The EU s Public Sector Spending Problem A 247 billion GDP gap haunts Europe and highlights an urgent need for European governments to prioritize their spending and create a new normal in the balance between government spending levels and GDP trends. 1
Europe s public sector has a problem. Government spending in the 27 member countries of the European Union (EU27) was $6.2 trillion in 2011. This was equivalent to almost 50 percent of gross domestic product, and a 1.96 percentage point rise from 2008, a period in which GDP rose by less than 1 percent. The result is a GDP gap of 247 billion in other words, the amount governments overspent last year. What s more, compared with other regions, Europe s ratio of government spending to GDP is troubling 9 percentage points higher than the nearest contender (the United States) and more than double that of the lowest (China). 1 Europe s ratio of government spending to GDP is historically high, primarily because of social security. European countries are hoping to survive while preserving social security for their citizens. The question is whether it will be possible to do so, and what roles industry and society will play in accomplishing this goal. To find out, A.T. Kearney performed preliminary research on government spending in the EU27. This paper presents our findings and proposed solutions. Current Situation: The GDP Gap Different countries organize their spending in different ways, allocating key categories such as healthcare, education, and sometimes national defense to different subsectors (see sidebar: Balancing the Imbalances on page 3). But the overall picture is clear: EU countries spent 6.2 trillion in 2011. Based on historical data through 2010 for all EU27 countries, central governments own the largest share at 36 percent, with social security funds a close second at 32 percent, local government at 24 percent, and state or county governments accounting for the remaining 8 percent (see figure 1). Figure 1 EU27 government spending by category, with the largest spend by the central government Expenditure by economic category 1 ( billion, 2011) 1,367 846 373 317 297 138 149 6,201 Expenditure by subsector (% 2010) 32% 36% 2,694 24% 8% Social transfers Compensation of employees Intermediate consumption Property income, consolidated Gross capital formation Other current transfers, consolidated Capital transfers, consolidated Subsidies Total expenditure Central government State government Local government Social security funds 1 Economic category or type of transfers in general government Note: From EU Commission regulation 1500/2000 and ESA 95 categories, compensation of employees... and intermediate consumption (the purchase of goods and services by government) are considered operational costs when analyzing economic categories (transfers) of government expenditure. Source: Eurostat database; A.T. Kearney analysis 1 Sources: U.S. 2011 government spend/gdp = 40.09 percent, usgovernmentspending.com; China government spend/gdp = 23 percent, Heritage Foundation 2012 Index of Economic Freedom 2
Balancing the Imbalances Countries throughout Europe are at different stages in recognizing and acting on the need to optimize spending. Here, we provide a closer look at three countries: Italy, the United Kingdom, and Greece. Italy Government debt as a percentage of GDP rose from 107 to 120 percent between 2006 and 2011, negatively impacting both the country s credit rating by major agencies and the spread compared to the German federal bond (more than 400 basis points). By the end of 2012, Italy plans to cut more than 3.8 billion in spending or be forced to increase the value-added tax (VAT) by another 2 percent to cover its debt and the costs from recent earthquake. The cost cutting includes centralized procurement, reduced compensation and benefits, spending caps, and the sale of or rental caps on public real estate. United Kingdom When the deficit reached its peace-time peak in 2009, the United Kingdom launched a deficit-reduction plan to cut public-sector net borrowing from 11.4 percent of GDP in 2009 to 1.1 percent of GDP by 2015-2016. This would deliver a 102 billion cut in public spending. So far, cost-cutting includes a 20 percent reduction in full-time equivalent employment in a number of government departments, with additional steps planned to reduce welfare, housing benefits, and tax credits, as well as raising the state pension age to 66 in 2020 and raising public sector employees pension contributions. The effects to date have been limited. Total general UK government expenditures decreased from 51.5 percent in 2009 to 49 percent in 2011, and total general government revenues rose from 40.1 percent of GDP to 40.8 percent in the same time period. Also, net lending as a percentage of net borrowing fell from -11 percent to 8.2 percent. Greece The first bailout of 110 billion in May 2010 was supposed to help the country recover from the crisis. Three waves of costcutting were planned to further Greece s recovery, including freezing government employee salaries and cutting salaries, bonuses, and overtime. But rather than implementing the planned government job cuts, the public sector instead grew by 12 percent between 2010 and 2011. The second bailout of 130 billion occurred in February 2012 with further waves of cost-cutting planned, including privatizing and selling government property, lowering pension payments, and eliminating 150,000 public sector jobs by 2015. According to the European Commission and others, Greece may need another bailout of 50 billion or more between now and 2016. Also clear is the mismatch between the increasing rate of government spending and the growth of GDP over recent years. Between 2006 and 2008, spending in the EU27 rose by 4 percent, while GDP rose by 3 percent. During the financial crisis (2008 to 2011), spending rose by 1.8 percent, while GDP increased by a marginal 0.5 percent. This mismatch created the 247 billion gap that now haunts Europe and highlights an urgent need for European governments to prioritize their spending (see figure 2 on page 4). So how can EU27 close the GDP gap? Obvious tactics focus on economic development, including job creation, GDP growth, and increased consumption. Industrial diversification is the key trend in this area, where mature industries transform to new ones. Each country would be wise to identify the industry sectors that can spur the next wave of economic growth and develop a comprehensive strategy with supporting policies to encourage the growth process. Although Europe has gone through several industrial diversification cycles in its history, today this is easier said than done. Many strategic initiatives in Europe are focused on increasing competitiveness, but their impact is long term. Addressing the GDP gap calls for short-term actions. 3
