Abstract

Governments are expected to tackle externalities such as pollution, epidemics and environmental catastrophes, but whether and how governments themselves generate externalities is a question equally important for exploring socially beneficial policies and institutional reforms. The problem with defining government externalities is that governments, through regulation and distribution, inevitably allocate costs and benefits asymmetrically due to preference heterogeneity in society. This problem also concerns the rules and rights governing market transactions, blurring the boundaries between market failure and government failure. In this paper, I define government externalities as costs passed on us by government actions taken outside a decision-making system in which we participate as insiders. Views about what being an insider is differ. Some will be content with democratic citizenship in majoritarian decision-making processes. Others may subscribe to Buchanan and Tullock’s liberal and more demanding normative theory based on constitutional consent. In either case, I argue, there will be externalities generated by clientelism, namely informal deals between politicians and special interests for the distribution of benefits that occur outside, and in violation of, the formal norms of participation. These are complex externalities, infiltrating policymaking and distorting institutions governing the operation of markets too. They create government failure on the same grounds that some market externalities are considered market failure: (a) the costs fall on outsiders and (b) negatively affect the terms for the production and exchange of goods and services. Government externalities influence both governance and markets simultaneously and illustrate the limits of what institutional design can constrain or achieve.