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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria1 5. Public expenditures in Canadian provinces: An empirical study of politico-economic interactions Kurs Public Choice WS 2009/10

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria2 5. Public expenditures in Canadian provinces: An empirical study of politico-economic interactions 1.Introduction 2.Review of Literature 3.The Theoretical Model of Frey and Schneider 4.Empirical Testing 5.Summary and Concluding Remarks

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria3 1. Introduction (1)Two widely accepted explanations of short-term fluctuations of public spending suggest that public budgets vary over time in a cyclical fashion. (2)One explanation, the electoral cycle, claims that public expenditures will increase before an election and decrease afterward. (3)The other explanation, the partisan cycle, argues that governments’ ideology shapes policies and outcomes. (4)Consequently, alternation in power between various political parties induces significant changes in the size of public budgets: Left-wing parties favor public spending increases while right- wing parties aim at budget reductions.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria4 2. Review of Literature (1)The earliest empirical study of electoral cycles on budgetary outcomes is usually attributed to Tufte (1978) for his work on US federal public expenditures. Tufte‘s findings revealed, among other things, that federal transfer payments to individuals were generally higher during election years. (2)In all cases (also in the studies of Nordhaus (1975) and MacRare (1977), it is assumed that elections create an incentive for governments to behave opportunistically. Because incumbent politicians wish to be re-elected, they will try to use public policy instruments to improve economic conditions, thereby boosting their popularity and their chances of victory in the upcoming election. Consequently, it is believed that public expenditures increase just before an election, and decrease afterwards.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria5 2. Review of Literature (cont.) (3)The partisan model developed by Hibbs (1977): (i)It postulates that ruling parties must implement policies consistent with the interest of their core constituencies that elected them. Consequently, politicians are driven by ideological motives. (ii)It is commonly assumed that left-wing parties favor public spending increases while right-wing parties aim at budget reductions. (iii)Because the partisan composition of governments changes over time, the size of public budgets should fluctuate.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria6 3. The Theoretical Model of Frey and Schneider Frey and Schneider offer a positive model of politico-economic interactions between the economy and the policy: The model aims at describing the interdependency between the government and the state of the economy. (1)The government is one of the major actors of the model. Its objective is to maximize its utility subject to a set of constraints. The government derives utility by establishing public policies that meet its ideological stance. (2)However, the government can pursue its goals only if it can secure its re-election. If the government fears defeat in the next general election, it will undertake an expansionary budget policy to stimulate the state of the economy and, therefore, its support among voters.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria7 3. The Theoretical Model of Frey and Schneider – Cont. A second group of actors in the model are voters: (3)They, too, are assumed to maximize their utility subject to constraints. Moreover, voters hold the government accountable for the state of the economy and believe that it can use policy instruments to change it. Consequently, they support the incumbent government if they are satisfied with its economic performance. (4)However, voters may find that gathering information about the true competency of the government required time and money at a cost that outweigh the benefits of being well informed. For that reason, it becomes rational for them to use broad macroeconomic indicators, such as unemployment and inflation, to evaluate the performance of the incumbent.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria8 3. The Theoretical Model of Frey and Schneider – Cont. (5)Whether a government can pursue its ideological goals or must address the electoral constraint can be determined by using the concepts of surplus and deficit of popularity. (6)It is assumed that there is a critical level of popularity necessary to win the next election. The critical level of popularity is a predefined value that takes into account the characteristics of political institutions (e.g. the number of competing parties) and the degree of risk aversion of the governing party. (7)If the actual level of popularity is greater than the critical value, the government faces a surplus of popularity and is free to pursue its ideological goals.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria9 3. The Theoretical Model of Frey and Schneider – Cont. (8)However, if the actual level of popularity is less than the critical value, then the government needs to secure its re-election. The larger the deficit, and the closer the next election, the more urgent is the need for the government to act. (9)Frey and Schneider pointed out that the interest of bureaucrats lies primarily in the continuous expansion of state activities, which is consistent with the observed incremental approach of the fiscal decision-making process.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria10 3. The Theoretical Model of Frey and Schneider – Cont. The model formulated by Frey and Schneider is: ΔβSpending t = β 0 + β 1 ΔRevenue t-1 + β 2 (1–Q)∙Election t + β 3 (1–Q)∙Popularity 2 t-1 + β 4 Q∙Left∙Popularity 2 t-1 + β 5 Q∙Center∙Popularity 2 t-1 + β 6 Q∙Right∙Popularity 2 t-1 + ε t (1) (1)The dependent variable (ΔSpending) is the annual percentage change of total provincial public expenditures, in constant dollars.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria11 3. The Theoretical Model of Frey and Schneider – Cont. (2)The theoretically expected signs are: A positive relationship between revenues and expenditures is expected, thus β 1 >0. The variables Election and Popularity measure, respectively, the amount of time that has elapsed since the last general election, and the support received by the government from the electorate, as expressed by opinion polls. Consequently, the estimated values of the coefficients are expected to be positive, β 2 >0 and β 3 >0.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria12 3. The Theoretical Model of Frey and Schneider – Cont. (3)It is generally assumed that left-wing governments favor budget increases and right-wing governments seek to cut public expenditures. Therefore, we expect β 4 >0, β 6 β 5 >β 6. (3)However, the assumption about the objective (to decrease spending) of right-wing governments may be too restrictive. A right-wing governments may not be in a position to cut the total amount of public spending as much as they desire. However, it should be expected that the values of the estimated coefficients, associated with the measures of ideology, respect the following conditions: β 4 >0, and β 4 >β 5 >β 6.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria13 4. Empirical Testing Table 1: Descriptive statistics of variables used in the regressions (N=65) VariableMeanStandard deviation Minimum value Maximum value Spending Revenue Q Popularity Election Left Center Right Budgetary Balance Transfers Personal Income

