Public Sector Reform in New Zealand and Its Relevance To Developing Countries

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Public Sector Reform in New Zealand

and Its Relevance to Developing


Countries

Malcolm Bale • Tony Dale

Does New Zealand’s success story have lessons for developing countries contemplating
public sector reform? That question usually elicits one of two reactions, both inadvisable
in the authors’ view. The first reaction is to be impressed with the efficacy of the reforms
and conclude that they should be adopted uncritically in other countries. The second
reaction is that the special conditions existing in New Zealand are such that none of its
reform experience is relevant to others. The authors take a middle position, maintaining
that poorer countries can indeed extrapolate from the experience of their higher income
neighbor despite the different conditions under which they have to operate. New Zealand’s
comprehensive overhaul of its public sector affords both general principles and specific
elements relevant to countries looking to improve the quality, efficiency, and cost effective-
ness of their public service sectors, and a careful analysis of those reforms can ascertain
what might be transferable and what principles might apply.

In 1984 New Zealand’s newly elected Labor Government took over an economy
characterized by comprehensive controls on the financial sector, extensive subsidies
to farmers and exporters, and a highly sheltered private sector. Its deficit was a high
9 percent of gross domestic product GDP, and public debt, at 60 percent of GDP, was
rising. High underlying inflation and slow economic growth had reduced per capita
income from one of the highest in the Organization for Economic Cooperation and
Development to one of the lowest (OECD 1983; 1984).
The new government put in place a macroeconomic stabilization plan and broad
structural reforms to correct the core problems; the design, implementation, and
outcome of the reform program are widely cited in the economic literature and busi-
ness press and will not be elaborated here (OECD 1990–94; Bollard 1992; Evans,
Grimes, and Wilkinson 1996). But government expenditures still accounted for about
40 percent of GDP, which, policymakers came to believe, meant that the improved
The World Bank Research Observer, vol. 13, no. 1 (February 1998), pp. 103–21
© 1998 The International Bank for Reconstruction and Development / THE WORLD BANK 103
performance of the economy as a whole might be limited by the large public sector.
Government departments were viewed as bloated, inefficient, and poorly managed.
The bureaucracy behaved in ways that stereotypically undermine the capability of
any government, and service delivery was poor. Departments habitually exceeded
their budgets; unused balances were spent in end-of-year shopping sprees; creative
accounting was used to give the appearance of good performance; and the manage-
ment of assets and cash was haphazard.
Most important, politicians felt that some core ministries had their own policy
agendas and could override or outlast the wishes of elected officials. Thus the objec-
tive of the new government was to create an efficient public sector that was also
responsive to the strategic policy direction of the government.
The first step was to decide which activities the government should provide and
which could be divested or spun off to the private sector. The second step was to
undertake structural and management reforms in the remaining “core” departments—
those concerned with broad, cross-cutting, nonsectoral issues such as Treasury, the
ministries of Defense and Commerce, and the Inland Revenue Department (for
details on the privatization program, see Boston and others 1991; Scott and Gorringe
1991). To paraphrase Holmes and Shand (1994), the government wanted the ethic
of value for money and customer service to take its place alongside the ethic of pro-
bity and stewardship in the public sector.

Reform of Government Commercial Enterprises


In 1984 the government owned much of the economic infrastructure, including
banking, postal, and telecommunications services; a steel mill; a shipping company;
production forests; electric power; and a large highway construction business. Most
of these activities were being run by departments that also had policy advice func-
tions; nearly all ran at a loss and required taxpayer support. To reform the provision
of these services, the government decided to “corporatize” these activities.
Corporatization involved forming government-owned enterprises with clear com-
mercial objectives, a neutral policy environment, managerial flexibility and author-
ity over decisions, performance monitoring, and explicit transfers for noncommer-
cial activities required by government to meet social objectives such as keeping open
small, unprofitable post offices or branch railway lines.
To meet these objectives, the enterprises were established under the normal com-
mercial company legislation common in all countries. The only difference from a
regular commercial company was that the stock of the state enterprises was not pub-
licly traded but held by government ministers. These firms were required to operate
profitably, to take on normal commercial levels of debt from the financial market,
and to pay taxes and dividends at commercial rates. Regulatory reform proceeded in

