Public goods and political accountability: the misuse of Public-Private Partnership to avoid binding budget constraint

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Abstract

Public good provision has always been a central role of government, but it is also an important element in political competition. The recent financial difficulties of public authorities have undermined their capacity to invest in public goods, requiring politicians to search for new ways to finance those investments.

A solution widely adopted is the Public-Private Partnership, an instrument designed to provide more valuable public goods thanks to efficiency gains coming from bundling building and operating phases in a single contract. However, despite these predictions, results are mixed and PPPs have often resulted in resounding failures. The most common explanation for this lack of results is that PPPs are often adopted not for efficiency purposes but to avoid financial constraints.

In order to analyze the incentives for politicians to use PPPs for pork barrel politics in presence of a binding budget constraint, we build a model where they have a better ability to look forward than their voters, and are limited in their possibility to stay in charge. We then release the assumption of homogeneous income among voters, and analyze how this modifies politician’s incentives to pander.

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Acknowledgments

I would like to take this occasion to express all my gratitude to my supervisor, Prof. Simone D’Alessandro, for his support during the elaboration of this work both through his enthusiastic adherence to my initial project both through helpful

insights and reviews during drafting.Moreover I would like to thank him for his

patience and geniality which allowed me to tackle these months of constant work with the right serenity.

I am also very grateful to Andrea Caravaggio, Giulio Galdi, Enrico Lupi and Elena Romito for their helpful reviews, their suggestions and, above all, their overwhelming generosity. Without their aid this work would surely have been poorer.

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CHAPTER 1

Introduction

A central role of government has always been the provision of public goods to its citizenry. One can even argue that public good provision was one of the main reasons for which states were born. Starting with the provision of some very basilar public goods, such as law enforcement and national defense, governments have firstly moved to the provision of public utility infrastructure and then to welfare programs, environmental protection and so on. This process led on one hand to a creation of a public bureaucracy necessary to manage both the collection of resources, mainly through taxation, both their allocation of res; on the other hand to a definition of a decision-making power, needed to decide how collection and allocation of resources should be made, and how this power should be allocated among citizens. As a matter of fact what has been defined was the political system.

Nowadays public choices are taken by elected politicians, who are members of political parties.1 Each of them formulates an electoral platform, containing the most important socio-economic variables such as taxation, economic policy, civil rights and so on, and through which they signal their objectives to voters before elections. Voters through election choose the political platform they evaluates to be better and, hopefully, a party, or a coalition of parties, will be winner, getting the power to govern and then to implement their electoral platform; at the end of

the mandate new elections will take place and the mechanism continues.2

Public Good provision is one of the elements of the electoral platform proposed by parties: choose what public good provide, in what quantity and how finance it

1

It is not purpose of this work to provide an historical review on how political system changed over the centuries, even if it would be extremely interesting, and after all also very useful to understand why different political systems, with their strengths and drawbacks, were born among different countries.

2_{Of course the description of this political system is a bit simplistic, somehow even visionary, but it will}

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are crucial questions that find different answers among politicians, and have usually been a crucial element in voters’ electoral choices. This is so especially al local level where authorities provide a wide range of services.

During years public intervention has exponentially increased, leading to a constant increase of public expenditure, both in efficient expenditure both into inefficient one and even to maintain the bureaucracy. In Italy the dynamic of public debt exploded in 80s bringing public finances almost to collapse; from that moment, driven firstly by efforts to enter in the Eurozone then by constraints to public finance set by European Community, many reforms have been set up, trying to restructure and restrain public expense.

A first structural step has been done through a decentralization process in which powers previously belonging to the central government were transferred to local ones. The ideas behind this reallocation were mainly two. On one hand it was thought that local politicians would be more efficient in picking policies for their communities because, thanks to their closeness to citizens, they better know their preferences. On the other hand there was the idea that it would be easier to reform and control public expenditure, mainly because of the smaller size of local authorities, which would result into an easier control that voters could exert on politicians’ work, reducing the possibilities for a misuse of public resources. This paradigm have been widely supported by standard economic theory: one of the most important results in this sense is the Oates’ Decentralization Theorem: absent policy spillovers, decentralization is more efficient than centralization if regions are not identical.

Results of this reform have been contradictory. Firstly because, due to the transfer of competition, there have been an increase of local bureaucracy that often was not followed by reduction of the central one, frustrating the supposed cost’s reduction. On the other hand local authorities have usually failed to reduce public expenditure; on the contrary the main results have been a reduction of transparency of balance sheets of local authorities and a reduction of central government’s control capacity on public debt. Many explanations have been

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proposed for this lack of results: firstly at local level both politicians and bureaucrats are usually less skilled than the ones that operates at higher levels, so the capacity to maintain the control of public expenditure is lower; another explanation is that politicians at local level face higher incentives to behave in a less responsible way, favoring their voters with less efficient policies; a third explanation have been recently proposed by Boffa, Piolatto and Ponzetto (2014): in this work they argue that when voter’s ability to monitor politicians and hold them accountable and information varies across regions, centralization, even if reduces the capacity to match local preferences, yields accountability gains.

Another stage of the fight to public authorities’ overspending was the privatization process, which began at the beginning of 90s: probably the most famous are the privatizations of the bigger national companies, but also local authorities were widely involved in this process. Many strategic services, which were once provided directly by the public authorities, were contracted to private companies or transferred to special semipublic companies, the so called

municipalizzate, expressly created, again with the aim to reduce public

expenditure and to increase efficiency. Once more results are not clear: increase in services’ quality is still a disputable point and the reduction of cost for public authorities often have been simply shifted to citizens thorough tariffs; the experience of semipublic companies was often a resounding failure, creating expenditure centers totally out of control from central government and under a weak control from local ones.

