Part III: Political Economy  In order to operate, a government needs to decide two things: 1)How are decisions made? 2)How are responsibilities split? Note: This chapter only covers select issues in political economy

Part III: Political Economy  Direct Democracy  Representative Democracy  Federal System Background  Advantages of Decentralization  Disadvantages of Decentralization

Public Choice PUBLIC CHOICE – a field of applying economic principles to the understanding of political decision making  We will examine two models of democratic decision making: 1)Direct Democracy 2)Representative Democracy

Direct Democracy In direct democracy, everyone has a say in the political decision making process, leading to a variety of approaches and issues: 1)Unanimity Rules 2)Majority Voting Rules 3)Logrolling 4)Arrow’s Impossibility Theorem

Unanimity Rules Lindahl (1919/1958) designed a procedure to ensure unanimous agreement on provision of public goods. Each voter has a demand curve, where PRICE is the fraction of the public good the voter will pay (tax share), and QUANTITY is the resulting quantity they will want. Two voters will agree on provision of public goods when their combined price equals one at a certain quantity level. This can be shown through the following overlay of demand curves:

Unanimity Rules

The prices, or tax shares, where two people demand the same amount of public goods, are LINDAHL PRICES. Unanimity Rules are feasible through an auction system, where an auctioneer keeps listing different tax schemes until everyone agrees on one.

Unanimity Rules Unanimity Rules suffer from two problems: 1)People can still misrepresent their preferences to partially free-ride 2)Unanimous decisions take a long time with many people  It is guaranteed that no one is exploited but…  Historically, unanimous decisions have been required to ensure no decision is made.

Majority Voting Rule Difficulty in unanimous decisions often leads to the MAJORITY VOTING RULE – one more than half the voters must favor a measure for it to be approved. To illustrate, assume Econ 350 had 3 different marking options: 1)Paper – long paper and one midterm 2)Exams – two midterms and a short paper 3)Assignment – two assignments, one midterm, and a short paper

Majority Voting Rule In this case, even though each person prefers a different arrangement, in a vote:  Exams beat paper (2 to 1)  Exams beat assignment (2 to 1)  Therefore, regardless of voting, exams win  This is not always the case however… Voter: ChoiceHouseSuper MariooGsMC FirstExamsPaperAssign SecondAssignExams ThirdPaperAssignPaper

Voting Paradox In this case:  Exams beat assignment (2 to 1)  Assignment beets paper (2 to 1)  Paper beats exams (2 to 1)  VOTING PARADOX – individual voter’s preferences are consistent, but the community’s are not Voter: ChoiceHouseSuper MarioChuck Noris FirstExamsPaperAssign SecondAssignExamsPaper ThirdPaperAssignExams

Voting Paradox In the case of a voting paradox, the order of the voting agenda can determine the winner AGENDA MANIPULATION – process of organizing the order of votes to assure a favorable outcome Alternately, if pair voting (option A vs. option B) is continually used a decision is never reached. CYCLING – when paired majority voting on more than two possibilities goes on indefinitely without a conclusion ever being reached.

Voting Paradox The voting paradox arises when one agent has a DOUBLE-PEAKED PREFERENCE – utility moves down as you move away from a preference, then up as you move farther way. SINGLE-PEAKED PREFERENCE – utility keeps moving down the farthest you move from a preference. If we examine the previous decision in terms of # of non-paper components, we see a double peak:

Double Peaked Preferences Here, Super Mario and Chuck Noris have single- peaked preferences while House has double peaked preferences (3 is better than 1 (less), but worse than 2 (less)  When choices are not based on a single dimension, multipeaked preferences are more common (ie: would you prefer teleportation, super strength, or mind reading as a super power?) Voter: ChoiceHouseSuper MarioChuck Noris FirstExams (2)Paper (1)Assign (3) SecondAssign (3)Exams (2) ThirdPaper (1)Assign (3)Paper (1)

Median Voter Theorem MEDIAN VOTER – voter who’s preferences lie in the middle of all voter’s preferences MEDIAN VOTER THEOREM – as long as all preferences are single peaked, the outcome of majority voting reflects the preferences of the median voter

Median Voter Theorem Example Assume that the final exam could be either 2, 3, 4, 5, or 8 questions long, each with exactly 20% of the vote. Moving from 8 to 5 would get 80% of the vote, and moving from 5 to 4 would get 60% of votes. However, moving from 4 to 3 would only get 40% of votes; 4, the median voter’s preference, wins through majority voting.