104 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
parallel with these reforms to ensure, wherever possible, competition in both the
input and output markets. The companies were given the opportunity to succeed or
fail based on their commercial performance.
Although corporatization was very successful, it had several drawbacks: the new
corporations tied up capital that could be used to repay public debt; they were not
subject to the ultimate discipline of the market because of the perception that an
implicit government guarantee existed; the large amounts of capital needed to de-
velop the businesses typically came at the expense of government investments in
social infrastructure, such as health and education; and the government was exposed
to commercial risk if the business suffered losses.
Thus successive governments have moved to sell their interest in activities, a rela-
tively straightforward procedure under commercial law. The government had a single
criterion in each sale—to maximize the value to the taxpayers by selling the enter-
prise in a competitive environment. By mid-1997, 35 companies had been sold, at a
value of approximately $1.5 billion. Most of the proceeds have been used to retire
sovereign debt. The privatized entities have prospered, benefiting from the addi-
tional capital available from the private sector. Telecom New Zealand, for instance,
went from one of the most inefficient telephone systems in the world to a position of
international leadership in telecommunications services (Duncan and Bollard 1992).
All the remaining government-owned companies now run as profitable businesses
and pay substantial dividends and taxes. For example, the quality of services pro-
vided by New Zealand Post has improved greatly. Although almost 80 percent of its
revenue in 1994 came from activities that are competitive, it paid $22 million in
taxes, paid dividends of $55 million to the government, and posted net profits of
$46 million. In 1995 it lowered the cost of first-class postage from 29 cents to 25
cents and in 1996 offered users a “postage free” day. In 1997 its exclusive franchise
over first class mail was removed so that its business is now fully contestable.

Reforming the “Core” Public Sector


To reform core activities, planners took their inspiration from public choice theory,
principal-agent theory, transaction-cost theory, and the new public management
literature (a brief explanation of these theories and a bibliography are provided in the
appendix.) Agency theory was perhaps the most powerful of these concepts. This
literature addresses the nature of contracts between two parties: the principal (or
government) and the agent (or bureaucrats). In New Zealand planners believed that
the problem was not with the bureaucracy—the civil service had many well-qualified
and capable managers and staff who were responding in a rational way to the set of
incentives they faced—but with the incentives themselves. The reforms were there-
fore intended to replicate, as closely as possible, the types of incentive structures for

Malcolm Bale and Tony Dale 105


performance that might be found in a well-functioning private-sector concern, while
taking into account the distinctive character of public services. The approach had
five characteristics:
• Establishing clear lines of accountability between government ministers and
their departments
• Defining performance in an unambiguous and measurable way
• Delegating authority to chief executives
• Establishing incentives that reward or punish results relative to the agreed
outcome
• Reporting and monitoring performance.
Two laws were passed to effect these changes: the State Sector Act of 1988, and the
Public Finance Act of 1989.

Accountability and Employee Relations


The emphasis on a strong accountability framework implied a new relationship be-
tween government ministers and permanent heads of departments. First, department
heads lost their permanent tenure and were appointed to fixed terms up to five years,
renewable for a further three years depending on performance. Now known as chief
executives, department heads work under specified, performance-based contracts that
they negotiate with the responsible minister. The State Services Commission monitors
performance on behalf of the minister. The chief executives are free to run their depart-
ments in the ways they deem best suited to meet the performance goals. It is said that
chief executives in the New Zealand public service used to have full tenure and limited
authority; now they have limited tenure and full authority (Ball 1994).
Second, public sector employees were placed under the same rules and regulations
as the private sector. That is, there are no public service employment regulations; all
sectors, public or private, in New Zealand must comply with the same general em-
ployment regulations. The chief executive of each department is free to operate un-
der more or less the same conditions as a chief executive officer of a private company,
making all decisions on the number of employees needed and the skill mix of per-
sonnel as well as all appointments and terminations (based on performance-based
contracts for managers and staff).

Defining Performance
Because vague or unachievable performance specifications undermine good account-
ability arrangements, it was necessary to define the performance that departmental
chief executives were expected to deliver. Four elements of departmental performance
were considered.

106 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
THE OUTPUT–OUTCOME DISTINCTION. In New Zealand accountability between min-
isters and their departments is based on the conventional distinction between out-
puts (goods and services produced) and outcomes (the effect of those outputs on the
community). Chief executives are responsible for specified outputs from their de-
partments, while the minister chooses which outputs will be purchased to achieve
certain outcomes. That is, the minister, not the department, is responsible for the
outcome. The distinction is important. Governments are interested in achieving
outcomes and would like to contract for them if it makes sense to do so. Outcomes
are often not within the control of the chief executive, however, and he or she cannot
be held accountable for them. But chief executives can be held accountable for out-
puts, which can be relatively well-defined and are within the executive’s control.
Say, for example, the police commissioner contracts with the minister of police to
provide a certain level of policing services, patrols, community security programs,
road safety commercials, and so forth. These are clearly outputs. The commissioner
does not contract to lower the crime rate. That outcome may be forthcoming, but
the crime rate is affected by many variables beyond the control of the commissioner,
such as the level of unemployment, immigration policy, social policy, perhaps even
the result of certain sporting events. Thus, holding the commissioner accountable
for outcomes is not operationally useful; this distinction between who is accountable
for outputs and who for outcomes is common in the private sector as well.
Accountability processes are much more effective if the outputs to be delivered are
well specified in advance. Vague specifications allow managers to determine exactly
what it is their organization will produce. For this reason, the minister and chief
executive prepare annual purchase agreements, or contracts, that set out in reason-
able detail the outputs to be delivered. The quality and robustness of this system
depend on the careful specification of outputs in the agreement. Many ministers
have “purchase advisers” to assist them with this task.
A common concern is that this approach emphasizes outputs at the expense of
outcomes. Critics maintain that unless departments are held accountable for out-
comes, they will not focus on these issues and therefore are less likely to achieve
them. That is not necessarily the case. Greater clarity over what is being produced
(outputs) can increase the attention to outcomes. Since 1990 the government, as
part of the annual budget process, has reviewed all the outputs produced by depart-
ments against the criterion: How does this help achieve the outcomes the govern-
ment wishes to pursue? This focus makes clear that policy advice should be about the
relationship between interventions (including outputs) and outcomes, about what
the government is trying to achieve and alternative ways to achieve it. This frame-
work has helped departments understand that, just as in the private sector, their
survival is dependent upon meeting the needs of their customer. Because their cus-
tomer is interested in outcomes, departments, given sufficient competitive pressure,
will strive to design and provide public services to help achieve those outcomes.

