Public Economics Paper 8 by wsj58G

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									Public Economics
     Paper 7
       Lecture 2
Growth in Government
Structural Explanations
                  Outline
• Structural models of growth in government

• Wagner’s Law

• Baumol’s cost disease

• Displacement hypothesis
                Wagner’s 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)
                       1. Industrialisation
 The driving force:    2. Increasing incomes
                       3. Social progress

                 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.
      General government expenditure, 1870-1996
                  (percent of GDP)

      45
      40
      35
      30
      25
                                                              UK
      20
                                                              Average
      15
      10
       5
       0                                                    17 OECD
           1870   1913   1937   1960   1980   1990   1996   countries
Source: Tanzi and Schuknecht (2000), Table I.1.
 Structural                  Direct effect               Effect on government
  change                   complexity of econ.           banking services
                           relations.                     Law & order


                           Urbanization
                                                              regulatory services
                                                 congestion
                                                              Urban sanitation
                           population density
Industrialization
income                    demand for income                 education
social progress             elastic goods

                                                                Social services
                           demand for redistribution
                                                                transfers

                           New industries                Government enterprises
                           with                          (transportation)
                           economics of scale
  Notice no feedback effects are considered.              non-tax revenues
            Testing Wagner’s Lawspending
                           Government
                             d ln g
                                        
                             d ln  y 
        Income elasticity:

                                                 GDP per capita

  Absolute version:          0       Normal good

  Relative version:           1      Superior good

(share of government spending
      in GDP increases).

  ln g i   0   ln yi  X i    i        cross country


  ln g t   0   ln yt   1 ln g t 1  X t   t
                    
         LR      1 2
                                              Time series in one country
             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.
                Education




Baumol (1993)
            Health care prices




Baumol (1993)
            Baumol’s 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.



 Why not cumulative productivity growth in public services?

1. Education and other services are very labour intensive.
2. W up => higher average costs
3. Less units supplied but higher total cost
                              Key assumptions
                                                        cumulative increase
(1) Differential productivity growth                    in productivity

             g t  Lgt                        yt  Lyte        rt

             Public sector                    Private sector

(2) Wage equalization across sectors   wt  e      rt
                                                                    Pyt  1

(3) Fixed supply of labour:     1  Lgt  Lyt
                                               
(4) Demand for public services:          pgt  
                                     g 
                                       d       wt  pgt w
                                                      
     0 (price elasticity)            tp               t


     0 (incomeelasticity)              yt 

(5) Demand for private goods:
                                    wt  pgt
                                y 
                                 d           gt  wt  pgt gt
                                 t p  p
                                    yt    yt
The average cost of producing public and private goods
                 wt Lg ,t                                                    wt Ly ,t
Pgt  Cgt                   e    rt
                                                         Pyt  C yt                    1
                    gt                                                          yt
                                               Pgt
                                                      e rt        increases over time
                         Pyt
 The relative size of government:

                  Pg ,t gt                  Pgt ( Pgt )  wt     e rt e r (   )t
  S gt                                                                             e r (   )t
            Pg ,t g t  Py ,t yt                   wt                   e rt

 S gt
  t
          r (   )                       Growth if             
     Income         Evidence               Price
     elasticity                            elasticity
                           
(1) Compensated price elasticity of public services:
                     (0.3,0.4)
(2) Income elasticity:
                       (0.5,1)

   Can we assume that these elasticities are constant?
                                           Central Government Spending in the UK
     Central government spending %of GDP
                                                         1830-1975
                                            80                                                    WWII
                                                                      WWI

                                            60




                                            40




                                            20




                                            0
                                                 1820   1840   1860   1880   1900   1920   1940   1960   1980
                                                                             Year
Source: Aidt et al. (2004)
   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.
          The “tolerable burden of taxation” T *

        gt  t   *
                         but         g t  t
                                        *       *


Actual spending                    spending desired by government

      Social upheaval causes a permanent shift upwards
      in the tolerable burden of taxation:

                      gt 1  t1  t  gt
                               *         *


    In times of crisis, formerly unacceptable means of
      taxation will be tolerated and, importantly, this
                 higher tolerance persists.
                 Graphical illustration

   g
ln( )
   y
                                          total spending
                                          civilian spending




                                          defence
                                                time
        normal          war    normal
                    Empirical tests
    • What qualifies as a major social upheaval:
      – WWI and WWII
      – Great Depression?
      – Oil Shocks?


          g t  a1  a2 DWWI  a3 DWWII  X t    t
               0 if year < 1914
D   WWI
                                                 test
               1 if year = 1923-38 or >1950     a1  0
              0 if year < 1914 or 1923-38       a2  0
WWII
D         
              1 if year >1950
          Some Problems
• Upwards trend, series correlation,
  stationarity.
• No modelling of the wars (catch up
  spending)
• Data relatively sparse before WWI.

• Model the times series properties of g.
• Model the war(s).
• Evidence much weaker when these things
  are taken into account.
                 Summary
• The displacement hypothesis and (textbook)
  Wagner’s Law have little empirical support.
• Baumol’s hypothesis has more support for
  particular services (health and education), but
  what about constant net size?
• 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 interactions between politics and
  economies are not considered.
            What is next?
• The median voter model

• Extension of the voting franchise
  – relaxing income and property requirements
  – relaxing gender restrictions
         The weak version of the displacement
                     hypothesis
   g                                          total spending
ln( )
   y                                          civilian spending




                                                defence
                                                     time
         normal         war      normal

        Underlying trend growth: level shift but not trend
                            effect.
ARIMA model of spending in
       the UK
             time series model

  gt  b0  b1T  b2 gt 1  b3 gt 2
       b4 PWt  b5Wt  X t b   t
      Dummy = 1 after WWII       Dummy for WWII

   Result: b4 negative and significant!!!

 Little systematic evidence of the
        displacement effect

								
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