07 Government

Question 1

Government and institutions affect:

Answer 1

• Accumulation
  
  • Public spending (e.g., roads)
  • Incentives
• Accumulation of human capita, through
  
  • Public spending, e.g. education & health services
  • Incentives
• Political uncertainty
• Population growth (e.g. China’s one-child policy)
• Technological change (public spending on R&D, incentives, patent system)
• Efficiency (tax system, regulation, security, administration of laws)

Question 2

Why do we need a government for encouraging growth?

Answer 2

• Correct market failure
• Redistribution of income

Question 3

Market failure

Answer 3

Market failure occurs when the market does not produce an efficient outcome. Due to:

• Public goods:
  
  • E.g. defence, infrastructure, rule of law, currency.
• Externalities:
  
  • E.g. R&D, pollution.
• Monopoly:
  
  • E.g. electricity transmission.
• Coordination failures:
  
  • When a group of firms could achieve a more desirable equilibrium but fail to because they do not coordinate their decision making.
  • E.g. car producers unwilling to invest bc of uncertainty about supply of car parts; supplier industry unwilling to invest bc of uncertainty about demand.

Question 4

Redistribution

Answer 4

High- to low-income

Between generations

But does it help growth?

Question 5

Does redistribution help growth?

Answer 5

• Lower inequality is correlated with faster growth.
• 􏰀Redistribution is correlated with higher growth (IMF, 2014).
• 􏰀Inequality affects physical and human capital accumulation.
• 􏰀More: Weil Chapter 13.

Question 6

The case against government intervention

Answer 6

• In theory government regulation can eliminate market failure.
• In practice, potential for government failure:
  
  • 􏰀When government intervention causes a more inefficient allocation of resources than would occur without that intervention.
  • 􏰀E.g. inefficiency in state-run firms (lack of incentives such as profits).
  • 􏰀What’s the lowest cost: Inefficiency of monopoly or inefficiency of goverment regulation?
  • Difficult to set the right tax/subsidy to internalize externalities.
• Redistribution: Trade-off between redistribution and efficiency?
  
  • 􏰀Efficiency loss by raising taxes.
  • 􏰀Benefits from greater degree of equality.
  • 􏰀Arthur Okun (1975) “Equality and Efficiency: The Big Tradeoff”

Question 7

Employment in general government as a percentage of the labour force (2011)

Answer 7

Question 8

Empirics: How the government affects growth

Answer 8

• Rule of law
• The tax system
• Economic planning and policy
• Absence of government (conflict)

Question 9

How the government affects growth:

Rule of law

Answer 9

• Essential public good.
• Existence of courts that enforce contracts.
• Patent laws.
• Existence of courts and police to enforce ownership.
• Lack of rule of law a major reason for low growth and underdevelopment for many countries.
  
  • “The inability of societies to develop effective, low-cost enforcement contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World” (Nobel price laureate Douglass North, 1993).
  • Impedes factor accumulation and inefficiency.

Question 10

How the government affects growth:

The tax system

Answer 10

• High growth in spending the last century.
  
  • Richer countries require more complex regulation.
  • Wagner’s law: The income elasticity for public goods > 1, e.g., health.

Question 11

Wagner’s law: The income elasticity for public goods ____

Answer 11

Wagner’s law: The income elasticity for public goods > 1

Question 12

Government spending as a percentage of GDP (1880 to 2010)

Answer 12

2009: Average spending among OECD countries 47% of GDP

Question 13

Efficiency loss: Recent estimate of deadweight loss is __ in lost output for $1 in government spending (Feldstein, 1997)

Answer 13

Efficiency loss: Recent estimate of deadweight loss is $1 in lost output for $1 in government spending (Feldstein, 1997)

Question 14

Deadweight loss

Answer 14

• Some transactions will not take place (transactions that would benefit buyers and sellers) => lower consumer and producer surplus
• Very high tax rate yields zero tax revenue and zero transactions

Question 15

Correlation between taxes and income

Answer 15

No negative correlation between taxes and income - in fact it’s positive. Governments tend to use tax revenue wisely - infrastructure, education, etc.

