The ideological impact on the trade-off between efficiency and equity

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The impact of partisan ideology on efficiency and

equity

by

Carla Maria dos Santos Azevedo

Master in Economics Dissertation

Supervised by:

Maria Manuel Pinho

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Biographical note

Carla Maria dos Santos Azevedo was born in Maia, Portugal, on January 29, 1991. In 2009, she concluded her high school education, in the same city. Economics has become an area of interest to the candidate since the high school.

In that same year, the candidate started her undergraduate course in Economics, at Faculdade de Economia do Porto, Universidade do Porto. She graduated in July, 2013, and two months later has integrated a Master in Economics at the same university. This dissertation is part of the Master’s study plan.

Alongside with her academic life, the candidate has developed an interest in playing piano and guitar, while she also has specialized in cooking pastry.

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Acknowledgements

The realization of this dissertation integrated in the Master in Economics was only possible due to the friendship, collaboration and willingness of many people, who directly or indirectly supported me along the entire journey, from the beginning until the finalization of this project. In this sense, I would like to express my sincere thanks to all those who contributed to it, from colleagues and teachers, to my family and friends.

I want to start by thanking the supervisor of this dissertation, Maria Manuel Pinho, for always being available to clarify all the doubts that have arisen, and for her effort and dedication to this project. Her rigor and commitment was of great value to be successful in my work. I must also thank the Faculdade de Economia, Universidade do Porto and, in particular, my other lecturers for all the knowledge transmitted during my academic career.

My special thanks to my brother in law Ulisses Sousa for being partly responsible for my growing interest in the economic science and for guiding me in my academic choices.

I am especially thankful to my parents and siblings for all the encouragement, persistence and emotional and financial support throughout the entire journey, highlighting the technical support provided by my brother Marcos. I also want to thank my cousins Joana and Luísa for allowing me moments of happiness and fun in the most difficult and stressful times of this task.

Finally, the most special thanks I want to give to my boyfriend Ulisses Seabra for always being by my side in good times and bad times, for making everything becomes easier. I want to show all my gratitude for his unconditional support and encouragement that have been essential to the realization of this dissertation.

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Abstract

The aim of this dissertation is to contribute to the understanding of the relationship between the political ideology and the trade-off between efficiency and equity. The work intends to gather the main theoretical foundations regarding the ideological approach of political models, as well as their connection with the economic goals of economic growth and income equality. In this sense, it begins by presenting the partisan ideology theory and its implications on the main macroeconomic variables. Then, reference is made to the main features of the trade-off between efficiency and equity, as well as how this trade-off is reflected in the economic goals. It is found that the different political ideologies, associated with different political parties, can influence economic growth and income equality, taking into account the role of political parties in government. Thus, right-wing parties tend to favour the economic growth and left-wing parties tend to favour the income equality.

So, this investigation aims to evaluate whether and how the different partisan ideologies have impact on the trade-off between efficiency and equity and, more specifically, how right-wing and left-wing ideologies influence economic growth and income equality. For this, we estimate an econometric model using panel data embracing 27 countries of the European Union (EU27) for the period between 1995 and 2012, in order to analyze the impact of ideology on growth and equality or efficiency and equity. The results suggest that this effect exists, although indirectly, meaning that the influence occurs through budgetary variables – economic tools – more specifically, through the composition of the government expenditure, rather than through economic goals, as the economic growth rate and income equality.

Keywords: Political ideology; efficiency; equity; economic growth; income equality; panel data

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Resumo

O objetivo desta dissertação é contribuir para a compreensão da relação entre a ideologia política e o conflito entre eficiência e equidade. O trabalho pretende reunir os principais fundamentos teóricos relativamente à abordagem ideológica dos modelos políticos, assim como a sua ligação com os objetivos económicos de crescimento económico e igualdade de rendimento. Nesse sentido, começa-se por apresentar a teoria da ideologia partidária e as suas implicações nas principais variáveis macroeconómicas. De seguida, faz-se referência aos principais aspetos do conflito entre eficiência e equidade, assim como à forma como este conflito se traduz nos objetivos económicos. Constata-se que as diferentes ideologias políticas, associadas a diferentes partidos políticos, podem exercer influência sobre o crescimento económico e a igualdade de rendimento, tendo em conta a forma de atuação dos partidos políticos no governo. Assim, os partidos de direita tendem a favorecer o crescimento económico e os partidos de esquerda tendem a favorecer a igualdade de rendimento.

Nesta investigação, pretende-se então avaliar se existe e como se concretiza o impacto das diferentes ideologias partidárias no conflito entre eficiência e equidade e, mais concretamente, avaliar a forma como a ideologia de direita e de esquerda influenciam o crescimento económico e a igualdade de rendimento. Para isso, procede-se à estimação de um modelo econométrico com dados em painel, abrangendo o conjunto de 27 países da União Europeia (UE27) para o período compreendido entre 1995 e 2012, com o propósito de analisar o impacto da ideologia no crescimento e na igualdade. Os resultados obtidos sugerem que esse efeito existe, embora de forma indireta, na medida em que a influência se faz sentir através de variáveis orçamentais – instrumentos de política – mais concretamente, através da composição da despesa do governo, e não através dos objetivos de política, como a taxa de crescimento económico e a igualdade na distribuição do rendimento.

