XI. Transfers to Public Enterprises

Ke-young Chu, and Richard Hemming
Published Date:
September 1991
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What forms of financial assistance do governments provide to public enterprises through the budget? In what other ways is support given to public enterprises?

Why do public enterprises rely so heavily on subsidies and other forms of government support?

How can the financial burden of public enterprises on the government be reduced?

What is an appropriate pricing policy for public enterprises? How should noncommercial objectives be taken into account?

In the majority of developing countries, nonfinancial public enterprises play an important role in the economy through their responsibility for a significant proportion of investment, employment and output. Their activities also have implications for the government budget, which in part reflects the inefficiency with which they undertake their assigned responsibilities. In particular, financial support to unprofitable public enterprises often accounts for a sizable share of government expenditure. As a consequence, the scope for reducing public expenditure, or for accommodating new expenditure demands within the constraint of fixed resource availability, is inextricably linked with the prospects for successful public enterprise reform.

The Budgetary Impact of Public Enterprise Operations

Financial transactions between the government and public enterprises affect both the expenditure and revenue sides of the budget. Government expenditure comprises subsidies, equity and loans. Subsidies can be related to specific activities or general operating subsidies. Thus if an enterprise is charged with the responsibility of noncommercial activities, such as selling goods at below cost, a subsidy can be directly related to the cost-price differential and either a prespecified or unlimited quantity sold. Alternately, an enterprise can receive a subsidy to cover its operating losses. In principle, if there is compelling justification for a subsidy it should be related to the cost of the subsidized activity. The problem with the general subsidy is that it does not distinguish between the losses resulting from commercial as distinct from noncommercial activities.

To the extent that an enterprise does not generate sufficient profit to finance its investment, the government usually puts up some of the necessary capital. Equity injections do not give rise to any repayment obligations, although they often entitle the government to receive dividends based upon profitability. Loans imply both amortization and interest payments by the enterprise to the government. Unlike the private sector, where the debt-equity ratio is managed with a view to optimizing capital structure in light of corporate objectives and capital market constraints, the choice between debt and equity in the case of public enterprises does not reflect the fine-tuning of financial policy. Enterprises generally prefer equity to loans, for obvious reasons. The government preference should be for loans, which provide a means of imposing financial discipline on enterprises that usually is missing in the case of equity.

In practice, the distinction between equity and loans is blurred. Moreover, to all intents and purposes, both equity and loans are often indistinguishable from subsidies. While the government may prefer to make loans, the provision of additional equity often reflects the realistic assessment that enterprises may not be able to service the resulting debt. It is also common for the government to convert outstanding loans into equity, and not only in the event of default. The government also writes off enterprise debt, which is equivalent to providing a capital grant. And insofar as equity carries with it little prospect of ever receiving dividends, this too is the same as a capital grant. In other words, the government heavily subsidizes public enterprise investment.

Government subsidies, however, extend even further. For example, government loans often involve on-lending of foreign borrowing contracted by the government. Interest rate differentials favoring enterprises and the costs arising from exchange rate risk borne by the government imply a subsidy. Moreover, even where public enterprises have to fill any financing gap by borrowing abroad or on the domestic market, the government usually guarantees the loans and is called upon to meet its contingent liability in the event of default. Preferential interest rates on nongovernment borrowing by public enterprises—including loans from public sector banks—also constitute an implicit subsidy. Less obviously, it can be argued that to the extent that the government receives a rate of return on its investment in public enterprises (including both outstanding loans and equity) lower than that which is typically obtained in the private sector, this should be reflected in any subsidy measure. However, insofar as a lower yield can be justified by noncommercial objectives, resource misallocation is not implied—indeed if these objectives are achieved, resources are more efficiently allocated—and an unwarranted subsidy does not result.

Offsetting government payments to public enterprises are enterprise contributions to government revenue. These include direct and indirect taxes, dividends, profits, and amortization and interest payments. Taking all these into account, and in particular large indirect tax payments on imported equipment and inputs, it is sometimes argued that public enterprises make a significant net contribution to the budget. However, any belief that this in a sense weakens the case for improving public enterprise performance and reducing government payments to public enterprises is entirely mistaken. Many activities undertaken by public enterprises would be attractive to the private sector if they were not precluded from them, either by statute or because private enterprises cannot compete on equal terms with public enterprises. The government would likely receive higher revenues from such activities if private enterprises undertook them. And even if private production is not a viable alternative, available revenue should not be diverted to supporting inefficient enterprises. It can be better used elsewhere.

Where the public enterprise sector is large and there are significant financial transactions between the government and public enterprises, consolidated public sector accounts are essential if a proper assessment of the role of government in the economy is to be made. While the necessary data are often not available for the whole public enterprise sector, it should be possible to reflect the activities of the largest enterprises in partially consolidated accounts. This would appear to be especially important where one enterprise rivals the government in size and influence, as is the case with the copper companies in Zambia and Zaire.

