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BIG PRODUCTIVITY LOSSES FROM OUTSIZED PUBLIC SECTORS IN RESOURCE-RICH COUNTRIES: New study of the resource curse

  • Published Date: March 2015

The puzzle that countries rich in natural resources often have worse economic outcomes than similar countries without the same resources may be due to a bloated public sector, according to new research by Radoslaw Stefanski to be presented at the Royal Economic Society’s 2015 annual conference.

The phenomenon of the ‘resource curse’ seems counter-intuitive: why would a country with a free source of revenue apparently be better off if that resource did not exist? The author suggests that the curse might be because the public sector in resource-rich economies employs too many workers who would otherwise be far more productively used in non-government sector work.

By using a model in which government provides only basic services and does not suffer from corruption, the author shows that the demand for workers who would be better suited to working in the private sector reduces the productivity of the economy as a whole. Among his findings:

• In the most resource-rich countries, productivity will be up to 8% lower than it otherwise could be.
• Even a middling resource-rich country will, on average, have a 2% lower productivity arising from misallocation.
• These high costs of misallocation are likely to be underestimates of the true costs of disproportionately larger government in resource-rich countries.

Even with this charitable view of government, the research suggests that public sector employment in resource-rich countries increases nearly ten times more than would be optimal. ‘Solving the government misallocation problem in resource-rich countries can thus go a long way to reversing the curse of natural resources’, the author concludes.

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A surprising feature of many countries that are rich in natural resources like oil, metals or minerals, is that they tend to have worse economic outcomes than otherwise similar, but resource-poor, economies. This counter-intuitive relationship has been dubbed the ‘resource curse’ and its prevalence has sparked a hunt among economists for the source(s) of this so-called curse.

This research establishes two facts. First, it shows that resource-rich countries tend to employ a much higher proportion of workers in the government sector than similar resource-poor countries.

Second, it shows that the large size of government in resource-rich countries represents a massive misallocation of talent, which in turn has large negative effects on productivity. In short – the public sector in resource-rich economies employs too many workers who would otherwise be far more productively used in non-government sector work. This creates a large distortion and lowers the economic potential of those economies.

To reach these conclusions, the researcher takes the most charitable view of government possible. He assumes that government’s role is to provide basic services (like law-enforcement, infrastructure or unemployment insurance) that serve to increase productivity in non-government sectors. Furthermore, he assumes that public sector employees are financed by so-called lump-sum taxes, known to be the least distortive form of taxation. Finally, he assumes that government is honest and faces no informational asymmetries.

Given these assumptions, it is incredibly reasonable to expect optimally higher public sector employment in resource-rich countries. Intuitively, countries that discover natural resources will have a windfall of revenue from selling those resources abroad. This higher income will increase demand in the resource-rich country for all types of goods and services.

While demand for most manufactured goods can be satiated simply by importing those goods from abroad, the basic services provided by government tend to be largely non-traded and hence must be produced locally. Thus, more workers need to be employed by the public sector in resource-rich countries to increase the production of government services in order to satisfy the higher resource-driven demand.

The study constructs a model that captures the above mechanism and uses it to determine the extent to which resource-rich countries should expect to have higher government employment. This makes it possible to compare the optimal and the observed size of government within countries.

The researcher shows that – even with the charitable view of government taken above – public sector employment in resource-rich countries increases nearly ten times more than optimal. This massive misallocation has enormous negative implications on productivity in resource-rich countries.

To see why, notice that a government will always initially hire workers whose talents are most suited to public sector work. As government size increases, the government will be forced to hire workers increasingly better suited to other types of work. The overly large size of public-sector employment in resource-rich countries indicates that governments in those countries are hiring workers who are very unsuited to government sector work and instead are far more suited to jobs outside the public sector. By hiring too many public sector employees, resource-rich countries misallocate workers towards activities at which the employees are relatively not good.

The impact of this misallocation on productivity is potentially huge. A middling resource-rich country will, on average, have a 2% lower productivity arising from misallocation, while in the most resource-rich countries, productivity will be up to 8% lower than it otherwise could be.

Finally, since the study assumes a high level of efficiency and benevolence of government, these high costs of misallocation are likely to be underestimates of the true costs of disproportionately larger government in resource-rich countries. Solving the government misallocation problem in resource-rich countries can thus go a long way to reversing the curse of natural resources.

ENDS


Radoslaw Stefanski