Fiscal Policy and Politics

Things become even more complicated once we allow for the role of politics. If various groups of economic agents have conflicting objectives, then distributional and political considerations will arise as well.

21.4.1 Distributional Considerations and Politics

Consider a simple example highlighted by Alesina [1988]. He assumes that there are three groups of agents: rentiers (who hold government debt), entrepreneurs (who hold equity in firms), and workers (who hold human capital). Obviously in reality, a continuum exists between these three groups, as each household may hold different amounts of each particular form of capital.

The three groups will favor different solutions to the government debt problem. Rentiers will oppose default or inflation and will favor reductions in government expenditure or taxes on firms and workers. The entrepreneurs will favor debt default and inflation as well as taxes on labor. Workers will favor default, taxes on capital, and inflation, provided their real wages are protected from inflation. The debt stabilization policies that will actually be followed will be the outcome of a political equilibrium, involving all three groups.

One potential solution is offered by Downsian median voter models (see Downs [1957]). In such models, politics converges to the preferences of the median voter. If the median voter is a worker, a democratic government will tend to favor default, capital taxation, and inflation. If rentiers and entrepreneurs prevail (in the sense of the median voter model), labor taxes will be increased and social expenditure reduced. However, median voter equilibria exist under very restrictive conditions. If every group can block the preferences of the other two but is unable to impose its own preferred solution, then government debt will not be tackled and will continue accumulating well after the war or the initial recession.

Such models provide an explanation as to why we have been observing a bias toward excessive fiscal deficits and rises in debt-to-output ratios in peacetime. Governments are reluctant to make decisions that would stabilize government debt, for fear of alienating one or more of the political groups that stand to lose from an adjustment program. Such decisions are even more difficult in electoral periods. Models of this form are analyzed in the new political economy literature.

Such considerations characterize models that directly try to explain why governments delay adopting effective fiscal adjustment programs. See Alesina and Drazen [1991] and Velasco [1999].

21.4.2 Electoral Factors and Partisan Differences

Electoral factors and partisan politics also play a role. Let us first consider electoral factors. The basic idea is that before the election, decision makers attempt to use fiscal policy to positively influence voters and thus maximize their chance of staying in power. This is called the opportunistic or electoral incentive. Contrary to what is generally believed, providing theoretical interpretations of such electoral fiscal cycles is not straightforward under the assumption of rational expectations. The question that arises is: Why would rational voters want to reward a government that causes a pre-election budget cycle, when they know that this is for opportunistic reasons?

Rogoff and Sibert [1988] and Rogoff [1990] provide a neat theoretical explanation based on asymmetric information between governments and voters and how governments can exploit this asymmetry. In their model, the effectiveness of government cannot be directly observed by voters. Voters simply observe an electoral improvement in their economic condition, which may result from an increase in government spending or tax cuts. They do not know during the election whether this improvement is artificial and temporary or the result of an effective economic policy. Voters will thus rationally attribute part of the economic improvement they observe to the effectiveness of government policy, and thus the popularity of the government will increase.

The model of Rogoff and Sibert for electoral cycles has been enriched by the introduction of partisan differences. Persson and Svensson [1989] and Alesina and Tabellini [1990] introduced partisan differences and the possibility of issuing debt to develop a theory of electoral cycles based on the strategic use of debt.

The basic idea of models based on partisan differences is that policymakers belong to political parties, which have different ideological premises and strive to meet the aspirations of different constituencies. Thus, a “left” leaning government would be aiming for a larger public sector than would a “right” leaning government. Left wing parties would tend to favor the role of the public sector, while right wing parties would tend to rely more on the private sector. Left wing parties would be less averse to high capital income and wealth taxes than right wing parties, having a stronger faith in the redistributive role of taxes. This somewhat stylized and oversimplified distinction is not far from the preferences of voters and parties in most mixed economies and is a key characteristic of partisan models.

Every government knows that, with some probability, voters will replace it at some future election. If it can control a state variable, such as government debt, it will try to use that variable strategically to influence the future choices of its successors in the direction of its own preferences or in the direction of the preferences of its constituents.

Persson and Svensson [1989] show that an increase in government debt from a right wing government can be an equilibrium strategy, as it binds its successors to restrain primary public spending in the future. Thus, if a right wing government were to cut taxes today and increase government debt, this puts pressure on its left wing successors to limit future primary expenditure along with a future increase in taxes. The intertemporal distribution of the tax burden may not be optimal, but the future path of fiscal policy will be nearer to the objectives of the right wing incumbent. When the ideological differences between political parties are large, then the trend is for an increase in government debt, even by right wing governments.

A related idea of Tabellini and Alesina [1990] is that governments disagree on the composition of public spending. Again we have an increasing trend in public deficits as the government borrows to increase the type of spending it prefers, knowing that future spending cuts or tax increases to service the debt will come from all areas, including those it does not favor.

Another strand of the literature focuses on the fact that elections result in myopic behavior on the part of incumbent governments. If governments do not care about the state of the economy in case they are not reelected, in election years, they will be more reluctant to incur the costs associated with adjusting government expenditure and taxes, as they discount the future benefits in terms of lower government debt more heavily. Lockwood et al. [1996] set up and estimate models of this nature. Their model is based on the shorter horizon that governments have at election times, which result in a weakening of the incentive to stabilize government debt.

This literature concludes that political institutions matter for the accumulation of government debt. Elections, political instability, and wide ideological differences between the main political parties result in greater deficits and debt.

The literature on the politico-economic causes of high deficits and debts grew exponentially in the early1990s. Among others, see the papers by Cukierman and Meltzer [1989], Alesina and Tabellini [1990], Aghion and Bolton [1990], Alesina and Drazen [1991], Tabellini [1991], and Velasco [1999]. Many cross-country studies have also emerged, focusing on the association between political instability and debt. See Roubini and Sachs [1989] and Grilli et al. [1991], among others. Many of the important early contributions to this literature are collected in Persson and Tabellini [1994b]. An early survey is in Alesina and Perotti [1995]. Comprehensive analyses of the main political economy models of fiscal policy can be found in Persson and Tabellini [2000] and Drazen [2000]. A more recent survey can be found in Alesina and Passalacqua [2016].

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