Logrolling LOGROLLING – trading of votes to obtain passage of a package of legislative proposals  Logrolling is common in the US, and allows laws to be passed that normally would fail through considering how strongly people feel for a proposal.  Consider the following table reflecting benefits from 2 proposals:

Logrolling  Without logrolling, each proposal would fail (2v1)  With logrolling, a hospital and pool (net benefit 315) would be supported by Melanie (net benefit 80) and Scarlet (net benefit 345)  Although this sometimes benefits society, through special interest groups it can sometimes harm society

Logrolling  Without logrolling, each proposal would fail (2v1)  With logrolling, a hospital and library (net benefit -20) would be supported by Melanie (net benefit 160) and Rhett (net benefit 40)  Society’s welfare decreases through a coalition of special interests

Arrow’s Impossibility Theorem  Thus far, all voting techniques we’ve examined have been flawed  Nobel laureate Kenneth Arrow (1951) proposed 6 criteria collective decision-making should follow in a democratic society: 1)A decision is made regardless of preferences (ie: multipeaked) 2)All possible outcomes can be ranked 3)Must be responsive to individuals’ preferences (if everyone prefers A to B, society must rank A higher than B).

Arrow’s Impossibility Theorem 4) Consistency (if A is preferred to B and B is preferred to C, C must be preferred to A) 5) INDEPENDENCE OF IRRELEVANT ALTERNATIVES – ranking of A and B cannot be influenced by another option C. 6) Dictatorship is ruled out. Unfortunately, Arrow’s Impossibility Theorem shows that all 6 requirements can’t be met (5 can); a democratic society cannot be guaranteed to make consistent decisions.  It may make good decisions often but 100% can’t be guaranteed

Representative Democracy Everyone voting on every decision is impractical in many areas, so often politicians are democratically elected to make decisions  Referendums occur, but are very uncommon and costly If certain qualifications hold, the median voter theorem can predict the policies of the elected representatives:

Success of the Middle  In the case of two candidates, M and S:  M will get all votes left of himself, and some votes between M and S  S will get all votes right of himself, and some votes between M and S  M will win the election  The representative that most follows the median voter will win

Middle Winning Qualifications Although this is a surprisingly common result, it doesn’t always hold true because: 1)Multi-dimensional rankings – often the median voter is different for different issues (ie: social issues vs. taxes) – a politician may win a vote through one policy and lose it through another 2)Ideology – some politicians may care about more than just winning elections – they may hold to an ideology  Carlyle King (former Co-operative Commonwealth Federation (CCF…now NDP) Saskatchewan president discussed ideology vs. election appeal:

Ideology vs. Election Appeal “The trouble is that socialist parties have gone a- whoring after the Bitch Goddess. They have wanted Success, Victory, Power; forgetting that the main business of socialist parties is not to form governments but to change minds. When people begin to concentrate on success at the polls, they become careful and cautious; and when they become careful and cautious, the virtue goes out of them.” – Carlyle King  Who said politics boring and wasn’t edgy?

Middle Winning Qualifications 3) Personality – often politicians win or lose depending on personality (many argue that Mulroney’s low popularity came out of his arrogance) 4) Leadership – often politicians can influence public opinion 5) Decision to vote – not everyone votes, so the ACTUAL median voter may not be the median voter of those who actually vote

EI and Income Redistribution  EI naturally redistributes wealth from those who don’t suffer employment loss to those who do  Since some people have claims more often and longer claims, there is even more redistribution  IS Employment Insurance good as an income redistribution program?  There are those who agree…(next slide)  There are those who disagree…(2 slides hence)

