Public Sector Economics

Explaining Government Behavior

Positive and Normative Interact

• The optimal policy may have to account for political reactions – SSA chairman: “a program for the poor is a poor program” – merit goods and tax incidence – government size and tax reform – Social Security reform • political reactions to a policy probably depend on its efficiency consequences

Approaches to Positive Political Economy (not mutually exclusive) • constitutional • instrumental rational voting • probabilistic voting • wealth maximization • social welfare maximizing • interest group competition • degrees of competition for public office • “irrational” • demand model

The Microeconomics of Voting • macro questions to be answered – does voting affect policy?

– does voting serve the purpose of aggregating preferences or information?

– is voting instrumental? or, • expressive voting?

• advertising/vote buying?

• separate political preferences?

• unanimity vs. majority rule • properties of majority rule • alternative voting rules • the voting paradox

Three Tenets of Formal Voting Theory

• voting mutes preference intensity • voting equalizes the distribution of political power • policies are sensitive to the form of “the game”

Equal Distribution of Political Power Illustrated: the NIT coalition

• NIT: constant marginal tax rate with negative intercept (i.e., guaranteed minimum income

r

).

T r

• what does the median person think about raising the NIT rate?

– (i) pays

y dt m

– (ii) suffers dwc – (iii) transfer increases by • Empirically, mean income always exceeds median, so the founding fathers (ignoring (ii)) were concerned that there was no limit to the median person’s preference for redistribution

dr



ydt

•

m

is an index of the intensity of that preference • Meltzer-Richard: (ii) is second order at

r

= 0, but there exists a large enough

r

so that dwcs cancel the mean median gap • [Meltzer Richard missing a couple of things … more later]

What Does “Economic Theory” say about the Characteristics of Public Policy in Democracies?

• skewness or inequality should increase redistribution.

– rejected by Peltzman, Benabou, Perotti – accepted by studies of Swiss localities • democracies will have different public policies than dictatorships – rejected by Easterly & Rebelo, Jackman, Lott (health), Mulligan-Gil-Sala-i-Martin – accepted by Lott (education) • form of the “game” matters • participation matters – Lott & Kenny 1998 – what determines participation?

• intensity of preference doesn’t matter

Reject Formal Voting Theory’s Three Tenets?

• preference intensity can be expressed in the public sector – voter turnout – log-rolling, vote-trading – voting buying – political advertising – lobbying – noncompliance – migration – riots, coups • voting does not equalize the distribution of political power. e.g., U.S. median voter has

more

than the mean income • policies are not sensitive to the form of “the game” – voting does not occur in an institutional vacuum. Institutions arise to alleviate the inefficiencies of voting processes (Wittman) – voting is not instrumental

Is Voting Rational or Instrumental?

• “voter’s paradox” – the probability of going to the polls and affecting the outcome is similar to the probability of being killed in a car crash on the way to or from the polls – voting or not cannot be primary motivated in terms of affecting election outcomes – once at the polls, might voting for one candidate or another be explained in terms of affecting the outcome ?

• rational voters would: – be influenced more by advertising than in private affairs?

– be influenced more by misinformation than in private affairs?

– conform more than in private affairs (even though voting is “secret”!)?

– all of the above are most applicable in large elections – respond to costs and benefits that are

unrelated to the outcome

. eg., travel costs

Wealth Maximization and the Theory of Institutional Response

• “democratic markets are organized to promote wealth maximizing outcomes” – democratically determined policies are always efficient? or – institutions respond to mitigate their inefficiencies • “wealth maximization”/Kaldor-Hicks efficiency defined – no one can be made better off, even with an appropriate set of lump sum taxes and transfers – almost tautological unless transactions and decision costs are ignored – example: regulating monopolies

Wealth Maximizing Institutional Response – Examples

• voter information • political opportunism, deriving from finite political lives, and alleviated by political parties – use of committee assignments to align party and member interests – facilitate vote trading – publicizing opposing party’s opportunism • excessive localism by Congress – parties again

Olson’s bandits

• tax revenue = 

t y

( 

t

 1 ) • the efficiency loss of redistribution is limited when governments are stable – eg., stable dictator – eg., stable democratic majority • a stable government limits taxation in order to keep the tax base sufficiently large

Internationally Common Features of OA Public Pensions

• SS spending dominates government budgets, • SS redistributes from young to old, even when the elderly consume as much or more than do the young, • Benefits increase with lifetime earnings and are hardly means-tested, • benefit formulas induce retirement, especially in the countries with the largest SS budgets, • elderly’s net income nears or exceeds nonelderly’s, and • similar public pension programs emerge and grow under very different political regime

Efficiency Theories of Social Security

• Social Security as risk sharing – risk of out-living one’s assets – risk of labor productivity shock – risk work disutility shock • Correcting retirement market failure • Preventing frugal people from being exploited by the prodigal • Economize on administration costs • Generational transfers as a side effect of intergenerational human capital investment • Chain letters in dynamically inefficient economies