Service Outsourcing and Government Fiscal Conditions: Do Market Competition, Bureaucrat Support, and Management Capacity Matter?

• Published date: 01 August 2024
• DOI: http://doi.org/10.1177/02750740241232678
• Author: Wenchi Wei,Xin Chen
• Date: 01 August 2024
• Subject Matter: Articles

Service Outsourcing and Government

Fiscal Conditions: Do Market

Competition, Bureaucrat Support,

and Management Capacity Matter?

Wenchi Wei

1

and Xin Chen

2

Abstract

Scholars have long regarded government f‌iscal stress as a crucial factor driving public service outsourcing; however, further

investigation is still needed to determine whether service outsourcing in turn helps governments improve f‌iscal conditions.

Public choice theory suggests that outsourcing services can lead to eff‌iciency improvement and cost savings. Nevertheless,

transaction costs theory implies that the costs associated with service outsourcing may offset or even outweigh its potential

benef‌its. Moreover, the extent of transaction costs depends on contextual factors such as market competition, bureaucrat

support, and government management capacity. Empirically, we employ an instrumental variable estimation approach to exam-

ine the impact of service outsourcing on the budget balances and debt levels of U.S. municipalities. We f‌ind that service out-

sourcing improves government f‌iscal conditions, with contextual factors playing an important role in moderating this effect.

Additionally, outsourcing services to different types of contractors has varying implications for government f‌iscal conditions.

Keywords

public service outsourcing, f‌iscal conditions, instrumental variable estimation

Introduction

Outsourcing public services to external entities constitutes an

essential alternative approach to public production and has

been one of the dominant themes addressed by public adminis-

tration and management scholars over recent decades (Boyne,

1998a, 1998b; Brown & Potoski, 2003a; Elkomy et al.,

2019). Advocates for service outsourcing have widely pro-

claimed its potential benef‌its in terms of eff‌iciency improvement

and cost savings (Bryson et al., 2014; Mohr et al., 2010; Rho,

2013). However, the presumed benef‌its of public service out-

sourcing rely largely on prerequisitessuchasvendorcompeti-

tion, government contract management capacity, and absence

of opportunistic behaviors by bureaucrats (Feiock & Jang,

2009; Girth et al., 2012; Hefetz & Warner, 2012; Johnston &

Girth, 2012). The lack of these prerequisites generally incurs

high transaction costs in the process of service contracting

(Petersen et al., 2018). Moreover, critics of public service out-

sourcing commonly contend that the gains in eff‌iciency

improvement and cost savings should be balanced against the

losses such as heightened inequality and diminished account-

ability (Kettl, 2011).

There is much extant evidence regarding the conse-

quences of service outsourcing, which are mostly related to

cost savings and service performance (e.g., Bauer &

Johnston, 2020; Boyne, 1998a; Brudney et al., 2005;

Dahlström et al., 2018; Elkomy et al., 2019). However,

most existing empirical studies that focus on the value of

service outsourcing in terms of cost savings fail to account

for the transaction costs that are associated with contracting,

such as increased spending on bid coordination, contract

management, and performance monitoring and evaluation.

As noted by Petersen et al. (2018, p. 147), “the general

lack of measurement of transaction costs in the vast majority

of studies clearly makes a comparison of the full costs of

public and contracted out service provision diff‌icult.”A

lack of awareness of the potential transaction costs poses a

challenge to the accurate assessment of the real costs that

are associated with service outsourcing, as well as its

impact on government f‌iscal conditions. An important contri-

bution of this research is its theoretical analysis and empirical

testing on how contextual factors, such as market competi-

tion, bureaucrat support, and management capacity, shape

1

School of Public Policy and Management, Tsinghua University, Beijing, China

2

Center for Chinese Public Administration Research, School of Government,

Sun Yat-SenUniversity, Guangzhou, China

Corresponding Author:

Xin Chen, Center for Chinese Public Administration Research, School of

Government, Sun Yat-Sen University, C209A North College Building,

Guangzhou 510275, China. Email: xinchen1910@gmail.com

Article

American Review of Public Administration

2024, Vol. 54(6) 568–589

© The Author(s) 2024

Article reuse guidelines:

sagepub.com/journals-permissions

DOI: 10.1177/02750740241232678

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transaction costs in service contracting, which in turn moder-

ate the impact of service outsourcing on government f‌iscal

conditions. Notably, previous studies have taken into

account similar contextual factors when examining service

outsourcing, but they primarily focus on how such factors

inf‌luence contracting decisions (Brown & Potoski, 2003a,

2003b; Hefetz & Warner, 2004, 2012). This study shows

that these contextual factors not only shape the decisions

regarding service outsourcing but also affect the conse-

quences of contracting public services.

