Economic Dynamics Newsletter

Fabrizio Zilibotti on the Equilibrium Dynamics of Policies and Institutions

Modern macroeconomics studies the effects of economic policies on economic performance over time. Policies are not exogenous, however. They reflect the aggregation of preferences of those agents who, in a society, are empowered with political rights. Such preferences vary across social groups and over time depending on a number of factors, both economic and non-economic ones. Among these factors, there are past policies: these shape the evolution of macroeconomic outcomes as well as of the asset and income distribution within a society, thereby affecting the future constituency of policies and institutions. The research agenda which I shall describe here focuses on the dynamic interdependence between political and economic equilibrium. I will focus on fiscal policy and labor market regulations.Incorporating politico-economic dynamics in general equilibrium macro models entails some analytical difficulties. The standard logic of competitive models, where agents optimize taking future equilibrium outcomes (e.g., prices) as given, breaks down when political choice is considered, since the current political choice has non-negligible effects on future equilibria, and it would be irrational for agents to ignore them. There are two avenues for tackling this problem. The first is to analyze the set of game-theoretic dynamic equilibria involving reputation and collective punishments. The main problem with this approach is that such set of equilibria is large. Moreover, enforcing punishments requires significant coordination among agents. The alternative approach focuses on Markov Perfect Equilibria (MPE). MPE emphasize lack of commitment entailed in democratic political processes by focusing on equilibria which are limits of finite-horizon equilibria. While restricting attention to MPE reduces the number of equilibria, their characterization is not straightforward. A first generation of papers has resorted to computational analysis (see, e.g., Krusell and Ríos-Rull, 1999). While useful, this approach entails two major limitations. First, the complexity of the analysis makes it difficult to transmit its insights to broad audiences including students and policy-makers, and, second, MPE often involve discontinuous policy functions which are hard to track even through numerical methods.

In a series of recent papers with various coauthors, I have tried to overcome these hurdles, and propose “tractable” dynamic macroeconomic models embedding politico-economic factors. The virtue of small-scale models is their transparent mechanics. This makes it easy to solve problems involving functional equations through guess-and-verify methods, even when equilibria exhibit discontinuous policy functions. The distinctive features of the theory are that (i) policies are decided through period-by-period voting without commitment and (ii) they affect asset accumulation decisions. In this environment, the current political choice affects the future income distribution, and this, in turn, affects the future political equilibrium. This dynamic feedback opens the scope for strategic voting: agents vote taking into consideration how their choice today affects politics tomorrow.

Fiscal Policy and Redistribution

In Hassler, Rodriguez-Mora, Storesletten and Zilibotti (2003), we model an economy where agents are born identical and make a human capital investment. Investments have a stochastic return that makes some agents rich while others remain poor. Since agents are risk-neutral and redistribution has distortionary effects, the welfare state is socially “wasteful”: if agents could commit ex-ante (i.e., before knowing the realization of the return to their investment) to a redistributive policy, they would choose no redistribution. However, such commitments are not feasible in democracies, and ex-post preferences determine the political outcome: the poor demand redistribution and a welfare-state system might be an equilibrium.The theory offers two main insights. First, if a temporary shock triggers sufficient support to initiate redistributive policies, these remain sustained over time, even after the effects of the shock have vanished. This result is due to high current redistribution reducing investments, implying that a larger share of future voters will benefit from redistributive policies. Thus, the welfare state survives beyond the scope for which it had been originally started. This prediction conforms with the evidence that the welfare-state system proved persistent after its first introduction. At the time of the Great Depression, many governments stepped-in with large programs aimed at reactivating the economy and supporting the impoverished generation. However, welfare-state programs would not be abandoned after economic recovery and would, on the contrary, grow in size and scope after World War II.

Second, there exist equilibria where an existing welfare state is irreversibly terminated, even when benefit recipients are initially politically decisive. The breakdown of the welfare state is more likely when pre-tax wage inequality is large, since this strengthens the incentives for private investment and reduces, ceteris paribus, the constituency of the welfare state. Strategic voting motives are key to the existence of this type of equilibria: if agents took future policy as parametric, there could be no welfare state breakdown. This result can cast some light on the dynamics of the Thatcherite revolution in the 1980’s. First, it came about during a period of growing wage inequality, and second its effects proved to be long-lasting. Even after the Tories went out of office in 1997, the constituency for traditional welfare-state policies seems to have faded in the UK. Labour governments by and large continued the economic and social policies inaugurated by Mrs. Thatcher, with limited public pressure for their reversal.

