Why public policy suffers when future government revenue is uncertain

As the Eurozone continues to struggle to recover from the economic fallouts of the 2008 crisis, and with Greece on the edge of exiting the currency union, it hardly needs to be said that politics has played a significant role both in the creation of the original crisis and in impeding an optimal solution to it. Since the 1970s economists have understood that politically chosen policy is unlikely to be socially optimally. Indeed, incumbent politicians have an incentive to move policy away from what is socially desirable, either because the probability of losing power makes them discount the future too much (Alesina and Tabellini 1990), or because this allows them to manipulate their re-election probability in a favourable way (Aghion and Bolton 1990, Besley and Coate 1998, Robinson and Torvik 2005, Robinson and Verdier 2013).

Uncertain government revenues

Yet none of this research takes into account a fundamental fact that potentially influences government policy – future government revenue is uncertain.  In recent research, we take a simple model of inefficient public policy by an incumbent politician that uses inefficient patronage employment to increase the probability of staying in power (Robinson et al. 2015). Our major innovation in this set-up is to consider the consequences of making post-election government revenues uncertain. We show that this has interesting implications for both the re-election probability and the efficiency of policy. With respect to the efficiency of policy, this works through two main channels. On the one hand, uncertainty about future government income tends to reduce the expected benefit of being in power to an incumbent. This makes policy more efficient, since policy inefficiencies are motivated by trying to manipulate the probability of staying in power. On the other hand, when revenues and future public good provision are uncertain, the continuation expected utility that the incumbent’s clients get from him being re-elected is lower and this reduces his re-election probability. This in turn makes inefficient policy less costly, since some of the costs of such policy are concentrated in the future, thus encouraging it. We study the circumstances under which the second effect dominates, suggesting that public income volatility reduces the efficiency of public policy.

These results have interesting implications for some big empirical facts. For example, the model identifies a new mechanism that can help explain the strong negative correlation between the volatility of output and the rate of economic growth (e.g. Ramey and Ramey 1995). Existing explanations emphasise the link between volatility and credit constraints; our model suggests another channel through which volatility may influence economic growth.

Public income volatility

But what generates this volatility of government revenues? Where does it come from? Interestingly, volatility is higher in poor and developing countries where most government revenues originate from rents from natural resources that have notoriously volatile prices. Hence a plausible source of uncertainty in government revenues comes from uncertainty about resource prices. As van der Ploeg (2011) points out, resource revenues are much more volatile than GDP and one way in which the volatility of resource prices can translate into poor economic performance is by making liquidity constraints more likely to bind (see van der Ploeg and Poelhekke 2009, who also present evidence that the adverse growth effect of natural resources results mainly from volatility of commodity prices).

Natural resource rents

We connect these interesting empirical facts by extending our framework to the case where government revenues may be generated from natural resource rents, the price of which is subject to uncertainty. This is particularly interesting since the revenues generated by resources in the future depend not just on the stochastic nature of the resource price, but also on the endogenously derived extraction path.

We first show that even when there is no patronage employment, the path of natural resource extraction determined in a political equilibrium tends to deviate from the socially efficient (utilitarian) path. Part of the reason for this has nothing to do with uncertainty per se. It is related to a simple fact that if an incumbent choosing resource extraction today may not be re-elected in the future, he tends to over-extract resources relative to the efficient path (Robinson et al. 2006, 2014). More interestingly, when resource extraction is chosen by a politician rather than a benevolent social planner, the politician only provides the type of public goods that he and his clients value. This implies that future uncertainty about the resource price creates greater volatility in public good provision (since the politician does not smooth public good provision across groups like the social planner would) and this volatility encourages greater extraction in the present. This mechanism leads to even more resource extraction than would be socially desirable.

Concluding remarks

Our framework suggests that when policies are chosen by politicians who want to win elections, the volatility of public income, a particular problem for poor countries reliant on natural resource wealth, has clear implications for the efficiency of policy. In particular, it can make both policy and the extraction path for natural resources less efficient. Returning to Greece, perhaps it was not just the low level of Greek government revenues which caused so many problems, but the volatility in a clientelistic political system. Though the Greek economy is not reliant on natural resource rents it is very undiversified, another source of volatility.

References

Aghion, P and P Bolton (1990) “Government domestic debt and the risk of default: A political-economic model of the strategic role of debt,” in R Dornbusch and MDraghi (eds) Public Debt Management: Theory and History, Cambridge: MIT Press.

Alesina, A and G Tabellini (1990) “A positive theory of fiscal deficits and government debt”, Review of Economic Studies, 57: 403-14.

Besley, T and S Coate (1998) “Sources of inefficiency in a representative democracy: A dynamic analysis”, The American Economic Review, 88(1): 139-156.

Ramey, G and V A Ramey (1995) “Cross-country evidence on the link between volatility and growth”, The American Economic Review, 85: 1138-1151.

Robinson, J A and R Torvik (2005) “White elephants”, Journal of Public Economics, 89: 197-210.

Robinson, J A, R Torvik and T Verdier (2006) “Political foundations of the resource curse”, Journal of Development Economics, 79: 447-468.

Robinson, J A, R Torvik and T Verdier (2014) “Political foundations of the resource curse: A simplification and a comment”, Journal of Development Economics, 106: 194-198.

Robinson, J A, R Torvik and T Verdier (2015) “The political economy of public income volatility with an application to the resource curse,” NBER Working Paper, No. 21205.

Robinson, J A and T Verdier (2013) “The political economy of clientelism”, Scandinavian Journal of Economics,115(2): 260-291.

van der Ploeg, F and S Poelhekke (2009) “Volatility and the natural resource curse”, Oxford Economic Papers, 61: 727-760.

van der Ploeg, F (2011) “Natural resources: Curse or blessing?”, Journal of Economic Literature, 49(2): 366-420.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Authors: James Robinson is a University Professor at the University of Chicago, Harris School of Public Policy, and ​a ​Research Fellow at the NBER and CEPR. Ragnar Torvik is a Professor of Economics, Norwegian University of Science and Technology. Thierry Verdier is a Professor of Economics at PSE and Programme Director, CEPR.

Image: U.S. one dollar bills blow near the Andalusian capital of Seville in this photo illustration taken on November 16, 2014. REUTERS/Marcelo Del Pozo.