Wednesday, June 16, 2010


Ever since the original proposition by a 19th century German economist Adolph Wagner, Wagner's law has undergone significant theoretical and empirical discussion on its long-run validity. In the most basic and rudimentary version, the law states that alongside the economic development of industrial societies, there is a persistent tendency of an increasing share of government spending in the GDP. Since the beginning of the 20th century course, the growth in government expenditures has escalated in all major industrial countries. The economic literature has centered the discussion on two elementary versions of Wagner's law. The first version of Wagner's law attributes the growing share of government spending to the ever expanding power of interest groups.

The concept of interest groups has been thoroughly developed by a rigorous theoretical analysis by Mancur Olson's The Logic of Collective Action. There is a remarkably positive correlation between the growth of government spending and the political power of interest groups. Back in 1954, Milton Friedman and Simon Kuznets have analyzed the income dynamics in independent professions (link). Although there has not been much discussion in the economic literature, the Friedman-Kuznets analysis is an important milestone in the explanation of the evolution of interest groups. Friedman and Kuznets examined five independent professions. Using a comprehensive statistical analysis, they showed how income growth in five profession has exerted an upward trend without significant gains in productivity. The five independent professions analyzed by Friedman and Kuznets emerged as pure interest groups. These groups have imposed a regulated labor market structure marred by occupational licencing and aimed at gaining an insider's earnings rent at the expense of entry restriction. Occupational licensing is one of the most powerful explanatory features of low coefficient of price and income elasticity of labor supply of physicians, dentists, legal consultants and medical practitioners. In most of the industrial countries, these groups have emerged as powerful interest groups and triggered an unbreakable increase on the growth of government spending. The evolution of interest groups in fields such as agriculture, social security and trade has resulted in the intensive pressure on the growth of government spending. The interest group perspective on Wagner's law emphasizes the state capture created by the democratic system and an irreversible pattern of increases in government spending centered on small and powerful interest groups. If interest group's representative utility function can be described as a relationship between the group's size and its price elasticity of labor supply: U(f,e)=f(1-|e|), then the effect of a unit change in price elasticity of labor supply dU/de=-f indicates that greater price elasticity of labor supply will reduce the size (f) of the interest group as a result of pure substitution effect at work. On the other hand, if price elasticity of labor supply of the particular interest group will decrease, causing more price inelastic labor supply, the size of the interest group will increase since most of the excess wage increases will spill into physician's pocket.

The second version of Wagner's law states that an increase in government spending in time is a result of a high income elasticity of demand for public goods. Rati Ram (1986) has tested this hypothesis on the sample of 115 countries between 1950 and 1980. His conclusions suggest that income elasticity of demand for public goods is very elastice (exceeding 1) in 60 percent of all countries in the sample. A comprehensive development of econometric methodology has enabled a more rigorous and empirical evaluation of Wagner's law on the basis of long-run simulation using time-series data. For example Sidelis (2006) has applied cointegration analysis and Granger casuality tests to determine whether long-run changes in income account for the growth of government spending in Greece between 1833 and 1938 (link). The author concludes that income elastic demand for public goods caused a growth in government expenditures. A recent study by Lamartina and Zaghini (2008) indicates (link) a negative relationship between government spending and economic growth in a sample of 23 OECD countries. The study further suggests that the correlation between income growth and government expenditure is stronger in countries with low initial levels of GDP per capita. Neck and Getzner (2007) collected data on government expenditure in Austria between 1870 and 2002 and examined whether the surge of government expenditure is attributed to either Wagner's law or Baumol's cost disease. The authors applied Phillipe-Perron and Augmented Dickey-Fuller stationarity tests, concluding that government spending time series more likely represents a stationary time series. In concluding remarks, the authors note that much of the increase in government expenditure is a problem of increasing prices in public sector, relating the growth in public expenditures to Baumol's cost disease where output reduction in public sector is a result of net decrease in productivity growth which yields a significant pressure from public sector interest groups on expenditure increases.

Wagner's law is an intriguing theoretical and empirical issue. In spite of the numerous empirical evaluation and theoretical design, the issue will probably remain an intensive course of the academic debate.

Tuesday, June 08, 2010


Greg Mankiw (link) and David Leonhardt (link) have opened a debate on whether govenrment policymakers should levy a tax on soda and other soft drinks as an attempt to reverse the growing trend of obesity among the U.S. population. The idea of taxing soda has become popular as governments around the world have recorded high budget deficits and revenue shortfall. The real question is what would be the effects of taxing soda and, if so, would the introduction of the tax contribute to the reversal of the obesity pattern, especially among the child population.

There is a decent amount of empirical studies and health policy analyses on the patterns and causes of obesity. Obesity and the risk of premature death resulted from high blood pressure and the potential heart attack is the most individual cost of fast-food consumption. For a long period of time, we assumed that these costs at the individual level could be internalizied and, thus, raise no cost to the society. In the article published in Sunday's edition of NY Times Greg Mankiw drew parallels between soda and tobacco tax. If individuals consume a lot of cigarettes at home, there is, presumably, no negative externality shifted onto the society. The logic could be applied to soda taxation. However, there is a flip side to the argument. Taxing soda, tobacco and other goods with a negative impact on bystanders is an answer to the growing cost of health care delivery to the individuals who consume these goods. The adverse impact levied on other individuals is seen through higher health insurance premiums and total cost of health care.

