Chapter 9 Political Economy Jonathan Gruber Public Finance

Introduction n In the real world, it is not always easy for the government to maximize welfare. n Politicians have considerations other than getting to the socially efficient level or conducting cost-benefit analyses in order to approve a project. Instead, such economic decisions are made in the context of a political system. n For example, a 2004 spending bill contained many projects of dubious value. $200 million was allocated to build one bridge in Alaska that would connect a small town with an island that housed 50 residents and the area’s airport (offering 6 flights a day). The crossing is now made by a ferry and takes 5 minutes. n Alaska’s representative, Republican Don Young, chairman of the Transportation and Infrastructure Committee, said “This is the time to take advantage of the position I’m in …”

Introduction n This lesson focuses on the fourth question of public finance: Why do governments do what they do? n We start by discussing the “best case scenario” in which government appropriately measures and aggregates the preferences of its citizens in deciding what projects to undertake.

Introduction n Then we examine both direct democracy and representative democracy. n Finally, we examine government failure, the inability (or unwillingness) of government to appropriately address market failures.

UNANIMOUS CONSENT ON PUBLIC GOODS LEVELS: Lindahl Pricing n Ideally, the government could provide public goods through unanimous consent of its citizens. n Lindahl pricing is a system where individuals report their willingness-to-pay for each quantity of the public good, and the government aggregates preferences to form a measure of the social benefit.

Lindahl Pricing n To illustrate Lindahl’s procedure, imagine that the public good in question is fireworks for two people (Ava and Jack). n First, the government announces tax prices for the public good, that is, the share of the cost that each individual must bear.

Lindahl Pricing n When a tax price is arrived at where both individuals want the same amount of the public good, the government has reached Lindahl equilibrium. n The government produces the public good at that level, and finances it by charging each person their tax price.

Lindahl Pricing n Each person announces how much of the public good he or she wants at those tax prices. n If the individual announcements differ, the government raises the tax price for the person who wants more of the good, and lowers it for the person who wants less. n Figure 1 illustrates this scenario.

Willingness to pay Adding up their individual demands curves vertically Jack’s surplus is this areademand. gives the aggregate While Jack’s Ava’s demand curve for $4 fireworksisisfairlysteep. flat. $3 $2 DJACK SMB=DAVA+JACK The And Thissocially agenerates With pricethis efficient of 25¢ marginal a tax for level price Ava cost, isof in 75 it is Ava’s surplus is this area 75¢ Lindahl socially for Jack units. equilibrium. beneficial in Lindahl to produce equilibrium. the good. S=SMC $1 $0. 75 DAVA $0. 25 0 Figure 1 25 50 Lindahl pricing 75 100 Fireworks

Lindahl Pricing n Fireworks production of 75 units is equilibrium for two reasons. n First, both Ava and Jack are happy to pay those tax prices to get that quantity. n Second, the government has covered the marginal cost of producing the fireworks by charging each person their marginal willingness-to-pay.

Lindahl Pricing n Lindahl pricing corresponds to the concept of benefit taxation, which occurs when individuals are being taxed for a public good according to their valuation of the benefit they receive. n With Lindahl pricing, the government does not need to know the utility functions of individual voters: it gets the voters to reveal their preferences by stating their willingness to pay for different levels of the public good.

Problems with Lindahl Pricing n Lindahl pricing is unlikely to work in practice, however. Preference revelation problem: Individuals may behave strategically, and pretend their willingness to pay is low in order to get others to bear a larger cost of the public good. n Preference knowledge problem: It is hard for people to properly value goods they do not shop for on a regular basis. n Preference aggregation problem: Aggregating millions of voters’ preferences is difficult in reality. n

MECHANISMS FOR AGGREGATING INDIVIDUAL PREFERENCES n This section discusses how voting can serve to aggregate individual preferences into a social decision. n For now, we focus on direct democracy, whereby voters directly cast ballots in favor of or in opposition to particular public projects.

