Usher Political Economy (Blackwell, 2003)

Political Economy

Dan Usher

Copyright © 2003 by Dan Usher

C h a p t e r T e n

ADMINISTRATION

The statesman who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with the most unnecessary attention, but would assume an authority which could not be safely trusted, not only to no single person, but to no council of state whatever, and which would no-where be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.

. . . The sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of other independent societies; second, the duty of protecting, as far as possible, every member of society from the injustice and oppression of every other member of it, or the duty of establishing an exact administration of justice; and, third, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be in the interest of any individual, or small number of individuals to erect and maintain . . . though it may do much more than repay it to a great society.

Adam Smith, The Wealth of Nations, 1776

Every modern society, no matter how suspicious of government or how devoted to the ideal of the competitive market, maintains, as it must, a large public sector. Adam Smith’s tasks of government are no less indispensable now than they were in his day. Defense can only be provided collectively. The police – together with the whole paraphernalia of courts and prisons – can only be provided collectively. Large public works are still required, and can only be acquired collectively. Government must provide roads, bridges, ports, airports, public buildings, clean water, supervision of food and drugs, and defense against epidemics. Beyond that, contemporary governments socialize some risk, provide a mechanism for the resolution of private disputes, specify the rights and obligations of corporations and other legal entities, impose taxes or

regulations upon privately advantageous behavior that is harmful to the environment or to society at large, and redistribute income, reducing the gap between rich and poor through progressive income taxation, welfare, and other measures.

Every modern society needs a vast bureaucracy to administer the public sector. Cadres of soldiers, police, judges, prison guards, tax collectors, diplomats, and administers are required to collect taxes, regulate the economy, monitor food, drugs, and industrial pollution, arrange basic research, control fraud in the stock market, supervise public lands, guard against monopoly, oversee money and public debt, write legislation, supply police protection, punish crimes, run the army, maintain roads and public buildings, and supervise the provision of social services including education, health care, the old age pension, unemployment insurance, welfare for the poor, and subsidies to firms. If the market is the realm of prices, the administration is the realm of command. The entire bureaucracy must be organized hierarchically. There is no other way to organize, though the chain of command may be more or less rigid: more rigid in the army and the police, less rigid in universities because a major task of the universities is to promote independent research which, almost by definition, requires the ordinary professor to choose the subject of his research and to conduct that research as he sees fit. Corporations are hierarchical too, but they are disciplined by prices and have no legitimate recourse to violence.

The governments of Canada employ about a sixth of the labor force, purchase about a sixth of the nation’s goods and services, and allocate just under half of the national income. In the year 2000, government expenditure on goods and services in Canada – federal, provincial, and local, with intergovernmental transfers canceled out – amounted to $228 billion out of a total gross domestic product (the value of all goods and services produced) of $1,056 billion. To conduct its business, the Canadian government employed 2.8 million people out of a total labor force of 16 million, plus another million, mostly doctors and other medical personnel, who were nominally independent but paid by the government per unit of service. Throughout history, less extensive bureaucracies were able to dominate their societies completely. A principal concern in this chapter is how our public officials may be subordinated to the voter and directed toward the attainment of the common good.

The growth of government since the 1920s is shown in table 10.1. Column headings are percentages of gross domestic product devoted to the different components of public expenditure: government expenditure on goods and services, transfers to persons, transfers to business, and interest on the public debt. As in virtually every country in the world, total government expenditure increased substantially. Even as a percentage of gross domestic product, the expenditure of the Canadian government grew over three fold, from 15 percent of gross domestic product in 1926 to 50 percent in 1944 at the height of the Second World War. It fell back to just over 20 percent after the war, then rose steadily to 45 percent in 1990 and then fell back to 40 percent in the year 2000. Since the Second World War, the growth of public expenditure was largely in transfers to people and firms and in the interest on the national debt. Expenditure on goods and services grew more modestly from 9 percent in 1926 to 12 percent in 1950 and then to 22 percent in 1990.

Ideally, the bureaucracy is entirely subordinate to the elected representatives of the people. The legislature formulates policy and the administration executes that policy

324 A D M I N I S T R A T I O N

Table 10.1 The size of government as a percentage of gross domestic product [Canada, all levels of government combined, selected years from 1926 to 2000.]