Figure 2 A mismatch between government spending and GDP growth resulted in a 247 billion gap General government expenditure versus GDP 1 ( billion, 2006-2011) General government expenditure as a percentage of GDP ( billion, 2006-2011) EU government spending GDP 3.2% 0.5% +2.0% 11,695 4.2% 12,398 12,467 1.8% 11,745 12,255 12,638 46.3% 45.6% 47.1% 51.0% 50.6% 49.1% 5,411 5,657 5,873 5,995 6,200 6,201 2006 2007 2008 2009 2010 2011 2006 2007 2008 2009 2010 2011 1 Government refers to general government as defined by Eurostat. Note: EU27 government expenditure was 6.2 trillion in 2011, when GDP was 12.6 trillion; percentage point difference equals 247 billion. Source: Eurostat database; A.T. Kearney analysis GDP growth can also be kindled by working harder while keeping costs the same. For example, if workers in EU27 countries worked just one more hour per week at the current salary level, they could create 317 billion in additional GDP value. 2 This would be enough to close more than 70 percent of the identified GDP gap. (The stipulations are that this extra hour must be fully productive, and there must be market demand for the products produced and services delivered within this hour, which is hard to predict.) Social transfers are a significant category of government spending. Redistributing income in the form of social transfers, in cash or in kind, cost 2.694 billion in 2011 43 percent of total EU27 government spending. 3,4 Because intergenerational solidarity is important to Europeans, it is not feasible to radically cut social security. Still, such measures remain a promising means for closing Europe s GDP gap if approached with care and if government rethinks the tools typically used for dealing with economic crises. Consider, for example, that in a recession, governments automatically increase social transfers to stabilize the economy. Yet between 2008 and 2011, social transfers and protections led to a 4 percent increase in government spending, which was in stark contrast to the meager 0.5 percent growth in EU27 GDP at market prices over the same period. Clearly, increasing social transfers in a recession is not sustainable, and crafting a balanced approach to social transfers is difficult. 2 The GDP per hour worked in the EU27 amounts to 31.7, and total employment is 217.2 million people. Assuming there are 46 working weeks in a year, the added GDP per year (GDP per hour times number of weeks times number of employees) is 317 billion. 3 Source: Eurostat 4 Source: Eurostat Statistics in Focus 4
European governments need more basic means for cutting costs. The EU27 can close the GDP gap if countries launch improvement initiatives to reduce costs, mainly in the areas of government employee compensation and intermediate spending, such as procured operating expenses. Balancing Public Spending and GDP To find a better balance between public spending and GDP, we took a closer look at intermediate spending and employee compensation. Our goal was to determine where reductions would be most feasible, so we picked spending categories that can be directly managed by more efficient spending in procurement (intermediate consumption) and by more efficient execution of business processes (employee compensation). Both intermediate consumption and employee compensation relate to day-to-day operating costs. We looked at two different scenarios, an optimistic one and a modest one, which were defined based on realistic ranges of savings achieved with our clients (see figure 3). Figure 3 In two scenarios, optimistic and modest, countries can free up 275 billion in government spending Government expenditures ( billion, 2011) +11% 152 123 41 82 275 108 247 Optimistic scenario Modest scenario 67 167 67% 85 Intermediate consumption (optimized) Employee compensation (optimized) Total savings from optimization 2011 GDP gap Source: Eurostat database; A.T. Kearney analysis Up to 275 billion of EU government spending could be released with the right strategies. Even in our modest scenario, it is possible to close 67 percent of the GDP gap. Optimizing Procurement We helped one central procurement agency in Europe save between 10 and 18 percent on addressed volumes. These savings were reached through direct savings on price discounts (2 to 6 percent), indirect savings from procurement process optimization (2 to 3 percent), and savings from a benchmark effect when the goods are procured centrally (6 to 10 percent). 5
The EU has to find the right balance between maintaining the European approach to social support and creating a competitive environment. A strong central procurement organization is vital to reducing intermediate consumption. Centralized procurement has many advantages, including standardizing and simplifying products and services, continually benchmarking prices, optimizing spending by buying fewer products and imposing stricter spending controls, and bundling volumes across products, services, and geographies. Few EU countries have central procurement organizations. The reasons vary by country but often revolve around public authorities reluctance to centralize procurement, weak product or service offerings, or volume limits used to protect supplier markets. Whatever the reason, it is important to recognize that wider coverage and deeper penetration of central procurement is the key to balancing public spending and GDP. Figure 4 illustrates one country s current and expected procurement penetration levels. Figure 4 Deeper penetration of central procurement is key to balancing public spending and GDP 30% Client example 21% 25% 24% 23% Current penetration 18% Expected penetration 15% 10% 11% 6% Central authority Local authority Health Other Total Source: A.T. Kearney analysis Central procurement agencies in Europe are responsible for less than 20 percent of purchasing volume, but for our analysis, we set an ambitious target to reduce the whole intermediate consumption ( 846 billion) no matter if procurement is managed centrally or individually by government bodies. If each EU27 government centralized procurement as much as possible and implemented procurement spending controls that could lead to sustainable reduction of intermediate consumption, they could save between 85 billion and 152 billion. 6
