07 Government Flashcards
Government and institutions affect:
- 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)
Why do we need a government for encouraging growth?
- Correct market failure
- Redistribution of income
Market failure
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.
Redistribution
High- to low-income
Between generations
But does it help growth?
Does redistribution help growth?
- 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.
The case against government intervention
- 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”
Employment in general government as a percentage of the labour force (2011)
Empirics: How the government affects growth
- Rule of law
- The tax system
- Economic planning and policy
- Absence of government (conflict)
How the government affects growth:
Rule of law
- 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.
How the government affects growth:
The tax system
- 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.
Wagner’s law: The income elasticity for public goods ____
Wagner’s law: The income elasticity for public goods > 1
Government spending as a percentage of GDP (1880 to 2010)
2009: Average spending among OECD countries 47% of GDP
Efficiency loss: Recent estimate of deadweight loss is __ in lost output for $1 in government spending (Feldstein, 1997)
Efficiency loss: Recent estimate of deadweight loss is $1 in lost output for $1 in government spending (Feldstein, 1997)
Deadweight loss
- 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
Correlation between taxes and income
No negative correlation between taxes and income - in fact it’s positive. Governments tend to use tax revenue wisely - infrastructure, education, etc.
How the government affects growth:
Economic planning and policy
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?
How the government affects growth:
Conflict
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
Conflict traps
Countries caught in conflict traps:
Conflict => growth ↓
Growth ↓ => conflict ↑
Violence and poverty is self-reinforcing
Multiple equilibria
Why does poverty increase the likelihood of conflict?
- Opportunity cost of conflict low
- Poor countries do not have necessary resources to stop violence
Armed Conflict by Type (1946 - 2013)
Why some govements do not facilitate growth
- 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.
Why some goverments do not facilitate growth:
A different objective function
- Environmental concerns
- Redistribution
- E.g. aim to increase GNH instead of GDP in Bhutan since 1971
Why some goverments do not facilitate growth:
Corruption (direct and indirect effects)
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.
Why poor countries have bad governments?
Causality goes both ways:
Low income <=> Bad government
Higher income can lead to better government quality because:
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.
Why did colonialism lead to bad government?
- 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.
Instrument variable for “What is the causal impact of institutions on economic development?”
Settler mortality.
Acemoglu, Johnson and Robinson find large effects of institutions (2001).
Bad gov’t not always bad for growth:
- Chinese growth dispite widespread corruption (117th out of 186 countries in corruption measure).
- New York City 1800s. High growth & widespread corruption.
Why can democracy improve growth?
- 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.
How can democracy hinder growth?
- 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).
Democracy and growth (figure)
Democracy data from Freedom House.
Correlation positive but not very strong.
Direction of causality?
