Intragenerational Redistributive Policies Advanced Political Economics Fall 2011 Riccardo Puglisi
Main Questions Why does Redistribution take place? Why do different countries feature different welfare states? How does Redistribution affect Growth?
Redistribution as transfer of resources Ø Government Expenditure: Welfare State (Transfers), Consumption, Investments Ø Taxation: Direct taxes (Labor and Capital Income, Corporate taxes), Indirect, Contributions Ø Regulations: Labor market, Goods market, Financial market, Trade policy Ø Government Production: State owned firms Ø Other Public Goods: Defense, Legal system
Size of the Government: Expenditure Source: Author’s calculation from OECD Economic Outlook Database (No. 71, Vol. 2002 Release 01) June 2002
Size of the Welfare State Expenditure on GDP
Economic Approach Government Intervention because of “market failures” Ø Public Goods (non-rival in consumption, non-excludible), [e. g. light house, parks, railroad, legal system, defense] Ø Externalities [e. g. pollution] Ø Natural Monopoly [e. g. energy providers] Ø Asymmetric information Ø Adverse Selection [e. g. health care] Ø Moral Hazard [e. g. health care, insurance provisions] ØEquity considerations Ø Paternalistic view
Political Economics Approach Ø Our focus: Welfare State and Labor Market Ø Lines of redistribution: Ø Income: Rich and Poor Ø Age: Young and Old Ø Employment Status: Insiders and Outsiders Ø Factors of production: Labor and Capital Ø Other lines: small but protected interests (taxi, small retailers)
Citizens Opinions: Welfare State
Intragenerational Redistribution General Transfer IDEA: Agents differ in their income. The redistributive system consists of – a Proportional Income Tax (t) – a Lump-sum Transfer (T) Political System to aggregate Individual Preferences Redistribution from the Rich to the Poor LIT: Romer (1975), Roberts (1977), Meltzer and Richard (1981), Krusell and Rios-Rull (1999)
A Simple Economic Model Ø Static economy: one period Ø Economic Agents work and consume Ø Agents are Heterogeneous in their working ability (e) Ø Time constraint: 1 + e = l + n Effective disposable time Leisure e [el, eu] el < 0, eu > 0 e ˜ G (e) E (e) = 0 Work Average Ability
A Simple Economic Model G (e. M) = 1/2 Distribution of Ability Median Ability e. M < 0 Median < Average Poor Rich el e. M E (e) = 0 eu e
A Simple Economic Model Ø Selfish Preferences Ue = c + V (l) V is increasing and concave, with V(0) = 0 Ø Budget Constraint c = (1 - t) n (e) w + T with w = 1 Ø Time Constraint 1+e = l + n Ø Government Budget Constraint T = t E (n(e))
How does this Redistributive Policy work? • Assume that everybody works “full time”: ne=1+e, l=0 – Tax Burden: t(1+e) – Transfer: T =t E(1+e) =t – Utility: since E(e)=0 Ue= c = (1 -t)(1+e)+T = = (1 -t)(1+e)+t Ue=1+e-te
Winners and Losers • Type-e Agent’s utility: Ue =1+e-te Winners: Poor (e < 0) -t e > 0 Losers: Rich (e > 0) -t e < 0 transfer t (1 + eu) contributions Losers t Winners t (1 + el) el e. M 0 eu
Economic Decisions and Distortions Ø Economic Agents choose how much to work: n(e) Ø Distortion: facing a tax they may decide to work less: lower production Max ØEconomic decision: l c + V (l) s. t. c = (1 - t) (1 + e - l) + T F. O. C. : 1 - t = V’(l) l(e)=V’-1(1 - t) 1 -t n(e)= 1+e- V’-1(1 - t) V’(l) l* l Distortion: t l* n* E (n* (e))
Welfare State and distortion Ø Government budget constraint: T = t E(n*(e)) T= t E(1+e-V’-1(1 - t))= t N(t) where N(t)=1 - V’-1(1 - t) Ø An increase in the tax rate, t, has two effects: – increase the government revenue – reduce the tax base and thus the revenue T LAFFER CURVE 0% t. L 100% t
Political decision Ø Voting behavior: every agent indicates the tax rate that maximizes her utility, given her economic decision: Max Ue (t) = (1 - t) n (e) + t E (n (e)) + V (e) Ø How agents vote depend on three elements: • Direct cost (tax burden): • Direct benefit (transfer): - n (e) E (n (e)) • Distortion: [t E(n(e)) / t]: t E (n (e))
Political decision
Political Equilibrium Ø Individual voting: Poor (e < 0) t > 0 Rich (e > 0) t = 0 [no redistribution] ØAgent’s votes can be ordered according to their type: poorer individuals vote for more redistribution Ø Preferences are single-peaked Median voter’s theorem applies Ø The equilibrium tax rate is the one voted by the agent with Median working ability
Results Ø In the political-equilibrium there is redistribution, since em < 0 t* > 0 Ø The amount of redistribution depends on the degree of income inequality – Income inequality is measured by the difference between Median and Average Ability ØMore inequality leads to more redistribution – If Rich agents become Richer More redistribution – If Poor agents become Poorer Less redistribution
Discussion Ø How does this theory compare with the data ? Ø Can theory explain the cross-country differences and the dynamics of Welfare State expenditure ? Early growth of welfare State may be also due to • extension of voting rights to poor voters • reduction in the cost of collecting taxes Recent growth and cross-country differences not well explained
Extensions Dynamic model: • Voting does not occur only once • Taxation affect Capital Accumulation and Economic Growth Krusell and Rios-Rull (1999) show that “Dynamic Distortions” lead to lower Welfare State Fairness: what if some voters are altruistic ? Intergenerational transfer: Income is not the only source of difference among agents
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