Public Administration Salary Setting: Principles and Mechanisms for Satisfying Them 1

Public Administration Salary Setting: Principles and Mechanisms for Satisfying Them 1 Laws governing public sector salary setting should reflect at least the following principles: (i) fiscal sustainability of the overall public sector wage bill, (ii) concentration of remuneration in those elements of pay that are linked to the human capital requirements of the position; (iii) consistency in the competitiveness of total remuneration across types of human capital required by the country s public administration, and (iv) transparency and fairness in the setting of public sector remuneration, both the overall structure and composition of remuneration within the public administration, as well as the remuneration of individual public servants. Such a legal framework should establish institutional mechanisms designed to improve the odds that each of these four principles will be reflected in major salary-setting policy actions, as well as in the setting of salary packages for individual public servants. Fiscal Sustainability Fiscal sustainability requires that any policy altering a salary setting parameter that is likely to have a significant impact on the wage bill should be subject to a check on its fiscal feasibility and sustainability. The typical mechanism for accomplishing this is to require that: 1. Any policy recommendation with respect to remuneration financed through the Central Administration budget must be accompanied with an analysis of its likely fiscal impacts. 2. Any such policy recommendation, with its fiscal impact analysis, must be reviewed by the Ministry of Finance (or its equivalent), who must then either clear or reject the proposed policy change on the basis of its consistency with the Government s macro/fiscal program. These arrangements would preclude concluding salary negotiations with trade unions or other such representatives of subsets of the public service, without first obtaining the clearance of the Ministry of Finance (or its equivalent) regarding the fiscal sustainability of the proposed agreements. They would also preclude individual public bodies financed through the Central Government s budget from making unilateral salary policies governing their staff, without first obtaining the clearance of the Ministry of Finance (or its equivalent). Concentration of Remuneration in Human Capital-linked Elements of Pay The primacy of pay as a means of attracting and retaining personnel makes it important to concentrate remuneration in human capital-linked elements of pay. Public administrations compete with the private sector (typically, with the domestic private sector) for scarce human capital skills. If a large fraction of public sector pay is tied up in allowances and salary supplements that bear little or no relation to the human capital skills being purchased with that remuneration, the public sector will be spending a large fraction of its wage bill on things that don t tailor its remuneration to the competition it faces for those scarce human capital skills. This will make it more costly for the public 1 Gary J. Reid, Lead Public Sector Management Specialist (ECSPE/PRMPS). Public administration salary setting principles.doc 1 12/20/2007

sector to attract skills that are particularly scarce and valued in the private sector, since lots of money will be wasted financing salary supplements and allowances that are invariant with the human capital requirements of particular positions. Most Eastern European and Central Asian public administrations provide a formidable array of salary supplements and allowances, for such things as transport allowances, housing allowances, meal subsidies, wedding leave, grieving leave, etc., which, while socially popular, are, as a set, costly and poorly targeted if your objective is to attract and retain the full range of human capital skills needed within the public administration. Certainly, if the domestic private sector provides that same array, and at similar magnitudes, then the public sector will probably feel compelled to follow suit. Governments facing such a situation should consider reforms of the private sector labor market first, since such practices will undermine the international competitiveness of goods and services produced domestically. Once that is accomplished, those same governments should undertake similar reforms within their public sector salary practices. A particularly important example of a costly and poorly targeted element of salary is seniority-based pay increases. While it is undeniable that experience typically brings with it increases in human capital, it is not at all clear that the relationship is linear; i.e., that each year of experience adds a constant increase in a worker s productivity. Rather, age-earnings profiles from developed country private sector labor market studies suggest that experience adds significant increments to human capital during the early years of one s career, but decreasing increments as experience increases. This evidenced is reinforced by economic theory, which provides a convincing explanation of why rational persons will invest more in human capital accumulation early in their life (initially through schooling, then through on-the-job training), while such investments will taper off as workers age, dropping to zero by retirement age. 2 Given these empirical regularities and analytic underpinnings, the typical linear increase in public sector pay with seniority (up to some limit, typically around 25 years of experience) is hardly justifiable on productivity grounds. A more sensible approach to seniority-related pay would be to make any seniority-related pay increases a continuously decreasing function of increased seniority. Rather than maintaining a constant, say, 0.5% of base pay per year, up to a maximum of 12.5% after 25 years of experience, such salary increments could start at, say, 1.0% per year, and drop by 0.1% per year for the next ten years, yielding a maximum of 5.5% after ten years, while remaining constant thereafter. While empirical research on the returns to seniority in a given country s private sector could fine tune a formula such as this, this simple formula would go a long way toward both recognizing that seniority does contribute to human capital growth, while also recognizing that it does so at a declining rate over time. Moreover, it would leave greater fiscal space for concentrating a larger fraction of wage bill expenditures in those elements of remuneration that more clearly reflect human 2 Becker, Gary, A Theory of the Allocation of Time, Economic Journal, 75 (1965): 493-517; Blinder, Allen; and Yoram Weiss, Human Capital and Labor Supply: A Synthesis, Journal of Political Economy 84 (1976): 449-472; Johnson, Thomas, Returns from Investment in Human Capital, The American Economic Review (1970): 546-560; William J. Haley, Estimation of the Earnings Profile from Optimal Human Capital Accumulation, Econometrica44(6) (November 1976): 1223-1238; Becker, Gary, Investment in Human Capital: A Theoretical Analysis, Journal of Political Economy (1962): 9-49. Public administration salary setting principles.doc 2 12/20/2007

