Political Economics Riccardo Puglisi Lecture 5 Content: Welfare State: Redistributive Transfers Economic Model Winners and Losers Political Decision

Welfare State: General Transfer IDEA: Agents differ in their income. The redistributive system consists of a Proportional Income Tax (t) a Lump-sum Transfer (T) Redistribution from the Rich to the Poor LIT: Romer (1975), Roberts (1977), Meltzer and Richard (1981), Krussel and Rios-Rull (1999)

Effective disposable time Economic Model 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

Features of Working Abilities e [el, eu] el < 0, eu > 0 e ˜ G (e) E (e) = 0 Average Ability G (eM) = 1/2 Median Ability eM < 0 Median < Average Distribution of Ability Poor Rich el eu e eM E (e) = 0

Individual Economic Decision Selfish Preferences Ue = c + V (l) V is increasing and concave Budget Constraint c = (1 - t) n (e) w + T with w = 1 Time Constraint 1+e = l + n

General redistribution: The Welfare State General redistribution: tax rate t transfer T Government Budget Constraint T = t E (n(e)) Average Income

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 since E(e)=0 Utility: 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 + e) contributions Losers t Winners t (1 + e) el eM eu

Economic Decisions and Distortions Economic Agents choose how much to work: ne Distortion: facing a tax they may decide to work less: lower production Economic decision: Max c + V (l) s.t. c = (1 - t) (1 + e - l) + T F.O.C.: 1 - t =  V (l) /  l l 1 - t  V (l) /  l Distortion: t  l* n*  E (n* (e)) l l*

Welfare State and distortion Government budget constraint: T = t E(n*(e)) An increase in the tax rate, t, has two effects: increase the government revenue reduces the tax base and thus the revenue LAFFER CURVE t T 0% 100% tL

Max Ue (t) = (1 - t) n (e) + t E (n (e)) + V (e) Political decision 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) How agents vote depend on three elements: Direct cost (tax burden): - n (e) Direct benefit (transfer): E (n (e)) Distortion: [t  E(n(e)) /  t]:  t   E (n (e))

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)  t > 0 Rich (e > 0)  t = 0 [no redistribution]

Results In the political-equilibrium there is redistribution, since em < 0  t* > 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