Malcolm Bale and Tony Dale 107


THE OWNER –PURCHASER DISTINCTION . In addition to purchasing most of a
department’s outputs, the government is also the department’s owner. As the pur-
chaser, the government wishes to obtain goods and services of a specified quantity
and quality for the lowest price, whether it is buying from the private or public
sector. To enhance price competition, all ministers are free to purchase their outputs
from nondepartmental sources. The finance minister, for example, may purchase
economic projections and advice from Treasury officials or from any private domes-
tic or international economic consulting firm. As the owner of the Treasury, the
government wants to obtain the best possible return on its investments in it. If the
Treasury fails to record a positive rate of return, public production lowers the wealth
of society. It would better in that case to close that department and contract out all of
its work (outputs).
The New Zealand approach recognizes these two perspectives as two different
dimensions of departmental performance. Performance agreements with each chief
executive separately specify each dimension, and both are monitored. The fact that
governments purchase goods and services from their departments and also own those
departments could give rise to conflicting objectives. This conflict is solved by pric-
ing departmental outputs at a price equivalent to that charged by the private sector.
The department’s performance as a business can then be fairly assessed using normal
business evaluations that enable governments to determine whether the department
is operating efficiently and whether owning the business is advantageous.
Where the private sector produces the same output, this model does not pose a
problem. But where there is no comparable private supplier, an alternative bench-
mark must be established. In some cases, prices charged by different public sector
entities can be compared, as in a 1993 study of the unit price of policy advice out-
puts provided by departments. Where no endogenous benchmark can be established,
officials are experimenting with establishing an initial price that applies some pricing
rule to costs (such as cost minus x). Although this method will not establish an
efficient market price, it does create some separation between cost and price.
Ministries regard the minister as a customer rather than as the recipient of a ser-
vice. Ministries are accountable only to their minister, not to taxpayers and service
recipients. Ministers are accountable to taxpayers and service recipients. This con-
trasts with the citizen charter approach used in the United Kingdom, which creates
a dual accountability for departments: to their minister and to the recipients of their
services. A difficulty can arise if those accountabilities are inconsistent—for example,
if the quantity or timeliness of services demanded by recipients is incompatible with
the amount ministers are prepared to pay for the services. The approach used in New
Zealand resolves this problem by having ministers make the tradeoff among quan-
tity, quality, time, place, and cost of service delivery; that is, between common inter-
est and individual interest. This does not mean that departments are not concerned
about whether customers are satisfied. Such a response will inevitably become a

108 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
concern of the minister, whose political antennae should be well attuned to such
feedback.

THE GOVERNMENT–DEPARTMENT DISTINCTION. Chief executives make all input de-


cisions, including capital investment decisions (within a defined capital base). In-
deed, such authority is necessary if they are to be held accountable for producing
outputs in the most efficient manner. Some departments, however, manage inputs
over which they do not have full control, that are not used to produce their outputs,
or for which the government does not wish to delegate authority. As a result, activi-
ties and assets have been divided into two categories: “the Crown” (ministers); and
the departments. For Crown activities or assets, accountability remains with the gov-
ernment. For example, the Department of Social Welfare is responsible for adminis-
tering the social support scheme, but the minister is responsible for the size and
number of welfare payments. Understandably, the chief executive cannot be held
accountable for, say, the number of people unemployed or the number of single-
parent children. Similarly, the national parks are managed by the Department of
Conservation for the government but are owned by the government and listed as a
Crown asset.

POLICY ADVICE–SERVICE DELIVERY DISTINCTION. Where an agency provides both


policy advice and service delivery, a potential conflict of interest arises between
the two functions. Separating them reduces the potential for policy advice bias.
Under the reforms, policy advice is an output provided by departments in much
the same way as consulting advice is an output provided by a consulting firm.
Good policy advisers must be able to evaluate the tradeoffs between different
outcomes and identify the nexus between outputs and outcomes. They must
evaluate spending proposals against all alternative interventions that could pro-
duce the same outcome. If, for example, the government decides it wants to
reduce road accidents, it may purchase outputs such as highway patrols, road
repairs, and vehicle inspection checks. Alternatively, it may intervene legisla-
tively with speed limits, higher alcohol taxes, different speed sanctions, or com-
pulsory driver-education programs.
Viewed from that perspective, policy advice is a specialized business that is inher-
ently different from service delivery. In most cases, it has been decided that policy
advice is most effectively and efficiently produced by a department dedicated to its
production rather than by one with distinctly different lines of business. For ex-
ample, in the environmental area, policy advice is the responsibility of the Ministry
for the Environment, while another agency, the Department of Conservation, is
responsible for delivering services such as operating the national parks. Because the
ministry does not deliver services, its advice about appropriate interventions can be
independent of the business implications for the department.

