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Structure and coherence in the political economy of public finance

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Structure and coherence in the political economy of public finance
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    Structure and Coherence in the Political Economy of Public Finance  byStanley L. Winer* and Walter Hettich**Corrected version, November 16, 2004.* Canada Research Chair Professor, School of Public Policy and Department of Economics,Carleton University, Ottawa (stan_winer@carleton.ca).*Professor, Department of Economics, California State University at Fullerton.(whettich@fullerton.edu)Prepared for the Oxford Handbook of Political Econom y. For helpful comments we thank Timothy Besley, Tom Borcherding, Roger Congleton, Amihai Glazer, Randall Holcombe, KaiKonrad, Gary Miller, Paul Rothstein, Dan Usher, and editors Barry Weingast and Don Wittman,as well as participants in seminars at Carleton University, the Claremont Graduate School andthe University of Western Ontario. Winer's research was supported by a Canada-United StatesFulbright Scholarship during the 2003/2004 academic year. The hospitality extended to Winer bythe Department of Economics and the Center for the Study of Democracy at U.C. Irvine is alsogratefully acknowledged. Errors and omissions remain the responsibility of the authors.     No one can quarrel with the requirement that the budget plan should be designed to maximize social welfare… Musgrave and Peacock (1958, ix)  At first sight it might be argued that anyone who set himself up as a judge and wished toestablish standards for the distribution of expenditure or amounts of revenue different from thoseapproved by Parliament, must belong to one of three categories: either he must be mentally theequal of that average intelligence [in Parliament], in which case he could not arrive at adifferent judgment; or he must be inferior to it, in which case his opinion would be less reliable;or he must be superior to it, which could not be proved. Pantaleoni (1883, 17)Economic journals continue to publish a steady stream of articles dealing with the public sector.Readers familiar with this literature will notice a crucial difference however. The field is passingthrough a transitional phase. A central paradigm – the model of the social planner – is losing itslong-held grip as an organizing principle. And although the search for a new coherence isapparent in much of recent work, it has not yet resulted in a different analytical view that enjoyswidespread acceptance.The current tension is foreshadowed by the two quotations at the head of this chapter, althoughthey belong to much earlier periods. Richard Musgrave and Alan Peacock wrote in mid-century.They expressed their belief in the importance of maximizing social welfare in the introduction totheir famous collection of classic articles in public finance published in 1958, and there is littledoubt that it was a view widely shared by economists of the day. In fact, it remained thedominant theoretical approach for another three decades or more in much of the literature dealingwith public sector issues. The longevity of the social welfare approach occurred in large part because the early contributions to the theory of taxation, by Edgeworth (1897), Ramsey (1927)and Pigou (1951), and the work by Samuelson (1954) and others on public goods and the use of the social welfare function in public economics, were later reinforced and extended in importantways by the literature on optimal taxation. 1 While Musgrave and Peacock provided a clear statement of the prevailing consensus, their collection of readings also had a second, quite different and somewhat subversive effect. 2 The Classics introduced the English speaking world to the writings of earlier European thinkers thathad pursued a different approach, but who had little impact on the English and Americaneconomic literature. Two names – those of Knut Wicksell and Eric Lindahl – are now widelyknown, but other continental writers included in the collection, such as Maffeo Pantaleoni, have 1 The optimal tax approach is presented in Mirrlees (1971 ) and   Atkinson and Stiglitz (1980). A more completediscussion of the relevant history of thought would of course have to mention many other significant contributions. 2 The quote continues “but much needs to be added to this formula”, and the research published by the two writerscovered a much wider range of topics than the above phrase would indicate. See especially Musgrave’s Theory of  Public Finance (1959) which heavily influenced the development of the field.   