Political Economy of
Taxation
Prof. Fabio Padovano
Reference Text
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Hettich, W. and Winer, S. L. (1997), « The
Political Economy of Taxation », in Dennis
C. Mueller (ed.) Perspectives on Public
Choice. A Handbook, Cambridge,
Cambridge University Press, pp. 481-505.
Introduction - 1
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Taxation gives government resources → without
it no effective political power
Schumpeter (1918) connects the establishment
of the power to tax to the birth of modern state
→ contemporary administrative state, welfare
state possible with expansion of power to tax
(income tax)
Positive knowledge of how government employs
tax instruments to pursue its ends necessary to
understanding the functioning of public economy
Introduction - 2
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3 sources of systematic differences
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Cross country differences in tax instruments
 Differences related to different stages of economic development
 Differences related to short term economic and political shocks
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Normative public finance offers little guidance in explaining such
differences → public choice can, by highlighting incentives and
constraints of public agents
Empirical data are available
Analysis so far focuses on
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Structure of tax systems
Use of public debt
Analysis neglects other substitutes
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Economics of regulation
Models of political economy
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Positive explanations of tax structures require
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3 models used to explain tax structures
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Multidimensional choices
Stable equilibria → comparative empirical analysis
Expected vote maximization (probabilistic voting models)
Median voter
Leviathan model
Models 1 and 2 assume democratic institutions (voting
process)
Leviathan disregards democratic control of government
by citizens/taxpayers
Expected vote maximization
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Candidates maximize expected votes being uncertain
about how voters respond to their platforms
Competition for offices pushes candidates to search for
policies that ensure political success
Also standing government affected by competition →
must ensure victory in next election
Tax structures are equilibrium outcome of a competitive
political process
Expected vote maximization produces stable equilibria
and can treat multidimensional choices
Median voter - 1
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Voters presented with competing alternatives and
support the one that yields highest utility
Equilibrium exists if choices are one-dimensional and
voters preferences are single peaked → preferences of
voter in median position prevail under majority voting by
virtue of the median
Single dimension hypothesis restrict model to the study
of single aspects of tax systems
Incapable to examine broader aspects of tax structures
that are inherently multidimensional
Median voter theorem: illustration
Median voter - 2
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When more than one dimension (and voting
strategy is discrete instead than probabilistic) →
cycling → instable equilibria
Shepsle and Weingast (1981) impute to the
working of given institutions (e.g., rules of the
game in parliaments, committees) the absence
of observed instability
Problem is how to relate the features of
observed equilibria to the structure of decision
making institutions → so far not solved
Leviathan model
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Disregards voting procedures as effective constraints on political
action → government ability to act unbounded → Leviathan
Government uses taxes to maximize revenues from private sector
Laffer curve (choices to work/leisure and tax evasion) is the only
limit to the state’s ability to tax
Model does not explain who joins the “government group” → no
prediction about what features the tax structure should have so to
benefit Leviathan group
Predictions about the structure of tax system can de derived from
the monopoly structure of government
Possible comparisons with tax structures of democratic/competitive
governments
Expected vote maximization
and tax structures
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The creation of tax systems fits within the broader
question of how governments choose policy instruments
and outcomes
In competitive electoral systems, fiscal choices are the
equilibrium result of the interaction between
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Governing party who seek to remain in power and shape tax
instruments to do so
Opposing parties who design fiscal platforms so to win elections
(generally neglected side of the process)
Voters who have heterogeneous tastes and interests and vote
so to maximize their utility
Model structure - 1
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Basic structure of the model
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Government provides 1 public good (expenditure side of the
budget)
Imposes N proportional tax rates t
One tax rate per voter
Each voter has one tax base B
Probability to receive support π depends on difference I
between voter’s evaluation of public services b and loss
of utility from taxation c, due to both the level of taxation
T and the excess burden d (distortion of individual
choices)
Government problem is to choose tax rates t and level of
public good G to maximize total expected support
Equilibrium
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Equilibrium characterized by 2 conditions
1. For every level of public spending G, government
adjusts tax rates among voters until the reduction of
expected votes (Marginal Political Costs MPC) is
the same across taxpayers → optimal tax structure
minimizes total political costs for any level of tax
revenues collected
2. Government sets public spending so that the
marginal political benefit of spending equals the
MPC
Diagram
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In fig. 1, 2 taxpayers a and b
Tax base is income from work
