Partisan Politics and Distributional Conflicts
In practice, economic policy is often rather concerned with redistributive policy than with growth-enhancing policies.
We often see that conflict of interests and special-interest policies determine economic policy and not maximizing any form of “social welfare”.
If there is (income) inequality, redistribution becomes even more likely.
In a dynamic perspective, redistribution very often involves accumulation of public debt.
Which links exist between inequality, redistribution, and debt?
Basic Model
There’s a continuum of individuals (summing to 1) with preferences over consumption and leisure.
They have individual endowments (effective labor) which translates into income and consumption.
Redistribution across individuals via taxation and transfers. All individuals receive lump-sum transfer 𝑇𝑇which is tax financed via a proportional income tax.
Voters decide on level of taxation. Assume Median-Voter decides
The individually optimal tax rate increases in the difference between average and individual endowment with labor (which translates into income). All individuals with below average endowment prefer positive taxes and vice versa.
The median voter would vote for redistribution form “rich” to “poor”
The consequence of this simple model is that there is redistribution from persons with above average endowment to those with below average endowment.
If the median voter decides, there will be redistribution since the median is usually „poorer“ than the average.
Redistribution should be increasing in inequality, at least in a democratic system.
More redistribution implies higher taxes, which in turn has negative incentive effects. People will work less and consume more leisure.
This negative incentive effect will, in general, restrict redistribution.
Higher inequality and possibly higher taxation will lead to less (official) economic activity and possibly less growth
Debt and Common-Pool Problems
There is a widespread tendency of governments of accumulating high levels of public debt.
While public debt in times of crises or large shocks (wars, environmental disasters …) can be explained by motives of tax smoothing, this is not the case for persistent accumulation of debt.
Empirical evidence shows that, all else equal, high debt levels are especially a problem under (instable) coalition governments or with decentralized spending decisions under a centralized budget.
Coalitions have to serve many and diverse interest groups.
Individual ministers do not (fully) internalize the consequences of spending on central budget (common pool problem)
Addressing special interest groups under political competition always involves redistributive policies.
Heterogeneity of interests among groups implies differences in demands for redistribution and spending on particular items.
Redistribution via public debt is especially attractive to politicians as debt has to be paid back in the future, possibly by different policymakers. Moreover, responsibility for accumulating debt can easier be deflected in later periods.
Thus, public debt accumulation typically results when several decision makers with conflicting interests make simultaneous choices.
Tendency to overspend is highest if spending decisions are decentralized while revenues are centralized.
Thus, deficits are likely to arise in political systems with more dispersed political powers
The Model
We consider a dynamic game with two periods, 𝑡 = 1, 2.
Assume a large number of individuals with similar preferences over consumption 𝑐𝑡 and leisure 𝑥 as well as endowment 𝑒.
Consumption possibilities depend on endowment in 𝑡 = 1, net income after taxation (1 − 𝜏 )𝐿, and income from holding public debt (1 + 𝑟)𝑏 in 𝑡 = 2. (To simplify we set 𝑟 = 0).
Income from debt is not taxed, and government is committed to paying back debt in period 2.
Apart from private consumption, there are two public goods, and individuals fall in two groups (political parties 𝐽 = 𝑅, 𝐷) with different preferences over those two goods („Guns and Butter“)
Private Decisions
Interest Groups and Public Goods
Dynamic Pool Problem
Now consider the case of decentralized spending. Both groups have direct access to the budget and can set expenditures on “their” public good freely. 𝑏𝑏is endogenous, 𝜏 is the residual.
While each group benefits only from “its own” good, it also contributes to financing the other good and to repaying debt from the first period.
We use backward induction (Subgame Perfect Nash Equilibrium).
In 𝑡=2, debt 𝑏 and expenditures by group 𝐼 are taken as given by 𝐽. Its period2 utility is
leading to FOC:
The common pool problem creates two public finance problems:
Taking only part of the costs and distortions created by public debt into account will lead interest groups to spend too much and to build up too much debt. There is a debt bias that leads to a structural debt problem.
Spending is strategically front-loaded because groups hope that higher debt will induce the other group to spend less later to avoid that taxes need to increase too much.
Given that all groups have the same incentive, the strategy will not work and the economy ends up with too much spending overall and spending not allocated optimally over time.
Theoretical base for public finance rules.