Malcolm Bale and Tony Dale 109


A related reason for separating these functions is to reduce the tendency for special
interest groups to “capture” the agency that regulates them (Posner 1974). This
rent-seeking behavior can be reduced if regulatory policy is designed in one agency
and enforced in another.

Reporting, Monitoring, and Coordination


Improved reporting and monitoring of departmental performance was the quid pro
quo for enhancing the chief executive’s autonomy. This required upgrading finan-
cial management systems and skills.

EX POST REPORTING. Defining and monitoring purchase and ownership performance


requires information about the full resource cost, including the consumption of as-
sets and the opportunity cost of capital, and about assets and liabilities, their utiliza-
tion, and the return being generated. For this reason, all government entities are
required to report financial performance on an accrual accounting basis, using the
same generally accepted accounting practices as does the private sector.1
Each department must provide a full set of financial statements to their minister
and to the Treasury on a monthly basis. In addition, departments must produce and
submit an audited annual Statement of Service Performance, outlining the outputs
produced versus the outputs agreed and giving information about purchase perfor-
mance in the same way that private companies produce annual reports showing their
financial statements and performance. As a result the government can simply sum all
of the accounts to produce national financial statements on an accrual basis. These
are published monthly, and annual audited financial statements are presented to the
Parliament within three months of the close of the fiscal year. Thus government
accounts look similar to an annual report produced by a private company. They
show, among other things, the net worth of the government.

EX ANTE BUDGETING. The reforms also changed the budget and appropriations sys-
tems in two ways to fit with the performance management system. First, appropria-
tions for departmental outputs (not inputs) are now made on an accrual accounting
basis, and managers are free to acquire their inputs from any provider. Second, only
capital injections into departments are appropriated (not capital expenditures), re-
flecting the chief executive’s authority to manage assets within a defined capital base.
Budgetary reporting at both departmental and national levels mirrors ex post report-
ing. Financial forecasts are prepared using generally accepted accounting practices
and are identical in form to financial statements produced by private corporations.

CAPITAL CHARGE. Twice a year departments pay a capital charge, calculated on the
basis of their net assets, for the cost of the capital the government has invested in

110 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
them. This charge has several benefits. First, it ensures that the cost of capital is
reflected in output prices because a department’s total cost must be allocated to its
outputs to ensure comparability with nongovernment producers. Second, the charge
encourages departments to manage their balance sheets carefully and to divest sur-
plus or redundant assets. Third, it encourages management to consider the mix of
assets needed to produce services efficiently. If a manager finds it more efficient to
purchase more computers and sell some cars, he or she is free to make this decision.
If the sale of assets reduces the overall capital charge, the savings can be applied to
other expenses.

STRATEGIC POLICY COORDINATION. Three means were devised to coordinate strate-


gic policy, which was a key objective of the reforms. Ministers were required to
specify and publish the outcomes the government wishes to achieve. Coordinating
committees were established, made up of senior government officials from depart-
ments with an interest in broad areas of government activity, such a social policy,
education and training, or environment. Their role is to ensure that policy options
are developed in a coordinated way across the government. The third method of
coordination is created by the policy-delivery split. Because ministers want advice
about policies that can be effectively implemented, and they want output proposals
that meet their objectives, policy and delivery departments have a relatively strong
incentive to coordinate with each other. Rather than weaken the horizontal linkages
between departments, these arrangements have served to strengthen them.
The use of the private sector profit center approach combined with market pric-
ing techniques has also solved one of the common public sector problems: transfer
pricing—the price of a good or service for a transaction within an organization.
Because there is no market price, the organization can set the price at any level,
including zero. Modern business practices require that transfer prices approximate
market prices so that accurate profit-loss data can be established by each unit of an
organization. Because each department is regarded as a profit center and all transac-
tions between departments are treated as arms-length transactions, the transfer pric-
ing problem has effectively disappeared.

Results
The core sector reforms have succeeded in improving both service delivery and effi-
ciency. The system is widely supported by departmental managers, although the
effect of the reforms on managerial behavior has varied depending on the quality of
leadership and the levels of efficiency prior to the reforms. In general, performance
has improved in tandem with the development of wage scales linked to performance.
Savings from improved cash management have been substantial (enough to pay for
all the system costs of the reforms), and unappropriated expenditures, which were

Malcolm Bale and Tony Dale 111


quite extensive, have now all but disappeared. Cost per unit of output has declined,
in some cases quite markedly (Deloitte, Ross, Tohmatsu 1990). Human resource
management has improved measurably, and explicit attention is paid to issues such
as succession and the development of management skills. The strategic gains are
more difficult to assess, although some improvement is evident.