EI and Income Redistribution YES  Employment Insurance supplements social assistance  People receiving EI may not need welfare programs  Some argue that Employment Insurance has less of a work disincentive than typical welfare  There is no implicit tax rate on earnings  EI requires a certain level of work, and therefore is similar to “workfare” (Osberg, 1995)  EI helps those who normally have employment while social assistance helps those who have limited ability to be self-supporting

EI and Income Redistribution NO  Employment Insurance does a poor job of redistributing income to the poor  People in equal positions are not treated equally (horizontal equity)  Tax burdens are not distributed fairly across people with different abilities to pay (vertical equity)  Employment Insurance causes major labour market distortions (firms and workers)

EI History – 1930’s  1933 – 25% unemployment, 15% “on relief”  “On relief” largely covered by provincial and municipal governments  1935 social insurance program ruled ultra vires; outside the federal government’s jurisdiction  1867 Constitution Act amended (by federal and provincial governments) to allow for federal unemployment insurance

EI History –1940’s and 1950’s  1940 Unemployment Insurance Act  Covered jobs with MODERATE risk of unemployment (not high or low risk)  42% of labour force  50% of wage benefits, plus 15% if married  lasting for 1/5 of days worked in last 5 years, minus 1/3 of days already claimed in last 3 years  1950’s – UI extended to seasonal workers and “self-employed” fishermen

EI History –1971 Reforms  1971 Unemployment Insurance Act (Bill C-229)  Covered 93% of labor force (including self- employed)  Minimum eligibility – 8 weeks of work  Benefit 66% of wage, 75% with dependents  Had a maximum insurable earnings level  Sickness and maternity benefits increased  Duration linked to weeks worked in qualifying period  Increased when national unemployment exeeded 4%  Increased when regional unemployment exceeded national by 1-3% (regional extended benefits)

EI History –1971 Reform Impact  Unemployment was constant between 1971 and 1972, yet:  People covered: 5.4 million to 7.8 million  Weeks of benefits: 22.6 million to 30.5 million  Average weekly payment: $40.28 to $61.79  Expenditure more than tripled:  $0.59 billion to $1.87 billion  Expenditure rose from 0.8% of GNP in 1971 to 2.1% in 1975

EI History –1975 Reforms  Those who quit or were fired from misconduct couldn’t claim for 6 weeks (up from 3)  Age limit reduced to 65 years (from 70)  75% dependent coverage eliminated (all 66%)  Increased benefits became linked to an 8 year moving average, instead of 4% trigger

EI History –1977 Reforms  New entrants, re-entrants to labor force and people with repeated claims needed more weeks of employment to qualify  Exemptions for repeat claimants in high- unemployment regions  Benefits reduced to 60% of wage (from 66%)  High income earners clawed back at 30% in net income was 1.5 times maximum insurable earnings

EI History –1980’s  Unemployment went from 7.6% (1981) to 11.9% (1983)  Benefits rose from $4.76 billion to $10.1 billion  Macdonald Royal Commission on the Economic Union and Development Prospects for Canada (1985) concluded:  UI increased unemployment rates since 1971  Income redistribution should be replaced by a NIT The commission was opposed by Altantic Canada and labor movement and was never adopted

EI History –1980’s  1989 Bill C-21 did some changes:  UI funds could be used for training, relocation assistance, and other employment measures  This was meant to fight long-term unemployment  Repeat users no longer had different qualification provisions  UI became entirely funded by employer and employee contributions (no general fund government funding) (as of )

EI History –1990’s  Unemployment rose to 11.3%, causing an UI deficit  Government increased employee and employer contributions  This may have lead to more lay-offs  1993 benefits reduced to 57% (from 60%)  Those who quit without just cause became ineligible for UI benefits

EI History –1990’s  1994 – UI eligibility in high unemployment regions increased to 12 weeks (from 10)  20 weeks was required in other regions  Benefits could last from 17 to 50 weeks depending on weeks worked and regional unemployment  Benefit reduced to 55% (from 57%)  But raised to 60% for low-income recipients with dependents  Employee contributions increased again

