Politico-economic Equilibrium Research Articles

Implications of market and political power interactions for growth and the business cycle II: politico-economic equilibrium

Implications of market and political power interactions for growth and the business cycle II: politico-economic equilibrium

Revisiting the Meltzer-Richard hypothesis of pretax income inequality and income tax rate

ABSTRACT The Meltzer-Richard hypothesis maintains that higher pretax income inequality entails higher income tax rate chosen by majority-rule voting. However, empirical studies found evidence against the Meltzer-Richard hypothesis. This article reconsiders the Meltzer-Richard hypothesis by dropping their assumption of lump-sum transfers. It finds that the Meltzer-Richard hypothesis is not robust to relaxing the lump-sum transfer assumption. Without lump-sum transfers, the Meltzer-Richard hypothesis no longer holds, as the effect of pretax income inequality on politico-economic equilibrium income tax rate is no longer certainly positive.

UN'ANALISI ISTITUZIONALE DEL DECLINO DELL'ECONOMIA ITALIANA

This paper attempts an interpretation of Italy’s recent economic decline, which began two decades before the Great Recession. It argues that its deeper roots lie in the political economy of growth. This interpretation is illustrated through a discussion of Italy’s recent growth trajectory and of its politico-economic equilibrium. The emphasis is placed on the country’s convergence to the productivity frontier and TFP performance, and on the evolution of its social order and institutions. The lens through which this case is reviewed, to illuminate the origins and evolution of the current constraints to growth, is drawn from institutional economics and Schumpeterian growth theory. It is exemplified by analysing two alternative reactions to the insufficient provision of public goods: an opportunistic one—employing tax evasion, corruption, or clientelism as means to appropriate private goods—and one based on enforcing political accountability. From the perspective of ordinary citizens and firms such social dilemmas can typically be modelled as coordination games, which have multiple equilibria. Self-interested rationality can thus lead to a spiral, in which several mutually reinforcing vicious circles lead society onto an inefficient equilibrium characterized by low political accountability and weak rule of law.

Dynamic tax externalities and the U.S. fiscal transformation

We propose a theory of tax centralization in politico-economic equilibrium. Taxation has dynamic general equilibrium implications which are internalized at the federal, but not at the regional level. The political support for taxation therefore differs across levels of government. Complementarities on the spending side decouple the equilibrium composition of spending and taxation and create a role for inter governmental grants. The model provides an explanation for the centralization of revenue, introduction of grants, and expansion of federal income taxation in the U.S. around the time of the New Deal. Quantitatively, it accounts for approximately 30% of the federal revenue share’s doubling in the 1930s, and for the long-term increase in federal grants.

세대중첩모형에서 공공부채, 조세 및 사회보장에 관한 정치-경제적 균형

세대중첩모형에서 공공부채, 조세 및 사회보장에 관한 정치-경제적 균형

Fiscal Federalism, Grants, and the U.S. Fiscal Transformation in the 1930s

We propose a theory of tax centralization and intergovernmental grants in politico-economic equilibrium. The cost of taxation differs across levels of government because voters internalize general equilibrium effects at the central but not at the local level. The equilibrium degree of tax centralization is determinate even if expenditure-related motives for centralization considered in the fiscal federalism literature are absent. If central and local spending are complements, intergovernmental grants are determinate as well. Our theory helps to explain the centralization of revenue, introduction of grants, and expansion of federal income taxation in the U.S. around the time of the New Deal. Quantitatively, the model can account for the postwar trend in federal grants, and a third of the dramatic increase in the size of the federal government in the 1930s.

Wedges: Distribution, Distortions, and Market Integration

This paper proposes a stylized model of policy determination and imperfect international integration. A policy wedge aims to correct laissez-faire market imperfections and/or redistribute welfare across heterogeneous agents. Policy is subject to both race-to-the-bottom and beggar-thy-neighbor forces if the country's politico-economic equilibrium interacts with the rest of the world. Variation of international market wedges induces patterns of country-specific regulation and deregulation that depend on political and structural features in non-obvious, intuitive, and empirically realistic ways.

