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Government and economic growth: Does size matter?

3.3  Evidence on public sector productivity

As well as the potential ‘crowding-out' effects of government expenditure, government provision of goods and services, as a big share of the economy, will directly affect productivity and economic growth. This section reviews the evidence of the potential drivers of weaker productivity growth - the inherent nature of public goods and services (Baumol's disease) and/or the existence of stronger incentives for the private sector to be efficient (see section 2.2).

3.3.1  Baumol’s disease

Section 2.2 suggested that some government services might be susceptible to Baumol's disease, suffering greater cost pressures and lower productivity growth than other parts of the economy. However, this is contentious. In particular, the theory assumes that the public sector has taken as much advantage of innovations as possible to boost productivity. If instead the public sector has been comparatively inefficient, then it could lift its productivity growth over the short-term by making best use of existing technologies and processes. In particular, some parts of the private sector service sector, notably those associated with financial intermediation, communications and ICT, grew as fast as other parts of the economy over the late 1990s and first half of the 2000s, as ICT technology transformed these areas.

These situations, however, seem to be exceptions to the general rule that the service sector is inherently constrained in its productivity growth. Recent empirical studies support the general applicability of Baumol's disease in the US (Nordhaus, 2008) and in the European Union (Hartwig, 2010). If Baumol's disease is accepted, then either the nominal share of public services in GDP will tend to increase over time or we would expect the real supply of public services to fall relative to other areas of economic activity. The cost pressure challenges, however, reinforce the importance of ensuring that our state sector institutions and processes encourage an ongoing focus on productivity improvements to maintain service levels while holding debt to sustainable levels (see Savings Working Group, 2011).

3.3.2  Private sector provision of public services

As well as the inherent nature of public services, section 2.2 outlined reasons why the private sector may be relatively more efficient. This proposition has led to a range of initiatives for increasing the private sector role in providing public goods and services, from privatisation to private-public partnerships to outsourcing specific elements of the production process. This section looks at the evidence around whether these initiatives have brought efficiency gains.

The privatisation literature includes a weight of evidence supporting the proposition that privatisations undertaken around the world have brought about a significant increase in the profitability, real output and efficiency of privatised companies (see, for example, OECD, 2003 and World Bank, 2004). Privatisation has led to better quality goods and services, improved competition, more rational pricing, efficient staffing levels, and fiscal gains for governments through lower subsidies to state enterprises. It is possible that some of these gains could have been achieved through lifting public sector performance, such as increasing competition (see section 2.2). The benefits of privatisation also vary depending on the nature of the business. While the empirical evidence on efficiency gains from privatisation is not as strong for natural monopolies, the benefits are particularly robust when the firm operates in a competitive market (OECD, 2003 and Shirley and Walsh, 2000). Building from this weight of evidence, the Treasury has recently argued that reducing public ownership of Crown-owned commercial companies would be beneficial for economic growth (Treasury, 2010c).

The evidence suggests that privatisation is more likely to boost productivity in areas without significant market failures or where market failures can be managed through regulation. However, even when privatisation is not an option, there may be innovation or efficiency benefits from some degree of private sector provision or contestability through mechanisms such as outsourcing or public-private partnerships (PPPs)/public finance initiatives (PFIs). The Savings Working Group (2011) emphasises the use of better practices, systems and technology from elsewhere, to produce more value, more efficiently. Empirical evidence of the success of these types of initiatives is mixed, perhaps partly reflecting methodological challenges. However, there is support for efficiency gains. For example, in a review of the evidence relating to contracting out and outsourcing, Hodges (1996) found that while the evidence on cost savings from outsourcing is not unanimous, the weight of evidence supports cost savings. Grout (2008) points to a number of studies that show efficiency savings from outsourcing but recognises that the experience with PFIs or PPPs has varied across sectors. Gains from involving the private sector vary dependent on: the ability to contractually define and measure service outputs and outcomes; the ability to genuinely transfer risk from public to private sectors, and to incentivise performance (including penalising poor performance); and the level of competition to provide such services. However, where the public sector is not operating at the efficiency frontier, and has made little progress over time in improving efficiency or outcomes, introducing contestability can generate productivity gains.

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