YET ANOTHER REASON TO CURB INEQUALITY: THE POLITICAL ECONOMY OF LONG-TERM CAPITAL SPILLOVERS

Abstract

Inequality is one of the main issues in economics and policymaking. One of the main policy tools to deal with inequality is the tax system, which may be used to redistribute income. However, if taxes are determined by the collective decision of voters, they will not necessarily maximize welfare. We show that when voters have different capital endowments, and capital has a long-lasting spillover effect, a poverty trap may arise. Poor voters opt for low capital taxes to benefit from the spillover when others invest in capital, but this effect is weakened if agents are impatient and receive at least part of that spillover in the future. Hence the voting equilibrium may exhibit large capital taxes, hurting investment. This reduces the accumulation of capital with a public good nature in poor countries, where low capital stocks typically lead to high interest rates, implying a large discounting of future payoffs.