The Political Economy of Social Security in a Borrowing‐Constrained Economy

This paper introduces a three‐income class, overlapping‐generations model with borrowing constraints. The labor income tax for financing pay‐as‐you‐go social security is determined in a majoritarian voting game played by successive generations. When the interest‐rate elasticity of consumption is low, the political equilibrium might be characterized by an equilibrium where the old and the middle‐income young individuals form a coalition in favor of a higher tax rate and greater social security, while the low‐ and the high‐income young individuals favor a lower tax rate and less social security. In this equilibrium, the size of social security is decreased by the mean‐preserving reduction of a decisive voter's wage if he/she is borrowing‐constrained.     

REDISTRIBUTIVE POLITICS AND GOVERNMENT DEBT IN A BORROWING‐CONSTRAINED ECONOMY

We develop a two‐period, three‐class of income model where low‐income agents are borrowing constrained because of capital market imperfections, and where redistributive expenditure is financed by tax and government debt. When the degree of capital market imperfection is high, there is an ends‐against‐the‐middle equilibrium where the constrained low‐income and the unconstrained high‐income agents favour low levels of government debt and redistributive expenditure; these agents form a coalition against the middle. In this equilibrium, the levels of government debt and expenditure might be below the efficient levels, and the spread of income distribution results in a lower debt‐to‐GDP ratio.     

Social security, public education and the growth-inequality relationship

We study how the relationship between economic growth and inequality depends upon the levels of funding of two of the largest government programs, public education and social security. We do this in the context of an overlapping generations economy with heterogeneous agents where the government collects a tax on labor income to finance these programs. We show that in our model an increase in government spending on social security reduces income inequality and can have a non-monotonic effect on growth. When the initial level of social security funding is low, as is the case in most poor economies, then its increase will enhance growth. When its funding level is high as is typical for developed countries, we show that its further increase can slow down growth while reducing income inequality. These results obtain regardless of whether the increase in social security funding is financed by a tax increase or by cutting the public education budget. We also find that the effects of increasing the level of public education expenditures or the overall size of the government budget (holding the budget composition fixed) are characterized by similar non-monotonic growth-inequality relationships.     

A model of the optimal allocation of government expenditures

Government expenditures can be used for various socioeconomic objectives, including public education, consumption of public goods and services, and social protection. This paper analyzes the optimal allocation of public expenditures among these competing functions. We establish an overlapping generations model with heterogeneous individuals in which the government optimally chooses income tax, transfer payment, educational spending, and public consumption. Our model characterizes the transitional dynamics and the steady state of each function with and without a pay‐as‐you‐go intergenerational contract. We also conduct a simulation illustrating that the presence of an intergenerational contract may raise public consumption and social welfare in the steady state.     

The political economy of contributive pensions in developing countries

This paper sheds light on the role of public institutions as a way to reduce tax evasion through a close link between payroll taxation and pension benefits. We use a political economy model in which agents have the possibility to hide part of their earnings in order to avoid taxation and, where the public system is more efficient in providing annuitized pension benefits than the private sector. We show that in the absence of evasion costs, agents are indifferent to the tax rate level as they can always perfectly adapt compliance so as to face their preferred effective tax rate. There is unanimity in favour of the maximum tax rate and, the public pension system is found to be partially contributive in order to increase tax compliance and thus the resources collected. This, in turn, enables higher redistribution toward the worst-off agents. When evasion costs are introduced, perfect substitutability between compliance and taxation breaks down. At the majority-voting equilibrium, individuals at the bottom of the income distribution who are in favour of more redistribution, and those at the top who want to transfer more resources to the old age, form a coalition against middle-income agents, in favour of high tax rates. In addition to the previous tax base argument, the optimal level of the Bismarkian pillar is now chosen so as to account for political support.     

The dual nature of public goods and congestion: the role of fiscal policy revisited

Abstract The role of fiscal policy is examined when public goods provide both productive and utility services. In the presence of congestion, the consumption tax is shown to be distortionary. Optimal fiscal policy involves using consumption‐based instruments in conjunction with the income tax. An income tax‐financed increase in government spending dominates both lump‐sum and consumption tax‐financing. Replacing the lump‐sum tax with an income tax to finance a given level of spending dominates introducing an equivalent consumption tax. These results contrast sharply with the literature, where the consumption tax is generally viewed as the least distortionary source of public finance.     

A Positive Theory of Social Security

In many countries, social security accounts for a large fraction of the government budget. Why is this so, given that at any point in time the number of recipients of social security benefits is smaller than the number of contributors? In the overlapping‐generations model studied in this paper, all individuals currently alive vote on social security in every period. In equilibrium, the size of social security is larger, the greater is the proportion of elderly people in the population, and the greater is the inequality of pre‐tax income within each generation. Both predictions of the theory are supported by the empirical evidence in cross‐country data.     