Economic Policy Reform


The reforms designed to determine the government’s overall economic policy are
embodied in two pieces of legislation: the Reserve Bank Act of 1989, and the Fiscal
Responsibility Act of 1994. The former is intended to make monetary policy deci-
sions transparent. The independent governor of the central bank manages the money
supply and interest rates to achieve a target rate of inflation established in an agree-
ment with the government. Apart from periodically determining the target inflation
range (currently 0–3 percent annually), the act prohibits the government from in-
volvement in monetary policy. The Fiscal Responsibility Act is designed to provide a
similar political discipline on fiscal policy, although clearly fiscal policy cannot be
made at arm’s-length in the same way as monetary policy can. In budgetary
decisionmaking, officials have a political incentive to trade off the government’s ag-
gregate fiscal position against increased expenditures. In countries around the world—
and formerly in New Zealand—the negative economic impact of fiscal deficits can
be easily pushed off for future generations to deal with. The act uses transparency
and accountability mechanisms to put the onus on governments to act in a fiscally
responsible manner to control the deficit.2
This approach has two notable features. First, the fiscal aggregates (debt, net worth,
operating surplus or deficit, operating expenses, and operating revenue) are defined
in accrual terms. As a result, the budget forecasts must include all noncash expenses,
such as depreciation and the unfunded liability to the government employee’s retire-
ment fund, and exclude capital transactions, such as the proceeds from asset sales.
This requirement significantly reduces the government’s ability to manipulate the
aggregates between years and prevents “off-budget” manipulations. It also forces the
government of the day to interpret the requirements of the law in the context of
prevailing economic conditions and to justify those interpretations to Parliament
and the public. This approach is designed to be more politically and economically
sustainable than legislated targets.
The second feature calls for regular reporting of fiscal intentions, forecasts, and
results. Transparency in a democracy is a powerful discipline. On the forecasting
side, the act requires the government to give Parliament a statement specifying its
strategic budget priorities, three-year fiscal intentions, and long-term policy objec-
tives; a fiscal strategy report showing whether the budget forecasts are consistent

112 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
with the budget policy statement (and if not, why those intentions have changed);
three-year economic and fiscal forecasts at the half-year point and within two to six
weeks before a general election; and a current year fiscal forecast with the supple-
mentary estimates that are normally tabled in the last quarter. On the reporting side,
aggregate financial statements of the Crown must be released within five weeks after
the end of the month. The existing requirement for audited, annual Crown financial
statements remains. All aggregate fiscal reporting, including fiscal forecasts, must
comply with generally accepted accounting practices.
The Reserve Bank Act is regarded as highly successful and is credited with New
Zealand’s good record on inflation in recent years. The value of the Fiscal Responsi-
bility Act has yet to be fully tested. It was enacted after the major fiscal correction
was completed and has yet to apply during a period of economic downturn. It has,
however, provided a frame of reference for public debate over the Crown’s fiscal
position, and most political parties have cast their economic policy with its prin-
ciples in mind. The quality and quantity of fiscal reporting has been welcomed by
the financial markets and rating agencies.

Relevance to Developing Countries


It is not difficult to understand how dysfunctional public sector agencies impair
development and perpetuate poverty. The most common solutions frequently in-
volve mechanics, such as streamlining procedures, banning dual employment, in-
creasing civil service salaries, fighting corruption, upgrading training, and decen-
tralizing government services. These ideas are useful, but they do not appear to
offer even a partial solution to the deeper problems encountered by public sector
agencies in many developing countries that have been seriously depleted by years
of neglect and corruption. In some cases public organizations are no longer able to
perform the task for which they were created. Thus civil service reform may re-
quire more than minor changes; it may need to be more fundamental and based on
a more finely tuned understanding of the causes of the malfunction. What lessons
can be drawn from New Zealand’s experience that may be applicable to develop-
ing countries?

The Value of a Consistent, Comprehensive Conceptual Model


The one aspect that sets New Zealand apart from other public sector reforms is its
underlying conceptual framework. That framework, which was based on identifiable
theoretical constructs, proved valuable in several ways. First, it helped ensure that
the reform was developed from a broad, systemwide perspective that focuses on the
causes, not the symptoms, of dysfunctionality. For example, some involved in writ-

Malcolm Bale and Tony Dale 113


ing the reforms considered issues such as financial waste, excessive rules, and poor
staff performance to be the problem. They were, in fact, only the symptoms; the real
problem was the lack of management incentives. Second, the framework provided
consistency for the multiple layers of decisions required in the design and implemen-
tation of the reform. These decisions, such as the nature of the accounting system,
the approach to budgeting, and the degree of personnel delegations, were all made in
a consistent manner. Third, it focused attention on a comprehensive approach. As a
result the reform addressed all aspects of public sector management and all parts of
the public sector (departments, government corporations, local governments). Fourth,
the framework guided the sequencing and implementation of the reforms. These
decisions were based on what was most important from a top-down perspective rather
than what took the fancy of departments. Fifth, it aided in marketing the reforms to
departments and the public. The coherence and comprehensiveness reduced fears
that the reform was just another ad hoc initiative. The lesson for other countries is
clear. Basing reforms on an analytically rigorous conceptual framework appropriate
for the jurisdiction concerned and having the framework apply to the entire public
sector is likely to improve significantly the chances that the reform will be successful.