n o i at c i pl p A Direct democracy in the United States n Direct democracy was very prominent in the news in 2003, when the citizens of California voted to replace their governor, Gray Davis, with Arnold Schwarzenegger in a recall election. n A recall election is a special election initiated by citizens with the goal of replacing a sitting official. n Only one sitting governor had been removed before. 18 states allow the recall of state officials, and 36 allow recall of local officials. n About 5, 000 recall elections have been held in the U. S. , with nearly half resulting in the removal of an elected official.

n o i at c i pl p A Direct democracy in the United States n Two other ways in which voters participate in direct democracy are through referendum and voter initiative. n n A referendum is a measure placed on the ballot by the government allowing citizens to vote on state laws or constitutional amendments that have already been passed by the state legislature. A voter initiative is the placement of legislation on the ballot by citizens. n For example, on October 5, 2003 (two days before he was recalled), Gray Davis signed a health insurance mandate on employers. In a referendum on the November 2004 ballot– Proposition 72–California voters narrowly overturned this law by a 51% to 49% margin.

Majority Voting: When It Works n The Lindahl pricing scheme had a very high standard for coming to a consensus: only when citizens were unanimously in agreement did the government achieve Lindahl equilibrium. n A common mechanism used to aggregate individual votes into a social decision is majority voting, in which individual policy options are put to a vote, and the option that receives the majority of votes is chosen.

Majority Voting: When It Works n Majority voting does not always provide a consistent means of aggregating preferences. n To be consistent, an aggregation mechanism must satisfy three goals: n n n Dominance: If one choice is preferred by all voters, then the aggregation mechanism much be such that this choice is made by society. Transitivity: Choices must satisfy this mathematical property. Independence of Irrelevant Alternatives: The introduction of a third choice does not change the ranking of the first two choices.

Majority Voting: When It Works n It turns out that with these three conditions, majority voting can only produce a consistent aggregation of individual preferences if preferences are restricted to take a certain form. n This is best illustrated with some examples. n Table 1 shows a case when majority voting works.

A town is deciding on education taxes (and Consider pair-wise voting: High Since Medium High vs Medium: has vs Low: beaten Parents both spending). There are 3 possibilities: high, High vs Low, High vs Table 1 Hand vote and Young L, for M H, is 3 vote Elderly the for overall & M, medium, and low spending. There also Their Finally, preferences the “young are couples” for medium do Medium, Medium winner Young Elderly Youngand in vote this for case. M. L. vs groups, represented in equal proportions. Majority voting delivers a consistent outcome the preferences the The preferences of While parents are not spending, haveofkids then andlow, do then not want high. to M Low. 2 -1. L wins 2 -1. elderly are exactlypay opposite. for high spending, then medium high taxes right now. Types of voters spending, then low spending. Preference Parents Elders Young rankings Couples First H L M Second M M L Third L H H

Majority Voting: When It Doesn’t Work n Table 2 shows a different scenario, where majority voting does not work.

Table 2 Majority voting AThus, towntheir is again deciding on education taxes Private Assuming parents, that ordering first doesn’t and is low, happen, foremost, then however, high, want then low High There High Medium This vs Hmmm Low: no violates Medium: vs clear Low: Only … the winner. “public Only Consider pair-wise voting: (andsospending). The high elderly have been taxes private they parents can medium. want afford to sent quality theirpublic kids to Young private transitivity parents” L is preferred Marrieds parents vote assumption for vote to 2 H, L, H. vs. L for so High vs Low, High replaced with “private parents. ” The other private education. schools. and HM, isleads M so preferred wins H wins to 2 -1. cycling. to 2 -1. M. vs Medium, and Medium groupsaare the same as before. doesn’t deliver consistent outcome M is preferred Low. to L. Types of voters Preference rankings Parents Private Parents Young Couples First H L M Second M H L Third L M H

Majority Voting: When It Doesn’t Work n This set of outcomes is problematic because there is no clear winner. These results violate the principle of transitivity resulting in cycling–when majority voting does not deliver a consistent aggregation of individual preferences. n Note that the failure to get a consistent winner from majority voting does not reflect a failure on the part of individuals–each group has a sensible set of preferences. n The problem is aggregation–we are unable to use voting to aggregate these individual preferences into a consistent social outcome.