Recently the economic crises, which in Italy soon became a crisis of national public debt, imposed an even stronger strict on public expenditure dynamic: the need for the central government to rapidly reduce expenditures and increase revenues brought to a spending review process. This process in the intentions of the legislator would have cut inefficiencies in public expenditure by an accurate process of analysis; what really happened is that central governments cut off resources to local ones indiscriminately, leaving them the task to reduce public

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expenditure.3 Government tried to offset this cuts allowing local authorities to

increase local taxes, or introducing new ones,4 however this compensation has

not been properly fair since economic crises hit also the capacity to collect taxes. Furthermore, in order to increase transparency in public balance sheets, a reform of local authorities accounting rules have recently been implemented, making municipalities’ balance sheet more congruent to the real financial situation of municipalities.

The combined action of mismanagement, government’s cuts, increasing difficulties in tax collection and stricter accounting rules creates an exploding mixture that lead to a crisis of municipalities system: recently many municipalities went bankrupt or were forced to require the access to financial recovery plans.

In this difficult situation public good provision has become very difficult and politicians face a puzzle difficult to be managed. At the basis there is the problem of the problems for each decision maker: on one side there is the will to keep providing public good, which often required costly, long term investments, while on the other there is the necessity to finance these projects; the news is that these choices must be done under strict financial boundaries that rules out most of the possibilities. The option of restrictive policies may be sometimes necessary but usually is politically extremely costly, especially at local level; hence politicians have looked for alternative ways to keep providing public goods bypassing financial constraints.

As we said the first attempt was the privatization of many services: this procedure allowed municipalities to reduce their direct cost maintaining a service.5 Besides the results of these choices, decide what service contract to

3_{In a recent report to Parliament about financial situation of Regions and Municipalities, Corte dei Conti}

(the supreme audit institution of the Italian judicial system) estimates that between 2008 and 2015, the cumulative effect of cuts in terms of contribution to net borrowing reaches 40 billion of euro, 21 for Regions and 19 for Municipalities.

4_{The most famous examples of these new local taxes were IMU and TASI, which revenue mostly}

remains to municipalities.

5_{As we already said this reduction is only partial because for example employees have rarely been}

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private sector and what keep providing in house may be difficult, mainly because usually when a municipality decides to externalize a service, it rarely will be able to internalize it again. Once more the choice of externalization is a political one, so is not often motivated by economic considerations only: Levin and Tadelis (2010) studied the make-or-buy choice at the level of U.S. city government looking for the determinants for privatization. The underlying hypothesis of their analysis is that in house provision suffers from productive inefficiency due to the weak incentives of employees, but enjoys low contracting costs; in contrast the productive efficiency of performance contracts comes at the cost of specifying and implementing performance requirements. Under these reasonable assumptions, the expected result is that services for which is harder to write, monitor or adjust performance standards are more likely to be provided in house, the same will be true for services for which city administrators are more sensitive to the ultimate quality provided. Their empirical analysis confirms in principle their prevision, but they find very important differences among cities that often cannot be justified by economic concerns but seem much more related to political factors such as cities history, public debt level, presence and strength of public unions and so on.6 Hence they conclude that political economy plays an important role in the make-or-buy decision, an importance that sometimes seems to be even higher than the economic factors’ one.

The problem of privatizations is that, even if they can work properly in case of public services for which a tariff is required, when we should afford investments, especially costly and long term ones, traditional procedures for awarding public contracts of work require a previous allocation of funds by the public procurer: given the financial difficulties of many municipalities this solution is not feasible and an innovative contractual solutions seems more a need than an opportunity.

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For example they found that cities in the western states, which historically have looked less to government to provide services and that usually vote for the Republican Party, are more likely to contract for service provision than northeast ones, where historically Democrats are stronger. Another example is that city run by an appointed manager, rather than an elected mayor, are more likely to contract for service provision.

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Recently there has been an increasing interest in a particular form a contract: the Public-Private Partnership. PPP is characterized by the bundling of investment and service provision in a single long term contract, and in last few years has become the common substitute for public provision of infrastructure services, usually the ones that require large up-front investments, such as highways, bridges, seaports, airports but also hospitals, jails and even schools. While originally intended as a method for procuring public services in a more efficient way, to many governments it has appeared to be the most suitable solution in order to keep investing in public good provision bypassing budget constraint issues. The problem of this approach of politicians is that, since these contracts are very complex to be designed, because of the long-lasting projects they refer to, often these investments reveals to be inefficient or unsustainable in the long run.

This is exactly what we want to analyze in this work. Can Public-Private Partnership be used by politicians in order to pander to public opinion bypassing budget restriction? What effect could have this pandering activity on the Social Welfare?

The starting point of this work is Russo and Zampino (2012), where authors explore the relationship between a difficult financial situation, which as we said is common among Italian municipalities, the use of Public-Private Partnership and the infrastructural gap from an empirical and econometric point of view. Their guess was that in the Italian experience Public-Private Partnership projects are implemented much more for difficult financial conditions than for the need to

increase quantity or quality of national infrastructural stock.7 Effectively while at

European level PPP usually refers to big and complex projects, which require great expertise both in the design and in the operational phases, in Italy conversely they are mainly used for small and medium projects, for example car parks, cemeteries and sporting plants, that usually do not require particular expertise in any phase. Moreover they are often promoted by local governments

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usually in form of Project Financing, which is a specific contractual form that does not require any payment from the local authority because the private provider directly finances the asset and will be ex-post refunded through the imposition of a tariff on the final users, while rarely the contractor is financially supported by the public partner’s contribution.

In order to test this hypothesis in an econometric way they built a unique data set

referred to provincial level:8 it includes the most relevant information related to

PPPs published by local authorities, the final balance data and their principal socio-economic, demographic and geographical indicators. Finally they estimate the relation between the number of published PPP tenders and a set of exogenous variables concerning the potential demand of and supply for PPPs (for example, per-capita GDP and fixed investments for demand, infrastructural endowments for supply) focusing on the motivation behind the adoption of such investments.