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria14 4. Empirical Testing – Cont. Table 2: Regression estimates for the Frey and Schneider hypothesis - Part 1 VariableEquation 1 Revenue (2.68)*** (1–Q)∙Election (4.70)*** (1–Q)∙Popularity (-0.80) Q∙Left∙Popularity (2.75)*** Q∙Center∙Popularity (3.63)*** Q∙Right∙Popularity (4.06)*** Election- Left- Center- Right- Popularity 2 - Left ∙Popularity 2 - Center∙Popularity 2 - Right∙Popularity 2 - Budgetary Balance 2 - Transfers - Personal income 2 - Constant (-2.37)** N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria15 4. Empirical Testing – Cont. (1)As indicated by the coefficient of determination, the model explains 40% of the variance of annual variation of provincial public spending. (2)Furthermore, five of the six estimated parameters have the expected sign and are statistically significant at a level of 1%. (3)A one percentage-point increase in real revenue increases public provincial budget by less than one quarter of a point (β 1 =0.2214). Therefore, the impact of the budgetary constraint, seems of little magnitude, at least if balanced budgets are the target.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria16 4. Empirical Testing – Cont. (4)The estimates also confirm the presence of a positive relationship between public spending and the proximity of the next election when the government faces a deficit of popularity. The closer the next election, the more the government will increase public expenditures. (5)If a government is struggling with a deficit of popularity during a whole year, (i)it will increase its budget on average by about 1.3 percentage points during its first year in office (β 2 =0.1113×12 months), and (ii)up to 6.7 percentage points during its last year (60 months).

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria17 4. Empirical Testing – Cont. (6)The findings reveal that left-wing governments increase public expenditures more than twice as much as centrist and right-wing governments do (β 4 >β 5 >β 6 ) when they have a surplus of popularity. Increases in public expenditures are also higher under centrist governments compared to the right (β 5 >β 6 ). (7)The estimates indicate, for instance, that a left-wing government, having a 10 percentage-point lead in opinion polls, will increase public expenditures by 1.22% per year compared to 0.55% for a centrist government and 0.40% for a right-wing government.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria18 4. Empirical Testing – Cont. – Sensitivity Analysis (8)Removing all indicators of popularity (Popularity and Q) from Eq. (1) one can estimate the following equation and verify if the effect of the two cycles are independent of each other. If they are, Eq. (2) should produce estimates that have the predicted sign, are statistically significant and explain a larger amount of the variance in public expenditures. ΔSpending t = β 1 ΔRevenue t-1 + β 2 Election t + β 3 Left t-1 + β 4 Center t-1 + β 5 Right t-1 + ε t (2)