Majority Voting: When It Doesn’t Work n This creates the problem of the agenda setter, the person who decides the sequencing of the votes. n In the second situation, he can affect the outcome. For low spending to win, for example, first set up a vote between H and M. H wins. Then a vote between L and H means L will win. n Any outcome can with appropriate ordering. n

Arrow’s Impossibility Theorem n In fact, there is no voting system that will produce a consistent outcome here. n Arrow’s Impossibility Theorem states that there is no social decision (voting) rule that converts individual preferences into a consistent aggregate function without either restricting preferences or imposing a dictatorship.

Restricting Preferences to Solve the Impossibility Theorem n One way to solve this problem is to restrict preferences to “single-peaked” preferences. A “peak” in preferences is a point that is preferred to all its immediate neighbors. Utility falls in any direction away from this point. n Multi-peaked preferences means that utility may first rise, then fall, then rise again. n n If preferences are single peaked, majority voting will yield a consistent outcome. n We can visualize our earlier examples. See Figure 2. 2

(a) (b) Utility Elders Young marrieds Private parents Parents Young marrieds Public parents M H Private Their utility parents goesare in indifferent either direction in the second from case. M. And young marrieds The elderly are single peaked at are single “M”. peaked at “L”. L Figure 2 Parents are single peaked at “H”. H M Voting rules School spending L School spending

Restricting Preferences to Solve the Impossibility Theorem n The failure of these preferences for the “private parents” in this second case is what leads to the inability of majority voting to consistently aggregate preferences. n Fortunately, single-peakedness is a reasonable assumption in most cases.

Median Voter Theory n When preferences are single-peaked, then majority voting will deliver a consistent aggregation of preferences of the individual voters. n Even stronger, the median voter theorem states that majority voting will yield the outcome preferred by the median voter if preferences are single peaked. n The median voter is the voter whose tastes are in the middle of the set of voters, so an equal number of other voters prefer more and prefer less of the public good.

Potential Inefficiency of the Median Voter Outcome n Thus, the voting would suggest that the government only needs to find the preferences of the median voter, and implement that level of public goods. n This does not account for intensity of preferences, however, so it does not follow that the social marginal benefits equal the social marginal cost. n For example, if small numbers of individuals derive enormous benefits from the public good, this should be accounted for in the total social marginal benefits.

Potential Inefficiency of the Median Voter Outcome n For example, imagine that there are 1, 001 voters in a town, who are considering building a monument that costs $40, 040 ($40/person). n Assume all 1, 001 voters have single-peaked preferences, so the median voter will determine the outcome. n If 500 citizens value the monument at $100 each, and the other 501 value it at $0, then the social marginal benefit is $50, 000, far greater than the cost. However, the monument doesn’t get built.

REPRESENTATIVE DEMOCRACY: Vote-Maximizing Politicians n In reality, voters elect representatives, who are supposed to aggregate their preferences and take them into account when they vote on the appropriate level of public goods. n If politicians care about maximizing the number of votes they get, they choose the outcome preferred by the median voter.

Vote-Maximizing Politicians n The public good in question is defense; the key question is what fraction of the budget (0% to 50%) should be spent on defense? Voters are uniformly distributed on this continuum. n Two politicians, John and George, are running for office and vying to maximize their votes. n Figure 3 illustrates this.

In this case, the John is trying to appeal to Figure 3 candidates split the vote. While George chooses a those who don’t want much higher level of equally. much defense, so he defense, G 1. places himself at J. 1 Voters for John Voters for George By But doing nowso imagine he gets that the (a) Defense John majority changes of the hisvotes. position spending to J. 2 J G 50% 0% 25% 1 1 Voters for George By. Indoing response, so, George now Defense lowers gets ahis majority position ofto the G 2. spending G 1 50% votes. Voters for John (b) 0% J 2 Voters for John (c) 0% J 2 Voters for John (d) 0% 25% Voters for George This process will continue until the median voter’s G 2 are arrived at. 25% preferences 50% Defense spending Voters for George J 3 = G 3 = 25% 50% Defense spending

Assumptions of the Median Voter Model n The median voter model is a powerful tool, but relies on a number of assumptions worth mentioning: n Single-dimensional voting: Voters only care about one issue. n Only two candidates: With a 3 rd candidate, there is no stable equilibrium. n No ideology or influence: Assumes politicians only care about votes, not ideological positions. n No selective voting: All citizens actually vote. n No money as a tool of influence. n Perfect information along three dimensions: voter knowledge of the issues, politician knowledge of the issues, and politician knowledge of voter preferences.

