1. CHAPTER 6
POLITICAL ECONOMY

2. Political Economy
Public decision making in public finance is complicated and not well understood.
Contrary to simple models of democracy, there appear to be forces pulling government expenditure away from levels that would preferred by the median voter.
However, critics of the budgetary process have not come up with a satisfactory alternatives.

3. Political Economy
The formulation of meaningful rules and constraints for the budgetary process, either at the constitutional or statutory level, is an important item on both the academic and political agendas for the years ahead.
It should be stressed that a judgment that the current system of public finance is inequitable or inefficient does not necessarily imply the government as an institution is “bad.”
People who like market-oriented approaches to resource allocation can nevertheless see to improve markets. The same goes for government.

4. Political Economy
Public finance in any state aims at redistributing the incomes in an ethically, desirable way. But can it do that???
Political economy determines this redistribution process of incomes taking into consideration selfishness and fairness principles.
Political economy is the product of direct democracy.
A procedure designed to elicit unanimous agreement was proposed in the early 20th century by Lindahl.

5. Lindahl Model
An obvious similarity exists between the role of tax shares in the Lindahl model and market prices in the usual theory of demand.
But there is an important difference. Instead of each individual facing the same price, each faces a personalized price per unit of public good, which depends on his or her tax share.
The tax shares are preferred to as Lindahl prices.

6. Direct Democracy-Unanimity Rules0’
DrE
Eve’s share (SE) S*
box and labels
1st click – Adam’s D
2nd click – Eve’s D
3rh click – equilibrium r and S
Adam’s share (SA)
DrA
r per year r*
The Lindahl Model

7. Feasibility of Unanimity Rules
Reaching equilibrium
Lindahl Model has two practical problems
Strategic behavior: sincere decision might not be taken by everyone
Time to reach equilibrium through election or referendum.

8. Direct Democracy-Majority Voting Rules
Majority voting rule – one more than half of the voters must favor a measure for it to be approved.
Majority decisions rules do not always yield such clear-cut results leading to voting paradox which refers to that fact that voter’s preferences are consistent while the community’s are not.
Voter
Choice
Brad
Jen
Angelina
First A C B
Second
Third

9. Direct Democracy-Majority Voting Rules
Problems of Direct Democracy-Majority Voting Rules:
Voting Paradox – community preferences can be inconsistent even though individual’s preferences are consistent.
Agenda Manipulation – process of organizing order of votes to ensure a favorable outcome.
Cycling – when paired voting on more than two possibilities goes on indefinitely without a conclusion ever being reached.
Voter
Choice
Brad
Jen
Angelina
First A C B
Second
Third

10. Graphing Preferences Single-peaked preferences Utility Jen
Double-peaked preferences
axes and labels
1st click – Brad
2nd click – Jen
3rd click – Angelina
4th click – “Single-peaked preferences” and two arrows
5th click – “Double-peaked preferences” and curved arrow
Brad
Angelina A B C
Missiles

11. Practical Importance of Double-peaked Preferences
If all voters’ preferences are single peaked, not voting paradox occurs.
But in fact, voters’ preferences are double-peaked or more.
Availability of private substitutes
Majority voting may lead to inconsistent decisions regarding the public goods if some people’s preferences are not single peaked.

12. The Median Voter
Median voter happens when the voter whose preferences lie in the middle of the set of all voter’s preferences; half the voters want more of the good than the median voter, and half want less.
The median voter theorem states that as long as all preferences are single peaked, the outcome of majority voting reflects the preferences of the median voter.
But remember, there might be two median voters, which must be broken arbitrary.

13. Direct Democracy - The Median Voter Theorem
Expenditure
Donald $5
Daisy
100
Huey
150
Dewey
160
Louie
700

14. Logrolling
Logrolling systems allow people to trade votes and hence register how strongly they feel about various issues.
However, minority gains may come at the expense of the greater general losses.

15. Direct Democracy - Logrolling I
Voter
Project
Melanie
Rhett
Scarlet
Total Net Benefits
Hospital
200
-50
-55 95
Library
-40
150
-30 80
Pool
-120
-60
400
220

16. Direct Democracy - Logrolling II
Voter
Project
Melanie
Rhett
Scarlet
Total Net Benefits
Hospital
200
-110
-105
-15
Library
-40
150
-120
-10
Pool
-270
-140
400
Melanie votes for library if Rhett votes for hospital; and Rhett and Scarlet trade votes for the pool and library

17. Direct Democracy - Arrow’s Impossibility Theorem
Arrow’s Impossibility Theorem states that, in general, it is impossible t find a decision making rule that simultaneously satisfies a number of apparently reasonable criteria.
The implication is that democracies are inherently prone to make inconsistent decisions.
Nobel Laureate Kenneth Arrow proposed that in a democratic society, a collective decision-making rule should satisfy various criteria.
Left box by 2nd level paragraphs
Right box by 2nd level paragraphs

