Political economy Government growth

1. Political economyGovernment growth Today: How do people vote in a democracy? Why did the government grow so much in the 20th century?

2. Democracy • Political decision making is important for public finance • Two types of democracy in this “mini-lecture” • Direct • Indirect, or representative

3. Direct democracy • There are different ways to make decisions in a direct democracy • Unanimity, especially of public goods purchases • Lindahl prices • Majority voting rules • Possible cycling with three or more choices • Median voter theorem • Arrow’s impossibility theorem

4. Unanimity with public goods • Suppose there are two people trying to find the efficient level of public goods purchases • Each person could decide on a quantity to purchase • Free-rider problem • Each person could decide on a quantity to purchase, given what fraction he or she would pay • The share paid is known as a Lindahl price

5. Direct democracy: Unanimity rules 0’ DrE Eve’s share (SE) Notice that by construction of graph, shares add up to one at each point S* Adam’s share (SA) DrA 0 r per year r* The Lindahl Model

6. Feasibility of unanimity rules • Reaching equilibrium • Time and negotiation costs are usually very high when many people are involved • Strategic behavior • One person could react to how he or she thinks the other will behave • Strategic behavior can prevent efficient results from occurring

7. Majority voting rules • Majority voting relies on all voters having single-peaked preferences • With single-peaked preferences… • The person with median preferences can essentially make the decision (under certain conditions) • Trading votes may or may not increase welfare • Programs that lower overall welfare are known as “pork”

8. Jen: Double-peaked preferences Single-peaked preferences Utility Jen Double-peaked preferences Brad Angelina Missiles B C A

9. Preferences • When at least one person does not have single-peaked preferences, we can get cycling • Cycling occurs when no clear winner can be established

10. Each person has single-peaked preferences here Brad’s peak is at A Jen’s peak is at C Angelina’s peak is at B A vs. B: B wins A vs. C: C wins B vs. C: B wins B is the clear winner Single-peaked preferences

11. This example is different from the previous one Jen now has double-peaked preferences A and C are both peaks We now get cycling A vs. B: A wins A vs. C: C wins B vs. C: B wins No clear winner This inconsistency is part of a voting paradox Back to Jen’s two peaks This example is the same as in the graph a few slides ago

12. Agenda manipulation: Someone can decide on the order of votes to get her or his first choice Suppose Angelina decides the order of votes to get her most-desired choice First, A vs. C: C wins Second, B vs. C: B wins B is implemented Suppose Angelina is in charge

13. The median voter theorem • When preferences of each person are single peaked, we can assign a “median voter” • Relative to the median voter • Half of the people want more • Half of the people want less • Under certain conditions, the median voter’s preferences will be approved

14. The median voter theorem Median voter theorem predicts that $1,100 will be voted on

15. Six reasonable criteria for decision making • Kenneth Arrow studied six criteria that many people would consider “ethically acceptable” • Unfortunately, there is no guarantee that all six criteria can be followed • This proof is known as Arrow’s Impossibility Theorem • What are the six criteria? Kenneth Arrow, 2004

16. The six criteria that Arrow proposed • It can produce a decision whatever the configuration of voters' preferences • No problems due to multipeaked preferences • It must be able to rank all possible outcomes • It must be responsive to individuals’ preferences • Example: If everyone prefers A to B, then society does too • Preferences must be transitive • If A is at least as good as B, and B is at least as good as C, then A is at least as good as C • Independence of irrelevant alternatives • Relative rankings of two goods do not depend on a third good • Dictatorship ruled out • Social welfare is a function of more than one person

17. Representative democracy • In a representative democracy, a subset of the population votes to determine who our elected politicians are • Median voter theorem applies here also, assuming single-dimensional rankings and exactly two candidates • Ideology, personality, and leadership abilities of the politician may matter to voters • If no candidate appeals to a voter he or she may not vote

18. 0 Median voter theorem in one dimension Number of Voters If a candidate takes position S, the opponent can take the median voter stance and get a majority of the votes Liberal Conservative Median voter S

19. Implications of the median voter model • Based on the median voter model… • Two-party systems tend to be stable • Replacement of direct referenda by representative system has no effect on outcomes

20. Logrolling • Logrolling is the act of politicians trading votes in order to pass legislation that is beneficial to their district • Some logrolling improves welfare • Some logrolling does not improve welfare • An example • Suppose that Waldo, Xavier, and Zach each live in a different congressional district • Note that this example uses a different approach than in the book

21. Logrolling • In each case, Waldo, Xavier, and Zach’s representatives can get together to try to pass each other’s projects • If all three projects are passed together, Waldo, Xavier, and Zach are each better off • Whether or not the logrolling leads to welfare improvements depends on the cost to others

22. Welfare-improving logrolling

23. Bring on the pork

24. Public employees • Public employees fulfill legislated mandates and operate many government operatives • Bureaucrats sometimes have interpretive power • Red tape criticism • Unresponsive to reasonable requests • No market-oriented incentives • Some bureaucrats want to maximize the size of their departments • Niskanen’s model of bureaucracy

25. Niskanen’s model of bureaucracy C $ V Bureaucrat’s suggested output Efficientoutput 0 Q* Qbc Q per year

26. What can the politician do? • A politician can change the quantity to Q* if he or she knows what Q* is • Sometimes, only the bureaucrat knows what Q* is • Make bureaucrats’ pay dependent on quality of work • Requires costly oversight • Hire bureaucrats that are reliable in determining what Q* is • Probably difficult