Palavras-chave: Ideologia política; eficiência; equidade; crescimento económico; igualdade de rendimento; dados em painel

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List of tables

Table 1 – Classical political ideologies ... 5

Table 2 – Values of left and right ideology ... 7

Table 3 – Slope of GDP growth rate and Gini coefficient change and correlation coefficient, 1990-2012 ... 34

Table 4 – Variables and descriptive statistics ... 39

Table 5 – Hausman test: growth equation and inequality equation ... 44

Table 6 – Estimation results: growth equation and inequality equation ... 45

Table 7 – Hausman test: productive government expenditure equation ... 47

Table 8 – Estimation results: productive government expenditure equation ... 48

List of figures

Figure 1 – Features of ideology ... 4

Figure 2 – Linear political spectrum ... 6

Figure 3 – Horseshoe political spectrum ... 7

Figure 4 – Two-dimensional political spectrum ... 8

Figure 5 – The Nolan chart ... 8

Figure 6 – Real GDP growth rate and Gini coefficient change by periods of alternate dominant/hegemonic ideology in government, 1990-2012 ... 29

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1. Introduction

There are two main different approaches to explain the relationship between the political system and the economic one, with regard to the preferences of decision-makers. In the first one, called opportunistic approach, the main goal of the government is to maximize the votes received in order to achieve re-election (Nordhaus, 1975). The second one, denominated ideological approach, assumes that supporters of different political parties have different preferences and that policymakers are concerned with the interests of their core constituency when they are elected and take decisions in government (Hibbs, 1977; Alesina, 1987).

The motivation for the subject matter of this investigation comes from the interest in the scientific area of politics and its different ideological facets. Although politics is a popular subject in world history, it becomes urgent to deepen the ideological approach, in the context of the economic science, due to the scarce literature on the topic.

Downs (1957) argues that ideology is often seen, by the political parties, as a means to an end and that end is the power, instead of considering ideology as a mere representation of the real interests of each political party. Beyond Downs’ argument, the present investigation intends to demonstrate that ideology is an important factor that may have a significant influence on decision-making and economic performance.

In addition to reviewing the existing literature about the ideological issues and their impact on macroeconomic variables, this dissertation aims at combining two strands of the economic literature – the partisan ideology models and the trade-off between efficiency and equity. Thus, the ideological approach is taken in order to explain the influence of the partisan ideology in these two specific economic principles: efficiency and equity.

A way to address the trade-off between efficiency and equity that arises here are the political goals with regard to public economic functions and the objectives associated to those functions: the allocation function, the redistribution function and the stabilization function. From the combination of the allocation and redistribution functions comes the conflict between efficiency and equity. This conflict between efficiency and equity can be assessed through the policy objectives, which are essentially economic growth, associated with efficiency, and income equality,

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2 associated with equity, or based on different types of policy instruments such as tax policies, investment policies and social protection policies that are studied by different authors cited in this dissertation. Hence, the main objective of this dissertation is to understand whether and how different partisan ideologies can influence the trade-off between efficiency and equity.

The present dissertation is structured in two parts, the first part is the literature review that involves sections 2, 3 and 4, and the second part concerns the empirical analysis. Beginning with section 2, this introductory section describes the different political ideologies and its implications in the light of political history and political science. Section 3 focuses on the behaviour of policymakers, according to the ideological approach, presenting the seminal contributions and works that study the impact of ideology on the economy. Section 4 comprises the trade-off between efficiency and equity, as well as how the partisan ideology can be related to this trade-off. Ultimately, section 5 presents a descriptive analysis of the main variables to be evaluated in this investigation, then a more robust econometric analysis is applied in order to obtain empirical evidence that supports the literature which is mentioned in the previous sections, and finally the conclusions are presented.

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2. A global view of political ideology

Before focusing on the main discussion of this dissertation, it is relevant to introduce some important aspects, namely the origin and history of ideology and its features and the right/left political spectrum. These introductory concepts will help to better understand the theoretical and empirical works, presented in the following sections, which discuss the relationship between the political system and the economic system.

2.1. History and definition of ideology

The French philosopher, Antoine Destutt de Tracy was the originator of the word

ideology, whose meaning is science of ideas (Love, 2006). The concept of ideology

suffered several changes over time, since its origins during the French Revolution in the eighteenth century. The Marxist theory of ideology is an important contribution to the construction of the concept. Following Love (2006) and Heywood (2007), Karl Marx, back in 1846, indicates some features of ideology, such as: ideology means illusion and mystification that shows a wrong view of the world, later defined as false

consciousness; ideology reflects the interests of the ruling class on society1; ideology is directly related with control and power.

Despite the Marxist criticism, some developments have been made with regard to the meaning of the term. Heywood (2007) cites a few more authors, for example: Lenine in 1902 defines ideology as ideas and interests of each social class, not just the ruling one; Gramsci in 1935 argues that ideology is the hegemony of the interests of the bourgeoisie who refuses rival ideas; Mannheim in 1929 says that each group of individuals in society has its own ideas and beliefs and the ideology that defines each one is a distorted and partial view of the world.

During totalitarian dictatorships in the inter-war period, the concept of ideology gains a different dimension and is then called by some authors closed system of thought,

1_{Following Marx, the ruling class is the one that rules the material and also the intellectual force of} society, is the one in control (Heywood, 2007).

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4 adding that ideology is an instrument of social control and subordination (Heywood, 2013). More recently, ideology became a set of ideas that explain the social action and has no connection with something false or oppressive. The modern society rejects the pejorative definitions and claims that ideology is “an action-orientated belief system, an

interrelated set of ideas that in some way guides or inspires political action”

(Heywood, 2013: 45). Love (2006) adds that ideology is a democratic concept that helps translate ideas into actions.

2.2. Features of different political ideologies

According to Heywood (2007), all ideologies have three features: (a) they provide an opinion about the real/present world; (b) they advance a vision of the desired future world; they explain how political action can help to achieve a better society (c). In other words, these features explain the fusion of understanding and commitment (a to b) and the fusion of thought and action (b to c). Figure 1 shows the linkage between the features of ideology.

Figure 1 – Features of ideology

Source: Heywood (2007).

With regard to political ideologies, the literature defines three or five classical ideologies that characterize the history of the world economy and politics, and also describes some others called modern ideologies. The classical ideologies are: socialism, liberalism and conservatism. There is controversy in the literature, but Heywood (2007)

Critique of the existing order (a)

Vision of the future society (b)

Theory of political change (c)

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5 admits that communism and fascism are also classical ideologies, defining communism as an extension of socialism. Table 1 summarizes the elements that characterize each of the classical ideologies. The new ideologies considered by Heywood (2007) are: feminism, ecologism or environmentalism, religious fundamentalism and multiculturalism.