Sources: Statistics Canada: National Income and Expenditure Accounts, Annual estimates, 1926–86

(13-531) and subsequent annual volumes (13-001-XPB).

under the direct authority of an elected President or Prime Minister who appoints the occupants of the top ranks of the civil and military hierarchy. In practice, legislative control of the administration may be less than complete, for the legislature can never cope with the multitude of decisions that have to be made. A few large decisions each year is as much as a legislature can be expected to accomplish. The legislature must pass the budget specifying how much money is to be spent and how money is to be allocated among the departments of government. It cannot supervise administration in detail. It must approve total expenditure on schooling, but it cannot write the curriculum of each and every subject taught, decide who within the school system is to be hired, promoted, or fired, or specify the locations of every net school. The authority of the bureaucracy over the economy depends on what citizens assign their government to do. Payment of interest on public debt requires little more than the writing of the appropriate cheques. Public provision of schooling and medical care require a cadre of civil servants and detailed supervision over a great deal of expenditure. The armed forces require a rigid hierarchy and an unambiguous chain of command.

With its monopoly of legitimate organized violence and its tentacles deep into the economy, the military and civilian bureaucracy would seem well equipped to establish a predatory ruling class as described in the fishermen–pirates–policemen story of chapter 2. Throughout history, from the praetorian guards of ancient Rome to the nomenklatura of contemporary communist societies, that is exactly how bureaucracies tended to behave. Difficulties in the legislative supervision of bureaucracy are compounded by the problem of faction discussed in the last chapter. Control of the bureaucracy may become the means by which a majority faction or governing plurality of legislators consolidates its authority. More will be said about the administration as a ruling class at the end of this chapter. For the present, it is sufficient to observe

that delegation requires subsidiary rules – rules supplied by custom, courts or the legislature itself – to guide the bureaucracy in its conduct of day-to-day business, for in no other way can the intention of the legislature be realized or the power of the administration over the rest of society be contained.

Within the bounds of its delegated authority, the bureaucracy must seek to promote the common good. In effect, the legislature says to the bureaucracy, “Take this sum of money and use it wisely within the confines of your legislated authority.” The National Research Council is told to do what it sees as the most appropriate research. The Ministry of Transport is told to build the most appropriate roads. Universities are told to strike the right balance between teaching and research, and to make available the appropriate selection of courses. The army is provided with a certain revenue, assigned tasks (which may be as broadly specified as keeping the country safe from invasion or as narrow as an instruction to buy such-and-such weapons that the legislature thinks appropriate), subjected to some ex post oversight, and told to get on with its business as best it can. Of course, departments of government are restricted in the range of their activities. The Ministry of Defence directs the army to fight wars or undertake peace-keeping missions abroad, but may not redistribute income among citizens, even if, in the opinion of the principals in the ministry, it would be in the national interest do so. There are jurisdictional disputes at the edges of each ministry’s authority, but no ministry can stray too far from its core territory in pursuit of its vision of the good of the nation as a whole.

Within its domain of authority, the administration is constrained by a principle of equality. That people in like circumstances be treated alike is a constitutional restriction, binding on legislature and administration and supervised by the courts. Public schooling and public provision of health care are to be the same for all. No child is to be less well educated than other children. No ill person is to be less well treated than other ill people. The principle is difficult to apply in practice because people differ in their needs and in the cost of the public services they require. It is one thing to say that two people with the same disease ought to be provided with equal medical service. It is another to allocate resources for medical care between pre-natal care and lung cancer. There is also a conflict between equality of expenditure and equality of service.

It costs a great deal more to treat any given illness in sparsely populated regions than in the big cities where nobody lives very far from a hospital. With equal expenditure per head, people in sparsely populated regions would be much less well cared for than people in the big cities. With equal care for all, expenditure on people in sparsely populated regions would be much larger per head than expenditure on people in the big cities. As a guide for the administration, the principle of equality subdivides into two competing principles, and there is, inevitably, a trade-off between them. Normally, expenditure per head on medical care would be larger but the standard of care would be lower in sparsely populated regions than in the big cities.

A second principle is efficiency. Like equality, efficiency may be thought of as a dimension of the common good. Efficiency boils down in practice to the maximization of the national income broadly defined to include all benefits “to whomsoever they may accrue.” On this cost–benefit principle and with only enough money to build one of two equally expensive roads, the Ministry of Transport should build road A rather

than road B if the value of all services to the users of road A exceeds the value of the services to the users of road B. The procedure may be justified on the grounds that the typical person can expect to be better off with this procedure than with any other in the long run when the procedure is used consistently, over and over again.

