1. Politics and growth Advanced Political Economics Fall 2011 Riccardo Puglisi

2. Main Question Are political factors and institutions correlated to economic growth?

3. Stylized facts Inequality in the distribution of income (or wealth) is significantly and negatively correlated with subsequent growth mixed evidence of the effects of growth on income distribution (Kuznets curve) Political instability (social unrest, violence, frequent regime change) is significantly and negatively correlated with growth Better protection of property right is positively correlated with growth No robust evidence on the correlation between democracy and growth

4. Literature 1.Inequality is harmful for growth because it promotes fiscal policy which decrease capital accumulation; PERSSON –TABELLINI (1994), ALESINA-RODRIK (1994) 2.Social conflicts and lack of protection of property right reduce capital accumulation and thus growth: poverty trap; BENHABIB- RUSTICHINI (1996) 3.Inequality induces more human capital accumulation through public education and thus promotes growth; SAINT PAUL- VERDIER (1993)

5. Persson-Tabellini (AER 1994) QUESTIONS Why do growth rates differ among countries and time? What’s the role of income distribution on growth? IDEA: Inequality is harmful, because it leads to economic policies that reduce growth, that is high taxation on physical and human capital accumulation

6. 2 period OLG with constant population growth utility of an agent i born at time t-1 with u is concave, well-behaved and homothetic agents are heterogeneous in their endowments y budget constraints with income of type i and r (exogeneous) rate of return of capital PT94: The Model

7. Fiscal policy: θ is the tax rate on capital accumulation, which is redistributed lump-sum to the old. Notice that is the capital accumulation of individual i, and is the average capital accumulated in the economy Income where w is the basic endowment and e is the idiosyncratic component, such that NOTE: K is the average stock of capital accumulated from the previous period. Interpretation: knowledge spillover as in Romer (1986). Capital creates an externality for the next period income PT94: The Model

8. PT94: Voting game t-1tt+1 Timing: Taxation is decided at the beginning of the period in order to avoid credibility or time inconsistency problems. Old, thus, do not vote since they will not be around when the policy is implemented. Young are the only voters

9. PT94: Economic Equilibrium From homoteticity: with The share of income consumed does not depend on wealth, just on intertemporal price. Every individual has the same Saving Rate: More wealthMore capital

10. Consumption levels: Growth rate of the economy ( growth rate of K or y) Notice: growth depends on the externality or the model would not display growth PT94:Solution

11. PT94: Political equilibrium Recall that Thus, type i maximizes his utility w.r.t.  and, by the envelope theorem, we obtain: If Benefit from redistribution Cost for distortion

12. Notice that Hence Individual preferences can be indexed by e, thus median voter theorem applies. The equilibrium policy: PT94: Political equilibrium

14. Theoretical Predictions (1) More equal distribution of income implies higher growth (2) The higher average level of basic skills, the higher is growth Empirical Evidence (Historical data on 9 countries) More Inequality & Lower Growth (highly significant) More Schooling & More Growth (not sign) More Political Participation & More Growth (not sign) Empirical Evidence (Post-war data on 56 countries) More Inequality & Lower Growth (but only in democracies) PT94: Predictions & Evidence

15. Saint Paul-Verdier (JDE 1993) Idea: Inequality does not need to lead to lower growth. Why? More unequal societies promote more public education to redistribute from rich to poor. Yet, more public education leads also to more human capital accumulation, and hence to higher growth. Moreovoer, growth is associated with a decrease in inequality.

