Intragenerational Redistributive Policies Advanced Political Economics Fall 2011 Riccardo Puglisi

Why does Redistribution take place? Why do different countries feature different welfare states? How does Redistribution affect Growth? Main Questions

Redistribution as transfer of resources  Government Expenditure: Welfare State (Transfers), Consumption, Investments  Taxation: Direct taxes (Labor and Capital Income, Corporate taxes), Indirect, Contributions  Regulations: Labor market, Goods market, Financial market, Trade policy  Government Production: State owned firms  Other Public Goods: Defense, Legal system

Size of the Government: Expenditure Source: Author’s calculation from OECD Economic Outlook Database (No. 71, Vol Release 01) June 2002

Size of the Welfare State Welfare State Expenditure on GDP

Economic Approach Government Intervention because of “market failures”  Public Goods (non-rival in consumption, non-excludible), [e.g. light house, parks, railroad, legal system, defense]  Externalities [e.g. pollution]  Natural Monopoly [e.g. energy providers]  Asymmetric information  Adverse Selection [e.g. health care]  Moral Hazard [e.g. health care, insurance provisions]  Equity considerations  Paternalistic view

Political Economics Approach  Our focus: Welfare State and Labor Market  Lines of redistribution:  Income: Rich and Poor  Age: Young and Old  Employment Status: Insiders and Outsiders  Factors of production: Labor and Capital  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 (  ) – 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)

 Static economy: one period  Economic Agents work and consume  Agents are Heterogeneous in their working ability (e)  Time constraint: 1 + e = l + n Effective disposable time Leisure Work e  [e l, e u ] e l 0 e ˜ G (e) E (e) = 0 Average Ability A Simple Economic Model

e Distribution of Ability elel eueu eMeM E ( e ) = 0 Poor Rich G (e M ) = 1/2 Median Ability e M < 0 Median < Average A Simple Economic Model

 Selfish PreferencesU e = c + V (l) V is increasing and concave, with V(0) = 0  Budget Constraintc = (1 -  ) n (e) w + T with w = 1  Time Constraint 1+e = l + n T =  E (n(e))  Government Budget Constraint

How does this Redistributive Policy work? Assume that everybody works “full time”: n e =1+e, l=0 – Tax Burden:  (1+e) – Transfer: T =  E(1+e) =  since E(e)=0 – Utility: U e = c = (1-  )(1+e)+T = = (1-  )(1+e)+   U e =1+e-  e

Winners and Losers Type-e Agent’s utility: U e =1+e-  e Winners: Poor ( e 0 Losers: Rich ( e > 0)  -  e < 0 eMeM elel 0 eueu   (1 + e u )  (1 + e l ) Winners Losers transfer contributions

Economic Decisions and Distortions  Economic Agents choose how much to work: n(e)  Distortion: facing a tax they may decide to work less: lower production  Economic decision: Max c + V (l) s.t. c = (1 -  ) (1 + e - l) + T F.O.C.: 1 -  = V’(l) l(e)=V’ -1 (1 -  ) n(e)= 1+e- V’ -1 (1 -  ) Distortion:     l*   n *   E (n * ( e )) l V’(l) 1 -  l* l

Welfare State and distortion  Government budget constraint: T =  E(n*(e)) T=  E(1+e-V’ -1 (1 -  ))=  N(  ) where N(  )=1- V’ -1 (1 -  )  An increase in the tax rate, , has two effects: – increase the government revenue – reduce the tax base and thus the revenue  T 0%100% LL LAFFER CURVE

Political decision  Voting behavior: every agent indicates the tax rate that maximizes her utility, given her economic decision: Max U e (  ) = (1 -  ) n (e) +  E (n (e)) + V (e)  How agents vote depend on three elements: Direct cost (tax burden): - n (e) Direct benefit (transfer): E (n (e)) Distortion: [   E(n(e)) /       E (n (e))

Political decision

Political Equilibrium  Individual voting:  Agent’s votes can be ordered according to their type: poorer individuals vote for more redistribution  Preferences are single-peaked  Median voter’s theorem applies  The equilibrium tax rate is the one voted by the agent with Median working ability Poor (e 0 Rich (e > 0)   = 0 [no redistribution]

Results  In the political-equilibrium there is redistribution, since e m 0  The amount of redistribution depends on the degree of income inequality – Income inequality is measured by the difference between Median and Average Ability  More inequality leads to more redistribution – If Rich agents become Richer  More redistribution – If Poor agents become Poorer  Less redistribution

Discussion  How does this theory compare with the data ?  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