Question 16

How the government affects growth:

Economic planning and policy

Answer 16

Macro policies

Industrial policies

• State ownership.
  
  • Government owned banks 98% of bank assets in China.
  • Value of govn’t owned stocks on Norwegian stock exchange 37%.
• Tax breaks / subsidies for certain sectors.
• Trade restrictions (tariffs and quotas on imports).
  
  • Infant-industry protection (e.g. South Korea and Taiwan).
  • Agricultural protection in Norway.

Potential concerns

• Lack of incentives. Rent seeking. Business decisions based on political connections etc.
• But outcome of policies varies across countries. Why?

Question 17

How the government affects growth:

Conflict

Answer 17

Lack of government & conflict dampen growth:

• Looting.
• Flight of refugees.
• Destruction of physical and human capital.
• Fall in investment, supply of public goods, domestic and international trade.

Example:
GDP of Mozambique fell by 1.3% every year during the civil war (1977-1994), then grew by 4.9% annually between 1995-2010.

• Conflit traps

Question 18

Conflict traps

Answer 18

Countries caught in conflict traps:

Conflict => growth ↓
Growth ↓ => conflict ↑

Violence and poverty is self-reinforcing
Multiple equilibria

Question 19

Why does poverty increase the likelihood of conflict?

Answer 19

• Opportunity cost of conflict low
• Poor countries do not have necessary resources to stop violence

Question 20

Armed Conflict by Type (1946 - 2013)

Answer 20

Question 21

Why some govements do not facilitate growth

Answer 21

• A different objective function.
• Corruption : staff of government act in their self-interest rather than the interest of the country.
• Self-preservation : low growth policies best way to preserve power.

Question 22

Why some goverments do not facilitate growth:

A different objective function

Answer 22

• Environmental concerns
• Redistribution
• E.g. aim to increase GNH instead of GDP in Bhutan since 1971

Question 23

Why some goverments do not facilitate growth:

Corruption (direct and indirect effects)

Answer 23

Direct effects:

• Waste/misuse of government funds.
• E.g. tax fraud (bribing tax authorities).

Indirect effects:

• Misallocation / entry barriers.
• Economic policies enacted just to facilitate corruption (import quotas).
• Undermines rule of law and possibility of building good institutions.

Question 24

Why poor countries have bad governments?

Answer 24

Causality goes both ways:

Low income <=> Bad government

Question 25

Higher income can lead to better government quality because:

Answer 25

Higher income can lead to better government quality because

• Public employees receive higher wages → less corruption.
• Less conflict within goverment / between interest groups when government spending/income is larger.
• Good governement is a luxury good.

Question 26

Why did colonialism lead to bad government?

Answer 26

• Borders did not follow ethnic boundaries.
• Divide and conquer strategies.
• Institutions maximized income of colonial powers, and not population.
  
  • 􏰀 Slavery, depletion of natural resources.
• Bad institutions persist over time.

Question 27

Instrument variable for “What is the causal impact of institutions on economic development?”

Answer 27

Settler mortality.

Acemoglu, Johnson and Robinson find large effects of institutions (2001).

Question 28

Bad gov’t not always bad for growth:

Answer 28

• Chinese growth dispite widespread corruption (117th out of 186 countries in corruption measure).
• New York City 1800s. High growth & widespread corruption.

Question 29

Why can democracy improve growth?

Answer 29

• Limits on power → bad rulers not re-elected.
• Milton Friedman’s “Capitalism and Freedom” (1962):
  
  • 􏰀Economic freedom necessary for political freedom −→ Growth.
  • 􏰀E.g. no real dissent possible if capital owned by the gov’t.

Question 30

How can democracy hinder growth?

Answer 30

• Prone to political instability.
  
  • Short-run gains versus long-run growth.
• Special interests and lobbying.
• Slow and inefficient.

Case study: India versus China.
7.9% growth in China vs 3.7% in India (1975-2009).

Question 31

Democracy and growth (figure)

Answer 31

Democracy data from Freedom House.
Correlation positive but not very strong.
Direction of causality?