Bargaining over Taxes and Entitlements in the Era of Unequal Growth

Entitlement programs have become an increasing component of total government spending in the US over the last six decades. To some observers, this growth of the welfare state is excessive and unwarranted. To others, it is a welcome counter-acting force to the rapid increase in income inequality. Using a political-economy model where parties bargain over taxes and entitlements, we argue that such dynamics can be explained by two factors. The first one is that institutional features of policy determination, in particular budget rules, make the status quo levels of taxes and entitlements difficult to change. The second one is that the country experienced a process of “unequal growth,” where top earners became richer while the income levels of the bottom 50 percent remained stagnant. Richer agents would like the government to provide more public goods as the economy grows. Low-income earners are willing to support such policies only in exchange for an expansion of entitlement programs. Sustained bargaining power by a party that represents the latter, amid budget rules, results in a rising share of entitlements. We explain how parties can take advantage of budget rules to tilt the evolution of policy in their favor in a simple two-period model. We then calibrate an infinite horizon version of the model to the US, and show that it delivers dynamics consistent with the data. Through counter-factual experiments, we find that while entitlements programs are sub-optimally large, welfare outcomes are better than those under alternative budget rules and in scenarios without rules, making it explicit that the type of budget rule matters for both welfare and equity.