EI History –1996 Reforms  1996 Employment Insurance Act eligibility:  Eligibility based on HOURS of last 52 weeks  , depending on unemployment rate  910 hours for new entrants to labor force and those entering after 2 years  600 hours for sickness, maternity, or parental benefits  Fishing benefits depend on earnings in a fishing season ($2500 to $4200 depending on regional unemployment)  This change took part time work and seasonal work into account much better

EI History –1996 Reforms Benefits  55% of insurable earnings, to a maximum of $39,000 (reduced from $42,380)  This has held constant, allowing a maximum $413 payment per week  Low-income claimants with children can get a Family Supplement to increase their benefits to 80% (family income less than $25,921)  Incomes exceeding $48,750 repay 30% of benefits  2 week waiting period  Coverage time depends on hours of work and regional unemployment rate  Week limits for maternity, sickness, and paternal

Labour Market Effects of EI  Moral Hazard problems exist if: a)An insured individual can affect the probability and magnitude of a loss and b)This changing behaviour is unobservable  Moral Hazard doesn’t focus on those who abuse and cheat the system  Moral Hazard can apply to both employers and employees

Labour Market Effects of EI  Some studies (Grubel et al. 1975) found that an increase in EI generosity increased the unemployment rate  But other studies (Corak 1994) found no aggregate effect (but he allowed for non- aggregate effects)  Other factors affect the unemployment rate aside from EI

Labour Market Effects of EI  The labour market effects of the Canadian Employment Insurance System can be divied into: 1)Direct Effects (layoffs, quits, duration of employment, labour force participation) 2)Systemic Effects (industrial mix, labour mobility, education) 3)Macroeconomic Effects (automatic stabilizing effects)

Direct Effects  Unemployment is caused by: 1)Seasonal variations in demand 2)Business cycle fluctuations in demand 3)Long term trends in the economy EI is aimed at the second cause.  Seasonal layoffs are predictable and therefore not an insurance risk  Trends require retraining or moving, not temporary income replacement

Direct Effects - Layoffs  From 1980 to 1988,  58% of lost jobs were permanent layoffs  21% temporary layoffs  21% quitting (Baker et al, 1996)  When a firm needs to cut costs, including labour, it can reduce hours or lay off  With EI, laying (which has EI support) off is more attractive than reducing hours (which has no EI support)  Therefore EI encourages layoffs  Some firms (incl. gov.) may design job length according to minimum EI work requirements

Direct Effects - Quits  Prior to 1993, workers who quit got UI in Canada but not the states, resulting in:  Equal job quitting in Canada and the US  20.6 weeks average unemployment in Canada  11.2 weeks average unemployment in US  (Baker et al, 1996)  If EI applies to quitters, the unemployment rate is increased by longer job searches

Direct Effects – Unemployment Duration  Better EI benefits can lengthen the time people spend looking for “the perfect job”  This increases the unemployment rate BUT  This extra time spent searching can lead to a better fit  This leads to better labour market performance  This leads to lower job turnover  This decreases the unemployment rate

Direct Effects – Labor Force Participation  All workers pay the same EI premiums, but marginal workers who are often unemployed benefit more  Therefore marginal workers are encouraged to join the labour force by better EI benefits  If the number of jobs is constant, this increases unemployment  Sharis and Kuch (1978) found EI increased the labor force, especially among married females

Systemic Effects– Industrial Mix  EI Premiums vary with wage  This relationship doesn’t vary among industries  Premiums are NOT based on expected EI benefits or layoff likelihood  This does vary among industries  This causes seasonal jobs and small firms to gain more benefits that they pay in  EI therefore subsidizes seasonal and volatile work by taxing stable employment  (See table in future slide)

Benefit-Tax Ratios 2004 High=More Benefits than Premiums

Systemic Effects– Labor Mobility  EI provides greater support to industries and provinces with higher unemployment rates  EI gives Unemployed workers the support to move to a lower-unemployment area and find a job, increasing labor mobility  BUT  EI also DECREASES the income gain from moving, decreasing labor mobility  Studies are inconclusive, plus 70% of people change provinces for non-work reasons

Benefit-Tax Ratios 2004 High=More Benefits than Premiums

Systemic Effects– Education  If EI is generous, there is a greater opportunity cost to stay in school instead of entering the workforce (especially in seasonal industries)  In the 1970’s many young people in rural Atlantic Canada chose a “pogey”/Employment Insurance lifestyle over education  Yet in 1991, a greater percentage of young people in Atlantic Canada attended university than the national average.

