Political Economics
Riccardo Puglisi
Lecture 5
Content:
Welfare State: Redistributive Transfers
 Economic Model
 Winners and Losers
 Political Decision
Welfare State: General Transfer
IDEA:
Agents differ in their income.
The redistributive system consists of
– a Proportional Income Tax (t)
– a Lump-sum Transfer (T)
Redistribution from the Rich to the Poor
LIT:
Romer (1975), Roberts (1977), Meltzer
and Richard (1981), Krussel and Rios-Rull
(1999)
Economic Model
 Static economy: one period
 Economic Agents work and consume
 Agents are Heterogeneous in their working ability (e)
 Time constraint:
1+e
=
Effective disposable
time
l
Leisure
+
n
Work
Features of Working Abilities
e [el, eu]
el < 0, eu > 0
e ˜ G (e)
E (e) = 0
Average Ability
G (eM) = 1/2
Distribution of Ability
Median Ability
eM < 0
Median < Average
Poor
Rich
el
eM
E (e) = 0
eu
e
Individual Economic Decision
 Selfish Preferences
Ue = c + V (l)
V is increasing and concave
 Budget Constraint
c = (1 - t) n (e) w + T
with w = 1
 Time Constraint
1+e = l + n
The Welfare State
 General redistribution:
– tax rate
t
– transfer
T
 Government Budget Constraint
T = t E (n(e))
Average
Income
How does this Redistributive Policy work?
• Assume that everybody works “full time”: ne=1+e, l=0
– Tax Burden:
t(1+e)
– Transfer:
T =t E(1+e) =t
– Utility:
Ue= c = (1-t)(1+e)+T =
since E(e)=0
= (1-t)(1+e)+t
 Ue=1+e-te
Winners and Losers
• Type-e Agent’s utility:
Ue =1+e-te
Winners:
Poor (e < 0)  -t e > 0
Losers:
Rich (e > 0)  -t e < 0
transfer
t (1 + e)
contributions
Losers
t
Winners
t (1 + e)
el
eM
0
eu
Economic Decisions and Distortions
 Economic Agents choose how much to work:
ne
 Distortion: facing a tax they may decide to work less: lower
production
Economic decision:
Max
l
c + V (l)
s.t. c = (1 - t) (1 + e - l) + T
F.O.C.:
1 - t =  V (l) /  l
1-t
 V (l) /  l
l*
l
Distortion:
t  l* n*  E (n* (e))
Welfare State and distortion
 Government budget constraint:
T = t E(n*(e))
 An increase in the tax rate, t, has two effects:
– increase the government revenue
– reduces the tax base and thus the revenue
LAFFER CURVE
T
0%
tL
100%
t
Political decision
 Voting behavior: every agent indicates the tax rate
that maximizes her utility, given her economic
decision:
Max Ue (t) = (1 - t) n (e) + t E (n (e)) + V (e)
 How agents vote depend on three elements:
• Direct cost (tax burden):
• Direct benefit (transfer):
- n (e)
E (n (e))
• Distortion: [t  E(n(e)) /  t]:  t   E (n (e))
Political Equilibrium
 Individual voting: Poor (e < 0)  t > 0
Rich (e > 0)  t = 0 [no redistribution]
Agent’s votes can be ordered according to their
type: poorer individuals vote for more
redistribution
 Preferences are single-peaked  Median
voter’s theorem applies
 The equilibrium tax rate is the one voted by the
agent with Median working ability
Results
 In the political-equilibrium there is redistribution,
since em < 0
 t* > 0
 The amount of redistribution depends on the degree of
income inequality
– Income inequality is measured by the difference
between Median and Average Ability
More inequality leads to more redistribution
– If Rich agents become Richer  More redistribution
– If Poor agents become Poorer  Less redistribution
Discussion
 How does this theory compare with the data ?
 Can theory explain the cross-country differences
and the dynamics of Welfare State expenditure ?
Early growth of welfare State may be also
due to
• extension of voting rights to poor voters
• reduction in the cost of collecting taxes
Recent growth and cross-country differences
not well explained
Extensions
Dynamic model:
• Voting does not occur only once
• Taxation affect Capital Accumulation
and Economic Growth
Krusell and Rios-Rull (1999) show that “Dynamic Distortions”
lead to lower Welfare State
Fairness: what if some voters are altruistic ?
Intergenerational transfer: Income is not the only source of
difference among agents