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Government procurement and macroeconomic outcomes

Whether the allocation of public procurement contracts should target small firms is the subject of active policy debate. This column uses firm-level evidence and a macroeconomic model to show that granting public procurement contracts to small firms may help them accumulate assets and overcome their financial constraints in the long run, but the reallocation of projects may damage the saving incentives of larger firms. Specific details on how procurement policies are implemented at the firm level are crucial for understanding their macroeconomic impact.

Governments may shape the long-run economic performance of countries through the implementation of policies that affect aggregate productivity and output. Some examples are credit subsidies to state-owned enterprises (Song et al. 2011), the reservation of goods for small firms (Garcıa-Santana and Pijoan-Mas 2014), labour market regulations (Garicano et al. 2016), and trade tariffs (Berthou et al. 2019). However, one of the most important roles governments plays in modern economies, as buyers of goods and services from private sector firms, has been overlooked.

Public procurement as a macroeconomic policy tool

Government purchases are made by awarding public procurement contracts to private firms. These contracts account for a significant fraction of aggregate output – 12.8% of GDP in the OECD countries, 14% in EU countries, and 9.3% in the US – and governments enjoy a high level of discretion in their allocation (see Bandiera et al. 2021 or Bossio et al. 2020 for a discussion on the merits of rules versus discretion in procurement). In the case of high-income countries, there seems to be a recent trend towards designing procurement systems that promote the participation of small firms. In the US, for example, the Small Business Act aims to “ensure that a fair proportion of federal contracts is awarded to small business”. Similarly, in the EU, promoting the participation of small firms is at the core of the European Commission’s agenda for public procurement regulation. 

Yet, little is known about how the procedure of awarding public procurement contracts to private firms may affect the macroeconomy. A recent paper by Cox et al. (2020) investigates the cyclical implications of government procurement. In a recent paper (di Giovanni et al. 2022), we instead study the long-run effects of public procurement on firm outcomes and the macroeconomy. In particular, we show that expenditure-neutral reforms that grant procurement contracts to small firms – either by directly targeting smaller firms or by slicing large contracts into smaller ones – help these firms grow and overcome financial constraints in the long run, but the aggregate effects can reduce output.

Public procurement and firm dynamics

We use a novel dataset that merges administrative data on public procurement, credit allocation at the bank-firm level, and firm outcomes for the Spanish economy over the 2000-2013 period. We show evidence consistent with the hypotheses that procurement contracts (a) provide useful collateral for firms – and more so than sales to the private sector; and (b) facilitate firm growth beyond the duration of the granted procurement contract. 

Some previous papers have looked at the effects of procurement on several firm outcomes (e.g. Ferraz et al. 2015, Hebous and Zimmermann 2021, Lee 2021). Our empirical evidence contains a host of novel results pertaining to the impact of procurement on credit supply. We show that the increase in credit after winning a procurement contract is larger for firms that are more likely to be financially constrained, comes exclusively from credit that is not backed by tangible collateral, and is associated with an increase in the acceptance of loan applications. Furthermore, we show that firms’ credit increases with procurement revenues when controlling for total revenues, providing evidence of the extra pledgeability of procurement contracts. In terms of real variables, we show that procurement decreases firms’ sales in the private sector on impact (a short-run negative within-firm spillover, see Figure 1a) but increases them afterwards as firms accumulate capital (a long-run positive within-firm spillover, see Figure 1b). 

Figure 1a Procurement and sales in the private sector 

 

            

Figure 1b Procurement and fixed assets

 

A macroeconomic model with public procurement

To assess the interplay between procurement and the macroeconomy, we build a model of firm dynamics with financial frictions and a government that buys goods and services from private firms. We calibrate our model to capture the most relevant aspects of firms’ selection into procurement and the treatment effects after it, as well as some aggregate moments of the Spanish economy.

A key finding is that changing the procurement allocation system in how firms are treated can have important macroeconomic implications. Specifically, we show that promoting the participation of small firms significantly affects capital accumulation and aggregate productivity in the long run. These results follow from the interaction of several economic channels, which the model allows us to identify.

