Public Economics Paper 8

1
Public EconomicsPaper 8

• Lecture 2
• Growth in Government
• Structural Explanations

2
Structural vs. political explanations
Structural theories

• Certain characteristics of an economy are seen as
  important determinants of growth in government,
  regardless of political institutions.
• How voters express their preferences and how the
  government react to these expressions are
  important determinants of growth in government.

Political economy theories
3
Structural Theories

• Wagners Law Industrialization, economic growth.
• The displacement hypothesis social upheaval.
• Baumols disease differential productivity
  growth.

Economic structures
Political institutions
4
Wagners Law
The law of increasing expansion of public and
particular state, activities becomes for the
fiscal economy the law of the increasing
expansion of fiscal requirements. Wagner (1883)

• Industrialisation
• Increasing incomes
• Social progress

The driving force
Modern (textbook) version
As per capita incomes rise in industrial
countries, their public sectors grow in relative
importance, or the income elasticity of public
services is greater than 1.
5
General government expenditure, 1870-1996
(percent of GDP)
17 OECD countries
Source Tanzi and Schuknecht (2000), Table I.1.
6
Direct effect
Effect on government
Structural change
banking services Law order

• complexity of econ.
• relations.

Urbanization
regulatory services
congestion
communication
?population density

• Industrialization
• income
• social progress

?demand for income elastic goods
education
Social services
?demand for redistribution
transfers
New industries with economics of scale
Government enterprises (transportation)
non-tax revenues
Notice no feedback effects are considered.
7
Testing Wagners Law
Government spending
Income elasticity
GDP per capita
Normal good
Absolute version
Relative version
Superior good
(share of government spending in GDP increases).
cross country
Time series in one country
8
The evidence

• The absolute version has considerable support,
  i.e., public services are normal goods.
• The relative version yields mixed results at
  best
• most studies find estimates of the income
  elasticity less than 1.
• those which do find larger effects are typically
  not robust to proper econometric specification.

Ball game estimate 0.75.
9
The Displacement Hypothesis
(Peacock Wiseman, 1961)
Government spending evolves in a step-like
pattern, where each step coincides with social
upheavals, notably wars.
Key assumptions

• The government can always find profitable ways to
  expend available funds (in terms of generating
  political support).
• Citizens, in general, are unwilling to accept
  higher taxes than they have grown accustomed to
  in the past.
• Governments must be responsive to the wishes of
  their citizens.

10
The tolerable burden of taxation
but
spending desired by government
Actual spending
Social upheaval causes a permanent shift
upwards in the tolerable burden of taxation
In times of crisis, formerly unacceptable means
of taxation will be tolerated and, importantly,
this higher tolerance persists.
11
The weak version
total spending
civilian spending
defence
time
war
normal
normal
Level shift but no trend
12
The strong version
total spending
civilian spending
defence
time
war
normal
normal
Underlying trend growth level shift but not
trend effect.
13
Central Government Spending in the UK 1830-1975
WWII
80
WWI
60
Central government spending of GDP
40
20
0
1820
1840
1860
1880
1900
1920
1940
1960
1980
Year
Source Aidt et al. (2002)
14
Empirical tests

• What qualifies as a major social upheaval
• WWI and WWII
• Great Depression?
• Oil Shocks?

0 if year lt 1914
test
1 if year 1923-38 or gt1950
0 if year lt 1914 or 1923-38
1 if year gt1950
15
Well, well, well

• Upwards trend, series correlation, stationary.
• No modelling of the wars (catch up spending)
• Data relatively spare before WWI.

• Model the times series properties of g.
• Model the war(s).
• Focus on WWII.

16
ARIMA model of spending in the UK
time series model
Dummy for WWII
Dummy 1 after WWII
Result b4 negative and significant!!!
Little systematic evidence of the displacement
effect
17
Baumols Hypothesis
(Baumol 1967)
The growth in government expenditure as a
fraction of GDP is driven by low productivity
growth in the public sector relative to that in
the private sector.
Key assumptions
cumulative increase in productivity
(1) Differential productivity growth
Public sector
Private sector
(2) Wage equalization across sectors
(3) Fixed supply of labour
18
The average cost of producing public and private
goods
increases over time
The relative size of government

• Public services price inelastic
• size of government UP relative
• to GDP.

• Public services price elastic
• size of government DOWN
• relative to GDP.

19
elastic part
relative size after
inelastic part
A
B
relative size before
20
Evidence
Two things are needed

• Compensated price elasticity of public services

(2) Differential productivity growth 1.5 p.a.
(implicit government price index and the price
index of private goods)
Why not cumulative productivity growth in public
services?

• Education and other services are very labour
  intensive.
• W up gt higher avereage costs
• Less units supplied but higher total cost

21
Summary

• The displacement hypothesis and Wagners Law have
  little empirical support.
• Baumols hypothesis has more support.
• Problem that the various structural theories are
  considered in isolation. What is really needed is
  a united (nested) framework.
• Problem that political institutions are not taken
  into account.
• Problem that potential feedback effects are not
  considered.

22
What is next?

• The median voter model
• Extension of the voting franchise
• relaxing income and property requirements
• relaxing gender restrictions