Optimal Fiscal Policies,Congestion and Over‐entry*

By shedding light on market imperfections and the congestion of public goods, we show that free entry in a market equilibrium will lead to excessive entry relative to the social optimum. Moreover, by specifying a generalized congestion function, it is also shown that different fiscal policies, including labor income tax, capital income tax and government expenditure, play a distinct role in terms of remedying market distortions. Specifically, optimal income taxes decrease with the degree of market imperfections in order to remove the monopoly inefficiency, while they increase with the degree of congestion in order to remedy the adverse externality caused by congestion distortion. Since a higher degree of increasing returns to an expansion in the variety of intermediate goods is found to intensify the congestion effect of government infrastructure expenditure, the optimal rule of government expenditure proposed by Barro (1990) should be modified.     

GROWTH AND WELFARE EFFECTS OF AN ENVIRONMENTAL TAX‐BASED PUBLIC PENSION REFORM*

This paper presents an overlapping generations model in which: (i) firms create emissions as by‐products of production; and (ii) tax revenue from the working young is transferred to the retired elderly as pay‐as‐you‐go pension benefits. The paper focuses on a replacement ratio, which measures the proportion of after tax work earnings replaced by the public pension, and considers a replacement ratio neutral reform in which the newly introduced environmental tax is devoted to cutting the social security tax, keeping the replacement ratio unchanged. It is shown that the reform may improve growth, environmental quality and the nonenvironmental utility of every generation.     

Existence of equilibrium and stratification in local and hierarchical Tiebout economies with property taxes and voting

Summary. This paper present the first fully closed general equilibrium model of hierarchical and local public goods economies with the following features: (i) multiple agent types who are endowed with both some amount of private good (income) and a house, who are mobile between houses and jurisdictions, and who vote in local and national elections; (ii) multiple communities that finance a local public good through property taxes which are set in accordance with absolute majority rule; and (iii) a national government that produces a national public good financed through an income tax whose level is determined through majority rule voting. In contrast to previous models, no overly restrictive assumptions on preferences and technologies are required to prove the existence of an equilibrium in the presence of property taxation and voting. Thus, the existence of an equilibrium is proved without any of the major restrictions used in the past, and sufficient conditons for stratification of agents into communities based on their public good preferences and their wealth levels are found. This model lays the groundwork for a positive applied analysis of local public finance and intergovernmental relations. It furthermore builds the foundation for the first parameterized computable general equilibrium model of local public goods and fiscal federalism. Received: February 1, 1996; revised version August 9, 1996     

The Intergenerational State Education and Pensions

When credit markets to finance investment in human capital are missing, the competitive equilibrium allocation is inefficient. When generations overlap, this failure can be mitigated by properly designed social arrangements. We show that public financing of education and public pensions can be designed to implement an intergenerational transfer scheme supporting the complete market allocation. Neither the public financing of education nor the pension scheme we consider resemble standard ones. In our mechanism, via the public education system, the young borrow from the middle aged to invest in human capital. They pay back the debt via a social security tax, the proceedings of which finance pension payments. When the complete market allocation is achieved, the rate of return implicit in this borrowing–lending scheme should equal the market rate of return.     

Marital Status and Derived Pension Rights: A Political Economy Model of Public Pensions with Borrowing Constraints

This paper develops an overlapping‐generations models featuring four types of households: single female, single male, one‐breadwinner couple, and two‐breadwinner couple. The paper considers majority voting over public pension in the presence of derived pension rights for one‐breadwinner couples. In an economy with a low intertemporal elasticity of substitution, borrowing‐constrained one‐breadwinner couples may prefer a lower tax rate than do other types of households, although the former attain a higher benefit‐to‐cost ratio of public pension than do others. Changes in the gender wage gap, the level of derived pension rights, and the fraction of two‐breadwinner couples produce an inverse U‐shaped relationship between the relevant variable and the tax rate.     

Fairness in tax compliance: A political competition model

This paper analyzes the political economy of income redistribution when voters are concerned about fairness in tax compliance. We consider a two‐stage model where there is a two‐party competition over the tax rate and over the intensity of the tax enforcement policy in the first stage, and voters decide about their level of tax compliance in the second stage. We find that if the concern about fairness in tax compliance is high enough, a liberal middle‐income majority of voters may block any income redistribution policy. Alternatively, we find an equilibrium in which the preferences of the median voter are ignored in favor of a coalition formed by a group of relatively poor voters and the richest voters. In this equilibrium income redistribution prevails with no tax enforcement.     

