DP7660 | Rational Crowd-Pleasing and Democratic Accountability

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Politicians frequently undertake projects whose budgetary costs are disproportionate to the benefits they create for the voters or shareholders those decision-makers represent. When they are not the result of simple random mistakes, such wasteful projects are often attributed to weak mechanisms of accountability, such as inadequate opportunities for voters to exercise oversight, or capture of the political governance mechanism by special interests. This paper argues instead that wasteful spending may be a by-product of the accountability of politicians to their voters, not a symptom of its weakness or absence. Specifically, we develop a model in which agents have to do two things: first, search for projects and secondly, screen them to decide which ones to fund. Funding projects that may be wasteful is a way for agents to signal their diligence, and principals who cannot observe project quality directly will rationally reward them for this provided the benefits of diligence exceed the expected costs of waste. We introduce mechanisms of value-for-money auditing and show how politicians and managers may publicly resist them while sometimes privately welcoming them; auditing may, however, weaken incentives for agents to exercise control of their own on project choices, since it now becomes less costly for them to signal diligence. We extend the model to show that the same politicians who are over-enthusiastic with respect to the funding of wasteful projects may also be too timid with respect to what we call "divisive" projects, namely those that impose localized costs even if they create generalized benefits; many economic reform policies have this character. We discuss implications for the auditing of public spending projects, and for controls on public expenditure such as those embodied in the European Union state aid rules, the subsidy provisions of the World Trade Organization, or the conditionality of loans from the World Bank and other international organizations. We also discuss analogies with corporate governance.