Elsevier

Journal of Economic Theory

Volume 167, January 2017, Pages 148-176
Journal of Economic Theory

Efficiency of flexible budgetary institutions

https://doi.org/10.1016/j.jet.2016.10.007Get rights and content

Abstract

Which budgetary institutions result in efficient provision of public goods? We analyze a model with two parties bargaining over the allocation to a public good each period. Parties place different values on the public good, and these values may change over time. We focus on budgetary institutions that determine the rules governing feasible allocations to mandatory and discretionary spending programs. Mandatory spending is enacted by law and remains in effect until changed, and thus induces an endogenous status quo, whereas discretionary spending is a periodic appropriation that is not allocated if no new agreement is reached. We show that discretionary only and mandatory only institutions typically lead to dynamic inefficiency and that mandatory only institutions can even lead to static inefficiency. By introducing appropriate flexibility in mandatory programs, we obtain static and dynamic efficiency. This flexibility is provided by an endogenous choice of mandatory and discretionary programs, sunset provisions and state-contingent mandatory programs in increasingly complex environments.

Introduction

Allocation of resources to public goods is typically decided through budget negotiations. In many democratic governments these negotiations occur annually and are constrained by the budgetary institutions in place. In designing budgetary institutions one may have various goals, such as efficiency, responsiveness to citizens' preferences, or accountability. There has been increasing interest among policy-makers in understanding how to achieve these goals in both developed and developing countries (see, for example, Santiso, 2006, Shah, 2007).1 Economic research has also recognized the importance of budgetary institutions (see, for example, Hallerberg et al., 2009).2 These studies emphasize the importance of various dimensions of budgetary institutions including transparency and centralization of decision-making. We focus on a different dimension in this paper: the rules governing feasible allocations to mandatory and discretionary spending programs.3 Discretionary programs require periodic appropriations, and no spending is allocated if no new agreement is reached. By contrast, mandatory programs are enacted by law, and spending continues into the future until changed. Thus under mandatory programs, spending decisions today determine the status quo level of spending for tomorrow.

Naturally, there may be disagreement on the appropriate level of public spending, and the final spending outcome is the result of negotiations between parties that represent different interests. Negotiations are typically led by the party in power whose identity may change over time, bringing about turnover in agenda-setting power. Bowen et al. (2014) show that in a stable economic environment, mandatory programs improve the efficiency of public good provision over discretionary programs by mitigating the inefficiency due to turnover. However, the economic environment may be changing over time, potentially resulting in evolving preferences. Hence, the party in power today must consider how current spending on the public good affects future spending when preferences and the agenda-setter are possibly different from today.

In this paper we address the question of which budgetary institutions result in efficient provision of public goods in an environment with disagreement over the value of the public good, changing economic conditions, and turnover in political power. In this environment it is natural to expect that rigid budgetary institutions that allow only discretionary or only mandatory spending fail to deliver efficiency. Indeed, in settings different from ours, Riboni and Ruge-Murcia (2008), Zápal (2011) and Dziuda and Loeper (2016) note that inefficiency can arise from mandatory only institutions when preferences are evolving.4 In our setting we show that rigid budgetary institutions in general lead to inefficiencies. More importantly, we show that efficiency can be obtained when appropriate flexibility is incorporated into budgetary institutions. We show this in increasingly complex environments.

We begin by analyzing a model in which two parties with concave utility functions bargain over the spending on a public good in each of two periods. The parties place different values on the public good, and these values may change over time, reflecting changes in the underlying economic environment. To capture turnover in political power, we assume the proposing party is selected at random each period. Unanimity is required to implement the proposed spending on the public good. We investigate the efficiency properties of the equilibrium outcome of this bargaining game under different budgetary institutions.

