Public Sector Crowds Out the Private Sector

Public Sector Crowds Out the Private Sector

December 20, 2011 Posted by J. Scott Moody - 3 Comments

Shockingly, the Maine Center for Economic Policy (MECEP) thinks that my recent study–showing Maine would lose more than 6,400 jobs if taxes are raised to cover the $121 million DHHS shortfall (pdf)–is “flawed out of the gate.” That’s an interesting conclusion coming from an organization that has “economic” in its title but doesn’t have a single economist on staff . . . hhhmmm.

At any rate, their rebuttal clearly shows that they didn’t even bother to read the study or the years worth of studies and blogs I’ve done showing the clear relationship between the size of a state’s private sector (as a percent of personal income) and the overall economic well-being of the state’s citizens.

Of course, higher taxes are part of the equation and, in this case, it doesn’t matter what taxes are increased. Taking an average of $215 per household out of the private sector will, obviously, reduce private sector activity through the very “multiplier effect” they discuss in their own study–except it’s on the tax side. What MECEP fails to mention is that their 4,464 jobs that would be saved with restored DHHS funding is really just a shift of jobs from the private to the public sector.

However, the story goes much deeper than that because those higher taxes are going to fund higher government spending. Government spending crowds out private sector in the competition for scarce labor and capital. Just ask any small business owner who has to compete with government pay scales. This transfer of private sector resources to the public sector lowers long-run economic growth.  This is not just conjecture, but an empirical observation.

To illustrate this effect, I recently came across this blog from the good folks at the Mercatus Center which shows that government grants crowd out private charity:

Extensive research has found that government provision of charitable services tends to crowd out private charity.

In a pair of papers, for example, Andreoni and Payne found that when U.S. charities receive an extra $1,000 in government grants, they tend to receive about $750 less in other donations (20032011). That is, public charity crowds out about 75 percent of private charity.

It appears that the effect cannot be explained by individuals giving less. Instead, it appears that charities themselves tend to reduce their fundraising when they receive more government money.

In a new paper, Andreoni and Payne exploit a more detailed Canadian dataset to delve deeper into the question. They find that crowding-out exceeds 100 percent. Of this, “77 percent can be attributed to reduced fundraising by the charities.”

Imagine that, people work less when something is given to them for “free.” MECEP may be familiar with this phenomenon since they receive government grants themselves.