Political uncertainty, public expenditure and growth

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Abstract

We set out an infinite-horizon political economy model with partisan and office motivation effects in an endogenous growth context to demonstrate that the existence of political uncertainty regarding re-election tends to reduce the amount of public investment by incumbent governments and underlies a switch from government investment to government consumption, thereby reducing growth. The political equilibrium is inefficient and so does not maximise social welfare. Using panel data regressions we show, for OECD countries, that there is empirical support for the hypothesis that political uncertainty tends to reduce public investment, and that there are partisan effects in public investment decisions.

Introduction

The notion that political uncertainty affects growth is well established in economic theory. Major political upheaval, social unrest and revolution are a major disincentive to invest. In these circumstances, the lack of protection for property rights harms prospects for private investment1 and reduces foreign direct investment in a country.2 Similarly, in countries where rulers are weak and confront the threat of being overthrown, policymakers have an incentive to allow rent-seeking activities, which may again reduce economic growth.3 There is also considerable empirical evidence that major political upheaval (as opposed to routine changes of governments that follow elections) and coups d'état can adversely affect economic growth (see Alesina et al., 1996, Barro, 1996, Easterly and Rebelo, 1993). Political instability can also adversely affect growth through effects on foreign aid (see Chauvet, 2003).

In modern democracies, where government changes are generally peaceful and follow constitutional norms, political uncertainty through electoral change may still have an impact on economic growth. The main mechanism at work in the models is through the impact of electoral uncertainty on government myopia. The myopia occurs when forward-looking governments are not interested in carrying out long-term economic policies4 because of uncertain re-election prospects. For instance, Svensson (1998) emphasises how governments may be less inclined to make improvements to the legal system. Calvo and Drazen (1998) show how policy uncertainty can distort the future path of investment decisions. Devereux and Wen (1998) suggest that political uncertainty encourages governments to run down the economy's assets, with the result that future governments are more likely to raise capital taxation, which depresses private investment. Persson and Tabellini (1998) propose a two-period model in which capital taxation is used to finance public investment, which drives economic growth and enhances the future tax base. In their model, public investment is valued less by an incumbent government if re-election is uncertain, because less of the economy's future tax revenues will be spent on the incumbent's preferred public goods. Hence, greater uncertainty of re-election for the incumbent increases policy myopia and reduces public investment.

Empirically, there seems to be some evidence indicating a negative link between minor political uncertainty (the frequency of changes in a government's political complexion) and economic growth (see Alesina et al., 1996, Perotti, 1996). However, this existing empirical evidence makes use of quite limited measures of political uncertainty, and does not always focus on industrial democracies.

In this paper, we focus on the link between political uncertainty in electoral outcomes in democracies and economic growth, through the effect on a government's decisions on how to allocate government expenditure between public consumption and public investment. The novelty of our contribution is the following. First, unlike existing two-period models of the impact of political uncertainty on growth (see Persson and Tabellini, 1998), we propose an infinite horizon model, and examine the dynamic interaction of an endogenous growth model with electoral turnover. This allows us to view political parties as paying attention to the longer-term impact of their policy choices.

Second, in existing models myopia generally arises because incumbent partisan governments realise that they do not have full control over the future benefits from current taxation and spending decisions that will accrue to their own political constituency.5 In our model, we combine partisan preferences with office motivation. Political myopia arises because of office motivation, so that an incumbent government perceives a more limited political benefit from decisions taken now which only impact with a lag on consumer utility. Thus, political uncertainty leads to a shift of government budgets from capital spending to current consumption. Unlike other authors, who have tended to concentrate on public expenditures on different types of public goods (e.g. Alesina and Tabellini, 1990, Tabellini and Alesina, 1990), and have ignored the public investment–growth link, our view is that the relationship between public investment and consumption is important for understanding the consequences of political uncertainty for growth.

Third, unlike other attempts to model political uncertainty, we take into account the preferences of consumers and how these affect the political equilibrium. We are therefore able to compare the stochastic steady-state growth equilibrium under political uncertainty with that which would prevail in the presence of a social-welfare maximizing social planner. This allows us to consider the welfare implications of political uncertainty.

Fourth, we use a newly constructed data set on measures of political uncertainty to provide empirical support for our theoretical model. Using data on a panel of European countries, we find considerable support for our hypothesis that political uncertainty affects public investment and consumption decisions.

The paper is structured as follows. In Section 2, we outline our theoretical model and its main results. In Section 3, we outline our empirical evidence. Section 4 concludes.

Section snippets

A theoretical model

We develop an endogenous growth model in which government spending is a major determinant of growth. We assume a partisan-type political economy set-up in which two political parties alternate in power and implement taxation policies and allocate government expenditures between government consumption, which increases the current utility of consumers, and government investment, which encourages future growth and benefits consumers in the future. Consumers are assumed to differ in their discount

Empirical evidence

Our theoretical model suggests a link between political uncertainty and public investment, with greater uncertainty leading to higher government consumption and lower public investment. In this section, we focus on this link and present new empirical evidence, particularly in relation to public investment.

Of course, our theoretical model also assumes a link between public investment and growth. This is not investigated here. A large literature on the impact of government investment spending on

Conclusion

This paper has developed a theoretical model to analyse the links between political uncertainty in democracies, public investment, and productivity growth in the OECD economies. Our model shows that, with greater political uncertainty, policy myopia effects set in and rational incumbent politicians tend to reduce spending on investment, and to increase the share of government consumption in total government spending. These effects remain, even if there is a prospect of exit from office and a

Acknowledgements

Muscatelli gratefully acknowledges research funding from the ESRC Award R000237816. We are particularly grateful to two anonymous referees and to the editor of this journal for extremely helpful comments that improved the paper considerably. We are also grateful to participants at seminars at the Universities of Aberdeen, Bari, Bristol, Glasgow, the Royal Institute for Economic Affairs and at the Royal Economic Society Conference in Nottingham, April 1999, and the Money Macro Finance Conference

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