Table 1 – Classical political ideologies

Political ideology Characteristics

Communism

• Historical materialism and fundamentalism • Absolute equality and classless society • Alienation (labour is a mere commodity)

• Proletarian revolution (revolutionary class consciousness) • Proletarian state (dictatorship of proletariat)

Socialism

• Community (social interaction)

• Fraternity (cooperation and collectivism) • Social equality (relative equality) • Need (satisfaction of basic needs)

• Social class (redistribution between social classes) • Liberal-democratic state

Liberalism

• Individualism • Freedom or liberty

• Reason (world with a rational structure) • Equality of opportunity

• Toleration (moral, cultural and political diversity) • Consent (representation and democracy)

• Constitutionalism (limited government)

Conservatism

• Tradition (conserve accumulated wisdom of the past) • Pragmatism (practical goals)

• Human imperfection (humans are limited, dependent and morally corrupt) • Organicism (maintenance of the community and social cohesion)

• Hierarchy (social position and status are natural) • Authority (leadership, guidance and support)

• Property ownership (measure of independence from government)

Fascism

• Anti-rationalism

• Leadership, power and elitism

• Organically unified national community (national greatness) • Corporatism and modernization/futurism

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6 Throughout history, each of the main classical ideologies has been associated to a social class. Thus, socialism is the ideology of the working class, liberalism is connected to the rising middle class, and conservatism belongs to the aristocracy and nobility. Thereby political parties play an important role in defending the interests of each social class. This leads to an interesting question that is to understand the position that each party or each ideology occupies in the political spectrum.

2.3. Political spectrum and party systems

The political spectrum is the framework of ideologies and parties or, in other words, political spectrum is a method of describing how ideologies and parties are positioned relative to each other.

The linear political spectrum brings us to the dichotomy left/right. The terms left and right are characterized politics since the French Revolution in the eighteenth century. Initially, left and right were not associated with the political ideology, but rather to how the members of the French National Assembly were standing on the right and left of the president: supporters of the king sat on the right and supporters of the revolution sat to the left (Knapp and Wright, 2001). Over time, this division has revealed the preference of different groups for different ideologies. Thereby, left-wing ideologies favour intervention and collectivism, while right-wing ideologies prefer market and individualism (Heywood, 2013). Figure 2 shows the position of political ideologies in the linear political spectrum.

Figure 2 – Linear political spectrum

Left Right

Communism Socialism Liberalism Conservatism Fascism

In addition it should be noted that the linear political spectrum reveals different values that are associated with left-wing ideologies and right-wing ideologies. Table 2 shows the values that distinguish left from right.

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Table 2 – Values of left and right ideology

Left Right Liberty

↔

Authority Equality

↔

Hierarchy Fraternity

↔

Order Rights

↔

Duties Progress

↔

Tradition Reform

↔

Reaction Internationalism

↔

Nationalism Source: Heywood (2013).

However, the linear spectrum is not the only theoretical model. Another implication of ideologies defines a different political spectrum. In the literature, communism and fascism are similar in some aspects, and thus they do not stand in opposite sides of the spectrum, because both regimes are seen as totalitarian and repressive and have authoritarian forms of political rule (Heywood, 2007). Thus, the linear spectrum no longer makes sense while the horseshoe political spectrum demonstrates that the extreme of left and the extreme of right tend to converge, distinguishing them from the democratic ideologies as socialism, liberalism and conservatism. Figure 3 shows the horseshoe political spectrum.

Figure 3 – Horseshoe political spectrum

Heywood (2013) adds another form of political spectrum – the two-dimensional political spectrum. This is an alternative to the horseshoe political spectrum, since it includes not only the left/right linear dimension, but also the dimension that opposes

Liberalism Communism

Socialism

Fascism

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8 authority to liberty. In this sense, it stands as a combination of the linear and horseshoe political spectrums. Figure 4 shows the two-dimensional political spectrum.

Figure 4 – Two-dimensional political spectrum

Authority

Left Right

Liberty

Bell (2013) shows a different approach by considering that liberalism transcend the typical left-right or linear political spectrum. The author indicates the Nolan chart as an explanation to distinguish liberalism from the other ideologies. The Nolan chart distinguishes two types of rights: social rights such as religion, freedom of expression and personal autonomy, and economic rights as freedom to own and exchange property. Bell (2013) separates totalitarians, who neglect all rights but their own, from libertarians, who have respect for both social and economic rights. Figure 5 shows the Nolan chart.

Figure 5 – The Nolan chart

+

Libertarian

₊

Left Right Totalitarian

−

Source: Bell (2013). So cia l ri_gh ts So cia l ri_gh ts Econ omic righ ts

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9 It is important to note that political parties are essential elements for the functioning of the entire political system. Modern politics encompasses four existing party systems: one-party systems, two-party systems, dominant-party systems and multiparty systems.

The one-party system is the system in which the monopoly of power belongs to only one party, and countries with this system have a permanent government. Heywood (2013) distinguishes two different types of one-party system: the socialist regimes ruled by communist parties that control the state, the economy and all institutions of society (People’s Republic of China and Russian Federation are examples of this party system); and the anticolonial nations and state consolidations in the developing world, like some countries in Africa and Asia.

The two-party system is characterized by the dominance of two major parties, which typically alternate in government, even if there are some minor parties. In this case, both major parties are able to govern alone, and while one has the power, the other is the opposition (Heywood, 2013). The most common examples of this party system are the United Kingdom (the labour party and the conservative party) and the United States of America (the democratic party and the republican party).

Heywood (2013) defines the dominant-party system as the one in which a number of parties compete for power in elections but it is consequently dominated by the same party that remains long periods in government. A typical example of this system is Japan.

Finally, the multiparty system comprises more than two parties, with the main feature being the high probability of coalitions. This system is characterized by the formation of coalitions including smaller parties in order to prevent the existence of a single party in government (Heywood, 2013). This type of system was common in France in the decade of fifty.

For the main objective of this investigation and to simplify the analysis, this dissertation is based on the existence of only two political ideologies: the right-wing ideology and the left-wing ideology. In other words, this work is based on a two-party political system, one representative of the left-wing ideology and one representative of the right-wing ideology.

