The public observes aggregate government expenditure but does not know the precise origin of such funds. Citizens are, on average, correct about how much is left for spending in period 2 (second term), but they do not all get it right (Ferejohn 1986). The less transparency there is, the more the estimates of individual citizens vary. Those who think too little is left for period 2 to punish the incumbent by supporting the challenger. Under such circumstances, the following result can be obtained:
Greater levels of transparency result in more efficient monitoring and disciplining of the government by civilians and result in more efficient expenditure profiles. Consider two other mechanisms that may generate perverse incentives.
Private Gain from Public Spending
Public spending may give politicians benefits other than stronger political support. There may, for example, be private benefits to spending more. Larger budgets –and consequently higher public employment – may give the members of the government social status and prestige, and greater opportunity for patronage. This could be seen as a personal investment for a policymaker since it could result in a return of favours once he or she is out of office. This would create a separate incentive for spending even when there is little political competition and the officeholder is certain that his or her successor will be from the same party or represent the same interest group.
This effect is likely to be especially important when the end of the politician’s term in office is imminent. More generally, the shorter is the average tenure of office, the stronger will be the incentive to boost the rate of public spending. The incentive is also likely to be stronger in societies where patronage positions and favours are important parts of the social fabric, and where meritocracy is weak so that a politician’s future welfare more strongly depends on the friendships and relationships he or she has established while in office.
Incentives to Change the Rules of The Game
In institutionally weak environments, the presence of large resource rents can also provide a “prize value” to state capture (Fearon and Laitin 2003). In cases in which violence or extra-constitutional means can be used to overturn a sitting government, the holding of valuable assets by weak political actors can be an especially risky enterprise. This effect can be captured (as with the case of endogenous re-election probabilities) simply by treating the probability of termination of office (now by constitutional or extra-constitutional means) at the end of the first period as an increasing function of the remaining assets.
As before, this would lead to a rise in first-period expenditure. Note, however, that this should occur only if other policymakers can expect to have easy access to government revenues upon removal of the sitting government.
This simple model of policy choices provides insight into the factors affecting government decision in the presence of accumulated revenues. The tendency to spend too much too quickly, far from being irrational, follows a simple logic. The incentives to overspend produce outcomes that have distributional as well as efficiency implications. These incentives cannot be changed simply by placing caps on expenditure. Instead, they require some form of coordination between governments at different time periods regarding not simply how much is spent, but how it is spent.
The adverse effects that we identify are likely to be more pronounced in some places than they are in others. The incentives are greatest in societies in which there are deep social divisions and in which political instability is high. They will be exacerbated in contexts in which current spending increases the chances of retaining power; a feature that is likely to prevail when:
- a large part of the population lives in poverty and has very high discount rates;
- due to horizontal or vertical income inequality, small but politically pivotal groups can affect policy choices disproportionately;
- governments have greater freedom to use expenditure decisions to fund patronage networks that increase their support base; or finally
- due to low education levels or a lack of transparency about the implications of government choices, the population is less able to exert control over policymakers.
However, in a more realistic environment, the decision-making processes described in the preceding text are repeated many times. In such a case, the effects identified can still be observed, but other outcomes are also possible. In particular, it is possible that if players are sufficiently patient, a form of tacit coordination across policymakers can emerge, in which each policymaker voluntarily moderates expenditure from fear of retaliatory action by future policymakers should they overspend. Such tacit coordination does not require the existence of formal institutions to ensure compliance. It does, however, depend on some of the same conditions that have been argued to help ameliorate the problem even in the two-period setting. In particular, it depends on a minimal degree of transparency that allows future governments to observe the actions of past governments and condition their behaviour on these actions.
A key outcome for new Petro-states such as Guyana is that a high degree of discretion by a single political constituency creates incentives to use up windfall revenues as soon as they come in instead of accumulating them. This relationship holds in practice as well as in theory. As discussed previously, the optimal economic policies should not let year-to-year government expenditures vary much in response to oil revenue fluctuation. On average, there is no discernible pass-through of year-to-year oil revenue changes to aggregate government consumption. The coefficient on year-to-year changes in oil revenues is statistically indistinguishable from zero (Humphreys and Sandhu 2007).
Policymakers have strong political incentives not to follow what economists might describe as the economically best policy. Therefore, do not be very surprised to find that economic logic is rarely followed in natural resource-rich countries. Nevertheless, it can be in the interest of all parties, including incumbents, to find institutional arrangements that help discipline expenditure.
Thus, this shows that overspending can result from the fact that individual policymakers cannot commit to undertaking a given set of actions in the future. The practical issue is, then, how to overcome this problem. In particular, what kind of institutional reforms might improve the ability of policymakers to make mutually advantageous, credible commitments?
It is in light of this question that the decision whether or not to establish a Natural Resources Fund (NRF) – and what kind of fund to design – should be resolved. Since an NRF is not necessary for strictly economic reasons, the rationale for it has to be as a vehicle for institutional solutions to the political economy problem. If that is impossible, an NRF is at best useless – and if designed without a view to its effect on political incentives, may even make such incentives worse – and should be eschewed. Designers of prospective NRFs, therefore, must determine whether an NRF can realign local incentives. As has been emphasized, this is different from answering the basic economic question of what the optimal time path of natural resource finance expenditure would be. Instead, it is recommended that the focus should be on what the agents entrusted with carrying out the expenditure policy are likely to do, and how different NRF designs may change their behaviour. Such analysis could conceivably prefer an NRF that encouraged a less-than-perfect expenditure path, but a path that policymakers would, in fact, implement, to one which called for policymakers to implement the optimal policy but gave them no incentive to comply.
The best design will be different in different countries. It has to take account of the local political economy, which is best understood by experienced practitioners with intimate knowledge of local political conditions. Hence, at a general level, list the types of institutional mechanisms that could be implemented through an NRF, and that may work in some local settings, if not in all. What is the aim to provide, then, is an inventory of potential institutional “fixes,” which designers of NRFs can use as a roadmap to identify solutions that are most likely to work in their local political setting. The ways in which NRFs could embody institutional solutions to the incentive problem fall, very roughly, into three categories:
- The NRF can be set up with rules that govern the magnitude and composition of spending from it. The use of rules rather than discretionary decisions can provide one way of improving the regularity of policy across governments and help solve the commitment problem identified above.
- An NRF can impose a separation or sharing of decision-making authority between different political constituencies. For example, the preceding discussion suggests that one way to remedy the commitment problem is to separate the authority to decide how much is to be spent from the authority to decide on what it is spent.
- An NRF can have an informational It can be seen that under certain conditions, transparency increases the ability of the citizenry to hold the government accountable. In addition, it is well known from the economics of information that when information is scarce and asymmetric, efficient outcomes are more difficult to sustain. An NRF could alleviate this problem by facilitating the flow of information within the government system and between it and the population or the international public.