1 2020 EXAMINATIONS MSc/MEcon/PhD (integrated) in Economics ECONOMICS ECON511 – Public Economics and Political Economy (2 hours) Candidates should answer one question from Part A and one from Part B. Each question carries equal weight. (Please turn over) 2 Part A 1. In 2014, the UK government published a study estimating the own-price elasticity of different alcoholic drinks. The table below summarizes the results. The category “on” refers to alcohol sold to be consumed on the premises (pubs, bars, restaurants), “off” refers to alcohol sold be consumed off the premises (shops) and “RTD” refers to “ready- to-drink” (for instance a pre-mixed gin and tonic). On Off Beer -0.34 -0.74 Spirits -1.25 -0.45 RTDs -0.24 -0.52 Cider -0.49 -0.74 Wine -0.24 -0.08 Source: Sousa, 2014, HRMC Working Paper 16 Using the models and intuitions from the literature on optimal commodity taxation, how would you use the information in the above table to choose the optimal indirect tax level for the different categories of drinks listed Good answers should contain at least the following information: Inverse elasticity rule should tell us to tax the most the more inelastic goods (wine, in particular off-premises) Main assumption however: no cross elasticity. Clearly not the case here (substitution between alcoholic drinks and between on and off premises). We would need to know the elasticity of a broader category “alcoholic drinks” Many-person Ramsey rule also tell us to treat differently the goods depending on the income of those who consume it. If alcohol is a higher share of the budget of the poor, it should lead to lower tax. If Wine is consumed by people with different income than Beer, they should not be taxed at the same level It would be useful to provide some formalization either of the many-person Ramsey rule or of the inverse elasticity rule, clearly stating the assumptions Then, some additional points and connections with the different topics of the lecture can be made (there are certainly more than the one I list below): Substitution with labour Perhaps a point can be made than drinking “On” premises is a better way to do social networking than drinking at home… Externalities On a pure health basis, alcohol is unhealthy and the NHS is free at the point of use, so taxation should be used to internalize the public health cost. In terms of other externalities (noise, anti-social behaviour), there might be a distinction between on and off-premises drinking 3 Paternalistic taxation One could consider that alcohol consumption presents the same problems when consumers use quasi-hyperbolic discounting than cigarette, so the result of Gruber and Koszegi should apply When discussing redistribution, it could be useful to provide some conditions (Atkinson-Stiglitz) such that redistribution should not be done through commodity taxation, but through income taxes. 2. The government of your country wants to develop a very large infrastructure project to increase accessibility in the North region. The prime minister argues that the central government should entirely fund the project and take the big decision on how to allocate the money. The (fictional) opposition group “better for the North” has just released the following statement: “Local priorities: the budget allocated to the project should be directly transferred to local authorities who would then decide how to use it, instead of bureaucrats in the capital city with no knowledge of local priorities.” The (fictional) “alliance for lower taxes” has released another statement: “No more money wasting: as a rule, we should only fund projects for which the private sector is willing to take a share of the cost. This is the only way to identify projects that create enough social value.” Using the models and intuition from the literature on the provision of public goods and fiscal federalism, critically assess the above proposals Good answers should contain at least the following information: Public good characteristics: it is important to define whether the project really is a public good (non-rival, non-excludable). It can be argued that building infrastructure benefits everyone in the region, even those who do not directly benefit from the infrastructure. Local priorities: there is a tradeoff between local preferences and spillovers. If we are talking about a project on accessibility and infrastructure, it is likely that a big part of the project is largely about spillovers (should be left at the central level). However, it is true that for the details of how the infrastructure is developed, local preferences could matter. A good way to illustrate the tradeoff is the result in Besley-Coate (2003) No more money wasting: private provision of public good is inefficient (this is the Samuelson rule). However, it may be possible to design mechanisms leading to the provision of the public good such as the Vickrey-Clarke-Grove mechanism. A convincing argument for the private provision however would have to include such a mechanism, in which it is indeed incentive compatible for the private sector to contribute. 4 Part B 1. Based on the material discussed in class – namely on the papers by Besley and Case (1995) and by Finan and Ferraz (2010a) – discuss how term limits can contribute to make politicians accountable. Briefly describe the methodology used in each paper and its main findings. Political agency models predict that politicians should behave better when they can run for re- election than when they cannot. However, testing this prediction empirically is challenging since simply comparing the average behaviour of term-limited vs. non-term limited politicians will deliver bias estimates, and since which politicians get re-elected is not random. Besley and Case (1995) is the first paper to rigorously tackle this important empirical question. The authors use comprehensive data on the policies implemented by governors in U.S. states between 1950 and 2000 (namely taxes and spending), and exploit variation across states in the presence of term limits. Using an econometric specification including both state and year fixed effects, they estimate the coefficient of a dummy indicating whether