We distinguish between static Pareto efficiency and dynamic Pareto efficiency. A statically Pareto efficient allocation in a given period is a spending level such that no alternative would make both parties better off and at least one of them strictly better off in that period. A dynamically Pareto efficient allocation is a sequence of spending levels, one for each period, that needs to satisfy a similar requirement except that the utility possibility frontier is constructed using the discounted sum of utilities. Dynamic efficiency puts intertemporal restrictions on spending levels in addition to requiring static efficiency for each period, making it a stronger requirement than static Pareto efficiency. Furthermore, due to the concavity of utility functions, any dynamically Pareto efficient allocation cannot involve randomization. This means that any equilibrium in which spending varies with the identity of the proposer (what we call political risk) cannot be dynamically Pareto efficient. We further show that when preferences evolve over time, dynamic Pareto efficiency typically requires that spending levels change accordingly, that is, dynamic efficiency requires that parties avoid gridlock.

Comparing equilibrium allocations with the efficient ones, we show that discretionary only institutions lead to static efficiency but dynamic inefficiency due to political risk. Specifically, since the status quo of a discretionary spending program is exogenously zero, the equilibrium level of spending varies with the party in power.

With mandatory only institutions, any equilibrium is dynamically inefficient because the second period's spending level either varies with the identity of the proposer, which leads to political risk, or is equal to the first period's level, which results in gridlock. Even static inefficiency may result with mandatory only institutions. This is because the parties' concerns about their future bargaining positions, which are determined by the first period's spending level, can lead the parties to reach an outcome that goes against their first-period interests.

In contrast, budgetary institutions that allow flexibility with a combination of discretionary and mandatory programs avoid both political risk and gridlock, resulting in dynamic efficiency.5 This is true because the party in power in the first period finds it optimal to set the size of the mandatory program to a level that is statically efficient in the second period. Given this, the status quo is maintained in the second period regardless of which party comes into power, thereby eliminating political risk. The party in power in the first period can then use discretionary spending to tailor the total spending to the desired level in the first period, avoiding gridlock. The main insight is that the flexibility afforded by a combination of mandatory and discretionary programs delivers efficiency. However, this efficiency result breaks down with a longer time horizon because to eliminate political risk in all future periods, the first-period proposer must be able to set all future status quos independently, which is not feasible with a simple combination of mandatory and discretionary programs. In this case, we show that efficiency is achieved with sunset provisions with appropriately chosen expiration dates.

To extend our result to an even richer environment, we consider a model with an arbitrary time horizon and stochastic preferences that depend on the economic state. We analyze a budgetary institution in which proposers choose a spending rule that gives spending levels conditional on the realization of the state. We show that the first-period proposer chooses a rule that is dynamically efficient and once chosen, this spending rule is retained because no future proposer can make a different proposal that is better for itself and acceptable to the other party. Thus state-contingent mandatory programs allow sufficient flexibility to achieve dynamic efficiency, even though we consider spending rules that cannot condition on the proposer identity.

The use of state-contingent programs dates back to at least Ancient Egypt, where the rate of taxation depended on the extent of Nile flooding in any given year (see Breasted, 1945, page 191). Such state-contingency can also be found in practice in modern economies as automatic adjustments embedded in mandatory programs. For example, in the United States unemployment insurance may fluctuate with the unemployment rate through “extended” or “emergency” benefits. These benefits have been a feature of the unemployment insurance law since 1971, and are triggered by recession on the basis of certain unemployment indicators (see Nicholson and Needels, 2006).6 Similarly, in Canada the maximum number of weeks one can receive unemployment benefits depends on the local rate of unemployment (see Canadian Minister of Justice, 2014, Schedule I, page 180). The efficiency of state-contingent spending programs may explain why they are successfully implemented in practice.

Our work is related to several strands of literature. A large body of political economy research studies efficiency implications of policies that arise in a political equilibrium.7 As highlighted in Besley and Coate (1998) inefficiency can arise because policies either yield benefits in the future when the current political representation might not enjoy them, or alter the choices of future policy makers, or may change the probability of the current political representation staying in power. Our paper shares with the rest of the literature the first two sources of inefficiency, but unlike the rest of the literature, our main focus is on linking these sources of inefficiency to budgetary institutions that specify the rules governing feasible allocations to mandatory and discretionary spending programs.

