Public Sector Pay in Spatial Equilibrium

In many countries, pay in the public sector is much less correlated to the local cost of living than wages in the private sector, leading to frequent calls for reform. This paper studies public pay reform using a general equilibrium spatial model. We introduce a public sector with market power in an otherwise standard spatial equilibrium framework. The model rationalizes several features in the French data, most prominently the dominant place of the public sector in the labor market and its similar relative size across local labor markets. We emphasize the tradeoffs between allowing governments to freely choose local public employment and wages (as in most of the US public sector), versus imposing rules that constrain public sector pay with some indexation to the local cost of living (as in many European countries). We show that wage indexation limits monopsony power --leading to a larger public sector-- but also imposes costs on private sector workers through higher taxes and distortions to labor allocation. We estimate our model using French data and show that, in the French context, greater wage flexibility in the public sector would lead to positive welfare gains, heterogenous across locations and types of workers.