The OLS regression model shows the relevancy of the local finance situation in explaining the decision to use PPP, and at the same time, the lack of a strong correlation between this strategic choice and the existence of an infrastructural gap. So what emerges from their analysis is that, even if a correlation between the use of PPP and an infrastructural gap actually exists, the infrastructural stock loses importance as the crucial determinant able to explain the using of PPPs in favor of local finance situation.

So empirical results suggest a positive answer to our first question: it’s seems plausible that Public Private Partnership may be used to pander to public opinion. Moreover they give us an hint for a positive answer also to the second question: given the difficulty to contract PPP projects, if the main reason to contract is the need to invest into a long term public service bypassing the financial constraint, it may be possible that the decision maker who decides to contract does not take into account the possible inefficiencies that may arise when he will not be in charge anymore.

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Starting from these hypothesis, we will build a three stage model where a local politician who is in charge in the first period must choose among three different public good provision projects that have a three periods duration: two of them, a big one and a small one, are provided in house by municipalities, both with proper employee or with a traditional private contract, the big project may also be contracted with a Project financing and paid by users through a tariff.

Politician in charge can be reelected at the end of the first period, facing an election against a challenger, but, if reelected, he is obliged to retire at the end of second period, so at the second election there will be two challengers.

We will show that when voters have a smaller knowledge than politicians, in our case they cannot infer the consequences of the contracts in the third period, politician in charge may choose a Public Private Partnership contract in order to avoid a financial constraint, even if there is an high probability that in the third period the contract will lead to an increase of tariffs, free riding on the politician that will be in charge in the third period, who probably will suffer the political consequences of the choice.

We then present a numeric analysis to highlight the importance of the probability to be reelected on the strength of the politician’s incentive to pander.

In order to obtain more general results we then built an extension of the model where we relax the assumption of homogeneous income among voters. We will show that, due to different methods through which projects are financed, income distribution modifies the incentives for politician to pander, reducing the incentive when PPP is not the optimal choice, as we highlighted in the initial model, but creating an opposite incentive for politician when on the contrary PPP would be the optimal choice.

This work is structured as follows: in Chapter 2 we discuss the public choice issue, focusing on the main features of the theory, presenting a brief literature review and introducing how we will use these issues in our model. In Chapter 3 we discuss much in details the Public-Private Partnership, presenting several

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papers that analyze many contractual issues of this kind of contracts. In chapter 4 we build a model and show the results when a boundary budget constraint is imposed. In Chapter 5 we present the model’s extension. In Chapter 6 we summarize our conclusions.

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CHAPTER 2

Electoral Competition and Political Accountability

Accountability is an English world, which does not have a proper translation in Italian, and that state the necessity for decision makers to respond to citizens for their decisions, which, in representative democracies, usually results to be the need to run through elections to be confirmed in charge.

Representative democracy is the standard form of government of modern states: even if in every Constitution are maintained elements of direct democracy, usually in the form of referendum, and some decisions are demanded to non accountable officials, the main decisions are taken by accountable officials. This allocation of decisions-making power, even affected by structural limits and drawbacks, has proved to be the best balance between citizens’ rights to decide and the need to take decisions in reasonable time intervals ensuring at the same time a sufficient expertise.9 Direct democracy may gives more power to voters but it also presents many serious drawbacks: it turns to be costly in term of time, it is likely to give rise to strong political instability and moreover it seems quite difficult to organize a stable direct democracy system involving million of voters.10 Furthermore public policy decision usually involves very specific and technical issues and requires lots of information: such a degree of knowledge cannot be owned by a single voter. Politicians on the contrary have access to much more information than voters and are supposed to have a better knowledge about bureaucratic function of government; hence they should be able to take better decisions than voters with direct democracy.

9_{Maskin and Tirole (2004) study exactly the decision-making power allocation problem comparing three}

different possible allocations: direct democracy, representative democracy and judicial power; for each of them they look for conditions in which it would be the best allocation system. Their more interesting results are that ceteris paribus the most important decision should be taken by elected rather than non-accountable, which conversely should take technical decisions.

10_{The debate on this last claim is increasing thanks to new technologies, which in the opinion of many}

experts would allow to avoid most of the organizational problems of direct democracy systems implementation.

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Elections therefore are the unique way in which voters can express their judgment about politicians’ work and, as a matter of fact, are the only way through which they can decide public policies. In this framework accountability is a fundamental requirement for the proper functioning of the system since it generates two principal benefits, which after all are two side of the same coin. On one side elections allow voters to remove those officials who are not congruent with public interest, or at least non congruent with the interest of the majority of voters, while on the other side elections may induce officials to act in the public interest. However accountability presents also some serious drawbacks: first of all the possibility to remove officials from office through elections may give the majority too much power with the risk of damages for minorities’ rights; a second, and more relevant for our purposes, drawback is that politicians may care more about their reelection possibilities rather than Social Welfare, so they have incentive to choose an action not because they consider it right for society but just because it’s popular; that is politician may “pander” to public opinion in order to increase his reelection chances. Actually this is a very awkward point because while some scholars speak about “pandering” others consider this behavior “responsiveness”. The debate is still open: on one side the dominant view is that, quoting the delegate George Clymer, “a representative of the people is appointed to think for and not whit his constituents”, that is representative democracy is a system in which voters delegate their representative without any binding power on their operate;11 on the other side in many countries, such as Italy, the abuse of this right has brought to parliamentarians who often change side during a mandate bringing to continuous political instability,12 leading in public opinion to a growing feelings against unaccountability during the mandate. Nevertheless for the purposes of this work we will share the view of delegate Clymer, firstly because it’s the current mainstream view and anyhow

11_{All modern democracies are founded on this principle: for example the Italian Constitution explicitly}

prohibit imperative mandate (Cost. Art 67).