capital requirements of a position, such as base pay (assuming it is properly defined, on the basis of human capital requirements, rather than simply education or something similar). If this limitation on seniority-based pay were twinned with an effective effort to tie promotions decisions to performance, those staff whose human capital continues to grow faster than the average (as evidenced by their superior performance), would dominate the pool of promotions, and their remuneration would rise accordingly. In short, promotions, if properly orchestrated, can provide a more effective means of tying salary growth to human capital-increasing experience than can seniority. 3 Another way of putting this is that an effective promotions process provides perhaps the best means of linking pay to performance. 4 Consistency in Competitiveness of Total Remuneration As with the principle of concentrating remuneration in human capital-linked elements of pay, the primacy of pay as a means of attracting and retaining personnel is an important part of the justification for the principle of consistency in the competitiveness of total remuneration. The other aspect of that justification is that the public sector must compete with the domestic private sector for the human capital skills it requires. Given these two considerations, consistency in the competitiveness of total remuneration across public administration positions is essential to ensuring that a public administration can attract all the various types of skills it requires. Public administrations rarely can afford to pay as much as the domestic private sector; nor should they, since they typically provide other attractive terms of employment, such as stronger due process protections (including greater tenure protections). But they can, if they set their minds to it, ensure that the total remuneration they offer for a position requiring any particular set of skills and abilities, including ability to shoulder particular types and magnitudes of responsibility and authority, is equally competitive across the various types of positions they need to fill. This may mean that a given public administration can pay only about 50% of what a similar set of skills and abilities could command in the domestic private sector, or that another public administration can afford to pay around 80% of its domestic private sector. The competitiveness of public administration salaries must be constrained by the fiscal sustainability constraint identified above as the first principle of public sector salary setting; and that is what will determine this percentage or ratio of public to private sector salaries for similar skill sets. Within that envelope, however, it is important to seek to achieve something close to 3 Getting promotions to work this way poses, of course, difficult challenges. First, the annual personnel performance review process must reliably rate staff performance. This requires that organizational units, themselves, be reliably held accountable for their performance, and that the performance of individual staff be judged, largely, by their contributions to the performance of the organizational unit within which they work. It is beyond the scope of this note to address this host of challenges. 4 Extensive research on pay-for-performance practices in OECD countries reveals that it is extraordinarily difficult to get such policies to work as intended in practice. See, e.g., OECD, Performance-related Pay for Government Employees: Main Trends in OECD Member Countries, GOV/PGC/HRM(2004)1, Human Resources Management Working Party Meeting (7-8 October 2004), and OECD, Performance-related Pay for Government Employees: Executive Summary (Paris, France: July 2005). http://www.oecd.org/dataoecd/16/11/35117916.pdf. Public administration salary setting principles.doc 3 12/20/2007

