CHAPTER 6 POLITICAL ECONOMY

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.

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.

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.

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.

Direct Democracy-Unanimity Rules 0’ 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

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.

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

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

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

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.

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.

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

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.

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

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

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

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

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

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

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

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.

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

Representative Democracy-Public Employees Function of bureaucrats Goals of bureaucrats

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

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.

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

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.

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.

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

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

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.

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