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The political economy of labor subsidies

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  • Marina Azzimonti-Renzo
  • Eva de Francisco
  • Per Krusell

Abstract

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.

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Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 06-09.

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Date of creation: 2006
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Handle: RePEc:fip:fedrwp:06-09

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  1. Laibson, David I., 1997. "Golden Eggs and Hyperbolic Discounting," Scholarly Articles 4481499, Harvard University Department of Economics.
  2. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  3. Klein, Paul & Krusell, Per & Ríos-Rull, José-Víctor, 2004. "Time Consistent Public Expenditures," CEPR Discussion Papers 4582, C.E.P.R. Discussion Papers.
  4. Krusell, Per & Kuruscu, Burhanettin & Smith, Anthony Jr., 2002. "Equilibrium Welfare and Government Policy with Quasi-geometric Discounting," Journal of Economic Theory, Elsevier, vol. 105(1), pages 42-72, July.
  5. Marco Bassetto & Jess Benhabib, 2006. "Redistribution, Taxes and the Median Voter," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(2), pages 211-223, April.
  6. Kenneth L. Judd, 1982. "Redistributive Taxation in a Simple Perfect Foresight Model," Discussion Papers 572, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Krusell, Per & Smith Jr., Anthony A, 2001. "Consumption-Savings Decisions with Quasi-Geometric Discounting," CEPR Discussion Papers 2651, C.E.P.R. Discussion Papers.
  8. Marina Azzimonti & Eva de Francisco & Per Krusell, 2006. "Median-voter Equilibria in the Neoclassical Growth Model under Aggregation," Scandinavian Journal of Economics, Wiley Blackwell, vol. 108(4), pages 587-606, December.
  9. Jose-Victor Rios-Rull & Per Krusell, 1999. "On the Size of U.S. Government: Political Economy in the Neoclassical Growth Model," American Economic Review, American Economic Association, vol. 89(5), pages 1156-1181, December.
  10. Meltzer, Allan H & Richard, Scott F, 1981. "A Rational Theory of the Size of Government," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 914-27, October.
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Cited by:
  1. Corbae, Dean & D'Erasmo, Pablo & Kuruscu, Burhanettin, 2009. "Politico-economic consequences of rising wage inequality," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 43-61, January.

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