Macro-industrial policy: Is the public procurement system an effective policy tool?

Governments play central roles in modern economies: they set taxes, provide subsidies, and produce services with a high social value, such as education, health, and safety. Along that production process, governments use intermediate goods and services produced by private sector firms that they buy through public procurement. These purchases are sizable, ranging between 10 and 20 percent of GDP. Because of its size and high level of discretion, governments often perceive their procurement system as an effective industrial policy tool to allocate resources to specific firms.

"Buy small" policies in procurement are widespread worldwide

Many governments have policies that promote the participation of small businesses in their procurement systems. In the U.S., for example, “set-aside” measures “ensure that a fair proportion of federal contracts is awarded to small businesses” (see a recent Congressional Research Service report), while similar policies exist in India and Brazil. The rationale for supporting small businesses relates to the presumption that these businesses may be constrained. Selling to the government has the potential to help them overcome these constraints and, therefore, improve their performance.

Are these policies powerful enough to affect the macroeconomy?

However, we know very little about either the effectiveness of these policies or the extent to which they may generate unintended consequences. Therefore, we know little about their net impact on the macroeconomy. In recent work (with Julian di Giovanni, Priit Jeenas, Enrique Moral-Benito, and Josep Pijoan-Mas), we quantify the macroeconomic impact of promoting the participation of small firms in procurement. In particular, we ask: How would the level of aggregate output, total factor productivity, and provision of public goods be affected if governments allocated more procurement toward small firms while keeping total expenditure fixed? 

Isolating a specific channel: Selling to the government may increase firms’ access to credit

We focus on a particular channel through which buying from small firms can positively affect the macroeconomy: in a context where small firms are financially constrained, becoming government suppliers may help them increase their borrowing capacity and improve their economic performance. Our analysis delivers three main results:

1. These policies help small firms grow and overcome financial constraints. The high pledgeability of procurement contracts increases firms' borrowing capacity, which translates into more profits, higher capital accumulation, and even more future borrowing capacity. Therefore, promoting the participation of small firms in procurement has the potential to increase countries' GDP by reinforcing the self-financing channel emphasized in the literature.
2. These policies generate an unintended consequence related to the change in capital accumulation incentives of relatively big firms (those for which the expected probability of receiving procurement contracts decreases). In an economy where receiving a procurement contract is less likely, big firms lose incentives to accumulate “precautionary capital,” that is, capital allowing them to “be ready to deliver” if they obtain a procurement contract. Therefore, promoting small firms' participation in procurement can also decrease countries' GDP by eliminating big firms' growth incentives.
3. These policies generate another unintended consequence related to the government’s efficiency in producing public goods: by buying relatively more from the pool of small firms, the government also buys from firms that are fundamentally less productive and thus charge higher prices. Under a constant government expenditure, this phenomenon inevitably translates into a higher price index paid by the government and a lower provision of public goods. 

Context matters

Our findings imply that the overall net effect of promoting small firms' participation in procurement depends on the relative size of the three above-mentioned channels. In particular, our analysis suggests that targeting small firms in procurement will be particularly GDP-enhancing when two conditions are satisfied. First, these policies will be effective only if financial frictions are severe enough. In an economy where financial frictions are not the main factor explaining firm size, targeting small firms will reallocate resources towards firms that are small because they are unproductive. Second, if financial frictions are severe enough, targeting small firms will be particularly effective if the pledgeability of government contracts is high. That is a situation in which lenders perceive government contracts as solid collateral against which firms can borrow. In that respect, the government's reputation (for example, low default rates or early payments) is crucial in making these policies effective.

Our analysis thus calls for caution when designing and implementing procurement policies that affect the allocation of resources across firms. At the same time, however, it shows that governments have a powerful tool in their procurement system to affect their macroeconomy positively. 

The future of public procurement: going beyond efficiency

Although much more work remains, our analysis suggests that the effectiveness of government procurement may go beyond efficiency.  For example, government procurement may be an effective tool to promote socioeconomic inclusion. In the context of the U.S., for instance, recent evidence shows that “set-asides”' policies for service-disabled veteran-owned businesses successfully improved outcomes for the target population without imposing significant costs on the government. Finally, more research is needed to analyze the potential effectiveness of the rising green procurement policies in accelerating the global green transition.