16. SPV93: The model Infinite sequence of non-OLG, each living one period Dynasty: each person generates a kid Preferences: people cares about their own current consumption and their children human capital (joy of giving model) Utility is homotetic, with

17. Define and assume that This condition is sufficient to ensure that poor people will vote for more redistribution (  decreasing in h) People are heterogenous in the endowment of human capital: where (1-z) constant exogenous fraction of time devoted to transfer human capital, δ is the coefficient of productivity of human capital inheritance and g is public education provided SPV93: The model

18. Aggregate productivity is Public (and private) education have the same production function for human capital: where h’ is the share of resources devoted to public education Therefore, for a generic type-i, consumption is and public education SPV93: The model

19. SPV93: Political equilibrium Type i maximizes (for τ≥0): The F.O.C. is hence

20. The previous assumption on the utility implies that Intuition: poorer wants more public education Moreover, preferences are single-peaked and median voter applies. Optimal tax level is: SPV93: Political equilibrium

21. SPV93: Income distribution and growth The dynamics of the average human capital is: therefore the growth rate is: Hence, the higher is taxation the higher is growth.

22. How does income distribution evolves over time? If τ>0, the income dispersion is shrinking overtime 1.Dynasties that are initially poorer than the mean grow faster than the economy 2.This convergence is quicker the larger is expenditure in public education SPV93: Income distribution and growth

23. SPV93: Evolution 1.Initially, as the meadian voter is far from the average human capital, the tax rate, human capital accumulation and thus growth are high 2.At the time evolves inequality decreases, and so does the tax rate…. and growth 3.Eventually…

24. If forthen we still have positive spending on education Eventually, we will have If for then we have no educational spending once we reach an equilibrium with no growth SPV93: Evolution

25. Benhabib-Rustichini (JEG 1996) Question: Why do (some) poor countries grow at a lower rate than rich countries? Idea: There are organized social group that try to capture a larger share of income. This fact reduces accumulation and thus growth. Under particular conditions on the utility and production function, we have slow growth at low level of wealth and rapid growth at high level of wealth. Organized groups play trigger strategies and take into account current benefits from redistributing against future consumption losses

26. The model 2 groups of player with concave, strictly increasing utility, having β as discount factor production is concave and increasing, with f(0)≥0 we define that a feasible path of consumption must satisfy: The first best solution gives utility

27. What happens if the two groups play Nash in deciding their current consumption? We can see how consumption is regulated for any given attempted consumption. For any given capital k, and attempted or planned consumption c, the actual allocation is: thus if

28. Notice that FAST CONSUMPTION STRATEGIES constitutes a S.P.E. for all values of capital : This is the worst possible S.P.E. The model

29. Trigger strategy equilibrium If we define as the utility in the fast consumption strategy, we use it in order to construct an agreed consumption path that represent an equilibium outcome of this problem. The allocation plan must satisfy the INDIVIDUAL RATIONALITY CONSTRAINT at every point in time:

30. Deviation Take a sequence, for any shock of capital and equilibirum consumption of the other player, the value of deviating is

31. IMPORTANT For an allocation path to be an equilibrium outcome it will have to be the case that This inequality could be satisfied for certain k levels but not for others (different from fast consumption)

32. Wealth dependent growth Now growth depends on the capital level. Thus there may be values of k s.t. and thus there would be maximum growth (First Best Solution). Besides, there may be values of k s.t. where v(k) is the value of an equilibrium with growth.

33. Example: Growth Trap Two key assumptions 1.Low (high) marginal utility at high (low) wealth level 2.marginal product of capital not too high for low level of wealth

34. There are three regions for

35. Now if we make some manipulation Now if we take the difference between the two equations ( the second minus the first) That implies: if e<0 if e>0 Political equilibrium

36. Now, recall that only e was indexed individually. We can apply the median voter theorem. The equilibrium policy is the one defined by: (this condition can be obtained by plugging in the F.O.C. the derivative of capital and the condition we got in the previous slide) Therefore: θ will be positive if the median voter has e<0, and negative otherwise

37. Empirically: From historical data: (1) InequalityGrowth (2) SchoolingGrowth (3) Political Growth partecipation (1) is significant with the right sign, (2) is not significant with right sign and (3) is not significant with wrong sign

38. From a cross-section of 56 countries InequalityGrowth But this result holds only in democracy! It seems we may need to explore more in depth the theoretical relationship between inequality and growth...