The Importance of a Clear Performance Definition


The second lesson relates to performance specification. The reforms were based on
identifying the various principal-agent relationships; specifying and reporting per-
formance in a clear and unambiguous manner; and ensuring that managerial author-
ity matched the department’s responsibilities. Providing state-owned enterprises with
a clear profit-maximizing objective is an example of this expectation. So, too, are the
features described in the discussion of performance, which are designed to clarify
what performance the principal expects of the agent in a way that holds the agent
unambiguously accountable. However performance is defined, the agent must have
control over it; for this reason, the outputs approach has great merit.
The existence of several principals (as in the U.S. separation of powers) does not
necessarily invalidate the principal-agent approach. Rather, it highlights the need to
be clear about the different aspects of performance each principal requires of the
agency, and for the principals to reconcile any mutually exclusive conflicts in those
requirements.
New Zealand sought to ensure that managers faced incentives congruent with the
performance expected of them. This basic notion is often overlooked in the design of
public sector reforms. Performance incentives are much more subtle and pervasive
than the “personal bonus or reward” incentive commonly mentioned. Other aspects
need to be considered, including
• Whether the institutional and organizational arrangements encourage the
performance required

114 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
• Whether agencies can be made more efficient and responsive to their customers’
needs, either by increasing competition or by direct customer purchasing of
services (rather than by the minister purchasing the services on behalf of
consumers)—the evidence is that they can
• Whether all aspects of the management system are sending the same signals
to managers—often budget and accounting systems define and measure
performance in totally different ways
• Whether the actual performance of all the actors in the systems is transparent;
• Whether the system is empowering or controlling
• Whether the systems encourage managers to actively manage all their re-
sources—the purchase of cleaning services, motor vehicles, or even personnel by
central agencies at no cost to operating departments discourages those
departments from efficiently managing their costs
• Whether the personnel system encourages good performance.

Focusing on What Government Does Best


It is important to focus the government’s resources on areas in which government
can add value, such as establishing an appropriate regulatory framework and eco-
nomic environment in which the private sector can thrive. Wherever possible, New
Zealand turned over businesses to the private sector because governments do not
have the ability to manage and monitor enterprises in the same thorough way as does
the private sector. Commercial objectives and decisions are easily compromised by
political and social ones. In addition, state enterprises compete for scarce govern-
ment financial and management resources; thus they tend to be undercapitalized
and undermanaged. Governments should concentrate on what they do best—estab-
lishing the regulatory and economic environment, financing public infrastructure,
and ensuring the delivery of public goods. And these activities can be operated along
commercial business lines to a much greater extent than is commonly believed.
A public sector management system is a means; not an end. It will not deliver
better fiscal performance on its own, but instead needs to work inside an overarching
political economy framework that sets clear macroeconomic goals and has the politi-
cal resolve to achieve them. This point is clear from the New Zealand experience. All
of the reforms were driven by the same central goal: to improve macroeconomic
performance by reducing the negative impact of the public sector. A good public
sector management system will provide politicians with the tools they need to achieve
those targets; a poor one will make a politician’s task more difficult.
It is more difficult to draw conclusions about whether specific practices adopted
in New Zealand are applicable to developing countries. If the cultural and political
environment is too dissimilar, the applicability of these practices may be limited.
The following precedents formed the basis for the reforms adopted in New Zealand:

Malcolm Bale and Tony Dale 115


a tradition of a politically neutral, relatively competent civil service; little concern
about corruption or nepotism; a consistent and well-enforced legal code, including
contract law; a well-functioning political market; and a competent, but suppressed,
private sector.
The right reform mix for any developing country must reflect any major differ-
ences in these preconditions; New Zealand’s reforms cannot simply be transplanted.
For example, because reducing corruption or nepotism and increasing democratic
participation were not objectives in New Zealand, the reforms did not address these
issues. If financial performance and service delivery are concerns, however, then spe-
cific New Zealand techniques may be appropriate. Subject to this caveat, the follow-
ing techniques are likely to find broad applicability in developing countries.
• If the performance of government commercial activities are issues, developing
countries would find it useful to separate trading activities from core
departmental functions, apply a “level playing field” regulatory regime, and
appoint independent boards with business—rather than political—expertise.
The success of such reforms is dependent on acquiring the necessary governance
and managerial skills from the private sector. Many developing countries have
this expertise.
• If the concern is about users of the service heavily influencing policy advice, then
separating policy advice and service delivery functions into different agencies is
likely to lead to both better advice and better service delivery because conflicting
objectives have been removed. If this route is pursued, the institutional design
should put more emphasis on processes to coordinate advice. These can operate
at the political level, the bureaucratic level, or both.
• If service delivery is a concern within core government agencies, a management
system focused on outputs would be relevant to developing countries. Politicians
and managers would need to make a significant paradigm shift in the way the
government operates, not least in securing the political commitment to such a
change. Publishing the agreed outputs would be a first step in transparency and
has the potential to improve accountability. To be fully effective, the planning,
budgeting, appropriation, performance assessment, and reporting systems all
need to be based on outputs. This does not preclude accountability for input
management as well, if that is considered desirable.
• If financial performance is an issue, improved measurement of financial
performance (through the use of accrual accounting) and explicit attention to this
information in budgeting and reporting systems is important, although skill
shortages may make implementation difficult for some countries. Significant gains
can be achieved through improved financial management and financial control
systems even without accrual accounting. The establishment of an effective cash
accounting system may be considered a precursor to accrual accounting.

