Academic journal article Economic Inquiry

The Composition of Government Expenditure: Economic Conditions and Preferences

Academic journal article Economic Inquiry

The Composition of Government Expenditure: Economic Conditions and Preferences

Article excerpt

I. INTRODUCTION

There are substantial variations among countries in their tax and expenditure policies, even among developed democracies sharing similar economic and political regimes, as discussed by Tanzi (2000) and Alesina and Glaeser (2004). This study examines the question of why expenditure patterns differ among democratic countries. Using a sample of countries with a high democracy index, Section II presents empirical evidence showing that the United States has a low ratio of expenditure on transfer payments to that on public goods despite its high-income inequality. Scandinavian countries typically combine low inequality and much higher expenditure on transfer payments relative to public goods. British Commonwealth countries have higher income inequality than Scandinavian countries and yet a lower ratio of transfer payments to public-goods expenditure. These findings seem inconsistent with the prediction of a large theoretical literature: more basic income inequality leads to a larger extent of redistributive expenditure. (1) However, the observed partial relationship between the expenditure composition and income inequality is possibly obscured by many other factors reflecting differences in economic and demographic conditions or cultural differences across countries; see Lind (2005) and Alesina and Glaeser (2004).

In order to attempt to understand the way in which cultural factors and economic conditions may combine to influence the composition of expenditure, this paper examines the division of expenditure between public goods and a transfer payment under majority voting in the context of an overlapping generations model. By taking a growth context and focusing on the expenditure composition for a given tax rate, the model allows for a range of factors which may contribute to cross-country variations in expenditure compositions, such as income and population growth rates, and the discount factor. In particular, cultural factors are captured by a parameter in the utility function reflecting individuals' preference for public goods relative to private-goods consumption. Direct independent evidence regarding preferences for public goods is extremely difficult to obtain in view of well-known problems of preference revelation mechanisms. A wide range of studies, however, take such differences as their starting point; see, for example, Haufler (1996). The transfer payment in the model is referred to as a pension, as it is received in the second period of life. (2) However, it may be thought of more broadly as a standard type of income transfer as it involves, in the present overlapping generations framework, a decision regarding income-shifting between periods within the life cycle as well as intra- and intergenerational redistribution.

Members of each cohort are considered to vote on their desired pension during the retirement period, on the understanding that during the working period each cohort finances the expenditure previously agreed by the preceding cohort, and voters are aware of the nature of the government budget constraint. Therefore there is a social contract in which each generation, in the retirement period, is able to benefit from the income and population growth of the following generation. The condition under which the social contract is supported by a majority of the members of any cohort involves extending the condition obtained by Aaron (1966) and Samuelson (1958). The model yields a closed-form solution for the majority choice of the expenditure ratio, defined as the ratio of transfer payments to public-goods expenditure. Consistent with previous theoretical literature, the model predicts a positive relationship between income inequality and the expenditure ratio.

A numerical exercise is then implemented to examine the sensitivity of the expenditure ratio to variations in model primitives, where baseline parameter values are calibrated to the dataset for a group of democratic countries. …

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