12_{In Italy the phenomenon led to a creation of a specific word: “Trasformismo”. Even if at the beginning}

had a neutral acceptation, during years it has become such a common practice that even the word assumed a derogatory meaning, referring to every practice used to secure a parliamentary majority through lobbying, compromises, clientelism, losing any ideological consistency with the party line.

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because we believe that “responsiveness” cannot justify any kind of decisions and that somewhere a threshold should exists.

Considering the other way round even voters’ behavior may induce pander choice from politicians: they may use their electoral power to induce politicians to favor their interests without any regard of the Social Welfare. Since usually a single voter cannot exert a great influence on politician’s behavior, there exists an incentive to act together in order to give more strength to their claims: these institutions are the so-called interest groups. They are of various kinds and they undoubtedly have a great influence in public decisions: for example they can request a specific policy both with a direct effort in favor of the required bill, for example rising public opinion, both with an indirect pressure on politicians trying to bring to bear their electoral influence. The stronger are influence and power of the interest group the higher is the probability to obtain a positive result on their claims; for these reasons interest groups are usually thoughts to be stronger at

higher government’s level.13

Nevertheless the incentive to pander can be particularly strong at local levels. First of all because proximity between politicians and voters creates a close contact between them; a contact that increases voters’ expectations about solutions of problems that touch their immediate interests. Secondly because at local levels politicians are usually required to implement a restricted set of projects, a set that can be easily recognized and evaluated by voters.14 The electoral need to comply voters’ expectations on these projects may has a much bigger importance than the overall social welfare, hence politicians are encouraged to overspend on those projects damaging other crucial sectors and public finance.

13

Nevertheless it should not be underestimated the influence of local interest groups, which may be less organized and even extemporary but can make the difference, especially in election competition.

14_{At local municipalities level, for example, voters’ judgment on mayor’s work often depends on few}

public projects that are considered particularly relevant by citizens, and a failure in these objectives often damages irreparably the entire mandate, regardless of all others results.

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Before introducing our specific issue we present a brief literature review which presents many works that concerns issues similar to objects of this thesis and that have inspired the dissertation.

2.1 Related Literature

Literature on electoral competition, accountability and pandering possibilities is constantly increasing, facing many issues; most of this literature is based on the modern Public Choice Theory approach.

Modern Public Choice Theory was born in 1962 with the publication of the work of James Buchanan and Gordon Tullock "The Calculus of Consent". Logical

Foundations of Constitutional Democracy: in this book they laid the theoretical

foundations required to take into account the presence of agents involved in

public choice issues.15 Concretely they release the classical “Social Planner”

assumption in favor of models characterized by the presence of politicians, bureaucrats and voters, all of them presented as rational, egoistic, utility maximizer agents. Besides the result obtained by Buchanan and Tullock, their main contribution was the new theoretical approach they introduced. The theory has been widely developed by many scholars, including more specific areas of

interest.16 The Public Choice Theory approach will be used in this work to model

the agent’s behavior.17

Starting from voters’ influence many studies have been proposed about the interaction between interest groups and decision makers: Velasco (2000) analyzes a situation in which a “weak” government is influenced by different interest groups that set net transfers on each group’s target item enjoying “common access” to government resources. This situation leads to a result quite

15_{Buchanan was awarded the Nobel Prize in 1986 for his contributions on Public Choice theory.}

16_{Several Public Choice scholars were awarded the Nobel Prize including George Stigler (1982), Gary}

Becker (1992), Vernon Smith (2002) and Elinor Ostrom (2009).

17

An important field of research that we do not consider in this work studies the role of bureaucracy: the basic idea is that bureaucrats are able, through the information advantage they have, to influence the decision making processes in order to obtain personal benefits. One of the most famous contributions in the study of this phenomenon was proposed by William Niskanen in 1971 with the famous book

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similar to the “tragedy of the commons”: transfers are higher than a Social Planner situation, fiscal deficits emerge even without intertemporal smoothing reasons and in the long run government debt tends to be excessively high. Wolton (2013) focused on lobbying activity exerted by special interest groups, which are in favor or against a government’s bill: his work highlights the importance of pressure that comes from groups to through a combined action of inside and outside lobbying activity. He shows that a government bases his policy decisions on the probability that pro and against interest groups engages in outside lobbying activity, therefore different strengths of interest groups lead to different possibilities to influence government’s decisions.

A research steam closer to our analysis is the microeconomic study of politicians’ behavior in presence of electoral competition, and incentives to pander to public opinion. Many works could be found on this topic, each of them concerning on a different side of this issues.

Panova (2009) investigates the consequences of nonbinding campaign talk for elections on public policy: she builds a model with successive elections in which candidates use campaign talks to signal their policy intentions, and she shows that, while campaign talk increases voter information about political intentions, they may also generates inefficiencies in public policy choice of the elected; an interest side result of her work is that limits to individual career devalue campaign talks. Dewatripont and Seabright (2006) argued that politicians often choose wasteful projects, namely ones that generate real benefit to their host economies but at a disproportionate investment cost, not because there is a lack of accountability but exactly because of accountability: in other words politicians finance projects that are wasteful as a way to signal their diligence and voters rationally reward them for this.

It is widely argued in literature that one of the main incentives for politicians to pander derives from the asymmetric information situation between them and voters. In this regard a phenomenon similar to pandering process has been studied by Morris (2001) where an informed advisor is supposed to provide

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information to an uninformed principal with the same preferences, which actually is a situation very close to the politicians-voter interaction. He shows that, despite the same preferences, the advisor may avoid conveying his information truthfully if doing so might compromise his reputation with the principal. Canes-Wrone, Herron and Shotts (2001) analyze conditions under which a reelection seeking official will act in the public interest: they characterize an executive’s policy choice when his private information suggests that a popular policy option is not truly in the public interest, they find that pandering depends on the strength of the challenger and on the probability that voters will learn if he chose the correct policy before the election, however they also show that election may encourage other deleterious behaviors. Maskin and Tirole (2014) develop a model of pork-barrel politics used by a government’s official to pander in order to improve his reelection chances and analyze the effects of such policies on public deficit. Pandering approach captures the idea that politicians like to signal that they stands for individual interest groups’ interest. An interesting result is that on one hand politicians like to distribute pork, generating excess public spending while on the other hand their desire to appear fiscally conservative provides an incentive to limit pork. In this paper Maskin and Tirole also show that budget or indebtedness caps, which are commonly used in EU and US, curb pork policies but also reduce the provision of public good and moreover create incentives for politicians to shift expenditures off-balance-sheet even increasing total spending.