Public Enterprise Performance and Problems

While the general perception is that, by commercial standards, the financial performance of public enterprises is poor, this is quite difficult to establish. Direct comparisons between public and private enterprises are rare, since there are few activities together undertaken by both. Where such comparisons are possible they are inconclusive, but this is hardly surprising. In competitive markets, markedly dissimilar performance should be the exception. Moreover, to the extent that there are differences, if public enterprises are charged with a wider range of objectives than private enterprises, profitability will be conceded in the process. The complicated issue is assessing how much profit should be forgone to achieve these objectives.

Rather than attempting an answer in this question, there is instead a tendency to point out how the environment in which public enterprises currently operate would be expected to result in inefficiency and lower profitability than justified by reference to multiple objectives, and to base a case for reform on these observations.

Control and management

As originally conceived, governments were to adopt an arm’s length approach to the public enterprise sector—managers were to be given clear objectives and left free to pursue them. The relationship between governments and public enterprises has, however, turned out to be one characterized by extensive political and ministerial involvement in management decisions affecting pricing, investment, and employment. As a result, management often finds itself charged with wide-ranging, and often conflicting objectives, with little guidance as to which it should be most actively pursuing. Indeed, ineffective monitoring by government gives rise to principal-agent problems, which allow managers to include their own self interest among the list of objectives.

Employment policy

A commitment to providing and protecting employment has often led to a significant enlargement of public enterprise sectors for this purpose alone. The takeover of enterprises that could not survive in the private sector has been primarily for this reason. Because of the priority attached to the employment objective, and the importance to the economy of the sectors dominated by public enterprises, trade unions are especially influential. As a result, public enterprises tend to be overstaffed and wages are often considerably higher than can be justified by reference to productivity levels.

Price control

High labor costs, together with excessive capital costs—mainly a consequence of inadequate monitoring of key investment decisions and poor project implementation—lead to productive inefficiency in that enterprises could generate the same output at considerably lower cost. However, administered prices that are set on a cost-plus basis shield the profits of public enterprises from their cost structures. While cost-plus pricing should ensure that enterprises make a profit, administered pricing is still often associated with losses, either because inefficiency is excessive or, more usually, because prices are held at a low level to meet social or other noncommercial objectives.

The competitive environment

Inefficiency is compounded in the uncompetitive environment in which most public enterprises operate. In monopolistic markets, or with only a few suppliers at best, consumers are forced to bear the higher prices that result from inefficiency. Also, consumers have little influence over the range and quality of public enterprise output. The resulting allocative inefficiency adds to the productive inefficiency of public enterprise activities. Moreover, in those instances when public enterprises do compete, they most times have an advantage over private firms, for example in purchasing inputs from other public enterprises. Nevertheless, many enterprises in competitive markets still fail to make a profit.

Budget support

When administrative prices are held below costs or enterprises are unable to compete in contested markets, the ready availability of budgetary resources prevents them from going bankrupt. While budget support can be justified by reference to those compelling noncommercial objectives that prevent otherwise efficient enterprises from making a profit, it often compensates for inefficiency.

To varying degrees, the problems identified above characterize public enterprise sectors in most industrial and developing countries, and, except in a few cases, it is difficult to argue that the current low profits and high levels of budget support are justified. Equally, the fact that public enterprise profits are high, and budget support modest, does not indicate that these problems are not present. Administered prices can generate profits from extremely inefficient activities. Moreover, an environment that encourages and sustains inefficiency is not one in which such inefficiency is likely to be reversed. Consequently, the key to improving efficiency, raising profit, and reducing unproductive government expenditure is to provide an appropriate environment in which public enterprises should operate.

Public Enterprise Reform

The note on Public Expenditure and Resource Allocation describes how a significant proportion of welfare economics is devoted to establishing the case for government intervention to compensate for market failure and to meet social needs. Clearly, some of the efficiency and distributional objectives of intervention have been achieved through the ownership of public enterprises. At the same time, the problems that currently afflict public enterprises provide a rationale for reform aimed at the efficient pursuit of clearly specified and appropriately costed objectives. However, current objectives reflect a wide range of economic, social, political, and strategic concerns which may prove resilient to charges of unreasonableness, and therefore difficult to dispense with. Moreover, many of these objectives may be hard to articulate in any precise way, especially insofar as they relate to the “national interest”. Consequently, the pursuit of public enterprise efficiency cannot in practice be conducted as a constrained optimization exercise. Rather, the only achievable goals may be the elimination of the least compelling objectives and the gradual implementation of measures to encourage efficiency.