consistency in the competitiveness of the total remuneration package across all types of public sector positions. Perfect consistency will, of course, never be achieved. Moreover, typical social pressures for less progressivity in salary structures in the public administration than exists in the private sector normally militate against complete consistency, particularly at the highest ranks within a country s public administration. But most developing countries are so far away from such a situation, that coming closer to such consistency is a reasonable objective. In any given country, a balance will unavoidably have to be struck between these efficiency aims (attracting required human capital skills at the high end of the skill spectrum) and equity aims (not introducing differences in remuneration that are too socially divisive between personnel at the bottom and the top of the skills spectrum). To achieve this requires at least two institutional mechanisms. 1. Compilation and analysis of empirical evidence on competitiveness of public sector remuneration: Some organizational unit within the public administration (e.g., a State Statistical Office) must be responsible for regularly (e.g., every one, two or three years or so) compiling and analyzing evidence on the competitiveness of public administration remuneration (total, including all elements) relative to relevant private sector comparators. This is a difficult technical task, but one for which there are established methodologies. 5 Such comparisons are used all the time by private sector companies (comparing their own salary packages with those of other, competing firms), as well as by the public sectors in developed countries, and are now being more and more widely used by public administrations in developing countries. 6 The more extensive and competitive is the domestic private sector, the more feasible is this approach. But it is not always possible to compare some positions within the public sector with readily identifiable private sector positions. Members of the military and the police are examples. Moreover, when the public sector is the only, or a very dominant employer for particular types of positions e.g., teachers, health care providers in some countries comparisons between public and private sector remuneration can be misleading. In such circumstances, private sector employers of such types of staff may mimic public sector wage policies. For these sorts of reasons, as well as the technical difficulties in conducting and interpreting public/private sector salary surveys, other types of data will need to be brought to bear. Two indicators, which can be readily tracked by a well 5 Those methodologies fall into two basic groups: (i) hedonic wage indices, and (ii) comparisons of a modest set of prototype positions requiring similar sets of skills and abilities and spanning the range of types of positions within the public administration. In either case, the survey must identify total remuneration (including all supplements and allowances), as well as the human capital requirements of any given type of position; i.e., within an occupation, the skills and abilities required, including capacity to exercise particular types and scopes of authority and responsibility. Many descriptors can be employed to capture human capital. For examples, please see the writings of Nobel Laureate Gary Becker (Human Capital (New York: Columbia University Press, 1964)) and the many researchers who have followed in his footsteps; e.g., Sherwin Rosen, M.W. Reder, Jacob Mincer. 6 Examples include Romania, Macedonia, Albania, Sierra Leone, Afghanistan, Croatia, Serbia and Montenegro. Public administration salary setting principles.doc 4 12/20/2007

functioning human resource management regime, can prove quite helpful in this regard: (i) average number of qualified candidates per advertised vacancy by type of position; and (ii) turnover rates among recent recruits by type of position. Qualified candidates per advertised vacancy: The number of qualified candidates by type of position can be, perhaps imperfectly, but at least reasonably measured as the number of candidates applying for an advertised vacancy for each particular type of position who meet the minimum qualifications requirements for the position. By type of position we mean, as above, the occupation and the human capital requirements of the position (i.e., skills and ability, including capacity to shoulder particular types and scope of authority). If such data is monitored for all the types of positions within a particular salary structure, analysis of variance in the average number of qualified candidates per advertised vacancy across types of positions can allow authorities to identify those types of positions for which those averages fall well below the system-wide average as the types of positions whose salaries are probably less competitive; and, hence, the higher priority positions for any upward adjustments during the next round of salary adjustments. Turnover rates among recent recruits: Turnover rates during the first, say, three to five years after recruitment into the public administration, can also provide systematic data for informing decisions about which types of positions are more likely to retain the skill sets they manage to recruit. Again, such data should be tracked by occupation and human capital requirements of the position. Analogous to the average number of qualified candidates per advertised vacancy, but in reverse, higher than average turnover rates within the first 3-5 years of recruitment would indicate that remuneration for those types of positions is probably not competitive enough to retain the better staff who have been recruited into those ranks; i.e., those who are able to find employment elsewhere. Accordingly, central authorities would be well advised to give higher priority to increasing remuneration within the ranks of the types of positions with higher than average initial three- to five-year turnover rates during the next round of salary adjustments. Taken in combination, public/private sector salary surveys and tracking of human resource management system data on qualified applicants per advertised vacancy and three- to five-year turnover rates among recent recruits can provide a formidable array of systematic data, which central authorities could employ to both continuously 7 tweak any given salary structure 8, as well as to defend their targeting of salary adjustments, rather than giving in to pressures for increasing all public sector salaries, either all at once or serially. 7 I.e., annually or every x years, as part of the budget deliberations process. 8 Regardless of whether it be a unified salary scale or a collection of separate salary scales for different subsets of the public administration. Public administration salary setting principles.doc 5 12/20/2007