The second key contribution of this study pertains to

research methodology. Due to a lack of valid evidence, it is

challenging to establish a reliable causal relationship

between service outsourcing and government f‌iscal condi-

tions (Bel & Fageda, 2017). Given the challenge of disentan-

gling whether f‌iscal conditions drive contracting decisions or

are affected by the decision to contract out, the provision of

causal evidence between service outsourcing and govern-

ment f‌iscal conditions is invaluable. To address potential

endogeneity problems arising from omitted variable bias or

reverse causation, we conduct instrumental variable estima-

tion (IVE) in the empirical analysis. Our IVE results show

that service outsourcing has a positive effect on the f‌iscal

conditions of U.S. municipalities and, moreover, the contex-

tual factors examined in this study serve as important moder-

ators of this effect. Additionally, outsourcing services to

different types of contractors has varying implications for

government f‌iscal conditions.

The second section of this article brief‌ly introduces the lit-

erature on the antecedents and consequences of public

service outsourcing. The third section presents the theoretical

analyses and hypotheses. The fourth section presents the esti-

mation strategy, which is followed by the empirical results

offered in the f‌ifth section. The last section concludes with

the empirical f‌indings and discusses the potential limitations

of the study and the opportunities for future research.

Literature Review

The literature on public service outsourcing primarily focuses

on its antecedents and consequences. Regarding the former,

early studies mostly examine how cost savings, political

inf‌luence, and f‌iscal pressure can shape local government

outsourcing decisions (e.g., Alonso & Andrews, 2020;

Ferris & Graddy, 1986; Florestano & Gordon, 1980;

Morgan et al., 1988). Later empirical studies widely

employ an economic-political-f‌iscal framework for theoreti-

cal analysis and empirical tests. Bel and Fageda (2007,

2017) systemically review this body of literature and summa-

rize three broad groups of explanatory factors in local out-

sourcing decision making, including f‌iscal stress (such as

local tax burdens, budget def‌icits, and outstanding debt), eco-

nomic eff‌iciency (such as the urban status of localities, asset

specif‌icities, contract management diff‌iculty, and market

competition), and political processes and ideological

attitudes (such as local institutions, pressure from interest

groups, and the ideological attitudes of both citizens and gov-

ernment off‌icials).

Regarding the consequences of contracting out public ser-

vices, a considerable amount of scholarly attention has been

paid to the effects of service outsourcing on public sector

employees, service performance, and governments’cost

savings (e.g., Buerger & Harris, 2021; Jang & Eger, 2019;

Lee & Lee, 2020; Lee et al., 2019; Yusuf & O’Connell,

2014). First, scholars f‌ind that contracting out public services

not only leads to increasing reliance on inexperienced, short-

term, and less educated public employees but also negatively

affects public employees’working conditions, salaries, and

job satisfaction (Fernandez et al., 2007; Rho, 2013;

Vrangbæk et al., 2015; Yang & Kassekert, 2010). Second,

with regard to the effect of outsourcing on service perfor-

mance, many previous studies employ citizen satisfaction

as an indicator of service quality, f‌inding that contracting

out services exerts either a negative or nonsignif‌icant effect

on citizen satisfaction (Dahlström et al., 2018; Elkomy

et al., 2019; Prager, 1994; Thompson, 2011). Some previous

studies directly examine the effect of outsourcing on service

performance outcomes, obtaining mixed empirical f‌indings.

For instance, Rho (2013) f‌inds that contracting helps

improve students’test scores in Texas school districts.

However, Bauer and Johnston (2020) f‌ind that contracting

out the management of detention facilities to private corpora-

tions leads to worse conf‌inement conditions. Moreover,

Elkomy et al. (2019) focus on 130 National Health Service

trusts in the UK and f‌ind that contracting out cleaning ser-

vices reduces the level of cleanliness and causes more

hospital-acquired infections.

Third, a plethora of previous studies have specif‌ically

addressed the potential benef‌its of service outsourcing for

cost savings (e.g., Alonso et al., 2015; Boyne, 1998a;

Petersen et al., 2018). Scholars compare the costs of in-house

productionand those of contractingout for a variety of services,

generally resulting in mixed or inconsistent f‌indings (e.g., Bel

et al., 2010; Elkomy et al., 2019; Petersen et al., 2018;

Thompson, 2011). Boyne (1998a) reviews more than 20

studies assessing the consequences of service contracting,

f‌inding that the outsourcing of public services generally leads

to lower expenditures and higher eff‌iciency. However, a

recent comprehensive review by Petersen et al. (2018) shows

that the magnitude of cost-saving effects ranges from a reduc-

tion of 45% to an increase of 18.3%.

As mentioned above, previous studies on the conse-

quences of public service outsourcing are generally limited

by a failure to account for and empirically test the contextual

factors that may modify the results of service outsourcing and

a lack of appropriate attention given to endogeneity problems

in empirical estimations. This present research contributes to

the literature by applying IVE to examine the effect of service

outsourcing on government f‌iscal conditions and how several

key contextual factors can moderate this effect.

Wei and Chen 569