Taxpayers differ in their
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Tastes for work → ability to trade off labor for leisure → different
shapes of Laffer curves (lower part of panels 1a and 1b)
Political tastes → intensity of reaction (in terms of reduced
political support) to a loss of income due to taxation
Government expected to know all functions
Panel 1c represents MPB and MPC of budget
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MPC is horizontal sum of individual MPC
Budget size R must be raised from two taxpayers
MPB from spending downward sloped → diminishing utility
Tax structure in political
equilibrium
Complexity
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Analysis predicts that tax structures will be complex, with
potentially as many tax rates as individuals
Complexity even greater if each taxpayer has more than
one taxable activitiy
In this case, fig. 1 represents the tax treatments of each
tax base of a given individual
Government raises a given amount of tax revenues by
equalizing the MPC of revenue, imposing different rates
on each taxable activity → similar to Ramsey rule
Administrative costs - 1
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A tax treatment specific to every single activity of every single
individual very costly to implement → this cost reduces
government’s ability to spend on the public good → government
tries to economize on administration costs of tax system
Administrative costs increase with number of tax rates → savings
can be made by sorting individuals into tax brackets where all
individuals are treated similarly (same tax rate)
The drawback is that MPC of revenues will vary among individuals
belonging to same group → higher costs per any budget
Government must find optimal number of tax brackets K (fig. 2) and
allocate optimally individuals among them
Administrative costs – 2
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As K increases, number of groups increases,
sorting decreases, total loss of support
decreases by differentiating the tax treatment
more among individuals (downward sloping
curve D)
As K increases, complexity of the tax structure
grows, and administrative costs as well (upward
sloping curve A)
K* is equilibrium → intersection of the 2 curves
Politically optimal tax
discrimination
Extensions
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Same logic applies to creation of tax bases
bases saves on administrative costs →
liberates resources to spend
 Discriminating bases reduces the costs of raising a
given amount of revenues
 Grouping
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Creation of more deductions and exemptions
counterbalances the loss of support due to
grouping tax bases → increases differential tax
treatment
Tax and expenditure structure
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Results obtained so far under the hypothesis that expenditure and
tax side of the budget not related
If cost of raising revenues are function of type of expenditure →
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MPC are lower in the case of PG complementary to private activities on
which taxes are imposed
 MPC are lower on lower demanders of PG
 Government trades off at the margin lower support by imperfect sorting
with higher support due to lower administrative costs on the spending
side
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Information about ind characteristics on the tax side are easier to
obtain for government than on the spending side → government first
creates a tax structure independent of G , then introduces on
discrimination on expenditure side by menas of special provisions
Redistribution and median voter
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MV limited to one-dimensional issues → cannot deal with complexity
Roemer and Rosenthal (1977) assume a linear progressive income
tax rate, a predetermined level of PG, ind discriminated by ability →
look at marginal tax rate
If AY>MY, voter with median ability demands and receives a positive
marginal tax rate → redistribution
Amount of redistribution depends on government size G → as G
increases, higher marginal rates generate larger excess burdens,
which will be higher the larger the elasticity of labor supply (Laffer
curve) → this will reduce the demand for redistribution
Meltzer and Richard (1981) model applies the same logic to growth
of government → growth depends on position of AY wrt MY → if
AY>MY and vote franchise expanded to encompass voters with
lower income levels → government grows
Rate structure and median voter
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MV cannot deal with complex issues such as the
presence of nonlinear rate structures → cycling results
Structure induced equilibrium
Example Inman and Fitts (1990) who look at
universalism to overcome political instability → each
legislator supports allocations preferred by every other
legislators
If benefits allocated on particular districts and taxes
spread over larger constituencies → larger budgets and
more tax special provisions than in the case of no
decision externalities
Leviathan model
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Choice of tax structure driven by logic of price
discrimination, limited only by Laffer curves
Leviathan chooses
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Broad tax bases to limit tax evasion
Levies high tax rates on less elastic tax bases to maximize
revenues
Special provision can expand tax discrimination
Tax structures chosen by Leviathan models
multidimensional, just like those observed
Problem of observational equivalence with PV models
might arise → one must still specify the source of
Leviathan power and of the stability of dictatorial
equilibrium
Taxing the future
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Time profile of taxation involves 2 other sources
of complexity
 Intertemporal
preferences of voters and politicians
 Time consistency of tax policies of successive
governments
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Usual simplification is choice between debt (with
intertemporal profile) and taxes (limited to
present) → taxes linked to debt via intertemporal
budget constraint
Various strands of literature
Deficit finance and excess
burden
Barro (1979) predicts that government
issues debt to smooth current tax rates
