Economic Integration and the Welfare State

Economic integration Increasing mobility of people, goods and factors of production institutions and policies through different channels. – Factor price equalization (e.g. Freeman) – Policy experimentation (e.g. Mukand and Rodrik) – System competition (e.g. Sinn)

System competition While competition among firms tends to be beneficial for the general public, this is not necessarily so for the case of competition among governments. Sinn (1997): ”Since governments have stepped in where markets have failed, it can hardly be expected that a reintroduction of a market through the backdoor of systems competition will work. It is likely to bring about the same kind of market failure that justified government intervention in the first place.” Ex1 Public goods financed by a mobile tax base Ex2 Redistributive taxation

System competition cont. Tax competition model formalized by Zodrow and Mieszkowski (1986), but topic in public finance for a long time: Break, 1967: “Active tax competition, in short, tends to produce either a generally low level of state-local tax effort or a state-local tax structure with strong regressive features”. Oates, 1972: “The result of tax competition may well be a tendency toward less than efficient levels of output of local services”. But welfare consequences of tax competition is not trivial… Brennan and Buchanan, 1980: ”The primary purpose of federalism … is to create competition between jurisdictions” Second best solution: Tax competition restrains a public sector that otherwise would have been too large.

Can the welfare state survive? The tendency to factor price equalization makes the income distribution in rich countries more unequal and increases the need for an active welfare state. But closer economic integration makes it more difficult to maintain the welfare state. – Each country has incentives to limit redistribution to avoid attracting net recipients and repelling net contributors. – In its most extreme form ’a race to the bottom’.

Openness and government size Rodrik (1998) empirically investigates the relationship between openness and government spending.

Openness and government size cont. This cross country relationship is robust to: – Including a set of control variables – Different measures of gov. Spending – Different subsamples (high and low income countries). – Excluding outliers Rodrik concludes that the association is not driven by omitted variables. The effect is strongest on transfer and social security spending.

Openness and government size cont. Table from Fiva (2006)Fiva (2006)

Openness and government size cont. Table from Fiva (2006)Fiva (2006)