Public Sector Economics

1. Public Sector Economics Explaining Government Behavior

2. Positive and Normative Interact • The optimal policy may have to account for political reactions • SSA chairman: “a program for the poor is a poor program” • merit goods and tax incidence • government size and tax reform • Social Security reform • political reactions to a policy probably depend on its efficiency consequences

3. Approaches to Positive Political Economy(not mutually exclusive) • constitutional • instrumental rational voting • probabilistic voting • wealth maximization • social welfare maximizing • interest group competition • degrees of competition for public office • “irrational” • demand model

4. The Microeconomics of Voting • macro questions to be answered • does voting affect policy? • does voting serve the purpose of aggregating preferences or information? • is voting instrumental? or, • expressive voting? • advertising/vote buying? • separate political preferences? • unanimity vs. majority rule • properties of majority rule • alternative voting rules • the voting paradox

5. Three Tenets of Formal Voting Theory • voting mutes preference intensity • voting equalizes the distribution of political power • policies are sensitive to the form of “the game”

6. Equal Distribution of Political Power Illustrated: the NIT coalition • NIT: constant marginal tax rate with negative intercept (i.e., guaranteed minimum income r). • what does the median person think about raising the NIT rate? • (i) pays • (ii) suffers dwc • (iii) transfer increases by • Empirically, mean income always exceeds median, so the founding fathers (ignoring (ii)) were concerned that there was no limit to the median person’s preference for redistribution • is an index of the intensity of that preference • Meltzer-Richard: (ii) is second order at r = 0, but there exists a large enough r so that dwcs cancel the mean-median gap • [Meltzer Richard missing a couple of things … more later]

7. What Does “Economic Theory” say about the Characteristics of Public Policy in Democracies? • skewness or inequality should increase redistribution. • rejected by Peltzman, Benabou, Perotti • accepted by studies of Swiss localities • democracies will have different public policies than dictatorships • rejected by Easterly & Rebelo, Jackman, Lott (health), Mulligan-Gil-Sala-i-Martin • accepted by Lott (education) • form of the “game” matters • participation matters • Lott & Kenny 1998 • what determines participation? • intensity of preference doesn’t matter

8. Reject Formal Voting Theory’s Three Tenets? preference intensity can be expressed in the public sector voter turnout log-rolling, vote-trading voting buying political advertising lobbying noncompliance migration riots, coups voting does not equalize the distribution of political power. e.g., U.S. median voter has more than the mean income policies are not sensitive to the form of “the game” voting does not occur in an institutional vacuum. Institutions arise to alleviate the inefficiencies of voting processes (Wittman) voting is not instrumental

9. Is Voting Rational or Instrumental? • “voter’s paradox” • the probability of going to the polls and affecting the outcome is similar to the probability of being killed in a car crash on the way to or from the polls • voting or not cannot be primary motivated in terms of affecting election outcomes • once at the polls, might voting for one candidate or another be explained in terms of affecting the outcome? • rational voters would: • be influenced more by advertising than in private affairs? • be influenced more by misinformation than in private affairs? • conform more than in private affairs (even though voting is “secret”!)? • all of the above are most applicable in large elections • respond to costs and benefits that are unrelated to the outcome. eg., travel costs

10. Wealth Maximization and the Theory of Institutional Response • “democratic markets are organized to promote wealth maximizing outcomes” • democratically determined policies are always efficient? or • institutions respond to mitigate their inefficiencies • “wealth maximization”/Kaldor-Hicks efficiency defined • no one can be made better off, even with an appropriate set of lump sum taxes and transfers • almost tautological unless transactions and decision costs are ignored • example: regulating monopolies

11. Wealth Maximizing Institutional Response – Examples • voter information • political opportunism, deriving from finite political lives, and alleviated by political parties • use of committee assignments to align party and member interests • facilitate vote trading • publicizing opposing party’s opportunism • excessive localism by Congress • parties again

12. Olson’s bandits • tax revenue = • the efficiency loss of redistribution is limited when governments are stable • eg., stable dictator • eg., stable democratic majority • a stable government limits taxation in order to keep the tax base sufficiently large

13. Internationally Common Features of OA Public Pensions SS spending dominates government budgets, SS redistributes from young to old, even when the elderly consume as much or more than do the young, Benefits increase with lifetime earnings and are hardly means-tested, benefit formulas induce retirement, especially in the countries with the largest SS budgets, elderly’s net income nears or exceeds nonelderly’s, and similar public pension programs emerge and grow under very different political regime

14. Efficiency Theories of Social Security Social Security as risk sharing risk of out-living one’s assets risk of labor productivity shock risk work disutility shock Correcting retirement market failure Preventing frugal people from being exploited by the prodigal Economize on administration costs Generational transfers as a side effect of intergenerational human capital investment Chain letters in dynamically inefficient economies