2received less attention. Yet, like Wicksell and Lindahl, he recognized what would be revealed asthe Achilles heel of social planning in a much later time. Because of the very nature of publicsector activities, budgetary decisions have to be made by collective institutions, such as parliaments. A planner model, however elegant, cannot come to grips with this central fact.   3 The work by the continental writers who had suffered neglect in the first half of the 20 th century became the source of a new and vigorous field of research in the second half dealing withcollective choice and governing institutions. It developed largely alongside public finance andoften had only limited influence on traditional writings, even though many of the questionsraised by scholars using the new approach had direct relevance to matters of taxation and publicexpenditures. By the end of the century, work on collective choice provided a fully developedcounterpoint to the social planning approach, and became one of the major reasons for thecurrent unsettled state of public sector analysis.The main criticisms of the social planning model may be summarized in three points. First,social planning does not provide any basis for empirical research designed to explain observedfeatures of actual fiscal systems or policies. Second, there is a growing insistence among socialscientists that behavioral assumptions in the public sector should be consistent with thosestipulated for actions in the private economy. And third, there is a new challenge to social planning as the appropriate foundation for normative analysis.The present chapter is written with this background in mind. We begin by outlining the structureof public sector economics when collective choice is regarded as an essential component of theframework of analysis, and point out the key issues that must be faced by economists and political scientists who insist that collective institutions cannot be ignored in research on public budgets and taxation. The analysis is comprehensive in the sense that both positive andnormative aspects are considered in some detail. References to the vast literature on the politicaleconomy of public finance are necessarily selective; we attempt to provide a point of view onthe field rather than a survey.While the emphasis is on the role of collective choice in the analysis of the public sector, thediscussion applies more broadly. The transitional phase mentioned earlier affects all analysis of  public policy. The search for a new coherence is a wider effort that must of necessity extend beyond the limited scope of the present discussion.1 . The structure of public sector economics when collective choice matters The analysis of public finance in modern democratic societies usually begins with a discussion of what markets can and cannot do. This approach is a natural consequence of work based on thefirst theorem of welfare economics which links competitive private markets with efficiency inresource allocation. The public sector is treated as an adjunct to the private economy and as anaid to the efficient performance of competitive markets, which may fail when externalities or  public goods are present. 3 In his discussion, Pantaleoni suggests that parliamentary decisions can be evaluated by comparing them to similar choices made by other legislatures, thus pointing toward the comparative study of institutions.   3 Although it is acknowledged that there are prerequisites for the functioning of markets, their nature is analyzed only infrequently in the literature. Among the preconditions is the existence of secure property rights. They are needed both in the private economy and in the public sphere,where they include the rights to vote and to participate in other ways in public life. As in the caseof all rights, those in the public sector must be well-defined and be subject to conditions thatcircumscribe how and when they can be exercised.Figure 1 gives a schematic presentation of the structure of public sector analysis. We begin with private and public property rights in the top box, which also lists behavioral assumptionsconcerning private agents, another necessary starting point for any empirical and theoreticalexamination. Given this basis, we can develop the analysis of markets and market equilibrium onthe one hand, and of equilibrium outcomes in the public sector on the other. The diagram makesclear that consistency in approach is important for a successful understanding. Behavioralassumptions affect the analysis of both the private and the public economy, with scholars of collective choice arguing that human motivation must follow the same principles in both areaseven though constraints facing individuals may systematically differ between private and publicchoice settings.In accordance with our focus, the diagram gives more space to the public sector, while also pointing out the interdependence between public and private spheres. Since the public sector must deal with situations where markets fail partially or completely, other decision mechanismsare needed. This is indicated by the top box on the right side of the diagram, which listscollective choice together with the electoral institutions required for the functioning of democracy. 4 One should note that the enforcement of rights generally falls into the public sector,one of the crucial difficulties of democratic societies, since public as well as private propertyrights are usually enforced through public means. 5  Market failure arises primarily because of non-excludability in the case of public goodsand common pool resources, and because of prices that do not reflect the welfare consequencesof private decisions, in the case of externalities. 