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Government and economic growth: Does size matter?

2.2  Public sector productivity

Section 2.1 followed the endogenous growth literature in using the terms ‘productive' and ‘non-productive' to mean the extent to which different types of expenditure enhance private sector production or productivity. However, the more conventional meaning of productivity is not about the type of expenditure but the efficiency of expenditure. If government is providing a large share of the goods and services in the economy, it will tend to drag down economic growth if it has lower productivity than the private sector. Government expenditure policies or programmes may also stifle private sector activity and innovation through the absorption of skilled labour.

It is possible that the intrinsic nature of government services leads to lower efficiency or productivity. Baumol (1967) was the first to highlight that there is limited scope to reduce the quantity of labour used in some types of services without reducing the quality of those services. Therefore, they will tend to lag behind the rest of the economy in turning innovations into productivity benefits. Many government services, such as education and police, may be susceptible to this type of ‘Baumol's disease', which could lead to persistent increases in costs relative to the general price index. If this is the case, then economic growth could be enhanced by reducing the share of these types of services in the economy, although this may not boost overall living standards if these services are highly valued. In addition, in some services with a significant government role, such as health care, technological change can often put upward pressure on costs by expanding the scope or quality of available services. Therefore, even where there are productivity gains, there may still be upward pressure on the share of health care in the economy, which is often one of the government's largest spending areas.

There are also arguments that the nature of the public sector leads to lower productivity. Incentives and contracting problems may make the public sector relatively inefficient. The concentration of ownership in the private sector (relative to the public sector where all citizens are owners) means that owners of private-sector companies have better incentives and ability to monitor the performance of their managers, to improve corporate governance and to align the managers' interests with their own. In the public sector, taxpayers have relatively little incentive to monitor the performance of government agencies (Barry, 2002).

In addition, competition and profit-maximizing incentives may make the private sector more productive than the sheltered public sector (Guriev and Megginson, 2005). The lack of competition in the public sector reduces the pressures for innovation and the lack of exit or ‘churn' removes a key market mechanism for allocating resources to their most efficient use. Though markets provide swift rewards and punishments, the signals and pressures for adjusting to changing circumstances, information, and technologies is slower for governments.

Given the strong evidence that competition stimulates economy-wide efficiency and innovation, there is an ongoing debate about the extent to which productivity gains can be achieved by enabling greater competition for public sector agencies, as in the state-owned enterprise (SOE) model (see, for example, Shirley and Walsh, 2000). However, competition does not solve the monitoring issues and it can be difficult for governments to allow public enterprises to go bankrupt (Sheshinski and López-Calva, 2003). These factors provide some insulation from competition to public sector managers and mean that competition may not have as strong a productivity stimulus as in the private sector.

The private sector productivity advantage will not necessarily hold in areas where there are market failures, such as a lack of competition from a monopolistic industry structure. However, even in such cases, regulation may be an alternative to public provision or the private sector may be able to play a useful role in providing aspects of the public good or service (Barry, 2002). Private sector involvement is more likely to provide efficiency gains where goods and services can be well specified, where quality can be measured and where the service requirement is likely to be relatively stable over time. Section 3.3.2 explores the empirical evidence on the extent to which these types of initiatives have increased efficiency.

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