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria19 4. Empirical Testing – Cont. Table 2: Regression estimates for the Frey and Schneider hypothesis – Part 2 VariableEquation 2 Revenue (1.89)* (1–Q)∙Election- (1–Q)∙Popularity 2 - Q∙Left∙Popularity 2 - Q∙Center∙Popularity 2 - Q∙Right∙Popularity 2 - Election (1.62) Left (-1.02) Center (0.85) Right (-0.13) Popularity 2 - Left ∙Popularity 2 - Center∙Popularity 2 - Right∙Popularity 2 - Budgetary Balance 2 - Transfers - Personal income 2 - Constant- N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria20 4. Empirical Testing – Cont. – Sensitivity Analysis (9)However we find, that the explanatory power of the regression drops to about 16% (compared to 40% for Eq. (1)) and that none of the estimated coefficients are statistically significant at the 5% level. (10)Moreover, some estimated coefficients linked with ideology display values contrary to prediction. For instance, our findings indicate that left-wing governments reduce public spending ten times more than right-wing governments. Clearly, Eq. (2) does not provide support for a refutation of the Frey and Schneider hypothesis.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria21 4. Empirical Testing – Cont. – Sensitivity Analysis (11)Our initial findings could also suggest that the behavior of governments might by influenced by the level of popularity, but not by the presence of a surplus or a deficit of popularity. The underlying assumption would be that the electoral and the partisan cycles are independent from each other. Dropping only the variable Q from Eq. (1) and assuming that there is no interaction between the level of popularity of the government and its ideology, the model can be rewritten in the following way: ΔSpending t = β 1 ΔRevenue t-1 + β 2 Election t + β 3 Left t-1 + β 4 Center t-1 + β 5 Right t-1 + β6 Popularity 2 t-1 + ε t (3)

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria22 4. Empirical Testing – Cont. Table 2: Regression estimates for the Frey and Schneider hypothesis – Part 3 VariableEquation 3 Revenue (1.99)* (1–Q)∙Election- (1–Q)∙Popularity 2 - Q∙Left∙Popularity 2 - Q∙Center∙Popularity 2 - Q∙Right∙Popularity 2 - Election (1.92)* Left (-0.98) Center (0.18) Right (-0.40) Popularity (1.30) Left ∙Popularity 2 - Center∙Popularity 2 - Right∙Popularity 2 - Budgetary Balance 2 - Transfers - Personal income 2 - Constant- N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria23 4. Empirical Testing – Cont. – Sensitivity Analysis (12)Devine (1985) has suggested that popularity can nonetheless interact with ideology. If this is the case, the model of estimation can be represented by Eq. (4): ΔSpending t = β 0 + β 1 ΔRevenue t-1 + β 2 Election t + β 3 Left∙Popularity 2 t-1 + β 4 Center∙Popularity 2 t-1 + β 5 Right∙Popularity 2 t-1 + ε t (4)

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria24 4. Empirical Testing – Cont. Table 2: Regression estimates for the Frey and Schneider hypothesis – Part 4 VariableEquation 4 Revenue (1.90)* (1–Q)∙Election- (1–Q)∙Popularity 2 - Q∙Left∙Popularity 2 - Q∙Center∙Popularity 2 - Q∙Right∙Popularity 2 - Election (1.77)* Left- Center- Right- Popularity 2 - Left ∙Popularity (1.10) Center∙Popularity (1.53) Right∙Popularity (1.18) Budgetary Balance 2 - Transfers - Personal income 2 - Constant (-0.56) N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria25 4. Empirical Testing – Cont. – Sensitivity Analysis (13)The estimates for Eqs. (3) and (4) are presented in parts 3 and 4 of Table 2. These additional estimates do not provide better explanations for changes in public spending than Eq. (1). (14)In both cases, the explanatory power is lower, and several estimated coefficients have a sign or value contrary to predictions, and are not statistically significant. (15)Overall, the sensitivity analysis presented here gives additional support to the Frey and Schneider hypothesis: the existence of an electoral or a partisan cycle is conditional to the presence of a surplus or a deficit of popularity.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria26 4. Empirical Testing – Cont. – Sensitivity Analysis (16)Finally, since nearly 50% of total provincial revenue comes from personal income and consumption taxes (in addition, about 15% is financed by federal transfers, 10% by investment income, and 6% by corporate taxes), it seems that the capacity of taxpayers to finance public budgets should also be taken into account. For this reason, three new indicators of the budgetary constraint can be substituted for the variable ΔRevenue.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria27 4. Empirical Testing – Cont. – Sensitively Analysis (17)The model can now be estimated as follows: ΔSpending t = β 0 + β 1 (1–Q)∙Election t + β 2 Q∙Left∙Popularity 2 t-1 + β 3 Q∙Center∙ Popularity 2 t-1 + β 4 Q∙Right∙Popularity 2 t-1 + β 5 Budgetary Balance 2 t-1 + β 6 ΔTransfers t + β 7 ΔPersonal Income 2 t-1 + ε t (5) where (1)Budgetary Balance is the ratio of public provincial deficit in percentage of total public expenditures, (2)Transfers, the annual variation in percentage of federal transfers (in real terms) to the provincial government, and (3)ΔPersonal Income, the annual variation in percentage of provincial personal income (also in real terms). (4)It is expected that all coefficients related to the budgetary constraint will be positive (β 5 >0, β 6 >0, β 7 >0). (5)The results are shown in table 2 part 5.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria28 4. Empirical Testing – Cont. Table 2: Regression estimates for the Frey and Schneider hypothesis – Part 5 VariableEquation 5 Revenue - (1–Q)∙Election (4.86)*** (1–Q)∙Popularity 2 Q∙Left∙Popularity (2.97)*** Q∙Center∙Popularity (2.41)** Q∙Right∙Popularity (3.91)*** Election- Left- Center- Right- Popularity 2 - Left ∙Popularity 2 - Center∙Popularity 2 - Right∙Popularity 2 - Budgetary Balance (4.49)*** Transfers (3.46)*** Personal income (3.53)*** Constant (-0.37) N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria29 4. Empirical Testing – Cont. – Sensitively Analysis (18)The modified model now explains about 60% of the variance in annual variations of provincial public spending. (19)In addition, all of the seven estimated parameters have the expected sign and are statistically significant at the 1% level for all parameters, except Q · Center · Popularity² (significant at the 5% level). (20)All of the fundamental assumptions identified in the initial model (Eq. (1)) are supported when the three new variables, related to the budgetary constraint, are incorporated in the model (Eq. (5)).

