Public, or private, providers of public goods? A dynamic general equilibrium study

Abstract

We study the differences between public production and public finance of public goods in a dynamic general equilibrium model. Under public production, public goods are produced by the government. Under public finance, the same amount of public goods is produced by cost-minimizing private providers with the government financing their costs. When the model is solved numerically using fiscal data from the UK, a switch from public production to public finance has substantial aggregate and distributional implications. Public providers cannot beat private providers, in terms of productive efficiency, even if they both act as cost minimizers. The following mix of reforms is found to be Pareto improving: (i) a transition to cost-minimizing private providers that allows the government to achieve efficiency savings, (ii) a reduction in distorting income taxes made affordable by these efficiency savings, and (iii) a mechanism to compensate the ex public employees. All these results hold if private producers use a more capital intensive production technology than public producers, or, even in the case in which they use the same technology, if capital is a relatively important productive factor quantitatively.