Chapter 4: Theories of the public sector
This chapter reviews a number of theories of public sector growth which have been designed to explain the growth patterns exhibited in Chapter 3. These theories consider in turn the historical process, the demand for public sector output, the production process and the politics of provision. Each theory provides a partial insight and has some elements of truth. Arguments for why the government may be excessive in size are considered. The analysis considers bureaucracy, the process of budget-setting and the idea of market capture.
4.1 Development models
Development models of public sector growth are based on the economy experiencing changes in its structure and needs as it develops.
The early stage of development is the period of industrialisation during which the population moves from the countryside to the urban areas. To meet the needs of this population there is a requirement for infrastructural expenditure.
In the middle stages of development, the infrastructural expenditure of the public sector becomes increasingly complementary with expenditure by the private sector.
In the developed phase of the economy expenditure is driven by the desire to react to issues of equity.
This theory of the growth of expenditure concurs broadly with the facts. Its weakness is that the process described is primarily mechanistic and lacks any behavioural basis.
4.2 Wagner’s law
Wagner’s law was an explanation of this trend and a prediction that it would continue.
The basis for the Law consists of three distinct components:
1. Economic growth results in an increase in complexity requiring continued introduction of new laws and development of the legal structure.
2. Urbanisation increases externalities which necessitate intervention.
3. The goods supplied by the public sector have a high income elasticity of demand.
It is the third point that differentiates Wagner’s law from other explanations and is founded on principles of economic choice.
Wagner’s law is compelling but by concentrating solely on the demand for public sector services it overlooks the supply side and the politics of provision.
4.3 A political model
A political model of public sector expenditure sets the desire of the government to supply expenditure against the unwillingness of the public to finance the expenditure. It is founded on the existence of a trade-off between the preferences of the government and those of the public.
The preference of the government is to spend money. In contrast, the public do not want to pay taxes.
In the absence of any exogenous changes or changes in preferences, the level of expenditure will remain relatively constant. Occasionally, though, economies go through periods of significant upheaval such as during wartime. The equilibrium between the government and the taxpayers becomes suspended.
The level of expenditure does not fall back to its original level after the period of upheaval. Firstly, taxpayers become accustomed to the higher level of expenditure and perceive this as the norm. Secondly, debts are incurred during the period of upheaval which have to be paid off later. Thirdly, promises are made by the government to the taxpayers during periods of upheaval. These are termed ratchet effects that sustain a higher level of spending. There may also be an inspection effect after an upheaval when taxpayers and government reconsider their positions and priorities.
4.4 Baumol’s law
Baumol’s law provides a supply-side explanation of expenditure growth. It does this by focusing upon the technology of the public sector. Baumol’s law begins by asserting that the production technology in the public sector:
i. is labour-intensive relative to that of the private sector;
ii. has little scope for increases in productivity; and
iii. makes it difficult to substitute capital for labour. For example, hospitals need minimum numbers of nurses and doctors per patient and maximum class sizes place lower limits on teacher numbers in schools.
This law is entirely driven by technology and does not consider aspects of supply and demand or political processes. Substitution of capital for labour has taken place in the public sector. There is also evidence of a steady decline in public sector wages relative to those in the private sector as lower-skilled labour is substituted for higher-skilled.
The theories of the growth of public sector expenditure above attempt to explain the facts but do not assess whether the level of expenditure is deficient or excessive. Many economists would argue that public sector expenditure is too large and places an excessive burden on the economy.
A first explanation of this excessive size is the theory of bureaucracy... bureaucrats resort to obtaining utility from pursuing non-pecuniary goals which are related to the size of their bureau. The bureaucrat therefore maximises the size of their bureau and as a consequence the size of government becomes excessive.
An alternative perspective upon excessive bureaucracy can be obtained by considering the process of budget determination for government departments.. In many government systems, budgets for departments are determined annually by a meeting of ministers. Assume that this meeting takes the budget bids from the individual departments and allocates a central budget on the basis of these.