Lobbying n The issues of money and information make it likely that elected officials will be lobbied by highly interested and informed subgroups. n Lobbying is the expending of resources by certain individuals or groups in an attempt to influence a politician.

Lobbying n Lobbyists can: n Inform politicians n Reward politicians n The problem with lobbying arises when an issue benefits a small group and imposes small costs on a larger (perhaps even a majority) group. n In this case, politicians might support socially inefficient positions.

Lobbying n The key point to remember is that large groups of people with small individual interest on an issue suffer from a free rider problem in trying to organize politically. n Small groups with large interest overcome the free -rider problem.

n o i at Farm c i pl p A policy in the United States n Even though only 2. 5% of workers are employed on farms, this sector receives $25 billion in direct support from the federal government. n This comes in direct subsidy payments to farmers, and price supports (guaranteed minimum prices for crops). n These subsidies costs each American household about $360 per year on average, and the average recipient of a subsidy receives $18, 000 per year.

n o i at Farm c i pl p A policy in the United States n The 2002 farm bill was estimated to cost $190 billion over the following decade. Although it motivated by preserving “family farms, ” this motivation is completely at odds with the facts. Only 8 of 400 crops are eligible for the subidy. n Subsidy increases with productions, so large farms benefit more than small farms. n Two-thirds of all subsidies accrue to 10% of recipients, most of who earn over $250, 000 per year. n

n o i at Farm c i pl p A policy in the United States n How do such expensive, and poorly targeted subsidies end up surviving? n The total cost per American family is modest ($360), and dwarfed by the enormous gain to the typical farm ($18, 000). n The small group of farms are able to effectively organize and lobby, while the much larger group of taxpayers hurt by the programs are not able to do so.

Evidence on the Median Voter Model n While the median voter model is a potentially powerful tool, does it have predictive power? n The empirical evidence is mixed. It certainly does not completely explain legislator behavior. There is strong evidence that legislators consider their own ideology, and that of their core constituency, when they vote on policies.

l a c iri nce p Em vide E Testing the median voter model n Stratmann (2000) found that redistricting, which changes the nature of the district’s median voter for largely exogenous reasons, affected the voting preferences of legislators. n He asked: When districts become more conservative through redistricting (as measured by the vote for the Republican presidential candidate in 1988 and 1992), but were represented by the same politician, did the politician start to vote more conservatively. n The answer: Yes.

l a c iri nce p Em vide E Testing the median voter model n There is also evidence that “core constituencies” matter as well. n Levitt (1996) compared two senators from the same state but different political parties. Median voter theory suggests they should take the same position on legislation, yet he found that the senators vote very differently. n n The senators vote very similarly to senators from other states who are in their party. He found that legislators care roughly equally about the median voter, voters in their own core constituencies, and the “party line. ” Yet most of the voting pattern is explained by individual ideological differences.

Cycling in Representative Democracies n An issue that arises in direct democracy, cycling, can also arise in representative democracy if legislator preferences are not single peaked. n There is some evidence that such cycling has occurred in Congress from time-to-time.

The Political Business Cycle n Another issue that arises in representative democracy is the “political business cycle. ” Pocketbook issues matter. n Bill Clinton’s mantra – “It’s the economy, stupid!” n Ray Fair has developed models relating the fraction of the vote for the incumbent to the economy’s growth rate and inflation rate. n Figure 4 shows the results.

Figure 4

The Political Business Cycle n On average, predicted share of the vote for the incumbent party is within 2. 6 percentage points of the actual vote received. n It has done a pretty good job at predicting winners in presidential elections.