A public administration that cannot track the latter two indicators (qualified applicants and turnover rates) should probably focus on establishing that capacity before attempting significant wage reforms. In the interim, they can cope by being careful to satisfy the wage bill sustainability criterion, while permitting modest periodic salary increases. 2. Central clearance of any policy that alters the pattern of competitiveness of public sector remuneration across positions and organizational units: Some central organizational unit within the public administration must be responsible for enforcing the consistency in competitiveness principle. A central personnel office (e.g., a Ministry of Public Administration, a Central Personnel Office, etc.) is the most obvious candidate for this role, but some countries establish separate offices responsible for salary setting. Such a central unit must have the authority to review and either clear or reject any salary policies, and at least one of its criteria must be consistency in competitiveness of total remuneration packages for similar packages of human capital. 9 Transparency and Fairness The final principle of effective public sector salary setting is to ensure transparency and fairness. These two objectives hardly need justification, as virtually everyone readily acknowledges their importance. But they do warrant some elaboration, both in order to ensure that we all mean the same things when we appeal to these objectives, as well as to suggest some mechanisms, procedures or institutional arrangements that can help to ensure these objectives will be respected in salary setting practices. Transparency can be facilitated by: 1. Simplicity: limiting the number of elements of salary (simpler salary systems are easier for people to understand than are more complicated ones), 2. Third-party clearance of individual salary-setting decisions: ensuring that individual salary-determining personnel actions are cleared by a third-party (i.e., a central authority), to ensure compliance with the underlying objectives of the rules governing such personnel actions, and 3. Audit-trails: having personnel management systems that reliably document all salary-determining actions, so they can be effectively audited whenever necessary. Fairness can be facilitated by: 1. Consistency in competitiveness: ensuring consistency in the competitiveness of total remuneration across packages of human capital skill requirements (see above) 2. Third-party clearance of individual salary-setting decisions: ensuring that individual salary-determining personnel actions are cleared by a third-party (i.e., a 9 Human capital includes all skills and abilities, where these are broadly understood to include not just education and years of experience, but the particular types of skills and abilities (e.g., IT, economist, lawyer, day laborer, clerical, etc.), as well as demonstrated capacities to accountably exercise particular magnitudes and types of managerial authority. Public administration salary setting principles.doc 6 12/20/2007

central authority), to ensure compliance with the underlying objectives of the rules governing such personnel actions, and 3. Audit-trails: having personnel management systems that reliably document all salary-determining actions, so they can be effectively audited whenever necessary (as required for transparency). 4. Independent redress: providing an effective, independent redress mechanism for public servants who believe they have a legitimate grievance with respect to a salary action directly affecting them. Devices for achieving these requirements of transparency and fairness include: 1. Simplicity: Legal framework limits number of elements of remuneration. 2. Third-party clearance of individual salary-setting decisions: a. Legal framework (i) establishes clear rules and criteria governing each element of remuneration and its magnitude, and (ii) assigns a central authority responsibility for reviewing and clearing or refusing to clear individual salary-determining personnel actions, on the basis of whether or not they are consistent with those rules and their underlying objectives. b. Central agency responsible for clearing individual salary-determining personnel actions has the capacity and incentives to exercise that authority effectively; i.e., in a way that ensures that remuneration decisions support the underlying objectives of the public administration salary-setting policies. 3. Audit-trails: Human resource management systems, be they paper or electronic, are designed to automatically generate audit trails for all personnel actions that impact an employee s remuneration. 4. Consistency in competitiveness: See earlier section on this requirement. 5. Independent redress: Legal framework establishes an independent redress mechanism. Rules governing appointment, terms and removal of the voting members of the organization assigned that redress function are designed to insulate those appointees from the executive branch of government. The organization assigned that responsibility is endowed with sufficient resources to effectively carry out its mandate. 10 Summary In sum, laws governing public sector salary setting should reflect four core principles: 1. Fiscal sustainability of the overall public sector wage bill, 2. Human-capital-linked pay: concentration of remuneration in those elements of pay that are linked to the human capital requirements of the position; 3. Consistency in the competitiveness of total remuneration across types of human capital required by the country s public administration, and 10 For an analysis of the application of these considerations in the creation of such a redress mechanism in a developing country, see Reid, Gary J., The Political Economy of Civil Service Reform in Albania, mimeo (The World Bank: 2005). Public administration salary setting principles.doc 7 12/20/2007

4. Transparency and fairness in the setting of public sector remuneration, both the overall structure and composition of remuneration within the public administration, as well as the remuneration of individual public servants. This note explains each of these principles and its rationale, and identifies mechanisms, procedures and institutional arrangements that can help a government to sensibly tailor salary structure adjustments on the basis of these four principles. Public administration salary setting principles.doc 8 12/20/2007