4.7 Monopoly and market capture
In the absence of monopoly power, market equilibrium is efficient. If the same reasoning could be applied to the goods supplied by the public sector, then efficiency would arise there also. Unfortunately, there are two reasons why this is not possible.
Firstly, the public sector can award itself a monopoly in the supply of its goods and services. Secondly, this monopoly power may be extended into market capture.
Generally, a profit-maximising monopolist will always want to restrict its level of output so that monopoly power will provide a tendency for too little output rather than the converse. This would be a powerful argument were it not for the fact that the government can choose not to exercise its
monopoly power in this way.
The idea of market capture arises from the nature of goods supplied by the public sector. Rather than being standard market goods, many of them are complex in nature and not fully understood by those consuming them. Examples of such goods are education and health care. In both cases, the consumer may not understand quite what the product is, or what is best for them. The additional feature of the public sector commodities is that demand is not determined by the consumers and expressed through a
market. Instead it is delegated to specialists, such as teachers or doctors. Furthermore, these same specialists are also responsible for setting the level of supply. In this sense, they can be said to capture the market. The consequence of market capture is that the specialists can set the
level of output for the market that most meets their objectives.
Reading: Jean Hindriks and Gareth D. Myles (2004), Intermediate Public Economics
Theories of the Public Sector
Two basic lines of argument can be advanced to justify the role of the public sector. These can be grouped under the headings of efficiency and equity. Efficiency relates to arguments concerning the aggregate level of economic activity whereas equity refers to the distribution of economic benefits. p29
"When market failure is present, the argument for considering whether intervention would be beneficial is compelling... In every case, it must be demonstrated that the public sector actually has the ability to improve upon what the unregulated economy can achieve." p31
"The basis of the development models of public sector growth is that the economy experiences changes in its structure and needs as it develops." p33
"Although this [development model] theory of the growth of expenditure concurs broadly with the facts, it has a number of weaknesses. Most importantly, it is primarily a description rather than an explanation. From an economist’s perspective, the theory is lacking in that it does not have any behavioral basis but is essentially mechanistic. What an economist really would wish to see is an explanation in which expenditure is driven by the choices of the individuals that constitute the economy." p34
Wagner’s Law: "The basis for the theory consisted of three distinct components. Firstly, it was observed that the growth of the economy resulted in an increase in complexity. This required continuous introduction of new laws and development of the legal structure. These implied continuing increases in public sector expenditure. Secondly, there was the process of urbanization and the increased externalities associated with it. These two factors have already been discussed in connection with the development models.
The final component underlying the Wagner’s Law is the most behavioral of the three and is what distinguishes it from other explanations. Wagner argued that the goods supplied by the public sector have a high income elasticity of demand. This claim appears reasonable, for example, for education, recreation and health care. Given this fact, economic growth which raised incomes would lead to an increase in demand for these products. In fact, the high elasticity would imply that public sector expenditure would rise as a proportion of income. This conclusion is the substance of Wagner’s Law." p34-35
Baumol's Law : "The basic hypothesis is that the technology of the public sector is labor-intensive relative to that of the private sector. In addition, the type of production undertaken leaves little scope for increases in productivity and that makes it difficult to substitute capital for labor... Competition on the labor market ensures that labor costs in the public sector are linked to those in the private sector. However, in the private sector it is possible to substitute capital for labor when the relative cost of labor increases. Furthermore, technological advances in the private sector lead to increases in productivity. These increases in productivity result in the return to labor rising.. If public sector output/private sector output remain in the same proportion, public sector expenditure rises as a proportion of total expenditure. This is Baumol’s Law which asserts the increasing proportional size of the public sector." p35
"There are a number of problems with this theory. It is entirely technology-driven and does not consider aspects of supply and demand or political processes. There are also reasons for believing that substitution can take place in the public sector. Finally, there is evidence of a steady decline in public sector wages relative to those in the private sector. This reflects lower-skilled labor being substituted for more skilled." p35
