On the Optimal Size of Public Employment

A public job can be seen as a source of insurance against income risk. Indeed, many public employees have job stability, which is compounded with a less volatile and more compressed wage distribution. Hence, by increasing its number of public employees, the government enhances the overall degree of insurance in the economy. In this paper, we introduce public employment in a standard incomplete markets model with overlapping generations. The aim is to explore the welfare gains or losses due to a larger government, accounting for this extra source of insurance. In a model economy calibrated to Brazil, we find that if the government relies on consumption taxes to balance its budget, the optimal size of public employment is nearly flat, ranging from 10 to 24 percent of the workforce. However, if the public employment is reduced from 22 to 10 percent, welfare losses due to a reduction in the degree of insurance are 4.5 percent, which are compensated by welfare gains due to level and inequality effects. Finally, if the wage distribution becomes even less volatile and more compressed, social welfare decreases.