The Political Business Cycle n That fact that voters respond to economic conditions close to the Presidential election has led some to posit the existence of a political business cycle, where politicians attempt to manipulate economic conditions. n Although the actual business cycle may or may not exist, it is clear that incumbents do use government powers of taxation and spending to try to win voter favor.

PUBLIC CHOICE THEORY: THE FOUNDATIONS OF GOVERNMENT FAILURE n The analysis in most of this course assumes a benign government intent on maximizing social welfare. n Public choice theory questions this assumption by noting that governments often do not behave in an ideal manner, so that traditional assumption of a benevolent social-welfare maximizing government may be inappropriate.

PUBLIC CHOICE THEORY: THE FOUNDATIONS OF GOVERNMENT FAILURE n Government failure is the inability or unwillingness of the government to act primarily in the interest of its citizens. Reasons include: Size maximizing bureaucracy n Leviathan theory n Corruption n

Size-Maximizing Bureaucracy n Niskanen (1971) developed a model of the budget maximizing bureaucrat. In this model, the bureaucrat runs an agency that has a monopoly on the government provision of some good or service. n Bureaucrat’s salary typically unrelated to efficiency. His compensation consists of salary, but also perks like the size of his office and support staff. n The larger government tries to rein in the bureaucrat.

Size-Maximizing Bureaucracy n A key question is then whether goods and services are more efficiently provided by the public or private sector. n n For most goods and services, it is abundantly clear that private provision is more efficient. In a review of the literature, Mueller (2003) finds that only 5 of 71 studies found state-owned companies outperformed their private counterparts. n For some goods, such as social services, public provision may be superior, especially when there is a market failure. n Hart, Shliefer, and Vishny (1997) compared public and private prisons. Private prisons were 10% cheaper, through lower wages to guards. The low pay led to more violence, however.

Leviathan Theory n Leviathan theory sees individual bureaucrats and the larger government as one monopolist that simply tries to maximize the size of the public sector. n This view would help explain rules that explicitly tie the government’s hands in terms of taxes and spending.

Corruption n Finally, corruption is where government officials abuse their power in order to maximize their own personal wealth or that of their associates.

n o i at c i pl p A Government Corruption n Former Illinois governor George Ryan was indicted in December 2003 for selling state contracts to his friends in exchange for cash, gifts, loans, and trips for his family. The case is still pending. n This was uncovered as part of “Operation Safe Road, ” which investigated bribes that many truck drivers had given to officials at then Secretary of State Ryan’s office to obtain a driver’s license. n At least 20 people had died in accidents involving drivers who had bribed officials for their licenses. n The investigation resulted in 70 indictments and over 60 convictions of many people who were close friends and allies of the former governor.

The Implications of Government Failure n There is clear evidence that governments fail in some instances to benevolently serve the interests of their citizens. n Can citizens “undo” these harms through actions like direct democracy? n Some evidence suggests that government failures can have long-lasting negative impacts on economic growth.

Government failures and economic growth l a c iri nce p Em vide E n Acemoglu, Johnson, and Robinson (2001) examined two sets of nations that were similar when they were colonized by European powers, yet colonization took very different forms. n n Treatment group: Nations in the Caribbean, Central America, and Africa. n The colonizers were focused solely on extracting natural resources, and not interested in setting up institutions to foster economic success. Control group: Nations in North and South America, Australia, and New Zealand. n The colonizers moved to these nations in large numbers and set up institutions to foster economic success.

l a c iri nce p Em vide E Government failures and economic growth n Why the lack of “hands-on” governing in the treatment group? n The odds of colonists dying from locally infectious disease was much higher. This exogenously affected settlement patterns of colonizers. n Despite their precolonization similarity, the treatment nations have grown much more slowly post colonization than have the control nations. n The treatment nations continue to suffer from the long-run detrimental effects of inefficient government.

Recap of Political Economy n Unanimous consent on public goods levels n Mechanisms for aggregating individual preferences n Representative democracy n Public choice theory: The foundations of government failure