Divided We Stand: A Fiscal Bargaining Model for Divided Countries

Abstract

I propose a multi-region fiscal bargaining model, where country border stability is determined by a trade-off between preference heterogeneity, income inequality and scale economies in the provision of public policy. I demonstrate how increasing preference heterogeneity can actually increase border stability in this framework; by increasing political disagreements over government expenditures, it functions as a tax-reducing mechanism that brings equilibrium tax rates more in line with the fiscal preferences of the discontented and the wealthy. I provide empirical evidence for the model's main predictions in a large panel of countries over the past half-century. I also show its capacity to match some of the main fiscal and political evolutions in Belgium since its inception. The model provides a rationale for the observed border stability in highly politically heterogeneous and economically unequal countries, such as Belgium, which is difficult to explain in existing models.