2.2 Implementation into the Model

As we said before, our purpose is to capture the incentive to pander for a politician in charge in a local municipality who faces two kinds of constraints. The first is a political one, since there is a limit to his career: any officer can be in charge only for two consecutive mandates, hence politician in charge in the first period can be reelected only once, and then he will be for sure substituted. The second constraint is an economic one: at a certain time he will face an expenditure cap which will rule out some investment possibilities.

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In our model there are only two kinds of actors: politicians and voters.

Politician in charge at the beginning of the period, let’s say the official, has to decide the kind of public good investment among the three available; following Maskin and Tirole (2004) the official is supposed to have a perfect knowledge of the future and he is moved by two key factors:

 The desire to leave a legacy. Politician wants to be remembered for great

things done during his mandate: in our framework we will assume that this legacy coincides with the Social Welfare that his choice generates.

 The interest to stay in office for its own sake.18 We can think to this both

in terms of prestige and power, both in terms of economical benefits: in our model this benefits will sum up into a constant term R, as a matter of fact we are supposing that every politician gives the same value to benefits

deriving from remain in office.19

The difference among politicians lies in the relative weight that each of them gives to these two motives. To model this differences in preferences we will use

a constant returns to scale where the

coefficient represents the relatively weight that politicians assigns to Social Welfare, while represents the relatively weight assigned to their interest to stay in office.

Voters are standard rational and self-interested agents who evaluate in each period policy as a difference between the benefits they receive and the cost they pay; in the first formulation of the model we will assume a representative voter with a fixed income. What characterizes this model is that voters are biased in the long run policies evaluation: effectively we assume that they can foresee only one period in the future, so when they have to choose whether or not to reelect the official they evaluates only the first and the second periods. This assumption reflects the idea that voters do not have enough information in order to evaluate a

18_{The desire to hold office is a commonly assumed motive in the political economy literature: first}

examples can be found in Roberto Barro (1973) and John Ferejohn (1986).

19_{This is quite reasonable for the economical benefits its more debatable for the evaluation of prestige}

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long-term investment, indeed if we assume that a period correspond to an electoral mandate, which lasts five years, this assumption seems quite reasonable.

In the extended model we will relax the representative agent assumption, we then characterize each voter’s through his share of total income and so, since each voter will vote for the reelection if and only if his utility is maximized, the possibility to be reelected will depend on the share of voters satisfied by the politician’s choice

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CHAPTER 3

Public-Private Partnership

Public Private Partnership is a contractual form that bundles finance, construction and operation into a long-term service contract between the government’s procurement authority and a private firm. For the duration of the contract, which can be as long as twenty or thirty years, the concessionaire will manage and control the assets, usually in exchange for user fees, which are its compensation for the investment and other costs. At the end of the franchise, the project reverts

to government ownership.20 Under traditional procurement, on the contrary, the

government deals directly with financiers, builder and the operator: the project is financed with public debt and budget appropriations; a government agency hires the builder and then the operator with separated contracts.

The basic claim is that Public-Private Partnership offers many important incentives since it allows government to benefit from private firms’ innovative solutions for providing additional and more valuable public services. The main incentives offered by Public-Private partnership are task bundling and risk transfer.

 Bundling: a PPP usually requires to bundle design, building, finance and

operation of the project, which are contracted with a single private company: this should allow the contractor to choose the most efficient investments reducing his incentives to free ride over the public procurer, or over others contractors.

 Risk transfer: PPP usually requires a greater transfer of risk to the

contractor than traditional procurement. Usually the government specifies

20_{There are several definitions for “Public-Private Partnership”. In this work we follow the definition}

given by Engel, Fischer and Galetovic (2013): an infrastructure project such that (i) assets are controlled by a private firm for a term; (ii) during the duration of the contract, the firm is the residual claimant, while the government is the residual claimant at the end of the concession. However, these claims are ambiguous due to contract incompleteness; and (iii) there is considerable amount of public planning in the design of the project.

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the service and the basic standards it requires but leaves to contractor control rights and responsibility over how to deliver the service. Provided that design, construction and operational risk are usually transferred to the private sector

Given these incentives the use of Public-Private Partnership to replace the provision of public goods has constantly increased over time. PPPs are being used across Europe, Canada, the United States and an increasing number of developing countries, as a part of a general trend of an increasing involvement of the private sector in the provision of public good services. PPPs have traditionally been used in transportation, energy, and water, but their use has recently been extended to other sectors that traditionally were strictly provided by government such as: accommodations, prisons, military training, waste management, schools and hospitals. In Europe the PPP approach was introduced by the private finance initiative in 1992 in the United Kingdom: by 2009 approximately 800 PFI projects have been signed for a capital value of 64 billion. Other European countries also invested in PPPs especially France, Portugal, Spain and Italy: from 1990 to 2009 more than 1300 PPP contracts have been signed in the EU, representing a capital value of more than 250 billion, and they are spreading in Latin America, Caribbean and East Asia.

