributing more than 20 percent of the regular budget and the development plan.

Most government enterprises have been able to realize these high profits not because of their efficiency or productivity but for other reasons:

  • Excessive protection through import restrictions and/or higher tariffs on competing imported products.

  • Banning local private sector producers from investing in competing projects for the production of commodities similar to those produced by the public enterprises.

  • Maintaining low wage rates and fixing prices to guarantee a margin of profit regardless of the efficiency or the productivity of public enterprises.

  • Ensuring the availability of internal and external credit to the government enterprises to finance production, marketing, and storage activities.

  • The availability of liquidity and the strong purchasing power in the economy under conditions of inadequate supply.

Despite the high profitability ratios (which can be attributed to the economic environment rather than to public sector efficiency) the Government decided to turn public enterprises over to private ownership. Several economic factors—such as the need to increase efficiency and productivity—were behind this decision. As the Government suffered a drop in revenues, especially during the past seven years, the productive capacity of these enterprises did not expand to match the rising demand. Aging and declining productive capacity aggravated the gap between supply and demand and adversely affected the quality of public services.

To improve this environment requires price liberalization on the one hand and increasing investment in these enterprises on the other. Price liberalization in the socialist sector could conflict with the state’s economic and social objectives through its negative impact on the population’s purchasing power. The increase in investment requires additional resources, since those available can no longer match the country’s needs and growth potential. Moreover, relying on external resources has become too costly, leading the Government to privatize to raise the productivity of public enterprises and improve their financial situation, in terms of quantity and quality, taking account of the population’s tastes.

Although privatization in Iraq started some time ago and the sale of public enterprises in the agricultural sector has already been achieved, the process of privatization in the industrial sector covered only a small portion of the sector.

The most important factors that may hinder privatization of the socialist sector in the economy of Iraq are (a) the absence of a stock exchange market, prohibiting establishment of private or public investment companies; (b) government control of both banking and financial markets; (c) suspicion of the private sector and its distrust of the measures taken by the Government; (d) the heavy reliance of industrial enterprises on imported raw materials and the unavailability of foreign exchange for the private sector; (e) the nonparticipation of the population in the privatization process, since there is no incentive to create shareholding companies that could collect a large amount of capital to allow for acquisition of large industrial enterprises; and (f) the limited financial capacity of local capital holders wishing to acquire the enterprises offered by the Government and the tied credit policies adapted by commercial and specialized banks.

The removal of obstacles to privatization is not an easy task. It will require a long time, which could become even longer if the Government does not take immediate measures to remove all the administrative and legal constraints on the private sector and to provide the necessary environment for competition among the different companies of the private sector on the one hand and between these companies and those of the socialist sector on the other.

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