While Hassler, Rodriguez-Mora, Storesletten and Zilibotti (2003) focus on inefficient redistribution, public redistribution may be ex-ante desirable to societies. Hassler, Krusell, Storesletten and Zilibotti (2005a) analyze one such scenario where agents are risk-averse and markets incomplete. The political mechanism is also different: instead of a standard Downsian model, we consider a probabilistic voting mechanism à la Lindbeck and Weibull (1987), where the winning politician maximizes a weighted average of the utility of all groups in society. In this environment, the equilibrium features positive redistribution in the long run. The reason is that by having a higher marginal utility of income, the poor exert a stronger influence on the determination of policies (in the jargoon, there are more “swing voters” among the poor). The transition towards the steady-state may exhibit monotonic dynamics or dampening fluctuations in tax rates, depending on the extent of risk aversion. An interesting result is that oscillating tax rates are not due to political distortions. On the contrary, a benevolent policy-maker with commitment power would choose sharper fluctuations, possibly non-dampening ones, than in the political equilibrium. Political distortions generate an inefficiently persistent fiscal policy. This finding lies in sharp contrast with the predictions of the literature on political business cycles arguing that political economy exacerbates fluctuations (see Alesina, Roubini and Cohen, 1997).

In Hassler, Krusell, Storesletten and Zilibotti (2005b), we extend the analysis of the dynamics of fiscal policy to a Chamley-Judd model of capital taxation, where we show that the absence of commitment can lead to sizeable inefficiencies in both the steady-state levels and the transitional dynamics of taxation. For instance, we show in a “calibrated” example that the steady-state Ramsey tax (with commitment) is 22%, while it is 50% rate in the political equilibrium. Moreover, in the Ramsey economy, taxes are negatively serially autocorrelated, while they are highly persistent in the political equilibrium (with an autoregressive coefficient of 0.4 on a four-year basis).

A large share of government spending is used to finance public goods. In Hassler, Storesletten and Zilibotti (2006), we investigate the political economy of public good provision in a model where governments finance their expenditure via income taxation and taxes are allowed to be age-dependent. Since the tax burden falls more heavily on agents with high labor earnings, the poor want more public good than the rich. The equilibrium is shown to be indeterminate, independent of the initial income and skill distribution among agents. There exists one “sincere” equilibrium with high taxes, where the poor are politically decisive, and a range of “strategic” equilibria with lower taxes, where the rich are politically decisive. In the latter, voters restrain taxation to induce a future majority that will keep taxes low, thereby strengthening the incentive of investors and enlarging the current tax base for the public good. This multiplicity can explain the existence of large cross-country differences in the size and composition of government expenditures. For example, in Scandinavian countries, the average size of government measured by tax revenue is more than half the size of GDP, while it is below one quarter of GDP in the United States and Switzerland. The theory shows that such differences are not necessarily due to variation in exogenous factors or preferences. Another interesting finding is that taxation and public good provision may be inefficiently too low — in contrast with the standard emphasis in the politico-economic literature on factors leading to excess taxation –.

An important aspect of the macro-policy debate is government debt. When debt policy is determined through repeated elections, and agents are less than fully altruistic towards future generations, there is a politico-economic force pushing towards progressive debt accumulation which arises from the lack of political representation of the future generations on which the burden of public debt largely falls. If debt cannot exceed a ceiling (e.g., equal to the maximum PDV of future taxation) governments would find it increasingly hard to finance public good programs. Thus, private affluence can be accompanied by growing “public poverty”: even though productivity and income grow at a sustained rate, public funding of education, health and other public services becomes subject to growing pressure. Indeed, over the last decade, many countries have been under strain to contain their public spending and to face a growing public debt (including both explicit and implicit debt through pension liabilities).