27. Special interests • “Special interests” has become a politically-charged term in today’s political arena • What are some special interest groups? • Labor groups • Groups that favor the rich, poor, young, or old • Groups that favor tax breaks for an industry • Groups that want to enhance social and religious goals • Rent-seeking behavior • Attempts for a firm to have positive economic profits

28. Rent-seeking behavior $ Cartel price and quantity Deadweight loss with a cartel Rents Competitive outcome S=MC D tons of peanuts per year MR

29. Other people involved • Other people help to carve the political landscape • Judges have control to enforce and interpret laws • Media influence • Providing information • Political leanings • Experts • Former politicians • Example: Al Gore

30. Summary: Democracy • Democracies can be direct or indirect • Both types of democracies have their own sets of problems • Direct democracies • Time consuming to people • Cycling • Arrow’s Impossibility Theorem • Indirect democracies • Bureaucrats • Special interests

31. Growth of government spending • Many western countries have had significant growth in government spending since 1900 • How is this growth justified? • Many theories examined • No single theory fully explains the growth • Can government growth be controlled?

32. Explaining Government Growth • Five theories of government growth • Citizen preferences • Marxist view • Chance events • Changes in social attitudes • Income redistribution

33. Citizen preferences • Take the median voter’s preferences of public sector goods and services • G = f(P, I) • G represents the median voter’s demand for public sector goods and services • P is the relative price of public sector goods and services • I is income

34. Citizen preferences • Assume median voter theorem is true • When income increases, if income elasticity of demand is greater than one for the median voter, increased public services would be provided • Growth of the middle class may explain why government spending has grown so much • This theory predicts that voters get what they want

35. Marxist view • A Marxist model would argue that the private sector overproduces • Government must expand expenditures to correct this • Worker discontent is curbed by social service spending • Some argue that this is not sustainable, since expenditures will eventually outpace tax revenue capacity • See Figure 18.6, p. 423, for more on tax revenue capacity

36. Government shocks • Chance events lead to shocks on the government • These shocks require the government to increase spending substantially • Examples: The Great Depression; the world wars; the financial crisis of 2008-’09 • Inertia  increased spending sticks • Special interest groups try to make sure that “their” spending does not go away

37. Changes in social attitudes • Are people making bigger demands on government? • Maybe • Due to median voter theorem? • Costs and benefits may also be incorrectly perceived by the public

38. Income redistribution • Two views • Government grows to help low-income voters • Some politicians can promise redistribution to median income and below • Incomes above the median get taxed to pay for income redistribution • Government grows to help the middle class • Appeals to voters near median income • With this view, the upper- and lower-income classes pay for the benefit of the middle class

39. Controlling government growth • Some people believe that government is not too big • Others disagree • If the government is too big, how can we make it smaller? • Change bureaucratic incentives • Change fiscal institutions • Institute constitutional limitations

40. Recall Niskanen’s model of bureaucracy Bureaucrat often worries about size of department, not what is efficient Financial incentives for cost-cutting could backfire, however Q could be below Q* Private provision may be more efficient Change bureaucratic incentives

41. Change fiscal institutions • Is the budget-making process undisciplined? • Many people believe so • Congress-imposed solution: Budget Enforcement Act (BEA) of 1990 • Spending and revenue targets are set • The cap can be exceeded when an elaborate set of parliamentary rules are followed • Problems with BEA • Some “emergency” spending is known in advance • 2000 census

42. Institute constitutional limits • If Congress cannot regulate its own spending, should there be a constitutional amendment that does limit spending? • Most economists believe “no”

43. Why not to impose constitutional limits • Revenue and spending is usually uncertain until it happens • If tax revenue was overestimated, severe spending cuts would have to occur mid-year • Spending could be forced on states instead • States could be mandated to provide part of Social Security • What would the consequences be if Congress circumvents the law? • Judicially-imposed budget? • Will Congress members be punished?

44. Outcome of government spending • Estimated public debt in 2010 • $9.9 trillion (up $2 trillion from 2009) • 67.1% of GDP (up 12.5 percentage points from 2009) Source: Wikipedia article on US public debt

45. Summary: Growth of gov’t spending • Although political models have appeal on government spending, they do not fully explain how governments behave • Many people believe that government spending needs more control • BEA and current incentive structure ineffective • No constitutional amendment for balanced budget • Probably goes too far

46. Problems • Lindahl model • Majority voting • Median voter theorem • Efficient government spending

47. Lindahl problem • Bill and Hillary have decided to be roommates in Washington DC • They decide to use Lindahl prices to determine the amount of money they will spend on a new sofa • Q represents spending on a new sofa • Bill’s share is SB = 1 – Q/500 • Hillary’s share is SH = 1 – Q/400 • Also note that SB + SH = 1

48. Lindahl problem • How do you solve this? • 3 equations • 3 unknowns • Plug in first two equations into the third equation • (1 – Q/500) + (1 – Q/400) = 1 • (1 – 4Q/2000) + (1 – 5Q/2000) = 1 • 2 – 9Q/2000 = 1 • 1 = 9Q/2000 • Q = 2000/9 = 222.22

49. Majority voting problem • 5 members on a city council • 4 options: A, B, C, D • Assume each member will vote no unless specified below • Frank: Will only vote in favor of A • Genevieve: Will vote in favor of B; will vote for A if B is defeated first • Holly: Will definitely vote in favor of B or C if either is voted on; will vote for A if B and C are both defeated first • Ivan: Will definitely vote in favor of A or D if either is voted on; will vote for B if A and D are defeated first • Jacqueline: Will definitely vote in favor of C and D if either is voted on

50. Majority voting problem • Which projects have a chance?