Normally, the legislature would want the administration to transact its business efficiently, doing what it is assigned to do at the lowest cost to the tax payer and creating as large a bundle of services as it can with the resources at its disposal. There are exceptions. As discussed in the last chapter, there is a trade-off between efficiency and equality in the redistribution of income. The legislature may favor one faction, or coalition of factions, over the rest of society. Small benefits for some people may impose large costs on others.

Cost–benefit analysis – the pursuit of efficiency in the public service – has a double role to play. Its primary purpose is prosperity, making people collectively as well off as possible with the resources at the disposal of the administration and devoting just enough resources to the public sector to undertake those tasks, and only those tasks, that are more than worth the cost. Cost–benefit analysis has a political purpose as well, to supply rules for the administration to follow, limiting its discretion and reducing the likelihood that the vast powers of the bureaucracy will foster conflict in the legislature or destabilize democratic government.

ASPECTS OF COST–BENEFIT RULES

Vote-trading as the foundation of cost-benefit analysis

Imagine a country of five million people living in five regions, A, B, C, D, and E, with one million people in each region. Every region elects a member of parliament who votes in accordance with the interests of his constituents. Three votes constitute a majority. Suppose parliament is voting about road building. Five roads are under consideration, one in each of the five regions. Parliament must decide whether to build all five roads, some of the roads or none at all. As shown in table 10.2, every road costs $100 million to build, conveys total benefits of $80 million to the people in its region, and conveys benefits of $10 million to the people in each of the other four regions. There is an established rule in this country that all public expenditure is financed by a head tax on everybody in the entire country. No matter where one lives, one’s tax bill is one five-millionth of total public expenditure. Thus, the building of each and every one of the five possible roads imposes a cost of $20 [100 million/5 million] on every person, no matter where he lives, conveys a benefit of $80 [80 million/1 million] to each person in the region where the road is built, and conveys benefits of $10 [10 million/1 million] to each person in each of the other four regions. The five roads in our example are public goods, like guns in the guns-and-butter example in chapter 5, but, though they benefit everybody simultaneously, they do not do so equally. Each road conveys large benefits to some people and small benefits to others.

The legislature might vote about each road, one at a time, or it might vote about several roads, perhaps all five, together. Suppose, first, that voting is about one road

at a time. Since the regions are identical, it is sufficient to consider the road intended for region A. No matter where one lives, the tax bill per head must be $20. The corresponding benefit per head is $80 for a resident of region A and $10 for a resident of any other region. Thus, everybody living in region A gains $60 [80 − 20], and everybody living in any of the other four regions – B, C, D, and E – loses $10 [20 − 10]. The net gain to people in region A exceeds the sum of the losses in the other regions, but ordinary voting takes no account of that. Each member of parliament votes for or against the building of the road in region A depending on the effect of the road upon voters in his region alone. Since the value of benefits falls short of the cost of taxation in four out of the five regions, four out of the five members of parliament vote against the proposal to build a road in region A, and it is not built. As the calculation is the same for the roads in the other four regions, no roads are built at all.

Nor would any road be built if road-building were the responsibility of the regional governments. People in region A would be left to build their road, or to desist from building it, on the understanding that the road would be financed by local taxation within region A. The benefit would be $80 per head, the cost of taxation would be $100 per head, and the road would not be built.

The outcome is entirely different when all five roads are considered together. Total expenditure would be $500 million. Tax per head would be $100. Benefit per head would be $80 from the road in one’s own region plus $10 from each of the roads in the other four regions, for a total of $120. Benefits worth $120 per head are obtained for a tax bill of $100 per head. All five members of parliament vote for the omnibus bill, and all five roads are built. Local authority over road-building would be adequate if (1) the benefits of each road accrued entirely within the region where that road is built, and (2) tax collection were sufficiently decentralized that residents in each region could pay for their road by region-wide, rather than country-wide, taxation. The first of these requirements is violated in our example because each road conveys some benefit in every region. The second requirement would be violated if the example were about diseases rather than about roads because, for example, there is no mechanism for taxing men rather than women for the cost of research on prostate cancer, or taxing women rather than men for the cost of research on breast cancer.

None of the five roads is built when they are considered separately. All of the five roads are built when they are considered together. This is a common situation. Public services – highways, hospitals, police, schools, universities – are often like the five roads in our example. Benefits accrue simultaneously to large numbers of people, these benefits are concentrated in one region or upon one subgroup of the population, but

they not so are completely concentrated that people outside the region are unaffected altogether. The combined benefits of a collection of projects may exceed their combined costs, though none of these projects would be undertaken if considered one at a time and if all voters looked to their immediate self-interest in every vote. A vote trade among people in all five regions together to build all five roads – in circumstances where none of the roads would have been built had the legislature voted about each road separately – can be looked upon as an appeal by the legislature to cost–benefit analysis: the principle that a project should be undertaken if and only if the sum of its benefits exceeds its cost to whomsoever the benefits and costs accrue.

