2Political EconomyPublic 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.
3Political EconomyThe 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.
4Political EconomyPublic 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.
5Lindahl ModelAn 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.
6Direct Democracy-Unanimity Rules 0’DrEEve’s share (SE)S*box and labels1st click – Adam’s D2nd click – Eve’s D3rh click – equilibrium r and SAdam’s share (SA)DrAr per yearr*The Lindahl Model
7Feasibility of Unanimity Rules Reaching equilibriumLindahl Model has two practical problemsStrategic behavior: sincere decision might not be taken by everyoneTime to reach equilibrium through election or referendum.
8Direct 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.VoterChoiceBradJenAngelinaFirstACBSecondThird
9Direct 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.VoterChoiceBradJenAngelinaFirstACBSecondThird
10Graphing Preferences Single-peaked preferences Utility Jen Double-peaked preferencesaxes and labels1st click – Brad2nd click – Jen3rd click – Angelina4th click – “Single-peaked preferences” and two arrows5th click – “Double-peaked preferences” and curved arrowBradAngelinaABCMissiles
11Practical 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 substitutesMajority voting may lead to inconsistent decisions regarding the public goods if some people’s preferences are not single peaked.
12The Median VoterMedian 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.
13Direct Democracy - The Median Voter Theorem ExpenditureDonald$5Daisy100Huey150Dewey160Louie700
14LogrollingLogrolling 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.
15Direct Democracy - Logrolling I VoterProjectMelanieRhettScarletTotal Net BenefitsHospital200-50-5595Library-40150-3080Pool-120-60400220
16Direct Democracy - Logrolling II VoterProjectMelanieRhettScarletTotal Net BenefitsHospital200-110-105-15Library-40150-120-10Pool-270-140400Melanie votes for library if Rhett votes for hospital; and Rhett and Scarlet trade votes for the pool and library
17Direct 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 paragraphsRight box by 2nd level paragraphs
18Reasonable 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 paragraphsRight box by 2nd level paragraphs
19Direct Democracy - Arrow’s Impossibility Theorem “Reasonable” collective decision-making criteriaIt can produce a decision whatever the configuration of voters' preferencesIt must be able to rank all possible outcomesIt must be responsive to individuals’ preferencesIt must be consistentIndependence of irrelevant alternativesDictatorship ruled outArrow’s Impossibility TheoremAll conceivable voting schemes have some potential for being unfair or producing a paradoxical resultMeaning of theoremconsistent rule not necessarily impossible to find, but cannot be guaranteedBuchanan’s critiqueInconsistencies 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 paragraphsRight box by 2nd level paragraphs
20Representative 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 paragraphsRight box by 2nd level paragraphs
21Representative Democracy - Elected Politicians Representative Democracy - Elected PoliticiansNumber of VotersDistribution and labels1st click - Female politician locates on right2nd click - Male politician locates directly to left of female3rd click - female moves to left of male (but still to right of mean)4th click - male politician moves just left of meanLiberalConservative
22Implications of the Median Voter Model Two-party systems tend to be stableReplacement 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.
23Other 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.IdeologyPersonalityLeadershipDecision to vote
24Representative Democracy-Public Employees Function of bureaucratsGoals of bureaucrats
25Niskanen’s Model of Bureaucracy $VAxes and labels1st click – V schedule2nd click – C schedule3rd click – two tangents, dashed line, Q* and “Efficient Output” tag4th click – dashed line, Qbc, “Actual output”Actual outputEfficient outputQ*QbcQ per year
26Representative Democracy – Special Interests What are “Special Interests”Establishment of Special Interest GroupsSource of Income: Capital or LaborSize of Income: Rich and poor.Source of Income: Industry of EmploymentRegion: Midwesterners favor agricultural subsidies while northeasterners favor the expenditure of urban developmentDemographic and Personal Characteristics: The elderly favor health care while young favor good schools and lower payroll taxes.
27Representative Democracy – Rent-Seeking $RentsAxes, labels, D, MR, and S=MC1st click - rentsS=MCDtons of peanuts per yearMR
28Representative 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.
29Explaining Government Growth Citizen PreferencesMedian 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.
30Controlling Government Growth Government growth as a non-issueGovernment growth as a problemCommitments made in the pastBasic flaws in the political system
31Improving the Workings of the Political System Change bureaucratic incentivesfinancial incentivesprivatizationChange Fiscal InstitutionsBudget Enforcement Act (BEA) – 1990Balanced budget rules at the state levelInstitute Constitutional LimitationsBalanced budget amendment
32Provisions 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.
33Critique of Balanced Budget Amendments Forecasting issuesDefinitional issuesPenalties for violation of the lawEconomic issues