Weingast B.R., Wittman D. The Oxford Handbook of Political Economy

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472 fiscal institutions

ministers can be reasonably sure that the ﬁnance minister shares their basic spending

preferences.

Second, delegation and contracts use diﬀerent enforcement mechanisms. Under

delegation, the ultimate punishment for a defecting spending minister is his dismissal

from oﬃce. This punishment is heavy for the individual, but light for the government

as a whole. It can be used, if the prime minister has the authority to select and replace

cabinet members, which is typically not true in coalition governments. Breaking up

the coalition is the ultimate punishment in coalition governments. This punishment

is heavy for the entire coalition. Finally, commitment to ﬁscal targets is per se much

less credible for one-party governments, who can always walk away from the targets

with no further consequences.

These diﬀerent enforcement mechanisms also explain the diﬀerent relations be-

tween the executive and the legislature. When a single ruling party enjoys a majority

in parliament, the main concern of the legislative stage is to limit the scope of defec-

tions from the budget proposals by individual members of parliament. This can be

achieved by limiting the scope of parliamentary amendments to the budget proposal.

With multiparty coalitions, in contrast, each party involved in the coalition will want

to watch carefully that the executive sticks to the coalition agreement. Therefore, the

contract approach typically vests the legislature with more information rights and

stronger amendment power than the delegation approach (Hallerberg, Strauch, and

von Hagen 2001).

Elections based on plurality rule promote the emergence of two-party systems and

one-party majority governments (Duverger 1954; Taagepera and Shugart 1989, 1993).

In contrast, proportional representation is consistently characterized by multiparty

coalition governments (Lijphart 1984, 1994; Taagepera and Shugart 1989, 1993). This

suggests that countries are more likely to opt for the contract approach if their elec-

tions are based on proportional representation (and low thresholds), while they are

more likely to opt for delegation if their elections based on plurality rule. Hallerberg

and von Hagen (1998)andHallerberg,Strauch,andvonHagen(2001)testand

conﬁrm this hypothesis for the European Union states. Thus, diﬀerent electoral rules

demand diﬀerent institutional solutions to the common-pool problem.

In presidential systems of government, the president does not rely directly on the

legislature for his position as leader of the executive. Voters can, and often do, support

a president from one party while denying his party a majority in the legislature.

The role of the executive in the budget process is not much diﬀerent in presidential

systems. Since the president typically appoints the members of his administration—

with conﬁrmation by the legislature where applicable—the structure of the admin-

istration lends itself more to a delegation approach than to a contract approach

to centralizing the budget process. The relationship between the president and the

legislature, however, is often more diﬃcult, since the two are conceived to be more

equal political institutions than in parliamentary forms of governments.

As a result, centralization of the budget process in presidential systems emphasizes

two institutional dimensions. One is the internal organization of the legislature. Here,

centralization can be achieved by creating a strong leadership in parliament, through

jürgen von hagen 473

an elevated position of the speaker and through a hierarchical committee structure.

The other dimension regards the relation between the executive and the legislature.

The more the constitution puts the two institutions on an equal footing, the more

budget agreements between the two must rely on the contract approach.

4.1 Empirical Evidence

The hypothesis that centralization of the budget process leads to lower government

deﬁcits and debts has been conﬁrmed empirically in very diﬀerent geographical and

political settings. Von Hagen (1992) provides evidence from twelve European Union

countries showing a signiﬁcant negative association between the centralization of the

budget process and general government deﬁcits and debts relative to GDP. Von Hagen

and Harden (1994b) extend and broaden the analysis and conﬁrm the hypothesis that

centralization of the budget process is associated with smaller deﬁcits and debts. De

Haan and Sturm (1994) work with EU data and show that the hypothesis holds up

empirically even when a number of political factors such as the composition and

stability of governments are controlled for. Hallerberg and von Hagen (1998, 1999)

use panel data for ﬁfteen EU countries and show that centralization of the budget

process goes along with smaller annual budget deﬁcits even when controlling for a

number of economic determinants of the budget deﬁcit and other political variables.

Country studies for Belgium (Stienlet 2000), Sweden (Molander 2000), and Germany

(Strauch and von Hagen 1999) point to the importance of centralization in achieving

(or, in the case of Germany, losing) ﬁscal discipline.

Gleich (2002) studies the budget processes in ten central and east European coun-

tries, an interesting sample since a budget process in the proper sense did not exist

under the socialist regime. All ten countries hold elections under various forms

of proportional representation. Gleich shows that centralization conforms to the

contract approach in these countries and that there is a strong negative association

between the degree of centralization of the budget process and the public sector

deﬁcits and debts that emerged in the second half of the 1990s. His results are largely

conﬁrmed by Yläoutinen (2004a, 2004b).

