There is an increasing interest in public-private partnerships (PPPs) around the world.2 In a typical

Public-private partnerships (PPPs) have become increasingly popular in recent years. We show that for these arrangements to be desirable from a public finance point of view, private firmsmust be productivelymore efficient than the public sector. In particular, PPPs are not a means to save on distortionary taxation. We also characterize the contract that trades off optimally demand risk, user-fee distortions and the opportu-nity cost of public funds, under the assumption that the private sector is more efficient. The private firm is fully insured against demand risk in the case of large and small projects, but bears risk for projects of intermediate size. For small projects, no subsidies are required and the optimal contract length is demand contingent. By con-trast, demand contingent subsidies are handed out in every state of demand for large projects and the contract lasts indefinitely. For projects of intermediate size the optimal contract involves a “minimum income guarantee” and states where the contract lasts indefinitely coexist with those where it is finite—the private firm collects more revenue in the latter than in the former. For large and small projects the optimal contract can be implemented with an auction where the bidding variable is the present value of use fee revenue. Having firms bid on the lowest subsidy in this case is not only suboptimal, but also leads to a subsidy that is higher, on average, than the one obtained under the optimal auction. Finally, a bidding variable different from the present value of user fee revenue is needed to implement the optimal contract for intermediate size projects