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Public Sector Economics
Explaining Government Behavior
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
Approaches to Positive Political Economy
(not mutually exclusive)
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constitutional
instrumental rational voting
probabilistic voting
wealth maximization
social welfare maximizing
interest group competition
degrees of competition for public office
“irrational”
demand model
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?
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unanimity vs. majority rule
properties of majority rule
alternative voting rules
the voting paradox
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”
Equal Distribution of Political Power
Illustrated: the NIT coalition
• NIT: constant marginal tax rate with negative intercept
(i.e., guaranteed minimum income r). T  ty  r
• what does the median person think about raising the NIT
rate?
– (i) pays ym dt
– (ii) suffers dwc
– (iii) transfer increases by dr  ydt
• 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
• y / ym 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 meanmedian gap
• [Meltzer Richard missing a couple of things … more later]
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
Reject Formal Voting Theory’s Three Tenets?
• preference intensity can be expressed in the public sector
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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
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
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
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
Olson’s bandits
• tax revenue =  t y( t 1 )
• 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
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
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