Educate or Adjudicate? Socioeconomic Heterogeneity and Welfare

Abstract

I present a formal framework to explore the welfare and distributional effects of a government’s optimal choice over two types of public spending in a closed economy: domestic security (DS) and investment in social capital (SC). Production is characterized as a function of social and physical capital stocks that both vary across the regions. DS stands for total factor productivity, while SC stands for human capital and civic cooperativeness combined. SC accumulates via public spending on universal primary education, cultural, and civic events and such, and is exposed to regional spillover effects. Numerical simulations of the static solution of the government’s welfare maximization problem reveal that the optimal rate of spending on SC (m^*) is negatively related with the income share of physical capital, SC spillovers and fiscal decentralization. Simulations also show that SC homogeneity is positively associated with both the level and equitability of aggregate income. The maximum attainable levels of income, welfare and social cohesion and the most equitable incomes are all observed to realize at some intermediate range of m^* values. In case DS augments SC, however, social cohesion improves and welfare declines monotonously in m^*.

Keywords:

• Social Capital
• Economic development
• Income equality
• Domestic security spending

JEL Codes:

• E02
• E6
• H11
• H52
• I24
• I25
• I31
• Z18

Acknowledgements

I am indebted to Cagri Saglam and two anonymous referees for their invaluable comments and suggestions. I also thank to the seminar participants of the seminar at Bilkent University, Ankara, and 2016 Economic Modelling Conference. All the remaining errors are mine.

Notes

¹ Figure 1 in Appendix 1 shows that ethnic fractionalization is not related with land area. Incidentally, of the sample countries, the Republic of Korea seems to be the only country which has no ethnic fractionalization.

² measured by protection of property and contract rights.

³ The discussion of the notion of SC dates back to early sociologists: primarily to Tocqueville, Durkheim and Weber.

⁴ Examples of SCI and DS are education and adjudication, the latter of which refers to legal and judicial system and enforcement characteristics.

⁵ In an international context, Solomon, Seiglie, and Xiang (2007) argue that FDI ties reduce international conflict. Douch and Solomon (2014) also argue that there are significant tradeoffs between military spending, which is found complementary to foreign aid, and non-military spending in middle power nations that face international threat. I refrain, in the interest of keeping the scope clear, from international considerations in this paper.

⁶ While several studies (see e.g. Collier and Hoeffler 2004) find no significant correlation between conflict and inequality, Huber and Mayoral (2014) point out that within-group inequality has significant positive effects on conflict.

⁷ Lange (2004) notes that dispersed power structure under colonialism reduces governance quality and leads to increased potential of political instability. Moreover, minority direct ruling under colonialism is observed to increase income inequality, as compared to the case where settlers constituted the majority; high inequality remained in those countries even after independence (Angeles 2007).

⁸ Figures 1 and 2 in Appendix 1 show that neither land size nor income level show a direct association with ethnic heterogeneity.

⁹ La Porta et al. (1997) argue that trust is lower in hierarchical religions than others.

¹⁰ Putnam (1993) and Heyneman (2000) argue for the positive association between public education and SC and social cohesion; Knack and Keefer (1997) finds positive association between trust and secondary education, and a negative one between trust and primary education. Huang, van den Brink, and Groot (2009) show empirically that while the level of education is positively associated with trust, its relationship with social participation is insignificant. The authors also argue that education has a greater effect on SC in the US than the rest of the sample, explained by the ‘melting pot’ approach. Imandoust (2011) argues that open distance education is key to building SC in Iran.

¹¹ Foa (2011) discusses the positive linkage between growth and social cohesion. Bjørnskov and Méon (2013) present evidence that trust increases income both directly and via its positive effects on education and political and economic organization.

¹² Huang, van den Brink, and Groot (2009) consider 65 empirical studies that measure SC by either trust or civic participation, or both. The authors show that the main source of variation across the earlier findings is the problem of endogeneity between the civic participation and education. Correcting for endogeneity, they report positive significant relationship between these variables.

¹³ Hanushek and Woessmann (2015) demonstrate that it is not school attainment that is significant in explaining differences in the growth performance across countries, but the quality of education or the knowledge capital. Imandoust (2011) argues that open distance education is key to building SC in Iran.

¹⁴ Putnam’s (1995a, 1995b) paradox of declining SC despite increasing average level of schooling in the US during the past decades are attributed to factors such as women’s inclusion in the labor force and electronic revolution that influence all levels of education similarly, as well as diminishing marginal effect of education on SC.

