The electoral origin of government spending shocks

By Raphaelle G. Coulombe, Queen’s University

The ratio of government expenditure to output fluctuated considerably after WW2. As shown in Figure 1, many countries experienced rapid decreases or increases in the share of central government expenditure in output at different points in time. For example, there were instances of sharp decreases in Canada, Italy, and Denmark since the mid-1990s, while the United States and United Kingdom experienced the opposite trend over that same time period.

Figure 1: Ratio of central government expenditure to output
Figure 1: Ratio of central government expenditure to output

Figure 2 shows that a pattern emerges when examining the change in the ratio of central government expenditure to output during a party’s time in office (in percentage points) against the same party’s ideology on the left-right scale for the twelve OECD countries in the sample since 1945. The color blue denotes right-wing parties (parties with ideological scores greater than zero) while the color red denotes left-wing parties (parties with ideological scores smaller than zero). When in office both right- and left-wing parties tend to turn the ratio of government expenditure to output in their preferred direction. The negative relationship between right-wing parties and the change in the G-to-Y ratio is statistically significant at the 1% level. In addition, while right- (left-) wing parties tend to decrease (increase) the ratio of government expenditure to output, it also seems that the decrease (increase) in the ratio becomes more pronounced the more right- (left-) wing the party is.

RCG Blog Figure 2
Figure 2: Change in G/Y during time in office against party’s ideology

The focus of my recent research is to model and document the origins of the variations in fiscal policy stance both across countries and time and to provide a deeper understanding of government decisions towards spending, which amounted to 38% of GDP on average in advanced economies in 2018 (IMF estimates, 2019). To that end, I relax a common assumption in traditional Keynesian and neoclassical macroeconomic models that government spending is an exogenous process (for example see Woodford 2011 or Baxter and King 1993).

I first develop a theoretical model of the joint determination of economic and electoral outcomes in which government decisions towards spending and taxation vary according to the ideology of the ruling party and the state of the economy. The model introduces heterogeneous parties and voters into a one-sector neoclassical model extended with repeated elections at fixed intervals. The key assumption of this model, which is motivated by the empirical evidence, is that the left-wing party wants a higher share of public consumption in output than the right-wing party. In my framework, the ruling party follows a fiscal rule for expenditure that operates like a ratchet mechanism by gradually turning the government spending-to-output ratio in its preferred direction.

I then exploit the large variations in the domestic political environment across twelve OECD countries in North America and western Europe as well as variations in the business cycle and in the stance of fiscal policy since 1945. To capture key differences in ideology and voting behaviour across countries, I use a rich dataset from the Manifesto Project database that documents electoral outcomes and time-varying ideological party positions estimated from electoral platforms.

The model shows that an important part of the variance in government spending can be linked to the political sector for most countries studied (54% on average). Overall, I find that elections are often a precursor to government spending shocks in countries like the United States and the United Kingdom with high political polarization and persistent government ideology. Intuitively, in these countries, an election that leads to a change in government tend to be followed by larger and more persistent government spending shocks.

Questions remain about why the political sector is more important for the variations in government spending in some countries. For instance, the differences in political polarization and in the persistence in government ideology can ultimately stem from a difference in political systems. In fact, the countries for which most of the variations in government spending is linked to the political environment are countries with a smaller number of dominant parties.

References

[1] Baxter, M. and King, R. (1993). Fiscal policy in general equilibrium. American Economic Review, 83(3):315–334.

[2] Volkens, A., Lehmann, P., Matthieß, T., Merz, N., Regel, S., and Werner, A. (Version 2018a). The manifesto data collection. Manifesto Project (MRG/CMP/MARPOR). 

[3] Woodford, M. (2011). Simple analytics of the government expenditure multiplier. American Economic Journal: Macroeconomics, 3:1–35.

