Chapter 12 3e - Boston College · Chapter 12 Modified ... – Eﬀec-veness(and(predictability(of(the(judiciary. – Controlling ... (ac-vity(became(uncertain,(leading(to(12(percentdecline(in

Copyright © 2013 Pearson Education, Inc. Publishing as Addison-Wesley

GOVERNMENT

Chapter 12

Modified for EC 375 byBob Murphy


Government and Growth

• Factor Accumula-on– Infrastructure– Educa-on– Immigra-on

• Speed of Technological Progress– Research and Development Funding– Patent System

• Efficiency– Taxa-on, Regula-on, Administra-ve Law– “Rules of the Game”

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Government and Growth

• Two Aspects:– Norma-ve:

• What should a government do?

– Posi-ve:• Why does a government do what it does?

– We will focus our aLen-on on both of these aspects:• Start with norma-ve aspect and explore how policy affects growth.• Consider posi-ve aspect and seek to understand why governments would do things that are detrimental to growth.

• Assess why poor countries seem to have bad governments.

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Proper Role for Government in the Economy

• Case For Government’s Role:– Market Failure:

• Provide public goods.• Internalize externali-es, both posi-ve and nega-ve ones.• Address coordina-on failures in the private sector.

– Income Redistribu-on:• Equity considera-ons.

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• Case Against Government’s Role:– Government Failure:

• ALempts to fix market failure but actually makes it worse.• For example, government enterprises.• Best advice is to target market failure narrowly, the theory of “second best.”

– Private Sector Could Supply Goods:• Priva-za-on and deregula-on.

– Equity-‐Efficiency Tradeoff:• Inefficiency of government regula-on versus inefficiency of monopoly-‐-‐comparing similar costs.

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– Equity-‐Efficiency Tradeoff:• But income redistribu-on reflects a different sort of tradeoff-‐-‐equality versus efficiency.

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• Historical Record Shows Shi[s in Consensus:– WWI through the early Post-‐WWII period saw an increased role for government in the economy:

• Communism and Facism, New Deal in U.S.• Western Europe’s welfare states, • Developing countries adopt state planning models.

– Last few decades have seen shi[ away from government involvement in the economy:

• Priva-ze state enterprises and deregulate private industries.• Collapse of communism.• Reduc-ons in generosity of welfare state.

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How Governments Affect Growth

• Maintenance of the Rule of Law:– Enforceability of contracts.– Effec-veness and predictability of the judiciary.– Controlling crime.

• Overall Size of Government:– Government spending, taxa-on.

• Prac-ce of Planning:– Industrial policy, central planning.

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• Rule of law is a public good:– Business contracts rely enforcement by courts.– Inventors rely on enforcement of patents.– Owners of private property rely on courts and police to enforce their property rights.

• Rule of law can work through two channels:– Factor accumula-on and produc-vity.– Example of Russia a[er collapse of Soviet Union:

• Legal structure for economic ac-vity became uncertain, leading to 12 percent decline in income per capita over next decade.

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• Measure rule of law by composite that includes:– Enforceability of contracts.– Effec-veness and predictability of the judiciary.– Incidence of crime.

• Uses data from:– Surveys of business people and ci-zens.– Opinions of experts at nongovernmental organiza-ons, think tanks, and risk-‐ra-ng agencies.

• Scale with mean of zero.

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Figure 12.1 Rule of Law and Factor Accumulation, 2009

Source: Kaufmann, Kray, and Mastruzzi (2010). Data are scaled to have a standard deviation of 1.

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Figure 12.2 Rule of Law and Productivity

Source: Kaufmann, Kray, and Mastruzzi (2010). Data are scaled to have a standard deviation of 1.

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• Taxa-on, Efficiency, and the Size of Government:– Wagner’s Law (1883): Demand for public goods increases more than in propor-on to wealth.

– So, government size rises as country becomes wealthier and regula-ons increase.