Exploitation of minorities through project selection

The exploitation by the majority of the minority was discussed in the last chapter in the context of the allocation by voting of a sum of money or of the entire national income. Exploitation may sometimes be arranged by project selection. Projects of value to the majority may be accepted and projects of value to the minority rejected regardless of the balance of costs and benefits. Though the spread between total benefit and total cost is greatest when all five roads are built, it may still be advantageous for any three members of parliament to form a majority coalition to vote for the roads in their regions and against the roads in the other two. Everybody has a net gain of $20 when all five roads are built. For the three regions in the coalition, the net gain per person is increased to $40 [80 + 10 + 10 − 20 − 20 − 20]. For the other two regions, the net gain is converted to a net loss per person of $30 [10 + 10 + 10 − 20 − 20 − 20]. The coalition is advantageous to its members, though the sum of the gains to the majority falls short of the sum of the losses of the excluded majority.

Cost–benefit analysis has a pronounced political dimension. It may be looked upon as a rule for circumventing the exploitation problem. Legislators and their supporters in the general population may be willing to desist from forming coalitions in support of projects in their regions when there is an understanding that other legislators will show equal restraint. A decision to respect the outcome of cost–benefit analysis may be the basis for such an understanding.

Diverse projects

The neat symmetry of the five-roads example is entirely artificial. Not all projects are alike. Some are worthwhile. Others are not. Road projects may be large or small, profitable or unprofitable, relatively concentrated in one region or relatively unconcentrated. Cost–benefit analysis discriminates among roads or other projects, signifying which roads ought to be built and which roads ought not to be built. Consider a modification of the five-roads example: Suppose, once again, that each of the five roads is designated for one of the five regions, and that each road conveys benefits of $80 per head to every person in its regions and $10 per head to every person in the other four regions, for an average benefit of $24 in all five regions together. Now, drop the assumption that every road costs $100 million (or $20 per head in all five

regions together), and suppose instead (1) that the roads cost different amounts to build and (2) that voters do not know at the time the vote is taken which roads will be expensive and which roads will be cheap.

Suppose, specifically, that all roads yield combined benefits of $120 million allocated among regions as indicated in table 10.2, that one road will cost $50 million, another $100 million, another $150 million, another $200 million, and another $250 million (equivalent to $10, $20, $30, $40, and $50 per head), but that nobody in parliament knows which road is which. That information will be discovered before any roads are built but after voting is finished. By adopting a cost–benefit rule, the legislature supplies the administration with a procedure for choosing whether or not to build any particular road, removing administrative discretion without at the same time specifying which roads are to be built. To adopt a cost–benefit rule is to instruct the Ministry of Transport to build all roads for which total benefit exceeds total cost regardless of the identities of the beneficiaries. With such a rule, the roads costing $50 million and $100 million are built, but the roads costing $150 million, $200 million, and $250 million are not.

Discounting

Cost–benefit analysis must compare projects with benefits and costs accruing at different times. Just as the market churns out prices for bread, cheese, and every other good today, so too, as explained in chapter 5, does it churn out prices for the same good, and for money, available at different times. The price today of money payable tomorrow is indicated by the rate of interest, though, as we shall see, the two concepts are not quite identical. Suppose the interest rate on savings deposits is 8 percent. When I deposit $1,000 in the bank at that rate, I am, in effect, buying money next year at a price which is a transformation of the rate of interest. I buy $1,080 next year at a price of 92.590¢ [1,000/1,080] per dollar. Generalizing, when the rate of interest is r percent, the going price is 1/(1 + r) per dollar delivered next year, 1/(1 + r)2 per dollar delivered two years hence, 1/(1 + r)3 per dollar delivered today for each dollar delivered three years hence and so on. In our discussion of cost–benefit analysis, we ignore the gap between lending rates and borrowing rates, all variations among year- to-year rates of interest at different times in the future, inflation and changes over time in the relative prices of goods, matters that would normally be covered in textbooks of macroeconomics or money and banking. Here there is one market-wide rate of interest by which values of costs and benefits accruing at different times may be compared. A cost C to be incurred in five years time is equivalent to a cost of C/(1 + r)5 incurred today. A benefit B accruing in three years time is equivalent to a benefit B/(1 + r)3 accruing today.