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3. Partisan ideology: theoretical grounds and empirical

evidence

It is widely recognised that the interests of policymakers are important determinants of macroeconomic policies, and through the policies that they pursue, their interests have an influence on economic outcomes. But there is no consensus on the nature of the actual behaviour of policymakers (Krause and Méndez, 2005). There are two main theoretical explanations in the political-economic literature for the behaviour of policymakers, regarding the interaction between the political system and the economic one.

The first explanation is based on the opportunistic approach that initially formalized the political business cycle through the argument that opportunistic policymakers choose macroeconomic policies to please voters, by promoting high income levels and low unemployment rates before the elections, in order to get more votes and remain in office (Nordhaus, 1975).

The other approach explaining the behaviour of policymakers is the ideological one, which is the core of this investigation. In this approach, political business cycles exist because there are ideological differences between political parties that alternate in power. On the one hand, left-wing parties prefer high employment and promote expansionary policies; on the other hand, right-wing parties are concerned with low inflation (Hibbs, 1977; Alesina, 1987). This section introduces a review of the main contributions concerning the different ideologies within the political sphere and their economic impact.

3.1. Seminal contributions – from adaptive to rational expectations

The theory behind the ideological approach is the partisan theory. The seminal contribution belongs to Hibbs which, in his work (1977), proposes that each party chooses a position on the Phillips curve, facing the trade-off between unemployment and inflation. The author argues that left-wing governments are more concerned about unemployment because their core constituency are essentially human capital holders,

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11 whereas the right-wing governments are more concerned about inflation because their core constituency are typically financial capital holders. It is argued that the core constituency of left-wing parties usually belongs to lower income and lower occupational status groups, while the core constituency of right-wing parties usually belongs to upper income and upper occupational status groups (Hibbs, 1977 and 1986).

Hibbs’ (1977) work is associated with adaptive expectations because he assumes that the electorate’s decisions are based upon the past economic performance. In this context, the literature assumes that voters are myopic and backward discounting, which means that they only remember the recent past (Nordhaus, 1975; Neck, 1991). Hibbs (1977) builds a Phillips curve with 12 west European and American nations and finds that nations governed by left-wing governments have high inflation and low unemployment rates for much of the period, and countries where centre and right-wing parties have dominated show low inflation and high unemployment rates. This conclusion also suggests that centre parties are more related to right-wing ideologies than left-wing ideologies. Furthermore, the author develops a model to explain unemployment rates in the United States of America and Great Britain where it is shown that during periods of democratic and labour (left-wing) administrations the unemployment rate has decreased and during periods of republican and conservative (right-wing) governments unemployment rate has increased.

Hibbs (1986) presents a different analysis arguing that policymakers control macroeconomic policies, as monetary policy, and do not control macroeconomic outcomes. So the author analyses the growth rate of money supply (that indicates the inflation behaviour) and the results show that right-wing parties are more likely to control the money supply than left-wing parties, putting in evidence the differences in the economic goals of political parties through the different use of political tools. Hibbs shows an evolution from 1977’s work to 1986’s work, by considering not only the political goals, but also the political instruments.

Alesina (1987) is another important reference in this matter and his work represents an evolution in this theme due to the transition from adaptive expectations (Hibbs, 1977 and 1986) to rational/forward-looking expectations. It is a significant contribution because he assumes that voters are rational and they take into account all the available and relevant information and they know that different parties ascribe

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12 different weights to unemployment and inflation. The author analyzes the volatility of the political cycle in relation with the economic cycle, considering the deviations in real macroeconomic variables, through the interaction of two parties with different policy goals and concludes that if the parties agree to follow similar policies, the economic cycle is attenuated. This leads to another Alesina’s (1987) crucial contribution that is the role of reputational mechanisms in attenuating the economic cycle. The author explains that a commitment to a cooperative policy rule is beneficial for both parties because it improves welfare for both of them in the long run. Even if binding commitments are not available, the author admits that reputational considerations are taken into account because the parties understand that their interaction is repeated over time and thus today’s action influences the tomorrow’s actions of the other parties and also has influence on voters' choices. The author admits that this happens in a balanced system of two parties, because in a system in which a party is clearly stronger than the other, the former has more incentive to deviate from the cooperation agreement than the latter. So, reputational forces due to the repeated interaction of the two parties and voters can create an incentive for both to converge to more similar policies and reduce the excess volatility of real macroeconomic variables when occurs a change of government (Alesina, 1987).

As shown before, the partisan theory is based on the hypothesis that the political parties have different objectives and incentives to pursue the macroeconomic policies. Swank (1993: 340) considers four assumptions for this theory:

“First, political parties promote the interests of their core constituencies. Secondly, the core constituency of a left-wing party consists of low and middle income groups, whereas the core constituency of a right-wing party consists of high income groups. Thirdly, different unemployment/inflation outcomes have effects on the income distribution. Fourthly, low income groups suffer more from unemployment and high income groups suffer more from inflation.”

Considering the partisan voter model developed by Swank (1993), it is assumed that voters formulate expectations of economic outcomes and make rational choices by voting for the party with whom they associate the highest utility. The voters are able to

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13 predict the economic outcomes under a leftist and rightist administration because the author assumes that they know the preferences of the different political parties. According to the partisan voter model, voters concerned with reducing unemployment will vote for the democratic (left-wing) party, and voters concerned with inflation stabilization will vote for the republican (right-wing) party. From this, it follows that the left-wing parties take advantage of rising unemployment, while the right-wing parties take advantage of rising inflation (Swank, 1993).

The author adds that administrations of right-wing parties are more averse to government intervention than administrations of left-wing parties. This means that the parties use the political instruments differently to achieve their goals and to meet the expectations of their constituents.

