# **1 Introduction**

Governments play a key role in economic activity. They are large employers, they set taxes and transfers, and they purchase goods and services from the private sector. These purchases are done by awarding _public procurement contracts_ to private firms. The size of public procurement varies over time and across countries, but it consistently represents a large fraction of GDP —12.8% in the OECD countries, 14% in EU countries, and 9.3% in the United States.<sup>1</sup> Because of its large size and high level of discretion, many governments use the public procurement process to allocate resources to specific firms. In the U.S., for example, the Small Business Act aims to “ensure that a fair proportion of federal contracts is awarded to small business”.<sup>2</sup> Similarly, in the EU, promoting the participation of small firms is at the core of the European Commission’s agenda for public procurement regulation.<sup>3</sup> A common justification for these policies is that small firms may face demand or financial constraints, preventing them from reaching their full potential and hence negatively affecting aggregate economic outcomes. Given the wide presence of these types of policies worldwide, it is surprising how little we know about their macroeconomic impact. This paper aims to fill this gap by asking if it is possible to achieve better aggregate outcomes when changing the composition of firms from which governments buy their goods and services.

Our research question is the following: how would the level of aggregate output, TFP, and provision of public goods be affected if governments change the composition of firms from which they buy while keeping total expenditure fixed? In order to address this question, we carry out an analysis that integrates a novel firm-level dataset with a macroeconomic model of firm dynamics. Our dataset 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. Our model builds on the canonical framework of firm dynamics with financial frictions (e.g., Midrigan and Xu, 2014) and incorporates two novel elements. First, there is a government that purchases goods and services from private sector firms. Firms that are willing to sell to the government must make a risky investment in advance, which reflects the costs of preparing a good proposal and increasing the chances to win the contract. Second, we allow for earnings-based borrowing constraints where the pleadgeability of firms’ earnings from procurement may differ from that from selling to the private sector.<sup>4</sup> And third, we allow for the pleadgeability of firms’ earnings from procurement to differ

> 1See EU Commission’s web and OECD for details.

> 2See Report from Congressional Research Service for details. Policies promoting small firms’ participation in public procurement are widely spread worldwide. Some other examples are Australia and Brazil.

> 3See the Public Sector Directive 2014/24/EU for details. There has been strong support from the European Parliament for explicit regulation that discriminates in favor of small firms: “From this House, we must insist that...administrative bodies incorporate terms into their tender specifications that facilitate positive discrimination in favor of SMEs and remove contractual provisions that hinder their participation.” See EU Parliament Debate.

> 4Other recent papers that embed earning-based borrowing constraints into macro models are Drechsel (2023), Brooks and Dovis (2020), and Li (2022). The importance of earning-based borrowing constraint is also supported by direct evidence, see Lian and Ma (2020).

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