Promoting competition

The market mechanism must inevitably play a central role in promoting efficiency. In a competitive economy, the product market guides prices and output while the capital market (including the market for corporate control) constrains costs. A firm that cannot sell its products will not make profits; unprofitable firms will go bankrupt or be taken over. The market therefore regulates firms, providing the incentive for them to achieve both productive and allocative efficiency. Certainly, some of the worst excesses of public ownership would be diminished by a shift to private ownership. Simply taking public enterprise decision making out of the political arena and withdrawing government financial backing will eliminate some inefficiency. But many of the problems associated with public enterprises arise not from the fact that they are publicly owned; rather, they reflect an absence of market discipline. Therefore, by exposing public monopolies to competition—for which privatization may or may not be necessary—significant efficiency gains are likely to result (for further discussion see the note on Privatization).

To the extent that public ownership reflects circumstances in which markets do not work well or produce outcomes that are considered socially or politically undesirable, removing barriers to competition would be insufficient or inappropriate. Natural monopoly, for example, is a market outcome; to introduce competition in a natural monopoly setting, the market has to be redefined. One solution is to make the right to run a natural monopoly the object of competition by auctioning franchises to the private sector. Also, some activities associated with natural monopoly, such as maintenance, are likely to be contestable, and these can be contracted out to the private sector. But insofar as the core activities of natural monopolies are inherently noncontestable, public ownership is likely to remain the most efficient way of regulating such activities. Also, priority social objectives will inevitably continue to be primarily a responsibility of the public sector, including public enterprises.

Administrative controls

The design of mechanisms to improve the efficiency of enterprises that must remain under government control constitutes a major challenge for public policy. Attention should be focused on the following: limiting the influence politicians can have over public enterprises; specifying clear goals for enterprises; providing managers with autonomy over business decisions, giving them incentives to pursue efficiency (such as profit shares) and making them accountable to the government; establishing appropriate reporting requirements and monitoring mechanisms; and putting in place incentive mechanisms (such as pay linked to productivity) to limit the impact of restrictive labor practices. A number of countries are making significant progress in this regard.

Pricing and subsidy policies

Exposing activities to the full implications of market forces presumes competitive prices and an absence of subsidies. Moreover, even where the market outcomes are tempered by noncommercial objectives and a subsidy is justified, insofar as market prices can continue to play an allocative role, this is preferable from an efficiency standpoint. As far as noncompetitive enterprises are concerned, pricing is a more complex issue. Efficiency considerations suggest that prices be set equal to marginal cost; but where public enterprises are required to contribute to government revenue—because the tax base is narrow or administrative capability is weak—prices can be set above marginal cost. Ramsey pricing implies larger deviations from marginal cost for goods in inelastic demand (see the note on Pricing and Cost Recovery for further discussion).

In the case of natural monopolies, continuously decreasing average costs imply that marginal cost pricing, and in some cases Ramsey pricing, will result in losses and a compensating subsidy will be needed. Otherwise, subsidies to competitive and noncompetitive enterprises should be matched to the specific objectives they support. They should reflect an assessment of benefits and costs of intervention, and be well targeted towards intended beneficiaries. Similarly, government support of public enterprise investment through equity and loans should reflect a careful appraisal of the returns to the projects involved.

Country Illustration

Government payments to public enterprises in Nepal

The public enterprise sector in Nepal is not large by developing country standards, but is does dominate key areas of the economy. Standard financial indicators also suggest that it performs rather badly; for example, in 1988/89 the major enterprises averaged an after-tax rate of return of -5 percent and financed less than 15 percent of capital spending out of their own resources. This implied significant explicit and implicit payments from the budget to public enterprises. In particular, the government provides equity and loans to the investment-intensive electricity, telecommunications, and water utilities and subsidies to agricultural trading companies to bridge the gap between the import cost and domestic price of fertilizer and to meet the cost of transporting food and fertilizer to remote regions. However, food and fertilizer subsidies are not sufficient to cover operating losses, and the Nepal Food Corporation, together with a number of other enterprises, has been forced to borrow from commercial banks but has defaulted on its loans; the government is in the process of paying off the resulting arrears. The Agricultural Inputs Corporation has resorted mainly to withholding the proceeds from the sale of fertilizer received as aid rather than depositing them in government counterpart funds. In addition, the government undertakes large capital projects on behalf of the major utilities, and then transfers them off-budget to the enterprises concerned, usually but not always upon completion. Taking all these transactions into account, total government payments to public enterprises were equivalent to 2.4 percent of GDP in 1988/89; the budget formally reflects only about two thirds of this amount.

Table 1.Nepal: Government Payments to Major Public Enterprises, 1988/89(In millions of Nepalese rupees)
Net lending602
(In percent of GDP)(1.6)
Payment of commercial bank arrears80
Shortfall in counterpart fund deposits58
(In percent of GDP)(2.4)
Source: International Monetary Fund.
Source: International Monetary Fund.

    Floyd R.H. C.S. Gray and R.P. Short Public Enterprise in Mixed Economies: Some Macroeconomic Aspects (Washington: International Monetary Fund1984).

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    “Strengthening Public Finance Through Reform of State-Owned Enterprises” in World Development Report (Washington: The World Bank1988).

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