Saturday, May 07, 2005

What causes government spending growth?

It certainly seems as though Prime Minister Martin and Smilin' Jack Layton are trying to commit the Federal Government to more spending than it can handle, and should the Conservatives take power, the Libs are trying to themselves in order to cast potshots at a fiscally hamstrung Conservative government. The Liberals are taking their cue from the rule of Bob Rae, whose government was pre-committed to expenditures just as the economy was about to go into decline. The Libs are simply sabotaging the country's finances in order to screw the Conservatives over.

Canada is not very good at predicting budget surpluses, at least as far as the IMF has found.

From the Globe & Mail:

"Canada has one of the worst track records in making budget forecasts of any of the leading industrial countries, according to research by International Monetary Fund economists.

And Ottawa would be better served if its budget forecasts, which have consistently underestimated surpluses since 1997, were more transparent, the IMF economists said in study posted on its website late Wednesday."

As an economist, I have to laugh whenever I hear someone like Ralph Goodale brag about a budget surplus on one hand, and then proceed to claim that their government has balanced the budget for 8 years in a row. A surplus does not a balanced budget make - it is a sign of over-taxation or under-estimation of revenues. We are supposed to cheer on cue whenever a government announces that it has "turned a profit" in the form of a budget surplus. All it has really done is announced that it has over-taxed Canadians over the past year. I bet Paul Martin has had his fair share of laughs back when he was Finance Minister, at the gullibility of Canadians who cheered him on as the Fiscal Messiah whose government has consistently over-taxed Canadians 8 years in a row. Hmmmm - what to do with this "unexpected" surplus? Spend it, perhaps? Yeah, surpluses can be the drivers of expenditure growth - ain't that funny?

If the Conservatives took power with all these budgetary commitments, they would probably have to make future cuts, or face a deficit. The Libs are racking up the spending and program committments of the government, just as the economy is starting to cool down in order to bend the Conservatives over a barrel. It's an insurance scheme of sorts, because the Libs will accuse the Conservatives of screwing up the budget, which should help them reel back any lost political capital.

The Conservatives, if they take power, will be accused of bringing in "american-style" budget cuts as they struggle to balance the budget. The Libs get to say "hey, we balanced that mofo 8 years in a row", and they could probably bring a Conservative budget into a non-confidence vote as early as next year as the Conservatives try to deal with a sabotaged budget.

Other than shady dealings between the NDP and the Liberals, what are some of the causes of government expenditure growth?

There are several interesting theories, and I'll go into them to help elucidate the reasons why our governments consistently increase their share of the national pie.

This view comes from Brennan and Buchanan, who saw governments as monolithic monopoly "governance" providers. The public sector, or "Gubbmint" extracts monopoly tax rates, and so a little competition in governments should decrease overall expenditures. People often tout "Decentralization" as the way out, as this will supposedly foster interjurisdictional competition in tax rates and services provided by local, municipal and regional governments. If a tax payer does not like the tax structure in one location, she or he presumably can move to a different locale offering their preferred bundle of public services.

However, Wallace E. Oates, in the September, 1985 issue of the American Economic Review, argued that there is very little empirical evidence for the Leviathan hypothesis. This is due to "economies of scale" in public goods provision. Economies of scale manifest themselves in the form of per-unit costs which decline as output increases. Fiscal decentralization can actually increase per-unit costs of providing public goods, especially if the lowest-cost is achieved at high levels of output, only achievable by a "monopoly" government.

However, increased costs theough decentralization isn't always a bad thing, and this has to do with "preference matching". People in different jurisdictions may be willing to pay more on a per-unit basis if the delivery of a good more closely resembles their preferences.

Oates' study found that there is little relationship between centralization and expenditure growth, so what other factors might be driving the growth in public expenditures?

Wagner's Law
Wagner's Law holds that as economies grow more complex, so do governments. If anyone has ever read the tax code, they'd realize just how complex the tax system is. If it weren't, then tax lawyers would not exist. Basically, as the government grows in its mandate of responsibilities, each taxpayer loses sight of their direct costs of providing a service. If you think that your use of a public service is not directly tied to your personal tax bill, you will be more willing to vote for more and more services you think the government should provide.