Alesina et al (1999) and Stein, Grisanti, and Talvi (1999) use panel data from

Latin America to show that centralization of the budget process goes along with

lower government deﬁcits. Jones, Sanguinetti, and Tommasi (1999) analyze Argentine

provinces and conﬁrm the same hypothesis. Lao-Araya (1997) provides similar results

for eleven Asian countries. Strauch (1998) uses data from the ﬁfty US state govern-

ments to show that centralization signiﬁcantly reduces annual budget deﬁcits. Finally,

Strauch (1998) and Gleich (2002) show that centralization of the budget process is

also associated with smaller levels of government spending, as the common-pool

argument suggests. Other empirical studies, however, have failed to conﬁrm this as-

pect of the theory. A suggestive explanation is that the common-pool problem implies

that actual spending exceeds its eﬃcient level, and that controlling for diﬀerences in

474 fiscal institutions

the eﬃcient level of spending is more diﬃcult in cross-country studies than in the

context of US state governments or the central and east European countries.

The possible endogeneity of institutions is an interesting and important issue in

this context. Historical experience suggests that governments make eﬀorts to cen-

tralize the budget process to overcome sharp ﬁscal crises. Relevant examples are

France in the 1950s(Wildavsky1986) and Sweden in the 1990s (Molander 2000).

Studying the imposition of line-item vetoes in US state governments, de Figueiredo

(2003) ﬁnds that ﬁscal conservatives strengthen the role of the executive in the budget

process when they anticipate losing control over the legislature to ﬁscal liberals.

Gleich and von Hagen (2002) ﬁnd that states in central and east Europe characterized

by greater social cleavages have adopted more centralized budget processes. This sug-

gests that legislatures were willing to relinquish powers, anticipating that budgeting

would be plagued by the consequences of severe common-pool problems otherwise.

Hallerberg, Strauch, and von Hagen (2001) ﬁnd that the choice between the dele-

gation and the contracts approach to centralization among EU states conﬁrms their

prediction that the former is more adequate for single-party majority governments,

while the latter is more adequate for coalition governments. Hallerberg (2004), in a

study of EU countries since 1973, argues that countries with more intense political

competition are more likely to adopt institutions that address the common-pool

problem. All these studies indicate that institutional design responds to political fac-

tors and circumstances. More work is necessary to understand this interaction better.

5 Conclusions

.............................................................................

The political economy of ﬁscal institutions has emerged as a fascinating and lively

ﬁeld of academic research in the last decade. Insights and implications of this research

are of considerable practical relevance as they touch on important questions of the

design and reform of constitutions, governments, and executive processes.

The research reviewed in this chapter takes the principal–agent relationship be-

tween the voter and the politicians and the common-pool property of public funds

as the starting points. It strongly suggests that institutional design matters for ﬁscal

performance. It also suggests that diﬀerent political and constitutional environments

demand diﬀerent institutional solutions to these problems. More research is needed

to explore this avenue. Furthermore, the research reviewed here has considered ﬁscal

institutions of diﬀerent kinds. Constitutional aspects such as electoral rules or the

degree of political decentralization seem to be more fundamental than budgetary

processes, but the latter should not be ignored. Future research into the ﬁscal eﬀects of

constitutions should pay more attention to controlling for the eﬀects of these lower-

level institutions. Furthermore, more research is needed on the endogeneity of con-

stitutional aspects and how the factors that impinge on them aﬀect the eﬀectiveness

of lower-level institutions.

jürgen von hagen 475

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chapter 27

..............................................................

VOTING AND

EFFICIENT PUBLIC

GOOD

MECHANISMS

..............................................................

john ledyard

Two neighbors are considering buying a street light. It costs $100 to install. Alice

values the light at $70.Bartvaluesitat$60. If they rely solely on the marketplace to

make this decision and do not act together, neither will buy the lamp. However, it is

clear that both would be better oﬀ if they acted together to make the purchase and

split the cost. This street light is a public good—a good that cannot easily be denied

to others once the allocation and payment for the good has been provided. Providing

clear air and water or providing national security are examples of public goods. There

are many others.

In this chapter, I am interested in processes for the allocation and ﬁnancing of

public goods. I begin by looking at markets. Market processes are widely used for

the allocation of many types of goods. There are several theoretical rationales for this

ubiquity. Stated concisely, they say “Markets Work.” But, as the above example shows,

markets won’t necessarily “work” when asked to allocate public goods. Instead, voting

processes are widely used for that task. There is little theoretical rationale for their

ubiquity. In an eﬀort to ﬁll the gap, I am going to look for conditions under which we

can say “Voting Works.”

∗

In this chapter, I have relied heavily on past collaborations with Ted Groves, Tom Palfrey, and

Marcus Berliant. I acknowledge each in the appropriate section below. They are responsible for aiding

and abetting me in my research. They are not responsible for the ﬂights of fantasy I have taken from our

past work.

480 voting and efficient public good mechanisms

1 The Story Behind “Markets Work”

.............................................................................

The rationale for the phrase “Markets Work” is contained in one of the most elegant

results in economics, and one of the easiest to prove—the First Fundamental The-

orem of Welfare Economics. It reads: if there are enough markets and if consumers

and producers take prices as given when they optimize, then Walrasian allocations

(where prices for all goods are announced simultaneously and supply equals demand

in all markets) are Pareto optimal.