Border Policies, Exchange Rates, and Canadian Retailers

By Beverly Lapham, Queen’s University

The nominal exchange rate between Canada and the U.S. fluctuates considerably over time. These fluctuations affect Canadian retailers in at least two ways. Firstly, exchange rate movements affect retail price differences between the two countries (see [3]). In response to these price differences, consumers travel across the U.S.-Canada border to purchase goods in the country with lower prices. This is illustrated in the figure below which shows that nominal exchange rates are correlated with cross-border travel by Canadians. Hence, through travel responses, Canadian dollar appreciations tend to decrease demand, revenue, and profits for Canadian retailers. Secondly, because Canadian retailers often use imported inputs, movements in exchange rates may cause fluctuations in retailers’ costs. Thus, Canadian dollar appreciations tend to decrease costs and increase profits of Canadian retailers. My research with co-authors estimates the effect of exchange rate fluctuations on heterogeneous Canadian retailers’ revenues and profits and examines the impact of changes in border policies on those relationships.[1][2]

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Queen’s Economics and Psychology Departments Jointly Welcome Dr. Anita Tusche

By Eliane Hamel Barker and Ardyn Nordstrom, Queen’s University

tusche_foto_caltech2017Last November, the Economics and Psychology departments at Queen’s University were pleased to welcome Dr. Anita Tusche as assistant professor and Queen’s National Scholar. The Queen’s Economics Department is delighted to be welcoming , and would like to take this opportunity to introduce the Queen’s community to Dr. Tusche’s work. Before joining Queen’s, Dr. Anita Tusche completed her PhD in Psychology in Berlin, Germany and continued with Postdoctoral research at the Max Planck Institute for Human Cognitive and Brain Sciences and then the California Institute of Technology. Most of Dr. Tusche’s research is in the exciting new field of neuroeconomics, which is at the intersection of behavioral economics, psychology, neuroscience and computational modelling. At the core of her research is the aim to understand the mechanisms that drive people’s differences in decision making by using computational models on data collected from computer experiments, eye-movement measurements to determine what people pay attention to, and functional and structural brain data.

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How Flexible is Inflation Targeting in Canada?

By Gregor W. Smith, Queen’s University

The Bank of Canada often describes inflation targeting as flexible. For example, the preamble to its October 2018 Monetary Policy Report says:

“Canada’s inflation-targeting framework is flexible. Typically, the Bank seeks to return inflation to target over a horizon of six to eight quarters. However, the most appropriate horizon for returning inflation to target will vary depending on the nature and persistence of the shocks buffeting the economy.” [3]

The flexibility thus involves a deferral in the planned return of the inflation rate to 2%, the mid-point of the target range. This deferral is applied because policy is being used to respond to some other goal. One can read more about this strategy in speeches by Bank of Canada officials or in the background documents at the last two renewals of the inflation target [1,2].Read More »

Understanding Fiscal Policy in a Changing Political Environment

By Raphaelle Gauvin-Coulombe, Queen’s University

Fiscal policy in response to the Great Recession of 2008-09 varied widely across OECD countries. The United States, for example, took an expansionary fiscal stance, adopting an important stimulus package in February 2009 on the order $787 billion (CBO estimate). Canada’s response went in the same direction with its Economic Action Plan, a $30 billion stimulus package enacted in January 2009 (Department of Finance, Canada). Alternatively, on the other side of the Atlantic, policy-makers in the United Kingdom, Germany, and elsewhere either proposed, or implemented, austerity measures. The effectiveness of these different responses is still debated among economists and policy-makers today, and the political drivers of such heterogeneity are still imperfectly understood. Read More »

Universal Basic Income: Our Solution to Automation?