the incumbent face a binding term limit. They find that, on average, term-limited governors raise higher taxes – particularly sales and income taxes – increase overall public spending, and reduce minimum wage. The average effects mask large differences between incumbents of different party affiliation, with the increase in taxes and spending being driven by Democrats and the decrease in minimum wage by Republicans. These results suggest that, when not facing re-election, politicians tend to implement policies that are ideologically more extreme and potentially unpopular with the median voter. Finan and Ferraz (2010) examine to what extent politicians facing re-election are less likely to engage in corruption. Using data from random audits of municipal governments in Brazil, they compare the relative frequency of corruption charges for mayors in their first term and mayors in their second term. They use a cross-sectional specification and control for a wide range of municipal characteristics (e.g., population, education, GDP) and mayor characteristics (e.g., education, age, gender, party). They find that audits are more likely to detect corruption for term-limited mayors than for mayors in their first term. They show their results are robust to comparing second-term mayors with: i) first-term mayors with political experience, and ii) first-term mayors that will later be elected for a second term. They also show similar results hold when comparing mayors that barely won and barely lost their second-term election in an RDD setting. Finally, they show that the term-limit effect is weaker in areas with well- functioning media and effective judicial prosecutor, both of which help keeping elected officials accountable even in the absence of re-election incentives. 5 (Please turn over) 2. Based on the evidence presented in Stromberg (2007), Eisensee and Stromberg (2007) and Durante and Zhuravskaya (2018), explain how mass media can influence government policy, and how policy-makers may attempt to avoid media scrutiny. Discuss the methodology used in each paper and explain why, in your opinion, their findings can inform our general understanding of the relationship between media and accountability. Mass media inform voters about government actions and, by doing so, can impact the policies that are ultimately implemented. First, more informed voters are more able to punish or reward politicians for their actions. Knowing that, politicians tend to cater policies to segments of the populations that are more informed. Stromberg tests this hypothesis by looking at the effect of the introduction of the radio in the U.S. in the 1930s on spending decisions by U.S. governors in the context of a New Deal program for unemployment relief. Using data on spending and access to radio at the county level, he shows that, controlling for a range of county characteristics and state fixed effects, counties where a larger share of households owned a radio, were more likely to receive funds. Eisensee and Stromberg (2007) study, instead, whether media coverage of specific events affects government policy. Specifically, they analyse whether natural disasters that are covered on U.S. news media are more likely to receive relief funds from U.S. government agency, US Aid. Estimating the causal effect of news coverage is difficult due to problems of reverse causality and omitted variable bias. To address these issues, the authors exploit exogenous variation in the news coverage of natural disasters due to the presence of other newsworthy events – that are likely to crowd out news coverage of disasters – which they use as an instrumental variable. Using this approach, they find that natural disasters that do not coincide with other events are on average 7% more likely to make the news and to receive funds. The effect is much larger for “marginal” disasters that would not be covered at all in the presence of competing news. News coverage of public policies increases public scrutiny of government actions and contribute to keep politicians accountable. Yet, sophisticated politicians can strategically time their unpopular policies to moment when the media and public opinion are distracted by other events so as to minimize the political costs of their actions. Durante and Zhuravskaya (2018) test this hypothesis for the domain of military politics by focusing on the context of the conflict between Israelis and Palestinians. Specifically, they test whether Israeli forces are more likely to attacks Palestinians on days when U.S. media are dominated by other events, as this would decrease the consequences of the attacks on U.S. public opinion. Following Eisensee and Stromberg’s approach, they use the occurrence of other newsworthy events that can crowd out coverage of the attacks on U.S. media. Their results indicate that indeed Israeli attacks are more likely to occur, and deadlier, on the days before important news events. The effect is driven by attacks that carry a higher risk of civilian victims, and by news about events that are predictable. Taken together this result indicate that i) mass media can have tangible effects on policy, ii) that policies tend to favour voters that are more informed, iii) that informing voters about government policies contribute to keep politicians accountable, but that iv) strategic behaviour by politicians can undermine the role of mass media as watchdog. (Please turn over) 6 References Besley, T. and A. Case (1995). “Does Political Accountability Affect Economic Policy Choices Evidence from Gubernatorial Term Limits,” Quarterly Journal of Economics, 110(3), 769-98. Durante R., and E. Zhuravskaya, “Attack when the World is not Watching: U.S. Media and the Israeli-Palestinian Conflict,” Journal of Political Economy, 2018. Eisensee, T. and D. Str mberg (2007), News Droughts, News Floods, and U. S. Disaster Relief, Quarterly Journal of Economics, 122(2): 693-728. Ferraz, C. and F. Finan (2010), “Electoral accountability and corruption: Evidence from the audit if local governments,” American Economic Review, 101, 1274-1311. Stromberg, 2004, “Radio’s Impact on Public Spending”, Quarterly Journal of Economics, vol. 119, n. 1, pp. 189-221. 7 (End of paper)