public employment and taxes

More recently, one study looking at metropolitan statistical areas (MSAs) in the US, finds that high public sector wages are connected with increased sensitivity of MSAs to aggregate shocks, while a high rate of public sector employment is associated with a decreased sensitivity. This holds for the private sector and the economy as a whole. The study also finds that high public sector wages are associated with high private sector wages and that a high rate of public sector employment is associated with lower private sector wages. This evidence mostly confirms previous findings but also sheds more light on the complex effects of the public sector on the generic economy. In particular, the authors stress that while higher public sector wages are always associated with crowding out and higher employment volatility in the private sector, the size of the public sector relative to total employment, at least in the US case, is associated with lower volatility and lower wages in the private sector.

The main source of competition between the private and public sectors is the connected wage rate. The rules adopted by the public sector to determine the compensation of public employees are crucial in deciding the overall effects of public employment. When the wage gap in favour of public employees is relatively small and wages react to productivity quickly enough, the public sector generates only “mild” competition and the crowding out effects are small.

The study also takes into account the equilibrium or balancing, effect between the private and public sectors, as a result of the resources collected from the private sector directly supporting the additional expenses of the public sector. A large public sector drains more resources, in the form of taxes, from private sector households which, as a result, have less disposable income. This leads households to supply more labour and to accept a lower wage for a job, which in turn leads to reduced volatility and lower wages, as well as a positive effect of public sector employment on the private sector. However, higher wage gaps between public and private sectors, and rigid wages, in particular, can reverse the effect of a bigger public sector on private sector employment.

It is important to note that this “equilibrium effect” holds only for as long as the resources collected through taxes are collected predominantly within the same market as where the effect is measured. This is the case for the US, for instance, where most of the public sector employment is state or city employment, and the corresponding taxes are collected within those jurisdictions. For other countries, especially in Europe, taxes are generally collected at the national level, even when public employees are not evenly distributed across the country. In this case, in addition to higher public employment, the result can be a redistribution of resources, which may then lead to a different type of equilibrium that includes higher wages for the private sector. For example, one study shows that higher local public sector employment leads to higher wages in the UK and, at the same time, to a higher demand for goods and services produced by the non-tradable sector. Another study shows that the uniform tax system in Italy exacerbates the crowding-out effects of public employment in the weaker regional area of Italy.


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