Regional economic growth disparities: A political economy perspective

Regional differences in economic growth have been observed within many countries. Our story emphasises three region-specific factors driving growth—capital, labour and political factors. Conditional on differences in production factor (i.e., labour and capital) variations across democratic states, what role do differences in underlying “political factors” across regions play in accounting for regional growth disparities? We build a political economy model of endogenous growth where regions have the same political institutions, but experience different (and estimable) distributions over voter political biases (i.e., our “political factors”). In our model, political factors affect regional productivity as a consequence of politico-economic equilibrium. We discipline our regional growth accounting exercises by calibrating/estimating each model to American state-level economic and political-survey data. We show that the capital factor is the predominant driving force behind growth in American states. Nevertheless, regional variations in distributions of voter's political biases also account a great deal for regional growth disparities. We also evaluate how much politics would have distorted agents' welfare and regional growth, were regional economies given the opportunity to live under an efficient social planner's allocation system; and, if agents were to live under the same democratic system but where all voters have equal voting influence.

Fiscal Federalism, Taxation and Grants

We propose a theory of tax centralization and inter governmental grants in politico-economic equilibrium. The cost of taxation differs across levels of government because voters internalize general equilibrium effects at the central but not at the local level. This renders the degree of tax centralization and the tax burden determinate even if none of the traditional, expenditure-related motives for centralization considered in the fiscal federalism literature is present. If central and local spending are complements and the trade-off between the cost of taxation and the benefit of spending is perceived differently across levels of government, inter governmental grants become relevant. Calibrated to U.S. data, our model helps to explain the introduction of federal grants at the time of the New Deal, and their increase up to the turn of the twenty-first century. Grants are predicted to increase to approximately 5.5% of GDP by 2060.

Politico-economic equivalence

Traditional “economic equivalence” results, like the Ricardian equivalence proposition, define equivalence classes over exogenous policies. We derive “politico-economic equivalence” conditions that apply in environments where policy is endogenous and chosen sequentially. A policy regime and a state are equivalent to another such pair if both pairs give rise to the same allocation in politico-economic equilibrium. The equivalence conditions help to identify factors that render institutional change non-neutral and to construct politico-economic equilibria in new policy regimes. We exemplify their use in the context of several applications, relating to social security reform, tax-smoothing policies and measures to correct externalities.

Political geography and income inequalities

We analyze political geography and the size of governments in the presence of income inequality. The social planner solution implies that income inequality is neutral on the size of countries but reduces the optimal provision of public goods within each country. Under additional conditions, a politico-economic equilibrium geography is characterized by suboptimal size of nations, but there may not be a stable equilibrium when inequality is high enough. Finally, we introduce globalization showing that inequality can increase the size of countries, reduce public good provision and, at the same time, decrease their degree of openness.

The Political Economy of Labor Subsidies

We explore a political economy model of labor subsidies, extending Meltzer and Richard's median voter model to a dynamic setting. We explore only one source of heterogeneity: initial wealth. As a consequence, given an operative wealth effect, poorer agents work harder, and if the agent with median wealth is poorer than average, a politico-economic equilibrium will feature a subsidy to labor. The dynamic model does not have capital, but it has perfect markets for borrowing and lending. Because tax rates influence interest rates, another channel for redistribution appears, since a decrease in current interest rates favors agents with a negative (below-average) asset position.By the same token — and as is typically the case in dynamic politico-economic models with rational agents — the setting features time-inconsistency: the median voter would like to commit to not manipulating interest rates in the future. Under commitment, and under the assumption that preferences admit aggregation, we show that labor subsidies subsist only for one period; after that, subsidies are zero. That is, under commitment, the median voter takes advantage of the voting power once and for all. His wealth moves closer to that of the mean (which is zero), but afterwards he refrains voluntarily from further subsidization. Under lack of commitment, which we analyze formally by looking at the Markov-perfect (time-consistent) equilibrium in a game between successive median voters in the same environment. Instead, subsidies persist — they are constant over time — and are more distortionary than under commitment. Moreover, in the situation without commitment, the median voter does not manage to reduce asset inequality, unlike in the commitment case.

Government Information Transparency

This paper studies a model of announcements by a privately informed government about the future state of economic activity in an economy subject to recurrent shocks and with distortions due to income taxation chosen by majority voting. Although transparent communication would ex-ante be desirable, we nd that even a benevolent government may decide to be non-informative in an attempt to countervail the tax distortion in a second-best type of policy. In a politico-economic (Nash) equilibrium, transparency critically depends on inequality, which inuences both tax and information distortions.

Two-sided intergenerational transfer policy and economic development: A politico-economic approach

We consider an overlapping generations model with public education and social security financed by labor income taxation, in which the overall size of these policies is determined in a repeated majority voting game. We investigate the interaction between these policies and economic development in stationary Markov perfect equilibria. In the politico-economic equilibrium, the labor income tax rate is represented as a linear increasing function of the ratio of the decisive voter's human capital and the average human capital level. A high level of initial income inequality reduces the size of public policies and retards economic growth.