John Cawley published an extensive analysis of the causes of early childhood obesity (link), suggesting greater government intervention and various cost-effectiveness measures to mitigate the adverse impact of childhood obesity on other members of the society. A study by Jason M. Fletcher, Daniel Frisvold and Nathan Tefft (link) has been one of the first attempts to measure the effect of vending machines restriction on childhood obesity. The authors concluded by suggesting higher tax rates and soft drink access restrictions in schools to fight the on-going increase in childhood obesity.

As Kelly Brownell of Yale Rudd Center for Food Policy and Obesity mentioned, the link between sugary drinks and obesity is stronger than the link between obesity and any other kind of food (link). The evidence suggests that distance from fast-food restaurant is a significant feature of childhood obesity. A study conducted by Janet Currie et. al (2009) has shown that among children in the 9th grade, a fast-food restaurant within 1/10 of the mile in school is associated with at least 5.2 percent increase in obesity rates (link). The study found that the direct impact of distance from the fast-food restaurant is significantly larger for less educated African-American and less educated women.

The question is whether taxing soda and other kinds of fizzy drinks could potentially reduce and/or reverse the growing trend of obesity. The basic question to start with, is what is the elasticity of demand for soda drinks. The estimates suggests that price elasticity of demand for the majority of soda drinks ranges from -0.8 to -1.0. For example, -1.0 elasticity coefficient suggests that a 10 percent increase in the price of soda would - ceteris paribus - lead to 10 percent decrease in soda drink consumption. The price elasticity of demand for soda drink is relatively high considering that coefficients of price elasticity of demand for other kinds of food ranges from -0.2 to -0.5. If policymakers considered the introduction of a tax on soda consumption, the relevant question is who would bear the burden of the tax? Given elastic demand, the tax would be beared by consumers. However, high price elasticity of demand suggests that there is a widely availible range of close substitutes with potentially negative adverse effects for the individuals. So it is not unlikely that children would switch to other kinds of fast food with equally negative impact on obesity, blood pressure and quality of living.

Given the lack of experiments and availibility of household surveys, it is difficult to estimate the consumer response to the introduction of tax on soda. The estimate of price elasticity of demand suggests that part of the tax would be beared by the consumer. However, it also suggests that a change in the relative price of soda would induce children to consume other varieties of fizzy drinks. Experimental studies by health policy experts suggests different approaches to tackling the adverse impact of soda drinks and other kinds of fast food. The most notable approach is the restriction of vending machines in school districts. However, restricting the access to vending machines would encourage the consumption of fast food outside school districts. A general tax on soda would be preferable to the restrictions of access of vending machines. There is absolutely no doubt that a tax would discourage consumption of soda and other kinds of fast food. Estimates suggest that soda and other kinds of fast food such as hamburgers, donuts and cakes are complementary. Assume, the cross-price elasticity of demand for burgers is -0.9 Thus, if the price per unit os soda increases by 10 percent, the demand for donuts, burgers and cakes decreases by 9 percent (0.9×10 percent). Since a tax on soda would raise the relative price of soda, the consumption of these kinds of fast food would diminish, resulting in less adverse impact of fast food consumption on the individuals. I would disagree with the statement that negative externalities from soda and fast food consumption are internalized by the individual. For example, an article by Trasande, Liu, Fryer and Weitzman (2009) published in Health Affairs (link) investigated the annual cost of childhood obesity in the U.S. between 2001 and 2005, based on the nationally representative data from U.S. hospitals admissions. The authors found that from 1999 to 2005, obesity-related hospitalizations doubled. In addition, costs related to hospitalization, treatment and diagnosis of obesity increased from $125.9 to $237.6 million, an 88.7 percent increase. The cost is partly beared by Medicare while the rest of the total cost is beared by the private insurance premiums.

Given the perverse system of employer-provided health care and implicit subsidizing of health insurance suppliers by the federal government, the periodic increase in obesity-related health care costs indicates a further rise in Medicare expenditures and health insurance premiums. In such conditions, there is little incentive for children and parents to reverse the consumption of soda drinks and fast food. Taxing soda and complementary fast food is a step in the right direction. But it should be noted that the introduction of a tax on soda should be compensated by a corresponding decrease in personal income tax. However, without the parent-guided awareness of the adverse impact of fast food on obesity, it would be difficult to reverse the increasing pattern and cost of childhood and adult obesity. Therefore, much of the obesity-related health care risk in childhood can be solved within the household. It would be irrational and foolish to believe that a tax on soda and government paternalism could solve the obesity puzzle and mitigate its neighborhood effects on bystanders.

Thursday, June 03, 2010


In WSJ, Vaclav Klaus, the president of Czech Republic, draw important conclusions from the long-term economic sustainability of the Eurozone (link), arguing that the eurozone is not an optimum currency area as suggested by the famous four criteria from economic theory. In a puzzling essay, Mr. Klaus demarks the eurozone as a monetary union of particular economic viability and, based on the assessment of growth dynamics in Europe, suggests that the eurozone will face a deepening problem in the future.


Gary Becker (link) and Richard Posner (link) have initiated an interesting debate on low economic growth as the main macroeconomic concern of European economies in overcoming the increasing burden of public debt.