Privatization has become the corner-stone of economic policy in many advanced economies and those in transition to the market. It usually aims to enhance long-run efficiency and thus welfare, but in some countries it is explicitly or implicitly associated with managing public deficits and the public debt. In Discussion Paper No. 831, Research Fellows Nicos Christodoulakis and Yannis Katsoulacos develop a theoretical model to relate privatization to public finance in which the optimal level of asset sales is endogenous. They examine the extent to which privatization proceeds can reduce taxes or retire public debt both by financing the public deficit directly and by financing public investment in infrastructure, which reduces costs for the economy as a whole. In the latter case, the government gains as the deficits of remaining state firms fall and the proceeds from taxing private profits and employment both increase.

Christodoulakis and Katsoulacos show that whether or not taxes can be reduced or public debt retired in each case (and if so to what extent) and the optimal level of privatization depend on various interacting factors including the initial levels of public debt and unemployment, the quality of infrastructure, the potential scope of privatization, the rates of corporate tax and unemployment benefit. Factors determining the effects of privatization on employment and efficiency and the size of the expected revenues also play a role; these include the market structures in which state firms operate, the extent of their inefficiency and their objectives.

Using privatization proceeds for infrastructure investment is often associated with a lower rate of income tax or a greater optimal number of privatizations. This becomes more likely if investment in infrastructure reduces firms' costs more sharply (as when its initial quality is low), the scale of privatization or the employment gains generated by investment in infrastructure are larger, and the market structure is more concentrated. Since these are exactly the circumstances that now characterize the Central and East European countries, the authors propose that their policy-makers devote greater attention to opportunities to invest privatization revenues in public works.

Privatization, Public Deficit Finance, and Investment in Infrastructure
Nicos M Christodoulakis and Yannis Katsoulacos

Discussion Paper No. 831, September 1993 (AM)