Most downsizing operations show high financial returns, but their economic returns depend crucially on their design. After comparing public sector employment across countries, the author analyzes the optimal design of downsizing operations from a microeconomic perspective. The author discusses how to identify redundant workers when individual productivity is observable, as is often the case in state enterprises. Comparisons of productivity and labor costs are misleading because overstaffing is only one among several distortions. The author proposes using a shadow cost of labor, much the same as in standard investment projects. The author then discusses how to identify redundancies when individual productivity cannot be observed, as in government administration. Voluntary separations in exchange for severance pay create an adverse selection problem, whereby the best workers leave the public sector and the worst workers stay. The author discusses other self-selection methods more likely to create an incentive for the best workers to stay rather than quit. Most offers of severance pay tend to overcompensate workers. The author analyzes how labor data can be used to predict the loss replaced workers will experience and to tailor compensation to their individual characteristics. Finally, the author discusses the appropriate sequence of downsizing and privatization, the consequences of early retirement programs, and the usefulness of training programs and other active labor policies.