Another important study is the effect of trade unions in the political business cycles and their negotiations with the government. The trade unions are assumed to negotiate wages, and they are interested in high wages and employment. Detken and Gartner (1992) assume that trade unions possess the monopoly power in that negotiation, which means they possess the power to raise the real wage, so that employment is determined by labour demand of companies and transformed into output through the macroeconomic production function. In other words, trade unions manipulate labour supply in order to promote their own political interests and thus manipulate aggregate output (Detken and Gartner, 1992). The authors assume that governmental actions are closer to the goals of trade unions if those actions are taken by leftist governments instead of rightist governments. In their analysis, Detken and Gartner (1992) find that trade unions can induce political business cycle, because they may maximize utility by manipulating labour supply in order to stimulate aggregate output under a left-wing government and to reduce aggregate output under a right-wing government.

A different approach to this subject is made by Krause and Méndez (2005) because, instead of looking at macroeconomic variables and their relation to political variables, they focus on how to measure the revealed preferences of policymakers with respect to inflation and output growth. The authors try to explore how preferences related to the main macroeconomic variables, specially inflation and output, change as the party in power and its ideology changes. The empirical findings of this work support

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14 the presence of a partisan cycle regarding the preferences of policymakers, as Hibbs (1977 and 1986) and Alesina (1987) propose, because Krause and Méndez (2005) also conclude that left-wing political parties have more preference for output growth than inflation, in order to reduce unemployment, while political parties with a right-wing ideology, are more concerned with inflation stability.

At this point, we can conclude that the authors mentioned above analyze the issue of the behaviour of policymakers from different point of views: Alesina (1987) emphasises the reputation of the political parties, Swank (1993) underlines the behaviour of the voters in elections, Detken and Gartner (1992) stress the interaction between trade unions and the government, Krause and Méndez (2005) focus on the revealed preferences of policymakers. All these authors contributed to build a solid and coherent theory of the partisan ideology. However, some of these initial contributions are criticized by other authors.

3.2. Contributions to the critique of the seminal works

The contributions of Swank (1993), Heckelman (2001), Tavits and Letki (2009) and Brauninger (2005) also add consistent knowledge to the theory of the partisan ideology, but somehow, they criticize the initial works, each one from a different perspective.

Swank (1993) remarks three aspects of Hibbs’ (1977) contribution. The first one is that one of the concerns of the partisan theory is the trade-off between unemployment and inflation, but Hibbs (1977) only develops a model to explain unemployment. Secondly, some external conditions may affect unemployment and inflation and not considering them may create a bias in the estimates of these variables. Swank (1993) gives the example of the oil crises in the seventies that have drastically affected unemployment and inflation rates, undermining the stability of the trade-off between unemployment and inflation; it was a period of stagflation. Finally, the partisan theory takes into account the preferences of political parties, but the empirical evidence from Hibbs (1977) only provides information about unemployment rates and not about the preferences of political parties.

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15 Another author criticizes the models followed by two of the seminal authors. The nomination that Heckelman (2001) gives to the Hibbs’ (1977) contribution is traditional

partisan theory, to Alesina’s (1987) is rational partisan theory, and to his own

contribution is variable rational partisan theory. The author argues that Alesina’s model shows that partisan differences will only influence and generate deviations in real macroeconomic variables when there is uncertainty over which party will win the next elections. Recalling Alesina (1987), the interaction between two parties with different policy goals causes volatility in real macroeconomic variables, so there is uncertainty over which party will be in government in the next period and over the behaviour of macroeconomic variables. The variable rational partisan theory by Heckelman (2001) says that there is uncertainty over which party will govern and control the policy tools after the elections, but also considers that uncertainty over when there will be elections, that is, over the election date, will as well influence and generate fluctuations in the business cycle, and so, in real macroeconomic variables. Heckelman (2001: 273) admits the existence of a limitation in his model:

“When elections are fixed by constitution however, there is no uncertainty over election timing and the VRPT (variable rational partisan theory) model collapses into a standard RPT (rational partisan theory) type model. This implies fixed elections would lead to less variation in the business cycle than for variable elections.”

Despite the Heckelman’s (2001) criticism, the author also highlights the important evolution from adaptive expectations to rational expectations – from Hibbs (1977) to Alesina (1987).

Tavits and Letki (2009: 555) argue that, in the context of the dual transition to democracy and market economy, experienced in the post-Communist period in Europe, the traditional partisan theory, which predicts that “Because the Left prefers more

government control of the economy (...) leftist governments are expected to produce a bigger government in general and increased welfare (including health and education) spending in particular than rightist parties”, might not apply. The argument of the

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16 Therefore they had a strong incentive to pursue rightist economic policies and implement fiscal austerity. Furthermore, leftist parties had a more stable and loyal electorate than the rightist parties because leftist parties in post-Communist Europe were well organized and they were much less fragmented than the rightist parties. Unexpectedly, the authors find evidence showing that the leftist parties have succeeded in implementing rightist policies and fiscal austerity in post-Communist period. Thereby, this context is an example that the traditional partisan theory might not apply in different contexts.

Brauninger (2005) does not criticize directly the partisan theory but he takes a different position on this matter by making the distinction between the ideological identity of the policymakers and their programmatic policy and spending preferences. The question explored in this work is whether the parties pursue their macroeconomics policies following their substantial preferences as stated in their election manifestos or if the parties pursue their macroeconomics policies because of what the author calls

“the supposed differences which are derived from their ideological identity”

(Brauninger, 2005: 423). The author studies the fiscal policy, specifically the level of the government expenditure, and in his empirical investigation finds that it is not the left-wing or right-wing ideology of the parties that has a significant impact on the level of government expenditure but the programmatic preferences of policymakers as stated in their election manifestos.

3.3. Augmented contributions – ideological effect on macroeconomic

variables

So far, we presented the theory behind the partisan political-economic approach, as well as some criticism of the seminal works. Now, the impact of the partisan ideology on macroeconomic variables will be the main focus of this section. In order to do so, some works that highlight the impact of political ideology on economic outcomes will be discussed.

