government vegovernment versus market: a historical and contemporary perspectiversus markets vito...

Government versus Market: A Historical and Contemporary Perspective*

Vito Tanzi

*For presentation at the Instituto Fernando Henrique Cardoso,

Brazil, April 2013.

Government versus Market: A Historical and Contemporary Perspective

There are no more important or difficult questions in economics than:

i. What should be the economic role of the state?

ii. With what instruments that role should be played?

iii. Can an optimal role be determined?

Intuitively one feels that the economic role of the state in a country may be too small (Guatemala?) or too large (Denmark or France?).

But in relation to what level? And how should it be measured? With respect to public spending? Tax levels? Regulations? Monetary or other tools?


Governments exist to prevent hell and not to create heavens on Earth. We need to be skeptical of politicians that promise heaven. Let us remember Soviet Russia.

In their work, economists have discussed positive (what governments actually do), and normative (what they should do) roles.

They have also discussed the use of different policy instruments by governments.


Over many years, famous economists theorized about the desirable role of the state. (Smith, Bastiat, Say, Mill, Pigou, Musgrave, Samuelson, and others).

Some advocated a minimalist role ( Friedman, Hayek, Buchanan); others a larger role.

In the past the economic role of the state had been smaller. After the Great Depression and, especially, after World War Two, it became larger in many countries.

In the 1940s and 1950s economists developed a normative role that was focused on market failure. The main role of governments was seen as correcting for these market failures.


At that time economists identified an increasing number of market failures, that justified a growing economic role for the

state and especially for more public spending.

As James Buchanan, a conservative economist, put it: The 1950s were dark days for classical liberals. Big government

[became] an idea tolerated across the political spectrum. He

argued that this change inevitably restricted personal liberty.


Private markets can fail because of:

(a) pure public goods and quasi public goods;

(b) significant positive or negative externalities;

(c) natural monopolies and monopolistic practices.

These failures were assumed to justify governmental intervention.

In more recent years, other failures have been added to the list such as: (a) incomplete markets, (b) asymmetry in information, (c ) myopia and other irrational behavior by citizens, and others justifying more government intervention.


However, markets are not static. Therefore, the normative role of the state should change with time.

More government because of: (a) increasing complexity and objectives, and more asymmetry in information, (b) growing

urbanization, (c) and some other reasons.

Less government because of : (a) more developed private market including financial and other markets; (b) more

information readily available; and (c) more exchanges with

other countries.

However, government failures have become more evident. See the School of Public Choice.


Conclusion: the more efficient and more developed a countrys market becomes, the less need there should be for the intervention by the state.

However, the concept of market failure had been related, mostly, to the role of the state in the allocation of resources. If allocation had been the only guide to the government role, it would require public spending and taxes of only around 15% of GDP. This is the level that existed in many countries before the Great Depression. In Brazil, in 1960, taxes were still only 17 % of GDP.

Most countries now spend much more than that. In Brazil taxes are now 36% of GDP. Why the change?


In the 20th century, two new government roles became very important: the redistribution of income and the stabilization of the economy. See (b) Adam Smith, for the allocation of resources;(b) Adolph Wagner, for income redistribution, and (c) John Maynard Keynes, for stabilization.

* Because of these new responsibilities, the role of the state was much expanded. Tax and spending went progressively up. The objective of preventing Hell on Earth changed into trying to promote Heaven.

After World War Two some landmark social legislation.


An expanded and optimal government role requires:

(a) A benevolent Gov.t focused on the public interest. (b) A well informed, and technically efficient Gov.t.

(c) A Govt. that is capable of balancing the needs of the present generation against those of future generations. Therefore no public myopia.

(d) The absence of principal-agents, rent seeking, and corruption problems, within the public sector.

Therefore, the Gov. would need to have: (a) the knowledge accumulated in Google; (b) the wisdom of King Solomon; and (c) the saintly personality of Mother Teresa.

Obviously most governments do not meet these requirements.


A brief digression on a difficult issue:

Industrial policy and the explicit promotion of economic growth have generally not been considered legitimate

government roles.

Adam Smiths mercantilism and Hayeks fatal conceit.

Contrast with Antonio Serra, writing in 1613.

See also the rise of state capitalism and of Sovereign Funds in recent years.


Two contrasting experiences with industrial policy in the allocation of resources are worth studying:

(a) Argentina in the 1950s-1970s and Korea in the 1970s and 1980s. The first a failure. The second a success.

The limits and dangers of industrial policy; but also of dogmatism.


Let us now consider income redistribution:

It is now an important objective of policy.

Should government policies be pro poor. or pro Ginis reducing? Universal or focused?

Should the government be concerned only with income levels? Or with creating opportunities and protection for all?

Should it be concerned with protecting citizens against particular risks (illnesses, old age, illiteracy, unemployment)?

Should the protection be for everyone? Or only for those unable to get it from the market because of low income?

How much redistribution is desirable? Who decides?

Are there trade offs between growth and redistribution? How important are they? Issues of horizontal equity?.