Despite this worldwide growth evidence on PPP performance remains mixed: for example while PPP in UK seem to bring cost saving, improvements in completion time and cost delivery compared to traditional procurement, in many other cases PPP has brought exactly to opposite results: deadlines are often not met, projects require substantial subsidies to be finished while sometimes contracts are renegotiated in favor of the contractor. One of the main reasons for these conflicting results may be that profitability of Public-Private Partnership projects is subject to large exogenous demand uncertainty, which is often not properly considered when designing the contracts, explaining why renegotiation takes place when demand is lower than expected, as well as the array of risk sharing agreements that are observed. This often happens because Public-Private

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Partnerships are not always driven by efficiencies concerns but may be used in order to relieve strained budgets and release public funds: this is a common

opinion among practitioners and governments.21

3.1 Literature Review

Literature on Public-Private Partnership is constantly increasing in recent years, due to the wider and wider diffusion of the use of this innovative instrument.

Since Public Private Partnership involves many phases of a project in a single contract, many different issues are present; hence there are many different approaches to study this phenomenon. We have already talked about Russo and Zampino (2012) and their results on the incentives to an opportunistic use of Public-Private Partnership to face periods of financial constraints rather than an efficient option to invest in public goods. In this section we present a brief literature on PPPs where the main contractual issues, such as bundling incentives, risk transfer and financial aspects, are discussed with less attention to the

political economy side.22 The most common approaches in these papers are moral

hazard and asymmetric information models, since they are able to capture the main aspects that differentiate traditional provision and PPP and that, given such conditions, generate incentives to choose one contractual form or the other.

An interest attempt to formalize the incentives for chooses PPP instead of traditional procurement have been made in Hart (2003). In this work he stated that issues of vertical integration and privatization have much more in common than not, since both are concerned with whether is better to regulate a relationship via an arms-length contract or via a transfer of ownership. So he developed a simple incomplete contracting model to analyze Public-Private Partnership, highlighting a trade-off between bundling and unbundling: under unbundling the builder does not internalize neither the social benefit neither the

21

“The boom is good news for governments with overstretched public finances: many local and national authorities have found themselves sitting on toll roads, ports and airports that they can sell for billions of dollars to fund other public services” Financial Times, July 5,2007.

22_{Even if some interesting hints for political economy are given, particularly in Engel, Fischer and}

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operating cost, while under PPP the builder internalize the operating cost but not the social benefit. This trade-off suggests that choice between PPPs and conventional provision turns on whether it is easier to write contracts on service provision than on building provision: when the quality of the service can be well specified in the initial contract while the quality of the building cannot be, PPP is the better choice, when conditions are the opposite conventional provision performs better than PPP.

Recently many scholars went deeper in the analysis of contractual issues, broadening the horizons of possible incentives and developing models that are much more formalized than the one built by Hart. Engel, Fischer and Galetovic (2013) focus their analysis on two main issues: firstly the structure of the optimal risk-sharing contract between government and concessionaire when there is exogenous demand risk and second the impact of PPPs on the government budget. They build a model where government contracts a risk adverse firm to build, operate and maintain an infrastructure project. In their opinion PPPs cannot be justified because they free public funds, while when are justified by efficiency issues, the contract that optimally balances demand risk, users fee distortions and the opportunity cost of public funds, features a minimum revenue guarantee and a revenue cap. They also state that, as far as the risk profile of the government‘s budget constraint in concerned, PPPs are much closer to public provision than to privatization, because from a public finance perspective there is a strong presumption that PPPs are analogous to public provision, because in essence they remain public projects, they should be treated as such. Another perspective can be found in Iossa and Martimort (2015), where, starting from the existing literature, they analyze the main incentive issues in PPPs and the shape of optimal contracts. They build a model of procurement and then consider under which conditions bundling of projects phases is optimal, focusing on the existence of positive and negative externalities across different stages of the project, and on the role played by risk transfers, which is a factor strictly related with bundling. After these main features they extend the analysis of PPPs in presence of many other factors such as: private finance, incentives for

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investments over the length of a long-term contract in presence of pervasive uncertainty over future demands and costs, the effects of institutional environment on contracts design and on incentives. Their results suggest that PPPs may be unsuitable in a variety of more complex circumstances and this coherently with many empirical results.

Moreover there exists an interesting empirical literature on PPP, which tries to confirm the theoretical previsions both studying real cases where PPPs were implemented successfully or where they led to failures, both through cognitive experiments, where attendees are required to play games that reproduce situations of public good provision. An example of the former case is Engel and Galetovic (2014), where they analyze the possibility to apply a Public-Private Partnership to deal with cities’ lack of funds to maintain and expand streets and urban highways: they present a study case of a successful implementation of Public-Private Partnership through which a 225 kilometers system of urban highways was built in Santiago, Chile’s capital, between 2000 and 2008. A very interesting example of the latter is instead Hoppe, Kusterer and Schmitz (2013). Following Hart’s initial contribution they consider a stylized model focusing on the incentives generated by the two different modes of provision and designed an experimental study to test the robustness of their theoretical outcomes. Their experimental results offer a strong support for the theoretical predictions: PPP induces very strong incentives to invest in cost reductions, which may be positive if the investments are also quality-enhancing, but may well be undesirable if, on the contrary, they have a negative side-effect on quality: under traditional procurement conversely incentives to invest are weak, both for quality increasing and quality decreasing investments. In addition they extend the analysis considering two subcontracting treatments: once more finding experimental support for the theoretical predictions.

An almost unique contribution to the literature was offered by Maskin and Tirole (2008) were they explicitly study Public-Private Partnership as an instrument for pork-barrel politics. They model a situation where a public official may have

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preferences that differ from those of a social welfare maximizer, more specifically for some reason he may have the incentive to favor the “pet” projects of particular interest groups, namely to practice pork barrel politics, even if that project may not be justifiable from the stand point of Social Welfare. Since politicians use PPP to underestimate the future costs of pet project, they derive the optimal accounting rule in order minimize the official’s incentive to understate the costs of his pet projects. When considering also the possibility of traditional procurement they discover that even if unbundling reduce the public accounts of forward information about future costs it reduces the possibilities for the official to favor the contractor by funneling him some hidden future rents.