Imbeau et al. (2001) analyze the relationship between the left-right composition of the government and the policy outputs through a meta-analysis technique. In this study,

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17 two different arguments are considered: convergence school and politics matters school. The defenders of the first one, convergence school (Imbeau et al., 2001: 1):

“(...) argue that industrialized societies of the twentieth century have become increasingly similar, facing the same kind of problems and applying the same kind of solutions. Consequently, the argument goes, political, institutional and cultural differences do not matter much when it comes to explaining variations in policy outputs.”

The second school argues that partisan ideology and political variables are correlated with policy results. The results obtained in the 43 empirical studies that the authors analyze vary and some works that use the same variables and their relation reach different conclusions. To summarize the results obtained by Imbeau et al. (2001), 22% of 693 estimates of the 43 empirical studies support the left-right party economic impact hypothesis, 7% contradict the hypothesis and 71% fail to support the hypothesis. We can conclude that in most studies is not possible to perceive the ideological impact on economic results.

Ellis and Thoma (1995) study the partisan effects in some variables. They show that, according to the model developed in their work, there is evidence for their theoretical predictions. Beginning with the current account on the balance of payments, it moves in opposite directions with the election of a left-wing party or a right-wing party, in the sense that if the current account improves after a right-wing party victory, it will worsen after a left-wing party victory, but the opposite is also valid. The real exchange rate also moves in opposite directions, as the current account, with the victory of left-wing party and the victory of right-wing party. Regarding the terms of trade, they improve after a right-wing party victory and worsen after a left-wing party victory. The authors remark that when limited to the period of flexible exchange rates, these effects are slightly larger and have greater significance.

One important aspect of these subjects that Dutt and Mitra (2005 and 2006) study is the importance of ideology as a determinant of trade policy. In their work, based on a partisan ideology model, they find that left-wing governments adopt more protectionist trade policies than right-wing parties in capital-rich countries, but adopt more pro-trade

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18 policies in labour-rich economies. The authors explain that an increase in leftist orientation results in redistributive policies that benefit labour. This means that in a labour-abundant country, the labour-intensive good is the exportable one, so an increase in leftist orientation will result in trade policies that favour labour and therefore a decline in protection will occur. The authors conclude that “Left-wing government that

is generally more interventionist and believes in state control of the economy may surprisingly have a preference for free trade” (Dutt and Mitra, 2005: 61). As Tavits and Letki (2009), Dutt and Mitra (2005) also agree that left-wing parties have greater preference for government control than right-wing parties.

Another study shows that in the short-term there are no stronger political cycles: considering 21 OECD countries over the 1951-2006 period, political ideology and electorate motives did not permanently influence short-term economic outcomes (Potrafke, 2012). According to the author, this might happen for three reasons: the fiscal and monetary policies implemented by left-wing and right-wing governments might be similar and this may result in similar short-term economic outcomes; fiscal and monetary policies may not have influenced short-term economic outcomes, at least during the studied period; finally, left-wing and right-wing governments still have different views of economic policy, but budgetary and monetary issues do not appear to be related to the question of ideology. Potrafke (2012) argues that a more elaborate theory is required to explain how political ideology affects the conduction of economic policy and the economic outcomes. This question seems to be important not only in the short-term economy but also in the long-term economy.

In contrast to the contribution of Potrafke (2012) that investigates the influence of political ideology in the short-term economic performance, Facchini and Melki (2013) explore the ideological effects in the long-term economic outcomes. More precisely, they explore whether and how variations in the political ideology of the voters can explain economic growth, which in their analysis it is seen as a long-term indicator. The authors also have the purpose of investigating the channels of policy transmission through which ideology affects economic growth. So, they focus on the size of government as a possible transmission mechanism between ideology and economic growth, and they analyze the size of government by the total public spending as a percentage of GDP (gross domestic product). The investigation uses a time-series data

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19 on the French democracy for the 1871-2004 period, because 1871 was the beginning of its stable democratic experience. This investigation of Facchini and Melki (2013), covering a period of more than a century, finds evidence supporting the relationship between political ideology and economic growth but only for recent periods: government intervention in the economy, approximated by government size, is the transmission channel through which ideology affects growth for the post World War II period, but not for the pre-war period. The results of the study show that right-wing ideology decreases government size only for the post-war period and more generally as voters become richer, because, following the authors: “as the median voter gets richer,

a move of its political ideology to the right of the average will lead him to demand smaller government size” (Facchini and Melki, 2013: 28). This explains the positive

influence of right-wing ideology on economic growth in the post-war period. In other words, the authors explain that, after World War II, the more the ideology of the party in government tends to the right-wing, the greater the positive impact of ideology on economic growth, only when this movement implies a decrease in the share on public spending (Facchini and Melki, 2013).

Ending this section of the dissertation, we can summarize different forms of identifying the impact of political ideology on the different macroeconomic variables. Imbeau et al. (2001) provide an institutional framework for this issue, Ellis and Thoma (1995) and Dutt and Mitra (2005 and 2006) highlight the external relations by studying the behaviour of the current account, the real exchange rate, the terms of trade and the conduction of trade policy, Potrafke (2012) emphasizes the fiscal and monetary policies and Facchini and Melki (2013) underline the importance of the size of government as a factor that can distinguish partisan ideologies.

The issues of ideology are directly connected with the macroeconomic problems that the economy face and also with the preferences of policymakers with regard to economic policy goals, as are the economic growth, associated with the efficiency principle, and the income equality, associated with the equity principle. The literature argues that each party has higher preference for achieving a goal instead of the other. The conflict between efficiency and equity, in the perspective of policy goals, will be the object of study in the next section.

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4. The balance between efficiency and equity

Before mentioning the conflict between efficiency and equity and its implications in the context of this dissertation, it is important to mention the classical economic functions of the state – the allocation function, the redistribution function and the stabilization function – stressing the first two functions because therein lies the conflict between efficiency and equity within the public sector.

The common supposition in the literature about this subject is that the main goal of the government is the maximization of social welfare (Downs, 1957). It is understood that this main goal is best defined by the economic functions of the State, each with specific goals that together contribute to the objective of maximizing social welfare.