If there are more than two groups that can decide unilaterally, each group internalizes even smaller fractions of the future cost of debt issue and spending as well as the debt problem should become worse.
Empirical evidence shows that budget discipline improves
with the extent to which spending power is centralized in the hands of the Finance Minister or Prime Minister, and
if the budget process entails sequential decision making. That is, the overall budget is fixed beforeexpenditure allocation is taken.
Spending and debt issue is positively correlated with:
the number of coalition partners in government
the number of spending ministers in government.
War of Attrition
Even if policymakers from different parties, representing different societal groups, can agree on the need of a particular policy change, it is often contested who should bear the (larger part of the) costs of policy adjustment.
If postponing the necessary policy adjustment is costly, optimal policy would be to agree on burden-sharing and immediate adjustment.
The party (group) with higher costs of waiting should agree to pay larger part of the burden because its incentive for immediate adjustment is higher.
If, however, the individual cost of waiting is private information, both groups have an incentive to outwait the other party in the hope that it will „surrender“ first and agree to pay larger share of adjustment costs.
Thus, asymmetric information gives rise to „war of attrition“.
Examples:
Budget needs to be stabilized, but groups fight over who should bear a larger share of the tax increase. If no adjustment takes place, inflation or debt is used to balance budget. If costs of these distortions are asymmetric, adjustment is postponed.
Capital and labor might be in conflict over wage increases.Which side can hold out longer if there is a strike? Income and production losses make holding out increasingly costly.
All groups agree on the need for additional public spending (infrastructure, schooling …) Should increase be financed by consumption tax (VAT) or a „wealth tax“?
Consequence of conflict is that policy adjustment is too late which creates efficiency (and income) losses.
There are two periods 𝑡=1,2. There is no discounting.
There are two groups 𝑖=𝑅,𝐿which consume public goods 𝑔𝑅 and 𝑔𝐿. Each group has only utility from consuming „its“ good.
Both unilaterally decide about spending on „their“ good.
Consumption is financed by an exogenous tax revenue 2𝜏and public debt 𝑏.
Groups can consume more than their share 𝜏 which leads to debt that has to be paid back in period 2 (and lowers consumption then). Groups can also save: −𝑏.
Groups are debt averse and have costs from debt 𝛾𝑖. This parameter is private information to group 𝑖𝑖. It has distribution function 𝛾𝑖~(0,Γ).
The incentive not to concede first is that the „loser“ pays a compensation to the „winner“.
Necessary policy adjustment is made but burden from this is distributed asymmetrically if only one group agrees to stabilization.
One-sided agreement thus creates redistribution between groups.
Tying the Hands of One’s Successor
If political parties are in conflict about what type of public good to spend money on, this can lead to too high expenditures.
As we have seen, debt will restrict possibilities to spend in future periods.
There is thus an incentive for governments to spend more today and leave paying back debt to future governments. Future governments will also have less leeway to spend on their preferred public good.
Of course, it will also restrain possibilities if own party is in power in future periods. There is, thus, a trade-off of spending more today and possibly being less able to spend tomorrow.
Reelection probability is thus a decisive factor
Policymakers can influence the spending level of the successors by running up debt. Thus, if parties have strongly divergent preferences over the consumption of different public goods, they can insure that their opponents have less money to spend on particular goods.
Thus, more debt is likely to be observed if there is a high probability of parties alternating in office because otherwise parties would be binding their own hands.
This is another explanation for the deficit bias of political systems.
Note that pattern is more likely to be observed in majority systems with frequent changes than in stable coalitions. Therefore, the US may be a better application for this than Switzerland
Political Cycles
So far we have considered the incentives of parties to manipulate economic variables because they have different preferences than their opponents. This leads them to strategically set their policies to influence the actions of their opponents, leading to excessive deficits and a secular increase in debt.
Another phenomenon is that policies change systematically over time, depending on whether elections are close or not, and depending on which party is in power.
Empirically we see that public expenditures often go up before elections to increase the chance of reelection, and that conservative and more left-leaning parties often implement different fiscal and monetary policies
Opportunistic Cycles
Politicians often try to produce a temporary economic upturn or to improve statistics (such as unemployment statistics) before an election. A good performance of economic indicators suggests a competent policymaker which improves the incumbent’s electoral prospects.
