Matt Yglesias writes a somewhat confused blog posting about "The Trouble With Contracting." He opines that governments are less efficient than the private sector. He lays the blame on just one aspect of the private sector: that badly run companies go out of business. Then he notes that when governments buy their services through badly run companies, they don't necessarily go out of business.
He is totally missing the reason why badly run companies go out of business. They fail because other companies out-compete them. Competition is what you get when multiple vendors try to cooperate with the customer more than anyone else.
If, as Matt suggests, companies are not chosen to maximize cooperation, then buying services through contractors is not likely to be any more efficient. He's quite right even though he doesn't understand why he's right.
But the real problem is not whether governments hire employees, or hire contractors. The real problem is when governments hire anybody. Governments don't have the flexibility to provide many different levels of service to different groups.
Compare, for example, restaurants to schools. Restaurants are subject to very little government control. They have to find an acceptable location if the community restricts business locations via zoning. They have to maintain certain standards of cleanliness and food preparation. Other than that, they can sell anything anytime anywhere in any quantity and combination to any customers. Schools have one curriculum for all students in a single grade. All students are expected to learn all material at the same rate at the same age at the same time of day. A tiny bit of flexibility is provided for special education students -- but even then the goal would be for them to learn the standard curriculum (aka mainstreaming).
School choice will have very little affect on any of this (or so I predict). "He who pays the piper calls the tune." Initially parents will be able to choose from a substantial range of schooling. Over time, taxpayers will rebel against, say, pagan schooling, or math-only schooling, or athletic schooling, and more and more restrictions will be placed on them.
That, in a nutshell, is the case against government provision of services. The private sector might be more efficient, but efficiency isn't really the goal. The goal is for everyone to get what they want, not for everyone to get what everyone wants. A free market provides the first; governments provide the second.