Bigger Government Isn't Always Better Government

By Priyanga Dunusinghe

Published in Ceylon Today on 9^th Nov. 2014

Since 2006, present government has taken a clear policy stance to do away with privatization of state-owned enterprises. It is said that government plans to transform state-owned enterprises to improve efficiency while keeping the public ownership. The budget 2015 has several proposals to expand public sector workforce and plans to extend public sector intervention into number of areas such as marketing goods and services and various commercial ventures. In addition, government plans to set up an entity to run plantation companies if they fail to improve present status quo of low productivity and low investment in essential areas. This piece of article attempts to discuss the rationale for public sector intervention in the economy and risks associated with such intervention. Moreover, it is expected to highlight some of the recent findings with respect to the effect of public intervention on economic growth and social development.

Why should the public sector intervene in the economy?

First, some goods and services have specific characteristics where a competitive market will not deliver an efficient amount of them, for instance, public goods and services. Those goods or services are said to be non-excludable in that it is impossible to restrict consumption of the good just to those who pay for it. The net result is that those goods or services will not be supplied (or will be under-supplied) by the market because producers are unable to earn income from its supply. Second, the government should intervene into the market whenever there are cases where producers and consumers do not bear the full costs and benefits of their activity. This is usually because there are costs or benefits obtained by people not directly involved in the transaction. An externality therefore describes a cost or benefit resulting from an economic transaction that is borne or received by parties not directly involved in the transaction.  Where externalities exist, the market will not deliver the efficient quantity of the good or service. Third, markets are efficient when all parties to a transaction have equal information about the good or service on offer. In practice, the overwhelming majority of markets are able to function even when this is not the case. However, particular problems may affect some markets displaying imperfect information. If the seller of a good or service has more information than the buyer on the quality of the good or service for sale then such a situation is known as asymmetric information and may result in less trade occurring than in a case where the consumer has better information. In the case where the consumer has much better information than the provider, information problems can produce examples of adverse selection with a similar result (lesstrade than in the case of perfect information). Moral hazard, meanwhile, exists when one of the parties to an agreement has an incentive, after the agreement is made, to act in a manner that brings additional benefits to himself or herself at the expense of the other party.It is in effect a problem of hidden action in that one party cannot observe the actions of the other party and yet the hidden actions of the other party are influencing the costs and benefits of their transaction. Fourth, imperfect competition usually occurs when there are not a sufficiently large number of suppliers in a market. In such a case there will be a lack of the competitive pressure necessary to ensure prices are kept at economically efficient levels. In other words, when there are few suppliers in a market then these suppliers have some market power and may in some cases be able to raise prices. Finally, interventions for social justice or equity reasons are based on the subjective decisions and judgments of democratically accountable politicians, but a market failure framework should still be used to inform decisions and to ensure the desired outcome is achieved in the most efficient and effective way.

What are the risks of public sector intervention?

The existence of a market failure is not a sufficient case for intervention. Public sector intervention comes at a cost. Therefore it also needs to be demonstrated that the intervention will make an improvement and that the benefits of intervention will exceed the costs.  The success of cost–benefit analysis, where all the costs and benefits of public sector intervention are considered, depends on the public sector’s ability to accurately assess both the costs and benefits of intervention. This is important because the public sector frequently has poor mechanisms available to it in deciding how to allocate resources. Indeed, government failure frequently occurs because the public sector faces the same, or worse, information problems than the market itself.  Public sector intervention may also fail to deliver the anticipated benefit if private agents do not respond to the intervention in the way the public sector thought they would. In particular there is a risk that public sector intervention may crowd out or displace future activity by the private sector, such that there is no overall improvement. Consideration also needs to be given to the displacement, substitution and income effects of an intervention.  Political failings arise when individual interests override the public interest, for example when special interest groups are successful in lobbying for an intervention for their own rather than the public’s benefit. Administrative failings arise primarily because public servants work for others rather than themselves and face different incentive structures to those of the private sector. In the public sector, there is limited or no profit motive. Because workers and managers lack incentives to improve services and cut costs it can lead to inefficiency. For example, the public sector may be more prone to over-staffing. The government may be reluctant to make people redundant because of the political costs associated with unemployment.

Neoliberal position on government intervention
 

Generally,neoliberal economists believe that the government's role should be severely limited. They feel that economic and political freedom is likely to be undermined by excessive reliance on government. Moreover, they tend to question the government's ability to solve social and economic problems. They believe that faith in the government's power to solve these problems is unreasonable. They call for more and better information about what government can reasonably be expected to do ­and do well. They point to the slowness of the government bureaucracy, the difficulty in controlling huge government organizations, the problems political considerations can breed, and the difficulties in telling whether government programs are successful or not. On the basis of these considerations, they argue that the government's role should be carefully limited.

  

Center-left position on government intervention

Center-left economists tend to question the market's ability to solve some of the failures just discussed. They point to the important limitations of the market system, and they claim that the government can do a great deal to overcome these limitations. Government can regulate private economic activity. It can also provide goods and services that the private businesses produce too little of. Moreover, they point out that the price system also involves a form of coercion by awarding goods and services to those who can pay the price. In their view, people who are awarded only a small amount of goods and services by the market are forced into discomfort and malnutrition.

Recent empirical evidence

According to Measuring the Size of the Government in the 21^st Century, published by the Fraser Institute, the average size of the public sector, both in developed and developing worlds, began to expand during the first decade of the 21^st century though its share in the economy declined during 1980-90s.For instance the average size of the government around the world, measured as a share of GDP, was 36 per cent; by 1999 it had declined to 31 per cent. However, by 2011, the average government-expenditure-to-GDP ratio for the world had climbed back to 33 per cent.

The authors of the Measuring the Size of the Government in the 21^st Century review a number of theoretical and empirical studies that look into the correlation between the size of the public sector and economic growth performance. They found that there is a hump-shaped relationship between the government expenditure to GDP ratio and the growth rate of per capita GDP. It implied that as government grows beyond a certain size, public sector can actually begin to hinder economic growth, thereby lowering living standards for average citizens. There also seems to be an association between smaller governments and greater efficiency in public service provision and often better performance outcomes. More specifically, the evidence suggests there are important implications for economic growth and social outcomes associated with the size of the public sector. It implies that there is an optimal size for the government sector when it comes to economic growth. Findings further suggest that government is indeed very important, and its programmes are important to improve quality of life. However, at the same time, the results demonstrate that more and larger government is not always associated with improved outcomes. In conclusion, authors argued that governments should learn how to provide more and better services while reducing the costs to the tax-paying public.

Conclusion

All the indications suggest that the government intends to expand public sector role in the economy further in coming years. Available data show that the share of public sector employment increased from 13 per cent in 2004 to 15.5 per cent in 2013. It is expected that this share will further increase with the new recruitments identified in the budget 2015. It is certainly sure that on-going public sector expansion is not going to deliver expected outcomes in terms of better public service delivery or it positively contributes to output expansion. This expansion not only eats out scarce resources but also send wrong signals to job seekers regarding their human capital investment decisions. It is important to reflect on recent empirical findings and authorities be reminded that bigger government isn’t always better government!