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Does public sector employment distort the private sector?

    Yes. That’s the conclusion of an excellent new paper published by Giulia Faggio and Henry Overman for the Spatial Economics Research Centre at the LSE.

    Using data on employment for English Local Authorities, they find that in the short-run increased public sector employment in an area – though increasing employment overall – changes the composition of employment in the private sector away from manufacturing towards services. In the long-run, they find the negative effect of manufacturing stronger and the positive effect on service industries weaker, meaning that public sector employment crowds out private sector employment overall.

    As Overman makes clear in his blog, this makes sense. If a new public sector job is created in an area, the extra money may generate additional new jobs in local shops or for local construction firms, which could increase employment even further overall. But this is likely to be offset somewhat by the effect of this new employment on local wages and prices. In other words, some private sector jobs are likely to be displaced or crowded out from other areas in the economy, because (for example) of the distortionary effects of pay differentials between the different sectors or the need to fund the new public sector jobs through higher taxes. And we’d expect this to be more significant over time.

    The numbers that they’ve generated via regression analysis suggest that in the short-run every additional public sector job creates another 0.5 jobs in local construction or services but crowds out 0.4 jobs in manufacturing. Public sector employment therefore does increase total employment but changes the composition. But over a longer time period, every job created crowds out jobs in the manufacturing sector but leaves service employment and total employment unchanged.

    These findings raise a number of issues which are particularly important as the impact of public sector spending cuts in different areas is discussed.

    First, it challenges the wisdom of those who feel that public sector employment should be used to increase employment in depressed areas of the economy – in the long term, the results suggest there is no beneficial effect on employment.

    Second, it raises the possibility that large public sectors in certain areas may have hastened the decline of any manufacturing that the area may have previously enjoyed, because of the displacement and crowding effects.

    Third, given that the displacement and crowding out effects are likely to be more significant where pay differentials between the public and private sector are large, the government must persevere with the policy of localised public sector pay bargaining. This is particularly true if the government’s aim is to rebalance the economy towards manufactured tradables.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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