4.1. Theoretical background – the economic functions of the state

It is recognized that the existence of market failures requires government intervention and this intervention has the purpose of increasing social welfare. Market failures, like imperfect competition, imperfect information, externalities and the existence of public goods, make the state of the economy inefficient. The rule of government is to intervene, through the resource allocation function, in order to address market failures and achieve Pareto optimality, which is the main objective of this function. The principle associated with the allocation function is efficiency. A particular state of the economy is Pareto optimal if a reallocation of resources increases the utility of one individual without decreasing the utility of any other (Cullis and Jones, 2009). In other words, a change in economic conditions is efficient if and only if the position of some person, in terms of welfare, is improved without that of anyone else being worsened, so overall, the welfare of society is improved (Musgrave and Musgrave, 1973). The first fundamental theorem of welfare economics says that if the market is perfectly competitive, the allocation of resources is Pareto efficient and this involves no government intervention (Just et al., 2004).

The economic growth is an important dimension of the efficiency principle because it depends on the degree of efficiency in the use of resources and is associated with investment in fixed and human capital. So, besides addressing market failures,

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21 policymakers can alter the allocation of resources between current consumption and capital formation and influence the future consumption of private and public goods (Davie and Duncombe, 1972).

In reality, it is impossible to achieve efficiency without addressing the question of equity. From another perspective, it is also important to consider not only the deliberate policies of government regarding the redistribution of income to achieve equity, but also that these policies can have a significant, usually negative, impact on efficiency (Cullis and Jones, 2009) and from there arises the conflict between efficiency and equity.

Policymakers adopt policies to complement the primary distribution of income dictated by the market in order to improve social welfare. The principle associated with the redistribution function is equity (Davie and Duncombe, 1972). In this case, the criterion that explains how to achieve efficiency does not apply to the redistribution measure because the improvement of the position of a person worsens the position of others (Musgrave and Musgrave, 1973). The traditional tool to promote equity is the incidence of taxes. Typically, equity is pursued by using progressive taxes because it is assumed that a reduction in the welfare of an individual with a high income decreases his own welfare less than the same reduction in the welfare of an individual with a low income. Another important concept of this principle are the groups of individuals that are considered. The most common is to refer to the distribution of income among income classes because the individuals are grouped according to their income. Although there are other ways to consider questions of equity: sex, age, race, geographical distinction and other demographic groups, the most typical, from the economic perspective, are the groups of individuals classified according to the amount of income (Davie and Duncombe, 1972).

With respect to the stabilization function, the goal is to use instruments of macroeconomic policy to achieve macroeconomic objectives, such as high employment, price stability, economic growth and the balance of public accounts. The existence of public policy guidance is important for this economic function because, without it, the economy may suffer from sustained periods of unemployment or inflation (Musgrave and Musgrave, 1973). This is consistent with the ideologies and concerns of political parties according to the partisan theory and reported in the first section of this investigation.

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22 Generally, the policy objectives are not fully achieved all at the same time. Regarding the conflicts among stabilization policy, the great difficulty is to achieve full employment and price level stability at the same time (Davie and Duncombe, 1972). According to the partisan theory, this is the main distinction between left-wing parties and right-wing parties. The next section will address the conflict between the principles of efficiency and equity, that is, between the allocation and redistribution functions.

4.2. The link between the partisan ideology and the efficiency/equity

conflict

It is widely accepted that measures taken to reallocate resources in order to deal with market failures may conflict with the promotion of equity through the redistribution of income (Davie and Duncombe, 1972). In fact, it is important to consider not only the social gains from improving the distribution of income, but also the possible negative effects that this improvement may have on the efficiency of the economy. This means that some redistribution measures may adversely affect economic growth by reducing incentives to work and restricting investment in innovation, since redistribution measures are essentially directed to education and health issues, social problems and programs to improve labour mobility (Musgrave and Musgrave, 1973). But, as it is shown in the next point of this section, some equity measures can, according to Mericková and Halásková (2014), attenuate the trade-off between efficiency and equity.

Back to the authors who essentially study the behaviour of policymakers according to their partisan ideology, Dutt and Mitra (2006) argue that an increase in leftist orientation of government results in strongest redistributive policies that bring benefits to labour owners. This means that left-wing parties are more associated with equity issues while right-wing parties are more associated with efficiency issues. However, the authors add that any government, due to the unequal nature of asset and income distribution, will have a tendency to redistribute income from those who are capital owners to those who are labour owners, as inequality increases. Taking into account the ideological differences, this transfer, may be more intense during periods of leftist parties in government, even though there is always measures of social protection.

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23 This preference of policymakers for the principles of efficiency or equity also meets the assumptions of Hibbs (1977) and Swank (1993) about the partisan theory. These authors assume that the core constituency of right-wing parties are high income groups who essentially are capital owners and therefore these parties are more concerned with inflation, economic growth and efficiency issues. On the other hand, the core constituency of left-wing parties are low and middle income groups who essentially are labour owners and so these parties tend to be more concerned with items such as labour and employment and with income distribution issues.

Looking at this conflict between efficiency and equity through economic tools instead of economic goals, Tavits and Letki (2009) refer that leftist governments are expected to increase welfare spending, including health and education, and produce bigger governments than rightist parties. This position is consistent with the argument that left-wing parties are more concerned with equity and favour public spending on social problems, health, education and labour issues. Like Facchini and Melki (2013), that analyze the size of government by the total public spending as a percentage of GDP, Tavits and Letki (2009) also consider the size of the government through the level of public spending as the factor that distinguishes the preferences of each party for efficiency or equity.

Swank (1993) addresses this question by saying that right-wing governments are more reluctant to government intervention than left-wing governments, from which it follows that more governmental intervention, under left-wing governments, means more public spending, which means more equity. Facchini and Melki (2013) add that the more the ideology of the party in government tends to the right-wing, the greater the positive impact of ideology on economic growth, but only when this movement implies a decrease in the share on public spending. This argument is in accordance with the theory which supports the argument that right-wing parties are associated with the efficiency principle through economic growth, and is also in line with the argument that right-wing parties prefer less governmental intervention and so less public spending than left-wing parties.

