Growth of the Public Sector Notes

Determinants of a Growing Public Sector

Widened Suffrage: A Political Economy Perspective

The public sector's growth is correlated with the extension of suffrage, a pattern observed across countries and decades, irrespective of political systems or ideologies (Lindert, 2004). This pattern is conducive to the technologies of managing a public sector and the politics of actors in this field of power struggle.

The expansion of the public sector, particularly the welfare state, stems from spontaneous changes in:

1. The compositions and practices of taxation.

2. The components and benefactors of public expenditure.

Extended State Leviathan: A Critical Juncture Perspective

The public sector expands following significant incidents that render prior fiscal institutions obsolete. These incidents include:

1. Changing Foci on the Major Tax Income

2. Aftermath of WWII

Deepened Globalisation: A Fiscal Perspective

Globalization reduces the importance and availability of revenues from direct income tax. Consequently, fiscal revenues shift from capital taxes to labor taxes and then to consumption taxes. This shift is driven by the increased mobility of capital compared to labor due to globalization.

Implications of a Growing Public Sector

The growth of the public sector influences the evolution of public finance, public expenditures, and budget (un)constraints.

Fiscal Policy and Capital Mobility

Swedish Experiment with the Tobin Tax

Sweden's experiment with the Tobin tax, a small tax on financial transactions, provides insights into the effects of capital mobility.

Timeline:

• 1984: 0.5% tax on purchase and sale of securities (1% round-trip tax).

  • Example: SEK 5,000 tax on SEK 1 million stock transaction.

• 1986: Tax increased to 1% per transaction (2% round-trip).

• 1989: 0.03% tax on fixed-income securities (government bonds).

Outcomes:

• 1986: 60% of trade in 11 most active stocks moved to London (approximately 30% of all trading).

• 1990: The London-bound share of trade increased to 52%.

• Trade in Swedish government bonds collapsed (85% decline in the first week).

• Tax revenue was significantly below expectation (SEK 80 million vs. SEK 1,500 million).

• Capital gains tax revenue fell by more than the Tobin tax revenue due to capital flight to London.

• April 1990: The tax on bonds was abolished.

• January 1991: All transaction taxes were abolished.

Lesson: Capital is mobile in a globalized financial market.

French Millionaire Tax

The proposed 75% top rate of tax in France led to concerns about businesses relocating to countries with lower taxes like Britain.

Fiscal Policy and Deadweight Loss

Hypothetical Scenario: Two workers with different elasticities in the labor market are subjected to tax increase.

• Before Tax: Employer's Cost of Hiring = Employee's Wage = 100

• 25% Social Insurance Tax: Tax Wedge + Employee's THP

The burden of the tax falls differently on high-skilled and low-skilled workers due to different elasticities of supply and demand.

• The burden of the tax falls predominantly on:

  • The employer of the high-skilled workers

  • The low-skilled employee

When either demand or supply is inelastic, taxation can raise revenue, but when both are elastic, there is little revenue and large dead-weight loss is incurred.

Personal Income Tax (PIT) rates have declined and were simplified due to globalization. Revenues have been replenished through indirect taxes (VAT) and payroll taxes (Social insurance payments), which are mostly regressive to keep capital from fleeing to other economies.

Life Expectancy in a Welfare State

Broader University Enrolment is a postwar phenomenon, facilitated by the public sector.

Benefactors of a Pension System

Two classes at opposite ends of the social stratum:

• Low-income earners:

  • Low education → early labor force entry (by up to 10 years).

  • Long period of contributions.

  • Low life expectancy → short period of benefits (by up to 6 years).

  • Earlier exit from the system relative to other groups

• High-income earners:

  • Higher education → late entry into the labor force.

  • Shorter period of contributions.

  • High life expectancy → long period of benefits.

Middle-income earners account for the most share and take the most benefits:

• A-level/university → more similar to high-income earners (late entry).

• Life expectancy in-between: close to high-income groups in some countries and low-income groups in others

Findings:

1. Who benefits and who pays over the life-time are neither pro-rich nor pro-poor.

2. The pension system benefits postwar middle class the most.

Some policies are redistributive towards the poor, while others redistribute from the poor (and rich) to the middle (and rich) or among the middle. These include:

• Public (tertiary) education

• Public pensions (potentially)

• Public sector jobs (require high education)

The current public sector is supported by a wide coalition of middle-income voters, which has lasted at least since WW2. Recently, the status quo has been upset by technology:

• Medical technology increases life-span, affecting demographic make-up

• Technology improves mobility of jobs and capital

The largest benefactors of a pension system are those who are already better-off, including:

1. Tax breaks

2. Mortgage interest deduction

3. Lower rates on interest on savings and capital

Other benefits cover public sector employment, job protection, severance pays and untaxed fringe benefits (vacations, office amenities).

Those who pay taxes and enjoys public service are also those who vote in elections!

Reluctance to Tax Cut

Chronic deficits start as spending growth halts, indicating governments have hit some budget constraint.

1. Raising revenue is harder (taxes are easier to avoid).

2. Borrowing is becoming more expensive

Long-term political gridlock exists because spending cuts/tax hikes are unfavorable to the coalition, and there is always a big enough constituency in the coalition to block reform.

(Deficit as % of GDP in OECD)

Technologies and Politics of Raising a Leviathan

The public sector operates in an environment affected by exogenous trends and shocks. The long-term rise in public spending is tied to extended voting rights and a more interventionist state.

The budget constraint of an elected government is determined by:

1. The Technology of collecting taxes taxation

2. The Technology of countering tax evasion

3. The Effect of public policies (a rather important dimension if it seeks re- election)

The actual redistribution of public and private money benefits the middle class the most in principle but may be affected by other factors in policy implementation.

It is the private economy to decide the politics in elections. It is the politics to decide the economy in the public sector. (Conclusion)