TEEE 4205 Economics of Power
Systems
Government’s Role in
Economy
Basic Concepts
Government
• organizations of individuals
– particular set of institutions and people
• authorized by formal documents
– legally empowered
• make binding decisions on behalf of a
particular community
– externally: war, trade, border control, ...
– internally: tax, education, health, welfare, ...
Good Governance
• Rule of law
• government can take no action that has not been
authorized by law
• citizens can be punished only for actions that
violate an existing law
• Property rights
• Regulatory regime
• Macroeconomic policies
• Absence of corruption
Government’s Power
• Power
– ability to get people or groups to do what they
otherwise would not have do
• Government’s power
– to develop institutions
– to carry out policies
– sometimes unpopular
– has to be sufficiently strong
Government’s Power
• sufficient power
• constrained power
• Madison: oblige the government to control
itself
• restraints to check arbitrary and corrupt
behavior by the government
• Key: building effective political institutions
Political Institutions
• Organizations, individuals, and agencies
• Electoral rules
– single-member district and first-past-the-post
– proportional representation system
• Constitutional rules
– division and limit of power
– between branches of government
– between central and local governments
Political Institutions
Constrain arbitrary exercise of power by
politicians and bureaucrats
– outline property rights between state and
private sector
– enforce property rights
– influence competition in political process
– hold public officials accountable for their
actions
Economic Policy Outcomes
• Political institutions play important role
• Resolve redistribution conflict from
economy policies
• Three examples of policy choices
– budget deficit
– financial market
– trade policy
Budget Deficit
• Difference between revenue and expenditure
• Government influence on budget
– muster political support for taxation
– resist demands for expansion of spending
• Political institutions of budget procedures
– balanced budget rules
– power of finance ministry
Balanced budget rules
are more likely to be effective if
– voluntarily adopted
– impose hard constraints
– difficult to reverse
– effectively enforced by
• a credible third party or
• higher level government
Financial market regulation
• Influence of political institutions
– independent financial regulatory agencies
• central bank independence
– checks and balances in political process
• Among developing countries, central bank
independence doesn’t seem to affect
inflation outcomes
International trade liberalization
• Government’s trade policy influenced by
domestic political conflict between gainers
and losers from trade liberalization
• Industries that tend to have tariff protection
– industries in decline
– industries that are highly unionized
– make substantial campaign contributions
– more geographically dispersed
Corruption
• Exercise of public power for private gain
has large costs for economic development
• undermines well-functioning markets
– a tax that distorts competition & lower returns
– a barrier to new entries in market competition
– subvert state’s legitimacy
– weakens state capacity to provide institutions
to support markets
Causes of corruption
• Distorted policy environment (opportunity)
• Weak judiciary (credible threat to punish)
• Poor civil service management
• Low public sector pay (not evident)
• Other factors
– Openness to international trade
– Complexity of regulatory environment
– High and variable inflation
Political institutions
• Political institutions can help reduce the
opportunities and incentives for corruption
– Restrain politicians from arbitrary actions
– Hold politicians accountable for their action
• Decentralization
• Electoral rules
• Press freedom
• Civil society
Taxation institutions & policies
• Tax provides the state with resources to
build market-supporting institutions
• Weak tax collection institutions lead to
disproportionate reliance on tax revenue
from more visible and easier sources
– international trade
– large firms
Tax collection institutions
• Poor countries tend to have weaker tax
administration & higher reliance on tariffs
Conclusions
• Political institutions matter
• Good governance is essential to economic
development
• Effective State
– plays a catalytic, facilitating role
– encourage and complement the activities of
private businesses and individuals
