Globalisation and the Welfare State

The paper considers two countries each populated by workers and capitalists and equipped with a government that collects taxes to finance productive expenditure and income redistribution. The share of income redistributed defines the size of the welfare state. Both groups in each country benefit from an abolition of the welfare state in the long run. Nevertheless, the optimal fiscal policy in autarky can be characterised by maintaining a large welfare state since transfer cuts induce transitional losses. Starting in a such a situation of policy inertia free trade and capital mobility is introduced. Fiscal policy competition leads to a reduction of tax rates and a relative increase of productive expenditure. The welfare state is largely reduced although not completely abolished. If both countries coordinate their fiscal policy the reduction of taxes and income transfers is less pronounced. The model explains why increasing globalisation may benefit the country with the formally larger welfare state and deteriorate welfare in the other country. In a calibrated version this result is shown for an average Europe G--4 country and the United States.