This incentive is, ceteris paribus, given independent of a particular political position. We assume that all politicians behave opportunistic to influence reelection prospects.
These policies usually also involve costs that, however, often realize only after the election, such as higher inflation or public debt.
Depending on how rational (or cynical) voters are, such a cycle of overspending and higher inflation, followed by stabilization after elections, may repeat over time
The Nordhaus Modell
Nordhaus (1975) has formalized this incentive for opportunistic politicians. Many empirical studies have followed.
Assumptions:
Voters are identical and vote only according to their preferences, defined over inflation and output.
Voters are not forward looking but vote retrospectively, based on the development of inflation and output before elections.
Policymakers are only interested in reelection and have no own preferences over these macroeconomic aggregates
Nordhaus’ model makes strong assumptions about political business cycles. Economy should boom before elections, followed by a bust after elections.
It should not work if voters vote rationally. They should only be interested in forward looking variables and not in past developments. Moreover, they should foresee the cycle and (depending on their time preferences) not vote for such a policy. With rational expectations, monetary policy would have no real effect.
Even if predictions are not fully convincing, one can observe that policies before elections differ significantly from those in other periods
Ideological Cycles
Hibbs (1977) and Alesina have developed approaches in which policymakers have different preferences concerning economic variables. They assume that left-leaning politicians are less inflation averse than right-leaning politicians.
In contrast to Nordhaus, politicians are not purely opportunistic but committed to their policy aims.
Depending on who is in office, one should therefore observe more or less strong differences in the development of economic variables, such as debt, employment or inflation.
While Hibbs assumes that voters are not rational, Alesina introduces rationality but uncertainty about election outcomes. Depending on their assumptions, policies are more or less effective.
In any case, however, different preferences lead to systematically different policies and thus the identity of policy makers influence economic policies
The Hibbs Model
The predictions are thus that inflation and output should have systematically different values, depending on whether 𝐿 or 𝑅 are in office. Inflation and output are higher under 𝐿 than under 𝑅.
This is the case over the whole tenure of the incumbent.
With rational expectations, however, output effects should only be observed when there is surprise inflation.
That is, the effect of changes over policymakers after election should wear off over time. It should matter more directly after elections
Ideology and Rational Expectations
Introducing rational expectations implies that monetary policy is not effective. Since there is no uncertainty about shocks, private agents can predict monetary policy and adjust their behavior.
Introducing uncertainty about the outcome of elections at the time wage setters form their expectations, however, creates another type of uncertainty (political uncertainty) that could lead to real effect of monetary policy.
Depending on who wins the election, we may observe an increase in output or a drop. Once wage setters have been able to adjust their expectations, the real effect vanishes.
The strength of this effect obviously depends on how big is the surprise about the election outcome
Uncertainty about election outcomes creates an interaction between the policy aims of competing parties. Their equilibrium policies are not only influenced by their own targets but by those of the other party as well. Policies thus become strategic complements.
Since only election surprises create real output effects, those depend crucially on the assumption that wage setters have to form their expectations before elections, and on the degree of uncertainty about election outcomes. As 𝑞𝑞 ≅ 0 or 𝑞𝑞 ≅ 1 election surprises disappear and so do real effects.
In cases with high political uncertainty, however, changes of incumbents can have effects on the real economy
Conclusion
Political competition between parties is likely to have influence on economic policies. Heterogeneities among voters will lead to distributional conflicts and parties addressing the interests of „their“ voters.
This has influence on fiscal policy, leading to different tax policies, a tendency for higher government debt, and attempts to manipulate the fiscal space of one‘s opponent.
Since election outcomes also depend on economic variables, incumbents have an incentive to manipulate economic variables before election.
After elections, given different preferences of political parties, one could expect systematically different economic policies. Policy changes, or political cycles, will be more pronounced the higher are ideological differences or distributional conflicts among voters and parties
Instability in economic variables are hence not only created by economic shocks but also through political shocks.
Policymakers are thus not always trying to stabilize the economy, but they may actually be responsible for creating instability in some variables.
This strengthens the case for policy rules rather than discretion and it also strengthens the case for delegating policymaking to independent, non-partisan, agents.
Monetary policy cycles have mostly disappeared with widespread central bank independence.
Fiscal cycles may still exist, but they are alleviated with fiscal policy rules and fiscal stability boards
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