– Government spending as share of GDP:• U.S. in 1870 about 4%, in 2005 37%.• OECD average in 2005 is 43%.• Poor countries today have much higher share at given level of income per capita than rich did in the past.

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Figure 12.3 Growth of Government Spending, 1870–2009

Source: “The Future of the State,” The Economist, September 20, 1997, OECD.

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• To fund spending need to raise taxes:– Taxes distort decisions and lead to deadweight losses.– As tax rate rises, revenue eventually begins to decline.– An es-mate for the U.S. is that the marginal dollar of tax revenue costs one dollar of lost output.

– So, the “cost” of one more dollar of spending is actually two dollars.

– Need to provide public goods, so also consider those benefits, but not all spending is for public goods.

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Figure 12.4 Effect of a Tax

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• Planning and Other Industrial Policies:– Post WWII period in newly independent countries.– Several policy tools of this sort:

• State enterprises-‐-‐corpora-ons owned by the government, o[en banking and heavy industry, and in some countries these enterprises produced more than half of manufacturing output.

• Marke-ng boards-‐-‐o[en used in agriculture where farmers sell output to government enterprise seeking to use its market power to get beLer prices.

• Trade restric-ons-‐-‐tariffs and quotas on imports, jus-fied by the “infant industry” argument.

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• Failure of planning and industrial policies:– When state enterprises were priva-zed:

• Observe large decline in cost per unit of output produced. Firms become profitable.

• Example of Mexico in 1980s and 1990s.

– Marke-ng boards end up failing to raise prices:• Government gra[.

– Infant industries don’t “grow up”:• Import protec-on extended to industries that never could compete on own, based on poli-cal considera-ons.

• Lack of foreign compe--on keeps industries inefficient.

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• Failure of planning and industrial policies:– These policies lead to rent seeking:

• Easier to make a profit by lobbying government bureaucrats who decide on the alloca-on of investment and import policies.

• Rent seeking is an unproduc-ve ac-vity reducing the efficiency of produc-on.

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• Planning is Not Always a Failure:– East Asian “Tigers”-‐-‐South Korea and Taiwan– Public enterprises in South Korea were autonomous, profit-‐seeking firms and in many cases were merged quickly into the private sector.

– Infant industry tariffs in both countries were maintained only to extent that industries showed produc-vity growth-‐-‐in South Korea, industries had to export an increasing share of their output.

– Honest bureaucrats ran policies.

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Why Governments Adopt Policies that are Bad for Growth

• Posi-ve Analysis:– Some other goal:

• For example, reducing pollu-on-‐-‐if measure output more broadly, then reducing pollu-on may not look as inefficient.

• Spending on na-onal defense, arts, or foreign aid may be in the na-onal interest even if reduces growth.

• Income inequality-‐-‐government may value equity and accept some inefficiency.

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– Corrup-on and Kleptocracy:• Government is ac-ng in own self-‐interest.• Corrup-on in many forms-‐-‐bribes to tax officials, government contracts for cash, gran-ng monopolies to rela-ves and cronies.

• Could corrup-on actually create incen-ves for faster growth?• Evidence suggests no:

– Wastes taxpayer money.– Policies to generate more opportunity for corrup-on.– Corrup-on undermines rule of law and judicial system.

• Some survey data allows “measurement” of corrup-on.

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Figure 12.5 Government Corruption versus GDP per Capita, 2009

Source: Kaufmann, Kray, and Mastruzzi (2010).

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Why Governments Adopt Policies that are Bad for Growth– Self-‐Preserva-on:

• Keep the exis-ng government in power:– Changes in social structure that accompany economic growth pose a threat to the people in power.

– New technologies, rising educa-on, movement of people from farms to ci-es, trade with foreign countries brings in new ideas.

• But lack of growth can also threaten a government’s survival:– More likely to tolerate growth if government is strong and/or faces external threat.