Even if both their purposes and their model are different from ours, this paper can be considered an inspiration for our work, which can be seen as a further step

in the research field they opened.23

3.2 Implementation into the Model

Following Maskin and Tirole (2008) we will model our Public-Private Partnership as a simple three period length Project financing where the investment produce in every period a benefit and a cost , which are constants in every period. The difference with the project financed in house is that in the third period, the more distant in time, the cost is not certain: there is an exogenous probability that the PPP projects costs are lower than in house choice, while with probability the PPP project is not sustainable in the long run, hence there will be an increase in cost in the last period.

This variation in costs may be justified by the consideration that there exists the possibility that the contractor will perform better than the in house provision, both in case of direct provision from the local authority both in case of traditional contracting with private firms. If the bundling of phases into a PPP produces efficiency gains, there will be a cost reduction, and so to a users fee reduction;

23_{Actually Maskin and Tirole themselves proposed the introduction of electoral accountability as an open}

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the other way round if the private contractor perform worse than the in house provision, there will be a cost increase, hence a users fee increase. The reason for which this may happen only in the third period is that we assume that in the first two periods the contract cannot be renegotiated so any change in costs situation

could be engaged only in the last period.24

Since we are not interested in the dynamic of the Project we do not even present the contractor behavior: we will simply assume that a Project financing is

available with a private contractor. The annual cost of the investment is

financed by the contractor through a constant tariff applied to users, and that in the third period the variation in costs reflects directly in the users fee, so with

probability the tariff will decrease in the third period while with

probability the tariff will increase.

24_{The renegotiation usually takes place after many years from the beginning of the project, so once again}

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CHAPTER 4

The Model

In this chapter we present a formalized model of public good provision by a local authority ruled by a politician in charge where different investments, included a PPP, are available.

In the first section we present a benchmark model built as a game setting time structure, players and possible actions, then we derive the optimal choice for a hypothetical Social Planner and we compare it with the one of the politician in office.

In the second section we impose an exogenous spending cap that limits politician's choices, highlighting conditions under which politician in office may have the incentive to choose an investment that does not maximize the Social Welfare but maximizes his reelection chance.

In the third section we will give some hints on the importance of the probability that the politician will be reelected in any case, highlighting the importance of “ideological vote”, through a numerical simulation of two possible cases.

In the last section we summarize the main results of the chapter.

4.1 Benchmark Model

We formalize the model as a Game with a precise time structure, two set of players and a set of possible actions available for politicians

4.1.1 Time Structure

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Each period can be considered as an electoral mandate,25 and has a beginning

in and ends in 26

Overall, the sequence of actions is as follows:

1. At the beginning of first period, the politician in charge has to choose how to supply a public service.

2. At the end of first period, namely politician in charge runs for an election against a challenger.

3. At the end of second period, , there is another election between two challengers because each politician can be in charge for a maximum of

two consecutive mandates.27

4. In the last period the winner is in charge, while the former official is supposed to be retired.

25_{For example if we suppose to analyze the case of an Italian local municipality, each mandate lasts for}

five years.

26_{For example}_{begins in and ends in , while}_{begins in and ends in .}

27_{This is a very reasonable assumption, since most of the political systems where the decision maker is}

directly elected by voters set limits to consecutive mandates: in Italy for example this is exactly the rule for elections of mayors, and also for many Regions’ Presidents.

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4.1.2 Players

Society in composed by a number of voters equal to , which is constant in

every period.28 At the beginning of the game each voter has a fixed yearly

income and preferences defined by a linear Utility Function that depends on

benefits deriving from public good provision by local authority and the

amount that he has to pay for this provision in each period, we also assume

no discount rate.29

(4.1)

is the sum over the only first two period since we assume that voter, because of his lack of information and expertise, is not able, at the end of the first period, to

foresee the expected situation of the third period; hence at the end of he takes

his electoral decision evaluating the policy only with respect of and .

This specific assumption may seem odd, and for sure is not usual, but if we consider each time interval as an electoral mandate, as we are doing in this model, it is perfectly plausible that, when they have to decide whether or not reelect the politician in charge, voters’ judgment is biased only to past and

immediate future periods.30

Furthermore we assume that, when voters have to decide whether or not reelect the politician in office, if their utilities are maximized they will for sure vote for the politician in charge, otherwise some of them will keep voting for the

politician in charge while some others will vote for the challenger.31

28_{Even if this is a simplifying assumption we can imagine that the growth rate of population is equal to}

zero, so the number of voters remains constant. This assumption is not unreasonable in European countries and especially in Italy where the growth rate of population is around zero, with the exception of immigrants, who however usually do not have voting right.

29_{Still following Maskin and Tirole (2008).}

30_{The same result can be obtained by imposing a discount rate that tends to zero in the third period.}

However this assumption, in addition to slightly complicates calculations, in our opinion is better to catch a lack of interest for the third period rather than a lack of awareness about it.

31_{Of course it is not plausible that everyone vote for the politician in charge, but this guarantees that if}

voters' Utility is maximized, official is sure to be reelected. The same would be true with the assumption that if is maximized the majority of voters will vote for the official.

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The local authority, at the beginning of the game, is governed by a politician in office, who is driven by two different motivations. The first is the Social Welfare; two explanations can be given for this motive: the first is that he is an altruistic agent who sincerely cares about citizens; the second is that he wants to leave a legacy in order to be remembered. The second drive is his selfish interest to remain in charge, which can be taught to be a mix of economic benefits, personal prestige and power.

We define:

is Social Welfare evaluated as the difference between total benefits and total costs.

is benefit for being in charge, we assume it to be a constant term.

