INSPER CONHECIMENTO

How do political clashes affect cash transfer programs?

Budgetary rules seek to prevent politicians from going overboard either in government spending or in taxing segments of society. They can be more or less fair and efficient according to the budget items they mobilize and the bargaining power of the groups involved in their preparation and execution.

In democracies, budget rules govern the annual negotiation of the public budget, defining items that cannot be changed at all, parameters for changing taxes, and even limits on spending, fiscal targets, and debt. Since the Great Recession of 2008, provisions forcing the government to spend on certain programs have gained prominence.

In Brazil and other Latin American countries, the debate over budget rules has focused on their macroeconomic costs. When revenues fall, due to reduced activity in the economy, it is difficult to adjust the budget in view of the share of mandatory expenditures.

A less appreciated aspect is that budget rules protect political groups from substantial harm when they are not in power. Without them, those defeated in the election would be subject to abusive taxation or to important programs being suppressed, which would be harmful to the entire country, causing abrupt swings in income, consumption, and welfare.

When these budget rules are designed and negotiated in an environment of heterogeneous groups – rich and poor, for example – the outcome of the clash will not always lead to the best balance in terms of the equitable distribution of resources or the efficiency of their use.

This simplified model to try to explain the dynamics of the political economy taking into account the degree of inequality was developed by researchers Marina Azzimonti, from the Richmond Fed, Laura Karpuska, from Insper, and Gabriel Mihalache, from the University of Ohio.

The simulation adopts the elementary structure of a society with only two parties, one representing the richest and the other, the poorest. It also assumes a tax code on the one hand, and a collection of mandatory income security expenditures for the poor on the other, which can only be changed by agreement between the two parties.

In the absence of change, for example due to a political deadlock, spending on each line remains the same as in the previous period. The party that is in power today is not sure if it will remain there in the next period. The ruling party has the power to propose reforms, and the opposition has the prerogative to veto them.

The rich favor cutting taxes and government spending. They prefer to authorize spending on public goods – such as administration of justice, security, and military defense – rather than endorse transfers of resources to the poor. The poor, on the other hand, are more interested in expanding these programs, which satisfy their desire to increase their private consumption, and for this they can plead for higher taxes.

In this context, a situation of high income inequality sharpens the party representing the poor to demand redistribution, via higher taxation and an increase in social transfers.

The fact that the party of the poor has already guaranteed a level of taxation and mandatory spending on social security despite partisan negotiations gives bargaining power to the party of the poor, which is able to offer its opponent an increase in spending on public goods, the preferred allocation of the rich, as long as it is accompanied by an increase in direct income transfers.

The extension of this game over time, according to the model’s prediction, tends to increase the share of the public budget reserved for transfers to the poorest, with taxation accompanying this escalation. It is even predicted that the optimal level of these expenditures will be exceeded, in contrast to a relative shrinking of spending on public goods.

Marina, Laura and Gabriel compare the results of this model with those of other models in which, for example, there is no tax code or legal obligation to spend on cash transfers. They conclude that none of the alternative hypotheses carries the level of material welfare for both sides of the dispute obtained in the model with strict rules for taxation and social spending.

The researchers then show that the trajectory of the U.S. economy since the 1960s harmonizes with the model. During that period, American income grew in real terms only for the richest workers. That of the bottom half has stagnated.

The share of total U.S. government spending on social cash transfer programs rises when the Democratic Party is in power, aligned with platforms of increasing the state and taxes. When the Republican Party is in power, with the opposite guideline, the tendency is for spending on these social programs to stabilize.