The interdependencies between the private and public sectors in open economies

Empirical evidence shows that countries with larger public sectors also have larger trade shares, also for the manufacturing sector, and a larger share of firms that export. We reconcile these links between the public and private sector in an analytically tractable general equilibrium model. We derive two-way causal relations between size (and composition) of the public sector and openness and industry structure of the private sector. First, an increase in public sector size or a shift in public expenditures toward public employment (away from transfers) increases openness of the private sector (trade share and fraction of firms exporting), and is also associated with higher average productivity, lower average unit labour costs, and improved wage competitiveness and terms of trade. These outcomes are driven by endogenous entry and selection of firms. A quantitative exercise reveals substantial quantitative differences in the effects from public sector reforms between the open and closed economy. Second, international spillovers imply that non-cooperative policies have an upward bias in the overall size of the public sector, but a downward bias in transfers as a share of public expenditures. Trade liberalization and the degree of firm heterogeneity magnify these biases and thereby shape the size and composition of the public sector.