Economic and Politico-Economic Equivalence of Fiscal Policies

We consider intergenerational transfer policies that are in terms of the allocation they support, in particular pay-as-you-go financed policies on one hand and policies with explicit government debt on the other. We analyze the conditions under which political decision makers are indifferent between such equivalent policies, i.e., the conditions under which a policy constitutes a politico-economic equilibrium if an economically policy does. We apply our findings to results in the recent literature on politico-economic equilibria with social security. Our results imply that many other fiscal policies beyond the pure social security policies considered in those papers support politico-economic equilibria as well. We also discuss the implications of our results for social security reform.

Ageing, government budgets, retirement, and growth

We analyze the short and long-run effects of demographic ageing – increased longevity and reduced fertility – on per-capita growth. The OLG model captures direct effects, working through adjustments in the savings rate, labor supply, and capital deepening, and indirect effects, working through changes of taxes, government spending components and the retirement age in politico-economic equilibrium. Growth is driven by capital accumulation and productivity increases fueled by public investment. The closed-form solutions of the model predict taxation and the retirement age in OECD economies to increase in response to demographic ageing and per-capita growth to accelerate. If the retirement age was held constant, the growth rate in politico-economic equilibrium would essentially remain unchanged, due to a surge of social-security transfers and crowding out of public investment.

The dynamics of inequality and social security in general equilibrium

This paper analyzes the dynamic politico-economic equilibrium of a model where repeated voting on social security and the evolution of household characteristics in general equilibrium are mutually affected over time. In particular, we incorporate within-cohort heterogeneity in a two-period Overlapping-Generation model to capture the intra-generational redistributive effect of social security transfers. Political decision-making is represented by a probabilistic voting à la Lindbeck and Weibull (1987). We analytically characterize the Markov perfect equilibrium, in which social security tax rates are shown to be increasing in wealth inequality. A dynamic interaction between inequality and social security leads to larger social security programs. In a model calibrated to the U.S. economy, the dynamic interaction is shown to be quantitatively important: It accounts for more than half of the social security growth in the dynamics. We also perform some normative analysis, showing that the politico-economic equilibrium outcomes can be fundamentally different from the Ramsey allocation.

Ageing, Government Budgets, Retirement, and Growth

We analyze the short and long run effects of demographic ageing—increased longevity and reduced fertility—on per-capita growth. The OLG model captures direct effects, working through adjustments in the savings rate, labor supply, and capital deepening, and indirect effects, working through changes of taxes, government spending components and the retirement age in politico-economic equilibrium. Growth is driven by capital accumulation and productivity increases fueled by public investment. The closed-form solutions of the model predict taxation and the retirement age in OECD economies to increase in response to demographic ageing and per-capita growth to accelerate. If the retirement age were held constant, the growth rate in politico-economic equilibrium would essentially remain unchanged, due to a surge of social security transfers and crowding out of public investment.

External Sovereign Debt in a Monetary Union: Bailouts and the Role of Corruption

We build a tractable stylized model of external sovereign debt and endogenous international interest rates. In corrupt economies with rent-seeking groups stealing public resources, a politico-economic equilibrium is characterized by permanent fiscal impatience which leads to excessive issuing of sovereign bonds. External creditors envision the corrupt economy’s fiscal impatience and buy its bonds at higher interest rates. In turn, this interest-rate increase exacerbates the problem of oversupplying debt, leading the economy to a perfect-foresight trap. In incorrupt countries which have entered a high-interest-rate/high debt-GDP-ratio trap because an immediately recent disaster has caused a sudden jump to a high outstanding debt-GDP ratio, we show that bailout plans with controlled interest rates can help in reducing debt-GDP ratios after some time. On the contrary, under corruption, we show that bailouts are ineffective unless rent-seeking groups are eradicated.

Redistribution in the Open Economy: A Political Economy Approach

This paper develops a two-country model of international trade in which citizens who are heterogeneous with respect to their factor endowments vote over tariffs and income tax rates. In the politico-economic equilibrium, each country chooses its national policies by majority voting, taking the policy choice of the other country as given. By incorporating both income and trade taxes in a unified international-trade framework, we uncover the interplay between majority voting over these two instruments at the domestic level and strategic interdependencies between countries’ trade policies. Our main result is that greater inequality can be conducive to more redistribution via income taxation, more protectionist policies in capital-abundant countries, and less protectionist policies in labour-abundant countries. The model can accommodate the predictions of recent empirical studies on the relationship between inequality, protectionism, and redistribution.