We estimate the effects of public wage expenditures on output and the labor market in U.S. data by identifying shocks to public employment and public wages using sign restrictions. Public wage shocks do not induce significant effects on output, but disaggregating by government level reveals that their effects can be contractionary at the federal level and expansionary at the state and local level. Public employment shocks are expansionary at all government levels by crowding in private consumption and increasing labor force participation and private-sector employment. Local government wage shocks lead to a similar crowd in of private consumption, while shocks to federal government wages lead to public-private wage spillovers, inducing a negative labor demand effect, a sharp fall in private-sector employment and an increase in unemployment. We develop a DSGE model with public good production, search and matching frictions, and endogenous labor force participation that matches the qualitative properties of the empirical evidence. The sign of the output response for public wage shocks depends crucially on the degree of complementarity between public and private goods in the consumption bundle.

The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.