18. Reasonable Criteria of Nobel Laureate Kenneth Arrow
Nobel Laureate Kenneth Arrow proposed that in a democratic society, a collective decision-making rule should satisfy various criteria.
Producing a decision whatever the configuration of voters’ preferences.
Ranking all possible outcomes.
Being responsive to individual preferences.
Being consistent to all individual preferences.
Being independence of irrelevant alternatives.
Not reflecting the preferences of only single individual.
Left box by 2nd level paragraphs
Right box by 2nd level paragraphs

19. Direct Democracy - Arrow’s Impossibility Theorem
“Reasonable” collective decision-making criteria
It can produce a decision whatever the configuration of voters' preferences
It must be able to rank all possible outcomes
It must be responsive to individuals’ preferences
It must be consistent
Independence of irrelevant alternatives
Dictatorship ruled out
Arrow’s Impossibility Theorem
All conceivable voting schemes have some potential for being unfair or producing a paradoxical result
Meaning of theorem
consistent rule not necessarily impossible to find, but cannot be guaranteed
Buchanan’s critique
Inconsistencies of majority voting have beneficial aspects. P#116.
Use of social welfare functions must be chosen collectively. Economists argue that the Arrow is merely a way of introducing value judgments and not representation of society’s preferences.
Left box by 2nd level paragraphs
Right box by 2nd level paragraphs

20. Representative Democracy - Elected Politicians
Explanations of government behavior require studying the interaction of elected officials, public employees, and special interest groups.
Under the restrictive assumptions, the actions of elected officials mimic the wishes of the median voter.
Left box by 2nd level paragraphs
Right box by 2nd level paragraphs

21. Representative Democracy - Elected Politicians
Representative Democracy - Elected Politicians
Number of Voters
Distribution and labels
1st click - Female politician locates on right
2nd click - Male politician locates directly to left of female
3rd click - female moves to left of male (but still to right of mean)
4th click - male politician moves just left of mean
Liberal
Conservative

22. Implications of the Median Voter Model
Two-party systems tend to be stable
Replacement of direct referenda by representative system has no effect on outcomes. Both simply mirror the preferences of the median voter.
Thus government spending cannot be “excessive” because politicians competition for votes leads to an expenditure level which is exactly in accord with median voter’s wishes.

23. Other Factors Influencing Voting
Single-dimensional rankings: If all political beliefs cannot be ranked along a single spectrum, the median voter theorem falls apart because the identity of the median voter depends on the issue being considered.
Ideology
Personality
Leadership
Decision to vote

24. Representative Democracy-Public Employees
Function of bureaucrats
Goals of bureaucrats

25. Niskanen’s Model of Bureaucracy$ V
Axes and labels
1st click – V schedule
2nd click – C schedule
3rd click – two tangents, dashed line, Q* and “Efficient Output” tag
4th click – dashed line, Qbc, “Actual output”
Actual output
Efficient output Q*
Qbc
Q per year

26. Representative Democracy – Special Interests
What are “Special Interests”
Establishment of Special Interest Groups
Source of Income: Capital or Labor
Size of Income: Rich and poor.
Source of Income: Industry of Employment
Region: Midwesterners favor agricultural subsidies while northeasterners favor the expenditure of urban development
Demographic and Personal Characteristics: The elderly favor health care while young favor good schools and lower payroll taxes.

27. Representative Democracy – Rent-Seeking$
Rents
Axes, labels, D, MR, and S=MC
1st click - rents
S=MC D
tons of peanuts per year MR

28. Representative Democracy – Other Actors
Judiciary: Court decisions on the legality of various taxes can affect public finance.
Journalists: They can bring certain issues to public attention which in turn gives press considerable influence.
Experts: Information is an important source of power. Legislation aides who gain expertise on certain programs often play important roles in drafting statues.

29. Explaining Government Growth
Citizen Preferences
Median voter’s demand of public good & services (G) is some function (f) of the relative price of public sector goods and services (P) and income (I).
G = f(P, I)
Marxist View: The private sector tends to overproduce, so the capitalist-controlled government must expand expenditure to absorb this production.
Chance Events: This includes wars and economic crisis. For example, the financial assistance given by the various government to save the crumbled business after the global financial crisis.
Changes in Social Attitudes: Increasing demand ignoring the cost of public programs.
Income Redistribution: The low income voters push governments to redistribute incomes towards them. To attract this category of voters, government find no way but to increase its expenditure.

30. Controlling Government Growth
Government growth as a non-issue
Government growth as a problem
Commitments made in the past
Basic flaws in the political system

31. Improving the Workings of the Political System
Change bureaucratic incentives
financial incentives
privatization
Change Fiscal Institutions
Budget Enforcement Act (BEA) – 1990
Balanced budget rules at the state level
Institute Constitutional Limitations
Balanced budget amendment

32. Provisions of a Typical Balanced Budget Amendment
Congress must adopt a budget statement “in which total outlays are no greater than total receipts.”
Total receipts may not increase “by a rate greater than the rate of increase in national income.”
“The Congress and President shall…ensure that actual outlays do not exceed the outlays set forth in the budget statement.”
The provisions can be overridden in times of war.

33. Critique of Balanced Budget Amendments
Forecasting issues
Definitional issues
Penalties for violation of the law
Economic issues