116 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
• If personnel performance is a concern, performance-based personnel systems are
likely to improve the staff’s incentives to perform. Such contracts may be
politically difficult, but they have been a central part of institutional reform in
New Zealand, are viewed as very effective, and were the key to changing the
public service culture. Even if this model is not fully acceptable in developing
countries, changing the appointment, appraisal, and promotion systems so that
they are based on performance is likely to be possible and beneficial.
• Transparency is an important incentive device; providing that voters are able to
replace their politicians if they do not make decisions in the public interest,
developing countries can require improved specification and reporting of
performance to government and to the public.
• The performance of civil service managers is often impeded by a lack of author-
ity. New Zealand’s approach of delegating authority for input management to
managers is likely to be useful in many developing countries providing that a
meaningful output accountability system is implemented. In cases where del-
egating process decisions, including personnel and capital matters, may not be
appropriate, separating the role of politicians and managers may be useful. The
former can determine the output to be produced, while the latter determine the
method of production.

Transplanting the system and structures in one country unchanged into an-
other is seldom possible because the efficacy of a system depends so much on the
complementary structures. At the same time, countries commonly study and adapt
systems and structures from other countries to fit their particular circumstance. In
the last decade, many industrial societies have moved to narrow the government’s
role in the economy and insist on a more sharply focused and less intrusive con-
duct. Part of that process has been not only a questioning of what governments do,
but also a reexamination of how they do it. Thus even if developing countries must
adapt the reform agenda to their own circumstances, policymakers can learn from
what may well be a best practice and draw lessons and principles from New Zealand’s
experience.

Appendix. The Theoretical Underpinning of the New Zealand


Reforms
The theoretical concepts that influenced New Zealand’s reform program included
public choice theory, agency theory or principle-agent theory, transaction-cost theory,
and new public managerialism. This discussion draws heavily on Boston and others
(1991).

Malcolm Bale and Tony Dale 117


Public Choice Theory
Closely associated with the work of Buchanan and Tullock (1962), Tullock
(1965), Olsen (1965), and Niskanen (1971), this theory seeks to explain how
voters, politicians, bureaucrats, and lobbyists will behave in different institu-
tional settings with different incentive rules. It is based on the idea that human
behavior is dominated by self-interest. Thus, government officials will attempt
to enlarge their department budgets, say, without regard to the overall govern-
ment budget. Similarly, public and private groups will undertake rent-seeking
activities to the disadvantage of the broader society, and politicians may pur-
sue their own objectives at the expense of many of their constituents. As a
result powerful interest groups may capture a disproportionate share of na-
tional income, and politicians may misuse their power. Democracy is thus
undermined.

Principal-Agent Theory
At the core of this theory is the idea that interchange between parties can be charac-
terized as a series of contracts where one party, the principal, enters into agreements
with another party, the agent, who agrees to perform tasks on behalf of the principal
in return for compensation (Moe 1984, 1990; Pratt and Zeckhauser 1985; Bendor
1988). Moe (1984:765) notes that politics can be seen as a series of principal-agent
relationships from citizen to politician to senior bureaucrat to subordinate bureau-
crat to service providers.
Agency theory assumes rational, utility-maximizing behavior by individuals. Hence
conflicts will arise between principals and agents as their self-interests differ. Add to
this asymmetric or incomplete information, the difficulty of observing and monitor-
ing agents’ behavior, and the imperfect mapping of agents’ outputs and the out-
comes desired by the principal, and an even larger ground for conflict will exist.
Principal-agent theory is concerned with the best way to construct and monitor
contracts so that these kinds of conflicts are minimized. The theory is useful in ana-
lyzing the selection of agents, designing incentives and pay systems, and choosing
between in-house or outside contractors.

Transaction-Cost Theory
This approach compares the costs of planning, adapting, and monitoring under al-
ternative governance structures. Decisionmakers wish to minimize their aggregate
costs of production and transaction. But like agency theory, this approach assumes
that principals and agents will act in their own self-interest and thus may be unreli-
able parties to a contract.