By Kyla Fisher, Queen’s University

Over the past few years there has been increasing discussion in the media about the potential that technological change has in leading large portions of society to be unemployed. On one side, doomsayers point to the rapid progress in automation and artificial intelligence (AI) as signs that human workers will soon be replaced. Their opponents note that these same predictions were made in the past during the industrial revolution and turned out to be incorrect. One thing that does seem clear is that large numbers of jobs are susceptible to automation. A study by Carl Benedikt Frey and Michael Osborne found that 47% of U.S. workers had jobs at high risk of future automation (Frey & Osborne, 2017). The remaining question is whether enough new jobs will be created in other industries that can employ the displaced workers. Whatever your opinion, it is interesting to consider our options as a society if we had a major increase in unemployment. To consider this, let us assume that it’s 20 years in the future and that we are facing a significant reduction in the number of jobs available. What are options? In this article, we’ll consider two of the most popular solutions: universal basic income (UBI) and guaranteed basic income (GBI).

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Canadian Policy Responses to US Protectionism

By Ian Keay, Professor, Queen’s University

After tearing up a long-standing trade agreement between the United States and Canada, a deeply divided, Republican controlled Congress dramatically raises US tariff rates on products predominantly imported from Canada. The federal government in Canada is faced with an acute policy dilemma – there are strong domestic interests pushing for rapid and dramatic retaliation, while other groups, including farmers and landowners, are not nearly so enthusiastic about the prospect of a trade war with our largest and fastest growing trade partner. To complicate matters further, Canada’s European allies are keen to promote the continued globalization of international markets by keeping trade barriers low. The Canadian government ultimately decides to respond to these conflicting forces by re-writing virtually every line in the domestic tariff schedule, explicitly adopting protectionism as a primary policy goal, and increasing average tariffs by more than 50%.

This series of events probably sounds very familiar to Canadians today, but this particular episode in Canada-US trade relations took place over 150 years ago, during the late 1860s and 1870s. John A. Macdonald’s Conservative government introduced the National Policy tariffs as a response to US protectionism just months after his party won the 1878 federal election. Economists and historians have long understood that this response marked a sharp U-turn in Canada-US relations. However, our understanding of this policy, and its consequences for Canadian growth and development, has been hindered by researchers’ reliance on incomplete evidence.Read More »

Can British Columbia’s Carbon Tax Success Happen Anywhere?

By Nikola Milutinovic, Queen’s University

Carbon taxes aren’t necessarily the job killer some provincial party leaders are making them out to be. Research by Ph.D. Candidate Akio Yamazaki of the University of Calgary should give Canadian politicians and pundits pause over the employment effects of carbon taxes. Yamazaki’s research suggests that British Columbia’s revenue-neutral carbon tax caused a net-gain in employment of 4.5% between 2007 and 2013. Governments can affect the labour market impact of carbon pricing by properly allocating their carbon tax revenues, according to Yamazaki.

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Smoking Bans Improve the Health of Children and Infants

By Fanny McKellips, Queen’s University

It is a well-accepted fact that smoking and second-hand smoke have harmful effects on health.

For this reason, many measures are taken by governments to decrease smoking and exposure to second-hand smoke. Canadian provinces, for instance, have banned smoking in all public places and workplaces. In the United States, 25 states have banned smoking in public places. While this limits exposure of non-smoking adults to secondhand smoke, it may create a displacement of smoking from public places to homes. Could this mean that children and infants, who cannot make their own decision to be exposed to second-hand smoke, are negatively affected by smoking bans? This issue is not well understood as the literature surrounding smoking bans tends to focus on the health impact on adults. Read More »

Closing the Income Sprinkling Loophole: Fair and Likely Efficient

By Frédéric Tremblay, Queen’s University

The Canadian government has recently announced that it intends to address what it considers to be three loopholes that allow tax planning using private corporations: income sprinkling, passive investments made by private corporations, and the conversion of a private corporations’ income into capital gains. This post will focus on the first form of tax planning, income sprinkling.

Income sprinkling refers to the use of the flexible structure of a Canadian-controlled private corporation (CCPC) to do income splitting with family members in lower tax brackets. This allows some Canadian small business owners to reduce their income tax burden in a way that is unavailable to other Canadians. Finance Canada estimates that closing the income sprinkling loophole would generate $250 million yearly in additional tax revenue[1]. Since the impact on federal finances is likely to be negligible, I focus my analysis on the issues of fairness and efficiency.

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