Improving Employee Productivity For government employees to become more productive, a citizen-centric shift is needed. Putting citizens needs at the core of state policies can optimize decision-making processes, promote change-management procedures, introduce accountability standards, and monitor the outcomes of government policies. Further, governments can join forces and integrate services, processes, systems, and resources across department and agency lines. For example, many institutions deal with unemployment. Typically, the ministry of economy, ministry of social affairs, and employment agency each develop policies to stimulate employment and oversee unemployment rights. However, those policies often work against each other, creating confusion, misunderstanding, and impatience among citizens. If departments and agencies work together, more work can be done with the same amount of resources, which increases productivity for the benefit of citizens. Once the basic concepts of citizen centricity and integrated government policies are in place, the public sector can begin to look at corporate strategies for improving productivity, including deploying lean processes initiatives and shared-services centers. A Lean Public Sector Lean processes in service industries can improve productivity by up to 20 percent. The impact is rarely that big for governments. A lean process optimization in the public sector takes place in four steps shown in figure 5, and supported through strong, continual leadership and stakeholder engagement (see figure 5). Figure 5 Establish the strategic context for getting lean 1. Establish breakthrough objectives 2. Generate ideas; identify and prioritize initiatives 3. Allocate resources 4. Apply lean techniques 5. Provide strong leadership, engage stakeholders Source: A.T. Kearney analysis In the first step, clear breakthrough objectives are set over a period of two to three years to mobilize the whole organization, and leaders also set objectives for annual targets that are understandable and achievable. Next, improvement ideas are generated and prioritized. The focus on breakthrough objectives allows everyone to see the big picture and identify the right processes and opportunities. In the third step, resources are allocated to the new processes and decisions are made based on how aggressively each objective should be pursued while still meeting citizens expectations. In the final step, lean techniques using the traditional approach of define, measure, analyze, improve, and control (DMAIC) are used to identify the metrics that will prove the value of lean optimization projects. 7
Shared Services In a corporate shared-services implementation project, productivity can be improved by up to 30 percent for support processes, including facility management and general services, procurement, human resource management, information and communication technology management, general administration, finance, and control. Governments are ideal for shared-service centers because they often have many fragmented organizational units with their own administrative support. These units often duplicate work and have overlapping processes. Shared services for select support functions can improve productivity significantly, and do so without citizens seeing an impact on their services. For analysis purposes, we speculated that employee productivity can be improved by up to 10 percent with the above improvement measures. To test the feasibility of this hypothesis, we evaluated how each EU27 country s GDP and its credit rating justify the number of public-sector employees. On average, productivity of public-sector employees should improve by 8 percent. Consequently, our optimistic productivity improvement scenario calls for a 9 percent reduction in employee compensation, and our modest scenario calls for a 6 percent reduction. European workers could create 317 billion in GDP value by working just one more hour per week without a salary increase. In addition to improving productivity, it is also possible to reduce compensation across the board. But fair warning: Cutting individual salaries usually means the best and brightest employees leave for better opportunities, while average and below-average employees stay. Instead, the directive should target compensation in which the main objective is to improve productivity. To balance public spending in the optimistic scenario, immediate consumption of 846 billion will be reduced by 18 percent and employee compensation of 1,367 billion by 9 percent. In the modest scenario, immediate consumption will be reduced by 10 percent and employee compensation by 6 percent. The total savings at stake are 275 billion in the optimistic scenario and 167 billion in the modest scenario. In the optimistic scenario, the whole 247 billion GDP gap will be closed, while in the modest scenario, the GDP gap will be closed by 67 percent. Kick-Starting the Recovery Some EU27 countries face tremendous challenges dealing with the crisis, but the picture is not all bad. Many issues can be solved by optimizing procurement and improving productivity. Wise leaders will help their governments put the right strategies in place to improve their spend-to-gdp balance and close the 247 billion GDP gap. Getting people talking and sharing ideas will be essential at all levels between governments, trade unions, and businesses and across society. The only question now is whether the current generation of leaders can move out from under their own shadows to create a better, more sustainable future for Europe. 8
Authors Branko Žibret, partner, Ljubljana branko.zibret@atkearney.com Mauricio Zuazua, principal, Dubai mauricio.zuazua@atkearney.com Tomislav Čorak, principal, Ljubljana tomislav.corak@atkearney.com Wayne Brown, principal, London wayne.brown@atkearney.com Luca Olivari, principal, Dubai luca.olivari@atkearney.com 9
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