118 The World Bank Research Observer, vol. 13, no. 1 (February 1998)
The literature on transaction costs indicates that some transactions are better suited
to market-type arrangements, while others are better suited to hierarchical or rule-
driven organizations. For example, contracting out is likely to be desirable where the
supply of a good is contestable, quality and quantity can be easily measured and
specified, and suppliers are numerous. In-house provision is likely to be more effi-
cient when the opposite conditions exist. When transactions occur frequently, are
associated with uncertainty, and involve specific assets or skills, hierarchical organi-
zation tends to be more efficient.
Where the supply is competitive and transactions costs are “average,” the preferred
organization is less clear. But generally, in-house provision is likely to be more efficient
where there is a high risk of self-interest, conflicts of interest, substantial uncertainty,
and recurrent, complex transactions. According to Williamson (1985), these factors
explain the concentration of production in some sectors in a few large firms. Thus
direct provision may be preferable when maintaining quality is critical and opportun-
ism poses a serious threat. It is for these reasons that governments are hesitant to con-
tract out the gathering of military intelligence and the collection of taxes.

The New Public Management


This approach (see Aucion 1990; and Caiden 1988) centers on the presumption that
a distinct activity called “management” can be applied to public and private busi-
nesses alike, and that it includes the following elements: a move away from input
controls, rules, and procedures toward output measurement and performance tar-
gets—the “accountability” framework; the devolution of management control with
improved reporting and monitoring mechanisms; a preference for private owner-
ship, contestable provision, and contracting-out of publicly funded services; the adop-
tion of private-sector management practices in the public sector, such as short-term
labor contracts, performance-linked remuneration schemes, the development of a
mission statement, greater concern with corporate image, and the development of a
corporate strategy and action plan; an emphasis on efficiency, often referred to as
“value for money” (Hood and Jackson 1991).

Notes
Malcolm Bale is principal economist, East Asia and Pacific Region, the World Bank, and Tony Dale
is a principal of Public Sector Performance (NZ) Ltd., a public management consulting business.
1. Accrual accounting is an accounting method that recognizes transactions and other events
when they occur and not as cash transactions or their equivalent. The events are recorded in the
accounting period and reported in the financial statements in the periods to which they relate.
2. The five principles of responsible fiscal management are (1) reducing total Crown debt to
prudent levels by ensuring that total operating expenses for the Crown are less than total operating

Malcolm Bale and Tony Dale 119


revenues in the same financial year; (2) maintaining prudent debt levels, once they have been achieved,
by ensuring that on average over a reasonable period of time, Crown operating expenses do not
exceed Crown operating revenues; (3) achieving and maintaining Crown net worth at a level that
provides a buffer against future adverse events; (4) managing prudently the fiscal risks facing the
Crown; and (5) pursuing policies that are consistent with reasonable predictability about the level
and stability of tax rates.

References
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Bollard, Alan. 1992. New Zealand Reforms, 1984–91. San Francisco: ICS Press.
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Zealand’s Bureaucratic Revolution. Auckland: Oxford University Press.
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Pratt, John, and Richard Zeckhauser, eds. 1985. Principals and Agents: The Structure of Business.
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tracting. New York: Free Press.

Reforming Health Care: Anatomy of Limited Success


Historically, New Zealand’s health care system has been predominantly publicly operated and
funded through general taxes. Before 1993, when the health care system was reformed, secondary
and tertiary (hospital) services were the responsibility of area health boards, with funding provided
according to population. The new system (which is similar to the United Kingdom’s) is based on a
Ministry of Health (a policy advice agency), four regional health authorities (who purchase primary,
secondary, and tertiary health services for specified regional populations), and a series of Crown
health enterprises (government-owned hospitals run on commercial business practices). Primary
services continue to be provided by private practitioners (who are heavily subsidized). The regional
health authorities determine the mix of health services to be provided to their populations within a
given funding level. They are then responsible for purchasing those services and monitoring delivery,
with oversight from boards of directors made up of health, community, and commercial
representatives.
The results have been mixed, but generally the public health system has failed to achieve the
performance gains expected, and considerable political and public debate continues about the
desirability of the arrangements. Although the quality of financial management and the degree of
transparency among the Crown health enterprises has improved significantly, efficiency gains have
been slow to emerge, and government funding has been required to keep many enterprises solvent.
The public remains uneasy with the notion of for-profit hospitals. The explicit division of policy
and purchasing responsibilities has been less successful than anticipated, health officials maintain
significant control over purchasing decisions, and there is a continuing demand for additional funding.
As a result of political compromises, most of the reforms to improve the delivery of social services
such as health and education have not been implemented as designed. The reforms were predicated
on the existence of market competition (on both the supply and demand side), which has not
developed. The quasi-commercial and social objectives of providers have diluted the focus on
performance. Political issues were also underestimated. Social policy concerns the public rationing
of private goods, and removing these concerns from the political arena has proved to be much more
difficult than anticipated. This has resulted in much more direct ministerial involvement (some
would say interference), which has undermined the authority of the various providers. The contrast
in performance between the purer commercial model versus the political-interference model provides
a salient lesson. If quantum efficiency gains are desired and it commercial objectives are to be achieved,
it is necessary to divorce political influence from commercial decision-making.

Malcolm Bale and Tony Dale 121

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