This is why the idea of a "user-pay" tax structure is so popular in public finance circles these days. If you use a service, then you should be the one to pay for it, so the theory goes. Projects such as tolled roads, bridges and highways cause people to pay the full cost of their actions. If you had to pay 10 dollars for the use of your favorite stretch of highway, you might change your economic behaviour a bit to accomodate. With direct taxation, people see how expenditures on public goods manifest directly in their tax bill. If you want lower taxes, then don't over-use the infrastructure.

However, there is a problem with direct taxation. The idea of "willingness to pay" for, say, health care, should not be confused with "ability to pay". Here is the Health care debate in a nutshell. Suppose there are two individuals, A - who earns 10,000 dollars per year, and B - who earns 100,000 dollars per year. The government provides a service - "Health Care" at a cost of 5,500 dollars per person and levies a flat tax of 10% on the incomes of the two groups. A 10% tax on 110,000 dollars in the economy yields 11,000 dollars, and this is paid out as 5,500 dollars per person in terms of health care. The point is that the service costs 5,500 dollars per person. The low income group pays 1,000 dollars for the service, whereas the high-income group pays 10,000 dollars. If health care were in the private sector, the high-income group would get to pay a "cost-based" price of 5,500 dollars.

Effectively, Person B is subsidizing person A. Person B pays 10,000 dollars in taxes for a service, were it provided at cost would be 5,500 dollars. Person B would be your advocate for private health care. They would want to have their health care provided by the market and keep their tax dollars, which would save them 4,500 dollars per year. Person A, however, sees their health bill go from 1,000 dollars to 5,500 dollars. Is that a fair proposition? Some people seem to think so. However, Person B's "willingness to pay" for health care will typically void Person A's "ability to pay". In the public health care debate, then, it makes sense that the highest-income Province (Alberta) would be an advocate of some private provision of health care.

The cause of this problem is that of indirect or hidden taxes. If users do not see the true cost of their use of a public good, the result is "over use" which drives the impression that the public good in question is "under-provided". In order to "improve efficiency" or "quality", critics will step in and claim that the free market will result in an outcome that is more allocatively and productively efficient. One theory of public finance holds that as blocs of voters vote in more spending initiatives, a counter-bloc will arise that will vote for less services; in this sense, government expenditures are self-limited by a fully functioning democracy.

Logrolling and Vote-trading
This is exactly what Smilin' Jack Layton and the Liberals have done. "Logrolling" occurs when you have two groups of voters who have unrelated interests, and they trade support for eachother's initiative to get their own initiative passed. For example, suppose "Labour" wants "higher wages" whereas "Feminists" want "day care". Nether can get their intitiative passed alone, so "Labour" supports "Day care" in exchange for the same from the "Feminists". In the Liberal/NDP case, the Libs have traded "Support for their budget" with the NDP for "Spending" that the NDP wants to see happen.

The "Baby Boomers", or people born in North America just after the War, have driven nearly every political and economic trend over the past decades. As Boomers age, their bodies break down and they are more interested in sustaining every bit of life they can get for their dollar. Right now, Boomers are interested in low taxes, which help them to save for their retirements, but maybe down the road they will vote in even more boosts to health care spending. Who knows?

Rent Seeking/Pork Barrelling

Rent seeking has a lot to do with Adscam right now. It's all about kickbacks, like how Paul martin mamanged to weasel 161 million dollars in subsidies for his CSL enterprise while registering his assets off-shore to avoid paying tax into the Canadian system. People will support a candidate in exchange for "kickbacks" such as no-competition bids on governmental contracts.

As for Pork Barrelling, Dalton McGuinty did his part to get Ontarians the money they feel they deserve today. An additional 5 billion dollars for Ontario. Well, 5.75 billion, but who's counting these days?

An end in sight?

Is there any end in sight to government spending? It's tough to say. If the Liberals manage to stay in power, Smilin' Jack Layton will hold the balance of power, and we can expect to see some huge increases in the future. As the Boomers age, their interests may change from a low-tax, pro-investment tax structure to a "health-care friendly" tax structure. It doesn't bode well for youg people like me, who already bear tremendous strudent debt loads. Something's gotta give. Expect the Euthanasia debate to be a hot topic in 2012.