We describe politician's preferences through a

_(4.2)

Where:

is the probability to be reelected, and, as we said, we assume that when voter’s utility is maximized politician is sure to be reelected, hence is the relative importance that politician assigns to Social Welfare

4.1.3 Possible Investments

At time three possible investments can be chosen by the official: two of them are provided through n house projects while one is provided through a PPP.32

32_{In this work we do not distinguish between an investment directly provided by an institution through}

his own workers and an investment contracted to a private in the standard way because, despite their differences, they both require to be directly financed by government.

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1. A big investment provided in house, reported in the Public Balance

Sheet and financed by proportional income taxation, with rate in each

period.

2. The same big investment provided in Project Financing, out of the

Public Balance Sheet and financed by users fee .

3. A small investment provided in house, reported in the Public Balance

Sheet and financed by taxation.

Public investments produce an annual benefit , which is a public good, and

cause an annual total costs that will be divided among all voters.

 gives an annual benefit and generates an annual cost both constant in

each period.

 gives an annual benefit and generates an annual cost both constant

in every period.

 gives the same benefits of and generates the same costs in the

first two periods while in the third period it generates an expected cost

, where

.33 (4.3)

As we stated in chapter 3 the idea of assumption (4.3) is that, while in the first two periods the contract is not negotiable, so costs are fixed, in the last period

two scenarios are possible. With probability the private firm running the

project performs better than the public agency, leading to lower cost, while with

probability the private firm performs worse than the public agency, leading to

greater cost.

We summarize benefits and costs of every project in the following table:

33

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We now introduce a very specific assumption on Public Balance Sheet requiring that in each period it must be balanced in case of in house provision, as well as the Balance Sheet of the private contractor should be balanced in case of PPP. While this assumption is normal for private firms, it is not usual for governments, because usually government is allowed to use Public Debt in order to shift payments. However if we restrict our analysis to local authorities this assumption is perfectly plausible because the new rules of Public Accounting for local authorities are now much more strict in budget control, requiring a perfect balance between expenditures and revenues.

We assume that in house provision is financed by local authority through

proportional income taxation with rate for each period, while the PPP project

is financed by the private contractor through users fee 34 For sake of

simplicity we assume that each voter pays the fee.

That is: (4.4) Which can be rewritten as

_(4.5)

Notice that by exploiting assumption (4.5) we can obtain two useful simplifications

34

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 In case of in house provision the assumption of constant costs throughout

each period implies that: which implies that the

required revenues in each period are constants. So taxation rate is constant over periods:

(4.6)

 In case of project financing our assumption on costs implies that in the

first two periods we have constant costs: and hence a

constant users fee

(4.7)

However, because of assumption (4.3), in the third period two possible

costs may occur , hence two different user fees are possible

(4.8)

4.1.4 Social Planner Solution

If we were in a Social Planner situation, he would decide which investments

form is better simply evaluating the Social Welfare as a simple difference

between benefits and total costs, and then choose the policy that . In this case the values of Social Welfare in the three different cases are:

(4.9)

Now we assume, for sake of simplicity, that:

35 _(4.10)

Which implies that:

35_{A plausible explanation for this assumption may be that building the asset and then run the service}

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(4.11)

Given assumption (4.10), strictly dominates so we can easily rule out

from the game, reducing our decision problem to a simpler comparison between

and .

So in this case

(4.12)

Now by exploiting equation (4.12) we obtain that implies that

which is true if and only if it holds the condition

.

Summarizing the results:

(4.13)

The optimal choice depends on the value of , which after all is a very intuitive result: the higher is the probability that the private contractor perform better than the local authority the higher is the incentive to choose a PPP investment, and the other way around.

4.1.5 Incentive to Pander

In our model on the contrary there is no Social Planner but there is a politician in charge. Therefore there could be a trade-off between the legacy and selfish motivations that may gives rise to an incentive to pander. Politician can chooses between the investment that maximizes Social Welfare, which will be optimal in

the long run, and the investment that maximizes voter's , which may not

be optimal in the long run but will ensure him to be reelected.

In order to analyze the existence of this incentive we rewrite equation (4.1) exploiting our assumptions on costs and financial rules in order to substitute the individual cost :

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Then we can note that can assume two values depending on the kind of investment.

(4.15)

Now recalling that tax rate and users fee are fixed for values equal to and .

(4.16)

We can now substitute τ and by exploiting equation (4.5) and obtain voter's for both choices.

(4.17)

In this case both investments maximize voters' , hence they are indifferent between the two possibilities: politician cannot pander to increase his reelection chances and so he simply chooses the Social Welfare maximizing investment.

Indeed, we recall equation (4.2) and notice that both choices maximize voters’ , hence in both cases, therefore . Politician’s maximization problem is exactly the Social Welfare maximization problem so results are exactly the same of the Social Planner situation, hence equation (4.13) still holds.

So whatever is the politician's choice, at the end of he will run for the election against a challenger and will be reelected.

4.2 Imposition of a Spending Cap

Let us now suppose that a balance sheet spending cap is imposed by National Government: due to this cap the big in house investment is not affordable

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anymore and the local authority can implement in house only the small project.36 The only option left to afford the big investment is the Public-Private Partnership project.

Due to this new situation we rule out the investment from the available

choices of politician in our game, hence the only possible actions left are the PPP

project and the small in house project .

Summarizing the investments still available we have:

With their associated levels of Social Welfare

(4.18)

Now, recalling the assumption (4.10) two main propositions are true:

 We already know that equation (4.11) holds

 It could be proved that 37 _(4.19)

4.2.1 Incentive to Pander

So when we compare these two investments in terms of Social Welfare three cases are possible:

1) (4.20)

When the probability that private contractor performs better than local authority

is sufficiently high, is the choice that maximizes both Welfare and voter's

36_{For example, considering the Italian case, local authorities must respect the well known "Patto di}

Stabilità Interno" decided by the Central government

37 _{requires that which is true if and only if .}