Political Economy of Mechanisms

Abstract

We study the optimal Mirrlees taxation problem in a dynamic economy. In contrast to the standard approach where the taxation mechanism is operated by a benevolent planner with full commitment power, we focus on economies in which policy decisions are made by self-interested politicians, who cannot commit to policies. The society controls politicians using elections. We show that the provision of incentives to politicians can be partly separated from redistribution across agents and that political economy constraints can be modeled as introducing additional aggregate distortions in the dynamic Mirrlees problem. We provide conditions under which the political economy distortions persist or disappear in the long run. If the politicians are as patient as the agents, the “best sustainable mechanism” leads to an asymptotic allocation where the aggregate distortions arising from political economy disappear. In contrast, when politicians are less patient than the citizens, positive aggregate labor and capital taxes remain even asymptotically. We conclude by providing a brief comparison of centralized