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4.3. Empirical evidence on the conflict between efficiency and equity

This section begins with an empirical contribution on the conflict between efficiency and equity that studies the trade-off between economic growth, measured by the growth rate of real GDP, and income inequality, evaluated by the Gini coefficient (Scully, 2003). The author uses a sample for the United States, from 1960 to 1990, and finds evidence supporting the trade-off between economic growth and equality in income distribution. The estimates reveal the existence of a trade-off, although with a small relation between economic growth and inequality income (the results show that one point increase in the economic growth rate adds 0.00075 points to the Gini inequality coefficient2).

Some authors as Barro (1990) and Scully (2003) that emphasize the contribution of public expenditure to economic growth distinguish productive expenditure from non-productive expenditure (Scully, 2003: 299):

“(...) certain types of government consumption and investment expenditure may raise the marginal productivity of factors of production, thereby raising the growth rate. Expenditures on national defence, infrastructure, public health, schooling, protection of property and contract fall into this category. Much beyond these activities, increases in the size of the fiscal state are related mainly to income redistribution.”

This means that activities related to income redistribution lower the economic growth rate, so they are considered non-productive government expenditure (Scully, 2003). The author employs a model developed by Barro (1990) based on the distinction between productive spending and productive spending and finds that non-productive public spending has a negative and significant impact on the economic growth rate, while productive public spending has a positive but insignificant impact on economic growth. This means that measures which are considered as promoters of

2_{The Gini coefficient is an indicator of inequality in the distribution of income, bounded in the unit} interval, where 0 represents perfect equality and 1 represents perfect inequality (Scully, 2003).

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25 equity have a negative effect on economic growth, whereas policies that are seen as promoters of efficiency have a positive but not significant effect on economic growth.

The main argument for the existence of a conflict between economic growth and income equality is the negative impact that the measures aiming the reduction of income disparities can have on the economy. The issue of the compromise between efficiency and equity is defined as the relation between economic development and social protection (Mericková and Halásková, 2014). These authors observe that in developed countries expenditures related to the redistribution function represent on average one half of total public expenditures and that this share is increasing. They develop a study based on the impact that three specific areas of social policy have on the reached level of economic development through the United Nations’ HDI (Human Development Index): social expenditure with family, with old age and with employment. Mericková and Halásková (2014) select 15 countries of the global economy with different levels of economic development (different levels of HDI) and find that in most countries the impact of social protection, in the areas of family policy and pension policy, on the level of economic development is positive (because it provides minimum living and working conditions), but in the area of employment policy this impact is negative (because it reduces the incentives for labour supply). Those results show that different social protection policies have different effects on the economic development of countries. This means that certain measures aiming to achieve equity can have a positive impact on economic growth. Thus, under certain circumstances and depending on the policy measures considered, the trade-off between efficiency and equity can be broken.

Another example that shows that the trade-off between efficiency and equity can be contained is the contribution of Muinelo-Gallo and Roca-Sagalés (2011). These authors consider 43 upper-middle and high income countries over the 1972-2006 period with the intention of studying how the dimension and the composition of the fiscal policy impacts economic growth and economic inequality. The results they obtain confirm the existence of a significant effect of fiscal policies on economic growth and inequality. The authors find that increasing the size of government, through increases in public current expenditures and increases in direct taxes, accentuates the conflict between efficiency and equity, because it reduces income inequality, which is positive, but also reduces the GDP, which is negative. The authors also find that indirect taxes do

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26 not have a significant effect on economic growth neither on inequality. The big surprise is that public investment has a positive effect on both economic growth and income equality. This item increases economic growth and reduces income inequality. Muinelo-Gallo and Roca-Sagalés (2011) suggest that it is possible to implement fiscal policies that increase economic growth and reduce income inequality at the same time, using indirect taxes to finance public investment and thus increasing the size of government.

Still regarding this topic, García-Penalosa and Turnovsky (2007) also analyze the impact of fiscal policy on the trade-off between economic growth and income equality. The authors distinguish two forms of income inequality: pre-tax income inequality and post-tax income inequality. The results suggest that policies that favour economic growth are associated with greater pre-tax income inequality. García-Penalosa and Turnovsky (2007: 371) explain that:

“This is because growth is fostered by policies that increase the return to capital, and since capital is more unequally distributed than is labour, higher returns to capital translate into greater income inequality.”

This conclusion confirms the positive correlation between economic growth and income inequality. On the contrary, the authors find that the same policies that increase the economic growth rate also reduce the post-tax income inequality, and in this case there is no trade-off.

Pontusson and Rueda (2008) explore why some countries have larger redistributive welfare states than others, so they study this question from the perspective of how income inequality affects government policies. They argue that the common assumption in the existing literature of this subject is to consider that the preferences of the median voter determine party policy, and the common conclusion is that inequality generates a more redistributive government. The authors formulate a model that opposes what is generally assumed in the literature. From another perspective, their model predicts that the core constituency of left-wing parties wants more redistribution as inequality rises and the core constituency of right-wing parties wants less redistribution as inequality rises. In their work, the authors distinguish between the effects of wage inequality among full-time employees and the effects of household

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27 income inequality. The main conclusion of this investigation is that different forms of inequality have different political effects. Pontusson and Rueda (2008) use a mobilization variable to describe the movements of the parties on the left-right dimension. According to them, an increase in wage inequality causes left-wing parties invest more in redistribution measures and the right-wing parties take less rightist measures in response to growing household income inequality. The authors conclude that higher levels of wage inequality influence left-wing parties and have no significant effect on right-wing parties, while higher levels of household income inequality influence right-wing parties and have no significant effect on left-wing parties.

Pontusson and Rueda (2008) make an important remark by saying that their theoretical model implies that changes in income distribution cause changes in party positions through the policy preferences of core constituencies. The authors admit that causality may also run in the opposite direction, meaning that changes in the political sphere can cause changes in income distribution. This is the direction that this dissertation aims to study – the impact of the partisan ideology on efficiency and equity, through the impact on economic growth and income equality.