– Example of Russia and Soviet Union-‐-‐development is risky, perestroika (restructuring) and glasnost (poli-cal openness).

– Example of Mobutu and Zaire (Democra-c Republic of the Congo)-‐-‐1991 has only 1/10 paved road mileage as in 1960.

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• Government Regula-on:– Regula-on might protect consumers and limit nega-ve externali-es-‐-‐“helping hand” view.

– Or it might be imposed by governments to benefit bureaucrats or supporters-‐-‐“grabbing hand” view.

– Study looked at 75 countries and collected data on requirements to open a new business:

• Countries with more regula-ons did not have less pollu-on or higher-‐quality consumer goods or beLer health than those with fewer regula-ons.

• More democra-c countries had fewer regula-ons and more corrupt countries had more.

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• Government Regula-on:– Example of star-ng a business in Peru (1984):

• 11 permits, licenses, etc. are needed.• Takes average of 289 days.• Fees and lost wages due to -me going from government office to government office ends up being 32 -mes the Peruvian monthly minimum wage.

– Example of star-ng a new firm in Bolivia compare to Canada:• Bolivia: 20 requirements, 82 days, $2696 in fees.• Canada: 2 requirements, 2 days, $280 in fees.

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Why Poor Countries Have Bad Governments

• Causa-on could run either way:– Income determines government quality.– Government quality determines income.– In other words, are countries poor because of their governments or is bad government a symptom rather than a cause of bad government.

– Both direc-ons of causa-on likely maLer, but which is more important?

– Look at both in turn.

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• Causa-on from Income to Government Quality:– Rests on two observa-ons:

• Bad government is not an impediment to economic growth:– Historical examples of Bri-sh army officers buying appointments or promo-ons and recouping cost from their budget.

– New York City and Boss Tweed-‐-‐lots of corrup-on yet city grew strongly.– “Crony capitalism” in Japan did not slow growth over period 1950-‐1990, and similarly in Indonesia under Suharto.

• Quality of government o[en improves with income:– Can afford to pay civil servants reasonable wages.– Larger pie to share means less need for destruc-ve gridlock.– Honest government may be a “luxury” good.

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Democracy and Economic Growth

• Level of democracy is higher in rich countries:– Measure by compe--veness of electoral system and accountability of elected leaders.

– Unlike other indicators of “good governance” such as rule of law and lack of corrup-on, democracy may not always be beneficial for growth:

• It does limit the power of rulers and thus reduce kleptocracy and corrup-on aiding growth.

• But democracies can lead to poli-cal instability which hurts growth.• And poli-cians may seek short-‐term gains and aim to redistribute income at the expense of long-‐run growth.

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Figure 12.6 Democracy and GDP per Capita

Source: Freedom House (2011).

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• Causa-on from Government Quality to Income:– Based mainly on evidence that government does affect the economy:

• Examples of policies that have encouraged or impeded growth-‐-‐North Korea vs. South Korea.

• Given that government policies are important for growth and differ so much across countries, this is a sensible conclusion.

– Legacy of colonialism:• Of the 30 most corrupt countries, 22 are former colonies of European powers.

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Why Poor Countries Have Bad Governments• Colonialism and Bad Governments:

– Government system installed by colonial powers was aimed at extrac-on rather than development:

• When European colonizers leave or are overthrown, the extrac-ve forms of government were le[ in place-‐-‐ in the form of a strong man or ruling na-ve elite, so these colonial ins-tu-ons ul-mately lead to bad governments later on.

• Not true in colonies where large numbers of Europeans seLle-‐-‐U.S., Canada, Australia.

– Colonial rule created ethnic mixes that made good government difficult:

• Arbitrary borders and “divide and rule” governance.

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Documents

Chapter 12 3e - Boston College · Chapter 12 Modified ... – Eﬀec-veness(and(predictability(of(the(judiciary. – Controlling ... (ac-vity(became(uncertain,(leading(to(12(percentdecline(in