6 When of necessity markets are replaced withcollective choice, other difficulties arise. Most prominent is the separation of spending andtaxing, a term that refers to the severance of marginal benefits from marginal costs inconsumption decisions for publicly provided goods. Because there is no complete revelation of  preferences for public goods, and because of the corresponding difficulty of matching anindividual's tax liabilities with his or her benefits, separation of spending and taxing and theattendant free riding become major problems. 7 The usual outcome is a system of compulsory 4   We refer here to 'institutions required  for the functioning of democracy' as our concern in this chapter is withcollective choice in democratic societies. It should be noted that some of the important activities observed indemocracies, such as the acquisition of information by the authorities about the preferences of citizens, will alsooccur in non-democratic regimes even though there are no elections and little civil liberty. 5 Rights can also be privately enforced at higher cost. The study of such situations of 'structured anarchy' is an areaof public finance that has not been well-explored. For further discussion and references, see Skaperdas (2003). 6 Recent studies of market failure and the role for government include Salanié (2000) and Glazer and Rothenberg(2001). 7 For a classic exposition of free riding, see Olson (1965).   4taxes levied in accordance with ability to pay or other non-benefit principles, with user fees being used where feasible to retain some elements of the benefit principle.Coercive action is represented by a separate box that lists it together with rent seeking. Oncecoercion enters, it can take on a life of its own. The literature on collective choice is filled withdiscussions and examples of coercive behavior by the majority, or of such behavior by minorityor special interests made feasible by particular institutional arrangements. 8 Appropriation of resources via collective choice leads to competition by those who want to share in rents obtainedin this manner, and thus to the dissipation of resources in the rent seeking process. 9 As in anysystem of governance, there will in addition be agency problems related to the monitoring of  politicians and public servants, who may engage in rent seeking behavior on their own behalf. 10  One should note that the traditional public finance literature only rarely deals directly withcoercion and rent seeking. The topic is often avoided with the assumption that a benevolent planner makes decisions that maximize welfare for the group as a whole.While redistribution through the public sector generally has a coercive aspect, voluntaryredistribution is also possible and can be encouraged, or subsidized, by various policies. 11  Particularly in its publicly aided version (which also may contain an element of coercion),charity can become an important part of economic life. This is indicated by a third, separate boxin the diagram.Competition among political actors, whether vigorous or somewhat attenuated, leads to a set of  policy outcomes. The size and structure of the budget are determined for the current year, and promises are made about the future, even though such promises are suspect due to the inability of current majorities to tie the hands of future electoral winners. 12 Other instruments such asregulation and the law also form part of the equilibrium. Policies determined in this way must beseen against the background of the market economy. In a complete system, the private and publiceconomies interact, as indicated in Figure 1 with arrows going in both directions, to determine private prices and quantities together with specific public policies.A major task of political economy is to explain observed policy choices. In addition, we areinterested in the normative evaluation of equilibrium outcomes. Because of the absence of market prices for public goods, the measurement and evaluation of public sector outcomes raisesdifficult questions. The traditional literature on public finance has emphasized the excess burdens of taxation that are related directly to the separation of taxing and spending alluded to 8 Riker (1986) provides a stimulating introduction to the art of political manipulation. 9 Classic treatments of rent seeking include Tullock (1967) and Krueger (1974). Mueller (2003) analyzes theliterature. 10 Gordon (1999) provides a history of the idea of checks and balances as a method for controlling government. Onthe problem of bureaucracy, see for example Niskanen (1971), Huber and Shipan (2002) and surveys by Wintrobe(1997) and Moe (1997). A recent study of the agency problem is provided by Besley (forthcoming). 11 See, for example, Hochman and Rogers (1969) and Andreoni (1990). 12 The commitment problem is discussed at length by Drazen (2000). Marceau and Smart (2003) is a recentcontribution, where vested interests attenuate the problem by engaging in political action to protect themselves fromexpropriation.
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