Does the private sector pay for the public sector?

Whitehall, in central London
Tbmurray, CC BY 3.0, via Wikimedia Commons

A common talking point: it is the private sector that actually pays for the public sector, and hence all public services ultimately. This argument is heard so often on the right, and considered such a truism, that it is never questioned by the right itself. The pro public sector side, of course, pushes back on this suggestion. Which side you pick is likely based on where your sympathies lie.

I’d like to explore this question, putting aside political biases.

The Argument

The argument typically goes as follows:

  • The Private Sector proponent says: Public sector workers are paid from the treasury which is in turn funded by the taxpayer. The gross pay the public sector worker receives is obviously more than what they then pay back in tax themselves. Therefore the tax they pay back is merely an accounting formality. As this is true of all public sector workers, someone else must be paying the wages of the public sector in the first place, and this must therefore be someone outside of this system. i.e all the private sector taxpayers.
  • The Public Sector side responds with “What are you talking about? If you look at my payslip I’m paying just the same tax rate as the equivalent private sector worker.”
  • Yes, says the Private Sector proponent, it may look like that, but that is just the accounting ruse done to make you feel better about it. If we net it all off then we can clearly see that we are paying for you. What you paid in taxes was paid by us to you in the first place. Therefore, we pay all the taxes ultimately, the public sector is entirely dependent on the private sector!

This is pretty much the extent of the debate, which then ends at this point with impasse. People might mention the relative efficiencies of the public and private sectors. But this is a distraction from the original question. Private Sector proponents of the argument do not say “because the public sector is less efficient, the private sector is paying proportionately more for it.” Their argument is a simple mathematical one applicable regardless of efficiency. The answer can also be complicated by infinite money tree ideas such as ‘MMT’ – that actually no one is paying the tax, it’s just a magical property of the system. We’ll largely step over these complicating points.

What is wrong with some of the assumptions being made by those in favour of the proposition that the private sector pays for the public sector? I’ll try and answer this through some economic analysis.

Interestingly, the Private Sector proponents of the argument have adopted a typically left-wing Keynesian framing of the economics involved, and, to complete the irony, the Public Sector side has adopted something of a right-wing Austrian microeconomics analysis in their response! Let me explain.

The Problems with the Circular Flow of Income Model

One feature of Keynesianism is that it always wants to create macro economic entities and then analyse these through flows of money. eg. All of the public sector, all of the private sector. This is essentially the basis of Keynesianism – categorising the entire economy and analysing these categories through aggregate equations. This approach largely focuses economics on the circular flow of income model – because money is a homogeneous unit that enables mathematical calculation. What this model misses is the concept of time – goods and services do not magically appear when money flows from one place to another, and it ignores the complexity of factors of production being non-homogeneous but also substitutable. (These last two sentences basically destroy Keynesian economics completely, but this is a topic for another day).

The inevitable consequence of this framing is a centrally managed economy driven by government spending. Proponents of our private sector argument may think that by recognising that the government must get its money from taxpayers means that they are recognising the economic reality and not falling into the pro-public sector mindset of the Keynesians. But – and this is the crucial point – they are still thinking about the problem in macro, aggregate and money flow terms and answering the question “who pays” with this model as the assumption. However, economic reality is not as simple as this model implies. This is the insight that makes Classical and Austrian economics far superior to Keynesianism as I will come on to explain. Ironically, it is the Public Sector side, who in this case, are adopting more of a classical/micro economic analysis by pointing out the economic reality on individual workers.

Say’s Law

This brings us to Say’s Law which provides the theoretical counter argument to Keynesianism. Say’s Law is the understanding that supply of economic goods creates the demand for them. Another way of looking at this is that economics starts with supply – with producing things – and this in turn enables people to buy goods and services from each other by trading these things in the broader economy. Under this model, rather than income and expenditure being seen as the focal point, money is seen more as ‘a veil’ laid over the real tangible economic activity. (Say’s Law addresses the things missing from the Keynesian model that I mentioned earlier – time and the fact that factors of production are non homogeneous.) Under Say’s Law, there is never an excess or shortage of demand in aggregate – as Keynesians like to think – because demand is merely the flip side of supply. The easiest way to understand this is to think of a small barter economy on an island where people are making different things that they trade with each other. You could airdrop bags of money onto the island but the production of actual things must always precede demand at a fundamental level. And each thing produced – if it has any value – creates an outlet for further supply and demand in the economy. In order to have demand you must produce supply, unless you receive charity or a government uses taxation to effectively transfer someone’s supply over to you.

If we apply this alternative way of thinking about economics to our original question, we may start to see the flaws in the premises of the original argument. Money ‘accounting’ allows you to make certain statements which appear grammatically correct and therefore true, but this in turn allows you to make mistakes. But the reality of economic production and consumption, as understood through Say’s Law – what you are really paying in terms of production and what you are really getting in terms of enabled consumption – are what matter.

A simple example will demonstrate this. Let us imagine a nurse working 45 hours in a week in the public sector earning £1000. And consider an equivalent nurse in the private sector with the same hours and pay. Both are taxed £300 or the equivalent to 15 hours of their output measured in time. This taxation reduces their effective demand, or ability to consume in the rest of the economy by the equivalent of 15 hours of their output. Both are producing the same, consuming the same, and foregoing the same in terms of taxation. Thinking that the public sector nurse’s pay came from the taxpayer puts the money ahead of the output she produced, and how much she gets to keep, which is what matters. You can play with the words about where the money comes from all you like, the economic reality is as I’ve outlined. You can then theoretically scale these concepts up to the entire economy.

Of course, if the public sector nurse is sat at the nurse station vending machine all day and doing no work but still getting paid, whilst the private sector nurse is providing a valuable service, then this changes matters. And you can even go so far as to say that the original argument is true to the extent that such an inequality of productivity exists between the public and private sectors in this respect. If the entire public sector provided zero output but still got paid then yes, effectively the private sector would be paying for the public sector (and getting nothing for it). This is Say’s Law of supply applied and you can see why it is so obviously correct. In comparison, Keynes had no problem with workers digging pointless holes and filling them back in.

The answer then to our original question is that all taxpayers pay for public services. You can at an aggregate level assign public or private sector labels to all these workers and then add it all up if you want to compare the totals but this is largely meaningless to the question at hand.

Finally, a debate can of course be had about the relative sizes of the public and private sectors. Whether a very large public sector and an ever more weakened private sector is actually sustainable given the failures of socialism and communism. But again, that is a somewhat different debate.

© JimmySP 2024