Fighting with one hand tied behind the back: political budget cycles in the West German states

Christina J. Schneider 0 0 C.J. Schneider ( ) University of California , San Diego, USA 1 Baden-Wrttemberg, Bayern, Berlin , Brandenburg, Bremen, Hamburg, Hessen, Mecklenburg- Vorpommern, Niedersachsen, Nordrhein-Westfalen, Rheinland-Pfalz, Saarland, Sachsen, Sachsen-Anhalt, Schleswig-Holstein and Thringen Theories of political budget cycles have been contested because scholars find that incumbents can manipulate deficits in the pre-election period only if fiscal transparency is low. I argue that these findings do not generally rule out the possibility of fiscal electioneering. Governments may increase spending on highly visible policies. The composition of the budget serves as a second-best strategy. It increases political support without straining the budget balance. An empirical analysis of the West German states reveals alternative electoral budget strategies and ultimately point to the importance of analyzing how governments choose between alternative fiscal instruments. An incumbent can increase her chances of re-election if she improves voter welfare before the election. She could inflate the economy to stimulate growth but the international integration of financial markets and the increase of central bank independence reduce her ability to control monetary policy, and effectively tie one of her hands behind her back. Another alternative is to pursue expansive fiscal policies, which allow the incumbent to provide more public goods or social services. With one of her hands already tied, she should have strong incentives to resort to manipulating fiscal policy. Deficit spending in the pre-election period is most often associated with a political budget cycle (PBC).1 In this scenario, incumbents 2Most approaches predict an increase in deficits before elections assuming that although voters dislike an increase in their individual tax contributions as well as deficits they only observe the level of taxes directly. Note, however, that cycles in fiscal policies are not necessarily limited to expenditure policies but can occur on the revenue side as well (Belke and Schneider 2006; Belke et al. 2007). - incur higher deficits in order to finance the expansion of public spending and transfer payments before elections.2 Yet, the ability to incur higher deficits is restricted by institutional constraints such as legal restrictions on the size of the deficit or membership in the European Monetary Union (EMU). Additionally, voters tend to punish leaders who are running up a budget deficit right before elections.3 This seems to tie her other hand, and as a result many scholars have concluded that in these cases electoral cycles in fiscal policies do not exist.4 I argue that this conclusion is too optimistic because the absence of deficit spending before elections does not rule out the possibility that leaders manipulate other expenditure policies for electoral gain. For instance, they can target certain groups of voters and improve their welfare while maintaining a balanced budget. Incumbents could increase spending on election-relevant items while reducing spending on other items (Drazen and Eslava 2005, 2006; Veiga and Veiga 2007). The increase in social transfers during the pre-election period is one of the most robust findings in the literature on PBCs (Franzese 2002a: 380). Yet, scholars tend to draw general conclusions from the analysis of isolated fiscal strategies such as deficit spending. My analysis of alternative pre-election strategies in the German states (Bundeslnder) shows that even when deficit spending is not possible due to institutional constraints or voter preferences, political budget cycles still exist and should be expected. I find that even though incumbents on the state level decrease deficit spending and maintain a balanced budget they do increase social transfers in the pre-election period. This echoes Alt and Lassen (2006a, 2006b) and others who argue that there should be no cycles in deficit spending in countries with relatively transparent fiscal institutions. At the same time, I show that incumbents are not restricted to deficit spending but may choose alternative fiscal policy instrumentse.g., an increase in transfer payments (retaining a balanced budget)to increase political support before an election. The findings demonstrate that inferences from the empirical analysis of PBCs should not solely rely on the analysis of deficit spending (or any other budget item). Even if deficit spending is not feasible for institutional or political reasons, incumbents usually draw from alternative fiscal strategies to increase voter support. My paper therefore provides the empirical basis for an integrated explanation of fiscal strategies. Governments choose between alternative fiscal strategies (e.g., taxation, deficit spending, composition of expenditures, revenues) in the pre-election period. To understand these opportunistic choices, it is vital to move away from examining alternative strategies in isolation. My paper points to some of the conditions under which governments rely on one or the other instrument. For example, deficit cycles should become less likely if fiscal transparency is high. Cycles in the budget composition, however, can still exist under this condition. Future research has to specify those conditions more explicitly in order to provide a unified account of political business cycles. 2 Can governments signal competence to the electorate? The incumbents incentive to stimulate the economy before elections has attracted scholarly attention in both economics and political science and a number of highly diversified theories 3See, inter alia, Peltzman (1992); Alesina et al. (1998); Brender (2003); Buti and van der Noord (2003); Von Hagen (2003); Andrikopoulos et al. (2004); Brender and Drazen (2005); Drazen and Eslava (2005); Mink and de Haan (2005); Alt and Lassen (2006a, 2006b); Schneider (2007). 4Some examples are Persson and Tabellini (2002, 2003b), Shi and Svensson (2000, 2002, 2006), and Brender and Drazen (2005). They argue that macro-political budget cycles are restricted to weak or new democracies. exist. Initially, scholars applied the logic of the Philips curve (which constitutes an inverse relationship between inflation and unemployment) to provide an explanation for opportunistic political business cycles. In these models, the electorate votes retrospectively and governments expand monetary policies to lower unemployment before elections (Kramer 1971; Nordhaus 1975; Tufte 1975, 1978; Lindbeck 1976; Fair 1978; Hibbs 1977, 1987). Later approaches relax the assumption that expectations about the inflation are adaptive and treat voter expectations as rational and anticipatory (Alesina 1987, 1988; Persson and Tabellini 1990). Governments cannot simply generate political business cycles because voters (who anticipate that lower unemployment before the election will lead to higher inflation after the election) adjust their beh (...truncated)