In late January, the Trump administration issued a series of executive orders that paused Treasury payments to a variety of federal contractors and grantees. These orders also often cancelled contracts with NGOS and other contractors altogether. Soon afterward, we began to see countless media stories about job losses at private NGOs and for-profit federal contractors. Many were so heavily reliant on revenue from taxpayer cash that they immediately began laying off employees.
This media frenzy over these job losses has helped to highlight the immensity of the world of federal contractors and grantees. Among workers in the real private sector—i.e., not in the tax-funded sector of government contracting—many often forget that millions of Americans work for these supposedly private organizations. Some of these are explicitly for-profit and some are non-profit. Federal contractors employ more than seven million workers while there are only three million federal employees who work directly for the federal government.
Even though there are more contractors on the federal dole than federal employees, we rarely hear about them in the context of budget cuts or federal deficits. Part of the reason for this is the fact that conservatives have long pushed the idea that federal contractors, unlike federal employees, are efficient workers who deliver a valuable service.
But there’s a problem with this characterization of contractors. Economically speaking, there isn’t much daylight at all between a tax-funded “private” contractor and a federal employee who works directly for a government agency. Whether a tax-funded federal employee, or a tax-funded contractor, the economic mechanism is the same: remove wealth from the private economy via taxation, then spend that money where central planners have decided to spend it. As such, both government employees and government contractors provide goods and services in line with political decision making, and not in line with the needs of the marketplace. In this equation, there is no room for actual efficiency, freedom, or voluntary exchange.
The Economics of Government Contractors
Federal contractors often behave like any other interest group in that they use lobbyists and public relations to convince politicians to hand over taxpayer money to their tax-fueled industry. The argument often given is that when governments use private contractors, government is operating “on a business basis.” Yet, the idea that government spending can ever be done “like a business” is a fallacy. Murray Rothbard has illustrated the lie beneath this claim:
This is often the cry raised by conservatives—that government enterprise be placed on a “business footing,” that deficits be ended, etc. … This, however, is incorrect. There is a fatal flaw that permeates every conceivable scheme of government enterprise and ineluctably prevents it from rational pricing and efficient allocation of resources. Because of this flaw, government enterprise can never be operated on a “business” basis, no matter what the government’s intentions.
This fatal flaw is the fact that government spending—whether spent directly, or through some contractor or grantee, is founded on the state’s coercive tax power. This is inherently inefficient because taxed wealth redirects resources from the efficient marketplace to the government sector. The efficient thing to do is to allow property owners to use their property in a way that satisfies customers or meets the needs of investors. After all, property owners are property owners precisely because they created value in the economy by satisfying customers and investors. Government revenue, in contrast, takes wealth from these efficient market actors and places it in the hands of the political class.
The political class then takes these resources and allocates them to satisfy political interest groups and pressure groups. Sometimes this money is spent directly by the state, and sometimes it is given to government contractors, but ultimately the process does an end run around the efficient market process.
Rothbard explains how we know this is an inefficient system:
Government … can get as much money as it likes. The free market provides a “mechanism” for allocating funds for future and present consumption, for directing resources to their most value-productive uses for all the people. It thereby provides a means for businessmen to allocate resources and to price services to insure such optimum use. Government, however, has no checkrein on itself, i.e., no requirement for meeting a profit-and-loss test of valued service to consumers, to enable it to obtain funds. Private enterprise can get funds only from satisfied, valuing customers and from investors guided by profits and losses. Government can get funds literally at its own whim.
With the checkrein gone, gone also is any opportunity for government to allocate resources rationally. How can it know whether to build road A or road B, whether to “invest” in a road or a school—in fact, how much to spend for all its activities? There is no rational way that it can allocate funds or even decide how much to have. When there is a shortage of teachers or schoolrooms or police or streets, the government and its supporters have only one answer: more money. … The profit-and-loss test serves as the critical guide for directing the flow of productive resources. No such guide exists for the government, which has no rational way to decide how much money to spend, either in total, or in each specific line. The more money it spends, the more service it can supply—but where to stop?
Thus, handing over taxpayer money to government contractors is nothing at all like an actual business, and it has nothing to do with efficient market allocation. Government contractors are nothing more than an additional layer added to the tax-and-spend process.
In response to such arguments, we can already anticipate the answer. Many government contractors and their allies—especially military contractors—will say this: “you can’t just end military spending, because you have to have a military. It would be inefficient to let the Chinese conquer America.” (These people are always making absurd claims that foreign natives will storm the beaches of San Francisco if military spending is cut even a little bit.)
For the sake of argument, let’s grant that a federal military of some kind is necessary. A question then immediately presents itself: how much ought to be spent on it. On this, the advocates of government spending can never offer a rational answer. The answer is virtually always just “spend more.” Often, the answer is “a lot more.” But here we see an illustration of Rothbard’s argument. Once an enterprise is based on tax funds, what is the correct amount of spending? This can only be determined by arbitrary political means, such as lobbying, special interest campaigns, and other forms of political pressure.
Even if one says this system is a necessary evil, we would be kidding ourselves if we pretend that this system is made “efficient” by adding contractor middlemen to the mix.
The Problem of Contractor-Produced “Value”
Government contractors will often also claim that they produce value to the economy by spending money in the private economy and hiring people. A typical claim sounds something like this: “The government contractor industry consists of about 205,500 firms that generate $1.1 trillion in annual revenue.” But here’s the problem with the claim. That “$1.1 trillion in annual revenue” is not a net addition to the economy. That is revenue that resulted from firm activities funded by tax dollars. That is, the revenue only exists because the federal government first extracted tax revenues from the private economy and then handed it over to private contractors. This isn’t market-based revenue, and as such we cannot say that it is necessarily adding any real value to the economy.
A second strategy used by contractors is to claim that they add value to the economy because employees at contractor firms pay taxes. This “tax revenue” produced by contractors who pay taxes is an accounting fiction, however. Indeed, the taxes paid by government contractors are no different from taxes paid by government employees. Rothbard explains:
government bureaucrats do not pay taxes; they consume the tax proceeds. If a private citizen earning $10,000 income pays $2,000 in taxes, the bureaucrat earning $10,000 does not really pay $2,000 in taxes also; that he supposedly does is simply a bookkeeping fiction. He is actually acquiring an income of $8,000 and paying no taxes at all.
When Rothbard says “private citizen” here, he means private citizen who doesn’t earn a living from taxpayer-funded government contracts. For the same reasons government employees don’t produce real tax revenue, government contractors do not pay taxes in any meaningful sense on their contractor income.
Economics and Politics Are Not the Same Thing
So, in terms of economic efficiency, there is no real difference between government employees and government contractors. This does not mean, however, that there is no political difference. Indeed, the turn toward vast armies of “private” federal contractors was done largely for political reasons. Every now and then, politicians, in an effort to create the impression that they are in favor of fiscal restraint, will announce plans to reduce the federal workforce or spend less money on “bureaucrats.” This is usually a ruse, however, and does not result in any reductions of federal spending. We can see this in how federal spending has increased relentlessly over time.
What usually happens is that the federal government simply finds workarounds to hiring more federal workers. The federal government then spends on more contractors, or pays state and local government workers to do what the federal government wants done. This is why federal “grants-in-aid” to state and local governments is now such a large part of federal spending. This is why, in spite of the federal workforce being largely flat for the past fifty years, federal spending has only gone up. Paying federal employees directly has become politically inconvenient, so the taxpayer money goes to contractors, grantees, and state and local governments instead. It cannot be said that this system is more efficient in any economic sense, but it is a savvy trick on the part of politicians.
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