(Mis)Allocation Effects of an Overpaid Public Sector

In an economy in which the public sector is productive and factor inputs are rewarded according to their marginal productivity in both the public and the private sectors, the presence of a large government does not generate necessarily any allocation problem. When the provision of public infrastructure is below its optimal scale, then an increase in the size of the government can lead to an increase in total factor productivity (TFP). There is, however, a large body of evidence showing that for many countries the structure of wages and pensions and the labor law legislation are different for public and private employees. Such differences affect the occupational decision of agents and might generate some type of misallocation in the economy. We develop an equilibrium model with endogenous occupational choice, heterogeneous agents and imperfect enforcement to study the implications of an overpaid public sector. The model is estimated to be consistent with micro and macro evidence for Brazil and our counterfactual exercises show that public-private earnings premium can generate important allocation effects and sizeable productivity losses.