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria30 Table 3: Additional Results: Disaggregating Provencial Spending VariableHealthEducationSocial Services Resources & Industry Transport & Communication General Government services (1–Q)∙Election (2.42)** (0.85) (0.79) (1.80)* (1.19) (-0.55) Q∙Left∙Popularity (2.70)*** (0.81) (2.39)** (-0.28) (1.69)* (0.51) Q∙Center∙Popularity (0.86) (-0.82) (0.80) (1.10) (1.38) (0.01) Q∙Right∙Popularity (1.51) (0.57) (1.37) (0.62) (0.51) (1.06) Budgetary Balance (4.44)*** (1.60) (1.79)* (2.39)** (2.25)** (-1.07) Transfers (3.49)*** (0.88) (1.79)* (1.92)* (0.01) (1.05) Personal income (3.40)*** (3.52)*** (0.45) (-0.24) (0.36) (1.49) Constant (1.42) (–0.31) (2.61)** (0.09) (-0.64) (-1.06) N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria31 Table 4: Additional Results: Disaggregating Provincial Spending VariableProtectionEnvironmen t Recreation & Culture Regional Planning Labor & Immigration Total spending net of debt service (1–Q)∙Election (0.87) (0.92) (1.08) (1.09) (1.60) (4.20)*** Q∙Left∙Popularity (0.56) (-0.41) (-0.43) (0.62) (2.36)** (2.62)** Q∙Center∙Popularity (1.22) (0.14) (0.76) (–1.19) (2.41)** (2.27)* Q∙Right∙Popularity (1.24) (-0.42) (-0.62) (-1.18) (1.61) (2.83)*** Budgetary Balance (1.91)* (2.15)** (3.07)*** (2.26)** (2.53)** (5.19)*** Transfers (-0.02) (1.29) (1.66)* (0.34) (-0.02) (3.84)*** Personal income (2.18)** (-0.33) (0.14) (0.93) (-1.01) (3.33)*** Constant (-0.07) (1.59) (0.71) (-0.09) (0.31) (-0.54) N65 Buse R

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria32 5. Summary and Concluding Remarks (1)The purpose of this paper was to investigate whether the hypothesis, formulated by Frey and Schneider, on the interaction between the electoral cycle and the partisan cycle could be validated empirically for Canadian provinces. (2)Using Canadian provincial public spending over the 1983–1995 period, we found empirical support for the Frey and Schneider explanation, validated by the sensitivity analyses. (3)This study is the first attempt to test the Frey and Schneider hypothesis at the subnational level. Does Canada constitute a unique case? At first sight, there seems to be no reason why this should be the case. Under democratic rules, it can be expected that politicians are driven by electoral and partisan motives.

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WS 09/10© Prof. Dr. Friedrich Schneider, University of Linz, Austria33 Literature Tellier, Genevieve, Public Expenditures in Canadian Provinces: An Empirical Study, Public Choice 126/3, 2006, pp Franzese, R.J.J. (2002). Electoral and Partisan Cycles in Economic Policies and Outcomes. Annual Review of Political Science. 5:

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