In Song, Storesletten and Zilibotti (2005), we analyze these issues with the aid of a politico-economic model of overlapping generations where the government finances public good provision through labor taxation and by issuing debt. First, we show a negative result: when taxation is not distortionary, public debt grows and converges asymptotically to its maximum level. Thus, both private and public consumption tend to zero in the long run. Then, we introduce distortionary effects of taxation on labor supply (a Laffer curve). Not surprisingly, an endogenous limit on taxation prevents private consumption from falling to zero. A less obvious result is that it can also prevent “public poverty”, namely, it reduces the incentive to accumulate debt. Intuitively, political support for growing public debt is sustained by the belief that future governments will continue public good provision by increasing taxes. However, when agents realize that this is not feasible (or increasingly expensive to achieve), they are induced to support more responsible debt policies today. In other words, endogenous limits to taxation discipline fiscal policy.

This result has implications on the effects of international tax competition. Such competition serves as a commitment device to avoid increasing future taxes above the international level. Consequently, tax competition may actually lead to lower debt and avoid the public poverty trap.

Labor Markets and Child Labor Laws

Dynamic general equilibrium models can also be used to study the introduction or evolution of specific policies and institutions. Some of my recent work analyzes a variety of labor and product market institutions. For instance, Hassler, Rodriguez-Mora, Storesletten and Zilibotti (2005) and Marimon and Zilibotti (1999) analyze the political economy of unemployment insurance to explain the contrasting labor market performance in the US and Western Europe during the last quarter of the XXth Century. Acemoglu, Aghion and Zilibotti (2005) analyze the political economy of industrial policy over the process of development. Doepke and Zilibotti (2005) study the political economy of child labor regulations. I shall now describe in some detail the research discussed in this paper.While child labor is today regarded as a cruel practice that deprives children of rights and opportunities, from a historical perspective, this view of child labor is of a relatively recent origin. In Western countries, until the nineteenth century most children worked, and there was no stigma attached to earning income from children’s work. A change in attitudes towards child labor occurred around the mid-XIXth Century, under the pressure of the union movement. How can this change be explained? According to our theory, the increasing political support for child labor regulation can be explained by economic motives. In particular, we identify two factors behind the increasing support to child labor restrictions. The first is the drive to limit competition: unskilled workers compete with children in the labor market, and therefore stand to gain from higher wages if child labor is restricted. Different from other types of competition, the potential competition comes (at least partly) from inside the unskilled workers’ families. For this reason, workers’ attitudes regarding child labor laws depend not only on the degree to which they compete with children in the labor market, but also on the extent to which their family income relies on child labor. The second motive is parent’s altruism: when the returns to education are sufficiently high, most parents prefer to have small families and educate their children. Then, the support to child labor restriction grows.

To formalize these ideas, we construct a model where altruistic agents age and die stochastically, and decide on fertility, education and family size. A ban on child labor is introduced when supported by a majority of the adult population. First, we derive some analytical results, showing that multiple politico-economic steady states can exist. In one steady state, child labor is legal, unskilled workers have many working children, and there is little support for banning child labor. In the other steady state, child labor is forbidden, families are small, and the ban is supported by a majority of voters. In each case, the existing political regime induces fertility decisions that lock parents into supporting the status quo. The existence of multiple steady states can explain why some developing countries get trapped in equilibria with a high incidence of child labor and weak political support for banning child labor, while other countries at similar stages of development have strict regulations and a low incidence of child labor.

Then, we use a calibrated version of the model to replicate the historical changes which occurred in Britain in the XIXth Century. A prediction of the theory which is in line with the empirical evidence is that the change in workers’ attitudes towards child labor occurs gradually. In the early stages of the transition, the working class does not unanimously back restrictions, since families with many children continue to depend on child labor. However, increasing return to schooling eventually induces newly-formed families to have fewer children and send them to school. Eventually, a majority of the unskilled workers support the banning of child labor. This explanation for the introduction of child labor restrictions is consistent with the observation that child labor regulation were first introduced in Britain (as well as in other Western countries) in the nineteenth century after a period of increasing wage inequality. Moreover, the introduction of child labor restrictions was accompanied by a period of substantial fertility decline and an expansion of education, which is once more consistent with the theory.

This study contributes to the debate on the introduction of child labor laws in developing countries. Even in countries where the majority currently opposes the introduction of child labor regulations, the constituency in favor of these laws may increase over time once the restrictions are in place. Naturally, this requires that other conditions be met. In particular, the cost of schooling must be sufficiently low, so that poor parents actually decide to send their children to school, once the restrictions are in place.

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