Policies of income redistribution and social protection have caused public spending to rise a lot, and economic policies to become more complex than before. See Brazil.

The rise of the nanny state ?. Long run dangers?


Consequences of universal versus focused programs. Cost and quality of programs, poverty traps, horizontal inequity

considerations, free riders problems.

The economic costs of a nanny states: inefficiencies in spending; welfare costs of high and complex taxes;

macroeconomic problems; governance problems; reduction in

growth rates. See European crisis.

But higher public spending leads to lower poverty levels.


What about the stabilization of the economy?

A lot of controversy about the form it should take.

(a) reliance (only) on automatic stabilizers?

(b) reliance on discretionary stimulus packages?

(c ) extreme fine tuning?

(d) relative reliance on fiscal or monetary policy?

Can these policies be kept separated?. Are they?

Heated debate during the recent Great Recession and the euro crisis. The current fiscal mess in the USA, the UK, Japan and the euro area.


There are major problems with discretionary, or active, countercyclical fiscal policy:

(a) Asymmetry in its use over time.

(b) Technical problems.

(c) Psychological reactions to high fiscal deficits and rising public debt.

(d) Sustainability of high fiscal deficits.

(e) Eventual impact on borrowing costs.


High public debt levels and their impact on economic growth:

(a) high levels in individual countries.

(b) high levels in the world.

(c) strange, ongoing controversy about growth versus austerity. About fiscal multipliers.

Stabilization policy and the nature of recessions:

(a) induced by weakening of animal spirits. (b) induced by imbalances and bubbles.

(c ) unemployment and the speed of recovery.

(d) current confusion of growth with recovery.


G/GDP now ranges from about 10% in a few, poorer countries to over 50% in some industrial countries (France, Belgium, Italy Denmark):

(a) What is the desirable level? It depends but compare Australia, Switzerland, Korea, Singapore, etc. with the high spending countries.

(b) Does more spending promote greater welfare?

Theory not helpful. Some answers may come from the impact of spending on socio-economic indicators. What happens to relevant socio-economic indicators when G/GDP rises? Is the relation positive: More spending better indicators?


Need to separate the effect (on socio-economic indicators) that comes from higher per capita income and from higher

public spending.

Given the per capita income of a country, with their policies, governments aim to generate, better socio-economic

indicators. Examples of socio-economic indicators.


When public spending rises as a share of GDP, how is public welfare affected? There can be significant costs to increasing public spending. Examples:

(a) Efficiency costs of higher and more complex taxes;

(b) Servicing costs of public borrowing;

(c) Inefficiency costs in the use of public revenue;

(d) Costs due to corruption and complexity;

(e) Costs due to principal-agents problems and rent-seeking;

(f) Costs in terms of inflation and growth.


Some conclusions from empirical studies:

High public spending does not necessarily lead to higher welfare; and it can generate macro-economic problems and lower the growth rate.

Relation between high public spending and levels of desirable socio-economic indicators is not a smooth, regular and positive one.

Efficient governments are those that get good socio-economic indicators with moderate public spending.

However, higher spending leads to lower Ginis.


Estimating public sector performance indexes (PSPs).What governments produce in terms od socio-economic indicators.

Estimating public sector efficiency indexes (PSEs). Taking taxes into account.

Empirical conclusion: normally 30-35% of GDP in public spending seem to be sufficient to achieve good socio-

economic objectives.

Brazil is already over that level.


Some additional issues.

(a) There is growing reliance on policy tools other than spending and taxes. Less transparency.

(b) Substitution between (good) regulations and public spending?

(c) A more active, preventive role versus the traditional ex post corrective role? The role of libertarian paternalism a la Bloomberg?. Emphasis on creating more equal opportunities?

(d) Growing complexity and government policy?

(e) Dealing with significant global externalities? Such as environmental problems and global warming?


Some comments on less advanced countries.

Greater need for a larger government role, but lesser capabilities.

Danger of making spending decisions by labels.

Limited revenue and administrative capability.

The large role of the informal economy.

Complexity and the termites of the state. Desirability of keeping policies simple and focused.


Is there a fundamental law of the growth of public spending, when additional resources are available from taxes or from

public borrowing?.

Why public spending keeps growing after new programs are introduced?.

Some final comments on Latin American countries.

Government versus Markets: A Historical and Contemporary Perspective

Some basic references:

Vito Tanzi, 2011, Government versus Markets (Cambridge University Press).

Vito Tanzi and Ludger Schuknecht, 2000, Growth of Public Spending in Industrial Countries (Cambridge University Press).

Vito Tanzi, 2013, Taxation in Latin America: a long run perspective, Mimeo.

Antonio Afonso, Ludger Schuknecht and Vito Tanzi, 2010. Public Sector Efficiency: Evidence for EU Member States and Emerging

Markets in Applied Economics, 42.

Vito Tanzi, 2008. The Role of the State and Public Finance in the Next Generation, OECD Journal for Budgeting , June.

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