  • First, we find that total factor productivity (TFP) in the private sector increases because there is an improvement in the allocation of resources across firms within that sector. By targeting small firms, the counterfactual procurement allocation system also allows relatively more constrained firms to participate in procurement, which facilitates their asset accumulation in the long run and diminishes capital misallocation across firms.
  • Second, we find that TFP in the procurement sector declines. By targeting small firms, the new allocation system will inevitably allocate procurement contracts to relatively less productive firms, which will manifest in a reduction of productivity with which public goods are produced.
  • And third, we find that the effect on aggregate capital accumulation is ambiguous. On the one hand, as already mentioned, relatively small firms will accumulate more assets in the new steady state, which will push up the amount of capital in the economy. On the other hand, savings incentives for medium/large firms will be lower under the alternative allocation system. In our model, one of the reasons why relatively large firms accumulate assets is the fact that they want to minimise the probability of being constrained in case they obtain a large procurement contract in the future. In counterfactual economies in which large firms are less likely to obtain a contract or/and the size of the contracts is smaller, the incentives for these precautionary savings decrease, which pushes down aggregate capital accumulation.

A key mechanism

Our empirical evidence shows that the short-run effect of obtaining a procurement contract is to decrease sales in the private sector, while in the long run private sector sales increase as firms accumulate assets. We argue that this short-run negative spillover is the result of asset-based borrowing constraints: in the short run, the amount of physical collateral is fixed, and it has to be split between the private sector and public sector sales. We show that the quantitative importance of this negative spillover depends on the extent to which government contracts can be used as collateral. Specifically, in economies where government contracts are poor collateral compared to revenues from the private sector, the arrival of a procurement project for a small firm generates a larger negative spillover of production in the private sector. This results in larger long-run output losses when reforming the procurement allocation procedures in favour of small firms.

Conclusions

Our results show that the actual sign and size of the effects of public procurement reforms on capital accumulation and aggregate output crucially depend on two factors. 

  • First, the specific way in which the promotion of small firms in procurement is implemented matters. We find that a counterfactual allocation system that facilitates the participation of small firms by decreasing the size of contracts are more detrimental than policies that directly target small firms in the allocation system. Therefore, policies aimed at helping small firms may consist of actions to improve transparency and increase publicity of procurement processes or to provide technical and financial support for preparing applications. 
  • Second, as discussed above, the extent to which government contracts can be used as collateral limits the negative effects of these reforms. Hence, targeting small firms in procurement in low-income countries, where governments tend to be characterized by low levels of credibility or/and solvency, may be particularly damaging for the macroeconomy.

References

Bandiera, O,  E Bosio, G Spagnolo (2021), “Discretion, efficiency, and abuse in public procurement: A new eBook”, VoxEU.org, November.

Berthou, A, J H Chung, K Manova and C Sandoz (2019), “Trade, Productivity, and (Mis)allocation”, CEPR Discussion Paper 14203.

Bosio, E, S Djankov, E Glaeser and A Shleifer (2020), “Public Procurement in Law and Practice”, NBER Working Paper 27188.

Cox, L, J Gernot, J Muller, E Pasten, R Schoenle and M Weber (2020), “Big G”, NBER Working Paper 27034.

Ferraz, C, F Finan and D Szerman (2015), “Procuring Firm Growth: The Effects of Government Purchases on Firm Dynamics”, NBER Working Paper 21219.

Garcıa-Santana, M and J Pijoan-Mas (2014), “The Reservation Laws in India and the Misallocation of Production Factors”, Journal of Monetary Economics 66: 193-209.

Garicano, L, L Lelarge and J V Reenen (2016), “Firm Size Distortions and the Productivity Distribution: Evidence from France”, American Economic Review 106: 11.

Hebous, S and T Zimmermann (2021), “Can government demand stimulate private investment? Evidence from U.S. federal procurement,” Journal of Monetary Economics 118 (1): 178–194.

Lee, M (2021), “Government Purchases and Firm Growth”, available at SSRN.

Song, S, S Storesletten and F Zilibotti (2011), “Growing like China”, American Economic Review 101: 196–233.