Modeling mandatory spending programs as an endogenous status quo links our work to a growing dynamic bargaining literature.8 With the exception of Bowen et al. (2014) and Zápal (2011) this literature has focused on studying models only with policies that have the endogenous status quo property. In the language of our model, this literature has focused on mandatory spending programs only. Bowen et al. (2014) model discretionary and mandatory spending programs, but do not allow for an endogenous choice of these two types of programs. Moreover, unlike in their model, we allow the values parties attach to the public good to vary over time, which plays an important role in our results. Bowen et al. (2014) show that mandatory programs ex-ante Pareto dominate discretionary programs under certain conditions, whereas we show that with evolving preferences mandatory programs with appropriate flexibility achieve dynamic efficiency. Zápal (2011) demonstrates that a budgetary institution that allows for distinct current-period policy and future-period status quo eliminates static inefficiency. This result parallels the efficiency of an endogenous choice of mandatory and discretionary programs that we show, but we do this in an environment with political turnover and arbitrary variation in preferences. Furthermore, we also demonstrate the efficiency of state-contingent mandatory programs in this richer setting.

Our focus on budgetary institutions connects our work to papers studying fiscal rules and fiscal constitutions.9 This literature has focused on other fiscal rules or constitutions, for example, constraints on government spending and taxation, limits on public debt or deficits, or decentralization of spending authority.

In the next section we present our model and in Section 3 we discuss Pareto efficient allocations and equilibria. In Section 4 we study rigid budgetary institutions, specifically mandatory only and discretionary only, and discuss why these lead to inefficiencies. In Section 5 we study flexible budgetary institutions, specifically an endogenous choice of mandatory and discretionary, sunset provisions, state-contingent mandatory, and show that these lead to efficiency in increasingly complex environments. We conclude in Section 6. All proofs omitted in the main text are in the Appendix.

Section snippets

Model

Consider a stylized economy and political system with two parties labeled A and B. There are two time periods indexed by t{1,2}.10 In each period t, the two parties decide an allocation to a public good xtR+. The stage utility for party i{A,B} in period t is uit(xt). Party i seeks to maximize its dynamic payoff from the sequence of public good allocations ui1(x1)+δui2(x2), where δ(0,1] is the

Pareto efficiency

In this section we characterize Pareto efficient allocations and define Pareto efficient equilibria, both in the static and dynamic sense.

Rigid budgetary institutions

In this section we show that budgetary institutions that allow only discretionary spending or only mandatory spending lead to Pareto inefficiency in general. For expositional simplicity, in this section, we assume uit(xt)=(xtθit)2, θi1θi2 and θAt<θBt for all i and t. As explained above, dynamic Pareto efficiency avoids political risk. We next show that it also generically requires variation in spending across periods, which we call avoiding gridlock.

Lemma 1

There is a continuum of dynamically Pareto

Flexible budgetary institutions

We have seen that discretionary or mandatory programs in isolation typically lead to dynamic inefficiency. A natural question is which budgetary institutions achieve dynamic efficiency. We address this question first in the two-period model with deterministically evolving ideals and then in more complex environments. For this section we return to the general model without the functional form assumption on uit and only assume that the parties' ideals are strictly positive.

Conclusion

In this paper we demonstrate that discretionary only and mandatory only budgetary institutions typically result in dynamic inefficiency, and may result in static inefficiency in the case of mandatory only budgetary institutions. However, we show that bargaining achieves dynamic Pareto efficiency in increasingly complex environments when flexibility is introduced through either an endogenous combination of mandatory and discretionary programs, sunset provisions, or a state-contingent mandatory

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    We thank discussants Marina Azzimonti and Antoine Loeper. We also thank Gabriel Carroll, Sebastien DiTella, Roger Lagunoff, Alessandro Riboni and seminar and conference participants at Stanford, Autonoma de Barcelona, Duke, Ural Federal University, Chicago, Mannheim, Warwick, LSE, Nottingham, UC Berkeley, Max Planck Institute in Bonn, Paris Workshop in Political Economy, the NBER Summer Institute Political Economy and Public Finance Workshop, the 2014 SITE Workshop on the Dynamics of Collective Decision Making, SED 2015 in Warsaw, SAET 2015 in Cambridge, EEA 2015 in Mannheim, Econometric Society 2015 World Congress in Montreal, EUI Workshop on Economic Policy and Financial Frictions, and AMES 2016 for helpful comments and suggestions.

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