Uncertainty, Commitment, and Optimal Taxation

This paper examines the optimal tax design problem in the presence of wage uncertainty. The wage has a continuous distribution, individuals are ex ante identical, preferences are separable in labor supply and goods, public policy aims at providing the population with social insurance, and the only restriction on the tax instruments is that emanating from lack of public observability of realized wages and labor supplies. We show that optimal tax structures depend crucially on whether it is labor supply or goods that consumers have to commit to before the resolution of uncertainty. Specifically, we prove that, in the absence of commitment, the social insurance problem collapses to the traditional optimal tax problem. Second, if labor supply is precommitted, it would be possible to effect a first-best outcome. Third, commitment to goods would make indirect taxation a useful instrument of tax policy even in the presence of a general income tax; it requires differential tax treatment of committed and noncommitted goods. Finally, if preferences are separable between the two types of goods, precommitted goods must be taxed at a uniform rate lower than that on the noncommitted goods.     

Majority Voting over Publicly Provided Goods, Redistribution, and Income Taxation

Federal, state, and many local governments make decisions that involve taxation, redistribution, and provision of public goods. Positive models to study these issues encounter the well‐known problem that majority‐voting equilibrium (MVE) may fail to exist in such multidimensional models. In this paper, with reasonable restrictions on preferences, I provide sufficient conditions for the existence of an MVE in a model with linear income tax and government expenditure policies that affect individual labor/leisure choices. My majority‐voting result takes account of the possibility that low‐skill individuals will drop out of the labor force under some tax and expenditure configurations.     

Conspicuous Leisure: Optimal Income Taxation When Both Relative Consumption and Relative Leisure Matter*

In previous studies on public policy under relative‐consumption concerns, leisure comparisons have been ignored. In this paper, we consider a two‐type optimal non‐linear income tax model, in which people care about both their relative consumption and their relative leisure. Increased consumption positionality typically implies higher marginal income tax rates for both ability types, whereas leisure positionality has an offsetting role. However, this offsetting role is not symmetric; concern about relative leisure implies a progressive income tax component (i.e., a component that is larger for the high‐ability type than for the low‐ability type). Leisure positionality does not modify the policy rule for public‐good provision.     

Improving Work Incentives and Incomes for Parents: The National and Geographic Impact of Liberalising the Family Tax Benefit Income Test*

The effective tax rates and possible work disincentives created by Australia’s tax and welfare systems have been receiving extensive policy attention in recent years. Family Tax Benefit‐Part A (FTB‐A) is one of the key causes of high effective marginal tax rates for many families. This study uses national and spatial microsimulation models to evaluate the national and local impacts of a possible FTB‐A reform option, which involves reducing the income test withdrawal rate associated with the FTB‐A income test. The modelling suggests that the option would be an effective way to reduce high effective marginal tax rates for around 415,000 parents of FTB‐A children, would benefit around 850,000 families, and would deliver additional assistance to middle income families living on the outskirts of our cities.     

Strategies for Fiscal Reform in the Context of the EMU: the Case of Portugal

The authors use an endogenous growth dynamic general‐equilibrium model, which accommodates the institutional constraints of the Stability and Growth Pact, to study tax reform in Portugal. Simulation results suggest that tax cuts financed in a nondistortionary way increase long‐term GDP; i.e., they are efficiency improving, but do not always increase welfare. The tradeoff between efficiency and welfare is alleviated when reductions in public spending or increased public indebtedness finance the tax cuts. Since these mechanisms are not realistic under the institutional setting of the Stability and Growth Pact, tax reform in Portugal must involve trading off distortionary tax margins. In this case, the best strategy to increase both efficiency and welfare is to increase investment tax credits and finance them either through personal income taxes or through employers’ social security contributions.     

Shifting Taxes from Labor to Consumption: More Employment and more Inequality?

This paper investigates the effect of shifting taxes from labor income to consumption on labor supply and the distribution of income in Germany. We simulate stepwise increases in the value‐added tax (VAT) rate, which are compensated by revenue‐neutral reductions in income‐related taxes. We differentiate between the personal income tax (PIT) and social security contributions (SSC). Based on a dual data base and a microsimulation model of household labor supply behavior, we find a regressive impact of such a tax shift in the short run. When accounting for labor supply adjustments, the adverse distributional impact persists for PIT reductions, while the overall effects on inequality and progressivity become lower when payroll taxes are reduced. This is partly due to increases in aggregate labor supply, resulting from higher work incentives.     

MACROECONOMIC AND REDISTRIBUTIONAL EFFECTS OF CONSUMPTION TAXES IN THE USA*

This paper studies the effect of an increase in consumption taxes using a dynamic general equilibrium model of overlapping generations calibrated to the US economy. When the proceeds are used to reduce income taxes, the reform raises the aggregate capital and labour supply in the long run. Workers increase labour supply immediately in response to the reform, while consumption rises only gradually. The tax reform also transfers wealth from old consumers to young consumers. As a result, while future generations experience significant welfare gains, current generations, particularly old consumers, tend to experience sizable welfare losses. When the proceeds are used for a lump‐sum transfer, the aggregate capital and labour both decrease in the long run. This reform is welfare‐improving for the current low‐income households.