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