"A political model of public sector expenditure needs to capture the conflict in public preferences between those who wish to have higher expenditure and those who wish to limit the burden of taxes... The main point that emerges is that the equilibrium level of public spending can be related to the income distribution, and more precisely that the growth of government is closely related to the rise of income inequality.." p35-36
Ratchet Effect: "Models of the ratchet effect develop the modeling of political interaction in a different direction. They assume that the preference of the government is to spend money. Explanations of why this should be so can be found in the economics of bureaucracy... In contrast, it is assumed that the public do not want to pay taxes. Higher spending can only come from taxes, so by implication the public partially resists this; they do get some benefit from the expenditure. The two competing objectives are moderated by the fact that governments desire re-election... The equilibrium level of public sector expenditure is determined by the balance between these competing forces." p37
"The final aspect of the argument is that the level of expenditure does not fall back to its original level after the period of upheaval. Several reasons can be advanced for this.... taxpayers could become accustomed to the higher level of expenditure and perceive this as the norm... debts may
be incurred during the period of upheaval which have to be paid-off later. Promises could be made by the government to the taxpayers during periods of upheaval which then have to be met. These can jointly be termed ratchet effects that sustain a higher level of spending. Finally, there may also be an inspection effect after an upheaval, meaning that the taxpayers and government reconsider their positions and priorities. The discovery of previously unnoticed needs then provides further justification for higher public sector spending." p38
".. the data cannot be employed as evidence that the model is correct, given that the model was designed to explain that data." p38
".. the theoretical analysis of bureaucracy starts with the assumption that bureaucrats are in fact motivated by maximization of their private utilities" p39
"The bureaucrat can therefore be modeled as aiming to maximize the size of their bureau in order to obtain the greatest non-pecuniary benefits. It is as a result of this behavior that the size of government becomes excessive.... What restrains the behavior of the bureaucrat is the requirement that the budget received from the government is sufficient to cover the costs of running the bureau." p39 (Shades of "Yes Minister")
"In the absence of monopoly power, the equilibrium that is achieved will be efficient. If the same reasoning could be applied to the goods supplied by the public sector, then efficiency would also arise there. Unfortunately, there are two reasons why this is not possible. Firstly, the public sector can award itself a monopoly in the supply of its goods and services. Secondly, this monopoly power may be extended into market capture." p42
"Generally, a profit-maximizing monopolist will always want to restrict its level of output below the competitive level, so that monopoly power will provide a tendency for too little government rather than the converse. This would be a powerful argument were it not for the fact that the government can choose not to exercise its monopoly power in this way. If it is attempting to achieve efficiency, then it will certainly not do so. Furthermore, since the government may not be following a policy of profit maximization, it might actually exploit its monopoly position to over-supply its output. This takes the analysis back in the direction of the bureaucracy model." p42
"Corruption does not emerge as a moral aberration, but as a general consequence of government officials using their power for personal gain. Corruption distorts the allocation of resources away from productive toward rent-seeking occupations... Monopoly profit is one example, but the concept is much broader... Perhaps the most important form of corruption in many countries is predatory regulation. This describes the process of the government intentionally creating regulations that entrepreneurs will have to pay bribes to get around.. .could we give a positive role for a bribe-based corruption system? One possibility is that bribery is like an auction mechanism that directs resources to their best possible use." p43
" To eliminate this temptation taxpayers must pay an extra amount r > 0 to the government in excess of its cost when the government pretends to have the low cost. This is called the informational rent." p44
"The last explanation we present for the possibility of excessively large government is the *common resource* problem. The idea is that spending authorities are dispersed while the treasury has the responsibility of collecting enough revenue to balance the overall budget... In all cases it leads to excess pressure on the common resource... The current trend toward federalism and devolution aggravates this common pool problem. " p45
"The bureaucracy models are particularly attractive since they show how economic analysis can be applied to what appears to be a non-economic problem. In doing so they generate an interesting conclusion which casts doubt on the efficiency of government. This illustrates how the method of economic reasoning can be applied to understand the outcome of what is at first sight a non-economic problem" p46