¹⁵ These platforms are different from the horizontal associations that Olson (1982) describes as leading to special interest group formation. Knack and Keefer (1997) provide empirical evidence that contrasts with Putnam (1993) and show that memberships to civic associations are unrelated with or harmful for economic performance. They also argue that the greater is trust the less resources are required for securing property rights and achieving social cohesion; this is the channel that trust enhances efficiency, investor confidence, and economic growth.

¹⁶ A review of defensive and preemptive counter-terrorism studies is provided by Bandyopadhyay and Sandler (2011) and Sandler (2015).

¹⁷ The relationship between citizens’ education level and preference for security spending appear ambiguous in a study of US survey (Wong 2010). The US Homeland Security Research shows a great deal of variation in the income share of national security spending across the countries: http://homelandsecurityresearch.com/2008/11/national-security-spending-outlook-in-20-countries-2009-2018/. However, data is too scant for a sensible empirical analysis.

¹⁸ In an international context, Shieh, Lai, and Chang (2002), argue that the relationship between defense spending and growth is nonlinear and optimal defense spending that maximizes economic growth is smaller than the level that maximizes welfare. While that model introduces military spending into both the utility and the production functions, the current model only focuses on the productivity effects of security spending. Similar to Knight, Loayza, and Villanueva (1996), DS is viewed to be positively related with total factor productivity.

¹⁹ F-de-Córdoba and Torres (2016) develop a theoretical framework to investigate the optimal level of military spending. Using defense spending both in the production and the utility functions, the authors analyze the response of military spending to technology and foreign threat shocks for the US economy and report that military spending is complementary to private consumption and is positively associated with the level of income.

²⁰ Based on 212 countries, it is observed that education spending (as percent of GDP) is correlated negatively with the size of the armed personnel (as percent of total labor) during the past decade, although the correlation is small: −0.10 (source: World Development Indicators).

²¹ Numerical simulations are based on two regions; hence homogeneity is measured by relative SC: A₁/A₂.

²² One may think of period t as the period of incumbency of a given government.

²³ I later relax this assumption and investigate the case of SC-augmenting DS.

²⁴ Given the complexity of the model, due to the accumulation of two types of capital over time, as shown below, a joint solution of the household’s and the government’s problem could not be obtained.

²⁵ Transfers for all the regions are positive when .

²⁶ While military equipment accumulation can be considered investment, depreciation in defense sector is viewed very high.

²⁷ It is this via these spillovers that this paper addresses the value of SC as the flow of benefits (see e.g. Imandoust 2011).

²⁸ The current model assumes human capital to be identical across the regions, which is constant and equal to 1 for simplicity.

²⁹ In the simulations below, holds since for all i, which implies that F ≥ 0.

³⁰ For simplicity, income shares of physical and SC (α and 1 − α, respectively) are assumed to be identical across the regions.

³¹ Alternatively, may be considered to augment the SC stock, in which case it would be modeled as SC-augmenting spending, leading to increasing returns to scale. Section 3.1.2 investigates the implications of this formulation.

³² No explicit solution to the problem can be obtained when the government chooses τ and m simultaneously to maximize welfare.

³³ This is a reasonable approach given the short-sighted nature of most democratically elected governments.

³⁴ The roots are obtained using the Matlab program; data generated with one of the roots only match the conditions that 0 ≤ m^* ≤ 1.

³⁵ A potential extension of the model involves reelection of the government by some exogenous or endogenous probability, which is outside the scope of the current paper.

³⁶ The partial derivatives are too long to report here. It is possible to identify their signs of the derivatives through numerical simulations, however, which are definitive given the feasible ranges of the model parameter and the feasibility constraints. The analysis is available in Matlab Program files and can be provided upon request.

³⁷ Same result is obtained for SC:

³⁸ measured by A₁/A₂.

³⁹ In addition, I investigated a case where the central government redistributes part of the tax revenue to one of the districts for, say, political considerations. As is the case for the tax rate, no explicit solution could be obtained for the optimal rate of such transfers when the government optimally selects m^* at the same time.

⁴⁰ I refrain from the political economy aspects of decentralization and assume that fd is given level the central government.

⁴¹ The derivative of (the second root of) is not given here to save space, but can be obtained from the author upon request. Because the expression is too long to observe the sign, the sign is confirmed via simulations that cover all the possible ranges of the model parameters.

⁴² It is straightforward to predict that substituting G^DS by its local version would produce an opposite effect.

⁴³ Simulation plots are available upon request.

⁴⁴ It is observed that the ranges the two roots span are: 0 < m₁ < 0.1764 vs. 0.375 < m₂ < 0.9508; of these, m₂ produces the feasible values of the model variables.