Discounting allows costs and benefits accruing at different times to be compared on a common scale of “present values.” Consider a project with costs C1, C2, and C3 in years 1, 2, and 3 and then with benefits B4, B5, and B6 accruing in years 4, 5, and 6. With a rate of interest of r, the total cost, TC, of the project assessed as a present value

The cost–benefit analysis certifies a project as worthy if and only if TB > TC, if the present value of total benefits exceeds the present value of total costs assessed at the going rate of interest.

A generalization of equation (2) will prove useful in the analysis to follow. If a project yields benefits every year forever and if the values of those benefits each year are the same, then the total benefit, TB, expressed as the present value of the stream of annual benefit, B, becomes

when the rate of interest, r, is invariant over time.1 For each project, there may be defined a “rate of return,” the rate of interest for which the total benefit of the project would be just equal to its total cost. When benefits are constant every year forever, the project’s rate of return becomes B/TC. The cost–benefit rule to undertake a project if and only if TB > TC becomes equivalent to the rule that a project is worth undertaking if and only if (B/TC) > r, that is, if its rate of return exceeds the target, or market-determined, rate of interest.

Consider the six roads described in table 10.3. Each road has a fixed cost of construction today and yields an annual flow of benefits each year forever. Roads are listed in the first column, their fixed costs are shown in the second, their annual benefits (assumed constant in perpetuity) are shown in the third and their rates of return, the ratio of annual return to fixed cost, are shown in the final column. Suppose the rate of interest is 8 percent, meaning that the market is prepared to exchange $100 today for an income of $8 in perpetuity. In choosing among roads, the Ministry of Transport can rely upon the market rate of interest for comparing costs and benefits, building all roads yielding at least 8 percent and rejecting all roads yielding less than 8 percent. The Ministry of Transport builds roads A, C, E, and F, and it desists from

Table 10.3 Costs and benefits of six roads

building roads B and D, reflecting citizens’ preferences in the choice between present and future consumption.

Nothing need be said about where the roads are located or about the identity of the users of the roads. All roads might be used equally by everybody, or each road might be specially beneficial to people in one of five distinct regions as was supposed above. Cost–benefit analysis recognizes no such distinction because benefits and costs are compared “to whomsoever they may accrue.” Invariably, a strict application of cost–benefit rules will turn out to favor some regions over others when projects are financed by taxes levied uniformly on the population as a whole. Only by accident will all regions gain equally.

Though cost–benefit analysis may yield unequal net advantages among regions and among people, there are several strong reasons why it is employed: (1) If benefits exceed costs, then everybody could be made better off by combining the project in question with an appropriate set of transfers from gainers to losers. While that is true, it may be cold comfort to the losers in any given project if, in fact, the transfers are not forthcoming. (2) Even without compensatory transfers, each person may expect to become better off in the long run from a series of projects, some favoring one group of people, some favoring another, as long as all projects for which benefits exceed cost are undertaken and all projects for which benefits fail to exceed cost are not. A long series of public projects would be like a long series of gambles at favorable odds. One can expect to come out ahead in the end. (3) A benefit–cost rule may be the only rule in sight and the citizen’s only protection against arbitrary and discriminatory behavior by the civil service. The rule to build all roads for which benefits exceed cost by some specified margin is, at least, a rule. Abandon that, and the allocation of funds for road-building becomes like the allocation of money in the exploitation problem of majority rule voting. With no objective basis for choosing among projects, bureaucracies are exposed to the temptation to serve clients who can be expected to return favors. Political parties coalesce around groups of people – identified by region, occupation, language, or religion – who expect to be rewarded for their support by favorable treatment in the allocation of public expenditure.

Admittedly, the choice of a target rate of interest is somewhat problematic. There are many rates of interest in the economy, and it is not always evident which rate of return ought to be applied. Should it be the rate of return on government bonds, on consumer borrowing, on bank deposits, on commercial loans or on some other transaction? There is no solid consensus on this matter, but the weight of opinion seems to be that the rate on bonds is probably the most appropriate.

THE MARGINAL COST OF PUBLIC FUNDS, THE REDISTRIBUTION OF

INCOME, AND TOTAL PUBLIC EXPENDITURE

Governments require a rule for choosing the size of the public sector, deciding which projects, programs, and activities to undertake and which to reject as too expensive. There is no end to the things governments might usefully do in providing for the army, the police, health care, education, basic research, support for the old, alleviation of poverty, and so on. The entire national income would not be sufficient to cover