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December 19, 2007

Starving the Budget Beast to Feed the Public Interest

To keep self-interested politicians from squandering public funds, governments should consider carrying more debt, more often.


In the aftermath of Hurricane Katrina, billions of dollars in federal funds were directed toward relief and rebuilding efforts along the Gulf Coast, many of them in the form of contracts to private firms. But taxpayers soon learned that much of the money was misused: Cruise ships used to house hurricane victims charged the government more than $5,000 a month per person, many times the cost of available apartment housing in the area. Close to $1 billion was spent on manufactured or modular homes that didn’t meet key safety standards for flood zones. Many of these contracts, worth millions, went to firms with close ties to elected officials from both sides of the aisle.

When faced with spending abuses like those exposed in the wake of Katrina relief efforts, as well as perennial pork-barrel spending, citizens may easily conclude that trusting elected officials to make spending decisions in the public interest is overly optimistic. Yet the notion that governments act benevolently by spending wisely and efficiently to benefit overall social welfare is popular with economists, and most base their fiscal-policy recommendations on this idea. Given so much contrary evidence, Professor Pierre Yared suggests it’s an assumption economists may want to reconsider.

To determine what kind of fiscal-policy prescriptions can best offset the conflict posed by politicians’ self-interest while ensuring that public money is spent more efficiently, Yared used a mathematical model to examine how electoral political decisions interact with the overall economy.

“When you view electoral democracy together with fiscal policy and the market for government bonds, you can identify two constraints. There’s a savings constraint, which emerges from the fact that politicians can’t sit on massive amounts of wealth without extracting rents — money they direct towards their own personal or political purposes,” Yared explains. “At the same time you have a debt constraint: politicians cannot take on as much debt as might be socially optimal because they would not be able to garner support from citizens if they did.” That’s because in the eyes of the public large amounts of debt are associated with making sacrifices, usually in the form of higher taxes.

“Economists have typically advised governments to do a very simple thing: save for a rainy day,” Yared says. “Like parents who begin to tuck away college tuition money when they start raising children, it seems logical for governments to save in anticipation of a big increase in spending for future needs.” That goes for expected needs, like covering increases in Social Security costs related to an aging population, as well as for unanticipated needs, like a large-scale natural disaster or a war.

But what is sound advice for a legitimately self-interested household doesn’t hold for governments. “The problem with the save-for-a-rainy-day policy is that it hinges on assumptions that rely on politicians to do the right thing,” Yared says. “When governments are wealthy, there’s a natural tendency — and temptation — for these officials to squander public wealth on questionable projects. Even in the United States we know that politicians like to use some of the resources in government coffers to pay themselves rents: instead of cutting taxes during peacetime or when the economy is burgeoning, they keep taxes as they are and use the extra resources for a project that lines the pockets of a friend or a donor,” he explains.

Citizens’ motives can perpetuate bad government spending habits. “Politicians have trouble getting support from citizens when they allow big deficits to accumulate, because high debt is associated with high taxes to finance the debt,” Yared explains. But the more money that’s available to politicians in the public till, the more that is available to be siphoned away from legitimate uses and into pet projects or elsewhere.

So what does Yared’s model prescribe to help governments manage their budgets and discourage elected officials from dipping into the public till? “Governments should tax conservatively, spend liberally and live in perpetual debt as a way of keeping politicians well-behaved. As long as there are high debts, there is less for politicians to ‘eat,’ since they need to service interest on the debt.” Economists describe this approach to fiscal management as starving the beast.

But governments can’t run on deficits forever. One reason economists typically recommend that governments accumulate rainy-day savings is to maintain constant tax rates, rather than responding to spending increases by moving tax rates up and down a lot, which is expensive and inefficient. But if a government, in order to keep its politicians from extracting rent, hasn’t accumulated a lot of savings and finds itself facing an event that requires a surge in spending — like a large increase in the number of children about to enter public schools — how can the increase be paid for? “The government will increase taxes and increase debt to accommodate the increase in spending. However, since citizens put a check on how much debt the government can actually take out, taxes end up increasing a little bit more during the rise in spending compared to after the rise in spending when the government is repaying its debt,” Yared explains.

In other words, Yared’s model suggests that temporarily raising taxes to respond to increased spending needs is a better approach to discouraging politicians from seeking too much rent and at the same time results in the most efficient use of public monies. “Governments shouldn’t run surpluses in anticipation of spending sprees. Moreover, they should take out lots of debt if they want to go on a spending spree, and raise taxes later to repay it.” The public keeps this spend-now-pay-later approach in check because there’s a limit to how much people are willing to be taxed.

Policies based on starve-the-beast fiscal models may have important implications for developing countries. “Governments in developing nations used to hold too much debt, and it wasn’t clear they would be able to repay those debts. The International Monetary Fund responded by closely monitoring these nations, asking, Is the debt sustainable? Is the country taxing enough? Is it running surpluses?” notes Yared. That is quickly changing now that commodities prices have boomed, boosting the income of many developing countries. “Right now, many of these nations don’t have those old problems because they are becoming wealthy. Nonetheless, this wealth leads to a host of new and different problems since politicians in these nations are likely to want to use this windfall for their own pet projects.”

However counterintuitive it seems for a government to run more debt instead of less as a lever to curb questionable spending by politicians, Yared emphasizes that it is more beneficial for citizens. “It’s better for the public to have money flowing in and out than to have politicians sitting on a tempting pile of cash,” he says. “You don’t want to have a lot of money in the cash register.”

Pierre Yared is assistant professor of finance and economics at Columbia Business School.

Read the Research

Pierre Yared

"Politicians, Taxes, and Debt"

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