over business cycle
 Excess burden rises with square of tax
rate → Increase debt when tax revenues
temporarily decline and viceversa lowers
overall excess burden
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Strategic use of deficit
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Voters cannot be sure that
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future majorities share their preferences for PG
Future government are committed to policies chosen in the
present
Voters in majority today who prefer e.g. a small public
sector and anticipate that next majority will increase
spending may favor issuing debt today to constrain the
ability to spend of the future government (Alesina and
Tabellini, 1990)
The larger the disagreement between current and future
MV → the larger the debt issue
Intergenerational conflict
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Voters who do not plan to leave positive bequest may
support deficit financing
Assuming that debt obligations are honored, bequest
constrained voters may favor issuing debt to increase
their own consumption
If not bequest constrained, debt finance allows current
voters to appropriate resources from future generations
Key assumption is that governments always honor debt
obligations inherited from the past → if they do not, no
intergenerational redistribution through debt
Wars of attrition and
democracies in deficit
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When fragmented government are affected by negative
economic shocks, they find it difficult to increase current
taxation to prevent large deficits → stabilization is
delayed, debt rises
The larger fragmentation and ideological polarization, the
larger deficit response
Buchanan and Wagner (1977) argue that deficit
spending involves short run political benefits, while rising
taxes to retire debt short run political costs →
democracies are inherently deficit prone
Why do people do not recognize future tax liabilities in
current debt is the problem inherent in “Democracy in
deficit” tradition
Empirical analysis
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Empirical analyses of tax structures fall within
5 theoretical strands
1.
2.
3.
4.
5.
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Vote maximization
Median voter
Leviathan
Structure induced equilibrium
Welfare maximization/Excess burden minimization
Extremely wide scope of application, for tax
systems, tax types, levels of government etc
(Hettich and Winer, 1997)
Problems of regression
analyses
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Difficult to distinguish the implication of vote
maximization from MV → some measure of
heterogeneity of voters’ preferences identifies
vote maximization → variables that describe
interest groups
Variables defining interest groups are not very
precise (number? wealth? size? expected
gains/losses?)
Qualitative and historical analyses highlight
better the role of interest groups
Stable results
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3 types of regressors of PV and MV always
come out significant
Revenue composition positively depends on
 size
and rate of growth of tax bases
 Possibility to shift tax burdens to other jurisdictions
 Interjurisdictional tax competition (yardstick or Tiebout
type)
Vote maximization and
Leviathan
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Leviathan and PV models have similar implications
(complexity)
Theoretical difference is that Leviathan taxes more →
how to distinguish more revenues due to economic
growth and to more repressive taxation?
A significant impact of democratic institutions and of
interest groups on tax structure equation should
distinguish vote maximization from Leviathan (under
Leviathan they should not be relevant)
In many countries (AUS, Schneider and Pommerehne,
1980; USA, Holcombe and Mills, 1995). In Italy they are
weakly significant (Galli and Profeta, 2007)
Predictions of Leviathan and democratic
government when output grows
Structure induced equilibrium
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Very little empirical research in this field
Inman and Fitts (1990) test universalism → legislators of
all parties design tax structures and size of budget to
accommodate all interests
LR analysis
In US, decline of centralized role of House appears to
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Explain growth of public spending
Insignificant for tax structure → possibly due to unchanged
power of House Ways and Means Committee on tax reform
agenda
Normative empirical analyses
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Most of public finance literature has
normative tone → need to verify whether
tax structures respond to normative goals,
such as
 Economic
 Equity
efficiency
Economic efficiency
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Some positive evidence that political equilibria (tax
structures) found by PV models are economically
efficient?
Link is political competition → individual voters care only
about personal welfare, but parties who would ignore
policy changes that could make some better off without
making others worse off would do more poorly in the
polls than the opposition
Look at efficiency of political systems → how they
facilitate flow of info, elimination of rents → how these
properties affect their shaping of tax structures
Equity
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2 concepts of equity
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Vertical equity → influence of taxation on the distribution of
income
Horizontal equity → are similar taxpayers treated equally?
In PV models the question is whether equity criteria are
political equilibria → normative evaluations apply one
step backwards to political institutions that determine
such equilibria
PV models suggest that tax structures depend on Laffer
curves, tax shifting and administrative costs, not on
Simons criteria (broad based taxes, comprehensive
taxation etc.)
Normative concerns with
Leviathan governments
Normative implications of Leviathan model
are constitutional limitations on
government
 Constitutional reforms are different type of
political equilibrium → require quasiunanimous agreements
 Veil of ignorance hypothesis often
misleading for empirical analysis
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