There is an important fact that must be addressed for new oil-producing states such as Guyana: The government’s spending decisions can affect the incumbent’s likelihood of remaining in power. As the incumbent foresees these consequences, they will modify their behaviour. There are myriad mechanisms through which such effects may be mediated – some mechanisms will make matters worse; others might alleviate the problem.
Mechanisms that are likely to exacerbate the incentives for overspending
Why may a politician be rewarded for a policy that deviates from the one that is best for the population? One reason is that citizens themselves may be myopic, and therefore ignore the long-term consequences of a policy that is satisfying in the short term. There is strong evidence from social psychology that such impatience (or “hyperbolic preferences”) is a common trait (Ainslie and Haslam 1992). Another situation in which politicians’ fortunes might be better served by spending more is when a political system gives disproportionate influence to the support of a small part of the population. In such circumstances, that small part of the population might expect always to be favoured by the spending policies of the government without having to pay the burden of future spending cuts, which may be more evenly spread across the population. Put differently, the future negative consequences of reckless spending today may be insufficiently internalized by the politically most powerful group. A third and important mechanism by which spending affects support is that larger budgets allow a government to employ more civil servants, which may lead directly to a rise in political support. Robinson et al. (2005) show an analysis of the effect of natural resource booms on the incentives for bloating the public sector with inefficient patronage jobs. Their model produces a general pattern similar to that described here: The ability to strengthen one’s political support by expanding the public sector leads to an inefficiently high level of extraction of the depletable natural resources. The more the power prospects can be manipulated in this way, of course, the higher the extraction/depletion rate.
This simple model also sheds light on these cases. The findings discussed in the preceding text were generated for cases where the probability of a power change is independent of policy choices. If the likelihood of remaining in power is instead improved by expansionary policies, as suggested by the literature on political business cycles and public debt (Persson and Tabellini 2000), then the problem is exacerbated. Suppose that instead of a fixed probability that they will be turned out of office, the probability of a power change depends on the amount of aggregate spending in period 1:
If the probability that a government is removed decreases when incumbents spend more, then the distortion effects are even greater than in the baseline case. Moreover, the more sensitive to first-period spending is the probability that power will change, the more inefficiently high is first-period spending. Conversely, if the probability of a power change depends positively on spending in the first period, then the level of aggregate spending in period 1 is lower than it would be with a fixed probability and consequently closer to the socially efficient level.
As the second part of the finding says, the need for political support can also encourage more prudent fiscal policy. Overspending, after all, can considerably reduce the welfare of the population, relative to the policies prescribed by the economic analyses discussed previously. In a well-functioning democracy, informed voters could impose discipline on the government by throwing the incumbent out of office if they overspend by too much in the first period. This type of mechanism will be affected by how well the citizenry can observe the fiscal policies of the government, in particular, the magnitude of natural resource revenues and the rate at which they are spent. Even in a country where the citizens are both motivated and have the ability to discipline the government, this cannot happen easily if they do not know what the government is doing.
There exist of expenditure intertemporal profiles that are not chosen but that would make all groups better off. [In the language of political economists, the increase in first-period spending results in a Pareto-inefficient expenditure profile.]
The challenge for institutional designers in countries where this is a big problem is to find ways to solve this problem and realize the efficiency gain that could in principle benefit all parts of society. Two types of improvements are possible. One involves risk-sharing. Since the policymakers in this model are risk-averse, they dislike the uncertainty of what the spending pattern across groups will be in period 2. Both will therefore, ex-ante, prefer outcomes that minimize the variation in the expected second-period expenditure. This is a consequence of diminishing marginal utility. The prospect of high spending in one state of the world is not enough to outweigh a correspondingly low level of spending in other states of the world. Policymakers would, therefore, prefer to secure similar levels of spending and benefit in all potential situations-they are averse to risk. This could be achieved in all cases by both parties committing ex-ante – were this possible – to implementing the same compromise allocation in period 2, the value of which would exceed the expected, risk-adjusted, value of the policies that may be implemented by the uncertain winner of the power contest. Such risk-sharing can be beneficial even without any change in the intertemporal allocation of aggregate resources and is a feature that has been studied elsewhere in settings in which total per period allocations are fixed (Alesina 1988; Dixie et al. 2000). Of course, the big obstacle to such joint commitments is the difficulty of making a credible commitment that one will not exploit an advantageous position once it has been determined who is in power.
The second type of improvement involves intertemporal smoothing of aggregate expenditure. From the point of view of this examination of Natural Resource Funds (NRFs), these concerns are especially interesting. Inefficiency arises in part because the first-period government increases the expenditure beyond their own optimum; this rise in expenditure implies a loss for their relative to the situation in which their return to office is guaranteed. However, as noted earlier, this loss for the first government does not imply a gain to the second-period government since the increase is in the direction of distributive allocations favoured by the incumbent only.
To see how an improvement, in this case, is possible, imagine a situation in which player b could commit, in the event that he takes office in the second period, to allocate shares that are more favourable to a relative to what he would normally like to allocate. With such a commitment, a would find it advantageous to shift more spending from period 1 to period 2, making themselves better off and more than compensating b for his reduced share, should he gain office. Again, the downside of such a solution is the commitment problem-a promise by player b not to take full advantage of being in power in period 2 is not necessarily credible. Nevertheless, note that this solution only requires the commitment on behalf of one player – the challenger – not both, as in the risk-sharing solution.
Here is where we reach the heart of the matter. Inefficient overspending occurs because of incentives created by diverging interests and competition for power to advance those interests. The inefficiency can be overcome if policymakers can commit not to take full advantage of their power when they are in government. If such commitments could be credibly made, incumbents would have fewer incentives to spend everything before losing power. Everybody would benefit from the resulting change: The challenger would benefit from having the prospect of more money to spend once they gain power, and the incumbent from the more efficient time path of spending on their group, as well as a more favourable treatment than their group, would otherwise receive at the hands of b should they gain power.
This point is really a special case of the more general idea that efficiency can be improved by the predictability made possible by the rule of law and checks and balances in government. Can a natural resource fund provide the kind of commitment device needed here? An NRF could place a cap on expenditures in each period, which, if implemented, could return the society to an efficient expenditure profile. This profile, however, would not necessarily make both players better off than in the situation which would otherwise obtain (that is, the fund may not constitute a “Pareto improvement” on what would prevail in its absence).
Imposing a limit on how much a is allowed to spend in the first period will reduce their expected welfare, and they, therefore, have a strong incentive to resist compliance with such a rule. They need to expect a compensation in period 2 (in the form of a less biased allocation by policymaker b should they gain power) for what they give up by shifting expenditure to a time during which it is uncertain that they would control how it is spent. An NRF design that did not take account of this would run a serious risk of being ignored, violated, or changed, with the possible further harmful effect of reducing the respect for policy commitments or the force of law.
A Pareto-superior time path would require some form of implicit contract compliance across governments, in which present governments that cap present expenditure that are compensated by actions of future governments. The implication is that expenditure stability might require not simply caps on how much can be spent, but also guarantees regarding on what the saved money is to be spent. Also implicit in this analysis is the fact that the problem is likely to be worse if a sitting government faces fewer and lesser constraints on what it can do. If the opposition, say, can prevent the worst excesses of the sitting government, the latter would be forced to take into account the interests of the former. Further, if the incumbent knows that they can prevent a new government’s excesses in the case that they lose power, they will be more willing to delay spending.