An important, but often unremarked, fact is that

the Walrasian allocations are also individually rational.

Running counter to these

results is the conventional wisdom that “in the presence of public goods, markets

fail.” Such wisdom is not a falsiﬁcation of the First Welfare Theorem. As we were

taught by Arrow (1969), even if there are public goods and other externalities, when

enough markets are set up and when agents take prices as given, market allocations

will be Pareto optimal and individually rational. Nevertheless there is a basis for the

conventional wisdom. It lies in the understanding, described by Samuelson (1954),

that once all of the markets needed to generate a First Welfare Theorem have been

created, price-taking behavior is no longer compatible with the incentives of the

agents—it is not incentive compatible. The assumption of price-taking behavior is just

not believable in this context. Free riders will inevitably arise because each consumer

is a monopsony buyer of their part of the public good. So, while the First Welfare

Theorem remains true with public goods, it lacks interest because it is simply not

applicable to the “real world.”

In this chapter I take incentive compatible behavior seriously. In order to say that “a

particular allocation mechanism works” I require the mechanism to be both eﬃcient,

in the sense that it select allocations that are Pareto optimal, and incentive compat-

ible, in the sense that individuals will be willing to follow the prescribed behavior.

Unfortunately ﬁnding mechanisms that are both eﬃcient and incentive compatible

is not an easy task. As Hurwicz (1972) taught us, even price-taking behavior is

not incentive compatible in small private goods environments. He showed that any

eﬃcient, individually rational mechanism will not be incentive compatible. Myerson

and Satterthwaite (1983) established a similar, but dual, result in a simple private

good economy. They showed that any incentive compatible, individually rational

mechanism will not be eﬃcient. Hurwicz and Walker (1990) went further, dispensed

with the requirement of individual rationality, and showed that there cannot be any

mechanism which is simultaneously eﬃcient and incentive compatible.

¹ In this section I use a number of terms from the economics and mechanism design literatures

without deﬁnition. I apologize to those who are not familiar with the literature but I think the basic

argument of this section is understandable even if certain words are not. All terms will eventually be

deﬁned later in the chapter and examples provided.

² Details, required assumptions, and proofs can be found in, e.g., Mas-Colell, Whinston, and Green

1995.

³ Individual rationality requires that all participants be left at least as well oﬀ at the chosen allocation

as they would have been able to accomplish on their own with just their initial endowments. Markets do

this because property rights to the privately owned initial endowments are respected.

john ledyard 481

Does this mean one should conclude that markets don’t work? Economists say no

by taking refuge in numbers. They note that in large private goods economies, either

price-taking is approximately incentive compatible and yields eﬃcient allocations

or incentive compatible behavior is approximately price-taking and yields eﬃcient

allocations.

I will also take this approach and say that “a mechanism works” if it is

approximately eﬃcient and approximately incentive compatible in large economies.

With this interpretation, “Markets do Work” in private goods economies.

But large numbers don’t help us with public goods. “Markets don’t Work” in public

goods economies, even if they are large. For example, Roberts (1976)showsusthat

in large public goods economies any mechanism that is individually rational, as is

certainly true of markets,

cannot be even approximately incentive compatible.

But

if markets can’t work, maybe something else will.

One is naturally led to ask: if we are prepared to dispense with a requirement of

individual rationality, are there any mechanisms, other than markets, which “work”

in public goods economies? In the following sections I provide some answers to this

question. In Section 2, I look at two well-known processes for the allocation of public

goods: majority rule and demand revealing processes. In Section 3,Iaskwhether

there is anything signiﬁcantly better and ﬁnd that, in certain large environments,

the answer is no. In Section 4, I look at voting in multidimensional issue spaces and

explore whether there is anything better there. In Section 5,Iprovidesomeaggressive

conclusions. In the process I establish several conditions under which one can say

“Voting Works.”

2 Imperfect Public Good Mechanisms

.............................................................................

In this section I examine a number of processes that are either used or have been

proposed for use in the allocation of public goods. Ultimately I end up focusing

on two particularly interesting incentive compatible processes: majority rule and

demand revelation. Neither of them produces eﬃcient allocations. Neither of them

guarantees individually rational allocations. They are imperfect but, as we will see

later, they are about the best processes one can ﬁnd.

But before I get to these processes I need to develop and illustrate a number of ideas

and terms including the simple public good environment, mechanisms, consumer

⁴ See, for example, Roberts and Postlewaite 1976. Various core-limit theorems also support this view.

See, for example, Bewley 1973.

⁵ McAfee 1992 provides an example of an incentive compatible mechanism for a simple private good

economy which is approximately eﬃcient in large economies.

⁶ The canonical version of price-taking equilibrium in markets with public goods is Lindahl

equilibrium. This equilibrium does satisfy individual rationality.

⁷ There is another literature which also arrives at similar results when considering the core of a public

goods economy. Muench 1972 provides a demonstration that the core with public goods need not shrink

as numbers grow. See also Conley 1994. Here, also, a requirement of individual rationality plays a crucial

role.