Macroeconomic Effects – Automatic Stabilization Effects  If EI benefits paid out increase and total premiums decrease in a recession AND  EI premium incomes increase and benefits paid out decrease during a boomTHEN  EI acts as an automatic economy stabilizer  This does seem to occur in the recessions of the early 1980’s and the early 1990’s and the boom of the later 1980’s BUT  EI structure has changed over time (especially increasing premiums and disallowing long-term deficits), reducing this effect

EI Revenue Minus Expenditure

Distributional Effects of Employment Insurance  Like many government programs, EI can have a variety of distributional effects, which can be divided into: 1)Distribution of Benefits 2)Financing 3)Regional Redistribution 4)Experience-Rated Premiums 5)Coverage

Distributional Effects – Distribution of Benefits  In the following slide, we see that individuals with income between $10K and $25k make only 31.6% of the labour force but make up 50.5% of claimants  EI does have redistributed effect BUT  Higher incomes receive higher benefits (often even after clawbacks)  EI often doesn’t affect lowest-income households (disabled, single parents, part-time workers, etc.)

Distributional Effects – Distribution of Benefits

Distributional Effects – Financing  2006 Premiums are $1.87 for employees and $2.62 for employers (per $100) up to a maximum insurable earnings of $39,000  Premiums are effectively a “payroll tax”  Studies show EI burden often falls on the employees (as opposed to employers)  Since very low (don’t work) and very high (many investments) income earners often are less a part of EI, its financing has only limited, imperfect optimal income redistribution

Distributional Effects – Regional Redistribution  EI tends to redistribute income from West to East (Quebec and Atlantic)  EI also therefore redistributes income to primary industries (agriculture, forestry, fishing, and trapping) and construction from other industries  EI violates horizontal equity (equal treatment of equals), since two identical people in different unemployment regions have different minimum work requirements

Distributional Effects – Experience-Rated Premiums  In the US, employers who lay off frequently have higher premiums (similar to auto insurance and high-risk drivers)  In Canada, this would mean  higher premiums in industries such as construction, therefore lower wages  Lower premiums other industries, therefore higher wages BUT  Some low wage jobs have high layoff rates

Distributional Effects – Experience-Rated Premiums  Experience-rated premiums tend to DECREASE unemployment, as firms have a penalty for layoffs  High layoff industries would contract as low layoff industries would increase  Unemployment would increase short term as workers move from high to low layoff industries  Quebec and Atlantic Canada have many high layoff industries, and would greatly suffer

Distributional Effects – Coverage (2005 Table)  EI covered 43.4% of unemployed  Gov. claims EI covers 80% of target; it is not meant to cover some categories

Employment Insurance Conclusion  EI has Insurance and Income Redistribution characteristics (based on loss and need)  Insurance Characteristics:  Only contributors are covered  Higher income have higher loses therefore higher benefits  Income Redistribution Characteristics  Low-income benefit enhanced through Family supplement  High-income benefits are clawed back

Employment Insurance Conclusion  Problem of Insurance and Income Redistribution  Balancing two goals may prevent doing either goal well  Perhaps there should be 2 separate programs?  But even 2 separate programs would interact  EI reforms (such as hour-based eligibility) have been improvements, but issues and tensions remain even after over 25 years

Chapter 11 Conclusion  Unemployment has increased since 1950, with fluctuations  Unemployment insurance has been essential, but often seen as increasing unemployment  EI affects unemployment through impact on layoffs, quits, employment duration, labor force participation, industrial mix, labor mobility, education, and automatic stabilization  EI is a government program due to insurance failure due to market failure and adverse selection

Chapter 11 Conclusion  EI has many income distribution effects:  Transfers to primary industries and construction  Transfers to Quebec and Atlantic Canada  In 1996, EI eligibility changed to hour-based  Changes over time have improved EI, but the tension between insurance and income redistribution remains